[TZubiri]

This is a common misconception, thinking that fractional reserve banking is the way in which banks lend. In actuality it's a limitation to how banks lend.

Without fractional reserve rules the banks could lend their money infinitely. I like Richard Wagner's theories/research on the subject, as in he actually asked for a loan and went through the books of the bank to verify where the money came from, it came from nowhere, they just credited their account and that's it.

[eru]

> Without fractional reserve rules the banks could lend their money infinitely.

What's that supposed to mean?

> I like Richard Wagner's theories/research on the subject, as in he actually asked for a loan and went through the books of the bank to verify where the money came from, it came from nowhere, they just credited their account and that's it.

That's a bit silly. Yes, when you get a loan and just let the money sit in your account, the bank can create the loan/deposit pair out of thin air (modulo legal requirements).

The constraint for the bank comes when you start spending that money. Most people take loans to spend the money, eg a company might invest in some new machinery or you might buy a house. The Mr Wagner in your story stopped his investigation too early.

[imtringued]

>The constraint for the bank comes when you start spending that money. Most people take loans to spend the money, eg a company might invest in some new machinery or you might buy a house. The Mr Wagner in your story stopped his investigation too early.

No, you don't get it. Imagine if there was a single bank and no cash withdrawals. The bank can't run out of liquidity, ever. If you buy something from a company, the money lands in the bank account of the company, which is managed by the same bank. This means as long as there is no cross bank transfer, there is no limit to how much money can be created.

Now you might argue that this is a bit unrealistic, but at least in principle you could artificially engineer a situation like that even in the current system by having large corporations agree to use the same bank for money created by a specific loan.

But here is where it gets weirder. Imagine if there are two banks now. Surely now the idea presented above breaks down the moment there is a cross bank transfer, right? Except it's not that simple. There is merely a limit to how much of the created money can leave the bank in one direction. If the cross bank transfers are balanced so that for every transfer from bank one to bank two, there is a transfer from bank two to bank one, then you are back in unlimited money territory.

This means there is no static limit to the amount of money that can be created. The limit is dynamic and depends on the interactions between banks. Specifically, it depends on the liquidity/solvency of a given bank. This means this limit is purely practical and more akin to friction, rather than a fundamental restriction in the math of banking/accounting. It's like how computers aren't turing machines because they have finite amounts of memory. There is no limit to how much memory a computer can have as long as you can manage to build a computer with that much memory.

[eru]

Thanks for arguing in good faith.

> No, you don't get it. Imagine if there was a single bank and no cash withdrawals. The bank can't run out of liquidity, ever. If you buy something from a company, the money lands in the bank account of the company, which is managed by the same bank. This means as long as there is no cross bank transfer, there is no limit to how much money can be created.

Yes, monopolies are bad. I completely agree with your analysis here. That's one reason why central banks can get away with so much.

> But here is where it gets weirder. Imagine if there are two banks now. Surely now the idea presented above breaks down the moment there is a cross bank transfer, right? Except it's not that simple. There is merely a limit to how much of the created money can leave the bank in one direction. If the cross bank transfers are balanced so that for every transfer from bank one to bank two, there is a transfer from bank two to bank one, then you are back in unlimited money territory.

Here's where it gets interesting.

Assume there are n banks. Let's also assume for the sake of simplicity that transfers behave a bit like Brownian motion. That means on average we don't expect any bias in transfers between banks, but we also expect some random variance.

Say, our banks settle their net transfers at the end of the day. With a bit of math, we see that the expected variance for any bank proportional to something like gross transfers of that bank, and thus the standard deviation is proportional to the square-root of gross transfers. (It also depends on n.)

Our commercial banks settle by exchanging reserves, eg central bank base money or perhaps they ship physical gold. We can assume that they want to avoid being short of reserves when it comes to settling, but it's not infinitely, and holding reserves costs money. So in practice they'll settle on some multiple of the standard deviation as their precautionary reserves. If the amount of total reserves in the banking system is fixed, that'll place a limit on how much banks will want to expand their total balance sheets.

See https://oll-resources.s3.us-east-2.amazonaws.com/oll3/store/... for more on this topic and a better analysis.

The above was about reserves and how demand for pre-cautionary reserves limits the size of the aggregate balance sheet of all banks.

Now the other question is: why do banks bother with deposits?

So, let's assume that our bank makes a loan to a customer: they create a deposit / loan pair out of thin air that adds up to zero. Now the customer spends that deposit. On average we can assume (n-1)/n parts of the deposit go to other banks and 1/n stays with the originating bank (by the assumption that our average bank has a market 1/n market share.) Those (n-1)/n parts get transferred to other banks, and thus they drain our reserves in the settlement at the end of the day.

If we can attract enough deposits, we can make up for that outflow and have a nice 0 in the net settlement.

The above is all assuming there's no regulation that requires a specific amount of reserves or capital etc, and it's all set by each bank purely by commercial necessity. You are right that there's no one fixed limit, but the limits are also not arbitrary.

Instead of attracting deposits a bank can also sell of the loan it just made. Or it can borrow and use that loan as collateral. But economically, that's all basically equivalent to a deposit in different guises.

About liquidity: in a functioning modern economy, as long as you are solvent you can always get liquidity. (But conversely that means that your counterparties will treat any liquidity problems they see with you as signs of underlying solvency problems.)

You might also like https://www.cato.org/blog/diamond-dybvig-panic-1907 (or https://archive.is/uRtmw) on bank runs.

[TZubiri]

>What's that supposed to mean?

The misconception is that if a bank has a capital X, the law gives them power to create loans up to 10X.

What I'm saying is that without the law, the bank could create loans without a constraint, so say 20X, 100X 1000X.

The fractional reserve policy is actually a limit, not the source of lending in excess of capital.

Loans are money creation, and this creation is organic, it doesn't need a charter from the government.

Another misconception is that this money creation is monetary emission or that it somehow causes inflation. It doesn't, because it is gross money creation, not net money creation.

[eru]

> What I'm saying is that without the law, the bank could create loans without a constraint, so say 20X, 100X 1000X.

No, they couldn't, and they didn't when no such laws existed. Canada and Scotland had prominent episodes in their histories when banking was fairly lightly regulated and no such laws existed; and their banks did not create '1000X' loans from thin air.

> Another misconception is that this money creation is monetary emission or that it somehow causes inflation.

No, it would absolutely contribute to inflation. As a thought experiment: just imagine the government banned private money creation tomorrow. Inflation would totally crash and the economy would collapse from a lack of demand.

> It doesn't, because it is gross money creation, not net money creation.

What is that supposed to mean?

> Loans are money creation, and this creation is organic, it doesn't need a charter from the government.

I agree on the first and last part. I'm not what you mean by organic.

[TZubiri]

Besides the discussion of who is right, I think both theories are quite standard and we would benefit from learning the standard terms.

Regarding your theory of gold deposits being behind money creation is on Wikipedia as Metallism.

Regarding how banks worked before such laws existed, we could look at the period immediately before the creation of fractional reserve, I would predict that immediately before the rule was put in place, the banks were creating these 1000X (maybe 100X? I don't know) which caused a bank run. Without looking, the history of fiat money is quite recent, 1 century or maybe even less? So this shouldn't be too long ago. It is possible for banking working correctly for a long time without the rule, it might have been a short period, kind of like how soccer worked without offside rule for a long time, but it was put in place to stop some specific type of play anti-sportsmanlike play, not to enable another.

>I agree on the first and last part. I'm not what you mean by organic.

I think a more standard term is endogenous, as in an emergent behaviour of private individuals, rather than exogenous, as in set by a central bank. https://en.wikipedia.org/wiki/Endogenous_money

>What is that supposed to mean?

You are right these are not standard terms, I meant gross money creation as money that is created with a corresponding liability. For example a loan, or a loan with a mortgage on land. The money base increases, but so does the size of the economy represented by that currency in equal increments. Endogenous money seems to map quite cleanly to gross money. Although not all exogenous money is "net" (as in creating currency without an underlying asset).

>No, it would absolutely contribute to inflation. As a thought experiment: just imagine the government banned private money creation tomorrow. Inflation would totally crash and the economy would collapse from a lack of demand.

One of the examples of exogenous money that does create inflation and I would say it's net money creation (for lack of a standard term I don't know about), would be seignorage, a term that comes from metal economies, where they would reduce the amount of valuable metal in coins, and the value of the coins was maintained by the trust, power and guarantee of the imperial seals imprinted on them, this gradually lead to fiat valuable metal was completely removed.

Nowadays it seems the term seignorage is still used to refer to the revenue created by the state whenever it 'prints' money without a liability. It is important to distinguish this from endogenous money creation like loans and clarify that the latter doesn't cause inflation, and if it does its effect would be minimal when compared to seignorage.

[eru]

> Regarding your theory of gold deposits being behind money creation is on Wikipedia as Metallism.

Huh, what? There's no gold deposits in a fiat system, and they still have money creation. And in eg in 19th century Scotland gold was the unit of account, but they scarcely had any gold in the country (yet alone any gold deposits), and they still had plenty of money creation.

> Regarding how banks worked before such laws existed, we could look at the period immediately before the creation of fractional reserve, I would predict that immediately before the rule was put in place, the banks were creating these 1000X (maybe 100X? I don't know) which caused a bank run.

Huh? When would that be? There was no banking system 'before' fractional reserve banking. And what bank run are you talking about? Historically, bank runs basically only happen when a bank has solvency troubles (or when a law pretty much compels bank runs).

> I think a more standard term is endogenous, as in an emergent behaviour of private individuals, rather than exogenous, as in set by a central bank. https://en.wikipedia.org/wiki/Endogenous_money

Sure, I agree that private money creation in commercial banks is endogenous in that sense.

> You are right these are not standard terms, I meant gross money creation as money that is created with a corresponding liability. For example a loan, or a loan with a mortgage on land. The money base increases, but so does the size of the economy represented by that currency in equal increments. Endogenous money seems to map quite cleanly to gross money. Although not all exogenous money is "net" (as in creating currency without an underlying asset).

OK. Technically even the central bank money is created with offsetting liabilities, at least for the mainstream economies and their central banks like the Fed, ECB, Bank of Japan, Bank of England etc.

I say 'technically', because the treasury can just create a T-bill from thin air, sell it to the market, and then the Fed will loan you newly created money against that T-bill.

There's an interesting debate to be had about seignorage and inflation, and about fiat currency vs fiduciary currency.

First, you don't need to print money without a liability to get seignorage income. When the central does a classic open market operation where they buy a bond yield eg 5% for newly created money (naturally yielding 0%, if it's cash), they earn a 5% interest rate differential for as long as that new money is in circulation. That's very similar to how any old commercial bank earns an interest rate differential.

Now this gets a bit more complicated with inflation and/or when the central bank pays interest on reserves held with them. At the moment the Fed pays 3.65% interest on reserves. (Source: https://www.federalreserve.gov/monetarypolicy/reserve-balanc...). But generally they still have a positive seignorage income.

Money created by the Fed and money created by commercial banks contributes to inflation in the same way. The Fed just measures the total inflation that's occurring (and tries to forecast future inflation), and then adapts its own policy instruments accordingly. They automatically take private money creation into account.

About inflation and seignorage: you might think that it's very straightforward and printing more money would lead to more seignorage income. However that's not true in general.

As we noted above, central banks mostly get their seignorage income from the interest rate difference between their assets and liabilities. (Cash and 'reserves' being the primary central bank liabilities.)

When inflation is high, people really cut back on how much cash they hold, at least in real terms. For an example: as the money printing in Zimbabwe really kicked off, people might have held more cash in nominal terms, but in real terms they wallets got lighter and lighter.

In contrast, Japanese people are famous for holding oodles of cash, partially because their years of mild deflation made holding cash relatively more lucrative.

(Turkey is perhaps a good example to follow along, because they want from relatively low inflation in the 2000s to much higher inflation since, but not nearly as catastrophic as Zimbabwe. Or you can look at real money balances in the US through the Great Inflation in the 1970s vs before and after.)

If all you want to optimise for is seignorage income, the optimal rate of inflation is something low-ish and stable. But details depend on how big your economy is, and how easy it is for people to switch to other currencies. So eg the optimal value for Singapore is probably lower than for the US. (Optimal just in the seignorage income maximising sense. Monetary policy typically has other goals.)

About fiat vs fiduciary money: you know fiat money already. Fiduciary money is where you promise to redeem the tokens in some underlying asset on demand. A classic example could be paper money that can be exchanged for gold on demand.

Confusingly, both intermix freely. What I mean is that in a fiat system, the central bank issues fiat money. But the private banks create fiduciary money: your bank typically lets you withdraw your deposit (fiduciary money) as cash (central bank fiat money).

Perhaps fiduciary money is a better term for what you describe as 'net money'?

https://cdn.mises.org/rae9_2_5_4.pdf has some good points on the distinction. (Though keep in mind that the target audience is 'Internet Austrians' who see everything but gold or silver coins as suspicious, and the authors are trying to convince them not to be so dogmatic.)

You might also like 'Those Dishonest Goldsmiths' https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1589709 about the myth that goldsmiths invented fractional reserve banking.