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Simple, obvious question about fractional reserve banking - I just wanna be sure I've got this right.

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Simple, obvious question about fractional reserve banking - I just wanna be sure I've got this right.

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Danno posted on Sat, Mar 2 2013 11:36 AM

I understand that this is basic stuff, but I haven't seen any examples of this particular line being drawn, and I want to be certain that I'm not missing something here.  I'm in the process of writing up a pamphlet explaining fractional reserve banking for people who opened an Economics text once, shuddered, and walked away from it forever.

Everyone here has already covered the basics like this, but bear with me, please - I'll make the setup brief.

Joe, John, and Julie each deposit $100 in the Bank of Dan - so the Bank has $300 in deposits.  At a fractional reserve of 10%, the Bank of Dan can now lend Mark, Mary, and Mabel each $1,000 - purely as accounting entries.  This is the point almost everyone makes, but I haven't seen the next step stated clearly. 

When Mark, Mary, and Mabel repay the loans, the bank has turned a profit of $3,000 plus interest, minus overhead expenses and interest paid to Joe, Julie, and John on their deposits. 

The bank loans money that doesn't really exist - but people have to repay those loans out of money they've made or earned - so the bank ends up owning the proceeds of every loan it makes, not just the interest it charges on those loans.

I expect that the average person is going to be a bit shocked by the implications of this, but it looks even more wrong than how Rothbard and Schiff have laid it out - so I'm wondering if there's some part of this that I'm missing, somehow.

Or is it really that profitable to run a fractional reserve bank?

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Answered (Verified) mickanomics replied on Sun, Mar 3 2013 9:46 AM
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One (of several) key points about "fractional reserve banking" that you are missing is that when the principal on the loan is repaid, that money expires out of existence. So the only money that the bank can make is indeed the interest. Money expiration is omitted in many popular explanations of our monetary system and appears to be unknown by many economists.

This video expains it: http://www.youtube.com/watch?v=CI5CFQXJxcA

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Answered (Verified) Smiling Dave replied on Sun, Mar 3 2013 8:16 PM
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But I'm still not entirely clear on this - according to Rothbard, with $300 in actual assets, the banks can loan out $3,000 - and the money created by this process has to land on someone's balance sheet, to exist at all.  Who has title to the money thus created?

Here's how I understand it:

A check is an IOU, stating the bank will give the bearer cash money on demand. With $300 of assets, the bank distributes $3,000 worth of IOUs payable on demand.

When a person takes out a loan from the bank, he is taking the bank's IOU, and in return promising to pay the bank the amount printed on the IOU plus interest. He then takes the IOU, the check, and buys things with it. In other words, if people are willing to accept the check as payment instead of getting paid in cash, then as long as the check is in existence it is being used as money, thus increasing the money supply.

At some point, the check might be presented to the bank. They have to hand out cash from their vaults in exchange for it. What do they do with the check? They  tear it up. Thus it has ceased to exist, and it no longer inflates the money supply.

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Answered (Verified) Clayton replied on Sun, Mar 3 2013 9:21 PM
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Okay - I hadn't though through that step - thanks for pointing that out.  But I'm still not entirely clear on this - according to Rothbard, with $300 in actual assets, the banks can loan out $3,000 - and the money created by this process has to land on someone's balance sheet, to exist at all.  Who has title to the money thus created?

There's a sizable difference between the per-bank view and the "systemic" view. An individual bank cannot loan out more money than it actually has on hand. So, the bank with $300 in deposits may loan out - with a 10% reserve system - $270 and keep $30 on hand for demand deposits. But the loaned money will almost certainly be redeposited in some bank, somewhere. That bank is also a fractional-reserve bank under the same system. Of the $270 deposited, $243 may be loaned out and $27 kept on hand. As you continue this process indefinitely, the loanable amount becomes smaller and smaller - yet the total deposits generated approach $3,000 more and more closely the more times you iterate this process. So, the "total bank reserves" - that is, the amount of deposits held by all banks taken together - grows by about $3,000 for each $300 in "new" money that is deposited into the fractional reserve system, for a 10% fractional reserve system, anyway.

But since the central bank is a guaranteed source for a constant injection of new money, the whole system is guaranteed to profit over time - immensely. Every million dollars injected by the central bank eventually turns into $10m of deposits. And while the banking system "merely" earns the interest on these deposits, it continues to earn the interest in perpetuity. And furthermore, it doesn't really matter how modest the percentage rate is at which the fractional reserve banks earn back the money injected into the system... the point is that they are earning interest on money that they did not have to acquire through either income or through credit to a depositor... money created out of thin air.

