10 December 2009

Answering Block's Bank Impossibility Claim

UPDATED WITH RESPONSE FROM BLOCK 12th Dec: Back in November 2008, Dr Walter Block, wrote a response to Prof. Eric Posner on fractional reserve banking (frb). Block is opposed to frb while Posner is not. Although I did respond to Block at the time, and posted these two posts:

Property Rights Analysis of Banking

and

Banking Defined and Defended, Part 1

which provide the best of my work explaining and defending fractional reserve banking, I took another look at Block's response to Posner again yesterday and realised he makes a further claim that also deserves an answer. The claim from Block:



'Under frb, it is a logical impossibility for B to make good his obligations to both A and C, on demand. Now, it is entirely possible that A and C will not call upon B to do so. But, IF they do, that is, constitute a "bank run" B will then be exposed as being unable to meet his financial obligations. In very sharp contrast, there are NO OTHER contracts quite like this in the economy. Yes, I buy 10 widgets from you for delivery today, in consideration for my promise to pay you $10, tomorrow. A day passes, and I am unable to carry out my part of the bargain. But, it is not a LOGICAL CONTRADICTION to suppose I am unable to do so, as in the case of frb. There is all the difference in the world between being unable to fulfill a contract due to contingent circumstances, as in the widget example, and it being IMPOSSIBLE to do so, as in the case of frb. It is not merely "intervening events" that make it a violation of the laws of logic for B, the Bank, to uphold contracts with lender A and borrower C. It is IMPOSSIBLE for B to do so, given frb.'

This claim deserves a reply because it is actually somewhat plausible, and because it a good reply can be made to it. I also have not dealt with this particular objection to frb before. The two points of reply are possibility and counterexample.

Possibility
Banks rely on two sources or types of liquidity to discharge their debts as and when they fall due, and Block is correct that all demand claims could fall due at the same time if the creditors did in fact make their demands at the same time. The two sources are called 'asset liquidity' and 'funding liquidity'. The first involves the capacity of the bank to sell or redeem assets, and second involves the capacity of the bank to replace one liability with another (or with capital). It is therefore POSSIBLE for a bank with marketable assets and/or fund-raising capacity to repay all demand liabilities by selling sufficient assets and/or replacing the demand liabilities with term liabilities or capital. I'm not saying that the bank is not at risk of non-payment, but I'm saying that the bank's asset and/or funding liquidity may be sufficient to make payment, even of all demand liabilities at the same time, POSSIBLE.

Counterexample
A second objection that bank demand deposits are 'like no other' contract also has a reply: demand debts are not only contracted by banks but also non-banks, for example, many commercial firms and also individuals borrow money by way of overdraft, which funds are repayable at the creditor's demand. This counterexample to Block is instructive on several fronts:
  1. Unlike bank demand deposits, overdrafts are typically secured over assets such as land or or all the assets and undertakings of a business company. This indicates that the creditor is a) not concerned about the debtor's legal tender cash assets or even liquid assets more generally defined and b) is concerned with the level of assets available to repay the credit, even illiquid assets. 
  2. Demand debt does not rely on the capacity of the debtor to strictly be in a position to repay at any time, it can instead rely on the adequacy of the security held by the creditor and/or the acceptance of a level of credit risk by the creditor. If this is OK for non-banks to obtain finance on this basis why not banks?
  3. In the same way, demand debtors need not rely on either funding liquidity or asset liquidity, they can instead rely on the creditor not demanding repayment unless the debtor's risk level is no longer within the creditor's tolerance. The debtor also does not rely on liability diversification, i.e. creditor A demanding funds while creditor B will probably be providing funds, instead the debtor relies on the creditor not demanding repayment. If this is OK for non-banks to have poor liquidity, what basis can imperfect liquidity of banks be objected to?
Block's response, in the comments below,  is to accept the possibility that a super-strong bank with super-strong assets and/or funding liquidity could pay all its demand liabilities immediately, and to object to overdrafts as well as to fractional reserve banking. I found this response to be surprising, so I had a further look into Block's work on the subject, and found that he is also on record as opposing any maturity transformation by financial institutions (see http://www.springerlink.com/content/a88l166702524r55/):
We ask whether or not time deposit banking can also be illicit, and answer in the positive, if there is a mismatch between the time dimensions of deposits and loans. To wit, if an intermediary borrows short and lends long.
I also find myself in a difficult position to argue with Block because:
  1. Although his positions appear untenable and absurd, they are at least internally consistent
  2. Leading free banking academic economists that have taken on Block on fractional reserve banking have taken some positions on bank note option clauses, the social value of and agent optimality of maintaining some non-zero level of metallic reserves under free banking, and the economics of money and banking that I do not, and that confuses matters, and opens themselves to fair attack,
  3. A significant amount of the arguments around this controversy rely on positions accepted (or allegedly accepted) by the said leading free banking academic economists, that I do not accept: Rothbard's title transfer theory of contract, and the relevance of the "present goods" and "future goods" categories, and the economic impact of bank-issued money.
  4. The level of research, analysis and argument needed to address all these issues is beyond my credentials, resources and influence.

