Do banks mislead their customers?

This article is an attempt to encourage people to move away from making empirical assertions without any empirical evidence – to actually look at literature that banks provide for customers to see whether or not they mislead them.

There’s been a lot of debate about the Carswell Banking Reform Bill (also see here for an introduction), and thus far I’ve not contributed too much. If you’ve missed it, I’m referring to comments at the Coordination Problem blog (here and here, but you might also find the comments following an interview with Steve Horwitz at The Daily Bell amusing).

My understanding of the bill (and I keep stressing that until it’s been made public we all need to keep an open mind) is that people like myself – who understand and are happy with fractional reserve demand deposit accounts – would need to replace any existing accounts with new ones. Therefore my position is akin to George Selgin’s:

the question is whether your solution of making all “demand accounts” into bailments (even though people already can chose a safety deposit option) is an appropriate solution to that problem. I don’t think so, first of all, because it punished those intelligent enough to know what a demand deposit really means, and to appreciate the advantages of such deposits (please let’s set guarantees aside for the sake of this point), and, second, because if ignorance is the problem the straightforward solution is to hand every depositor sign a document declaring “I understand that my “demand deposit” is actually a debt contract and not a bailment, and that the banker is therefore under no obligation to hold cash reserves fully backing it” or whatever. For good measure the banks could also be required to hand their customers dictionaries for the purpose of looking up fancy words like “debt.”

But seriously: there is already too much legislation designed to protect the ignorant at the expense of the less ignorant. Let’s by all means help the former–but not at the latter’s expense.

The really exciting facet of the bill is that it attempts to eradicate deposit insurance by providing a safety net of custodial banking. Given that deposit insurance is one of the key problems identified by fractional reserve free bankers and 100% reservers alike, this could so easily be grounds for consensus – indeed no “free bankers” I know have any problem with the provision of custodial banking. Indeed during the financial crisis deposit insurance in the UK rose from £30,000 to £50,000 as an “emergency measure”. It should be obvious that anyone stupid enough to have more than 50k in a single current account probably deserves to lose their money, but at some point the public debate should come around to how to get rid of these emergency measures. I see a real opportunity for Doug Carswell and Steve Baker to say “as part of our efforts to reduce these emergency provisions we will facilitate the adoption of custodial accounts”.

My disagreement with their proposal centres on what we define as the status quo, and whether fractional reserve accounts should be opt-in or opt-out. It seems wrong to me to convert existing current accounts to custodial ones, and force people to then set up new ones to perform the same function as the old ones. It seems far simpler (and indeed politically feasible) to mandate that banks offer custodial accounts so that customers concerned about the elimination of deposit insurance can move some of their money into them.

Indeed compared to my own proposal, “2 Days, 2 Weeks, 2 Months” the difference with the Carswell/Baker bill boils down to framing effects and the status quo.

Therefore the only real argument that would convince me to support the Carswell/Baker proposal for transition is if I believed that current banking contracts are fraudulent, and thus should not be allowed to stand. However this poses several tricky issues. Firstly, it’s abundently clear that in UK law demand deposit accounts treat deposits as loans to the bank. As Current has alluded to, if the Cobden Centre simply took out full page adverts in the national newspapers and various billboards that say:

Your current account is an IOU not a receipt – it is *not* being stored for you in a vault, it is being lent out.

possibly with the following…

In the event of a bank run you will not be able to redeem it immediately, but the interest we pay compensates you against this risk.

…maybe even ending with

If you don’t like this by all means put your money in a safety box. No one is forcing you to give it to us

… then us Austrian school economists would have nothing left to quibble about! The law is clear – the problem is the public understanding of the law. But since this issue rests on public ignorance, there’s a few problems:

