Pros and Cons of a Gold Standard

[stone]

Tortoise, I think it is individuals and not just governments that instigate credit money. The system you describe with many decentralized gold money issuers would not prevent individuals moving to informal credit money systems. The Jacksonian free banking era in the US had no central bank and diverse private banks that created mini credit booms and busts. If you had seed to sell and a farmer had land but no seeds and neither of you had any gold, then the temptation would be to set up a credit arrangement without involving paying out a commission to a gold holder. I got the impression that historically that is how credit money typically comes about rather than by government intervention. I thought that for local trade (rather than international trade) precious metals as money have historically typically prevailed over credit money systems only when war has caused too much disruption and mistrust for credit money to function properly. Am I totally wrong about this?

[Tortoise]

Tortoise, do you think 1930s USA (or even the developed world at the present time) show no signs of the paradox of thrift phenomenon? From what I can see there are idle machines and unemployed workers and all that is preventing them from being put to use is the lack of customers able to afford what is on offer.

That's certainly one piece of the puzzle. But I think businesses would be able to absorb a lot of those unemployed workers if it weren't for certain government regulations. For example, minimum wage laws benefit people who already have jobs at the expense of those who don't. In the absence of minimum wage laws, businesses could hire whoever they wanted for as low of a wage as they could negotiate. Instead, you have unemployed people on the one hand who would prefer to be earning money--any amount of money--and you have businesses on the other hand with a lot of work to do but not enough money for payrolls to get it all done at the minimum wage. If the government would simply let those two groups meet each other halfway voluntarily and serve each other by allowing arbitrarily low wages, that would greatly improve the unemployment situation. It wouldn't completely solve it, but it'd help.

Minimum wage laws are just one example. There are others. My point is simply that a dearth of consumer spending may not be the only--nor even the primary--cause of idle machinery and unemployed workers in a recession.

Another thing to consider is that some of the machinery used during a credit bubble should become idle after the bubble bursts, because it may have been used primarily as a result of bubble-induced malinvestment. During the U.S. housing bubble, for example, I'm guessing a lot of machines were being used to pump out all the extra furniture, big-screen TV sets, boats, ATVs, and jet-skis being purchased by people who were using home equity lines of credit based on over-inflated property values, unusually low interest rates, and laughably lax lending standards. Then the house of cards came crashing down and companies realized a lot of the demand for their products had been illusory. They had been producing too much of the stuff... an unsustainable amount of it. I would sincerely hope some of those specialized machines should go idle--the alternative would be to perpetuate a fantasy and contribute to continued misallocation of scarce resources.

If there is stuff in the UK or US that is not done simply due to lack of funding rather than due to it being stupid, then perhaps we need to wonder whether we simply have a demand shortfall situation (ie a paradox of thrift situation).

The bursting of a credit bubble always involves a temporary period of pain, just as most big changes in a person's or organization's life do. The painful transition period is necessary in order to sort out all the misallocated resources in the economy. Nobody--not even a brilliant government official--is sufficiently knowledgeable about the mind-numbingly complex global economy that he or she can redirect the misallocated resources into their proper billion-and-one channels... let alone do it so rapidly and seamlessly that idle machines and unemployed workers are completely avoided as an intermediate step.

These deflationary credit busts simply have to be allowed to sort themselves out in their own time, and that means allowing people to associate and contract with each other freely in order to minimize the friction while the market realigns itself with reality. Sometimes the creation of something new involves the destruction of something that came before.

[Tortoise]

Tortoise, I think it is individuals and not just governments that instigate credit money. The system you describe with many decentralized gold money issuers would not prevent individuals moving to informal credit money systems. The Jacksonian free banking era in the US had no central bank and diverse private banks that created mini credit booms and busts.

The following passage regarding "wildcat banking" in the mid-1800s U.S., taken from the book The Politically Incorrect Guide to Capitalism by Robert P. Murphy, discusses aspects of your comment.

From 1837 to 1861, the federal government left bank regulation up to the individual states. This period of relatively free banking is often viewed as a chaotic wasteland in which individuals could open up a bank and start issuing currency just as easily as they could open up a restaurant and start serving food. The frequent bank collapses and financial panics supposedly proved that unregulated banking was foolhardy.

As with so many other historical justifications of government intervention, this one is largely a myth. For one thing, the era of so-called free banking was hardly laissez-faire; the state governments set numerous regulations, and moreover these regulations may have encouraged the very problems at issue. Second, it is by no means clear why the panics of the 1800s were worse than the Great Depression and rampant price inflation of the 1900s.

