Tuesday, December 28, 2010

The Federal Reserve: Heart of Tyranny #4. Fractional Reserve Banking, Inflation, and Boom-Bust

#1. Introduction
#2. What is Money?
#3 An Introduction to Paper Money

#4 Fractional Reserve Banking, Inflation, and Boom-Bust

In the last post in this series, I discussed some general concepts underlying fractional reserve banking (FRB), and I argued that it should not be upheld by the courts since it necessitates the recognition of a contradictory legal condition, i.e., it enables the the simultaneous possession of the same physical asset by more than one owner.  But why is this even important?

FRB actually predates the modern concept of the central bank, i.e., FRB can exist even under a gold standard.  In fact, various catastrophes emanating from FRB throughout the 19th century and early 20th century helped set the stage for the modern central bank.  Furthermore, FRB continues to be a major economic force.  It is responsible for most of the money creation that has occurred since the advent of the Federal Reserve System and therefore, is a major factor in causing the boom-bust cycle.  For example, today the total money supply is in the neighborhood of $6T, while the total creation of money by the Federal Reserve (the "monetary base") is about $2T.

For an excellent overview of the topic of FRB, see the recent article, The Faults of Fractional-Reserve Banking, by Thorsten Polleit (HT: Per-Olof Samuelsson).

To review, let's take a simple example. 

1) Joe deposits 100 oz. of gold in Bank A.  Bank A sets aside 10 oz. of gold in a vault and lends out 90 oz. to a farmer. 

Joe: "I have 100 oz. of gold available to me at all times"
Farmer: "I have 90 oz. of gold available to me at all times"
Total Money Supply = 190 oz. of claims to gold
Actual Money = 100 oz. of gold 

Note that two parties now believe they have title to the same physical asset.  Joe thinks he has 100 oz. of gold and the Farmer thinks he has legal title to 90 oz. of gold.

2) Continuing, let's say the farmer deposits the 90 oz. of gold in Bank B.  Bank B sets aside 9 oz. of gold in its vault, and lends out 81 oz. of gold to a grocery store.

Joe: "I have 100 oz. of gold available to me at all times"
Farmer: "I have 90 oz. of gold available to me at all times"
Grocery Store: "I have 81 oz. of gold available to me at all times"
Total Money Supply = 271 oz. of claims to gold
Actual Money = 100 oz.

This process can repeat until there is 1000 oz. of total money supply, all backed by the original 100 oz. of gold. (Ludwig von Mises would call the 900 oz. of claims "circulation credit.") 

In other words, through FRB with a 10% reserve ratio, the banking system can create 10 times as much money as is on deposit.  The increase in the quantity of money over the increase in quantity of precious metals is inflation.  In the same way, if banks stop lending, or their loans lose value, or customers choose not to borrow, then FRB can result in a decrease of the previously created money by up to 10 times.  This decrease in the quantity of money is deflation.

Of course, such a process of money creation and destruction causes the notorious boom-bust cycle. Inflation, among other things, distorts the investment of capital throughout the economy and causes a general increase in the price level (or increase in prices above what they would have been otherwise).  The corresponding liquidation of this malinvestment and consequent decrease in the quantity of money, or deflation, corresponds to the bust phase of the cycle - a phase for which most of us are now well versed.  See my post, Boom-Bust Part 1, Reisman's Capitalism: A Treatise on Economics or his recent post "Boom Bust in Microcosm", or Jesus Huerta de Soto's Money, Bank Credit, and Economic Cycles, for more on this.  As Reisman writes (see Capitalism p. 542):
...depressions are caused by government sponsorship of a fractional-reserve banking system, which increases the quantity of money unduly, thereby artificially reducing the demand for money and raising its velocity of circulation, thus setting the stage for a subsequent financial contraction, deflation of the money supply, and depression. 
Now, as a further practical consequence, what if all these people come to the bank at the same time demanding to redeem the paper notes in gold?  Of course, it would be impossible for the banks to redeem 1000 oz. of gold when they only have 100 oz.  As I argued in the last post, the conflation of the legal concept of deposit with the concept of loan results in a situation where many independent parties are legally entitled to the same physical asset - a situation which would not arise if deposits were treated separately from loans.  When all these parties simultaneously demand their gold, it is known as a run on the bank.  
 
