| Copyright © 2004 by Antal E. Fekete |
February 15, 2004 |
GOLD STANDARD UNIVERSITY
Winter Semester, 2004
Addendum to: Monetary Economics 101:
The Real Bills Doctrine of Adam Smith
SPECIAL EXTRA
FRACTIONAL RESERVE BANKING REVISITED
¶ Does Fractional Reserve Banking Involve Counterfeiting?
¶ Horizontal Division of Labor ¶ The Self-Liquidating Bill of
Exchange ¶ The Bill Market ¶ Vertical Division of Labor ¶
Bank Credit Financing Production Not Inflationary ¶ Chairman Patman's
Mistake ¶ Paradise Lost ¶ Mises versus Adam Smith ¶
The Second Greatest Story Ever Told
Does Fractional Reserve Banking Involve
Counterfeiting?
A new dispute has flared up between protagonists and detractors of
fractional reserve banking. This is a welcome development because the
burning issues under the ashes jeopardize the success of the honest money
movement.
Joseph N. Tlaga challenges the long-standing position of the
Austrian School of Economics, reflecting the views of Ludwig von Mises,
that the commercial banking system is creating money "out of thin air"
when it issues note and deposit liabilities backed by fractional reserves of
gold, so that if all depositors and note-holders presented their claims
simultaneously, then the banks would go bust. In the view of the Austrians
this "counterfeiting process" is at the root of the boom-bust cycle.
I wish to congratulate Tlaga on his courage to defy conventional wisdom,
and on his insight that there is no counterfeiting per se involved in
fractional reserve banking, so the root of the boom-bust cycle must be
found elsewhere. He goes on record as saying that the Austrians have never
grasped the real meaning of fractional reserve banking. Since lending more
than available reserves would send the bank bust in a matter of days, the
question is raised why the Austrians never re-examined their position on
this issue.
Tlaga also observes that the incorrect perception of fractional
reserve banking is endemic. It is never questioned, and the error has been
shared by too many for too long. In particular, it is being cultivated by
the fiat money establishment as well as the banking fraternity (presumably
because of one's reluctance to dispel the myth of one's own importance, not
to say omnipotence). According to Tlaga 100 percent reserve banking
advocated by Mises would never work. "If the misguided Austrian imperative
to use police power to enforce 100 percent bank reserves were carried out,
then an immense amount of credit would disappear instantaneously, the
economy would be paralyzed, and the honest-money movement would have to take
the blame... People who stick to the mantra that abolishing fractional
reserve banking is a prerequisite for returning to honest money should know
that they are doing a disservice to the cause..."
Horizontal Division of Labor
Unfortunately, Tlaga's demonstration that loans extended by the fractional
reserve bank do not add one iota to the stock of purchasing media as they
merely mobilize otherwise idle bank balances, does not hold water. Brian
Macker has published a short rebuttal in Mises Economics BLOG, but it
hardly does justice to this important issue.
In his argument Tlaga uses the example of producing automotive
fuel called gasohol. The Distiller raises a number of bank loans to purchase
corn, potato, rye, and sugar cane from his suppliers who deposit the
banknotes in their banks which promptly collect the fractional gold reserve
from the Distiller's bank. Tlaga concludes that the banknote and the gold
coin cannot circulate simultaneously. In his view the banknote is merely a
substitute for, never a supplement to, the gold coin.
Tlaga's description of what happens is erroneous. The horizontal
division of labor of the Distiller and his suppliers obscures the fact
that the latter must use the proceeds to pay their own suppliers, and are in
no position to leave large cash balances idle in the bank. If we want to
decipher the mysteries of fractional reserve banking, then we should
consider vertical division of labor and track the footprints of
banknotes that way.
The truth of the matter is that banknotes and bank deposits arising
out of loans raised by the producers do indeed add to the stock of money.
They enter into circulation and finance further transactions, as Macker
says. Still, Tlaga is right in asserting, and Macker is wrong in denying, that
money created this way did not come out of thin air.
Self-liquidating Bills of Exchange
"Fractional reserve banking" is a misnomer as it suggests that part of the
money created through the loan process is backed by nothing. In reality,
the part not backed by gold reserve is fully backed by a bank asset called
self-liquidating bill of exchange (bill for short). As Mises himself
would admit, bills are capable of monetary circulation (as they did indeed
circulate in the Manchester area that lay outside the boundaries of the
monopoly of the Bank of England in the 19th century).
