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To answer the question of whether fractional-reserve banking is compatible with Bitcoin it may be helpful to first inquire as to whether fractional-reserve banking is compatible with the free market. As compelling new evidence is presented, I change my views. In this context, I think Bitcoin can be viewed a grand economic experiment that can help us better understand money in a free market.
The issue of fraud in fractional-reserve banking can be broken down into two parts. First is the question of whether fractional-reserve banking was historically conducted in a fraudulent manner. The second is whether fractional-reserve banking could be conducted in a non-fraudulent manner going forward. The answer to the first question is empirical. Admittedly, I do think there may have been some fraudulent activity in the case of the London goldsmiths.
Wealthy merchants stored their gold with the King at the Royal Mint. During the English revolution Charles I raided the Royal Mint causing a loss of confidence in the safety of deposits. The merchants started looking around for a place to put their gold and ultimately settled on the goldsmiths.
Now we may ask, why goldsmiths? I think the answer is pretty obvious — they had experience storing gold. The fact that the goldsmiths started lending out the gold deposited with them seems, to me at least, to be prima facie evidence that fraud may have taken place.
George Selgin disputes this claim in his article Those Dishonest Goldsmiths and provides some circumstantial evidence of contractual fractional-reserve banking. In my opinion the evidence is inconclusive. Again, the most likely scenario is that fraud took place in some instances and not in others. History aside, what we really want to know is could fractional-reserve banking be practiced legitimately going forward.
The answer is obviously yes. Neither am I pessimistic of the ability of a bank to effectively manage its reserves and avoid bank runs. Bank runs are typically a byproduct of government intervention instilling moral hazard in the banking system, causing the business cycle etc. In a stable economic environment, I would expect bank runs to be few and far between. To the extent that they do occur, a simple suspension clause in the contract could help the bank avoid total collapse.
So while I see the benefits of fractional-reserve investment banking, I do not believe it would translate into a fractional-reserve monetary system in a genuine free market.
Why do I say this? It may be helpful to remind ourselves on how money originates in the marketplace. What do you do if you are unable to obtain what you want through a direct barter spot transaction?
By this process, the most saleable good or goods becomes the medium of exchange Menger Essentially what he is saying is that whichever good or goods is the most liquid will establish itself as the medium of exchange in the free market. This seems logically false on the surface. Each bank is located in a different geographical region, is staffed by individuals of varying talents, and has differing risk exposures.
How could financial instruments issued by such institutions trade on par with each other? Again, it seems very unlikely. Surely there could be fractional-reserve Bitcoin investments such as savings accounts, but imagine what it would take to have a fractional-reserve Bitcoin monetary system. People would have to start issuing risk-bearing Bitcoin financial instruments and the general public, including merchants, would have to decide that they would rather accept these most likely heterogenous risk-bearing instruments in place of Bitcoin proper.
Does that seem even remotely plausible? Now there are Bitcoin financial instruments out there see Bitcoin Trading Co. Now one could object that Bitcoin is still in its infancy, just give it time. A fractional-reserve monetary system did evolve on the free market. Using a similar line of reasoning one could easily say: Saying it must be 1 without expounding on why my reasoning is wrong, while ignoring possibility 2 , is not a serious argument.
Now I want to turn to the few genuine attempts to rectify this discrepancy. Since the banknotes are designed to circulate, there is no way of identifying the person currently in possession of a note to bill them for storage. The bank will have no choice but to subtract the fee when the note is redeemed.
This will result in each note in circulation having a different value relative to par, which would be unworkable for a medium of exchange. Thus fractional-reserve banking evolved out of convenience. Before I address this argument, first let me say that Bitcoin renders it null and void. Since bitcoins are traded electronically, banknotes to the extent anyone would bother to produce them would be little more than a novelty.
Still, I find this argument particularly odd. We could have a banknote-less monetary system could we not? After reading his article I jotted down a list of possible ways to conveniently issue such notes:. In fact, for those familiar with the Bitcoin industry, this is the exact business model of Coinbase. Coinbase offers free bitcoin storage to its customers as a means means of incentivizing them to buy its other products — namely merchant services and bitcoins sold at a small markup over spot.
For example, if we assume a deposit-to-note ratio of 3 to 1, the bank could simply charge. Consider, merchants who accept credit cards payments must pay fees to the issuing bank. That means they receive varying amounts for their products depending on what type of payment the customer uses. Cash, of course, has zero fees. Yet, with the exception of a few gas stations here and there, nearly all merchants charge the same price no matter what type of payment you use.
Most notes wear out too quickly to circulate much longer than a few years. If a banknote circulates for three years, it would be worth If I remember right, his argument was something like: And 5 Bitcoin once again renders this argument moot since storage fees are zero. Let me start with a story about myself that might serve as anecdotal evidence. When I opened my first checking account as a teenager, I naturally assumed the money I deposited in that account was simply kept in a vault somewhere.
It never occurred to me that the bank was loaning out my money. Why did I make that assumption? I knew that savings accounts paid interest, so the bank must be loaning out those funds. But I checked other sources, and sure enough, it was right. Now what percentage of the public thinks like I did? Given that most of the public is financially illiterate, I highly doubt that is a valid assumption.
Is there anything on them to indicate that they are, in reality, financial instruments? Is there any statement regarding credit risk? Any statement regarding liquidity risk? Does it say anywhere on them they constitute a loan to a bank an interest free! Now a free banker would likely say: If I want to sell you a broken down car I must disclose that fact to you, else I mislead you into making a purchase you otherwise would not have made.
I would have never known they were really risk-bearing financial instruments. My guess is that there is a large portion of the financially illiterate public, both back then and now, who would do the same. Not to mention the banks have zero incentive to actually disclose this information to their customers without a legal requirement to do so. The more their notes resemble actual warehouse receipts, the more liquid they will likely become given the lack of financial literacy among the public.
Not necessarily untruthful, but not exactly full disclosure either. So what happens if a significant percentage of the public is driving up the liquidity of fractional-reserve banknotes under the mistaken belief that they are fully backed? And of course once governments got involved in the in the 18th and 19th centuries this only served to institutionalize the practices that originated in the early days of banking.
So to wrap it up, the market case for a fractional-reserve monetary system is not nearly as compelling as it is made out to be. Had that been the case with gold and silver, the banking system would likely have evolved on a completely different path than it did. You are commenting using your WordPress. You are commenting using your Twitter account. You are commenting using your Facebook account. Notify me of new comments via email. Notify me of new posts via email.
The Fraud Question The issue of fraud in fractional-reserve banking can be broken down into two parts. Fractional-Reserve Money So while I see the benefits of fractional-reserve investment banking, I do not believe it would translate into a fractional-reserve monetary system in a genuine free market. After reading his article I jotted down a list of possible ways to conveniently issue such notes: Take a look at the following fractional-reserve notes: Iakovos Alhadeff July 4, at 2: Leave a Reply Cancel reply Enter your comment here Fill in your details below or click an icon to log in: Email required Address never made public.
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