On Money and Banking, Part 1

There has been a great deal of discussion about the gold standard and related issues of fractional reserve banking, money creation, and inflation in recent years. In order to have a useful conversation and debate, however, we must begin with a serious discussion of money and intermediation. What follows is a broad discussion of money. The reason is both to organize my thoughts and to define and contrast public and private money as well as what is meant by backed versus fiat money. Subsequently, the discussion turns to the interaction between money as a store of value and medium of exchange. Finally, I discuss private note issuance on the part of banks and the “backing” of such notes.

Money: Public and Private

Our current monetary system consists of both public and private money. By public money, I am referring to what is typically called base money (although it might even be more accurate to refer to the physical currency in circulation). Private money is that which is created by banks. This naturally raises questions as to whether there is something that distinguishes each from one another. In order to understand this, we need to think about what banks are and what banks do.

Banks are financial intermediaries. They issue liabilities in order and invest the proceeds in assets. In this sense, they are no different than an insurance company or a pension fund. Where they differ is in the types of liabilities that they issue. An insurance company issues state-contingent liabilities (i.e. if there is an auto accident, the insurance company pays out to the policyholder). A pension fund pays out state-contingent liabilities. Bank liabilities, however, most often offer immediate redemption in base money. There is nothing, however, that states that banks need to offer this type of liability. It is entirely possible that banks could offer time-contingent liabilities just like a pension fund. For example, a bank could issue a deposit liability and promise redemption a date in the future. The bank could then serve as intermediary between borrowers and lenders.

The primary difference between banks and the other financial intermediaries is the type of liability that they issue and its characteristics. Insurance and pension liabilities do not routinely circulate as medium of exchange. What makes bank liabilities special is that they do circulate as medium of exchange. When one uses a check at the store, it is like saying, “I don’t have any physical currency on me, but if you contact these people, they will give it to you.” Why do bank liabilities have this quality? Conceivably, it is because the liabilities promise immediate redemption. I can take the check to the bank and cash it whereas I would have to wait until the purchaser reached retirement age to redeem a liability tied to the pension fund.

Thus, banks are not only financial intermediaries, but money creators. A natural question is then where does the money come from? Do banks simply create money out of thin air?

Money: Backed and Fiat

Under a gold standard, money is redeemable in gold. In other words all money (both publicly and privately issued) is redeemable in gold. Assuming that there is a central bank, it is possible that I could show up at a bank and redeem my deposit for currency issued by the central bank or in gold (or a gold certificate). Even if I redeem the deposit for currency, I could always go back to the bank and redeem the currency for gold. (If there is no central bank, there is no public money, but we will leave this until later.)

In modern economies, there is no gold standard. If you show up at the bank to redeem a deposit, you will be handed physical currency. If you try to redeem that currency, say a $20 bill, you will receive a $10 bill and two $5 bills or some such combination.

Under a gold standard, money creation is directly tied to the stock of monetary gold (this is true even under a fractional gold standard). An over-issuance of money results in a wave of redemptions (either by individuals or foreign central banks) thereby providing a natural mechanism for controlling the money supply. Under a fiat currency, this mechanism does not exist. However, it doesn’t mean that no mechanism exists.

Critics of fiat money often assert that there is a direct correspondence between money creation and fractional reserve banking. As a result, a common neo-Austrian argument is that fractional reserve banking combined with fiat money will lead to excessive money creation. An extreme Austrian argument is therefore to require banks to hold 100% reserves that are backed by gold.

Defenders of fractional reserve banking often point out that the fractional reserve system is one that naturally arises as a result of profit-seeking. For example, a bank that accepts deposits will, over time, realize that only a fraction of the deposits are actually redeemed on any given day or in any given week and that other deposits are issued during this time. If deposits and withdraws are random, there might be a net inflow or a net outflow to the bank on any given day. By the Law of Large Numbers, the bank would not need hold reserves equal to the amount of deposits over this period, but rather only an amount of reserves that are a fraction of the amount of deposits (enough to cover net outflows of reserves caused by excessive redemptions).