How could state regulations make the banking system more precarious? Well, because, as economists George Selgin and Larry White explain, "they required banks to collateralize their notes by lodging specified assets (usually state government bonds) with state authorities." Why did that matter? Because later on, "clusters of 'free bank' failures were principally due to falling prices of the state bonds they held, suggesting that the bond-collateral requirements caused bank portfolios to become overloaded with state bonds." In other words, government regulation actually unbalanced the banking system.

[...]

State regulations that limited branch banking also lent support to fly-by-night organizations. How? Because by keeping reputable, solid banks from sweeping the country, the government ensured that residents in rural areas had fewer banking choices and might have to patronize less stable banks.

Ironically, runs on banks and other "panics" were the very mechanism to keep the bankers honest. In a truly competitive market, if Joe Smith opens a bank, he can't force anybody to hold Smith Notes or force any merchants to accept them at their stores. The only way for Joe Smith to convince the public to accept his bank notes is to pledge to redeem them for a specified amount of gold (or other valued commodity). Assuming he can get his operation off the ground, what is to prevent Smith (and other private bankers) from printing up more notes than he can actually redeem?

One way is to trust government regulators to design an honest system and run it responsibly. Another, less naive, way is to let banks go out of business when they default on promises to their customers. Bankers are grown-ups; they can take it. If they know they'll be held liable for their decisions, bankers will be more careful with their funds. A bank that is deemed "too big to fail"--meaning it will get billions in government bailouts if its investments turn sour--is a bank that takes too many risks.

If you had seed to sell and a farmer had land but no seeds and neither of you had any gold, then the temptation would be to set up a credit arrangement without involving paying out a commission to a gold holder. I got the impression that historically that is how credit money typically comes about rather than by government intervention. I thought that for local trade (rather than international trade) precious metals as money have historically typically prevailed over credit money systems only when war has caused too much disruption and mistrust for credit money to function properly. Am I totally wrong about this?

In your seed/farmer example, using the term "credit money" is unnecessary and probably a bit misleading. I see it as a standard example of lending: you forsake some of your seeds right now in exchange for a larger number of seeds in the future (the amount of seeds you lent plus some more as "interest"). The key is that in that lending/borrowing transaction, you are giving up something in the present, and in exchange the farmer is gaining something in the present. Vice versa when the loan comes due. No resources are magically created by this transaction. And the number of claims on the world's finite resources has not changed as a result of this transaction.

By contrast, when a bank "lends" out money it doesn't have by creating money out of thin air (a fictional checkbook entry), the bank is giving up nothing in the present in exchange for giving the borrower something in the present. So when the borrower pays back the loan plus interest, the bank is effectively pocketing the interest in exchange for doing nothing. The bank did not have to forsake anything in the present in order to enable the borrower to have more in the present. What this effectively means is that the number of claims on the world's finite resources increases until the bank loan is repayed. Same amount of resources + more claims on those resources = inflation. It's like a form of embezzlement: the bank embezzles a small fraction of everyone else's finite resources for the duration of the loan, and its reward for this embezzlement is the interest payment it receives from the borrower when the loan is repayed.

It's defined as embezzlement for me to use my company's computer network to run my own business for my own profit. Yet it's legal for banks to embezzle other people's finite resources by creating money out of thin air and lending it out to borrowers at a profit. Go figure.

[MediumTex]

It's defined as embezzlement for me to use my company's computer network to run my own business for my own profit. Yet it's legal for banks to embezzle other people's finite resources by creating money out of thin air and lending it out to borrowers at a profit. Go figure.

That's an interesting perspective.

If you log onto your company's network to check your email from home using your personal internet connection and computer would the company be embezzling from you?

[moda0306]

I'm not saying that banks aren't subsidized in this venture, but people are completely complicit in this.

If you want to "save" and earn zero interest, put it under the mattress.  You will never earn interest on money AND have it not be used by someone else at the same time, so to ask a bank to have 100% reserve banking means we'll be paying them to hold it for us.  I thought the purpose of a bank WAS to run fractional reserves, and be an intermediary to bring easier borrowing to people who need a loan, and interest to people who are willing to enter a pool of lenders who MAY want their money at some point.  That's what a bank is, isn't it?  In the 1800's, was a bank simply a money storage b!tch that also used some CD's to make mortgage loans?

In fact, we should probably draw a line between "saving" in the sense of setting something aside for later, and "loaning," which is what we do to some degree with all of our money in our checking account and savings account.

