A Bit of Sound Money: BTC & FRB

Blogs, Commentary, Scholars' Corner — By on June 21, 2011 at 2:18 PM

In the argument between proponents of fractional reserve and 100% reserve banking, it often comes down to a moral argument with the Full Reservers usually charging that fractional reserve banking (FRB) is inherently fraudulent because it is placing two full, separate claims on the same item, i.e. a piece of purchasing power*. The Fractional Reservers will counter that if you have a parking pass or a plane ticket, no one thinks it immoral that the lot may be full when you get there, or that the airline overbooked the flight. Cost of doing business, they say. But this is a false analogy. You did not go to the airline and hand them a physical seat, then pay them for the privilege of having a seat on a route. Had you, then when you got to the plane and found your seat taken you would justifiably feel defrauded; to the extent that you allowed someone else to have access to your seat, hoping your schedules wouldn’t conflict, you would pay the airline less – and the more extra users you allowed them to attract, the less you would pay for the seat to be on the plane.  This, the argument goes, is the interest that banks are able to pay you for your account.  And if there are limits to withdrawals that mean that the money won’t be “double-lent,” it’s fine as far as it goes.  But when the bank is creating credit and gambling that it won’t all be redeemed at the same time they are committing the same act as the airline that bets you won’t show for a flight and leaves you high and dry.

It is easy to see how the reality of parking lots and airline flights is different from FRB. You do not have a claim on the bank that allows you the opportunity to ask for a loan at any time, fully cognizant that the bank may unfortunately be out of loanable funds at the moment; you are demanding that they give over what they have labeled a “demand deposit.” To the extent that your contract stipulates a waiting period to withdraw certain amounts of funds, the deposit in question is not a “demand” deposit anyway, it is a form of “time” deposit. This is why FRB, without explicit notice of, and strict adherence to, it’s reserve ratio, is fraudulent. If banks were honest and accurate with their books and with their clients, then fully informed and voluntary consumers could have no argument with the bank’s way of doing business; consumers of the bank’s fractional currency would have nothing to complain about if a crisis hit and they were unable to redeem, or if they were forced to accept less than par value for the notes.
This brings us back to Bitcoins (BTC). Some in the debate surrounding BTC claim that, because there is a definite limit to BTC there will eventually come a time when there are too few BTC to be useful as a currency (all of this supposes, of course, that BTC grow to the point of general usage and reach their maximum of 21,000,000BTC in the market), and therefore some banks will step up and begin issuing notes (or, digital “coins”) backed by fractional reserves of BTC. This scenario will, I think, be very useful in the FRB vs. 100% reserves debate.
I am a “free banking” guy, in that I believe that the market, and not a central authority, should be left to handle money and banking. However, I believe that the only way to turn a profit with FRB is through deception; otherwise, any purchasers of your notes will duly discount their value by something close to, if not above the reserve ratio (owing to the inherent uncertainty of accepting a note backed by a fraction of its stated value versus one that is fully backed). I just can’t figure out why anyone would take a note with a risk of default at par with a note representing an equal value, yet fully backed and hence with no default risk. These are two different items with two different expected values. Someone please explain the logic of this to me. At the end it just boils down to whether you think the discount will be greater than, equal to, or less than the reserve ratio. If the discount can be generally less, with all market participants fully aware of the ratio of notes to reserves, then I see no reason to ever quit printing money. I believe this would imply that the notes had become more valuable than the specie they were originally backed by, and that to turn them in for the reserves would be a loss for the note-holder. Holders of gold would be paying a premium to buy their inflated tokens!
This is important in the free-banking/100% reserves argument because my argument is that FRB would lose on the market to 100% reserves. It is not that I believe FRB should be outlawed, just that it should be fully advertised as what it is, and that to deviate from your advertised ratio would be fraud in the same way that if a food company advertised certain ingredients in its bread, using a different recipe would be fraud. If it were a digital currency (e.g. BTC), then anyone and everyone (buyer and seller) would know exactly what the exchange rate is. You have to ask then, why would someone accept at par a privately issued currency (we’ll call them EarlCoins) that was backed by BTC 1/.90, if you knew the exact amount at the time of the transaction? Why would you accept a BTC substitute for your product, where you knew the exact ratio of BTC to EarlCoins, at any exchange rate other than the current ratio of EarlCoin/BTC? It would be the equivalent of selling in BTC at a discount, and this is even if we assume there is no cost to convert your EarlCoins into BTC.
If your items are priced in gold, and there is an exchange rate of 50 silver oz./1 gold oz., you will not accept 45 oz. of silver for your product if the price is 1oz. of gold. This is, I think, where the rabbit comes out of the hat for FRB’ers. They will argue that this is not the same thing, that the notes they would pass would say 1 oz. of gold, or 50 oz. of silver, it would just be backed by less at the vault. And here’s the trick, even if they won’t say it. They must count on the receiver of the note not being the last to redeem, lest their transaction be revealed as fraudulent. This is the exact same criticism of the common counterfeiter. The notes he prints circulates until someone discovers that they are un-backed, and the last person is left holding the bag. But no one would ever argue that the counterfeiter is not a thief unless someone notices that his bills are illegitimate. And no one would ever seriously argue that his money printing was justified because he had experienced an “increase in his demand to hold money.” They would say he should spend less or sell assets.
It seems that FRB is able to survive, and to trade above its proper discount, because those who accept the notes are uncertain as to what they are getting and assume that it’s what is described on the note. But with the electronic currency scenario there can be no such ambiguity. We will examine this dynamic next week, and discuss whether a general increase in the “demand to hold money,” or such an increase in the value of the remaining BTC above a useful level, might necessitate some new form of currency to fill the gap or to take its place. But keep in mind that these are different things. Fractional reserve banking to increase loanable funds and to stimulate the economy, and competing currencies backed at different ratios by well-defined specie are two different things.

