AUSTRIAN "INFLATION" AND "DEFLATION"
Copyright 2004 J. N. Tlaga
This short article was excerpted from the incoming part 2 of Questions and Answers related to "How To Defang All The Banks Once For All". Taken separately, it may put to rest a hundred years old myth that refuses to die.
Question:
In his essay "The Money Multiplier: Myth or Reality", Dr Frank Shostak, an adjunct scholar of the Mises Institute, is educating us that "not only does fractional reserve banking [give] rise to monetary inflation; it is
also responsible for monetary deflation."
This is how his thesis is illustrated:
"...a depositor-John-deposits $100 in cash at a bank (Bank A) and this constitutes the bank's current total cash deposits. The bank then lends $50 to Mike. By lending Mike $50, the bank creates a deposit for $50 that Mike can now use. This in turn means that John will continue to have a claim against $100 while Mike will have a claim against $50. This type of lending is what fractional reserve banking is all about. The bank has $100 in cash against claims of $150. The bank therefore holds 66.7% reserves against demand deposits. In short, the bank has created $50 out of 'thin air' since these $50 are not supported by any genuine money."
"...not only does fractional reserve banking [give] rise to monetary inflation; it is also responsible for monetary deflation. We have seen that banks-by means of fractional reserve banking-generate money out of 'thin air'. Consequently, whenever they do not renew their lending they in fact give rise to the disappearance of money."
"On the day of maturity when Mike repays the $50 the money goes back to the bank-the original creator of this empty money; that is, money disappears from the economy, or it vanishes into the 'thin air'."
In plain English, is Dr Shostak wrong? And if he is wrong, then why is he wrong? Please be specific. This matter is of fundamental importance because the entire monetary universe is now based on the theory that fractional reserve banking produces credit money out of thin air, and that that money is subsequently destroyed when the credit is repaid. If you can prove that Dr Shostak is wrong, this would also be a proof that we are being fed the false theory of reality, that we are being deliberately kept in darkness about what is being done to us.
Answer:
Dr Shostak is as wrong as wrong can be.
Bank A never created $50 out of thin air to lend to Mike. It merely took $50 from John's $100 without writing him a "Dear John" letter. And when Mike repaid his loan, John's $50 was put back into his account without
telling him it was ever absent to run interest errand for Bank A.
It is true that by repaying his loan Mike reduced available money supply by $50 but for completely different reason than Dr Shostak is trying to make us believe.
It is essential to grasp that available money supply in the economy is not what exists, but what circulates.
This is the reason why economic activity is measured by velocity of money. Each time money changes hands, yet another business transaction is added up to the gross national product, and the more often it happens the faster economy grows.
When all existing money stock is in the circulation, and is changing hands without cessation, the economy is at its peak performance. If at this point, additional fiat money is injected into the economy, it will accelerate
velocity of money beyond the natural safety limit and will inevitably land the economy in a ditch. And if, on the other hand, some of the circulating money is withdrawn from the economy, this will slow down all the economic activities because many transactions will have to await their turn in queue for scarce money.
When the economy slows down because of scarcity of money, there are two ways to return it to its peak performance:
- To return withdrawn money back into circulation; or,
- To reduce all prices to the level where the diminished money supply can support all forthcoming transactions without forcing them to wait for credit.
Every time somebody puts some money under a mattress, that money is removed from circulation and that slows down the economy.
The same thing happens when somebody puts some money into a checking account, or into a safe deposit box. That money is no longer making its rounds through the economy, and is no longer lubricating the economic machinery.
There is not much that can be done about money sitting in somebody's safe deposit box or under somebody's mattress. But the money sitting in people's checking accounts can be plowed back into economy without letting them know it was ever done. This is known as fractional reserve banking. By
keeping on hand a fraction of people's deposits that is likely to be required, the banks can safely return the non-required part back into the economy to keep it rolling.
When Bank A lent $50 to Mike, it did not create those 50 dollars out of thin air. It merely returned into the economy a part of what was withdrawn from it by John and stashed in his checking account. And when Mike repays his loan, those 50 dollars are again withdrawn from the economy and stashed in John's checking account. They can return back to the economy only if someone else with borrow a part of John's stash again.
Thus, it is true that bank credit adds to the available money supply, and repayment of credit reduces the available money supply, but it is not true that banks create this credit out of thin air, and its repayment returns
it into thin air.
Only the central bank counterfeiting can create new money out of thin air. Fractional reserve banking can only return into the economy the existing money that was withdrawn and placed in people's checking accounts.
To nail the closed door on the fallacy of the alleged creation of new money out of thin air by way of fractional reserve banking, we must ask Dr Shostak a simple question that may put this issue to rest once for all:
What if Bank A would have asked John for permission to lend 50 dollars to Mike, and upon receiving such permission would have reduced John's account by $50 and issued to him a certificate of deposit in that amount repayable upon repayment of Mike's loan? Would Mike's loan still require creation of new money out of thin air, or direct transfer of already existing money from John's account would suffice?
The explanation how central bank counterfeiting interlocks with fractional reserve banking will be provided in Part 2 of Questions and Answers.
16 January 2004
J. N. Tlaga
jtlaga@bellsouth.net
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