Rebuttal To Mish: FRL

These are always so much fun (blogger debates – [ original article by Mish here: Case Against the Fed and Fractional Reserve Lending] ):

Fractional Reserve Lending (FRL) is fraudulent. Indeed, FRL in conjunction with micro-mismanagement of interest rates by the Fed is the root cause of the financial crisis we are in.

No it’s not (fraudulent), provided it is performed properly.

The latter (Fed argument) I will ignore for now.

Here’s Mish’s list of 5 things he claims to refute:

1. FRL is not fraud because the lending is backed by assets.
2. FRL is not fraud because it is allowed by law.
3. Eliminating FRL would require unwarranted "regulation".
4. No one is harmed by FRL.
5. People have a legal right to make agreements with banks allowing their money to be lent with no reserves

I’m going to ignore 2 (because whether something is allowed by law doesn’t change whether its fraudulent), #3 is immaterial, #4 does not bear on the question (is it fraudulent) and neither does #5.

Instead, I will deal with #1 and dispose of this issue right here and now.

We will take a fictional bank that we set up with no capital or assets.  That is, it has a balance sheet that has zero on it.  We will also simplify this to two transactions, which is sufficient to show the math works; if it works with one transaction it works with 100 – or 10,000.

Joe comes into the bank and deposits $10,000.  The balance sheet now has $10,000 on the asset side and $10,000 on the liability side.  The bank physically has $10,000 that Joe deposited.

Jane comes in and borrows $9,000 to buy a car.  Jane now has $9,000 that originally belonged to Joe.  The bank has a promissory note from Jane and in addition is named as the secured lien-holder on the title to the vehicle, which is shows as an asset.  Jane owes the bank $9,000.

Now the argument against Fractional Reserve Lending is that it constitutes "printing" money.

It most certainly does not.  The same $10,000 – the original $10,000 – is the only actual money that has ever changed hands.  The velocity of that money has increased, but the amount of it has not.

(That credit has "moneyness", that is, it is fungible with and spends like money, doesn’t make it money.)

If Joe comes in and demands his money, the bank only has $1,000 of it.  This is the argument for "Fraud!" claims. 

But if the bank has a good note from Jane, a fully-secured note, this is not true.  The bank can sell that note into the market, recover the $9,000, and pay Joe.  Nobody has been defrauded and Jane didn’t get a free car (the person she pays has changed but not her obligation.)

Mish lays out a whole host of things like "Toggle bonds" and other silly loans (including a lot of mortgages) as evidence for the fraud.

But that’s not evidence that Fractional Lending is fraudulent any more than someone printing up $100 bills on their color copier is evidence that money is fraudulent.

So long as the bank never lends out more unsecured than it has in excess capital, there has been no fraud.  The instant the bank does so, it has committed fraud.

The purpose of proper and prudent regulation (indeed, the purpose of government) is to prevent fraud in all of its forms.  This is why we have a government – to provide a framework for punishing frauds that is more civilized than the person who gets robbed picking up a weapon and braining the person who committed the fraud.

The failure in our system was not fractional reserve lending or even The Federal Reserve and its allowance of sweeps.  The latter made fraud easier to commit but did not cause fraud to occur.

Fraud is a conscious choice of action.  In the case of fractional lending it is the loaning of money that is neither secured or covered by bank capital reserves.

Once a bank does this it is immediately insolvent in that it is not possible to liquidate the holdings of the bank and repay all the depositors; any bank that represents that it is solvent when it has done this is committing fraud, and that fraud is repeated each and every time said bank accepts a deposit while in an insolvent condition. 

Note that the value of assets changes from one day to the next – your house is worth something different today than it was tomorrow.  Your car depreciates.  For this reason no bank can legitimately loan all the way up to the secured value of an asset, or it risks becoming instantly insolvent – all banks must in fact lend with a cushion against current asset values and as those cushions erode they must sell those assets into the market so as to prevent ever being rendered actually insolvent – and in a condition where the acceptance of any further deposit or processing of any transaction without disclosing their financial condition is an act of fraud.

Our failure is regulatory.  It is against the law to commit fraud and yet we have refused to prosecute those who have claimed to be solvent when they are not. 

We require no new law and no "reorganization" of the banks. 

We simply must enforce the law as written which instantly forces banks to make only prudent loans and forbids them to loan unsecured funds that exceed their excess capital at any point in time.

The sooner we the people understand that this crisis is the result of massive fraud commited by our banking class and covered for and bailed out by our government, the sooner we can force prudent regulation, clear the bad debt out of the system and return to having a stable, productive economy.