Does Fractional Reserve Banking Involve
Counterfeiting?
A new dispute
has flared up between protagonists and detractors of fractional reserve
banking. This is a welcome development because the burning issues under the
ashes jeopardize the success of the honest money movement.
Joseph N. Tlaga challenges the long-standing position of the
Austrian School of Economics, reflecting the views of Ludwig von Mises, that the commercial banking system is creating
money "out of thin air" when it issues note and deposit liabilities
backed by fractional reserves of gold, so that if all depositors and
note-holders presented their claims simultaneously, then the banks would go
bust. In the view of the Austrians this "counterfeiting process" is
at the root of the boom-bust cycle.
I wish to
congratulate Tlaga on his courage to defy
conventional wisdom, and on his insight that there is no counterfeiting per
se involved in fractional reserve banking, so the root of the boom-bust
cycle must be found elsewhere. He goes on record as saying that the Austrians
have never grasped the real meaning of fractional reserve banking. Since
lending more than available reserves would send the bank bust in a matter of
days, the question is raised why the Austrians never re-examined their
position on this issue.
Tlaga
also observes that the incorrect perception of fractional reserve banking is
endemic. It is never questioned, and the error has been shared by too many
for too long. In particular, it is being cultivated by the fiat money
establishment as well as the banking fraternity (presumably because of one's
reluctance to dispel the myth of one's own importance, not to say
omnipotence). According to Tlaga 100 percent
reserve banking advocated by Mises would never
work. "If the misguided Austrian imperative to use police power to
enforce 100 percent bank reserves were carried out, then an immense amount of
credit would disappear instantaneously, the economy would be paralyzed, and
the honest-money movement would have to take the blame... People who stick to
the mantra that abolishing fractional reserve banking is a prerequisite for
returning to honest money should know that they are doing a disservice to the
cause..."
Horizontal Division of Labor
Unfortunately, Tlaga's demonstration that loans extended by the
fractional reserve bank do not add one iota to the stock of purchasing media
as they merely mobilize otherwise idle bank balances, does not hold water.
Brian Macker has published a short rebuttal in Mises Economics BLOG, but it hardly does
justice to this important issue.
In his argument
Tlaga uses the example of producing automotive fuel
called gasohol. The Distiller raises a number of bank loans to purchase corn,
potato, rye, and sugar cane from his suppliers who deposit the banknotes in
their banks which promptly collect the fractional gold reserve from the
Distiller's bank. Tlaga concludes that the banknote
and the gold coin cannot circulate simultaneously. In his view the banknote
is merely a substitute for, never a supplement to, the gold coin.
Tlaga's
description of what happens is erroneous. The horizontal division of labor
of the Distiller and his suppliers obscures the fact that the latter must use
the proceeds to pay their own suppliers, and are in no position to leave
large cash balances idle in the bank. If we want to decipher the mysteries of
fractional reserve banking, then we should consider vertical division
of labor and track the footprints of banknotes that way.
The truth of
the matter is that banknotes and bank deposits arising out of loans raised by
the producers do indeed add to the stock of money. They enter into
circulation and finance further transactions, as Macker
says. Still, Tlaga is right in asserting, and Macker is wrong in denying, that money created this way
did not come out of thin air.
Self-liquidating Bills of Exchange
"Fractional
reserve banking" is a misnomer as it suggests that part of the money
created through the loan process is backed by nothing. In reality, the part
not backed by gold reserve is fully backed by a bank asset called self-liquidating
bill of exchange (bill for short). As Mises
himself would admit, bills are capable of monetary circulation (as they did
indeed circulate in the Manchester area that lay outside the boundaries of
the monopoly of the Bank of England in the 19th century).
A bill is a
written promise by the Producer to pay the Supplier the face value at
maturity, less than 91 days away, for supplies shipped. When endorsed by the
Producer, the bill can circulate through further endorsing. First, the
Supplier can use it to pay his own suppliers who can, in turn, do the same.
Such payments are subject to discounting at the going discount rate (not
to be confused with the rate of interest!) by the number of days
remaining till maturity. Therefore using the bill for payment is also called discounting
it.