  1. Let’s say a judge finds that banks have indeed misled their customers, and therefore those contracts are not valid. What would the response be? Have the account holders been harmed by the fact that they’ve been holding debt contracts and not bailments? No! They’ve probably benefited from receiving a positive interest rate! So should the depositors have to pay back money to the bank?!
  2. People probably spend more time researching where to go on holiday than what bank to put their money in – should our aim be to insulate them against getting this decision wrong, or trying to encourage them to actively confront this decision? I’m for raising the costs of stupidity, not subsiding it!
  3. Why is banking any different to other industries? We know that the general public are “confused” about the health benefits of various foods. Are people surprised to learn that a particular Pret a Manger sandwich contains a third of your recommended daily salt intake? Or as their spokesman says, “People know that when they buy an All Day Breakfast sandwich it’s not the healthiest option” – if we did a survey that finds most people did think the sandwich was healthy would that be grounds to ban it? Or grounds to force Pret A Manger to offer a healthy range of sandwiches to provide a “choice”? You can see why there’s a suspicion that the Carswell bill is merely an example of conservative paternalism
  4. The specific survey that Carswell uses in his bill is “Public Attitudes to Banking“, which is not peer-reviewed and not perfect. Here’s my earlier post presenting the findings and responding to criticisms from Steve Horwitz. Aside from reflecting the well-known phenomenon of widespread public ignorance, the key question is “who do you think owns the money in your current account(s)?” The “correct” answer is “the bank does”, which only 8% of the people surveyed answered. However as a thorough subjectivist this leaves me uneasy. Is it possible that some of the remaining 12% (accurately believed) “I hold a property right with regards to the money in my account”?. I’m not sure. These are the perils of survey data. Handle with care.

All that said, I reiterate that when used with caution the survey improves our understanding of the sound money debate. As I mentioned in my talk on the findings (video, slides):

My claim is that these are empirical assertions and to my knowledge neither side has attempted to resolve this by commissioning a study of the general public. Therefore claims about deception are moot until such a study is made

I’ve tried to take a step forward on this and encourage other people to improve on the questions and gather more data. Let’s go beyond pop quizzes in class and get some robust evidence.

Indeed – and this is the point of this article, apologies for taking so long to get here – these debates seem to have generated another set of empirical assertions similarly devoid of study: the extent to which banks mislead their customers.

I won’t provide citations, but anyone familiar with the academic literature (and indeed the resulting internet comments exchanged) will recognise this. It is my intuition that banks are less than open about the products they offer, and my priors are that the general public are understandably confused. But given etymology is such an important component of 100% reservers’ arguments, why does no one point out that in the UK at least the phrase “demand deposit” is hardly ever used?

Indeed the last few times I’ve been in town I’ve popped into the main high street banks and read their literature on how banking operates. My simple conclusion is this:

Banks aren’t clear about how their accounts operate, but I don’t see outright falsehoods and this is therefore “merely” a profit opportunity for banks to improve on their customer services

I believe in the power of the consumer to encourage banks to improve the information they provide. My wife was recently talking to the people behind the redesign of the Lloyds TSB website, and passed on my joy that you can now download your statements as a CSV file. Why can’t you also use tools to label different items on your balance, so that you can have a breakdown of spending? I don’t know, but in the same way that banks now compete over switching costs, let’s apply consumer pressure to put:

Your current account is an IOU not a receipt – it is *not* being stored for you in a vault, it is being lent out.

on every website/statement. Yes, as interventions go this wouldn’t be a particularly bad one, but let’s exhaust voluntary pressure before turning to the state.

That said, let’s look at some of the evidence that can be easily found via the internet. Firstly, notice how Santander explain their savings accounts (below): they make a *clear* distinction between “instant access accounts” and “fixed rate savings bonds”. No mention of “demand deposit”, just a trade off between easy access vs higher interest rates.

San 2

My aim here is to concentrate on the public information, so I’ll leave it to others to read the small print (although I’m surprised if no one has already done this yet??) but note that the links for the legal documents for Santander’s current accounts don’t work.

Barclays are similar. As you might expect, they play up the “security” of a fixed rate bond rather than the “insecurity” of an instant access one, but I’d have though most people can tell the difference.

Barclays1 Barclays2

Also see Lloyds – they very clearly label their fixed term savings accounts:

Lloyds2

Again, there’s little information about how they are able to offer a positive interest rate on their current accounts/instant access savings accounts. But this also brings home the point on deposit insurance. They provide an FAQ on whether savings are “protected”:

Lloyds10
I hadn’t known about the FSCS but this also raises the possibility of private deposit insurance:

Lloyds11

Of course the debate then becomes whether the FSCS must be “100% reserved”(!) but I’ll point out that this is a separate insurance company (not a bank), so at this point the argument that “insurance companies don’t need to be 100% reserved because they’re not banks” falls down completely.

