When Is Fractional-Reserve Banking

Inflationary?
By: Michael Rozeff | Thu, Aug 30, 2012
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The takeaway here is that fractional-reserve banking is not inflationary per se.
Fractional-reserve banking is inflationary when combined with central banks with
unconstrained fiat money powers. The real culprit in inflation is an unconstrained
central bank. Since central banks are created or enabled by governments, the real
culprit in inflation is government. In turn, inflation cannot be controlled unless proper
government, which really means proper law, is instituted and respected.
To understand the logic of inflation, we start with an economy that uses gold as
money. We then introduce one new factor at a time.
How does gold as money work? Let's start by assuming an economy that has an asset
money such as gold. There is a gold industry that brings new gold into production and
distribution when the price of gold rises relative to production costs or when profit
margins remain the same but demand for gold rises, if the industry is a constant cost
industry. If the gold price rises high enough relative to other goods, even with new
production, then this stimulates the production of substitutes for gold, such as silver or
other metals or other kinds of goods, assuming that the profit margins in those
industries have widened. This competition to produce different kinds of money keeps
down the cost of money in general. It also stimulates the production of paper money,
but we defer discussion of banks and paper money until later.
Suppose that a company wants to finance a new project. It will borrow or issue equity.
This distinction makes no difference for our current analysis because in both cases it
is getting money from other people. There are four possible sources of the money of
the money-suppliers. They can sell assets. Giving up money they have stored comes
under the heading of selling assets, since stored money is an asset. They can cut back
on consumption. They can work more or cut back leisure. Last, in exchange for the
stocks or bonds, the gold miners can supply gold that they produce.
The shifting of money from one use to another does not per se alter the price level.
The money that the company gets to carry out its project is going to be spent back into
the economy. If assets were sold to provide the money for the financing, the
company's spending shifts it to other uses. There is no predictable overall impact on
prices from mere shifting. (The possible effect of greater productivity in reducing
prices is not mere shifting.) If people cut back on consumption, the same conclusion
holds. The new money, if anticipations are correct, will produce enough to pay a
return subsequently, and that allows greater consumption in the future. At most there
is time-shifting of consumption at some rate of interest. Price levels again show no
systematic impact. If people work more to finance the project, then overall product is
increased. The effect is to make prices fall. If gold miners finance the project, then

money in the economy rises. Prices rise. This tends to offset any price-deflating effect
of the new product brought on line by the project.
The gold miners conceivably are a source of price inflation. The more they mine and
spend or invest, the greater the impact on prices. What stops them? What stops them
is that if they are able to mine and produce a great deal of the good being used as
money, then prices will rise in terms of that good. The miners' profit margins will
shrink and they will not have as much incentive to overproduce. Furthermore, as
prices of goods rise, people will then reduce their use of that good serving as money
and as a store of wealth and as a unit of account. A necessary condition for a good to
serve as money is that it either cannot or won't willingly be produced in unlimited
amounts at low cost. There has to be a constraint on its production coming from
somewhere. In the case of gold, it is a combination of increasing costs to mine gold
and that the utility of gold falls when it's in such great supply that price inflation
occurs.
What happens in an economy where many projects are being financed? Then we look
at the demand curve for money for all such projects. If the demand for money to
finance projects shifts to the right because of new projects that people want to finance,
demand will intersect supply of money at a new price. If the long run supply curve of
money is highly elastic (or horizontal) as in a constant cost industry, then there are
lots of money substitutes that can be brought on stream. The price of money need not
alter much in the long run. This means that prices need not alter much. We conclude
that, even if people sell assets, cut back on consumption, work more, or supply more
gold, this need not greatly impact the overall level of prices. However, a stream of
profitable new projects has a tendency to increase productivity and lower prices. That
effect is separate from price changes that might be brought about by shifting money
from one use to another use.
Let us bring banks and paper money into the picture and ask what banks do and what
happens when there are banks.
If banks are 100% gold or money depositories, nothing changes from the above.
Banks in this scenario are storehouses for gold. If people wish to finance projects with
gold, they can subscribe to securities from their own personal stores of gold or else
they can draw gold from their bank depositories and transfer it to companies.
A second possibility is that people farm out their investment decisions to investment
companies by buying their shares for gold. The money received by these companies is
intended for investment in projects by the companies. This changes nothing essential.
The people in this case have chosen intermediaries to make investments in projects.
They can sell their shares in a secondary market if they wish to liquidate their
holdings.
The third possibility is that banks are fractional reserve in nature. This is in between
the other two cases. People make deposits at the banks that belong to the bank and
that can be invested by the banks at will. However, people also can liquidate their
deposits and get gold at bank windows to the extent that such gold is readily available.
Banks may delay or stop such payments under conditions where it runs out of ready
gold. This bank is not perfectly liquid, but its investments do not exceed the size of its

