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When Is Fractional-Reserve Banking Inflationary?

Economics / Inflation Aug 30, 2012 - 10:10 AM GMT

By: Michael_S_Rozeff


Best Financial Markets Analysis ArticleThe takeaway here is that fractional-reserve banking is not inflationary per se. Fractional-reserve banking is inflationary when combined with central banks with unconstrained fiat money powers. The real culprit in inflation is an unconstrained central bank. Since central banks are created or enabled by governments, the real culprit in inflation is government. In turn, inflation cannot be controlled unless proper government, which really means proper law, is instituted and respected.

To understand the logic of inflation, we start with an economy that uses gold as money. We then introduce one new factor at a time.

How does gold as money work? Let's start by assuming an economy that has an asset money such as gold. There is a gold industry that brings new gold into production and distribution when the price of gold rises relative to production costs or when profit margins remain the same but demand for gold rises, if the industry is a constant cost industry. If the gold price rises high enough relative to other goods, even with new production, then this stimulates the production of substitutes for gold, such as silver or other metals or other kinds of goods, assuming that the profit margins in those industries have widened. This competition to produce different kinds of money keeps down the cost of money in general. It also stimulates the production of paper money, but we defer discussion of banks and paper money until later.

Suppose that a company wants to finance a new project. It will borrow or issue equity. This distinction makes no difference for our current analysis because in both cases it is getting money from other people. There are four possible sources of the money of the money-suppliers. They can sell assets. Giving up money they have stored comes under the heading of selling assets, since stored money is an asset. They can cut back on consumption. They can work more or cut back leisure. Last, in exchange for the stocks or bonds, the gold miners can supply gold that they produce.

The shifting of money from one use to another does not per se alter the price level. The money that the company gets to carry out its project is going to be spent back into the economy. If assets were sold to provide the money for the financing, the company's spending shifts it to other uses. There is no predictable overall impact on prices from mere shifting. (The possible effect of greater productivity in reducing prices is not mere shifting.) If people cut back on consumption, the same conclusion holds. The new money, if anticipations are correct, will produce enough to pay a return subsequently, and that allows greater consumption in the future. At most there is time-shifting of consumption at some rate of interest. Price levels again show no systematic impact. If people work more to finance the project, then overall product is increased. The effect is to make prices fall. If gold miners finance the project, then money in the economy rises. Prices rise. This tends to offset any price-deflating effect of the new product brought on line by the project.

The gold miners conceivably are a source of price inflation. The more they mine and spend or invest, the greater the impact on prices. What stops them? What stops them is that if they are able to mine and produce a great deal of the good being used as money, then prices will rise in terms of that good. The miners' profit margins will shrink and they will not have as much incentive to overproduce. Furthermore, as prices of goods rise, people will then reduce their use of that good serving as money and as a store of wealth and as a unit of account. A necessary condition for a good to serve as money is that it either cannot or won't willingly be produced in unlimited amounts at low cost. There has to be a constraint on its production coming from somewhere. In the case of gold, it is a combination of increasing costs to mine gold and that the utility of gold falls when it's in such great supply that price inflation occurs.

What happens in an economy where many projects are being financed? Then we look at the demand curve for money for all such projects. If the demand for money to finance projects shifts to the right because of new projects that people want to finance, demand will intersect supply of money at a new price. If the long run supply curve of money is highly elastic (or horizontal) as in a constant cost industry, then there are lots of money substitutes that can be brought on stream. The price of money need not alter much in the long run. This means that prices need not alter much. We conclude that, even if people sell assets, cut back on consumption, work more, or supply more gold, this need not greatly impact the overall level of prices. However, a stream of profitable new projects has a tendency to increase productivity and lower prices. That effect is separate from price changes that might be brought about by shifting money from one use to another use.

Let us bring banks and paper money into the picture and ask what banks do and what happens when there are banks.

If banks are 100% gold or money depositories, nothing changes from the above. Banks in this scenario are storehouses for gold. If people wish to finance projects with gold, they can subscribe to securities from their own personal stores of gold or else they can draw gold from their bank depositories and transfer it to companies.

A second possibility is that people farm out their investment decisions to investment companies by buying their shares for gold. The money received by these companies is intended for investment in projects by the companies. This changes nothing essential. The people in this case have chosen intermediaries to make investments in projects. They can sell their shares in a secondary market if they wish to liquidate their holdings.

The third possibility is that banks are fractional reserve in nature. This is in between the other two cases. People make deposits at the banks that belong to the bank and that can be invested by the banks at will. However, people also can liquidate their deposits and get gold at bank windows to the extent that such gold is readily available. Banks may delay or stop such payments under conditions where it runs out of ready gold. This bank is not perfectly liquid, but its investments do not exceed the size of its deposits. Still, we call it a fractional reserve bank because its gold holdings are a fraction (less than 1) of its deposits.