If banks were simply a money-storing operation, they'd charge us for the service, not pay us interest on the balances.  In fact, if there was some huge demand for this, then these types of banks would pop up, would they not?  They kind of already do, given the safety deposit box option.  The fact is, whether by sheeple-headed complacency or by conscious will, people want to loan-out, not save (in it's purest sense), their money.  This should calm the use of the word "fraud" a bit in our discourse about fractional reserve banking.

Everyone has their options.  If you want to "save" in the purest sense, hold your own money.  If you want the bank to "hold" your savings for you, get a safety deposit box and pay the fee.  If you want to engage in the FDIC-insured activity that will see your money "loaned out" and you know the bank may not have all your money in its vaults, go ahead and engage in that, and you can earn a little interest doing so.

Now, you say, but the bank gets to lend that money out again!! (something I've been pontificating about) Well that's up to the recipient of the loan!  The recipient of the loan that is, in effect, paying you your interest, CHOSE to put his money back a bank... or spend it... or put it under a mattress... and each of the recipients of the cash he spends have that same choice.  The bank simply agreed at the beginning of this whole process to hold a certain % of reserves.

Not only do I, as an interest-seeking depositor, KNOW the bank will loan out XX% of my money at a higher interest rate than I'm earning, but I also know that if the person the bank lends the money to deposits that loan, that his bank will (or can) do the same thing.

Does this speak to a certain overreliance and trust of fractional-reserve banking by all of us?  Very well so.

Is there some crony capitalism involved?  Yes, but maybe not so much in this area as others.

Is this fraud on behalf of the banks?  Sorry, I'm just not seeing that as being an accurate term.

[stone]

Tortoise, in the example of the person lending seeds to the farmer in return for payment when the crop was harvested- the seed seller was acting both as a seed seller and as a banker of sorts but with just himself as the only depositor. A loan was made to the farmer who spent the "money" on seed. If the farmer's crop fails then the farmer will default on the loan. The seed seller/banker/creditor could also potentially use the IOU from the farmer to exchange for other goods or services whilst waiting for the harvest. The whole edifice would default in the event of a crop failure.
The seed seller and the farmer could alternatively have chosen to employ some sort of professional banker to mediate between them and supposidly to take the risk in the event of the crop failing. In a "hard money" world with no fractional reserve banking they would have needed what in effect would be a venture capitalist to put up the money to buy the seed. The venture capitalist would do so in return for a share of the harvest. The venture capitalist would be taking some sort of equity stake in the farmers harvest. The distinction between that "hard money" solution and the fractional reserve situation is that there is actually somewhere for the buck to stop in the event of a crop failure. In the fractional reserve system the bank would have made the loan to the farmer who would have used it to buy seed and the seed seller would have deposited the money with the bank. Come the time the harvest failed, the seed seller would have gone to withdraw the money from the bank. The farmer would have defaulted on the loan and the bank would be unable to honor the seed seller's deposit unless the Fed stepped in etc etc.
I don't see how a "hard money" world can ever be compatible with money lending not entailing the lender taking on the risk of the enterprise for which the money is being lent. What our current system does is to shelter money lenders from that risk. The massive problem with a "hard money" solution is that by definition people with money have money. Why would they want to risk loosing that money? The tendency would be to just hoard the money rather than risking it by lending it out. That is what causes deflation which makes money ever more valuable and enterprises ever more likely to fail due to customers not having money to buy stuff. That leads to "soft money" solutions being brought into place. That is why I can only envisage a hard money system working if a tax and citizens' dividend constantly keeps money recirculating.

moda, I think money storage (not lending) banks are called giro banks.

[moda0306]

Well saying that we need to drop fractional reserve banking is just ignoring reality.  Maybe we should have people able to check an option with their bank as to whether they want their account to be a "savings storage" account or a "loanable" account, and let it go from there.

Maybe the FDIC shouldn't exist, but that seems to me to be a reasonable user-fee-based service that the government can provide to eliminate systemic risk to a system people actually want to be there.

Fractional reserve banking may be flawed, but it's hardly fraud.  People who want to earn interest can "loan" to a bank, and people who want to save purely can pay for a safety-deposit box or put it in their mattress.  Maybe there should be an option for peoples' checking accounts & savings accounts to operate electronically but still have 100% reserve banking if they want (they'd pay the bank for the storage and transfer of dollars... you think that'd be popular?).

I don't think there's a market for that, though.

