Month: February 2014

Fractional Reserves in Free Banking

Fred Foldvary Economics, Liberty , ,

by Fred Foldvary

A bank is a firm that accepts funds as deposits. The generic term “bank” includes various institutional types, such as credit unions. The bank is an intermediary between savers and borrowers. The interest paid by borrowers pays the expenses of the bank, and what remains is paid to the depositors.

There are two ways to organize a banking system. The first is with central banks, such as the Federal Reserve (the “Fed”) in the USA. The central bank issues the currency and regulates the private banks. In the USA, the Fed includes regional Federal Reserve Banks, which are the bankers’ banks. The private banks hold accounts with a Federal Reserve Bank; the funds are called “reserves.” The Fed creates money by buying bonds: it pays the seller a check, the seller deposits the check into a bank, the bank presents the check to the Federal Reserve Bank, and the Federal Reserve Bank covers the check by increasing the reserves of that bank, thus creating money out of nothing. The interest income from bonds pays the expenses of the Fed, and the remaining interest is paid back to the US Treasury.

The other method of banking is with free-market banking, or “free banking,” whereby there is no central bank; the private banks issue their own currencies and are not restricted other than by laws that prohibit fraud. The banks would usually use the same unit of account, such as the dollar or euro.

There are two ways to do banking. The first is called “one hundred percent reserves” or “full reserve” banking. In that method, the bank may not loan out the funds that are deposited. One of the challenges of banking is that with checking accounts, also called “demand deposits,” the account holders may withdraw their money at any time. In contrast, loans are typically long term, such as for mortgages or business loans or car loans. So if depositors suddenly want to withdraw much of their funds, the money will not be there. With full-reserve banking, the money is always there, but the bank get no interest payments. The depositors pay a fee to have their money stored at the bank.

The workings of a banking system also depend on the money system. The three basic types of money are 1) commodity money, where a commodity such as gold or silver is used as a general medium of exchange, 2) a fiat money system, in which the currency has no fixed convertibility to any natural commodity, and 3) an artificial-commodity system, where the unit of account is constructed in a way that limits the supply.

With commodity money, banks create money substitutes convertible to the real money at a fixed rate. For example, if gold is the real money, banks issue paper currency convertible into gold, so that, for example, a $20 paper note can be exchanged for a $20 gold coin with $20 worth of gold. All government-created money today is fiat. With fiat money, the real money is paper currency and coins, and bank deposits are money substitutes. The prime example of artificial-commodity money today is the bitcoin, an electronic currency created by computer programs.

The other method of banking is called “fractional reserve banking.” With that method, a bank holds only a small fraction of deposit funds in its reserves. Governments typically impose some minimum of required reserves. The remainder are “excess reserves,” which may be loaned out.

For example, suppose Samantha deposits $100 of currency into her account, and the required reserves are ten percent. The bank keeps $10 in reserve, and loans out the other $90 to Ralph. The loan consists of an account created by the bank. The loan therefore creates $90 in new money, since Samantha still has her $100 in the bank. With the $90 account, the bank again keeps 10%, or $9, and loans out $81. This money creation can continue until all the excess reserves are fully loaned out, in which case the original $100 deposit is multiplied into the creation of $1000.

With all reserves loaned out, if the depositors seek to withdraw their money, the bank will not have sufficient currency. A bank can deal with this liquidity problem in several ways. One is to have most of the funds in time deposits, funds that are held for a fixed period of time, unless the account holder pays a large penalty. Another method is for a bank to be able to borrow funds from other banks or from a central bank. A third way is for the bank to have contracts that state that the bank may not be able to provide withdrawals at times when it has insufficient funds.

Critics of fractional reserve banking claim that the private banks are a private monopoly cartel that inflates the money supply by making loans and obtains interest that robs the economy of money and goes to privileged bank owners.

With fiat money and central banking, there is indeed a potential for inflation, as there is no limit to money creation. The main problem with central banking is that there is no scientific way to know in advance the optimal money supply, and historically, the Fed created destructive deflation in the 1930s, high inflation in the 1970s, and the cheap credit that generated the real estate bubble and the Crash of 2008.

Some critics of central banks want the government to directly issue money. But if the Treasury or Finance department can issue money at will, political influences can induce inflation, and even hyperinflation as happened in Zimbabwe.

However, with free banking and commodity money, these problems do not arise. Banking would not be a monopoly cartel, since new banks, including credit unions can be created. The convertibility of money substitutes into real money prevents inflation, as the quantity of money substitutes is limited by the demand by the public to hold them. Competition among banks limits their profit to normal returns, as the rest of the debt service paid by borrowers goes to interest payments to depositors. Fractional-reserve free banking generates a flexible yet stable money supply. Free banking does not generate inflation, because new deposits into the banking system come from additional real money, such as from gold mining, which is costly to produce.

The failures of central planning in the economy include the failure of central banks to successfully manage the money supply and optimally manipulate interest rates. Free banking worked well where tried, such as in Scotland until 1844, when the Bank of England took over its money system. A pure free market would let the market determine both the money supply and the natural rate of interest. In Scotland, the banks formed an association to lend funds to banks that needed more liquidity. With free banking, the market’s natural rate would avoid the distortions that arise from either cheap credit or a shortage of credit.

The boom-bust cycle will only be eliminated by the prevention of the fiscal and monetary subsidies to real estate. Sustainable economic progress requires both the public collection of land rent and a free market in money and banking.

Note: this article appeared as “Fractional Reserve Banking” in the Progress Report.

The Power of Propaganda and the Japanese Empire

Brandon Christensen History , , , , , , , , , , , , ,

Economist Kurt Schuler has a fascinating post on the various currencies that were used in mainland East Asia during World War II over at the Free Banking group blog.

Unfortunately, there are three paragraphs in the post that attempt to take libertarians to task for daring to challenge both the narrative of the state and the narrative of the nation regarding that horrific reminder of humanity’s shortcomings. He is writing of the certainty of the US’s moral clarity when it came to fighting Japan (the post was published around Pearl Harbor remembrance day):

The 1940 U.S embargo of certain materials frequently used for military purposes was intended to pressure Japan to stop its campaign of invasion and murder in China. The embargo was a peaceful response to violent actions. Japan could have stopped; it would have been the libertarian thing to do. For libertarians to claim that the embargo was a provocation is like saying that it is a provocation to refuse to sell bullets to a killer.

Then, in December 1941, came not just the Japanese bombing of Pearl Harbor, but an attack on the whole of Southeast Asia: Hong Kong, Singapore, what is now Malaysia (British colonies), Indonesia (a Dutch colony), the Philippines (scheduled under American law to become independent in 1945), Thailand (independent). In 1942 there followed the invasion of Burma, a bit of India, and a few of the Aleutian Islands, plus the bombing of Darwin, Australia.

With that history in mind, how can anybody think that the United States could have made a durable peace with Japan? It would have lasted as long as would have been to Japan’s military advantage, no longer. Japan was hell-bent on conquest. Nothing since its emergence as a major international power suggested a limit to its ambitions. It only ceded in the face of superior force. Even as Allied forces retook territory, Japanese fanaticism was such that the government did not surrender until after the U.S. military dropped two atomic bombs. To ignore the long pattern of Japanese aggression as quite a few libertarians are wont to do is not just historically ignorant but dangerous, because it closes its eyes to the hard truth that some enemies are so implacable that the only choice is between fighting them and being subjugated by them. It took a prolonged U.S. military occupation to turn Japan from the aggressor it was to the peaceful country it has become. (source)

This is an unfortunate mischaracterization of what went on in World War 2, but it also does a fairly good job of demolishing some of the arguments that libertarians have come up with in regards to this debate. You see, the issue of World War 2 is one that is usually foisted upon libertarians as an example of the benevolence of the State: Washington crushed two powerful, evil war machines in one fell swoop and then stood up to a third evil empire for forty years.

Libertarians often get confronted with this interpretation of history and they get bothered by it. This argument gets under their skin. They often make up excuses for Japan’s actions, or they avoid dealing with what actually happened in the time period. This response is also unfortunate because the general principles of libertarianism – individual freedom, strong property rights, internationalism – explain the events of World War 2 well, but only once the facts are looked at clearly and thoroughly. The power of propaganda is immense. The fact that so many people believe that the United States was the good guy in the war against Japan is astounding, and I think the heavy weight that is placed upon the shoulders of those who dare to defy the standard account of the US’s war with Japan flusters the seeker of truth.

Even though libertarians get hot-headed on this issue and stumble, thus making Schuler right in a sense, his argument is absolutely wrong. What follows is an attempt to calm things down, and to explain why Schuler is wrong and what libertarians need to get right.

Tokyo did not want to expand beyond a certain point, due to the ideological consensus of the governing party at the time. The narrative of the governing party was that great civilizations had natural territories over which they naturally lorded. For the Japanese, this natural territory (which was, of course, entirely arbitrary and ahistorical) was called, amongst other things, the East Asia Co-Prosperity Sphere. It included the Korean peninsula, Manchuria, Southeast Asia, Indonesia, the Philippines, coastal China, Mongolia, Malaysia (including Singapore and Brunei), and a separatist region in India known as Azad Hind. Any territory beyond these lands were inhabited by – again according to the ideology of the dominant political party at the time – peoples who did not conform to the standards set by the Japanese people (and those ranked directly beneath them; the ones I just mentioned). These foreign peoples were treated accordingly, especially in Melanesia.

What this suggests is that, contra Schuler, the Japanese were not “hell-bent on conquest.” Rather they simply wanted to carve out a territorial space that has obvious parallels with the German conception of Lebensraum. This is not a coincidence, by the way, for the ideologies of the dominant parties in Germany and Japan were cut from the same racist cloth.

