The Mystery of Banking

Free banking, then, will inevitably be a regime of hard money and virtually no inflation. In contrast, the essential purpose of central banking is to use government privilege to remove the limitations placed by free banking on monetary and bank credit inflation. The Central Bank is either government-owned and operated, or else especially privileged by the central government. In any case, the Central Bank receives from the government the monopoly privilege for issuing bank notes or cash, while other, privately-owned commercial banks are only permitted to issue demand liabilities in the form of checking deposits. In some cases, the government treasury itself continues to issue paper money as well, but classically the Central Bank is given the sole privilege of issuing paper money in the form of bank notes—Bank of England notes, Federal Reserve Notes, and so forth. If the client of a commercial bank wants to cash in his deposits for paper money, he cannot then obtain notes from his own bank, for that bank is not permitted to issue them. His bank would have to obtain the paper money from the Central Bank. The bank could only obtain such Central Bank cash by buying it, that is, either by selling the Central Bank various assets it agrees to buy, or by drawing down its own checking account with the Central Bank.

For we have to realize that the Central Bank is a bankers’ bank. Just as the public keeps checking accounts with commercial banks, so all or at least most of them keep checking accounts with the Central Bank. These checking accounts, or “demand deposits at the Central Bank,” are drawn down to buy cash when the banks’ own depositors demand redemption in cash.

To see how this process works, let us take a commercial bank, the Martin Bank, which has an account at the Central Bank (Figure 9.1).

FIGURE 9.1 — CENTRAL BANKING

We are ignoring Central Bank notes kept for daily transactions in the Martin Bank’s vault, which will be a small fraction of its account with the Central Bank. Also, we see that the Martin Bank holds little or no gold. A vital feature of classical central banking is that even when the banking system remains on the gold standard, virtually all bank holdings of gold are centralized into the Central Bank.

In Figure 9.1, the Martin Bank is practicing fractional reserve banking. It has pyramided $5 million of warehouse receipts on top of $1 million of reserves. Its reserves consist of its checking account with the Central Bank, which are its own warehouse receipts for cash. Its fractional reserve is 1/5, so that it has pyramided 5:1 on top of its reserves.

Now suppose that depositors at the Martin Bank wish to redeem $500,000 of their demand deposits into cash. The only cash (assuming that they don’t insist on gold) they can obtain is Central Bank notes. But to obtain them, the Martin Bank has to go to the Central Bank and draw down its account by $500,000. In that case, the transactions are as follows (Figure 9.2).

FIGURE 9.2 — DRAWING DOWN RESERVES

In a regime of free banking, the more frequently that bank clients desire to shift from deposits to notes need not cause any change in the total money supply. If the customers of the Martin Bank were simply willing to shift $500,000 of demand liabilities from deposits to notes (or vice versa), only the form of the bank’s liabilities would change. But in this case, the need to go to the Central Bank to purchase notes means that Martin Bank reserves are drawn down by the same amount as its liabilities, which means that its fraction of reserves/deposits is lowered considerably. For now its reserves are $500,000 and its demand deposits $4.5 million, the fraction having fallen from 1/5 to 1/9. From the point of view of the Central Bank itself, however, nothing has changed except the form of its liabilities. It has $500,000 less owed to the Martin Bank in its demand deposits, and instead it has printed $500,000 of new Central Bank notes, which are now redeemable in gold to members of the public, who can cash them in through their banks or perhaps at the offices of the Central Bank itself.

If nothing has changed for the Central Bank itself, neither has the total money supply changed. For in the country as a whole, there are now $500,000 less of Martin Bank deposits as part of the money supply, compensated by $500,000 more in Central Bank notes. Only the form, not the total amount, of money has changed.

