Fractional-reserve question

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Shaggetz's picture
Shaggetz
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Fractional-reserve question

Forgive me if this has been covered before, and forgive me if I'm being thick, but I can't wrap my head around some of the specifics of our monetary system.

There seems to be an implication and a common concensus among posters here that our current fractional reserve system is unsustainable.  Certainly my gut instincts tell me that this is the case, but whereas I objectively understand why we can't keep consuming non-renewable resources at the current rate (because they are non-renewable....), I don't understand the problem with continuing to expand the money supply given that it's a man made creation and the numbers used are purely arbitrary.

It's the 'turning the corner' analogy that I don't really understand - if we are plotting an exponential function, as CM mentions in one of the first chapters, there is no corner per se.  Given that money has no intrinsic value and is only used as a temporary store of wealth, does it really matter how high the numbers get as long as they are increasing at a constant value? (Question 1)

I understand that in our current monetary system, new loans have to keep increasing in order to cover the interest repayments on already existing debt.  I also understand that as loans are paid back, money disappears, which leads me to conclude that the system we currently use relies on ever increasing credit.  Ever increasing credit means an ever increasing interest burden, and potentially I understand that this would mean that an economy would reach unsustainable levels of debt - that is, the interest on the debt gets greater and greater, so more loans need to be made, and this results in greater debt, etc etc, and we reach the point where rather than our money supply growing at a stable fixed rate per year it grows at a high fixed rate or the rate of growth of the money supply starts to increase as well.  So is this the answer to my Question 1 above - that given the nature of our system, hyperinflation is inevitable?

Now, if that's the case (and I could be well wrong by this point so you can disregard this part if I've missed the boat), it would seem to me that there's another answer once we hit the point of unsustainable debt - and that is money printing.  As there are 2 types of money - bank credit, which has debt attached, and thin air fed money, which has no debt attached, wouldn't the perfect solution to huge debt levels just be to print money?  Of course this would cause more inflation, but it would 'dilute' the total amount of debt until it was at sustainable levels, wouldn't it?  And long term it would require less bank credit to be issued, which would mean less debt, and less interest etc etc etc.

Is fractional reserve banking always going to result in hyperinflation?  Is it possible if it's managed properly and the amount of bank credit and federal reserve money are balanced?  Does my question make any sense?

My other somewhat related question relates to the history of fractional-reserve banking.  I'm assuming FR has been in operation in the US for a long time, so correct me if I'm wrong, but how did the inflation rate remain at 0 over hundreds of years if it is a necessity of FR banking that larger and larger loans are constantly being made?  I'm obviously missing something here, can anyone enlighten me - was there a different banking system in place, or was it a case that because the gold standard was in existence, creditors only wanted to finance productive investment rather than speculation and hence the number of loans never got to unsustainable levels?

Thank you for your time, if anyone can make any sense of my ramblings I'll be most appreciative.

Tom

Travlin's picture
Travlin
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The short answer

Shaggetz

Welcome to the forums.  That is an impressive first post.  You have obviously done your homework.

You will probably get many views in response, but the fundamental answer is pretty simple, and you have already identified it.  The key to fractional reserve banking is that it only works when the creation of money is in balance with growth of real wealth, which is the “secondary wealth” of the three levels Chris explains on page 58.  Take a look at chapter 9 once more for clarification.

Fractional reserve banking goes back several hundred years.  Historically, it has usually worked reasonably well when resources were abundant and capital was needed to develop them.  The USA has been the shining example.  Wiki offers more information. http://en.wikipedia.org/wiki/Fractional-reserve_banking

Here are some of the main problems today.

1 – Too many loans are being made for consumption, not to increase production.  We are eating the seed we need to plant new crops.

2 –  The world of finance has become a gigantic game divorced from the real world needs it once served.

3 – In order to keep the game going we are creating excessive amounts of money.  Thus money itself becomes suspect and eventually destroyed by loss of confidence in its value.  That’s why we can’t print our way out of this mess.

4 – As you said, we are running up against the limits of resources, and “growth” as we have practiced it can’t continue forever..

I hope we see more posts from you.

Travlin 

JAG's picture
JAG
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Fractional Reserve Banking Myths

Welcome to the community Shaggetz,

The common model of FRB is not an accurate portrayal of how lending occurs in real life, in fact it's backwards. In actual practice, the bank extends the loan prior to obtaining the necessary reserves. Also, the idea of the "endless loop" of debt chasing interest is an incomplete model, as it confuses money stocks with money flows. 

