Making Money

by Eric Zencey on May 7, 2010 · 19 comments <span>Print this article</span> Print this article

in Economics & Empire


Saratoga Springs, NY Chances are that unless you’re a total financial wonk, you’ve never heard the term “seigniorage.” But you should, because doing the right thing with it could help solve several major, interrelated problems.

As a concept, seigniorage is as old as money. It’s the difference between the face value money and its cost of production; it’s the profit that comes from creating money. When money was coined in valuable metals, seigniorage wasn’t very significant; a shekelhad to contain something like a shekel’s worth of silver, or it wouldn’t be accepted as a token of exchange. The advent of paper money and the more recent development of fiat money—money backed not by metal but by the faith and credit of a government—led to a dramatic increase in seigniorage. If it costs one cent to print a hundred dollar bill, the seigniorage on that bill is ninety-nine dollars and ninety-nine cents.

By long tradition, and by general consensus among anyone who ever thought much about it, seigniorage belongs to the sovereign power that issues money. In our system, that’s us: we, the people. But in the largest subsidy program ever instituted by any government anywhere, most of our seigniorage is given away free to the institutions that create most of our money supply: private banks.

To most of us the idea that banks create money comes as a surprise. Here’s how it happens: when you deposit $100 into your checking account, the bank is required to keep only a fraction of it on deposit against the chance you’ll show up and ask for cash. The rest it lends out as quickly as possible. With a reserve requirement of 10%, your bank can lend out $90 of your $100 deposit, which it does by simply crediting the borrower’s account—an act that costs almost nothing. And 90% of that new deposit can be lent out as well, which becomes a fresh $81 dollar deposit in the system. And so on. Eventually, the introduction of $100 into a system with a 10% reserve requirement leads to a $1000 increase in the money supply.

This system of fractional reserve banking evolved organically from the goldsmith’s practice of issuing notes for sums of coins held on deposit—and from some enterprising goldsmith’s recognition that the notes themselves, and not the coins, were being used in commercial transactions. Since few people actually brought the notes in to redeem them for gold held on deposit, it was possible to lend out the gold and collect interest on the loans. The loans could be issued as notes, with the gold remaining unmoved within the goldsmith’s safe. A single bag of gold coins could do double, triple, quadruple duty: two, three, or four people could hold certificates claiming it—as long as they didn’t actually claim it.

Clearly, the practice of leveraging loans against deposits in this way made goldsmith shops (and, later, banks) vulnerable to a cascading collapse of confidence—a “run”–when holders of certificates of deposit show up and demand the return of what they’ve deposited. This is exactly what happened during the Depression, sparking a round of bank failures and deepening the economic downturn.

In the wake of that experience, the practice of fractional reserve banking might have been forbidden, and the creation of money be reserved to the sovereign power of government. Instead, fractional reserve banking was formalized, and the perceived problem—that cascading collapse of confidence—was addressed by the creation of the Federal Deposit Insurance Corporation, which assures customers that the government will make good their deposits (up to the generous limit of $250,000 per account) if the banks fail. Banks were given free rein to go on creating money, and to collect seigniorage in the form of interest on the loans they make with the money they create.

How much is that seigniorage worth? The money supply on which the U.S. economy operates is $7.7 trillion. Of that, scarcely a tenth–only $746 billion–is actual currency issued by the Treasury, the seigniorage on which goes into the public coffers. The rest, $7 trillion, is bank balances in various forms. And since the cost of entering pixels into databases is negligible, the seigniorage is almost equal to the supply of money created this way. Seven trillion dollars is more than the federal government has spent on two world wars, Korea, Vietnam, Iraq, the moon mission, and Social Security combined.

Capturing seigniorage for the public treasury presents no technical challenge. To make money creation the exclusive prerogative of the sovereign, the money-creation activity of banks could be curtailed by a 100% reserve requirement on demand deposits. The change could be phased in gradually, as Herman Daly and other ecological economists have advocated. Banks could earn their income not from seigniorage but by charging for such legitimate and useful services as safekeeping, accounting, check clearing, and mediating loans between savers and borrowers. As the new reserve requirement is phased in, the Treasury could spend money into existence at an appropriate rate, replacing exactly the quantity of money that banks are no longer creating. The immediate macroeconomic effect would be minimal; the net result would be a shift in the way money is created, and an end to a huge public subsidy to the banking system.

