Wednesday, September 16, 2015

Banks and the Stock Market, VI: How Fractional Reserve Banking REALLY Works

Yesterday we dismissed the Keynesian money multiplier as hooey.  It simply does not — and cannot — work as described in virtually every textbook on the face of the earth.  There are two very good reasons for this.  We covered these yesterday in some detail, but we can state them very simply — as long as you keep yesterday’s explanation in mind:

Only the reserve currency set aside is reserves.
1) Loans are not made out of reserves.  Period.  “Reserves” consist of an amount of the reserve currency set aside for contingencies, i.e., “in reserve” (hence the name “reserves”).  What contingency?  A loan goes bad, someone paid with a check wants cash for the check instead of depositing it, or someone cashes a check to meet his or her need for cash instead of a check.

2) Checks are not reserves, nor does depositing a check result in an increase in the total money in the system.  Instead, cashing or depositing a check results in shifting an amount of the reserve currency out of reserves and into someone’s account when the check is presented for payment and clears.  There’s a change in where the money is, but no change in the aggregate amount of money.

Clearinghouse Receipt for Interbank Tranfers
For example, instead of Bank A having $1,000 in reserves after Mr. X writes a $1,000 check on Bank A to Mr. Y who deposits it in Bank B, and the amount of money in the system going from $1,000 to $2,000, Mr. X writes a $1,000 check on Bank A to Mr. Y who deposits it in Bank B . . . which presents the $1,000 check to Bank A for payment through the clearinghouse.  Bank A subtracts $1,000 from its reserves and transmits it to Bank B through the clearinghouse, and Bank B adds $1,000 to its reserves.  End result?  Bank A, which started with $1,000, now has $-0-, while Bank B, which started with $-0-, now has $1,000.  There is no net increase in the money in the system.

So — how does the amount of money increase in the system?  By making loans by discounting (accepting) bills of exchange.  A bank of deposit cannot do this.  Neither can a bank of issue.  Only a bank of discount, or a bank with discounting power such as a commercial or mercantile bank, can create money by making loans.

Some loans go bad.
Strictly speaking, it is possible for a commercial or central bank to create money without any reserves at all.  Is that a good idea?  No.  Early on, banks found that some loans go bad, while other people will demand payment in cash instead of depositing a check in the same bank or another bank.  A bank needs reserves for these purposes.

The question is, how much?  Frankly, every cent tied up in reserves is “wasted” money, meaning it could be out in the economy doing the job currency is supposed to be doing: facilitating transactions.  You can’t risk that, however, because you know you’re going to need cash.  So banks make an educated guess as to how much they will need, and set that aside as a reserve, then loaning out the rest (if it is a bank of deposit) or creating money by accepting bills to a multiple of the reserves: “fractional reserves.”

You see the problem immediately.  An amount of reserve over this estimate is “excess reserves,” so the temptation is to loan it out or create more money as fast as you can in order to put it to work.  Any amount below that, and you have either a run on the bank, or you’re paying money to “rent” somebody else’s reserves to cover your reserve requirement.  And that can get expensive.  (That, by the way, is why the central bank of the U.S. is called “the Federal Reserve System.”  It allows banks to get reserves almost instantaneously . . . but only if they pay for it and their asset list — the loans the bank has made — qualifies them.)

The problem with fractional reserve banking, then, is not that it allows commercial banks to create money.  That’s what commercial banks were invented to do, anyway.  No, the problem is that fractional reserve banking either penalizes a bank for making too many loans, or not enough loans, regardless of the quality of the loan, based on some preconception as to how much new money the system needs, regardless of the system’s actual needs.  Except by lucky guess, there is always either too much, or not enough money in the economy, because somebody already decided that was how much you were allowed to have.

There is, however, a way to fix this problem, just by changing how we look at banking and money creation — and keeping in mind what “money” really is.  That is what we will look at tomorrow.


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