For a brilliant explanation of these processes check out this work from Dr. Steve Keen:

The Roving Cavaliers of Credit

Are We "It" Yet? (video and paper)

All the best....Jeff

P.S. Mish also has a good post on this as well:

Fictional Reserve Lending

 

Shaggetz's picture
Shaggetz
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Thanks for the replies guys,

Thanks for the replies guys, greatly appreciated.

My understanding so far is this - in theory, in an absolutely perfect physical and political environment, FRB will work perfectly.  The money supply will continue to grow steadily, inflation will be modest, growth will continue forever, all will be rosy.

In practice, the following problems will inevitably occur -

1. The monetary system has to grow, and when the availability of natural resources begins to decline prices of all goods and services will fluctuate dramatically (generally in an inflationary direction - more money chasing fewer goods).  In itself this would not be a monetary problem if everyone pretended that nothing was happening, but given that prices are unstable it will create purchasing and consumption patterns that are damaging to the economy as a whole.

2. The incentives offered to manipulate the money supply are too great to resist (for both politicians and the voting public), which will lead to inequality at the least and total breakdown of society at the worst.

3.  Banks make money by making loans, and there is a huge incentive for banks to make as many loans as possible.  This leads to overwhelming debt levels (measured in debt/GDP or debt/income rather than just an arbitrary nominal measure) and greatly increases the likelihood of inflation, malinvestment and eventually debt defaults.  Debt defaults themselves are absolutely devastating in a FRB system, while inflation has the previously mentioned problem of instigating irregular economic activity - the result of too much debt will be ugly one way or another.

There are probably many other reasons that I haven't thought of but basically what I'm trying to confirm is this - FRB COULD work in theory, but never will in practice - a fair statement?

I did purchase a copy of the book via the net but I'm travelling at the moment and haven't been able to read it yet.  If everything I need to know is covered in there just dismiss me.  And JAG - I'm quite familiar with Steve Keen - he's been the one voice of sanity in the Australian media over the last few years regarding our housing market.

Thank you again!

Tom

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darbikrash
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I think you have done a good

I think you have done a good job covering the bases, and I would echo JAG’s comments that Dr. Keen has one of the better grasps of the dynamics of money flows and why debt based currency can be stable –but usually isn’t.

 

There really are at least three very separate issues in your thesis a.) Debt based currency, b.) Federal Reserve banking, and c.) Infinite growth with respect to non financial matters, such as natural resources.

 

They're somewhat interrelated, but I believe they have different conclusions to the question “Are they sustainable”. Based largely on Keen’s work (and other post-Kenysian economists) I think the answer to the first two topics is yes, in theory they are sustainable- with some very significant caveats. Keen has showed that debt based currency is, at least in theory, not prone to runaway interest cycles such as widely claimed. But in his words, it usually does result in exactly this. He posits that this is largely due to the influence of both speculative and Ponzi lending using low interest rate money, which causes cascading destructive effects in the economy.

 

Significantly, he suggests that if speculative and Ponzi lending are eliminated than debt based financing is indeed sustainable, and offers mathematical proof of this conclusion.

 

To the issue of Federal Reserve financing, I believe his opinion is very similar. Current reserve requirements of US banks are in the 10% range (or lower) and at this threshold the propensity for abuse and instability is too high to answer the question of sustainability for a positive outcome. However, if the reserve requirements were modified (increased) to a more reasonable number, say 50%-75%, then the system of reserve financing would have a much better chance of being  sustainable, assuming theft and corruption can be mitigated.

 

The issue of natural resources is fundamentally different, as these resources have a finite quantity. So it cannot be sustainable to grow indefinitely, when we are faced with a shrinking set of critical resources. Obviously, when these resources are depleted, they cannot be replaced in kind, and some other technology or means must be found as a replacement. If such a replacement is not available or cannot be deployed in a time  relevant fashion, then we have a predicament with no clear solution. This outcome is far more severe that either of the two previous examples.

 

Perhaps another point could be made that external factors govern the interrelationships between these three seemingly disparate subjects, and maybe a fourth could be added- labor. Free market capitalism requires uninterrupted growth in these four areas to maintain functionality. If one or more are disrupted, the system comes to a grinding halt with catastrophic results.

