The Fractional-Reserve Banking Question

Having studied this article I, Byron Dale having studied the Fractional Reserve Question for 29 years, would like to make some comments.  I will add my comments in red and italics.

Austrian economics is superior to Marxism in every respect, and this includes internal, sectarian squabbles. When we Austrians feel the time is ripe for another bloodletting — it keeps us strong by thinning the herd once in a while — we argue over fractional-reserve banking.

If you have never had the pleasure of watching such fireworks, I point you to Joe Salerno's recent blog post; it has enough links to bring you up to speed. In the present article, I want to walk through a simple example to make sure everyone understands exactly why some of us think fractional-reserve banking is just plain weird.

Suppose a teenager, Bill, is rummaging in the attic and finds $1,000 in physical currency in an old chest. Bill is ecstatic and runs to the local bank, where he opens a checking account and deposits the green pieces of paper.

Under a 100-percent-reserve banking system, this would be the end of the story. In the act of making the deposit, Bill's currency holdings would fall by $1,000, while his checkbook balance would rise by $1,000. Putting the money in the bank wouldn't affect the total amount of money in the economy. 

However, in our current system, Bill's bank would see a new profit opportunity. After the bank put the $1,000 of paper currency into its vault, its reserves would be that much higher, while its outstanding deposit liabilities would have risen by $1,000 as well (in the form of Bill's new checking account). But since banks in the United States are subject only to a reserve requirement of (approximately) 10 percent, the bank would have new excess reserves of $900. If it found a suitable borrower, the bank would have the legal ability to grant a new loan for this amount.  Up to this point I basically agree with Mr. Murphy with two exceptions. The first one is that he didn’t explain that the currency was also a liability of a private bank and the Federal Government. Someone some place had to borrow before the currency could have gotten into the old chest.   Second he didn’t make it real clear that when the $1000 in currency moved from Bill’s hand into the bank’s vault, the value of the currency changed from just face value currency, worth $1000, to currency that was worth $9000 (high powered currency) to the banking system.

Suppose the bank found such a borrower, Sally, and charged her 5-percent interest for a 12-month loan. Assuming she paid off the loan in a timely manner, here is what the bank's balance sheet would look like at various stages in the process:

In the above chart, Mr. Murphy makes it look like the bank only created $900 of checkbook money as a loan to Sally from the $1,000 vault cash. When, it is clear that the bank had already created $1000 of checkbook money in Billy’s checking account.  Money, that Billy could spend and surely will spend this checkbook money, at least part of it, just as quickly and easily as Sally.

 In the above chart Mr. Murphy goes way off the reservation.  If Sally had spent the checkbook money that the bank created there would be no decrease in vault cash.  If there had been a decrease in vault cash there wouldn’t have been an increase in checkbook money and no increase in the money supply.  He is right in that when Sally spends her borrowed checkbook money that banks liability would have gone down. 

Here is how the bank’s balance sheet would really look like.

Here again Mr. Murphy is off the reservation.  He seems to flip-flop between checkbook money and currency and calls them both cash.  As this article is about fractional reserve banking and the creation of checkbook money we must believe that Mr. Murphy is talking about checkbook money.  If Sally had sold her products for $1,000 of checkbook money and that checkbook money was deposited in her bank account there would be an increase in bank liabilities in that bank and a decrease in the liabilities of the bank the check was written upon, but there would not be an increase in vault cash and the chart would look like this.

  If Sally had sold her products for currency and gave that currency to the bank as payment the vault cash would have increased to 2,000,  $1000 from Billy’s currency deposit and $1,000 from Sally’s currency deposit. There would be an increase in sally’s checking account of $55.  The bank’s $45 in interest income, bank equity would be in vault currency. .

