Fractional Reserve Banking I
There was a time when it was possible to go slumming on the Net and only risk being mildly perturbed, rather than long term psychological counseling and subsequent arrest for the contents of your browser’s cache. Back before the binary newsgroups got completely out of control, when an occasional foray over to alt.tasteless was just harmless fun.
Its been years since that was a good idea, but an acceptable substitute for those lost innocent pleasures in these online days of rage and diatribe, is a Google search for “Fractional Reserve Banking”.
So before attempting to explain how Economists appear to think Fractional Reserve Banking works, and then examining how it in fact seems to be working in the presence of at least two bugs in the official description which apparently doesn’t in fact exist, let’s take a look at how it demonstrably does not.
There seems to be a fairly common misconception that fractional reserve banking allows a Bank to lend 10 times its customer’s deposits. Oh, I wish. Let’s assume for a moment that that is true, and see what happens if a couple of computer scientists, Alice and Bob, were allowed to set up banks.
Bank of Alice takes its $1000, and lends out $10,000 to a trusted intermediary, Eve; who deposits it in Bank Bob. Bank Bob then lends $100,000 (10 times the deposit), back to Eve. Eve then uses $10,000 to repay her debt to Bank Alice, and ponders what to do with the remaining $90,000. Since $90,000 isn’t really enough to buy 3 people tropical retirement these days, Eve deposits the $90,000 back at Bank of Alice. Bank of Alice now has $101,000 in deposits, and so can lend Eve $1 million, and well, you see where this is going.
Since it only takes $5 million to establish a bank in the USA, I think the world would have noticed the mass retirement of American computer scientists by now.
This particular misunderstanding appears to be traceable to an article by Murray N. Rothbard,, where he writes:
I set up a Rothbard Bank, and invest $1,000 of cash (whether gold or government paper does not matter here). Then I “lend out” $10,000 to someone, either for consumer spending or to invest in his business.
There is a reason why it’s called fractional reserve banking, Banks are allowed to lend a fraction of their deposits, where a fraction is defined as a number that can represent part of a whole, i.e. no more than 1, no matter what dark thoughts may be harboured about 5/4. In the classical textbook explanation, banks are allowed to lend up to 9/10 of their deposits, and required to keep 1/10 in reserve. That situation today is a tad more complicated, but we’ll look into that some other time.
Rothbard was an educated economist and mathematician, so it seems a strange mistake for him to have made, particularly given the detail he uses in other places in the book. He was a member of the Austrian school, but this isn’t as far as I know part of von Mises analysis, who stands out as an economist who was trying to understand the economy as a distributed system – long before computer science started formalizing an understanding of them. Rothbard wrote this particular piece in the 1980’s, which is when the macro-economic statistics started looking distinctly odd. It’s possible that he noticed from the macro economic statistics that there was clearly something wrong, but then leapt to completely the wrong idea about what that was.Which is a pity, because some of the other points he makes later on about deposit insurance are actually quite prescient.
Unfortunately, the book and paper that contain this error, are hosted fairly prominently by the Austrian Economists on the von Mises website, amongst other places, and the abstract from it containing the error is currently the third hit on Google for “Fractional Reserve Banking”.
It bears repeating. Individual banks cannot do what Rothbard claimed, they can individually only lend a fraction of their deposits. They are required to file quarterly call reports demonstrating that. The recursive nature of the deposit, and redeposit of the money that they lend back into the system results in the banking system, which is to say all the banks, multiplying the original deposit into the system 10 times. But the implications of the system multiplying by 10 are completely different to any individual bank being able to do that.
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