    4 comments:

    David Hillary said...

    I've had some very interesting correspondence with Walter Block in which he concedes the 'possibility' point and condemns overdrafts!


    from Walter Block walterblock@cba.loyno.edu
    to David Hillary
    date 11 December 2009 10:10
    subject RE: Answering the bank impossibility claim
    mailed-by cba.loyno.edu

    hide details 10:10 (20 hours ago)




    Dear David:



    May I make a suggestion: stick on a few footnotes, add some biblio, and publish your letter to me as a rejoinder in a ref'd journal (see below for my pubs on frb). I promise then, to write a substantive reply to your article.



    As for now let me just say that, yes, if there is a small enough bank opened by a Bill Gates, it would be possible to pay, out of capital, or other resources, some small proportion of the outstanding debt created by frb. Maybe, possibly, even likely, enough to cover that one small bank.



    Best regards,



    Walter



    Walter E. Block, Ph.D.
    Harold E. Wirth Eminent Scholar Endowed Chair and Professor of Economics
    Joseph A. Butt, S.J. College of Business
    Loyola University New Orleans
    6363 St. Charles Avenue, Box 5, Miller Hall 318
    New Orleans, LA 70118
    tel: (504) 864-7934
    fax: (504) 864-7970
    wblock@loyno.edu


    Barnett, William and Walter Block. Forthcoming. “Financial Intermediaries, the Intertemporal-Carry Trade, and Austrian Business Cycles; or; Crash and Carry: Can Fraudulent Time deposits lead to an Austrian Business Cycle? Yes.” Journal Etica e Politica / Ethics & Politics



    Barnett, William and Walter Block. 2009. “Time deposits, dimensions and fraud,” Journal of Business Ethics; www.WalterBlock.com/publications; 88: 711-716; http://www.springerlink.com/content/100281/?k=walter+block&sortorder=asc&v=condensed&o=20; http://www.springerlink.com/content/a88l166702524r55/



    Hoppe, Hans-Hermann, with Guido Hulsmann and Walter Block. 1998. "Against Fiduciary Media," Quarterly Journal of Austrian Economics, Vol. 1, No. 1, pp. 19-50, http://www.mises.org/journals/qjae/pdf/qjae1_1_2.pdf; http://www.qjae.org/journals/qjae/pdf/Q11_2.pdf; translated into Spanish and published as "Contra los medios fiduciaros," Libertas, No. 30, May 1999, pp. 23-73.



