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Home | Blog | Fractional-Reserve Banking and Money Creation

Fractional-Reserve Banking and Money Creation

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Tags Money and Banking

06/16/2017

According to traditional economics textbooks, the current monetary system amplifies initial monetary injections of money. The popular story goes as follows: if the central bank injects $1 billion into the economy, and banks have to hold 10% in reserve against their deposits, this will allow the first bank to lend 90% of this $1 billion. The $900 million in turn will end up with the second bank, which will lend 90% of the $900 million. The $810 million will end up with a third bank, which in turn will lend out 90% of $810 million, and so on.

Consequently the initial injection of $1 billion will become $10 billion, i.e., money supply will expand by a multiple of 10. Note that in this example the central bank has actively initiated monetary pumping of $1 billion, which in turn banks have expanded to $10 billion.

But in a world where central banks don't target money supply but rather set targets for the overnight interest rate (e.g. the federal funds rate in the United States and the call rate in Japan) does this continue to make sense? Additionally, in some economies like Australia banks are not even compelled to hold reserves against their deposits. Surely then the entire multiplier model in the economics textbooks must be suspect.

Indeed, economists from the post-Keynesian school of economics (PK) have expressed doubt about the validity of the popular framework.

It is argued that the key source of money expansion is the demand for loans together with the willingness of banks to lend.

The supply of loans, in this way of thinking, is never independent of demand — banks supply loans only because someone is willing to borrow bank money by issuing an IOU to a bank.

Accordingly, the driving force of bank credit expansion and thus money supply expansion is the increase in the demand for loans and neither the money multiplier nor the central bank. Bank lending is not constrained here by reserves that are injected by the central bank, but by the demand for loans.

Is this objection valid?

Fractional-Reserve Banking and Creation of Money

Let us say that an increase in the demand for loans has taken place. How is a bank going to accommodate this increased demand? One way is by borrowing in financial markets or by raising equity funds. Another way of funding this increase is by using part of deposited money.

Note that banks are legally permitted to use some of the money that is placed in demand deposits. Banks treat this type of money as if it were lent to them.

For instance, if John places $100 in demand deposit he doesn't relinquish his claim over the deposited $100. He has an unlimited claim against his $100. This demand deposit should be properly regarded as not different from money in a safe deposit box. Hence, when a bank uses the deposited money as if it were lent to him the bank generates another claim on this deposited money.

Let us say that a bank lends $50 to Mike. By lending Mike $50, the bank creates a deposit for $50 that Mike can now use.

This in turn means that John will continue to have a claim against $100 while Mike will have a claim against $50. This type of lending is what fractional reserve banking is all about. The bank has $100 in cash against claims, or deposits, of $150. The bank therefore holds 66.7% reserves against demand deposits. The bank has created $50 out of "thin air" since the $50 is not supported by any genuine money.

A case could be made, however, that people who place their money in demand deposits do not mind banks using their money. Notwithstanding all this, as long as people trade, there will always be a demand for money, which will be held either in cash or in bank demand deposits.

Consequently, regardless of people's attitudes, once banks use deposited money, an expansion of money that is not backed by ‘real’ money is set in motion.

Although the law allows this type of practice, from an economic point of view it produces a similar outcome to that achieved by the counterfeiter. It results in money out of "thin air" which leads to consumption that is not supported by production i.e. the dilution of the pool of real wealth.

On this Mises wrote,

It is usual to reckon the acceptance of a deposit which can be drawn upon at any time by means of notes or checks as a type of credit transaction and juristically this view is, of course, justified; but economically, the case is not one of a credit transaction ... A depositor of a sum of money who acquires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to, has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him. The depositing of money in no way means that he has renounced immediate disposal over the utility that it commands.1

Similarly, Rothbard argued,

In this sense, a demand deposit, while legally designated as credit, is actually a present good — a warehouse claim to a present good that is similar to a bailment transaction, in which the warehouse pledges to redeem the ticket at any time on demand.2

Why the Existence of a Central Bank Permits Fractional-Reserve Banking

Let us say that for whatever reason banks are experiencing an increase in the demand for loans. Also, let us assume that the supply of loanable funds is unchanged. According to PK, banks will facilitate this increase. The demand-deposit accounts of the new borrowers will now increase.

Obviously the new deposits are likely to be employed in various transactions. After some time elapses, banks will be required to clear their checks and this is where problems might occur.

Some banks will find that to clear checks they are forced either to sell assets or to borrow the money from other banks (remember the pool of loanable funds stays unchanged).

Obviously, all this will put an upward pressure on money market interest rates and in turn on the entire interest-rate structure. To prevent banks bankruptcy the central bank will be forced to pump money e.g. through open market purchases of securities. Once the central bank starts pumping money it in fact gives the green light to the money multiplier process (the creation of credit out of "thin air"). So the conceptual outcome as depicted by the multiplier model remains intact here. The only difference is that banks initiate the lending process, which is then accommodated by the central bank.

If the multiplier process requires the support of the central bank then one can infer that, in a free market without the central bank, the likelihood of such a process emerging is not very high.

In a free market, if a particular bank tries to expand credit without backup from a genuine lender — i.e., by practicing fractional-reserve banking — it runs the risk of not being able to honor its checks, which raises the risk of bankruptcy.

  • 1.  Ludwig von Mises 1980, The Theory of Money and Credit. Indianopolis, Ind: Libery Classics( pp300-01).
  • 2. Murray N. Rothbard 1978, Austrian definitions of the supply of money, in New Directions in Austrian Economics p 148.

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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