One macroeconomic effect would be eventually significant: loans could only be made out of savings, not from the creation of money. This means that someone, somewhere in the system, would have to refrain from consumption today in order to increase consumption later. The only argument that can be made against this essentially boils down to “we’d have to change how we do things.” One consequence of doing this is that we would no longer pay for our consumption today by passing the expense to our children and grandchildren.

Bankers, of course, will be against this change, and will do everything in their considerable power to prevent it. Creating money, it turns out, is a very lucrative business. But there are positive effects that make this policy change very attractive.

One benefit would be a dramatic dampening of our economy’s boom-and-bust cycles. As chemist-turned-economist Frederick Soddy pointed out in the 1920s, the creation of money by banks is also the creation of debt, and boom-and-bust cycles are one inevitable result of letting debt grow too rapidly. Soddy’s logic: debt is a claim on the future production of wealth. When the creation of debt exceeds the capacity of the economy to create the real wealth that is needed to pay it off, eventually a trigger event will set off a cascading crisis of debt repudiation—a run on the bank, writ large. Inflation, bankruptcies, foreclosures, stock market crashes, bond failures—these are forms of debt repudiation, and (inflation excepted) they tend to come in a spasm, a crisis, a collapse.

The Great Recession we find ourselves in today follows this pattern. A run-up in the price of gasoline to $4 a gallon reduced the disposable income of Americans, including many who had been encouraged to take on more mortgage than they could afford. That they were encouraged to do this was one result of “demand-pull” for risky mortgages. With banks like Goldman Sachs actively assembling portfolios of bad mortgages so that hedge fund managers could bet against them, loan officers nationwide stepped up to supply the demand. They responded to an increased call for risky mortgages by issuing more risky mortgages. When some mortgagors defaulted, housing prices declined, and many homeowners found themselves “underwater”—owing more on their houses than the market said they were worth. This led to more defaults, which led to more defaults, which led to more defaults.

The version of the crisis that began in 2008 had its origin in mortgage loans. But the same dynamic lies underneath all crises of debt repudiation—the Savings and Loan crisis, the Enron affair, the crisis of Asian debt refinancing, the stock market crash of 1987. They all trace to the process of letting claims on wealth grow faster than wealth can grow, and the driver of that is the process of money-and-debt creation through fractional reserve banking.

Money that is created and spent into existence by the government does not create this equal-and-opposite burden of debt. At bottom, fractional reserve banking is a routinized, publicly funded machine for inflating speculative bubbles, based on the bizarre supposition that $100 of wealth can be made to support $1000 worth of claims upon it. It takes a lot of economic growth to produce $1000 worth of wealth in the future for every $100 worth that exists today.

One reason that economic growth can’t match the rate of debt creation is the ongoing decline in the energy-return-on-energy-invested, or EROI, of oil, our economy’s primary fuel. In 1920, one barrel of oil invested in drilling and production yielded 100 barrels of usable product—an astounding 10,000% return, large enough to disguise quite a few structural flaws in our system. But by the close of the twentieth century the EROI of oil had fallen, worldwide, to 20:1 (For newly discovered oil, it is even lower: 5:1, by some estimates). This decline is both an underappreciated root of our current economic downturn and a warning that we have to change our institutions–and the thinking that underlies them.

The decline in EROI is a portent that austerity in public spending is not a temporary passage from which recovery is possible, but something like the permanent condition of governance in the post-petroleum era. Oil’s 10,000% rate of return was magic. It created fortunes (think Rockefeller and Getty), fuelled philanthropy, and ultimately paid for a lot of public works: schools and bridges and roads, Medicare and Social Security, moon missions and foreign wars. Today, governments at every level are struggling to sustain their revenues and provide essential services, even as their tax bases decline as a result of the recession. Meanwhile, the disposable incomes of many Americans have tumbled, and Tea Partiers shout that they’ve been “Taxed Enough Already”—taxes being one sizable household expense which citizens of a democracy feel they ought to have some say over.