 Here again the above chart is not correct, but only in that the vault cash should be $1000, as shown above in red, not $1,100.  The bank’s interest income would be in checkbook money not currency. This is because checkbook “money is created when loans are issued and debts incurred; money is extinguished when the loans are repaid.”  John B. Henderson Senior Specialist in Price Economics Congressional Research Service

As our hypothetical example[1] makes clear, with the power of fractional-reserve banking, bankers can apparently earn income out of nothing! So long as Billy leaves his money in the bank, and so long as Sally is able to earn enough revenues from her business to avoid defaulting on her loan, the bank's shareholders end up with $45 of the community's cash, free and clear. 

Here is an almost a perfect example of a statement that contains truth, half- truth, make believe and misdirection.  The first part, reworded a little, banks can earn income form loaning nothing is true.  The statement that,” So long as Billy leaves his money in the bank, While it seems to be true that Billy may need to leave the currency he deposited in the bank or the bank will lose some of it’s reserves. However, there is no reason that Billy can’t spend the checkbook money that the bank created and put in his checking account when he deposited the currency.  However, this checkbook money Billy spends would not be an increase in the money supply, because this checkbook money didn’t arise directly from a loan.  It arose from a one for one exchange of currency that was taken out of circulation   If Billy went to the bank and asked for the currency the bank would give him the currency and Billy’s checkbook money would be destroyed. The money supply would not change.  and so long as Sally is able to earn enough revenues from her business to avoid defaulting on her loan, the bank’s shareholders end up with $45 of the community’s cash free and clear.” This is misleading.  Before the shareholder wouldn’t end up with any of the bank’s profit until the bankers would have take there large cut.        

Now, the bank didn't stick a gun in anyone's belly,  While this is physically true.  The bank doesn’t need a gun.  The banking system has made it impossible for anyone to have any money, until someone borrows from the banking system.  Someone had to borrow before Billy could find any money in a chest. There would be no money for anyone to buy any thing at a profit for Sally unless someone else had borrowed more money.   and the original owners of that $45 voluntarily traded them to Sally in exchange for whatever goods or services her business produced.  That is true but they couldn’t have any money to exchange if there had not been more borrowing.  Still, something seems a bit fishy in that the bank created $900 in new money, earned $45 in "old" money held by the outside community, and then destroyed the $900 when Sally paid back her loan.  The “old” money held by outside community was also created by the banking system as interest bearing loans to someone.  Russell L. Munk writing for the U. S. stated it very clearly [The banks owns all the money all the time and the people only borrow it and pay interest on it.]  

Incidentally, it is because of these strange machinations that many critics of our current financial system describe it as "debt-based money." In a very real sense, if people stopped taking out new loans (from banks) and paid off their outstanding loans, In this money system there is no way to pay off any outstanding loan without shifting part of the debt to some one else. the total quantity of money would shrink drastically.  In this money system it is impossible to pay off all the loans.  Because before all the loans were paid off the total money system would have be extinguished.  In my opinion this would be a good thing — only if one wanted a total monetary collapse.especially if the politicians and the Fed sat back and let it happen — but it is nonetheless a very strange feature of our current system.

Creating Money Out of Thin Air?

Some people deny that commercial banks "create money out of thin air." They agree that the Fed does so when it buys assets by writing a check on itself. However, in our example above, it seems that the commercial bank at worst is taking $900 of "Bill's money" and handing it over to Sally. Sure, that might be dubious, but it's not as blatant as when the Fed literally writes checks drawn on thin air, right?  This again is false information.  The commercial banks never loan the depositors money to anyone else, they always create new money with their loans.  That is what fractional banking is all about. 

Actually, I think this standard textbook description — in which each new bank in the sequence create new loans equal to 90 percent of the new deposit — is a bit misleading. There is nothing in the legal reserve requirement to prevent banks from making new loans that are large multiples of a new deposit. Instead, it is prudence on the part of the banks that enforces this restraint.

To see this, let's repeat the above story but have the bank make a much larger business loan to Sally:

 Let's stop at this point and consider what has happened. The bank's balance sheet still checks out — $10,000 in assets and $10,000 in liabilities. So the accountant's head won't explode on account of the large loan to Sally.