    Block, Walter and Kenneth Garschina. 1996. "Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process," Review of Austrian Economics, Vol. 9, No. 1, pp. 77-94; http://www.mises.org/journals/rae/pdf/rae9_1_3.pdf; http://www.mises.org/journals/rae/pdf/r91_3.pdf



    Block, Walter. 1989. "Ludwig von Mises and the 100% Gold Standard," The Meaning of Ludwig von Mises, Llewellyn Rockwell, ed., New York, Lexington Books



    Block, Walter. 1988. "Fractional Reserve Banking," Man, Economy and Liberty: Essays in Honor of Murray N. Rothbard, Walter Block and Llewellyn Rockwell, eds., Auburn University, The Mises Institute, pp. 24-31.



    Block, Walter and Bryan Caplan. 2008. “The Danger of Fractional-Reserve Banking: Walter Block versus Brian Caplan on Fractional Reserve Banking.” Nov 1; http://www.lewrockwell.com/block/block110.html



    Block, Walter. 2008. “Is Fractional Reserve Banking Fraudulent?, rejoinder to Eric Posner,” November 6; http://www.lewrockwell.com/block/block111.html

    David Hillary said...

    from David Hillary
    to Walter Block
    date 11 December 2009 10:23
    subject Re: Answering the bank impossibility claim


    10:23 (20 hours ago)

    Walter,

    Thanks for your reply, suggestion and concession re possibility. Any concession on non-banks borrowing on overdraft, as a comparable contract? I'll follow up on your suggestion.

    Regards

    David Hillary

    from Walter Block
    to David Hillary
    date 11 December 2009 16:01
    subject RE: Answering the bank impossibility claim
    mailed-by cba.loyno.edu

    hide details 16:01 (14 hours ago)




    Dear David:



    I don't see the difference between a bank and a non bank. Any entity that engages in frb is to that extent violating rights.



    Best regards,



    Walter



    Walter E. Block, Ph.D.
    Harold E. Wirth Eminent Scholar Endowed Chair and Professor of Economics
    Joseph A. Butt, S.J. College of Business
    Loyola University New Orleans
    6363 St. Charles Avenue, Box 5, Miller Hall 318
    New Orleans, LA 70118
    tel: (504) 864-7934
    fax: (504) 864-7970
    wblock@loyno.edu

    David Hillary said...

    I also notified Prof. Eric Posner on email about this debate and he wrote me this comment:
    'Thanks but the premise of his argument is wrong. The fact that a type of contract is unusual or even unique is no reason to think there is anything wrong with it.'

    Good point!

    Rafael said...

    Thanks for treating this fascinating topic, David. Walter appears to be under the impression that consensual maturity transformation is fraudulent. But is maturity transformation in the other direction also fraudulent? For example, is a retailer that sells electronics on 90-day payment plans defrauding its business partners if it finances itself with 10-year bonds? Presumably not. Debts are written off if the debtor is insolvent, and insolvency has nothing to do with maturity transformation. If that retailer makes bad credit assessments, it will go bankrupt no matter how long it has to pay off its debt. What about a car retailer who sells cars on 10-year payment plans but finances itself with 30-day commercial paper? Is that also fraudulent? Professor Block appears to be contorting legal theory in order to provide a non-utilitarian basis for opposing frb (even though his real motivation is likely the utilitarian argument that frb is illegal because it will cause a business cycle). What the Professor fails to see is that absent government guarantees, bank paper funded by demand deposits would no more be cash than commercial paper is cash. The bank would have to pay market interest rates on deposits, instead of artificially low rates due to government guarantees. Thus, banks could no more print money than anyone else, regardless of whether they hold fractional reserves. The lower the reserve fraction, the higher interest rates required by holders of the bank's paper. Thus, frb creates a business cycle only with government guarantees of banks. Absent these guarantees, free banking (including frb) has no ability to suppress interest rates and cause a business cycle. There is no need to create arbitrary and contorted prohibitions against maturity transformation, which have no basis in a libertarian theory of property rights.

    David, please keep us in the loop on your journal article, and on any academic replies to it. Cheers!