 In my now, uh, many years of, um, of, uh, teaching economics, I've, I've learned that, um, no matter what time it is, you should always start when the lull, you know, occurs in the crowd. So we're gonna go ahead and start, you sort of settle down, and, uh, this is a good time to, uh, jump in. Um, so in this, uh, session, we're gonna talk about the economics of fractional reserve banking, and I want to emphasize that, uh, we're going to, uh, concentrate our effort on the economics. Uh, the economic theory of fractional reserve banking, we will not, uh, delve into the legal questions, uh, or the, uh, moral questions of fractional reserve banking, all very interesting, uh, areas of, uh, discussion. Um, and if you're interested in reading, uh, something on those, uh, points, I highly recommend, uh, Guido Holtzman's book, The Ethics of Money Production, a very excellent, uh, treatment of all these issues, the economic and the, uh, ethical issues involved. So let's start, uh, what will, uh, the outline here is, uh, we'll start with a, um, a review of the market system of money and banking, and then, uh, and to see how this, uh, uh, integrates into the, the working of the economy, and then we'll introduce fractional reserve banking, we'll give a definition and talk about, uh, you know, what it, how it operates, and then what its, uh, implications are for the working, uh, of the market economy. And then, uh, the third thing we'll do at the end, we'll talk about the, uh, the justifications that have been given, uh, or the main justification, at least it's been given for, uh, treating fractional reserve banking as a part, uh, of the market economy. So we'll deal with this question of whether or not, uh, economic theory would lead us to the conclusion that fractional bank, uh, fractional reserve banking is or is not a kind of natural part of the working of, uh, of a market economy. Okay, so let's, uh, just review real quickly what, uh, what Dr. Englehart talked about yesterday on the, on the market development of money. We know that out of a barter economy, we think about, uh, just to remind you, in economic theorizing, of course, we always think about these things in the, in the structure of logic, right? We're not, we're not interested in the details of, uh, time and place and so on. We're just, we're just interested in the flow of the logic of how, uh, uh, things arise in the market and so on and so forth, right? So we start with a barter economy because that would be the precursor to money. And, uh, we notice, uh, logically the double coincidence of one's problem is, uh, uh, Dr. Englehart was explaining yesterday. And then the solution to this, uh, is just an entrepreneurial innovation. Somebody in the market just hits upon the notion that, um, he can take his goods and trade with a third party who has a general, more generally saleable good that he can then take and trade for what he wants with his intended trading partner. And of course, if one person can see this, it's not a, uh, you know, rocket science. If one person can perceive that a more generally saleable good solves the double coincidence of one's problem, then of course other people can see this too, right? So it's just a question of, um, development of this insight that one person in history would have made initially, uh, that, uh, leads to the development of a general medium of exchange. Again, as Dr. Englehart has already, uh, uh, outlined for us. Now I might add one, uh, one other element to this though. And, uh, this is the, uh, certification of money. So as Dr. Englehart explained, it may have been in history that, um, some of the things that were used initially as, uh, a medium of exchange, uh, were not suitable to be a general medium of exchange. Things like cattle or copper pots or, uh, you know, wheat, uh, bushels of wheat or, you know, things of this sort. So another entrepreneurial innovation would have been that someone noticing people using these different various things as a, uh, media of exchange would have, uh, hit upon the notion that there might be just one commodity or just a handful of commodities. They're actually superior in their physical properties as a medium of exchange. They're durable and divisible and, you know, the standard kind of, uh, uh, desirable, uh, elements of, uh, of commodity money that you would read in any, uh, money in banking text. So this too is just a natural entrepreneurial innovation. It's just, it's just the, the natural entrepreneurial inclination to provide a superior product, right? And then to, uh, be a profit, earn the profit from providing a superior product to people. So once this is done, it probably would occur synchronously with certification. That is, you would, an entrepreneur would think, you know, gold is probably the best commodity for medium of exchange for the reasons that, uh, again, Dr. Englehart has already explained, but it'd be even better if I certified it, if I stamped on the gold, if I formed it into a standard, uh, uh, shape and size, and I stamp on it that as the producer of this money, I guarantee the weight and fineness of the gold in this coin. So coinage too would have just been a natural entrepreneurial, uh, strategy, right? It's a business strategy. You can make money, right? You can survive and make a business minting, uh, minting coins, either buying the gold from a mining company and then minting it and earning the fee from minting. And of course the, uh, customers are willing to pay the fee, uh, because