Tuesday, November 11, 2008 36 Comments

A quick explanation of "fractional-reserve banking"

Elsewhere, Eric Posner, Walter Block, and Bryan Caplan debate "fractional-reserve banking." Aren't you glad you read UR, rather than these other blogs, with their little premasticated spoonfuls of brain? Here at UR we don't send you away hungry, that's for sure.

It pains me to have to say that all three participants in this debate are out to lunch. Posner and Caplan get the wrong answer for the right reason. Block, and the Rothbardians generally, get the right answer for the wrong reason.

The critical fact about FRB is that it's a special case of our favorite financial solecism, maturity transformation. As I explain in more detail here, MT is the cause of the credit cycle, including of course our current unpleasantness. It is a source of grim hilarity to me that, almost a century after Mises first discovered this, most people still don't get it.

100%-reserve banking, as Block proposes, is of course MT-free and thus not a cause of credit oscillation. So, again, he gets the right answer. But I suspect what strikes most readers about the dialogue is that Posner and Caplan seem more or less sensible, while Block seems to have some weird abstraction he can't let go of. So let me provide a brief overview and try to straighten everyone out.

In classical "fractional-reserve banking," a bank balances liabilities which are demand deposits with assets which are loans of nontrivial maturity. Let's assume for simplicity that our currency is gold. So a fractional-reserve bank might issue notes redeemable for 100kg of gold, while having only 10kg of gold in the vault, plus bonds whose net present market price is 95 kg. Our bank's "reserve ratio" is thus 10%, and its "leverage ratio" is 20 to 1 (because it has liabilities of 100kg and capital of 5kg). Rocket science, this ain't.

Block asserts: the bank is fraudulent, because it does not have the gold to redeem its notes. Posner and Caplan assert: the bank is solvent, because it can sell its bonds for 95kg of gold. In a frictionless market, this transaction can happen as fast as customers can redeem.

Posner and Caplan are hereby directed to Arnold Kling, who seems to have finally understood the problem with MT. In short, the assumption that mark-to-market accounting and frictionless transactions imply that term loans can be liquidated at market price is wrong. It ignores the collective game theory of the bank-run problem.

Briefly: the price of a bond or loan is a function of its interest rate. Interest rates in a free market are set by supply and demand. In a bank run, all banks must sell future money for present money, driving yields arbitrarily high and loan prices arbitrarily low. An obvious, extreme, but historically common absurdity occurs when the financial system as a whole has issued more demand notes for present gold than the amount of monetary gold in the world. (Believe it or not, this was the case even for the 19th-century "classical gold standard.") There's simply no way it can redeem. Time travel is impossible; transmutation is impractical; matter is conserved.

So Block is right. In general. However, Block's argument (not his, but originally due to Rothbard) is awfully strange, and bears only a remote resemblance to either logic or reality. I suspect that this confuses a lot of people into thinking that there's no there there, FRB is fine, these are not the droids we're looking for and the financial system may go about its business. Let me try to untangle Rothbard's twisted libertarian reasoning for you.

Rothbard, certainly one of the 20th century's top five philosophers, was a generalist and synthesizer of incredible breadth and power. What strikes the reader of Rothbard immediately is his razor-sharp consistency: hardly a piece is out of place. It is almost impossible to find a crack in his edifice.

So how does he get to this weird view of FRB? He starts with an ethical premise: slavery is wrong. If slavery is wrong, it must be unethical to sell myself into slavery. In the world of Rothbardian ethics, this is because I have inalienable rights which I cannot alienate (sell), namely, the control over my own body, which will always be mine no matter what I do.

(I part ways with Rothbard here. While hereditary slavery is more debatable, I don't have a problem at all with selling yourself into slavery. For me, a contract is an enforceable promise; removing my option to make enforceable promises cannot benefit me. If you don't want to make the promise, don't sign the contract. And promising to be your faithful servant so long as you and I shall live is a perfectly normal, legitimate, and (in a sane world) common sort of promise.)

In order to keep slavery illegal, Rothbard has to reach for what I consider a very odd definition of a contract. To Rothbard, a contract is always a transfer of goods. So, for example, if you pay me $1000 in exchange for painting your house, I have not entered into a slave-like bond to faithfully paint your house. Rather, I have transferred to you the shadowy, metaphysical, and thoroughly virtual object of a paint job on your house. If I then fail to paint your house, I have in a sense stolen your paint job, and thus am a thief.