But this is only the immediate effect of the cashing in of bank deposits. For, as we have noted, the Martin Bank’s fraction of reserves/deposits has been sharply lowered. Generally, under central banking, a bank will maintain a certain fraction of reserves/deposits, either because it is legally forced to do so, as it is in the United States, or because that is the custom based on market experience. (Such a custom will also prevail—at significantly far higher fractions—under free banking.) If the Martin Bank wishes to or must remain at a fraction of 1/5, it will meet this situation by sharply contracting its loans and selling its assets until the 1/5 fraction is restored. But if its reserves are now down to $500,000 from $1,000,000, it will then wish to contract its demand deposits outstanding from $4.5 million to $2.5 million. It will do so by failing to renew its loans, by rediscounting its IOUs to other financial institutions, and by selling its bonds and other assets on the market. In this way, by contracting its holding of IOUs and deposits, it will contract down to $2.5 million. The upshot is shown in Figure 9.3.

But this means that the Martin Bank has contracted its contribution to the total money supply of the country by $2.5 million.

The Central Bank has $500,000 more in outstanding bank notes in the hands of the public, for a net decrease in the total money supply of $2 million. In short, under central banking, a demand for cash—and the subsequent issue of new cash—has the paradoxical effect of lowering the money supply, because of the banks’ need to maintain their reserve/deposit ratios. In contrast, the deposit of cash by the public will have the opposite inflationary effect, for the banks’ reserve/deposit ratio will rise, and the banks will be able to expand their loans and issues of new deposits. Figure 9.4 shows how this works. Let us take the original Martin Bank balance sheet of Figure 9.1. People decide to deposit $500,000 of their previously issued Central Bank notes and get the equivalent in checking accounts instead. The Martin Bank’s balance sheet will change as follows (Figure 9.4):

FIGURE 9.3 — ULTIMATE RESULT OF DRAWING DOWN RESERVES

FIGURE 9.4 — DEPOSITING CASH: PHASE I

But then, the Martin Bank will take this bonanza of cash and deposit it at the Central Bank, adding to its cherished account at the Central Bank, as shown in Figure 9.5:

FIGURE 9.5 — DEPOSITING CASH: PHASE II

But now, in Step 3, the banks will undoubtedly try to maintain their preferred 1/5 ratio. After all, excess reserves beyond the legal or customary fraction is burning a hole in the bank’s pocket; banks make money by creating new money and lending it out. After Step 2, the Martin Bank’s fractional reserve ratio is $1.5/$5.5, or a little over 27 percent, as compared to the preferred 20 percent. It will therefore expand its loans and issue new deposits until it is back down to its preferred 1/5 ratio. In short, it will pyramid 5:1 on top of its new total reserves of $1.5 million. The result will be Step 3 (Figure 9.6).

FIGURE 9.6 — DEPOSITING CASH: PHASE III

The Martin Bank has expanded its contribution to the money supply by $2.5 million over its original $5 million. As for the Central Bank, its own notes outstanding have declined by $500,000. This amount was received in cash from the Martin Bank, and the Martin Bank account at the Central Bank is credited by an increased $500,000 in return. The Central Bank notes themselves were simply retired and burned, since these obligations were returned to their issuer. The Central Bank balance sheet has changed as follows (Figure 9.7):

FIGURE 9.7 — DEPOSITING CASH: THE CENTRAL BANK

Thus, as a result of $500,000 of cash being deposited in the banks by the public, the Martin Bank has created $2.5 million in new bank deposits, the Central Bank has decreased its notes outstanding by $500,000, and the net result is a $2 million increase in the money supply. Again, paradoxically, a drop in paper money outstanding has led to a multiple expansion in the supply of money (paper money + bank demand deposits) in the country.

We should note, by the way, that the total money supply only includes money held by the public (demand deposits + Central Bank notes). It does not include demand deposits of the banks at the Central Bank or vault cash held by the banks, for this money is simply held in reserve against outstanding (and greater) components of the money supply. To include intrabank cash or deposits as part of the money supply would be double counting, just as it would have been double counting to include both gold in the banks and warehouse receipts for gold as part of the money supply. Warehouse receipts are surrogates for reserves, even when they are pyramided on top of them, so that reserves cannot also be included in an account of the supply of money.

