Most economists are of the view that the current monetary system amplifies the initial monetary injections of the central bank. Thus, according to a popular view, if the Fed injects $1 billion into the economy and banks have to hold only 10% in reserves against their deposits, this will cause a first bank to lend 90% of this $1 billion. The $900 million in turn will end up with a second bank, which will lend 90% of the $900 million. The remaining $810 million will end up with a third bank, which in turn will lend out 90% of $810 million, and so on.
Consequently the initial injection of $1 billion will become $10 billion, i.e., money supply will expand by a multiple of 10. Observe that in this example banks are responding to the injection of $1 billion of reserves by the Fed, which coupled with the legal reserve requirements of 10%, sets in motion monetary expansion of $10 billion. In other words, within this framework, banks are responding to the injection of reserves by the central bank.
Recently some commentators have questioned this logic.1 They argue that in the present US monetary system there is no such thing as a money multiplier since banks make loans first and worry about reserves later. Moreover, it is argued, within the present lagged reserve requirement framework it is pointless for the Fed to pump reserves, for these reserves cannot be used by the banks since required reserves are only calculated on the past 30 day’s deposits. Consequently, if the Fed injects an extra $1 billion to the system, the banks won’t respond at all—so it is argued.
Is the objection raised valid? The main issue is not whether the current banking system is on a lagged or contemporaneous reserve requirements framework as such, but the fact that the present monetary system, which is supervised by the central bank, gives support to fractional reserve banking. It is this fact that gives rise to the so-called money multiplier.
Fractional reserve banking and the creation of money
When Tom lends his $100 to Mike, the transaction doesn’t create new money since Tom simply transfers his saved money for the period of the loan to Mike. This type of transaction temporarily transfers the ownership of the $100 from Tom to Mike.
Likewise, when a bank mediates between Tom and Mike, it borrows from Tom $100 and simply lends the $100 to Mike. The bank doesn’t create new money. Similarly if a bank lends $1 million, which was obtained by issuing stocks to this amount, no new money is created. People who bought the bank’s stocks have paid with their savings, which the bank in turn employs in its lending activities. While lending that is fully backed up by savings doesn’t give rise to the creation of new money this is not the case with regard to fractional reserve banking.
Fractional reserve banking arises as a result of the fact that banks are legally permitted to use money that is placed in demand deposits. In short, banks treat this type of money as if it was loaned to them. If John places $100 in demand deposit he doesn’t, however, relinquish his claim over the deposited $100. He has an unlimited and immediate claim on his $100. Demand deposits must be regarded as no different from a safe deposit box. Hence when a bank uses the deposited money as if it were loaned to it, the bank generates another claim on a given amount of deposited money.
For instance, let us say that a depositor—John—deposits $100 in cash at a bank (Bank A) and this constitutes the bank’s current total cash deposits. The bank then lends $50 to Mike. By lending Mike $50, the bank creates a deposit for $50 that Mike can now use. This in turn means that John will continue to have a claim against $100 while Mike will have a claim against $50. This type of lending is what fractional reserve banking is all about. The bank has $100 in cash against claims of $150. The bank therefore holds 66.7% reserves against demand deposits. In short, the bank has created $50 out of “thin air” since these $50 are not supported by any genuine money.
Now Mike buys for $50 goods from Tom and pays Tom by check. Tom places the check with his bank, Bank B. After clearing the check Bank B will have an increase in cash of $50, which it may take advantage of and use to lend out $25 to Bob. In short, as one can see, the fact that banks make use of demand deposits sets in motion the money multiplier. Note that the multiplier is the outcome of the fractional reserve-banking framework.
A case could be made, however, that people who place their money in demand deposits do not mind if banks use their money. Notwithstanding all this, as long as people trade, there will always be a demand for money, which will be held either in cash or in bank demand deposits. Consequently, regardless of people’s attitudes, once banks use deposited money, an expansion of money that is not backed by money proper is set in motion. In short, if an individual has a demand for money then he cannot at the same time not have a demand for money. Hence, if against his demand for money, which is manifested by him holding money in demand deposit, the bank lends out part of the deposited money, an unbacked lending must emerge, i.e., money out of “thin air” is generated.