The Bill Market
It is important
to understand that the economy could very well operate entirely without
commercial banks (as it did in the Manchester area in the 19th century).
Suppliers would draw bills on producers and discount them in the bill market.
At maturity bills are paid in gold coins. The market would keep bill trading
under tight control. If too many "Miller on Baker" bills were
discounted, the market would refuse to trade them. If in the event the miller
and the baker conspired to finance their speculative stores of grain, they
would be blacklisted. The market would not touch any paper on which the
signature of either of them appeared. Not as if anything was wrong with speculation
in grains, but speculative stores ought to be financed through other means.
The bill market was meant specifically to finance the production of
merchandise that moved fast enough to the final consumer so
that the gold coin of the latter could liquidate all claims in less than 91
days (or 13 weeks, or 3 months, or one quarter, that is, the length of the
seasons of the year). Bills drawn on merchandise that did not move fast
enough were not eligible for discounting. The production of such slow-moving
merchandise, as well as holdings of goods in speculative stores, was supposed
to be financed by the loan market at the higher interest rate.
The bill market
would watch like a hawk that the 91-day rule was not violated. The reason for
this rule is that consumer demand changes with the seasons. Goods that could
not be sold in 91 days might not be sold for 365 days, till the same season
of the year has come around once more. But by that time consumer taste may
change, and the merchandise may be un-saleable except at a loss.
Vertical Division of Labor
The circulation
of the bill mirrors vertical division of labor. We may track it through the
example of the "Weaver on Tailor" bill. The Tailor is producing
clothes for his customers. The Weaver delivers cloth to the Tailor and bills
him. The Tailor "accepts" the bill by endorsing it, agreeing to pay
the face value in 91 days or less, and returns it to the Weaver. The Spinner
delivers yarn to the Weaver and gets paid by the same bill, after the Weaver
has also endorsed it. Through endorsement the claim to the proceeds is
transferred to the Spinner. The Sheep Farmer delivers wool to the Spinner and
gets paid by the same bill, after the Spinner has also endorsed it. The claim
to the proceeds has been transferred once more, this time to the Sheep
Farmer. In this way the bill continues its journey from supplier to supplier,
the last of whom presents it to the Tailor for payment at maturity. By that
time the latter has the gold coins from the sale of clothes to the final
consumer. When he pays the bill in gold, all claims that have arisen during
the course of this particular production cycle are extinguished.
As can be seen,
the bill has "telescoped" several payments into one, and the pool
of circulating gold coins had only to be invaded once instead of several
times. The final consumer's gold coin was all that was needed to finance the
production of the consumer good, regardless how many hands were involved in
producing it. Thus the bill makes great economy in the use the gold coin
possible. This is quite important, as a dearth of gold could threaten the
production process with seizing up. Moreover, during certain times of the
year (such as crop-moving time, or at Christmas) the existing pool of
circulating gold coins may not be sufficiently large to accommodate all
demand if it is invaded every time anybody moves a maturing product, however
briefly. The bill of exchange comes to the rescue, by providing an elastic
supply of purchasing medium. Bill circulation waxes and wanes together with
the volume of business to be transacted.
Bank Credit Financing Production Not Inflationary
As already
pointed out, every time the bill is endorsed and passed on, a discount is
applied to its face value at the going discount rate by the number of days
remaining to maturity. Thus the bill is an earning asset that banks are eager
to have. Moreover, the bill is the most liquid asset a bank can have, second
only to the gold coin itself. It is called "self-liquidating" as it
is paid at maturity with the gold coin of the final consumer. For these
reasons banks compete for the bills by offering to discount them at the best
(i.e., lowest) discount rate that is still compatible with the
profitability of the commercial banking business.
Banks replace
bills with bank deposits on which producers draw checks to pay their
suppliers. Writing checks is more convenient than discounting bills, and the
producers are glad to pay for this convenience in the form of forgone
discount. It goes without saying that the bank is not supposed to "roll
over" a mature loan even if (or, more to the point, because of) the
underlying merchandise has failed to sell. A new loan ought to be
negotiated to finance the next production cycle.
