The full demand-notes variant of FRB by legal means
So far we have large quantities of short-dated credit-notes being issued by professional financial houses with solid credit ratings. They trade at a small discount when in bulk, mostly just for interest with only a tiny part for credit-risk. For example, at a 4%pa rate a $100 note repayable in three months would trade at $99.02 and go up as the days passed. For smaller denominations, a lot of the time most people wouldn’t even bother with a discount. Trade both at discount and at par is precisely what happened in history.
Going to a full demand-note variant rather than credit-note would only take one more tweak, also something that should be legal, and already is in general credit law independently of its application specifically to money substitutes.
Each working day yay many notes would mature. However, the issuers of credit notes will find that some of the notes continue to trade even though they are mature, and so some of the cash they had made available is sitting idle. They will further find that this is not just a one-off but happens consistently and predictably, where, ceteris paribus, the better the issuer’s credit rating the larger the amount kept outstanding. Obvious implications then arise.
Should the issuers be legally obliged to have the whole of that money sitting idle in vaults and tills, waiting for redemption of mature notes that they know full well aren’t going to be redeemed, even though such a requirement may not be a term of contract? Should law not inherently bar them from reinvesting a portion? Indeed, should law declare void a term of contract that expressly allows the issuers to reinvest what amounts they honestly forecast aren’t going to be redeemed? No.
The situation is now that the economic difference between the credit-notes and the banknotes is only the law they come under, where both are now redeemable on demand. It is the content of the law that makes the difference: the credit notes are under credit contracts while the banknotes are under bailment contracts. The nature of bailment contracts is that the holders of the notes have direct property in the specie they are redeemable for (specifically, tantundem in genere), so it should be flat-out illegal (and would be under laissez-faire) for the note issuers to use that specie for anything. The nature of credit contracts is something else: the ownership of the specie remains in the hands of the issuers of the now-mature credit notes, and the creditors who hold the notes only have property in uncrystallised claims to being paid on demand. This makes all the difference in the world, because it is no longer illegal for the issuers to keep on using the specie - it is legally theirs to do with as they judge fit. There is a legal gulf between, on the one hand, something that ought be outright illegal and which is also imprudent, and, on the other hand, something that is imprudent but which must remain legal despite being imprudent. The law should and does recognise the existence of this gulf.
This is the key to the affair. Unless there is a specific clause setting out an express covenant regarding what happens on and after maturity, the credit contracts only require that the issuer pay on demand. Without such clauses it is not a breach of contract to fail to have the money on hand. The issuer may only be found at fault if there is an actual failure to pay on demand. The issuer may not, and indeed is not, found at fault for a mere potential that would arise under particular circumstances. The law can, does, and should recognise the crucial distinction between the actual and the potential - this is the same distinction crucial in the abortion debate, for instance.
So, yes, it is physically impossible to satisfy every holder of credit notes if not all the money is actually on hand to pay on demand, and yes, in economics it would be catastrophic were there enough demands made at once. The fact remains, however, that the financial houses would, under laissez-faire, be legally at liberty to keep available only a fraction of the amount of coin required to pay out on credit notes that have become mature and yet which are still trading.
The final tweak is to issue credit-notes with no maturity at all to begin with. The benefit for issuers and holders alike is that now there are far fewer tranches to deal with and discounts are now just appraisals of risk. Each issuer only has one or a few contract types, with notes differing only in the unitised amounts of their principals. So, now we have large numbers of pieces of paper evidencing rights under credit law to immediate payment of unitised quantities of coin on demand, which credit was granted solely on the back of the confidence in the issuer to pay coin on demand (ie ‘created out of thin air’), which notes evidencing the credit circulate alongside actual coin, and which notes do not have a matching quantity of coin actually available to pay on demand were every single demand made at once.
This is identical in every meaningful way to fractional reserve banking for notes, both in its mechanics (eg redeemable upon presentment, trading at a discount that varies predominantly with appraisals of risk) and in its economic effects (eg credit expansion in their creation, ephemeralisation of part of the money supply, potential for boom-bust cycles). The only difference is that the word 'deposit' is nowhere to be found, there is no hint whatsoever of the notes being warehouse receipts or equivalent thereof, and that the applicable commercial law is that of credit. In light of all those similarities, and despite that difference (and which difference was rendered meaningless by Foley v Hill), what purpose is served in not identifying this as fractional reserve banking?