Also, there’s another chance to stray too far into debates about terms – some might argue that “instant access accounts” can’t possibly be called “savings”. Well if my jar of pennies counts as savings, and my collection of books, so can some callable loans from Lloyds TSB.

Now, I don’t want to be dismissed as some dogmatic “free banker” – after all I have modified my opinion on this debate over the last few years and have moved more towards the White/Selgin/Horwitz view because I have recently re read their works and find them more persuasive than the alternatives. But just to show that I do try to find a middle ground, here’s some ammunition for the “current practice is fraud” crowd:

Barclays1

:-)

Finally, taking the historic route: see a selection of bank notes from Larry White’s personal website, or the following text via George Selgin:

Bank of Scotland L5 note, 1730-65: “one pound sterling on demand, or in the option of the Directors one pound and sixpence sterling at the end of six months after the day of demand.”

My fear is that if our goal is to eradicate public ignorance we commit the same errors as the socialists – ignorance is our starting point, a fact of nature. It’s the institutions we build to deal with that which are important – eradicating deposit insurance, adopting living wills, removing emergency liquidity support, eradicating moral hazard, keeping banking experiments localised, improving regulation through competition, closing the discount window. We do have a positive program for laissez-faire.

Cross posted at The Filter^

10 Comments

  • George Selgin says:

    In the US, Tony, language like the following (from Bank of America) appears in the “Agreement and Disclosure” supplied to every bank customer upon the opening of a new demand deposit account:

    “Our deposit relationship with you is that of debtor and creditor. This Agreement and the deposit relationship do not create a fiduciary, quasi–fiduciary or special relationship between us. We owe you only a duty of ordinary care. Our internal policies and procedures are solely for our own purposes and do not impose on us a higher standard of care than otherwise would apply by law without such policies or procedures.”

    That seems to me very explicit and complete.

    • George, this is where we need to get to in the UK . Nothing at all is a clear as this in any banking docs I see. I would change and make sure they are a fiduciary though. At its very basic level all banking is a fiduciary arrangement .

  • Current says:

    Part of the problem with interpreting survey results is that normal people often use “money” to mean money-in-the-broader-sense. That is, to refer to both government fiat notes and bank account balances.

    The question “who do you think owns the money in your current account?” means something different depending on whether “money” means money in the narrower sense or the broader. The account holder doesn’t own any money-in-the-narrower sense, and if he or she believes that they do then they’re wrong. But, if they mean that they own a “money substitute” then they’re right because the debt the bank owes them is a money substitute, they own the title to that debt.

    I’m going to read the terms and conditions for my bank account soon and see whether it is clear or misleading. But, not today, I’ve spent most of today with boring paperwork.

  • waramess says:

    Given the clear choice of being a creditor of the bank and earning a rate of interest or having the bank hold the money as trustee and charging a fee for so doing I suspect the decision would be overwhelmingly in favour of earning a rate of interest.

    Has nobody ever done a survey?

    The matter of priority in the event of a liquidation would, I suspect, vaporise.

  • jm says:

    I’d really like to make sense of the FRFB view – but I can’t. My problem is that Current says on the Coordination Problem thread “Let’s suppose that a bank is operating normally. It’s reserves are sufficient to meet normal redemption requirements. It has more assets than liabilities.”

    By this I think he means something similar to what Lee Kelly says further down – “Consider 2 FRFBs, A and B, each with a 10% reserve ratio. Assume this ratio is optimal given the withdrawal rate of its depositors. That is, a lower ratio would leave the bank unable to satisfy the demands of its depositors, while a higher ratio would require foregoing profitable loans.” And George Selgin says there is a “greater supply of real loan funds…. compared to a warehouse system” – that is, we have more paper circulating (or account entries or whatever) than gold (assuming reserves are all gold).

    It is taken as read that this situation where there is a fraction of reserves being held, enough to satisfy “normal redemption requirements”, is “normal”. But this seems to me to be starting half way up the ladder and is in fact anything but normal to me. The step from 100% commodity reserves to fiduciary media requires that we just assume we can replace a scarce commodity (gold coins) with something else that, whatever else it is, IS NOT a scarce commodity in a market, and this complex system we call the economy will go on as before.

