2-13-12_THEORY of MONEY_The Money Multiplier__Myth or Reality_.pdf

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The Money Multiplier: Myth or Reality?

Most economists are of the view that the current monetary system

amplifies the initial monetary injections of the central bank. Thus, according to a

popular view, if the Fed injects $1 billion into the economy and banks have to hold

only 10% in reserves against their deposits, this will cause a first bank to lend 90% of

this $1 billion. The $900 million in turn will end up with a second bank, which will lend

90% of the $900 million. The remaining $810 million will end up with a third bank,

which in turn will lend out 90% of $810 million, and so on.

Consequently the initial injection of $1 billion will become $10

billion, i.e., money supply will expand by a multiple of 10. Observe that in this

example banks are responding to the injection of $1 billion of reserves by the Fed,

which coupled with the legal reserve requirements of 10%, sets in motion monetary

expansion of $10 billion. In other words, within this framework, banks are responding

to the injection of reserves by the central bank.

Recently some commentators have questioned this logic [1]. They argue

that in the present US monetary system there is no such thing as a money

multiplier since banks make loans first and worry about reserves later.

Moreover, it is argued, within the present lagged reserve requirement framework it is

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pointless for the Fed to pump reserves, for these reserves cannot be used by the

banks since required reserves are only calculated on the past 30 day's

deposits. Consequently, if the Fed injects an extra $1 billion to the system, the banks

won't respond at allso it is argued.

Is the objection raised valid? The main issue is not whether the current

banking system is on a lagged or contemporaneous reserve requirements framework

as such, but the fact that the present monetary system, which is supervised

by the central bank, gives support to fractional reserve banking. It is this

fact that gives rise to the so-called money multiplier.

Fractional reserve banking and the creation of money:

When Tom lends his $100 to Mike, the transaction doesnt create

new money since Tom simply transfers his saved money for the period of the loan to

Mike. This type of transaction temporarily transfers the ownership of the $100 from

Tom to Mike.

Likewise, when a bank mediates between Tom and Mike, it borrows from

Tom $100 and simply lends the $100 to Mike. The bank doesn't create new

money. Similarly if a bank lends $1 million, which was obtained by issuing stocks to

this amount, no new money is created. People who bought the banks stocks have

paid with their savings, which the bank in turn employs in its lending activities. While

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lending that is fully backed up by savings doesnt give rise to the creation of new

money this is not the case with regard to fractional reserve banking.

Fractional reserve banking arises as a result of the fact that

banks are legally permitted to use money that is placed in demand deposits.

In short, banks treat this type of money as if it was loaned to them . If John

places $100 in demand deposit he doesn't, however, relinquish his claim over the

deposited $100. He has an unlimited and immediate claim on his $100. Demand

deposits must be regarded as no different from a safe deposit box. Hence

when a bank uses the deposited money as if it were loaned to it, the bank

generates another claim on a given amount of deposited money.

For instance, let us say that a depositorJohndeposits $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.

Now Mike buys for $50 goods from Tom and pays Tom by check. Tom

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places the check with his bank, Bank B. After clearing the check Bank B will have an

increase in cash of $50, which it may take advantage of and use to lend out $25 to

Bob. In short, as one can see, the fact that banks make use of demand

deposits sets in motion the money multiplier. Note that the multiplier is the

outcome of the fractional reserve-banking framework.

A case could be made, however, that people who place their money in

demand deposits do not mind if banks use their money. Notwithstanding all this, as

long as people trade, there will always be a demand for money, which will be held

either in cash or in bank demand deposits. Consequently, regardless of people's

attitudes, once banks use deposited money, an expansion of money that is not backed

by money proper is set in motion. In short, if an individual has a demand for money

then he cannot at the same time not have a demand for money. Hence, if

against his demand for money, which is manifested by him holding money

in demand deposit, the bank lends out part of the deposited money, an

unbacked lending must emerge, i.e., money out of "thin air" is generated.

Although the law allows this type of practice, from an economic point of

view it produces a similar outcome to that which counterfeiting activities do. It

results in money produced out of "thin air" which leads to consumption that

is not supported by production; that is, the dilution of the pool of real

funding.

