Money out of “thin air”

By fulfilling the role of an intermediary, banks are an important factor in the process of real wealth formation. Banks facilitate the flow of real funding by introducing ‘suppliers’ of real funding to ‘demanders’. When a saver lends money, what he in fact lends to borrowers is final consumer goods he has not consumed. Credit then means that unconsumed goods are loaned by one productive individual to another, to be repaid out of future production.

For instance, a farmer Joe produced 2kg of seeds. For his own consumption he requires 1kg, and the rest he decides to lend for one year to a farmer Bob. The unconsumed 1kg of seeds that he agrees to lend is his savings. In short, the precondition of lending is that there must be savings first. This means that lending must be fully backed up by savings.

By lending 1kg of seeds to Bob, Joe agrees to give up for one year the ownership of this quantity of seeds. In return, Bob provides Joe with a written promise that after one year he will repay 1.1kg of seeds. The 0.1kg constitutes an interest.

What we have here is an exchange of 1kg of present seeds for 1.1kg of seeds in a one year’s time. Is there anything wrong with this type of transaction? Not at all, both Joe and Bob have entered into this transaction voluntarily because they both have reached the conclusion that it would serve their objectives.

The introduction of money will not alter the essence of what lending is all about. Instead of lending 1kg of seeds Joe will first (sell) exchange his 1kg of seeds for money, let us say for $100. Joe may now decide to lend his money to another farmer John for one year at the going interest rate of 10%. John the farmer in turn buys a piece of equipment, which lifts his production to 200 seeds in one year’s time. Observe that the introduction of money didn’t change the fact that real savings precede the act of lending.

Now, when credit is fully backed up by saving and in turn is employed in the production of real wealth, then everything is ok. However, when real savings do not back up credit then it means that no real savings have been exchanged in this mirage transaction. The borrower that holds the empty money, so to speak, exchanges them for goods and services. In short, what emerges is an exchange of nothing for something, or consumption of goods that is not backed up by a corresponding production. This leads to the diversion of real wealth from wealth-generating activities towards the holders of credit, which was generated out of “thin air”.

Obviously such types of credit lead to the depletion, i.e. consumption, of real savings, which undermines the production of real wealth – what we then have here is an increase in money debt and a money supply and the weakening in the real wealth generation process. (Needless to say, the weakening of the production of real wealth diminishes the borrowers’ ability to repay their debts).

Fractional reserve banking as the source of money out of “thin air”

How is it possible that lenders can generate credit out “of thin air”? As we have already seen, ordinary lenders cannot lend something that they do not have. However, things are different once we introduce the central bank and fractional reserve banking into our analysis.

The existence of the central bank and the system of fractional reserve banking permits commercial banks to generate credit which is not backed up by real funding, i.e. the production of credit out of “thin air.” For instance, a farmer Joe sells his saved 1kg of seeds for $100. He then deposits this $100 with the Bank A. Note that the $100 is fully backed up by the saved 1kg of seeds. Also, observe that Joe is exercising his demand for money by holding them in the demand deposits of the bank A. (Joe could have also exercised his demand for money by holding the money at home in a jar, or under his mattress).

Whenever a bank takes a portion of Joe’s deposited money and lends it out it sets in motion serious trouble. Let us say that bank A lends $50 to Bob by taking $50 out of Joe’s deposit. Remember that Joe still exercises his demand for $100. No additional real savings back up these $50. Once Bob uses the money he in fact engages in an exchange of nothing for something. This amounts to non-productive consumption of real wealth. What we have here is $150 that only backed by $100. (Remember, that $100 is fully backed up by 1kg of seeds – real savings).

Now, when loaned money is fully backed up by savings, on the day of the loan’s maturity it is returned to the original lender. Thus, Bob – the borrower of $100 – will pay back on the maturity date the borrowed sum plus interest. The bank in turn will pass to Joe the lender his $100 plus interest adjusted for bank fees. To put it briefly, the money makes a full circle and goes back to the original lender.

In contrast, when credit is created out of “thin air” and returned to the bank on the maturity day this amounts to a withdrawal of money from the economy, i.e a decline in the money stock. The reason for this being that there wasn’t any original saver/lender because this type of credit was created out of “thin air”.

As long as banks continue to expand credit out of “thin air” various non-productive activities continue to prosper. Once however the extensive creation of credit out of “thin air” lifts the pace of real-wealth consumption above the pace of real-wealth production the positive flow of real savings is arrested and a decline in the pool of real funding is set in motion. Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to rise. In response to this, banks curtail their lending activities and this in turn sets in motion a decline in the money stock. (Remember, the money stock declines once the loan that was generated out of “thin air” is repaid and not renewed). The fall in the money stock begins to undermine various non-productive bubble activities, i.e. an economic depression emerges.

Note that a depression is not caused by a collapse in the money stockas such, but comes in response to a shrinking pool of real funding on account of previous loose money. It is the shrinking pool of real funding that leads to the decline in the money stock. Subsequently, even if the central bank were to be successful in preventing a fall of the money stock, this cannot prevent a depression if the pool of real funding is declining.

42 Comments

  • mrg says:

    All very puzzling, and I look forward to responses from Current and other FRFB supporters.

    “Once Bob uses the money he in fact engages in an exchange of nothing for something. This amounts to non-productive consumption of real wealth.”

    It seems to me that, at the point of lending, Bob has been the beneficiary of an operation very close to counterfeiting.

    The bank manufactures claims on real wealth, and so confiscates purchasing power from existing holders of money. This much is similar to when central banks print actual notes.

