Why Fractional Reserve Banking is Not the Problem

Early this week we watched and posted a video interview with Sandeep Jaitly of Feketeresearch.com.

Sandeep covered many points but one in particular reminded us of a lecture of his we were privileged to hear here in Auckland a couple of years ago. 

In the video interview Sandeep stated that extending credit does not cause boom and bust cycles.

But rather it’s when you extend credit beyond the duration for which it was intended that the problems occur.  That is borrowing short to lend long. You don’t match the purpose for which the credit was taken with the purpose for which the credit was granted.

He went on to say that it is fraud to borrow short to lend long, as you are disobeying the principles of a bailment which is that a demand deposit must be accessible at all times.

[Definition of Bailment from wikipedia- Bailment describes a legal relationship in common law where physical possession of personal property, or chattel, is transferred from one person (the 'bailor') to another person (the 'bailee') who subsequently has possession of the property. It arises when a person gives property to someone else for safekeeping.]

So you can’t have your money available at all times and earn interest on it. The two don’t make sense and yet that is what people today believe they have today with on call accounts that pay interest.

Anyhow, as we mentioned this reminded us of a lecture of Sandeep’s and so we dug out our notes from then with the hope or rediscovering a few gems of info that we could share with you.

First up, perhaps we should attempt to explain some of Sandeep’s terminology above:

Demand deposit – This is where funds deposited with a bank are available on demand.  i.e. You can withdraw them at any time without waiting and so should everyone else with funds deposited on demand.

As the bank runs and subsequent government guarantees in recent years have proven, in the current banking system the funds deposited in your “on call” account are not really demand deposits at all.  If everyone shows up at the bank at the same time to “demand” their on call deposits – you get a really long queue and unhappy customers, as the bank does not hold in reserve enough funds to repay everyone “on demand”.

Borrow short to lend long – This is how the modern banking system works.  They borrow from you in the short term to lend out to other customers with say 20 year mortgages.

As Sandeep said in the video the modern banking system doesn’t match the purpose for which the credit was taken with the purpose for which the credit was granted.  There is a duration mismatch.

Back to our lecture notes now to hopefully expand on this concept further. And apologies to Sandeep if we make any errors or missteps in our retelling of his tale as it was a couple years ago!

Silver and the Birth of Fractional Reserve Banking

In the beginning silver was money.  A conundrum was what to do with your hoard when you had built up a decent excess that you didn’t need for daily use [a nice problem to have!].

A large business could have very large holdings of silver so the need arose for a safe storehouse.  But not just any old fellow on the street with a lock and a warehouse would do, you had to be noble and ethical to store someone else’s money.

So initially temples were preferred, as the priests had sacrificed material gain and so were trusted more than merchants.

You were charged for the storage of your silver and given a receipt, which you could “cash in” at any time and get your money back in the form of silver coins.

How Much Did the Silver Storehouses Keep on Demand?

You would only need a portion of your silver holdings to cover day-to-day expenses such as food and clothing and the like.  Say you determined you only needed 10% of your reserves on demand for day-to-day use.  The other 90% is put to use to create a silver bond and a time deposit.  But it would be you who determined this amount not the silver storehouse.  And for the time deposit you would determine how many months or years you were willing to have your cash silver tied up for. i.e. how long it could be lent out for.

Key point: This amount is an entirely subjective decision by you the depositor.

A loan could be created for a business owner from the non-demand or time deposits. When the borrower spends the loan this would result in a subset of people whose overall increase in physical silver would not be greater than the amount initially lent. 

 

Expand this out and you get a system made up of demand deposits and time deposits of widely different maturities, but so that the respective assets and liabilities match perfectly in their duration.

  

As opposed to modern banking where there is a dictat of say 10% to be kept on demand by the authorities regardless of the depositors time preference.

Economists observed the above process but instead of allowing at each stage each person to decide how much of their savings to keep on demand, and how much could be lent out, they decided on a fixed arbitrary percentage.

Whereas this overall percentage should vary day to day as peoples needs varied. That is…

The people control the supply.

[We are sure the likes of Ben Bernanke and Co may have trouble with this concept, as they seem to think they can and should determine the supply of money and credit.]

So it’s not necessarily that fractional lending is “bad” per se, but rather the complete removal of the subjective depositor matching of time deposits to loans.

How This Concept has Degraded Even Further Over the Centuries

Obviously an unethical and dishonest storehouse owner could fraudulently lend out the “on demand” silver.

If demand deposits were (fraudulently) lent out and people then wanted more cash silver than was available (i.e. their demand deposits back)

Then…

Assets would have to be liquidated. This would happen very fast and so as a result there would be falling prices.  A.K.A deflation.

Recall 2008, this is what was happening then. If governments hadn’t stepped in and nationalised the deposits of savers, prices would have collapsed.  Actual physical cash would have regained 90 years of devaluation incredibly quickly but most people would have been made destitute.

Couple this with the complete removal of silver and gold as the units of account and then the lending to governments with debt rolled over and over in perpetuity, has given banks the ability to paper over the cracks.

What Lies Ahead

This nationalization of the monetary system means no persons time deposits will be at risk, and so once the peoples psychology grasps this fact (still yet to happen it would seem), the system will revert but with a much greater monetary base, and stock prices and the like will soar.