A bill is a written promise by the Producer to pay the Supplier the
face value at maturity, less than 91 days away, for supplies shipped. When
endorsed by the Producer, the bill can circulate through further endorsing.
First, the Supplier can use it to pay his own suppliers who can, in turn, do
the same. Such payments are subject to discounting at the going discount
rate (not to be confused with the rate of interest!) by the number of
days remaining till maturity. Therefore using the bill for payment is also
called discounting it.
The Bill Market
It is important to understand that the economy could very well operate
entirely without commercial banks (as it did in the Manchester area in the
19th century). Suppliers would draw bills on producers and discount them
in the bill market. At maturity bills are paid in gold coins. The market
would keep bill trading under tight control. If too many "Miller on Baker"
bills were discounted, the market would refuse to trade them. If in the event
the miller and the baker conspired to finance their speculative stores of
grain, they would be blacklisted. The market would not touch any paper on
which the signature of either of them appeared. Not as if anything was
wrong with speculation in grains, but speculative stores ought to be
financed through other means. The bill market was meant specifically to
finance the production of merchandise that moved fast enough
to the final consumer so that the gold coin of the latter could liquidate all
claims in less than 91 days (or 13 weeks, or 3 months, or one quarter, that
is, the length of the seasons of the year). Bills drawn on merchandise that
did not move fast enough were not eligible for discounting. The production of
such slow-moving merchandise, as well as holdings of goods in speculative
stores, was supposed to be financed by the loan market at the higher interest
rate.
The bill market would watch like a hawk that the 91-day rule was
not violated. The reason for this rule is that consumer demand changes with
the seasons. Goods that could not be sold in 91 days might not be sold for
365 days, till the same season of the year has come around once more. But
by that time consumer taste may change, and the merchandise may be un-saleable
except at a loss.
Vertical Division of Labor
The circulation of the bill mirrors vertical division of labor. We may
track it through the example of the "Weaver on Tailor" bill. The Tailor is
producing clothes for his customers. The Weaver delivers cloth to the
Tailor and bills him. The Tailor "accepts" the bill by endorsing it, agreeing
to pay the face value in 91 days or less, and returns it to the Weaver. The
Spinner delivers yarn to the Weaver and gets paid by the same bill, after
the Weaver has also endorsed it. Through endorsement the claim to the
proceeds is transferred to the Spinner. The Sheep Farmer delivers wool to
the Spinner and gets paid by the same bill, after the Spinner has also
endorsed it. The claim to the proceeds has been transferred once more, this
time to the Sheep Farmer. In this way the bill continues its journey from
supplier to supplier, the last of whom presents it to the Tailor for payment
at maturity. By that time the latter has the gold coins from the sale of
clothes to the final consumer. When he pays the bill in gold, all claims that
have arisen during the course of this particular production cycle are
extinguished.
As can be seen, the bill has "telescoped" several payments into one,
and the pool of circulating gold coins had only to be invaded once instead
of several times. The final consumer's gold coin was all that was needed to
finance the production of the consumer good, regardless how many hands
were involved in producing it. Thus the bill makes great economy in the
use the gold coin possible. This is quite important, as a dearth of gold
could threaten the production process with seizing up. Moreover, during
certain times of the year (such as crop-moving time, or at Christmas) the
existing pool of circulating gold coins may not be sufficiently large to
accommodate all demand if it is invaded every time anybody moves a
maturing product, however briefly. The bill of exchange comes to the
rescue, by providing an elastic supply of purchasing medium. Bill
circulation waxes and wanes together with the volume of business to be
transacted.
Bank Credit Financing Production Not Inflationary
As already pointed out, every time the bill is endorsed and passed on, a
discount is applied to its face value at the going discount rate by the
number of days remaining to maturity. Thus the bill is an earning asset that
banks are eager to have. Moreover, the bill is the most liquid asset a bank
can have, second only to the gold coin itself. It is called "self-liquidating"
as it is paid at maturity with the gold coin of the final consumer. For these
reasons banks compete for the bills by offering to discount them at the best
(i.e., lowest) discount rate that is still compatible with the
profitability of the commercial banking business.
