Criticism of fractional-reserve banking
Some critics of fractional reserve banking and the related monetary system may refer to it by the political term debt-based monetary system.[1] Their criticisms are based upon non-mainstream economic theories.
The term, "debt-based monetary system," and related terms, such as "debt money"[2] are not used by conventional economists or academic neoclassical economists. Mainstream economists often refer to "debt money" simply as credit, and make no material distinction between fiat currency, representative money and "debt money".[3]
Critics of fractional reserve banking include a number of mainstream economists such as Irving Fisher[4], Frank Knight[5], Milton Friedman[6] and others; strong non-mainstream critics include the Austrian economists, Murray Rothbard[7] and Ludwig von Mises.
Conventional economic analysis
Conventional economic analysis essentially characterizes fractional reserve banking as a benign feature of modern monetary systems, which exists independently from the currency regime and is a tool of monetary policy.
The link between the currency regime (for example, fiat currency or precious-metal backed currencies) and the banking regime (fractional reserve or full reserve banking) is not seen as fixed, as virtually all banking systems worldwide operate on some form of fractional reserve banking, and full-reserve banking is often considered "hypothetical."[8][9] Neither is the insight that banks "create money by extending loans" considered new, and the subject is covered in most introductory economics textbooks and many popular reference works.[10] Mainstream economics also utilizes specific, technical definitions for different types of money, from narrow definitions (such as physical notes and coins) to "broad money" which may include various types of bank deposits, chequing accounts and others.[11]
Banks will also hold "reserves" (cash or other liquid assets) to meet the demands of depositors on their own, in some fraction of total deposits, to avoid potentially damaging liquidity shortages, bank runs or even ultimately bankruptcy. In addition to the minimally required reserves, banks will usually hold cash or other assets that qualify as reserves or can be converted readily into cash or equivalents.[12] Reserves, in this sense, represent a form of protection against withdrawals of currency.[13]
Traditional economics sees fractional reserve banking as a mechanism for transmission of monetary policy: reserves and other limits upon the banking sector's ability to "create money" are to some degree controlled by the government or central bank.[14] According to this approach, the monetary authorities use the pricing mechanism (via various monetary policy instruments) to adjust the quantity of money in circulation and protect depositors and the integrity of the financial system. The use of these tools is adjusted according to the nature of the banking system's propensity to create money by lending.[15]
The weaknesses of the nature of fiat currency (and the capacity of the banking system to create money) and the relationship to the business cycle (including booms, busts and credit cycles) are widely recognized.[16] In particular, the possibility that governments or central banks will create too much money (either directly or through the banking system) is a frequent topic of academic, economic and political commentary.[17] Conventional economic analysis differs primarily in that it does not hold that the more extreme predictions of certain monetary reformers (regarding, for example, the inevitability of "debasement of the currency" or periodic crises) are necessarily true; they do not, however, exclude the possibility of such events due to exogenous events or poor management of monetary, fiscal and financial policy.[18][19] The negative effects of inflation are also frequently and widely addressed in conventional macroeconomic and monetary analysis.[20]
According to this analysis, "debt-based money" is a heterodox economic theory that, although it may differ little in analysis of the basic structure, is largely irrelevant, and the main issues are addressed in various schools of economic thought. Economists generally address the issue of choice of monetary regime (such as fiat currency) and banking policy as entirely separate issues, since fractional reserve banking dominates most economic systems; the level of banking reserves and other regulatory measures are simply instruments of monetary policy that help to determine the money supply.[21] Differences in terminology (debt money, for example) do not represent, from the "mainstream" perspective, new analysis, and the more extreme conclusions about the "inevitable" negative impacts of so-called debt-based money and "fraud" perpetrated by banking circles upon the public are considered akin to conspiracy theories.[22][23] The subject of debt-based money (as distinct from traditional monetary policy) is absent from reputable academic economic publications, and is largely relegated to fringe status.[24][25]
It should be noted that various other schools of monetary thought, including other "monetarists" such as the Austrian School, do not necessarily ascribe to, for example, the conclusion that full-reserve banking is an issue; some explicitly advocate "free banking" with no required reserves at all. Some have referred to the concept of monetary policy with full-reserve banking as "nonsense" (that is, a contradiction in terms). More detailed analyses argue that full-reserve banking would impose similar costs of price adjustments in reaction to growth (through a reduction in the overall price level) as would inflation, and hence offer no inherent advantages over fiat currencies and fractional reserve banking.[26]
Basic debate
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In stark contrast to conventional economic analysis, some commentators focus on the combined use of fiat currency, fractional reserve banking and central banking as a powerful - some would argue destructive - feature of modern monetary systems. These commentators use the term debt-based monetary system to refer to an economic system where money is created primarily through fractional reserve banking techniques, using the private banking system.[27] This form of money is called "debt-based" because as a condition of its creation it must be paid back plus interest at some time in the future.
