The Theory of Central Banking | Robert P. Murphy

Welcome everyone to the second pre-recorded lecture for the mis's Academy online class anatomy of the fed this is lecture two the theory of Central Banking now this lecture is going to rely very heavily on the PowerPoint presentation to the point where you really are going to need to have it on your computer to uh refer to or perhaps to to print the slides out so you can at least be be going through Them in fact I would recommend that above anything else to to get the PowerPoint on your computer and actually print the slides out

so you can have them on paper in front of you and you can compare them to see several at a time while I'm going through this because we're going to be looking at balance sheets of Banks and it's the kind of thing where if you really follow the numbers and you know have to hit pause on the the video lecture so that You can check my math and make sure you understand the argument you're going to understand this topic a lot better than if you're just sort of tuned in halfway kind of following my general

observations but you're not really checking the numbers yourself okay so again I would stress to get the most out of this lecture have the stuff in front of you and follow along and stop me when you need to to make sure you really understand the Argument okay so now I'm going to move to the first main slide which is the uh the outline now I should point out that even though this dovet tales with Roth bir's uh book mystery of banking specifically the chapter on the theory of Central Banking removing the limits I think he

calls it it's his first first one chapter nine in that book The material I'm going to be covering in this lecture actually could more Appropriately be titled the theory of uh B balance sheets or something like that because I'm not going to really even be talking except at the very end of this lecture about central banks per se because I think roord does a great job discussing that and what I really want to hit home in this is to make sure you guys taking the class understand how a balance sheet really works and what happens

when a Commercial Bank engages in a fractional Reserve Loan all right and it creates money out of in air okay cuz that's that's a crucial part of this I'm going to say it now and then we're going to build up to that near the end of this lecture and I'm going to repeat it at that time but I just want you to realize it's not the case at least in the rothbardian framework it's not the case that a central bank is the sole culprit when it comes to generating credit inflation and The boom bus cycle

it's rather that rothbart says it's fractional Reserve banking per se even if a private Commercial Bank does fractional Reserve banking roord argues that is illegitimately counterfeiting money as it were creating money out of thin air and setting in in motion the seeds of of the boom bus cycle now what we're going to see is that left to its own devices in a in a market Economy uh there are strong Market forces to limit fractional Reserve banking and that roord argues the whole point of Central Banking is to break down those limits to Foster the inflationary

engine to sort of encourage the type of inflation that individual commercial Bankers want to engage in but yet they're normally restrained by market forces okay so that's a very important point that I think a lot of people who Uh just have a passing familiarity with the mechanics of banking when they read the Austrian literature they just assume that oh it's it's Ben Bernan it's the Federal deserve that creates money out of thin air and that's true but it it's beyond that it goes beyond that it's also commercial Banks themselves when you go to into Commercial

Bank and you apply for a car loan unless that loan that they give you is backed up 100% by reserves meaning in Our economy paper dollars in the vault or reserves on deposit with the FED then that also is inflationary the mere Act of that Commercial Bank giving you a loan so you can go buy your car from the car dealer the bank has just created money at least under certain definitions of the money supply okay so I'm I'm sort of anticipating where we're going to go here but I want to make sure you you

grasp that aspect of this so that's why in case you're wondering you Know why is Dr Murphy spending so much time focusing on an individual Banks operations when are we going to get to the fund stuff when when the FED comes along or the Central Bank comes along and and starts creating money out of thin air through open market operations that that what I'm telling you that don't think of it like that that the essence of what's going on here is fractional Reserve banking again in the rothbardian view and the the the danger Of the

central bank is not merely that it creates money when it it buys assets and creates new reserves stuff that nowadays we like quantitative easing and say oh the fed's going to buy $600 billion dollar of new bonds where does it get the money to do that oh it creates it out of thin air that's kind of stuff people are talking about right now but in this class we want to go beyond that and see that in rothberg's view it's again the the commercial Banks Themselves through fraction Reserve banking that create money out of thin air

push interest rates below where they ought to be and so forth all right so that's why I'm going to spend so much time in this because if if you get it at the individual Commercial Bank level then it's pretty easy to just generalize and to see okay if the commercial bank now is a client of the Central Bank and how that works so again that's why to make it as simple as possible I'm Focusing so much on uh the balance sheet of a Commercial Bank okay so the next slide is a Roman numeral one balance

sheet Basics so here this is going to be simple for those of you who are actually in the financial sector but I don't want to assume anything on the part of the students here so this is a a balance sheet uh showing sort of double EMP bookkeeping and or it's often called a te account and it's very simple on the left side you've got your assets on the Right side you've got your liabilities and your shareholder Equity okay so as we go through the numerical examples this is going to be a lot clearer to you

if you've never really worked with something like this before so I just put one little equation here underneath showing that it because it to some people it seems a little counterintuitive because we're going to what's always going to be the case with the balance sheet is that the stuff on The left-and column is going to add up to the stuff in the right hand column okay so uh to some people it seems a little odd that why would assets equal liabilities plus shareholder Equity that those don't seem intuitive so I rearranged that same identity to

say that total assets minus total liabilities equals equity and that might that should make sense to people okay because the idea is the shareholders Legally own the corporation so whatever net assets the corporation has is is the property of the shareholders so how do you figure out what the net assets are you say okay what are its total gross assets but then you it's not enough to say oh so now the shareholders split that up because what about things that the corporation owes to outside people creditors people who lent the corporation money or people to

whom the corporation is liable Financially so you can see okay to really understand what do the shareholders actually own free and clear it would be the total assets minus the total liabilities and then that whatever is left over the sort of you know assets that have no other claimants on them that's what the shareholders own and so that's that's how the balance sheet works so you just it's just a rearrangement of terms that okay that's why if you've got total assets on the Left side and you have all the total liabilities on the right hand

side then the last entry you put on the right hand side is shareholder Equity so really all you're doing there is is showing that the shareholders own whatever is left over after you've subtract the liabilities away from the assets um I don't have this on the slide but just to make sure you understand so when you talk about a corporation becoming Insolvent you mean that Equity goes negative all right so if some if a corporation's bankrupt if it's insolvent it means that their liabilities are bigger than their assets they don't have enough assets to satisfy

all their creditors and so that means you know somebody's got to take a hit the corporation can't pay off off everybody it's got to go into bankruptcy right that's the idea okay another little point I made here is that the balance Sheet is a snapshot in time so at any given moment boom you freeze things you say right now this second what are the total assets of the corporation in terms of their current market values the total liabilities the current shareholder equity in contrast if you want to say what's the income of the corporation or

you want to say let me see the profit and loss statement those concepts are flow Concepts they're not what's called a stock concept like a Static Point estimate they are a flow that occurs over a certain time period so it would so let just give you an example it would make sense to say right now on Friday January I think it's 14th at 12:30 p.m. eastern time what are the total assets of IBM and what the total liabilities of IBM and what's the size of its balance sheet I mean we might not know those numbers

EX just because we don't have the information our fingertips but it makes sense to talk Like that but it doesn't make sense to say what is the income of IBM at this particular moment in time because income refers to a time period you you could say well I can tell you the income over the last quarter or I can tell you you know over the last 12 months what the income has been but it doesn't make sense to say what's the income right now okay because income is something that happens over a period of time

Okay next slide uh introducing the topic Roman numeral 2 of loan banking so here with my uh silly pictures I'm just trying to remind you that everything that I'm going to talk about in this section muray roord is totally fine with all right so there I mean we're going to get into stuff about people defaulting on loans and and the shareholders losing money and so forth that's fine I mean it's it's it's regrettable but there's nothing fraudulent about that okay it's Okay in the market for investors to put money into a bank the bank makes

loans and they make a mistake or uh well yeah it's a it's a mistake I mean they might make plenty of loans knowing that a certain fraction of them are going to default and so in that sense you could say it wasn't even a mistake but clearly if if the loan officer at the bank knew the money that they were giving to a a particular borrower wasn't going to come back Because the person was going to default then they wouldn't give him the loan in the first place there's no way around that right unless there's

some strange government program involved okay so that's the sense in which I mean these loan defaults require entrepreneurial errors but my point is don't think that that's the kind of thing that rothbart is against when we say he's against certain practices in the commercial banking sector we we'll see later on in The lecture the kind of thing Roth's against so everything under loan banking is perfectly admissible as far as libertarian Theory or rothbardian take on it okay so letter A capitalization so at this beginning stage we're just W we're going to look at a particular

Bank in the in the free market that's uh being formed here and then we're going to follow it through some potential scenarios so what I have in mind here is That 20 investors each put up 50 ounces of their saved gold so let me just mention two things in terms of the uh the pedagogy here I'm using gold so in all these examples in the balance sheet and so on I'm going to have ounces of gold as opposed to dollar signs and I'm doing that because I want I want to really isolate the essence of

banking and fractional Reserve banking in particular and what happens with the balance sheet there so I don't want you to get confused I if I were to use dollar signs even if I said $50,000 in Gold like rothberg does in his examples I'm afraid some of you would be picturing it in terms of dollar bills and you wouldn't really be you wouldn't be divorcing yourself from the IDE of Fiat money so I'm purposely trying to make you think by making these things a little bit jarring so that's why I'm using ounces of gold and also

you'll notice the Numbers that I've picked they're not nice round multiples of 10 so you might wonder why am I using 20 investors putting up 50 ounces of gold why didn't I say 10 investors putting up uh you know 100 ounces it's because I'm afraid if I start using multiples of 10 you're going to be thinking in terms of Reserve ratios that you learned in your econ classes and I don't want you to think that right now because that stuff right now that sort of thing means nothing We're not talking about Reserve ratios there is

no Central Bank enforcing a reserve ratio right now this is just a a Commercial Bank in a free market economy there's no such thing as a central bank okay so that's in anyway this is loan banking so there's no issue of Reserves at all so that that's why I'm choosing in case you're wondering what guided me in picking these numbers is I'm making them cumbersome to force you to do the ma from scratch and not just be lazy and Think you know what the answer is going to be okay so the asset side of the

bank you say where are the assets of this Bank well each of the investors put up 20 o or excuse me 50 ounces of gold so they have 1,000 ounces of gold in their vault I mean technically speaking you could say their asset is the Vault itself because if they went out of business they might be able to sell that on the secondhand Market but let's forget the physical building when I'm Talking about the assets I'm just we're focusing on the actual physical yellow metal that's sitting in the bank vault that's an asset they own

that outright the investors put that into the business originally it's their's free and clear so it's it's an asset on the on the right hand side there's no liabilities okay all the and so the thousand ounces of gold is all shareholder Equity okay so they haven't done anything yet they just formed their Bank and they've each chipped in 50 ounces of gold and there's 20 guys or 20 men and women let's not be sexist who have uh founded this new bank in in libertopia okay next slide letter B making loans so now this bank is

going to make two separate loans it's going to lend 400 ounces of the physical gold to Jim and another 400 ounces to Sally but for whatever reason Jim is considered a safer loan and so they only charge him 5% Sally is riskier you know she explains what what her business model is and what she's going to do with the money and so you know if it if it pans out if what s wants to do Works she'll have plenty of ability to pay them back the 20% but it might not work whereas Jim what he

wants to do with the money you know he's been in business for years and they're pretty sure yeah it's not likely that Jim's going to default so we can Give him the loan at 5% and of course I didn't mention this in the slide but why would they just charge everybody 20% well because of competition because Jim is a safer loan a safer risk I should say um if they tried to charge him 10% he could probably shop around and get a loan at a lower rate from some other bank so that's why to be

competitive they can't overcharge uh but yet they got to Protect themselves they can't give they can't give s the loan for 5% because there's a good chance she's not going to pay it back and they'll lose money okay so in terms of the balance sheet what does this look like well on the asset side remember they start out with 1,000 ounces of physical gold in the vault and and they just handed out 400 to Jim and 400 to Sally so that means they only have 200 left sitting in the vault okay now those aren't reserves

because this Is not deposit banking this is loan banking okay there's nobody who could come in at any moment and say give me some of my money and then they say oh few it's good we got those 200 ounces and no I'm just have the 200 in there just so you you know to make sure you understand that I'm taking away the 400 loans from the original th000 that's why I kept the 200 there just so you could be straight as to what's happening with the money that 200 ounces isn't backing Up anything that be

be sure you understand that okay because this is loan banking um now on the asset side also what does the bank have it has IUS from Jim and Sally so what Jim did he signed a a legally binding contract saying I am receiving 400 ounces of gold from the bank today whatever the date is and in 12 month's time I will return to the bank 400 oun of principal plus 5% interest okay so that is an asset the Bank has this legally binding document that says this guy Jim whatever his last name is is going

to pay the bank uh what would be 420 ounces of gold in 12 months time so that's clearly an asset it's like a bond except it's issued by a person rather than a company and a similar thing with Sally now when I evaluate the market value of these bonds you have to use the present market value it's true in 12 months time that IOU from Jim is going to be worth 420 and the IOU from Sally is going to be worth 480 but I wouldn't write that those values in right now because it's not 12

months from now we're talking right now right so that's one thing incidentally uh that's a little bit it's not that it's wrong what rothberg does because bir's trying to not deal with nine different things at once so he's trying to isolate one or two main points for the reader and he's Trying to keep everything else simple so in in at least some of the balance sheets I noticed that rothberg does this kind of stuff he writes in the value of the loan with the interest already acred and I'm just I'm worried that might confuse some

of you so that's why I'm doing it this way so I just want to make sure I'm announcing explicitly the way I'm doing it here differs from how rothberg doeses it and it some of his examples and the reason I'm doing this Is because this is more technically correct I mean again it's not that Roth doesn't know what he's doing he's just trying to simplify it okay but technically the moment the loan is made it's it's only worth the face value okay which kind of makes sense that the loan obviously to Jim when he gets

the 400 oun is worth 400 and so the thing he's exchanging to the bank is also has a market value of of 400 it'd be like you know if you if you buy a car for $1,000 you say what's the market value of the car it's clearly $1,000 right even though the subjective preferences are different and that's why people do the trade the market value of what they're trading is equivalent because that's what it means for market value it means what can you fetch in the marketplace so the bank is paying 400 ounces of gold

for Jim's IOU think of it like that the bank is buying a bond from Jim and it's paying Him 400 ounces so if I ask the second after the bank makes that purchase how much is that thing worth that you just bought well it's 400 ounces that's what we just paid for that's this market price looked at another way if the bank for some reason had to liquidate these loans right if they needed to raise physical gold for some reason and they wanted to sell the loans from Jim and Sally to some other financial Institution

before Jim and Sally owed them the money well they couldn't sell it for for the full matured value because the other bank would say no I have to wait around a year for those guys to pay off right now I'll only give you 400 for that thing okay so that's why the IUS are priced right now at less than what their face value will be in a sense if you took into account the interest that would acre okay um and then on the liability side it's The same thing there's still no liabilities okay because liabilities

from the bank's perspective mean people to whom the bank owes money but right now the bank doesn't owe anybody money people owe the bank money okay so there's no liability so that means the thousand in assets is all represented in the shareholder Equity so at this stage the shareholders haven't made or lost any money all they've done is converted their assets from one form To another originally they had 1,000 ounces of physical gold now they have 200 ounces of physical gold and two separate 400 ounces of market value deter uh IUS from people okay and

of course my computer is freezing up okay all right so next slide is uh number one payback so here what we're doing is what We're going to do just to anticipate we're look at two different scenarios one scenario we're going to say what happens if Jim and S both pay back their loans just is they contract specified and we'll look at what happens to the bank's balance sheet and the shareholders and then the next scenario Sally is going to default so we can just see how those things play up but so for right now easiest

case to to consider assume a year goes by and now Jim and S Both pay off their loans so Jim pays back a total of 420 ounces of of gold and Sally pays back 4 80 so for Simplicity just assume they walk in with physical metal you know actual gold coins let's say or or bars of gold depending on how how heavy they are okay so so they walk in you know a year has passed Jim and s's businesses both do well and they earn revenue from their customers and then Jim walks in hands over

a bag full of 4201 oce gold coins It says there you go you and I are square now thanks for the loan walks out so Jim the bank's relationship now is terminated Sally does the same thing but since she had a higher interest rate her loan she of course has to give them a bag full of uh 480 1 o gold coins okay so now we say okay what's what happens to the bank's balance sheet now well the asset side those loans are gone right that Jim and S before the bank was holding legally binding

documents signed By Jill Jim and Sally entitling the bank to payment from them and in theory the bank could have sold them to somebody else so those were clearly assets but now that Jim and S have paid off their loan those IUS are are satisfied they get you know they're they're completed so they're not assets anymore they're done so those disappear but the bank has a lot more gold in the vault so remember before it had 200 ounces now Jim just gave it 420 and Sally gave the bank 480 So that's um 900 total ounces

more plus the original 200 that's why well you put in 50 ounces a year ago and now um as of today I ran the numbers in the balance sheet of that particular Bank says that they have 1100 ounces of gold and total assets no liabilities and you're an equal uh shareholder with 19 other people so that means your aliquat share of the company works out to 55 ounces so you have earned a 10% return on your money in a year and so you know you given the riskiness of the of this operation you can compare

it to other potential Investments but that's that's how you did so far and right now your money's pretty safe it's all it's sitting in yellow metal discs in a vault so you know you can you can decide for yourself if you think that was a good thing for you to do with your money okay I I probably just should Mention in this example when those loans were made to Jim and Sally the money supply did not change in the in the community right all that really happened was the investors effectively took some of their money

and handed it over to Jim and Sally and they went out and spent it all right so to the extent that Jim and S pushed prices up by spending money in certain areas of the economy in a sense you could say well that was counterbalanced by the fact That the investors had to uh red reduced their own spending because that money that otherwise would have been in their cash balances now wasn't in their cash balances okay so it's the the total stock of money in the community was unaffected by those loan transactions it's just the

people who were in possession of the money changed for a year and then it reverted back to the shareholders okay next slide number two default so here we're going to assume Jim still pays back his loan but Sally defaults on hers so let's make sure we understand the numbers and then we'll talk about the significance on the asset side there is now only 620 ounces of gold in the vault because remember there was a 200 originally and then Jim paid back 420 and so that's where the 620 comes from Sally just calls the bank up

and says I'm sorry I have nothing my I went out of business I owe a bunch of people Money and I have no assets what are you going to do you can try to send me to jail but I got nothing for you okay so the bank just writes off that loan and says okay you know that's that's uh Sally's never going to pay us right so in the real world a lot of times when when somebody defaults on a loan they still pay something it's just they don't pay what they were supposed to here

just to keep things simple I'm assuming Sally pays nothing and there's no hope that She ever will so the bank is completely eliminating her IOU from its asset side of the balance sheets that that would be called a write down that originally they had that thing carried on the books saying she was going to pay them uh what 480 ounces as of the when it matured and then they come to find out no instead of getting 480 we're getting Jack so they they write that down okay so um so because of that now the assets

are only 620 when all is said and done the Smoke Clears what does the bank have to say for itself it has 620 yellow metal discs sitting in its Vault nobody else owes it any money technically Sally did owe them money but she went bankrupt and legally speaking now you know that just that's just gone and uh but the bank doesn't know anybody else money so it's it's liabilities are still zero so what that means is of the 620 ounces divided 20 different ways that's 31 ounces of Equity for each shareholder so a given shareholder

asks his accountant how do we do this year on that particular investment they're going to say well sir you lost 38% you put in 50 a year ago right now your share of this bank's assets entitles you to 31 ounces of equity so going from 50 to 31 that's a 38% loss not too good all right um let me just mention one other little subtlety uh th this is highlevel stuff Or higher level stuff strictly speaking as the as the year is passing I mean I'm not showing the bank's balance sheet six months into these

loans okay strictly speaking the the IOU from Jim and IUS from Jim and Sally it's not that they're carried at 400 ounces for 364 days and then boom the day of maturity they all of a sudden jump up to what 420 and 480 respectively that's not the way it happens they Appreciating market value uh smoothly over time or technically exponentially right that they as they get closer to maturity the discount on their future value drops so their current market value Rises so uh so six months into it the bank on its asset side is going

to be carrying those IUS somewhat halfway between 400 and and their ultimate value I mean not quite because things grow grow in percentages It's not a you get what I'm saying it's not a uniform thing but they're going to be in between those two values and so they're gonna the the the bonds or the IUS from Jim and Sally their market value is going to increase steadily until they just reach 420 and 480 on the day that Jim and S have to pay them the loan back okay and so and by the same token then

the shareholder Equity at any time during that year slowly increases in accordance with the Increasing market value of those IUS so in particular 6 months into the loan if for some reason the bank needs to raise money it it needs liquidity and it sells off those IUS to some other bank that's willing to sit on them for the remaining six months the the first bank is going to get more than the 400 that it originally lent out it's going to be able to sell those IUS for some number higher than 400 but less than 420

in the case of Jim's IOU and 480 in the case of Sally's because the other bank that's buying them is still going to have to wait another six months to actually get paid off from Jim and Sally so so everything I've written in these balance sheets is correct I just want to make sure you understand it's not that all of a sudden the shareholder Equity goes from 50 to the higher number instantly or even in the case of the Loss probably if if the bank's uh Personnel are on the ball they're going to see that

Sally's probably not going to be able to pay the back it's not that the IOU from s is going to be carried at its full value you know just chugging along appreciating and then boom the 365th day it gets marked down to zero probably if they're smart they're going to see that coming and start to take that into Account as Sally's business continues to flounder during the course of that year okay next slide slide is leverage a slide with the letter c called Leverage so here I just want to um walk you through the same

scenario but now I'm going to change the initial assumption instead of the 20 original shareholders each putting up 50 ounces of gold a piece instead the way the bank is going to get the original thousand ounces of gold in the vault that that's going to then lend out the is that the shareholders are only going to put up half the money so now the 20 shareholders so we still got 20 shareholders in both cases but in this second case with leverage each shareholder only puts up 25 ounces of his own money and then where do

they Raise the other 500 o they go out into the community and the bank issues certificates of deposit or what's called CD and they and they had these standardized legally binding contracts where the bank says hey if you give us one ounce of gold today we'll give you this CD and what the CD does is it entitles you in exactly one year's time to come in and give it to us and then at that point we'll give you 1.01 ounces of Gold all right so you'll earn 1% on your money but your money is going

to be tied up for a year okay so it's crucial to understand this this is loan banking these 500 people in the community who each lend one ounce to the bank they're not depositing their money they're not opening a checking account they can't go around writing checks on this money that they've given to the bank okay it's not their money anymore they are lending it to the bank just Like when the bank lends to Jim and Sally and they go out and spend it the bank that's not the bank's money anymore right it's exchanged present

money for a claim on future money for an IOU it's the same thing with respect to the shareholders or sorry with respect to the uh the people who buy the CDs they are lending money to the bank and they're renouncing their claims on that money and what they're getting instead is a CD which is a legally Binding claim on future money okay so um the rest of the numbers are fairly similar it's still a th000 ounces on both sides of the balance sheet but one way that you can quickly tell that in this situation is

is more leveraged is that what's called the debt to equity ratio has changed so originally the bank had no debt and we got to make sure you Dr get mixed up here I'm talking about the bank itself so yeah there was debt in the First example because Jim and S went into debt but we're not talking about them we're talking about the people running the bank from their point of view what has changed if they don't put up as much of their own money and instead they borrow from others in order to fund the same

