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Toby, couple of thoughts in relation to your 5:32 PM comment.

Much (perhaps most) of the confusion surrounding these issues stems from the fact that the systemic consequences of fractional reserve banking are quite different to the way things look at the level of an individual bank.

Steve's right that to make a loan, a bank must have the reserves on hand (or be completely confident of being able to acquire them before the borrower spends the proceeds).

Once spent, the proceeds re-enter the banking system. If they're redeposited with the bank that made the loan, then the transaction is complete. Nothing more need be done. If the proceeds are deposited with another bank, then the lending bank must transfer reserves to that bank via the clearing system. That possibility (or in a multi-bank financial system, that likelihood) is the reason why a bank needs to have the reserves on hand before it makes the loan.

If, however, most banks happen to be in an expansionary mode (and they usually tend to run in herds) then they can all largely rely on getting their share of redeposited loans. As long as a bank doesn't extend fresh credit at a rate greater than that of its fellows, it can reasonably rely on its liabilities (i.e. fresh deposits) growing roughly in accord with its assets (i.e. fresh loans).

In any case, banks rarely operate right up against their reserve requirement limit, and reserve requirements have anyway in most countries either been radically reduced, or done away with altogether.

At the system level, the effect of all this is that credit can grow largely unconstrained by the need for genuine savings. New loans automatically generate new deposits (which are often, in my view mistakenly, called "savings") via the process described above and these (subject to any reserve requirements) can of course be lent out again. And so on. For as long as it lasts (in other words, until either a central bank reins in reserves or fear for one reason or another re-enters the system), it's a kind of perpetual motion machine.

All banking systems to some degree generate their own deposits in this fashion through making new loans. Even one operating with 100% reserves will do so because loans extended based on term deposits will still end up coming back into the system as new deposits. The great difference is the rate at which this process can operate. In a fiat FRB system with an accommodating central bank, the sky's the limit, so to speak (as we've seen).

So, your gut feel is in my view about right. Even though individual banks have to abide by some apparently fairly commonsense "rules of the road", at the systemic level the relationship between new credit extended and genuine economic savings is very loose indeed. Endless reiterations of lend, redeposit and lend again do nothing to add to savings. More likely the opposite as the resulting illusion of plentiful savings generates misdirected economic activity. And, unfortunately, much higher prices for existing assets.


I think the view that banks "usually tend to run in herds" naturally is a Minskyian view. What it really says is that banks don't care very much if they go bankrupt in the future when the consequences of over-expansion occur. If we accept that view then we must really accept the same about all other businesses too, unless there is some reason that banks are special.

If they aren't special then the same applies to insurance companies, stock markets and so on. In that case free markets are self-destabilising and there will always be a business cycle. In that case only Keynesian demand-management or socialization-of-investment can prevent crises.

Toby: "So I work my nuts off and save and invest and become more productive in the process. I sell more for the given amount of factors of production I deploy. Absent state messing around with the money unit, my purchasing power should go up. With my increased purchasing power, I go and buy say a shop for $1m with my money units. Then a competitor who has the confidence of his FRFB bank manager comes along and issues a new FRFB IOU for $1.10m. Happy days for the shop vendor and sad days for me. The new created bank IOU , which is created on a fraction of money IOU's out bids me and allows the bank's client to buy the shop."

I'm frankly not sure I follow this at all. If everyone has access to the same FRFB system, everyone can take advantage of the greater supply of real loan funds that such a system involves compared to a warehouse system. I don't see why Toby's productive saver would be at all disadvantaged by such a system, which increases his opportunities for securing loans as much as it does that of other potential borrowers--and moreso to the extent that, thanks to his superior productivity, he is in fact the better credit risk.

But I am by no means certain I've understood Toby's concern here. Is it that more productive workers won't see real wage improvements? In fact the level of real wages doesn't ultimately depend on whether prices rise or fall or stay the same. If there is inflation, then money wages have to rise proportionately more, and will tend to do so. But beware: when the productivity gains are traceable not to workers specific skills but to improved technology or management, there's no reason to expect workers alone to benefit from them. Instead, such gains generally are enjoyed by consumers generally, through falling product prices or through general money wage increases or both.