This also implies that as the money supply and the economy grows, the nation becomes increasingly indebted at the same time, and increasing interest payments are needed to pay bondholders as the money supply grows.[28][29][30]
Although money created through fractional reserve banking techniques is a form of fiat currency (because it is not backed by a real asset such as gold or silver), it can be distinguished from "true" fiat currency in that it is intrinsically "temporary" money, requiring its eventual repayment as a condition of its creation.
The debt-based monetary system is a departure from traditional monetary systems, which were backed by gold deposits or the gold standard, or other precious metals. Because of this departure, it is the subject of continuing political and economic debate. Some critics of fractional reserve banking consider it to be a recent, transitory and unsustainable aberration from traditional, slower-growing, asset-based monetary systems, with potentially destructive economic effects.[31][32]
Some argue that since debt and the interest on the debt can only be paid in the same form of money, the total debt (principal plus interest) can never be paid in a debt-based monetary system unless more money is created through the same process. For example: if 100 credits are created and loaned into the economy at 10% per year, at the end of the year 110 credits will be needed to pay the loan and extinguish the debt. However, since the additional 10 credits does not yet exist, it too must be borrowed. This implies that debt must grow exponentially in order for the monetary system to remain solvent.[33][34]
Others argue that there is in fact no mathematical necessity for the money supply in a debt-based system to grow, since the interest portion of loan payments is not taken out of circulation, but goes into the lender’s account, where it can be spent back into circulation and eventually be used to pay off some loan principal. The exponential growth of debt need not give any concern because if GDP growth is positive GDP is also growing exponentially and the ratio of debt to GDP might change in any direction. [citation needed]
Basic nature of system
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The economic, environmental and social effects arising from a central government's concessional granting of the legal power to create money through fractional reserve banking techniques to the private banks of the world has been subject to much heated political debate for well over two centuries.[35][36][37][38][39]
In contrast to "debt money" (which is money created through the issuance of debt or credit), "true" fiat currency is issued by the Treasury of a central government debt-free, as no requirement for its eventual return is made as a condition of its creation.[40][41] Government-issued debt-free fiat currency (such as debt-free notes and coins) can circulate perpetually in the economy as "stable" or even sound money (if backed by gold or silver) and although not as stable as hard currency, government-issued debt-free notes and coins (such as United States Notes and silver certificates) do not have the same effects of debt-based money described below.[42] It should be noted however that fiat currency can be a source of hyperinflation if its production is not controlled, as the government has the potential to issue unlimited amounts of fiat currency - provided it is accepted as "money" by the private banking system. Notes and coins in circulation (being defined as M0) now account for a tiny fraction of the total M3 money supply in all developed, debt-based capitalist economies (M0 generally being less than 10% of the total M2 money supply in most developed economies).[43][44]
Similarly, gold, silver and other precious metals have in the past been used as debt-free money. Because of the difficulty in increasing the supply of precious metals quickly, some monetary reformers believe a return to the gold standard, or a similar system of "hard" or "real" asset-backed currency, is the only way to stabilize the growth of the money supply. These monetary reformers often refer to the gold standard and silver standard as "sound money" or "honest money".
See also
- Austrian School
- Austrian Business Cycle Theory
- Credit money
- Debt
- Hyman Minsky
- monetary reform
- Murray Rothbard
- Sound money
References
- ^ For an example of the public use of the term, see the speech of the Earl of Caithness in the House of Lords on 5 March 1997
- ^ For an example of the use of the term "debt money", see this example from the "Bible Believers" website
- ^ For an example of the mainstream use of the term "credit" instead of "debt-money" see this example from the Financial Times, 1 May 2008
- ^ Fisher, Irving, 100% Money, Pickering & Chatto Ltd;, ISBN 978-1851962365
{{citation}}: CS1 maint: extra punctuation (link) - ^ Daly, Herman E; Farley, Joshua, Ecological Economics: Principles and Applications, Island Press, p. pg 250, ISBN 1-55963-312-3
{{citation}}:|page=has extra text (help) - ^ Friedman, M., A Program for Monetary Stability, New York, Fordham University Press, 1960, pp. 65
- ^ Murray Rothbard, The Mystery of Banking
- ^ http://books.google.com/books?id=DFv6OzeBWpQC&pg=PP3&dq=steven+horwitz++banking&sig=VZasp_8pGVvpQsFKMI3W9yp4AlM#PPA231,M1 Microfoundations and Macroeconomics: An Austrian Perspective, Steven Horwitz, pp. 223.
- ^ http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=full-reserve+banking AmosWEB, "Full Reserve Banking".
- ^ See, for example, Peter Kennedy, Macroeconomic Essentials: Understanding Economics in the News, p. 133 "The key thing to recognize is that banks create money by extending loans."
- ^ http://books.google.com/books?id=I-49pxHxMh8C&pg=PA303&dq=deposit+reserves&lr=&sig=hMQtESrWP6IBRYiiaZgKwIoDWVk#PPA285,M1 Macroeconomics: A Contemporary Introduction, William A. McEachern, p. 285
- ^ See, for example, Monetary History of the United States, 1867-1960, Milton Friedman, Anna Jacobson Schwartz, p. 123
- ^ http://books.google.com/books?id=ar4-mvqsDpgC&pg=RA1-PA479&dq=deposit+reserves&lr=&sig=VBO4GXUTDAWRMSuM2Kxu_qqBzLc James Tobin, Essays in Economics, p. 479.