    The bank hands this new purchasing power to Bob (in exchange for a promise of future repayment).

    I don’t think it’s necessarily true that Bob’s actions will lead to a depletion of the real wealth in society (just as a government that prints money and spends it on infrastructure projects will not necessarily destroy wealth, though it is very likely to do so in practice).

    If Bob invests his loan wisely, he may well increase overall real wealth, irrespective of the dubious origin of the loan. The question from a utilitarian perspective is whether he uses purchasing power more productively than those from whom it was indiscriminately confiscated.

    (It would be interesting to know what portion of fractional reserve money goes into non-productive bubble inflation, such as rising house prices; certainly this represents a destruction of real wealth)

    Where Bob’s loan differs from central bank money printing is that (as Frank says) the expansion in the money supply will be reversed when the loan is repaid. So it doesn’t really matter that the principal Bob repays isn’t backed by real savings. He can still add to the overall wealth of society if the goods he produces using the loan exceed those he consumed in the making of them. As far as I can tell, this would lead to ‘good deflation’. When the money supply returns to its original level, but with more real goods available, all holders of money benefit (at least in theory).

    Setting aside questions of opportunity cost (discussed above), what strikes me as unjust is the distribution of wealth. Supposing Bob does create wealth, and indeed creates more wealth than would have been created by those whose wealth the bank confiscated.

    Now the overall supply of goods, relative to the money supply, has increased, but it is Bob who commands the new goods. He gives a cut to the bank (his partner in crime), but the previous holders of money have still lost out to Bob, and they haven’t in any way been compensated for risk they were forced to take (instead of increasing overall real wealth, Bob may well have destroyed it).

    This contrasts strongly with the 100% reserve situation Frank describes, where the creditor (who takes the risk) shares the gains with Bob (who did the work), and the bank gets a cut as intermediary. Fractional reserve banking forces all existing holders of money to act as creditor (even those who hold money in jars and mattresses).

    • Toby Baxendale says:

      “The question from a utilitarian perspective is whether he uses purchasing power more productively than those from whom it was indiscriminately confiscated.”

      We go down a very slippery slope if we start putting a utilitarian ethic above that of some ethic of absolute right to your own private property , even if you are an economic numpty with it!

      • mrg says:

        I didn’t say I was convinced by the utilitarian perspective.

        Hopefully my last three paragraphs make my own position clear.

  • Tony says:

    Sir

    I am confused by your post which seems to be contradictory. In the first paragraph you say:

    “By fulfilling the role of an intermediary, banks are an important factor in the process of real wealth formation. Banks facilitate the flow of real funding by introducing ‘suppliers’ of real funding to ‘demanders’. When a saver lends money, what he in fact lends to borrowers is final consumer goods he has not consumed. Credit then means that unconsumed goods are loaned by one productive individual to another, to be repaid out of future production.”

    This is an excellent explanation of the role of banking. However, you then say:
    “Whenever a bank takes a portion of Joe’s deposited money and lends it out it sets in motion serious trouble. Let us say that bank A lends $50 to Bob by taking $50 out of Joe’s deposit. Remember that Joe still exercises his demand for $100. No additional real savings back up these $50. Once Bob uses the money he in fact engages in an exchange of nothing for something. This amounts to non-productive consumption of real wealth. What we have here is $150 that only backed by $100. (Remember, that $100 is fully backed up by 1kg of seeds – real savings).”

    This really makes no sense. Following this transaction the banks balance sheet would be:

    Assets
    Loan to Bob $50
    Cash (Held from Joe) $50

    Liabilities
    Owed to Joe $100

    I do not understand why you say we have “$150 that only backed by $100” by definition Assets –Liabilities = Capital.

    Assuming in this case capital = zero, therefore Assets = Liabilities.

    Assets of the bank can never be greater than $100 unless the bank borrows from some one else.

    Indeed, earlier in the post you say:

    “The introduction of money will not alter the essence of what lending is all about. Instead of lending 1kg of seeds Joe will first (sell) exchange his 1kg of seeds for money, let us say for $100. Joe may now decide to lend his money to another farmer John for one year at the going interest rate of 10%. John the farmer in turn buys a piece of equipment, which lifts his production to 200 seeds in one year’s time. Observe that the introduction of money didn’t change the fact that real savings precede the act of lending”

    My only guess is that you are saying if Joe deposits his $100 with the bank and they lend $100 to Bob this is fine.

    The balance she would be:

    Assets
    Loan to Bob $100

    Liabilities
    Owed to Joe $100

    However, if the bank then lends another $50 to Bob it would be creating money. You are a 100% correct except its balance sheet would now be:

    Assets
    Loan to Bob $150

    Liabilities
    Owed to Joe $100

    Assets No longer = Liabilities.

    This cannot occur since it breaches the fundamental rules of accounting. Banks cannot lend money they do not have to do so is not only impossible in an accounting sense but in practice.

    The above comments apply only to commercial banks as we have seen with QE these rules do not apply to central banks.

    If you disagree with my analysis please reply.

    • Rob Thorpe says:

      Tony, I agree.

    • Toby Baxendale says:

      Tony, thank you for your comment.

      The accounting entries in double entry book keeping will always balance . I do not know anyone who disputes this, including the author of this article .

      What is stated here is that when you and I earn money, we do some labour, provide some good and or service for it, in exchange for some such other set of goods and services via money.