There’s room for hope in the fact that the best renewable energy technologies come close to matching today’s world-wide average EROI of oil. But no energy technology will ever again offer the heady returns of the early days of oil. As we enter a crowded, ecologically straitened, post-petroleum era, the need for sound, far-sighted public expenditure on infrastructure, including renewable energy infrastructure, has never been greater, while the resources to pay for it have never been more constrained. Capturing seigniorage is one way out of this conundrum, and phasing out fractional reserve banking is the best way to do that.

Think back to that unnamed goldsmith who first had the idea of making loans against money that belonged to someone else. Through one conceptual lens, the man was an innovator, a banking genius: the gold was just lying there, not being used, so why not issue additional notes against it? Through another lens, though, the man committed fraud: he treated as his own something that was not his to lend. The fact that we’ve had centuries of routine acceptance of that basic fraud doesn’t change the essential character of the act. And aside from the moral considerations that call into question the foundation of fractional reserve banking, there are also large practical reasons for changing our practice. The pyramiding of debt through fractional reserve banking is one strong driver of heedless economic growth, “growth for growth’s sake,” which has expanded our economy’s ecological footprint beyond sustainable limits. Returning seigniorage to its rightful owner is a strong step toward ecological, and civic, sanity.

Eric Zencey is a novelist, essayist, and Visiting Associate Professor of Historical and Political Studies for Empire State College in Europe and New York. His writing in environmental history and political theory has been supported by grants from the Rockefeller, Guggenheim, and Bogliasco Foundations. This essay is from the forthcoming The Other Road to Serfdom: Essays in Sustainable Democracy (University Press of New England, Fall 2011).

(This essay was also published at History News Network)

{ 19 comments… read them below or add one }

avatar Tony May 7, 2010 at 10:19 am

I’m sorry for being obtuse, but if I understand you correctly, wouldn’t phasing out fractional reserve banking also mean that banks could no longer make loans? That is, if a bank had to keep 100% of it’s deposits on reserve, then it would have nothing to lend out? I’m not arguing whether this would be a good thing or a bad thing – just want to make sure I’m not missing something here.

avatar polistra May 7, 2010 at 11:15 am

Another question from a total non-expert: The interest-free banking system you propose sounds a lot like Islamic banking, where interest is forbidden by the Koran but banks work around the prohibition by various service charges and “gift exchanges”. This system appears to be even more corrupt than ours in practice, and Islamic countries have even more disparity between rich and poor than we do. (Though we’re catching up with them quickly.)

Seems to me that fractional-reserve banking worked quite well for several decades as long as it was properly regulated, and as long as interest rates were allowed to float upward when necessary.

avatar Albert May 7, 2010 at 11:43 am

Tony, that is incorrect. Full reserve banking means that there are two kinds of “deposits”: demand deposits (i.e. checking accounts) which require the 100% reserve for the logical reason that all of the deposits may be withdrawn on demand; and savings which are simply like CDs or other bonds which after “deposit” may not be withdrawn on demand until the CD matures.

This is the critical difference: that deposits may only be used once, either for the bank to loan out at interest (in which case such deposits may not be withdrawn by the depositor until a set time when the loan is paid back to the bank and so to the depositor) or for the depositor to have full access on demand to. Either. Or. Not both, because allowing on demand access to deposits which are also simultaneously lent out even while leaving a fractional reserve is precisely where the multiplication of the money supply (private money creation) occurs, with its concomitant volatility.

avatar Tony May 7, 2010 at 1:29 pm


I’m not sure I see your distinction. If I give a bank $100, and in return get a CD with a maturity date of one year, and the bank loans out that $100 to Joe Borrower, the bank has $100 in assets (the loan) and $100 in liabilities (the $100 CD.) But, if Joe Borrower spends that $100 in my store, and I use it to get another $100 CD from the bank, doesn’t the bank now have $200 in assets (i.e., its $100 loan, plus my second $100 deposit) and $200 in liabilities (the two CDs)?

I can see how put the time restriction on my IOU’s from the bank would prevent me from making a run on the bank, but I don’t see how forcing a bank to stay financially sound by monitoring various due dates on CD’s is fundamentally different from forcing a bank to stay financially sound by monitoring the percentage of demand deposits that might actually be withdrawn at any given point.