Please note
that the gold coin is absolutely essential in this system of financing the
production of merchandise in urgent consumer demand. The gold coin is the
ultimate extinguisher of debt. Without it a perpetual debt tower would keep
growing. No irredeemable currency, whether issued by a private bank, by a
central bank, or by the Treasury of a country possessing the most formidable
arsenal of weapons of mass destruction can match the debt-extinguishing power
of the humble gold coin.
I have observed
that bank deposits arising out of loans, contrary to Tlaga's
view, do in fact add to the stock of purchasing media. Does this then mean
that financing the production of consumer goods through bank credit is
inflationary? No, it does not. Inflation means the issuance of purchasing
media in excess of goods available. In the present case, the bill
emerged simultaneously with the emergence of new merchandise in urgent demand
of the same value, and would disappear from circulation at the same time as
the merchandise is sold. The net effect on the stock of purchasing media is
nil.
This is a point
which the Austrian School stubbornly refuses to admit. Its view is rigidly
governed by the untenable Quantity Theory of Money according to which any and
all credit in excess of gold in the vault plus bank capital
are inflationary. Adam Smith's Real Bills Doctrine is proscribed by
the Austrians - a most regrettable position from the point of view of the
honest money movement.
Can the banking
system, operating on the principle of fractional reserves as described above,
be embarrassed by gold withdrawals? Hardly. On average one ninetieth of the
bills outstanding mature every single day bringing in gold coins the final
consumer has disbursed in exchange for merchandise he urgently wanted. These
coins are available to satisfy normal demand for gold. If one particular bank
experiences extraordinarily heavy withdrawals, it can get gold from another
experiencing an overflow, by rediscounting bills yet to mature. As long as
the government is not out to sabotage the gold standard, and banks do not
violate the 91-day rule, the system will work smoothly and efficiently. The
charge that fractional reserve banking creates money "out of thin air"
is preposterous.
Chairman Patman's Mistake
Wright Patman, the legendary populist chairman of the Ways and
Means Committee of the U.S. House of Representative in the 1950's, made the
following erroneous statement in his 1128th Weekly Letter of April 7, 1955 , to his
constituents: "Money and credit are manufactured by the commercial
banking system. For every one dollar in reserves that a commercial bank has,
it can create six dollars of additional credit, which it can then loan and
earn interest upon."
Assuming that
the bank is required to keep a ratio of $1 of reserve against $6 of deposits
(approximately 17 percent), this does not mean that for every additional
dollar of reserve the bank obtains it could lend $6 and create $6 additional
deposits. If that were the case, then banks could earn 30 percent interest on
each dollar of surplus reserve provided that loans were made at the rate of 5
percent. Patman does not allow for withdrawals of
deposits arising from loans. However, the fact is that people do not borrow
in order to leave all the proceeds as an idle balance in the bank.
Assuming that
an average of 80 percent of deposits resulting from loans (called derivative
deposits) are drawn out and cash deposits (called primary deposits) remain
undisturbed, furthermore, that the bank is required to maintain a reserve of
17 percent against its deposits, the bank could lend only about 99½
cents for each $1 gained as a cash deposit, or approximately $1.20 for each
dollar of surplus reserve, and not the $6 alleged by Patman.
Here is the maths in full details.
Suppose that
some depositor places a sum C in a bank (primary deposit), thereby
increasing the bank's cash or reserve by the same amount; we want to
calculate the amount X of additional credit the bank can create. Let r
denote the ratio of reserves to deposits that the bank is required to keep,
and let K denote the ratio of funds to loans that, on average,
borrowers leave on deposit. Then
|
1
|
X = C(1 - r)[1 + K(1
- r) + K2(1 - r)2 + K3(1
- r)3 + ...] = C(1 - r)
|
-----------------
|
|
1 - K(1 - r)
|
Indeed, C(1 -r) is the amount of deposit the bank
can create in the first place. The borrower leaves K times that sum on
deposit, enabling the bank to create further deposits in the amount
C(1 -
r)K(1 - r)
The next
borrower leaves K times that sum on deposit, enabling the bank to
create further deposits in the amount
C(1 - r)K2(1
- r)2
We see that the
bank is enabled to create a (decreasing) sequence of deposits, every one K(1 -r) times the previous. We have a
geometric series and, applying the sum formula, we get the result announced
above.