      It is clear that with a central bank minting up new purchasing power, this will have a clear effect of facilitating an exchange of noting for something.

      If we have a series of FRFB expanding their balance sheet , some more than others, whilst account entries are coherent, there must be some where at some point in time, as that fraction shrinks in relation to reserves and more bank credit is issued, this implies a real transfer of nothing, for something. Only in an entirely static FRFB system can this never happen or in a fully reserved system.

  • John says:

    Tony,

    Suppose that Bob redeposited his the $50 that the bank loaned him back in the bank. The balance sheet would then be:

    Assets
    Loan to Bob $50
    Cash $100

    Liabilities
    Owed to Joe $100
    Owed to Bob $50

    Now, suppose that both Bob and Joe go down to the bank to withdraw their cash. You might say, no problem, the bank need only call the loan to Bob, wiping out the liability.

    But suppose that Bob had lent his $50 to Susan, who deposited the money in the bank, and that it is Joe and Susan who descend on the bank to withdraw their cash. Now we can see that a credit unwind needs to occur. This is the essence of the problem with fractional reserve banking.

    The cash (savings) cannot be owned by more than saver.

    • Rob Thorpe says:

      The cash (savings) cannot be owned by more than saver.

      The cash cannot be owned by more than one entity, and in fractional-reserve banking it isn’t. It’s owned by the bank. The bank’s customers are creditors to the bank.

      If the bank fails to meet it’s commitments as you describe then it will be in breach of contract. It can be sued and if it doesn’t pay taken into receivership.

      What you are talking about here is quite a different question, it’s the issue of whether banks can estimate redemption rates. It’s about whether they can figure out how much base money they will need from one time to another to meet customer demand. This is the point Lee Kelly makes elsewhere in this thread. As he says, if the bank is solvent it’s redemption rates will not vary quickly. That means that the bank can safely keep a fractional reserve.

      • Toby Baxendale says:

        Of course , you and Lee assume that all contracting parties are aware of this creditor / debtor relationship to legitimise these actions. If there and not contracting parties who think they are saving their money and not lending it to a bank, would that lead to presumably what John saying to hold true right?

        • Rob Thorpe says:

          What John describes is the bank failing to keep up it’s contractual obligation to redeem. In this case the bank is in breach of contract.

          If the bank’s customers aren’t aware that they are lending to the bank then I agree that’s a problem. Legally ignorance of the law is no defence. But, in this case I think it would be beneficial if the government passed a law requiring banks to clearly state the nature of bank accounts.

          This has no direct connection with the situation that John describes though. Why would banks become worse at estimating redemptions because their customers are not aware of what they are doing? If anything the opposite is true. Banks will be more careful because they won’t want to be caught up in that breach-of-contract situation since it will reveal to those customers who didn’t know how banks operate.

          The real risk here is that customers are not as careful in choosing their banks. It’s that they don’t realise that they need to pick a bank with careful management and a good loan book. To rectify that problem though legal changes are needed as well as information. If deposit insurance continues then customers will continue to lend to risky banks because they know the deposit insurance scheme will cover them.

  • joebhed says:

    I guess I was waiting for the writer to say……. ‘and so the solution is to end the creation of money-substitute private bank-credits through fractional-reserve banking, and make a transition to full-reserve banking’ ….. and then, to say……… ‘such-and-such is how we transition to full-reserve banking’.

    It’s just that fractional-reserve banking – the legalized crime of banking – is such an easy target. Bankers get to lend money they don’t have, and earn the rent. That’s why everyone from private-propertied Austrians to public-money monetary reformers all want to end the practice.

    Discussing the transition method, and the potential for stability-inducing alternatives is where the fun starts.

  • Lee Kelly says:

    There is a simple thought experiment one can use to refute Shostak’s argument.

    Suppose the bank divides the $100 deposit, unbeknownst to Joe, into a $50 demand deposit and a $50 time deposit. The bank now lends Bob $50. Joe thinks he can withdraw $100 at any time, but the bank actually has only $50 until Bob repays his loan. Obviously, this is fraudulent, and I do not mean to defend such banking practices. However, the thought experiment illuminates an important point: unless Joe actually planned on spending more than $50 before Bob repays his debt, there will be no lending not backed by real savings. In the period starting from when Bob borrowed the $50 to when he repaid it plus interest, Joe never tried to spend any more than $50 of his savings. To put this another way, the fraudulent practices of my hypothetical bank produce the same allocation of resources as in the case that Joe had agreed to lend Bob the money in the first place.

    Now let’s suppose the bank warned Joe that it would lend out some of his deposit — after all, how could they afford to pay interest on deposits or offer payment services free of charge? In other words, Joe accepts some risk that his deposits may not be redeemed immediately or not redeemed at all if the bank makes bad loans and has insufficient capital. The bank now makes the same $50 to Bob; Joe does not try to spend more than $50 before the loan is repayed; Joe receives some interest and other banking services for bearing the risk.

    The difference between the first and second scenarios (besides the first being fraudulent) is the effect of banking on the money supply. However, in both scenarios the composition of spending and, therefore, the allocation of resources is the same. That is, from when Joe made the deposit to when Bob repaid the loan plus interest, Joe spends $50 and Bob spends $50 — total spending on final goods and services is $100 in both cases. There is no inflation. All lending is backed by real saving.

    • Toby Baxendale says:

      “To put this another way, the fraudulent practices of my hypothetical bank produce the same allocation of resources as in the case that Joe had agreed to lend Bob the money in the first place.’

