Part Two – The problem with fractional reserve banking
In this Part I show the reasons why the practice of fractional reserve banking has nothing to offer. The physical argument consists of demonstrating the fact that the practice has a net negative influence on the drivers of real capital formation, and so leads to there being less total production than would exist without the practice. The monetary argument consists of naming and shaming the practice for what it is – mere monetary expansion – and showing that every deleterious consequence normally associated with such expansion applies equally strongly to the practice.
The advocates’ tunnel vision
Remember how in Part One I noted that the practice of fractional reserve banking increased credit managers’ available lending budgets by Z-Y? When I denied that this was beneficial, I bet what immediately came to your mind was something like “Huh?? Z-Y>0! What sleight of hand is he going to use to deny that!” My answer is simple: I employ no sleight of hand because I don’t deny that. Instead, let me begin by reminding my fellow Objectivists of this valuation principle:
Never evaluate anything out of context.
Rather than denying that Z-Y>0, I have no problem accepting it. I am not even going to say it is purely nominal and has no reality, because there is indeed an increase in the real value of capital funded by the banks through credit, even after the effects of devaluing the money unit by monetary expansion are taken into consideration. That is, the real-terms value of W+(Z-Y) with fractional banking is still genuinely greater than the real-terms value of W without fractional banking even though the devaluation of money does devalue W in real terms.
What I will do instead is say that the advocates of fractional reserve banking are practicing a form of tunnel vision. They have neglected to consider the whole context of which bank activity is but a part. The advocates of fractional reserve banking have forgotten the fact that the supply of credit by banks is only one part of a whole market for capital funding. There are sources of credit funding besides banks, and, there are sources of equity funding which compete with all sources of credit in the overall capital market. Having forgotten about that total capital market, the advocates have not asked what the long-term effect of fractional reserve banking upon it is.
My argument consists of demonstrating that bank action crowds out non-bank providers of both debt and equity capital, and where the non-bank providers pull out more than what the banks put in. More precisely, if there were no issue of increased risks then the practice would be neutral for total real capital, changing only who owns what on what legal basis and what the nominal values are, but the inclusion of concern for the increased aggregate risks does shift the change in total real capital into negative territory. Proving all this is what Part Two is about.
The drivers of real capital
I said before that there were two prongs of the attack. The first, reference to the real value of actual physical capital, is the most important because it involves going back to first principles and reiterating that a major function of the finance sector is to make it easier and more cost effective for suppliers and users of capital to get together. The financial sector earns its keep through its particular mode of contributing to the increase in the physical production of goods and services. The first attack is showing that the practice actually harms that process.
At any given time, there is physical capacity to produce only so much total output. That capacity is the real capital, and that output is the real output. However, all capital goods have to be actively maintained and replaced over time, and the nature of that output isn’t fixed. People must constantly choose what proportion of the total physical output goes to producer goods and what proportion goes to consumer goods. If the total capacity is to be maintained at the same level then, in line with its physical nature and that of the physical output, a certain proportion has to be dedicated to capital goods’ maintenance and replacement. That proportion is called the maintenance proportion (*). If the actual proportion dedicated to production goods differs from the maintenance proportion then the total amount of capital will begin to change until the maintenance proportion associated with a given level of total real capital changes to match that actual proportion. If actual is below maintenance then total real capital will fall until the maintenance also falls to match actual, and likewise if actual is above then total capital will rise until the maintenance also rises to match actual.
(* The ratio of this proportion to the total is not linear, changes in line with other factors about the economy besides total physical capital, but we can ignore these complexities).
What determines the proportions of output channelled one way or the other is people’s relative preferences for consumption in the future versus consumption in the present. This time-preference factor is the core determinant of all capital formation: the greater the orientation to the present the higher the time-preference and the lesser amount of capital they will invest in and maintain, whereas the greater the orientation to the future the lower the time preference and the greater amount of capital they will invest in and maintain.
