Tuesday, February 24, 2009

Fractional Reserve Banking and Growth

Very busy week (I guess I can't complain about having more work than I can easily deal with!). As a result, unfortunately, just another quick thought for this week's post (and a day late, at that):

I've just finished reviewing "Crisis of Civilizatoin," a new book by Nafeez Mossadeq Ahmed of the Institute for Policy Research and Development, a London-based think tank. It's an outstanding book, and one that I will review properly on this blog when published and available to the public. In the mean time, however, I want to briefly discuss a comment made by Mr. Ahmed on fractional-reserve banking.

For the past few weeks, I've been hinting that I'm going to return to the causes of our civilization's demand for perpetual growth (formerly discussed in The Problem of Growth). One element, that I hadn't properly considered before reading Mr. Ahmed's book, and that I must now consider more carefully, is the role of fractional-reserve banking.

Put simply, by lending out at interest more "money" than a bank has deposits, the bank creates a situation where significantly more money must be repaid than was borrowed. In order to generate this difference, the community is forced to put the money to growth-oriented tasks, rather than merely borrow money now and save to pay it back. So the firm that borrows money must use it to finance growth--in production, consumption, etc.--in order to generate the money necessary to pay back the principal plus interest. This is fairly straight-forward, of course, but the systemic result of the practice of fractional-reserve banking, when spread throughout society, is that society as a whole must grow in order to have enough incrase in "wealth" to be able to repay its lenders.

Wouldn't simple interest cause this same problem, without considering fractional-reserve banking? The discussion on the rationale behind the prohibition on usury is best left for another day, but the bottom line is that fractional-reserve banking is more than a mere escalation on the catalyst for growth caused by interest alone. Interest is, in theory, equal to the opportunity cost of the lender (as in, the value of what the lender could do with the money) plus the risk of non-payment. So if a lender lends at interest, they are not really creating a catalyst for growth by the act of lending, because it could have used that money for a growth-oriented purpose itself. In actuality, they are only redistributing capital to where it can work more effectivley, and facilitating economic efficiency. Fractional-reserve banking, on the other hand, allows the lender to create far more growth than he himself could have created by putting his own capital to use.

Food for thought for the time being, more on this in the near future...

17 comments:

Matt Goff said...

I recently read a short book called Interest and Inflation Free Money by Margrit Kennedy. It was written in 1995, but seemed fairly applicable still. I found it quite interesting with some compelling arguments. The first chapter makes the argument that the current monetary system will inevitably suffer failure due primarily to compound interest and its consequences. Subsequent chapters provide describe how interest and inflation free money might work, provide arguments for why the change would be beneficial for almost everyone, give examples where such money has been used, and finally offers ideas for how to implement such money on a local and/or regional scale, since getting that sort of change to happen on a global scale seems unlikely.

The book is available for on-line reading. Interest and Inflation free Money

messianicdruid said...

Some more good reading on this subject:

www.hypertiger.blogspot.com

http://goldismoney.info/forums/showthread.php?t=352850

I don't think you can separate usury from fractional reserve banking. They both require you to "take more than you give".

Chase Saunders said...

Simple interest need not be tied to perpetual growth if the growth of the money supply is tied to the growth of actual (non-monetary) wealth. For example, in the good old days, credit became available to a company when it could show a bank increased value in its inventory and pipeline. As I understand it this is how things used to work in the US. Bankers naturally want to see this sort of thing when they aren't incentivized to create endless supply of money (if they don't leverage the competition will) and when their losses aren't insured by taxpayers.

As Matt mentioned, it is also possible to create interest free currencies, including local currencies. Remember, interest-bearing loans were considered "usury" and many past societies have functioned quite well on them. The problem with past systems is not a lot of credit was available, and of course interest is a good thing, for example to retire on. But when you add modern information technology and open source ideas a lot more can be accomplished with an interest free systems, at least in terms of access to local loans. There is a modern system, in Switzerland I think, which has been operating for 40+ years on this principle and has the equivalent of billions of US dollars in it.

IMO the solution is to return US monetary policy to the earlier system where banks create money at their own risk, eliminating the Fed, while simultaneously freeing communities to manage their own interest-free local currencies. free.

A wonderful book that covers both subjects is Money: Understanding and Creating Alternatives to Legal Tender by Thomas Greco

Chase Saunders said...

Whoops, meant to say "many past societies have functioned quite well without them"

In response to messianicdruid, I'd love to see a return to the gold standard but I think it's probably impossible. The very acceptable alternative is any system in which money growth is tied to real wealth creation (and vice versa)... there's a case to be made that this is actually easier without gold as an intermediary (although the nice thing about gold is that it keeps the government honest).

