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What limits the amount of money that can be put into an efficient reserve banking system?
Is it (A) the amount of money that is in existence or (B) the amount of money that can be used profitably?
Surprise -- the answer is (B).
If a bank doesn't have any money on hand -- the bank manager simply agrees to create money for a borrower by making a loan to that borrower who promises to use the money wisely and pay it back at some future date.
When the loan is paid back, the new money is extinguished.
Why should it be otherwise?
Shouldn't there be as much money available as (a) can be borrowed, (b) used to create wealth and (c) paid back?
That is one of the wonderful parts of fractional reserve banking -- as long as there are qualified borrowers available -- the system will provide whatever amount of money they need.
Why would anyone design a system where qualified lenders went begging?
I know this is a little mind boggling. Because of the laws of physics, we all tend to think (a) you can't make something from nothing. That is fallacious thinking.
In fact, laws of physics teach that Matter and Energy can neither be created nor destroyed -- but they can be made to change form.
Reserve banking essentially allows wealth to change form. A farmer can turn money into turnips and back again to more money if that farmer uses borrowed money to grow turnips that he sells for more money than he borrowed. Doesn't that make sense? (this a restatement of (i) at B-7)
But what about the theories of the Austrian School of Economics?
I think they teach that adding money to a monetary system always causes inflation. That would be true if the added money did not create wealth. But if the new money is created as a loan and that money creates enough wealth to pay the money back and still have a surplus -- there will be no inflation.
I know creating money by loans seems weird. But how would you place new money into the system without making a loan? -- would you simply give the money away? If you did that, it would be inflationary as taught by The Austrian School. But lending the money eliminates that problem of inflation since the debt has to be paid back -- thus canceling the surplus money and leaving the surplus wealth that was created with the loan.
Of course the government could spend the money into circulation by buying needed infrastructure, but that raises all sorts of problems. Who would decide which projects to fund? I think it is simply easier to lend money to borrowers who would a-prioi prove to the government that the project will wind up creating wealth beyond the cost of the project.
Martin R. Carbone -- 9/23/08
NOTE -- Heretofore, we always used the phrase "fractional reserve banking," but we just realized the word "fractional" is a misleading, superfluous, empty word -- it has no relevant meaning in the context of lending and banking. Under the system described above, there are no "reserves". Nothing is held back by the bank as a "reserve" that somehow protects or insures a loan.
When a loan is made, the amount of the loan is entered on the banks books as an asset -- a "note receivable". That asset essentially becomes the basic collateral for the loan (of course, the bank can prudently demand additional collateral if they think that is necessary).
In other words, all loans create their own collateral if the loan documents are written with that stipulation. Such a stipulation would give the bank the right to seize all assets that are generated by the loan. We assume all auto loans, all capital equipment loans and all construction loans have that stipulation.
In general, all U.S. banks currently operate on a 10% (or less) fractional reserve. As we see it, because each loan can generate its own collateral -- it would make no difference to the amount of money a bank can lend if the reserve were 100% or 0%.
Please let us know if you think our logic is faulty with regard to this note.
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