Fractional Reserve Banking and the Money Multiplier

Here is the John Tamny commentary that was the subject of James Miller’s piece, which I commented on here.  Tamny’s commentary is worth a read, and I find several items worth expanding upon.

He begins by discussing the dialogue occurring about increasing bank reserve requirements as a possible step toward improving stability in financial markets today.  He suggests that any such rule likely will not be helpful, as well-run banks will see profits reduced due to having less available to lend, while poorly run banks will then be recipients of these profits.  Underlying his comments here is an idea with great merit: a regulated, one-size-fits-all policy will do nothing to improve the health and stability of the financial sector (as is true for every sector).  Competition will determine the best practices, and top-down mandates – no matter how “conservative” – can never be as efficient or as stable (even a top-down mandate of 100% gold reserves).

As he does not see a one-size-fits-all reserve requirement as beneficial, he finds even less merit in the call for 100% reserves:

And then there are those, most notably Rep. Ron Paul, who believe that no reserve requirement is enough. Their view is that fractional reserve banking – whereby banks lend out the vast majority of their deposits on hand – is the height of moral hazard such that banks should operate under 100% reserve requirements.

I cannot claim to know all of the things Dr. Paul has said and has written about money and banking.  I do know he has called for competitive currencies and has even recently held hearings on this subject (I am waiting to see transcripts of his opening and of some of the testimony).  I have read and heard enough of Dr. Paul to know that – overriding all economic positions he advocates – free-markets and open competition represent the optimal structure for man’s economic well-being.

Paul’s intellectual mentor in this area is the late Murray Rothbard who proclaimed that “Fractional reserve banks…create money out of thin air. Essentially they do it in the same way as counterfeiters.”

This is certainly Rothbard’s position.  However, Dr. Paul has many intellectual mentors when it comes to money and banking.  In addition to Rothbard, there is Mises.  Most directly, I have read Dr. Paul give credit to Hans Sennholz.  While Rothbard has a strong focus on the problems caused by fractional reserve banking, Mises and Sennholz are not so focused on this, in fact seeing other issues as more fundamental in causing ills in the modern banking system – primarily, looking for free competition. 

In my last post, I referenced several Mises quotes regarding this subject.  Today, I will bring Sennholz into the discussion, referencing an earlier post I wrote on the subject of his work in banking.  Sennholz is quite focused on the monopoly and government protection, not concerned with issues of the amount of reserves held at individual banks:

The primary objective must always be the abolition of the money monopoly and legal tender coercion.

He then lists his conditions for returning the banking system to a sound basis:

1)          Mint gold and silver coins denominated only by weight and purity.

2)          Repeal legal tender laws and permit specific performance of payments.

3)          Permit financial institutions to issue private notes, and permit banks to accept deposits denominated in foreign currencies and weights of gold and silver.

4)          Permit free entry into banking.

5)          Permit interstate banking.

6)          End mandatory membership in the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and any other agency or cartel.

7)          Prevent tax discrimination against all forms of money.

Nowhere does Sennholz call for any specific reserve requirement, let alone a 100% reserve requirement.

I am not certain what Dr. Paul suggests here, but I do not believe it is as clear as Tamny suggests.  I believe Sennholz and Mises loom as large if not larger in Dr. Paul’s thinking in this subject as does Rothbard.

Back to Tamny:

About Rothbard’s assertion, underlying it is a fanciful belief that the alleged “money multiplier” is fact as opposed to fiction. It’s the latter. Indeed, wise minds should quickly understand that there’s no such thing as a money multiplier such that Bank A can take in $1,000,000 and lend out $900,000, Bank B can then lend out $810,000, then Bank C can lend out $729,000 such that $1 million in deposits miraculously turns into nearly $2.5 million.

But this is precisely what occurs.  What is the point of Tamny’s discussion about reserve requirements if it is not this?  A bank makes a decision – hopefully a prudent one – about how much assets should be held in reserve, then loans out the rest (assuming good creditors are available).

I will focus here not on the contractual issues (upon which I have commented several times recently), but strictly the economic / financial.

Let’s begin with Bank A and the $1,000,000 deposit.  Bank A has made a reasoned judgment that the depositor will not demand the entire amount of his funds immediately.  The bank makes a judgment that 90% of this amount can be loaned out and still meet the demand expectations of the depositor – expected to be not more than $100,000.

