WEBVTT NOTE Problems for the Fractional-Reserve Banker: Insolvency 1 00:00:00.000 --> 00:00:05.000 Problems for the Fractional Reserve Banker, Insolvency 2 00:00:05.000 --> 00:00:18.000 This unfortunate turn of the legal system means that the fractional reserve banker, even if he violates his contract, cannot be treated as an embezzler and a criminal. 3 00:00:18.000 --> 00:00:24.000 But the banker must still face the lesser but still unwelcome fact of insolvency. 4 00:00:24.000 --> 00:00:29.000 There are two major ways in which he can become insolvent. 5 00:00:29.000 --> 00:00:50.000 The first and most devastating route, because it could happen at any time, is if the bank's customers, those who hold the warehouse receipts or receive it in payment, lose confidence in the chances of the bank's repayment of the receipts and decide en masse to cash them in. 6 00:00:50.000 --> 00:01:00.000 This loss of confidence, if it spreads from a few to a large number of bank depositors, is devastating because it is always fatal. 7 00:01:00.000 --> 00:01:10.000 It is fatal because by the very nature of fractional reserve banking, the bank cannot honor all of its contracts. 8 00:01:10.000 --> 00:01:24.000 Hence the overwhelming nature of the dread process known as bank run, a process by which a large number of bank customers get the wind up, sniff trouble and demand their money. 9 00:01:24.000 --> 00:01:37.000 The bank run, which shivers the timbers of every banker, is essentially a populous uprising by which the duped public, the depositors, demand the right to their own money. 10 00:01:37.000 --> 00:01:42.000 This process can and will break any bank subject to its power. 11 00:01:42.000 --> 00:01:50.000 Thus, suppose that an effective and convincing orator should go on television tomorrow and urge the American public, 12 00:01:50.000 --> 00:01:55.000 People of America, the banking system of this country is insolvent. 13 00:01:55.000 --> 00:01:58.000 Your money is not in the bank vaults. 14 00:01:58.000 --> 00:02:01.000 They have less than 10% of your money on hand. 15 00:02:01.000 --> 00:02:06.000 People of America, get your money out of the banks now before it is too late. 16 00:02:06.000 --> 00:02:15.000 The report is too late. If the people should now heed this advice en masse, the American banking system would be destroyed tomorrow. 17 00:02:15.000 --> 00:02:24.000 This holocaust could only be stopped by the Federal Reserve and Treasury simply printing all the cash demanded and giving it to the banks. 18 00:02:24.000 --> 00:02:29.000 But that would precipitate a firestorm of runaway inflation. 19 00:02:29.000 --> 00:02:59.000 A bank's customers are comprised of several groups. They are those people who make the initial deposit of cash, whether gold or government paper money, in a bank. They are, in the second place, those who borrow the bank's counterfeit issue of warehouse receipts. But they are also a great number of other people, specifically those who accept the bank's receipts in exchange, who thereby become a bank's customers in that sense. 20 00:02:59.000 --> 00:03:02.800 Let's see how the fractional reserve process works. 21 00:03:02.800 --> 00:03:09.520 Because of the laxity of the law, a deposit of cash in a bank is treated as a credit rather 22 00:03:09.520 --> 00:03:14.920 than a bailment, and the loans go on the bank's balance sheet. 23 00:03:14.920 --> 00:03:21.680 Let us assume first that I set up a Rothbard deposit bank and that at first this bank adheres 24 00:03:21.680 --> 00:03:25.980 strictly to 100% reserve policy. 25 00:03:25.980 --> 00:03:33.460 Suppose that $20,000 is deposited in the bank. Then, abstracting from my capital and other 26 00:03:33.460 --> 00:03:41.820 assets of the bank, its balance sheet will look as in figure 4. Figure 4, 100% reserve 27 00:03:41.820 --> 00:03:51.100 banking, Rothbard deposit bank, simple T account, assets on the left, cash, $20,000. Equity 28 00:03:51.100 --> 00:03:58.260 Receding Liabilities on the Right, Warehouse Receipts to Cash, $20,000 29 00:03:58.260 --> 00:04:03.320 So long as Rothbard Bank receipts are treated by the market as if they are equivalent to 30 00:04:03.320 --> 00:04:11.520 cash, and they function as such, the receipts will function instead of, as surrogates for, 31 00:04:11.520 --> 00:04:13.180 the actual cash. 32 00:04:13.180 --> 00:04:19.760 Thus, suppose that Jones had deposited $3,000 at the Rothbard Bank. 33 00:04:19.760 --> 00:04:26.680 He buys a painting from an art gallery and pays for it with his deposit receipt of $3,000. 