- ^ http://books.google.com/books?id=Oco-yeAJhaEC&pg=PA63&lpg=PA63&dq=united+states+empirical+money+multiplier&source=web&ots=OramxjOSGb&sig=Hk0lI1jjWTEL3rqRXRIU4e-R0UE#PPA64,M1 Anna Jacobson Schwartz, Money in Historical Perspective, p. 64
- ^ See, for example, Brookings Papers on Economic Activity: 1, Macroeconomics, edited by William C. Brainard, George L. Perry, p. 149 (Christina Romer and David Romer, "New Evidence on the Monetary Transmission Mechanism").
- ^ http://books.google.com/books?id=Oco-yeAJhaEC&pg=PA24&dq=money+and+business+cycles&lr=&sig=UWFFKAlwUeN7gj08L_dMrR5_gvQ Money in Historical Perspective, Anna Jacobson Schwartz, p. 160
- ^ See, for example, [http://books.google.com/books?id=XVCgcHQS_nQC&printsec=frontcover#PPA76,M1 Milton Friedman, The Optimum Quantity of Money, p. 75
- ^ See, for example, The Pressures on American Monetary Policy, Thomas M. Havrilesky, p. 85
- ^ http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_nov93/bu_1193.pdf Reserve Bank of Australia, The Separation of Debt Management and Monetary Policy, Reserve Bank of Australia Bulletion, November 1993.
- ^ See, for example, [http://www.blacks.veriovps.co.uk/content/3869.html Black's Academy, "The Negative Effects of Inflation".
- ^ See, for example, Abel, Bernanke, and Croushore, Macroeconomics (Presentation for coursework by Dr. Syed Mushtaque Ahmed.
- ^ http://www.capitalspectator.com/archives/2005/11/does_m3_matter.html Capital Spectator, "Does M3 Matter", November 16, 2005.
- ^ http://www.financialsense.com/editorials/hultberg/2005/0919.html Financial Sense, "Is Fractional Reserve Banking Fraudulent?", September 19, 2005.
- ^ See, for example, [[http://gregmankiw.blogspot.com/2006/04/austrian-economics.html Greg Mankiw's Blog, "Austrian Economics", April 3, 2006; as noted in other citations, criticisms of fractional reserve banking are not central to the Austrian School.
- ^ Paul Krugman, writing at Slate.com, says the Austrian theory of business cycles is "about as worthy of serious study as the phlogiston theory of fire". http://www.slate.com/id/9593
- ^ http://books.google.com/books?id=DFv6OzeBWpQC&pg=PP3&dq=steven+horwitz++banking&sig=VZasp_8pGVvpQsFKMI3W9yp4AlM#PPA231,M1 Microfoundations and Macroeconomics: An Austrian Perspective, Steven Horwitz, pp. 223-232.
- ^ For an example of the public use of the term, see the speech of the Earl of Caithness in the House of Lords on 5 March 1997
- ^ Rowbotham, Michael (1998). The Grip of Death: A Study of Modern Money, Debt Slavery and Destructive Economics. Jon Carpenter Publishing. ISBN 9781897766408.
- ^ Antal E. Fekete, The Twilight of Irredeemable Debt
- ^ The Forgotten War
- ^ Cox, Jim (1997). "The Gold Standard". The Concise Guide to Economics (2nd edition ed.). Savannah-Pikeville Press. ISBN 1-57087-292-9. Retrieved 2007-12-15.
{{cite book}}:|edition=has extra text (help); External link in|chapterurl=|chapterurl=ignored (|chapter-url=suggested) (help); Unknown parameter|origdate=ignored (|orig-date=suggested) (help) - ^ A History of Money from Ancient Times to the Present Day by Glyn Davies, rev. ed. Cardiff: University of Wales Press, 1996. ISBN 0 7083 1351 5
- ^ Rowbotham, Michael (1998). The Grip of Death: A Study of Modern Money, Debt Slavery and Destructive Economics. Jon Carpenter Publishing. ISBN 9781897766408.
- ^ Antal E. Fekete, The Twilight of Irredeemable Debt
- ^ Brown, Ellen H. (2007). Web of Debt. Baton Rouge, Louisiana: Third Millennium Press. ISBN 0979560802. Retrieved 2007-12-15.
- ^ Rowbotham, Michael (1998). The Grip of Death: A Study of Modern Money, Debt Slavery and Destructive Economics. Jon Carpenter Publishing. ISBN 9781897766408.
- ^ The Forgotten War
- ^ Antal E. Fekete, Fractional Reserve Banking Revisited
- ^ Antal E. Fekete, The Twilight of Irredemable Debt
- ^ The Forgotten War
- ^ Stephen A. Zarlenga, The Lost Science of Money AMI (2002)
- ^ Honest Money
- ^ Global Money Supply Ratios
- ^ Why the Money Supply Made News