This is why the idea of a bank deposit as a bailment contract is so appealing to Rothbard. It fits his definition of a contract perfectly. It is also perfectly clear that if the bank and its customers agree that the contract is a bailment, and notes are warehouse receipts, a fractional-reserve bank is fraudulent. Historically this is a very common case, and Rothbard knew his history.

However, the suggestion that openly-agreed fractional-reserve banking is fraudulent is - as Posner and Caplan point out - untenable. (Remember, Posner and Caplan follow their correct argument to the wrong answer because, while open FRB is not fraudulent, as a case of MT it remains imprudent - for the depositor. Unless of course it is insured by a fiat issuer acting as a lender of last resort. Which is equivalent to the case in which the LLR is an LFR and just makes the loans itself. As it seems to be doing these days. But I digress.)

Moreover, Rothbard slips here. His argument is untenable even in terms of Rothbardian ethics. There is a crack in the great edifice.

Rothbard approves of the normal financial practice of term loans, or as he calls them "time deposits." In a time deposit, A gives B $(X) at time (T), in exchange for the promise to return $(X+k) at time (T+u). Of course, as a Rothbardian contract, this promise becomes the shadowy construct of virtual future money.

The problem is that a demand deposit is an extreme, but qualitatively indistinguishable, case of a time deposit. A demand deposit is the limit of a time deposit as (u) approaches 0. For example, one might imagine a time deposit in which case (u) equals one second. When the loan times out, it is automatically renewed (rolled over), unless of course you are standing at the ATM and you want your money back. In which case you have to wait one second for your latest loan contract with the bank to time out, and the bank to return your money.

This clearly has exactly the same practical effect as a demand deposit. If a second is too long to wait at the ATM, we can make it a tenth of a second, etc. And it is clearly a time deposit. And there is certainly no way we can draw a line at any interval of time, and say that if the term of the loan is more than five minutes it is nonfraudulent, and if it is less it is fraudulent.

Thus, Rothbard and Block are just plain wrong. But they get the right answer anyway, because FRB is a special case of MT and MT is harmful. The real reason that 100%-reserve banking will defeat FRB in the free market is that depositors will avoid financial institutions that practice MT, and absent MT the natural rate of interest at a term of 0 is 0 - because there are no productive investments that can produce an instant return on capital.

36 Comments:

Anonymous kaseer said...

Would you then say that whenever the mere possibility of a bank run exists, a bank run will inevitably occur?

In this sense, A self fulfilling panic is always a panic overdue.

And isn't there another side to this story, which is that the surplus that the money-maker (private or public) makes from FRB is really an illusory tampering with the unit of measurement of output that creates no benefits, since it doesn't increase the economic activity of a society, only produces an illusion of doing so.

A free market in currencies would then drive out FRB simply because it is a form of monopoly rent extraction that state-sponsored currency monopolies have exercised. Right?

November 11, 2008 at 8:37 AM  
Anonymous Curve of Freedom said...

I part ways with Rothbard here. While hereditary slavery is more debatable, I don't have a problem at all with selling yourself into slavery. For me, a contract is an enforceable promise; removing my option to make enforceable promises cannot benefit me. If you don't want to make the promise, don't sign the contract. And promising to be your faithful servant so long as you and I shall live is a perfectly normal, legitimate, and (in a sane world) common sort of promise.

But but but Mista Moldbug, faithful servant and slave aren't the same thing! Are they? Slaves lack civil rights, including the right to sue. Also, they lack the right to own property. If they have both of those rights then, in the sense used mostly in the English-speaking world, they're not slaves. (I know "slave" is the translation of words from faraway places used to describe, you know, high-ranking civil servants, elite soldiers, and the like. This is a translation problem. "High-status public servant bound to his job" should not be translated into slave. Didn't George Schultz have his offer resign rejected several times by Bush I? Schultz the Slave???)

Problem I - Right to Sue: I sell myself to my noble master Mencius I of the Duchy of Castro. In the contract, I specify that while I'll be Slave of Mencius, I will not wash any windows, or marry anybody I'm not in love with, or eat any Hostess products. Then Mencius orders me to have a Twinkie and wash his windows real good. I refuse. He refuses to feed me. I sue him for food. Does the judge accept my suit, or does she Taney my tush right out of court? If it's the latter, my contract is not really a contract, since it admits only one detail - that I am a slave. All other details in the contract die before that detail, since you can just starve/beat me to death. Part of the nature of a contract is that it can be as detailed as the consenting adults agree to, right?

