I’ve run across an internet troll or two railing against fractional reserve banking in the past, but I had the impression it was sort of a fringe-of-a-fringe thing, in the same realm as the “NASA faked the moon landings” idea.
(Fractional reserve banking is where the bank can loan out some of the money that is deposited with it, as explained by Professor Stewart in that scene from It’s a Wonderful Life.)
But now I’ve just finished L. Neil Smith’s Pallas (a wonderful and awful piece of escapist fiction that I ought to write more about, related to that Waking from Libertarianism posting that I also ought to write), and in one memorable scene an “overstuffed” banker is arranging a loan to Our Hero from his (Our Hero’s) best friend and lover (a hooker with a heart of gold and a big bank account), and the narrative voice mentions that the banker can’t just lend him money himself because he (the bankers) isn’t rich, and he can’t loan from the bank’s deposits because fractional reserve banking is considered “felony fraud”.
Now L. Neil Smith isn’t exactly a moderate, but I have the impression he’s more or less a mainstream libertarian writer, so this suggests that the idea is at least a bit more popular than secret government treaties with space aliens.
Last time I was within hearing distance of a troll blaming our economic problems on fractional reserve banking, I used a little just-so story to show how it seems perfectly consistent with libertarian ideas about individual liberty and so on. He replied by contemptuously dismissing me as not understanding, which is what that flavor of troll does when you ask a hard question, and I didn’t pursue the issue.
But if L. Neil Smith is saying the same thing, it occurs to me I should write out the just-so story in a little more detail, and put it here in the weblog where it can be picked up by Major News Media.
So, the story.
Without fractional-reserve banking, a banker is just a particular kind of warehouse guy, one who specializes in storing high-value low-volume stuff (like gold nuggets, hundred-dollar bills). You give him a box with your gold in it, and he promises to keep it safe and give it back to you when you ask, for a mere four-fifty a month. Maybe he even specializes in stuff that is valuable solely for its monetary value, in which case you give him two thousand dollars worth of gold, and he promises to give you back the same value in gold (although not necessarily the same actual atoms), when you ask for it, for either four-fifty a month, or possibly some fee scaled to the value of money on deposit.
This guy isn’t going to make much more money than any other warehouse guy, probably; he can charge more per cubic foot because the stuff is more valuable, but then he also has to spend more on security for the same reason; a vault costs more than a simple warehouse, and the guards have to be paid more to resist the extra temptation offered by small valuable stuff that’s easy to resell.
(Similarly, at this stage of the story, an investment guy is pretty much just a matchmaker. In the example in Pallas, where Cherry has lots of money and wants to lend some to Emerson, and they already know each other (in the Biblical sense, even), he serves no purpose at all except to allow Smith to show that he doesn’t like bankers.)
Now one day a warehouse guy of the “you give us money, we give you money back” type notices that there is all this money sitting in his warehouse, and it’s doing nothing. And he starts up a brand-new service, where if you sign up for it, he will take oh say ten percent of the money that you give him, and lend it out at interest. He will then keep part of that interest for himself (his profit on this great idea), and use the rest to lower your monthly fee.
Sure, it’s possible that if you want all of your money back at once, and when he tries to call in the loans that he’s made with ten percent of it, the people with the money won’t be able to come up with it all at once, but that’s not very likely really is it? That small risk is worth the lower monthly fees, at least to some depositors.
And in version 2, he has the bright idea of changing the contract so that it says that if that does happen, he can use on-deposit funds from anyone else in the program to pay back the difference. Then he can only come up short if lots of people want to withdraw more than 90% of their funds at once, and at the same time lots of people that he’s lent to can’t pay up when he calls in the loans. And (since this is such a good idea that he is prospering, and has lots of depositors and lots of borrowers now), the chances of that are so small that he can actually insure himself against it.
This works out really well, and he dominates the money-warehousing market because of his low fees, and dominates the money-lending market because he has lots of money to lend.
Since this is a libertarian just-so story, his success naturally leads to competitors improving on the idea!
One competitor in particular notices that people have so much faith in this whole system now that hardly anyone ever gets cold feet and wants to withdraw even half of their money all at once. So in his contracts, it says that he can use up to 60% of the deposited funds for loans. Also, because he can get insurance against the bank runs that seldom happen anyway, he can say in his loan contracts that he will never call in the loan unless the client doesn’t keep up the payments; naturally this extra sweetening of the loan contract means he can charge higher interest.
His calculations show that with this much money to lend, and these higher interest rates, not to mention needing a smaller vault, he’ll be able to make a modest profit and not only eliminate the monthly fees to his depositors, but actually pay interest on deposits!
Naturally, customers flock to him, and eventually almost everyone in the money-warehousing industry is doing it this way.
So now we’ve got fractional reserve banking: you deposit money, the bank keeps some of it in the vault, lends the rest out at interest, and pays some of that interest back along to you, the depositor. Banks are insured against runs up to some amount. All of this is clearly documented in the contracts between depositors and the bank, borrowers and the bank, and the insurance company and the bank.
There is no fraud of any kind.
Basically, if we want to describe it more briefly and collectively, a bunch of people have got together and said “hey, we never need all of our money at once, so why don’t we pool it together and lend some of it out at interest, and get free profits?”.
It’s not at all clear that there’s any step in here that a libertarian government can step in and stop. No one is being lied to, no one is being forced to do or not to do anything. People are voluntarily deciding to try to maximize their individual utility by making certain agreements with other people. And the result is pretty magic; there’s lots of loan money available to start new companies and invest in new things and carry out research, and yet on the other hand there’s also lots of liquidity, and you can withdraw some money to buy that special Solstice gift anytime you want.
I admit I don’t quite understand the railing against it by internet trolls and L. Neil Smith; but whatever objections they have to the resulting institutional arrangements, it seems pretty clear that there’s nothing inherent to fractional reserve banking simpliciter that a libertarian government can forbid and still keep its credentials.
Unless I’ve overlooked something?