Fractionally Reserved

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?

8 Comments to “Fractionally Reserved”

  1. Pardon me for saying this, but I think you’re making too much sense for the folks who are libertarian without having thought through the implications. The question is going to be how many libertarians there are who HAVE really considered exactly what they’re asking for.

    (Snide side comment: … and how many of those remain Libertarians.)


    • Thanks for the comment! I’ve found that libertarians are often pretty open to rational argument, at least to start with, and at least more than, well, than people whose belief systems are based on a rejection of human rationality in favor of something else. :) I do think that it turns out that various common libertarian assumptions, some explicit and some usually implicit, turn out to be not true of the real world, but other than that little problem :) it’s not a bad belief system.

      I really do need to write that Waking from Libertarianism posting sometime. Or maybe I should not let the Finished be the enemy of the Draft :) and just braindump some notes on it…


  2. It turns out that fractional reserve banking isn’t really true of the real world anymore. When you have a fiat money system, and traditional central banking, banks can cover any loans they like by borrowing from the central bank at the central bank’s lending rate. The banks just have to decide that they want to take on the requisite risk. Of course, fiat money gets various flavours of libertarians even more exercised…

    See various MMT blogs for more on this.


    • Thanks, that is interesting stuff! I searched around a bit on MMT (Modern Monetary Theory (assuming you didn’t mean Million Metric Tons or Meyer Memorial Trust)) and ended up facebooking this overview: ” “.

      I don’t think I’d go so far as to say that fractional reserve banking isn’t true anymore; banks still do have to keep some (tiny) fraction of your deposits in the vault (or the Federal Reserve), but it’s true the government / Central Bank has added so many additional frobs to it that there’s alot more to the story.

      A libertarian can object to those frobs on various libertarian grounds, I just don’t think they can object to fractional reserve banking itself. Until someone points out how I am wrong. :)


  3. That’s a very nice link. Here’s another, more explicitly about fractional reserve banking and the money multiplier:

    The short version is that banks can always borrow from the central bank to make sure that they’re holding enough reserves. And thus, banks are only constrained in their lending by whether or not they think they can make a profit (which will boil down to the cost of getting reserves (from normal depositors, the central bank or wherever), the likelihood of default, and the interest rate they can charge the borrower).


  4. Let’s say that Joe puts $10 into the bank. The bank then lends out $9 under the terms you describe. The $9 actually got lent to Jane. What does Jane do with the $9 while she waits to spend it? Why, she puts it in the bank! Who then turns around and lends $8 to Mike. Who then? Yup… put it into the bank. Who then lends it out. Lather. Rinse. Repeat. In essence the bank, via fractional reserve banking, is allowed to print money. They inflate the money supply. Which has the tendency to devalue the money and thus contributes to inflation.

    Now in theory what prevents this inflation is the fear of losing money. After all if some number of people who were lent money don’t pay it back then eventually there isn’t a full $9 to give back to Joe (remember, $1 was never actually lent out). So Joe loses money. This concern restricts how fast the money supply grows since it keeps people from putting money in banks who aren’t investing it in ‘good things’ and one can argue that so long as banks only put the money into ‘good things’ well then a little inflation is o.k.

    We have literally hundreds of years of examples of a system just like the above and your just-so story and unfortunately they were filled with was endless bankruptcies and recessions/depressions.

    There were several reasons for this.

    First, most people (including the professionals) aren’t qualified to tell good banks from bad. And that assumes they spend all day monitoring their bank. Well having everyone monitoring their bank isn’t a good use of time and most folks couldn’t do a good job of it (or do a good job of picking someone to do it for them, just see the results in our own era of ‘investment advisers’) so the end result was that people used banks a lot less than would be good for everyone because of the inability to tell the good banks from the bad banks (or tell when a bank switched from one to the other). This slowed down the over all economy and made everyone poorer.

    Second, humans aren’t rational (at least not in the Homo Economicus sense). This isn’t an insult, it’s simply a statement of fact (see anything written by Dan Ariely). What happens is that when things are good people are hard wired to assume they will keep being good. And when things are bad, well the same applies. So what happens is that there is a ‘good’ period, people (mostly those who weren’t alive during the previous bad period) forget that ‘bad’ things can happen and they don’t apply enough caution. Suddenly no is worried about bank risk, money flows in, the economy grows, making people think the good times will never end which inflates a bubble which explodes and survivors are overly cautious (thus slowing recovery) until the next generation is born. And yes, Lather. Rinse. Repeat.

    But since the great depression that isn’t how things work. Since then we have deposit insurance which guarantees Joe that no matter what he’ll get his money back (possibly inflated to no real value but that’s a different story).

    And in theory if the government wasn’t suffering from complete regulatory capture it could have regulated the banks such that the probability of a mass loss was extremely low and it could work with the reserve requirements to limit how much money the banks could ‘print’.

    Except it turns out that at least the U.S. government (not to mention most of the governments in Europe) are so completely corrupt that they don’t regulate the banks worth a damn (see the latest scandal with HSBC which proves that the rich are simply beyond any law) so the end result is that the banks have a strong incentive to inflate the money supply since it creates income for them. And their mechanism for doing this is fractional reserve banking.

    Part of the reason that deposit insurance and heavy bank regulations were introduced in the great depression were to get away from this nonsense. It’s hard to argue if they worked because this coincided with WWII when the entire industrial world except for the U.S. and Canada were kind enough to blow themselves up thus leaving the U.S. and Canada with a free hand to make money like bandits. So I honestly don’t know if, even in a perfect world, that deposit insurance and heavy bank regulations would make fractional reserve banking viable.

    Now one can very reasonably argue that in any system in which it’s possible to get loans we get the kind of money supply inflation that we see with fractional reserve banking. Without this inflation there is no credit and societies without credit don’t generally do terribly well. So the goal isn’t to get rid of loans but rather to create entities that manage those loans that don’t benefit if loan mania occurs. This is where books like, Jimmy Stewart is Dead, by Kotlikolf (very easy to read btw) come from. In those you will see that his ideas aren’t all that different than yours. Essentially he wants loans to be put together into mutual funds that the banks aren’t allowed to hold and that people can choose to put money into. These would effectively be closed end funds with a fixed maturity date. At that date whatever money was made is paid out. If too many loans went bad, then you loose money. But the risk is clearer and the banks are taken largely out of the equation. Also loans that aren’t systemically corrupt (vis the mortgage theft debacle) will have very predictable risk curves so one doesn’t have to be a genius to pick a fund that is likely to have a reasonable return. But loss is always possible and that’s the real world.

    This is very similar to your just-so story. But unlike fractional reserve banking the bank can’t control the flow of money. They have no money. The people who buy into the closed end mutual funds are the ones who have to put up the money. If they don’t put it up, it doesn’t go out. So the banks lose control of currency velocity. Until, of course, the good times role and no one cares about risk and banks want to make as much in the way of fees as possible. But at least there are no too big to fail banks.


    • I take it then that you aren’t a libertarian, Yaron? Not that that’s a bad thing necessarily :) just want to make sure that this isn’t proposed as an answer to my question about why libertarians in particular might be against fractional reserve banking.



Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: