If banks would not be allowed to lend out more than what they have in terms of deposits, or if they would only be allowed to lend out twice that amount, what would be the most significant difference with the current fractional reserve system (in which the cash-reserve ratio can be as high as 1:9)?
I’m reading that the current system increases the availability of credit, which in turn helps the economy to grow. But if banks would only be allowed to lend out half of what they are currently lending out, wouldn’t the supply of money simply go down, and thus the value of money up, effectively leaving banks with the same lending power?
Current system:
- Total amount of money in circulation: central bank money x money multiplier. Most money is created by commercial banks.
Alternative system:
- Total amount of money in circulation: central bank money. All money is created by central banks.
I’m not asking what would happen if this would change over night (e.g. sudden decrease of money, monster deflation etc.). I’m asking what is the benefit (and to whom) of doing it the way it is currently done.
When money is loaned into existence, both the supply and the demand are created at the same time. When there are real investment opportunities (opportunities to make money by expanding production and improving productivity) allowing the money supply to expand makes it easier for expansion to occur. The problem is when such opportunities are thinned out, and people just start rent seeking for want of real investment opportunities. At this point cheap credit fuels not expansion, but just pushes up prices of existing resources and facilitates the transfer of wealth into the hands of people that already have wealth to use as collateral.
Your suggestion would create a money supply that was fixed until and unless whoever happened to be in control of the central bank for whatever political reason decides to expand it. It also has no means of contracting the money supply, not as stated. The current systems relies on financial institutions presumably needing to be paid back, and thus generally issuing loans when repayment looks likely (which will sometimes be a good business plan). This keeps the decision as close to the business reality as you can, making borrowers and lenders the eyes and ears of the system. Centralize that, and you cut off an enormous supply of information, information absolutely necessary to make these decisions.
Personally, I think the problem with the current system isn’t a banking problem, but a problem of rent seeking opportunities just being left out there to serve as sources of private revenue. It’s the equivalent of selling tax farming contracts but then letting the taxman keep everything they take. Start treating them as sources of public revenue (start with land value taxation), and you won’t have banks making loans for non productive “investments”. Without these opportunities, there would be no basis to continue making loans when there aren’t any real investment opportunities to put that money into. The credit supply would naturally wax and wane with the rest of the economy.
Most “money” exists as credit. It allows the central bank to control the growth of the money supply. The higher leverage allows more loans, that go into making things. It ultimately allows our economy to grow faster.
Yeah, but how would banks have less lending power if they would only be allowed to lend out half. Wouldn’t that simply reduce the amount of money in circulation and thus increase the value of money?
Velocity of money is one of the most vital monetary policy concepts. The more time/faster money flows through the economy the more things are bought with each dollar. Fraction reserves means if your bank is allowed to lend 90% of what is deposited. That gets spent and deposited somewhere else where 90% of it is spent and so on down the line.
This keeps cash flowing and available throughout the economy. When people feel like they can no longer access funds for things, they stop spending money. People spending money is what keeps the economy working. Keeps everyone employed, making products and providing services.
It’s pivotal to our entire current economic system and changing it would have severe ramifications. I don’t entirely agree with how credit, fractional reserves and leverage is used today. But there’s no denying changing it would be painful.
But if banks would only be allowed to lend out half of what they are currently lending out, wouldn’t the supply of money simply go down, and thus the value of money up, effectively leaving banks with the same lending power?
Well that leads to deflation and it’s bad.
While money is often a representation of wealth, ultimately, money is just a medium of exchange. Think of it as the blood of the economy. Pooling the blood in 1 location isnt beneficial for anything, you want money flowing all over as much as possible and this is facilitated through fractional reserve. The only time you dont want money flowing everywhere, is if you have high inflation, in which case you take measures that restrict the availability/flowing of money.
Even if you could slowly and carefully raise the ratio, why do you want a higher reserve ratio? What does that achieve? Ideally, you want 0 money being unused, though for practical reasons(people being able to withdraw money when they want to), you want to keep some money in the vault.
To think of it in a more conventional terms, imagine if a company had really deep stock of shoes. You dont want to store 1 million pairs of shoes in case 1 million people suddenly decide to buy shoes in 1 day. You only want to keep in storage as many shoes you sell on average, + a percentage. Sometimes this will lead to supply chain issues, like with covid, but 99.9% of the time, it works great.
In the words of the ancient greek philosopher Chrome “unused memory is wasted memory”. The same principle applies to money.