loan portfolio we're saying here now so originally they didn't do it with any debt they raised all of their um money that they were going to then Lend out they raised it all through what would be called issuing Equity or um you know taking in capital becoming capitalized here there only half of it is is shareholder Equity or capital and the other half is raised through debt financing through through going into debt so at this point now the bank is in debted 500 gold ounces to people in the community so the debt to equity ratio

went from 0% to 100% or you could say from zero to one to one to one Now the reason I'm I'm pointing this out here this issue isn't going to come up so much in this particular lecture and I don't even think roord gets into this stuff the reason I'm mentioning it now is later on when we want to understand what happened with the housing bubble and why you know when when certain banks failed uh and we'll see a lot of people were saying well gee the the reason low interest rates weren't helping the banks

in the in the fall of 2008 and the Reason we allegedly needed to have the tar program was that the banks were suffering from a capital problem not a liquidity problem and so there's that's why I'm emphasizing some of these these things and then also You' say the Reon what happened with some of these Banks is that they were very very leveraged sometimes 50 to one and I just want you to understand what that means it means that in terms of how much Equity do the Shareholders have at stake um versus how much did they

owe to others so just to make sure you understand that number came from here the debt to equity means what's the debt of the bank right now it's 500 ounces of gold what is its equity it's also 500 ounces of gold so that's where the the 100% or the one to one is coming from so when you hear about certain but like long-term Capital Management I don't remember off the top Of my head what its debt to equity ratio was but it was big it was a lot bigger than one to one it was some

big multiple like I'm making this up but something like 35 or 50 to one and the way they would make their money is they would take trades that just had a very very small rate of return on them you know they would they would look for AR what seem to be Arbitrage opportunities of difference between bonds that were older And ones that were just coming off The Auction Block but that were economically equivalent and for some reason people had a slight preference for the freshly issued bonds and so there's a slight price discrepancy that theoretically

there shouldn't have been and so long-term Capital Management one of their strategies is they would go in and and you know buy one and short the other to to gain that little differential but it was this it was a tiny little Differential but the way they made huge returns is they levered up so they would borrow a ton of money from other people and then you know really magnify their uh exposure to that particular trade and so long as the trade worked and they and they had what originally would have been a slight little gain

because they were so levered it got magnified but then of course the problem is well we'll see what the problem is we'll see both the benefits and the Dangers of engaging in leveraged transactions or or Investments okay so the next slide is payback number one payback same scenario as before Jim and S both pay off their loans um now when all is said done When the Smoke Clears there's less gold in the vault than in the first payback scenario but that's because here remember the shareholders only put up 500 ounces of gold originally and they

borrowed the Rest all right and so this scenario now assumes not only did Jim and S pay off the bank their IUS but then the bank turned around and paid off the CDs because the 500 creditors of the bank showed up a year later and said hey here's my CD you promised me uh 1% interest on my my original loan to you and so the bank has to pay off those 500 people so that's 500 ounces in principal plus 5 ounces of gold total in uh interest to all those people all right So when all

a sudden done if you do the numbers you'll see that there's 595 ounces of gold left in the vault that works out to 29.75 ounces per shareholder and the percentage rate of return because originally now in this scenario each shareholder put up 25 now a year later they end up with 29.75 you do the numbers that works out to a 19% rate of return compared to a 10% rate of return for the same successful loans in The first scenario so that let me just make sure you see where that number come from that number is

very intuitive that 19% because effectively what's happened is the shareholders only put up half as much money and yet they got the same absolute return right they still made the same loans to Jim and s in terms of number of physical allowances and so Jim and S paid back those things plus the same Size of interest payments and so since the investors only put up half of the money the rate of return would have been doubled on that score but it's not 20% because they didn't get to borrow the money for free they had to

pay 1% okay so to put it differently if if the investors in the bank if the shareholders could borrow from the community at 0% if they could have issued CDs raised money and not had to pay those lenders anything then and by Becoming by going from 0% debt to equity to 100% they would have effectively doubled their return because they would have had the same absolute return yet only putting up half as much money but they don't actually earn 20% rather than 10% which is a doubling because there's that 1% in finance costs okay so

they can't they can't become leveraged for free they had to pay 1% in interest to the lenders okay so that's where the 19% is coming From from it's a doubling of the original scenario but minus one percentage Point okay now so so you see the benefits of Leverage if everything goes well you earn a higher rate of return as a shareholder but now what happens if things don't go well and you see well there's a bigger chance of loss or or the loss is more severe when a loss does occur so you run the numbers

in the second scenario where Jim pays back his loan but Sally totally defaults And there's no chance she's ever going to pay so that IOU is completely gone is still the sharehold or yeah the shareholders are still legally on the hook to pay those lenders the people who bought the CDs from the bank and lent them 1 ounce each hoping to get 1.01 ounces next year there was nothing in that contract that said unless we have a bad Loan in which case we don't owe you anything no that the the people lending to the bank

they don't care what the Bank does they're saying you promised me you know no no strings attached no conditions no Clauses that you owed us this money and so the bank so long as it's able to still has to pay them put differently the shareholders don't have any claim on any of the assets until their creditors are satisfied so they still have to pay off the CD holders the same amount the 500 ounces plus 5 ounces of Interest so you run the numbers now that's left in the In the Vault When the Smoke Clears is

115 ounces of gold on the left side and that works out to 5.75 oun per shareholder so going from an original 25 o down to 5.75 o that's a loss of 77% instead of the 38% loss that we calculated in the first scenario okay so here you see leverage works the other way too it it magnifies your losses and so where that 77% comes from it's a similar thing 38% doubled would be 76% so just because of the leverage per se the fact that the investors only put up half as much money now that there's

a loss the loss gets doubled because it's the same absolute loss of money right Sally has still lost them 400 ounces of gold I mean that that's the the absolute magnitude of the loss on the books oh 400 ounces um disappeared that or depending how you Calculate you could even say 480 if because you thought that's what she was going to pay you and now she pays you zero so depending on what what time frame you're looking at the loss is either 400 or 480 but the point is um the size of the loss is

the same in terms of physical ounces of gold but in terms of rates of return on the original investment obviously that's a bigger loss when you're investment was only half as much and so that's why from That fact alone the loss would now be 76% not 38% but it's even more it's 77% because on top of that in order to become leverag they had to pay 1% to the lenders the people who bought the CDs so that's why it's actually not 76% but 77% okay so that's um you can see the the the rewards and

risks of of becoming leverage that it magnif I the uh the gains or the losses in percentage Terms relative to the case of where you're not leveraged and so again working through these examples when you understand these basic principles that should shed light for you on discussions that people have about when again when the when the banks were really in trouble and people say stuff like oh well the reason the banks aren't lending right now it doesn't matter that they can borrow from the FedEd basically 0% and then make loans they're not doing that because

their Capital constraint their balance sheets are so shot right now they need to go out and recapitalize it's not a matter of them borrowing money it's a matter of them taking in new investment New Capital to to bolster their balance sheets so I'm hoping some of you have heard talk like that and I'm explaining to you what that means because if You' got a bank that had a lot of bad loans and so they had to Write off a lot of their assets and now they're starting in the fall of 2008 you know let's say