deposits. Still, we call it a fractional reserve bank because its gold holdings are a
fraction (less than 1) of its deposits.
The fractional reserve bank has an inherent illiquidity because its total assets exceed
the assets that it holds in gold that are ready to pay depositors on demand. Suppose a
bank has $100 in deposits. If it has $100 in gold, it has no illiquidity of the kind I am
explaining. It has zero illiquid loans relative to $100 in gold. Define an illiquidity
ratio as the illiquid loans divided by the amount of gold. The illiquidity ratio is 0/100
= 0. If the bank has $65 of gold and $100 of gold, its illiquidity ratio is 35/100 = 0.35.
Let's now go one step further in understanding the nature of a bank. Let's suppose that
the fractional reserve bank can make loans and simultaneously create deposit account
credits. This amounts to financing the purchase of a loan with a new liability, which is
the deposit. The bank that makes a loan is buying a security from the borrower, which
is the loan. In return the bank issues a security to the borrower, which is the deposit
account. Suppose the bank with $100 in gold and $100 in deposits makes a $70 loan
and creates a $70 deposit account for the borrower. The bank then has $170 in assets
and $170 in deposit liabilities. It has expanded its balance sheet.
The peculiar aspect and the defining feature of a bank is that its deposit liabilities are
convertible into money, i.e., gold, if available, and so the deposits become regarded as
being about as good as gold under many conditions, mainly being that the loans are
good loans. Deposits brought into the bank in gold and deposits created by the bank
when making loans are intermingled.
This bank now has $100 in gold and $70 in illiquid loans. Its illiquidity ratio is 70/100
= 0.7. The ratio increase from 0 to 0.7 indicates the rise in illiquidity.
If depositors withdraw gold, the illiquidity ratio rises further. Suppose that $70 in gold
are drawn out of the bank. This reduces deposits back to $100. The assets are now $30
in gold and $70 in illiquid loans. The illiquidity rises to 70/30 = 2.33.
From the bank's side, the reason for any illiquidity at all is to amplify the bank's
earning assets by making loans. The amplification is a kind of leverage. Call it
illiquidity leverage. From the side of those making deposits, their risk rises with
illiquidity. Unless they get a return in some form, they will not fund or finance an
illiquid bank in this way. Their return seems to be a set of conveniences such as use of
checking and money storage.
Let's return to the question of how money and inflation work when someone obtains
finance for a new project. What happens when a bank is present that can create loans
and deposits? It means that there is now a fifth means of obtaining money. Rather
than people directly providing the company with credit, a bank can do it and it can do
it by creating a new credit altogether while simultaneously creating a new deposit that
is regarded by the depositors as money.
The bank and the borrowing company expect to complete the lending cycle when the
company's project is a success and it returns gold to the bank. The bank will then
cancel the loan and deposit of the company.

The bank competes with the other four methods of providing the company with
capital. None of those four methods was inherently inflationary, i.e., produced a
systematic or continuing increase in prices. Neither is bank lending. Remember that
the production of money has to face constraints or else the good serving as money
loses its utility and will no longer be acceptable as money. The banks are producing
deposits by granting loans. This is a relatively low cost way to create money.
However, the depositors have the right to withdraw their money in gold at any time.
This constrains the bank. Remember that its illiquidity rises as depositors withdraw
gold. The bank is at the mercy of its depositors. The bank, in effect, is acting as an
agent for the depositors when it makes loans. The depositors, in effect, are extending
the loans to borrowers via their bank. They can force the bank to call in and reduce
loans by withdrawing capital in the form of gold. If their money in the form of
deposits is losing purchasing power because the bank is creating too many loans and
deposits, they have an incentive to withdraw funds in the form of gold. This
constrains the bank from lending.
This is an important conclusion. Fractional-reserve banks are not inherently
inflationary in a system in which the market participants are using real money, such as
gold. By real money, I mean a money that those participants themselves regard as a
good that has the attributes that they require from money.
Another important constraining factor is the competition of banks. In a fractionalreserve banking setup with gold, bank deposits can be withdrawn as bank notes that
are used as currency and substitute for gold money. Each bank has its own notes. If a
bank issues too many notes or makes bad loans so that gold is not returned to the
bank, its illiquidity ratio rises. Depositor risk rises. The depositors have an incentive
to withdraw gold and place it elsewhere or store it themselves. This possibility of a
bank run constrains the bank. At the same time, a competing bank that receives the
notes of another bank presents them for payment to the issuing bank immediately.
There is a daily clearing mechanism. If the issuing bank starts to run high balances
such that their redemption in gold is questionable, it must call in loans or constrain its
lending.
The situation in the economies of today differs drastically from what I've described
above. Although gold and silver are available in the market, a number of obstacles
such as taxes stand in their way as being used as money. Furthermore, governments
have erected laws and regulations that make their fiat currencies serve the medium of
exchange purpose. In this situation, the depositors are unable to constrain banks. They
cannot withdraw gold, because gold is no longer being used as money. They can
withdraw only paper, and the banking system can easily manufacture more paper. In
this kind of fiat money economy, as opposed to a gold money economy, the banks
have an inherent inflationary bias. It pays to make more loans because the depositors
can't do anything about it and can't constrain the banks. Beyond the lack of gold in the
system, deposit insurance virtually eliminates the incentive even to withdraw cash in
paper form. This induces many banks to raise their illiquidity ratios drastically and/or
to make imprudent loans. When banks make nonproductive loans, the deposit money
doesn't go into projects that succeed in lowering prices. Instead prices are bid up.
When the bad projects are revealed, the loans and deposits have to be written off. A
deflation then occurs.

