Friday, 5 March 2021

Fractional reserve banking causes excessive debts.


There is a widely accepted view that the existing, i.e. “fractional reserve” bank system, is partially responsible for the amount of debt owed by households and other entities in the private sector. Indeed, the latter “excessive debt” charge is one of the basic points made by advocates of full reserve banking, the alternative to fractional reserve.

For a list of about sixty economists who oppose fractional reserve and back full reserve, see here.

While I basically agree with the above sixty economists, there is a glitch in the argument they often put which could do with being rectified, as follows.

It is often claimed that the right that private banks have under fractional reserve to print money amounts to a subsidy of those banks, which in turn leads to an unjustified expansion in the whole lending and debt creation process. For an example of that sort of claim, see the second half of p.31 of “Creating New Money” by Joseph Huber and James Robertson.

In addition, critics of fractional reserve often argue that there is something much worse involved in fractional reserve than the latter subsidy: fraud. That is, a fractional reserve bank is one which (among other things) accepts deposits, 2, grants loands, and 3, tells depositors that their money is safe, which it quite clearly cannot be: reason is that when a bank makes enough silly loans (and banks have done that regular as clockwork for at least five hundred years), the relevant bank CANNOT repay depositors their money.

However, if a bank were to engage in the latter “accept deposists and lend” activity and tell depositors that the bank will do its best to ensure depositors’ money is safe, while not ACTUALLY PROMISING to be able to repay depositors their money, that would be an entirely open and honest free market transaction. Ergo there is, at least in a sense, nothing wrong with money creation by private banks: i.e. there is nothing wrong  with letting banks create the latter sort of INSECURE money.

The problem  comes however, when governments get involved. That is, when depositors lose money, there’s an outcry and demands are made that government should do something, which of course they do in the form of implementing taxpayer backed deposit insurance and multi-billion dollar bail outs for banks.

And that is a subsidy – for several reasons. First being insured by an insurer with  an infinitely deep pocket, i.e. the right to grab limitless amounts of money off taxpayers, is a subsidy. Second, multi billion dollar bail outs are clearly a subsidy.

Third, banks are actually just one type of lender: there are also for example pension funds and mutual funds which lend to corporations when the former funds buy corporate bonds. There’s no multi-billion dollar bail outs for those funds when things go wrong. Thus deposit insurance and bailouts amount to preferential treatment for one type of lender, and that ipso facto is a subsidy of the latter lender.

So to summarise, the subsidy of banks that occurs under fractional reserve does not lie in the fact of private banks being allowed to create / print money as long as that money creation is confined to the above mentioned relatively INSECURE form of money.

The subsidy occurs when government gets involved and tries to turn that insecure form of money into near totally secure money, backed by the right, where necessary, to extort money from taxpayers. And I'm pretty sure that point was missed in the above "Creating New Money" work.

So is central bank created money also subsidised?

And from that it might be deduced that, by approximately the same token, a subsidy is involved when the state creates money in a slightly different way: i.e. has its central bank create money (so called “base money”) with that money being spent into the economy. Certainly George Selgin seems  to make the latter claim.

Well the answer to that is that creating and spending money in the latter way does not NECESSARILY  involve preferential treatment for any given sector of the economy. Of course government and its central bank CAN CHOOSE to use new central bank money to favour a particular sector, but that form of money does not OF ITS NATURE involve a subsidy of any  one sector in the same way as fractional reserve banking plus bank bail outs involves a subsidy of private banks.

For an example of using new central bank money to favour a particular set of people, perhaps the most obvious and large scale recent example is QE, which has raised asset prices and which has been a boon for the rich.  

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