Problem IA: The contract details that I have no right to sue. Then someone comes along and beats up my kid right there on the playground. I can't sue, and Mencius I is too busy to make the case. Who protects my kid?

Problem II - Right to Own Property: You've already dismissed this one in a previous post, I think (I'll try to find it for TGGP when he asks). It is irrational for me to sell my right own property, because then the money that you pay me more it will be yours. Minor irrational decisions don't prove someone insane, but major/ permanent/ irreversible ones do. Loons and/or people who don't understand property rights can't enter into binding contracts. I know you'll disagree with me there, but that's my feeling.

And, regarding the last part - why do you think this is/would be a common sort of promise in a sane world? I'm stumped on that one.

(Sorry to take this discussion off of $ary policy.)

November 11, 2008 at 10:48 AM  
Anonymous Leonard said...

The real reason that 100%-reserve banking will defeat FRB in the free market is that depositors will avoid financial institutions that practice MT

It's worth pointing out in this connection that there is an obvious financial attack available against any MT banker:
(1) make a large demand deposit.
(2) wait for a while. Let them loan up fully
(3) short their stock
(4) withdraw the large demand deposit
(5) spread rumors of their insolvency

Variants are possible, i.e., add step 6:
(6) step in as "white knight" and buy MT bank at discount before they firesell too many assets

So, it's not just that you rely on common people being smart about avoiding MT.

November 11, 2008 at 10:57 AM  
Anonymous Curve of Freedom said...

kaseer, tell me more about the free market in currencies. Is this what prevailed in that couple of decades after Jackson vetoed the Bank of the United States? I think the argument against that is transaction costs are too high, right? Any estimates of the increase in transaction costs that would occur under a free market in currencies?

I myself have enough trouble finding change for a soda machine. Shouldn't Gresham's Law guarantee that my ATM gives me a roll of quarters instead of a freakin' $20 bill? Srsly though, I really don't know how multiple currencies would work for ordinary folks.

November 11, 2008 at 11:17 AM  
Blogger TGGP said...

Block does not accept Rothbard's position on indentured servitude/voluntary slavery. So his objection is is because he thinks its fraud due to the impossibility of the terms.

Posner/Caplan aren't arguing about whether the firm is following a good business practice (maybe Posner is), but about whether its fraudulent, because that's what Block is arguing about. The free-bankers like Hummel also reject government fiat money, so bringing that up is not any objection to Caplan.

Also, Arnold Kling doesn't think fractional reserve is necessary for bank runs and hasn't come around to 100% reserves.

November 11, 2008 at 11:30 AM  
Anonymous Anonymous said...

"Rothbard, certainly one of the 20th century's top five philosophers"...

That's funny. You economics & computers types are funny, even you with your subtleties, MM.

November 11, 2008 at 11:40 AM  
Anonymous Curve of Freedom said...

Wuzzat Anon? You're not going to give us your top 5?

Or at least tell us if Christopher Lasch and/or Eric Voegelin are on it??

November 11, 2008 at 12:00 PM  
Anonymous Anonymous said...

All I see from TGGP is "blah blah blah does not blah blah does not blah blah blah" without any reasons to support his argument. Way to go man, you are SUPER.

November 11, 2008 at 2:40 PM  
Anonymous Terry North said...

curve of freedom:

Shouldn't Gresham's Law guarantee that my ATM gives me a roll of quarters instead of a freakin' $20 bill?

Gresham's Law guarantees that the ATM gives you quarters instead of silver dollars.

November 11, 2008 at 3:11 PM  
Anonymous sj071 said...

I am a huge fan of MM's musings but this smells like 'fiddling while Rome burns'.....

Given that those nasty Germans consider GM = 0 in a real life, this particular post reads like IT freshmen discussing the 'truth' behind the Matrix trilogy...

November 11, 2008 at 3:39 PM  
Anonymous Curve of Freedom said...

Yes Terry North, a quick Google search revealed that I had remembered Gresham's Law all wrong. It's not the nominal value of Money A vs. the nominal value of Money B, it's how much of the nominal values are real. A subtle point which is joined by dozens of other economic points in being lost on me.