[stone]

moda, fractional reserve banking with the Fed behind it is fabulous for depositors. Why would any depositor not want to take up that free service? The cost is borne by everyone else. There is a very great cost because banks lend to create asset bubbles etc etc and when they burst they get bailed out at everyones expense.

[moda0306]

Depositors rarely earn that great of ROI on their savings, so I wonder if it's so "fabulous" except for the safety it provides.

If it's fabulous for anyone, it's the banks.  Borrow at 1%, loan most of it out at 5-10%, and get bailed out if the whole thing goes to crap.

That said, the fed is simply greasing the wheels of a machine that's already there.  Through FDIC insurance and interest rate managment, they're not really fundamentally changing the game so much as tweaking the rules.  People would still want to earn interest on their "savings," and others will want to borrow.  Banks fulfill the role of intermediary.

I'm not trying to defend "all things fiat" here, but simply saying that fractional reserve banking is completely natural.  Attack the fed for how it gets its fingers in it, but to call it fraud on its face because the bank can lend the money back out is complete nonsense (that's what a bank is... that is the service they offer... it's how you earn interest on savings)... at least that's the conclusion I've come to after pontificating about this a bit.

[Gumby]

Interesting observation from Barry Eichengreen's The Great Slump Revisited. As countries went off the gold standard — in the following order: Japan, Britain, Germany, US, France — here’s what happened to their industrial output:

The timing and extend of depreciation can explain much of the variation in the timing and extent of economic recovery. Britain's early devaluation, for example, helps to explain the early date of its recovery so evident in figure 5. Japan's early and extensive depreciation helps to account for its unusually rapid growth in the 1930s. US recovery was clearly associated with the dollar's devaluation. France's delayed recovery was clearly associated with its unwillingness to devalue until 1936...There is a strong contrast between relatively rapid recovery in countries which abandoned the gold standard and the persistence of the slump in countries that maintained it.

[align=center][/align]

Source: The Great Slump Revisited

It goes on in further detail...

[stone]

Moda, I agree that words like "fraud" tend to muddy debate unnecessarily. I think the problem comes from the system where you can lend something to someone else and get a third party to bail you out if you lose what you lent. That is a recipe for reckless lending. That is why banking has steadily increased as a proportion of GDP ever since our system allowed an infinite financial capacity for bailing out banks.

[Tortoise]

I'm not saying that banks aren't subsidized in this venture, but people are completely complicit in this.

If you want to "save" and earn zero interest, put it under the mattress.  You will never earn interest on money AND have it not be used by someone else at the same time, so to ask a bank to have 100% reserve banking means we'll be paying them to hold it for us.  I thought the purpose of a bank WAS to run fractional reserves, and be an intermediary to bring easier borrowing to people who need a loan, and interest to people who are willing to enter a pool of lenders who MAY want their money at some point.  That's what a bank is, isn't it?  In the 1800's, was a bank simply a money storage b!tch that also used some CD's to make mortgage loans?

In fact, we should probably draw a line between "saving" in the sense of setting something aside for later, and "loaning," which is what we do to some degree with all of our money in our checking account and savings account.

Moda, indeed we should! Austrian economists have been saying for years that banks should make that distinction crystal-clear for their customers. As I pointed out a few weeks ago on a different thread, there are two fundamentally different types of deposits in banking: (1) demand deposits and (2) time deposits. Those two types of deposits are completely different and should be treated separately by the bank. Alas, they are not.

Demand deposits are deposits that the bank is contractually obligated to return to the customer on demand. This means if the customer walks into the bank and asks for some, most, or even all of his entire demand deposit balance, the bank is legally obligated to provide it to him in a timely manner (presumably, right then and there).

By contrast, time deposits are deposits that the bank is contractually obligated to return to the customer only after an agreed-upon period of time has passed. During that period of time, the bank is free to lend the deposit out and earn interest on it.

Using your terminology of "saving" vs. "loaning," one could say that making a demand deposit is saving and making a time deposit is loaning. A customer should pay a small fee for the former and earn interest on the latter.

If banks were simply to draw this distinction clearly for their customers, so that a customer could use a given deposit to make either a demand deposit or a time deposit, but not both with the same deposit, there would be no fundamental problem. The problem begins when banks mix, or hybridize, the two types of deposits by lending out demand deposits--actually, quite a bit more than the demand deposits, god bless 'em!--and paying interest on them. That creates an inherently unstable situation that makes it logically impossible for the bank to remain solvent if all of its customers get spooked and demand all of their demand deposits returned at the same time.

If banks were simply a money-storing operation, they'd charge us for the service, not pay us interest on the balances.

Now you're getting it!