    The whole price system is originally based on an amount of gold. Then it becomes (some gold + “a bunch of promises to do something”). The first is a conserved quantity, the second is not – it is a non-scarce entity and therefore much more volatile and unstable than the first and in my estimation is totally unsuited to be used as the measuring stick for prices (rather like replacing a thermometer with your elbow). Currencies which are scarce have evolved on the free market, moving step by step from no price system towards a full price system and therefore have proven they can “measure” prices sufficiently well, whatever that means. Unbacked paper money has only ever piggy-backed on top of an existing commodity money price system.

    This jump to fiduciary media seems to be a gigantic and wholly unwarranted assumption to me. A question to a FRFB person is, do you just say that this system will work the way it did before; or do you say that it will be different but equally useful; or do you admit there is some cost associated with it but that the benefits of only having to use a fraction of the gold that would be necessary for 100% reserves outweigh these costs. I genuinely don’t know the answer.

    Lawrence White talks a lot about listening to what kind of money the people want. Firstly, that this might be the type of money people indicate that they want is irrelevant to establishing the objective consequences of this change.

    Secondly, this ignores the fact that something called money only exists AT ALL because someone found something fungible, hard to fake etc. which gradually took hold and all the time prices, using this measuring stick, were in line with each other. The thought of trying to introduce “fiduciary media” if people carried gold with them at all times (impractical but entirely possible in a thought experiment) makes less than no sense at all – but now suddenly because we use paper, we can do this?

    • Current says:

      > The step from 100% commodity reserves to fiduciary media
      > requires that we just assume we can replace a scarce
      > commodity (gold coins) with something else that, whatever else
      > it is, IS NOT a scarce commodity in a market, and this complex
      > system we call the economy will go on as before.

      The discussions that you refer to were concerned with showing that not assets can be created “out of thin air”. That is, fractional reserve banking without government privileges doesn’t give banks privileges. But, that doesn’t mean that money based on fractional reserve banking would be good money that keeps a relatively stable value. The argument about that is different.

      > The first is a conserved quantity

      Whether it is depends on the supply of gold. Ask yourself: do we want money to be a conserved quantity? I would say that we don’t. What people are interested in for economic calculation isn’t that a certain amount of money exists, it’s that the purchasing power of money doesn’t fluctuate excessively.

      > Currencies which are scarce have evolved on the free market,
      > moving step by step from no price system towards a full price
      > system and therefore have proven they can “measure” prices
      > sufficiently well, whatever that means. Unbacked paper money
      > has only ever piggy-backed on top of an existing commodity
      > money price system.

      How has it “piggy backed”? In many places fractional reserve notes overtook commodity money without government help.

      > This jump to fiduciary media seems to be a gigantic and wholly
      > unwarranted assumption to me.

      As you mention in that next line it’s worth mentioning that it has worked before.

      > A question to a FRFB person is, do you just say that this
      > system will work the way it did before

      I think it would work pretty much as it did before. What we didn’t mention very much in the other threads is why we think fractional reserves would not lead to wide fluctuations in the price level.

      Think about the position of a bank planner in a fractional reserve bank. As Lee Kelly mentions he must ensure that he has adequate reserves to meet redemption demand. That means that the amount of money is limited on two fronts, firstly by the amount of good loans that can be made and secondly by the amount of gold reserves. Redemptions are a limiting factor, there’s little banks can do about redemptions. As a result the amount of money they can create is limited. Technological improvements and improvements in clearing processes may expand it slowly over time, and that did happen in Scotland. Finding good borrowers is also a limiting factor.

      Read about the theory of adverse clearings. It’s at the start of Larry White’s book “Free banking in Britain” and in “The Theory of Money and Credit”.

      > or do you admit there is some cost associated with it but that
      > the benefits of only having to use a fraction of the gold that
      > would be necessary for 100% reserves outweigh these costs. I
      > genuinely don’t know the answer.

      It’s not just about the costs of the gold reserves themselves. More importantly, a 100% reserve system is not flexible in a crisis. It has no way to accommodate a rise in demand for money without price deflation. No 100% reserve system has existed in a modern monetary economy.

      > The thought of trying to introduce “fiduciary media” if people
      > carried gold with them at all times (impractical but entirely
      > possible in a thought experiment) makes less than no sense at
      > all – but now suddenly because we use paper, we can do this?