Me, I think Gresham's Law should be banned, along with marijuana, greed, and squinting. I want my silver dollars!

November 11, 2008 at 4:24 PM  
Blogger TGGP said...

Apologies for the lack of links, Anonymous. I only had a few minutes available and just wanted to get out some quick points.
Block on selling yourself into slavery here.
Kling's praise for MM is similar for MM's praise for Caplan: good thinking, wrong answer. In the post MM links to Kling says we would be likely to see two different kinds of banks in the absence of government intervention. MM thinks there would just be one.

Posner is a law professor, so in his post he discusses contract vs property rights. Whether 100% would outcompete fractional is not really his focus (which makes sense as that's not what Block was arguing about). If you read Caplan's linked post he clearly states that the subject is the "moral legitimacy" of FRB, rather than the solvency. In the Caplan post that Block originally quoted Hummel is said to debunk the view that FRB is "fraudulent" (quote-marks in the original). Do a search for "solvent" or "bankrupt" in the Caplan-Block article at LRC and you will find nothing.

Off-topic, but for those who can't get enough upstart Austrianism check out Matthew Mueller's Post-Austrian Economics.

November 11, 2008 at 4:31 PM  
Anonymous Nullify said...

Top 5 in no particular order.

Hmmmm. I'll get back to you.

November 11, 2008 at 5:21 PM  
Anonymous kaseer said...

Curve of Freedom,

I'm no expert on Jackson's era, but will answer based on what I do know.

Gresham's Law actually only applies when currencies are backed by the state. If the state backs a bad currency (one based on Fractional Reserve Banking and/or being highly inflated) by using its monopoly of power, and its ability to enforce legal tender, it will drive out all competitors with good money who are not inflating but cannot compete with the state's guns.

In a free market, as Hayek and George Selgin will tell you, Gresham's Law applies in reverse. Any money that is in any way bad will simply disappear, and quickly in my opinion, because as soon as people get a wind of it being bad, they will stop transacting with it and would resort to another one. Only the best can survive.

The transaction cost argument is completely wrong because private actors competing to provide any good will always do it more efficiently than the state, at least in the long run. If you think transaction costs would be too high, then presumably you'd also want the government to manufacture and distribute computers to make sure ours can all play nicely together. No. The market does a much, much better job.

The best case to see this is to look at the emergence of private coinage in Britain at the dawn of the industrial revolution. As the mint didn't care about making coins for the non-aristocracy, private minters took it upon themselves to make money that was traded excellently and didn't have any of the problems we have today. Until, that is, the state decided to get in on the action, ruined it all, and enforced a monopoly. Check out George Selgin's Good Money for a good discussion of this fascinating story.

The reason the money supply in America is shafted (in monetary terms, but also in terms of the dumb way the bills and coins are made) is precisely down to it being a state monopoly.

I would strongly recommend you check out Hayek's Competition in Currencies. It's a short paper, written shortly after he won the Swedish Central Bank Bribe for Economists. As soon as he got the recognition from the church of economics, he started writing about this issue, but sadly, he was largely ignored by the mainstream.

November 11, 2008 at 6:05 PM  
Anonymous Curve of Freedom said...

If you think transaction costs would be too high, then presumably you'd also want the government to manufacture and distribute computers to make sure ours can all play nicely together.
-kaseer

Oh, dear, no, I don't "think" any such thing. I just "idly considered" that the transactions costs might change. "Think" implies I have two brain cells to rub together on this matter!

My thinking was: currencies in the pre-EU European Economic Community used to compete, right? The soft ones always looked crummy compared to the hard ones (i.e. the pound and the Deutschmark, if I remember correctly). So, as Thatcher's monetarists and their German equivalents argued, hard money would win in a fair fight, which it should, because inflation is a bastard who deserves a good beating.

Not exactly a nuanced viewpoint, I know, but it's the best I can do.

Anyway, the thing is, changing from one currency to another has a cost, right? Like, arbitrage has a profit which is less than its gross receipts? If that's the case, I would think having more than one currency in a given country would have costs too. One of the currencies would be run by hard money types who know what they're doing. They issue kaseers. Then their competitors issue CoFs, but those are only, say, 95% as hard as the kaseers. Folks move away from CoFs; the best hotels in town only take kaseers, middle-class guests are left at the front counter late at night with red eyes, husbands and wives going through their wallets finding only CoFs.

