My latest contribution to the debate on Milei´si banking reform and the 100% reserve ratio has received a response in form of a video by Juan Ramón Rallo who defends a fractional reserve banking system based on real bills. The video is mainly about the question of whether fractional reserve banking necessarily triggers an Austrian business cycle, given that fractional reserves allow banks to create new money (fiduciary media) and channel it into the loan market, thus lowering interest rates. Rallo argues that the credit expansion of fractional reserve banks poses no problems, if it is based on real bills and is even beneficial because it avoids deflation and a change in relative prices.
In the following, I would like to make a few brief comments on his argument and the example he employs in the video.
First of all, there is no doubt that when a fractional reserve bank discounts commercial paper (real bills) it creates money (perfect monetary substitutes) and increases the purchasing power of the recipient entrepreneur, as he does not have to wait the 30-60-90 days to get paid. In this way, savings are freed up that he had previously committed to give its customers a payment term. These savings he can now dedicate to investments without anyone having previously decided to increase their savings, generating an Austrian economic cycle.
Second, this new money is also reintroduced into the fractional reserve banking system. The entrepreneur who discounts his bills receives the ability to dispose of an account. Due to this account, the entrepreneur can pay his suppliers in cash, emptying the account. The entrepreneur´s suppliers deposit that cash with other banks which in turn do the same (keep a fraction and lend the rest), and so on. Another way of looking at it is that the entrepreneur does not withdraw the cash and pays with fiduciary media that reaches other banks (or the same one), multiplying these in the end in relation to the monetary base. In other words, fractional reserve banks reduce their cash ratio by granting new loans without prior savings.[1] In this way, the initial discount of the real bills arrives in successive iterations, multiplying fiduciary media and loans, always without the backing of new savings, aggravating the business cycle.[2]
Third, money is fungible. As mentioned in the previous point, once the new money is introduced into the system it can flow to other places. What is important, therefore, is less the quality of the initial loan (i.e., whether it is a discount of a real bill or a real estate loan) but the total quantity of the loans and fiduciary means created. If fiduciary media is introduced into the system through a commercial paper discount, the general conditions of the credit market become easier. Since the entrepreneur has received fiduciary media, funds are liberated. For example, the entrepreneur can now pay in cash instead of on credit, so that another entrepreneur now has more financial resources. Overall credit conditions in the market are relaxing. It’s easier to get loans and financing. And additional investments will tend to be made where the highest return is expected, i.e. in longer-term investments. Money, once introduced into the system, is like water and makes its way through small cracks into longer-term investments.
Fourth, if a bank issues new fiduciary media by discounting commercial paper, thereby alleviating the financial situation of the entrepreneurs who invest the money, there is only one scenario for the new investments to be sustainable: When the new money reaches the owners of the factors of production, they will not spend it on consumer goods, but will save it entirely until the new production projects are completed. However, this implies a relative increase in savings and thus a decrease in the social rate of time preference. In any case, this decrease in time preference would have made it possible to lengthen the structure of production without the need to produce new fiduciary media. Even in the unrealistic and purely theoretical case that all the fiduciary means created are saved and therefore the new projects do not represent malinvestments, their creation was unnecessary.
Fifth, the companies in Rallo’s example are not banks but wheat and barley producers that issue financial assets. The main business of banks today, however, is not to issue commercial paper but money, which is something categorically different. The problem is that fractional reserve banks issue perfect monetary substitutes in a greater amount than they hold money proper, i.e., banks issue fiduciary media. Economic agents subjectively regard these monetary substitutes as money. Money substitutes are money in a different form. Money is neither a consumer good nor a capital good, but money is sui generis. It is the generally accepted medium of exchange. It makes economic calculation possible. It’s the reference in an economy. Therefore, there is no difference of degree between money and financial assets such as commercial paper, but a difference of class. They are radically different.
Sixth, Rallo contests the argument that fractional reserve credit expansion is unbacked by real savings by arguing that if a real bill is discounted and the real bill is backed by highly liquid consumer goods, then the credit expansion is backed by real savings, because the entrepreneur could consume the consumer goods. Since the entrepreneur doesn’t consume the consumer goods backing the real bill, the entrepreneur is saving, according to Rallo.
The first question that arises is how, in a market economy based on the division of labor, the entrepreneur could consume his output in order to sustain himself during the production process. Let’s imagine a toothbrush manufacturer (not to mention a pet food producer). He can’t and won’t consume the thousands of toothbrushes he produces himself. He produces them to sell them in the future in exchange for money. And here we come to the crucial point. The production process is not yet complete if the toothbrushes are in the entrepreneur’s warehouse. If not, one would have to ask why the entrepreneur has not yet sold the supposedly finished consumer goods and collected money, because then he would not need the discount at all. He needs the loan because the production process is not yet complete. It is only completed when the products are transported to the consumer and paid for. The entrepreneur still must search and find consumers and convince them to pay with a proper sales strategy. Marketing is an important stage in the production process. Toothbrushes in the warehouse not yet charged are not real savings, but intermediate goods that have not yet fully matured (there are still some 30-60-90 days to go).
Seventh, the deflation that seems to scare Rallo so much is deflation derived from productivity increases. At least in his example, he’s just talking about production. Although Rallo insists on talking about an increase in the demand for money, the concept is nowhere to be found in his example. The increase in the demand for money due to a sudden increase in perceived uncertainty is not dealt with in his example. Rather the example deals with the production of commodities that are exchanged for money.
Eighth, maturity mismatching is not the cause of the business cycle in a free market. Entrepreneurs try to predict the future flow of savings. Short-term savers always replace other short-term savers. In fact, if the social time preference does not change, the gross flow of savings remains constant. In this way, entrepreneurs can use this savings stream to finance longer-term investments, replacing the savers who finance them. Therefore, maturity mismatching does not pose a problem if there is a foreseeable flow of savings and some savers are taking the position of others.
Ninth, Rallo’s scheme does not compensate for deflation but generates inflation that feeds on itself. For the real bills doctrine connects the money supply to a nominal value: the market value of consumer goods, which is obviously not independent of the money supply. When you start discounting bills by creating fiduciary media, the price of consumer goods begins to rise. And as the price of consumer goods rises, a larger volume can be discounted by creating even more fiduciary media, and so on.
Tenth, in practice Panama is a mini-financial market integrated into that of the United States and whose vicissitudes it has always followed in general terms.
Eleventh, the banking crises of the nineteenth century had their origins in the discounting of commercial paper. And there was no central bank in the U.S. For this reason, the American bankers (JP Morgan, Rockefeller, Kuhn, Loeb) pushed for the introduction of a central bank.
Finally, it must be said that for anyone interested in a systematic critique of the doctrine of real bills and a fractional banking system based on them, all the arguments can be found in my book “Anti-Rallo“. The English translation with the title “Full Reserve Banking vs. the Real Bills Doctrine” will soon be published by the Ludwig von Mises Institute. I would also recommend an in-depth study of Huerta de Soto’s book, “Money, Bank Credit and Economic Cycles,” especially chapter 8. The study of these works allows a global understanding of the issues and problems of the fractional reserve and, therefore, also of the unprecedented significance of the reform of the financial system sought by Javier Milei by enforcing the legal principles that require to maintain a reserve ratio of 100% for demand deposits.
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[1] This process is limited by the system’s maximum ability to expand credit.
[2] For this point and the previous one, see also the lecture by Jesús Huerta de Soto (2024) ) “Lincoln y la Unión Europea (con una crítica de la denominada “Teoría de la liquidez” (English version)