Leman just crashed and everything and they have a bunch of bad loans and now they're starting out with very little shareholder Equity just because you come up and say hey I'm willing to lend you money at 0.1% so don't you want to go and and borrow a bunch from me and then go lend it out well they don't want to do that because then they become really Leveraged you see so yeah if the loans work out if they if the people they're lending to pay them off and they're earning a higher rate of return on

those loans than what the fed or whoever is willing to lend to them for sure they earn a nice profit and they can dig out of that hole but the point is it's very risky when you start out with a very low base of shareholder Equity to then become massively levered by taking in a bunch of loans from one party and then Lend it out to somebody else okay so that's what I'm why I'm focusing so much on this I want you to understand that and that's why with the tar program people were saying okay

it's not the banks need to borrow money we need to invest in the banks we need to have new shareholders namely the US Treasury come in okay because think of it this way if you raise Capital by having more investors come in so you're increasing the number of Shareholders in in a sense duding the proportional ownership of the existing shareholders what you what you do there that's the opposite of becoming lever that that's that dilutes the rewards and the risks the more shareholders you take in and the more Capital you bring in because then there's

a bigger base so if for a given size return or loss or profit or loss it gets split up among more people who can Weather the storm so that's the difference between raising your funds through Equity through in you know selling shares in the company or just bringing in more investors versus selling bonds and bringing in more debt Finance is that with the investors you all sink or swim equally and so you sort of uh dilute the risk to anyone shareholder the more shareholders there are whereas with debt financing you owe those creditors the same

dollar amount Or in this case the same ounces of gold regardless of the success of your own portfolio so if you do well then that means there's more left over for you because you have to pay them a fixed amount but if you do poorly that means there's a lot less for you you because you still have to pay that fixed amount okay that's that's the idea okay so let's move on now slide number three fractional Reserve deposit banking so here with the pictures I'm stressing That this is what rothberg does not like so all

that stuff I talked about before that happens in a pure market economy that is stamped with approval from Murray and rothberg whereas here this is fractur reserve deposit banking okay so the stuff I'm walking through here rough things is illegitimate and fraudulent to repeat in a free market banks are going to make bad loans some banks are going to make so many bad loans that they could go out of business There's nothing fraudulent about that the stuff we talked about in the earlier example where Sally defaults on the loan Sally's not a criminal unless she

you know falsified the loan documents and said her income was something when it wasn't or you know she said I'm going to use this money to buy supplies from my factory but really she went out and bought heroin with it I mean that's unless she's heroin dealer because it's libertopia you get what I'm saying that The mere fact that a loan officer approves loans that turn out bad or that a business person borrows money and then can't pay it back that's not criminal that's not fraudulent there's nothing there's nothing immoral about that in Roth bir's

system the problem comes in under deposit banking when it's uh fractional Reserve deposit banking okay so the next slide a taking into the deposit so here I'm going to walk you Through a a simple example and just for Simplicity I'm not dealing with shareholders who are investing their own capital in this bank but in reality even with a fractional Reserve Deposit Bank you would need shareholders to put up some of their own money just to get the thing going okay just in terms of the accounting and also with legal requirements you couldn't just start a

fraction Reserve Commercial Bank and not have any investors you Couldn't do that but I don't want to confuse you I want to really home in on the fractional Reserve checking accounts per se and where the money creation comes from so that's why I'm not dealing with that stuff so just keep that in mind once you have those issues down from the previous discussion about how the Banker's Capital interacts with taking in loans from the community and then making loans to bank customers once you understand that in the case Of uh loan banking well that's also

going to be going on with actual uh deposit banking with 900% reserves it's just I don't want to mix the two things up because it it might be confusing okay so in practice modern commercial Banks do a mixture of the two things we're talking about they take deposits and they borrow money and they take in um capital from shareholders from investors and then they go and do all that stuff Particularly in investment Banks uh clearly mix all those things as well all right so uh or sorry I should say the investment banks that own commercial

Banks as well so it gets tricky where you've got a given bank that's uh taking you know in shareholder deposit or shareholder equity and then it also takes in deposits from customers who think they're opening checking accounts and it also sells CDs and stuff like that so You' got a modern Bank Blurs all these theoretical conceptual distinctions that we're going to make to understand Roth's Viewpoint okay but back to this slide again we're on the slide it's says a taking a deposit um so the scenario I have in mind here is that this guy Billy

walks into the bank and he's got a bag with 100 ounces of gold coins in it he hands over Say Hey I want to open a checking account And so that just to be clear he says he says now this I can spend this money right this is this is this is my money I'm not lending this to you this is my money right because Billy has read up on rothbart and he thinks he knows how the world works and the bank says oh yeah sure that's your money here's a checkbook you can go around

town you know you don't have to call us your money is always is always going to be there and you can write checks and in Fact if you ever have a problem with our bank you can come in the bank you know as long as it's business hours the bank's open for business you come on in and whatever your balance is at that moment we will go to the Vault and take out that many gold coins and hand it to you and say have a nice day okay so yeah this is this is a what's

called a demand deposit or a lot of people in the community will call it a checking account that you can go around writing Checks on it so Yep this is your money there you go thanks a lot okay but even though that's the case next slide B making a loan what does the bank do it doesn't just have Billy's 100 ounces or 100 metal discs sit in the vault the banker says that's crazy that money's not doing anything it's just sitting there and you know Billy's probably not going to show up and want to withdraw

the whole thing or of course more realistically they have thousands Of billies and they know that not all 10,000 of them are going to show up so what uh what happens here is so they want to loan it out right so here and I want you to pay particular attention to how I did this slide so this guy gido walks in looks surprisingly like Arnold Schwarz nagger comes up he applies for a business loan and He he says he needs 90 ounces of gold and the bank you know looks at the model it's something wacky

about doing a biography of some some funny German Economist that the bankers never heard of he say no one's going to be interested in that kind of bug but all right you seem like an intimidating guy so I'm going to approve the loan but we're going to charge you 20% gido says all right that sounds good so GTO signs the uh signs the document And so forth so now and I did this on purpose there's two ways the bank could give gido the money one way would be to hand him to to open the vault

and take out 90 of the yellow discs and put it into a bag and hand it to GTO and say there you go but G doesn't want to be walking around town with a bag clanking full of 90 ounces of gold I mean even though be GTO is a big guy he could probably defend himself he doesn't you know he doesn't need to to welcome such Assaults it's much more convenient if he goes around with either Bank notes or a checkbook okay so back in the day the the bank may have just given gido paper

notes issued from the bank that said you know the bearer of this note can redeem whatever 1 ounce of gold or there could be a 5 ounce denomination or 10 ounce and so they would count them out to add up to 90 ounces and hand them to gido and then he would walk out after having signed his name saying in one Year time I owe the bank uh what 180 or 108 ounces of gold the 90 principal plus um 18 in uh interest payments in one year time okay so that that's that's how it could

have happened way back in the day when individual Banks issued their own idiosyncratic notes but in our time that's not how banks operate they just give you a checking account okay so now G walks around with checks tailored to that specific bank so a Merchant you know if gido tries to write a check drawn in cran you know and that he printed on his home printer saying that the gido bank of Austria of course the merant going say what the heck is this but if it's a a reputable looking bank that you know the checkl

professional the Merchant's going to say oh okay yeah I've heard of this bank this is fine okay so that's so what I'm saying to in this in this slide here look at this Carefully there's still 100 ounces of gold in the vault and the bankers are still counting that as assets and now on top of that the bankers are counting the 90 ounce IOU from gido is an asset too because G they're in their mind they're saying No this is a legally binding contract he just signed with us and he's a he's a smart guy

he's going to come up with the money even if that weird book he's writing doesn't pan out he's probably going to just go Shake somebody Down for it so we're going to get paid so this is clearly an asset and we still have the 100 ounces in the vault and the way these fractional Reserve Bankers work they think money in the vault is our money we can you know that's our asset so they so the asset side is 190 so we know because of the double entry bookkeeping it's got to be the case the that

the liabilities and shareholder Equity have to equal 190 and and so where where does that Come in well right now there's still no equity okay because nothing is you know all the bank has done is made a loan that per se doesn't earn them income they earn income over time through interest acral so right now the at the moment of giving that loan to to gido they haven't earned anything so where that 190 comes from on the right hand side is the fact that Billy still thinks the bank that he has a claim on the

bank of 100 ounces of gold that at any time He wants to he can either write checks or he can show up and withdraw money so when the bank legally speaking wants to say what are our liabilities well Billy has the right to withdraw 100 ounces of gold but so does gido okay so it's true gido didn't walk out of the bank he didn't want to walk out with 90 ounces in metal but he could have if he wanted to and now with his checking account if he wants to he can Go to a bank

