Fractional Reserve Banking Revisited

Fractional Reserve Banking Revisited

by Antal E. Fekete

GOLD STANDARD UNIVERSITY

Winter Semester, 2004

Addendum to: Monetary Economics 101: The Real Bills Doctrine of Adam Smith

SPECIAL EXTRA

· Does Fractional Reserve Banking Involve Counterfeiting?

· Horizontal Division of Labor

· The Self-Liquidating Bill of Exchange

· The Bill Market

· Vertical Division of Labor

· Bank Credit Financing Production Not Inflationary

· Chairman Patman's Mistake

· Paradise Lost

· Mises versus Adam Smith

· The Second Greatest Story Ever Told

Does Fractional Reserve Banking Involve Counterfeiting?

A new dispute has flared up between protagonists and detractors of fractional reserve banking. This is a welcome development because the burning issues under the ashes jeopardize the success of the honest money movement.

Joseph N. Tlaga challenges the long-standing position of the Austrian School of Economics, reflecting the views of Ludwig von Mises, that the commercial banking system is creating money "out of thin air" when it issues note and deposit liabilities backed by fractional reserves of gold, so that if all depositors and note-holders presented their claims simultaneously, then the banks would go bust. In the view of the Austrians this "counterfeiting process" is at the root of the boom-bust cycle.

I wish to congratulate Tlaga on his courage to defy conventional wisdom, and on his insight that there is no counterfeiting per se involved in fractional reserve banking, so the root of the boom-bust cycle must be found elsewhere. He goes on record as saying that the Austrians have never grasped the real meaning of fractional reserve banking. Since lending more than available reserves would send the bank bust in a matter of days, the question is raised why the Austrians never re-examined their position on this issue.

Tlaga also observes that the incorrect perception of fractional reserve banking is endemic. It is never questioned, and the error has been shared by too many for too long. In particular, it is being cultivated by the fiat money establishment as well as the banking fraternity (presumably because of one's reluctance to dispel the myth of one's own importance, not to say omnipotence). According to Tlaga 100 percent reserve banking advocated by Mises would never work. "If the misguided Austrian imperative to use police power to enforce 100 percent bank reserves were carried out, then an immense amount of credit would disappear instantaneously, the economy would be paralyzed, and the honest-money movement would have to take the blame... People who stick to the mantra that abolishing fractional reserve banking is a prerequisite for returning to honest money should know that they are doing a disservice to the cause..."

Horizontal Division of Labor

Unfortunately, Tlaga's demonstration that loans extended by the fractional reserve bank do not add one iota to the stock of purchasing media as they merely mobilize otherwise idle bank balances, does not hold water. Brian Macker has published a short rebuttal in Mises Economics BLOG, but it hardly does justice to this important issue.

In his argument Tlaga uses the example of producing automotive fuel called gasohol. The Distiller raises a number of bank loans to purchase corn, potato, rye, and sugar cane from his suppliers who deposit the banknotes in their banks which promptly collect the fractional gold reserve from the Distiller's bank. Tlaga concludes that the banknote and the gold coin cannot circulate simultaneously. In his view the banknote is merely a substitute for, never a supplement to, the gold coin.

Tlaga's description of what happens is erroneous. The horizontal division of labor of the Distiller and his suppliers obscures the fact that the latter must use the proceeds to pay their own suppliers, and are in no position to leave large cash balances idle in the bank. If we want to decipher the mysteries of fractional reserve banking, then we should consider vertical division of labor and track the footprints of banknotes that way.

The truth of the matter is that banknotes and bank deposits arising out of loans raised by the producers do indeed add to the stock of money. They enter into circulation and finance further transactions, as Macker says. Still, Tlaga is right in asserting, and Macker is wrong in denying, that money created this way did not come out of thin air.

Self-liquidating Bills of Exchange

"Fractional reserve banking" is a misnomer as it suggests that part of the money created through the loan process is backed by nothing. In reality, the part not backed by gold reserve is fully backed by a bank asset called self-liquidating bill of exchange (bill for short). As Mises himself would admit, bills are capable of monetary circulation (as they did indeed circulate in the Manchester area that lay outside the boundaries of the monopoly of the Bank of England in the 19th century).

