Friday, 27 January 2012

Fractional reserve causes artificially low interest rates.

The argument put here for thinking that fractional reserve causes artificially low interest rates is a much expanded version of the argument I put here.

But first, let’s be clear on the various possible money regimes, of which four are thus.

1. A commodity based regime where the commodity based currency (e.g. gold coins) are the only form of money. In this regime, the gold coins are also the monetary base.

2. A commodity based regime where commercial banks build a pyramid of credit on the monetary base.

3. A fiat monetary base without commercial banks building a pyramid of credit on the base. This is the sort of regime that most present day advocates of full reserve want.

4. A fiat monetary base regime where commercial banks build a pyramid of credit on the base (which is the regime in most countries nowadays).

A fiat base regime.

Let us assume fiat base regime and that the base is large enough to ensure full employment, but not so large as to cause excessive inflation. (The full employment assumption is dropped a few paragraphs hence.)

As the economic text books explain, people and firms hold money for two motives: the precautionary and the transaction motive. Assuming everyone aims to keep these two stocks constant, then lenders can lend only by forgoing consumption. Thus the rate of interest charged by lenders will reflect the pain involved in this forgone consumption. And the advantage of that is that (at least at the margin) the benefits of any investment are equal to the cost in terms of the pain involved in forgoing the consumption needed to make the investment possible.

At any rate, let’s say that rate of interest in our hypothetical “monetary base only” economy is 5% for essentially risk free loans.

Enter commercial banks.

Now let us assume that commercial banks enter the scene. What banks do, amongst other things, is to offer loans (normally on the basis of collateral, of which property is the most common form). But no one needs to forgo consumption for a bank to lend, or so it would seem! Thus the bank will be happy to lend at a lower rate than those who forgo consumption in order to lend. A bank takes the title deeds of someone’s property, creates money out of thin air, and lends it to the person concerned.

Or as Murray Rothbard put it (and putting himself in the shoes of a banker) “I can charge a lower rate of interest than savers would. I don't have to save up the money myself, but can simply counterfeit it out of thin air.” (BTW: I don’t normally agree with Austrians!)

Let’s say banks can cover their costs by lending at 2%.

Some people are FORCED to reduce consumption.

Next, when the borrower spends what they have borrowed, the effect is inflationary (given the above full employment assumption). Hence government has to withdraw some monetary base to compensate, e.g. by raised taxes. Thus the reduced consumption that must take place to make room for the borrower to spend is FORCED onto those paying extra taxes.

So the net effect is that commercial bank created money displaces central bank money. Friedman alludes to this sort of effect when he says, “Private promises to pay the monetary commodity are as good as the monetary commodity itself – so long as they command widespread confidence that they will be fulfilled – and far cheaper to produce, since the issuers can meet possible demands for redemption by keeping on hand an amount of the monetary commodity equal to only a fraction of their outstanding promises. A pure commodity standard therefor tends to break down.” (That’s in Chapter 1 of his book “A Program for Monetary Stability”).

He goes too far in saying the “commodity standard breaks down”: the gold standard did not break down for the reason given by Friedman: it “broke down” because of a POLITICAL decision. However, and to repeat, Friedman alludes the sort of effect described here.

Anyway, commercial banks certainly will try to induce an economy to make maximum use commercial banks’ money and minimum use of the monetary base.

And this tussle between the two forms of money was played out in dramatic fashion when Abraham Lincoln issued green backs to fund his side in the American civil war. Commercial banks didn’t like it. See here, in particular the paragraph starting, “Abraham Lincoln. From this we see….”

Expansion of commercial bank loans versus a steady state.

The above way in which some consumers are FORCED to reduce consumption so as to make room for an EXPANSION in commercial bank loans must be distinguished from the scenario where commercial bank loans are NOT EXPANDING.

In the latter scenario, commercial bank loans presumably have no effect on demand because the creation of new loans is balanced by the repayment of existing loans. (See Steve Keen for more on this.)

But there is a permanent effect of allowing commercial bank credit or money creation, which is that interest rates are permanently reduced: they become sub-optimum.

After all, it is profitable for borrowers to borrow at 2% and invest in something that brings a 3% or 4% return. That beats all those investments that had to make a minimum of 5% return. Also a very significant proportion of borrowers take their “return” in kind: that is, when people borrow to buy a house, the return is the utility or satisfaction derived from living in a house (or owning a house rather than renting one).

Let’s assume some unemployment.

Full employment was assumed above. Let us now assume excess UNEMPLOYMENT. Here, there are two ways of raising demand. 1, expand the monetary base. 2, expand the amount of private bank lending.