To understand why that matters, imagine you had some special legal privilege whereby you could write a check of any size regardless of what was in your account... with the catch that the check had to be paid back in one year with, say, 1% interest. Now, as long as you can go out into the market and give a loan for more than 1%, you can make a guaranteed profit at no risk to your assets... precisely because you are not backing your loans with assets at all! You're just writing a check. "Here, Mr. Jones, I hereby loan you $1M." In one year's time, Mr. Jones must repay you $1.2M, you must redeposit $1.1M to the bank, leaving a handsome $100K profit on non-existent money. Meanwhile, any of your would-be competitors must actually first accrue $1M before they can loan it out, at 2% or any other rate. They might accrue it by saving their own cash or by convincing other small investors to pool their cash together, or whatever. But the point is that they can't just write a check for $1M out of thin air. So, what do you think the inevitable consequence of this kind of behavior will be on the loan market? It will be monopolized forthwith as the "small-timers" are squeezed out by their inability to compete with artificially low interest rates and the massive expansion of thin-air-based credit.

The central bank can write checks out of thin-air. That's its whole raison d'etre. The commercial banks can't do that but they can do something almost as good... take as many loans as they please from the central bank (who writes checks out of thin-air) and then re-loan that money out to people who can neither write checks out of thin-air nor take loans directly from somone who can (the central-bank). In the process, the money multiplication occurs as depositors engage in a tangled chain of deposit-borrow-deposit-borrow for every dollar that emanates from the central bank. Thus, every $1M check the central bank writes out of thin-air has the potential to become $10M in deposits in the commercial banking system.

From the horse's mouth.

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eliotn replied on Sat, Mar 2 2013 12:00 PM

I think you have your numbers wrong:

"Joe, John, and Julie each deposit $100 in the Bank of Dan - so the Bank has $300 in deposits.  At a fractional reserve of 10%, the Bank of Dan can now lend Mark, Mary, and Mabel each $1,000 - purely as accounting entries.  This is the point almost everyone makes, but I haven't seen the next step stated clearly."

If the bank does not make any new receipts, the bank can only lend $270 from these deposits, assuming it is a strictly 10% reserve bank.  The 10% reserve refers to the fact that the bank stores 10% of the deposits (holds them in reserve) and uses the rest to lend out.  Also, its not that the money doesn't exist, so much as two people having claims on the same money when we are talking about fractional reserve banking and bank reserves.

What you might be thinking of is the bank getting some amount of gold, keeping it in reserve, but then actually printing $2,700 dollars in fake receipts (for it to be 10% reserve with these receipts it would actually print $3k of receipts, 300 would go to the original donors, the rest would be fake ones held by the bank).  While this is another way to do fractional reserve banking, it is fundamentally different.  In the former case, the depositors gold is being loaned without their consent, in the latter case the claims to gold are themselves faked. The really high profit you see with the method you describe actually comes with the act of money-printing, keep in mind that these receipts do not have to be merely loaned out, although they probably will be in practice.

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Smiling Dave replied on Sat, Mar 2 2013 1:45 PM

The bank loans money that doesn't really exist - but people have to repay those loans out of money they've made or earned - so the bank ends up owning the proceeds of every loan it makes, not just the interest it charges on those loans.

Mark, Mary, and Mabel bought $3,000 worth of goods with the checks they got, and those checks will some day be cashed, so all the bank gets is the interest.

 

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Danno replied on Sun, Mar 3 2013 3:27 AM

Okay - I hadn't though through that step - thanks for pointing that out.  But I'm still not entirely clear on this - according to Rothbard, with $300 in actual assets, the banks can loan out $3,000 - and the money created by this process has to land on someone's balance sheet, to exist at all.  Who has title to the money thus created?

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Meistro replied on Sun, Mar 3 2013 3:32 AM

http://mises.org/money/3s9.asp

 

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Answered (Verified) mickanomics replied on Sun, Mar 3 2013 9:46 AM
Verified by Danno

One (of several) key points about "fractional reserve banking" that you are missing is that when the principal on the loan is repaid, that money expires out of existence. So the only money that the bank can make is indeed the interest. Money expiration is omitted in many popular explanations of our monetary system and appears to be unknown by many economists.

This video expains it: http://www.youtube.com/watch?v=CI5CFQXJxcA

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Answered (Verified) Smiling Dave replied on Sun, Mar 3 2013 8:16 PM
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But I'm still not entirely clear on this - according to Rothbard, with $300 in actual assets, the banks can loan out $3,000 - and the money created by this process has to land on someone's balance sheet, to exist at all.  Who has title to the money thus created?

Here's how I understand it:

A check is an IOU, stating the bank will give the bearer cash money on demand. With $300 of assets, the bank distributes $3,000 worth of IOUs payable on demand.

When a person takes out a loan from the bank, he is taking the bank's IOU, and in return promising to pay the bank the amount printed on the IOU plus interest. He then takes the IOU, the check, and buys things with it. In other words, if people are willing to accept the check as payment instead of getting paid in cash, then as long as the check is in existence it is being used as money, thus increasing the money supply.