      Good Morning Lee,

      To run the above argument, leaving aside the fraudulent aspect, that there is still the same level of net savings backing real activity, you also have to set aside property rights. This is a problem with supporters of FRFB, they seem to have a blind spot when it comes to property rights and a need to want to aggregate , like a Keynesian or Monetarist , not an Austrian , when it comes to these matters. Joe’s deposit has been used when he did not want it used. The allocation of real resources has now been re allocated. In a central bank environment, the CB has the guiding hand in this, with its private sector mints, the private banks, in a FRFB world, we have the private sector free banks deciding this. Why not the property owner if he wants his property safe of lent, then he should be able to instruct the bank accordingly . Never should a property owner , unless he consents have anything other done to his property as would be done in a FRFB?

      • Lee Kelly says:

        Toby,

        You begin by claiming to be “leaving aside the fraudulent aspect,” but then proceed to address only the fraudulent aspect, even though I explicitly said that “I do not mean to defend such banking practices.” It’s like you got the end of my first paragraph and stopped, because the whole point of my second paragraph is that we can get the same result without fraud. Then you have the nerve to say that I have a “blind spot” when it comes to property rights. Why do I bother responding if you are going to willfully misinterpret my arguments?

        I used to agree with you: I used to believe that fractional reserve banking was inherently inflationary, pro-cyclical, and fraudulent. I made all the same arguments that you make again and again on this website. I dare say that I could make the same arguments today better than you could! But they’re wrong.

        • johng says:

          I decided to look up my bank’s (citibank) checking account terms and conditions.

          “””
          Unless otherwise expressly agreed in writing, our relationship with you will be that of debtor and creditor. That is, we owe you the amount of your deposit. No fiduciary, quasi-fiduciary or other special relationship exists between you and us. We owe you a duty of ordinary care. Any internal policies or procedures that we may maintain in excess of reasonable commercial standards and general banking usage are solely for our own benefit and shall not impose a higher standard of care than otherwise would apply in their absence.
          “””

          followed later by

          “””
          Cash withdrawals or payments at any Citibank branch may be
          restricted due to the limited amount of currency on hand. If we do not have sufficient cash for a large withdrawal or payment, we may make arrangements for a later cash payment or offer to make payment with an Official Check. We assume no responsibility to provide personal protection for customers who elect to carry large sums of money off our premises.
          “””

          and finally

          “””
          Withdrawal Notice
          We reserve the right to require seven (7) days advance notice before permitting a withdrawal from all interest checking, savings and money market accounts. We currently do not exercise this right and have not exercised it in the past.
          “””

          • Good Morning Johng,

            I am delighted that this is said on your account with Citi. This is honest disclosure. Did you know this before you looked at it? I also wonder how many people actually realise the significance of this creditor / debtor relationship.

            We did a survey of 2000 people on this site and only 8% actually knew the true legal position.

            • johng says:

              I went and read the agreement only recently even though I have been a customer for about two decades. I never believed that my checking account money is kept in a vault and not loaned out.

              My actual legal status as a creditor is something I’ve only learned in recent years here and at Mises.org. The presence of government deposit insurance serves as an effective reserve that is available in case things go badly at the bank.

              I don’t worry since I actually owe Citi much more than they “owe” me.

              • Good Morning Johng,

                Just be careful here, you may think that common sense tells you that should Citi go belly up, they will offset what they owe you v what you owe them (to contra). This will only happen if you have a formal contractual right of set off (to contra a account). If this is not contractually explicit, you may well find yourself in the very bad position of being an un secured creditor with little chance of getting anything and the administrator of Citi asking you , in fact demanding from you with the full force of law, that you pay your debts now. He will remind you that he is there to collect out for the creditors and you have no right to set off (to contra). You will think this is unjust and unfair. Contractually you will not have a leg to stand on, so do watch out!

          • Anthony J. Evans aje says:

            @johng
            Thanks for sending this. I wrote on this topic a while back and learnt that Bank of America do something similar:

            http://www.cobdencentre.org/2010/10/do-banks-mislead-their-customers/

            Clearly in the USA there is no real issue here about banks misleading customers.

        • So Lee, I have had a look at what you have said again.

          Lets take this quote “To put this another way, the fraudulent practices of my hypothetical bank produce the same allocation of resources as in the case that Joe had agreed to lend Bob the money in the first place’

          So, I think we do not agree that in the fraudulent case there is the same allocation of resource as one party Joe never wanted the resources re allocated.

          In the second case, if Joe had consented, then yes, the allocation would have been as the parties had consented.

          By the way, Joe would lend $50 to Bob and Bob would return it with interest. Great, this is all good timed deposit lending. This is totally consistent with 100% reserve banking, or honest banking as I prefer to call it.

          If we leave aside the fraud then we imply consent, we are saying the same thing.

          Lee, where is this going?

          N.B. You assue I think FRB is fraudulent . No , I do not, I think there is a strong case for negligent misrepresentation on behalf of the banks with regards to their customer base. If you are an American, you may not be familiar with this terminology , but it is the lowest form of contractual common law misrepresentation . I would put this as a civil and not a criminal law matter. I do not see evidence of fraud.

          • Rob Thorpe says:

            To put this another way, the fraudulent practices of my hypothetical bank produce the same allocation of resources as in the case that Joe had agreed to lend Bob the money in the first place.

            I think the problem here is what each of you are assuming each of the people will do if they know more.

            Lee’s initial point was that fractional-reserve banks don’t create “false savings” as Shostak supposes. Every pound of a current account is backed by a pound of bank assets.

