Fractional Reserve Banking Made Simple

I’m about to kick a dead horse, but every once in a while you see the horse’s ghost gallop about the internet. The notion that fractional reserve banking is “fraudulent” and “unstable” is a “brain worm” that deserves to be extinguished.

Part of what a bank does is intermediate between savers and borrowers. When you put your money into a savings account, the bank will lend it out. Fractional reserve banking works the same way, but deals with relatively liquid type of deposits. There’s nothing fraudulent about it.

I’m relatively young and I don’t make a big income, so I keep a good amount of money in a demand deposit. If I ever unexpectedly need it, it’s there. Most of the time, it just sits there. Anything not being presently consumed is being saved for future consumption, so those dollars are savings — just like a savings deposit, but (given regulatory rules) with no interest and greater liquidity. The bank will lend these savings out.

Are there two claims on the same money? In a sense, yes, but that’s true with just about any savings vehicle. The money you’re lending is yours, you’re just not currently spending it, so it can be lent out. You might argue that the problem with fractional reserves is when depositors go to the bank to withdraw their money. This isn’t an issue unique to deposit banking. It’s called a maturity mismatch and it can happen with any kind of asset. In fact, it’s something that is inherent to banking: banks borrow short and lend long.

The “trick” is to manage these different assets and rely on the law of large numbers to make sure you always have the sufficient liquidity to pay-off short-term liabilities. That’s what successful banks accomplish. Without the ability to juggle assets of different term lengths, the intermediation industry is going to be very inefficient.

What’s the relationship between fractional reserves and economic crises? Some see that many financial crises are preceded by bank runs, so they conclude that it must have been the maturity mismatch that was at fault. It’s strange, actually, that some Austrians would believe this, because they’re the ones always stressing about their peers mistaking the symptoms (the crash) for the cause (credit expansion). Business cycles are caused by excess supplies of money, which change the distribution of profits. When money supply growth begins to slow down this distribution changes — thus, the sudden loss in profitability for large swaths of industry.

Just because too much sugar is bad for you doesn’t mean all sugar is bad. There’s nothing inherently destabilizing with fractional reserve banking as long as excess money is minimized. What’s the difference between “excess money” and lending on fractional reserves?

Like with any other economic good, there is a point at which demand and supply are equal. Unlike many other economic goods, money has to clear in multiple markets. When the demand for money increases, ignoring for a minute the ability to increase supply, the prices of other goods that exchange for money have to decrease in order to clear against the higher relative value of the currency. If prices don’t clear and exchange suffers, we call that a shortage of money. On the other hand, if there’s more money than people are willing to hold, this is called excess money. It will continue to circulate (the “hot potato” effect) until it returns for redemption or the price level increases, the relative value of money falls, and demand and supply are again equal to each other.

That a bank lends on fractional reserves doesn’t really say anything about whether there is excess money. When the demand for money increases, the volume of deposits might swell (the amount of liabilities returning to the bank for redemption will fall) and it will allow the bank to issue credit. In this case, the banking system is increasing the supply of money to meet the heightened demand. That’s why, if you’re worried about the business cycle, blaming fractional reserve banking is the wrong way to go. What you should really be worried about is surplus money.

How do we accomplish limiting the ability of banks to create liabilities, without enforcing full reserves? Through coordinating monetary institutions (rules or constraints), which may include:

  • In a competitive banking system, banks holding other banks’ liabilities will send them in for redemption, draining on the issuing bank’s assets. If a bank over-issues money, it will suffer from illiquidity. If a bank under-issues money, they will be foregoing the revenue they could have earned had they maximized the use of their assets.
  • If banks could pay competitive interest on demand deposits, they’d have to raise this rate to attract new deposits to fund their lending. But, as the supply of loanable funds increases, the rate of interest on these loans will fall. If the latter rate (on loans) falls below the former (on deposits), the bank is making a loss.

That’s why it pains me when I read Austrians cheering for recent IMF studies and old Chicago research papers supporting 100 percent reserves. They’re worrying too much about the symptom and they don’t realize that they’re supporting the cause: bad monetary institutions (after all, it’s not like these IMF and old Chicago School economists are advocating for free banking).