I don’t mean to turn this into a class on banking, but I think this isn’t the first condemnation of fractional-reserve banking I’ve seen on FPR, and I’m still not sure exactly why. Again, I don’t mean to be obtuse, and if you said, “Trust me, banks are bad and the Federal Reserve worse, so let’s get rid of them both”, I’d be inclined to say fine by me. But, it’s always good to understand the nature of the evil being fought.

avatar John Médaille May 7, 2010 at 3:51 pm

100% reserves means that banks could still make loans, they just can’t create money. They would make loans in the same way that investment banks currently do: brokering money between savers and borrowers rather than by creating money as credits. If a bank has a million on deposit, it can make a $900,000 worth of loans (holding bank some for daily transactions), not the $10 million it can currently make. Of course, the banks can raise money to loan in other markets, such as the bond market. Or more simply, they can broker publicly-created money. That is, the community (which at present means the gov’t, for better or worse) would create money and lend it to the banks in competitive auctions. The banks would then lend it to borrowers at a higher rate, the difference being their fee for servicing the loan. This would allow them to solve one of the biggest problems in banking, the fact that they must borrow short to lend long, a recipe for instability. But with the community money, they can give 10 years bonds, and make 10 year loans, five year bonds for their portfolio of five year loans, etc.

There is a further problem with privatizing the money creation function in the banks. It means that all money begins as credit, as an interest bearing note. But this sets up the impossible contract, because while the loan creates the principle, it does not create the interest. Take $1,000 loan at 10% simple interest for a year. It requires $1,100 be repaid at the end of the year. But while the loan created the $1,000, it does not create the $100 interest. That depends on somebody else borrowing $100, which requires that somebody else borrows $10, which requires another loan of $1, etc. The original loan can only be fulfilled by an infinite series of further loans, which is impossible. Sooner or later the system breaks, wiping out enough debt so the cycle can begin again.

The hardest thing for people to understand is that the banks do not actually lend out deposits; they create money. Before you sign the mortgage on your house, the note on your car, the credit slip for that burger at MacDonald’s, the money for the home, the car, the burger does not exist; it is called into being by the act of borrowing it.

avatar Tony May 8, 2010 at 10:20 am

I gather, then, that basic idea behind 100% reserves is to make the banks actually lend out deposits, is that right? Once a bank with a million in deposits makes a “loan” of that million, to maintain 100% reserves it would have to take that million off its books – it couldn’t still owe a million to the depositor, since it now has nothing left with which to pay that depositor back (having “actually loaned out” that deposit.) The only way this could happen would be, as you say, for the bank to act as a broker, with the asset and liability for that million being held by the depositor and the third party borrower, not by the bank.

In which case, neither demand deposits nor long term CD’s would be allowed, because even a CD is a contract between the bank and the depositor, not between the depositor and some third person borrower. It seems a bit misleading to say that banks would still be “lending” money, since, as you point out, they would really be acting as brokers.

You raise an interesting point about where does the money come from to pay the interest. But, doesn’t this apply to any type of interest-bearing loan? Even if I loaned you a million dollars directly, where would you get the money to pay the interest? Doesn’t the very concept of “interest” presuppose an expanding money supply (whether it expand through more money, or an increase in its relative worth through price deflation)? In fact, shouldn’t this expansion rightly take place, if money is meant to reflect an underlying reality? If a craftsman borrows a set of tools and uses them to create a beautiful piece of furniture, then doesn’t the world now contain both a set of tools and a piece of furniture? Why shouldn’t the money supply increase to reflect this?

In his post, Mr. Zencey’s seems to argue that banks capture seigniorage through fractional reserve banking, and that that seigniorage should be captured by the government instead. But, at the same time he seems to argue that such seigniorage is inherently bad, because it leads to headless economic growth. Am I right in seeing this contradiction, or am I not understanding his argument? A further question – is there any warrant for the presumption that government would be any more adept at avoiding “heedless economic growth”?

avatar John Médaille May 8, 2010 at 10:46 am

You wouldn’t normally lend out demand deposits, save for short-term loans. The profit from demand deposits would be from fees, the same way that credit/debit card processing companies make their money today (they charge the merchant, rather than the buyer, so you don’t “see” the fees, but they are there.)