A bill is a written promise by the Producer to pay the Supplier the face value at maturity, less than 91 days away, for supplies shipped. When endorsed by the Producer, the bill can circulate through further endorsing. First, the Supplier can use it to pay his own suppliers who can, in turn, do the same. Such payments are subject to discounting at the going discount rate (not to be confused with the rate of interest!) by the number of days remaining till maturity. Therefore using the bill for payment is also called discounting it.

The Bill Market

It is important to understand that the economy could very well operate entirely without commercial banks (as it did in the Manchester area in the 19th century). Suppliers would draw bills on producers and discount them in the bill market. At maturity bills are paid in gold coins. The market would keep bill trading under tight control. If too many "Miller on Baker" bills were discounted, the market would refuse to trade them. If in the event the miller and the baker conspired to finance their speculative stores of grain, they would be blacklisted. The market would not touch any paper on which the signature of either of them appeared. Not as if anything was wrong with speculation in grains, but speculative stores ought to be financed through other means. The bill market was meant specifically to finance the production of merchandise that moved fast enough to the final consumer so that the gold coin of the latter could liquidate all claims in less than 91 days (or 13 weeks, or 3 months, or one quarter, that is, the length of the seasons of the year). Bills drawn on merchandise that did not move fast enough were not eligible for discounting. The production of such slow-moving merchandise, as well as holdings of goods in speculative stores, was supposed to be financed by the loan market at the higher interest rate.

The bill market would watch like a hawk that the 91-day rule was not violated. The reason for this rule is that consumer demand changes with the seasons. Goods that could not be sold in 91 days might not be sold for 365 days, till the same season of the year has come around once more. But by that time consumer taste may change, and the merchandise may be unsaleable except at a loss.

Vertical Division of Labor

The circulation of the bill mirrors vertical division of labor. We may track it through the example of the "Weaver on Tailor" bill. The Tailor is producing clothes for his customers. The Weaver delivers cloth to the Tailor and bills him. The Tailor "accepts" the bill by endorsing it, agreeing to pay the face value in 91 days or less, and returns it to the Weaver. The Spinner delivers yarn to the Weaver and gets paid by the same bill, after the Weaver has also endorsed it. Through endorsement the claim to the proceeds is transferred to the Spinner. The Sheep Farmer delivers wool to the Spinner and gets paid by the same bill, after the Spinner has also endorsed it. The claim to the proceeds has been transferred once more, this time to the Sheep Farmer. In this way the bill continues its journey from supplier to supplier, the last of whom presents it to the Tailor for payment at maturity. By that time the latter has the gold coins from the sale of clothes to the final consumer. When he pays the bill in gold, all claims that have arisen during the course of this particular production cycle are extinguished.

As can be seen, the bill has "telescoped" several payments into one, and the pool of circulating gold coins had only to be invaded once instead of several times. The final consumer's gold coin was all that was needed to finance the production of the consumer good, regardless how many hands were involved in producing it. Thus the bill makes great economy in the use the gold coin possible. This is quite important, as a dearth of gold could threaten the production process with seizing up. Moreover, during certain times of the year (such as crop-moving time, or at Christmas) the existing pool of circulating gold coins may not be sufficiently large to accommodate all demand if it is invaded every time anybody moves a maturing product, however briefly. The bill of exchange comes to the rescue, by providing an elastic supply of purchasing medium. Bill circulation waxes and wanes together with the volume of business to be transacted.

Bank Credit Financing Production Not Inflationary

As already pointed out, every time the bill is endorsed and passed on, a discount is applied to its face value at the going discount rate by the number of days remaining to maturity. Thus the bill is an earning asset that banks are eager to have. Moreover, the bill is the most liquid asset a bank can have, second only to the gold coin itself. It is called "self-liquidating" as it is paid at maturity with the gold coin of the final consumer. For these reasons banks compete for the bills by offering to discount them at the best (i.e., lowest) discount rate that is still compatible with the profitability of the commercial banking business.

Banks replace bills with bank deposits on which producers draw checks to pay their suppliers. Writing checks is more convenient than discounting bills, and the producers are glad to pay for this convenience in the form of forgone discount. It goes without saying that the bank is not supposed to "roll over" a mature loan even if (or, more to the point, because of) the underlying merchandise has failed to sell. A new loan ought to be negotiated to finance the next production cycle.

