Tuesday, 16 October 2012

“Debt based money” exacerbates indebtedness?

Summary. There is a widespread belief that every dollar of money under fractional reserve is matched by a dollar of debt, and hence that fractional reserve increases the total amount of debt. This story is pushed by two books: “The Grip of Death” by Michael Rowbotham and “The Web of Debt” by Ellen Brown.

The above idea is flawed, but that THERE IS a mechanism via which fractional reserve results in more debt (and lower interest rates) than full reserve. This is that when fractional reserve is introduced to a full reserve system (or when fractional reserve banks are in irrational exuberance mode) those banks can create and lend out money created from thin air at below the going rate of interest (a phenomenon alluded to by George Selgin and Messers Huber and Robertson.)


When a commercial bank makes an $X loan, it does not need to “get the money” from anywhere: it can simply take collateral off the borrower and credit the borrower’s account with $X created out of thin air.

But commercial banks do not necessarily create ALL THE MONEY for loans out of thin air. That is, in addition to creating money, commercial banks are clearly in the business of connecting borrowers and lenders. Thus some of the money for loans comes from lenders (i.e. those depositing money in banks). And the relative importance of those two varies from year to year. For example over the last two years or so, deleveraging has taken place on a big scale, thus little or no thin air money has been created by commercial banks.

The flaw in the debt based money idea.

So banks engage in two distinct activities: money creation and connecting lenders and borrowers. Let’s take money creation first.

Suppose a country has no form of money, and the population decides it wants the advantages of trading via money rather than barter. Suppose also that no one wants to lend or borrow.  They decide to set up organisations called “banks” whose job it is to take collateral off those wanting money, and credit the accounts of those people. The actual value of the money unit chosen to start the process would not desperately matter: the value of a gram of gold or kilo of aluminium would do. Though whether the country subsequently stuck to the gold or aluminium standard is a separate issue.

In that scenario, people would not owe banks any more than banks owed people: that is, a bank would owe each person in that banks would promise to return the collateral if and when someone wanted to cancel the arrangement, and people would likewise promise to return the “loan” to banks when they wanted to cancel the arrangement.

Moreover, there is absolutely no reason for banks to charge interest in that scenario. That’s because banks would not need to pay interest to anyone to “obtain” the money: the money is created out of thin air. All that banks would charge would be administration costs (plus the usual profit that any business expects to make if the banks were commercial operations rather than mutual operations like some British building societies). And if no interest is charged on a so called debt, what’s the big problem with such debt? None! I’m happy to be in debt to tune of a trillion trillion as long as I don’t have to pay interest.

And not only that, but no REAL LENDING OR BORROWING has taken place. By “real” lending, I mean one person abstaining from consumption so as to enable another, the borrower, to consume resources over and above what the borrower has actually earned or created.

Real lending and borrowing.

As distinct from money creation, banks in the real world are (to repeat) also involved in connecting lenders and borrowers. Lenders always try to get interest on sums lent, and normally succeed. To the extent that they succeed, banks have to charge interest to borrowers, plus banks have to charge for administration costs, bad debts, etc.

But it’s nonsense to claim that because banks charge interest to BORROWERS, that therefor banks charge interest to those who want $X credited to their account simply to enable them trade via money rather than via barter.

Of course, if someone who has had $X credited to their account goes and spends a significant proportion of it, there must be someone else doing the opposite: i.e. lending. And if that “lender / borrower” relationship lasts for any time, the lender will want interest. In contrast, as long as the person who has had $X credited to their account just treats the money as a float, with the actual balance fluctuating fairly quickly between $X+ and $X-, no one will regard the so called debt as any sort of permanent debt on which the creditor demands interest. Indeed, this situation exists in the real world in that trade creditors normally allow trade debtors at least a month of grace before interest is charged.

Another way in which that sort of situation also exists in the real world, is thus. Suppose I gave a bank extremely good collateral in exchange for the bank giving me some “float money”.
Suppose also that the bank charges me interest only in proportion to the time and amount by which the float is below the initial amount agreed (as actually happens with some overdraft facilities at some banks). Suppose also that when I have surplus funds, I put them in a deposit account which earns the same interest as I’m charged when my float is below the initial amount.

In that scenario, I could end up paying no interest at all!

In short, fractional reserve banks charge for the ADMINISTRATION COSTS involved in creating money, but a bank which gets its costings right would not charge INTEREST on its money creation activities as opposed to its lending activities.

How fractional reserve increases indebtedness.

So does the above argument totally demolish the claim that fractional reserve increases indebtedness? The answer is “not quite”. That is, there IS ONE route via which fractional reserve does increase debts, but it’s not the above one.

This route was actually set out (sort of) by George Selgin and Messers Huber and Robertson.  As the latter pair point out, “Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves.”

I would just add to that that the difference between the going interest rate and the zero rate referred to by H&R would not accrue SIMPLY to banks in the form of profit: competitive forces would force banks to share part of the profit with borrowers and lenders. I.e. H&R should have said something like “the difference between the going interest rate and zero will tend to depress interest rates”.

As to Selgin, he makes a similar point. As he explains, when fractional reserve is introduced to a full reserve system, banks can initially go on a lending orgy, which causes inflation until the monetary base is reduced to a value that is just enough to enable commercial banks to settle up between themselves.

The relevant passages in Selgin and H&R are respectively as follows.

For Selgin, it’s the third paragraph starting, “Perhaps the simplest….” – (although his first two paragraphs are quite short, so there’s no harm in starting at the beginning of his paper). And for H&R, it’s p.31, last paragraph: “Allowing banks to create…”

In short, under fractional reserve, interest rates are lower and more borrowing takes place than under full reserve.

So which system, full or fractional reserve, is better? My answer is that (as explained here) however safe fractional reserve is, there is always a finite risk that banks fail, and that risk is covered by taxpayers. I.e. fractional reserve just can’t work without a subsidy. And a subsidised business does not make sense unless there are clear social reasons for the subsidy - as is the case with health care and education.


P.S. (next day – 17th).

There is a point arising from the passage above which read:

“Of course, if someone who has had $X credited to their account goes and spends a significant proportion of it, there must be someone else doing the opposite: i.e. lending. And if that “lender / borrower” relationship lasts for any time, the lender will want interest.”

The point is thus. Where a depositor wants a significant amount of interest on their money its quite likely their so called money will not be actually counted as money – though whether it actually IS COUNTED as money depends on the category of money concerned (M0, M1, M2, etc) and the country concerned.

But in general terms, the more difficult it is for a depositor to get money out of a deposit account, the more the interest they will get, and the more their relationship with their bank and those the bank lends to is a creditor/debtor relationship rather than a “float” arrangement.

In short, and to oversimplify the above point a bit: money is not debt based.

P.S. (7th Nov 2012). The basic idea advocated in the above post, namely that debt based money does not increase the total amount of debt is supported by two Fed charts. These seem to indicate that lending by banks accounts for only about one tenth of the total amount of lending or debt. (Hat tip to Angry Bear)


P.S. (30th Jan, 2013). 

George Selgin (p.52/3) goes into the above mentioned distinction between money which depositors hold essentially as an investment (i.e. a loan to those borrowing from their bank), and in contrast, money held for TRANSACTION purposes.

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