Although the law allows this type of practice, from an economic point of view it produces a similar outcome to that which counterfeiting activities do. It results in money produced out of “thin air” which leads to consumption that is not supported by production; that is, the dilution of the pool of real funding.
The legal precedent to fractional reserve banking was set in England in 1811, in the court case of Carr v. Carr. The court had to decide whether the term “debts” mentioned in a will included a cash balance in a bank deposit account. The Judge, Sir William Grant, ruled that it did. According to Grant, because the money had been paid generally into the bank, and was not earmarked in a sealed bag, it had become a loan to the bank. The Judge also insisted that money deposited with a bank becomes part of that bank’s assets and liabilities. 2
On this Mises wrote,
It is usual to reckon the acceptance of a deposit which can be drawn upon at any time by means of notes or checks as a type of credit transaction and juristically this view is, of course, justified; but economically, the case is not one of a credit transaction. If credit in the economic sense means the exchange of a present good or a present service against a future good or a future service, then it is hardly possible to include the transactions in question under the conception of credit. A depositor of a sum of money who acquires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to, has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him. The depositing of money in no way means that he has renounced immediate disposal over the utility that it commands. 3
Similarly, Rothbard argued,
In this sense, a demand deposit, while legally designated as credit, is actually a present good–a warehouse claim to a present good that is similar to a bailment transaction, in which the warehouse pledges to redeem the ticket at any time on demand. 4
Fractional reserve banking vs. free banking
In a truly free market economy, the likelihood that banks will practice fractional reserve banking will tend to be very low. If a particular bank tries to practice fractional reserve banking it runs the risk of not being able to honour its checks. For instance, if Bank A lends out $50 to Mike out of $100 deposited by John, it runs the risk of going bust. Why? Let us say that both John and Mike have decided to exercise their claims. Let us also assume that John buys goods for $100 from Tom while Mike buys goods for $50 from Jerry. Both John and Mike pay for the goods with checks against their deposits with the Bank A.
Now Tom and Jerry deposit their received checks from John and Mike with their bank—Bank B, which is a competitor of Bank A. Bank B in turn presents these checks to Bank A and demands cash in return. However, Bank A has only $100 in cash—it is short $50. Consequently, Bank A is running the risk of going belly-up unless it can quickly mobilise the cash by selling some of its assets or by borrowing. In other words, the fact that banks are required to clear their checks will be a sufficient deterrent against practising fractional reserve banking in a free market economy.
Furthermore, it must be realised that in a free market the tendency of being “caught” practicing fractional reserve banking, so to speak, rises, as there are many competitive banks. In short, as the number of banks rises and the number of clients per bank declines, the chances that clients will spend money on goods of individuals that are banking with other banks will increase. This in turn increases the risk of the bank not being able to honour its checks once it practices fractional reserve banking.
Conversely, as the number of competitive banks diminishes, that is, as the number of clients per bank rises, the likelihood of being “caught” practicing fractional reserve banking diminishes. In the extreme case of there being only one bank, it can practice fractional reserve banking without any fear of being “caught” so to speak. Thus if Tom and Jerry are also clients of Bank A, then once they deposit their received checks from John and Mike, the ownership of deposits will now be transferred from John and Mike to Tom and Jerry. This transfer of ownership however, will not have any effect on Bank A.
We can conclude then that in a free banking environment if a particular bank tries to expand credit by practicing fractional reserve banking it runs the risk of being “caught”. Hence in a true free market economy the threat of bankruptcy will bring to a minimum the practice of fractional reserve banking.
The Central Bank and fractional reserve banking
Whilst in a free market economy the practice of fractional reserve banking would tend to be minimal, this is not so in the case of the existence of a central bank. By means of monetary policy, which is also regarded as the reserve management of the banking system, the central bank permits the existence of fractional reserve banking and thus the creation of money out of “thin air.”
In this respect the modern banking system can be seen as one huge monopoly bank which is guided and coordinated by the central bank. Banks in this framework can be regarded as branches of the central bank. In other words, for all intents and purposes the banking system can be seen as being comprised of one bank. (As we have seen, one monopoly bank can practice fractional reserve banking without running the risk of being “caught”).
Through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks can engage jointly in the expansion of credit out of “thin air” via the practice of fractional reserve banking. The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out, because the redemption of each will cancel the other redemption out. In short, by means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.