Banks replace bills with bank deposits on which producers draw checks to
pay their suppliers. Writing checks is more convenient than discounting bills,
and the producers are glad to pay for this convenience in the form of forgone
discount. It goes without saying that the bank is not supposed to "roll over"
a mature loan even if (or, more to the point, because of) the underlying
merchandise has failed to sell. A new loan ought to be negotiated to
finance the next production cycle.
Please note that the gold coin is absolutely essential in this system
of financing the production of merchandise in urgent consumer demand.
The gold coin is the ultimate extinguisher of debt. Without it a perpetual
debt tower would keep growing. No irredeemable currency, whether issued
by a private bank, by a central bank, or by the Treasury of a country
possessing the most formidable arsenal of weapons of mass destruction can
match the debt-extinguishing power of the humble gold coin.
I have observed that bank deposits arising out of loans, contrary to
Tlaga's view, do in fact add to the stock of purchasing media. Does this
then mean that financing the production of consumer goods through bank
credit is inflationary? No, it does not. Inflation means the issuance of
purchasing media in excess of goods available. In the present case, the
bill emerged simultaneously with the emergence of new merchandise in urgent
demand of the same value, and would disappear from circulation at the same time
as the merchandise is sold. The net effect on the stock of purchasing media is
nil.
This is a point which the Austrian School stubbornly refuses to
admit. Its view is rigidly governed by the untenable Quantity Theory of
Money according to which any and all credit in excess of gold in the vault
plus bank capital are inflationary. Adam Smith's Real Bills Doctrine is
proscribed by the Austrians - a most regrettable position from the point of
view of the honest money movement.
Can the banking system, operating on the principle of fractional
reserves as described above, be embarrassed by gold withdrawals? Hardly.
On average one ninetieth of the bills outstanding mature every single day
bringing in gold coins the final consumer has disbursed in exchange for
merchandise he urgently wanted. These coins are available to satisfy
normal demand for gold. If one particular bank experiences extraordinarily
heavy withdrawals, it can get gold from another experiencing an overflow,
by rediscounting bills yet to mature. As long as the government is not out
to sabotage the gold standard, and banks do not violate the 91-day rule, the
system will work smoothly and efficiently. The charge that fractional
reserve banking creates money "out of thin air" is preposterous.
Chairman Patman's Mistake
Wright Patman, the legendary populist chairman of the Ways and Means
Committee of the U.S. House of Representative in the 1950's, made the
following erroneous statement in his 1128th Weekly Letter of April 7, 1955
, to his constituents: "Money and credit are manufactured by the commercial
banking system. For every one dollar in reserves that a commercial bank
has, it can create six dollars of additional credit, which it can then loan and
earn interest upon."
Assuming that the bank is required to keep a ratio of $1 of reserve
against $6 of deposits (approximately 17 percent), this does not mean that
for every additional dollar of reserve the bank obtains it could lend $6 and
create $6 additional deposits. If that were the case, then banks could earn
30 percent interest on each dollar of surplus reserve provided that loans
were made at the rate of 5 percent. Patman does not allow for withdrawals
of deposits arising from loans. However, the fact is that people do not
borrow in order to leave all the proceeds as an idle balance in the bank.
Assuming that an average of 80 percent of deposits resulting from
loans (called derivative deposits) are drawn out and cash deposits (called
primary deposits) remain undisturbed, furthermore, that the bank is
required to maintain a reserve of 17 percent against its deposits, the bank
could lend only about 99½ cents for each $1 gained as a cash deposit, or
approximately $1.20 for each dollar of surplus reserve, and not the $6
alleged by Patman. Here is the maths in full details.
Suppose that some depositor places a sum C in a bank (primary
deposit), thereby increasing the bank's cash or reserve by the same amount;
we want to calculate the amount X of additional credit the bank can
create. Let r denote the ratio of reserves to deposits that the bank is
required to keep, and let K denote the ratio of funds to loans that, on
average, borrowers leave on deposit. Then
|
1 |
| X = C(1 - r)[1 + K(1 - r) +
K2(1 - r)2 +
K3(1 - r)3 + ...] = C(1 - r) |
----------------- |
|
1 - K(1 - r) |
Indeed, C(1 -r) is the amount of deposit the bank can create
in the first place. The borrower leaves K times that sum on deposit,
enabling the bank to create further deposits in the amount
C(1 - r)K(1 - r)
The next borrower leaves K times that sum on deposit, enabling the bank
to create further deposits in the amount
C(1 - r)K2(1 - r)2
We see that the bank is enabled to create a (decreasing) sequence of deposits,
every one K(1 -r) times the previous. We have a geometric series
and, applying the sum formula, we get the result announced above.
