[eliashakansson]

Is fractional reserve banking more efficient? I have com across an argument which states that the velocity of money circulation is higher in an economy of fractional reserve banking since the money can be in multiple places simultaneously.

If I were to refute this, I would say something like this. “Spending money backed by nothing but a promise is fine as long as the customer can make the distinction between real money and unbacked money. Unbacked money may be an IOU that is redeemable at a certain rate, at a specific time in the future. This way ‘not yet existent’ money can be used as long as people are willing to accept them as forms of payment. The problem arises when people cannot distinguish real money from IOU:s and are unable to calculate the risks that come with using money that may or may not be redeemable at a specific date in the future.”

Does anybody have anything else they’d like to add to this? Or is my line of reasoning wrong? Is fractional reserve banking more efficient compared to a society which fully honors property rules (thus opposing fractional reserve banking) since fiat money can be exchanged at different places simultaneously and hard money cannot?

[jmherbener]

These arguments about the technical efficiency of media of exchange miss the point of economic efficiency. To use an analogy, consider the thermal efficiencies of different types of engines. Electric engines may have higher thermal efficiency than gasoline engines, but that does not determine which engine is economical efficient, i.e., superior in economizing resources. To determine economizing or economic efficiency, the only guide is economic calculation, i.e., the profitability of production.

In like manner, to determine the economically efficient media of exchange, one must refer to the profit of its production. The issue of fiat money and fiduciary media are not subject to the test of profit and loss. It is always profitable to issue more of them. Put another way, the issuer do not bear the opportunity cost suffered by others when of issuing more. Neither fiat money nor fiduciary media, therefore, can be part of the market economy. They are foreign elements because their production cannot be determined by profit and loss.

The arguments about the technical efficiency of money falsely conclude that the monetary arrangement that allows people to minimize the holding of money proper (or as you put it, maximize velocity) is the economizing monetary system. This is analogous to someone concluding that choosing electric engines over gasoline engines economizes resources in society because electric engines have higher thermal efficiency than gasoline engines.

[eliashakansson]

If I understand your response correctly, you are saying that since the production of a given unit of a fiat currency does not correspond to its intrinsic value, any issuance of money units will be profitable to the issuer no matter what, rendering any attempt at economic calculation nothing but a fumble in the dark?

What about the example in which a bank holds $1,000,000 and lends out $750,000 to three different entrepreneurs, and the three entrepreneurs build one restaurant each. Upon repayment, society has more restaurants than would be permissible in a hard money economy. I assume that what you are saying is that we have no way of telling if three restaurants actually makes more economic sense than, say, one restaurant, which would be the case if the bank only issued real money. Or am I missing something?

[jmherbener]

Your example illustrates the first step of the business cycle, not efficiency. The issue of fiduciary media by banks leads to malinvestments during the boom which must be liquidated during the bust. Likewise, during the housing the boom the additional houses produced (and the additional capital capacity produced to support housing production) was not efficient.

It is only better for society to have another restaurant built if it proves to produce goods more valuable to people in society than the alternative production facility that could have been built with the same resources. That the restaurant owner pays back his loan is not a sufficient condition to prove social benefit. Lots of homeowners were paying back their mortgages during the housing boom.

In the market, profit and loss calculations reveal when the use of resources in one line of production have greater value than in another alternative line of production. An enterprise earns profit if the revenue generated by the sale of its output exceeds the costs incurred from the purchase of its inputs. The revenue generated is determined by the demand people have for its output. The costs incurred is determined by the demand other entrepreneurs have to produce their output which, in turn, is determined by the demand people have for their output. An enterprise earns profit by compensating the input owners for the loss of value they cannot receive from other entrepreneurs and then uses the inputs to produce output that people value more highly than that which would have been produced by other entrepreneurs.

Now apply these general principles to banking. If a bank intermediates credit, then they compensate savers by paying interest to borrow funds from them. Because they have lent money to the banks, the savers must reduce their demands for goods. But they have willingly entered into an agreement to do this. If the bank issues fiduciary media, then it pays no opportunity cost to obtain command over these funds. And yet, when it lends the funds out to borrowers, they are able to bid resources away from other people without anybody agreeing to such restrictions in their command over resources. Such activity is inefficient on these grounds alone.

We can come to the same conclusion about fiat money. If the government prints more fiat money and spends it to build three more bridges is society better off? Clearly not. All such spending of the government is inefficient by the nature of how the resources are transfers out of the hands of some people and into the hands of other people. Unless this is done in voluntary exchange under the guidance of economic calculation, then the activity is socially inefficient.

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