The fractional reserve bank has an inherent illiquidity because its total assets exceed the assets that it holds in gold that are ready to pay depositors on demand. Suppose a bank has $100 in deposits. If it has $100 in gold, it has no illiquidity of the kind I am explaining. It has zero illiquid loans relative to $100 in gold. Define an illiquidity ratio as the illiquid loans divided by the amount of gold. The illiquidity ratio is 0/100 = 0. If the bank has $65 of gold and $100 of gold, its illiquidity ratio is 35/100 = 0.35.

Let's now go one step further in understanding the nature of a bank. Let's suppose that the fractional reserve bank can make loans and simultaneously create deposit account credits. This amounts to financing the purchase of a loan with a new liability, which is the deposit. The bank that makes a loan is buying a security from the borrower, which is the loan. In return the bank issues a security to the borrower, which is the deposit account. Suppose the bank with $100 in gold and $100 in deposits makes a $70 loan and creates a $70 deposit account for the borrower. The bank then has $170 in assets and $170 in deposit liabilities. It has expanded its balance sheet.

The peculiar aspect and the defining feature of a bank is that its deposit liabilities are convertible into money, i.e., gold, if available, and so the deposits become regarded as being about as good as gold under many conditions, mainly being that the loans are good loans. Deposits brought into the bank in gold and deposits created by the bank when making loans are intermingled.

This bank now has $100 in gold and $70 in illiquid loans. Its illiquidity ratio is 70/100 = 0.7. The ratio increase from 0 to 0.7 indicates the rise in illiquidity.

If depositors withdraw gold, the illiquidity ratio rises further. Suppose that $70 in gold are drawn out of the bank. This reduces deposits back to $100. The assets are now $30 in gold and $70 in illiquid loans. The illiquidity rises to 70/30 = 2.33.

From the bank's side, the reason for any illiquidity at all is to amplify the bank's earning assets by making loans. The amplification is a kind of leverage. Call it illiquidity leverage. From the side of those making deposits, their risk rises with illiquidity. Unless they get a return in some form, they will not fund or finance an illiquid bank in this way. Their return seems to be a set of conveniences such as use of checking and money storage.

Let's return to the question of how money and inflation work when someone obtains finance for a new project. What happens when a bank is present that can create loans and deposits? It means that there is now a fifth means of obtaining money. Rather than people directly providing the company with credit, a bank can do it and it can do it by creating a new credit altogether while simultaneously creating a new deposit that is regarded by the depositors as money.

The bank and the borrowing company expect to complete the lending cycle when the company's project is a success and it returns gold to the bank. The bank will then cancel the loan and deposit of the company.

The bank competes with the other four methods of providing the company with capital. None of those four methods was inherently inflationary, i.e., produced a systematic or continuing increase in prices. Neither is bank lending. Remember that the production of money has to face constraints or else the good serving as money loses its utility and will no longer be acceptable as money. The banks are producing deposits by granting loans. This is a relatively low cost way to create money. However, the depositors have the right to withdraw their money in gold at any time. This constrains the bank. Remember that its illiquidity rises as depositors withdraw gold. The bank is at the mercy of its depositors. The bank, in effect, is acting as an agent for the depositors when it makes loans. The depositors, in effect, are extending the loans to borrowers via their bank. They can force the bank to call in and reduce loans by withdrawing capital in the form of gold. If their money in the form of deposits is losing purchasing power because the bank is creating too many loans and deposits, they have an incentive to withdraw funds in the form of gold. This constrains the bank from lending.

This is an important conclusion. Fractional-reserve banks are not inherently inflationary in a system in which the market participants are using real money, such as gold. By real money, I mean a money that those participants themselves regard as a good that has the attributes that they require from money.

Another important constraining factor is the competition of banks. In a fractional-reserve banking setup with gold, bank deposits can be withdrawn as bank notes that are used as currency and substitute for gold money. Each bank has its own notes. If a bank issues too many notes or makes bad loans so that gold is not returned to the bank, its illiquidity ratio rises. Depositor risk rises. The depositors have an incentive to withdraw gold and place it elsewhere or store it themselves. This possibility of a bank run constrains the bank. At the same time, a competing bank that receives the notes of another bank presents them for payment to the issuing bank immediately. There is a daily clearing mechanism. If the issuing bank starts to run high balances such that their redemption in gold is questionable, it must call in loans or constrain its lending.