At some point, the check might be presented to the bank. They have to hand out cash from their vaults in exchange for it. What do they do with the check? They  tear it up. Thus it has ceased to exist, and it no longer inflates the money supply.

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Answered (Verified) Clayton replied on Sun, Mar 3 2013 9:21 PM
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Okay - I hadn't though through that step - thanks for pointing that out.  But I'm still not entirely clear on this - according to Rothbard, with $300 in actual assets, the banks can loan out $3,000 - and the money created by this process has to land on someone's balance sheet, to exist at all.  Who has title to the money thus created?

There's a sizable difference between the per-bank view and the "systemic" view. An individual bank cannot loan out more money than it actually has on hand. So, the bank with $300 in deposits may loan out - with a 10% reserve system - $270 and keep $30 on hand for demand deposits. But the loaned money will almost certainly be redeposited in some bank, somewhere. That bank is also a fractional-reserve bank under the same system. Of the $270 deposited, $243 may be loaned out and $27 kept on hand. As you continue this process indefinitely, the loanable amount becomes smaller and smaller - yet the total deposits generated approach $3,000 more and more closely the more times you iterate this process. So, the "total bank reserves" - that is, the amount of deposits held by all banks taken together - grows by about $3,000 for each $300 in "new" money that is deposited into the fractional reserve system, for a 10% fractional reserve system, anyway.

But since the central bank is a guaranteed source for a constant injection of new money, the whole system is guaranteed to profit over time - immensely. Every million dollars injected by the central bank eventually turns into $10m of deposits. And while the banking system "merely" earns the interest on these deposits, it continues to earn the interest in perpetuity. And furthermore, it doesn't really matter how modest the percentage rate is at which the fractional reserve banks earn back the money injected into the system... the point is that they are earning interest on money that they did not have to acquire through either income or through credit to a depositor... money created out of thin air.

To understand why that matters, imagine you had some special legal privilege whereby you could write a check of any size regardless of what was in your account... with the catch that the check had to be paid back in one year with, say, 1% interest. Now, as long as you can go out into the market and give a loan for more than 1%, you can make a guaranteed profit at no risk to your assets... precisely because you are not backing your loans with assets at all! You're just writing a check. "Here, Mr. Jones, I hereby loan you $1M." In one year's time, Mr. Jones must repay you $1.2M, you must redeposit $1.1M to the bank, leaving a handsome $100K profit on non-existent money. Meanwhile, any of your would-be competitors must actually first accrue $1M before they can loan it out, at 2% or any other rate. They might accrue it by saving their own cash or by convincing other small investors to pool their cash together, or whatever. But the point is that they can't just write a check for $1M out of thin air. So, what do you think the inevitable consequence of this kind of behavior will be on the loan market? It will be monopolized forthwith as the "small-timers" are squeezed out by their inability to compete with artificially low interest rates and the massive expansion of thin-air-based credit.

The central bank can write checks out of thin-air. That's its whole raison d'etre. The commercial banks can't do that but they can do something almost as good... take as many loans as they please from the central bank (who writes checks out of thin-air) and then re-loan that money out to people who can neither write checks out of thin-air nor take loans directly from somone who can (the central-bank). In the process, the money multiplication occurs as depositors engage in a tangled chain of deposit-borrow-deposit-borrow for every dollar that emanates from the central bank. Thus, every $1M check the central bank writes out of thin-air has the potential to become $10M in deposits in the commercial banking system.

From the horse's mouth.

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Southern replied on Mon, Mar 4 2013 9:52 AM

 

1. The savers deposit their money into the banks @ 5%
    Borrower + Bank + Saver + Everyone Else = Society
  Begin $0.00   $0.00   $1,000.00   $9,000.00   $10,000.00
        $1,000.00   ($1,000.00)        
  End $0.00 + $1,000.00 + $0.00 + $9,000.00 = $10,000.00
                     
2. There is a 10% reserve requirement so banks lend 90% of deposits to the Borrowers @ 10%.
    Borrower + Bank + Saver + Everyone Else = Society
  Begin $0.00   $1,000.00   $0.00   $9,000.00   $10,000.00
    $900.00   ($900.00)            
  End $900.00 + $100.00 + $0.00 + $9,000.00 = $10,000.00
                     
3. The Borrowers then buy goods and services from Everyone Else expecting a 15% return.
    Borrower + Bank + Saver + Everyone Else = Society
  Begin $900.00   $100.00   $0.00   $9,000.00   $10,000.00
    ($900.00)           $900.00    
  End $0.00 + $100.00 + $0.00 + $9,900.00 = $10,000.00
                     
