Fractional Reserve.

Once upon a time there was an economy with a central banker called Ab Lerner. He spent money into the economy at a rate that brought full employment (and occasionally raised taxes and withdrew money when the population was gripped by irrational exuberance).

He didn’t want to operate bank accounts for households and businesses, i.e. “private sector entities” (PSEs). That function was performed by Lloyd Bankfiend, the commercial banker.

Each PSE wanted a stock of money to meet its need to make transactions, plus some extra money against a rainy day: the so called precautionary motive for holding money. Each PSE kept pretty well to its “transaction and precautionary” stock of money.

That in turn meant that no PSE could borrow unless some other PSE took the deliberate decision to forgo consumption and save money.

PSEs wanting to borrow sometimes borrowed direct from other PSEs, and sometimes they borrowed via Mr Bankfiend.

Mr Bankfiend only lent money that had been deliberately deposited with him in savings accounts rather than current or checking accounts.

The rate of interest in this economy was determined by market forces, that is, it was determined by the relationship between borrowers and lenders. That in turn optimised the amount of borrowing and lending and investment. Reason was that at the margin, the benefits of borrowing (e.g. the return on capital that businesses could obtain by making investments) was equal to the pain or disutility suffered by those abstaining from consumption so as to save.

Then one day Mr Bankfiend had an idea. “Why”, he said to himself “do I bother waiting for people to deposit money with me before crediting the accounts of those who want to borrow?”

He couldn’t think of a reason for not doing this. So next day when people came in applying for loans, and after making sure they had adequate incomes and net assets, Mr Bankfiend just clicked his computer mouse and credited the accounts of the borrowers.

The big advantage of this for Mr Bankfiend was that he collared the interest paid by the borrowers without having to pass any of it on to those who had put money in deposit accounts at his bank. Or as Murray Rothbard put it, fractional reserve bankers “can charge a lower rate of interest than savers would”.

But of course there is no such thing as a free lunch. The going rate of interest dropped, which meant that lenders (i.e. those with deposit accounts) lost income, while Mr Bankfiend gained.
Moreover, interest rates were no longer at the level at which costs and benefits at the margin were equalised. As a result GDP fell.

To make absolutely sure he retained this easy source of income, Mr Bankfiend paid the election expenses of various politicians so as to make sure they didn’t interfere with his new source of income.

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P.S. 28th Jan 2012. There is a much more detailed version of the above argument here.