WorldSys: Austrian Home Study Course, Week 19

READINGS: Sections from Murray Rothbard’s What Has Government Done to Our Money, Henry Hazlitt’s Economics in One Lesson, and Lew Rockwell’s The Economics of Liberty.

1 What are the functions of a bank?

In Rothbard’s vision banks act as warehouses storing big piles of gold on behalf of depositors. The banks might issue gold-substitute certificates so that large transactions don’t require physically moving gold around, but otherwise they would do little in the way of investing or speculating (except, one assumes, in those cases when the bank makes clear upfront that they intend to do so and gets advance consent from depositors)

2 How does the existence of banks encourage saving and investment?

With banks around you have a safe place to store money long term. If you have to keep piles of gold in your house or buried in your yard, you’ll be less incentivized to accrue large amounts of it because it’s a hassle to guard and organize and also takes up a lot of space. Not so with banks.

By analogy, we can say that banks encourage saving and investment in the way that gyms encourage exercise. There’s nothing stopping people from doing push-ups or even building an entire workout facility in their home basement, but that places hurdles in your way which don’t appear if you just go somewhere else to workout.

3 What is fractional reserve banking?

Fractional reserve banking occurs when banks only retain a small fraction of total deposits in reserve. So if bank A has $1,000,000 in deposits and keeps all $1,000,000 in its vault, it’s just a money warehouse, but if bank B has $1,000,000 in deposits and loans out all but $10,000 of it, it is engage in fractional reserve banking.

The latter approach has all sorts of potential dangers, most obviously being the possibility of many depositors asking for their money simultaneously and precipitating a ‘bank run’.

4 What is central banking?

A system in which an often nominally private bank will be closely intertwined with the government and enjoy state-backed monopoly on issuing currency. In the United States the system of central banking began with the Federal Reserve Act of 1917, which established our central bank and set up various provisions. Among these, for example, is the fact that all banks must keep a fraction of their reserves in deposit at the Federal Reserve — they can’t just keep gold reserves in their own vaults.

Central (and sometimes even private) banks are afforded the privilege of suspending specie payments; that is, they can refuse to redeem bank notes when their depositors come demanding their deposits back. This is a big part of why there were economic crises even prior to the instantiation of the Federal Reserve.

5 Is government oversight necessary to ensure sound banking?

If anything, government involvement in the banking sector just introduces more problems and distortions in the incentive structure. In a truly free banking system each bank would be constrained by a handful of factors: the narrowness of its own clientele, the narrowness of the clientele of the whole banking industry, and the overall confidence of the clients in their banks.

So if a single bank begins drastic inflation it will lose the supports of its patrons, who will then move on to another bank. As with any other business banks would be compelled to provide the product and service most demanded by the public.

Now let’s examine how government oversight has changed this picture. By gradually pulling society away from using gold and silver and toward using paper money the government has made inflation possible at a scale inconceivable before; by allowing for the suspension of specie payments the U.S. government made it possible for a nominally private banking sector to precipitate numerous economic crises throughout the 20th century. Of course the establishment of the Federal Reserve in 1913 was meant to head off these swings, and it has accomplished nothing but to profoundly exacerbate them.

All in all it looks to me as though banking, like most things, should be left to the private sector.

6 Why is the government interested in controlling the banking system?

Such control affords the government a fair bit of power in the form of being able to manipulate both the money supply and the over all level of inflation in the economy. And If a government has enough control over the central banking system it can go off the gold standard, effectively removing the last check on its power.

7 In what sense can banks “create money” by making loans?

They can simply write checks for assets against their reserves. If there isn’t a gold standard this is relatively straightforward — a central bank can buy a $1000 asset by writing a cheque for $1000. Obviously if this is taken too far too fast then the resulting inflation could cause the economy to spiral into depression, but if used judiciously then why shouldn’t a bank simply declare itself to have more of the baseless green pieces of paper floating around?

8 Wouldn’t banks lose money if they held 100 percent reserves?

No, they would charge fees for handling and storing money like any other warehousing operation. It’s conceivable that such banks in the free market might work out some sort of investment vehicle to be funded with depositor money with the depositor’s consent, in which case you’d have <100% reserves without the nightmare of ultra-leveraged fractional-reserve banks.

9 Don’t high interest rates slow economic growth?

In some ways and in some circumstances. The Austrian view of interest rates is that they are a kind of price, an exchange rate between current and future dollars. This price might be prohibitively high and thereby discourage investment in a manner similar to the way in which high startup and overhead costs might discourage someone from opening a capital-intensive business on credit. But the point isn’t simply economic growth at all costs, it’s sound, sensible, sustainable growth which steadily enlarges the pie for everyone.

That having been said it’s hard to know whether or not a high interest rate set by the free market would actually slow economic growth because other things like regulatory burden and regime uncertainty would be less of a problem in the absence of state meddling.

10 Should the government give (or guarantee) low-interest loans to farmers and other important groups?

Look at it this way: almost by definition the government only lends to those whom individuals that had to risk their own funds didn’t think were safe bets. Armed with this insight alone we can probably conclude that the government shouldn’t be providing loans to such people with taxpayer money.

But we can expand this analysis and ponder the consequences of taking from one group of people to loan to another; just as we have to avoid the broken window fallacy, we must avoid the isomorphic ‘awesome government loans to poor farmers whom other people considered an unsafe bet’ fallacy (for which we really need a better title).

When taxpayer funds are diverted to beet farmers to buy tractors they are not loaned to another group, used on public works projects, or (preferably) returned to private individuals with a little note that says ‘sorry I robbed you.’ While we may never see the gap created by these non-ventures, it still exists, and we cannot ignore it for the sake of focusing on the spike in capital-goods ownership in the beet industry.

We needn’t stop at funds, though: the number of tractors is finite, and if the government is taking finite money and loaning it to farmers to buy one of the finite number of tractors no one else can buy that tractor. And government lenders needn’t pass the same rigorous tests as private lenders. A successful private lender must repeatedly exercise his judgement and risk his own funds with each transaction; a civil servant does not.

The distortions keep piling up.

11 Does saving cause business depressions?

No, it is only by saving that one can gain the funds required to invest, and only investments of this sort are what allow businesses to expand their stock of capital goods. It might conceivably be argued that if a large enough fraction of people simply buried their cash in their yards a depression might ensue. But the burden of proof is on them to demonstrate such conditions exist, because as far as I know no one ever saves money in this fashion.

As Hazlitt points out ‘active saving’ — putting your money in a bank, or investing it — is really just another, longer-term form of spending.

12 How does saving lead to capital accumulation?

People saving money and loaning it to businesses so that the businesses can buy capital goods.

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