Jeff Vail said...

Ran Prieur has linked to some interesting articles on demurrage currencies, and I've long been a fan of local currencies--I think some form of both will be an essential step in controlling this spiral.

Another point I'm meaning to write about addresses the application of these kinds of tools. I don't think that wholesale adoption of a demurrage currency or a local currency is realistic, and unless presented with a coherent plan for how people are to gradually transition, I think the objection will be along the lines of "what, am I supposed to take my Ithaca Hours (a prominent local currency) to the hospital to pay for my son's appendix to be removed?" I think it's necessary to state to obvious to some extent--to provide a clear plan by which people don't need to pick only A (mainstream existence) or B (completely "off grid"), but rather present a proposal where people can gradually shift to a more local, more resilient personal economy.

Of course, this goes far beyond banking and currency, but I think that is a critical component. An idealized example might be a couple where both have part time "main stream" jobs (preferably as independent contractors) in different industries tied to the global economy, where both also participate directly in production of basic necessities locally (in their yard, at a CSA, etc.), and where their spending is, in order of preference, with local currency to local producers where possible, with global currency to local/regional producers where possible, and with global currency to global providers where necessary.

A bit of a ramble, but I just wanted to briefly tie this discussion back to some main themes of scale-free localization and self-sufficiency. Thanks for the links above, it looks like I have some reading to do...

Philip Bogdonoff said...

Richard Douthwaite has written extensively on this topic:

The Growth Illu$ion: How Economic Growth Has Enriched the Few, Impoverished the Many and Endangered the Planet
http://www.amazon.com/Growth-Illu-ion-Impoverished-Endangered/dp/0865713960/

Short Circuit: Strengthening Local Economics for Security in an Unstable World
http://www.amazon.com/Short-Circuit-Strengthening-Economics-Security/dp/1870098641/

The Ecology of Money
http://www.amazon.com/Ecology-Money-Schumacher-Briefing/dp/1870098811

Big Gav said...

If we're going to throw in links to articles about local currencies I may as well add my own effort (plenty of interesting discussion was generated at TOD) :

http://anz.theoildrum.com/node/4633

David Z said...

You might want to check out some of the "Austrian" economists' writings on the topic of fractional reserve banking if you're going to write more about it in the future. But you've arrived essentially at the Reader's Digest simplification of the problem.

By lending money into existence, growth isn't necessarily "created," so maybe poor choice of words. By lending money into existence, all of the value conveyed by the price system in the market is essentially falsified. Sure, to some extent it arguably stimulates growth, somewhere. But this is basically a zero-sum situation, where the recipient of the newly created money is able to bid a higher price than he previously could've bid, thus encouraging the squandering/misallocation of scarce, productive economic resources.

Anonymous said...

"I've been hinting that I'm going to return to the causes of our civilization's demand for perpetual growth (formerly discussed in The Problem of Growth)."

after reading through your publications - especially "a theory of power" - im excited to hear what you have to say on this topic. i have been digging down a bit after the roots of this issue and came across an interesting piece of the puzzle - Julian Jaynes "Origins of Consciousness in the Breakdown of the Bicameral Mind" puts forth the idea that subjective/reflective consciousness emerged recently as a result of rapid cultural evolution based on the increasing awareness of our world as developed by linguistics and writing. He points out that the poets and authors of ancient literature do not display characteristics of subjective awareness - the drivers of action in the Illiad, for example, are "the gods." Jaynes explains that the origin of authority and human intention/volition were admonitory voices originating in the language centers of the brain, which was "bicamerally" organized.

In order for pre-subjective humans to maintain mental conceptions of tasks and duties (sharpening a stone...) before language evolved the analog "I" for a representation of the "self" there were verbal commands (the voices of the gods) to guide social behavior.

So, civilization originates in a extremely limited perception of humankind's place in the world - the base biological, unconscious urges to seek safety, propagate through sex, dominate others in hierarchal societies (a common primate model) hoard and consume "resources" endlessly, and expand the one's influence in the assumption that the "self" as percieved by limited and inchoate bicameral and then subjective awareness was the goal/purpose of life. So our most complex cultural elements of social relation (banking, violent competition for resources, etc) are hypertrophic manifestations built up on what now appears - oblivously to some of us - to be fallicies of our nature and place in evolution.

