Thursday, May 30, 2013

More on Fractional Reserve Banking


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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