In a very long article in today’s Forbes, online edition, John Tamny writes on the Closing of the Austrian School’s Economic Mind. Tamny finds the “modern evolution” of the school “disappointing” in its “more and more … statist, monetarist” appearance. He especially addresses the never-ending debate on fractional reserve banking (and manages to find a single misspelling in an article referring to “fractural” such, which he makes fun of), and the “error” of Austrians who see something wrong with it. One cannot create money, Tamny informs us, so banks don’t.

I must admit that I haven’t read all of Tamny’s very long article, but that should not be considered a problem for two reasons. First, because Tamny starts out making outrageous errors due to assumptions that are so clearly in line with his critique (and so unknown to him) that they cannot be corrected further down. And second, because Tamny himself obviously haven’t read much more than a couple of phrases spewed out by a quick google search. Nevertheless, I think my addressing these assumptions made by Tamny are relevant whether or not he (which is likely) adds more “errors” of Austrians to his list. Let’s look at what Tamny says.

Regarding the statism of Austrians:

it’s well known that some Austrians have a major problem with “fractional reserve banking” whereby banks pay for liabilities (deposits) by virtue of turning those liabilities into assets (interest paying loans). This stance is downright strange. Fractional reserve banking is a tautology.

Banks aren’t in business, nor could they remain in business if they simply warehoused money. Instead, they borrow money from depositors seeking a return on their savings, and who don’t need access to their savings right away, only to lend the money borrowed to individuals who do need it right away. The profits come from borrowing at one rate of interest, then lending longer term at a higher rate. To many Austrians, this non-coerced act of exchange between consenting individuals is a fraud, and needs to be treated as such by the state.

I cannot say I know any of the Austrians who demand the state to step in and outlaw fractional reserve banking (FRB). Tamny seems to be referencing Murray N. Rothbard’s labeling of FRB as “fraud,” but the step from this (even including the claims that “libertarian law” would prohibit FRB) to statism is a bit unclear. But to be honest, Tamny doesn’t make more of this point but quickly moves on to claim that FRB is “tautological” (in the sense, obvious/natural/sound):

well-run banks making quality loans arguably need the smallest of cash cushions. They don’t require large cash reserves nor is it economically advisable for them to keep lots of cash on hand simply because the assets on their books will always make securing short-term operating loans from other businesses (including other banks) very simple.  Put more plainly, well-run banks should logically be the most prominent fractional lenders.

So now we’re getting somewhere, but let’s hurry along to the blatant error in Tamny’s rather uninformed “reasoning”:

The problem is that the very notion of a “money multiplier” is a logical impossibility; one that dies of its illogic rather quickly if analyzed in the lightest of ways. To explain what isn’t, banks are generally required to keep a 10% deposit cushion. Simplified, if a bank is the recipient of a $1,000 deposit, it can generally only lend out $900, or 90% of its deposits. What might surprise some is that the previously described loan is what has many Austrians up in arms.

… the act of lending out paid-for deposits is what leads to massive multiplication of credit; what von Mises referred to as a “crack-boom.” To the Austrians, money can be multiplied. Bank A takes in $1,000, lends $900 to Bank B, then Bank B lends $810 to Bank C, only for Bank C to lend $729 to Bank D, etc. Pretty soon $1,000 has been “multiplied” many times over as the credit is passed around.

This alleged “multiplication” of money all sounds so frightening at first glance, but for those who think there might be some truth to the “money multiplier,” DO try it at home among friends. Hand the first friend $1,000, and let him lend $900 to the person next to him, followed by an $810 loan to the next tablemate. What those who try it will find is that far from creating $2,710 worth of access to the economy’s resources, there will still be only $1,000; the original holder of $1,000 with $100 in his possession, $90 in the second person’s hands, followed by $810 in the third. Though Keynesians and modern Austrians may tell you otherwise, money doesn’t grow on trees, nor can it be multiplied.

