Fractional Reserve Banking
& Monetary Reform

Article by Paul Cresham 2009
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I read the Salvation Island story passed to me by Bill Kruse and considered it quite a muddle. It confuses the development of paper money with that of fractional reserve banking and I think the two need to be clarified and separated. I would also like to expand from that and talk about some criticisms of fractional reserve banking and discussion of the subject of monetary reform.

Paper money and banks are closely linked, as the issuance of paper money made possible the development of the practice of fractional reserve banking. Paper money is widely believed to have first originated in China between the 7th and 13th centuries: the burden on wealthy merchants of carrying large amounts of coins around lead to a practice of depositing the coins with a trustworthy third party who would issue a receipt for them and they would be redeemable on request. Eventually, these notes became tradable as this was easier than withdrawing the coins for each exchange.

Similar money and banking systems evolved in the Muslim world over a similar period. In other parts of the world it evolved later.

As mentioned, when coinage and other valuables, often gold and silver, were deposited at banks or goldsmiths, receipts would be issued and these receipts became tradable as money themselves. The goldsmiths became aware that because the receipts (or notes) were traded directly between people and merchants, very few people actually came to withdraw their coins or gold at any one time. This allowed the goldsmiths to issue more receipts than gold they had on deposit as loans.

This process and some of its ramifications are described in Chris Waller's article Money Troubles in issue number 25 of Economania, so I shall not repeat it here. However I will look at some more issues that fractional reserve banking may cause.

The money supply and inflation

Monetarists argue that inflation is caused, essentially, by an increase in the money supply: what might be called debasement. This can be explained using the Fisher formulation of the quantity theory of money:

 

where M is the total money supply, V is the velocity of money, P is the average price and T is the number of transactions.

In the long run, assuming V remains constant, increases in the money supply M in excess of the rate of growth of the economy (the change in T) will result in changes to average price P (Alain Anderton: Economics, Causeway Press Ltd ISBN 0-946183-65-1 p509).

There are two measures of money supply in the UK: narrow money or M0, and broad money or M4. M0 money is actual notes and coins held by banks in their vaults and their Bank of England accounts, and by people in their wallets and purses, under their beds and so on. M4 money is the total value of balances of bank deposit accounts, plus narrow money.

M4 is a multiple of M0 because of the practice of fractional reserve banking: banks create money by making "loans" of a certain percentage of their deposits, by (in simple terms) creating a new account with the loan balance in it. Take a simple economy with £100 of notes and coins in total (M0). That some is deposited in a bank which operates a reserve ratio (the percentage of money actually retained to satisfy the day-to-day withdrawals by customers) of 10%. The bank can therefore lend £90 of this back out by creating a new account with a balance of £90. It now holds the depositor's account with a balance of £100 and a borrower's account with a balance of £90, so total M4 money supply is now £190. (Remember that in the modern economy this is being done on a large scale but with a large number of small transactions making it more sustainable than my simple example here: if both account holder went to withdraw their money, the bank would be unable to pay: a bank run.)

However, it doesn't stop there. That £90 borrow will of course be spent, and the merchant receiving the money will then deposit it in their bank account, and the bank can lend 90% of it back out again. This process continues up to a theoretical maximum which is the M0 money supply (original notes and coins) multiplied by the credit multiplier which is calculated as:

Credit multiplier=1/reserve ratio

In my simple example with a 10% reserve ratio, the credit multiplier is 10, meaning the theoretical maximum M4 money supply with a M0 supply of £100 is £1,000. That is £1,000 of bank balances backed up by £100 of actual cash (Alain Anderton: Economics, Causeway Press Ltd ISBN 0-946183-65-1 p356).

The actual M4 money supply is not near this theoretical maximum but is expanding towards it. Firstly, it takes time to reach this as the money filters through, is lent back out, is repaid and re-lent, and so on. Secondly, there exists 'currency drain' whereby not all notes and coins are deposited in the banking system: some is always held by people for day-to-day spending, some is stashed under the bed and in piggy banks and so on.

Much money used by us on a day-to-day basis is M4 money. Most of us deal little in notes and coins but pay by Direct Debit, debit card, bank transfer and so on. This is just 'electronic money' moving around the banking system and does not necessarily have to be backed up by notes and coins. Our bank balance, whilst each of us may consider it to be quite real, is mainly M4 money. Therefore M4 is the relevant money supply figure to look at here.