For example,
let C = $1000, K = 1/5 = 20/100 or 20 percent, r = 1/6 =
16⅔/100
or approximately 17 percent, then
$1,000(1
- 0.17) $830
|
X = ------------------ =
--------- = $995.20
|
1
-0.2(1 - 0.17) 0.834
|
or 99.52
cents for every dollar gained as a primary deposit. This is approximately
$1.20 for every dollar of the $830 surplus reserve.
Before any
withdrawals and consequent reduction in deposits resulting from the loans
take place, the balance sheet of the bank would be as follows:
Assets:
|
|
Liabilities:
|
|
Reserve
|
$1000.00
|
Primary deposits
|
$1000.00
|
Loans
|
995.20
|
Derivative deposits
|
995.20
|
|
________
|
|
________
|
|
$1995.20
|
|
$1995.20
|
As soon as 80
percent of the derivative deposits is withdrawn, the
following transactions take place: $796.16 are withdrawn, and derivative
deposits are reduced to $199.04. The $796.16 must come out of the $1000 of
cash reserve reducing it to $203.84. The balance sheet of the bank now stands
as follows:
Assets:
|
|
Liabilities:
|
|
Reserve
|
$203.84
|
Primary deposits
|
$1000.00
|
Loans
|
995.20
|
Derivative deposits
|
199.04
|
|
________
|
|
________
|
|
$1199.04
|
|
$1199.04
|
The ratio of
reserve to deposits is now 17 percent; but this does not mean that for every
$1 of surplus reserve the bank might get it could lend $6, as alleged by Patman. Legal reserve requirements must be maintained
after loans have been made, derivative deposits created and, following
withdrawals, reserve and derivative deposits reduced. It is correct to say
that in the above balance sheet the reserve ratio is 17 percent and that each
$1 of reserve supports $4.88 of loans and $6.88 of deposits; but that is very
different from an assertion that each additional $1 of reserve will admit $6
in new loans. The balance sheet of Patman's bank
would appear as follows:
Assets:
|
|
Liabilities:
|
|
Reserve
|
$1000.00
|
Primary deposits
|
$1000.00
|
Loans
|
4980.00*
|
Derivative deposits
|
4980.00
|
|
________
|
|
________
|
|
$5980.00
|
|
$5980.00
|
*(6 X 830 surplus reserve)
Not one cent
could be withdrawn from that bank since the reserve ratio is already below
the legally required 17 percent. And, of course, borrowers do not borrow, and
pay interest on, $4980 in the expectation of not being able to draw on the
sum borrowed.
Paradise Lost
The paradise of
fractional reserve banking was lost, and the gates of hell of the boom-bust
cycle and credit collapse were thrown open, when banks yielded to the
temptation and started sheltering fraudulent bills in their portfolio. What
was the apple tempting the banks? Well, it was the spread between the higher
interest rate and the lower discount rate. The banks were hell-bent to
increase their profits by pocketing the spread to which they were not
entitled. Thanks to banking secrecy, there was no danger of being caught
red-handed. The fraudulent paper was out of sight, well-hidden in the
portfolio of the bank.
Here we touch
upon another sacred cow of the Austrian School of Economics: the denial that
an indelible difference exists between the rate of interest and the discount
rate, reflecting the fundamental difference between saving and clearing. When
the Supplier delivers supplies to the Producer and bills him, the terms
"91 days net" for the payment of face value are part of the deal,
according to merchant custom. It definitely does not mean that the Supplier
has made a loan, or the Producer has borrowed a sum, amounting to the face
value of the bill. The shipment of supplies of semi-finished products is on
consignment, subject to the sale of the finished product to the final
consumer. There is no obligation on the part of the Producer to prepay the
bill and therefore if he does, he will only do it for a consideration.
