Fractional Banking is a Mirage

Some economists call for 100% reserve requirements of demand deposits. Reserving requirements and the money multiplier are often discussed at the same time.

The economic theory in support of increased reserving requirements and fractional banking is the theory of banks as creators of money.

The essence of this theory holds that:-

1. bank credit is accepted as money, and
2. customer deposits can be leveraged to create money.

Perhaps one should differentiate between “bank deposits” and “customer deposits”. The premise is that a bank can give a debtor a credit limit and the debtor can utilise the “credit” as if it is money.

The theory is normally simplified in the Monopoly bank with a 20% reserve requirement as follows:-





The model is static so a new deposit originating outside the construct must be introduced to facilitate the money creation process. This external source could be the activity of a Central Bank but is simply defined as an external source. The absence of a defined source allows the model to be built on fiction and is a logical quickstep required to make this theory work.

Introducing 100 units of deposit from an external source would allow the Monopoly Bank to use the new deposit for reserving requirements and “create” credit for 400 units. The new Balance sheet would be as follows:-





The 20% reserve requirement can be tested at 1500 x 0.2 = 300 units and the model is stable again.

This theory is generally taught as true but with criticism. It is actually fatally flawed and incorrect. The fatally flawed components are disguised in the undefined external source. Even more relevant is the time between the introduction of the External Deposit and the re-balancing of the Monopoly Bank’s balance sheet. The most important omission is that a production channel is accessed in this period.

The Source of all Deposits

There are two sources of deposits:

1. Savings which originates form a production surplus. Such “Savings” are available for a specific time period which can be for an hour, a day, a week a month, ten years or any such period in accordance with the specific needs of the Saver. Thus a person receiving wages on Friday afternoon may allocate his or her wage income over the next 7 days towards consumption yet a portion will enter the pool of savings and an ever diminishing portion will be available as “Savings” for the next 7 days. Note that the wage was earned in the production process. The “Savings” is 100% supported through production.
2. Unfunded monetary credits originating from “an external source”. Unfunded monetary credits are not “backed” by a production input to the economy and as such are imposters pretending to be savings.

Testing the Fractional Banking Model against the origin of deposits.

The receipt of the 100 units of External Deposit by the Central bank as a reserve requirement may have been sterilised at the Central Bank. Let’s make it so for the sake of simplicity but it is not a prerequisite requirement. Monopoly Bank granted credits of 400 units but such credits did not simply go from the recipient of the credit straight back to the Monopoly bank. No, the recipients used the credits for a purpose, to pay taxes (government spending), to buy consumables (consumer spending) or for investment (investment spending).

The 400 units of money entered the economy and the recipients received economic value for the credits. Economic value in the form of production value. Let’s proceed with a short cycle and state that the producers deposit the proceeds with Monopoly Bank.

The fact is that the 400 new units of deposit originating from the bank credits are backed by a production process. This is an absolute truth. To borrow on one hand and re-deposit on the other would only be possible under arbitrage conditions and can never fulfil any role in general economic theory. The application of the 400 units will cause malinvestment and misallocation of resources as it was made possible by a supply of unfunded monetary credit. The external origin of unfunded monetary credits is the malaise, not the banking sector when it performs its functions as expected.

It is therefore not valid or true to claim that the Monopoly Bank had created money. The Monopoly Bank did anticipate the receipt of savings backed by a production process. How was this possible? Again the model is silent. It could only happen if the Monopoly Bank could obtain a “loan” from an external source to fund the process until such time as the 400 units returned from the production process. Such a loan could have no other nature than that of an unfunded monetary credit.

Interventionism
The fractional banking model is incorrect and economically dishonest by omission. It requires two very specific monetary interventions to facilitate debt formation. A pre-existing much more menacing intervention is reserving.

Economists seldom realise that the very act of reserving is a severe intervention. It acts against the interests of the very economic participants it pretends to favour, the Saver. Any form of reserving requires that a portion of legitimate Savings must be removed from the economy, logic enmeshed in true Keynesian tradition. Savings sterilised is the only Savings not available to the economy in the normal course and robs the Saver of potential rent.

The interventions in the relationship between the Borrower and the Bank should receive the criticism of the libertarian economist. Similarly should the interventions in the relationship between the Saver and the Bank be criticised. Proposals to sterilise the Savings in the economy through reserving should not be confused with sterilisation of money creation from nothing. The one is a result of a production process in the economy, the other comes from nothing.

A 100% reserving requirement would entirely remove any rent that the Saver could earn, limit available savings and severely damage the economy.

The problem of money creation must be addressed at the intervention where it happens and not be exacerbated by punishing the Saver, the Bank, the Borrower and the economy. Each of these entities is a legitimate participant to the market and entitled to pursue its own best interests in true libertarian fashion.

The collection of short term savings in demand accounts is still legitimate savings. A discretionary subjective judgement regarding “demand deposits” should not take the place of a functional intent, that is, the bank must at all times comply with such demands of fail as a bank. Such is the nature of free market economics.

It is a fundamental function of banks to manage the pool of all deposits to achieve a transformation of funding time preferences inherent to the management of a dynamic deposit pool. Any deposit pool will have a predictable and stable component which can be utilised across the yield curve to provide much needed term funding. A 100% reserving requirement would destroy this market function of banks, invite the inevitable intervention spiral, impose an economic cost on unsuspecting economic participants, distort the much maligned savings market even further and starve the economy of the largest pool of savings available.

The interventionism of reserve requirements is similar to all other interventions and will generate the usual outcome of unintended consequences.


2 February 2009

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