RESERVE BANKING REVISITED
|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:
As soon as 80 percent of the derivative deposits is withdrawn, the following transactions take place: $796.16 are withdrawn, and derivative deposits are reduced to $199.04.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:
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:
*(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Not one cent could be withdrawn from that bank since the reserve ratio is already below the legally required 17 percent.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.
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 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.
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.
J. N. Tlaga, How to Defang All the Banks, January 5, 2004, www.gold-eagle.com
J. N. Tlaga, Questions and Answers, January 15, 2004, www.gold-eagle.com
J. N. Tlaga, Why the Austrian School Needs to Purge Its Flaws, January 24, 2004,
Brian Macker, Fractional Reserves and the Creation of New Money, January 8, 2004, Mises Economic BLOG, www.mises.org
Gary North, Mises on Money, Part IV, Fractional Reserve Banking, January 24, 2002, www.lewrockwell.com
Antal E. Fekete
Memorial University of Newfoundland
St.John's, NL, CANADA A1C5S7
e-mail: [email protected]