There still circulates a well-nurtured myth. You deposit your savings in a bank and while you don’t use your money, the bank lends it with interest to an entrepreneur or somebody who will put it to good use. The situation is allegedly a win-win-win situation. The entrepreneur gets the investment they need, you get a share of the interest, and the bank the rest. An almost ideal world – if only it were true.
What is fractional reserve banking?
Actual reality was explained in 2006 by one of the few who did see the 2007 crisis coming, Ann Pettifor at the New Economics Foundation:
“The money for a bank loan does not exist until we, the customers, apply for credit. In other words, far from the bank starting with a deposit, and then lending out money, the bank starts with our application for a loan, the asset against which we guarantee repayment, such as our house, and the promise we make to repay with interest. [Emphasis original]” Pettifor, A. 2006. The coming First World debt crisis. New York: Palgrave, p. 61.
How does this work? This is the magic of fractional reserve banking. You deposit your share of the mortgage in the bank (usually somewhere between 20 and 40%) and then the bank does not lend you the rest of the money from cash it already possesses, but it literally creates the rest of the money. What Pettifor and others call ‘bank money’.
Why does this work? Think about the amount of money you use in cash compared to the amount you think you have in your bank account. Most of us conduct only small transactions in cash, like buying a newspaper, coffee, a lunch. Bigger transactions you’d probably pay online and by card. So, really, you very seldom convert a significant amount of your wealth into cash. What you pay in, the ‘currency’ you actually use for the biggest share of your transactions, is not the official state currency (‘cash’), but the numbers on the screen your bank tells you you own.
What is the difference? Think about this from the perspective of the bank: with a few thousand clients, the fraction of their wealth being deposited or withdrawn as actual hard cash tends to be small and stable. The bigger the number of clients and the greater the equality of their wealth, the more stable the fraction of cash they need and the fewer fluctuations. And that’s why the magic works: because on average an insignificant amount of people withdraw big chunks of their wealth in cash.
In other words, because they trust their respective banks could give them their money – the bank can surf this ‘average-wave’ and simply increase the number of total ‘bank money’ (the electronic number) compared to the number of state currency (‘cash’) that they own. So it can, literally, write a number into an account – and there’s the extra money for your mortgage. The money the bank has not created itself is somewhat cynically called the bank’s ‘reserve’.
But, in the end, the mortgage does pay for the house – how so? The beauty is that even if your construction company works with a different bank and you transfer your total mortgage to that bank, it is very likely that your bank also receives money from that bank too because of some other payment. And, of course, the banks only transfer the net settlement of all transactions – it’s surfing the average-wave again. Put graphically, as long as the net effect of all deposits, withdrawals and transfers is small, all of these transactions are mostly changes in numbers on the screen.
A short example
Let’s say 1,000 people with £1.000 each get together and start a bank (Total: £1 million). They test this for a year and realise that the £1 million only ever fluctuates by 10%, or £100.000 – the rest just sits there. Now, the stupid thing to do would be to lend out the remaining £900.000 and charge an interest. The much cleverer thing is to leverage and simply create an extra £9,000 into each account. The total of ‘money’ is now £10 million: £9 million ‘bank money’ and the £1 million cash they put in at the beginning and now use as ‘reserves’ to cover their 10% fluctuations.
Of course, banks don’t give money to their clients like that – but they do create ‘bank money’ like that. There is bit of debate about whether the need for ‘reserves’ limit the bank’s ability to create money. Some think it does, some think it does not. Whatever the truth of the matter, suffice it to add that when you take out a mortgage, the money you had to provide yourself already covers the ‘reserves’ needed for the magic trick.
Note that normally this is explained more politely. It is said that banks don’t need to deliberately create ‘bank money’. But, rather, even if the people in the example lend out the extra £900,000, the loan(s) will eventually end up in a bank again; which will again keep 10% and loan out the rest (£810.000), which in turn ends up in a bank which loans out 90% (£729.000), and so on… Until you eventually arrive at the same extra £9 million of ‘bank money’ distributed across different banks.
