banknote

Banknotes and fractional reserve

Economist Larry White at George Mason University submitted a thought-provoking written testimony the other day. Discussing the issue of fractional reserve banking before the House Subcommittee on Domestic Monetary Policy and Technology, he made the following claim:

For payment by account transfer, FRB offers a more economic way of providing payment services. A money warehouse or 100% reserve institution could also offer payments by account transfer, but its services would be significantly more expensive. 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 unemcumbered by storage fees.

I admit I have not read enough economics to be conversant on the topic of free vs. full-reserve banking. My initial thoughts are that the deposit contract with a fractional reserve bank cannot really be called a contract (more of a gamble). But I do not doubt, as Dr. White proposes later in the testimony, that fractional reserve banks would be fully capable of discovering and adjusting the level of reserves necessary to ensure full redemption on demand.

But regarding the quote above, I cannot find reason to disagree with White in that banknotes are not feasible without fractional reserve banks. However, I do not understand why banknotes need to exist at all.

In other words, why cannot individuals simply carry around coins with which to make transactions, keeping the bulk of their funds in full-reserve warehouses? When they want to make a major purchase, they write a check, thereby informing the warehouse that they have transferred funds. This form of “account transfer” would not be expensive as White suggests. It can easily be done electronically in a matter of seconds. Indeed, we do it every day at the ATM.

Of course, individuals would only pay a fee for what they have in the warehouse, and not other money that they possess. This removes the difficulty with assessing storage fees for money warehouses and retains a full reserve system that I suspect (at the moment) is the only system that retains the legitimacy of the deposit contract.

White cites this as a defense of fractional reserve banking. But if it is not the case that the banknotes created by fractional reserve banks are any ‘easier’ than carrying around a few coins, does his defense fall apart? Yes, banknotes make transfer of funds easy once you presuppose the existence of fractional reserve banks. But that presupposition is what I am questioning.

It is possible that I am missing some important relevant points. It wouldn’t even surprise me that I am making some gross oversights. But these are my initial thoughts, and ones that I will try to develop further in the future. I welcome any input, questions, or corrections.

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10 Responses to Banknotes and fractional reserve

  1. Nicholas Freiling July 2, 2012 at 11:36 pm #

    Another consideration…modern technology makes possible for individuals to transfer funds over to someone else in a matter of seconds via debit card. This is quickly rendering banknotes unnecessary. It would thus seem to me that we would not even have to carry around coins in a full reserve system, as we could leverage technology to ensure banks can keep an extremely accurate tab on who owns what deposit and can then charge a fee to depositors based on their average deposit over a period of time.

    • Jonathan M.F. Catalán July 5, 2012 at 3:03 pm #

      “Virtual” money might replace banknotes, but White is talking mostly from a historical perspective. Certainly, debit cards weren’t entirely relevant even twenty years ago.

      • Nicholas Freiling July 5, 2012 at 3:07 pm #

        Of course. But do you think I am right in saying that the argument from “ease of payment”, if you will, falls short in the modern day (whether or not White meant it to apply in the modern day)?

  2. Artir July 3, 2012 at 4:12 am #

    1 gold gram coin at this moment is worth over 60 USD. Now, with the increased demand that everyone using gold coins would imply, price could reach a hundred times that.
    And for everyday transactions, that’s not practical.

    And on fractional reserve banking, after having read Huerta de Soto’s book and having personally talked to him on the issue, I’ve come to the conclusion that his possition is actually wrong: It’s true that FRB is not a deposit nor a loan. It’s a differente kind of contract not present in traditional law.

    It’s irrelevant it’s a gamble, or if it’s impossible for the bank to return every coin at the same time: as long as it can meet its everyday necessities, it won’t have any problems. And if it does, the clients must know beforehand what the FRBank is doing and deal with it. (Of course, in a free monetary system there would be supersecure 100% reserve banks). You loose property over your coins and get a ‘I Owe you’ in the form of a banknote.

    The other argument made by anti-FRB theorics is that it causes the economic cycle, and so I thought myself, but after having a deeper look into the subject, not so. The actual problem is when long term assets are financed by short term passives (i.e. the bank investing 1 month deposits into 30 years mortgages). That can happen even with 100% reserves!

    In a free banking system, the market would devise mechanisms to avoid that problems, I’m sure of it, so I’d rather let it work than impose the 100% burden onto it.

