Based Underground is now a conservative news aggregator AND curated newsletter.
Drug addicts suffer major withdrawal symptoms when they go cold turkey. In the case of high-tech startups and their banks (like Silicon Valley Bank), the super-low-interest-rate stimulant has been taken away by the drug dealer (the Fed) via interest rate hikes. With cheap credit drying up, firms switched to pulling cash out of SVB, all while the same interest rate increases caused the value of SVB’s assets to fall. SVB’s balance sheet couldn’t handle the fast withdrawals, which became a classic, self-propagating, panicky bank run, and the simultaneous fall in value of its liquid assets.
When banks practice this kind of maturity mismatch—potentially immediate-term liabilities (deposits) backed by long-term assets (loans and Treasury securities), it is called “fractional reserve banking.”
The failure of SVB and other recent bank crises have reignited the debate over fractional reserve banking. While Austrian economists across the board are critical of central banking and government manipulation of the money supply and interest rates, there are differences of opinion on fractional reserve banking. Murray Rothbard was firmly against the practice for both economic and ethical reasons; however, “fractional reserve free bankers” (FRFB) like George Selgin and Larry White have written extensively about how fractional reserve banking per se does not make for an inherently unstable banking system and does not cause business cycles. The FRFB position is that the business cycles and instability are caused by government interference, primarily via central bank monetary policy.
To understand how fractional reserve banks operate, we first need to make a distinction between warehouse banking and loan banking. Warehouse banking refers to the way banks accept deposits and act on instructions from the depositor to send or withdraw money at par on demand. In warehouse banking, there is no multiplication of deposits or creation of credit—the bank simply stores, or “warehouses,” depositors’ cash. Importantly, depositors have to pay a fee for this service at warehousing banks.
Loan banking refers to the way banks can act as financial intermediaries. A bank customer can purchase a certificate of deposit or other time deposit that, importantly, represents a parting with funds. The customer cannot access these funds for spending or withdrawing. The bank uses these funds to extend loans. The interest earned on these loans is shared (according to the contract) between the bank, which administered and intermediated, and the customer, who relinquished the money. Here, there is also no multiplication of deposits, expansion of the money supply, or creation of credit ex nihilo.
The issues with fractional reserve banking come from combining these two functions: warehouse banking and loan banking. Banks combine these functions by using demand deposits (which depositors can withdraw at par on demand) as a basis for extending loans. Hopefully, the potential problems with this are obvious: What if depositors request more money than the bank has on hand, due to the fact that not all deposits have matching cash reserves, but instead are backed by long-term loans?
Coffee the Christian way: Promised Grounds
This is exactly what happened to SVB. Depositors wanted to withdraw more cash than the bank had in reserves. SVB had used depositors’ funds to purchase Treasury securities and mortgage-backed securities, and to extend loans to high-tech firms. SVB might have had less foresight than other banks, but it is important to note that all banks do this sort of thing. No bank keeps 100 percent reserves—no bank keeps its warehousing and intermediation functions separate. In fact, in 2017 the Federal Reserve blocked a new bank that intended to be such a safe haven for depositors.
The repeated bank runs and associated financial crises caused by fractional reserve banking have led to the creation of central banking, government deposit insurance, a multitude of bank regulations, and a host of agencies to design and enforce these regulations. It’s worth pointing out, however, that if the government simply ignored bank runs, then the standard mechanisms of profit and loss would be at work. Banks would fail in the same way other private businesses fail. Potential bank customers would avoid unsound banks and flock to sound banks according to their own preferences and expectations. This prospect leads the FRFB crowd to conclude that fractional reserve banking per se isn’t a problem—it is the moral hazard and money creation by the government that causes all the problems.
In my view, the debates over the sustainability and ethics of fractional reserve banking suffer from poorly defined terms. If a deposit is defined as “redeemable at par on demand,” then that constitutes a promise by the bank to have the funds available at par on demand, meaning no loans are purchased with those funds. If a contract stipulates that the bank will offer accounts for which deposits are defined as such but then uses the funds to provide loans, then the bank is in breach of contract. If, however, the bank and the customer agree on a looser definition of the term “deposit,” such that deposits are not always redeemable at par, or are redeemable at par but sometimes with a delay, then that is their prerogative. It seems to me that such an arrangement is more properly called an “unsecured callable loan” and that if these coexisted with true, fully backed deposits on the market, the callable loans would trade at a discount against the fully backed deposits.
I also think that the debates over the sustainability and ethics of FRFB are less important than the economic consequences of fractional reserve banking. No matter what the fine print in a deposit agreement says (and the language is not standard, by the way), if depositors view their checking account balances as one-to-one money substitutes, then prices and spending patterns will reflect the depositors’ own net worth calculations and expectations of disposable income. If a bank expands credit on top of that via fractional reserve banking, then the supply of credit and interest rates no longer reflect the depositors’ underlying real savings and rates of time preference. This wedge is what triggers the boom-bust cycle.
This brings us back to the addict analogy. Suppose an addict had the ability to magically create, ex nihilo, his own stimulating drug, as fractional reserve banks can do with money and credit. Suppose that the negative side effects of using the drug could be spread to all other members of society, as central banks and government deposit insurance allow for fractional reserve banks. Would you expect moderation? Would you expect healthy outcomes? Or would you expect an endless cycle of highs and crashes?