If deposits are being lent out, rather than created, then the money is not created by the loan, and money ceases to be a function of usury. Hence, there is no need to create new money to pay the interest on old loans; new money needs to be created only for new wealth (new factories, etc.) The point is this: if all money (save coinage) is created by debt, then all money carries an interest rate. But if money is simply created debt free, than the money to repay any interest does not carry an interest rate itself. There is no need to make interest bearing money to pay off previous creations of interest bearing money.

Seigniorage was always an important revenue for the state, or at least the states than had mines. It is the difference between the cost of mining and minting, and the number stamped on the coin, which becomes its nominal value (pacé the Austrians, gold and silver have no “intrinsic” value.)

Will the community print too much or too little money? Very likely. But the effect will be immediate and the cause well known. If the responsibility is easy fix, then the remedy will be easy to implement. In our current system, most people (and includes a lot of economists) do not understand how money is created, and even if they did, there is not much we can do about it. The Fed influences, but does not control the banks. The only thing the Fed can do is increase/decrease they amount of loans the banks can make, but they cannot force them to create money or to stop creating money. Volcker found this out in the 70′s, when no matter how high he raised the interest rates, the money supply kept expanding. Oddly enough, the problem was solved when he stopped trying to fix it.

avatar Peter B. Nelson May 10, 2010 at 10:47 am

Dear Mr. Zencey,
I love your article. It’s nice to see someone getting to the roots of the problems in the modern economy – the finance and energy sectors (EROI). Great stuff.

But I am unclear what you think the seignorage is worth? You make two contradictory claims…

1. “[Banks may] collect seigniorage in the form of interest on the loans they make”.
2. “[The value of] seigniorage is almost equal to the supply of money created [from fractional reserve lending]“.

So, which is it? Does “capturing seignorage” for the public purse yield all of the $7 trillion, or merely the $350 billion interest on that amount (5% interest on $7T)? The former might begin to dent the U.S. gov’s $62T unfunded liabilities, but the latter is barely enough to pay for a single Katrina disaster. So, which is it?

Follow-up question: If 90% of the money in ciruclation ($7T) is seignorage created by and for the banks, how can the size of the total U.S. economy be $13T? Shouldn’t it be $7.7T, i.e. the amount of money in circulation?

Also, why assume the government can manage the risk of excess money creation (i.e. inflation) any better than for-profit corporations? Would not a return to hard-money currency (aka gold and silver coinage) remove the risk of “excess seignorage” altogether?

Finally, how does this fit into the global economy? What would be the effect of inflated Euros or Yens or Remnibis on the no-fraction-reserve-lending American dollars?

Yours Truly,
Peter B. Nelson

P.S. I’m not trying to ask leading questions, I would really like to know what you think about this.

P.P.S. Perhaps Mr. Medaille can answer these questions, as I doubt Mr. Zencey will check this cross-post forum for comments, eh?

avatar John Médaille May 10, 2010 at 10:36 pm

Peter, the easy question first. A $13T economy does not need $13T in money, because money circulates. It needs 13T/V, where V is the velocity or efficiency of money, that is, the number of times it is used in a transaction for that year. If a dollar changes hands 10 times in a year, then it does the work of 10 dollars. In fact, there is too much money in circulation, relative to the size of the economy. This is tolerable because the dollar is also an international currency, and many markets (such as oil) are traded in dollars, money which never comes home to claim assets in this country. If the world were to lose confidence in the dollar, then all that money would come flooding back as foreigners sought to convert their dollars into hard assets (land or homes or factories or gold or whatever) which would cause massive asset inflation.

Seignorage for gold is simply the difference between the cost of mining and the monetary value of the coin, which is the number stamped on it. Seignorage for credit created ex nihilo is both the principle and the interest as they are repaid. To the extent they are not repaid or are still outstanding, there is no seignorage. The total amounts received are the seignorage.

Why assume gov’t can manage the risk of excess money creation? I don’t. I just know that with gov’t you can create a precise amount of money, and if that is too much or too little, the effect will be nearly immediate, the blame easy to fix and the remedy well known. This is not true with the banks. They always have in interest in the wrong direction: to create too much in booms and too little in busts.

