“Debt based money” exacerbates indebtedness?

Summary. There is a widespread belief that every dollar of money under fractional reserve is matched by a dollar of debt, and hence that fractional reserve increases the total amount of debt. This story is pushed by two books: “The Grip of Death” by Michael Rowbotham and “The Web of Debt” by Ellen Brown.

The above idea is flawed, but that THERE IS a mechanism via which fractional reserve results in more debt (and lower interest rates) than full reserve. This is that when fractional reserve is introduced to a full reserve system (or when fractional reserve banks are in irrational exuberance mode) those banks can create and lend out money created from thin air at below the going rate of interest (a phenomenon alluded to by George Selgin and Messers Huber and Robertson.)

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When a commercial bank makes an $X loan, it does not need to “get the money” from anywhere: it can simply take collateral off the borrower and credit the borrower’s account with $X created out of thin air.

But commercial banks do not necessarily create ALL THE MONEY for loans out of thin air. That is, in addition to creating money, commercial banks are clearly in the business of connecting borrowers and lenders. Thus some of the money for loans comes from lenders (i.e. those depositing money in banks). And the relative importance of those two varies from year to year. For example over the last two years or so, deleveraging has taken place on a big scale, thus little or no thin air money has been created by commercial banks.


The flaw in the debt based money idea.

So banks engage in two distinct activities: money creation and connecting lenders and borrowers. Let’s take money creation first.

Suppose a country has no form of money, and the population decides it wants the advantages of trading via money rather than barter. Suppose also that no one wants to lend or borrow.  They decide to set up organisations called “banks” whose job it is to take collateral off those wanting money, and credit the accounts of those people. The actual value of the money unit chosen to start the process would not desperately matter: the value of a gram of gold or kilo of aluminium would do. Though whether the country subsequently stuck to the gold or aluminium standard is a separate issue.

In that scenario, people would not owe banks any more than banks owed people: that is, a bank would owe each person in that banks would promise to return the collateral if and when someone wanted to cancel the arrangement, and people would likewise promise to return the “loan” to banks when they wanted to cancel the arrangement.

Moreover, there is absolutely no reason for banks to charge interest in that scenario. That’s because banks would not need to pay interest to anyone to “obtain” the money: the money is created out of thin air. All that banks would charge would be administration costs (plus the usual profit that any business expects to make if the banks were commercial operations rather than mutual operations like some British building societies). And if no interest is charged on a so called debt, what’s the big problem with such debt? None! I’m happy to be in debt to tune of a trillion trillion as long as I don’t have to pay interest.

And not only that, but no REAL LENDING OR BORROWING has taken place. By “real” lending, I mean one person abstaining from consumption so as to enable another, the borrower, to consume resources over and above what the borrower has actually earned or created.


Real lending and borrowing.

As distinct from money creation, banks in the real world are (to repeat) also involved in connecting lenders and borrowers. Lenders always try to get interest on sums lent, and normally succeed. To the extent that they succeed, banks have to charge interest to borrowers, plus banks have to charge for administration costs, bad debts, etc.


But it’s nonsense to claim that because banks charge interest to BORROWERS, that therefor banks charge interest to those who want $X credited to their account simply to enable them trade via money rather than via barter.


Of course, if someone who has had $X credited to their account goes and spends a significant proportion of it, there must be someone else doing the opposite: i.e. lending. And if that “lender / borrower” relationship lasts for any time, the lender will want interest. In contrast, as long as the person who has had $X credited to their account just treats the money as a float, with the actual balance fluctuating fairly quickly between $X+ and $X-, no one will regard the so called debt as any sort of permanent debt on which the creditor demands interest. Indeed, this situation exists in the real world in that trade creditors normally allow trade debtors at least a month of grace before interest is charged.

