By Dr Frank Shostak
According to some commentators, the US banking crises is over. In addition, the Fed Chairman has vouched for the health of the US banking sector. We suggest that the banking crisis is likely to be in its early stages. What has started as the collapse of regional banks is likely to spread to national banks. The key reason for that is the likely decline in the pool of savings and fractional reserve lending.
We suggest that fractional reserve lending arises because banks are legally permitted to use money placed with them in demand deposits in lending activities. Banks treat this type of money as if it was loaned to them.
Although the law allows this type of practice, from an economic point of view, this results in the money out of “thin air” which leads to consumption that is not supported by production, i.e., to the dilution of the pool of wealth. According to Mises,
It is usual to reckon the acceptance of a deposit which can be drawn upon at any time by means of notes or checks as a type of credit transaction and juristically this view is, of course, justified; but economically, the case is not one of a credit transaction. … A depositor of a sum of money who acquires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to, has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him. The depositing of money in no way means that he has renounced immediate disposal over the utility that it commands.
Similarly, Rothbard argued,
In this sense, a demand deposit, while legally designated as credit, is actually a present good — a warehouse claim to a present good that is similar to a bailment transaction, in which the warehouse pledges to redeem the ticket at any time on demand.
Why a free unhampered market will curtail fractional-reserve lending
In a truly free market economy, the likelihood that banks will practice fractional-reserve lending will tend to be very low. If a particular bank will try to practice fractional-reserve lending it will run the risk of not being able to honor its checks.
The fact that banks must clear their checks will be a sufficient deterrent for the practice of fractional-reserve lending. Furthermore, it must be realized that the tendency of being “caught” practicing fractional-reserve lending increases when there are many competitive banks.
As the number of banks rises and the number of clients per bank declines, the chances that clients will spend money on goods from individuals that are banking with other banks will increase. This in turn increases the risk of the bank not being able to honor its checks once the bank begins the practice of fractional-reserve lending.
Conversely, as the number of competitive banks diminishes, that is as the number of clients per bank rises, the likelihood of being “caught” practicing fractional reserve lending is diminishing. In the extreme case if there is only one bank it can practice fractional-reserve lending without any fear of being “caught,” so to speak.
We can thus conclude that in a free market with many banks if a particular bank tries to expand credit by practicing fractional-reserve lending it runs the risk of being “caught.” Hence, in a truly free market economy the threat of bankruptcy will bring to a minimum the practice of fractional-reserve lending.
Hence, in a free market the threat of bankruptcy is likely to prevent banks from lending money taken from demand deposits without the depositor’s consent.
This however, is possible in the framework of the existence of the central bank. By means of monetary injections, the central bank is preventing the bankruptcy of banks that lend depositors money without their consent. Consequently, this results in the unbacked by savings lending, or lending out of “thin air”. This leads to an exchange of nothing for something. Please note that savings do not back the loans generated through the fractional reserve lending i.e. it is an empty money.
Obviously, such type of lending undermines the wealth generation process. Needless to say that the weakening of the production of wealth diminishes the borrowers’ ability to repay the debt.
Credit out of “thin air” causes the disappearance of money
When loaned money is fully backed by savings on the day of the loan’s maturity, it is returned to the original lender. Bob – the borrower of $10 – will pay back on the maturity date the borrowed sum plus interest to the bank. The bank in turn will pass to Joe the lender his $10 plus interest adjusted for bank fees. The money makes a full circle and goes back to the original lender. Note that the bank here is just a mediator; it is not a lender so the borrowed money is returned to the original lender.
In contrast, when credit originates out of “thin air” and is returned on the maturity date to the bank, this leads to a withdrawal of money from the economy i.e. to the decline in the money stock.
The reason being because we never had a saver/lender, since this credit emerged out of “thin air”.
Credit out of “thin air” sets platform for non-productive activities
As long as banks continue to expand credit out of “thin air”, various non-productive activities continue to expand. Once however, the continuous generation of credit out of “thin air” lifts the pace of wealth consumption above the pace of wealth production, the positive flow of savings is arrested and a decline in the pool of savings is set in motion.
Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to increase. 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 loans generated out of “thin air” are repaid and not renewed).
A fall in the pool of savings begins to undermine various activities i.e. an economic recession emerges. According to the popular view held by many mainstream economists, a severe economic slump also known as an economic depression is on account of the sharp fall in the money supply. This way of thinking originates from the Chicago School championed by Professor Milton Friedman.
We suggest that the economic depression is not caused by the collapse in the money stock as such, but comes in response to the shrinking pool of savings on account of previous easy monetary policy. The shrinking pool of savings leads to the decline in the credit out of “thin air”. This in turn causes the decline in the money stock. We suggest that even if the central bank were to be successful in preventing the fall of the money stock, this cannot prevent a depression if the pool of savings is declining.
Current banking crisis is in response to the previous loose monetary policies
We suggest that in the present framework of the fractional reserve lending and the existence of the central bank all the banks irrespective of their size are fundamentally unstable. It is not possible to make the current banking system stable without making the banking system completely free. As long as we have the central bank this is not possible.
Hence, we envisage that further instabilities in the banking system are going to be accompanied by an ever expanding monetary pumping by the Fed. This however, may not be able to prevent a decline in the money supply if the pool of savings is declining. Note that as a result of the decline in banks credit out of “thin air” the money supply is likely to decline.
The Fed’s attempts to counter this decline is likely to lead to extremely loose monetary policy. This however, is going to inflict a further damage to the process of wealth generation. Note that the Fed could engage in the direct pumping of money via the so called “helicopter money”. If this were to eventuate, there is a risk of the destruction of the present monetary system.
To conclude then, banks do not lend as such, they are merely facilitators of the lending of savings. Banks facilitate the flow of savings by introducing the ‘suppliers’ of savings to the ‘demanders’. In this sense by fulfilling the role of the intermediary, banks are an important factor in the process of wealth formation.
Once however, banks begin to engage in the lending activity by attempting to replace genuine lenders/savers, this sets in motion the menace of the boom-bust cycle and economic impoverishment. It is not possible to increase genuine credit without the corresponding increase in savings.