In an economy where just government and central bank create money, private banks can easily steal the right to create money from government. Irving Fisher called this the “usurpation of government’s prerogative”*.
George Selgin (ironically a leading advocate of fractional reserve) explains how private banks do this. His explanation, which I agree with, is that where fractional reserve is introduced to a full reserve economy, the result is a temporary bout of excess inflation, which reduces the value of government / central bank produced money to near nothing, at which point the excess inflation stops. And that’s the end of the story according to Selgin. I’ll argue below that the excess inflation might continue, absent government intervention to stop it.
Selgin’s explanation starts with a hypothetical “monetary base only” economy where the base consists of gold. Fractional reserve is introduced, and that enables banks to do what goldsmiths did in England in the 1700s: lend out receipts for gold not backed by real gold. Those receipts are of course used as money. That is a profitable business and tends to cause inflation.
Under a real world gold based currency (as existed for example in England in the 1800s) serious inflation is prevented by the fact that market forces won’t allow the price of gold to vary to any huge extent relative to other goods. (The price of bread in England at the end of the 1800s was the same as at the beginning).
Selgin gets round the latter awkward fact in his hypothetical economy by assuming a constant demand for gold regardless of its price relative to other goods.
That is a bit unrealistic, though it doesn’t invalidate his basic point. It would have been better in the hypothetical economy to have had monetary base in the form of fiat currency: the value of that can easily be eroded by inflation. So in the rest of this article, I’ll assume a fiat currency: after all, that is the type of currency in all major economies nowadays.
So inflation rises in the hypothetical economy. However, the inflationary episode comes to an end according to Selgin when the real value of the monetary base has been reduced to a level just sufficient to enable commercial banks to settle up with each other.
I don’t agree. Reason is that private banks don’t actually need any reserves at all in order to settle up. Certainly the fact of having reserves at the central bank and having a central bank provided “settling up system” is CONVENIENT. But absent that system, banks could easily set up their own settling up system.
As to what they’d use for settling up, any type of asset would do: shares, bonds or bank branch buildings. Or in extremis, a badly indebted bank could hand over ownership of its head office building to creditor banks. Ultimately the debtor bank’s assets might decline to a level where the most sensible option would be for creditor bank(s) to take over the debtor bank.
The latter system would not involve so much INSTANT settling up at the end of every day. But that wouldn’t matter as long as banks trusted each other. That is “unsettled up debts” could be left in place for weeks or months, and in many cases those debts would be netted off against debts owed by creditor banks to debtor banks. Indeed, this sort of “not settling up immediately” happens currently on a large scale in that there is a huge amount of inter-bank lending.
Anyway, Selgin then claims implicitly that there are no further effects after the temporary burst in inflation. I suggest THERE ARE further possible effects: possibly leading to a permanent rise in inflation.
Individual banks versus the banking system.
It is important to note that the constraints facing an INDIVIDUIAL BANK are very different to those facing the private banking system (PBS) as a whole. Selgin rightly refers to these differences over and again in his book, “The Theory of Free Banking”. In particular, an INDIVIDUAL BANK cannot expand the amount it lends RELATIVE TO the rate at which other banks are expanding without experiencing a drain on its reserves.
However, I’ll assume to keep things simple that given plenty of creditworthy borrowers, EVERY BANK expands at about the same rate. So the argument below is just about the PBS.
Interest paid to depositors.
Strictly speaking, if every bank is equally efficient and expands at the same rate, there is no reason for banks to pay any interest to depositors. That is, the only reason banks pay interest is that if they lose depositors to other banks, they also lose reserves (or “branch buildings”). And if all banks are equally efficient and expand at the same rate, there is no reason for depositors to move money from one bank to another.
But I’ll assume that banks pay some finite rate of interest to depositors (which might be zero or might be more than zero).
Anyway . . fractional reserve is introduced and inflation reduces the monetary base to a small portion of the total money supply.
There are then three possibilities. 1. The desire by depositors to save cash produces enough cash to supply all credit worthy borrowers with just the funds they need at the prevailing rate of interest. That’s an equilibrium. 2, the amount depositors want to save exceeds the amount borrowers want to borrow, and 3, the latter exceeds the former. I’ll take those three in turn.
Re No.1, that has the merit, to repeat, of being an equilibrium.
2. If the amount that credit worthy borrowers want to borrow is LESS THAN the amount that savers voluntarily save at prevailing rate of interest, the effect would be deflationary. Government would have to print and spend money into the economy. But that’s not a big problem. It would just mean that the monetary base would be larger than the amount banks needed to settle up between themselves (a situation that prevails in the real world at the time of writing).
An alternative, which produces the same end result, is that scenario No.2 is operative DURING Selgin’s temporary bout of inflation. In that case, the bout of inflation would not last long enough for the base to decline to the minimum level that banks need to settle up).
3. If the total that creditworthy borrowers want to borrow EXCEEDS the amount that savers voluntarily want to save, PBS will simply lend money into existence to meet borrower’s requirements. But that will result in depositors having more money than they want (because “loans create deposits” as the saying goes). So depositors will spend the excess, which will be inflationary. But that in turn means the REAL VALUE of loans by banks to borrowers declines. And assuming that the value of loans needs to stay constant in real terms, then banks will lend even more money into existence. Now that’s an inflationary spiral: it’s a feed-back loop.
To summarise No.3, where the amount that non-bank private sector entities want to borrow exceeds the amount of cash and deposits at banks that savers / depositors want to hold, an inflationary spiral takes hold.
As for evidence that the latter phenomenon actually occurs, the Chinese government at various times in recent years has been concerned at the inflationary effects of excessive bank lending. And in Britain there have been numerous occasions since WWII on which government has clamped down on lending.
And finally, if the above argument is correct (which is a big “if”), having the central bank raise interest rates will not curtail lending. That is, to the extent that commercial banks can by-pass the central bank’s settling up system, commercial banks just aren’t bothered about what the central bank pays for borrowing back it’s own money: PBS can just fire ahead and lend money into existence willy nilly.
I.e. in the above excess inflation scenario, it is QUANTITATIVE controls on lending that are required, rather than PRICE CONTROLS (exactly what the Chinese have done on one or two occasions in recent years).
Indeed since the desired effect is the opposite of “quantitative easing”, I’d like to introduce a new phrase to the English language: “quantitative squeezing”.
* “100% Money and the Public Debt”, published by Michael Shemmann, p.18.
The relevant passage in the above work of Irving Fisher’s reads, “At present our nation’s chief money is at the mercy of the mob rules of 15,000 banks. These are tantamount of 15,000 private mints independently creating and destroying the nation’s money every day, while the Government looks helplessly on at this usurpation of its prerogative.”