Time Deposits: Fraud and the ABCT

0:00There's a debate in the Austrian libertarian movement between those who say that fractional reserve banking for demand deposits should be illegal in the libertarian society and creates the Austrian business cycle. On the side of those who say that it should be illegal and does create the business cycle are people like Rothbard, Hoppe, Holtzman, myself, Barnett, people associated with the Mises Institute and the quarterly journal of Austrian economics. On the other side are people such as White, Selgen, Seacrest, people associated with the SDAE and George Mason. Today's paper, we're extending this, we're sort of ratcheting it up a bit. Not only are we saying that demand deposits, fractional reserve banking is illicit and creates the Austrian business cycle, we're also saying if you borrow short and lend long for time deposits, this also is illicit and creates the business cycle.

0:56The people on the other side say, well, to just talk about fractional reserve banking and demand deposit, they say, well, it's a contract. And I say, contract, schmontract. There's something more important than contract, and that's property rights. And if the contract is incompatible with property rights, then it's an illegitimate contract per se. For example, if I contract with someone else to murder a third person, that's an illicit contract, or if I contract to sell a square circle. There is no such thing. That's a silly contract, an illicit contract. Right now in a small town there are 10,000 cars and 10,000 property titles to cars. If someone starts creating extra property titles to cars and tries to circulate them, that is per se a fraud and illegitimate, unless it's done as sort of a joke like you make monopoly money.

1:48Let me give you one example. Suppose I deposit 100 gold ounces in a bank and the bank has a 10% fractional reserve on the basis of demand deposits and they give me a demand deposit for 100 gold ounces. Fine. Then what the bank does is turns around and using its 10% reserve ratio lends out $90 or 90 ounces of gold to someone else and that other person also has Demand Deposit. Now Ayn Rand is very famous for saying that rights can't conflict and yet here rights are conflicting. I and this other person both have a right to a demand deposit for this well 90 or 190 gold ounces and yet there are only 100 gold ounces in the system. So there's a conflict in rights. You can't have two different people owning 100% of one thing. Yes, two people can own a car. I can use it Monday, Wednesday and Friday. You can use it Tuesday, Thursday and and the time deposit case.

2:47Walter had originally assured me he'd take two minutes. How much did he take? Yeah, that's what I thought. Okay, first of all, I don't know if Laura Davis is here, but I'm sure she is. And I'm sure she's here. Yeah, that's what I thought. Okay, first of all, I don't know if Laura Davidson's here, but we'd like to thank her because this is, what you're hearing today is two different papers that we put together. And she caught something, a mistake we made in one of them, and I'd just like to thank her publicly. I know she's here at the conference for catching a mistake for us, so thank you very much, and we thank her in the paper.

3:35Walter and I have lunch three or four times a week and we invariably talk economics and come up with ideas for things we think ought to be done. The Austrian theory of the trade cycle or business cycle, if you think back, I mean Mises writes about it in 1912, that's the origins, but there's not much in the theory of money and credit there. The first This real, lengthy exposition, I think, of the Austrian theory of the trade cycle, most people would say, is Hayek's book, The Monetary Theory of the Trade Cycle, which is late 20s, right? Listen to the title, The Monetary Theory of the Trade Cycle.

4:21But as far as I know, Mises never referred to it that way. Mises always referred to it as a circulating credit theory of the trade cycle. and I think there's a reason for that probably. If you go look in the estuary of somebody, give us a quick synopsis of the Austrian theory of the trade cycle. Well, the government inflates the money supply, drives down interest rates, that causes a systematic distortion of the allocation of resources, a systematic misallocation, distortion, right? And so it distorts the structure of production, but it's unsustainable and at some point you to get a hyperinflation which brings the system down or interest rates have to tighten up the money supply, interest rates skyrocket and at any rate, in either case, the mistakes that were caused in the boom by the inflation come to light and we have to have our correction.

5:17But to say that monetary inflation causes the business cycle is not necessarily true. Okay. Why not? Because what we do when we say that, we're assuming something. And what we're assuming, and Austrians are very clear that injection and distribution effects are very, very important, unlike mainstream economics. What we're assuming when we say that is that the way the new money, the monetary inflation enters the system is through the credit markets, the new money is lent into existence, but if instead government were just to print it, you know, if you got rid of the Fed, if you had private banks, you know, and that kind of thing, whatever, but the Fed, the U.S. Treasury, the government would have spent more than it takes in and print the money then and just spend it that way, not lending it into existence, but spending it into existence. Say, for example, paying all the policemen's and Salaries. But we'll just do that with printed money. Everything else we'll pay

6:21for with taxes, we'll print money to pay policemen salaries. That's not going to affect interest rates. That's not going to cause, yes, we're going to end up with more policemen than we otherwise did, but certainly it's not going to cause the systematic distortion of the allocation of resources as we think of in an Austrian business cycle theory. So So monetary inflation, if the new money is linked into existence, is a sufficient condition to cause a business cycle, but if it's not, then it won't cause a business cycle. So that's one thing that we need to look at. Then the question becomes, and this is something that comes up, is what the heck's a demand You deposit money in a bank and it's payable on demand. What does that mean? Suppose the bank puts in and says, okay, you deposit money here and you've got to leave it with us for five seconds before you can get it out. Is that a demand deposit? Ten seconds. Is that