The logic of the former is thus. The BASIC PURPOSE of an economy is to provide what the consumer wants. Thus given excess unemployment, the obvious and best solution is to give the consumer more that the stuff that lets the consumer have more of what they want: i.e. give the consumer more money. (Plus, public spending needs to be expanded by the same proportion as consumer spending expands if the economic expansion is to be politically neutral – that is, not biased towards the public or private sector.)

As regards expanding the amount of private bank lending, whence the assumption that resources are best allocated by such an expansion? That makes as much sense as assuming that given excess unemployment, it’s just spending on the military or education or airports that should be expanded.

Moreover, if stimulus is effected by giving the consumer more money and expanding public spending, THERE IS NOTHING TO STOP consumers or public sector entities from using the additional funds at their disposal to borrow more, where and when they see fit.

A new equilibrium.

The net effect of introducing commercial banks is that a new equilibrium arises. It is NOT an equilibrium at which at the margin the benefit derived from investments equals the pain or disutility of forgone consumption. It is an equilibrium at which at the margin the benefit derived from investments equals the costs to commercial banks of creating credit / money. (At least that’s my theory!).

The borrower’s property IS forgone consumption.

There might seem to be a flaw in the above argument, as follows. It was argued above that the private bank creates money / credit without any consumption being forgone. But it could on the face of it be argued that the borrower DID HAVE TO forgo consumption to acquire the property used as collateral to back the loan. The answer to that is that the property is not CONSUMED during the “lend and eventually pay back” process. Put another way, the lender does not forgo the results of the saving which was needed in order to purchase the property.

By the way, I’ve assumed above that all loans are backed by collateral in the form of property, as readers will have noticed. While this is the biggest single type of collateral, obviously there are other forms. And some loans are based on no collateral at all. However that does not change the argument much.

Full reserve’s big hitters.

And finally, please note that we full reservers have some big hitters on our side. William F. Hummel is one. Irving Fischer and James Tobin also favoured full reserve according to Mervyn King – see p.16 here. Plus there is Milton Friedman and Mike Shedlock.

Bibliography – or rather a list of other works on this subject, with some quotes from some and reasons why I think some are flawed.

Brown, Ellen Hodgson.
“The Web of Debt”. This is a full length book which argues against fractional reserve. It’s full of historical detail, but it says nothing about fractional reserve bringing artificially low interest rates, far as I can see.

Huerta De Soto, Jesus. “Money, Bank Credit and Economic Cycles”. This is a full length book which argues against fractional reserve. It is available online. It has “Austrian” written all over it.

Given the length of the book, it is short on good IDEAS. For example he devotes the FIRST THREE CHAPTERS to arguing that fractional reserve breaks legal principles. Well there is a simple answer to that. The important question relating to any activity is WHETHER ON BALANCE IT BRINGS BENEFITS. If it does, and in doing so, a legal principle is broken, then it’s the legal principle than needs amending, not the activity that should be banned.

Selgin, George. “Should We Let Banks Create Money?” Selgin is an advocate of fractional reserve, and his book is far better than Ellen Brown or Huerto de Soto’s. The book is well thought out, and sets out a detailed step by step argument.

On his p.97 Selgin DOES ADDRESS the artificially low interest point, and argues that commercial bank created money will not be inflationary if there is a DEMAND for that extra money. Agreed.

But Selgin then argues that if commercial banks lend too much, that results in creditors (i.e. those who deposit money in banks) holding more money they want, which according to Selgin means banks have to pay excessive rates of interest to persuade them keep their money there. (Exactly this phenomenon, incidentally, is spelled out by Warren Mosler in his hypothetical “parent, children and business card” economy.)

However there is a flaw in Selgin’s argument, as follows. Why should commercial banks be bothered if depositors find themselves with too much cash? The excess cash has an inflationary effect (as mentioned above), but that won’t bother banks too much. As far as commercial banks are concerned, inflation is a problem for government and central bank.

Moreover, if I can borrow at 2% rather than 5% to fund some project, I can afford to pay my suppliers a better price than someone doing a similar project and borrowing at 5%. Now if you are a supplier, and you already have your preferred stock of cash, and you spot the generous prices I’m offering for your product, you’ll just abandon those you currently supply, and take up my offer instead. Alternatively, you might opt to expand your business and supply BOTH me and your original customer. As to what you will do with the extra cash: well that’s not difficult: you’ll spend it on wine women and song – or something like that! And that will raise demand.

This is not to suggest that fractional reserve leads to instant hyper-inflation: clearly it does not. Amongst other reasons, that is because of the well known fact that if any INDIVIDUAL bank expands its lending much faster than its rivals, it is in trouble.