Integration with other bank practices
Not only is there no benefit in that refusal, recognising this credit-variant as FRB allows much easier integration of it with other issues in prudential bank management. For instance, I hold that FRB is itself an instance of an even broader questionable practice, which a previous commenter rightly asked me about. The practice of FRB - in the wider sense I use - is a concrete instance of maturity transformation (also of duration mismatch, but that’s too arcane to discuss). This is where the maturities of the assets one invests in is different than the maturities of the liabilities and equities used to fund those investments.
Mismatch is pursued because of the tendency of longer maturities to have higher rates of return than shorter maturities. In the majority of cases, the practice is of having assets of greater maturity than liabilities and equities, giving rise to net interest margins and hence increased profits for the equity-holders. This, however, is dangerous because the obligation to pay can arise much faster than the right to take payment. The result is failures to pay and hence legal proceedings for default. (The opposite, having longer liabilities than assets, is inefficient because it cuts into net margins for no good reason).
So, given the zero-maturity of the notes and accounts that are payable on demand, for the most part there’d be some sort of skewed distribution curve heavily concentrated in the low-maturity range but allowing for small amount of investment in higher-maturity assets. This curve would be calculated and constantly monitored by specialists advising the bank’s overall credit policies for regions of varying sizes and economic conditions etc.
With that in mind, it should also be clear both that FRB even in the wider sense I mean is not sui-generis but is part of a whole system of financial practices and that, despite courting danger for the banks, shouldn’t automatically be illegal. Where FRB differs from other instances of maturity transformation, though, lies in its more direct connection to the money supply, which leads to the danger being an issue for more than just the bank practicing it.
A side observation, one perhaps too technical to bother discussing besides mentioning the fact of integration, is further connection of the practice of using bills and other “money market” instruments as media of exchange and how they are part of M3. Their use in this fashion is also an instance of maturity transformation, with the same dangers being attendant for the same reasons. But I will leave exploration of this issue to others who may be interested in this sort of arcanery.
An accounts-variant of FRB
The above was the notes-method credit-variant of FRB. With the requisite legal principle even for mature credit now in place, it is not hard to come up with an accounts-method credit-variant. Indeed, this can be discussed very quickly.
Instead of the issuer issuing unitised notes to holders, the issuers make book-entries in their accounts that list specific amounts. The holders can then either demand payment (eg at ATM’s or inside actual branches) or demand reassignment (eg cheques, EFTPOS, internet banking). In the past, customers could get information on their accounts either by asking in person or by consulting passbooks or chequebooks etc, while today these options have been added to by ATM queries, telephone queries, internet monitoring, and probably other methods too.
To facilitate trade and promote custom, the issuers can also be members of clearinghouses to deal with transactions among holders who are customers of different issuers. (One of the things that central banks have done is monopolise that clearinghouse role for their respective political jurisdictions.)
After that, complexities relate only to the range of services that financial institutions might provide. The only things limiting the financial engineer are imagination and marketability.
Epistemology regarding ‘deposit’
Without a doubt there has definitely been epistemological corruption regarding the word deposit. If one considers the wider, non-economic meaning of the word, it means something that is just sitting there, such as a deposit of ore in the ground. The word was brought into banking on the application of this to having specie or bullion 'just sitting there' in the vault.
Thanks to various injustices now long-since normalised, 'deposit' in banking has come legally to mean having amounts outstanding owed and payable on demand, irrespective of where the physical owings happen to be or what is being done with them. This was recognised piecemeal in case law, then formalised by Foley v Hill, 1 Ph. 399; 2 H. L. C. 28; 9 ER 1002, at least for Commonwealth countries anyway (emphasis mine):
Money, when paid into a bank, ceases altogether to be the money of the principal (see Parker v. Marchant, 1 Phillips 360); it is then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it. The money paid into the banker's, is money known by the principal to be placed there for the purpose of being under the control of the banker; it is then the banker's money; he is known to deal with it as his own; he makes what profit of it he can, which profit he retains to himself, paying back only the principal, according to the custom of bankers in some places, or the. principal and a small rate of interest, according to the custom of bankers in other places. The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach, of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal, but he is of course answerable on the amount, because he has contracted, having received that money, to repay to the principal, when demanded, a sum equivalent to that paid into his hands.