I believe that this defense of fractional reserve banking is correct, but it goes above and beyond the critique leveled by neo-Austrians. What 100% reservists are arguing is that fractional reserve banking leads to money creation. However, as noted above, this is not the source of money creation. For example, insurance companies and pension funds are both financial intermediaries and hold an amount of cash that is a fraction of the liabilities that they issue. However, nobody accuses these intermediaries of money creation. Why? The reason is because their liabilities do not circulate as medium of exchange. Bank liabilities do. But why do bank liabilities circulate? Conceivably it is because they offer immediate redemption. It is not because of fractional reserve banking.

Indeed it is entirely possible that a bank with 100% reserves could create money. Banks could issue deposit liabilities with the promise of redemption at some date in the future and then invest the proceeds in assets in the intermediate term. Barring legal restrictions, it is entirely plausible that deposit holders could write a check for less than or equal to an amount of their deposit and this claim to the deposit could circulate as a medium of exchange just as a standard checking deposit. The reason that this does not seem probable (but is completely plausible) is because of the characteristic of the liability. The deposit issued by the 100% reserve bank is less liquid than a deposit that is instantly redeemable. This counterfactual would again seem to lend credence to the view that it is not fractional reserves that create money creation, but rather the unique characteristics of the deposit liability.

This similarly leads into another issue regarding banks and fractional reserves. A related argument to the link between fractional reserve banking and money creation is that money is being created out of thin air. Since there does not exist any sort of physical commodity for which money can be redeemed, there is a view that money is simply created out of thin air. But is money being created out of thin air? Let’s consider an insurance company. The insurance company issues a state-contingent liability and uses the proceeds to purchase assets. Among the assets is a cash reserve that is a fraction of the liabilities issued. Has money been created out of thin air? No, money hasn’t even been created. So long as the value of the assets are greater than or equal to the liabilities issued, the liabilities are completely “backed” by those assets. The same is true of a deposit issued by a bank. The bank issues deposits and uses the proceeds to purchase assets. So long as the assets on the bank’s balance sheet are greater than or equal to the deposits, the liabilities are completely “backed” by those assets. Thus, deposits are no more created out of thin air than are insurance of pension fund liabilities. What is different is that bank liabilities circulate whereas the others do not.

This represents a very broad overview of money and intermediation. An obvious question, however, is why we care about these properties and what the implications are. As alluded to in the introduction above, in part 2 I will discuss the role of money both as a medium of exchange and as a store of value and why the interaction between these two characteristics might matter. In addition, if we are to take such interactions seriously, what are the possible implications for monetary institutions? In particular, I will consider the implications of private note issuance on the part of banks and whether it matters if these notes are “backed” by some type of commodity. Finally, part 2 will conclude with a summary of the implications for the gold standard and other monetary arrangements.

16 responses to “On Money and Banking, Part 1

  1. Josh:

    I have several working papers on this very subject, which you can find by clicking my name above. The paper with the highest ratio of thoughts per word is probably “Introduction to the Real Bills Doctrine”, while the paper that readers say they like the best is “The Law of Reflux”.

    I’ll focus on just one of your points: The relation of backing and convertibility. Before 1933, the dollar was convertible into gold, and then suddenly gold convertibility was suspended. Would you say that on the day of suspension, the dollar suddenly changed from backed to unbacked? The gold and bonds that were in the Fed’s vault the day before suspension were still there on the day after. It is clearly more accurate to say that the dollar used to be backed and convertible, but one day it became backed but inconvertible. After all, the Fed always closed every weekend. This meant that every weekend, the dollar became inconvertible. But of course the Fed’s assets were in its vault the whole time. In 1933, nobody knew if the suspension would last for a few weeks or a few decades. If convertibility is expected to be resumed at some arbitrary future date, then the currency is not truly inconvertible.

    There are many different kinds of convertibility: physical (dollars for gold) financial (dollars for bonds), instant, delayed, certain, uncertain, etc. In 1933, the fed suspended just one kind of convertibility: Instant physical convertibility into gold. But there are still many other ways that a dollar can be redeemed by the fed.