Bank B, in receipt of the $900,000 makes a similar judgment.  And so on.  Thus, from the original $1,000,000 deposit, several accounts are credited with sums exceeding $1,000,000 – as Tamny suggests, nearly $2.5 million.  Each bank is comfortable with this activity as it is comfortable that its depositor will not immediately demand the entirety of his deposited funds.  I do not see why Tamny criticizes the math, and even Tamny seems to realize this himself in his next paragraph:

In truth, just as there are no sellers without buyers, there are no borrowers without savers; thus rendering the very notion of a money multiplier moot.  $1 million doesn’t multiply into $10 million if it changes hands enough times; rather for someone to borrow someone else must be willing to cease using money in the near-term so that they can.

It is because someone else has been “willing to cease using money” that the bank feels comfortable lending the money.  (Again, my focus here is on the numbers, not the contract – as I have previously presented, the contract makes quite clear that the banks perform in this manner.)  However, make no mistake – when these several depositors look at their banks balances and add them together, the sum will be nearly $2.5 million in Tamny’s example.

The end of this activity results in $2.5 million of account balances with the best judgment that only $1.0 million of this will be demanded at any one time by the entire group of depositors.  If each bank judges correctly, I don’t see any money circulating more than what was honestly deposited.  However if any bank judges incorrectly and lends out too much, first the liquidity and eventually the solvency of the bank comes into question.

This is where the problem arises, and I must give Tamny credit – he sees the problem as being with central banking.  It is the lender of last resort, backstopped by the government and afforded a monopoly by the government, that is the root of the problem:

There is, however, one area of agreement between this writer and the fractional reserve skeptics, and it has to do with bailouts. Those who decry the bank lending of deposits dislike the government backstops in the form of the Fed as lender, and they also dislike federal deposit insurance. They have a point there, but the logical conclusion from this should not be that banks should have 100% reserve requirements.

Instead, the Fed’s role as lender of last resort should be abolished (and while we’re at it let’s abolish the Fed, but that’s for a different article). If so, private market actors would quickly take over the Fed’s role with ease, and they would do so far more effectively for only lending to banks with good balance sheets that are merely experiencing near-term cash shortfalls.

As for deposit insurance, markets could quickly handle this too. Basically depositors would buy insurance on their deposits from private financial companies. Depending on the level of risk taken by banks, they would either pay a lot or a little for the insurance. It would really be simple.

Tamny properly sees the centralization and government protection as the root of the cause.  He also rightly sees that private actors can and would take on these roles.  He does not seem to fear- as I do not – that private actors might form cartels.  I fully expect they would.  However, absent government protection and backstop, these cartels would either provide good service and maintain good balance sheets or they will soon enough be out of business.

As for fractional reserve banking, its detractors need to be serious. Businesses are in the business of profits, and the path to banking profits is to lend out as much money as possible as prudently as possible. The highly confused detractors don’t hate fractional reserve banking; instead they dislike bailouts of banks that don’t lend monies entrusted to them effectively. That’s fine, but they would be wise to train their eyes on what’s actually the problem over essentially yelling at the scoreboard.

In all of my consideration of the topic of fractional reserve banking, I find only one item of agreement with those who rail against it.  Two people cannot own the same asset.  This inherently is true – the laws of physics and economics make it so, and this is why Joe Salerno, for example, says such a contract can never actually be written. 

But in today’s banking environment, two people DO NOT own the same asset.  When you make a deposit at a bank, you are making a loan.  The bank is free to do with the funds as it pleases.  The bank realizes that if it doesn’t make your deposit available to you in a timely manner, you will take your business elsewhere.  For this reason, the bank keeps reserves.

However, the bank is your unsecured creditor.  It is not a warehouse – the idea of demand deposits in the true and classical sense does not exist in modern banking.  Again, if you want a true demand deposit withdraw cash from the bank, store the cash in a safe or a vault somewhere, get the cash on demand whenever you like.  I am certain such a service can be had for a fee – it is called a safe deposit box or a home safe.  Most people don’t want to bother with this, and certainly most don’t want to pay fees for storing cash.

The problem is the monopoly, it is not fractional reserves.  Tamny seems to have this correct, and other than his detour into Ron Paul and his inability to properly recognize the multiplication of deposits I find nothing to criticize with his article.