So fractional reserve banking is simply a mix of full reserve banking and savings and loans banks. Banks keep some reserves say 10% and loan out the other 90%, then the money loaned is spent within the economy, redeposited and the process repeats.
In full-reserve banking the deposits are simply stored and not loaned out. In essence, it is more like storage than banking. No interest is paid.
For savings and loans banking, the depositor cannot withdraw his money until after a certain period of time while his money is being loaned to someone. Interest can be paid at the expense of not having access to the money.
Fractional reserve was created because there is no reason to have idle cash sitting in storage when not everyone needed to withdraw all their money at the same time.
The claim is that fractional reserve banking expands the money supply. This is technically true but only on paper. I don't believe that the price level rises. The reason that it seems as though the money supply expands is because banks pretend to have all their deposits and now there is more money in the economy because they loaned out their deposits. So if a bank had 100$ in deposits. They would loan out 90$ and pretend they had 100$ which would add up to a total of 190$. What people seem to forget is that the deposits in the banks won't be withdrawn and spent. So the money supply hasn't really expanded we're just counting the money that the banks claim to have.
You might also think that the reason the money supply expands is because money is continually loaned out and then redeposited. An example is the bank has 100$ in deposits so they loan out 90$, that money is spent then put back in the bank, so they loan out 81...etc. However, this shouldn't be inflationary because the exact same thing happens for the savings and loans banks. The only difference between savings and loans banks and fractional reserve banks is that the former tells the depositors they can't withdraw their money and the latter hopes the depositors won't withdraw all at the same time. Savings and loans banks take deposits and loan them out, those deposits are spent within the economy and then redeposited, just like for fractional reserve banking. No one claims that savings and loans banks are inflationary.
So why do people think fractional reserve is inflationary? What part of my understanding is flawed?
**The reason fractional reserve banking gets out of hand is simply because of the central banks that are a moral hazard, a "lender of last resort". This is why banking crises can occur. However, it is does not affect my claim.
thanks
So fractional reserve banking is simply a mix of full reserve banking and savings and loans banks. Banks keep some reserves say 10% and loan out the other 90%, then the money loaned is spent within the economy, redeposited and the process repeats. In full-reserve banking the deposits are simply stored and not loaned out. In essence, it is more like storage than banking. No interest is paid.
Only in the case of demand-deposits. Full-reserve banking does not preclude loans... after all, you could directly loan your own money without the intermediation of a bank... where would the fractionation be? If "full-reserve" loans by individuals are possible then, certainly, full-reserve loans by banks (aggregation of individual savers) are possible.
For savings and loans banking, the depositor cannot withdraw his money until after a certain period of time while his money is being loaned to someone. Interest can be paid at the expense of not having access to the money. Fractional reserve was created because there is no reason to have idle cash sitting in storage when not everyone needed to withdraw all their money at the same time.
Nonsense. If a depositor did not need his money on demand, then he could put it in a savings account where it would be available after some fixed waiting period on demand. This waiting period represented an implicitly renewed maturity so long as the money was left in the savings account. If the bank could return the money sooner, all the better for the depositor. Certificates of deposit are an even more advanced version of this concept.
The claim is that fractional reserve banking expands the money supply. This is technically true but only on paper. I don't believe that the price level rises.
Look at the True Money Supply metric versus the Dow Jones Industrial Average. It's virtually a 1:1 correlation. Prices absolutely are affected by expansion of the money supply (which effect fractional reserves has).
The reason that it seems as though the money supply expands is because banks pretend to have all their deposits and now there is more money in the economy because they loaned out their deposits. So if a bank had 100$ in deposits. They would loan out 90$ and pretend they had 100$ which would add up to a total of 190$. What people seem to forget is that the deposits in the banks won't be withdrawn and spent.
Until it is. This is called a "bank run". Government protection of banks during bank runs (read "government screwing over depositors during bank runs") is the sufficient condition for fractional reserve banking.
So the money supply hasn't really expanded we're just counting the money that the banks claim to have.
Yeah, when the amount of money banks have expands, the money supply has - by definition - expanded. Here is an article by Joseph Salerno on Rothbard's TMS that breaks this down in excruciating detail what exactly is and is not part of the money supply in the US fiat dollar system.
You might also think that the reason the money supply expands is because money is continually loaned out and then redeposited. An example is the bank has 100$ in deposits so they loan out 90$, that money is spent then put back in the bank, so they loan out 81...etc. However, this shouldn't be inflationary because the exact same thing happens for the savings and loans banks. The only difference between savings and loans banks and fractional reserve banks is that the former tells the depositors they can't withdraw their money and the latter hopes the depositors won't withdraw all at the same time.
S&L's are also expansionary. You seem to be conflating S&L with your (mistaken) definition full-reserve given above.