            Toby’s point is that every pound isn’t backed up by an actual pound. He’s pointing out that if customers knew about the situation they may act differently.

            As I wrote earlier, I agree with both positions to some extent. If every current account holder knew they were a creditor then some may withdraw money or cease to hold a current account. So it wouldn’t leave balances the same overall.

            Also, customers may be more careful about which bank they use. The big risk in banking is that a pound of bank assets may not be worth a pound. That will affect how savings are allocated to investments. That said, not much will change there unless deposit insurance is removed.

  • Lee Kelly says:

    One has to understand that “demand deposits” in a fractional reserve bank are, from the perspective of bankers, de facto time deposits. While customers might attempt to withdraw all their deposits at any moment, the probability of such an event is vanishingly small. Unless depositors become worried about the liquidity or solvency of a bank, they will, in fact, only withdraw a fraction of their deposits in any given period. From the perspective of bankers, it is as though that portion of deposits not withdrawn are time deposits. So long as bankers do not misjudge the withdrawal schedules of their depositors, the macroeconomic consequences of lending “unused” deposits will be almost as though such “unused” deposits were time deposits to begin with.

    • Toby Baxendale says:

      Lee you hit the nail on the head, the two parties, the banker and the customer have different conceptions of what legal and economic transaction they are getting involved with. Sort that out and you can have truly free banks, consistent with the application of private property rights.

      • Lee Kelly says:

        Toby,

        My post is not about whether bankers and their customers both understand their transaction in the same way. It is about how demand deposits are de facto time deposits; “unused” deposits can be lent out with similar consequences as in the case where they were time deposits to begin with.

        As it happens, I do not think it is necessary, to avoid the charge of fraud, that bankers and their customers both understand the nature of their transaction; it is only necessary that bankers do not intentionally mislead or withhold information. After all, it is not the responsibility of bankers to make sure that their customers understand banking; I would be surprised if most bank employees even understand the economics of banking. The vast majority of people just do not care; their family and friends successfully use bank accounts for holding wealth and using payment services — how the sausage gets made is none of their concern. They may even be vaguely aware of things like central banking and deposit insurance, which is just all the more reason to spend less time trying to understand banking and more time watching football.

        There used to be a tradition of banks advertising the strength of their balance sheets to attract customers. More care was taken to explain exactly how their bank offered a better combination of risk, return, and services than competitors. Critics of fractional reserves claim that banks intentionally obscured the nature of their business to lull customers into a false sense of security. But the real reason why banks stopped such practices is that customers stopped caring — once the government guarantees deposits, customers no longer want to know and banks do not tell. A generation or two later, and almost nobody in the general public understands how banking works.

  • Lee Kelly says:

    Here’s another thought experiment.

    Suppose that a fractional reserve bank knows precisely when all its customers will attempt to withdraw funds. The bank organises its loan portfolio so that every time a customer attempts to withdraw funds, there is a debtor paying back his loan by the same amount at the same moment, i.e. the bank simply transfer funds straight from the debtor to its customer.

    In this case, the bank does not need to hold any reserves, since all withdrawals are simultaneous with loan repayments for the same amount, but then it isn’t a fractional reserve bank after all. It operates just like a time-depository institution — customers deposit funds for a precisely known period, and in the meantime the bank uses the funds to make loans; the loans are all paid off before the customers arrive to withdraw their deposits.

    The only difference between this hypothetical (omniscient) bank and ordinary time depository institutions, is that the hypothetical bank doubles the money supply. However, this doubling of the money supply is completely innocuous, because it is the composition of spending (not the quantity of money) which determines the allocation of resources, and the composition of spending is no different in either case.

    • Toby Baxendale says:

      Lee, I submit you have a misunderstanding here.

      If a bank has 100% matched deposits, which is a bank that does know when all its customers wants its deposits bank, it does not have demand deposits , but timed deposits matched by timed savings.

      The balance sheet entries would show a series of creditors matched with a series of debtors. A timed saver can’t spend his money early as it is lent to a timed saver for the duration he agreed until he contractually can get it back. Thus there is only one money supply amount and not a doubling of it as you suggest.

      This bank by the way that you describe , with this accounting treatment is consistent with 100% reserve free banking.

      • Lee Kelly says:

        Toby,

        The thought experiment concerns an omniscient banker. It is a limiting case used to illuminate the nature of fractional reserve banking. We assume the banker knows precisely when customers will withdraw funds and arranges his loan portfolio accordingly. Every time a customer demands a withdrawal, a debtor is repaying his loan by the same amount.

        (You object that no money is created, but you misunderstand the situation. The bank does not credit any depositors’ accounts when creating a new loan. Everybody has the same chequing balance as before, except for the borrower.)

        This brings to light an important principle: holding reserves is a cost, not a benefit, of fractional reserve banking. Ideally, banks would be like our hypothetical omniscient banker and not hold any reserves at all.

        If you understand how a omniscient bank with zero reserve is neither fraudulent or inflationary, and how the same is true for a bank with full reserves, then how is it that reserve ratios in between cause such problems?

        • Lee Kelly says:

          I said,

          “This brings to light an important principle: holding reserves is a cost, not a benefit, of fractional reserve banking. Ideally, banks would be like our hypothetical omniscient banker and not hold any reserves at all.

