FRB still misunderstood!

Commenter MadMax asked me if I could respond to a post by Doug Reich about Fractional Reserve Banking. The topicality of that topic is a bit more 'perishable' than econ method, so I decided the latter can wait and I spent what time I had this past week on making that response. Besides, it also ties in with some on-going email (and now tardy) discussions I've been having with a few people and they all have the same issue that is at fault with Doug's post. I hope that this will help clear up a few things in that regard.

Also, note that I am not here actually to defend FRB. Other than when there is a bona-fide physical dearth of specie, such as in remote and rarely-visited locations or where bad law hampers the circulation of specie, there is no economic benefit to the practice and so should be heavily frowned upon. There is no excuse for it in a free economy that has decent communication with the rest of the world.

This is not all of my response, and I’ll post the rest later (update, here it is). It is not the best time of year to be doing this sort of thing!

For those who missed it, previous posts by me are here, here, here and here.


The essence of Fractional Reserve Banking
The issue at hand lies in what exactly is FRB in principle. Over and over I see people having the same misunderstanding of this point, by means of them committing a particular conceptual fallacy, implicitly expressing faulty reasoning that includes that fallacy as a premise, and then on the basis of those fallacies subsequently drawing from the empirical data a particular hasty generalisation.

The essence of FRB is the monetisation of credit. This is what it IS in economic substance, independently of how concrete forms of this monetisation historically came about. In all its variants, FRB is where a debt owed by a debtor to a creditor can be used by that creditor as a medium of exchange independently of the original principal. What makes it fractional reserve banking is that this new form of money is not wholly backed by tangible specie but by the general assets of the issuers of the credit, of which only a fraction is actual specie. The rest of the assets backing the money is other goods, both tangible and intangible.

The different types of FRB differ on the mechanics by which credit is monetised. They also differ in the morality of those mechanics. Some implementations of FRB are immoral, such as the historical origin of particular implementations that gave the principle practical legs in the first place, but not all. In order to say that the whole of FRB is inherently something that ought be illegal one must say it should be illegal to use credit as money. The problem is that there are no grounds for such a law. By all means, one can and should criminalise particular practices that result in FRB, but that is as far as one can go in terms of what the law can say. As soon as you accept that it should be legally permissible to use credit as a medium of exchange you have accepted that at least some form of FRB can be legal. Once that is accepted then generating an instance of FRB that is consistent with both epistemology and morality is but a matter of technical know-how.

In regards to those historical origins the legal-based opponents of FRB are committing the fallacy of the Frozen Abstraction. What the legal-based opponents are doing is rightly noting various immoralities, observing that they lead to FRB, but then concluding that the immorality is necessarily attendant with all instances of FRB. That is fallacious.

They then mention the deleterious economic consequences of FRB, which they are right to note are indeed inherent in FRB as such (and why I am not a fan of FRB despite accepting that in principle it should be legal). But here they are committing another fallacy. They are implicitly reasoning that since the immoral is the impractical, instances of systematic impracticality can only arise from systematic immorality. They then integrate this fallacious reasoning with the actual instances of systematic immorality they've discussed and so further bolster their claim regarding the whole of FRB as such.

Their reasoning is fallacious because there are other reasons for systematic impracticality besides immorality. The critical ones in this regard are systematic ignorance and systematic error, neither of which are inherently the result of immorality on the part of the ignorant or erroneous. For instance, you should see some of my grad school notes, written by some of the top members of the financial profession in Australia yet which have howlers such as “interest is the price of money.” Imagine the consequence of these howlers being taught to thousands of financial services students every year. Thus the systematic impracticality must be dealt with on economic grounds, because dealing with the particular immoralities of the referents of the frozen abstraction still leaves open moral means of generating a fractional financial system. It is time, then, to show how that impracticality arises by otherwise moral means.

Constructing a notes-variant of FRB by perfectly legal means
The actual fact is that FRB can proceed with its full vigour, without injustice, by the simple method of making the contracts of a credit nature from the beginning with everyone knowing exactly what is going on. (I’ll deal with the epistemological and metaphysical claims later). This is an example of that technical know-how - and note that it is the bread and butter of the financial engineer to think up things like this and put them into actual practice.

The context is that the economy is laissez-faire, and that the money supply initially consists exclusively of specie. That is, there are physical coins circulating around, be they made of gold or silver or copper or whatever. This core constituent does not change. There are also banknotes circulating in the place of coin, where the contracts for those particular notes specifies 100% reserves. People in the economy are well-use to using these notes as substitutes for money. For all practical purposes, these banknotes can be treated as one treats coin.