34 00:04:26.680 --> 00:04:34.040 The receipt, as we shall see, can either be a written ticket or an open book account. 35 00:04:34.040 --> 00:04:39.240 If the art gallery wishes, it need not bother redeeming the receipt for cash. 36 00:04:39.240 --> 00:04:45.080 It can treat the receipt as if it were cash and itself hold on to the receipt. 37 00:04:45.080 --> 00:04:50.360 The art gallery then becomes a customer of the Rothbard Bank. 38 00:04:50.360 --> 00:04:57.960 It should be clear that, in our example, either the cash itself or the receipt to cash circulates 39 00:04:57.960 --> 00:05:01.840 as money, never both at once. 40 00:05:01.840 --> 00:05:09.120 So long as deposit banks adhere strictly to 100% reserve banking, there is no increase 41 00:05:09.120 --> 00:05:16.120 in the Money Supply. Only the form in which the money circulates changes. Thus if there 42 00:05:16.160 --> 00:05:23.160 are 2 million dollars of cash existing in a society, and people deposit 1.2 million dollars 43 00:05:23.720 --> 00:05:30.720 in deposit banks, then the total of 2 million dollars of money remains the same. The only 44 00:05:31.020 --> 00:05:37.740 difference is that 800 thousand dollars will continue to be cash, whereas the remaining 45 00:05:37.740 --> 00:05:43.740 1.2 million dollars will circulate as warehouse receipts to the cash. 46 00:05:43.740 --> 00:05:54.740 Suppose now that banks yield to the temptation to create fake warehouse receipts to cash and lend these fake receipts out. 47 00:05:54.740 --> 00:06:03.740 What happens now is that the previously strictly separate functions of loan and deposit banking become muddled, 48 00:06:03.740 --> 00:06:13.740 The deposit trust is violated and the deposit contract cannot be fulfilled if all the creditors try to redeem their claims. 49 00:06:13.740 --> 00:06:21.740 The phony warehouse receipts are loaned out by the bank. Fractional Reserve Banking has reared its ugly head. 50 00:06:21.740 --> 00:06:41.740 Thus suppose that the Rothbard deposit bank in the previous table decides to create $15,000 in fake warehouse receipts unbacked by cash, but redeemable on demand in cash, and lends them out in various loans or purchases of securities. 51 00:06:41.740 --> 00:06:47.740 For how the Rothbard Bank's balance sheet now looks, see Figure 5. 52 00:06:47.740 --> 00:06:54.740 Figure 5, Fractional Reserve Banking, Rothbard Deposit Bank, a T account. 53 00:06:54.740 --> 00:07:07.740 Assets on the left, cash, $20,000. IOUs from debtors, $15,000. Total assets, $35,000. 54 00:07:07.740 --> 00:07:19.740 The right hand of the T, equity plus liabilities, warehouse receipts to cash, $35,000. Total, $35,000. 55 00:07:19.740 --> 00:07:25.740 In this case, something very different has happened in a bank's lending operation. 56 00:07:25.740 --> 00:07:33.740 There is again an increase in warehouse receipts circulating as money and a relative decline in the use of cash. 57 00:07:33.740 --> 00:07:39.740 But in this case, there has also been a total increase in the supply of money. 58 00:07:39.740 --> 00:07:50.740 The money supply has increased because warehouse receipts have been issued that are redeemable in cash, but not fully backed by cash. 59 00:07:50.740 --> 00:08:02.740 As in the case of any counterfeiting, the result, so long as the warehouse receipts function as surrogates for cash, will be to increase the money supply in the society. 60 00:08:02.740 --> 00:08:08.740 In the society, to raise prices of goods in terms of dollars and to redistribute money 61 00:08:08.740 --> 00:08:15.020 and wealth to the early receivers of the new bank money, in the first instance the bank 62 00:08:15.020 --> 00:08:21.840 itself and then its debtors and those whom the latter spend the money on, at the expense 63 00:08:21.840 --> 00:08:27.740 of those who receive the new bank money later or not at all. 64 00:08:27.740 --> 00:08:36.600 Suppose if the society starts with $800,000 circulating as cash and $1.2 million circulating 65 00:08:36.600 --> 00:08:44.300 as warehouse receipts, as in the previous example, and the banks issue another $1.7 66 00:08:44.300 --> 00:08:52.140 million in phony warehouse receipts, the total money supply will increase from $2 million 67 00:08:52.140 --> 00:09:03.320 to $3.7 million, of which $800,000 will still be in cash, with $2.9 million now in warehouse 68 00:09:03.320 --> 00:09:10.960 receipts, of which $1.2 million are backed by actual cash in the banks. 