7:31a demand deposit? In other words, we're into one of those many continuum problems in economics, Well, so we get to thinking about this and saying, look, what's the real problem with a demand deposit? And with the real problem with demand deposits, why they cause, you know, why fractional reserve demand deposits cause a problem, and that's what we're talking about, the real reason they cause a problem is because there's a mismatch here. Banks are borrowing short and lending long. That's what they do with time deposits. I mean with fractional reserve banking, right? They borrow the money from the depositors for a very short period of time and then they make loans. Now I know occasionally they make call loans which are demand loans if you would, but most of their loans are not call loans, okay? So banks are borrowing short and lending long. Well, don't they do that with time deposits

9:00is the distortion of the structure of production. What we're doing here is that people in general want to be as lenders more liquid than they want to be as borrowers. So if all credit were direct, okay, if the only financial intermediaries were brokers, i.e. agents, if there were no The financial intermediaries who are dealers, think about that term broker-dealer and the recent problems in the financial markets, but if brokerage were the only thing we had in no dealers, where the dealers are principals, banks are dealers. They take possession, they issue IOUs, bank notes or deposit slips, they take possession and then they lend the money out, and they have new notes coming in that way. So they are intermediaries who are dealers.

10:02A broker just matches buyers and sellers and takes a commission, right? Well, if all we had were brokers, then this mismatch between lenders wanting to lend short, not totally, but you know, if you think about the average of what, you know, the trend, and borrowers If the borrower is wanting to borrow a loan, that couldn't exist. They would have to be brought together, you see, by doing what? By offering higher interest rates to the lenders, and the borrower is saying, well, wait, those high interest rates, we don't want to borrow as much, and so they would say, well, then we won't borrow for as long a period of time. So what happens is we get these dealers in between, and we think of them as banks, but they could be other types, and you go in and you deposit your money for a short term, and credit, if you think about it, has two dimensions. It's got a dollar or value dimension, and it's got a time dimension. A hundred dollars lent for one year is very different than a

11:42Walter's interested in the morality of this. As everybody knows, I'm amoral. I'm only interested in the business cycle part. But the bank has no right to lend my money for longer than it has title to it. If I've lent the bank $100 for six months, where do they get a right to turn around and lend that money for longer than six months? I didn't give them the right to lend my money for longer than six months. So what they are doing, if you think about it, is it's not the monetary inflation, it's the credit inflation that causes the business cycle. Because what? Because credit, if you think about both dimensions, When I put $100 in for six months, that's a half-year $100 loan, right? And then they turn that into a much larger amount of credit because of the two dimensions, the time dimension as well as the value dimension. So they don't stretch the value dimension, but by stretching In the time dimension, they're increasing the volume of credit.

13:02We have a credit inflation, and it's the credit inflation that causes a distortion. And if you think about it, the people who are lending and want to lend short, preferably on average, in other words, if you've thought about some sort of distribution of what the lenders want versus distribution of what the borrowers want in terms of time, okay, well Well, what they've done is they've mismatched this and it shows up in the distortion of the production structure, right? Because the lenders really didn't want to lend money for that long a period of time. And so, we look at this and say we need to extend the Austrian theory of the trade cycle a bit, the Austrian theory of the business cycle. First of all, We've got to be very careful when we say that monetary inflation causes the business cycle.

13:57Not true. It's credit inflation that does that. And be careful to understand that the injection effects, if you inflate the money supply by spending it into existence, it causes inflation. You get some misallocation of resources, but not in a business cycle way. If you want business cycles, that's when you inflate credit. And how do you inflate credit? By having dealers in the financial markets who borrow short and lend long. Now that's not to say that there isn't room for dealers in the financial markets. Because in addition to changing the term structure, the time structure of credit, there are other things that you can't do directly in direct loans with just an agent.

14:45For example, if five people over here each want to lend $100 for one year and one person over here wants to borrow $500 for one year, well, okay, they can each lend me $100 for one year and I can turn around and lend him $500. So there are things like that that dealers can do that are very useful functions, okay? So I'm not suggesting that everything dealers do is wrong, but I am saying from an economic point of view, if you want a business cycle, okay, then this thing about the credit expansion by borrowing short and lending long, that's the way to do it. Now, obviously, one way is through demand deposits, fractional reserve demand deposits, but you can do it without expanding the money supply at all. I just gave you an example. I give the bank whatever $100 for six months and they turn around and give the $100 to Walter for five years. No No increase in the money supply whatsoever. No fractional reserve banking, but we've just

15:49inflated the credit. Now, one other thing, under the standard traditional, Walter loves this, the traditional Austrian theory of the business cycle, the monetary inflation through and Fraction Reserve Banking Causes Business Cycles. Not necessarily true, in my opinion. If we take the system that we have right now, you know, and they increase, assuming we weren't in this crazy cycle we're in right now anyway, but you know, quote, in equilibrium, you know, And somebody deposits a million dollars in the banks and they lend out $1. So they keep $999,999 in reserves and lend out $1. Nobody who has any sense of proportion thinks that's going to cause a business cycle, right?

16:51So you have to look at magnitudes, too. If I deposit $100 for six months and they lend it out for five years, that's not causing a business cycle. You've got to look at magnitude. But if there's enough of that, you can do it. And so you can have business cycles of the Austrian type through this time mismatching, borrowing short and lending long, even in the system without fractional reserve banking and even without inflating the money supply. Thank you very much.