Many spiritual traditions, sages, and cultures have retained many elements of this selflessness through time (the word of Christ, Eastern mystic enlightenment, etc) but until recently the forces of natural selection working at the memetic level allowed cultures based on subjective perception/hierarchy/civilization to persist. Now that civilization is collapsing we can see the resurgence of the importance of these memes throughout culture, especially in popular music: "So crucify the ego
Before it's far too late
To leave behind this place so
Negative and blind and cynical

And we will come to find
That we are all one mind
Capable of all that's
Imagined and all conceivable

Just let the light touch you
And let the words spill through
Just let them pass right through,
Bringing out our hope and reason."

- from the popular rock n roll band, "Tool"

So, civilization's demand for perpetual growth is rooted in basic primate biology which lead us into culturally-reinforced consumptive, goal-oriented behavior in service of hollow, absurd goals.

Perhaps as civilization rapidily continues to collapse (that whole climate change/global change thingy is going to get real, real bad quite soon) the recalcitrant memes of experience-orientated behavior and collective consciousness will be retained in a significant enough/well connected population of humans to pull them through the collapse. Or, as Trent Reznor sings it:
"and you never get away
and you never get to take the easy way

and all of this is a consequence
brought on by our own hand

if you believe in that sort of thing

and did you ever really find
when you closed your eyes
any place that was still
and at peace

and i guess i just wanted to tell you
as the lights start to fade
that you are the reason
that i am not afraid
and i guess i just wanted to mention
as the heavens will fall
we will be together soon if we
will be anything at all"

;)

-ryan king

Aaron said...

There's much more to learn.

I would like to refer you to the following economists:

Michael Hudson (More HERE)

Mark Anielski

Anonymous said...

Banking currently creates money from nothing digitally, this means bankers have not accumulated money from hard work, nor do they have a opportunity cost...if they were to put the money to work themselves, they would risk loss in business, they would have to labour make plans and compete.

The banks represent the ultimate case of parasitic behavior "let me do little and get others to work for me". They distort the whole of society with their operations, they will loan money to anti-social businesses, destructive businesses if it means they get a 'return' on their loan. Bankers are criminals, they loan to governments which create the National Debt (taxation is collected to pay the interest on this National Debt), the governments are encouraged to wage wars, because bankers can loan more money to governments...this is the nature of The State.

King of the Paupers said...

"Put simply, by lending out at interest more "money" than a bank has deposits, the bank creates a situation where significantly more money must be repaid than was borrowed."
Jct: Everyone borrows the Principal P into existence, everyone's owed P+I with interest. That's why it's called mort-gage from the French "mort" meaning "death" and "gage" meaning "gamble." There's never enough chips in the economic pool for everyone to repay both the principal they all got out of the pumphouse and the interest that was never created but is nevertheless owed to the pumphouse. It's an elimination deathgamble with the banks doing to morting on losing businesses. Foreclosure of the collateral backing up the chips causes the same money to chase less collateral, Shift B inflation, not more money chasing the collateral, Shift A inflation. See my youtube video "Shift B inflation" for the full analysis.
"In order to generate this difference, the community is forced to put the money to growth-oriented tasks, rather than merely borrow money now and save to pay it back. So the firm that borrows money must use it to finance growth--in production, consumption, etc.--in order to generate the money necessary to pay back the principal plus interest. This is fairly straight-forward, of course, but the systemic result of the practice of fractional-reserve banking, when spread throughout society, is that society as a whole must grow in order to have enough incrase in "wealth" to be able to repay its lenders.

Jct: And eternal exponential growth is impossible.

Matt Goff said:
'I recently read a short book called Interest and Inflation Free Money by Margrit Kennedy. It was written in 1995, but seemed fairly applicable still. I found it quite interesting with some compelling arguments."

Jct: Compelling arguments to run money like poker chips is an easiest model to explain her banking systems engineering is right.

Chase Saunders said:
"As Matt mentioned, it is also possible to create interest free currencies, including local currencies."
Jct: I was consulting engineer on the first LETS Local Employment-Trading Software and since the timebank tokens were available interest-free, I financed it's development.
Best of all, peg your local currency to the Time Standard of Money (how many dollars/hour child labor) and Hours earned locally can be intertraded with other timebanks globally!
In 1999, I paid for 39/40 nights in Europe with an IOU for a night back in Canada worth 5 Hours.
U.N. Millennium Declaration UNILETS Resolution C6 to governments is for a time-based currency to restructure the global financial architecture.
See my banking systems engineering analysis at http://youtube.com/kingofthepaupers with an index of articles at http://johnturmel.com/kotp.htm
Big Gav said...
"If we're going to throw in links to articles about local currencies I may as well add my own effort (plenty of interesting discussion was generated at TOD)" http://anz.theoildrum.com/node/4633

Jct: Wow. Quite the article. What I dislike are the constant references to the negative interest demurrage charges to spur activity. Chips run right need no such spur and having tokens whose value remains stable (an Hour of labor is best) is far smarter than having chips whose value changes!

prunes said...