Make no mistake, I decry that epistemological degeneration. But I think that heavy reliance upon undoing this corruption as a means to trying to refute FRB in principle is cut off from reality. There is no doubt that part of eventual reform must include restoring the original meaning of deposit, but now that the practice of FRB has been normalised and has defenders not just among free-marketeers but even knowledgeable Objectivists it will take a damn sight more than linguistic reformation to deal with the practice. Without that extra work, these other Objectivists can and have condemned the deductions from the etymology of ‘deposit’ as rationalist.
The need for extra work can be seen from the fact that the linguistic complaints can be satisfied by mere equally linguistic change. All that the financial institutions need do to maintain FRB while doing justice to epistemology and legal clarity is to abandon any and all reference to deposit and related concepts in their brochures, advertisements, and contracts. This is not a tall order, because a panoply of nouns and verbs with 'credit' as their root already exists and is in use in banking. For instance, instead of depositing into an account the bank will refer to customers crediting their accounts, or instead of withdrawals it is debiting, and so on. Likewise, instead of the bank making reference to “accessing your money” it could refer instead to the physical acts themselves along with catch-all words like “or” and “so on.” In this project, the financial engineer would use the services of the lawyer and the linguistic engineer.
With that in place, the word "deposit" could then easily be returned to its original meaning by the courts without causing economic disruption, with all new contracts using the word treated accordingly (as instances should have been so treated all those centuries ago). The problem is the only thing that has changed is making public recognition of the fact that under FRB there is the use of credit alongside specie as a medium of exchange, interchangeable by means of common money-substitutes. There has still NOT been given any reason as to why credit should not be used in this manner. And so, other free-marketeers and those other Objectivists will continue to defend the principle in general until they understand the actual economics.
Conceptual structure
The argument I’m having with the legal-based opponents of FRB is not that their arguments are false - on that score they are substantially correct and I don’t have much quarrel with their arguments - but regards how broad the concept of FRB is. Their argument on this issue is that FRB applies only where deposit contracts are being technically violated by banks lending from the funds deposited. My argument is that they are right to identify the violation for what it is but are wrong to restrict FRB solely to the outcome of that violation. I am trying to point out that what the violation achieves in economic substance is the forcible (and hence immoral) transition of banker-customer relations away from bailment towards credit and the monetisation of that credit, which fact is being masked (extremely thinly) by continued use of depositary nomenclature, and yet that this particular outcome can also come about perfectly legitimately by simply entering into contracts of credit from the beginning. The conflict, therefore, is about conceptual structure.
Here is the conceptual structure I have in mind:
At the top-most level is fractional reserve banking in general. Its defining feature is the use of credit owed by banks to customers (whether or not identified as “depositors”) as media of exchange. This is fractional because there are more rights to payment on demand outstanding than there is cash on hand to pay those demands. Within this concept, differentiable by legality, there are two main variants (and other, lesser, demi-variants I wont discuss here). These are deposit-variant and credit-variant.
The deposits-variant is where customers are told (or are lead to believe) that they are making deposits when they hand cash (or cheques or whatever) over to a teller etc. The etymology of the word ‘deposit’ once legally implied that the amounts so deposited were stored in vaults, in the same way that ore still in the ground is a deposit of that ore. They are also being lead to believe - or at least not being expressly disabused of the inference - that the money is there being safely held for them (*). This variant is fractional because that is not actually the case - only a fraction of the amount deposited is actually there as a physical deposit.
(* At least, that is the claim I have heard from some quarters. From personal experience both anecdotally and as a former professional taker of surveys that included bank satisfaction surveys - I once worked for Roy Morgan Research and AC Nielsen - I know that real people from a variety of walks of life are nowhere near that naive. They know what happens to money in banks and credit unions and building societies. Heck, part of the charters of these latter two types of institutions includes member education.)
The credit-variant is where customers are told that they are told (or have sufficient notice) that they are creditors to the bank and that when they hand over cash etc they are making loans to the bank. The customers can demand full or partial settlement immediately, whether by drawing on them in specie or through reassignment. This variant is also fractional because only a fraction of the amount that is legally payable on demand is actually available for payment.