For example, let C = $1000, K = 1/5 = 20/100 or 20 percent,
r = 1/6 = 16⅔/100 or approximately 17 percent, then
| $1,000(1 - 0.17)
$830 |
| X = ------------------ = --------- = $995.20 |
| 1 -0.2(1 - 0.17)
0.834 |
or 99.52 cents for every dollar gained as a primary deposit. This is
approximately $1.20 for every dollar of the $830 surplus reserve.
Before any withdrawals and consequent reduction in deposits resulting from
the loans take place, the balance sheet of the bank would be as follows:
| Assets: |
|
Liabilities: |
|
| Reserve |
$1000.00 |
Primary deposits |
$1000.00 |
| Loans |
995.20 |
Derivative deposits |
995.20 |
|
________ |
|
________ |
|
$1995.20 |
|
$1995.20 |
As soon as 80 percent of the derivative deposits is withdrawn, the
following transactions take place: $796.16 are withdrawn, and derivative
deposits are reduced to $199.04. The $796.16 must come out of the $1000
of cash reserve reducing it to $203.84. The balance sheet of the bank now
stands as follows:
| Assets: |
|
Liabilities: |
|
| Reserve |
$203.84 |
Primary deposits |
$1000.00 |
| Loans |
995.20 |
Derivative deposits |
199.04 |
|
________ |
|
________ |
|
$1199.04 |
|
$1199.04 |
The ratio of reserve to deposits is now 17 percent; but this does not
mean that for every $1 of surplus reserve the bank might get it could lend
$6, as alleged by Patman. Legal reserve requirements must be maintained
after loans have been made, derivative deposits created and, following
withdrawals, reserve and derivative deposits reduced. It is correct to say
that in the above balance sheet the reserve ratio is 17 percent and that each
$1 of reserve supports $4.88 of loans and $6.88 of deposits; but that is very
different from an assertion that each additional $1 of reserve will admit $6
in new loans. The balance sheet of Patman's bank would appear as follows:
| Assets: |
|
Liabilities: |
|
| Reserve |
$1000.00 |
Primary deposits |
$1000.00 |
| Loans |
4980.00* |
Derivative deposits |
4980.00 |
|
________ |
|
________ |
|
$5980.00 |
|
$5980.00 |
*(6 X 830 surplus reserve)
Not one cent could be withdrawn from that bank since the reserve
ratio is already below the legally required 17 percent. And, of course,
borrowers do not borrow, and pay interest on, $4980 in the expectation of
not being able to draw on the sum borrowed.
Paradise Lost
The paradise of fractional reserve banking was lost, and the gates of hell
of the boom-bust cycle and credit collapse were thrown open, when banks
yielded to the temptation and started sheltering fraudulent bills in their
portfolio. What was the apple tempting the banks? Well, it was the spread
between the higher interest rate and the lower discount rate. The banks
were hell-bent to increase their profits by pocketing the spread to which
they were not entitled. Thanks to banking secrecy, there was no danger of
being caught red-handed. The fraudulent paper was out of sight, well-hidden
in the portfolio of the bank.
Here we touch upon another sacred cow of the Austrian School of Economics:
the denial that an indelible difference exists between the rate of interest
and the discount rate, reflecting the fundamental difference between saving
and clearing. When the Supplier delivers supplies to the Producer and bills
him, the terms "91 days net" for the payment of face value are part of the
deal, according to merchant custom. It definitely does not mean that the
Supplier has made a loan, or the Producer has borrowed a sum, amounting to
the face value of the bill. The shipment of supplies of semi-finished
products is on consignment, subject to the sale of the finished
product to the final consumer. There is no obligation on the part of the
Producer to prepay the bill and therefore if he does, he will only do it
for a consideration. He will apply a reduction (discount) to the face
value of the bill, proportional to the number of days left to maturity. The
same is true if anyone else discounts the bill.