The situation in the economies of today differs drastically from what I've described above. Although gold and silver are available in the market, a number of obstacles such as taxes stand in their way as being used as money. Furthermore, governments have erected laws and regulations that make their fiat currencies serve the medium of exchange purpose. In this situation, the depositors are unable to constrain banks. They cannot withdraw gold, because gold is no longer being used as money. They can withdraw only paper, and the banking system can easily manufacture more paper. In this kind of fiat money economy, as opposed to a gold money economy, the banks have an inherent inflationary bias. It pays to make more loans because the depositors can't do anything about it and can't constrain the banks. Beyond the lack of gold in the system, deposit insurance virtually eliminates the incentive even to withdraw cash in paper form. This induces many banks to raise their illiquidity ratios drastically and/or to make imprudent loans. When banks make nonproductive loans, the deposit money doesn't go into projects that succeed in lowering prices. Instead prices are bid up. When the bad projects are revealed, the loans and deposits have to be written off. A deflation then occurs.

The conclusion is that fiat money combined with fractional-reserve banking is an inflation source. The problem of inflation and then deflation is not fractional-reserve banking per se because, when combined with gold, that system works. The bottom line problem is eliminating gold in the fractional-reserve bank and replacing it with fiat money supplied by a central bank. The central bank can liquify any bank loan at its discount window or liquify the entire banking system by creating bank reserves. It can nullify the normal process by which depositors in a gold system withdraw gold from banks that are too illiquid. Regulation of illiquidity has proven to be a poor substitute for market incentives that control illiquidity, but those incentives are undermined in a central banking system.

Even with central banking, banks clear balances with one another. This does constrain loans. And banks still seek out good rather than bad loans. Even with central banking, banks can cease to lend each other bank reserves. That continues to act as a constraint on illiquid banks, but a central bank can even overcome that by targeted credit measures.

The more usual feature of the fiat-central bank system is that the central bank over time is relatively generous in creating reserves and loosening the natural constraints one finds in a gold-based market system. Additionally, the government and central bank are lax in controlling bank illiquidity and lending. One result across many countries is usually annual inflation in a 3-12% range, unless the government legislates a constraint. Another is periodic waves of bank failures. Generally, under looser constraints due to the loss of market constraints, banks make bad loans to sovereign governments. They overextend into risky activities, off-balance sheet financing, derivatives, and long-term loans. They compound their illiquidity.

The central bank produces its money, empowered by the government. In the U.S., the Federal Reserve's notes are an obligation of the U.S. The central bank is the institution that is the central cause and enabler of all the money and banking problems emerging from fiat money creation, not the institution of fractional-reserves. Making all banks into 100% depository institutions gets rid of banking itself. This is unnecessarily drastic because banks have plusses. They are used by depositors even when they have some degree of illiquidity. However, if America ever does rework its banking system, a much clearer legal separation should be made between 100% depository banks and illiquid banks in which depositors are actually lenders.

It's the central bank that should be ended in order to mitigate money and banking problems. This is a heavily political problem because the government's size and power hinge on having a central bank in place to handle its financing. This is especially true for the U.S. with its massive borrowing requirements. There would be no government bond market of its current size and form without a central bank and the system of primary dealers and banks attached to it. Because of the connection to big government, I see no realistic prospect of either central banking or the existing fiat money system being eliminated. There does exist some prospect of gold being brought back into the system in some ways, such as allowing banks to use gold as reserves or re-introducing gold in international payments. The impetus for these steps might be from overseas or from an institution like the BIS, not domestically. They might actually involve movement toward a world central bank.

Now and in the foreseeable future, the U.S. is taking no steps to end its central bank as a solution to its money and banking problems. Its first response was to save the banking system as currently constituted. Its second step was Dodd-Frank.

My main point is that fractional-reserve banking is not in and of itself the problem, and thus it shouldn't be the main target of reform or change. The key problem is an incentive system caused by fiat money and central banking that generates illiquidity that is too high, risky bank practices, and poor financing practices. Another important cause is that there are often government pressures to expand credit and to target loans to specific sectors. There are pressures to finance governments and pressures to bail out banks and sovereigns. There is lax and ineffective government regulation that does not suffice to overcome the incentive problems resulting from the absence of gold as money and the introduction of central banks. In addition, the government regulation itself causes incentive problems.

Because the basic money and banking problems are not being addressed in a fundamental way but instead have been addressed with palliatives like Dodd-Frank, whose effectiveness is likely to be very muted or even counter-productive, what we can expect is a continued period of financial strain, under-performance, shakiness and instability. Threats of collapse are not going to disappear. The best that could happen under the prevailing politics would be for vigorous finance committees in the Congress not to let the ball drop but to work at the margin to reshape the system and move it in the direction of sound money and sound banking.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire.

    © 2012 Copyright Michael S. Rozeff - All Rights Reserved
    Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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