In fact, if there was some huge demand for this, then these types of banks would pop up, would they not?  They kind of already do, given the safety deposit box option.  The fact is, whether by sheeple-headed complacency or by conscious will, people want to loan-out, not save (in it's purest sense), their money.

Of course--it's natural to want to have one's cake and eat it too! The problem is that you can't have it both ways. If you want the guarantee of knowing your money will always be there if you need it, you pay a fee to store it somewhere... and perhaps pay slightly higher fees for conveniences like checking and online banking. If you want to earn interest, by contrast, you have to make a sacrifice--you must forgo the money for a certain period of time in order to let the bank lend it out and pay you interest for your sacrifice.

I don't do my banking via a safety deposit box for the simple reason that I can't write checks against a safety deposit box, nor can I use online banking to check the balance in my safety deposit box. If my bank would offer me the option of a true demand deposit checking account, which they would explicitly guarantee would not be lent out, I would gladly take them up on that offer for the money I use to pay my monthly bills. The rest (the money I don't need immediately), I would put in time deposits (such as CDs) to earn interest.

Everyone has their options.  If you want to "save" in the purest sense, hold your own money.  If you want the bank to "hold" your savings for you, get a safety deposit box and pay the fee.  If you want to engage in the FDIC-insured activity that will see your money "loaned out" and you know the bank may not have all your money in its vaults, go ahead and engage in that, and you can earn a little interest doing so.

Or, how about the banks offering an online checking account that's the electronic equivalent of a safe deposit box that I don't have to physically open up with a key to use? Is that such an outlandish option?

If you're arguing that not many people would pay a fee to be certain their money is there when they need it most, I must object strenuously. Treasury bill investors are earning a negative real rate of return right now because they are willing to pay a premium for safety. If more banks were to offer similar safety with the convenience of electronic access, people would likely take advantage of it. Since banks don't offer that, people are forced to find their safety in the arms of Uncle Sam and his T-bills.

Not only do I, as an interest-seeking depositor, KNOW the bank will loan out XX% of my money at a higher interest rate than I'm earning, but I also know that if the person the bank lends the money to deposits that loan, that his bank will (or can) do the same thing.

Does this speak to a certain overreliance and trust of fractional-reserve banking by all of us?  Very well so.

Is there some crony capitalism involved?  Yes, but maybe not so much in this area as others.

Is this fraud on behalf of the banks?  Sorry, I'm just not seeing that as being an accurate term.

Perhaps the word "fraud" is a bit strong, even inflammatory, given that most bankers are decent people just like you and I. But even under a more lenient interpretation of what banks are doing, what we have here is at least a massive, widespread, institutionalized blending of what should be two fundamentally and legally different types of accounts--demand deposits and time deposits--that must remain separate to prevent systemic instability. It's about time people (bankers included) learned the distinction and why we all ignore it at our peril.

[Tortoise]

I'm not trying to defend "all things fiat" here, but simply saying that fractional reserve banking is completely natural.  Attack the fed for how it gets its fingers in it, but to call it fraud on its face because the bank can lend the money back out is complete nonsense (that's what a bank is... that is the service they offer... it's how you earn interest on savings)... at least that's the conclusion I've come to after pontificating about this a bit.

Moda, the banks aren't just "lending the money back out." They are lending the money back out PLUS a whole lot more! Where did that "whole lot more" come from?

The answer is that they are "lending" out lots and lots of money that they simply don't have.

(Sanity check: Am I really the only one on this entire forum [except for maybe AgAuMoney] who doesn't think it's rocket science to be able to spot the inherent theft in the act of "lending" out something one doesn't have? )

[MediumTex]

(Sanity check: Am I really the only one on this entire forum [except for maybe AgAuMoney] who doesn't think it's rocket science to be able to spot the inherent theft in the act of "lending" out something one doesn't have? )

A banker would say: "But if we didn't do it that way we couldn't make any money."

Of course it's fraudulent, but we've sort of all bought into the arrangement to a sufficient degree that it has become legitimate.  That doesn't mean it's not still fraudulent, but it's not the first fraudulent thing that a whole society has bought into.

People will believe all sorts of dumb things if a guy in a suit is the one telling them.  That's why bankers historically have worn suits.