          This deserves some clarification in light of current events. It is possible that credit demand can be so low, creditworthy applicants so few, and bank capital so fragile, that banks prefer to hold base money than make additional loans. This is the situation which currently prevails; it is why the supply of base money has increased tremendously while inflation has been below average. This situation has an analogue in a 100% reserve system, where people convert their time deposits into demand deposits for the same reasons. In both cases, spending will decline and deflation will follow; both are fundamentally an excess demand for money; neither is inherently good for the economy.

          Unfusing the unit of account from the medium of exchange would go some way to alleviating these problems. Indeed, in a monetary system with such a distinction (where the medium of exchange has a price of its own), the arguments of 100% reserves and hard money advocates are simply irrelevant.

        • Good Morning Lee,

          A bank with zero reserves and a complete match between redemption requests and liquidity needs no reserves. In reality it is not a bank, but a loan broker.

          I loan broker is consistent with part of the operations of a 100% reserve bank (the lending part).

          I do not know where you are trying to go with this . Sorry!

  • Joebhed, Re the “transition method” to full reserve which you claim would involve difficulties, Milton Friedman (for what his opinion is worth) thought this would not be a problem. He said “There is no technical problem of achieving a transition from our present system to 100% reserves easily, fairly speedily and without any serious repercussions on financial or economic markets.” That’s from Ch 3 of his book “A Program for Monetary Stability”.

    He claimed it would just be a case of raising compulsory reserves by say 10% of total bank assets every three or six months for example till 100% reserve was achieved.

    Lee Kelly, The scenario you set out does not involve fractional reserve (FR) does it? I.e. you have Joe and Bob messing around in different ways with the original $100 deposit. The crucial question is what are the effects of turning the $100 deposit via FR into about $1,000 of money and loans.

    Mrg, I like this sentence of yours: “The question from a utilitarian perspective is whether he uses purchasing power more productively than those from whom it was indiscriminately confiscated.” Therein lies the weakness of fractional reserve, as I pointed out in my recent article here on FR: the extra spending power that FR brings necessarily means less spending elsewhere. And under FR this reduced consumption is effected in a more or less random manner (or “indiscriminately” to use your phraseology).

    If both FR and maturity transformation are banned, then for every borrower wanting to borrow £X for Y years, there has to be savers willingly abstaining from consuming £X of consumption for Y years. That produces a genuine market is savings and borrowings which would bring a genuine market price for borrowed money.

  • Lee Kelly says:

    Ralph,

    A bank cannot lend out $1000 off the back of $100 of deposits. With a reserve ratio of 10 percent, a bank can only lend $90 off the back of $100 of deposits.

    The so-called “money multiplier” is both irrelevant and misleading. Steve Horwitz explains this in that link I provided in our previous conversation. You evidently did not understand Steve’s argument, because it was an an attempt to dispel precisely this kind of confusion. Here are some relevant passage:

    opponents of FRB … often say something like: “If I deposit $1,000 in my bank and it has to hold only 10 percent reserves, it can create $10,000 in new money.” This claim is ambiguous at best and downright wrong at worst. As stated it betrays a lack of understanding how fractional reserve banks (whether under free or central banking) actually work.

    Now you say, “Yes, but that $900 will be spent and deposited at another bank, which will keep $90 and lend out $810, and so on.” And you are quite right, which leads us to Banking Rule #2: The banking system can expand by a multiple of those original excess reserves.

    He then proceeds to explain why this “money multiplier” effect is innocuous:

    But this is hardly the whole story — and we need the help of our old friend Monsieur Bastiat to see the unseen. If the $1,000 I deposited came from your bank, it loses the $1,000 in reserves transferred to my bank. That forces your bank to call in loans to make up the lost reserves, which leads to reserves being lost by other banks, which then have to do the same thing. The result is that the $10,000 created by my bank’s gain in reserves is canceled by the $10,000 destroyed by your bank losing those reserves. When you write a check to me and I deposit it, there is no bank multiplier on net … Thus we see the reverse of Banking Rule #2, as the system simultaneously contracts by a multiplied amount of the original deposit/withdrawal.

    This analysis is not controversial except within a small subset of Austrians. It is banking 101. If you haven’t figured it out yet, then you probably don’t want to figure it out, like a Catholic insisting that 1 = 3.

  • Lee, I’ve fully grasped Horwitz’s point. It’s a very simple “economics 101” point, to use your phraseology. And it’s economics 101 which is wrong in my view and in the view of the Bank of International Settlements (see below).

    Lest there is any doubt as to whether I understand Horwitz’s point, I’ll put it in my own words. He is saying that when £X is deposited in a bank, that £X must have been withdrawn from another bank (or even the same bank). Therefore, so he argues, fractional reserve does not cause a money supply expansion. But the first problem with that argument is that banks are not always up against their reserve limits. E.g. they currently have massive excess reserves. In this scenario, the Horwitz argument is irrelevant.

    Second, where the banking system really is up against its reserve limit, and irrational exuberance takes hold, demand for borrowed money at the existing rate of interest rate will exceed supply. Thus interest rates are forced up. In this scenario, the central bank is forced to supply extra reserves, else it loses control of interest rates. Again, the Horwitz argument is irrelevant.

    So the real weapon that central banks have (if it works) is interest rate adjustments. Reserves are near irrelevant. That’s why Canada and some other countries have abandoned reserve requirements.