      I don’t see why you think this doesn’t make sense. If everyone used gold coins then I think people would be quite happy to change to fiduciary media such as bank accounts because they provide extra services that gold coins don’t provide. What part of it do you think doesn’t make sense?

      • jm says:

        “Whether it is depends on the supply of gold. Ask yourself: do we want money to be a conserved quantity? I would say that we don’t.”

        Conserved is a first approximation to what I mean, maybe that wasn’t very clear. Let’s say a “conserved” quantity is one which you can only increase the supply of by interacting with the price system – that is, by utilising the required amount of capital/labour/materials at the current market prices. This act of increasing (or more accurately of deciding to try to increase) a conserved is therefore something that is part of normal economic calculation. In contrast to unbacked credit, whose supply can be increased at will (and, as de Soto says, the demand for it can be created at will also).

        “What people are interested in for economic calculation isn’t that a certain amount of money exists, it’s that the purchasing power of money doesn’t fluctuate excessively.”
        Well if this is true, and IF we demonstrate that paper money without corresponding reserves brings about business cycles/credit crunch/economy wide liquidations, then I think you must agree that paper money does not satisfy your requirement “the purchasing power of money doesn’t fluctuate excessively”. So you must think that unbacked credit (without a central bank) cannot bring about the business cycle?

        “How has it “piggy backed”? In many places fractional reserve notes overtook commodity money without government help.”

        FRB has “worked before”? It depends what you mean by “work”. I’m not denying that introducing a way for some members of the economy to manufacture purchasing power without having to go to the bother of correctly weighing up the price of the factors and the desire of the market participants and persuading someone to part with their real, hard savings etc. won’t catch on. I’m sure it will. The questions are, 1) is this violating anyone’s rights? 2) is this inconsistent with the desire that “the purchasing power of money doesn’t fluctuate excessively”.

        “Think about the position of a bank planner in a fractional reserve bank. As Lee Kelly mentions he must ensure that he has adequate reserves to meet redemption demand. That means that the amount of money is limited on two fronts, firstly by the amount of good loans that can be made and secondly by the amount of gold reserves. Redemptions are a limiting factor, there’s little banks can do about redemptions. As a result the amount of money they can create is limited. Technological improvements and improvements in clearing processes may expand it slowly over time, and that did happen in Scotland. Finding good borrowers is also a limiting factor. Read about the theory of adverse clearings. It’s at the start of Larry White’s book “Free banking in Britain” and in “The Theory of Money and Credit”.”

        ‘Adverse clearings’ is not mentioned in my copy of TMC as far as I can see. But if you mean the process by which the redemption requests of other banks will limit the credit expansion of a given bank, then I understand this process as described by Rothbard in, say, The Mystery of Banking. Like I said though, this is half way up the ladder – this just assumes banks can and should create credit unbacked by reserves, that there is some economic problem (say a greater desire to hold cash balances which would cause prices to lower) that is solved by this. I think this is an absolutely ridiculous solution to this (non-) problem, and if something like it were proposed to solve a problem in an engineering context on some complex system, it would be laughed out of the room. It is truly an awful way to proceed. I accept that right now this is assertion on my part but that doesn’t make it any less true.

        “It’s not just about the costs of the gold reserves themselves. More importantly, a 100% reserve system is not flexible in a crisis. It has no way to accommodate a rise in demand for money without price deflation. No 100% reserve system has existed in a modern monetary economy”

        I just don’t understand what “accommodate” means here. People want to hold more money (let’s say after an earthquake). Prices OUGHT to go down, to reflect this – prices are the information and why would you would want these prices to be inaccurate? This will cause a problem for producers, who now have capital and loans that are prices incorrectly, is that it? I see this as a non-problem – that sound plans are sound plans and (as described by Hulsmann in his essay Deflation and Liberty) adjusting to dropping prices has costs, yes, but so long as the price information available to the bankers and entrepreneurs is sound, loans and the like can be renegotiated. The problem is when the prices and/or interest rate are wrong (that is, when unbacked credit has lowered the rate below the natural market rate).

        “I don’t see why you think this doesn’t make sense. If everyone used gold coins then I think people would be quite happy to change to fiduciary media such as bank accounts because they provide extra services that gold coins don’t provide. What part of it do you think doesn’t make sense?””