He will apply a reduction (discount) to the face value of the bill,
proportional to the number of days left to maturity. The same is true if
anyone else discounts the bill.
Not only is
discounting conceptually different from extending a loan; the factors
determining the height of the discount rate are also
very different from those of the rate of interest. The former is governed by
the propensity to consume and, the latter, by the propensity to
save. (In either case the relationship is inverse:
the higher the propensity, the lower is the rate.) The wide-spread confusion
between the discount rate and the rate of interest is one of the most amazing
errors in monetary science.
The idea that a
bill of exchange can circulate on its own wings and under its own power is
ridiculed by the devotees of monetarism, in particular by their high priest,
Milton Friedman. No wonder. The Real Bills Doctrine is the Achillean heel of the Quantity Theory of Money. It
establishes the fact that an increase in the quantity of purchasing media
need not cause a rise in prices. If the new purchasing media emerges
simultaneously with new merchandise in high demand of equal value, and the
two disappear together as the latter is removed from the market by the final
cash-paying consumer (as in the case of financing the production and
distribution of consumer goods through fractional reserve banking subject to
the 91-day rule), then there will be no price rises on account of the
increase in the stock of money.
The commercial
banker's original sin was that he yielded to the temptation of higher profits
and compromised the standard for papers eligible for discounting. As long as
the bill market was allowed to function, standards could not be compromised
because everything was done in the open. Bills were a public document and
could be inspected by anybody. The market would refuse to touch dubious paper
and would blacklist cheaters. But when the banking system entrapped and
subsequently annexed the bill market, sheltering illiquid paper became
possible, and there was no umpire to blow the whistle.
The government
helped the perpetrators of fraud by all means at its disposal. It relaxed the
standards of bank inspection. It made a sweetheart deal with the banks. In
returning the favor of the banks' in finding a cozy place for Treasury bills
and bonds in the asset portfolio (thus sheltering them against the ravages of
the market), the government was willing to introduce double standards in
contract law. It exempted the banks from punishment in case they could not
pay gold on their sight liabilities - a predictable consequence of the policy
of loading the portfolio with phony, illiquid, and overpriced paper. The
granting of special privileges to the banks was the grave-digger of honest
fractional reserve banking.
The government administered
the coup de grâce to honest fractional
reserve banking when it exiled gold coins from the economy, a banishment that
still continues today in spite of the availability of souvenir gold coins
(issued to throw dust into the eyes of the public). Without gold redeemability bank lending has become arbitrary and has
been detached from the task of serving the satisfaction of urgent consumer
demand. The Consumer lost his emissary, the gold coin, with which he
communicated his demand to the Producer. From then on it wasn't the Consumer
but the issuer of irredeemable currency that would call the shots in setting
priorities and dictating directives to the Producer.
Mises versus Adam Smith
Mises
divides credit into two broad categories, according as "sacrifice"
is or is not involved. The former originates in savings; the latter is
"fiduciary credit" that banks create "gratuitously". Mises specifically rejects the view of Adam Smith that
the source of fiduciary credit is the quantum reduction of risk in the
production of certain basic goods (e.g., food and clothes) brought
about by the urgency of the demand, and the near certainty that the product
will definitely be removed from the market during the coming quarter by the
cash-paying consumer. This reduction in risk facilitates more refined
division of labor in production, as well as more streamlined clearing in the
financing thereof. Marginal producers may participate with greatly reduced
capital requirements. Distributors need not pay cash, they simply endorse the
bill. The upshot is "socialized credit", another apt name for
fiduciary credit created collectively, and made available at the nominal
discount rate, for the benefit of the entire society.
Mises
sees it differently. When the bank discounts a bill, it exchanges a present
good for a future good. Moreover, the bank creates the present good
"practically out of nothing". The question is not raised how the
banks have acquired their supernatural power to create something out of
nothing. The suggestion is not made that, in some cases, criminal fraud might
be involved. Mises fails to distinguish between two
types of fiduciary credit: (1) credit emerging as a result of financing the
production of urgently needed consumer goods, (2) credit emerging as a result
of fraud, e.g., pretending that merchandise is moving in response to
urgent consumer demand when in fact it has been forestalled in the
expectation of speculative profits. Bearing the cost, there is a victim. He
may be unaware that he is being victimized by the banks, so well-hidden is
the prestidigitation. But there is a cost. Denying it would be tantamount to
denying the laws of physics, in particular, the law of conservation of
matter.