Jeff: the best analysis of the effects of fractional reserve banking in general that I have read is the book 'Money, Bank Credit, and Economic Cycles' by Jesús Huerta de Soto.
He illustrates how inflation is induced by banks utilizing fractional reserve lending, the bank's profit comes from making investments with more than they actually have (non-liquid assets.) This mathematical/accounting content is delivered in the context of historical examinations of the fractional reserve banking practice, which I found fascinating, as he translates from Roman legal writings on the matter The practice has been banned periodically every time it's cropped up until modern times.
Anyway, the book is hefty but it's still the clearest (and deepest) exposition of the topic I've been able to find.

Theo_musher said...

When it comes right down to it what you are calling growth is simply an increase in intelligent organization.

Banks obviously can't just keep lending money to businesses that fail. People from the perspective of the Austrian School really hate fractional reserve banking, because they equate it with creating money out of thin air. Its doesn't seem fair. Its like a visceral reaction. But banks don't just create money out of thin air. They have to take intelligent risks. They have to lend money to people with good ideas.

If for example, they lend money to people with a stupid idea like giving mortgages to people who can't afford to pay them, and then spreading these bad mortgages all over the place inside complex financial instruments the banks risk going bust as we have just seen.

So the banks aren't omnipotent are they?

If there was no increase in intelligence over time there could be no growth. Why do you miss that part of the equation?

Its not just the exploitation of resources that creates growth. It not just matter. Its intelligence.

Theo_musher said...

Put simply, by lending out at interest more "money" than a bank has deposits, the bank creates a situation where significantly more money must be repaid than was borrowed.

I don't see how. they pay back the principle plus the interest. I don't see how the fraction of the actual reserve enters the equation from the perspective of the borrower. Most people don't even know how fractional reserve banking works. So how would that affect their decision making?

In order to generate this difference, the community is forced to put the money to growth-oriented tasks, rather than merely borrow money now and save to pay it back.

Again I don't follow you. To the borrower a dollar is a dollar. It may be only pennies on the dollar in terms the banks actual deposits but it still spends the same.


So the firm that borrows money must use it to finance growth--in production, consumption, etc.--in order to generate the money necessary to pay back the principal plus interest.

Right. They would have to do that anyway. They have to grow in order to pay back the interest. They have to grow in order to make a profit also. They can't just grow enough to pay back the principal and interest. You seem to be arguing for banks lending money at no interest rather than arguing against fractional reserve banking.

This is fairly straight-forward, of course, but the systemic result of the practice of fractional-reserve banking, when spread throughout society, is that society as a whole must grow in order to have enough incrase in "wealth" to be able to repay its lenders.

It's not straightforward to me the way you are describing this.

Wouldn't simple interest cause this same problem, without considering fractional-reserve banking?

Yes. So far you haven't explained anything about the effects of fractional reserve banking itself, imo.

The discussion on the rationale behind the prohibition on usury is best left for another day, but the bottom line is that fractional-reserve banking is more than a mere escalation on the catalyst for growth caused by interest alone. Interest is, in theory, equal to the opportunity cost of the lender (as in, the value of what the lender could do with the money) plus the risk of non-payment. So if a lender lends at interest, they are not really creating a catalyst for growth by the act of lending, because it could have used that money for a growth-oriented purpose itself. In actuality, they are only redistributing capital to where it can work more effectivley, and facilitating economic efficiency. Fractional-reserve banking, on the other hand, allows the lender to create far more growth than he himself could have created by putting his own capital to use.

Well...The opportunity cost thing is just something that hearkens back to an earlier time in history. The bank is designed to lend money. Its not like they are going to go into manufacturing or anything. I mean they used to have vaults full of gold too.

Fractional reserve banking just spreads out the risk. They are really only lending out a few pennies, but then they get several times that back plus interest. If its a bad loan they lose pennies on the dollar.

If they lent out the actual money plus interest without doing fractional reserve banking and it was a bad loan, they would be out the full value of the actual money in reserve, plus they would have missed out on making a return. But hopefully their other loans would work out.

If they lent just the actual real money straight from their reserves and no interest, no one would lend anyone any money.

It would be too risky. So then the economy would be totally stagnant. I guess that would be good for people that don't like change, but if there was anything in society you wanted to change it would have to be really slow. No one could move up economically. Stratified social classes would remain stratified.

Do you see any connection between Moslem nations and lending money without interest?

Fractional reserve banking helps the economy grow by making lending less risky. But the economy still can only grow based on good ideas.

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