    Re the Bank for International Settlements (URL below), they published a paper last year setting out reasons for thinking that reserve requirements are a feeble method of constraining commercial banks. They say (p.5) that there is “no causal relationship from reserves to bank lending.” If that’s the case, then the Horwitz point is blown right out of the water.

    http://www.bis.org/publ/work297.pdf

    There is an analysis of this paper here:

    http://bilbo.economicoutlook.net/blog/?p=15383

    • Rob Thorpe says:

      Ralph,

      This debate is mostly about what happens in normal times. Not what happens in these extraordinary times. In these time myself (and I think Horwitz) would agree that banks have enough reserves to make a great deal more loans than they are in fact making. I explained some of the reasons for this in my last article.

      What’s important here is the maximum amount of money that can be created. You’re quite right that fractional-reserve theory doesn’t tell us about the minimum. In the example you give of our current recession that is given by the actions of the central bank, since they create base money.

      I don’t really believe in “irrational exuberance”, but you’re quite right that if the demand for credit increases when banks are working at the minimum reserve then that means the central bank must raise interest rates. That’s just a fact of the interest rate targeting system though, it’s not about economics. If the central bank targeted money supply then it wouldn’t be true.

      Canada, New Zealand and the other countries that have abandoned reserve requirements have simply replaced them with capital requirements. Banks are required to keep a certain amount of their assets in “safe” investments such as government bonds of the nation involved. The central bank can then control the interest rate (or money supply) by changing the amount of those bonds or by changing the regulatory requirement.

    • Toby Baxendale says:

      Ralph, thank you very much for all your contributions here, you are spot on.

      You may have seen comments before from me on just this matter. It does seem that our FRFB friends are only assuming a very abstract static world that they call a “mature” FRFB system, when in fact , this very un-Austrian assumption in the dynamic world we live in , never ceases but to change. As the fraction of reserves ebbs and flows, new bank credit , created from nowhere will come into existence and go back to non existence with the economic consequences of boom and bust continue. Granted, one hopes with less ferocity than under freely competing banks, but nevertheless, no panacea as described by some of the more enthusiastic advocates .

    • Lee Kelly says:

      Ralph,

      I don’t just doubt you understood the Horwitz piece, I am increasingly doubting that you ever read it in the first place. Here is another quote:

      As Robert Higgs points out in a recent blog post, for increases in the monetary base to become increases in the supply of money, the banks have to cooperate by lending out their excess reserves. Banking Rule #1 does not say that fractional reserve banks must lend out their excess reserves, only that they cannot lend more than their excess reserves. Higgs argued in an earlier post that the reluctance of banks to lend out those excess reserves is what is preventing the remarkable increase in the monetary base since the fall of 2008 from turning into significant inflation.

      Your second point is such a complete non-sequitur that I struggle even to begin a response.

      Apparently, you think Horwitz’s case is irrelevant because “the central bank is forced to supply extra reserves, else it loses control of interest rates.” This beggars belief, since nobody here is advocating central banking, much less targeting interest rates. Moreover, it is exactly Horwitz’s point: the fractional reserve system can only increase the money supply so far its reserve ratio permits. And, “in a free banking system, the reserve ratio is determined by the banks themselves, not by the central bank.”

      As for your comments about “irrational exuberance,” it’s a complete non-sequitur. If anything, being up against the reserve requirements means that money is tight. Nobody here is arguing in favour of reserve requirements; banks should be free to hold how ever many reserves they want. Nothing in the arguments defending fractional reserve banking depends on there being reserve requirements.

  • Rob Read says:

    I’m not sure I follow the logic in this article.

    In the standard version of ATBC the damage from credit expansion is done when it causes interest rates to drop below the natural rates and causes investments to be made that turn out to be unprofitable when interest rates rise back to equilibrium . This article seems to argue a different line, that all investments unbacked by previous savings somehow lead to a “consumption of goods that is not backed up by a corresponding production”. I struggle to see how this can be. If money (fiat or commodity) could be fed permanently into the economy without affecting interest rates and this money was used to divert spending (and resources) away from consumption and towards new production then from an economic perceptive these changes to the production structure would be just as real as ones that came through the use of previously existing savings. They would be inflationary and they would be unfair to those who became poorer as a result but they would still be real. Of course in a free market economy a money that manifested this behavior frequently would likely soon lose its role as money in favor of a more stable commodity.

  • Rob Thorpe says:

    Regular readers of the article and comment here won’t be surprised to hear that I don’t agree with Shostak. I’ll write an article about this in due course arguing the other side of the case, but I’m busy right now.

  • joebhed says:

    Ralph,

    Sorry, I never meant to imply that a transition to full-reserve banking would be a problem – just trying to enjoin the differing views for a discussion.

    In Fisher’s 100 Percent Money book, in his academic writings on central bank policy, and in his epic 1939 Program for Monetary Reform along with Douglas, Graham, Hamilton, et al,
    he laid out very specific methodologies that would work today in an updated electronic version.

    http://www.economicstability.org/wp/wp-content/uploads/2010/07/revisedAProgramforMoA7DF1B1.pdf

    The America Monetary Institute and Congressman Dennis Kucinich in his recent NEED Act also have same.
    http://kucinich.house.gov/UploadedFiles/NEED_ACT.pdf

    As does Rothbard in the Mystery of Banking – to some degree- and Huerta de Soto, again more updated.

    Unfortunately, many MMT and Neo-Keynesians see full-reserve banking as limited to a conservative view that is only capable of deflationary monetary policies.
    This is untrue.
    And Friedman knew that.
    Just looking for clarification on the point with my allies, the Austrians.