69 00:09:10.960 --> 00:09:13.040 Are there any limits to this process? 70 00:09:13.040 --> 00:09:20.400 Why, for example, does the Rothbard bank stop at a paltry $15,000, or do the banks as a 71 00:09:20.400 --> 00:09:37.400 Why doesn't the Rothbard Bank seize a good thing and issue $500,000 or more, or umpteen millions, and the banks as a whole do likewise? What is to stop them? 72 00:09:37.400 --> 00:09:47.400 The answer is the fear of insolvency. And the most devastating route to insolvency, as we have noted, is the bank run. 73 00:09:47.400 --> 00:09:59.400 Suppose, for example, that the banks go hog wild. The Rothbard Bank issues many millions of fake warehouse receipts. The banking system as a whole issues hundreds of millions. 74 00:09:59.400 --> 00:10:10.400 The more the banks issue beyond the cash in their vaults, the more outrageous the discrepancy and the greater the possibilities of a sudden loss of confidence in the banks. 75 00:10:10.400 --> 00:10:25.400 A loss that may start in one group or area and then, as bank runs proliferate, spread like wildfire throughout the country, and the greater the possibility for someone to go on TV and warn the public of this growing danger. 76 00:10:25.400 --> 00:10:39.400 And once a bank run gets started, there is nothing in the market economy that can stop that run, short of demolishing the entire Jerry-built fractional reserve banking system in its wake. 77 00:10:39.400 --> 00:10:41.400 in its wake. 78 00:10:41.400 --> 00:10:49.400 Apart from and short of a bank run, there is another powerful check on bank credit expansion under fractional reserves, 79 00:10:49.400 --> 00:10:54.400 a limitation that applies to expansion by any one particular bank. 80 00:10:54.400 --> 00:11:01.400 Let us assume, for example, an especially huge expansion of pseudo-warehouse receipts by one bank. 81 00:11:01.400 --> 00:11:10.400 Suppose that the Rothbard deposit bank, previously hewing to 100% reserves, decides to make a quick killing and go all out. 82 00:11:11.400 --> 00:11:26.400 Upon a cash reserve of $20,000, previously backing receipts of $20,000, it decides to print unbacked warehouse receipts of $1 million, lending them out at interest to various borrowers. 83 00:11:26.400 --> 00:11:32.400 Now the Rothbard Bank's balance sheet will be as in Figure 6. 84 00:11:32.400 --> 00:11:36.400 Figure 6, one bank's hyper-expansion. 85 00:11:36.400 --> 00:11:43.400 Rothbard Deposit Bank, a T account, assets on the left, cash $20,000. 86 00:11:43.400 --> 00:11:47.400 IOUs from people, $1 million. 87 00:11:47.400 --> 00:11:51.400 Total, $1,020,000. 88 00:11:51.400 --> 00:11:55.400 Liabilities on the right, warehouse receipts to cash, 89 00:11:55.400 --> 00:12:08.120 Everything may be fine and profitable for the Rothbard Bank for a brief while, but there 90 00:12:08.120 --> 00:12:15.600 is now one enormous fly embedded in its ointment. Suppose that the Rothbard Bank creates and 91 00:12:15.600 --> 00:12:22.600 lends out fake receipts of one million dollars to one firm, say the Ace Construction Company. 92 00:12:22.600 --> 00:12:27.060 The ACE Construction Company, of course, is not going to borrow money and pay interest 93 00:12:27.060 --> 00:12:29.600 on it, but not use it. 94 00:12:29.600 --> 00:12:34.320 Quickly it will pay out these receipts in exchange for various goods and services. 95 00:12:34.320 --> 00:12:39.760 If the persons or firms who receive the receipts from ACE are all customers of the Rothbard 96 00:12:39.760 --> 00:12:42.940 Bank, then all is fine. 97 00:12:42.940 --> 00:12:47.640 The receipts are simply passed back and forth from one of the Rothbard Bank's customers 98 00:12:47.640 --> 00:12:49.320 to another. 99 00:12:49.320 --> 00:12:54.760 But suppose instead that the receipts go to people who are not customers of the Rothbard 100 00:12:54.760 --> 00:12:58.760 Bank, or not bank customers at all. 101 00:12:58.760 --> 00:13:03.920 Suppose for example that the Ace Construction Company pays one million dollars to the Curtis 102 00:13:03.920 --> 00:13:09.880 Cement Company, and the Curtis Cement Company for some reason doesn't use banks. 103 00:13:09.880 --> 00:13:16.900 It presents the receipts for one million dollars to the Rothbard Bank and demands redemption. 104 00:13:16.900 --> 00:13:18.240 What happens? 