Ep. 141 Do You Want the Crankish Monetary System We Have Now, or This Other Crankish Monetary System?

2 June 2018     |     Tom Woods     |     12

It’s one thing to find problems with the current monetary system. It’s quite another to recommend an alternative. Switzerland has establishment commentators going berserk over its own proposal — why, this would return us to the “Dark Ages,” warns Business Insider. We’re less interested in Switzerland than we are in figuring out what changes would move us in the right direction, and what changes would amount to the cure being worse than the disease.

Articles Mentioned

Switzerland is about to vote on whether to send its financial system back to the Dark Ages in a referendum to ban banks from creating moneyFiat Money and the Euro Crisis,” by Will Martin
Popular initiative ‘For crisis-safe money: Money creation by the National Bank only! (Sovereign Money Initiative)’” (The Federal Council of the Swiss Government)

Professor Herbener’s Congressional Testimony

Separation of Money and State

Related Articles

Is Our Money Based on Debt?,” by Bob Murphy
What Does “Debt-Based” Money Imply for Interest Payments?,” by Bob Murphy
Why Fractional Reserve Banking Poses a Threat to Market Stability,” by Bob Murphy

Episode Mentioned (Tom Woods Show)

Ep. 269 End the Fed, Then What? (Jeff Herbener)

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  • DMS

    I think the argument against fractional reserve banking can be shown to be wrong on its own terms, at least as presented here. Specifically, it is not fractional reserve banking that results in banking instability, but rather poor underwriting and/or liquidity mis-management. Specifically:

    1. Bob concedes that there would be no issues if, rather than checkable deposits, consumers bought Certificates of Deposit (CDs). See 15:30 mark.

    2. Assume all consumers put 10% of their money into checkable deposits and buy 5-yr CDs with the rest of their funds. Assume the bank keeps the 10% in vault cash (or the equivalent – deposits at the Fed), and loans the other 90% out to worthy creditors, also for 5 year terms. Presumably no issue presents itself given point #1 above.

    3. Assume instead that the same type of arrangement exists as above, but that the matched durations are instead 3 years each. Also, presumably no issue arises.

    4. Now instead assume the matched durations are one year. Again no issue exists, as would continue to be the case by assuming durations of 6 months, 3 months, etc.

    5. Now, finally assume that the CDs are immediately redeemable, and that the matching loans issued by the bank are immediately callable. It simply makes no sense to speak of this situation as “creating money” let alone “creating money out of thin air”, nor would it be correct to consider it unbacked lending, i.e. not from previously saved funds.

    And yet, the final scenario above is precisely the situation of real-world fractional reserve banking, except that the deposits are of zero duration, while the bank loans are not. That doesn’t make anything “fractional” – it just means the balance sheet of a bank has unmatched durations for assets and liabilities. Again, putting aside bad credit underwriting, it is clearly the issue that mis-matched duration is the source of any potential banking risk, not the mathematical articulation of “fractional reserve” banking. By the way, this is precisely what banks are designed to accomplish in the market (other than mere warehousing), which is to borrow short and lend long. This banking need exists because the overall market seeks the opposite, which is to lend short and borrow long.

    Perhaps the central confusion arises because the pricing offered to the customer should differ between vault cash and loaned funds, but the customer is presented with a single blended price (or return). For example, a given customer might pay a fee for his/her 10% vault cash, but earn a rate of return on his/her immediately redeemable CDs. But bundling the two into a single price (which can be done because all the accounts are fungible and held in the same 90/10 ratio) does not magically make anything “fractional”.

    Banking instability occurs when there is poor management of the inherent risk of mis-matched durations, i.e. liquidity. It is NOT because 90% of a bank customer’s funds are arbitrarily labeled “deposits” rather than “immediately redeemable certificates of deposit”, nor because the separate pricing of each is hidden in a single blended rate.

    • Intersnooze

      The error in your reasoning is in ignoring that, /for the duration of the loan/, the lender is not able to dispose of and spend that money – and that changing the duration of indisposability from non-zero to zero changes the character of the asset.

      • DMS

        Thanks for responding, but I still don’t see it.

        I think the problem may be the conceptual notion (which I maintain is false) that two dual claims on funds exists in the marketplace with checkable deposits, i.e. the lender (depositor) can access funds even though they have been loaned elsewhere by the bank. But practically that doesn’t happen. When the depositor submits his/her claim (i.e. writes a check), those funds must be sourced elsewhere by the bank, either by selling assets and/or raising capital (equity, debt, or new deposits). Those are very real funds, representing very real saving elsewhere in the marketplace. That is why I emphasize the liquidity and/or mis-management issue – the “dual-claim” argument makes no sense to me in the practical world of banking, and I cannot construct any double-entry bookkeeping that supports the “dual-claim” theory. But I may be missing something…

        Again, try the thought experiment that the bank restricts itself to solely making callable loans. There is obviously no problem there in terms of dual claims – the depositor writes a check; the bank calls its loan and everything clears. Now imagine the bank believes a better model is to make non-callable loans, and instead meet any depositor claims as I said above – by selling other assets and/or raising capital through equity, debt or new deposits. That is simply Fractional Reserve Banking. But again, FRB does not introduce instability per se, but rather the source is poor bank management, either of asset quality and/or liquidity.