Savings and loans banks take deposits and loan them out, those deposits are spent within the economy and then redeposited, just like for fractional reserve banking. No one claims that savings and loans banks are inflationary. So why do people think fractional reserve is inflationary? What part of my understanding is flawed? **The reason fractional reserve banking gets out of hand is simply because of the central banks that are a moral hazard, a "lender of last resort". This is why banking crises can occur. However, it is does not affect my claim. thanks
OK, I'll try my best.
Full-reserve banking system: Bob: Deposits $100 in Bank A
Alice: Goes to Bank A seeking a loan. She acquires a loan of $50 which she uses to buy fertilizer.
Bob: Goes to Bank A to withdraw his $100 to buy a lawnmower. Bank A tells him that $50 is available for immediate withdrawal but the remaining $50 is currently out on loan to Alice (as per the terms and conditions of the bank account when Bob signed up) and he will have to await her repayment before he can collect his remaining $50. Bob now has to wait until Alice repays her loan to Bank A before he can buy the lawnmower.
This shows that it may be fraudulent for the bank to lend long money which it has for short duration. If the terms of the account were that the bank would repay Bob within 30 days of his request but the bank lent Bob's money to Alice for 90 days, Bob has a case to sue against the bank for loaning out his money against the terms of the contractual arrangement between himself and the bank.
Fractional-reserve banking system:
Bob: Deposits $100 in Bank A
Alice: Goes to Bank A to secure a $50 loan. Bank A grants the loan to Alice without diminishing Bob's account, which still has $100. Alice immediately purchases fertilizer.
Bob: Comes in to Bank A to request his $100 so he can buy a lawnmower. Bank A does not have the funds on hand but, since they are part of the Federal Reserve System, they ask for and receive a temporary line of credit from the Fed of $50, with which they pay Bob. Bob immediately goes out and buys his lawnmower.
There is now really $150 in existence where there had been only $100 before. This can be seen because Alice has purchased fertilizer with the $50 loan and Bob buys his lawnmower immediately. This would not have been possible in the full-reserve system where the money on loan must first be repaid before it can be spent to buy anything else.
The essence of loaning money is that the creditor must give up the use of that money for the duration of the loan. In fractional-reserve, lenders do not have to give up the use of their own money. But when the lender and borrower are using the "same" money simultaneously, this is logically equivalent to monetary expansion and necessarily results in a rise in prices.
Hope that helps.
Clayton -
"...since they are part of the Federal Reserve System, they ask for and receive a temporary line of credit from the Fed of $50". THEY CAN DO THAT??? The reason in this case that fractional reserve banking is inflationary is because they would be receiving a "temporary line of credit". The Federal Reserve would be expanding the money supply, not fractional reserve banking in itself. Right??
In a free market where there was no central bank. Banks that were storing gold/money would see that, lets say, 100% of the time they only needed 90% of their gold because depositors aren't withdrawing more than 90% of total deposits at once. So they would engage in loaning out 10% of the gold that the depositors never use. This would be fractional reserve banking however it would not be inflationary.
so.... thoughts?
"...since they are part of the Federal Reserve System, they ask for and receive a temporary line of credit from the Fed of $50". THEY CAN DO THAT??? The reason in this case that fractional reserve banking is inflationary is because they would be receiving a "temporary line of credit". The Federal Reserve would be expanding the money supply, not fractional reserve banking in itself. Right?? In a free market where there was no central bank. Banks that were storing gold/money would see that, lets say, 100% of the time they only needed 90% of their gold because depositors aren't withdrawing more than 90% of total deposits at once. So they would engage in loaning out 10% of the gold that the depositors never use. This would be fractional reserve banking however it would not be inflationary. so.... thoughts?
Until there is a hiccup in the market and more than 10% of depositors want to cash out... without a central bank, such fractional banks in a gold coin economy will collapse. This was the whole rationale for central banking in the first place. The public was told that the cause of bank collapses was "panics" and that these if only the public could be given a little time to "cool down" from its panic, the depositors would see there was no reason to go all bananas and all withdraw their money simultaneously, and so on, and then the bank wouldn't collapse and everyone will be happy forever and ever amen. The catch is that you gotta have a "lender of last resort"... turns out that such a lender is inflationary. Inflation can occur even without a central bank but it's dangerous to the inflating banks (they are putting themselves at increased risk of collapse). When there is a hiccup in the market, then you have Warren Buffet's quote, "when the tide goes out, you can see who's been swimming naked"... people run on the banks and those banks that were playing the fractional reserve game go bust and end up in bankruptcy court.
"Inflation can occur even without a central bank but it's dangerous to the inflating banks". What?? How can you inflate the money supply, without having a central bank that has the capability of printing money? Fractional reserve banking will not magically produce more gold/money.
Fractional reserve banking was not possible until people began to accept bank notes and loans on the bank's ledger. Of course it won't make more gold exist but a dishonest banker can make his customers believe more gold exists in his vault than actually does.