For capital valuation, this time-preference is expressed as the first component of “hurdle rates” used to judge the merits of investments. Adding to the time-preference factor is consideration for risk. The greater the risk people judge to exist, and the greater is people’s aversion to risk, the greater is the risk premium people will add to their time-preference factors to form their hurdle rates. This combined hurdle rate is then used as a benchmark for judging prospective returns. If people forecast returns that exceed the hurdle rates then they will increase their spending on investment and decrease their spending on consumption. If they think the forecast returns will merely match their hurdle rates then they will only maintain existing investment and consumption spending patterns. And, of course, if they think the forecast returns are lower than their hurdle rates then they will either not renew their investments as much or even start liquidating them.
It is these valuations and spending patterns that are then translated into what is physically done with the output and so set what levels of physical capital are maintained over the long run. The actual amount of physical capital so maintained arises from the combination of the hurdle rates, demographics and labour supply, and the physical productivity of labour as arising from the influence of the state of natural resources and the history of technology etc, and so on. Here’s the key: unless those hurdle rates and other factors change, any other momentary cause for change in total real capital will eventually be fully countered because people will shift their spending patterns in such a way as will end up bringing the total amount of real capital back to where it was before. If the initial change is upwards (more total real capital) then actual rates of return in real terms will fall and people will not renew capital as much until total real capital comes back down and actual real rates rise back to acceptable levels. Conversely, if the initial change is downwards (less total real capital) then actual rates of return in real terms will increase and people will increase their investment activities until total real capital comes back up and actual real rates fall back to the least acceptable levels. In time the only remaining signs of the initial changes will be shifts in the compositions of who owns what and whose capital goods are shinier than whose.
The effects of fractional reserve banking
Financial institutions act as intermediaries between providers and users of capital. The use of financial intermediation makes it easier for people to act in conjunction with each other, lowering costs through economies of scale and lowering risks through better information processing and implementation. The improvements in productivity increase the amount of real capital that can be maintained for unchanged hurdle rates, while the lowering of risks leads to a lowering of risk premiums and so lowers the hurdle rates. Both lead to an increase in total real capital. In this way, finance is genuinely a productive enterprise even in the physical world of men, machines and materials.
However, the practice of financial reserve banking does not contribute to that effect. To get to this we must first make a key distinction between motives for having various kinds of bank accounts. When depositors put money in demand deposit accounts or make use of bank notes they are not primarily motivated by the want of making savings but want of having spending power in a more convenient form than lugging specie around. This is why to this day the banks still retain a distinction between savings accounts and transaction accounts, where it is the latter that most people want for daily needs. Here’s the headline: the holding of funds in a daily transaction account is not an act of saving and is instead only a particular means of expressing demand for money. Even having a large sum parked in a transaction account, waiting for you to figure out what to do with it, is still not an act of economic saving (technically speaking, having sums like that is a non-economic kind of originary saving on par with having unopened groceries in your pantry). The interest receivable on such accounts, besides being paltry, is only a means by which banks compete for custom from which they earn account-keeping and transaction fees (there are today significant political controversies in Australia regarding the considerable size of these earners, which was $A1.2b in 2009). In terms of bank accounts, actual saving means the investment in time deposits (“term deposits” in Australia), purchase of Certificates of Deposit, and use of similar bank-provided means of saving. Amongst other errors, those who advocate fractional reserve banking are committing the error of not understanding the distinction between saving and the demand for money.
We can now see that the actual owners of capital have not changed anything regarding their hurdle rates or the other physical factors when they choose to hold money in daily transaction accounts, and have not provided real capital resources to ground the credit expansion engaged in by banks when they practice fractional reserves. The practice of financial reserve banking does nothing to improve time preference to a greater future orientation, does not reduce risks, and does not do the slightest thing for the other non-financial factors determining total real capital. In fact, as already noted, because the practice increases risks because it makes calculation with the money supply riskier, the practice leads to people putting their risks premiums up, and so leads to hurdle rates going up. That means that unless there are effects of the practice that counter it, the practice contributes to a lowering of the total amount of real capital that people are willing to maintain.
