02 Dec 2008

Fractional Reserve Banking Explained

Loren Howe runs a vlog and asked the Mises Institute for help in understanding how modern banking systems create money. I thought his email raised some interesting questions, so (with his permission) I reproduce it here and hopefully provide decent answers.

I run an online vlog with around 20,000 viewers who would be very grateful for a layman’s explanation to this question. What is the fundamental method by which the currency supply inflates? Here is my current understanding:

I understand the standard explanation that under fractional reserve lending the banks lend out say 90% of the money on deposit. However, any investment entity – say a REIT, a mutual fund, a private money manager, etc. – can do exactly the same thing. In fact any other investment entity can and does lend out nearly 100% of deposits. Then that money can eventually be deposited back with say the private money manager and 100% can be lent out again over and over.

What I don’t understand is that this action does not appear to create any new money. If you start with 1,000 one dollar bills. It can be given to a private investor, lent out to people, re-deposited with the private investor, and on and on – it is still only 1,000 one dollar bills regardless of what percent the investor holds as reserves during each loan cycle. There does not appear to be any “new” currency in the overall economy and ultimately no new inflation (beyond the initial creation of \$1,000 by the Federal Reserve). However, the “money multiplier formula” used by economists and the M 1, 2, & 3 data show that under current banking practices “new” money is being created beyond what the Federal Reserve initially creates. There are two explanations I hear for this in the online community.

The first explanation I hear is that a bank (unlike a private investor or other investment entity) can call its loans “deposits” or “reserves” and then, in effect, type new money into its accounts to lend out. This would explain inflation, whereas fractional lending (as practiced by any investment entity) does not appear to. For example (at 10 to 1 fractional lending) you start with the 1,000 one dollar bills and you lend out 900 and then call that loan a “deposit” or asset. Based on that “asset/deposit” you then type into your account what amounts to 810 new pieces of paper to lend out again. After just one iteration there are no longer 1,000 dollar bills in existence, but instead 1,810 dollar bills (100 in the bank vault, 900 given to the first borrower and 810 given to the second borrower).

The second explanation I hear for inflation is that (at a 10 to 1 fractional ratio) banks take in the original deposit, hold that deposit and then self-create 90% of the value of the deposit to lend out. Then the original depositor is allowed to withdraw 90% of the original deposit and the bank only keeps 10% as reserves. When starting with \$1,000 – after one iteration there would then be \$1,900 in existence (\$100 held by the bank, \$900 taken back by the original depositor, and \$900 given to the borrower). In effect this would be a convoluted way of allowing banks to self-create 9 times as much money as they hold on deposit.

I tend to believe one of these examples is the case since it would explain inflation and the “principal” I hear banks “extinguish” as a loan is repaid. This type of lending seems fundamentally different from the standard economics description I hear of banks only lending 90% of “true” deposits. To my knowledge, no other investment entity (REIT, mutual fund, private investor, etc.) is allowed to self-create loan money in this way.

Sorry for the long email and I really appreciate your time in clearing up this issue. My questions boils down to: Are banks allowed to call a loan an asset/deposit and then self-create new money to lend based on that “deposit” or is the second method used where banks in effect self-create 10 times what they hold on deposit? If neither method is true, then I’m wondering why there is inflation of M 1, 2, & 3 beyond the initial money created by the Federal Reserve and what “principal” banks are supposedly “extinguishing” when loans are paid off.

If you can clear up this question in layman’s terms, I and many thousand viewers would be greatly appreciative and better informed.

I’m not so sure about the distinction between his two proferred explanations, but at the very least I can explain why banks are said to “create money out of thin air” while a hedge fund can’t.

The fundamental reason has to do with our definition of money, and this gets into the differences between monetary base, M1, M2, M3, MZM, etc. Note that I’m not going to go into a big description of these definitions; I just want to make the basic point here.

It’s true that only the Treasury (not the Fed, mind you) can create additional pieces of paper with numbers and US presidents printed on them, i.e. currency. But in a modern economy, it doesn’t make much sense to confine the definition of money to currency. Since presumably the whole point of the analysis is to gauge the impact on prices, and also to accord with common usage, most economists would say that demand deposits (i.e. checking accounts) are part of the total quantity of money. From an individual’s point of view, whether he has a \$20 bill in his wallet, or a \$20 balance in his checking account at his local bank, he has \$20 in “money” that he can go spend. It’s true we can come up with scenarios where the currency is more liquid, and hence more money-ish; e.g. maybe he wants to buy some black market items or he wants to tip the bellman, and checks or debit cards are fairly cumbersome in these situations. But in the grand scheme, it makes sense to count demand deposits as part of the total quantity of money. All of the aggregates besides monetary base–namely M1, M2, M3, and MZM–include demand deposits.

So quickly let’s review why, in a fractional reserve system, banks can “create money” (if we define demand deposit balances as part of the total quantity of money). Someone has \$1000 in crisp bills that he finds in his grandpa’s attic after the old guy knocks off. He deposits them into his checking account. His balance goes up by \$1000; he walks around town, writing checks and pushing up prices. He thinks he has \$1000 more than he had the day before.

But because of FRB, his bank only needs to keep \$100 of the currency in its vaults as reserve against the \$1000 in its customer’s checking account. So a guy who wants to buy a used motorcycle walks in and applies for a loan for \$900, and the bank gives him the currency. So already, the quantity of money has shot up \$900. The guy who found the money still thinks he has \$1000 extra in his checking account, and the guy who got the loan to buy a motorcycle thinks he has an extra \$900.

The seller of the motorcycle now has an extra \$900 in currency, and deposits it at his local bank into his checking account. But because of FRB, his bank only needs to set aside \$90 of the cash in its vault, and can lend out the remaining \$810.

When all is said and done, if ultimately all of the newly discovered currency ends up in bank vaults as reserves and the banks are “loaned up,” then the \$1,000 discovery will translate into an increase of \$10,000 more money in the economy. I.e. the \$1000 in currency sitting in bank vaults will support \$10,000 in higher checking account balances.

Last, we need to ask why a similar process doesn’t occur with, say, a hedge fund. The answer is that claims on institutions other than banks, are not as liquid as demand deposits, and hence are less money-ish. This is why economists have broader and broader measures of money. Money market accounts and other very liquid assets are included in higher measures, but not in M1.

Think of it this way. When I deposit \$1,000 in currency with my bank, it in effect gives me \$1,000 in bank notes. (Yes we write checks and merchants have to hope the checks don’t bounce, but that’s just a detail.) You can go to the grocery store and write a check on your local bank, and they will hand over groceries, at par. (I.e. a \$100 check gets you the same amount of food as \$100 in currency.)

In contrast, if you lend \$1,000 to a hedge fund, what you get in exchange is not nearly as liquid as a checking account balance. You can’t take your bonds to the grocery store and buy steak and milk with them.

So this is why banks in a fractional reserve system can “create money” while other institutions can’t. It is ultimately because we include bank liabilities as part of the definition of money, while only broader notions of money include things that can be created out of thin air by non-bank institutions.