Not only is discounting conceptually different from extending a loan; the
factors determining the height of the discount rate are also very different
from those of the rate of interest. The former is governed by the
propensity to consume and, the latter, by the propensity to
save. (In either case the relationship is inverse: the higher the
propensity, the lower is the rate.) The wide-spread confusion between the
discount rate and the rate of interest is one of the most amazing errors in
monetary science.
The idea that a bill of exchange can circulate on its own wings and
under its own power is ridiculed by the devotees of monetarism, in
particular by their high priest, Milton Friedman. No wonder. The Real Bills
Doctrine is the Achillean heel of the Quantity Theory of Money. It
establishes the fact that an increase in the quantity of purchasing media
need not cause a rise in prices. If the new purchasing media emerges
simultaneously with new merchandise in high demand of equal value, and
the two disappear together as the latter is removed from the market by the
final cash-paying consumer (as in the case of financing the production and
distribution of consumer goods through fractional reserve banking subject
to the 91-day rule), then there will be no price rises on account of the
increase in the stock of money.
The commercial banker's original sin was that he yielded to the
temptation of higher profits and compromised the standard for papers
eligible for discounting. As long as the bill market was allowed to
function, standards could not be compromised because everything was done in
the open. Bills were a public document and could be inspected by anybody.
The market would refuse to touch dubious paper and would blacklist
cheaters. But when the banking system entrapped and subsequently
annexed the bill market, sheltering illiquid paper became possible, and
there was no umpire to blow the whistle.
The government helped the perpetrators of fraud by all means at its
disposal. It relaxed the standards of bank inspection. It made a sweetheart
deal with the banks. In returning the favor of the banks' in finding a cozy
place for Treasury bills and bonds in the asset portfolio (thus sheltering
them against the ravages of the market), the government was willing to
introduce double standards in contract law. It exempted the banks from
punishment in case they could not pay gold on their sight liabilities - a
predictable consequence of the policy of loading the portfolio with phony,
illiquid, and overpriced paper. The granting of special privileges to the
banks was the grave-digger of honest fractional reserve banking.
The government administered the coup de grâce to honest
fractional reserve banking when it exiled gold coins from the economy, a
banishment that still continues today in spite of the availability of
souvenir gold coins (issued to throw dust into the eyes of the public).
Without gold redeemability bank lending has become arbitrary and has been
detached from the task of serving the satisfaction of urgent consumer demand.
The Consumer lost his emissary, the gold coin, with which he communicated
his demand to the Producer. From then on it wasn't the Consumer but the
issuer of irredeemable currency that would call the shots in setting
priorities and dictating directives to the Producer.
Mises versus Adam Smith
Mises divides credit into two broad categories, according as "sacrifice" is
or is not involved. The former originates in savings; the latter is "fiduciary
credit" that banks create "gratuitously". Mises specifically rejects the view
of Adam Smith that the source of fiduciary credit is the quantum reduction
of risk in the production of certain basic goods (e.g., food and clothes)
brought about by the urgency of the demand, and the near certainty that the
product will definitely be removed from the market during the coming quarter by
the cash-paying consumer. This reduction in risk facilitates more refined
division of labor in production, as well as more streamlined clearing in the
financing thereof. Marginal producers may participate with greatly reduced
capital requirements. Distributors need not pay cash, they simply endorse the
bill. The upshot is "socialized credit", another apt name for fiduciary credit
created collectively, and made available at the nominal discount rate, for the
benefit of the entire society.
Mises sees it differently. When the bank discounts a bill, it
exchanges a present good for a future good. Moreover, the bank creates the
present good "practically out of nothing". The question is not raised how
the banks have acquired their supernatural power to create something out
of nothing. The suggestion is not made that, in some cases, criminal fraud
might be involved. Mises fails to distinguish between two types of
fiduciary credit: (1) credit emerging as a result of financing the production
of urgently needed consumer goods, (2) credit emerging as a result of
fraud, e.g., pretending that merchandise is moving in response to urgent
consumer demand when in fact it has been forestalled in the expectation of
speculative profits. Bearing the cost, there is a victim. He may be unaware
that he is being victimized by the banks, so well-hidden is the
prestidigitation. But there is a cost. Denying it would be tantamount to
denying the laws of physics, in particular, the law of conservation of
matter.