That being said, while this point on capital-formation motives does wipe out the great majority of the basis for its advocacy, this point alone does not kill the merits of the practice entirely. The economies-of-scale argument still requires examination. It is making use of these economies of scale that are the major part of what banks profit from doing, how they produce value and trade it to their and everyone else’s benefit, and hence how they earn those profits. If this argument holds water then this would indicate that the practice taken to a small extent is beneficial because of an increase in operational efficiency. This potential upside may counter the capital-reduction effect caused by increases in investor hurdle rates. We’ll get to this later.
Monetary expansion is monetary expansion
The point regarding capital formation may be beyond most people’s ability to understand. Indeed, this lack of understanding was what was missing during the era of free banking. It took geniuses such as Bohm- Bawerk to identify the theory required for such understanding (see Capital and Interest, Vol II, Book IV.) The other prong of the attack should be simpler to understand: naming mere monetary expansion for what it is and showing what its standard consequences are.
Remember how the difference in banks’ books was that assets went up by $Y in cash + $(Z-Y) in credit and that liabilities went up by $Z in demand deposits? There are no new term deposits, no new commercial notes or bonds issued, no new stock issued to fund the extra credit, nor any other capital raising from originary capital-providers: V+T is unchanged. That’s the capital-issue as above, but it also indicates another point: the new credit arises exclusively out of the monetisation of existing credit and then spending the new money.
With that identified, it should be clear that the introduction of the practice, its extension by lowering reserve fractions, and its contraction by increasing reserve fractions, only has effects of a nature that is in-principle identical to any other form of monetary expansion. The standard boom-bust-recovery cycle ensues when reserve ratios are reduced, and in reverse when ratios are increased. If the shift is downwards then there is growth in the money supply. First, the growth of money causes a temporary boom as businesses find their revenues increasing. Then the boom tapers off and then peaks as general prices rise and people begin noticing en masse, occasioning them to temporarily increase their hurdle rates because of the devaluation of the monetary unit (*). The contraction ensues when this pull-back arising from higher hurdle rates begins exceeding the growth in bank lending. The trough is when the influx of money is finally adjusted to and investors unwind their monetary-devaluation premiums. Lastly, the recovery phase is people settling back into routine after the effects of initial influx wear off. What differs is only that, by the end of it, the banks who created that new money have increased their proportional share of capital holdings, economic risks have increased because the new money is riskier to calculate with, and these economic risks having increased permanent hurdle rates then lead to less real capital being maintained.
(* these are ‘inflation premiums’ when fiat currency is in use, but since the growth of monetised credit under laissez-faire is not in fact inflation it is inappropriate to call these premiums by that term)
This is no different than were a new big find of gold to be taken to the mints and used to purchase investments before everyone else in the economy adjusts to the change in the money supply. The mere creation of more money does nothing to increase real capital formation when the prior existing supply of money was already physically adequate to act as a medium of exchange. The mere act of identifying pure monetary expansion for what it is should put advocates on notice that there is very little merit to the practice in terms of making more real capital available. It is not permissible to say “free markets are doing it!” and think oneself absolved from responsibility of judgement.
Do remember that, under laissez-faire, there’d actually be no problem with the monetary-expansion effect of the practice once everyone had gotten use to it. Even the devaluation premiums would become negligible, only moving from zero to positive to the extent that reserve ratios are reduced, moving from zero to negative to the extent that reserve ratios are increased, and returning back to zero once the effects of the move in ratios to the economy wears off. If it weren’t for the additional risks created by the mere presence of the practice then economically the practice would be neutral in the long run, being no different to people bringing more specie into circulation and occasionally taking some out (this is the virtual-ships analogy again). If there weren’t risks created by ephemeralisation of the money supply then there’d be no fuss to kick up, but the presence of those risks is a game-changer.
As before, of course, what remains is the economies of scale argument, which could be argued as countering that risks effect. That, however, I will leave to the next part, along with dealing with every other argument for and against the practice.
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