        • Intersnooze

          Thanks. I have to consider your response in a serious way.

          • DMS

            No, you are correct, there is no error. But I think there is a misinterpretation that the result is some form of double-counting, or that a “dual claim” exists, resulting in excess credit creation and inherent instability.

            The depositor could in theory make a direct callable loan to a third party. The depositor (lender in this case) has full “access” to this amount, in the same manner that a depositor has full “access” to his/her checkable deposit balance at a bank. Said differently, the asset side of this personal balance sheet is the same in both cases, under the category of “immediately liquid assets” there could be listed both “bank deposits”, or “callable loans to third-parties”. The are operationally fungible. The loan side remains the same in both cases. As I said before, the only difference in the real world is to instead use a bank as an intermediary, and for the bank to choose to lend at duration, not callable. The bank then has the responsibility to manage the resultant liquidity exposure through different means.

            Perhaps the confusion is that “access on the books” is very different from actual use. When the depositor (or lender) in fact accesses the balance on the books for transactional purposes, i.e. writes a check (or calls a loan), the bank (or the borrower) must find an alternative source of capital in the marketplace to meet that demand, i.e. clear the check with another bank (or scrape together funds to meet the call). As I said before, in the banking case it could be any combination of asset sales, equity, debt, or new deposits. [In fact, on a day-to-day basis, it is actually managed out of the slight excess of needed reserves managed by the bank, assuming normal operations and no bank run. Think of it this way – these might be labeled “deposits otherwise available to lend, but held back for liquidity management”, and is at the core of FRB.]

            Importantly, all of these possibilities represent genuine savings in the economy. This is the part of the Austrian story that I don’t get, or at least the anti-FRB side of the Austrian School that escapes me. N.B. All of this occurs (or could occur) on a free market, volitional basis, outside of state regulation.

            Or I am missing something, which I mean sincerely. I appreciate any guidance you have – I have yet to get a proper rebuttal, even from the likes of Bob Murphy, let alone in Murray Rothbard’s writings. They just seem to mis-characterize the actual banking hydraulics in an FRB system. Any light you might shed is quite welcome.

          • Intersnooze

            Thanks for your reply.

            Yes ‘access on the books’ is the questionable practice of telling someone ‘their money’ (it’s not legally theirs when deposited) is in their account when in reality most of it has been lent-out to someone else.

            The fact hat the bank needs to come-up with ‘real money’ for an actual withdrawal doesn’t contradict the claim that the bank ‘printed’ more than one claim to the money.- that people think and act as if they are owners of the sum of money listed on the account balance.

            It seems analogous to the goldsmiths who issued more warehouse receipts than the actual gold they had in storage plus what had been lent-out.

            Many Austrians advocate seperate categories of deposits: 1) Interest-bearing accounts that are loaned-out and not callable until their term expires and 2) Accounts in which the deposited money is held by the bank, do not bear interest , where the money remains property of the depositor. These accounts would probably command fees for the service of safely storing and transferring money.

            AFAIK, not all in the Austrian school oppose FRB. I have heard mises.org lecturers who have advocated free banking – including letting each bank decide on whatever risk and fractional reserve their local market will bear. (Without bailouts, obviously.)

  • http://2vnews.com 2VNews

    What would happen if the only things that changed were that gold, silver and cryptocurrencies were treated as as legal tender (not as assets) for tax purposes and tax collection?

  • ProfessorBernardoDeLaPaz

    Fie on Greenbacks and Greenbackers! I prefer the Wheatback, myself, backed up by both Hard Money and United $tate$ Legal Tender. Trade ’em with your friends! For example:

  • Charles Rosa

    I’m about halfway through this podcast….awesome. I love when you guys discuss fractional reserve

  • Charles Rosa

    This was a great podcast. I would recommend this to anyone wanting to better understand money. Great job!

  • Bob_Robert

    I only disagree with the “plain inflation doesn’t cause business cycles” because we have an example of it happening.

    During the Spanish Empire period, so much gold and silver was imported into Spain from its slave-labor mines around the world, they entered a HUGE boom period, with all that same mal-investment which, when it busted, took Spain into the backwater of history for hundreds of years.

    • Bob_Robert

      I can also see un-due downward pressure on interest rates because of competition between lenders and the “free” money from the central bank.