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Guest Post: The Problem With Fractional Reserve Banking

Zero Hedge
Friday, 3 August 2012

Guest Post: The Problem With Fractional Reserve BankingSubmitted by James E. Miller of the Ludwig von Mises Institute of Canada

*John Tamny and the Problem with Fractional Reserve Banking *

John Tamny of Forbes is one of the more informed contributors in the increasingly dismal state of economic commentating.  Tamny readily admits he is on the libertarian side of things and doesn’t give into the money-making game of carrying the flag for a favored political party under the guise of a neutral observer.  He condemns the whole of the Washington establishment for our current economic woes and realizes that government spending is wasteful in the sense that it is outside the sphere of profit and loss consideration.  In short, Tamny’s column for both Forbes and RealClearMarkets.com are a breath of fresh air in the stale rottenness of mainstream economic analysis.

Much to this author’s dismay however, Tamny has written a piece that denies one of the key functions through which central banks facilitate the creation of money.  In doing so, he lets banks off the hook for what really can be classified as counterfeiting.  In a recent Forbes column entitled “Ron Paul, Fractional Reserve Banking, and the Money Multiplier Myth,” Tamny attempts to bust what he calls the myth that fractional reserve banking allows for the creation of money through credit lending.  According to him, it is an extreme exaggeration to say money is created “out of thin air” by fractional reserve banks as Murray Rothbard alleged.  This is a truly outrageous claim that finds itself wrong not just in theory but also in plain evidence.  Not only does fractional reserve banking play a crucial role in inflationary credit expansion, it borders on being outright fraudulent.

So what exactly is ethically wrong with fractional reserve banking?  In his book Money, Bank Credit and Economic Cycles economist Jesus Huerta de Soto explains that the clear distinction between what would be considered demand deposits and savings available for loans has been enforced in banking history dating all the way back to ancient Greece.

Demand deposits were considered those deposits which banking customers believe they have direct access to at any time.  Because of the fungible nature of currency, identical gold coins did not have to be redeemable to the original depositing parties.   Deposits which were used to lend to entrepreneurs for a fixed amount of time were understood to be off limits by the patrons who provided them.  Typically the saver who placed his money in a bank for a specified period of time would do so to profit from a predetermined rate of interest. Under this system of strict separation between demand deposits and deposits used for lending, a duration mismatch, or a bank not having enough money on hand to pay all demand deposits, will not occur.  Back in the days of Ancient Greece and Rome, it was always considered fraudulent for bankers to lend out money put in their possession for safekeeping though that didn’t stop some who couldn’t resist earning a nice profit.

To understand precisely how fractional reserve banking can be seen as fraudulent, just consider if I were to sell my car to two different drivers where both are under the impression that they had full use of the vehicle at any given time.  Because both can’t have access to the car at the same time, the crime of contractual fraud was committed.  In the case of fractional reserve banking, if depositors were to agree that their money was to be used for additional lending, there would be no issue.  But usually depositors don’t fully realize that their funds are not really there in whole.  In a recent study commissioned by The Cobden Center, it was found that 74% of U.K. residents polled believed they were the legal owners of their banking deposits.  And while 61% answered that they wouldn’t mind if their money was used for additional lending, 67% responded that they wanted convenient access to what they saw as their money.  Whether or not one regards fractional reserve banking as a clear case of fraud, it seems that a good portion of the public is wrongly informed on the mechanics of modern day banking.

Besides standing on shaky ethical grounds, what is problematic with fractional reserve banking in practice?  As the Austrian Business Cycle Theory stipulates, credit expansion distorts relative prices and economic calculation to the point where entrepreneurs see long term investment projects as profitable.  The inter-temporal coordination between consumption and production is thrown off by fiduciary media entering the economy which lowers interest rates below the level that would normally exist under natural conditions.  The cheap money causes investment to funnel into high order capital goods while fewer resources are used in the production of consumer goods.  But because consumers themselves haven’t changed their spending patterns so that the pool of real resources isn’t drained as quickly, precious capital ends up being consumed as the eyes of business are blinded by the illusion of low-cost money.  As this truth comes to light, long term investment projects must be abandoned and liquidated.  The large number of “for sale” signs which still dot the yards of the areas most affected by the housing bubble in the U.S. are demonstrative of the harmful effects an inflation-induced boom. And just as money printing by the central bank pushes down interest rates in order to facilitate a boom, unbacked credit expansion has the same effect.