 

This is an interesting viewpoint, although unpopular, as it is much more fashionable (and less disconcerting) to use deterministic thinking which suggests that the financial system (or the Federal reserve, or the Government) is to blame for the mess we are in, and if the financial system is corrected, than we can go back to business as usual and the party can resume again in earnest.

 

 

Travlin's picture
Travlin
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Shaggetz wrote: My
Shaggetz wrote:

My understanding so far is this - in theory, in an absolutely perfect physical and political environment, FRB will work perfectly.  The money supply will continue to grow steadily, inflation will be modest, growth will continue forever, all will be rosy.

In practice, the following problems will inevitably occur -

1. The monetary system has to grow, and when the availability of natural resources begins to decline prices of all goods and services will fluctuate dramatically (generally in an inflationary direction - more money chasing fewer goods).  In itself this would not be a monetary problem if everyone pretended that nothing was happening, but given that prices are unstable it will create purchasing and consumption patterns that are damaging to the economy as a whole.

2. The incentives offered to manipulate the money supply are too great to resist (for both politicians and the voting public), which will lead to inequality at the least and total breakdown of society at the worst.

3.  Banks make money by making loans, and there is a huge incentive for banks to make as many loans as possible.  This leads to overwhelming debt levels (measured in debt/GDP or debt/income rather than just an arbitrary nominal measure) and greatly increases the likelihood of inflation, malinvestment and eventually debt defaults.  Debt defaults themselves are absolutely devastating in a FRB system, while inflation has the previously mentioned problem of instigating irregular economic activity - the result of too much debt will be ugly one way or another.

There are probably many other reasons that I haven't thought of but basically what I'm trying to confirm is this - FRB COULD work in theory, but never will in practice - a fair statement?

I did purchase a copy of the book via the net but I'm travelling at the moment and haven't been able to read it yet.  If everything I need to know is covered in there just dismiss me.  And JAG - I'm quite familiar with Steve Keen - he's been the one voice of sanity in the Australian media over the last few years regarding our housing market.

 

Shaggetz

Your three points show a good grasp of some important fundamentals.  I think your explanations of the consequences could use some work but you’ll get there with time.

Nothing run by humans will be perfect.  Fractional reserve banking is very unpopular in these forums.  It certainly has its flaws, but some good points tend to be overlooked.  It does promote development of resources with higher living standards.  When recessions happen and output declines, those who made bad decisions are punished as bad debts cannot be repaid.  This encourages discipline in the system.  The money supply shrinks and should maintain a rough equilibrium with production, creating a self-regulating system.  This is advocated by the Austrian School of economics.  However, that can be very painful, especially to innocent parties.

One big problem is the tendency for boom and bust business cycles to develop.  One justification for central banks is that when the economy begins to overheat they can raise interest rates – take away the punchbowl at the rowdy party.  They can also add money to smooth out the busts.  This is the position of the Keynesian School.  It has proved very difficult technically to do this, and then the political factors overwhelm any sincere efforts to use this correctly.  No one wants to suffer any pain for their excesses.  That’s part of the problem in point number two.  In point one the financial sector is also prone to use manipulation.  Point three becomes a problem when discipline is lost on a large scale.

Shaggetz wrote:

There are probably many other reasons that I haven't thought of but basically what I'm trying to confirm is this - FRB COULD work in theory, but never will in practice - a fair statement?

My tentative assessment is that fractional reserve banking always had disproportionate rewards for the insiders, but it usually worked well enough in the past that most people benefited, so as a practical matter is could be called a success.  However, some important circumstances have changed, and there is good reason to think that, as it is now practiced, it has become destructive.  I don’t think it can be reformed before we have a major upheaval because entrenched interests are too powerful.  It looks like major change will happen because it seems to require growth of an unsustainable kind in a world of scarce resources.

I thought you had already read The Crash Course.  Chris does an outstanding job of explaining these matters in a clear, concise, and comprehensible way.  You’ll find many answers there and enjoy the process.  Meanwhile, we’ve had a good discussion.

Travlin

 

PS  Darbikrash posted while I was composing. He offers good guidance.  Keen's theory on interest rates has been debated here extensively.  The critical question is could it be implamented in practice.  I don't know.  Chris has argued against that.  It certainly hasn't so far.  Otherwise, I agree with everything Darbikrash said. Smile

wildcat444's picture
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Fractional-reserve question

Sorry to add more to such  a lengthy discussion.

