Friday, November 28, 2008

The Immorality of Fractional Reserve Banking

Here's a 40 minute lecture by Paul McKeever on fractional reserve banking and Ayn Rand's ethics of rational self-interest. Paul is especially good at explaining banking in everyday common sense terms.

When I call the fractional reserve banking practice immoral, I mean that the bank does not obtain your consent in order to use your money for its purposes. Thus in this way it sets up the boom/bust cycle since you, the original owner of the money, have no check on the bank if you see it doing something stupid with your money. (There may be other causes of the boom/bust cycle. I'm not an economist. But I bet that at root they are always caused by an immoral action, not a lack of nor inability to obtain knowledge.)

This is another example that the use of force, which is what is going on when the bank uses your money without your consent, nullifies responsibility. It nullifies the individual's responsibility, i.e., to look ahead at potential consequences and take appropriate action to either accept or reject those potential consequences, for the safekeeping of his money by the bank.


Mark Cancellieri said...

I don't consider fractional reserve banking immoral, because the bank isn't trying to deceive depositors into thinking that the deposits are fully reserved. The fractional reserve system is not a secret. The bank doesn't *explicitly* obtain your consent to use your money. The consent is implied.

Furthermore, "the original owner of the money" *does* have a check on the bank if he sees it doing something stupid with his money. He can withdraw the money when he sees it happening.

Butler T. Reynolds said...

I'm no economist either, but I don't think that the problem or moral issue is with fractional reserve banking.

I'd imagine that the problem has to do with government running the banks AND being in control of the coinage. The usual inefficiences of command and control organizations apply. Without the discipline of markets, government screws up the fractional reserve part of banking as well as other things.

I'm going to have to give Paul's lecture a listen. Thanks for the link.

You might find this recent EconTalk podcast episode on free market banking to be enlightening:

Elena C. said...

Even if fractional reserve is implied in banking it doesn't make it moral. You don't expect your coat to be let to somebody when you go to the theater hoping that by the time the show is over your coat will be returned or you'll have another one available. Fractional reserve causes inflation, causes boom-bust cycle and undermines capitalism. Whenever economy busts "capitalism" is blamed, although fractional reserve is not as much a product of capitalism as it is of the government intervention. If the government stopped controlling the banks and allowed them to be really free, after a few busts only honest banks with 100% reserve would stay in business. If that was allowed to happen boom-bust problem would be a part of history. However it's very unlikely. As usual long dead capitalism is blamed for everything, we are desperately trying to replace it with more "fair" socialism, welcome to the USSR...

principlex said...

I carried on a separate conversation with Elena C since I was not persuaded that fractional reserve banking was by definition immoral but was a product of the way the banks and the government bypass the depositor and, in essence use his property for their permission without his consent, i.e., steal his property.

She made the point that if the bank has a specific agreement with a depositor to use his money whereby he doesn't have use of it for a specified time, then this is not fractional reserve banking.

I agree with her point since fractional reserve banking is the practice of making loans with money created out of thin air and consequently assert that the practice of fractional reserve banking is immoral and the cause of the boom/bust business cycle.

It should be made illegal - immediately! Fat chance of that.

John Grover said...

Fractional Reserve banking is not immoral in a free market. In fact, a bank must use fractional reserve banking to earn a profit.
What is immoral is the setting of the reserve by the government. Just as with building codes, it ensures that people must adopt the standard
the government sets or fail to be competitive. The government standard is arbitrary. Who decided that 5% is right? Why not 10% or 8.5%?
In a free market, a depositor could compare banks by all sorts of measures, and there would be private firms who would audit the bank and rate them
just like Morningstar does for mutual funds.

The depositor could look at a range of types of deposits and choose the one the fits them.
If they needed cash security like a checking account for a small depositor, they would choose no interest and "cash storage" and would probably pay a fee.
if they needed modest income, they could choose how to let the bank loan it out. There would be some lower risk versions of this mode that might allow
on demand redemptions (as we supposedly have today). There would also be higher risk versions where you might even sign a risk disclosure that you might lose
some of your principal in exchange for a higher rate of return. All of these are fractional reserve setups ranging from 100% reserve for the small depositor all the way to
say 5% for the risk taker. Everything would be set up in the deposit contract. Interest rates would be set by the free market rather than the government, so that rational
reward would be available for each level of risk. Now, there is almost negative interest as the government attempts people to borrow and to continue inflation.
A tactic that has failed in Japan for the last 10 years and which damages savers and benefits debtors (I wander which category the government falls in!!!)

The government has set it up where everyone is taking maximum risk, but with the assurance of FDIC insurance (which is about as sound as social security).
They never intended to have to pay up just like social security expected people to die at age 70 on average. Both assumptions fail to take reality into account.
Economic events do not follow the bell curve perfectly. The distribution of events on the extremes is "fat" which means more very good and very bad days than
you would expect given statistical distributions in general. So now they have let the banks loan out deposits to this 5% fractional reserve level, and suddenly more
than 5% of the funds are needed. Literally overnight banks went from solvent to insolvent. There are huge problems now because of this. Just think of your own situation
and what would happen if you only kept 5% in reserve. One life event would bankrupt you. Many people live that way of course, and it is hard for them but not for the
economy at large at that point. But then take the Government, which creates nothing except politically motivated legislation, and see how they spend much more than
they take in. Then see how they pass laws that eliminate proper business practice as in the banking regulations requiring fractional reserve, the FDIC and the Fed., laws protecting
union members from being fired etc. and you have locked up the economy so it cannot move. That is why we are at the busting point now.