[6 Iron]

(Sanity check: Am I really the only one on this entire forum [except for maybe AgAuMoney] who doesn't think it's rocket science to be able to spot the inherent theft in the act of "lending" out something one doesn't have? )

Tortoise, when I deposit money in a bank, it is with the understanding that I will likely not need all of it immediately, and that the bank will loan some and maintain a fractional reserve, based on historical account activity averages.  I see fraud when the taxpayer has to bail out failed banks with excessive nonperforming loans. But I am not understanding where you see the theft in the act of lending in this system, that I have agreed to, in order to earn interest on my deposit.

[TBV]

Let me throw some red meat into the discussion, if only to stir things up.

Those who deposited money with Bernie Madoff also didn't mind if he made investments with it or lent the money out, so long as they earned interest.  His ability to pay them interest and/or refund portions of their principal rested entirely on his ability to lure new depositors.  He certainly didn't have enough liquidity to repay everyone.  This arrangement was highly popular with his clients until confidence in his system collapsed.  The ability of banks to function is also dependent on the unwitting level of confidence that customers have in the "system."  Had Madoff's system not collapsed, presumably he'd still be in business. Had he been an irresponsible investment banker instead of an irresponsible investment salesman, he might have even been bailed out by the government.  Aside from that distinction, in recent years both types of institutions might be said to have "invested" in schemes of dubious, if any, value.  [I am equating the sale of dubious collateralized debt instruments with investment in phantom securities, both of which were worthless or nearly so.] One wonders, given the high degree of congruence between the one operation and the other, was Madoff's shortcoming simply that his scheme came to a halt?  Or is there something inherently wrong with all pyramid schemes?

Like most people, I was shocked to hear that the former head of NASDAQ could possibly be involved in such an enterprise.  However, is it really so surprising given that the operating premise of both bankers and fraudsters is that they promise money they don't own to several people at once?

[Tortoise]

I don't see how a "hard money" world can ever be compatible with money lending not entailing the lender taking on the risk of the enterprise for which the money is being lent. What our current system does is to shelter money lenders from that risk.

A similar result can be accomplished in a hard-money world by the banks simply purchasing private insurance on their loans. That's what insurance companies do--pool together the risk of a large group of people and use their premium payments to "bail out" any person in that group who would otherwise have suffered a catastrophic loss. Or, for the less libertarian-leaning folks out there, the FDIC could continue to provide that "insurance" in our hypothetical hard-money world.

The system we have is only one way of sheltering bank depositors from default risk. The above example is another way of doing it.

The massive problem with a "hard money" solution is that by definition people with money have money. Why would they want to risk loosing that money? The tendency would be to just hoard the money rather than risking it by lending it out. That is what causes deflation which makes money ever more valuable and enterprises ever more likely to fail due to customers not having money to buy stuff. That leads to "soft money" solutions being brought into place. That is why I can only envisage a hard money system working if a tax and citizens' dividend constantly keeps money recirculating.

Sorry, I'm not quite following your logic. As I just explained, hard-money lenders would not have to risk losing their money if they were to buy insurance on it (or be covered by the FDIC). Also, I've already explained in previous posts why deflation does not continue indefinitely in the absence of government intervention. The economy has inherently counterbalancing forces. As more and more money is sucked out of circulation by savers, businesses do respond by scaling back their operations. But it is impossible for the net saving to continue indefinitely, because at some point the savers will have reached the point of buying only bare necessities like food, clothing, and shelter, and at that point net saving must stop unless people choose to starve themselves to death voluntarily.

I'm beginning to sense the discussion looping back around to where it started, with neither one of us having changed our position on the topic (despite our ostensibly open minds), so I suppose we can just agree to disagree on the Paradox of Thrift. I'll refrain from commenting on that sub-topic any further on this thread.

[stone]

Tortoise, isn't your insurance idea  just another word for the same pooling mechanism that banks supposidly rely on to safeguard themselves against everyone withdrawing money at the same time? If the insurance was good then wouldn't it have to  consist of a pool of stagnant bank reserves exactly matching those that the banks were lending out? In other words it would be a pointless complication? I guess I'm not quite following your meaning. Currently banks are backed by the Fed so that they will always pay back your money up the amount the government guarentees (in the UK it is £50k per person). People with lots of cash do not keep it in deposit accounts because it is not guarenteed. Apple and BerkshireHathaway have tens of billions of dollars of cash and as you say keep it in treasury money market for just that reason. If you really want to use a deposit account that is a giro bank, then does HSBC offer an Islamic banking service with such a thing? Personally I see my deposit account as a state sanctioned fraud conducted for MY benefit at the expense of people who  have little money deposited and yet pay tax (since the risks are spread across all citizens via the central banks backstop of the system).
For me the paradox of thrift thing loops back in because when I see how exposed to risk a non-subsidized money lender would be in a hard money world, I see that people with money would tend to genuinely save money (mattress style) rather than loaning it out. Our system has the spongyness of credit creation out of thin air. I think it is important to get our heads around just how unyielding a non-expanding money economy would be. It is like moving from a modern car to one with steel tires and no suspension.