* It can be argued that you have no claim to “purchasing power” because it can change for various reasons while the money is deposited; this would be like saying that, because an asteroid from space might have landed on your house I should be allowed to burn it down while house-sitting.  It matters how and why your purchasing power is being diluted.  It matters how and why your purchasing power is being diluted, in the same way that it matters to you if you’re broke because of Hummer payments or because someone stole your wallet.

Food for thought:
-Can Bitcoins be thought of as specie?
-If BTC became the dominant form of money but then became too scarce to be useful, by what process could another electronic money supplement or replace them? What would be the incentives to a new creator, or to early adopters?
-How “Austrian” are BTC and their development, and what would Menger, Mises, Hayek, and Rothbard think of them?

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    9 Comments

  • Theodore Phalan says:

    Juno, thanks for reading and pointing out the blog post. I have read and replied to his article, but I will re-post the reply here, as well:
    I enjoyed your article. I would like to quibble, however, with this :
    “However, the paradox of counterfeiting is that so long as it remains
    hidden, it actually helps the economy. To damage the reputation of the
    symbol it mimics, counterfeit cash needs to be recognised as
    counterfeit.”
    If I print $10 trillion counterfeit dollars and spend them but never get caught, prices will eventually rise. Those who receive the new bills last will see prices rise before their income rises. The new bills I have printed have therefore taken from the economy without adding to it, and I have received $10t worth of goods, while those paying the higher prices have paid for those goods for me with their efforts.
    Of course, if I print only $10k it’s harder to see, but the effect is exactly the same. And when the State does it, the exact same process plays out, except that I am not the one benefiting, the State and its favorites are.
    Counterfeiting money either robs the person left holding the bills when they are discovered, or robs those who lose purchasing power if it is not.

  • Jeff says:

    Bitcoin is an informational commodity. It is specie in its own right. I think your analysis is spot-on. Especially given the ease of transfer and impossibility of counterfeit, no one would confuse bitcoin claim notes as real bitcoin specie.

    • Theodore Phalan says:

      Jeff, I think this is the real value of BTC. I don’t think that, even if the technology was exactly the same, these could have taken off even a few years ago. People have learned a lot about money recently (thanks in large part to Ron Paul and other sound money advocates) and a something that cannot be manipulated by a government, and can be transacted under the nose of the government (both, so far…) has value to people in itself.

  • manuelgar says:

    Hello, I think that Menger and Mises wouldn´t have the same interpretation about BTC.

    Bitcoins are a present good, this is important because it means that they are not anyon else´s liability (the same as gold and silver).

    I also thingk BitCoins are not that new. They are just scarce information, just as a unique trademark (cocacola), music or software. Present goods may be tangible or intangible.

    The electronic representation of BitCoins is not relevant for the economic nature of the good. The technology that allows bitcoins to exist is equally relevant than metallurgic technology for gold or silver (mining, melting, minting would be the equivalent to encrypting, hashing).

    I have written a short article about Bicoins and Mises Regression Theorem. You can find it here:
    http://eleconomistaprudente.wordpress.com/2011/06…

  • Jason R says:

    Didn't free, fractional reserve banking exist successfully in Scotland for many years?

    • Theodore Phalan says:

      Jason, “free banking in Scotland” was backed by the government with “bank holidays” often being called to prevent runs. Dr. Larry White has written approvingly of this period, and Dr. Murray Rothbard challenged him on the issue. I will let them speak for themselves and I strongly encourage you to read them both.

  • Juno Moneta says:

    "…no one would ever argue that the counterfeiter is not a thief unless someone notices that his bills are illegitimate."

    Actually, someone does and does so quite interestingly.

    "Counterfeiters do not create fake money; what they do is make a false claim on the custodianship of money-power. All of us are at least guilty of overstating our money-power at some point in our lives. Banks especially. It comes with the capitalist territory."
    http://jonone100.blogspot.com/2009/04/money-6-cou…

  • Theodore Phalan says:

    Tom, as I understand it BTC can be divided down to 8 decimal places. So while I agree with you that there is a lot of room, I’m not sure that there will “always be enough.” Population and productivity are (almost) always growing, and I don’t want to make such a definitive statement. You have a finite supply of BTC and a growing population and productive capacity; it’s above my pay grade to start doing a bunch of math, but I do agree with your sentiment that the price level will fall to match supply of BTC with demand – I’m just worried about buying my penny candy in 2050. Will .00000001 BTC be too much? Will I have to buy a ten-pack?