There are other explanations of inflation but I prefer the monetarist explanation as it makes natural sense: increase the amount of money in an economy, but nothing else, and prices will increase to compensate. Interested in whether real figures would give any indication of this existing, I sourced figures for M4 money supply (and derived 12 month percentage change), RPI 12 month change and GDP growth (annual change in Q1) from the Bank of England and Office for National Statistics for as far back as I could get all three series together (1983) and plotted them on a graph. The correlation between the figures is interesting, particularly around the last recession in the early 90s:

Paul's money graphic

As the money supply starts to grow more slowly in the early 90s, inflation reduces. GDP growth also closely matches money supply and inflation, which could be seen to support Austrian Business Cycle Theory. Also note that the growth in the money supply is consistently higher than economic growth, and that where the gap is at its smallest, inflation is roughly at its lowest.

One can therefore argue from this viewpoint that: inflation is caused by an expansion in the money supply in excess of economic growth, that expansion is purely under the control of commercial banks and will no doubt be influence by their own interests (profit) and therefore modern day inflation is a result of the practice of fractional reserve banking. That is not to say that it would exist without fractional reserve banking, though it may not exist if whatever system replaced it controlled money supply effectively without any debasement.

Perpetual debt

Let's look back at my earlier simple example of a £100 narrow money supply and a reserve rate of 10%. When the money (the principal) is lent out, it is repayable with interest. Interest is the price paid to another for them to defer consumption to a later date (i.e. not spend their money now for goods, but rather later).

In principle this is okay: interest can come from future profits and economic growth. However fractional reserve banking introduces an anomaly: it must charge more interest to borrowers than it pays on deposits in order to make a profit on the lending transaction. This means that insufficient narrow money exists to repay the original debt (bear in mind only the principle of the loan is created at its inception). To pay the interest, either the economy must grow by at least that amount to cover it, or money supply must expand by enough to cover it, or both. If the M0 money supply and economy do not grow enough, then the M4 must grow (by the extension of more credit), and it can be seen from the graph that it has been growing constantly for at least the past 25 years (in fact it has been growing much longer than this).

Transfer of wealth to the banks

Following on from above, it would seem the banks are in a very advantageous position. They are relied upon to provide credit to the economy and be the principle money creators. However, by charging more for loans than they pay on deposits, they are constantly removing an amount of money from general circulation.

Some is required to cover off running costs and to cover write-offs of defaulted loans, and so on, but because banks are businesses there is a drive for profit, and also a drive for personal profit as part of a typical principle-agent problem (bonuses), more money than this must be made. All of this money will be spent back into the economy, be it in paying their overheads and salaries and bonuses, investing in the business or by passing dividends to their shareholders. Whether it is spent or kept, let us not forget that money itself is not wealth, it is merely an exchange medium. When it is spent for new goods and services, it then becomes wealth. If it is invested it can be used to acquire real wealth in the future, or can give a regular return to be spent to provide wealth.

Because money is being 'skimmed off' by banks through the normal circulation of money, there is a gradual transfer of wealth to banks (for provision of what is very little consideration for their return). It is easy for you and I to get in on this game actually: buy some bank shares (though perhaps not at times like this!) but on the grand scale, by just their presence and their nature of operation there is a constant transfer of wealth into them: a specific type of entity. Is this healthy?

I have seen it pointed out that the richer areas of the world are where the banks reside, though personally I do not know for sure which follows which, or if this 'rule' really holds true.

Business cycles

As the UK and much of the rest of the world enters recession, this is a subject that is hot on many people's tongues. Two things interest me here given recent events and those of the early 2000s with the dot-com bubble: the Austrian Business Cycle Theory and Hyman Minsky's theory around credit cycles or bubbles. Both are closely related to fractional reserve banking and credit expansion (effectively the expansion of M4 money supply).

The Mises Institute has an article that gives a good overview of Austrian Business Cycle Theory and also points in the direction of more in-depth reading (Mises, Rothbard). The essence of the theory is that a distortion in real interest rates, those being time preference for money, created by the practice of fractional reserve banking as an intermediary, causes a subsequent distortion in the market by unnaturally encouraging investment in unviable business when credit is cheap: a credit boom. (That is done by separating the lender from the borrower.) This artificial situation must be brought to reality eventually (by some market event).