having the certification is valuable. Then you don't have to weigh in a say the raw commodity every time it's used, right? So this is a viable business strategy or to put it, to put it in the more general terms. This is how the production of money would be integrated into the, uh, regular system of economic calculation that all goods, the production of all goods is subject to on the market. It's no different. It's just private enterprise, the entrepreneurs in the market, uh, producing a product, uh, and earning a profit. They earn the profit by charging fees for the, uh, differential advantage that, uh, consumers get from having certification of the money. And so that, so that's how money would develop, uh, to its, uh, sort of, um, uh, at least historically known end state of perfection, if you will, or development. Now what about banking? Well, banking, uh, would develop along two lines. There could be other things too, but they're not, uh, necessary for us to go into in this talk. But along two lines that, uh, we need to talk about fraction reserve banking. Uh, the first is what, uh, is sometimes called deposit banking. So we see, again, the logic of how you could establish a business as an entrepreneur by innovating and providing a superior product to the customer, for which the customer will pay a fee that generates revenue so you can cover your costs, right, just like any business. And this is, uh, to deposit banking is where the, uh, entrepreneur who runs a bank would take the certification that's on the coin, and place the certification on a piece of paper, or an electronic ledger. So something like a bank note. Now what's the advantage of a bank note to the customer? Why would a customer pay for a bank note instead of, you know, just using the coins? And hopefully you can see right away it's the convenience and safety. You can carry around large amounts of, uh, uh, purchasing power, uh, with, with paper, um, you know, instead of gold or silver, uh, to be, you know, safer to carry. It doesn't clink in your pocket as Dr. Engelhardt was explaining and alert the thieves among us, uh, to your, to your stash, uh, and so on. So there are various sorts in electronic versions of this course. They're even more, uh, beneficial because we can transfer the, the claim electronically, right? Then we don't even have to carry any, we just, you know, we just, uh, we're just on Amazon. And, you know, just, you know, put it on my account, you know, take it out of my checking account. Here's my debit card number and we swipe our debit cards. So it's that, it's that kind of thing. Of course people will pay fees for this because it's, it's valuable to them. Or to the extent that it's valuable to them, they'll pay fees. And so you can have a, uh, an entrepreneurially run bank that's deposit banking. And, and so this would be the first step. Now the key though, to the, the bank note or this, this certification on a piece of paper, uh, becoming a medium of exchange, the key to this, of course, is the absolute and unequivocal redemption of the bank note for money proper on demand at par. So this is a condition that, uh, Ludy von Mises, uh, emphasized in theory of money and credit is great treatise on money. Uh, so if, if, if customers are to take their bank notes instead of gold coins and spend them, uh, uh, with merchants who aren't customers of the same bank, then the merchant has to have very high confidence that he can take the bank note down to the customer's bank and redeem it for an equivalent amount of gold, right? Money proper. It has to be a firm and, uh, secure, uh, redemption claim. If that happens, then, then, uh, the, uh, the bank note, the so-called money substitute, uh, can be also then a medium of exchange. It can actually be a substitute for money or a companion medium of exchange if you wish to put it this way. Now the natural progression of this development, of course, as, as we're sort of unfolding it, would be for what Mises like to call money certificates, and a money certificate Mises defines as a money substitute, a claim to money, this redemption claim to money, uh, for which there is a 100% reserve of money, um, uh, that the customers can have for redemption. So the deposit bank would first initially start as a 100% reserve bank, not a fractional reserve bank. I mean, it seems the first step would be a 100% reserve bank. This would give, uh, you know, greater confidence to the merchants at large that they could, in fact, redeem these claims on demand at par. There would be no question of this, uh, or at least very little, uh, uh, uncertainty about this if there were a 100% reserve. So we see this then as the initial development of, of a market institution of banking. Now, let's, uh, so here we summarize this, right? The money emerges from the market activity as this commodity, and then entrepreneurs certify the commodity, and the customers get this benefit of standardization of the bank note or the checking account and so on. And the key point that the production of this, uh, money, and then the money substitutes, as we were speaking about, would be integrated into the market. All the production is based upon the same system of economic calculation. Is it profitable? Are there losses? You know, the entrepreneur would adjust production according to the regular pattern of profit and loss. Now, there could be different ways in which the money certificates could be, uh, issued by the bank, and we want to make just a, we want to