Hawaii might have been a target for the Japanese military eventually, due to the large number of people living there with Japanese ancestry, but even this is stretching the limits of generosity. Hawaiians of Japanese ancestry considered themselves to be Hawaiians, or Americans, before Japanese (this probably due to the fact that the Japanese government sent some of its citizens over to Hawaii by force, but that is another story for another day; hopefully you can see why loyalty to Hawaii and the US was a given to people of Japanese ancestry on the islands). A Japanese invasion of the US mainland is simply an incredibly silly notion, which is why I think Dr Schuler relies upon the irrefutable fact of Japanese lust for conquest. Can you not see where propaganda is at work here?

Now, obviously the Japanese were warmongering at the time. There is no doubt about this. However, it hardly follows that the Japanese were a threat to the American republic.

For instance, look at what the Japanese military ended up attacking:

  • European and American colonies (which were burdens rather than boons for both the colonized and the colonizing)
  • Thailand, a kingdom with a long history of playing foreign powers off on each other
  • and parts of China (which could hardly lay claim to much of its territory anyway)

If I’m not mistaken, Europe and the United States are thousands of miles away from Japan, and yet they had militaries occupying foreign lands in East Asia. Again, Japan was certainly an aggressive state in the early 20th century, but it seems extremely unfair to ignore the military occupation – by Western states – of Asian lands and the Jim Crow-esque political regimes that they enacted and enforced. Notice, too, that the military incursions of the Japanese Empire do not stray too far from the official ideology of the governing political party. This is also true of Nazi Germany and Fascist Italy. It was also true of Soviet Russia, but for different reasons. The Soviets engaged in worldwide imperial ambitions (“spreading the revolution”) after solidifying their rule at home, and this imperialism was part and parcel of the dominant ideology of Leninism. I am digressing.

Japan did declare war on the US, so I think Washington’s war was just, but it hardly follows that Japan was “hell-bent on conquest,” or that its military would have invaded the United States, or that Tokyo’s decision not to curl up in the fetus position and simply accept US economic warfare was “unlibertarian.” Suppose Japan had conquered the US. What would its armies have uncovered?

Think of it this way: What incentive would Japan have to conquer the United States? Where were the plans to do so? Doesn’t it make more sense to look at Japan’s war on the US as part of its broader effort at creating and maintaining its hold over the territory it deemed to be the natural lord over? Why waste so many resources invading and occupying a territory dominated by people who were part of another race (as per the prevailing ideology of Tokyo at the time)? Oh, that’s right: Because Japan was “hell-bent on conquest.”

Propaganda is very powerful, but it’s also important not to label everything you disagree with as propaganda. That makes you sound like a crackpot. For instance, I don’t think anything Dr Schuler argues is driven by pure propaganda. Such an insinuation on my part would simply be garbage, and (rightly) treated as such in the public sphere. However, the notion that the US military stopped a war machine “hell-bent on conquest” is a product of propaganda. This notion is strengthened by personal and cultural narratives, and in time it takes on a life form of its own.

One last thing: Dr Schuler argues that the embargo Washington placed on Tokyo “was a peaceful response to violent actions,” but surely you can see how that policy was actually a violent response to violent actions. Whether that violence to counter other violence was a good thing or not is a question that cannot be answered in this already-too-long post.

(One more last thing: Here is an excellent essay on ideology in developing states that might be worth checking out; it doesn’t deal directly with the Japanese Empire but does deal with some of the concepts [especially nationalisms] that confront us when thinking about the rise of the Japanese Empire.)

A Zoo in the Streets

Jacques Delacroix Current Events

A couple of years ago the kind of youngish women who spend two hours a day seven/seven at the beach starting showing up in the streets in tights, with nothing on top. Before I could catch my breath, the same streets were turned into zoos. I mean women who don’t spend two hours a day at the gym, or an hour a week, began joining the fad. Then, it was camels on one side (camel toes, actually), hippopotamuses on the other side.

The total horror! It makes you wonder if American women have any real girlfriends, friends close enough to say, “Don’t do it honey,” or boyfriends men enough to say, “Who do you think you are going with in this outfit, honey?”

I am almost sure this does not happen in France because French women have mean girlfriends.

I have been neglecting this blog because I am busy with the nth proofing of my manuscript: I Used to Be French: An Immature Autobiography. I will be back soon, I think.

African development and mismeasuring economies (two separate topics)

Brandon Christensen Economics, Links , ,

Sorry I’ve been away for so long. I’ve been much busier than I wanted to be. I’ve been reading an essay by an economic anthropologist (Keith Hart) on African development that is definitely worth your time, though be sure to grab a cup of coffee first.

I liked this blog post from economist Ed Dolan on GDP versus GDP per capita measurements (I myself like to use the GDP (PPP) per capita measurement).

Addendum: Be sure to read Warren’s blog post on informal economies in the post-colonial world before reading the economic anthropologist’s essay. Warren’s post is a great primer for the topic.