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Fernando Ulrich @fernandoulrich
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#Bitcoin and fractional reserve banking (FRB). Thread 👇

Ok, this is going to be a controversial one. I've avoided the topic for a long time, but since there are many important experts -- ppl that I truly admire -- discussing the subject, I can no longer ignore it.
1/ Since the @Bakkt announcement, the issue has gained steam, especially through the works of @CaitlinLong_ (who's a real champion of #Bitcoin and liberty btw) and her concerns on WallSt's financialization of crypto. B/c of that, FRB is now inserted frequently into debates.
2/ As a background for laymen, FRB is considered THE BIG CONTENTIOUS & UNRESOLVED DEBATE within adherents of the so-called Austrian School of Economics. Rothbardians tend to think it's fraudulent, inflationary and causes economic cycles. They are the proponents of 100% reserves.
3/ The other side, of which famous partisans are @GeorgeSelgin and @lawrencehwhite1, defends FRB is neither of those claims (George & Larry, correct me if I misrepresent your views). As a postgraduate student myself under Jesús Huerta de Soto, the leading 100% reservist...
4/ ... among spanish speaking economists), I venture to say I understand both sides of the debate. Let's call henceforth 100% reservists full-bankers and the other side free-bankers. Full-bankers claim demand deposits (sight deposits) should be required by law to be covered 100%
5/ by specie (paper-currency or, in the past, gold). Any other way constitutes malpractice or outright fraud. Free-bankers claim no law should constrain banks' business practice as long as it's voluntarily agreed by customer and bank.
6/ A clear problem in the debate is everyone is talking past each other. There's a lot of noise in the arguments that prevent both sides from really converging (perhaps they never will). Until 2014, I was a staunch full-banker. Free-bankers were completely wrong, I used to think.
7/ But now I can confess I see myself much more as a free-banker. Curiously, I was convinced through the writings of the "liquidity scholars" from Spain (also students of Huerta de Soto) like @juanrallo and many others from @juandemariana .
8/ I was also a BigBlocker (😂) prior to understanding #Bitcoin's security. So it's ok to change one's mind. But back to FRB, why do I think full-bankers are mistaken and how it may impact bitcoin's future?
9/ First, the legal argument. Is FRB a crime? Is it fraudulent? No, it's not a contravention. Thankfully, many full-bankers already concede to the legal question. But why is FRB perfectly in accordance with legal principles?
10/ A deposit at a bank is an IOU. It's no bailment. Period. Sure, there's confusion or omission in the contracts nowadays, won't deny that. However, in many countries there's plenty of jurisprudence acknowledging once a deposit is made, a depositor has a claim on the bank...
11/ and the latter is now a debtor to the customer. That simple. So much so that a deposit is a liablity for the bank, that's why it sits on the right side of a bank's balance sheet. If it were mere bailment, it shouldn't even be recorded on its books (like valuables stored in a
12/ bank's safe deposit box). A bank demand deposit is like a debt a creditor can ask for repayment at any moment. "But if all depositor's try to redeem cash at the same time the bank won't be able to honor its obligations! That's why this contract is null and void. Fraud!"
13/ No. A demand deposit contract is between bank and a customer, it's not a collective contract between bank and all customers jointly cosigning. A bank would only be in breach of contract if it failed to redeem cash once a customer so demanded. But breach of contract is fraud?
14/ No, not at all. Deposit contracts should (yes, "should" because there are clear confusion or omission these days, again, won't deny it) stipulate what happens in case a depositor can't withdraw his money. Any contract has clauses to account for unfulfilment of obligations.
15/ Maybe the contract contains a clause allowing the bank to ask for a few days to sell some assets and then repay its creditor (w/ a penalty). There are many forms. But again, a demand deposit where property is indeed transferred to the bank - the money no longer belongs to the
16/ depositor, the bank is the rightful owner now - is not an inherently fraudulent practice as many full-bankers to this day insist in asserting. Therefore, to take a demand deposit and loan out even 100% of the funds to another customer is not a crime. It's perfectly legal.
17/ Or,in a similar fashion, to take deposits and grant several loans by creating new deposits (issuing new liabilities), is a legitimate business practice. That, however, doesn't mean it isn't a risky practice. But legality and imprudent liquitiy management are different issues.
18/ To sum up: Rothbardians first claim is clearly unfounded: FRB is not a fraud. For now, I'll stop here. Still have to address whether FRB is inflationary and causes economic cycles. I'll also explain why the very term "fractional reserve banking" is misguided.{to be continued}
19/ "Fractional Reserve Banks create money out of thin air! It's highly inflationary!" This is where the debate gets a bit tricky. First, no, commercial banks do not create money out of thin air. Even central bankers get this wrong sometimes.
20/ Banks create deposits, they issue liabilities, IOUs. These are bank debts that may circulate and be used as money but they're not money proper. Money substitutes may be an apt term as long as we understand these r simply bank liabilities that have moneyness, but aren't money.
21/ That's why bank deposits are not legal tender, only paper-currency is. Let's not confuse the printing of paper-money by CBs - which could be considered "conjuring money out of thin air" - with issuance of new deposits/liabilities by commercial banks.
22/ A paper-currency once issued is never liquidated or destroyed (ok, wear & tear, granted). A bank deposit, on the other hand, is indeed extinguished after a depositor withdraws its money (paper-currency) from the bank.
23/ So is FRB really inflationary? In the sense of a persistent and continuous inflation, no, FRB isn't inherently inflationary either. Firstly, a bank sight deposit is a promise to pay on demand base money (paper-currency or gold in the past).
24/ Whereas base money (paper-currency) can be produced infinitely by CBs, banks can't create deposits ad infinitum without running into serious illiquidity troubles and possibly going bankrupt. So, there is a limit to how much liabilities can safely be issued by banks.
25/ Where is that limit? Only bankers and the market process can determine. The reason today commercial banks can consistently create more deposits year after year is because CBs keep producing base money year after year. The problem then isn't with deposits, but with fiat money.
26/ As long as CBs remain churning out new money into the economy, banks will be able to issue more liabilities. This is the first reason why FRB per se isn't inflationary. But there's a second and more nuanced explanation.
27/ Let's assume the following: there are no CBs and no fiat money; gold is base money. Banks now start relaxing their reserve ratios and instead of holding 100% of base money to all outstanding demand deposits, bankers allow less liquid assets to be used as reserves,
28/ like short-term commercial bills, for instance. How low will reserves in terms of base money go? 10%? 5%? 2%? Remember, there's no lender of last resort (LoLR). Let's say it stabilizes at 2% (as free-banker scholars claim was the case in Scottland's free-banking episode).
29/ Up to that 2% we could say there was an inflationary event: banks issued liabilities and these do affect prices (despite not being money proper) because they function as money, they're monetary liabilities. But this is a one-shot inflation and not a persistent inflation.
30/ Banks are unable to lower reserve ratios (RR) indefinitely - issuing more and more IOUs - because of liquidity constraints. Once reserves stabilize at a certain ratio, total level of deposits tends to remain roughly the same. As new deposits r created, old ones r liquidated.
31/ Unless gold production picks up (new base money) banks are incapable of causing persistent inflation by issuing more liabilities. This is the second reason why FRB isn't inherently inflationary. When this thread continues, I'll tackle FRB & economic cycles. {to be continued}
32/ Just one additional point, in today's world, base money = paper-currency + reserve balances at the Central Bank (commercial bank deposits at the CB).
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