The conclusion is that fiat money combined with fractional-reserve banking is an

inflation source. The problem of inflation and then deflation is not fractional-reserve
banking per se because, when combined with gold, that system works. The bottom
line problem is eliminating gold in the fractional-reserve bank and replacing it with
fiat money supplied by a central bank. The central bank can liquify any bank loan at
its discount window or liquify the entire banking system by creating bank reserves. It
can nullify the normal process by which depositors in a gold system withdraw gold
from banks that are too illiquid. Regulation of illiquidity has proven to be a poor
substitute for market incentives that control illiquidity, but those incentives are
undermined in a central banking system.
Even with central banking, banks clear balances with one another. This does constrain
loans. And banks still seek out good rather than bad loans. Even with central banking,
banks can cease to lend each other bank reserves. That continues to act as a constraint
on illiquid banks, but a central bank can even overcome that by targeted credit
measures.
The more usual feature of the fiat-central bank system is that the central bank over
time is relatively generous in creating reserves and loosening the natural constraints
one finds in a gold-based market system. Additionally, the government and central
bank are lax in controlling bank illiquidity and lending. One result across many
countries is usually annual inflation in a 3-12% range, unless the government
legislates a constraint. Another is periodic waves of bank failures. Generally, under
looser constraints due to the loss of market constraints, banks make bad loans to
sovereign governments. They overextend into risky activities, off-balance sheet
financing, derivatives, and long-term loans. They compound their illiquidity.
The central bank produces its money, empowered by the government. In the U.S., the
Federal Reserve's notes are an obligation of the U.S. The central bank is the
institution that is the central cause and enabler of all the money and banking problems
emerging from fiat money creation, not the institution of fractional-reserves. Making
all banks into 100% depository institutions gets rid of banking itself. This is
unnecessarily drastic because banks have plusses. They are used by depositors even
when they have some degree of illiquidity. However, if America ever does rework its
banking system, a much clearer legal separation should be made between 100%
depository banks and illiquid banks in which depositors are actually lenders.
It's the central bank that should be ended in order to mitigate money and banking
problems. This is a heavily political problem because the government's size and
power hinge on having a central bank in place to handle its financing. This is
especially true for the U.S. with its massive borrowing requirements. There would be
no government bond market of its current size and form without a central bank and
the system of primary dealers and banks attached to it. Because of the connection to
big government, I see no realistic prospect of either central banking or the existing fiat
money system being eliminated. There does exist some prospect of gold being
brought back into the system in some ways, such as allowing banks to use gold as
reserves or re-introducing gold in international payments. The impetus for these steps
might be from overseas or from an institution like the BIS, not domestically. They
might actually involve movement toward a world central bank.

Now and in the foreseeable future, the U.S. is taking no steps to end its central bank
as a solution to its money and banking problems. Its first response was to save the
banking system as currently constituted. Its second step was Dodd-Frank.
My main point is that fractional-reserve banking is not in and of itself the problem,
and thus it shouldn't be the main target of reform or change. The key problem is an
incentive system caused by fiat money and central banking that generates illiquidity
that is too high, risky bank practices, and poor financing practices. Another important
cause is that there are often government pressures to expand credit and to target loans
to specific sectors. There are pressures to finance governments and pressures to bail
out banks and sovereigns. There is lax and ineffective government regulation that
does not suffice to overcome the incentive problems resulting from the absence of
gold as money and the introduction of central banks. In addition, the government
regulation itself causes incentive problems.
Because the basic money and banking problems are not being addressed in a
fundamental way but instead have been addressed with palliatives like Dodd-Frank,
whose effectiveness is likely to be very muted or even counter-productive, what we
can expect is a continued period of financial strain, under-performance, shakiness and
instability. Threats of collapse are not going to disappear. The best that could happen
under the prevailing politics would be for vigorous finance committees in the
Congress not to let the ball drop but to work at the margin to reshape the system and
move it in the direction of sound money and sound banking.