Please note that the gold coin is absolutely essential in this system of financing the production of merchandise in urgent consumer demand. The gold coin is the ultimate extinguisher of debt. Without it a perpetual debt tower would keep growing. No irredeemable currency, whether issued by a private bank, by a central bank, or by the Treasury of a country possessing the most formidable arsenal of weapons of mass destruction can match the debt-extinguishing power of the humble gold coin.

I have observed that bank deposits arising out of loans, contrary to Tlaga's view, do in fact add to the stock of purchasing media. Does this then mean that financing the production of consumer goods through bank credit is inflationary? No, it does not. Inflation means the issuance of purchasing media in excess of goods available. In the present case, the bill emerged simultaneously with the emergence of new merchandise in urgent demand of the same value, and would disappear from circulation at the same time as the merchandise is sold. The net effect on the stock of purchasing media is nil.

This is a point which the Austrian School stubbornly refuses to admit. Its view is rigidly governed by the untenable Quantity Theory of Money according to which any and all credit in excess of gold in the vault plus bank capital are inflationary. Adam Smith's Real Bills Doctrine is proscribed by the Austrians - a most regrettable position from the point of view of the honest money movement.

Can the banking system, operating on the principle of fractional reserves as described above, be embarrassed by gold withdrawals? Hardly. On average one ninetieth of the bills outstanding mature every single day bringing in gold coins the final consumer has disbursed in exchange for merchandise he urgently wanted. These coins are available to satisfy normal demand for gold. If one particular bank experiences extraordinarily heavy withdrawals, it can get gold from another experiencing an overflow, by rediscounting bills yet to mature. As long as the government is not out to sabotage the gold standard, and banks do not violate the 91-day rule, the system will work smoothly and efficiently. The charge that fractional reserve banking creates money "out of thin air" is preposterous.

Chairman Patman's Mistake

Wright Patman, the legendary populist chairman of the Ways and Means Committee of the U.S. House of Representative in the 1950's, made the following erroneous statement in his 1128th Weekly Letter of April 7, 1955, to his constituents: "Money and credit are manufactured by the commercial banking system. For every one dollar in reserves that a commercial bank has, it can create six dollars of additional credit, which it can then loan and earn interest upon."

Assuming that the bank is required to keep a ratio of $1 of reserve against $6 of deposits (approximately 17 percent), this does not mean that for every additional dollar of reserve the bank obtains it could lend $6 and create $6 additional deposits. If that were the case, then banks could earn 30 percent interest on each dollar of surplus reserve provided that loans were made at the rate of 5 percent. Patman does not allow for withdrawals of deposits arising from loans. However, the fact is that people do not borrow in order to leave all the proceeds as an idle balance in the bank.

Assuming that an average of 80 percent of deposits resulting from loans (called derivative deposits) are drawn out and cash deposits (called primary deposits) remain undisturbed, furthermore, that the bank is required to maintain a reserve of 17 percent against its deposits, the bank could lend only about 99½ cents for each $1 gained as a cash deposit, or approximately $1.20 for each dollar of surplus reserve, and not the $6 alleged by Patman. Here is the maths in full details.

Suppose that some depositor places a sum C in a bank (primary deposit), thereby increasing the bank's cash or reserve by the same amount; we want to calculate the amount X of additional credit the bank can create. Let r denote the ratio of reserves to deposits that the bank is required to keep, and let K denote the ratio of funds to loans that, on average, borrowers leave on deposit. Then

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

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 = 16b/100 or approximately 17 percent, then

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:

Assets: Liabilities:

Reserve $1,000.00 Primary deposits $1,000.00

Loans 995.20 Derivative deposits 995.20

$1,995.20 $1,995.20

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:

Assets: Liabilities:

Reserve $203.94 Primary deposits $1,000.00

Loans 995.20 Derivative deposits 199.04

$1,199.04 $1,199.04

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:

Assets: Liabilities:

Reserve $1,000 Primary deposits $1,000

Loans 4,980 Derivative deposits 4,980

(6×$830 surplus reserve) $5,980

$5,980

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.

Paradise Lost

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 phoney, 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 versus Adam Smith

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.

The Second Greatest Story Ever Told

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.

References

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, www.gold-eagle.com

Brian Macker, Fractional Reserves and the Creation of