follow along one line of how this could be done. And the argument that we're making throughout the talk, it doesn't depend on whether it's done one way or another, but I want to do this for purposes of illustration. So once the money substitute is issued by, or the money certificate is issued by the bank, the bank could treat in the sense of its own assets and liabilities. The bank can make a contract with the customer with respect to this bank note in one of two ways. One way would be, as we've, uh, the case that we're taking, is deposit banking. Deposit banking is when the customer would come into the bank and deposit the coins in the bank for safekeeping and deposit them. And then when they're deposited, the bank, uh, the customer transfers ownership of the coins to the bank in exchange for the bank note. That would be one feasible way in which this could be arranged. Uh, and, and I want to do it this way just, again, for purposes of illustration. Uh, Murray Rothbard in his work does it the other way. The other way is to, is that this relationship between the customer and the bank could be treated as a warehouse relationship, a bailment contract, where the customer comes in and doesn't, uh, trade the ownership of the money for the ownership of the money certificate, but pays a storage fee to the bank. And the bank is just a warehouse then storing the customer's gold. And the bank note, legally then, is just a, uh, a ticket of ownership. It's just a sign of ownership. So, so we're not going to, we're not going to follow out in that legal path. We're going to follow this other legal path. And the reason to follow the other legal path is because we can, we can, uh, make a nice contrast between how it affects the bank's assets and liabilities compared to fractional reserve banking. So that's the only reason to do this. So this is what it would look like a typical, uh, arrangement between the customer of the bank. This is what the bank's, uh, balance sheet would look like, the T account and their balance sheet would look like. If a customer came into the bank and deposited $1,000 in gold and then gave up ownership of that to the bank, you now own the gold and I now own this, uh, claim. So the claim is in a checking account. So the claim is electronically, uh, recorded in a checking account. That's what the customer owns. In other words, the bank now has a liability. They must pay the, uh, the owner of the checking account funds on demand at par, the money that they're holding in reserve. That's the contract that they enter into. Whoever has the checking account funds present them at the bank and the bank will redeem on demand at par the, uh, the money reserve. Uh, by the way, uh, hopefully you can see right away if the, if this is a warehouse contract that the customer forms with the bank, then it won't affect the bank's balance sheet at all, right? Because the bank doesn't own anything. The bank doesn't own the gold. It doesn't have any liability claim with respect to the, uh, you know, IOUs that it has to other people. So, so it's a different, uh, impact. So we do it this way so that we can, we can make a direct comparison to fractional reserve banking where again it affects the bank's balance sheet as we'll see. Now the other main point though that we want to make here is that, um, this, uh, this production of the money certificate then leaves the total stock of money the same. Nothing has changed, right? The bank has simply replaced one form of the medium of exchange with another. They've taken money off the market and used it now as a reserve instead of a medium of exchange or not using it as a medium of exchange or using it as a reserve. And now they've issued another medium of exchange, the bank note or the, in this case, a checking account that serves in place of or as a substitute for money. So when the banks issue checking accounts, they do not change the total stock of money in society. They just change the form of the medium of exchange from money proper to money, uh, the money substitutes. By the way, just as an aside and before the financial meltdown that began in 2007. If you looked at the M1 money supply in the U.S., um, it was roughly 25% money proper, Federal Reserve notes, and 75% checking account balances. When we got into the middle of the financial crisis in 2009, the balance between the two is 50-50. So this is still a live issue in our economy, right? People choose between the two that they can move their funds between the two forms of the medium of exchange. Sometimes they prefer money proper, sometimes they're more inclined to prefer the money substitute. And it's quite obvious why they, hopefully it's obvious to you at least, why they prefer the money proper during financial meltdown. You don't want to rely upon the redemption claim of the fraction reserve banks. Okay, so anyway, that's the first point to make with respect to the economic consequences of the deposit banking. Now, here's just a quote from a famous economist about 100% reserve banking. And the quote goes, the bank money, the money substitute, or the bank issued money substitute, what this author calls the bank money. Just offsets the amount of ordinary money, gold or currency, placed in the bank's vault. No money creation has taken place. 