Joe lends Pete some coin, say $98. Pete gives Joe a verbal promise to pay $100 back at some specified later date, say three months hence. Joe accepts the verbal promise because he knows Pete well. Pete spends the $98 on something productive either by purchasing and using capital goods himself or on-lending it to someone else who will purchase and use capital goods (you can also daisy-chain that as much as you like, too). The profits of this investment will afford him a profit even after paying a little more back than he borrowed.

One day, about a month later, Joe comes across Sally selling something that he wants. He finds that he does not have enough coin on hand... but he gets the idea of calling Pete and asking him if it is okay that he (Pete) owe the $100 to Sally instead. Both Pete and Sally agree to this. At no point is Pete required to go to Sally’s shop and provide $100 in coin, it is just a direct reassignment of debt. Sally accepts this because she wants Joe’s business, and she (like Joe) thinks Pete is a good credit risk anyway so she has a good chance of earning some interest. She accepts the debt for the value of say $98.67 (eg Joe had to pitch in an additional $1.33 in cash to buy something with a $100 price-tag).

Do you follow that much? If you accept that it consistent with standard commercial law as should be recognised under laissez-faire then you’ve just accepted the economic basis for a legally legitimate system of fractional reserve banking. You’ve done that because the root of FRB is the reassignment of debt as a means of settling other debts (in this case, Joe settling his debt to Sally when he takes that $100 item). The monetisation of credit is where the practice of debt reassignment becomes widespread enough for it to be taken for granted and incorporated into people’s regular economic calculations: that is, they include the use of high-quality debt as a medium of exchange when examining the economy, when examining and calculating price structures, and when taking account of their own and others’ money stocks.

To get from debt reassignment to credit monetisation (and hence an instance of FRB) that all we need is a series of tweaks, each tweak being equally legitimate. Follow this evolution, and see if you can point out where, if anywhere, an act that should be illegal has been committed.

Instead of a verbal promise, Pete gives Joe a paper note evidencing the fact of credit by it saying “I, Pete, owe Joe $100, payable on or after X date.” By means of this paper, instead of Joe calling Pete to reassign the debt Joe just crosses his name out, signs this crossing-out, and puts Sally’s name there instead. This makes it easier to reassign the debt because it no longer requires Pete be available to answer his phone. It also makes the debt more marketable because the written evidence of who is owed what is clearer and more legally presentable. This has just described the economic substance of creating a Bill of Exchange. It is no accident that Bills of Exchange are included in expanded definitions of money and are known in the finance industry as an example of “money-market instruments.” It is also no accident that discussion of them in general, and also of the economic merits of their use as backing for notes issuance in particular, is included in arguments about FRB.

Instead of a creditor being named on the note, it says “I, Pete, will pay the bearer $100 on or after X date.” This allows the debt underlying the credit-note to be reassigned much more easily still because it becomes “without recourse” and eliminates any lingering contingent liabilities on the part of holders who on-trade it. Bearer instruments and “without-recourse” clauses should be legal, and mostly still are. For instance, there are such things as bearer bills, bearer bonds, and also cheques payable to “bearer”. Similarly, many mortgages and other debts have without-recourse clauses in their contracts. This should continue to be legal under laissez-faire.

Pete recognises the fact that his credit-note could be traded around, just as banknotes already are, so as an enticement to prospective creditors he breaks the single $100 debt into a series (called a ‘tranche’ in the jargon) of identical $1 credit-notes. There are now 100 of these credit-notes circulating around in the economy, used alongside coin as media of exchange and independently of the original $100 in coin that Pete borrowed and spent. There’s no disputing this tweak either. If one has the right to borrow as such then one is at liberty to break up that borrowing into as many little units of whatever size as one finds practical. Indeed, that is precisely what is done today, with the unit sizes being tailored to the market being targeted. Certainly, they do trade at a discount, of course, but so did fractional notes in actual history (ditto Bills of Exchange) and that didn’t stop them from being widely used as money (as money substitutes, to be precise), so one cannot claim lack of significance in trade to skirt the issue at hand.

Pete recognises that his excellent reputation means that he can have quite a turnover of tranches going. So, he borrows $5,500 or so in the form of about 55 tranches of 100 $1 notes, each having three-month maturities such that one tranche matures each working day of the year. Each time he repays one tranche he issues another to replace it so that his total debt outstanding remains around $5,500. Now there are 5,500 $1 three-month credit-notes constantly circulating, with 55 different maturity dates. This is just more of the same as above, differing only in quantity. Again, the significance-of-trade argument is irrelevant.