4. Everyone else buys goods and services from the Borrowers at the expected 15%.
    Borrower + Bank + Saver + Everyone Else = Society
  Begin $0.00   $100.00   $0.00   $9,900.00   $10,000.00
    $1,035.00           ($1,035.00)    
  End $1,035.00 + $100.00 + $0.00 + $8,865.00 = $10,000.00
                     
5. The Borrowers repay the Banks.
    Borrower + Bank + Saver + Everyone Else = Society
  Begin $1,035.00   $100.00   $0.00   $8,865.00   $10,000.00
    ($990.00)   $990.00            
  End $45.00 + $1,090.00 + $0.00 + $8,865.00 = $10,000.00
                     
7. The Banks repay the Depositors.
    Borrower + Bank + Saver + Everyone Else = Society
  Begin $45.00   $1,090.00   $0.00   $8,865.00   $10,000.00
        ($1,050.00)   $1,050.00        
  End $45.00 + $40.00 + $1,050.00 + $8,865.00 = $10,000.00
                     
8. The Bank then pays its employees, shareholders,dividends, expenses, etc.
    Borrower + Bank + Saver + Everyone Else = Society
  Begin $45.00   $40.00   $1,050.00   $8,865.00   $10,000.00
        ($40.00)       $40.00    
  End $45.00 + $0.00 + $1,050.00 + $8,905.00 = $10,000.00

Maybe this will help illistrate how it works.  Banks dont accumulate cash indefinitely.  They will maintain a certain level of capital but in the end it all goes back into the economy, because bankers cant eat money.  They will buy goods and services from everyone else.

 

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mickanomics replied on Mon, Mar 4 2013 4:11 PM

Clayton, I'm sorry but your understanding of the monetary system is wrong in a great many ways. The "from the horses mouth" document is simplified teaching material - and the choice of simplifications are not good. Watch this http://www.youtube.com/watch?v=CI5CFQXJxcA

 

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Clayton replied on Mon, Mar 4 2013 4:43 PM

@mick: Hmm, I watched your video and saw nothing I disagreed with, so I'm at a loss as to how you concluded that almost everything I wrote in my post is wrong. Your accent sounds British - are you in Britain? This could explain our disagreement. In the US system, the commercial banks operate under a 10% reserve ratio meaning that they do not have the ability to create money out of thin air on their own, unaided. Thus, when you go to your local banking branch and take out a loan for $100,000, the bank must really have $100,000 in assets backing this loan.

Under the Bank of England system, (which I believe is modeled throughout the empire and former empire, such as CA, AU, NZ, etc), there is no reserve ratio - which means that banks may loan out as much as they are permitted to, under the regulations. Thus, a bank may have outstanding loans far in excess of its assets, which is the essence of "creating money out of thin air".

As far as the dynamics of continual money creation/destruction, I don't believe my post actually touched on that, but this feature is shared by all central banking systems. Whenever a loan is repaid, the "money" associated with that loan is, in essence, destroyed. This is as true under the US system with a non-zero reserve ratio as it is in any other system.

In the US, the economy-wide control for the total rate of money creation/destruction is the bond market - whenever the Federal Reserve enters the bond market as a buyer, the money supply is increased, and vice-versa. But the key is that the money supply is further increased by money multiplication through inter-bank loans. I don't know how it works in the British system though I can't imagine that it is substantially different.

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mickanomics replied on Mon, Mar 4 2013 5:20 PM

"US system, the commercial banks operate under a 10% reserve ratio meaning that they do not have the ability to create money out of thin air on their own, unaided."

In the US there are minimum reserve ratios (not sure its 10%) on some types of loan and on others its zero. Even if it were 10% across the board, it still wouldn't put a cap on money creation because of reasons that are not apparent from the simplified textbook description. There are top quality peer reviewed papers and writings of central bankers that would concur.

"Thus, when you go to your local banking branch and take out a loan for $100,000, the bank must really have $100,000 in assets backing this loan."

That's actually not true on a second by second basis. The banks can temporarily break the rules and patch things up later (not mentioned in the simplified textbooks). This break-rules-then-patch-up-later creates a leak which prevents the money multiplier model from working (there are other leaks too).

 

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Clayton replied on Mon, Mar 4 2013 5:57 PM

@mick: Cool - can you point me to any specific info on the varying reserve requirements by loan type? I know you have the links on your site(s) but there are actually quite a few links and I don't have time to sort through them just to find this one data point.

And to be clear, when you say "prevents [it] from working" what you mean is working as a money cap, not working as a money multiplier, which it indeed does do, that is, the power to create money out of thin air is itself the most unlimited conceivable "money multiplier" of all.

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mickanomics replied on Mon, Mar 4 2013 6:16 PM

@Clayton:

Source - http://www.federalreserve.gov/monetarypolicy/reservereq.htm

I mean prevents the multiplier acting as a cap.

 

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