The net effect is the same: an additional £9 million in ‘bank money’ has been created. However, the polite explanation assumes the first bank acts highly irrationally. After all, it can invest the first extra £900,000 only because it has realised that it suffices to keep 10% as ‘reserves’ and simply bluff by telling everybody that there is a collective £1,000,000, or an individual £1,000, that they own. Now, why would it not do the same with the £900,000 loan(s)? Why loan out actual cash if you just realised you don’t need 100% actual cash to make people think they have money? So, rather than loan out £900,000 of cash, much better to leverage it to £9 million in ‘bank money’ right away and make much more money.
And what is liberalism?
So far, I have explained fractional reserve banking . Now, however, I want to draw attention to the question of whether the creation of ‘bank money’ is compatible with liberalism. I do this because the framework of justice provided by liberal philosophy is probably rather easy to agree with – if, of course, it’s not confused with the ruling ideology of neoliberalism, which as a word has an interesting genesis itself and is in my opinion more properly described as neo-conservatism.
What, then, is the framework of justice provided by liberalism? Unlike conservatism, but like socialism and anarchism, liberalism is a revolutionary philosophy. Liberal philosophers almost invariably derived notions of justice and morality from principles they thought should be ahistorical and universal, like the inalienable rights of the person (human rights), or the natural right to own property. It is thus ‘revolutionary’, because it inevitably leads to the conclusion that those traditions and the powers that be which contradict these principles are illegitimate.
Also, in general, liberal ethics privilege the individual over the collective. Society, whether in the form of tradition or power, has no self-evident right to infringe upon individual rights. No matter if two wolves and a sheep democratically decide what to have for dinner; in liberalism, democracy cannot trump the sheep’s individual rights (here, the right to life).
It is important to stress that this individualism does not negate being a society or group. You may join as many groups as you like, indeed, most liberals would say society should and does self-organise as a civil society. But, still, in civil society, the collective has no right to force you to join a group or remain in it – a notion resonating currently in the commonplace distinction between a religion and a cult.
Now, back to banking. The argument that money creation by banks is compatible with liberalism goes something like this:
If you don’t like banking, leave it! In a free market-place, we are free to find banking immoral and not use it. The ‘bank money’ they create is thus freely accepted as currency by people who could also leave it. If a bank goes bankrupt, those losing their money pay the consequences of selecting a bad bank. Banking, in this view, is just like deliberately buying a product you know may be faulty at a reduced price and then complaining that it has turned out to be faulty.
Some points critics might make centre around information asymmetry, the risk of contagion and incentive structures. So, it is seen as almost impossible for clients to judge the credibility of a bank because banks almost invariably know more and better what is going on in the market. It’s a bit like asking a shop assistant in a city you don’t know if their products are the cheapest, best or safest. Of course she or he will say ‘yes’. Moreover, a mishap of a bank you did not choose may affect the bank you did choose, because banks are so tightly interlinked and therefore infect one another. Finally, and partly because of this risk of contagion, it may be said that the incentive structures bankers are exposed to are highly unhealthy, because they can be sure that the regulator of the economy – the state – would probably not let them go bankrupt anyway. They are ‘too big to fail’.
All of these factors reduce the power of individual decisions, which is to say they tend to annul the market mechanism and thereby the market regulation of banks. In liberal language, then, you would potentially suffer consequences (and the bankers not) of risks which you could not have decided against – and, in a liberal market place, this is illegitimate. In this view, banking is like buying a product you could not have known was potentially faulty.
However, there is a much more damning fourth reason. Even if the market mechanism worked perfectly, it could at best regulate banks to have a sane amount of ‘reserves’ and require sane amounts of security on their loans. The market participants – we – could never change one basic state of affairs – the fact that the banking infrastructure is inserted so deeply into our economy that you can pay almost everything except petty transactions by card (also, in Greece and Italy you’re not allowed to use cash above €1,500 and €5000, respectively).
