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.
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| 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 —
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| 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,
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| 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.)
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| 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.
#30#