and write it write it out to cash you know if you've ever done that if you write a check out to cash and give it to the bank they give you cash for it okay so so he can do that if he wants it's just he doesn't want to do that right now and in any event if he writes checks to merchants in the community then this bank is going to be obligated if the people who get those checks want to hand over physical gold okay so so now the assets and Liabilities are 190 ounces

so when we talk about you know so so notice what happened here is the bank's balance sheet expanded or grew because of granting the loan to gido and that's why I did it this way I didn't want you know because probably most of you when you hear examples like this you're thinking okay first there's 100 ounces in the vault and then they took out 90 and gave it to gido and he walked away but what I want I'm trying To isolate and show you is no the first thing that happens conceptually in terms of the

accounting is the mere granting of a loan to gido all of a sudden increases both sides of the balance sheet and to the extent that gido may not withdraw the money then at that point in time in that period the money supply or the money stock in this community is now bigger and and what do I mean well I'm saying to the Extent that we consider checking account balances or demand deposit balances part of the money supply or the money stock um clearly it's gone up by 90 ounces so it if if Billy is the

only person in the community originally it's gone up by 90% now of course there's a lot other money in the economy so it hasn't gone up very much but you get the idea okay so this is the sense in which fractional Reserve banking increases the money supply at least Depending on how you define it so obviously it hasn't increased the amount of physical gold which what we would call reserves but it has increased M1 all right and later on in the course we'll Define what's the difference between monetary basee reserves M1 M2 that kind of

thing but I'm saying this is what rothbart has in mind when he says fraction Reserve banking can increase the money supply another thing I keep using different Terminology strictly speaking I think it's more appropriate to say money stock or quantity of money because money supply like you say what's the supply of apples there you have in mind a supply curve meaning it various hypothetical prices for apples what's the qu of apples that Merchants would want to sell so when when you say money supply by analogy strictly speaking that should mean it various purchasing powers of

money how much money do the producers of Money want to bring to Market but obviously that's not what we mean usually in everyday conversation when you say what's the money supply you mean what is the quantity of money in existence right now okay so that's I'm it's hard for me to avoid saying money supply because it sounds so natural but that's why I keep catching myself and saying money stock or quantity of money okay next slide C the reserves flow out so now here what's happened is GTO went around the community with his checkbook and

he starts writing checks with various Merchants he's got to go you know buy a laptop let's say because he's got to write his Masterpiece biography of mises and he's got to go interview some people in Vienna so he has to go buy a plane ticket all right so he's writing checks on his business checking account getting ready for you know all doing all these things that he needs for his Business so now as that happens so he'll let's say go to the airline he writes a check for whatever one ounce of gold for an air

uh airplane ticket the the airline takes it deposits it with its own bank and then what does the airlines Bank do assuming it's not the same bank that gido banks with well they say okay we have a check saying transfer from the account of GTO hoseman one ounce of gold to the account of John Delta the founder Of Delta Airlines okay and John Delta is a client in our bank so what does that bank do it calls up gido's bank and says hey we have this note written by one of your customers to one of

our customers so you know settle up now in practice of course the banks they don't need a physical transfer of gold for every single check that's written what they do is they wait a certain period of time and then they just cancel each other out and they only pay each other whatever The net difference is okay so really what would happen is after you know after a week or a month all the banks in the community settle up with each other and then there's a net physical movement of gold so everyone become square based on

who had more checks written on their bank's customers than vice versa Okay so but abstracting away from all that to keep it simple just assume there's nothing else going on then gido Completely drains his checking account so he writes checks until oh he thinks he's out of money and so all those checks eventually find their way back to his bank that gave him that loan initially so now what happens when the Smoke Clears so that so that bank has to take out physical gold put it in the armored cart and drive it over to these

other banks that are demanding payment because they have checks that GTO wrote and the checkbook Was given to him by this bank and they and their own computers their own ledgers said that yet GTO has 90 ounces of gold in our in his checking account with us up front and so that's why they satisfy the claims for Redemption okay so in terms of the balance sheet what happens now there's only 10 ounces of gold left in the vault originally there was 100 and now as those checks come rolling in it gets drawn down to now

there's only 10 o in there but they Still have that 90 o IOU from gido so there're still 100 o in assets there's now just 100 ounces in uh liabilities okay so the balance sheet of this bank now has shrunk down to 100 but notice it the composition is different from the original scenario when Billy first put in his 100 ounces the balance sheet was still 100 ounces of assets and liabilities but the composition position of the assets was 100 ounces in the vault at that point it Was still 100% Reserve banking but now it's

only 10 ounces are in reserve and 90 ounces are um owed to it by gido okay so in particular at this point if Billy shows up and wants to withdraw more than 10 ounces of gold or if Billy writes checks for more than 10 ounces of gold this bank is going to be in trouble it's going to have to default it's going to have to close its doors because everyone's going to realize whoa you can't trust that bank you know no Merchants aren't going to want to accept checks written on this bank if it gets

caught with its pants down so that's why the bank has to be careful okay but right now technically disaster hasn't struck these Bankers are still okay because they still have 10 ounces in the vault and Billy they just hope doesn't spend more or want to withdraw more than 10 ounces before GTO pays off this loan okay next slide D the German does well so gido's book is a hit gets good rever Good reviews from Israel Kerner all sorts of other uh experts on mises it sells really well and he ends up um earning 128 ounces

of revenues of net revenues okay that um you know because maybe he had maybe he has people that did work for him or something and and we're going to get paid uh out of the share of revenues you know people we're going to get a cut based on how well the book did but when all is said and done gido's the Smoke's cleared he has 128 Ounces from his business from selling uh his book so what does he do well what does anybody do when you get a bunch of money and and let's just suppose

for the sake of argument he gets paid in physical gold coins well he goes to his bank to deposit into his into his checking account right that's what everybody does so after that happens what look what does this look like now there's 138 ounces of gold in the vault the original 10 from the last slide plus gido's 128 and and so the asset side's now 228 because there's still that IOU from gido all right so I'm I'm breaking up the transactions here at this point gido has not paid back the the bank all he's done

is made a deposit into his checking account okay so that's still gido's money legally speaking okay you know maybe he did this two days before the note was Due okay now and you can see that the right hand side is 228 because Billy's still 100 and now gido's balance is up to 128 okay next slide finally we see the completion of the process that um the gido pays off the loan the 90 ounce principal plus the 18 ounce interest because it was 20% interest rate so how does he actually do it this is you know

it's so this is the opposite of that first transaction when they Granted the loan to gido before he actually spent it and it was just a bookkeeping accounting entry that magically increased the money supply well here that operation happens in Reverse so remember gido you know looking back at slide letter D gido owed the bank 108 ounces because it was the 90 plus it had grown to 108 from interest and he had 128 in his checking account so what do you do when you owe somebody Money you write him a check and so G happens

to be that the recipient of this check is gido's own bank but that's fine so gido goes into the bank he says Hey today I owe you 108 right and they say yep and he says okay well I'm going to pull up my checkbook that happens to be with you guys and write you a check for 10 pay to the order of whatever this bank is you know Shady Bank Incorporated uh maybe the Steve Horwitz bank because Steve hor is in favor of Fraction Reserve banking 108 ounces of gold signed Holzman rips it out gives

it to him and then GTO in his checkbook he says okay I had 128 and I just paid 108 so now how much so now GTO thinks he has 20 ounces left in his bank balance and that's of course the bank's computers agree yep now you've got 20 ounces left but from the point of view of the bank's books here what happened that loan disappeared because it was paid off and now the Outstanding liabilities Billy still thinks he has 100 ounces in his checking account and gido thinks he has 20 ounces in his checking account