To see how credit, or what is also called fiduciary media, expansion can and does become pyramided through fractional reserve lending, it helps to consult Murray Rothbard’s textbook on banking “The Mystery of Banking.”  To show in detail how exactly banks within a hypothetical competitive banking system with a 20% required reserve rate governed over by the Federal Reserve create fiduciary media and expand credit, Rothbard writes:

To make it simple, suppose we assume that the Fed buys a bond for $1,000 from Jones & Co., and Jones & Co. deposits the bond in Bank A, Citibank. The first step that occurs we have already seen (Figure 10.9) but will be shown again in Figure 11.1. Demand deposits, and therefore the money supply, increase by $1,000, held by Jones & Co., and Citibank’s reserves also go up by $1,000.

 

With a 20% reserve requirement, the multiplier then becomes 5:1 where Citibank could in theory create as much as $4,000 out of thin air to lend out while still keeping $1,000 on hand as required.   But Citibank can’t just recklessly extend credit by the multiplier of 5:1 immediately, thereby creating a demand deposit of $4,000 for the borrower.  Doing so would risk the newly created money coming into the possession of a rival bank that would demand payment which could obviously not be redeemed.  $4,000 would be called for redemption while Citibank only has $1,000 in possession.  Rothbard notes this and explains further that Citibank will likely “expand much more moderately and cautiously.”  If Citibank were to expand credit by 80% or $800 and create a demand deposit in the form of a loan to Macy’s, the store may in turn purchases furniture from Smith Furniture Co. Smith Furniture Co. then deposits the $800 in its account with Chembank.  Chembank then calls upon Citibank for the $800 which Citibank pays through its reserves of $1,000 provided initially by the Fed’s purchase of a bond from Jones & Co.  Rothbard’s next figure shows how the money supply initially expanded with Citibank’s creating of an $800 loan:

The money supply went from $1,000 to $1,800; an 80% increase.  But as Rothbard notes in regards to Citibank

its increase of the money supply is back to the original $1,000, but now another bank, Bank B, is exactly in the same position as Citibank had been before, except that its new reserves are $800 instead of $1,000. Right now, Bank A has increased the money supply by the original reserve increase of $1,000, but *Bank B, ChemBank, has also increased the money supply by an extra $800*.

The following figure shows the final result:

The Federal Reserve may have only injected $1,000 into the economy at first but now the money supply stands at $1,800 with $800 being created out of thin air.

With the extra $800, Chembank can now make a loan of $640, or 80%, to another borrower, Joe’s Diner, who could then proceed to purchase goods from a supplier, Robbins Appliance Co., who has an account with Bank C otherwise known as the Bank of Great Neck.  Again, a deposit was created out of thin air that has the backing of the reserves acquired from the previous transactions with Citibank.  The balance ledgers of Chembank and Bank of Great Neck at the end of transaction are presented below:

As the Bank of Great Neck clears the transaction and receives its money from Chembank, Chembank is left with $160 in reserves which is enough to satisfy its 20% reserve requirement.  Throughout this whole affair it becomes clear just how fractional reserve banking works in practice.  As Rothbard writes:

…the process of bank credit expansion has a ripple effect outward from the initial bank. Each outward ripple is less intense. For each succeeding bank increases the money supply by a lower amount (in our example, Bank A increases demand deposits by $1,000, Bank B by $800, and Bank C by $640), each bank increases its loan by a lower amount (Bank A by $800, Bank B by $640), and the increased reserves get distributed to other banks, but in lesser degree (Bank A by $200, Bank B by $160).

 The next step will be for Bank C to expand by 80 percent of its new reserves, which will be $512. And so on from bank to bank, in ever decreasing ripple effects.

Demand deposits end up being ratcheted up in a way where the multiplier, if taken to its full theoretical extent, works its magic as the money supply can go from just $1,000 to $5,000.  Accounting wise, it is obvious exactly how banks extend credit not backed by reserves.  Admittedly this scenario can be a bit difficult to follow so I will present just one more example from economist Robert P. Murphy that will make clear that banks really do have the legal ability to create money out of thin air.  In this scenario which is comparable to Rothbard’s example above, Billy finds $1,000 stuffed away in his attic which he then proceeds to deposit in his account at Bank A.  Bank A, seeing a profit opportunity in Billy’s idle funds, proceeds to make a $9,000 loan to Sally which would still keep the bank within an imposed 10% reserve requirement.  Bank A’s balance sheet is as follows:

Again, Bank A still has $1,000 in physical currency to back its $10,000 in liabilities; thus adhering to the 10% reserve requirement.  But should Sally use her new loan to purchase goods she needs for her business, Bank A would eventually be called on by another bank to redeem the $9,000 which it clearly does not posses.  While Bank A would be foolish to make such a hefty loan, it would still be within the legal confines of the 10% reserve requirement.  So by adhering to the reserve requirement, banks really can create money out of thin air simply by adjusting their ledgers in a way to extend credit.