        When the argument for time preference is put forward, that goods are preferred sooner rather than later, an objection can be “I might reasonably prefer an ice cream next August than one now while it is Autumn (in the UK)”. But of course the reply is – “it is a different good”. Physically it is the same, but one of its relationships with the external world is different – you can say “coldness” is more scarce in summer than winter or something. Well, when bits of paper and gold are in a 1:1 ratio and are then like deeds to a house or the log book for a car, they are Good A. When they are not – when someone creates a new one for 100 Oz of gold and spends it exactly as he would have done were it not printed up but in fact corresponded to 100 Oz of allocated gold, then my view is that these bits of paper immediately become a different good, Good B. That is, people are using Good B, with a different value and different properties to Good A (it is, not “conserved” as I described above), as “money” and therefore the relative prices will change – because no’one’s preferences changed, this guy who got the 100 Oz note spent it on the next thing on his preferences list, on something that previously (with 100% reserves) the prices and preferences deemed him unable to afford. Prices are not out of whack. This is what doesn’t make sense to me – we are exchanging one good for another and thinking we can just get on with it exactly as before.

        • Current says:

          > “Whether it is depends on the supply of gold. Ask yourself: do
          > we want money to be a conserved quantity? I would say that we
          > don’t.”
          >
          > Conserved is a first approximation to what I mean, maybe that
          > wasn’t very clear. Let’s say a “conserved” quantity is one
          > which you can only increase the supply of by interacting with
          > the price system – that is, by utilising the required amount of
          > capital/labour/materials at the current market prices. This act
          > of increasing (or more accurately of deciding to try to
          > increase) a conserved is therefore something that is part of
          > normal economic calculation. In contrast to unbacked credit,
          > whose supply can be increased at will (and, as de Soto says,
          > the demand for it can be created at will also).

          But, in any economic system capital, labour and so on are only part of the story. There are also, debts, shares, contracts and titles, all these things are part of economic calculation too.

          Fiduiciary media are part of economic calculation in a free banking system. In a free banking system they are not “unbacked”, in the sense that’s normally associated with that word. They are backed by the bank’s assets.

          > “What people are interested in for economic calculation isn’t
          > that a certain amount of money exists, it’s that the purchasing
          > power of money doesn’t fluctuate excessively.”
          >
          > Well if this is true, and IF we demonstrate that paper money
          > without corresponding reserves brings about business
          > cycles/credit crunch/economy wide liquidations, then I think
          > you must agree that paper money does not satisfy your
          > requirement “the purchasing power of money doesn’t fluctuate
          > excessively”. So you must think that unbacked credit (without a
          > central bank) cannot bring about the business cycle?

          Yes, roughly speaking that is what I think. To be more precise, I don’t think that we can escape all fluctuations in the value of money. But, I think that free banking would work better than other systems.

          > “How has it “piggy backed”? In many places fractional reserve
          > notes overtook commodity money without government help.”
          >
          > FRB has “worked before”? It depends what you mean by
          > “work”. I’m not denying that introducing a way for some members
          > of the economy to manufacture purchasing power without having
          > to go to the bother of correctly weighing up the price of the
          > factors and the desire of the market participants and
          > persuading someone to part with their real, hard savings
          > etc. won’t catch on. I’m sure it will. The questions are, 1) is
          > this violating anyone’s rights? 2) is this inconsistent with
          > the desire that “the purchasing power of money doesn’t
          > fluctuate excessively”.

          Free banks cannot “manufacture purchasing power”. The main problem here is that explanations by Rothbard concentrate on reserves but they ignore bank assets.

          Rothbard discusses things as though a bank need only own, say 10% of the sum of balances in reserves and that is all. He underplays the fact that they must have the rest in other assets or they would be bankrupt. Think about it… If you owned a free bank how would you go about manufacturing purchasing power for yourself?

          If free banks really could “manufacture purchasing power” without cost to themselves, then why didn’t they when there was free banking?

          > “Think about the position of a bank planner in a fractional
          > reserve bank. As Lee Kelly mentions he must ensure that he has
          > adequate reserves to meet redemption demand. That means that
          > the amount of money is limited on two fronts, firstly by the
          > amount of good loans that can be made and secondly by the
          > amount of gold reserves. Redemptions are a limiting factor,
          > there’s little banks can do about redemptions. As a result the
          > amount of money they can create is limited. Technological
          > improvements and improvements in clearing processes may expand
          > it slowly over time, and that did happen in Scotland. Finding
          > good borrowers is also a limiting factor. Read about the theory
          > of adverse clearings. It’s at the start of Larry White’s book
          > “Free banking in Britain” and in “The Theory of Money and
          > Credit”.”
          >
          > ‘Adverse clearings’ is not mentioned in my copy of TMC as far
          > as I can see.