Wouldn't this have a cost? Maybe it would be small, but it would have to bigger than the current situation, which involves only one currency. I'm not saying the government currency monopoly doesn't impose worse costs (e.g. the inflation bastard - anyone who lived through the 70s should want him tried, convicted, and hanged).

On the whole, I'm pretty sanguine about the effects of massive currency reform. Simple procedure: stick all the money in a vat of acid and only use what remains at the end of the process. It would work fine until someone started coating greenbacks in glass.

Seriously though, I'm dead sick of the perennial, almost neurotic fear of bank runs. It stands to reason this fear has negative economic effects even outside of recessions - neurosis generally seems like a bad thing.

I feel like fractional reserve banking is like flying a plane, where gold-standard stuff is like driving a car. Everyone assumes that the plane-crash danger is acceptable because planes fly faster, but then the Austrians come along and measure the airspeed as being equal to or less than the road speed. (This is a terrible metaphor, because planes crash less than cars, but imagine that the plane is being flown by someone with the aviation skills of the average driver.)

The Keynesians say that fiat money is superior because commodity money (I guess that is what gold is, since gold is useful for fillings, art, etc.) allows periods of deflation with no central bank empowered to countercyclically expand the money supply. So, what happens if there is deflation? Absolute meltdown, say the Keynesians. What say the Austrians, goldbugs, etc.

Thanks for the reading recommendation. I'll get to it after I baste the chicken.

November 11, 2008 at 6:34 PM  
Anonymous Curve of Freedom said...

I left out some words here:

"Maybe it would be small, but it would have to bigger than the current situation, which involves only one currency. I'm not saying the government currency monopoly doesn't impose worse costs"

I mean, the total costs of fiat money are probably more than the total costs of free-market goldbuggy-type money, I just think there is a (smallish?) transaction cost associated with the latter alone.

November 11, 2008 at 6:36 PM  
Anonymous kaseer said...

Curve of Freedom,

In your scenario, what would happen, provided government stayed out, through arbitrage and free exchange, is one of two things:

1- The price of CoF's would drop to take account of the increase in production, and their exchange rate would soon enough expose the minters' profligacy with their printing press.

2- People would just completely drop CoF's, since why the hell would you bother anyway when kaseers are available and are fully reliable.

Another scenario is that kaseers' issuers would buy out CoF's issuers' gold and make more kaseers.

The number of currencies remaining in circulation in a world of private banking is not something we can forecast, anymore than you could've predicted how many potato producers would exist in Russia after the Soviet state gave up its potato production. It's a purely ecologically determined outcome. Maybe we'll get a few in each country, maybe one in each country, maybe a few for the whole world, maybe different moneys for different things. Nobody can tell ahead of time.

On pre-Euro Europe, the one problem that prevented healthy and useful currency competition is that all these countries had an army and a state monopoly of legal tender backing them. No matter how badly Spain abused its currency, you still had to use it in Madrid, or Tio Carlos would stick a bullet up your skull. This can hardly be called a free market. Further, the whole system since WWII has been confusingly and incestuously backed with green papers from Uncle Sam making the whole exercise a sham.

This gets us to what Hayek referred to as Monetary Nationalism, which is a very bad thing, he (and I) would argue. To understand this fully (something I certainly cannot claim myself) I recommend a large bottle of Scotch whiskey, a strong stomach and a night in the company of Hayek's Monetary Nationalism, available online. If this book doesn't make you really worried about the next 10 years of human history, then you probably can't read.

As for deflation, it is not the monster you have been brought up to hate. It's actually at worst innocuous, though likely beneficial. With deflation, less money can buy more stuff. That's good. In a free market for money, economic growth, led by growing productivity, would lead to a drop in prices over time. Over the years, money could arguably continue to deflate and we would need smaller and smaller denomination units to accommodate our increasing purchasing power. Nothing is bad about that.

When Turkey lopped off six zeros from their currency a few years ago, nobody became destitute; prices adjusted and everyone got on with their lives.

Finally, the important point to keep in mind is that none of these answers I offered are set in stone. We don't know much about how a free market in currencies would look. But what we do know is that like with computers and potatoes, the private market would provide a much better currency system. Selgin's Good Money, and various other writings by him should make this clear.