'Appears to me folks do not appreciate the rate at which our economy is disintegrating at the hands of the FED.  Inflation is increasing at an increasing rate.  This administration (and, regrettably congress) are feeding/increasing the money supply at such a rate that the U.S. dollar stands a good chance of losing its place as the primary unit of exchange used throughout the world.

We may already have reached the point of its 'inevitability'.  (Hazards of another Weimer Republic! ... We seem to have forgotten.)

Enter, then, some other named currency established by those controling the International Monetary Fund, Bank of International Settlements, World Bank and United Nations - towards the creation of their One World Governement. -- or "New World Order"!

I would urge our compatriots to think in terms of, essentially, a wholesale replacement of the existing congress with like-minded individuals who understand the economics of inflation - and the need to eliminate the FED, and,  over a period of time, increase reserve requirements to 100 percent, while reducing spending and the size of government, retiring these absurd congressional pensions, ridding us of the burden of illegal immigrants, and returning to a Constitutional form of government which would restore our individual freedoms and an environment for the resurection of a truly free market.

Thanks for the opportunity to air my grievances.

Bob.

Travlin's picture
Travlin
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Wildcat444 Welcome to the

Wildcat444

Welcome to the forums.  We all need to blow off steam sometimes. Smile

Travlin 

MG_Andrew_Jackson's picture
MG_Andrew_Jackson
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Usury

FRL is necessary in a banking system that charges interests, rather than fee for service banking, or pure investment banking.

 

No magic pills, no "new math" can change it.

That's not to say we can't reform the banking system, we must, but after the Repeal of State Usury Laws, that's how things got so bad in the U.S. Banking system.

Them:

Money Changing

Usury

Us:

Greed

Covetous

 

Reforming "Them", without reform us, is useless, they will turn back to this system in less than a generation if we do not teach everyone better about good loans and bad, and contract laws.

 

Travlin's picture
Travlin
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Welcome
MG_Andrew_Jackson wrote:

Reforming "Them", without reform us, is useless, they will turn back to this system in less than a generation if we do not teach everyone better about good loans and bad, and contract laws.

Andrew

Welcome to the forums.  You have made a good point.  Consumers share responsibility for taking on loans for unnecessary consumption.

Travlin 

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dps
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Yes

The easiest way to not produce waste is to not buy "stuff" in the first place.

hugs ... dons

MG_Andrew_Jackson's picture
MG_Andrew_Jackson
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stuff

Sometimes I need stuffLaughing

Exponentially Compounding Growth( ECG ) is needed in a system like what we have now, it's not FRL that's the biggest trouble, it's the need for ECG to keep the system going, the monies to pay the interest on the loan do not exists when they loan you the money, they must keep making loans, but as we have seen, you need credit worthy borrowers, who have JOBS.

Don't take that the wrong way, I blame the BANKS/GOVERNMENTS, they knew better, and they get paid to make "good" choices.

What we are seeing today, The Fed and it's member banks printing monies to buy government bonds and Treasuries, I think, is the end of the pyramid scam, just won't stand, they are naked buying the short side at Government debt Auctions, if I were running the scam, this would be the point I'd be looking to "Jump Ship".

Be aware, and beware!

 

 

ao's picture
ao
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MG_Andrew_Jackson
MG_Andrew_Jackson wrote:

Sometimes I need stuffLaughing

Exponentially Compounding Growth( ECG ) is needed in a system like what we have now, it's not FRL that's the biggest trouble, it's the need for ECG to keep the system going, the monies to pay the interest on the loan do not exists when they loan you the money, they must keep making loans, but as we have seen, you need credit worthy borrowers, who have JOBS.

Don't take that the wrong way, I blame the BANKS/GOVERNMENTS, they knew better, and they get paid to make "good" choices.

What we are seeing today, The Fed and it's member banks printing monies to buy government bonds and Treasuries, I think, is the end of the pyramid scam, just won't stand, they are naked buying the short side at Government debt Auctions, if I were running the scam, this would be the point I'd be looking to "Jump Ship".

Be aware, and beware!

 

 

So true.

BTW, a couple of useful communication tools. 

http://en.wikipedia.org/wiki/Comma

http://en.wikipedia.org/wiki/Full_stop

MG_Andrew_Jackson's picture
MG_Andrew_Jackson
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Communication

I'm not a great Communi-anything, I'm an Honest Private Free Market kind of ManCool

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