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:
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| 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.
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| 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.
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| 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.