In other words, nowadays, privately created ‘bank money’ is just as real as cash. With the banking infrastructure, ‘banking money’ has become just as much a base fiat of our economy as the state currency. If anything, ‘bank money’ is more real than the state currency – consider that everything from recessions, to inflation rates, to exchange rates is often more influenced by what private banks do with their ‘bank money’ than by what the central bank does with the state currency. If private banking turns against the central bank, it is usually the latter that loses out.
The bottom line, in my view, is the main precept of our western economies:
Private institutions create money (‘bank money’) that is indistinguishable from the official state currency.
If normal people did that, they’d quite rightly be convicted of counterfeiting. The same thing, however, is also the basic business model of practically every bank there is and conducted on a scope and scale that would embarrass the most ingenious criminal.
Of considerable importance to this discussion is that states generally impose and enforce the use of their respective currencies. So, the purchasing power of a Pound Sterling arises to a great degree because everybody knows that the entire 63 million strong advanced (post-) industrial economy that is Britain will accept this currency. One big factor explaining why everybody does accept it is that the state guarantees this – which is just another way of saying that it forces us to accept the currency.
This is significant for liberalism in the following way. Because ‘bank money’ is indistinguishable from state currency, which is backed up by the state’s monopoly of violence, the creation of it therefore amounts to the use of the state’s monopoly of violence by unaccountable private institutions for private gain. In the liberal framework of justice outlined above, the state directly forces you to accept the purchasing power of ‘bank money’ that was created by private institutions which are completely and utterly unaccountable to you, and at the same time it forces you to accept the diminished purchasing power of the state currency.
Note that this arrangement may be practical. My claim is not that fractional reserve banking cannot work – apparently it does, but for whom?
The question of practicality is quite apart from the question of justice. Many social arrangements (slavery, apartheid, totalitarianism) we have overcome not because they did not work, but because they were unjust. In the same manner, fractional reserve banking by private banks may be practical, but it is certainly not liberal or just. Liberals should recognise the ‘bank money’ created by fractional reserve banking as illegitimate and a fraud.
From this position, it is probably hard not to conclude that one side-effect of illegitimate ‘bank money’ is that it creates the mother of all inflations too. For every pound created by the only liberally legitimate money creator of official currency (the state), private banks create from 18 to 26 extra pounds of ‘bank money’ – depending on whether you count M1 or M2, or in the UK also M4, and if you count now or before the crisis. (The different money multipliers are given in Figure 1.)
Figure 1: View larger version.
Because ‘bank money’ is equivalent to the state currency, but not legitimate, this also means the purchasing power of the legitimate part of money (that produced by the state) has been illegitimately blown up by 95% by private banks and thus inflates the legitimate part of the money supply.
Another side-effect of private banks’ grip on our money creation is that the state’s ability to stimulate the economy by running an expansionary monetary policy is seriously undermined, because even if the state lowers interest rates, as long as private banks ‘feel insecure,’ only expensive credit will be available to entrepreneurs.
Finally, what kind of banking would be liberal? I have argued that the source of the illegitimacy of ‘bank money’ is that it is indistinguishable from and equivalent to state currency, that it therefore amounts to counterfeiting, which is the private misuse of the state’s monopoly of violence that backs up the purchasing power of the state currency.
It follows quite logically that only three kinds of banking could be compatible with liberalism: full-reserve private banking, in which private banks are not allowed to counterfeit state currency as ‘bank money’; second, free private banking, in which private banks issue their own private currency distinguishable from the state currency; and, third, state-owned fractional reserve banks. The latter is not as exotic as it may sound: the fourth largest bank in my country of origin, Switzerland, the Zürcher Kantonal Bank, is owned by the canton of Zürich. Actually, almost every canton in Switzerland has such a canton-owned bank.
The point about each of the three possibilities above is that the state currency cannot legitimately be created by private organisations. Hence, banks either don’t create ‘bank money’, create their own ‘bank money’ currency, or are state-owned. Which of these is the most practical is quite another matter – all I have to say is that the indistinction between state currency and ‘bank money’ we have today is unjust and profoundly illiberal.