About the Author
Dr. Jonathan Newman is an Associate Professor of Economics and Finance at Bryan College and a Fellow at the Mises Institute. He earned his PhD at Auburn University while a Research Fellow at the Mises Institute. He was the recipient of the 2021 Gary G. Schlarbaum Award to a Promising Young Scholar for Excellence in Research and Teaching. His research focuses on Austrian economics, inflation and business cycles, and the history of economic thought. He has taught courses on Macroeconomics and Quantitative Economics: Uses and Limitations in the Mises Graduate School.
Article cross-posted from Mises.
Angel Reese Slammed After Bragging About COVID Vaccinations – ‘Waiting for the Next One to Come Out’
by Western Journal
When young people say dumb things, those who know better tend to err on the side of grace. After all, let them make their mistakes. On the other hand, when those young people emerge as athletic stars and then build a platform from which to spew nonsense in a way…
Sylvester Stallone Survived an Abortion: “I Was Brought Into the World by Accident”
by Life Site News
Sylvester Stallone, known for his roles in Creed and Rocky, opened up about surviving an abortion attempt. His daughters, Sophia and Sistine Stallone, host the Unwaxed Podcast. They interviewed their father about his new Netflix documentary, “Sly.” During the episode, they discussed Stallone’s childhood, something that is addressed in the…
‘What the F***’: Joe Rogan Destroys NYT Headline Warning About Dangers of Constitution
by Daily Wire
Podcaster Joe Rogan absolutely destroyed a recent New York Times headline that warned about the dangers of the U.S. Constitution, suggesting that there’s no amount of “gaslighting” the news organization could do to make him see their side. During “The Joe Rogan Experience” podcast, Rogan and his guest evolutionary biologist,…
What Do They Know? Russia Increases Daily Gold Purchases by 700%
by Sponsored Post
In a significant move, Russia’s Finance Ministry has announced plans to allocate 8.2 billion rubles ($92 million) each day for gold and foreign currency purchases until October 4, the nation’s Finance Minister announced. “The amount of funds allocated for purchases of foreign currency and gold totals 172.9 billion rubles,” the…
CNN Data Guru Says Trump Will Win if He “Outperforms His Current Polls by Just a Single Point”
by Jason Cohen, Daily Caller News Foundation
(DCNF)—CNN senior data reporter Harry Enten said on Friday that former President Donald Trump will win the November election if he can slightly surpass his current poll projections. Vice President Kamala Harris is leading Trump by just 0.2% in the top seven battleground states, according to the RealClearPolling average. Enten,…
New Jobs Report Shows Millions of Americans Lost Jobs to ‘Foreign-Born’ Workers, F/T Work Yields to P/T
by Red State
Trying to nail down Joe Biden or Kamala Harris on the number of jobs they’ve “created” — the government does not create jobs; it can create economic conditions that can lead to job creation or job losses — during the last disastrous three-and-a-half years is like trying to nail Jell-O…
Putin Avoids ‘Kursk Trap’ as His Troops Poised to Take Pokrovsk
by SHTF Plan
President Putin has continued to downplay Ukraine’s major Kursk invasion, which has resulted in Russian territory occupied by Kiev forces, and has instead maintained that capturing and holding all the Donbas in eastern Ukraine remains the goal. “We have to deal with these thugs who made it into Russia,” he…
Leaked Army Advisory Warns of Migrant Gang Violence in Major Cities
by The National Pulse
A threat advisory issued by the U.S. Army to Department of Defense (DOD) personnel across the country warns the Venezuelan gang Tren de Aragua (TdA) has established a significant foothold in multiple American cities and poses a serious danger to local, state, and federal law enforcement. The document—designated as Controlled…
Are You Ready for the Big Steal … Again?
by Richard Blakley, WND
(WND)—The 2020 election was a mess. Only the gullible and self-deceived believe Joe Biden legally obtained more votes than any presidential candidate in U.S. history. If this were true, Democrats would have beaten their drums concerning this “historic” vote, like the pig in the old Valleydale Sausage commercials, but even…
YouTube Uses DOJ Allegations to Justify Axing Tenet Media’s Channel Without Due Process
by The Federalist
The widely used video platform YouTube removed Tenet Media and related channels from its services on Thursday after the Justice Department accused the company of partaking in a secret Russian influence operation. The revelation comes days after the Biden Department of Justice (DOJ) announced the seizure of nearly three dozen…
Has Anyone Noticed That We Know More About Yesterday’s School Shooter Than Crooks?
by Hot Air
The mainstream media has already done a deep dive into the bizarre details of the perpetrator of yesterday’s school shooting, and we have gotten more media availabilities from law enforcement on the events than we have yet gotten from July 13th’s attack on Donald Trump and the three other victims…
Strong Dad Engagement Programs Are Funding the Fight for Fatherhood to Save the Fatherless
by Caldron Pool
“The men the world is raising are not the men the world needs.” No man is born an expert on fatherhood. Good fathers are taught through blunt advice, wise counsel, observation, experience, and their environment. This is why responsible fatherhood programs are saving lives, and why we should be talking…
Ex-CNN Analyst Says Commiela Harris “Has More Riding On” the Debate Than Trump, She’ll Be “More Nervous”
by Jason Cohen, Daily Caller News Foundation
(DCNF)—Former CNN political analyst Chris Cilizza said Friday he believes that the upcoming presidential debate holds more significance for Vice President Kamala Harris than it does for former President Donald Trump. Trump and Harris are slated to compete in their only scheduled presidential debate on ABC News on Tuesday. Cillizza…