all right so there's a discrepancy there there's 138 yellow metal discs sitting in the vault and yet there's only two people who collectively have claims to 120 of them so that 18 difference is the equity the 18 ounces so there's 18 gold coins now in the Vault they're unspoken for and so that means that's the excess now now ass are higher than liabilities by 18 ounces and so that's what shows up as the shareholder equity and so the shareholders now of this fractional Reserve Bank Steve Horwitz and his cronies now uh have 18 ounces free

and clear if they wanted to they could withdraw that and spend it you know they could take a like a dividend from the corporation of The bank and they they wouldn't be getting in trouble okay because that 18 ounce is is again is totally free and clear okay so two two more things to note on this slide before we move on we're running out of time here the uh just as the granting of the loan to gido expanded the money stock by the same token when gido writes that check for 118 or 108 ounces and

gives it to the bank and they process it they you know eliminate his loan and Then they clear the check and his checking account balance shrinks that money just disappeared from the economy okay so um it's it's a little bit odd perhaps but that money just disappears because it's um how can I put it normally we think that when when I write a check to you that the bank just you know debits my checking account but credit yours and so you think the total you know M1 Doesn't change and that's true but if you're writing

a check to a bank to your own bank I should say so the way they process that is they simply reduce how much your outstanding checking account balances that just lowers their liabilities in a fractional Reserve banking situation okay so it's not that when you pay your when you write a check to the bank that your account goes down but their account goes up because as we can See here when they lent the money to GTO in the first place they didn't draw down the money from somewhere they just just said okay here you go

they just you know gave him an account and just put a number on it put 90 on it so there that's yours now that 90 didn't come from anywhere okay that's and again that's why I purposely did that I didn't want to just have them take out 90 from The Vault and hand it to gido because then you would be thinking the bank loan isn't creating money it's just taking Bill's Billy's money but that's not what happened there in terms of the accounting they created that 90 out of thin air and just gave it to

them in theory just to drive home the point the bank could have given gido a loan for 9 billion ounces of gold and just credited and gave it to him now of course that would have come back to bite them if GTO Ever spent too much of it but the point is the the loan itself is what was creating the money again if we count the money stock as including checking account balances which is a very plausible thing to do in a modern economy okay and so then going the other way if you buy that

it's got to be the case when GTO writes a check on his account to that same bank the way they handle it is it's not there's this tangible amount of money that gets Transferred from his account to their account they don't have an account they create money or they destroy it and so it's the same thing uh in Reverse in that situation okay what last point and then we got to move on that 18 in equity that number it's not a coincidence that that number is the exact interest payment that gido had to make okay

so the the bank ends up with 18 ounces in equity and that's Exactly how much interest that GTO had to pay okay so that's the whole point of fraction Reserve banking Loosely speaking under fraction Reserve banking the bankers create money out of thin air lend it to somebody and then that person pays back the principal plus the interest and so the loan is extinguished the principal disappears but the interest remains because that's what the person paid above and beyond the money That was created okay so um when it's a Commercial Bank doing fractional Reserve banking

this is kind of an important but subtle point the the bankers do not it's not that the bankers create money and then go spend it right it's not that the bankers uh give each other checking account balances and then go buy their wives mink coats with them that would be foolish because that would eventually Catch up with them and the same thing with the goldsmiths back in the day they didn't have a th000 oun or 100 ounces of gold in the vault and then print up 110 notes give the hundred to their depositors and then

take the 10 extra ones and then go and just buy stuff with it because that would be the end of it and then you know they would they would always be in danger of of being caught with their pants down what they would do is with The extra 10 they would lend them out and so those eventually would come back they could destroy the 10 and then the prin the interest that was paid is theirs free and clear and so that's what this bank has done here that 18 o now so in other words at

this point unless the bankers engage in another loan right now this bank is is 100% Reserve Billy thinks he's got 100 in there gido thinks he's got 20 in there and the bank actually has 138 in The Vault of physical metal discs so there's the bank right now is totally fine there if there's a bank run they're they can they can pay them off that 18 is theirs free and clear and so so that's the idea so the reason at any given point a fractional Reserve Banker is in trouble is that they keep the process

going now you in other words this Banker in the next slide if we continue this story would make another loan to somebody else and they would Again be vulnerable to a bank run but I'm saying with a successful completion of a given loan once that loan is paid off that new money disappears it's extinguished and the banker is left with profit so where did that come from where that 18 ounces come from well it came from the community GTO produced a biography of mises that people in the community wanted and they gave him yellow metal

discs in exchange for it so that's where it came from so effectively Through fractional Reserve banking Steve Horwitz and his cronies have uh if you want to use the term redistributed the existing yellow discs in the community and so now 18 more of those discs are in the legal possession of Steve Horwitz and his cronies okay for people who don't know I'm I'm just making a joke Steve Horwitz is an Austrian Economist who is very much in favor of free market fractional Reserve Banking and so I'm just being funny by Picking him as the the

fraction Reserve Banker okay next slide because we're just about out of time here Roman numeral 4 fractal Reserve banking under Free banking so I'm going to have to be quick with these uh last two slides but I hope by spending so much time on the first stuff and then also of course you you still need to read Roth Bird's treatment it'll it'll make a lot more sense now the stuff Roth's talking about will be crystal clear to you because I Walked you through the mean of it so under what's called Free banking usually what we

mean by that term at least the way austrians use it is a system or a a regime a property rights environment in which the government does not um it doesn't prohibit fractional Reserve banking so it's it's not a crime to uh to take in deposits that are considered demand deposits and then to Lend some of them out to other people so if if you're a client of such a bank you can't go to the court system and say holy cow that guy you know I've deposited my money thinking they were going to put it in

the vault and watch it for me and the next thing I know they lend it out to some German guy that the judge is going to say yeah what's your point okay in contrast if if you put your furniture in a storage facility and then you saw that the guy lent it out to Gido to have a party with then you know you could go bring suit and say what the heck clearly you know I I expected when I dropped off my furniture that they weren't going to lend it out to or weren't going to

give it to somebody else how however temporary they may have thought that would be and the judge would probably say yeah you're right okay but that doesn't happen under Free banking under Free banking we we assume it's legal to engage in fractional Reserve banking but it's sink or swim right the government doesn't give you any special privileges as Banker if you tell people uh this is a demand deposit account then you better be able to pay them when they show up and if you can't then you know you've defaulted on your contract so that so

that's maybe a different way of putting it generally speaking under in the Austrian literature when we Talk about Free banking what we mean is it's legal to have less than 100% reserves but it's not legal to refuse to redeem uh either a check or somebody showing up at the counter wanting to withdraw their money that that's you know you've defaulted at that point on your legal obligations okay so uh mises and others you and rothberg doesn't dispute this either we we all agree with the free Banker and also so in modern Austrian circles to talk

about the free Bankers typically means people like Steve Horwitz and others who have no problem with fractional Reserve banking per se as long as it's on a market as opposed to you know under a government sponsored system so everybody agrees that uh fractional Reserve banking would have certain limits on it and the idea is that you know think back to what we what we showed in the in the example we Went over when the bank gives a loan to a customer that is using that is you know based on deposits that somebody else still thinks

is is their money well they set themselves up they're they're they're vulnerable because now when that customer goes and spends money elsewhere by writing checks uh that makes it more likely that when the Clearing House operations occur The bank that just granted that new loan is going to owe money on net to the other banks in the area and that it's going to have to have a physical transfer out of its vaults of the gold or whatever the the money is that's another thing too I don't know if I stressed I'm choosing gold in these

examples because I want you to see that fraction Reserve banking isn't just about Fiat money those are two separate things you can have fraction Reserve Banking with gold is the money and as the reserve or you can have it with Fiat money and by the same token you can have 100% Reserve banking with gold or in principle with Fiat money I mean it's that would be weird because you don't have have Fiat money presumably because of the government and so the government would want to encourage fractional Reserve banking but but conceptually those are distinct okay