100% reserve banking system has a neutral effect on money and the macroeconomy because it has no effect on the money supply. Now, that quote was from the great economist Paul Samuelson. So, even the Archkainsians recognize this point, right? This is not a nutty right wing conspiracy argument. This is a well accepted conventional view. Okay, so now let's think about the next step. What about money production? And this here I've just borrowed Rothbard's diagrammatic analysis where he borrows it from Wich's need. Where we have the total stock of money as a vertical line, right? The total stock of money at any given time or the total stock of any good at a given point in time is fixed. So it doesn't depend upon what its price is, right? It's just physically fixed. So that's the amount of money, let's say we start at M zero. That would be the amount of money, a trillion dollars or whatever it is. And then the purchasing power of money would be determined by the extent of total demand for money given that total stock. And the total demand for money is the total demand that people have to hold money or whatever this good is as a good in their stock of goods, as an asset. So we're all holding money balances right now, cash on our person or checking account balances or so on. We're not instantly and completely taking those money balances and buying goods or investing to earn the rate of interest. We're holding money. And again, we're not going to go into the reasons of why this is done, but we'll just rely upon that background for our analysis. Now in the market system that we've described so far where money is something like gold coins and their money certificates issued by banks, then this purchasing power of money here at point A where we begin this dynamic analysis corresponds to a cost of producing the gold coins that generates a stable rate of return, a rate of return on investment that doesn't inspire profit, more production in profit or include losses and then a decrease in production or equilibrium so to speak with respect to the production of money. And then we ask the question, well, what could possibly occur? What would be the cause of an increased production of money? For example, would the miners and the minting companies just sort of arbitrarily increase the money supply? Just, hey, we're producing money. Let's just produce another 20%. Well, no, if they did this, they would drive the purchasing power of money down below its cost and suffer losses, just like if Tim Cook at Apple Inc. decided, so how many iPhones are we producing a month? Oh, it's 12 million. Let's produce 25 million a month. No, he's not going to do that, right? Because if he did that, in order to sell that volume, he would have to lower his price, and presumably that price would be below his cost and he'd suffer losses. So again, this is just a general analysis of how production of any good is regulated by profit and loss. The only way it would be forthcoming for entrepreneurs who are producing money to produce more of it is just like any other good if the demand for it first goes up or they anticipate that the demand for it's going to go up. If the demand for money goes up, then if they don't produce more money, the market value of money is going to be way up here, way above cost, right? So then they'll want to ramp up production, they'll buy more inputs, they'll open up more mines, they'll make more capital investment in new technology to get the gold out of seawater or whatever, and all of this has higher costs. And so their cost structure would increase and their total stock would increase to the point where again there's a balance of the return that's earned on investment in money production that would be similar to the rate of return that's earned in other like production processes, the mining of copper or the timber cutting or whatever other things are in a similar class of investable projects. So that's how the market production of money would function. To say this in a slightly different way, under a system of a market produced gold standard, the supply of money is not fixed. The supply of money expands or contracts according to the demand for money, just like any other good. The production of it expands or contracts according to demand. It's no different. Okay, so that's the gist of the market system for money. Now let's turn to a credit. This is the second function that banks perform that we need to investigate here, that they would perform on the market economy. And this is the intermediate credit. The banks borrow from savers, they pool the funds, and then they lend to investors. And for this function as a middleman, they're just performing again the generalized function of an entrepreneur who's a middleman, like Walmart, who buys wholesale products, and then they package them in a retail environment and sell them for retail prices. Same thing here. The banks are paying wholesale interest rates to the savers to borrow the money, and then they're making a more efficient use of the money so that they can earn retail interest rates when they lend to investors. So this is how the system of credit intermediation would work. And again, this is even the language of financial intermediation indicates this middleman function, right? It's just that's where the interest spread comes from in a market economy. It doesn't come from leveraging. It comes that is borrowing short and lending long, right? Exploiting the yield curve. It comes from the greater efficiency of performing the lending activity to investors, investigating who are credit worthy borrowers and bearing the uncertainty of making these investments and relieving the savers of these difficulties so that they're