Thursday, October 11, 2012

Fractional reserve produced money IS debt free.

Advocates of full reserve banking sometimes claim that a defect in fractional reserve is that it involves paying interest in order simply to have enough money to do business: to effect normal day to day transactions (never mind borrowing).

And that is a plausible argument. After all, assuming no monetary base (i.e. central bank money), all money would be supplied to the population by fractional reserve banks. And fractional reserve banks, as we all know, “lend money into existence” and charge interest for doing so. So it might seem that banks charge interest simply for providing a money supply. But there is a flaw in that argument as follows.

Assume an economy where the population wanted just enough money in order to do business, but did not want to borrow (at least not from banks). People would ask banks to credit their accounts and people would supply banks with collateral.

However banks in that scenario would not themselves need to borrow money: they would not need to pay interest to anyone to obtain the money (in the same way as banks in the real world, if they don’t want to lose reserves, have to cling on to their depositors and/or get money from bondholders and/or from the wholesale money market).

In that hypothetical scenario, banks would simply charge for administration costs and for the normal sort of profit that any business expects to make.

Thus IN AS FAR AS fractional reserve banks simply supply the economy with money, as distinct from lending, the population do not pay any interest in order to obtain money.

Administration costs.

As to costs, it might seem that central bank provided money is cheaper than commercial bank provided money. Reason is that where a central bank provides the money supply (which is what full reserve amounts go), there are no administration costs worth talking about and no collateral is needed.

Central banks do of course incur costs, but those costs are costs that are for the most part being born anyway. That is, whether central banks provide a large or small proportion of the money supply, they are still into the business to issuing money and withdrawing it depending on whether stimulus or the opposite are needed. For example, they’ve been issuing money big time over the last two years or so under the guise of QE.

This it might seem that the ADDITIONAL costs involved in having central banks supply ALL MONEY are small.
However, a similar argument applies to commercial banks, and as follows.

Assuming commercial banks are into the business of lending IN ADDITION TO providing the money supply, the ADDITIONAL costs of providing that money is probably small. To illustrate by reference to typical household, if a household wants to borrow £50,000 for a mortgage, and wants an additional £2,000 as a float or “petty cash” for day to day transactions, the additional costs of supplying that £2,000 will be marginal costs, as distinct from the inevitable FIXED COSTS that are involved in arranging a mortgage, big or small.

But having said that, my hunch is that a central bank can supply an economy with money more cheaply than commercial banks: that is, I’d guess the additional administration costs per person in having the central bank create and spend a few billion extra into an economy are less than fiddling around with mortgages, collateral, etc.

So how do commercial banks manage to knick the seignorage business from central banks? For the answer see here.

Central bank base rates.

There might seem to be a weakness in the above argument as follows. I said that where fractional reserve banks supply all the money, and people do not want to borrow from such banks, there is no need for those banks in turn to borrow.

There is of course an exception: where the central bank wades into the market and imposes an interest rate above the free market rate. However, while I favour independent central banks, the latter activity is a “non-free market” activity: central banks can only engage in that non-free market activity because they are backed by government, the police, the army, etc.

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