Generally, FRB leads to the business cycle and an untenable legal condition in which many parties have rightful claim to the same asset.  Historically, this practice led to one disaster after another throughout the 19th century, even when the U.S. was on a gold standard.  As I discuss in more detail in my post, Boom-Bust Part 3, when banks endured runs as investors panicked, states allowed banks to suspend redemption in specie, thus introducing profound form of moral hazard into the monetary system, as banks who pushed the envelope were effectively bailed out.  Friedman and Schwartz quote Clark Warburton in a footnote (p. 328):  
By the middle of the 1830's most of the states had adopted or were in the process of developing general banking codes, with the insertion of provisions for severe penalties for failure to pay note in specie, or had placed such provisions in bank charters when renewing them or granting new ones.  Under such provisions, suspension of specie payments meant forfeiture of charters, or at least curtailment of business until specie payments were resumed...We know of no instance where any legislature or bank supervisory authority declared bank charters to be forfeited as a result of a general restriction of convertibility.  Instead, legislation was enacted postponing or relieving banks of the penalties the law imposed for suspension of specie payments.
Although I will discuss this in more detail in a later post, it should be noted that the various panics set off by this process ultimately led to a political movement, not to insist that the state serve its proper function which is to enforce banks' contractual obligation to redeem, but rather, a drive towards the establishment of a central bank to act as "lender of last resort" or to increase the currency's "elasticity" - all code for a central statist authority to backstop the banks (at taxpayer expense) when they got in trouble. Such a movement served the ends of both the turn of the century progressives', who sought inflation as an economic elixir (or a means to not be crucified on a "cross of gold"), and groups of statist bankers, who sought to profit from FRB without subjecting themselves to risk.    
 
Looking ahead, it should be noted that FRB is a major factor in the determination of the total money supply.  FRB provides the means to multiply and decrease a monetary base by orders of magnitude.  The connection to the central bank is as follows.  In the absence of a gold standard, a central bank that controls the monetary base, controls the fundamental base of that multiplication.  In other words, the creation of money can be thought of as emanating from two central causes:  1) the central bank (the Fed) which creates money out of thin air that serves as the so-called monetary base and 2) the private banking system, which multiplies this amount as it lends money to its customers or contracts money as loans go out of existence.  The recent history of monetary growth in the United States can be thought of as an ever increasing curve (as the Fed continuously adds to the monetary base) with additional cycles of expansion and contraction caused by the banking system's shorter term lending behavior.        

Further looking ahead, this is the reason why the Fed can, at times, create money but not actually increase the total money supply if this money creation is met by an offsetting contraction in lending from the private banking system.  Such a state is exactly what has been happening over the past year as the Fed finds new ways to increase the monetary base (expand its balance sheet) while private banks and individuals "deleverage" or pay off debt and raise cash.

FRB has been and is today an integral part of the banking system and warrants close re-examination if we are ever to fully and properly establish a private banking system based on the legal and moral principles of laissez faire.

7 comments:

Per-Olof Samuelsson said...

People who advocate fractional reserve banking (FRB) under free banking seem to fear that if banks were not allowed to practice FRB, banking would grind to a halt, because there would be to little money to lend out. I wonder if you have considered this objection. (I don't agree with it, but I haven't been able to formulate a short and succinct answer to it.)

Per-Olof Samuelsson said...

If you have the time, could you take a look at this video presentation from someone who is in favor of FRB:

http://www.khanacademy.org/video/banking-4--multiplier-effect-and-the-money-supply?playlist=Banking+and+Money

What I find odd is that this video (and other arguments I have seen in favor of FRB) presents the same scenario as you do in this post - but they take it as an argument *for* FRB, and you take it as an argument *against* FRB.

The only validity I can see to this type of argument is that under a "modest" amount of FRB, prices will still become lower, although not as much lower as they would under a 100% gold standard.

Again, I think this argument is wrong, but hard to answer in a short and succinct way.

John McVey said...

Per-Olof (I hope Doug doesn't mind me jumping in):

First, consider that under laissez-faire there'd be none of the licensing barriers and investor protection laws that reduce the number of lenders and hinder the ease with which loans of varying tenors can be made.