Another way in which that sort of situation also exists in the real world, is thus. Suppose I gave a bank extremely good collateral in exchange for the bank giving me some “float money”.
Suppose also that the bank charges me interest only in proportion to the time and amount by which the float is below the initial amount agreed (as actually happens with some overdraft facilities at some banks). Suppose also that when I have surplus funds, I put them in a deposit account which earns the same interest as I’m charged when my float is below the initial amount.

In that scenario, I could end up paying no interest at all!

In short, fractional reserve banks charge for the ADMINISTRATION COSTS involved in creating money, but a bank which gets its costings right would not charge INTEREST on its money creation activities as opposed to its lending activities.



How fractional reserve increases indebtedness.

So does the above argument totally demolish the claim that fractional reserve increases indebtedness? The answer is “not quite”. That is, there IS ONE route via which fractional reserve does increase debts, but it’s not the above one.

This route was actually set out (sort of) by George Selgin and Messers Huber and Robertson.  As the latter pair point out, “Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves.”

I would just add to that that the difference between the going interest rate and the zero rate referred to by H&R would not accrue SIMPLY to banks in the form of profit: competitive forces would force banks to share part of the profit with borrowers and lenders. I.e. H&R should have said something like “the difference between the going interest rate and zero will tend to depress interest rates”.

As to Selgin, he makes a similar point. As he explains, when fractional reserve is introduced to a full reserve system, banks can initially go on a lending orgy, which causes inflation until the monetary base is reduced to a value that is just enough to enable commercial banks to settle up between themselves.

The relevant passages in Selgin and H&R are respectively as follows.

For Selgin, it’s the third paragraph starting, “Perhaps the simplest….” – (although his first two paragraphs are quite short, so there’s no harm in starting at the beginning of his paper). And for H&R, it’s p.31, last paragraph: “Allowing banks to create…”


In short, under fractional reserve, interest rates are lower and more borrowing takes place than under full reserve.


So which system, full or fractional reserve, is better? My answer is that (as explained here) however safe fractional reserve is, there is always a finite risk that banks fail, and that risk is covered by taxpayers. I.e. fractional reserve just can’t work without a subsidy. And a subsidised business does not make sense unless there are clear social reasons for the subsidy - as is the case with health care and education.

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P.S. (next day – 17th).

There is a point arising from the passage above which read:

“Of course, if someone who has had $X credited to their account goes and spends a significant proportion of it, there must be someone else doing the opposite: i.e. lending. And if that “lender / borrower” relationship lasts for any time, the lender will want interest.”

The point is thus. Where a depositor wants a significant amount of interest on their money its quite likely their so called money will not be actually counted as money – though whether it actually IS COUNTED as money depends on the category of money concerned (M0, M1, M2, etc) and the country concerned.

But in general terms, the more difficult it is for a depositor to get money out of a deposit account, the more the interest they will get, and the more their relationship with their bank and those the bank lends to is a creditor/debtor relationship rather than a “float” arrangement.

In short, and to oversimplify the above point a bit: money is not debt based.




P.S. (7^th Nov 2012). The basic idea advocated in the above post, namely that debt based money does not increase the total amount of debt is supported by two Fed charts. These seem to indicate that lending by banks accounts for only about one tenth of the total amount of lending or debt. (Hat tip to Angry Bear)

 
P.S. (30th Jan, 2013). 

George Selgin (p.52/3) goes into the above mentioned distinction between money which depositors hold essentially as an investment (i.e. a loan to those borrowing from their bank), and in contrast, money held for TRANSACTION purposes.

Krugman’s flawed criticism of full reserve.

I normally agree with Krugman, but not with this article where he criticises full reserve banking. He is obviously not up to speed on the subject.

On the subject of money market funds, he claims these represent some sort of quandary for advocates of full reserve, and on the grounds that those depositing money in such funds can write cheques on the funds.

There is actually no quandary there at all because money market funds pretty much obey the rules of the “full reserve game” already.

The basic rule of full reserve is that banks, or any organisation acting like a bank, cannot create money. To that end, where a depositor wants instant access to their money, that money cannot be lent on or invested, else two parties then have a legitimate claim to the same tranche of money: the money has so to speak been doubled. Money creation has taken place.

