Anonymous Coward wants to know what exactly is wrong with the logic in the paragraph I linked to below. Let me explain:
Rothbard claims that when I open a current or savings account with the bank (“checking account” or “demand deposit” for you Americans) the bank is implicitly promising to keep the money locked up in its vault, which means that lending it out constitutes fraud. I don’t see how that makes sense. The bank is only promising to pay me my money on demand. How it manages to do it is the bank’s business.
Rothbard’s argument is that this is a distinction without a difference, because if all the bank’s customers demanded their money back at the same time, the bank would not be able to pay. I don’t see why that should matter. The contract is between the bank and its individual customers, not its entire class of customers. How the bank should manage its internal business to juggle its priorities is not for us to say and certainly not for the government.
In the example Rothbard gives, he makes two elementary errors, one less important and one more important. The less important one is where he says: “I simply open up a checking account of $10,000 …” The “I” in question is Rothbard bank, but Rothbard neglects to tell us that the $10,000 is actually real money, deposited by a real customer. The way he says it makes it seem like the money has been conjured out of thin air by the bank.
The other, more serious error is that he forgets the whole concept of “fraction” in “fractional reserve banking” at a convenient stage in his narration. The reason why FRB works is that banks can estimate, to a high degree of accuracy, what fraction of customers will demand their money back at one time. If it underestimates this fraction, it becomes insolvent. If it overestimates it, it loses on its interest income. But that is a business judgement like any other. Rothbard ignores this fact, forgets that a bank has many customers and assumes that his simple bank with one customer describes the banking system adequately.
In the rest of the article, he throws around words like “counterfeiting”, “swindle”, etc. casually, and equally casually manages to confuse the inflating of currency by the central bank to “inflating” of money by the banking system. Two minutes of thought will tell you that FRB would exist and be stable even if the central bank ceased to exist and stopped printing any more money.
He further thinks that the reason the system persists is that the government has restricted entry, thereby enforcing a cartel. That is silly. Yes, there are restrictions on entry – and there shouldn’t be – but we have seen that there is no reason to doubt the attribute the stability of the system to any Cartel. The system is a stable equilibrium in itself. Besides, in his free banking system, what advantage would an entrant have over a bank that practices FRB? A bank that does not lend out its checking deposits would have to charge a fee from depositors. It would also have to charge higher interest rates on its loans. I doubt if buying low and selling high is a good way to grab market share.
Rothbard thinks that the “general public” does not know that the money it deposits in a bank are in fact lent out, and that the system will fall apart “whenever the public finally understands the swindle”. That is an astonishing insult to the intelligence of the public. I know that when I put my money in a bank, the bank will lend it out to others and put it into productive use. I expect nothing less of my bank.
Here, here. For critiques of Rothbard’s current-day followers on the 100-percent-reserve question, see this article and this shorter piece.
Oops. That should have been “Hear, hear.”
FRB is a swindle all right, we shouldn’t be swayed by the fact that it is status quo. The public is not unaware of it, true, but it certainly isn’t aware of it in full either.
The question is all about risk and return.
On average:
If I invest in govt bonds, I make say 5%.
If I invest in stock index funds, I make say 15%.
If I invest in riskier mutual funds, I make say 20%.
Hedge funds, even more.
This isn’t magic: it just describes how greater risk implies greater returns.
Now let’s take banks. If I put my money in there, I expect it to have zero risk: even lower than govt bonds since govt bonds yield me higher interest.
But how can the bank make money by zero risk investment???
By definition, if it is getting a higher return, it is investing with higher risks. But how can it absorb these higher risks without passing on these risks to the consumer?
Answer: the govt bails it out via “insurance” from the central bank; and more!!
This is not just a simple risk transfer from the smaller bank to the central bank. If so, would the central bank also allow mr. seven_times_six to make his risky investments and yet “insure” me against any risk?
Sounds like a sweet deal. a deal which is swindling others.
I should mention that I’m not against FRB or the concept of insurance in finance: that would be a silly position.
How else can investment take place if not by accumulation of capital and transference of risk via insurance. By beef is with the fact that this is done not via free and fully disclosed channels: in essence the
(1) banks are cheating the depositors out of interest, (2) cheating taxpayers by getting “free” or “cheap” insurance from govt.
This isn’t magic: it just describes how greater risk implies greater returns.
You are wrong. Higher returns mean higher risk, but just having higher risk doesn’t assure higher returns.
Lawrence, thanks for the links. It is instructive to learn just how ridiculous the opposing position is.
Sabzi Mandi, you both are right, but 7*6 is righter than you. It is true that there are many projects that give high risk and low return, but such investment opportunities do not survive for long, for obvious reasons. 7*6 is right in saying that a high risk low return form of investment should not really exist.