Thus, whenever the Fed injects money into the system, it inevitably ends up as an increase in the deposits of a particular bank. This bank, based on its portfolio strategy, will decide how much of this increase in deposits it will lend out and how much it will keep in reserves. (Even in the modern banking system banks voluntary keep certain amount of reserves, regardless of legal requirements, in order to settle transactions) 5 .
Now, if Bank A decides to keep 20% in reserves against the new increase in deposits, then it will lend out 80% of the new deposits. In other words, if as a result of the Fed’s monetary injections Bank A’s deposits increase by $1 billion then the bank will lend $800 million and the rest will be kept in reserves. Now let us assume that the borrowers of the $800 million buy goods from individuals that bank with Bank B, who in turn present checks for clearance of this amount to Bank A. Since Bank A has in its possession $1 billion it would have no problem clearing the check.
However, a problem can emerge if the original depositor of $1 billion decides to use his $1billion. Then there is a risk that Bank A will not be able to honour his checks. In the event of such an occurrence the Fed is likely to provide Bank A with a loan to prevent bankruptcy. However, by ongoing coordination the Fed makes sure that such disruptions do not occur too frequently.
Regardless of the nature of legal reserve requirements, when the Fed pumps new money into the system, the new money is not reserves as such but new money that the bank is likely to use in its lending activities. Moreover, even in the present monetary system that is coordinated by the central bank, banks do not lend first and worry about funding later on. On the contrary, like any other business, banks are constantly engaged in the management of assets and liabilities.
So before any lending is undertaken, it must be fully funded. Any unfunded lending runs the risk of undermining the existence of a bank. What’s more, if the bank fails to clear its checks and runs a deficit in its account with the central bank, the Fed will charge the bank a penalty rate for having a deficit. In short, while the central banking system provides support for fractional reserve banking, it doesn’t approve completely reckless lending by commercial banks. Otherwise the whole system would have collapsed very quickly.
Finally, not only does fractional reserve banking gives rise to monetary inflation; it is also responsible for monetary deflation. We have seen that banks—by means of fractional reserve banking—generate money out of “thin air”. Consequently, whenever they do not renew their lending they in fact give rise to the disappearance of money.
This must be contrasted with the lending of genuine money, which can never physically disappear unless it is physically destroyed. Thus when John lends his $50 via Bank A to Mike, the $50 is transferred to Mike from John. On the day of the maturity of the loan, Mike transfers to Bank A $50 plus interest. The bank in turn transfers the $50 plus interest adjusted for bank fees to John—no money has disappeared.
If, however, Bank A practices fractional reserve banking, it lends the $50 to Mike out of “thin air”. On the day of maturity when Mike repays the $50 the money goes back to the bank—the original creator of this empty money; that is, money disappears from the economy, or it vanishes into the “thin air.”
Hence, in order to prevent monetary disruptions brought about by monetary deflation, what is needed is the establishment of a genuine free market and not a reliance upon the Fed’s aggressive, loose monetary policies as suggested by the popular view.
Conclusions
Whether legal reserve requirements are applied on the average of the last four weeks deposits or on same day deposits is beside the point, so far as the money multiplier is concerned. The existence of the money multiplier is the outcome of fractional reserve banking, which the current banking system makes possible. In short, it is the existence of the central bank that enables banks to practice fractional reserve banking, thereby creating inflationary credit.
- 1Gene Epstein, “Money Supply Makes the World Go ‘Round”, Barron’s, October 21,2002.
- 2Murray N. Rothbard, The Mystery of Banking , New York: Richardson and Snyder; (1983) p. 93.
- 3Ludwig von Mises 1980, The Theory of Money and Credit, Indianopolis, Ind.: Liberty Classics;( pp. 300–01).
- 4Murray N. Rothbard 1978, “Austrian Definition of the Supply of Money,” in New Directions in Austrian Economics, p. 148.
- 5Jeffrey M. Wrase, “Is the Fed being swept out of control?”, Federal Reserve Bank of Philadelphia November/December 1998. See also, Richard G. Anderson and Robert H. Rasche, “Retail Sweep Programs and Bank Reserves”, 1994–1999, Federal Reserve Bank of St. Louis January/February 2001.
