On Tuesday I wrote an article, “Fractional reserve Banking: The Real Story,” in which I discussed the workings of fractional reserve banking. Mish (Mike Shedlock) responded critically to my article on his blog, “Central Bank Authorized Fraud; Fractional Reserve Lending Problems Go Far Beyond “Duration Mismatch“. This post is a response to his comments. I think there can be no more important topic than the discussion of a proper gold standard, and integral to this topic is the question of whether fractional reserve banking is perfectly fine, or whether it is by nature fraudulent.
Let me first address a few things that I could have made clearer in my paper. First, I consider myself a student of the Austrian School. My disagreement is with the (modern day) notion that fractional reserve banking is intrinsically fraudulent, which I don’t think is part of the Austrian School proper.
Second, when I said I was not aware that others had written about duration mismatch, I should have stated clearly: duration mismatch as the root (or one of the main roots) of systemic instability. I read your blog every day, and I have seen you discuss the problem but to my recollection you have addressed this as a problem for the lender, which I agree it is. But I think we both agree that it is also a problem for the financial system and the currency itself. (By the way, I looked at your 17 links search results page, which has now proliferated to 5 pages, and most of the links are to unrelated posts that have a link to your present post in the sidebar.)
Third, the lending of money that is supposed to be available on demand is in fact a case of duration mismatch (the duration of the liability is zero and the duration of the asset is whatever the term of the loan is).
Fourth, I certainly agree with you that there are other kinds of illegitimate lending whereby the bank lends money it does not have the right to lend for reasons other than duration. In my paper, I did not try to address this.
Fifth, the central bank allows (and encourages and incentivizes and in some cases forces) banks to do all sorts of illegitimate things. Again, I was not trying to address this. I deliberately choose to look at a gold standard without a central bank (which I could have made more explicit). My goal was to look at the essence of fractional reserve banking as such, vs. the present system of irredeemable paper money + a central bank + FDIC moral hazard insurance + GSE’s + social-engineering-masquerading-as-tax-policy + hundreds of thousands of pages of regulation + deliberately inflationary monetary policy + massive deficits + “open market operations” + US Government bonds crowding out other investments + Fed-authorized “sweeps” + too many other things to mention. I agree 100% that those things (and many others) are illegitimate, coercive, fraudulent, and contribute to systemic risk.
The scope of our disagreement might be as narrow as your statement “…I cannot lend you $1,000 if I only have $1.98. However, and this may surprise many people, banks can.”
I think I showed how fractional reserve banking (stripped of central banks and other accidental stuff), in its essence, does not provide a way for banks to lend more money than they have. Of course, in today’s irredeemable debt-backed currency system, there is no distinction between money and credit. In my examples, the difference between a gold coin vs. a claim to a gold coin to be delivered in the future is black and white. In a free market with a proper gold standard, banks can multiply *credit* but not *money*, and if they are prohibited from borrowing short to lend long, then they cannot fraudulently extend the duration of a loan beyond the specified preference of the actual owner of the gold coin: the depositor.
I want to emphasize one last–but vitally important–point. There is no such thing as lending without fractional reserves. If a bank takes in a deposit and lends the smallest portion of it, that is a fractional reserve (i.e. less than 100%). A so-called 100% gold-backed deposit means that the bank is relegated to the roles only of payment transfers plus safe depository. Clearly both of these are legitimate services and would be available in the free market. Savings as well as hoarding (storing gold without being willing to lend it) both play crucial roles in a proper gold standard, and there are important arbitrages between them. But this is outside the scope of my paper.
I look forward to Mish’s response.
