#1.
Introduction
#2.
What is Money?
#3
An Introduction to Paper Money
#4
Fractional Reserve Banking, Inflation, and Boom-Bust
In the last post in this series, I discussed some general concepts underlying fractional reserve banking (FRB), and I argued that it should not be upheld by the courts since it necessitates the recognition of a contradictory legal condition, i.e., it enables the the simultaneous possession of the same physical asset by more than one owner. But why is this even important?
FRB actually predates the modern concept of the central bank, i.e., FRB can exist even under a gold standard. In fact, various catastrophes emanating from FRB throughout the 19th century and early 20th century helped set the stage for the modern central bank. Furthermore, FRB continues to be a major economic force. It is responsible for most of the money creation that has occurred since the advent of the Federal Reserve System and therefore, is a major factor in causing the boom-bust cycle. For example, today the
total money supply is in the neighborhood of $6T, while the total creation of money by the
Federal Reserve (the "monetary base") is about $2T.
For an excellent overview of the topic of FRB, see the recent article,
The Faults of Fractional-Reserve Banking, by Thorsten Polleit (HT:
Per-Olof Samuelsson).
To review, let's take a simple example.
1) Joe deposits 100 oz. of gold in Bank A. Bank A sets aside 10 oz. of gold in a vault and lends out 90 oz. to a farmer.
Joe: "I have 100 oz. of gold available to me at all times"
Farmer: "I have 90 oz. of gold available to me at all times"
Total Money Supply = 190 oz. of claims to gold
Actual Money = 100 oz. of gold
Note that two parties now believe they have title to the same physical asset. Joe thinks he has 100 oz. of gold and the Farmer thinks he has legal title to 90 oz. of gold.
2) Continuing, let's say the farmer deposits the 90 oz. of gold in Bank B. Bank B sets aside 9 oz. of gold in its vault, and lends out 81 oz. of gold to a grocery store.
Joe: "I have 100 oz. of gold available to me at all times"
Farmer: "I have 90 oz. of gold available to me at all times"
Grocery Store: "I have 81 oz. of gold available to me at all times"
Total Money Supply = 271 oz. of claims to gold
Actual Money = 100 oz.
This process can repeat until there is 1000 oz. of total money supply, all backed by the original 100 oz. of gold. (Ludwig von Mises would call the 900 oz. of claims "circulation credit.")
In other words, through FRB with a 10% reserve ratio, the banking system can create 10 times as much money as is on deposit. The increase in the quantity of money over the increase in quantity of precious metals
is inflation. In the same way, if banks stop lending, or their loans lose value, or customers choose not to borrow, then FRB can result in a decrease of the previously created money by up to 10 times. This decrease in the quantity of money
is deflation.
Of course, such a process of money creation and destruction causes the notorious boom-bust cycle. Inflation, among other things, distorts the investment of capital throughout the economy and causes a general increase in the price level (or increase in prices above what they would have been otherwise). The corresponding liquidation of this malinvestment and consequent decrease in the quantity of money, or deflation, corresponds to the bust phase of the cycle - a phase for which most of us are now well versed. See my post,
Boom-Bust Part 1, Reisman's
Capitalism: A Treatise on Economics or his recent post "
Boom Bust in Microcosm", or Jesus Huerta de Soto's
Money, Bank Credit, and Economic Cycles, for more on this. As Reisman writes (see Capitalism p. 542):
...depressions are caused by government sponsorship of a fractional-reserve banking system, which increases the quantity of money unduly, thereby artificially reducing the demand for money and raising its velocity of circulation, thus setting the stage for a subsequent financial contraction, deflation of the money supply, and depression.
Now, as a further practical consequence, what if all these people come to the bank at the same time demanding to redeem the paper notes in gold? Of course, it would be impossible for the banks to redeem 1000 oz. of gold when they only have 100 oz. As I argued in the last post, the conflation of the legal concept of deposit with the concept of loan results in a situation where many independent parties are legally entitled to the same physical asset - a situation which would not arise if deposits were treated separately from loans. When all these parties simultaneously demand their gold, it is known as a run on the bank.
Generally, FRB leads to the business cycle and an untenable legal condition in which many parties have rightful claim to the same asset. Historically, this practice led to one disaster after another throughout the 19th century, even when the U.S. was on a gold standard. As I discuss in more detail in my post,
Boom-Bust Part 3, when banks endured runs as investors panicked, states allowed banks to suspend redemption in specie, thus introducing profound form of moral hazard into the monetary system, as banks who pushed the envelope were effectively bailed out.
Friedman and Schwartz quote Clark Warburton in a footnote (p. 328):
By the middle of the 1830's most of the states had adopted or were in the process of developing general banking codes, with the insertion of provisions for severe penalties for failure to pay note in specie, or had placed such provisions in bank charters when renewing them or granting new ones. Under such provisions, suspension of specie payments meant forfeiture of charters, or at least curtailment of business until specie payments were resumed...We know of no instance where any legislature or bank supervisory authority declared bank charters to be forfeited as a result of a general restriction of convertibility. Instead, legislation was enacted postponing or relieving banks of the penalties the law imposed for suspension of specie payments.
Although I will discuss this in more detail in a later post, it should be noted that the various panics set off by this process ultimately led to a political movement, not to insist that the state serve its proper function which is to enforce banks' contractual obligation to redeem, but rather, a drive towards the establishment of a central bank to act as "lender of last resort" or to increase the currency's "elasticity" - all code for a central statist authority to backstop the banks (at taxpayer expense) when they got in trouble. Such a movement served the ends of both the turn of the century progressives', who sought inflation as an economic elixir (or a means to not be crucified on a "
cross of gold"), and groups of statist bankers, who sought to profit from FRB without subjecting themselves to risk.
Looking ahead, it should be noted that FRB is a major factor in the determination of the total money supply. FRB provides the means to multiply and decrease a monetary base by orders of magnitude. The connection to the central bank is as follows. In the absence of a gold standard, a central bank that controls the monetary base, controls the fundamental base of that multiplication. In other words, the creation of money can be thought of as emanating from two central causes: 1) the central bank (the Fed) which creates money out of thin air that serves as the so-called monetary base and 2) the private banking system, which multiplies this amount as it lends money to its customers or contracts money as loans go out of existence. The recent history of monetary growth in the United States can be thought of as an ever increasing curve (as the Fed continuously adds to the monetary base) with additional cycles of expansion and contraction caused by the banking system's shorter term lending behavior.
Further looking ahead, this is the reason why the Fed can, at times, create money but not actually increase the total money supply if this money creation is met by an offsetting contraction in lending from the private banking system. Such a state is exactly what has been happening over the past year as the Fed finds new ways to increase the monetary base (expand its balance sheet) while private banks and individuals "deleverage" or pay off debt and raise cash.
FRB has been and is today an integral part of the banking system and warrants close re-examination if we are ever to fully and properly establish a private banking system based on the legal and moral principles of laissez faire.