so if you're a fractional Reserve commercial Banker you have to be careful you cannot you can't expand unilaterally you can't just start granting a bunch of new loans to people you have the incentive to right because the benefit of granting new loans the the higher the volume of loans in your portfolio the more interest you're earning and as we saw that's how the bankers get money free and clear that they can then go spend um is by earning interest payments But you but they have to be careful because if they expand more than the other

banks in the area that means statistically their customers are out out in the community spending more than the customers of the other Banks and so that just means on average now when the Clearing House operations occur the that has expanded more aggressively than its competitors is going to have more net Redemption claims on it at the end of the week or the end of the month or Whatever the the Clearing House period is okay so it's its vaults are going to get drained very quickly if it expands more than its Partners now okay so because

of time constraints I think that's the most I can say there let's move on well let me just say one thing the difference in Viewpoint is um is where we think where we predict the equilibrium uh Reserve ratio would be Okay so we all agree as austrians on the principle I just said that any given Bank can't expand too aggressively relative to its competitors under fraction Reserve banking in a in a pure Market setting because it's going to get hit with net Redemption claims but the idea is if all the banks let's say all the

banks originally start out at 100% Reserve ratio if they all say you know what let's try 99% let's try 98% let's Try as long as they're doing it uniformly not necessarily because they all have a pack with each other but just for whatever reason as long as they're doing it um and no one bank is is is expanding more than the others at any given time then it all sort of cancels out okay because yeah the one bank's customers are spending more but so are the other Banks because all the banks are expanding their loan

portfolio Simultaneously and so they all end up canceling out and there's no net flows of gold from One bank vault to another now of course in practice it's not going to be perfect but you get the idea that as long as the banks are expanding uniformly there's not going to be any trouble where any One bank is going to get caught and run out of gold in the vault okay so that the mere observation that I just gave you that if One Bank expands too quickly or relative to its Peers it gets hit that doesn't

prove what the reserve ratio is going to be in equilibrium so the free Bankers the modern free Bankers are going to say for all we know it could be 1% who knows and so rothberg goes farther and he predicts it would be close to 100% And just to give you a quick argument as to why that would be I would you know you could say well there's always competition there's always free entry under Free banking and so somebody could Just start a new bank so even if all the other Banks because they see the advantages

and maybe they go out to lunch together and they have you know secret deal maybe they go from 60 or 100% to 90 to 80 to 70 to 60 and they get down to 50% Reserve ratio and they're not getting pinched because they just you know they're canceling out each other's checks but then at some point somebody could start a new bank and say okay well I'm going to start a bank that's 100% reserve and then he jumps into the mix and now all these other bank customers are going to be writing checks to clients

of this new 100% Reserve Bank when the Clearing House operations occur there's going to be huge net obligations to the newcomer and so all the gold from all the other Banks is going to start flowing out of their vaults into the Vault of the 100% Reserve Bank okay and so um but but Again I just want to point out to you that that doesn't prove that by itself that INE equilibrium the reserve ratio has to be 100% because you know why the new bank that comes into but yeah he starts draining all the gold and

so the other Banks start increasing their Reserve ratios because they're going to get crushed otherwise but why would the you know at any given point the bank that has the highest Reserve ratio why would he keep it at 100% if the other Banks are at 60 when he's at 100 he could still inflate himself and only have like a 90% Reserve ratio and he's still going to be getting gold from them okay so it's sort of like a game theory thing um we can't conclude from what I've just said that therefore in Long Run equilibrium

if the government's not encouraging things then you necessarily can predict that there would be 100% Reserve ratio you would have to have other things involved Like for example people in the community prefer having their money in 100% Reserve Bank even if it means they don't get paid interest and stuff like that right so you you would need to have other considerations um to to come up with the with the uh the argument but but you can see the point that the banks can only you know they have to have a uniform Reserve ratio you can't

have some banks expanding very quickly and having very Low reserve requirements whereas other Banks um have very high reserve requirements because over time the the higher Reserve Banks would end up just siphoning off all of the reserves from the other ones the other ones eventually would get caught with their pants down okay so so that's the the issue under Free banking so now the last slide Roman numeral 5 fraction Reserve banking under Central Banking well you see the that this is the point That rothberg views Central Banking not as it's commonly depicted as this Valiant

effort to stop the rapacious free market Bankers from inflating and the common man has no defense against their rampant inflation no rthur says it's the exact opposite the market left to its own devices has strong checks on any individual Bank expanding and so it takes the government to come in and form a cartel under the opes of what's called the central bank To set a common Reserve ratio for all the banks so they can all inflate in unison and no one Bank gets gets caught with its pants down and then another thing that central banks

do according to rothbard is they monopolize the issue of paper notes okay so here again here we're not talking yet about Fiat money versus commodity money there are still Bank notes even if we have a commodity money is the Base reserve money but the point is you can't you don't have under Free banking you would have uh you know rothbart bank would issue its own paper notes saying the the bearer of this note can get one ounce of gold uh if he shows up at the bank and turns this thing in and then you'd have

the the Holzman bank and You' have the Horwitz bank and so forth and they would be different notes so people in the community would have different things in their wallet notes from different banks to different uh denominations just like right now you Could have checks written from different banks okay but again the difference between a check check in a note is that a check has a particular individual's name on it so it's it's not just the bank it's also the individual's account whereas a bank note is not tied to the person who gives it to

you the note is a more generic thing just saying the only information on the note is the bank that issued it So it's um it's it's it's closer to a money order but even a money order I think the person signs it but you get you're trying to get the the distinction there um okay so what a central bank does is it monopolizes the note issue so now you don't have individual commercial banks with their own paper notes everybody has to use just the notes issued by the Central Bank okay and again that's true whether

Or not the underlying actual money the reserves is Fiat money itself or is um commodity money okay so you can again you can imagine a situation where there's commodity money and yet you have paper notes issued by the central bank which are claims on the commodity money okay so why do they do that well rber talks about it but one main reason is to get people out of the mentality of thinking there's competing Banks right if you're a central Banker you don't Want people worrying about the solvency in the loan portfolio of individual Banks you

want them to just think banking is banking is banking and that's it and you don't even have to care where you put your money because it's all backed up and you're not going to get in trouble because the central bank is the lender of Last Resort if any particular Bank gets in trouble the Central Bank comes in and rescues them so they don't want the community worrying about the Safety of their money because once you that the market check of banks expanding at different rates the only thing left to stop just pure inflation of just

the bankers creating ever more money so they can earn more interest the one remaining check on that is a bank run right because it's still the case that people can show up at a given bank and say give me my money back and if if you're engaging in fraction Reserve banking there's no defense against that Except you know like FDR coming in and closing all the banks and calling it a holiday okay but in terms of just normal day-to-day operations and how to keep the public happy um that that's the the one danger of the

fra you know so so now the in other words the bankers under fra or under Central Banking they don't need to worry about forming a cartel and all going down to a very low Reserve ratio so they can inflate more and earn more interest they don't have to worry About some newcomer coming in and setting up a 100% Reserve Bank right because now there's a cartel the banking system sector is now tightly regulated it's hard to come in and open up a new bank and so they've effectively gotten rid of that check on inflation but

again the one remaining check is if Joe Blow Joe sixpack gets paranoid about the bank and shows up and wants his money then you know the game's up for that particular Branch so I think you know Part of what's going on here is the the Central Bank the philosophy of it is they don't want people thinking in terms of individual Bank corporations because then that makes you think oh gez some might be better than others you don't want the public thinking like that you just want them to think there is the money there is the

bank note that's it and so that's why the Central Bank monopolizes it now all the commercial Banks they don't issue their own bank Notes they just use the notes issued by the central bank so in the United States it's a Federal Reserve Note you don't have notes from City Bank or notes from uh HSBC they all have uh Federal Reserve notes in the United States okay so we're over time here let me stop there there's plenty more material that's important that's in Roth's chapter the tail end of chapter 8 and chapter n and will uh

so you're still responsible for that and Perhaps we'll Circle back and and pick some of that up in in later lectures all right thanks [Music] everybody