Now when someone writes a cheque on a money market fund and the fund immediately sells investments of the same value, which is more or less what these funds do, then no money creation takes place. No problem.

Of course there might in some cases be a few days delay between honouring the cheque and selling the relevant investments, which strictly speaking is breaking the rules, but that does not make money market funds the sort of big time creators of money that fractional reserve banks are.


Keeping tabs on money creators.

Krugman then says, “So would a Ron Paul regulatory regime have teams of “honest money” inquisitors fanning across the landscape, chasing and closing down anyone illegitimately creating claims that might compete with gold and silver? How is this supposed to work? OK, I don’t expect a serious answer.”

Well here’s a serious answer.

First, whether the monetary base consists of a rare metal or is in fiat form, as in almost every country nowadays, makes no difference to the basic principles involved. I’ll assume a fiat monetary base.

Creating money or “claims” that constitute money is not easy. IN THEORY anyone can do it in that anyone can write an uncrossed cheque in payment for something, and the recipient can endorse the cheque, and pass it on, in the same way as bills of exchange were passed from hand to hand in the 1800s. But that phenomenon is almost unheard of nowadays.

To all intents and purposes the only organisations that can create BIG quantities of money are BIG organisations (surprise, surprise). That is because no one trusts the paper money produced by tin-pot unheard of organisations. Plus it’s very difficult to set up a bank of any size, or anything that acts like a bank, without being noticed by the authorities. That is, if the income tax authorities can spot self-employed plumbers or electricians who are trying to avoid being noticed, the authorities shouldn’t have too much trouble noticing organisations with a turnover a hundred or a thousand times that of the average plumber or electrician.

So there is no need, as Krugman puts it, to “fan across the landscape”.

There are of course local currencies, like Bristol pounds, and supermarket loyalty points, Airmiles, Bitcoins, etc. But if you look at these carefully, you’ll find that no money creation takes place, and if it is, it’s on a very small scale.

In short, getting full reserve to work would not be difficult.

And finally, the authorities in different countries actually impose reserverequirements on banks, varying from 30% to 0%. If 30% can be imposed, then presumably so can 70% and 100%.

Banks contribute to economic growth?

The shysters, liars, fraudsters and criminals running the banking industry are forever trying to persuade us that banks contribute to economic growth – and in particular that any constraints on bank activities would constrain economic growth. And of course politicians lap up this story. Or if they don’t, they paid to change their minds.

Now the bank industry has expanded no less than TEN FOLD relative to GDP in Britain over the last thirty years. So we should see a positive explosion in economic growth. So what do we actually see? We see this:

The black line was inserted by me. Feel free to draw alternative black lines, but the result will be similar.

What can I say but “hilarious”!!!

And is it unfair in describe top bankers as shysters, liars, fraudsters and criminals? Well the Financial Times had a front page article entitled “Bankers accused of dishonest lobbying” about a year ago: and that was BEFORE the stench of Libor rate fiddling wafted into the air.

Of course there are plenty of factors influencing economic growth other any contribution to growth that banks might make. Nevertheless, the above chart hardly supports the idea that a big banking industry promotes growth.

BTW, the “tenfold” figure comes from a Bank of England paper “Banking: From Bagehot to Basel, and Back Again”, p.3.

Roger Altman praises US house building recovery.

Roger Altman (US deputy Treasury Secretary 1993-4) praises the recent recovery in US house building.

I think I get it. We have a credit crunch, trillion dollar bank bailouts, a recession, thousands of home repossessions  - all caused by excessive and irresponsible lending (mainly to house owners). So the authorities respond by cutting interest rates to record lows so as to encourage more borrowing. And when the housing bubble starts to reflate, they think they’ve done a good job.

With idiots like that in power, the only real surprise is that the above economics disasters don’t happen more regularly.