willing to accept the wholesale interest rate in lieu of having to do all this themselves. They're just relying upon the division of labor. It's just an extension, if you will, of the division of labor. So credit intermediation, too, would be regulated by profit and loss. If the banks wanted to, I mean, they wouldn't just say, hey, it's nice and sunny today. I'm in a good mood. Let's lend 20% more, right? Because if they did this, again, they would have to move down the demand curve, right? And they'd have to accept lower interest rates from the borrowers. And they'd have to pay the savers higher interest rates to increase the supply of saving and their interest spread would be squeezed. It'd be squeezed to the point where they don't get enough revenue from that interest spread to cover their costs. And that's what we mean when we say that credit intermediation is regulated by profit and loss. It's no different, then, in that respect than the production of anything in the market. It's integrated fully into the market. Okay, so now let's turn to, oh, let me provide this one, again, kind of stylistic example of this just to drive the point home, and then we'll turn to the fractional reserve banking. Now, like my other example, the balance sheet of the bank, this one is an extreme example, right? It's a particular example. It's not meant to be always the case. It's just an illustration of what might happen. So in the extreme case, the bank's balance sheet might look something like this, right? Where they borrow from savers, they pay them certificates of deposit for one year. Savers come in and the bank negotiates and they take in $5,000, and then they make one-year loans equal in the time structure of that $5,000. And then they do the same thing with longer-term loans that savers are willing to grant them, $10,000 in five-year CDs. Now they owe savers $10,000 in five years, then they make a loan, a structure of loans that are five years long so that they can be paid back in a timely way to pay their liabilities, right? Now, of course, they don't have to do exactly this, but they do have to pay attention to the time structure of their assets and liabilities. For example, a more reasonable case would be that a bank finds out that over time that a lot of the one-year CDs roll over. Maybe like 60% of their one-year CDs are renewed or new customers come in and they have this kind of fund that's fairly stable over time. Well, then they could take the entrepreneurial venture of lending that pool out for longer periods of time, right? This would just be another entrepreneurial innovation that would be subject to uncertainty and maybe losses, but maybe profit, right? So there's just a normal business activity for them to try something like this. The point is they have to be sensitive. They're always put under pressure, the banks are, by the market, by us in the market, to keep the time structure of their assets and liabilities in balance. They can't get out of balance. They have to satisfy our time preferences to put it in the theoretical sense. So credit intermediation leaves the bank liquid. It leaves it solvent, right? They're the ones who are making, you know, experts in deciding who to lend the money to and so they're better than the customers are at doing this, the savers. So their loans are good or at least better again than they would be otherwise. And so their balance sheet is intact. There's nothing unusual about this. There's nothing different about the character of their balance sheet relative to an auto company or a tech company or anything else. All businesses in the market economy have to pay attention to liquidity and solvency of their activity. So credit intermediation does not change the supply of credit or the time structure of it fundamentally, right? So it looks something like this. Again, if we were to diagram this, the only way in the market economy, if we start with conditions of demand and supply for credit at point A, the only way for the interest rate to be pushed down or the supply of credit to be increased is for people's time preferences to fall. Now again, we're simplifying from other factors that can affect credit. We'll take this up tomorrow in the time preference lecture. But here the basic point is that time preference would drive interest rates down in the market as a reflection of the fact that savers time preference rates have gone down. And so we would get something like this, I1 and C1. Okay, so now that we've canvassed over how the market would work, let's turn to the issue of fiduciary media and fractional reserve banking. So these are just the terms or definitions. Fiduciary media are money substitutes for which a bank holds only a fraction of money reserve. Dr. Engelhardt referred to the Goldsmiths introducing in England, introducing this innovation of running their reserve. Simply seeing that there was a big pool of funds sitting in their bank vault, they didn't pay much attention to the legal status of, you know, whether it was legally permissible or morally okay for them to lend out these funds, they just started lending them out. And so they run the reserve fraction down. So that's where we get the language of fractional reserve banking, right? So fiduciary issue is when the banks issue checking account balances for which they only hold a fraction of reserve as money. So that's our language. Now, how do they do this? How does the bank issue fiduciary media? And the answer is they just extend credit. They