In fact the pace at which commercial bank money in the UK over the last few decades has grown in prominence compared to central bank money has been very leisurely.

The M0/M4 ratio declined from about 16% in 1969 to about 3.5% in 2000 (see here). Incidentally that decline in the importance of M0 is not explained to any great extent by the reduced use of physical cash. Physical cash as a proportion of M0 decline from around 10% in 1970 to roughly 2% in 1997 (see Chart 1 here – you’ll have to do your own calculations to check this).



  1. "Next, when the borrower spends what they have borrowed, the effect is inflationary"

    Why are the credit licences in your economy allowing this?

    The money supply as a whole (credit money + fiat money) must not generate a flow greater than the capacity of the economy. If you have 100% fiat money in the system, then you need to have 100% reserve requirement and a closed discount window.

    So the fault is in the licences issued to the commercial banks to print money. You need to tighten them up

  2. Neil, OK – you could tighten up the credit licences. But they’d need to be tightened up to the extent of not allowing commercial banks to create credit / money and lend it out – which is exactly what full reserve consists of.

  3. While I appreciate the general aims you want to achieve (full employment, etc.), I am afraid the flaw that runs through the first part of your post is the assumption of the economy running at full capacity (no unemployment, no idle resources, no unused stocks/inventories of goods, no unused capacity at plants). In reality, capitalism generally has many idle resources and is far from an equilibrium state.

    Equilibrium states are pure fiction.

    "Next, when the borrower spends what they have borrowed, the effect is inflationary (given the above full employment assumption)"

    What about international trade? If inflationary pressures build up this is how in real life they get reduced.

    "But no one needs to forgo consumption for a bank to lend, or so it would seem! Thus the bank will be happy to lend at a lower rate than those who forgo consumption in order to lend. A bank takes the title deeds of someone’s property, creates money out of thin air, and lends it to the person concerned. "

    (1) You appear to be subscribing to the pure time preference theory of interest rates - this is an erroneous idea. Interest is merely the price of borrowing money. Whether actual real resources exist is a totally different question.

    (2) FRB is not fraud, although you say you don't follow the Austrian view of this.

    Anyway, the monetary production economy with growth requires a growing money supply:

  4. Lord Keynes,

    First – for the benefit of those who don’t know who “Lord Keynes” is, he runs a high quality blog. It is good (amongst other things) at demolishing various aspects of Austrian economics and at demolishing some of the sillier anti fractional reserve arguments. See:

    Re my full employment assumption, I meant this in what I think is the normal sense, in other words an economy with as high a level of employment as is feasible before inflation becomes serious. I certainly didn’t mean “no unemployment”. As to other resources, I’m well aware of those charts which show plant capacity utilisation never rising much above 80% even when unemployment is unusually low.

    Re equilibrium, I didn’t mean to suggest that absolutely everything at the micro economic level is at equilibrium. Even at the full employment “equilibrium” there are, for example, obviously hundreds of firms going bust every week and hundreds of others starting up.

    In other words I meant equilibrium at the macro level. Obviously that is unrealistic in that economies never are at equilibrium even at the macro level, but it’s common practice to make simplifying assumptions in economics and other subjects.

    Re international trade, I should have made the closed economy assumption to keep things simple. But even if an economy is open, I suggest that the availability of imported stuff does not ameliorate inflation. Reason is that if more is imported, the currency declines, which in turn raises the cost of imports, which is inflationary.

    It’s true that if a close economy is opened up to international trade FOR THE FIRST TIME, THAT CERTAINLY WILL improve the inflation / unemployment relationship. Reason is that the above balance of payments deterioration probably won’t occur because increased imports are likely to be matched by increased exports. But that’s a different point entirely.

    Re your “(1)”, I don’t understand.

    Re (2), I didn’t mean to suggest that fractional reserve is fraudulent, and I don’t think I said that. In fact under the heading “Huerto do Soto” above, I point out that I think the first three chapters of his book (which argue that fractional reserve is fraudulent) are hot air. Incidentally I also think the standard Austrian “lengthening the production process” idea to which de Soto devotes thousands of words is hot air as well. Obviously production processes do tend to lengthen given low interest rates, but this is just one example of the blindingly obvious point that the lower are interest rates, the more firms will invest all else equal.

    Re the idea that growing economies require a growing money supply – agreed. I should have mentioned that. But under full reserve, that is easily arranged by having the monetary base expand a small amount annually.

  5. Read Mish Shedlock on this whole subject. Here is the link - Mish is a money manager not an academic, but he is very well read and quite entertaining. Anyone of his his primal screeds lambasting fractional reserve is well worth the read!


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