  • joebhed says:

    Ralph,
    Sorry, just read your last paragraph and cannot agree more. The way I think of it, that market power of the savers is going to transform the banking industry. Over time, depositors’ money will be in the bank whose lending policies they support – a lengthy transition to more cooperative, credit-union and other limited-purpose institutions.

    Along with full-reserve banking, at that point, lending, and therefrom financial services in general, will become a truly more conservative, though socially directed, enterprise.

    This is a good thing, if monetary and economic stability are the objectives.

  • Ross Smith says:

    When money is withdrawn from demand deposits bankers under a FRBS are obliged to curtail further lending when in normal circumstances they are fully loaned up. This is the direct cause of busts because it shrinks the money supply (liquidity).
    On a broader perspective, money supply should ideally reflect productive output. When money is artificially added then there is an inflationary effect on prices and the costs of production are adjusted accordingly. When the artificial increase is discontinued and productivity is unchanged then there is a problem. Consumers can no longer afford to purchase the same quantity of goods as the old prices. In turn producers need to cut costs by some combination of decreasing wages (most likely via job cuts in a heavily unionised market)and paying less for commodities and higher stage capital goods. Again this is the bust. The cause is not a lack of money but rather the artificial creation of money via FRB supported nowdays by CBs. The solutions are politically unpalatable (100% reserves and hard currencies) but ultimately the market seems to have it way.

  • Frank Shostak says:

    In a free market economy intermediaries such as banks will have difficulty expanding unbacked credit. For instance a farmer Joe sells his saved 1kg of seeds for $100. He then deposits this $100 with the Bank A. Note that the $100 is fully backed up by the saved 1kg of seeds. Also, observe that Joe is exercising his demand for money by holding them in the demand deposits of the Bank A. (Joe could have also exercised his demand for money by holding the money at home in a jar, or keep it under the mattress).

    Let us say that Bank A lends $50 to Bob by taking $50 out of Joe’s deposit. Remember that Joe still exercises his demand for $100. No additional real savings back up these $50. What we have here is $150 that are backed by $100.

    Now, Joe demands money not to hold it as such but to use it as a medium of exchange. So let us say that Joe decides to use $100 to buy goods from Sam who banks with Bank B. Let us also assume that Bob who borrowed $50 from Bank A uses them to also buy goods from Sam. (Both Joe and Bob pay Sam with checks). All this however will pose a problem to Bank A. On the following day the Bank B will ask the Bank A to honour the checks for $150. Bank A will have difficulty honouring the checks since he has only $100 in cash. In short the Bank A is “caught” here so to speak.

    In a free market then, if a particular bank engages in an unbacked expansion of credit this bank runs the risk of being “caught”. Consequently, the threat of bankruptcy is likely to deter banks from pursuing the expansion of unbacked credit.

    But what is it in the modern capitalistic institutional framework that enables banks to engage in the reckless expansion of credit ? Careful examination will show that it is the existence of the central bank.

    Why the central bank is the key to financial instability
    By means of monetary policies, the central bank makes it possible for banks to engage in the expansion of unbacked credit. Thus if Bank A is short of $50 it can sell some of its assets to the central bank for cash thereby preventing being “caught”. Bank A can also secure the $50 by borrowing them from the central bank. Where does the central bank get the money? It actually generates them out of “thin air”. (Obviously Bank A could also attempt to borrow the money from other banks. However, this will push interest rates higher and will slow down the demand from borrowers – this will diminish the creation of credit out of “thin air”).

    The modern banking system can be seen as one huge monopoly bank, which is guided and coordinated by the central bank. Banks in this framework can be regarded as branches of the central bank. Through ongoing monetary management i.e monetary pumping, the central bank makes sure that all the banks engage jointly in the expansion of credit out of “thin air”. The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out. In short, by means of monetary injections the central bank makes sure that the banking system is “liquid enough” so banks will not bankrupt each other.

    We can thus conclude that in a true free banking without the central bank the likelihood that banks will practice fractional reserve banking is going to be very low.

  • Lee Kelly says:

    Frank,

    Let us say that Bank A lends $50 to Bob by taking $50 out of Joe’s deposit. Remember that Joe still exercises his demand for $100. No additional real savings back up these $50. What we have here is $150 that are backed by $100.

    The bank does not take $50 out of Joe’s deposit. The bank uses $50 of its base money to finance a $50 loan to Bob. Joe’s deposit is not changed, because it is not a bailment. When opening the account, Joe exchanged outside money for inside money; the latter is a financial asset. The bank still has $50 dollars in base money in case Joe calls in some of the debt.

    Obviously, $50 is not enough to satisfy Joe if he wants to spend all $100 before Bob repays his loan. In that case, the bank may lose capital to meet its obligations; or it may have to liquidate its loan to Bob to get more base money. These are the risks of banking. The bank isn’t going to immediately fold just because it misjudged Joe’s level of desired spending.

    So why would Joe prefer to hold inside money rather than outside money? 1) payment services, 2) interest, and 3) less chance of loss or theft, to name but a few.

    Clearly, a bank with one customer is going to have difficulty correctly estimating rates of withdrawal, since the spending of an individual may vary considerably from day to day. It may be prudent to hold an extremely high reserve ratio or 100% reserves. However, in the real world, there are millions of farmer Joe’s. The average rate of redemptions is relatively stable except under exceptional circumstances; the chance that any particular farmer Joe will be unable to get repaid on demand is vanishingly small.

    We don’t need to speculate what is the “likelihood” that banks will practice fractional reserve banking, because there is ample historical evidence the freest of free market banking systems actually did.

Comments are closed.