Bank Run Incentive, Central Bank Bankruptcy, and The Fallacy of the Credit Theory of Money

[Editor’s Note: this is from the World Dollar Foundation, and can be found here] Part 1: The Bank Run Incentive

There is an incentive to start bank runs due to a) the fallacy of fractional-reserve banking, and b) the fallacy of deposit “guarantees”.

A. The Fallacy of Fractional-reserve banking

A fractional-reserve bank issues more property titles than there is actual underlying property. The total value of property titles cannot exceed the total value of actual underlying property. Therefore, holders of property titles have an incentive to act quickest in withdrawing the actual underlying property. Those who act slowest are the losers, as they fail to withdraw any of the actual underlying property.

B. The Fallacy of Deposit “Guarantees”

In the event of a systemic run on fractional-reserve banks, all of the actual underlying property is withdrawn. Therefore, no actual underlying property exists with which the government could fulfil deposit “guarantees”, unless new underlying property is created.

However, the government does not create new underlying property at will. Only the central bank can create new underlying property, doing so on the expectation that it is to be repaid, for its subsequent destruction. Therefore, the central bank will not issue the government with the new underlying property to fulfil the deposit “guarantees” with, unless it believes the government can credibly repay it. In other words, the deposits are not “guaranteed” at all by the party that actually has the power to create new underlying property.

If the central bank determines that the government cannot credibly repay, it is a concession that the risk is too high that the central bank cannot meet its own liability to destroy the property (upon its intended repayment). Therefore, the government that forces the central bank (against its wishes) to issue it with new underlying property can perceivably drive the central bank into declaring bankruptcy, jeopardising the entire monetary system.

However, even if we reject the idea that deposit “guarantees” are a fallacy, there is still a big problem. The entire monetary system is jeopardised by the reality that the business model of the central bank is, in fact, bankrupt. This fact is seemingly unbeknownst to even the central bankers themselves, and is covered next in Part 2.

Part 2: The Bankrupt Business Model of the Central Bank

The business model of the central bank is bankrupt due to a) the impossibility of making a profit in the long run, b) the virtual certainty of making a loss in the long run.

A. The Impossibility of Making a Profit in the Long Run

The central bank lends money into existence, and destroys it upon its repayment. It is impossible for more money to be repaid than is lent into existence. Therefore, it is impossible for the central bank to make a profit in the long run.

B. The Virtual Certainty of Making a Loss in the Long Run

All money lent into existence carries the risk of not being repaid. Therefore, it is virtually impossible for the central bank to recover 100% of the money it lends into existence. Therefore, it is virtually guaranteed that the central bank makes a loss in the long run.

In terms of the balance sheet (a “snapshot” of the present affairs) of the central bank, it must be the case that it its liabilities always exceed its assets, provided that the provision for doubtful debts is correctly factored in.

However, in order for the central bank not to be declared bankrupt, it must be held that there is no virtual certainty of making a loss in the long run. Therefore, it must be held that the central bank can recover 100% of the money it lends into existence (with virtual certainty). This incorrect belief is based on a fallacy called the credit theory of money, covered next in Part 3.

Part 3: The Fallacy of the Credit Theory of Money

According to the credit theory of money, the value of money ultimately rests on the obligation of the debtor to pay his debt. It is held that money must, in the long run, return to the creator of the money, for the money keeps being chased by those debtors who have an obligation to pay their debt to the creator of the money.

However, the credit theory of money is a fallacy. The value of money ultimately rests on its use as a medium of exchange, eliminating the inefficient “double coincidence of wants” present in barter. Money can circulate among members of the trading public (in perpetuity) for precisely this reason.

There is no rule that money must eventually return to those who have debts to pay, and indeed this is a highly unrealistic assumption, due to a) market forces in the supply of goods and services, b) market forces in the supply of money.

A. Market forces in the supply of goods and services

In the market economy, there is no rule that those who receive a greater amount of loans must outcompete those who receive a lesser amount of loans. Those who who receive a lesser amount of loans can win in market competition by being more efficient in meeting the demands of the trading public.

In addition, when investment is financed by credit not backed by true saving, it is termed “malinvestment”, as it tends to be inconsistent with the tastes and preferences of consumers and producers, and of the availability of scarce resources, thus increasing the likelihood of defaults.

B. Market forces in the supply of money

By having a (credit) money creator, winners and losers are created as a result of artificial barriers or prejudices or preferences. The recipients of greater amounts of loans tend to be benefitted, but the key winner is, of course, the (credit) money creator itself, as it canperpetually misappropriate wealth from the rest of society.

This fundamentally unfair system means there can be legitimate demand for heterogeneity to be introduced into the money supply. For instance, if in a given time period, the (credit) money creator expands the supply of money by a disproportionately large amount, the market could decide to scale down the value of these monetary units, as it amounts toexpropriation of the existing holders of money. Alternatively, new monetary units could be rejected entirely. There is simply no need to have a growing supply of money in order to have a growing economy. Instances such as these would make it highly challenging for the money to assuredly go back to the debtors of the (credit) money creator.

Another strong market incentive is to switch to an alternative monetary system, such as one with the use of precious metals such as gold or silver, or one with the use of World Dollar, a new currency based on the idea that the ultimate basis for money, a social convention, is for it to be issued to everyone, equally. If the market does switch, the (credit) money risks declining rapidly in value, even to the extent of becoming entirely worthless.