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The legal precedent to fractional reserve banking was set in England in

1811, in the court case of Carr v. Carr. The court had to decide whether the term

"debts" mentioned in a will included a cash balance in a bank deposit account. The

Judge, Sir William Grant, ruled that it did. According to Grant, because the money had

been paid generally into the bank, and was not earmarked in a sealed bag, it had

become a loan to the bank. The Judge also insisted that money deposited with a bank

becomes part of that banks assets and liabilities. [2]

On this Mises wrote,

It is usual to reckon the acceptance of a deposit which can be drawn upon

at any time by means of notes or checks as a type of credit transaction and juristically

this view is, of course, justified; but economically, the case is not one of a credit

transaction. If credit in the economic sense means the exchange of a present good or

a present service against a future good or a future service, then it is hardly possible to

include the transactions in question under the conception of credit. A depositor of a

sum of money who acquires in exchange for it a claim convertible into money at any

time which will perform exactly the same service for him as the sum it refers to, has

exchanged no present good for a future good. The claim that he has acquired by his

deposit is also a present good for him. The depositing of money in no way means that

he has renounced immediate disposal over the utility that it commands. [3]

Similarly, Rothbard argued,

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In this sense, a demand deposit, while legally designated as credit, is

actually a present gooda warehouse claim to a present good that is similar to a

bailment transaction, in which the warehouse pledges to redeem the ticket at any time

on demand. [4]

Fractional reserve banking vs. free banking:

In a truly free market economy, the likelihood that banks will

practice fractional reserve banking will tend to be very low. If a particular

bank tries to practice fractional reserve banking it runs the risk of not being

able to honour its checks. For instance, if Bank A lends out $50 to Mike out of $100

deposited by John, it runs the risk of going bust. Why? Let us say that both John and

Mike have decided to exercise their claims. Let us also assume that John buys goods

for $100 from Tom while Mike buys goods for $50 from Jerry. Both John and Mike pay

for the goods with checks against their deposits with the Bank A.

Now Tom and Jerry deposit their received checks from John and Mike with

their bankBank B, which is a competitor of Bank A. Bank B in turn presents these

checks to Bank A and demands cash in return. However, Bank A has only $100 in cash

it is short $50. Consequently, Bank A is running the risk of going belly-up unless it

can quickly mobilise the cash by selling some of its assets or by borrowing.

In other words, the fact that banks are required to clear their checks will be a

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sufficient deterrent against practising fractional reserve banking in a free

market economy.

Furthermore, it must be realised that in a free market the tendency of

being "caught" practicing fractional reserve banking, so to speak, rises, as there are

many competitive banks. In short, as the number of banks rises and the number of

clients per bank declines, the chances that clients will spend money on goods of

individuals that are banking with other banks will increase. This in turn increases the

risk of the bank not being able to honour its checks once it practices

fractional reserve banking.

Conversely, as the number of competitive banks diminishes, that is, as the

number of clients per bank rises, the likelihood of being "caught" practicing

fractional reserve banking diminishes. In the extreme case of there being only

one bank, it can practice fractional reserve banking without any fear of being "caught"

so to speak. Thus if Tom and Jerry are also clients of Bank A, then once they deposit

their received checks from John and Mike, the ownership of deposits will now be

transferred from John and Mike to Tom and Jerry. This transfer of ownership however,

will not have any effect on Bank A.

I can conclude then that in a free banking environment if a particular

bank tries to expand credit by practicing fractional reserve banking it runs the risk of

being caught. Hence in a true free market economy the threat of bankruptcy will

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bring to a minimum the practice of fractional reserve banking.

The Central Bank and fractional reserve banking:

Whilst in a free market economy the practice of fractional reserve

banking would tend to be minimal, this is not so in the case of the existence

of a central bank. By means of monetary policy, which is also regarded as the

reserve management of the banking system, the central bank permits the

existence of fractional reserve banking and thus the creation of money out

of "thin air."

In this respect the modern banking system can be seen as one

huge monopoly bank which is guided and coordinated by the central bank.