7*6, it is good that you have learnt about the trade-off between risk and return. I now recommend that you turn your attention to learning about the Yield curve, why it exists and why it slopes upwards generally.
The interest rate on a demand deposit is low because their tenor is generally short and because they can be called back at any time. If you maintain a lot of money in your SB account for a lot of time, you are in fact being swindled, but you have only yourself to blame for it.
The yield curve is my friend here RR.
It says: on demand and “liquid” deposits give ~zero interest.
My point: so there should be ~zero risk investment on part of the bank — this would preclude fractional reserves wunnit?
But let’s continue to the right along the X axis of yield curve. The yields of consumer bank “locked” or “fixed” deposits are pathetic compared to what the market and investment banks/planners would give you. Why would you lock your money up then?
Because of the “zero” risk! But how do the banks make money then?
So my main point holds true throughout the yield curve: that banks seem to have this magical risk nullification machine that I want a piece of. That is the only explanation for FRB. Either that or swindling. Take your pick.
something doesn’t add up…
1. fractional reserves ==> greater risk
2. greater risk ==> greater return
3. greater risk ==> non zero risk
4. consumer banks ==> zero risk, low return
5. consumer banks ==> fractional reserves
Ayyo!
When I explain a concept, try to understand it. Don’t scan it looking for debating points to use against me.
eh, you know my tone is usually brusque like that, but that I’m not debate-point-ifying right?
I really am leery of the risk nullification I stated above.
I thought I was expansive enough in previous comment no — all along the yield curve, consumer banks give lower yields, e.g. even with n yr fixed deposits, and consumers are ok with that because all along the yield curve, they view these deposits as having “zero risk”. How can it be so?
OK, in the first place, you did not grasp the fact that the risk-return trade-off holds ONLY WHEN YOU KEEP THE TERM CONSTANT. You cannot compare a corporate bond with a 3-day maturity with a government bond with one year maturity, find that the corporate bond gives you a lower yield, and conclude that the corporate bond carries lower risk. You have to compare 3-day corporate bond with a 3-day government bond. That is the whole idea of a yield curve. The yield curve is the curve for risk-free returns. It is drawn by looking at the returns given by government bonds vs. their maturity periods.
In the second place, you’ve moved to fixed deposits and are now asking why they give such low returns. The answer is: they are low risk, because their default rate is low. No, they are not zero risk, but the difference is small enough for the average consumer to ignore. No, they do not give a lower return than government bonds, but yes, they do give a lower return than any other kind of investment, which is as it should be.
Finally, you may say that part of the low risk is because the RBI guarantees the safety of the deposits. Yes it does, but this works both ways. Government insurance must increase the moral hazard for banks. If even after this the probability of a bank going bellyup is so low as it is now, then banks would have an even lower default rate if they were not insued.
Finally, you may say that part of the low risk is because the RBI guarantees…
finally!
Contrary to your suspicions, I was not confusedly conflating terms and durations of investments. I do not know what gave you that idea. Let us set aside your moral hazard comment — interesting as it is — for the moment and get back to my remark in an earlier comment:
no matter the term of investment, bank inestments have ~ zero risk to the consumer (how can it be “low” when it is fully backed by RBI in India, FDIC in US) Under this guise the banks give a low return. You say this is “as it should be”.
But wait — the point was that the bank is indulging in fractional reserve banking, and ergo higher risk investment. Which is insured by RBI/FDIC.
The banks seem to be getting a free ride.
Do you not see a problem in this?
First point:
“The yield curve is my friend here RR.
It says: on demand and “liquid” deposits give ~zero interest.
My point: so there should be ~zero risk investment on part of the bank — this would preclude fractional reserves wunnit?”
What am I supposed to make of this line? You are assuming that approximately zero interest should mean approximately zero risk regardless of the term of the investment.
Second point: Why are you assuming without any evidence that FRB is high risk?
You are assuming that approximately zero interest should mean approximately zero risk regardless of the term of the investment.
I know I make hastily worded comments, but look at the entire comment, I was walking along the X axis of the yield curve, I started off with “on demand” deposits meaning no term restrictions, etcetera.
so, rest assured, I was not disregarding term of investment. and that I was not conflating 20 year desposits and checking accounts.
let’s get back to your more interesting second point:
why do you think FRB is close to zero risk? It is investment no? If it is indeed investment, then the returns on said investment *should be shared with the depositors* no?
“If it is indeed investment, then the returns on said investment *should be shared with the depositors* no?”
If I read you literally, the answer to that question is “yes”. But if you meant “risk” instead of “return” in the above question, then the answer is “no”.
i think 7*6 pwned you suitably,amigo.