just, they keystroke on a computer, right? They just hit a keystroke. Just like, it's very similar to, and we'll make a few analogies here, it's very similar to the Federal Reserve, they just hit a button on a printing press. And then more money comes out at the end of the process. The bank just hits a key on their keypad and a checking account balance increases of a customer. So a customer goes into the bank and says, I want to borrow money for a new car. And the bank says, yeah, you've been a good customer for us. Sure. We'll lend you the money. They don't borrow the money from a saver. They just write the loan into the customer's checking account. That's how fiduciary media comes into existence. We call this credit creation. The issue of the fiduciary media, we call monetary inflation. And the issue of the credit out of thin air, if you will, we call credit creation. Notice neither one of these phenomena can occur on the market economy that we've described so far, right? We're leaving open the question as to whether this is integratable into the market economy. But so far, this could not happen with commodity money and 100% reserve banking. Okay, so what's the effect of this? How does this look on the balance sheet? So let's say the bank again has a cash reserve of 1,000 that the customer has deposited. And then they opened up a checking account and put the 1,000 in the checking account. And now customers come into the bank and want to borrow money. And the bank says, sure. And they just make $9,000 worth of loans. And they write the loan balances in their customer's checking accounts. Then the customers take the balance and they go out and buy things. By the way, it's no different if the bank, again, there can be various ways in logistically in which this is done. Banks typically would write a cashier's check, right? So if you go borrow money for a car or whatever, they'll write your cashier's check. Or sometimes they would write the check directly to the home builder if you're building a house or something like this. It's no different though because the merchant's going to get the cashier's check and deposit the funds in his bank, right? And so it's still fiduciary, right? It doesn't matter where the funds are and whose checking account they are. What matters is the ratio between the overall checking account balances and the reserve. If that's a fraction, well, then we've got fiduciary issue. Okay, so this is what happens. Now the first thing we want to notice about this, of course, is that this activity cannot be regulated by profit and loss. And this is our first indication that it's not integrable into the market. It would seem that any process whose production cannot be regulated by profit and loss could not be part of the market. The reason for this, again, is that the bank earns the full rate of interest, the full retail rate of interest on the loan that they make. And yet they don't pay a rate of interest to anyone to borrow the money. In fact, what they do, instead of contractually paying someone to borrow the money and then intermediating being a middleman in between the saver and the investor, instead of doing that, they just create the funds out of thin air. Now again, if you don't see right away that this is different, let me just rely upon the analogy of our friends at the Federal Reserve who just print money. Isn't it similar though, right? They just print money. They don't bear the opportunity cost of production of the money. And so when people who get this new money spend it, who does bear the opportunity cost? Who is the loser of command over resources when the new money is being spent? The answer is, well, it's indiscriminate people who get the new money later in the process, right? It's people who haven't contracted to give up their command over resources. They're just victims of how the process plays itself out. So the same thing here. Nobody borrows these. I mean, nobody contractually agrees to reduce their command over resources by lending money to the bank. The bank just creates money, substitutes out of thin air, lends them to people. Those people have more command over resources. Somebody else has to have less. And the people who have less, of course, are people who get the newly spent money later in the process, right? So that sort of a process is, again, not integratable into the market because if the bank took the rule of production, let's issue all the fiduciary media that's profitable for the bank to produce. If that were their only rule of production, aside from obeying all the general laws of society and so on, they would bankrupt the bank, right? They would instantly drive the bank into non-solvency. They would make loans to any Tom Dick or Harry, walks in off the street, right? They can get maybe one payment out of them, and that's still profitable. So, of course, they can't proceed this way. They have to have a policy. They have to have an arbitrary policy that says, we'll only lend the credit scores that are this high. We'll only lend to these classes of assets. We'll only make collateral loans and so on and so forth. So we have something new here, something different from what we had before. Now, hopefully, regardless of how you absorb that argument, you can see right away that the bank, the issues fiduciary media is illiquid. The bank has instantaneous liabilities. Whoever holds the checking account balance can come to the bank on demand and receive the money reserve at par. It's an instantaneous