Quote of the Week

Thus as a consequences (perhaps unintended) of monopolized note issue, the liabilities of the privileged bank acquire a special status in the banking system; they become a kind of reserve media, supplementing and even superseding reserves of commodity money. Unlike deposit liabilities of non-note-issuing banks and unlike any of the bank liabilities in a system with competing note-issuers, the liabilities of a monopoly bank of issue are a form of high-powered money. Issues of such liabilities add to the base money of the system. This means, in effect, that a monopoly bank of issue i, in the short in the short run at least, exempt from the principle of adverse clearings. The liabilities it issues not employed as currency in circulation become lodged in the reserves of deposit banks, where they cause a multiplicative expansion of credit. In general (assuming a closed economy) these liabilities will not be returned to their issuer for redemption even though their issue, and the multiplicative expansion of credit caused by it, is not justified by any prior excess demand for inside money. In other words, in a closed system a monopoly bank of issue can cause an inflationary increase in the money supply — without suffering any negative consequences. Unless some external short-run control is imposed on it, a monopoly bank of issue even when its issues are convertible into commodity money can for some time at least pursue any loan-pricing policy it desires, arbitrarily expanding or contracting the money supply and causing widespread changes in nominal income and prices.

— George A. Selgin, The Theory of Free Banking (Totowa: Rowman & Littlefield, 1988), pp. 48–49.

Resist the Noah Smith Brain Worm

The more confident the seller, the more confident you should be that it's B.S.

In a recent Bloomberg View piece, Noah Smith ridicules “Austrian economics” for a number of silly or wrong things certain professors and investors, but mostly young high school and college students, have said between 2007 and the present: (a) high inflation/hyperinflation, (b) a non-useful definition of inflation, (c) math is used to obfuscate,…, and so on. It’s basically a poor literature review of what hundreds of bloggers have already said.

Noah is technically not wrong on any of the individual points he makes. The problem is not with the evidence, but with the overall tone of the argument. He’s telling his audience to ignore “Austrian economics” on the basis of what a minority of actual Austrian economists believe in. Someone who really knew what he was talking about would take you through a deeper exploration of the literature and show you what academic Austrians really think. In fact, since Noah apparently couldn’t be bothered with doing actual research, I’ll give you some brief examples.

The Federal Reserve — Take three of the most well-known economists who oppose the Fed: George Selgin, Larry White, and Roger Garrison. Do you think their argument in favor of their position is that the Fed prints money to benefit big banks? It isn’t. Selgin and White developed a theory of free banking, and make a further theoretical argument that in a comparative analysis central banks do not pass the cost–benefit analysis. This line of reasoning isn’t obscure. There is a big literature on competitive currencies and competitive monetary institutions, much of which was written by clearly “mainstream” economists. Unfortunately, Noah doesn’t show you that side of the story.

Inflation — Yes, many Austrians, some professors, many rich old guys, and many more exuberant youths made predictions of hyperinflation or very high inflation. In 2009–10 I was eaten by the brain worm, I must confess, and I was one of those youths. But, fortunately, there were many level-headed Austrian economists, such as Steven Horwitz, who were making a different prediction: that the demand for money had significantly increased and that the best response is an increase in the supply of money. Another example is Selgin, who is well known as a proponent of the “productivity norm,” differentiating between “good” deflation (productivity increases) and “bad” deflation (rightward shifts of money demand).

By the way, do Austrians really use such an idiosyncratic definition of inflation? It’s true, some do. Most Austrians, nevertheless, might use a technical definition, such as: an excess supply of money. But, that’s basically the definition that most mainstream economists ascribe to the term. So, no, Noah is not characterizing the Austrian School well in this case (points 2–4), either.

Mathematical Mumbo-Jumbo — Again, Noah Smith is absolutely right. The real mumbo-jumbo is the nonsense argument that economists use math to support government policies, or to confuse readers, or to mesmerize their peers. Math was introduced into economics to help make a theory explicit. When an argument is advanced in pure prose, the written word can be vague. In a formula, though, all the factors you have in mind are explicit and it forces you to be more careful about where you take your reasoning. One, however, might make the argument that the use of math in econ can be suboptimal, especially if the models are intractable or, frankly, not very interesting. By the way, no serious Austrian economist argues that the use of math in mainstream econ has malicious motivations. Again, Noah is doing his readers a disservice.

Noah is a professor. He knows how to teach. It’s my view, at least, that the professor is supposed to open the student’s mind, so that the latter knows how to compare, analyze, and verify different arguments. That’s the exact opposite of what he does in his Bloomberg article. He prefers to hard sell his audience a very poorly researched article on Austrian economics that essentially tells them to ignore the Austrians. That is anti-science. Science progresses via a dialectic, where people weigh different theories against each other. The market for ideas is like governance, you want pluralism and competition. Excluding an entire group of economists from the debate hurts economic science, and I’m disappointed Noah took his trolling to such a low level. He’s better than that. Although, yes, that Noah’s argument is as shallow as it is turns a very bad article into one of the worst I’ve read in a long time.