          Mises doesn’t mention those words, but he approves of the idea. It’s on p.325-326 on the Mises institute PDF and p.361-363 in the Liberty fund edition.

          Mises also gives the Banking school “law of reflux” in that book and explains why it’s wrong. That’s a useful adjunct because it shows the difference between the two. To be clear, I don’t think that the law of reflux is correct.

          > But if you mean the process by which the redemption requests of
          > other banks will limit the credit expansion of a given bank,
          > then I understand this process as described by Rothbard in,
          > say, The Mystery of Banking. Like I said though, this is half
          > way up the ladder – this just assumes banks can and should
          > create credit unbacked by reserves, that there is some economic
          > problem (say a greater desire to hold cash balances which would
          > cause prices to lower) that is solved by this.

          I think that there is a problem that is solved by this. That problem is fluctuations in the demand for money over time. Also, as you mention earlier it frees up the supply of gold for other things.

          > I think this is an absolutely ridiculous solution to
          > this (non-) problem, and if something like it were proposed to
          > solve a problem in an engineering context on some complex
          > system, it would be laughed out of the room. It is truly an
          > awful way to proceed. I accept that right now this is assertion
          > on my part but that doesn’t make it any less true.

          Markets don’t necessarily evolve structures that you would intuitively expect. Thinking about problems as an engineer does is not always useful in economics. I should probably mention that I’m an engineer myself.

          There are various systems though that are very similar. Consider tech support desks for example. Anyone who buys computer product X or Y can ring the tech support desk. But, the computer company doesn’t keep one tech support person available for each customet who has bought a product. The company has far few tech support staff than customers because it knows that it can rely on call volumes to behave in certain ways. By doing this the computer company isn’t cheating it’s customers if it has agreed only to provide a certain service and has provided that service. Its only cheating a customer if it promises to allocate a person to their tasks exclusively but doesn’t actually do so.

          > “It’s not just about the costs of the gold reserves
          > themselves. More importantly, a 100% reserve system is not
          > flexible in a crisis. It has no way to accommodate a rise in
          > demand for money without price deflation. No 100% reserve
          > system has existed in a modern monetary economy”
          >
          > I just don’t understand what “accommodate” means here. People
          > want to hold more money (let’s say after an earthquake). Prices
          > OUGHT to go down,

          Why? I agree that it is one way that the economy can recover, but I don’t think that it’s the only way.

          Consider what happens with FRFB if there is a rise in the demand for money. That rise means that people are offering a larger volume of loans to the bank. The bank may then lend out those loans. If the rate of redemptions falls then the bank doesn’t need to keep such large gold reserves. So, if the bank can find more suitable loan applicants it can enlarge the amount of fiduciary media it circulates.

          > to reflect this – prices are the information and why would you
          > would want these prices to be inaccurate?

          I don’t believe that it would make them inaccurate. I think that the argument that it would stems from a misunderstanding of Austrian economics. When a free bank issues fiduciary media and spends them that doesn’t add noise to prices. It represents the result of a transaction between customers of the bank, and the bank.

          Let’s suppose I have 1000 ounces of gold and I take them to a bank and ask for a note in return. The bank can then lend out those 1000 ounces of gold. Let’s suppose the bank then lends the gold out to another customer.

          Some would say, now I have a note for 1000 ounces of gold and the other customer has 1000 ounces of gold – that means we have created the illusion of a growth of resources. This isn’t true in the case of fiduciary media any more than it is true in the case of normal loans. That’s because the other customer has a corresponding debt that he owes to the bank, and the bank has a corresponding debt that it owes to me.

