Fractional reserve hogwash · Rebel Economist (Free)

Fractional reserve hogwash

Over a decade ago, when I first became interested in the nature of the money system and before I had any knowledge of economics, I was absorbed by the efforts of several different kinds of people and activist-groups, calling for the abolition (after the 2007-8 crash) of fractional reserve banking. Today, having seen Steve’s lectures, his double-entry book-keeping and read more widely, I now realise that call was wrong. How do you abolish something that doesn’t exist?

Perhaps the easiest objection to the money-multiplier model, and to the consequent idea of fractional reserve banking, is that it departs from reality. It claims that the average depositor (averaged over households and firms, rich and poor) has a very strong liquidity preference, holding unused in their deposit account about nine times their regular spending (between inflows of income). It surely sounds unlikely that the average depositor is a miser, firmly unwilling to increase their day-to-day spending despite having an abundant ability to do so.

A more technical objection is that, as Steve has quoted from Mankiw’s 2016 textbook, the deposits are demand deposits. The bank legally owns the money but of course it also owns a demand-liability to return it immediately on request. So the depositor still has title to the value of the money. Yet Mankiw says that such demand deposits can correctly be lent by banks to borrowers who are able to spend them. So these borrowers are spending money whose value is owned by someone else, someone who has a legal claim on it. Since when can you spend someone else’s money?

Mankiw has an escape route from this problem, which he seemingly chooses not to take. His miserly depositors seem to have surprisingly little avaricious appetite for acquiring more money. They are seemingly content to forgo the interest they could earn by putting their horde of money in a term-deposit account. This would, of course, correct the dubious legality of the borrower spending someone else’s money - that person has given up any current claim to it, in return for interest payment. So Mankiw’s depositors are not only misers but stupid ones, happy to stare a financial gift-horse in the mouth.

Perhaps Mankiw chose not to adopt this improvement to his money-multiplier description because of how it deviates even more from reality. Demand-deposit accounts are common-place, but term-deposit accounts are less common. Not only is the average person not a miser, but most folk seem reluctant to put their liquid assets beyond easy reach.

There’s worse yet. The average depositor is a miser, according to the money multiplier. So if a Government was to print more money, when Government spending modestly exceeded taxation, then (with a reserve ratio of 10:1) only 10% of that money would be likely to enter general circulation in the ’consumption’ economy. The other 90% would be saved by the misers, allowing banks to lend that 90% to capitalists for innovation and new forms of productivity - forms that are not likely to trigger inflation, but might even cause deflation through creating value in excess of the money that was spent to create it. The supposed actions of the money-multiplier therefore suggest a kind of automatic regulator, that pushes any newly-printed money towards establishing more productive capacity rather than stimulating more eager consumption. Even if the banks directed their extra money in lending to speculation, that’s surely likely to inflate only the price of fixed assets rather than all prices in the general economy.

The consequent message of the money multiplier, to orthodox economists, therefore ought to be that governments should print rather than ‘borrow’, when government spending mildly exceeds taxation. The inflation risk from printing money is low, according to the money-multiplier model, because the average depositor is a miser who’s reluctant to increase their spending on consumption.

But this contradicts the mantra that governments should avoid printing money to fund excess spending, because the inflation risk is then high. Most of the new money is said to be spent rather than saved to fund investment - implying that the ‘multiplier’ reserve ratio is close to unity and therefore that no money-multiplier effect exists. If the money-multiplier is true, governments should avoid ‘borrowing’ and print the money instead, but if governments are correct in choosing to ‘borrow’ then the money-multiplier is false. Which is it?

Not only is the money-multiplier a piece of fiction, it’s poorly-written fiction at that and riddled with flaws. It’s incoherent, even on its own (incorrect) terms, because of internal inconsistencies. That’s why I think it’s first-class hogwash.

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