Banks in this framework can be regarded as branches of the central bank. In other

words, for all intents and purposes the banking system can be seen as being

comprised of one bank. (As we have seen, one monopoly bank can practice fractional

reserve banking without running the risk of being caught).

-Through ongoing monetary management, i.e., monetary

pumping, the central bank makes sure that all the banks can engage jointly

in the expansion of credit out of thin air via the practice of fractional

reserve banking. The joint expansion in turn guarantees that checks presented for

redemption by banks to each other are netted out, because the redemption of each

will cancel the other redemption out. In short, by means of monetary injections, the

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central bank makes sure that the banking system is "liquid enough" so that

banks will not bankrupt each other.

Thus, whenever the Fed injects money into the system, it inevitably ends

up as an increase in the deposits of a particular bank. This bank, based on its portfolio

strategy, will decide how much of this increase in deposits it will lend out and how

much it will keep in reserves. (Even in the modern banking system banks voluntary

keep certain amount of reserves, regardless of legal requirements, in order to settle

transactions) [5].

Now, if Bank A decides to keep 20% in reserves against the new increase

in deposits, then it will lend out 80% of the new deposits. In other words, if as a result

of the Feds monetary injections Bank A's deposits increase by $1 billion then the bank

will lend $800 million and the rest will be kept in reserves. Now let us assume that the

borrowers of the $800 million buy goods from individuals that bank with Bank B, who

in turn present checks for clearance of this amount to Bank A. Since Bank A has in its

possession $1 billion it would have no problem clearing the check.

However, a problem can emerge if the original depositor of $1 billion

decides to use his $1billion. Then there is a risk that Bank A will not be able to

honour his checks. In the event of such an occurrence the Fed is likely to

provide Bank A with a loan to prevent bankruptcy. However, by ongoing

coordination the Fed makes sure that such disruptions do not occur too

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frequently.

Regardless of the nature of legal reserve requirements, when the Fed

pumps new money into the system, the new money is not reserves as such but new

money that the bank is likely to use in its lending activities. Moreover, even in the

present monetary system that is coordinated by the central bank, banks do not lend

first and worry about funding later on. On the contrary, like any other business, banks

are constantly engaged in the management of assets and liabilities.

So before any lending is undertaken, it must be fully funded. Any

unfunded lending runs the risk of undermining the existence of a bank.

What's more, if the bank fails to clear its checks and runs a deficit in its account with

the central bank, the Fed will charge the bank a penalty rate for having a deficit. In

short, while the central banking system provides support for fractional reserve

banking, it doesn't approve completely reckless lending by commercial banks.

Otherwise the whole system would have collapsed very quickly.

Finally, not only does fractional reserve banking gives rise to

monetary inflation; it is also responsible for monetary deflation. We have

seen that banksby means of fractional reserve bankinggenerate money

out of thin air. Consequently, whenever they do not renew their lending

they in fact give rise to the disappearance of money.

This must be contrasted with the lending of genuine money, which can

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never physically disappear unless it is physically destroyed. Thus when John lends his

$50 via Bank A to Mike, the $50 is transferred to Mike from John. On the day of the

maturity of the loan, Mike transfers to Bank A $50 plus interest. The bank in turn

transfers the $50 plus interest adjusted for bank fees to Johnno money has

disappeared.

If, however, Bank A practices fractional reserve banking, it lends the $50

to Mike out of thin air. On the day of maturity when Mike repays the $50

the money goes back to the bankthe original creator of this empty money;

that is, money disappears from the economy, or it vanishes into the thin

air.

Hence, in order to prevent monetary disruptions brought about by

monetary deflation, what is needed is the establishment of a genuine free market and

not a reliance upon the Feds aggressive, loose monetary policies as

suggested by the popular view.

Conclusions:

Whether legal reserve requirements are applied on the average of the last four weeks

deposits or on same day deposits is beside the point, so far as the money multiplier is

concerned. The existence of the money multiplier is the outcome of fractional reserve

banking, which the current banking system makes possible. In short, it is the

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existence of the central bank that enables banks to

practice fractional reserve banking, thereby creating

inflationary credit.

A

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2-13-12_THEORY of MONEY_The Money Multiplier__Myth or Reality_.pdf