Mises dismisses Adam Smith's Real Bills Doctrine as deus ex
machina. Yet the great merit of Adam Smith is the recognition of
circulation credit, the fact that bills circulate spontaneously even in the
complete absence of banks. This makes it plausible that fraud appears as
soon as the banks establish their monopoly over fiduciary credit. One can
only speculate that the aversion of Mises to the Real Bills Doctrine is due
to his unfailing adherence to the Quantity Theory of Money. Be that as it
may, this aversion has led Mises to creating a faulty theory of credit. The
Austrian School of Economics would do well to recognize this fact and,
belatedly, correct the error, as urged by Tlaga.
The great evil of our age, unlimited credit expansion, cannot be
understood, still less corrected, on the basis of a faulty theory of credit.
For this reason I have taken the trouble and liberty to restore Adam Smith's
Real Bills Doctrine to its proper place in monetary science, and to draw
attention to the fact that it is possible to run the modern economy entirely
without commercial banks, with real bills providing the financing for the
production of consumer goods in urgent demand. While fractional reserve
banking per se is not the cause of credit collapse that is threatening the
world, the banks will have earned such a bad reputation for betraying the
public trust that, after they have self-destructed as part of the coming
monetary Armageddon, reconstruction may be easier if their resuscitation
is side-stepped. All that is needed is that the United States open its Mint to
the free and unlimited coinage of gold, as stipulated by the Constitution, in
order to make the coins needed to pay wages, and to liquidate the credit
represented by maturing bills, available. The banks have to live down their
betrayal of the public trust without help from monetary science.
The Second Greatest Story Ever Told
To recapitulate, there was nothing sinister about fractional reserve banking
as it was conceived originally. Bank loans were fully backed by gold
reserve and self-liquidating bills of exchange. We may conceptualize bills
as bank assets maturing into gold pari passu with the underlying
semi-finished goods maturing into finished goods ready for sale to the final
gold-paying consumer. Loans were not inflationary, since they did not increase
the stock of purchasing media beyond the stock of goods available for
consumption, and were extinguished at maturity by the gold coin that the
final consumer surrendered. Fractional reserve banking merely streamlined
spontaneous bill circulation which had existed, and would exist,
independently of the existence of banks. Fractional reserve banking
became sinister after the banks monopolized fiduciary credit and started
sheltering fictitious and slow paper in their portfolio.
Any critical examination of fractional reserve banking must start with an
examination of the spontaneous circulation of self-liquidating bills of
exchange as it originated in the Italian city states, and the spontaneous
circulation of clearing house receipts as it originated at the great mediaeval
city fairs elsewhere in Western Europe. Under the title The Second Greatest
Story Ever Told I have published the genesis of the self-liquidating bill
of exchange in twelve Chapters. The title has an oblique reference to the
Bible and to the ethical foundations of bill trading, a foundation of which
the regime of irredeemable currency is utterly devoid. It also includes an
account of how honest fractional reserve banking grew out of the Discount
House and, the dishonest, out of the Acceptance House. Moreover,
the story covers the genesis of banknotes and the two cardinal sins of banks,
namely, illicit interest arbitrage and borrowing short to lend long. The
interested reader will find it in my course at the Gold Standard University:
Monetary Economics 101 entitled The Real Bills Doctrine of Adam Smith,
on the website: www.goldisfreedom.com.
The continuation of this course, Monetary Economics 201 entitled The Bill
Market and the Formation of the Discount Rate, is in preparation.
References
J. N. Tlaga, How to Defang All the Banks, January 5, 2004,
www.gold-eagle.com
J. N. Tlaga, Questions and Answers, January 15, 2004,
www.gold-eagle.com
J. N. Tlaga, Why the Austrian School Needs to Purge Its Flaws, January
24, 2004,
www.gold-eagle.com
Brian Macker, Fractional Reserves and the Creation of New Money,
January 8, 2004, Mises Economic BLOG, www.mises.org
Gary North, Mises on Money, Part IV, Fractional Reserve Banking,
January 24, 2002, www.lewrockwell.com
Antal E. Fekete |
Professor Emeritus |
Memorial University of Newfoundland |
St.John's, NL, CANADA A1C5S7 |
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