[Tortoise]

Tortoise, isn't your insurance idea  just another word for the same pooling mechanism that banks supposidly rely on to safeguard themselves against everyone withdrawing money at the same time? If the insurance was good then wouldn't it have to  consist of a pool of stagnant bank reserves exactly matching those that the banks were lending out? In other words it would be a pointless complication? I guess I'm not quite following your meaning.

No, you had commented that you thought lending would be prohibitively risky in a hard-money system, so I was explaining how lenders could mitigate default risk in a hard-money system. What you're describing here is how lenders in a fractional-reserve banking system protect against bank runs. Those are two different things.

Personally I see my deposit account as a state sanctioned fraud conducted for MY benefit at the expense of people who  have little money deposited and yet pay tax (since the risks are spread across all citizens via the central banks backstop of the system).

If the fractional-reserve banking system facilitates the inflation of a massive credit bubble, which subsequently bursts, wreaks havoc in the economy, and ultimately causes you to lose your job and remain unemployed for two years, would you still see fractional-reserve banking as a net benefit to you? Would your state-subsidized bank savings account keep you warm on those cold, rainy nights on skid row?

Our system has the spongyness of credit creation out of thin air. I think it is important to get our heads around just how unyielding a non-expanding money economy would be. It is like moving from a modern car to one with steel tires and no suspension.

Do you consider debt financing to be inherently better in some sense than equity financing? In a hard-money system borrowing would certainly become more expensive, but that would simply tilt more of the economy's overall financing away from debt and towards equity.

If debt financing is indeed "better" than equity financing, please help me understand why. One relative disadvantage I can see to debt financing is that it places a burden of obligation on the borrower in a kind of "master/servant" dynamic.

[stone]

Tortoise, I clearly have given the wrong impression. Like you I think equity financing is the best way. I also think credit expansion is damaging. We agree. The only quibble is that I see our system as feather bedding money lenders to the detriment of people at large. I also see the danger that if that feather bedding were not in place- then money lenders would become money hoarders. That is why I DO think it is a good idea to have a hard money system with purely equity financing but ALSO think it is neccessary to have government mediated fiscal measures in place to ensure money gets recirculated. Hope I've managed to make more sense this time around .

[stone]

TBV, I've wondered whether the Madoff scam was actually all that different from our entire economic system. So much of our system seems based around increasing asset prices. That asset price inflation does not seem to be based on growth of the real economy. In the developed world the growth has been in finance, insurance and real-estate  ("FIRE" sector). To me that looks like a positive feedback loop where credit expansion feeds the value of the FIRE sector and that supposidly gives the collateral (along with government bonds) for more credit expansion.

[moda0306]

Tortoise,

I am not disagreeing with you that 1) there are inherant risks when a society overly-relies on "loaning" vs "pure saving," or that the bank shouldn't be giving us some better options of having a TRUE "demand deposit" option that is still usable to pay bills, make transfers, etc within their electronic or checking system.

The point is, though, that they DO have the money to lend out.  If person A deposits $100 into the bank (we'll say for now it's the only bank the US has) and there's a 20% reserve requirement, the bank then can lend out $80 to person B.  Now if person B decides to take that money to Europe on vacation, that bank won't see the money... nor with the bank see the money if that person takes the loan as cash and goes to different businesses and spends it there.

When the bank gets the money again will be either when Person B redeposits the loan or people he buys stuff from do.  If they put $80 into the bank, now the bank has $100 again, so they can lend out another $80.  The thing is, it took the decision of Person B or other parties to come back in and do business with the bank with their own moneythat created the new deposits.  That $80 is out of the banks hands until someone brings it back in under the terms as they understand them to be.  That person, now is taking the risk that there might be a run.  They WANT to take that risk to earn interest or because of the convenience/cheapness it provides.  But they doesn't change the fact that they are taking $80 of their own dollars and engaging with the bank to earn interest on that money.

Surely just because that $80 came from a loan from the bank, originally, doesn't mean that the people who earned it are banned from engaging with the bank, are they?  What you're saying is that somehow that $80 is "tainted" and can't be freely used by the citizenry.

