Last week in response to our posting on fractional reserve
banking (“Binary Banking Theory, V: Fractional Reserve Banking,” 05/22/13),
we got the following comment: “So,
Fractional Reserve banking isn't the same thing as printing money from nothing?
Those two ideas are seen as equivalent. The fractional reserve is only
referring to the amount of cash or currency (maybe gold or silver) on hand,
there is still ultimately 100% reserves, correct?”
To this we responded that it’s a bit more complicated than
that . . . or we wouldn’t have anything to write about, now, would we? There is, frankly, massive confusion today as
to how money is actually created. There
is also confusion between reserves, fractional or otherwise, and what backs the
money.
Reserves are cash — accumulations of past savings — set
aside to meet the transactions demand of a bank. They do not back the money, but offer
conversion of one form of money (the bank’s promissory note) into another form
of money (legal tender currency).
A bank of issue or central bank cannot create money (issue a
promissory note) out of nothing. It can
only issue a promissory note to discount (purchase) a bill of exchange, that
is, a contract offering the present value of a future marketable good or
service. True, the good or service does
not necessarily exist at the time the bank issues the promissory note, but it
must exist when the bill matures or the borrower to whom the promissory note
was issued is in default and loses his or her collateral.
The value of a future marketable good or service is a
present value of something promised in the future, but no less real for
that. A promise has value. In this case, its value is based on the
expectation that the maker of the promise to deliver something of value will
make good on that promise, and the value now of something that you expect to
receive in the future. The former is the
“risk” associated with all credit transactions (and, as Henry Dunning Macleod
observed, money and credit are simply two aspects of the same thing), while the
latter is the “time value” associated with having something today versus having it tomorrow.
A fractional reserve requirement mandates that a bank can
only accept (discount) up to a multiple of the reserve requirement, e.g., if the reserve requirement is 10%,
and the bank has $1 million in reserves, it can issue promissory notes up to
$10 million. This $10 million liability
is redeemed when the borrowers to whom the notes were issued pay their debts
(redeem their bills), thereby cancelling the promissory notes.
Other holders of the bank’s promissory notes can’t pay a
debt for which they are not liable. (There’s
more to that than meets the eye. If you
could pay my debts, you would own whatever I acquired by incurring the
indebtedness, unless you let me keep it out of charity.) Other holders can, however, either open up a
demand or time deposit with the notes they hold, or demand legal tender
currency in place of the bank’s promissory note. This legal tender currency is provided out of
reserves.
Obviously, most promissory notes issued by the bank will be
used to repay debts owed the bank and not involve any payout of reserves. Others will be taken care of by compensating
balances and transactions, i.e.,
reserves that other banks owe the issuing bank offset against reserves that the
issuing bank owes the other banks. Relatively
few holders of a bank’s promissory notes ever present the notes and demand cash.
The problem with fractional reserve banking is that Richard
Baron Kahn, who worked with Keynes, developed the “money multiplier” to explain
how, in his opinion, banks create money.
The “money multiplier,” however, is a total fantasy, as Harold Moulton
explained in The Formation of Capital,
written the year after Kahn published his theory. (Harold G. Moulton, The Formation of Capital.
Washington, DC: The Brookings Institution, 1935, 77-84.)
According to the “money multiplier” theory, a bank does not
issue promissory notes, but makes loans only out of its reserves. With a 10% reserve requirement and $1 million
in reserves, the bank allegedly lends out $900 thousand, which is deposited in
another bank. This second bank in turn
loans out 90%, and so on, until the money supply is ten times greater than it
was before. Money is created out of thin
air.
This is utter nonsense.
Kahn and all the textbook authors who have included this in their books
made one slightly gigantic error that Moulton pointed out: CHECKS ON DEPOSIT ARE NOT RESERVES.
There’s a giant “whoopsie” for you that isn’t quite covered
by tittering, “My bad.” Checks cannot be reserves because checks
are not legal tender currency.
When a check is deposited in a bank, it is presented for payment at the
bank on which it is drawn. The bank on
which the check is drawn transfers reserves to the bank that accepted the
check. This reduces the reserves of the
bank on which the check was drawn, and increases the reserves of the bank in
which the check was deposited. As
Moulton pointed out the obvious, THERE
IS NO NET INCREASE IN THE MONEY SUPPLY.
The real purpose
of the phony money multiplier was to debunk the real bills doctrine that is an
application of Say’s Law of Markets.
Keynes rejected Say’s Law and ignored the real bills doctrine. This made it essential to spread the false
idea that money can be created out of nothing.
It is bologna no matter which way you slice it, but it is today
considered economic orthodoxy, especially as it reinforces the belief that only
the State can or should create money.
Yes, there is a link between fractional reserve banking and
money creation by banks, but it is not what the textbooks have been telling us
since Keynesian economics established its hegemony during the New Deal. Fractional reserve banking does not result in
creating money out of thin air, thereby inflating the currency. Rather, fractional reserve banking imposes an
artificial limit on the amount of money a commercial bank can create by issuing
promissory notes to discount bills of exchange representing the present value
of future marketable goods and services, as well as for any other purpose.
Fractional reserve banking forces future growth rates to be
determined by the amount that has been withheld from consumption in the
past. Past cuts in consumption are used
to restrict future increases in production.
That is why fractional reserve banking is so bad, and why we must shift
over to a system in which the amount of money created is determined exclusively
by the present value of existing and future marketable goods and services in
the economy, not by how much has been saved out of production by restricting
consumption, or how much a politician can spend.
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