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John Tamny at Forbes comments in a blog post titled “Ron Paul, Fractional Reserve Banking, and the Money Multiplier Myth” that
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.
Paul’s intellectual mentor in this area is the late Murray Rothbard who proclaimed that “Fractional reserve banks…create money out of thing [sic, ‘thin’] air. Essentially they do it in the same way as counterfeiters.”
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.
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. That such an absurd bit of witchcraft has so long transfixed so many bright minds is one of life’s great mysteries. So while banks doubtless commit all manner of errors – capitalism is about both failure and success – the fact that they lend out the funds put in their care does not make them counterfeiters….
It’s certainly true that banks could maintain 100% of funds deposited, but if so, they wouldn’t be banks. Instead, they’d be warehouses for money, and those warehouses would charge depositors a fee for the right to deposit with them.
Thus, Tamny’s understanding of fractional reserve banking is that banks merely “lend out the vast majority of their deposits on hand”, and since they are just lending money they already have, no new money is created. Tamny believes that every dollar borrowed from a bank by one person must be a dollar that was saved and deposited at the bank by another. It is a self-evident “myth”, he contends, that banks effectively counterfeit money by creating it out of thin air. It is a “fanciful belief”, a “fiction”, and talk of “witchcraft” to suggest that there is a “money multiplier” effect in fractional reserve banking, in which banks “miraculously” create more money than they have on deposit. Apparently, in Tamny’s view, if you believe this, you might as well believe in Santa Claus or the tooth fairy.
Indeed, Tamny is correct about one thing: if banks merely lent out funds that they actually had, it would not make them counterfeiters. Unfortunately, however, Tamny is grievously ignorant of how fractional reserve banking actually works. Ron Paul has tried to explain it to him, and Murray N. Rothbard has, as well—and a right fine job of it he did, too, in his book The Mystery of Banking, which our skeptical Virginia has quite obviously never read. We might agree that it is “an absurd bit of witchcraft”, but it happens to be true that banks do indeed create money out of nothing and increase the money supply by loaning out money they don’t actually have.
Let’s turn to The Mystery of Banking and take a closer look at what it is that Tamny is trying to “debunk” here. To illustrate how fractional reserve banking works, Rothbard showed how “T” account entries work on a bank’s balance sheet, with an example of a $50,000 gold deposit from Jones in the Rothbard Bank. So $50,000 in gold coin is entered into the asset side of the bank’s ledger, and $50,000 in warehouse receipts (demand deposits) is also entered into the liabilities side. The bank now has 100% reserves.
|$50,000 (gold)||$50,000 (warehouse receipts)|
However, as Rothbard explained:
The irresistible temptation now emerges for the goldsmith or other deposit banker to commit fraud and inflation: to engage, in short, in fractional reserve banking, where total cash reserves are lower, by some fraction, than the warehouse receipts outstanding…. [T]he banker will either lend out the gold, or far more likely, will issue fake warehouse receipts for gold and lend them out, eventually getting repaid the principal plus interest. In short, the deposit banker has suddenly become a loan banker; the difference is that he is not taking his own savings or borrowing in order to lend to consumers or investors. Instead he is taking someone else’s money and lending it out at the same time that the depositor thinks his money is still available for him to redeem. Or rather, and even worse, the banker issues fake warehouse receipts and lends them out as if they were real warehouse receipts represented by cash. At the same time, the original depositor thinks that his warehouse receipts are represented by money available at any time he wishes to cash them in. Here we have the system of fractional reserve banking, in which more than one warehouse receipt is backed by the same amount of gold or other cash in the bank’s vaults.
It should be clear that modern fractional reserve banking is a shell game, a Ponzi scheme, a fraud, in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts.
Returning to the ledger, suppose that the Rothbard Bank, from the $50,000 deposit, now issues $80,000 in warehouse receipts and lends them to Smith, who must repay the $80,000 plus interest. The assets side of the bank’s book now shows $50,000 in gold deposits from Jones plus the $80,000 IOU from Smith, for total assets of $130,000, while the liabilities side shows $130,000 in warehouse receipts for gold. The bank has increased the supply of money by the amount of additional receipts it issued (the $80,000), and the bank now has a reserve ratio of $50,000/$130,000, or 5/13.
|$50,000 (gold)||$50,000 (original receipts)|
|$80,000 (IOU)||$80,000 (newly created receipts)|
|Total: $130,000 (reserves plus loans due)||$130,000 (warehouse receipts)|
Now suppose that Smith uses his $80,000 in warehouse receipts to buy widgets. The seller of the widgets now has the receipts, which the Rothbard Bank must redeem for him on demand, just as it must redeem Jones’s receipts for his $50,000. But while the bank has liabilities in the form of receipts for gold to the tune of $130,000, it actually only has $50,000 in gold in its vault. If the widget seller attempted to redeem the full amount of his receipts, the insolvency of the bank would immediately become apparent, and the fraud exposed. As Rothbard put it:
Thus, fractional reserve banking is at one and the same time fraudulent and inflationary; it generates an increase in the money supply by issuing fake warehouse receipts for money. Money in circulation has increased by the amount of warehouse receipts issued beyond the supply of gold in the bank….
Where did the money come from? It came—and this is the most important single thing to know about modern banking—it came out of thin air. Commercial banks—that is, fractional reserve banks—create money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, which then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails to treat the receipts as counterfeit.
That is to say, fractional reserve banking is just legalized counterfeiting. Rothbard continued:
Another way of looking at the essential and inherent unsoundness of fractional reserve banking is to note a crucial rule of sound financial management—one that is observed everywhere except in the banking business. Namely, that the time structure of the firm’s assets should be no longer than the time structure of its liabilities. In short, suppose that a firm has a note of $1 million due to creditors next January 1, and $5 million due the following January 1. If it knows what is good for it, it will arrange to have assets of the same amount falling due on these dates or a bit earlier. That is, it will have $1 million coming due to it before or on January 1, and $5 million by the year following. Its time structure of assets is no longer, and preferably a bit shorter, than its liabilities coming due. But deposit banks do not and cannot observe this rule. On the contrary, its liabilities—its warehouse receipts—are due instantly, on demand, while its outstanding loans to debtors are inevitably available only after some time period, short or long as the case may be. A bank’s assets are always “longer” than its liabilities, which are instantaneous. Put another way, a bank is always inherently bankrupt, and would actually become so if its depositors all woke up to the fact that the money they believe to be available on demand is actually not there.