Under central banking, then, the total supply of money, M, equals cash in the hands of the public plus demand deposits owned by the public. Cash, in turn, consists of gold coin or bullion among the public, plus Central Bank notes. Or, putting this in equation form,

M = gold in public + Central Bank notes in public + Demand deposits of the commercial banks

When a nation is taken off the gold standard, gold dollars or francs are no longer part of the money supply, and so the money supply equation becomes (as it is in the United States and all other countries now):

M = Central Bank notes + Demand deposits

It is clear that, even under central banking, if the public is or becomes unwilling to hold any money in bank deposits or notes and insists on using only gold, the inflationary potential of the banking system will be severely limited. Even if the public insists on holding bank notes rather than deposits, fractional reserve bank expansion will be highly limited. The more the public is willing to hold checking accounts rather than cash, the greater the inflationary potential of the central banking system.

But what of the other limits on bank inflation that existed under free banking? True, the Central Bank—at least under the gold standard—can still go bankrupt if the public insists on cashing in their deposits and Central Bank paper for gold. But, given the prestige of the Central Bank conferred by government, and with government using the Central Bank for its own deposits and conferring the monopoly privilege of note issue, such bankruptcy will be most unlikely. Certainly the parameters of bank inflation have been greatly widened. Furthermore, in most cases government has conferred another crucial privilege on the Central Bank: making its notes legal tender for all debts in money. Then, if A has contracted with B for a debt of $10,000 in money, B has to accept payment in Central Bank notes; he cannot insist, for example, on gold. All this is important in propping up the Central Bank and its associated commercial banks.

What of the dread bank run? Cannot a bank still be subjected to drastic loss of confidence by its clients, and hence demands for redemption, either in gold or in Central Bank notes? Yes, it can, under the gold standard, and bank runs often swept through the American banking system until 1933. But under central banking as contrasted to free banking, the Central Bank stands ready at all times to lend its vast prestige and resources—to be, as the Englishman Walter Bagehot called it in the mid-nineteenth century—a lender of last resort. In the tradition of central banking, the Central Bank always stands ready to bail out banks in trouble, to provide them with reserves by purchasing their assets or lending them reserves. In that way, the Central Bank can help the banks through most storms.

But what of the severe free market limits on the expansion of any bank? Won’t an expanding Bank A quickly lose reserves to Bank B, and face bankruptcy? Yes, as in free banking, one bank’s expansion will meet a severe shock by other banks calling upon it for redemption. But now, under central banking, all banks can expand together, on top of new reserves that are pumped in, across the board, by the benevolent Central Bank. Thus, if Bank A and Bank B each increase their reserves, and both expand on top of such reserves, then neither will lose reserves on net to the other, because the redemption of each will cancel the other redemption out.

Through its centralization of gold, and especially through its monopoly of note issue, the Central Bank can see to it that all banks in the country can inflate harmoniously and uniformly together. The Central Bank eliminates hard and noninflated money, and substitutes a coordinated bank credit inflation throughout the nation. That is precisely its purpose. In short, the Central Bank functions as a government cartelizing device to coordinate the banks so that they can evade the restrictions of free markets and free banking and inflate uniformly together. The banks do not chafe under central banking control; instead, they lobby for and welcome it. It is their passport to inflation and easy money.

Since banks are more or less released from such limitations of free banking as bank runs and redemption by other banks by the actions of the Central Bank, the only remaining limitation on credit inflation is the legal or customary minimum reserve ratio a bank keeps of total reserves/total deposits. In the United States since the Civil War, these minimal fractions are legal reserve requirements. In all except the most unusual times, the banks, freed of all restrictions except reserve requirements, keep “fully loaned up,” that is, they pyramid to the maximum permissible amount on top of their total reserves. Suppose, then, that we aggregate all the commercial banks in the country in one set of T-accounts, and also consider the Central Bank T-account. Let us assume that, in some way or other, total bank reserves, in the form of demand deposits at the Central Bank, increase by $1 billion, that the legal minimum reserve ratio is 1/5, and that the banks make it a practice to keep fully loaned up, that is, always pyramiding 5:1 on top of total reserves. What then happens is shown in Figure 9.8.