It comes down to reserves on deposits, and the agreements made around them.  If the banking system agrees to hold a certain % of reserves, that's all it's saying.  If recipients of loans insist on redepositing money into the same scheme, then it's perfectly natural for it to be re-lent out... or at least some of it.

This is a perfectly natural function of both supply and demand for "loans."  People eagerly willing to redeposit their cash into a fractional-reserve loaning system have chosen to do so, on purpose, to earn interest (though we've discussed some road blocks to other alternatives).  That means they are "submitting their fund to be loaned" or adding to the supply of loanable funds... their choice.  For the banks to tell them "no, you can't do that" would be a bit odd.

[Tortoise]

Stone,

Okay, I understand your position more clearly now. Thanks for clarifying it. But I should point out that I have never argued in favor of "pure equity financing." Some level of debt financing will probably always exist, even in a hard-money system, and that's perfectly fine. The hard-money system will just have a higher proportion of equity financing relative to debt financing; that's all I'm saying. For some businesses in certain situations, debt financing will always make more sense than equity financing. But for consumers, simply saving up for purchases instead of taking out loans is almost always the more prudent--and ultimately less costly--strategy.

Also, I still fundamentally disagree with you that in a hard-money system, lenders would become "money-hoarders." Perhaps it would help me understand your position better if you could define the term "money-hoarding" more precisely and how it differs from the situation we were just discussing where a hard-money system simply causes some--but not all--debt financing to switch over to equity financing.

Moda,

I think we are in agreement on the mechanics of how fractional-reserve banking works. But I also think you vastly overestimate the average person's understanding of exactly what they--and the bank--are doing when they make a deposit at the bank.

Joe Six-Pack has never heard of "reserve requirements," nor will he ever care even if he does. All he knows is that every two weeks, his bank account balance increases by the amount of his paycheck, and when he goes to an ATM, he wants money to shoot out when he presses that button. Period.

I don't say this to be elitist or condescending towards people who are less finance-savvy than we are. I'm just saying we should be realistic about most people's understanding of the banking system; that's all. I'm highlighting the fact that the average person has absolutely no idea why he earns interest on his bank deposits. He just knows that he does.

Given that that's the case, I consider it slightly misleading to claim that fractional-reserve banking is acceptable simply because most people voluntarily participate in it. Fraud is illegal not because one person is forcing another person to do something (they are not), but because the true terms of the transaction are partially hidden by one person from the other. I submit that the average person actually believes the money they deposit in the bank is guaranteed to be there whenever they go to the ATM to make a withdrawal. They don't know anything about reserve requirements, the probability of a bank run, or how the bank's lending activities are related to their bank account. Just being realistic here.

[stone]

Tortoise, If there was not fractional reserve banking with credit creation conjuring money out of thin air, then loans would need to come from loan companies that were financed by selling bonds and issuing shares (just like any non-bank company). Handling money would be conducted by giro banks that did not make loans (just electronic safe deposit boxes in effect). Obviously all money would always be in the giro bank but peoples willingness to hold loan company bonds or shares rather than money would determine the cost of getting a loan. The velocity with which savers passed on non-interest yielding giro bank money in exchange for loan company bonds or shares would set the price of lending. If savers were scared of holding loan company bonds or shares then deflation would set in. That's what I meant by saying hoarding rather than lending would be deflationary.

[TBV]

Tortoise, If there was not fractional reserve banking with credit creation conjuring money out of thin air, then loans would need to come from loan companies that were financed by selling bonds and issuing shares (just like any non-bank company). Handling money would be conducted by giro banks that did not make loans (just electronic safe deposit boxes in effect). Obviously all money would always be in the giro bank but peoples willingness to hold loan company bonds or shares rather than money would determine the cost of getting a loan. The velocity with which savers passed on non-interest yielding giro bank money in exchange for loan company bonds or shares would set the price of lending. If savers were scared of holding loan company bonds or shares then deflation would set in. That's what I meant by saying hoarding rather than lending would be deflationary.

Stone:

I, for one, wouldn't be the least skittish about holding loan company bonds/shares, so long as I could stick you with any losses I might incur.  In fact, I might discount my expected rate of interest in return for such a guarantee.  Maybe even just an implied guarantee.  Are you game?  Probably not, since it's heads I win, tails you lose.  Sound familiar?

It sounds like the rate of interest you describe is one that would accurately track the perceived risk in making loans available. Isn't that what an interest rate is supposed to do?

For all those who wish to make below market rate loans available, why not have them pool their funds and lend them out? Credit unions already do that, but apparently they aren't doing enough.  I guess the catch is they too expect to be repaid.