Drug addicts suffer major withdrawal symptoms when they go cold turkey. In the case of high-tech startups and their banks (like Silicon Valley Bank), the super-low-interest-rate stimulant has been taken away by the drug dealer (the Fed) via interest rate hikes. With cheap credit drying up, firms switched to pulling cash out of SVB, all while the same interest rate increases caused the value of SVB’s assets to fall. SVB’s balance sheet couldn’t handle the fast withdrawals, which became a classic, self-propagating, panicky bank run, and the simultaneous fall in value of its liquid assets.
When banks practice this kind of maturity mismatch—potentially immediate-term liabilities (deposits) backed by long-term assets (loans and Treasury securities), it is called “fractional reserve banking.”
The failure of SVB and other recent bank crises have reignited the debate over fractional reserve banking. While Austrian economists across the board are critical of central banking and government manipulation of the money supply and interest rates, there are differences of opinion on fractional reserve banking. Murray Rothbard was firmly against the practice for both economic and ethical reasons; however, “fractional reserve free bankers” (FRFB) like George Selgin and Larry White have written extensively about how fractional reserve banking per se does not make for an inherently unstable banking system and does not cause business cycles. The FRFB position is that the business cycles and instability are caused by government interference, primarily via central bank monetary policy.
To understand how fractional reserve banks operate, we first need to make a distinction between warehouse banking and loan banking. Warehouse banking refers to the way banks accept deposits and act on instructions from the depositor to send or withdraw money at par on demand. In warehouse banking, there is no multiplication of deposits or creation of credit—the bank simply stores, or “warehouses,” depositors’ cash. Importantly, depositors have to pay a fee for this service at warehousing banks.
Loan banking refers to the way banks can act as financial intermediaries. A bank customer can purchase a certificate of deposit or other time deposit that, importantly, represents a parting with funds. The customer cannot access these funds for spending or withdrawing. The bank uses these funds to extend loans. The interest earned on these loans is shared (according to the contract) between the bank, which administered and intermediated, and the customer, who relinquished the money. Here, there is also no multiplication of deposits, expansion of the money supply, or creation of credit ex nihilo.
The issues with fractional reserve banking come from combining these two functions: warehouse banking and loan banking. Banks combine these functions by using demand deposits (which depositors can withdraw at par on demand) as a basis for extending loans. Hopefully, the potential problems with this are obvious: What if depositors request more money than the bank has on hand, due to the fact that not all deposits have matching cash reserves, but instead are backed by long-term loans?
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This is exactly what happened to SVB. Depositors wanted to withdraw more cash than the bank had in reserves. SVB had used depositors’ funds to purchase Treasury securities and mortgage-backed securities, and to extend loans to high-tech firms. SVB might have had less foresight than other banks, but it is important to note that all banks do this sort of thing. No bank keeps 100 percent reserves—no bank keeps its warehousing and intermediation functions separate. In fact, in 2017 the Federal Reserve blocked a new bank that intended to be such a safe haven for depositors.
The repeated bank runs and associated financial crises caused by fractional reserve banking have led to the creation of central banking, government deposit insurance, a multitude of bank regulations, and a host of agencies to design and enforce these regulations. It’s worth pointing out, however, that if the government simply ignored bank runs, then the standard mechanisms of profit and loss would be at work. Banks would fail in the same way other private businesses fail. Potential bank customers would avoid unsound banks and flock to sound banks according to their own preferences and expectations. This prospect leads the FRFB crowd to conclude that fractional reserve banking per se isn’t a problem—it is the moral hazard and money creation by the government that causes all the problems.
In my view, the debates over the sustainability and ethics of fractional reserve banking suffer from poorly defined terms. If a deposit is defined as “redeemable at par on demand,” then that constitutes a promise by the bank to have the funds available at par on demand, meaning no loans are purchased with those funds. If a contract stipulates that the bank will offer accounts for which deposits are defined as such but then uses the funds to provide loans, then the bank is in breach of contract. If, however, the bank and the customer agree on a looser definition of the term “deposit,” such that deposits are not always redeemable at par, or are redeemable at par but sometimes with a delay, then that is their prerogative. It seems to me that such an arrangement is more properly called an “unsecured callable loan” and that if these coexisted with true, fully backed deposits on the market, the callable loans would trade at a discount against the fully backed deposits.