The legal-opponents rightly condemn the deposit-variant, but exclude the credit-variant from the broader FRB concept entirely. I don’t do that.
These legal variants can then be further distinguished by the concretes of mechanical methods. There is the notes-variant of FRB, which is where the issuer has more paper notes outstanding than cash on hand to pay them, and there is the accounts-variant, which is where the issuer has more amounts listed under liabilities than there is cash listed under assets.
Metaphysical claims
A frequent element in treatments against FRB is the claim that two (or more) people are trying to lay claim to the same thing at once, that a given unit of specie is being used several times simultaneously. This argument against FRB requires that the law recognise multiple ownerships of the same thing - not in the form of shares of ownership, but that each is trying to claim 100% ownership at the same time as others are doing likewise.
The problem with this is that it is confusing the issue of who exactly owns what. The law no longer recognises ownership of specie on the part of depositors - again, that is one of the things the finance industry took from Foley v Hill. By the violation of the deposit contracts, which then became normalised, the customer’s relation to the bank was forcibly switched into one of being a creditor. What the customers own is right to payment, not to a share in the present stock of what that payment must be in.
The trade in ownership of rights to payment separate from trade in the goods actually payable with is no different to trade in any other intangible, such as in factoring, or in the rights to buy or sell stocks at given prices (calls and puts respectively) separate from the trade in stocks themselves (giving rise to the distinction between covered and naked). These rights are separate assets from the physical underlyings, are recordable in accounts books as such (cue arguments about expensing executive stock options...), can be used as collateral, and are subject to tax laws.
Further, this trade in rights is but an instance of the broader trade in all intangibles in general, such as the purchase and sale of copyrights or other intellectual properties. So, so long as the debtor pays on demand and is not insolvent (ie total assets are greater than total liabilities), this trade should be and is recognised as perfectly normal by the courts. There is no metaphysical difficulty at all, so long as one properly identifies that the legalisation of the original violation of deposit contracts included the forcible switch of property relations from owners’ reclamation rights to creditors’ repayment rights, and that one remembers that intangible does not mean unreal. Again, if the issue of the meaning of deposit were resolved as reason and justice demand that would still leave this principle of trade in credit intangibles untouched, and would just see the marketing and legal arms of financial institutions try to push customers in that direction.
Inflation and dilution
One last issue I’ll discuss is whether or not the consequence of monetary expansion is always inflationary. This is the particular topic that got a few people emailing me after I published something on HBL. My answer is yes and no, but that properly speaking the answer is no and that Dr Binswanger is correct as far as he goes (but he is wrong to hold that there is nothing wrong with FRB).
The answer is yes, if by inflation it is meant an increase in either the total money supply or in general prices. The problem is that I don’t hold to either of those identifications of “inflation”, so the proper answer is no.
Inflation occurs under fiat currency, and is best kept strictly to that context. It is the act of increasing the quantity of notes or numbers in accounts denominated in a numeraire whose sole value lies in its ability to satisfy tax and legal tender laws. Without taxes and legal tender laws, fiat currency would have no value whatsoever - modern polymer notes wouldn’t even do as toilet-paper or kindling. Thus the expansion of fiat currency is an injection of worthless air, which is consistent with the etymological origin of the term.
However, when the money supply is being increased through the monetisation of credit, ie where banks are borrowing money from current-customers in the form of credit notes or credit accounts (NOT credit cards, which is a different issue entirely) and where this credit is instantly reassignable by direct transference of substitutes from one person to another, I would not call this inflationary. Instead, dilutionary would be the better term (I don’t claim origination of the term - I co-opted it from Hazlitt’s dilution-of-wine idea he used to analogise inflation with). Dilution implies a thinning with something that is much more substantial, which something can and does have value in its proper context. Unlike fiat currency, the credit issued by the expanding bank does have real value independently of its use as a medium of exchange. The problem - and why it is a dilution - is that it does not actually add anything to the overall economy and merely redistributes value from everyone else in the economy to the issuer (and others to a declining degree in the spending cascade that follows).
One could then discuss the interrelationships of inflation and dilution, but I wont go into that. Besides, right at this point in time I don’t have a matching concept for the opposite of dilution in the way that deflation is the opposite of inflation in the fiat context. “Concentration” strikes me as unwieldy in this context. Feel free to suggest something.
JJM
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