Why wasn't fractional reserve banking possible? If you had 100 pieces of gold on deposit. You could loan out 90 pieces and keep 10 in case anyone wanted to withdraw some money. "Hiccups" in the market can occur for the individual but for a class of people it is different. There is consistency. A class of people will only withdraw a certain amount of money at all times which makes fractional reserve banking viable.
If the banker can trick customers into believing that there is gold in their vaults when there really isn't then it will not be inflationary. No one can withdraw the money to spend it so prices will never be affected. If depositors try to withdraw money then obviously that will result in a bank run where the banks tell depositors they don't have the money.
Why wasn't fractional reserve banking possible? If you had 100 pieces of gold on deposit. You could loan out 90 pieces and keep 10 in case anyone wanted to withdraw some money.
That is what I mean by "loans on the bank's ledger" - before the ledger, your account was your gold pieces sitting in the vault. Handing those out would have just been simple theft. I don't know how people kept track of gold deposits - I remember reading about a Sumerian clay tablet that was a receipt for grain in a warehouse that was made out "to the bearer", meaning that it was exchangeable, like a bearer's banknote. Anyway, when banks started using ledgers, then it was possible to loan out X gold coins and place an entry in the ledger indicating that X coins had been lent out. Once the bank ledger was invented, there was the concept of an "account balance" and account balances could be "inflated" by simply crediting gold coins to one account without debiting them from another account. But this really wasn't the origin of inflation because this sort of fractioning is very risky since you can't artificially increase the number of gold coins. It was once people began to accept bank notes that inflation became really powerful because now the bank could loan out bank notes rather than gold coins. When the bank loaned gold coins, its reserves went down by the amount of the loan but when the bank loaned bank notes, its reserves did not have to go down. This made the prospect of a bank run much more manageable and you could get away with a profitable amount of inflationary expansion without incurring too much risk of collapse.
"Hiccups" in the market can occur for the individual but for a class of people it is different. There is consistency. A class of people will only withdraw a certain amount of money at all times which makes fractional reserve banking viable.
Tell that to the banks that collapsed in the 30's ... or to IndyMac bank. Or Lehman Brothers.
If the banker can trick customers into believing that there is gold in their vaults when there really isn't
That would be some trick. Even David Copperfield couldn't pull that one off.
then it will not be inflationary. No one can withdraw the money to spend it so prices will never be affected.
But you're missing the point... the money has been withdrawn and spent and all that is left at the bank are ledger entries or paper notes that give individuals the illusion that they have gold in the bank when, in reality, the gold is out there being spent and driving up prices (inflation).
If depositors try to withdraw money then obviously that will result in a bank run where the banks tell depositors they don't have the money.
Yep.
Lehman Brothers failed because of the moral hazard of the Federal Reserve. And the ultra low interest rates, freddie and fannie and the tax code which all perpetuated the bubble. In the 30s, it was the same thing. The banks failed because the Federal Reserve encouraged them to lever up. I believe fractional reserve banking can be very useful for people who want immediate access to their money who don't know which days they will need the money and which days they won't. Fractional reserve banking satisfies this need and can pay interest as well, rather than just sitting in a vault.
"then it will not be inflationary. No one can withdraw the money to spend it so prices will never be affected."
No. fIt is true that the money has been loaned out and therefore is being spent however that is real money. It's not like the money supply is being increased. The depositors think they have their money when they really don't. The people who are abstaining from purchases are the depositors. It's not like the money is being spent twice. It is just the people who got the loan who are spending it instead of the depositors.
All a bank needs to increase the money supply in a fractional-reserve banking system is acceptance of his bank notes. He can inflate his bank notes.
If the bank can inflate bank notes why do bank runs occur? The bank could just issue more and more bank notes and never have to default???
If the bank inflates bank notes then why does the money supply shrink when the bank goes bust?
The bank run is caused by people claiming the real money to which the bank note entitles them. They don't want more notes, they want their money.
In a fiat money system it is the same thing. Explain how the money supply shrinks if a bank fails
"It's not like the money is being spent twice. It is just the people who got the loan who are spending it instead of the depositors."
It is being spent twice. I think what is tripping you up is that you are assuming that they can only spend the physical money. But that is not the case. Most transactions made are not done with physical money. They are done by checks or electronic transfers. This is how the money is spent twice. The bank does not need to produce any physical money to cover the vast majority of transactions. The banks simply lower the balance in one account and increase the balance in another account.
As you can see no physical cash was used at all by the banks customers. Yet they were able to buy $1800 worth of goods. The demand for physical cash is (under normal circumstances) very, very low. No one uses cash for large puchases, so the banks only need a small amount on hand to cover all of the small, petty transactions. Everything else is electronic.
Thanks! That helps a lot.
You don't need a central bank at all to conduct this sort of business though. The banks are just creating their own type of money(credit). They are allowing people to bid up prices with money they create.
How does credit get destroyed, allowing the money supply to shrink? What are the chain of events?