We have not finished the Central Bank balance sheet because we have not yet explored how the increase in commercial bank reserves has come about. But whichever way, the banks’ fraction of total reserves to demand deposits is now higher, and they can and do expand their credit by another $4 billion and therefore their demand deposits by a total of $5 billion. They do so by writing out new or increased demand deposits out of thin air (as fake warehouse receipts for cash) and lending them out or buying IOUs with that new “money.” This can be seen in Step 2 (Figure 9.9).

FIGURE 9.8 — INCREASING BANK RESERVES

FIGURE 9.9 — PYRAMIDING ON TOP OF NEW RESERVES

Thus, an increase of $1 billion in total commercial bank reserves has led, over a short period of time, to a $5 billion increase in demand deposits, and hence in the total money supply of the country.

If banks remain fully loaned up, then the amount that, in the aggregate, they will pyramid on top of reserves can be precisely known: It is the inverse of the minimum reserve requirement. Thus, if the legal reserve requirement is 1/5 (total reserves/total deposits), the banks will be able to pyramid 5:1 on top of new reserves. If the reserve requirement is 1/10, then the banks will be able to pyramid 10:1 on top of total new reserves. The amount banks can pyramid new deposits on top of reserves is called the money multiplier, which is the inverse of the minimum reserve requirement. In short,

MM (money multiplier) =1/reserve requirement

If the banks remain fully loaned up then, we can alter our equation for the nation’s money supply to the following:

M = Cash + (total bank reserves x MM)

Since banks earn their profits by creating new money and lending it out, banks will keep fully loaned up unless highly unusual circumstances prevail. Since the origin of the Federal Reserve System, U.S. banks have remained fully loaned up except during the Great Depression of the 1930s, when banks were understandably fearful of bankruptcies crashing around them, and could find few borrowers who could be trusted to remain solvent and repay the loan. In that era, the banks allowed excess reserves to pile up, that is, reserves upon which they did not pyramid loans and deposits by the legally permissible money multiplier.

The determinants of the money supply under central banking, then, are reserve requirements and total reserves. The Central Bank can determine the amount of the money supply at any time by manipulating and controlling either the reserve requirements and/or the total of commercial bank reserves.

In the United States, Congressional statute and Federal Reserve Board dictation combine to fix legal reserve requirements. Let us see what happens when a reserve requirement is changed. Suppose that the Fed cuts the reserve requirement in half, from 20 percent to 10 percent—a seemingly extreme example which has, however, been realistic at various times in American history. Let us see the results. Figure 9.10 assumes a hypothetical balance sheet for commercial banks, with the banks fully loaned up to the 5:1 money multiplier.

FIGURE 9.10 — BANKS, RESERVE REQUIREMENT AT 20 PERCENT

The banks are fully loaned up, with total reserves of $10 billion in legal reserve requirement at 20 percent, and demand deposits therefore at $50 billion.

Now, in Figure 9.11, we see what happens when the Fed lowers the reserve requirement to 10 percent. Because of the halving of reserve requirements, the banks have now expanded another $50 billion of loans and investments (IOUs), thereby increasing demand deposits by another $50 billion. Total demand deposits in the country are now $100 billion, and the total money supply has now increased by $50 billion.

FIGURE 9.11 — LOWERING THE RESERVE REQUIREMENT

One way for the Central Bank to inflate bank money and the money supply, then, is to lower the fractional reserve requirement. When the Federal Reserve System was established in 1913, the Fed lowered reserve requirements from 21 percent to 10 percent by 1917, thereby enabling a concurrent doubling of the money supply at the advent of World War I.

In 1936 and 1937, after four years of money and price inflation during an unprecedentedly severe depression under the New Deal, the Fed, frightened at a piling up of excess reserves that could later explode in inflation, quickly doubled bank reserve requirements, from approximately 10 percent to 20 percent.

Frightened that this doubling helped to precipitate the severe recession of 1938, the Fed has since been very cautious about changing reserve requirements, usually doing so by only 1/4 to 1/2 of 1 percent at a time. Generally, true to the inflationary nature of all central banking, the Fed has lowered requirements. Raising reserve requirements, then, is contractionary and deflationary; lowering them is inflationary. But since the Fed’s actions in this area are cautious and gradual, the Fed’s most important day-to-day instrument of control of the money supply has been to fix and determine total bank reserves.