I also think that the debates over the sustainability and ethics of FRFB are less important than the economic consequences of fractional reserve banking. No matter what the fine print in a deposit agreement says (and the language is not standard, by the way), if depositors view their checking account balances as one-to-one money substitutes, then prices and spending patterns will reflect the depositors’ own net worth calculations and expectations of disposable income. If a bank expands credit on top of that via fractional reserve banking, then the supply of credit and interest rates no longer reflect the depositors’ underlying real savings and rates of time preference. This wedge is what triggers the boom-bust cycle.
This brings us back to the addict analogy. Suppose an addict had the ability to magically create, ex nihilo, his own stimulating drug, as fractional reserve banks can do with money and credit. Suppose that the negative side effects of using the drug could be spread to all other members of society, as central banks and government deposit insurance allow for fractional reserve banks. Would you expect moderation? Would you expect healthy outcomes? Or would you expect an endless cycle of highs and crashes?
About the Author
Dr. Jonathan Newman is an Associate Professor of Economics and Finance at Bryan College and a Fellow at the Mises Institute. He earned his PhD at Auburn University while a Research Fellow at the Mises Institute. He was the recipient of the 2021 Gary G. Schlarbaum Award to a Promising Young Scholar for Excellence in Research and Teaching. His research focuses on Austrian economics, inflation and business cycles, and the history of economic thought. He has taught courses on Macroeconomics and Quantitative Economics: Uses and Limitations in the Mises Graduate School.
Article cross-posted from Mises.
Five Things New “Preppers” Forget When Getting Ready for Bad Times Ahead
The preparedness community is growing faster than it has in decades. Even during peak times such as Y2K, the economic downturn of 2008, and Covid, the vast majority of Americans made sure they had plenty of toilet paper but didn’t really stockpile anything else.
Things have changed. There’s a growing anxiety in this presidential election year that has prompted more Americans to get prepared for crazy events in the future. Some of it is being driven by fearmongers, but there are valid concerns with the economy, food supply, pharmaceuticals, the energy grid, and mass rioting that have pushed average Americans into “prepper” mode.
There are degrees of preparedness. One does not have to be a full-blown “doomsday prepper” living off-grid in a secure Montana bunker in order to be ahead of the curve. In many ways, preparedness isn’t about being able to perfectly handle every conceivable situation. It’s about being less dependent on government for as long as possible. Those who have proper “preps” will not be waiting for FEMA to distribute emergency supplies to the desperate masses.
Below are five things people new to preparedness (and sometimes even those with experience) often forget as they get ready. All five are common sense notions that do not rely on doomsday in order to be useful. It may be nice to own a tank during the apocalypse but there’s not much you can do with it until things get really crazy. The recommendations below can have places in the lives of average Americans whether doomsday comes or not.
Note: The information provided by this publication or any related communications is for informational purposes only and should not be considered as financial advice. We do not provide personalized investment, financial, or legal advice.
Secured Wealth
Whether in the bank or held in a retirement account, most Americans feel that their life’s savings is relatively secure. At least they did until the last couple of years when de-banking, geopolitical turmoil, and the threat of Central Bank Digital Currencies reared their ugly heads.
It behooves Americans to diversify their holdings. If there’s a triggering event or series of events that cripple the financial systems or devalue the U.S. Dollar, wealth can evaporate quickly. To hedge against potential turmoil, many Americans are looking in two directions: Crypto and physical precious metals.
There are huge advantages to cryptocurrencies, but there are also inherent risks because “virtual” money can become challenging to spend. Add in the push by central banks and governments to regulate or even replace cryptocurrencies with their own versions they control and the risks amplify. There’s nothing wrong with cryptocurrencies today but things can change rapidly.
As for physical precious metals, many Americans pay cash to keep plenty on hand in their safe. Rolling over or transferring retirement accounts into self-directed IRAs is also a popular option, but there are caveats. It can often take weeks or even months to get the gold and silver shipped if the owner chooses to close their account. This is why Genesis Gold Group stands out. Their relationship with the depositories allows for rapid closure and shipping, often in less than 10 days from the time the account holder makes their move. This can come in handy if things appear to be heading south.
