Market Forces and Fractional Reserve Banking

By Peter Šurda
Economics of Bitcoin
Monday, January 21, 2013

http://www.economicsofbitcoin.com/2013/01/market-forces-and-fractional-reserve.html

Ralph Musgrave made a blog post "Lawrence White Tries to Argue for Fractional Reserve Banking" where he criticises some of the arguments made by Lawrence White in testimony on his fractional-reserve banking. I tend to agree with many of the things Ralph wrote, but here I'll concentrate on one aspect where I disagree.

Ralph writes:

"In fact there is no reason to suppose that “payment services” provided by a fractional reserve bank are any cheaper or “more economic” than those provided by a full reserve bank. That is, the ACTUAL COSTS (clearing cheques, issuing bank statements, etc) are the same in both cases. However, fractional reserve offers depositors interest on their deposits. And if you deduct that interest from the costs of payment services, then of course the cost of those services could be said to be reduced. But the reality is that this is just cross-subsidisation of one bank activity by another." [emphasis original]

Ralph missed several things here.

Storage costs

The first one (which I cannot find explicitly in White's testimony), is that holding less than 100% reserves decreases storage costs. Even if the "excess" reserves were used in a different manner than loaned out, FRB would still have lower operating costs. Storage costs are a subset of what I call "maintenance costs of money substitutes". One might argue that if a withdrawal request arises in excess of reserves, the transaction costs of facilitating redemption (e.g. sale of assets) would be higher in an FRB. But the operational issues of redemption are not a feature specific to FRB. Even in a full reserve system, as long as branch operations are allowed, it is still possible that someone wants to withdraw more than the available reserves in that specific branch. The withdrawal would still have to be postponed and either the reserves transported from another branch, or some assets sold (the latter might be still chosen even in a full reserve banking if it has lower transaction costs, which is entirely possible).

Bank notes

The second thing is mentioned by White: "The other bank payment instrument, redeemable banknotes circulating in round denominations, simply cannot exist without fractional reserves. Banknotes are feasible for a fractional-reserve bank because the bank doesn’t need to assess storage fees to cover its costs. It can let the notes can circulate anonymously and at face value, unencumbered by fees, and cover its costs by interest income. An issuer of circulating 100% reserve notes would need to assess storage fees on someone, but would be unable to assess them on unknown note-holders. There are no known historical examples of circulating 100% reserve notes unencumbered by storage fees."

 Now, I have a minor addition here, it is hypothetically possible to create a bearer instrument with demurrage (e.g. stamps) even on a 100% reserve banking. Whether there is a practical merit in that I will leave open, but I'll ignore it for the time being, in order to explain the argument of White. So, let me reformulate White's argument: In a metallic monetary system, as long as people prefer bank notes to coins, FRB will emerge. This is a straightforward logical necessity. Irrespective of what people think about legitimacy of FRB, in this particular case it is an unavoidable consequence of consumer demand. Why might people prefer bank notes to coins? I'll address that right away.

Why are substitutes substitutes?

Here it gets a bit tricky, because anti-FRB-ists, when criticising FRB, tend to "objectivise the boundaries of goods". They argue that an instrument issued by the bank is treated by the users of that good as a substitute because they think it's the same good (i.e. it is a claim, an ownership title). But this is a non-sequitur. The best refutation of this assumption are so called "complementary currencies", in particular those of type "mutual credit". Mutual credit are a form of circulating medium of exchange which is derived from a "normal" money (e.g. the USD or EUR), but they are not based on deposit banking. Some of the more popular examples are WIR and TEM.

In other words, a subsitute medium of exchange (money substitute) does not need to be a claim. Mutual credit is not even convertible into the base money. This leaves the question open: why are then some goods accepted as a substitute medium of exchange? The Austrians know this, but magically, when talking about FRB, they forget about it. They are accepted as substitutes because they decrease transaction costs. Practically all of the anti-FRB Austrians realise this, but only when not talking about FRB: Rothbard, Hoppe, Salerno, de Soto.

So what are money substitutes? Money substitutes are copies of the monetary base. They are persistently causally related to the original (e.g. by a peg, by using the same name, etc.), and they act as substitutes from economic point of view. And, at the latest since Kinsella's Against Intellectual Property, the Austrians increasingly come to the realisation that copying is not per se a violation of property rights. Analogously, creating an instrument which is subsequently then accepted as a substitute by the market is not, per se, a violation of property rights either.

Cross-subsidising

Now that we have clarified what are money substitutes, we can look at cross-subsidising. The instruments issued by the banks are copies. They have two important features that distinguish them from the originals:

1. They have lower transaction costs
2. They allow credit expansion

Here the error of anti-FRBists becomes apparent. They do not realise that the instruments are goods separate from the original. They draw the boundaries of goods based on their own desires, not based on how these goods are treated by the market. The result of banking is a new good, that unifies lower transaction costs with credit expansion. Even if they don't like it, this is the economic fundamental of the banks' activities.

Since this new good, this copy, satisfies both the demand for lower transaction costs and credit expansion, these two activities economically manifest themselves as one. The merging of these two activities by the bank is simply a response to this unified demand. As long as this new good, copy, satisfies both demands, the activities of the bank are economically inseparable. Therefore, there is no cross-subsidising, similarly as the manufacturing of tires is not cross-subsidising the manufacturing of chassis as long as people demand the whole car, even if some people have a fetish for the tires and want to ban car assembly.

How to fix this?

Unlike the free banking branch of the Austrian school, I actually agree with the gold standard branch that credit expansion [EDIT: and I mean any credit expansion] leads to distortions, such as the business cycle. So I'm at odds with both of them, as I argue that FRB is economically detrimental, yet not a violation of property rights, but a consequence of market forces. I could just end here, leaving everyone baffled and annoyed. But this blog is called "Economics of Bitcoin". And here it comes in.

To explain why, I'll first start with a quote by none other than professor White, in Competitive Payments Systems and the Unit of Account:

"Coinage reduces transaction costs compared to simple exchange, because of authentication and weighing. Bank liabilities also reduce transaction costs. But these are empirical factors, and not something inherent in all possible monetary systems."

Now, putting it all together, if the transaction costs of monetary base are sufficiently low, money substitutes do not emerge, and thus there is no credit expansion. Bitcoin shows that such a system is empirically possible. It "fixes" credit expansion without "fixing" FRB. Is that a hack? No. Money substitutes are a hack, and credit expansion is a result of that. Bitcoin shows that a proper solution is possible.

Reprinted with permission.