Techno Economics

The Electric Daily Carnival is a major music festival that takes place every year in a number of cities, originally in the U.S. but not spread to U.K. and Mexico. You may remember an article of mine on EDC, which I wrote back in 2011.There I discussed some qualitative aspects, with my mind on prohibition in particular. I discussed how the market helps mitigate some of the adverse consequences of drug use, while the government tends to do the opposite of help.

Dancing Astronaut has an interesting infographic on with hard data on EDC’s economic impact on Las Vegas. They find that total spending amongst attendees was $158 million, and broken up into more specific categories the distribution of that income looks as follows:

  • $52.2 million → Food and beverage
  • $29 → Hotel rooms
  • $25.6 → Transportation
  • $22. 7 → Gaming
  • $15.2 → Entertainment
  • $13.7 → Retail spending

$20 million eventually became tax revenue. According to the infographic, $131.9 million represents “increased labor income,” which I’m assuming means wages/salary. To put that figure into context, that’s 83.5 percent of total cash flow.

To me this says something about the “labor v. capital” inequality question. Sure, EDC, hospitality, and most of these other industries are labor-intensive. Other sectors of the economy, particularly manufacturing, might see distributions of income between the two factors that are different. But, aren’t we see seeing a structural shift towards the service sector? Aren’t we moving back to a labor-intensive dominant economy? In Capital, Thomas Piketty ascribes human capital to labor. It seems to me, when comparing margins, the return to human capital is quickly growing relative to the return to much of the physical capital the growing service industry uses.

Quote of the Week

[P]urely instrumentally rational agents cannot reason themselves into being rule followers and yet rule following seems absolutely critical to social life. What reason cannot achieve on its own, cultural (and biological) evolution has: normal humans have evolved into social creatures who care about following moral rules. So far from being mysterious, our best understanding of the evolution of social cooperation strongly endorses the conclusion that Rule-following Punishers — agents who care about following moral rules and ensuring that others follow them too — are a prerequisite of a cooperative social order. Thus Hayek rightly points out that our reason presupposes morality (and our caring for it) as much as it presupposes our goals; it does not construct either.

— Gerald Gaus, The Order of Public Reason (Cambridge: Cambridge University Press, 2011), pp. 146–147.

Ancient Athens’ Economic Freedom Ranking

The abstract:

We use the Economic Freedom Index to characterize the institutions of the Athenian city-state in the fourth century BCE. It has been shown that ancient Greece witnessed improved living conditions for an extended period of time. Athens in the fourth century appears to have fared particularly well. We find that economic freedom in ancient Athens is on level with the highest ranked modern economies such as Hong Kong and Singapore. With the exception of the position of women and slaves, Athens scores high in almost every dimension of economic freedom. Trade is probably highly important even by current standards. As studies of contemporary societies suggest that institutional quality is probably an important determinant of economic growth, it may also have been one factor in the relative material success of the Athenians.

— Andreas Bergh and Hampus Lyttkens, “Measuring Institutional Quality in Ancient Athens.”

My Day Job

Part of what my day job consists of:

You have most likely heard of the term “keyword optimization.” If you haven’t, the gist of the concept is to optimize the content of a webpage to maximize the probability of a user finding your site on Google, Yahoo!, or some other search engine. Seems straightforward enough, right? Keyword optimization, nevertheless, becomes difficult when choosing which keyword(s) to optimize for. A common strategy is to choose “obvious” search terms and optimize the content for this keyword — which sometimes really means: use that keyword as often as possible (remember, there are diminishing returns to keyword usage!). What many people don’t realize is that such a strategy can hurt, rather than help, your search engine results.

Suppose that you are a dentist with an infosite dedicated to dental implants. You want to draw traffic to your website by pushing it to the top of the Google search page. An easy method of doing this, one might think, is to use the term “dental implants” as often as possible. The problem with this is that there are thousands of dental implant providers out there, all of which might be using the same exact SEO approach as you. In other words, you are competing with thousands of other websites which are optimizing for the same exact search term. You might, instead, refine your optimization by adding your city name: e.g. “Dental implants in Albuquerque, NM.” You are now dipping your big toe into the world of long-tail SEO optimization.

— “The Short and Long-Tail of SEO Optimization