Dr Hyman Minsky proposed some interesting theories around financial crises. His Financial Instability Hypothesis about the credit system is quite interesting, and has received increasing interest over recent years since the Russian Financial Crisis when he was cited by Paul McCulley in respect of the 'Minsky moment'. He argued that the financial sector essentially created business cycles through its swings.

Minsky argued that the key mechanism pushing an economy towards a bust phase is accumulation of debt. Here we meet the three types of Minsky borrowers, in chronological order: Hedge Borrowers, Speculative Borrowers and Ponzi Borrowers.

Hedge borrowers borrow with intention of making payment from future inflows from other investment (or employment). The speculative borrower is one that believes they can service the loan but must roll over the principle into new (higher value) investments to cover themselves. Eventually the market experiences Ponzi Borrowers who borrow on the absolute reliance on increase in market value of assets.

Here the "greater fool" principle kicks in: at some point no greater fool can be found to pay the required price for the asset, so the Ponzi Borrower has greater difficulty finding a buyer. This is where asset prices start to tumble (as people reduce their acceptable prices until a buyer is found) and the Minsky moment starts.

The key element here is the existence of credit without the perceived risk. One can borrow speculatively with little worry of repercussion (in the form of immediate loss) if the decision is bad.

The UK housing market is currently in a "Minsky moment" following a credit-backed boom with ever-increasing loan-to-value percentages and ever-decreasing borrower requirements. Banks as a business need to increase lending to expand profits, so when they reach the maximum amount they can lend, that being the amount lendable to trusted individuals, they must either increase the amount lendable (loan percentage to property value) or decrease the trust required (e.g. sub-prime) in order to increase (or perpetuate) profit. Of course this must eventually lead to a point where Ponzi Borrowers default: the situation can no longer be perpetuated.

Monetary reform

Given these inherent flaws in the way money is distributed through the modern global economy, many ideas for alternative monetary systems have emerged over the last few days.

There are numerous proposals for reforming the monetary system to something that is suggested would work better. In essence, these generally share similar characteristics:

  • Remove the practice of fractional reserve banking from existence (using various methods from gradual recapitalisation to full reserves, to cancelling all debt)
  • Centralised, government-controlled money creation (at present it is in the hands of private entities, i.e. banks, in terms of M4 creation (the government still creates notes and coins now))
  • Government issued 'debt free' money

Some advocate a change in essentially what is used by money. We currently operate on a 'fiat currency': that is a currency that has no inherent value in itself (unlike gold, which does) but is accepted for trade on the basis that the government deems it legal tender and good to pay taxes (government fiat). Some advocate a return to the gold standard, but fiat currency can suffice provided its supply is tightly controlled. (A gold standard can still also easily have its supply altered, and a pure hard currency (e.g. gold itself) can be debased by melting down and reforming with cheaper metals, as used to happen.)

The key is in how credit is provided to enable businesses to be started up, and to function, and to allow people to buy higher value assets more easily. It has been suggested that much of this can be achieved by using equity finance instead of debt finance. For example, savers could pool money into a building society of sorts, and that money could be used to buy investment stakes in housing. People could buy the houses by paying into this fund a proportion of capital (to purchase) and rent (as return on investment).

Most business finance could be achieved through the use of equity finance: even an overdraft could be secured on non-voting shares.

Debt finance could still be provided through a full-reserve framework but some responsibility would have to be borne by the investor. Rather than just putting some money aside in a savings account, they would have to choose investments to put their money into, and risk losing money if the borrower failed or defaulted. A system like this operates on a small scale through the lending and borrowing marketplace Zopa.

Another alternative is to use government issued debt-free money, such as the Colonial Scrip used in the American Colonies prior to the Revolution. The money can be created and lent out without any associated debt (i.e. the government does not owe it back to anyone) and so there is no interest rate (there is no time preference for money because no-one is being asked to delay consumption to provide the money). In the case of Colonial Scrip, this was loaned out at low interest rates, secured on land and the interest income used to lower the tax burden on the people.

There is much talk at the moment about reforming how our money system works, and how the banks will operate going forward from the 2008 Financial Crisis. There are some interesting alternatives available, though I don't think we can realistically expect to see anything so drastic in our lifetimes.

This article originally appeared in the January 2009 issue of Economania, newsletter for the British Mensa Special Interest Group on economics, trade and finance.

Members can discuss this and other articles on the economics forum at International Mensa.

 

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