November 11, 2008 at 7:02 PM  
Anonymous Curve of Freedom said...

"People would just completely drop CoF's, since why the hell would you bother anyway when kaseers are available and are fully reliable."

This is perfectly understandable but I don't know where a currency goes when it it's dropped. Surely people don't just dump it down the sewer. And CoFs aren't as soft as Marks were in those bad high-inflation years of Weimar Germany, when people were burning them for heat.

Would CoFs be hoarded? Quite the opposite, I'd think, but wouldn't that mean that the ... velocity? ... of CoFs would increase?

Is it just that institutions sell their kaseers for CoFs because the rate is so good, and put their CoFs into mutual funds because THAT rate is even better? That would be my gut feeling.

But maybe you've already answered my question. CoFs could theoretically just be melted down, technically a similar process to burning paper Marks in the 1920s, since the activity is designed to regain the inherent value of a debased currency.

November 11, 2008 at 7:34 PM  
Anonymous kaseer said...

curve of freedom,

That's a very interesting question, and to be honest, I cannot claim to be able to foresee how the market would handle such a thing as a private currency being debased.

One scenario is the Betamax scenario: one day, a lot of people decide CoF's are worthless (or worth less) and start a stampede away from them, which would quickly have their issuers selling their gold. As more people move away, more people have an incentive to move away.

The other is the more gradual, which would see the value of the currency drop to match the supply of gold (or whatever) in CoF's coffers. We should remember there is still gold in their coffers, and so CoF's is still a claim on value, though at lesser price.

I would think the second scenario is more likely initially, but then the negative brand name of CoF's would lead to a takeover of its reserves by people with a better name, or a new competitor.

Anyone else care to venture a guess, or god forbid, an informed opinion to counter my ranting?

November 11, 2008 at 7:43 PM  
Blogger G. M. Palmer said...

to veer a bit:

100%-reserve banking will defeat FRB in the free market

Wait, what?

Isn't FRB inherently bad money? Doesn't bad money always win against good in our financial Ragnarok?

Unless you mean in an actual free market, which is to say, a government and regulation-free market. But in one of those, FRB would never exist (or not for long, anyway) because there would be no LLR.

But under the current system there's no good reason not to practice FRB, especially if you can give yourself lavish retirements with the ensured bailout booty.

November 11, 2008 at 8:11 PM  
Blogger TGGP said...

G. M. Palmer, the "free-bankers" such as Selgin, White and Hummel argue that FRB did in fact exist in the absence of government providing a lender of last resort and those systems persisted for a considerable length of time (over a century in Scotland). When the government did intervene, it was not because the banking system had collapsed.

November 11, 2008 at 9:51 PM  
Blogger Daniel A. Nagy said...

I disagree that issuing more demand notes for gold than there is gold makes their redeeming impossible. Similarly, the argument in "Zeitgeist" (a popular propaganda movie about the evils of the present monetary system) that the fact that central banks lend at interest and they are the only source of money makes sure that someone will get bankrupt, is also bogus.

Suppose, you owe me 5 kilos of mencium, and there are only 3 kilos of mencium in the universe.

No problem! You mine all those 3 kilos, repay 60% of your loan, then sell me some groceries, provide me with accommodation and internet service for an extended period of time: I will pay you with mencium. Once you earn 2 kilos of mencium by selling goods and services to me, you can pay back the rest of your debt. Voila, you covered a debt of 5 kilos of mencium with only 3 kilos of the stuff in the known universe!

November 11, 2008 at 11:39 PM  
Blogger Less Antman said...

The debate was over whether FRB is FRAUDULENT.

November 12, 2008 at 1:22 AM  
Anonymous terry north said...

daniel a. nagy:

I will pay you with mencium. Once you earn 2 kilos of mencium by selling goods and services to me, you can pay back the rest of your debt.

The problem you would run into is that as the quantity of mencium on the free market goes to zero, the price of mencium would goes towards infinity (for a recent example of this see the Porche-VW fiasco) and your ability to repurchase 2/3 of the total supply of mencium at such marginal rates is quite suspect.

In short, you are ignoring the fact that I as the loan issuer could force you into breach of contract, and might if it were rational for me to do so.