    Once you recognize that ‘inconvertible’ does not mean ‘unbacked’, the whole notion of fiat money falls apart, and all those artificial distinctions between base money and private money, paper money and deposit money, etc, will disappear.

  2. The bank issues deposits and uses the proceeds to purchase assets. So long as the assets on the bank’s balance sheet are greater than or equal to the deposits, the liabilities are completely “backed” by those assets. Thus, deposits are no more created out of thin air than are insurance of pension fund liabilities. What is different is that bank liabilities circulate whereas the others do not.

    Right. I think the overriding problem is that people use the word “money” in multiple, inconsistent ways, and erratically switch between these usages without much self-awareness. Sometimes, “money” is used specifically to refer to a certain class of liquid, nominally riskless assets—or ones that “circulate as the medium of exchange”, as you like to say. Other times, “money” is used much more broadly, to denote wealth in general.

    Banks create money in the first sense but not the second sense. They transform a base of assets such that it becomes liquid and nominally riskless, suitable for exchange and certain other purposes. But they don’t create any net wealth—unless banks are trying to pull something sneaky, their liabilities will be fully backed by their assets, as you point out. I think people get confused because they realize that banks are creating “money” in the first sense, and then arbitrarily switch to the second sense and conclude that banks are unfairly creating new claims to wealth (which they do not). No one is magically inflating his net worth; instead, banks are providing a service, rearranging a pile of assets so that it becomes more useful.

  3. Your attempt to rationalize that money creation is not a problem is pretty silly. In 1970 the US money supply was about $300 billion, since then over $15 trillion of debt/money has been created by Fractional Reserve Banking. Now virtually every dollar in circulation is debt that needs to be paid back with interest – where to get that money? Create exponentially increasing amounts of debt/money.

    Since 1970 we have seen technological advances give us a 400% increase in productivity, but instead of prosperity we have seen families, businesses and government buried deeper and deeper in economy-killing debt. And the wealth of the economy has been transferred from people and businesses who actually produce to the financial sector which produces nothing. When private banks create all money as debt, there is no other outcome for growing economies than what we are seeing now, the dominoes falling from Greece to the USA as this Ponzi scheme of debt collapses.

  4. Matt,

    Banks create money in the first sense but not the second sense. They transform a base of assets such that it becomes liquid and nominally riskless, suitable for exchange and certain other purposes. But they don’t create any net wealth—unless banks are trying to pull something sneaky, their liabilities will be fully backed by their assets, as you point out. I think people get confused because they realize that banks are creating “money” in the first sense, and then arbitrarily switch to the second sense and conclude that banks are unfairly creating new claims to wealth (which they do not). No one is magically inflating his net worth; instead, banks are providing a service, rearranging a pile of assets so that it becomes more useful.

    Precisely.

    Twaikuer,

    You have presented conjecture without evidence.

    Your logic is similarly confused when you talk about debt and money interchangeably.

    Who says that the financial sector produces nothing? On the contrary, it is the financial sector that creates liquidity by turning liquid assets into liquid liabilities. This facilitates a the investments necessary to finance innovations.

    Note also that the problems in Greece have to do with sovereign debt, which is an entirely different issue.

    Finally, you seem to suggest that there is too much debt. But this begs the question: How much debt is too much debt? In order to answer this question one needs to have an explicit account of preferences, how individuals make decisions as well as an understanding of intermediation, liquidity, etc. It’s substantially harder to answer that question than one might think.

  5. Your ability to live in denial is astounding. First of all the expansion of the money supply is not conjecture, not controversial, the Fed’s own stats and graphs will show you that. If you are truly that ignorant – educate yourself (although of course they started hiding the M3 in 2006 because it was too obvious the curve would soon approach infinite money expansion). The idea that you can look at what is going on in the world, including the recent credit downgrades of the USA and major banks, and be in denial that the exponential increase of debt is a problem is laughable, it makes me realize I was nuts to consider this a serious worthwhile forum, it’s just more MSM financial sector cheerleader rationalizing which has gotten the whole world into this mess.