The problem with all of these examples is that they assume that the original depositors will not drawdown their accounts which would put banks that lend out more than they have on reserve under pressure to remain solvent.  If a bank experiences a large withdraw of funds, the money supply will end up contracting since it can’t extend credit like before as it loses reserves to meet its requirement.  The same happens, as Rothbard shows, when borrowers repay their loans.  Take for example the Rothbard Bank that has $50,000 of deposits but makes an $80,000 loan to Smith.  When Smith eventually repays his loan with interest, the $80,000 that was recorded as a liability and asset is then erased.  Because fractional reserve banks end up making money off of inflationary lending to many different patrons, one borrower repaying his loan doesn’t present too great of a risk.  This doesn’t dispute the fact that fractional reserve lending leaves banks as, in Rothbard’s words, “sitting ducks” because while credit can expand, it can also contract.  Just take a look at the following chart.

If fractional reserve banking doesn’t create money out of thin air, how then exactly did M1 grow by negative percentages?  Where did the money disappear to then if it wasn’t created solely by the magic of adjusting the bank ledger to represent a newly created credit?  If, as Tamny alleges, the money supply doesn’t expand via the money multiplier, how did it then contract?

Tamny ends up confusing the money multiplier of fractional reserve banks creating money out of nothing with the Keynesian multiplier which holds that government spending creates extra income “if it changes hands enough times.”  While it’s true that money changing hands does not lead to an increase in the money supply, attempting to cash in on lending long with funds you don’t really have does.  As long as a majority of the customers leave their deposits intact and don’t withdraw them too quickly, the pyramid scheme can continue ad infinitum if only in theory.  Milton Friedman, who knew something about banking and monetary policy, made the distinction in Capitalism and Freedom between the non-effect of the Keynesian multiplier with the fact that banks can take in a dollar deposit and

add fifteen or twenty cents to its cash; the rest it will lend out through another window. The borrower may in turn rede-posit it, in this or another bank, and the process is repeated. The result is that for every dollar of cash owned by banks, they owe several dollars of deposits. The total stock of money — cash plus deposits — for a given amount of cash is therefore higher the larger the fraction of its money the public is willing to hold as deposits.

Despite his shortcomings in recognizing the utterly destructive nature of central banking, Friedman understood that fractional reserve banking does create money out of thin air and puts the whole system at risk if depositors begin withdrawing their funds en masse.

Tamny proceeds to claim that fractional reserve banking runs counter to capitalism.  He claims that if banks were mere storehouses that charged depositors a fee, then they wouldn’t be banks.  This is basically correct.  But then he goes on to say because individuals want to be paid for storing their monies, these warehouses don’t exist and hence fractional reserve banking becomes the norm.  What Tamny gives is a false choice; one or the other.  In reality, just as people pay storage unit owners to safeguard their possessions, some may pay for warehousing of their money as history has shown.  If some individuals in turn wish to be paid interest for their deposits, they may sign over their funds for a specific period of time and interest for the bank to lend it out at a higher rate.  Capitalism doesn’t rely upon fractional reserve lending; a government and financial sector addicted to cheap money do.

In the end, Tamny thankfully realizes that the backstop provided by the Federal Reserve and government deposit insurance provides the perfect mix of incentives for banks to engage in risky lending.  Abolishing both would be a great first step in achieving sounder money and a healthier banking system.  It is unfortunate that he doesn’t hold the same to be true of fractional reserve banking.  As Ludwig von Mises, whom Tamny quotes frequently in his work, wrote:

It would be a mistake to assume that the modern organization of exchange is bound to continue to exist. It carries within itself the germ of its own destruction; the development of fiduciary media must necessarily lead to its breakdown.… It will be a task for the future to erect safeguards against the inflationary misuse of the monetary system by the government and against the extension of the circulation of fiduciary media by the banks.

In ancient times, the penalty imposed on bankers for lending out money held strictly as demand deposits would vary from being forced onto a diet of bread and water to public beheading.  Though these punishments were extreme, they show just how unethical fractional reserve banking used to be seen as.  Tamny’s mischaracterization of fractional reserve banking may not be unethical but it certainly begs for his re
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