That isn't to say that this doesn't happen all the time. It's just that usually no single actor has enough of the pie to be able to reason effectively about global effects.

As a practical matter, I suspect that banks have to reach some minimum level of leverage before bank runs become endemic. Your example would look quite different if you owed 60 kg instead of 5 kg.

November 12, 2008 at 2:37 AM  
Anonymous terry north said...

Apologies. Somehow I got the loan issuer and recipient swapped.

November 12, 2008 at 2:52 AM  
Blogger Daniel A. Nagy said...

Oh, I definitely agree that there is a huge upward pressure on the price of anything which is owed in excess of its actual quantity in existence. The VW Porsche fiasco was the first example on my mind as well.

I was just saying that it is not true that such debt cannot be settled.

November 12, 2008 at 2:56 PM  
Anonymous nazgulnarsil said...

Daniel, I recently watched zeitgeist to see what all the fuss was about. It is the documentary equivalent of shock and awe. Hit your audience with so many claims of corruption and malice that by the time you start making suggestions to fix things (i.e. pushing your own ideological agenda) the audiences capacity for critical thought has been exhausted and can't put up a good fight.
the only section of that movie with useful factual data is the section on fractional reserve banking, and even that is shot through with propaganda techniques.

Do any more intellectually honest documentaries exist about the subject?

November 12, 2008 at 3:51 PM  
Blogger Daniel A. Nagy said...

I don't. Zeitgeist, of course, is crude propaganda; its importance lies not in its inherent qualities (or lack thereof), but in its impact. You wouldn't believe how popular this piece has become.

November 14, 2008 at 12:23 AM  
Blogger Daniel A. Nagy said...

I mean, I don't know. :-)

November 14, 2008 at 12:24 AM  
Anonymous winterspeak said...

Mencius: I don't think FRB is a special case of MT. FRB is this weird halfway chimera -- neither fish nor fowl -- that has come into existence as the mental model we have in our head for money is close to the gold standard, while in reality we live in a fiat world.

If you're on a gold standard (or some "money is a store of value" model) then FRB makes no sense for all the reasons Rothbardians say -- it really *is* essentially immoral! How can you be giving away my money?!

But if you're in a fiat world, then FRB makes no sense either. Why bother with this weird "reserve" thing when, in practice, you simple make all the loans you think are good, and then borrow the reserves you need either from other banks (the interbank lending market) or the Fed directly through the Federal Funds window? In our mind, we think that people first deposit their money in banks, and then banks make loans. In practice, banks make the loans first, and the act of making those loans create the deposits. A bank does not need to hold money "in reserve" any more than the NBA needs to hold points "in reserve" on the off chance they have a high scoring game.

Note that none of this has anything to do with MT. MT can exist (or not) in both a gold standard world and a fiat world. FRB is not a special case of MT, it is an atavistic chimera which should just be done away with as it 1) makes no sense in a gold standard world and 2) makes no sense in a fiat world. Given how ridiculous it is, it's a good thing it has no actual operational impact at all today. Eliminating it would just help everyone understand how much of a non-issue it is, letting us all think about more important things.

-winterspeak

November 14, 2008 at 8:22 AM  
Anonymous kaseer said...

Curve of Freedom,

You said: "This is perfectly understandable but I don't know where a currency goes when it it's dropped."

I apologize, but for some reason I completely ignored this when i answered you. When a currency is dropped people take it back to the issuer to ask for their gold (or whatever) that should be on demand at the issuer's vaults.

If a good 100% gold currency is dropped for whatever reason (bad graphics on its paper make it extremely unpopular compared to the other currency with pictures of Bond Girls in the buff) anyone with a bill can go back to the issuer and ask for their gold. As more and more people stop using it, more and more people have an incentive to stop trading with it and so take it to the issuer to get their gold. The issuer's gold reserves diminish until they disappear, which is precisely the point the currency stops existing and becomes a pile of worthless paper in an empty goldless vault (A bit like today's central banks, one could snark, and one wouldn't be too wrong).

But this is all nice and dandy and nothing bad happens in it to anyone, except the currency makers who are now out of business and may need to rediscover their pizza delivery talents.

If, however, a currency is debased and isn't matched with gold, then as soon as someone suspects it, it will trigger a run on the bank that will result in the bank being declared insolvent and the note holders getting back only the fraction of their gold by which the currency issuer had debased their currency.

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