  6. First of all the expansion of the money supply is not conjecture, not controversial, the Fed’s own stats and graphs will show you that. If you are truly that ignorant – educate yourself

    In my comment did I deny that the money supply was growing? No, I did not. Also, this highlights my point that you are confusing debt with money.

    The idea that you can look at what is going on in the world, including the recent credit downgrades of the USA and major banks, and be in denial that the exponential increase of debt is a problem is laughable.

    Again, as I stated in my comment there is a distinction between private debt and sovereign debt. My entire post was about banking. You continue to make comments about sovereign debt. If you cannot distinguish between the two, then you have indeed found the wrong forum.

  7. The Federal Reserve really can create too much debt. For every debtor, there is a creditor. Normally, creditors are also savers; they forego the use of scarce resources and transfer them to debtors. However, the Federal Reserve is a creditor that doesn’t have to save before lending. It really can create too much debt, because it can create the impression of more resources being available for debtors than is really the case. This idea is at the heart of Austrian business cycle theory.

    However, just because the Federal Reserve can, in principle, create too much debt by purchasing financial assets, it does not follow that all expansionary monetary has this result. When the public (or their banks) choose to hold larger balances of base money, they are effectively lending scarce resources to the Federal Reserve. In this case, the proper response is to create debt through open market operations, because otherwise the consequence would be too little debt.

  8. Insurance Cos. and Pensions do not create money just as a finance co. like CIT does not create money. When money is given to these financial cos. they credit a liability account and debit cash on hand. When they make a loan they debit Notes Receivable and credit cash on hand. No money is created.
    A bank gets a deposit and credits a liability account and debits cash on hand (before they put the money at their account at the Federal Reserve Bank). When they make a loan they like a finance company debit Notes Receivable but the credit goes to new liability account (a deposit account) and not a credit to cash on hand. Thus money is created. The finance cos. don’t have that deposit liability account to create that the banks have.

  9. This is a fascinating conversation, if perhaps a little beyond me, a novice to monetary theory. Still, I’ll respectfully press my most nagging concern: you seem to be saying that gold standard proponents advocate the gold standard as the key to preventing fiat currency creation, which would ipso facto stabilize the economy. And perhaps that does represent some (most?) gold standard proponents.

    But I was under the impression that the theory began with central banking, in any of its forms, which we have had for most of our nation’s history. For the reasons that any other centralized industry fails, the product — currency in this case — is of a weaker quality than it would be under decentralized or “free” banking. THEN, if we arrive at decentralized banking, gold proponents say, banks will have to back their money, and gold (or silver) happens to be what humans, after centuries of experimentation, have come up with as the best candidate for the job (because it doesn’t spoil, is easily transferrable, malleable, divisible, etc).

    In short, are you therefore addressing a straw man?

    A second question: much of free banking scholarship deals with how a free currency market would deal with “market failures.” The answer usually sounds like this: (barring industry-level or legal banking standards) if a bank engages in poor currency stewardship — like printing too much money — and the bank’s currency fails for whatever reason, then at least the rest of the system does not fall apart, unlike that of a centralized banking system. So when you say, “Banks [with 100% reserves] could issue deposit liabilities with the promise of redemption at some date in the future and then invest the proceeds in assets in the intermediate term,” you use an example that sounds like a Ponzi scenario. If that bank falls apart in the future, it would at least leave the rest of the nation relatively unpained. Where am I going wrong?

    Looking forward to Part II.

  10. Just stumbled on this video. Walter Block makes my point: that this post seems to be attacking a straw man that gold proponents want the gold standard. Rather, they want decentralized banking and THEN whatever hard currency standard arises will simply be chosen due to market banking forces (0:15-0:25): “If we ended the Fed, we wouldn’t have any of these problems with M1 or M2 or anything. We’d presumably become a gold standard or silver standard or something like that and there would be no more business cycle…”
    youtube(.)com/watch?v=4jwmuSA6DgI
    youtube.com/watch?v=4jwmuSA6DgI

  11. Pingback: Here We Go Again: How Much is Too Much? | The Everyday Economist

  12. (On money and banking) Tripple Check, thanks for the video.

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