Lots of Potable Water
One of the biggest shocks that hit new preppers is understanding how much potable water they need in order to survive. Experts claim one gallon of water per person per day is necessary. Even the most conservative estimates put it at over half-a-gallon. That means that for a family of four, they’ll need around 120 gallons of water to survive for a month if the taps turn off and the stores empty out.
Being near a fresh water source, whether it’s a river, lake, or well, is a best practice among experienced preppers. It’s necessary to have a water filter as well, even if the taps are still working. Many refuse to drink tap water even when there is no emergency. Berkey was our previous favorite but they’re under attack from regulators so the Alexapure systems are solid replacements.
For those in the city or away from fresh water sources, storage is the best option. This can be challenging because proper water storage containers take up a lot of room and are difficult to move if the need arises. For “bug in” situations, having a larger container that stores hundreds or even thousands of gallons is better than stacking 1-5 gallon containers. Unfortunately, they won’t be easily transportable and they can cost a lot to install.
Water is critical. If chaos erupts and water infrastructure is compromised, having a large backup supply can be lifesaving.
Pharmaceuticals and Medical Supplies
There are multiple threats specific to the medical supply chain. With Chinese and Indian imports accounting for over 90% of pharmaceutical ingredients in the United States, deteriorating relations could make it impossible to get the medicines and antibiotics many of us need.
Stocking up many prescription medications can be hard. Doctors generally do not like to prescribe large batches of drugs even if they are shelf-stable for extended periods of time. It is a best practice to ask your doctor if they can prescribe a larger amount. Today, some are sympathetic to concerns about pharmacies running out or becoming inaccessible. Tell them your concerns. It’s worth a shot. The worst they can do is say no.
If your doctor is unwilling to help you stock up on medicines, then Jase Medical is a good alternative. Through telehealth, they can prescribe daily meds or antibiotics that are shipped to your door. As proponents of medical freedom, they empathize with those who want to have enough medical supplies on hand in case things go wrong.
Energy Sources
The vast majority of Americans are locked into the grid. This has proven to be a massive liability when the grid goes down. Unfortunately, there are no inexpensive remedies.
Those living off-grid had to either spend a lot of money or effort (or both) to get their alternative energy sources like solar set up. For those who do not want to go so far, it’s still a best practice to have backup power sources. Diesel generators and portable solar panels are the two most popular, and while they’re not inexpensive they are not out of reach of most Americans who are concerned about being without power for extended periods of time.
Natural gas is another necessity for many, but that’s far more challenging to replace. Having alternatives for heating and cooking that can be powered if gas and electric grids go down is important. Have a backup for items that require power such as manual can openers. If you’re stuck eating canned foods for a while and all you have is an electric opener, you’ll have problems.
Don’t Forget the Protein
When most think about “prepping,” they think about their food supply. More Americans are turning to gardening and homesteading as ways to produce their own food. Others are working with local farmers and ranchers to purchase directly from the sources. This is a good idea whether doomsday comes or not, but it’s particularly important if the food supply chain is broken.
Most grocery stores have about one to two weeks worth of food, as do most American households. Grocers rely heavily on truckers to receive their ongoing shipments. In a crisis, the current process can fail. It behooves Americans for multiple reasons to localize their food purchases as much as possible.
Long-term storage is another popular option. Canned foods, MREs, and freeze dried meals are selling out quickly even as prices rise. But one component that is conspicuously absent in shelf-stable food is high-quality protein. Most survival food companies offer low quality “protein buckets” or cans of meat, but they are often barely edible.
Prepper All-Naturals offers premium cuts of steak that have been cooked sous vide and freeze dried to give them a 25-year shelf life. They offer Ribeye, NY Strip, and Tenderloin among others.
Having buckets of beans and rice is a good start, but keeping a solid supply of high-quality protein isn’t just healthier. It can help a family maintain normalcy through crises.
Prepare Without Fear
With all the challenges we face as Americans today, it can be emotionally draining. Citizens are scared and there’s nothing irrational about their concerns. Being prepared and making lifestyle changes to secure necessities can go a long way toward overcoming the fears that plague us. We should hope and pray for the best but prepare for the worst. And if the worst does come, then knowing we did what we could to be ready for it will help us face those challenges with confidence.