105 00:13:18.240 --> 00:13:24.920 The Rothbard Bank, of course, has peanuts, or more precisely, $20,000. It is immediately 106 00:13:24.920 --> 00:13:32.280 insolvent and out of business. More plausibly, let us suppose that the Curtis Cement Company 107 00:13:32.280 --> 00:13:38.640 uses a bank, all right, but not the Rothbard Bank. In that case, say, the Curtis Cement 108 00:13:38.640 --> 00:13:44.920 Company presents the $1 million receipt to its own bank, the World Bank, and the World 109 00:13:44.920 --> 00:13:49.620 The Rothbard Bank presents the receipt for one million dollars to the Rothbard Bank and 110 00:13:49.620 --> 00:13:51.920 demands cash. 111 00:13:51.920 --> 00:13:58.400 The Rothbard Bank, of course, doesn't have the money and again is out of business. 112 00:13:58.400 --> 00:14:04.680 Note that for an individual expansionist bank to inflate warehouse receipts excessively 113 00:14:04.680 --> 00:14:09.040 and go out of business does not require a bank run. 114 00:14:09.040 --> 00:14:13.080 It doesn't even require that the person who eventually receives the receipts is not a 115 00:14:13.080 --> 00:14:15.560 Customer of Banks 116 00:14:15.560 --> 00:14:22.920 This person need only present the receipt to another bank to create trouble for the Rothbard 117 00:14:22.920 --> 00:14:26.520 bank that cannot be overcome. 118 00:14:26.520 --> 00:14:32.320 For any one bank, the more it creates fake receipts, the more danger it will be in. 119 00:14:32.320 --> 00:14:38.480 But more relevant will be the number of its banking competitors and the extent of its 120 00:14:38.480 --> 00:14:45.320 and its own clientele in relation to other competing banks. Thus, if the Rothbard Bank 121 00:14:45.320 --> 00:14:50.920 is the only bank in the country, then there are no limits imposed on its expansion of 122 00:14:50.920 --> 00:14:58.240 receipts by competition. The only limits become either bank run or general unwillingness to 123 00:14:58.240 --> 00:15:00.920 use bank money at all. 124 00:15:00.920 --> 00:15:08.880 On the other hand, let us ponder the opposite, if unrealistic extreme, that every bank has 125 00:15:08.880 --> 00:15:15.480 only one customer and therefore there are millions of banks in a country. 126 00:15:15.480 --> 00:15:22.240 In that case, any expansion of unbacked warehouse receipts will be impossible, regardless how 127 00:15:22.240 --> 00:15:23.800 small. 128 00:15:23.800 --> 00:15:30.900 For then, even a small expansion by the Rothbard bank beyond its cash in the vaults will lead 129 00:15:30.900 --> 00:15:53.900 One force, of course, could overcome this limit of calls for redemption by competing banks, a cartel agreement among all banks to accept each other's receipts and not call on their fellow banks for redemption. 130 00:15:53.900 --> 00:16:04.900 While there are many reasons for banks to engage in such cartels, there are also difficulties, difficulties which multiply as the number of banks becomes larger. 131 00:16:04.900 --> 00:16:11.900 Thus, if there are only three or four banks in a country, such an agreement would be relatively simple. 132 00:16:11.900 --> 00:16:19.900 One problem in expanding banks is making sure that all banks expand relatively proportionately. 133 00:16:19.900 --> 00:16:41.900 If there are a number of banks in a country and banks A and B expand wildly while the other banks only expand their receipts a little, claims on banks A and B will pile up rapidly in the vaults of the other banks and the temptation will be to bust these two banks and not let them get away with relatively greater profits. 134 00:16:41.900 --> 00:16:49.900 The fewer the number of competing banks in existence, the easier it will be to coordinate rates of expansion. 135 00:16:49.900 --> 00:16:59.900 If there are many thousands of banks on the other hand, coordination will become very difficult and a cartel agreement is apt to break down. 136 00:16:59.900 --> 00:17:08.900 An example of a successful cartel for bank credit expansion occurred in Florence in the second half of the 16th century. 137 00:17:08.900 --> 00:17:24.900 There, the Riese Bank was the dominant bank among a half dozen or so others and was able to lead a tight cartel of banks that took in and paid out each other's receipts without bothering to redeem in specie. 138 00:17:24.900 --> 00:17:31.900 The result was a large expansion and an ensuing long-time bank crisis. 139 00:17:31.900 --> 00:17:38.140 It is likely that the establishment of the Bank of Amsterdam in 1609, followed by other 140 00:17:38.140 --> 00:17:45.420 100% reserve banks in Europe, was a reaction against such bank credit-generated booms and 141 00:17:45.420 --> 00:17:49.300 busts as had occurred in Florence not many years earlier.