Sunday, November 7, 2010

In Which we (Fail to)* Explain Fractional Reserve Banking (but possibly explain something else)

Talking of set theory (as I was yesterday in the introduction to the post), the intersection of the set of regular readers of this blog with the set of people who know less about economics than me is also likely to be very small indeed. In any case, those who know something about economics may well find the following painful reading. It derives from an attempt to explain the subject to myself while cycling up a tall and steep mountain:

If I lend my friend Sam €10 (I don't seem to have a pound sign) to buy a blouse she's seen in Zara and wants for Friday night but she only has a Saturday job and won't have the money before then, she gets her blouse and I am out a tenner, at least until Saturday.

Or am I?

Later, feeling peckish, I go down the road to the market to see my friend Tony at the chicken stall. Let me have a chicken, I say, and I'll pay you on Saturday, because Sam's going to give me €10. Ok, he says. Now Sam has her blouse, I have my lunch, and that €10 has been spent twice.

My friend Tony, on the strength of the sale, is feeling chipper and buys some earrings for his wife, who is made happy by them, and in consequence she makes Tony happy.

The €10 has now been spent three times, everyone involved has what they wanted and is happier because of it. But money has not in fact been created. My original €10 has not become €30. What has been created is liquidity. A chain of possibilities has been called into being, virtual money, a chain which collapses back on itself on Saturday when Sam goes to work, gets paid, gives me €10 which I pass on to Tony, and he puts them back in the account he took them from. Now there is are just €10 again, sitting in Tony's bank, but the goods that have changed hands, and the happiness caused by those exchanges, are real and continue to exist.

The key to all this is confidence. I am sure that Sam will pay me back, and Tony knows I'll pay him. (If he really wanted he could get me to sign soemthing, but in fact his knowledge that I will have the money and will give it to him is worth more than a piece of paper.) But what if he doesn't have that certainty.

What if he thinks €10 is too much to give on credit? For whatever reason. He tells me he can't let me have a whole chicken, but he can do me a leg. A leg is not lunch, so I give him the money, Sam doesn't get her blouse, Amancio Ortega doesn't get a bit richer and his employees get a slightly smaller bonus. Tony gets his money, but he sticks to it, so his wife doesn't get her earrings, and Tony doesn't get... whatever he might have had.

Or perhaps I munch a chicken leg so Sam can have her blouse, but, because I may have to go hungry, I decide that if Sam really wants her blouse she can pay me back €11, instead of the €10. I have put a price on my inconvenience, my risk. Either way, the lack of confidence of one or other of us has left us all without the things, and the contentment, we might otherwise have had. Liquidity has been lost.

And that, boys and girls, is the idea behind fractional reserve banking (er no, it isn't*), the multiplier effect, and the fact that greedy bankers can't get rich, and much less cause a recession, unless there are lots of other greedy people squealing for money they might not be able to pay back. Welcome to the economy, boys and girls- we're all in this together.

Is any of this even remotely accurate?

*Mark Wadsworth, in the comments, patiently explains that I haven't said anything about FRB, which is a different matter entirely.


Mark Wadsworth said...

In cash flow terms, spot on.

But this has nothing to do with "FRB" which is a bit of a myth (a bit like explaining that you 'suck' a drink through a straw; you actually create a vacuum and atmospheric pressure pushes the drink into your mouth).

1. There is no such thing as 'money' in itself, there is merely a vast mass of financial liabilities and financial assets, which inevitably net off to plus/minus zero.

2. Contrary to popular myth, banks do NOT 'take deposits from savers and lend to borrowers', what they just do is just make loans willy nilly, safe in the knowledge that whoever receives that money will put it back in the bank. In other words, loans create deposits. Up until the stage when people realise that banks have been making reckless loans which won't be repaid and the whole system grinds to a halt.

3. There is an upper limit to the amount of 'money' that people are prepared to borrow (i.e. take on a liability) and an upper limit to the amount of 'money' that people are willing or able to entrust to banks (and therefore an upper limit to the amount of money that banks can lend).

4. Even if the Basel capital ratios or minimum cash ratios were reduced from 8% to 0.8% or even to 0%, this would not increase the amount of 'money' sloshing around by a factor of ten or even infinity, because the upper limit to this is set in step 3 above.

CIngram said...

Thanks for dropping by. And for the explanations. The more I argue about politics the more I realise that I don't understand money/finance/the economy, not even at a very basic level. Neither do most of the people I argue with, fortunately.

What I was trying to understand in this little story was the apparent creation (by banks) of phantom money. The banks are blamed for treating money they have lent out as an asset that still has value to them, but clearly it does, and can in fact be used, without any of the 'printing money' business or runaway inflation that people shout about. We all do it all the time and it's a good thing, until we stop believing in it.

A question I keep asking people who understand economics/money etc- where do I start to make sense of it all? What should I be reading?