    • ryanbud July 4, 2012 at 1:02 pm #

      It is my understanding that the miss-matching of short and long term investments is really a managerial rather than economic problem. If the bank managers are poor at this they will go under and this this is just the market’s way of cleansing out the relatively bad bank managers.

      The problem with the theory of the boom bust cycle you (Artir) put forth is that it doesn’t explain the cluster of error that characterizes the bust. There seems to be no reason why many, many bankers will make the same mistake and temporally misalign investments all at the same time.

      Credit expansion, on the other hand, does explain the cluster of error. Any time there is an artificial lowering of interest rates there is a boom that must be corrected by a bust because the real resources to complete the projects are simply not available. The illusion of saved resources in the form of credit expansion (fiduciary media) fools entrepreneurs into thinking there are more saved resources than are actually there. Every instance of credit expansion creates an illusion and is a essentially a lie about what resources are available for investment.

      Whenever banks extend loans which aren’t backed by real savings they create the illusion that resources have been diverted from consumption to investment even though this hasn’t happened. The result is that the entrepreneurs cannot complete their projects and when they (and their investors) realize this, they all start to pull out. This starts the bust which is the necessary outcome lending funds independent of real savings (what happens in fractional reserve banking).

  3. Nicholas Freiling July 3, 2012 at 9:09 am #

    Artir,

    Good points. Any books you recommend I read to better understand this issue?

    Two questions:

    Why would the coins have to be pure gold? Cannot they be some sort of compound so that even 1/50 oz can be a “regular” size coin?

    In my comment, I explored the idea of using debit card to immediately transfer funds. Wouldn’t this solve the problem?

    I am not saying that this issue rules out FRB. Obviously, it only means that this particular argument of White’s is a little weak, but says nothing about the rest of his argument.

  4. nickik July 4, 2012 at 4:39 am #

    @Nicholas Freiling

    Coins dont have to be pure gold. The can be a mix but thats not the point. Even coins used to be fractional, in that the had not the fully content of gold, silver or copper in it. You could get that on demand too. This is how the issuers of coins mad money, they earned float.

    Selgin talks about this in this video: http://www.youtube.com/watch?v=-gn55fTRXZw

    Coins are heavy to carry around, people dont like it. Look into the Scottisch Free Banking System, coins where used less and less.

    Now what about debit cards? It is true that you do not have the same problem with debit cards but there is a reason people still use traditional money. Having money in the traditional way is useful, it is not an argument to say that we just don’t need it anymore. As long as people use notes banks will supply them with notes, if the demand goes down they will stop.

    We can argue about how useful it is to hold notes, but the still have some uses.

  5. Jonathan M.F. Catalán July 5, 2012 at 3:08 pm #

    Nicholas,

    Ultimately, the consumer decides between banknotes and metallic money. Why might a consumer choose money substitute? There are probably a wide variety of practical reasons, including the fact that it’s lighter. But, money substitute also solves the problem of issuing currency in small denominations. While it might be difficult to divide gold, or even silver, into small enough pieces, it’s not difficult to divide money substitute. Also, note that banks and customers don’t have to worry about wear and tear when dealing with money substitute, because banks can replace them when they circulate back (similar to how dollars are replaced as they circulate back to banks).

    Two comments above, you ask what book would be worth reading. The most enlightening that comes to mind is Selgin’s “The Theory of Free Banking.”

    • Nicholas Freiling July 5, 2012 at 3:15 pm #

      I understand those practical reasons. But they are irrelevant when payment is entirely electronic and problems like small denominations, portability, and “wear-and-tear” are eliminated. The only advantage to banknotes in the modern day that I can think of is their anonymity.

      I’m not sure how constructive these speculations are as I’m sure it is not solely because of the existence of banknotes that people like White and Selgin favor FRB. But interesting thought experiments, nevertheless.

      And thanks for the book suggestion. I’ll check it out!

      • Jonathan M.F. Catalán July 6, 2012 at 6:21 am #

        Well, the fact is that people still carry bank notes. That is, people still pay in cash. This must mean that some people prefer physical money to electronic money (or paying by means of credit or debit). Another, unrelated, advantage of physical money is that you can withdraw it and hold it, which may be preferred in an environment such as that of Spain’s.

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