liability. And yet the loans that balance out that liability on the asset side have a time dimension. So now they've leveraged, right? They've created an interest rate differential by leveraging. And, well, okay, that's different. We saw the banks in the under 100% reserve don't leverage. They're restricted, at least, in their leveraging. Okay, so this is a problem. The banks also become insolvent because, as we suggested before, if they're going to increase their supply of credit by 20%, what kind of customers are they going to lend to? They've already lent to their best customers. They're still economizing, right? Their supply of credit. So they have to lend to customers that they wouldn't lend to before. Less credit worthy customers. So the whole integrity of their asset side of their balance sheet is put in peril. This process of fiduciary issue then provides the monetary fuel for asset price inflation. So how do we get, you know, asset bubbles in the economy? Well, we get the fuel. The cause of it is this continuous increase in, well, in our economy in both fiat money and in fiduciary issue. Without that, if people wanted to finance their investments in one line of production, they would have to draw them out of another line. And so prices would be moderated in some lines when they increase in others. But with asset price bubbles, that doesn't happen, right? We get something new again that doesn't occur in the market as we've developed it so far. It's also true that this makes the whole banking system unstable. And the reason for this is because as asset prices rise, it affects the balance sheet of all the banks, whether they engage in fiduciary issue or not. As all the housing prices rose in the housing bubble in the early 2000s, then all the collateral values of all the banks that were holding loans against these houses improved. And suddenly they had equity on their balance sheet, right? That they could exploit by extending further liabilities, by leveraging even further. And so on this process goes, again, something that would not happen in the unhampered market economy. So this is how we would diagram monetary inflation. So now we can have a system of monetary inflation where the supply of fiduciary issue, the money substitutes, can just be increased ad infinitum. There's no restriction of profitability on the issue. And so we see this progressive reduction of the purchasing power of money or progressive price inflation in the economy. And the same with credit expansion. We get credit creation or credit expansion. This sort of artificial increase in the supply of credit that isn't driven by a lowering of time preference, but is just additional fiduciary issue comes into existence by additional fiduciary issue over time. Now, as you'll hear in lectures later on, this process of monetary inflation and credit expansion generates the business cycle. So this may generate a boom-like economic environment. It may look great on paper for a while, but it's self-reversing. And you'll hear about this later. At this point, we just want to establish the conclusion that if there is fiduciary issue, if there are fractional reserve banks, then they will put in motion monetary inflation and credit expansion, whereas 100% reserve banks and commodity money system will not do this. So a big difference between the two systems. Okay, here's another quote. Just to again rely upon arguments from authority. The transformation into fractional reserve banks holding fractional rather than 100% reserves against deposits was in fact revolutionary. It led to the leveraged financial institutions that dominate our financial systems today. I can't fool you twice, right? It's Paul Samuelson again. Okay, well. But rather remarkable, okay? That's just helpful to be reminded that we're not right-wing nuts, right? Not like crazy conspiracy theorists when we come up with this. It's just a, it's a logically recognized implication of the difference of the systems. Okay, now let's turn to the last issue, this issue of whether or not an argument can be made to justify the inclusion of fractional reserve banking in the market economy. What sort of, we've already indicated that this seems, it seems like you can't do this, right? The microeconomics of it seem like it's a different phenomena, fiduciary issue from money certificate issue. We get an entirely different dynamic, entirely different economic macro effects. So, but is there a counter argument? Is there some sort of position one could take that makes us think, well, it's still part of a market because it gives us some sort of market result that we can't get with the other system. So that's the issue now. And so that's what those in favor of this fractional reserve banking argue. They argue that this fiduciary media issue would exactly or roughly offset any increases in money demand that if you didn't have this fiduciary issue would lead to price deflation. And we're going to set aside in this talk, we just don't have time to do this. You'll see some of this in other lectures. But there's a presumption that price deflation is damaging to the operation of the market economy. We'll leave it at that, right? This line of argument just assumes that price deflation that's put in motion by an increase in money demand leads to depressing economic results. We'll set that aside. That's a separate issue. There are many of us on our side of this argument to claim that that's not so. But again, we don't have time to run through the