But perhaps the bank in our updated scenario is running afoul of the 10-percent reserve requirement enforced by the Fed? Again, no — as of the moment of the new loan to Sally, the bank's total customer checking account balances are $10,000, and the bank has $1,000 in physical currency in its vault, "backing up" those accounts. So the bank is satisfying the 10-percent reserve requirement.

To understand why the bank would be foolish to make a $9,000 loan to Sally after receiving Billy's $1,000 in cash, we must look ahead one step:

Here again Mr. Murphy goes off the reservation.  If you go back up to the chart before this one you will see that the vault cash was only $1,000.  There is no vault cash (Federal Reserve Notes) used or created by the $9,000 loan to Sally so it would be impossible for the vault cash to go from the $1000 to the $8000 in the chart.

Now we see the problem: Presumably, Sally is not going to borrow $9,000 at interest, in order to let that balance sit in her checking account. She is going to spend the money, by writing checks on the account. The people who receive those checks are going to deposit them in their own banks; and, during normal interbank clearing operations, the original bank will receive requests to transfer out $9,000 of its reserves.  I know the current ‘wisdom’ is that banks pay checks by transferring reserves.  However, any thinking person knows that it is impossible to pay $9,000 worth of checks with only $1,000 of vault cash; even if the $1,000 was high-powered money and could support $9,000 of checkbook money.  If Billy came into the bank and asked for his cash back the bank would not have it.  To say nothing about what would happen if someone else asked for just a $1,000 in currency, of that $9,000.  Banks simply pay other banks by transferring the checkbook money (the numbers) out of Sally checking account to the other person’s checking account.  If that is not true then currency in the banks vault would not be high powered money to the banks.

We now see why standard economics textbooks have banks only making new loans equal to 90 percent of the amount of each new injection of deposits. The assumption here is the root problem with most all economists’ thinking; it is based on assumptions not facts is that the new depositor won't withdraw his money anytime soon, but that the new borrower (i.e., the person getting the loan) will withdraw the money very soon.

Let's be clear though on the moral of the story: in this second scenario — which is not in violation of the reserve requirement (though it might violate capital requirements or other regulations) — the commercial bank is quite obviously "creating money out of thin air."  Here Mr. Murphy is agreeing with what I just said and if the bank is creating money they can’t be loaning anyone else’s money.

Consider: The bank received $1,000 in currency from Bill, and it then made a loan of $9,000 to Sally. This new money didn't "come from" anywhere; it existed as soon as the bank clerk changed the numbers on the ledger. Sally went from having $0 in her checking account to having $9,000, with the simple push of a button.  Here Mr. Murphy gets to the fact that banks create all our medium of exchange.  They do this by simply writing numbers in a bank account as interest bearing loans to the borrowers. This brings profit to the banking system and  monetary enslavement for the people.  This has put Americans into economic servitude.  People can only have economic freedom if their medium of exchange is debt and interest free and based on the peoples production.

Conclusion

In the present article, we have walked through a simple example to illustrate the strange nature of fractional-reserve banking. In a very real sense, this process creates money out of thin air. This observation alone doesn't prove its illegitimacy, But it does prove illegitimacy when one considers that the banks only loan the principal and then demand to be paid back  the Principal plus the interest which in fact does not exist.  let alone its connection with the business cycle, But it does connect to the business cycle.  When the banks loan lots of credit (money) to the people the economy picks up and everyone seems to do a lot better.  The debt also grows faster than the credit (money) supply and the people are actually getting worse off.  Then when the banks stop loaning the credit (money) supply starts to decrease and people can’t make their payments to the bank and ‘Walla’ we have recession or depression.  but it should give pause to those who see nothing wrong with the practice.

Robert Murphy is an adjunct scholar of the Mises Institute, where he will be teaching "Principles of Economics" at the Mises Academy this fall. He runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. Send him mail. See Robert P. Murphy's article archives.

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