Tuesday, September 15, 2015

Banks and the Stock Market, V: Shocking Facts About Fractional Reserve Banking

Yesterday we promised to take a look at what we called “the baffling puzzle of fractional reserve banking.”  To be frank, however, it’s not all that great a puzzle.  The problem is that banking itself is so loaded with misconceptions that the mysterious functioning of the different types of banks that we discussed yesterday can assume conspiratorial incomprehensibility.

Making Money the Old-Fashioned Way
To understand fractional reserve banking (and why we don’t need it) we first have to understand the role of reserves — and what reserves are.  The task is made infinitely easier if we first step back and forget everything we think we know about the subject, i.e., approach the discussion with an open mind.

Instantly, of course, all the Chestertonians (followers of G.K. Chesterton) out there of all stripes of economic orthodoxy and lack thereof have an instant kneejerk.  The Great Man once said that we don’t want to be so open-minded that our brains fall out . . . which many seem to understand as Chesterton asserting that bigotry, ignorance, and close-mindedness are somehow a virtue.

We can only be grateful that Chesterton is dead and can’t hear this sort of thing . . . especially with a large mug of beer in his fist as he face-palms himself on hearing yet one more oversimplification and distortion of what he said.  Not only would he knock himself cold (if he weren’t already so), he’d get beer everywhere, a shocking waste.

Anyway —

Making Loans the Old-Fashioned Way
Shocking Fact #1: Banks do not make loans out of reserves.

No, they don’t.  “Reserves” are a minimum amount of cash in the form of the reserve currency that a financial institution is required to keep on hand.

Read that again; “Required — to — KEEP — ON — HAND.”  That’s right.  You can’t loan out something that you are required to keep on hand.  A bank can only lend out money that is in excess of reserve requirements.  It can’t loan out reserves, or it has violated its charter by exceeding the amount it is permitted to loan out.  This goes for all types of banks.

Shocking Fact #2: Banks do not “create money” by re-depositing reserves.

Forget what you learned in economics or finance.  The Keynesian “money multiplier” is a gigantic fraud.  The math doesn’t work or even make sense.  Baron Kahn developed the Keynesian money multiplier in the early 1930s in an effort to explain how commercial banks can create money by making loans within a past savings (Currency Principle) framework.  A year or so later Dr. Harold G. Moulton totally demolished Kahn’s theory in The Formation of Capital.  As Moulton explained,

Dr. Harold G. Moulton
“Suppose now that Mr. A writes a check for $98,000 in favor of Mr. B. Suppose also that B desires to be a customer of this bank, and upon receipt of the check presents it at the bank and asks that an account be opened in his name and that the $98,000 check be deposited to this account. It is evident that the result of this operation, so far as deposits are concerned, is merely to deduct $98,000 from A’s account and add $98,000 to B’s account. The total deposits owed by the bank remain unchanged. While B’s deposit account comes over the counter in the form of a check presented to the bank, it is obvious that it is still indirectly the result of the loan that was made to A.

“Since it is more convenient for B to meet his obligations by means of checks rather than in the form of actual cash, we may assume that he will write checks to those to whom he is indebted. Let us assume that he writes four checks of $24,500 each; and that Messrs. C, D, E, and F, desiring to do business with this bank, in turn present these checks for deposit. The net result still is to leave the total of deposits unchanged; though instead of being credited to A or B the deposits are now credited to the accounts of other individuals. In their turn C, D, E, and F may write checks against their deposit accounts for varying amounts and to the order of sundry persons. If all the people receiving such checks in turn present them to this bank for deposit to their respective accounts, it is obvious that, while there would be an ever-shifting personnel among depositors, the total deposits would remain at $98,000.” (Dr. Harold G. Moulton, The Formation of Capital.  Washington, DC: The Brookings Institution, 1935, 79-80.)

Keynesian Money Multiplier: The Old Shell Game
Shocking Fact #3: The Keynesian money multiplier is hogwash.

Reading the above passage with care, we realize that the Keynesian money multiplier simply doesn’t make sense.  In the Keynesian framework, A writes a check for $98,000 to B, who deposits it, and the bank lends out $96,040 to C, who deposits it, and the bank lends out $94,119.20 to D, who deposits it, and so on, until it cycles down to no further loans.  The amount of “new” money allegedly created in this process is equal to the amount of reserves times the reciprocal of the reserve requirement, e.g., a 20% reserve requirement would mean that an increase in reserves would mean that the money supply could increase by 5 times the amount of the increase (1/.2).

Do you see the flaw in the Keynesian reasoning?  Of course you do: a check is not cash and cannot serve as reserves, nor (ignoring for the sake of the argument that reserves aren’t lent out anyway) can it be lent out again.  Instead, the check is presented for payment, and reserves transferred to cover it.  There is no money creation!  Like the pea in the old shell game con, there is only one pea, and it isn't under any of the shells.  Instead, the operator of the game (known as a "thimblerig" because he rigs the thimbles that have been used instead of shells) "palms" the pea, and then puts it wherever the mark didn't guess.  The pea in the shell game — and the money in the Keynesian money multiplier — is nowhere and everywhere at the same time, whichever best serves the interest of the one running the game.

Thus, when B deposits A’s check, the bank transfers $98,000 from A’s account to B’s account.  When C deposits B’s check, the bank transfers $96,040 to C’s account, and so on down the line.  As Moulton noted, there is no increase in the money supply, just a shifting around of who holds the original money.

So how does money get created under fractional reserve banking?  We’ll look at that tomorrow.


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