          > “I don’t see why you think this doesn’t make sense. If everyone
          > used gold coins then I think people would be quite happy to
          > change to fiduciary media such as bank accounts because they
          > provide extra services that gold coins don’t provide. What part
          > of it do you think doesn’t make sense?”
          >
          > When the argument for time preference is put forward, that
          > goods are preferred sooner rather than later, an objection can
          > be “I might reasonably prefer an ice cream next August than one
          > now while it is Autumn (in the UK)”. But of course the reply is
          > – “it is a different good”. Physically it is the same, but one
          > of its relationships with the external world is different – you
          > can say “coldness” is more scarce in summer than winter or
          > something.

          Yes, that’s true, Mises discussion of time preference refers to ends not to means. It’s the various composite ends that we prefer sooner rather than later not the individual goods and services that go towards attaining them.

          > Well, when bits of paper and gold are in a 1:1 ratio and are
          > then like deeds to a house or the log book for a car, they are
          > Good A. When they are not – when someone creates a new one for
          > 100 Oz of gold and spends it exactly as he would have done were
          > it not printed up

          Think about this step more. Can the bank that issues the note spend it “exactly as he would 100 Oz of gold”? No, he can’t. Let’s suppose we have two men Jim and Frank lending money to Terry.

          Terry wants to borrow an amount of 200 Oz of gold. Jim is a normal citizen, he lends 100 Oz of gold in coinage to Terry. Jim and Terry sign papers and leave. Then Frank who is a banker arrives, he lends a 100 Oz gold note to Terry. Both parties sign papers and leave. It may seem that Frank has created the note out of thin air and spent it. But, this isn’t how it is to Frank at all. He knows that Terry hasn’t borrowed money worth 200 Oz of gold in order to keep it, but to spend it. When Terry spends the 100 Oz gold note the person who recieves it will redeem it, if they don’t then the person after them will. By issuing a banknote Frank has put into circulation something which is money to other people, but is to him a promise to redeem. He gets an interest-free loan from all of those other people until the time when someone redeems the banknote, and at that time he must pay.

          > but in fact corresponded to 100 Oz of
          > allocated gold, then my view is that these bits of paper
          > immediately become a different good, Good B. That is, people
          > are using Good B, with a different value and different
          > properties to Good A (it is, not “conserved” as I described
          > above), as “money” and therefore the relative prices will
          > change – because no’one’s preferences changed, this guy who got
          > the 100 Oz note spent it on the next thing on his preferences
          > list, on something that previously (with 100% reserves) the
          > prices and preferences deemed him unable to afford. Prices are
          > not out of whack. This is what doesn’t make sense to me – we
          > are exchanging one good for another and thinking we can just
          > get on with it exactly as before.

          I agree that gold coins and fiduciary media are different. In a pure gold system you own an amount of gold, in a FRFB system you own a debt which is priced in terms of gold and returned to you using gold. But, I think that fiduciary media provide a good substitute for money. My earlier point was about something a bit different from your reply. I was explaining why people would choose to hold FM with it’s slight increase in risk rather than gold coins. The answer is because FM can provide extra services. Those extra services are now things like bank transfers, in the past they were things like the ability of banknotes to fit in envelopes.

  • George Selgin says:

    Toby, the notion of a “fiduciary” relationship in common law has a very special meaning. Among other things a “fidiciary” relationship is generally one in which the fiduciary agent _does not profit_ from its fiduciary undertakings. Consider the case of a trustee. Obviously to make banks “fiduciaries’ in this sense would rule out any role for them as (profit-making)intermediaries!

    These clearly are matters were careful use of language–and understanding of terms’ legal meanings–are of paramount importance. It is, of course, tempting to think that a “fidiciary” relationship is necessarily desirable–as if it meant nothing more than “trustworthy.” But that’s far from being the case.

    • Morning George,

      In equity I have the highest standards of care as a director, for which I get paid on my fish company. This is a profit focused enterprise for its shareholders for which I represent 76%. As a director of a mutual fund, for which I get paid, I have the highest duty of care to our shareholders, this is a profit maximising body, of which I am one of them.

      So, one should distinguish the fiduciary relationship that should exist between your banker (as employee) and you and the profit making entity of the bank itself.

      Also, in all arrnagements of equity, if the parties consent to a profit making activity, then this is always allowed.

      For me, this fiduciary relationship is long lost in modern banking.

      Your USA bank T&C’s is actually shocking. People entrust money to a bank thinking that there is a duty of care, we need to see a bit more of this and a bit less of the gambling aspects (unless consented to). Back to boring banking is the way forward.

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