Tamny seems to be thinking of money as only the existing, physical “cash.” It is true that banks do not create cash, the proverbial printing press is not a real printing press (at least not in banks). But even though Tamny avoids the outright creation of money (which happens when banks grant for example mortgages – they actually create the money in their computers), he completely misses the point. The crack-up boom (not the “crack-boom”) is not a result of coinage or printing more bills – it is an increase of credit (fiduciary media). This is why Tamny’s example is outrageously ignorant, and it makes a whole lot of difference.

The “minor” fact he’s missing in the example quoted above, and that makes his analogy inapplicable, is that what we’re talking about here isn’t a CD or an old-style savings account – we’re talking about on-demand deposits. So my deposit of $1,000 in Bank A doesn’t mean the bank “takes” that amount, but that it holds that amount and promises to produce it to me on demand. In other words, I have not given up $900 by placing $1,000 in my bank account – I have only replaced my $1,000 in cash with $1,000 worth in demandable funds (checks, debit cards, whatever). I still have those $1,000 (or so I think). So the $900 that Bank A lends to Bank B is in fact an addition to the money supply in the economy.

What matters here is not the number of coins available, but the relationship between the quantity of money and its assumed purchasing power – that is, the relationship between money and other products it can buy. This relationship is screwed up by the bank by pretending that it can produce my $1,000 at any time while they really only keep $100 and have spent the rest (whether or not temporarily). I still act as though I have $1,000 in the account, blissfully unaware of the fact that the bank doesn’t have my money (and neither do I), and Bank B (or its customers) act as though they have the $900 that are no longer available to me. That’s $1,900 in the minds of consumers, and that’s what we’re talking about.

It is not what Tamny is talking about. He has no clue, and pretends his ignorance is a Great Weapon he can use against Austrians.

So let’s look at Tamny’s “analogy” where I have $1,000 and lend $900 to a friend, who lends $810 to another friend, and so on. Does this loan to my friend come with on-demand access to the lent funds? Tamny skips that point as though it were unimportant (of course, it is not) and instead notes that the $1,000 in cash have not multiplied because there is still $1,000 in cash. Well… duh.

There is also no money multiplier in the sense Tamny talks about it unless my friend acts fraudulently, that is if he or she borrows $900 from me promising to pay back all of it on demand yet still lends a big chunk of it to somebody else. Because if this is the case, then it means the promise is no such thing (it is fraudulent) – I cannot get my money on-demand, since my friend doesn’t have it. Somebody else has it. To produce my cash on demand, my friend will have to literally produce money out of thin air, and it is the perception of money “on hand” (fully accessible on demand) that is the basis for our market actions and therefore money prices in the economy. Tamny is messing things up by skipping the crucially important point, the very issue Austrians (especially Rothbardians) have with FRB.

Banks (especially FRBs with deposit insurance, which subsidizes consumers’ trust in placing their hard-earned money in unbacked bank accounts) pool their customers deposits so that they won’t get caught doing this. If they have 10 customers each depositing $1,000 of which the bank re-lends 90% and the customers on average won’t demand more than 10% – then the bank is “safe.” The real state of deposits and thus the bank’s bluff won’t be called, and can thus go on much like any pyramid scheme. Until…

It is the “until” that matters, since banks have promised to produce customers’ cash on demand. It is not important if it happens or not, but that it creates the perception of money that isn’t there – in sum, consumers believe they have more money than there actually is (and more money than is reflected in goods prices). Whether or not we want to call it fraud is really beside the point; this is not the real question, as Joseph Salerno notes: “It is about whether the creation of fiduciary media … produces the sequence of phenomena we recognize as the business cycle.” In other words, if it creates the “crack-up boom” followed by a bust due to the mismatch between the perceived money supply and the economic goods it can buy.

Given the present [unsustainable] banking system, it may very well be the case that, as Tamny puts it, “well-run banks should logically be the most prominent fractional lenders.” But that’s beside the point, since what we’re talking about isn’t really the banking business – but the effect of FRB on the perceived money supply, and therefore the effect on resource [mis]allocation through mismatched prices. That’s what Mises was talking about and what most Austrian economists are talking about. But it isn’t what Tamny is talking about. Yet, again, perhaps he gets to it several pages further down in his hit piece?