Second, find out the total capital invested per capita and compare that to the amount of cash savings per capita. It has been a while since I did it, but a few years ago it was in the vicinity of $200,000 in modernised countries. Contrast that M1 per capita, which for Australia is about $12,000 (M3 per capita is about $50,000 but I have my doubts about the continuing merits of M3). Then note that under laissez-faire the amount of capital (and its rate of turnover) would increase markedly because of elimination of costs etc.

As part of that, observe that the vast bulk of all financing comes not from deposits but from a wide variety of sources, particularly pension funds and insurers, plus also vast amounts of direct investments. They have (as per above) plenty of capital to invest and with a high enough turnover not to present any difficulty to investment efficiency. When I checked for June 2009 in Australia, non-fractional institutional funding was over seventeen times the size of borrowing from current deposits. Do some educated extrapolation from there, too, along with noting the potential for non-banks to muscle in on much of the lending trade (which to some extent already happens here).

Lastly, if you're up for it, consider the quantity of actual gold and silver both in known deposits and in estimated total crustal prevalence, and work up a basic model. I did one for an entire globe living the western lifestyle, where money is gold and silver, and I calculated that there'd be enough of each, though with gold being anywhere between 50% and 500% more expensive than now depending on the ratio of the value of trade by gold to silver (among other variables of lesser relative importance). The quantity of gold could conceivaby get problematic, but not so silver.

JJM

Doug Reich said...

Per-olof,

I have heard that argument of "too little money" and it is completely and utterly absurd if you think of money as a commodity.

First, lending must take place out of savings. Savings are just commodities or assets that have not been consumed by someone. So, the argument that there is too little "money" really is an argument that there is too little savings, which is totally separate point. If people do not save or save too little, then there will be nothing or very little to lend. That is a constraint of reality, not the monetary system.

Second, if a given commodity that is being used as money, such as gold, becomes short in supply and therefore, incredibly valuable, it will just rise in price and a given amount will equal a larger amount of money. So instead of borrowing 10 oz. for a tractor, you borrow 5 oz. for the same tractor. And if gold becomes even more valuable, you borrow 1 oz. for a tractor, and so on. So what, right?

In reality, if it gets too expensive, it will probably cease to be used as money as it will be impractical, i.e., the market will choose another commodity to serve as money, where a practical amount can serve as money in every day transactions. Right now, silver at $30 per oz. would serve more practically for everyday transactions than gold at $1400 per oz. Gold would be used for larger purchases.

Let me know if that helps.

Per-Olof Samuelsson said...

Thanks, Doug. I agree with what you write here. My main problem is that this issue about FRB is fairly clear in my own mind, but I find it exceedingly hard to explain my thoughts to other people. Well, that's a psychological problem, not an economic problem.

Doug Reich said...

Per-olof,

If you think of money as another commodity, which it is, it becomes a lot simpler. It's just a more effective form of barter. There is really nothing special about money. The free market price of gold or silver or whatever represents reality, and these other arguments represent the wishes and dreams of academics and politiicans.

What's interesting, I recall that historically, this "too little money" was being made even under FRB. I think it was partly a populist argument pre-Fed and later a Keynesian argument that savings was a kind of "hoarding" and that gold (i.e., reality) was putting a constraint on lending, etc. etc. I think this idea was behind the scheme that led to the government mandating that silver be equal to gold in price which led to the panic of 1893. See my post:

http://dougreich.blogspot.com/2008/11/wheres-grover-cleveland-when-you-need.html

Per-Olof Samuelsson said...

There is a good rebuttal of the "scarcity of money" argument in Reisman's "Capitalism", p. 955f. Let me quote the salient point:

"However paradoxical it may seem, the 100-percent-reserve gold standard would be a system of *enormous financial liquidity*. It would be a system in which the quantity of money measured in terms of absolute buying power and relative to such things as current liabilities, would be far greater than under any other system. It is precisely for this reason that there would be no basis for any sudden increase in the need and desire of people to own money. They would *already own* all the money they need."

It does sound paradoxical, and maybe I will have to re-read this whole section of Reisman's book to fully grasp this point.