Bankers get caught up in broad societal mood swings like any other group. It's not that they don't care about going bankrupt, it's just that their risk perceptions (like almost everyone else's) tend to be procyclical.

Nor do I see how it follows that free markets are "self-destabilising". It's a question of how tight the connection is between markets and the underlying economic reality. The more extreme credit cycles are allowed (or, worse, encouraged) to become, the looser that connection will be.

> Bankers get caught up in broad societal mood swings like any other group.

Yes, I'm not denying that. I just don't think that it's necessarily the cause of the business cycle. If the idea of account falsification is correct then it could be an *effect* of that underlying cause.

In your discussion above you implicitly link the herd behaviour of banks to their use of fractional-reserves. But, the two are quite separate.

Let's suppose we have country X which has fractional reserve free banking. The banks become very optimistic about the future and start lending at lower rates reflecting a belief in lower risk premiums and/or higher future profitability of industry. In that case the banks may become over-extended.

But, consider country Y which has 100% reserve banking. In that country borrowed funds must come from savings and loans. But, exactly the same problem can occur. If the banks become optimistic about the future then they will reduce risk premiums and become over-extended just as in country X.

Now, if there is a special property of money (and I agree that money is special, not like other goods) that causes this to be more of a problem in country X than country Y then there's an argument for 100% reserves on this basis.


I'd have thought it was clear (consider the quote you chose, for example) that I see herd behaviour as an aspect of human nature. So yes, of course bankers can get carried away under any system.

It's also true, though, that the systemic effects of their getting carried away under a fractional reserve system are likely to be an order of magnitude greater than under a 100% reserve system.

> It's also true, though, that the systemic effects of
> their getting carried away under a fractional reserve
> system are likely to be an order of magnitude greater
> than under a 100% reserve system.

Why do you think that?

"Why do you think that?"

Because credit creation is much easier under a fractional reserve system.

I'm not sure about that. What we have to do here is compare a fractional reserve system against a hypothetical 100% reserve system, since no 100% reserve system has occurred historically in any modern economy.

In that 100% reserve system the savings & loans market would be between timed savings and timed loans. There would be none of the on-demand savings that we have now. If a nation were to change to that system then after a transition period prices would adapt to the 100% reserve regime. Once that has occurred though I can't see any reason why the 100% regime would be any different than a fractional reserve free banking regime in terms of sensitivity to herd behaviour.

In both cases excess credit creation requires a similar underestimate of risk. Can you explain to me why you think credit creation would be any easier. Remember as we have discussed above, banks do not create money "out of thin air", they make it out of debt, which is exactly what they make bonds out of.

Current, I can only assume I'm somehow missing what you're getting at.

To me, it seems axiomatic that if some portion of a banking system's deposits have to be locked up in holdings of cash currency, then that system will have less capacity to generate new loans than one where they don't. One can reasonably argue about how large the difference would be, but I don't see how its direction can be in dispute.

> To me, it seems axiomatic that if some portion of a
> banking system's deposits have to be locked up in
> holdings of cash currency, then that system will have
> less capacity to generate new loans than one where
> they don't.

It will have less capacity to generate new loans. We need to ask the question at this stage: what does that mean for the long-term future? Well, there are various possibilities. Some would say that the price of capital equipment and other assets would fall. Some would say that the growth rate would be permanently hampered.

But, that question is beside the point of what happens with the business cycle. The issue for the business cycle is the *variation* of outstanding loans. You are supposing that with both Fractional-reserves and with 100% reserves there would be a tendency for banks to "run in packs". That is they would all underestimate risk premiums at the same time and issue too much credit. If that happened then why would the expansion of credit necessarily be larger in the FR case? Both would have a broad effect on the capital markets, as cheaper borrowing caused profits to rise elsewhere.

There are certainly some differences. But I don't see why the differences would necessarily make 100% reserves more preferable.

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