In an economy where just government and central bank create money, private banks can easily steal the right to create money from government. Irving Fisher called this the “usurpation of government’s prerogative”*.
George
Selgin (ironically a leading advocate of fractional reserve) explains how
private banks do this. His explanation, which I agree with, is that where
fractional reserve is introduced to a full reserve economy, the result is a
temporary bout of excess inflation, which reduces the value of government /
central bank produced money to near nothing, at which point the excess
inflation stops. And that’s the end of the story according to Selgin. I’ll
argue below that the excess inflation might continue, absent government
intervention to stop it.
Under a real
world gold based currency (as existed for example in England in the 1800s)
serious inflation is prevented by the fact that market forces won’t allow the
price of gold to vary to any huge extent relative to other goods. (The price of
bread in England at the end of the 1800s was the same as at the beginning).
Selgin gets
round the latter awkward fact in his hypothetical economy by assuming a
constant demand for gold regardless of its price relative to other goods.
That is a
bit unrealistic, though it doesn’t invalidate his basic point. It would have
been better in the hypothetical economy to have had monetary base in the form
of fiat currency: the value of that can easily be eroded by inflation. So in
the rest of this article, I’ll assume a
fiat currency: after all, that is the type of currency in all major economies
nowadays.
So inflation
rises in the hypothetical economy. However, the inflationary episode comes to
an end according to Selgin when the real value of the monetary base has been
reduced to a level just sufficient to enable commercial banks to settle up with
each other.
I don’t
agree. Reason is that private banks don’t actually need any reserves at all in
order to settle up. Certainly the fact of having reserves at the central bank
and having a central bank provided “settling up system” is CONVENIENT. But
absent that system, banks could easily set up their own settling up system.
As to what
they’d use for settling up, any type of asset would do: shares, bonds or bank
branch buildings. Or in extremis, a badly indebted bank could hand over
ownership of its head office building to creditor banks. Ultimately the debtor
bank’s assets might decline to a level where the most sensible option would be
for creditor bank(s) to take over the debtor bank.
The latter
system would not involve so much INSTANT settling up at the end of every day.
But that wouldn’t matter as long as banks trusted each other. That is
“unsettled up debts” could be left in place for weeks or months, and in many
cases those debts would be netted off against debts owed by creditor banks to
debtor banks. Indeed, this sort of “not
settling up immediately” happens currently on a large scale in that there is a
huge amount of inter-bank lending.
Anyway, Selgin
then claims implicitly that there are no further effects after the temporary
burst in inflation. I suggest THERE ARE further possible effects: possibly
leading to a permanent rise in inflation.
Individual
banks versus the banking system.
It is
important to note that the constraints facing an INDIVIDUIAL BANK are very
different to those facing the private banking system (PBS) as a whole. Selgin
rightly refers to these differences over and again in his book, “The Theory of
Free Banking”. In particular, an INDIVIDUAL BANK cannot expand the amount it
lends RELATIVE TO the rate at which other banks are expanding without
experiencing a drain on its reserves.
However,
I’ll assume to keep things simple that given plenty of creditworthy borrowers,
EVERY BANK expands at about the same rate. So the argument below is just about
the PBS.
Interest
paid to depositors.
Strictly
speaking, if every bank is equally efficient and expands at the same rate,
there is no reason for banks to pay any interest to depositors. That is, the
only reason banks pay interest is that if they lose depositors to other banks,
they also lose reserves (or “branch buildings”). And if all banks are equally
efficient and expand at the same rate, there is no reason for depositors to
move money from one bank to another.
But I’ll
assume that banks pay some finite rate of interest to depositors (which might
be zero or might be more than zero).
Anyway . .
fractional reserve is introduced and inflation reduces the monetary base to a
small portion of the total money supply.
There are
then three possibilities. 1. The desire by depositors to save cash produces
enough cash to supply all credit worthy borrowers with just the funds they need
at the prevailing rate of interest. That’s an equilibrium. 2, the amount depositors want to save exceeds
the amount borrowers want to borrow, and 3, the latter exceeds the former. I’ll
take those three in turn.
Re No.1,
that has the merit, to repeat, of being an equilibrium.
2. If the amount
that credit worthy borrowers want to borrow is LESS THAN the amount that savers
voluntarily save at prevailing rate of interest, the effect would be
deflationary. Government would have to print and spend money into the economy. But
that’s not a big problem. It would just mean that the monetary base would be
larger than the amount banks needed to settle up between themselves (a
situation that prevails in the real world at the time of writing).
An
alternative, which produces the same end result, is that scenario No.2 is
operative DURING Selgin’s temporary bout of inflation. In that case, the bout
of inflation would not last long enough for the base to decline to the minimum
level that banks need to settle up).
3. If the
total that creditworthy borrowers want to borrow EXCEEDS the amount that savers
voluntarily want to save, PBS will simply lend money into existence to meet
borrower’s requirements. But that will result in depositors having more money
than they want (because “loans create deposits” as the saying goes). So
depositors will spend the excess, which will be inflationary. But that in turn
means the REAL VALUE of loans by banks to borrowers declines. And assuming that
the value of loans needs to stay constant in real terms, then banks will lend
even more money into existence. Now that’s an inflationary spiral: it’s a
feed-back loop.
To summarise
No.3, where the amount that non-bank private sector entities want to borrow
exceeds the amount of cash and deposits at banks that savers / depositors want
to hold, an inflationary spiral takes hold.
As for evidence
that the latter phenomenon actually occurs, the Chinese government at various
times in recent years has been concerned at the inflationary effects of
excessive bank lending. And in Britain there have been numerous occasions since
WWII on which government has clamped down on lending.
And finally,
if the above argument is correct (which is a big “if”), having the central bank
raise interest rates will not curtail lending. That is, to the extent that
commercial banks can by-pass the central bank’s settling up system, commercial
banks just aren’t bothered about what the central bank pays for borrowing back
it’s own money: PBS can just fire ahead and lend money into existence willy
nilly.
I.e. in the
above excess inflation scenario, it is QUANTITATIVE controls on lending that
are required, rather than PRICE CONTROLS (exactly what the Chinese have done on
one or two occasions in recent years).
Indeed since
the desired effect is the opposite of “quantitative easing”, I’d like to
introduce a new phrase to the English language: “quantitative squeezing”.
_______
* “100% Money and the Public Debt”, published
by Michael Shemmann, p.18.
The relevant
passage in the above work of Irving Fisher’s reads, “At present our nation’s
chief money is at the mercy of the mob rules of 15,000 banks. These are
tantamount of 15,000 private mints independently creating and destroying the
nation’s money every day, while the Government looks helplessly on at this
usurpation of its prerogative.”
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