arguments at this point. We want to focus on a different question, right? Okay. So this is how the argument would run. If money demand goes up, then this would signal to the fractional reserve banks that they need to issue more fiduciary media and they would issue it. And since the money demand has gone up, this additional fiduciary media, the additional checking account balances and so on, would be held by people and not spent because money demand's gone up. That's the assumption, right? And then the purchasing power of money would stay roughly the same. So we can increase the money demand, roughly commensurate increase in the total stock of money, and everything's wonderful. We get no price deflation. We save the market economy from sliding into this depths of depression from price deflation. So that's the basic thrust of the argument. Now Ludwig von Mises actually dealt with this issue in the theory of money credit, the book he published in 1912, where he said there's a difference in the operation between what he called a banking system, how banks operate in a system of banking, and what he called independent banks. So let's follow out the logic of this. Now we're going to take the independent banks in the second step, but suffice it for the case that I want to make about the banking system itself. If we have independent banks, then independent banks cannot, as a group, issue significant amounts of fiduciary media. We'll see why in just a minute. But let's take that as a conclusion that Mises reaches about independent banks. They cannot. So the only way that you can have a banking regime that has fiduciary issue increasing to meet increased money demand is if you have a banking system. It's the only way it can be done. You have to have a banking system. In a banking system, what happens is in order to absorb the additional fiduciary media, what has to happen is the clientele who are not customers of banks have to be given some kind of a reason to hold the money. Because when the customers of the bank gets the additional fiduciary issue, they'll spend some of it. And while some of it will go into the hands of clients who just turn it back to the bank, right? They redeem it. And then you wouldn't get this expansion that you need. So the argument depends upon some sort of a system of banks agreements among the banks that they will redeem the notes of other banks or something like this. So that the whole system can increase in lockstep. But once you take that step, as Mises pointed out, then the issue of fiduciary media will not be regulated by money demand. And the reason for this is on the chart that we show before, right? It's always profitable for the banks to issue more fiduciary media. They earn interest. And if they issue fiduciary media in excess of the increase in money demand, it will simply push the purchasing power of money down so that the quantity demanded of money will rise. And the entire issue of new fiduciary media will be held. And so the system, you're caught in this dilemma, right, if you take this line of argument. You have to have a banking system for the argument to work. If you have a banking system, well, the banking system can't, in fact, check the issue of fiduciary media in the way that it's been suggested, or at least it's problematic. Now, what about this other claim, though? This all rests upon Mises' argument that independent banks will not issue more significant amounts of fiduciary media. And here the point he makes is, again, a very basic one. If you're in a competitive environment with other banks and they're issuing fiduciary media and you get wind of this, your strategy as a competitor, of course, would be to accumulate some of these notes and then present them to the profligate bank and bankrupt them. So there's this competitive pressure among the banks. They don't cooperate with each other by redeeming each other's notes or anything of the sort. Quite the contrary, their cutthroat, their wildcat bankers who are constantly trying to put their competition at a disadvantage, right, by hoarding up their notes and presenting them en masse for redemption. So we get this almost complete restriction of the issue of fiduciary media as long as banks are independent. They operate with their own reserve, independent of agreements among themselves to have mutual redemption clauses or whatever the legal aspects of this might be. Now, let me just summarize with one last comment, and this has to do with, well, could price deflation be problematic and what would the market, how would the market system react to this if it were? So again, we're setting aside the issue of whether or not it is, let's just assume it is. So let's suppose that we had a commodity like gold produced in a market economy and it didn't expand enough as money demand went up, the production didn't expand enough to prevent price deflation, and let's say for whatever reason this created economic problems. Then are we just stuck in this world? Do we now have to go to fraction reserve banking to solve this problem? And no, we don't. This is just another opportunity for entrepreneurial innovation during profit. The entrepreneurs would just now select instead of gold a different commodity that had similar properties that was more readily producible, like silver, and then the production could be more expandable and the problem of price deflation could be avoided. So I've run over a little on time. Sorry about that. So we'll quit here. Thank you very much.