Mises
dismisses Adam Smith's Real Bills Doctrine as deus
ex machina. Yet the great merit of Adam Smith
is the recognition of circulation credit, the fact that bills circulate
spontaneously even in the complete absence of banks. This makes it plausible
that fraud appears as soon as the banks establish their monopoly over
fiduciary credit. One can only speculate that the aversion of Mises to the Real Bills Doctrine is due to his unfailing
adherence to the Quantity Theory of Money. Be that as it may, this aversion
has led Mises to creating a faulty theory of
credit. The Austrian School of Economics would do well to recognize this fact
and, belatedly, correct the error, as urged by Tlaga.
The great evil
of our age, unlimited credit expansion, cannot be understood, still less
corrected, on the basis of a faulty theory of credit. For this reason I have
taken the trouble and liberty to restore Adam Smith's Real Bills Doctrine to
its proper place in monetary science, and to draw attention to the fact that
it is possible to run the modern economy entirely without commercial banks,
with real bills providing the financing for the production of consumer goods
in urgent demand. While fractional reserve banking per se is not the
cause of credit collapse that is threatening the world, the banks will have
earned such a bad reputation for betraying the public trust that, after they
have self-destructed as part of the coming monetary Armageddon,
reconstruction may be easier if their resuscitation is side-stepped. All that
is needed is that the United States open its Mint to the free and unlimited
coinage of gold, as stipulated by the Constitution, in order to make the
coins needed to pay wages, and to liquidate the credit represented by
maturing bills, available. The banks have to live down their betrayal of the
public trust without help from monetary science.
The Second Greatest Story Ever Told
To
recapitulate, there was nothing sinister about fractional reserve banking as
it was conceived originally. Bank loans were fully backed by gold reserve and
self-liquidating bills of exchange. We may conceptualize bills as bank assets
maturing into gold pari passu with the underlying semi-finished goods
maturing into finished goods ready for sale to the final gold-paying
consumer. Loans were not inflationary, since they did not increase the stock
of purchasing media beyond the stock of goods available for consumption, and
were extinguished at maturity by the gold coin that the final consumer
surrendered. Fractional reserve banking merely streamlined spontaneous bill
circulation which had existed, and would exist, independently of the
existence of banks. Fractional reserve banking became sinister after
the banks monopolized fiduciary credit and started sheltering fictitious and
slow paper in their portfolio.
Any critical
examination of fractional reserve banking must start with an examination of
the spontaneous circulation of self-liquidating bills of exchange as it
originated in the Italian city states, and the spontaneous circulation of
clearing house receipts as it originated at the great mediaeval city fairs
elsewhere in Western Europe. Under the title The Second Greatest Story
Ever Told I have published the genesis of the self-liquidating bill of
exchange in twelve Chapters. The title has an oblique reference to the Bible
and to the ethical foundations of bill trading, a foundation of which the
regime of irredeemable currency is utterly devoid. It also includes an
account of how honest fractional reserve banking grew out of the Discount
House and, the dishonest, out of the Acceptance House. Moreover,
the story covers the genesis of banknotes and the two cardinal sins of banks,
namely, illicit interest arbitrage and borrowing short to lend long. The
interested reader will find it in my course at the Gold Standard University:
Monetary Economics 101 entitled The Real Bills Doctrine of Adam Smith,
on the website: www.goldisfreedom.com. The
continuation of this course, Monetary Economics 201 entitled The Bill Market
and the Formation of the Discount Rate, is in preparation
Antal E. Fekete
San Francisco School
of Economics
aefekete@hotmail.com
Read
all the other articles written by Antal E. Fekete
DISCLAIMER
AND CONFLICTS
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Copyright
© 2002-2008 by Antal E. Fekete
- All rights reserved
|