Tom, Dick, and Harry et al each independently see what Pete is doing and profiting from, so they repeat it themselves. They too borrow money and evidence the debts with multiple tranches of $1 credit-notes. Now there is say a hundred thousand dollars worth of paper physically circulating around the economy, all independently of the original principals. Again, this is just an increase in quantity.

The financial houses see what is going on and so themselves begin systematically emulating Pete, Tom, Dick and Harry, issuing tranches of fungible $1 credit-notes by the truck-load. They are credit contracts, rather than the bailment contracts that the banknotes are issued under, and so do not legally require the whole of the outstanding amount of debt be backed exclusively by coin in their vaults. The amount of these notes circulating in the economy now runs into the millions. One cannot legally disallow this enormous increase in quantity given the previous developments!

The credit-notes are exactly that – notes evidencing credit claims upon their issuers, and whose issuers back those claims by the totality of their assets and not just the small amount of cash actually on hand. By the ready transferability of the credit notes, and hence of legal title to the credit itself, that actual credit has been monetised and so the notes themselves have become money-substitutes. This is an instance of notes-based FRB even though the notes are not repayable on demand until on or after the maturity date, because the nominal amount outstanding is not backed by an equal quantity of specie held by the issuers.

Just these straight-forward and completely moral tweaks on an equally moral original situation are enough to create a variant of fractional reserve banking. One could even envisage the lending of the notes themselves (which, again, must be legal), in time generating credit from credit in standard multiplier style - but it should be clear by now that this would be belabouring the point. I also can, and will, develop this into a demand-notes variant, but I wont just now because it would raise another issue that is the subject of misunderstanding and dealing with that just now would get in the way of that main point.

The need for economic argument
FRB can be done in a completely above-board fashion simply through sophisticated developments of the practice of reassigning debts, all of which are and must remain legal. At least some form of FRB in principle must be legal under laissez-faire because at no point in the evolution from simple debt reassignment to the mass monetisation of credit is anyone defrauded or stolen from, nor was there any epistemological corruption or attempted metaphysical voodoo. At no point may anyone forcibly intervene and say “You shall not do that.” Thus one cannot ban FRB without ultimately requiring a ban on debt reassignment for the ban on FRB to be effective - but such a ban is impermissible because it would be a violation of rights.

The fact that the immoral is the impractical has the exact opposite consequence for this topic than the legal-based opponents intend: an effective ban on FRB would be enormously destructive. A ban on debt reassignment would redound not just on FRB but effectively destroy much of the short-term debt market - it would make Bills of Exchange illegal, for instance. The ban would also end up obliterating most of the liquidity of shares in corporations, because the sale of stocks requires that the debts owed by corporations, insofar as corporate debt is actually owed by the shareholders, is also transferred from a selling shareholder to a buying shareholder (ie not as Joe selling debt to Sally, but Pete clearing his debt through Eddie assuming it as part of him buying out Pete’s investments). The result of a ban, once consistently enforced, would be a wiping out of huge amounts of wealth, and, as it would constitute an enormous exit-barrier, would heavily discourage further capital formation.

There are a number of other comparatively minor consequences too (eg to ban factoring), but to top this all off, a ban on debt reassignment would ultimately require that the government ban barter or any form of payment in kind whatever, dictate what shall and shall not be money, regulate its value, and institute legal tender laws. I’ve said before and I’ll say it again: a ban on FRB-in-principle damn-well IS an intervention, and once that process is begun it will lead to controls breeding controls.

Trying to curtail FRB by means of legal proscriptions is totally the wrong way to go about it. You can and should ban wilful breach of contract, but that’s not enough to prevent FRB. So long as debt reassignment is legally allowed, as it must be, then at least some form of FRB can legally arise, with all the deleterious economic consequences that follow. More to the point, so long as debt reassignment is legally allowed at least some form of FRB will arise, as will those economic consequences, unless the hard work of making proper economic arguments is undertaken. The only normative prescriptions that can be made regarding FRB relate to what people should do in their capacity as customers of financial institutions and as participants in markets, not in their capacity as citizens and lawmakers.

A pause
Here is where I will stop for the time being. I’ve proven my chief point: it is wrong to say that all FRB should be always illegal, and the reference to particular injustices as though they exhausted the whole of what FRB refers to is to commit the fallacy of Frozen Abstraction. The heart of fractional reserve banking is the monetisation of credit, irrespective of the legal status of how credit comes to be monetised in any given instance. It is the economics that must be dealt with, not those particular injustices, if FRB is to be eliminated in entirety.

When I come back I will continue tweaking so as to arrive at a full demand-notes variant and then convert it into a full demand-accounts variant, again by steps that are and must remain legal. I will then deal with the epistemological and metaphysical claims.

JJM