Hard money currency is a permanent state of deflation, except in periods when new mines are discovered, in which case there is inflation. But in practice, the banks issued more in money then they had gold on deposit. The gold reserve system is the origin of the fractional reserve system; the later is the former without the gold. But even using gold as fractional reserves rather than as actual currency leads to money shortages and deflation. The system is simply too rigid to match the real needs of an economy.

avatar richard May 11, 2010 at 11:15 am

Hi John Medaille,

Could you further elaborate on why you believe a hard money system is too rigid to match the real needs of an economy? Guess I am surprised that distributist thought would advocate fiat money. I thought Cobbett was death on it and assumed Belloc would be too. It did seem like the economy was doing OK back when I was a little agrarian kid with silver coinage. I have read where Govt messed with the silver supplies in Ron Paul’s book.



avatar John Médaille May 11, 2010 at 7:36 pm

Belloc understood what money was: a mere accounting system. The amount of money in circulation should match the amount of goods and services in circulation. The money you carry in your pocket represents your credits against these goods, and when you buy something and hand the money to the merchant, you automatically debit your account and credit the merchant’s account.

If the money supply varies at a different rate from the supply of goods and services, then inflation or deflation is the result: inflation if the supply of money grows faster than the goods, deflation if it grows slower. It was the rigidity of the money system which contributed–was really at the root of–the great deflation from the late 1860′s to the 1890′s. Wheat was at $2.06/bushel in 1866, $1 in 1876, and by the 1890′s it was .60 and in some places .35. Corn in the same period went from $0.66 to $.30 and in some places .10. Deflation kills the farmer, the small businessman, the young family, anybody who must have a debt, since the value of both the debt and the interest is constantly increasing while the value of the labor to pay off the debt is declining. Gold systems are inherently deflationary. Deflation is actually a transfer of value from the borrower to the lender over and above what is stated in the contract. Inflation is a transfer in the opposite direction, except that loan rates usually attempt to account for inflation and build in some anticipated rate.

It is not “fiat” money that is the problem, since all money (including metals) is by fiat. It is who owns the fiat. We have privatized the fiat with the banks. Aristotle got it right when he noted that money is not natural, but a man-made thing: “That is why it is called money (noumisma) because it exists by law (nomos), not by nature.”

avatar Clare Krishan May 12, 2010 at 9:41 am

John is partially correct with who owns the fiat – what monetarists call “legal tender laws” but more correct would be who “pawns” the fiat? Any citizen of a state who believes the fiction that they “create” or produce or mint the legal tender they hold in their pockets is woefully deluded. Seignorage is serfdom by another name and is incompatible with democracy. Absolutists and monarchists defend it as compatible with “natural law” only in so far as they enjoy the privileges of the legal monopoly. In a truly free monetary system anyone could trade with anyone in any accountable unit they chose to tender payment, but in the American system they are forbidden from using gold, silver, platinum, semi-precious stones etc and must use the pieces of worthless paper their Overlords (Seignors) print at will.

The abject injustice and complete contradiction to natural law that such pawning of the wealth and human capital in our society is monstrous.

The author does the FPR community a service in raising the specter, but rather than impale its evil heart he simply advocates a socialist-collective custody of the beast in a nation-state zoo, contained side-by-side with the serfs fettered in service to the Hive. No… Absolutist monarchists could be better served making an Aristotolean contribution by advocating for personal sovereignty rather than aggregate seignorage. Any capital, no matter how small, secured by sacrificial deferrals of current consumption for future outlays necessary for any economic activity creates the wealth upon which catallactics (exchange, ie tendering payment for value received) is predicated.

As I have maintained elsewhere over a period of months, the terms money, capital, and wealth are NOT interchangeable they are ontologically DIFFERENT things, nor sadly any longer sovereign (we are in hock to our creditors, we have been “pawned”). The illusion distributists insist on peddling is as Gothic as a Vampire romance from Romania… but its more Frankenstein-ian than that, for the lunatics are now in charge of the asylum, ie the much vaunted “government” central planners are now at liberty to expropriate us at will… the subsidiarity natural to a civilized economy has been suborned to a tyranny of relativism of previously unforeseen despotism… and its political center gravitates in the Orient not the Occident. The doctrine of usury is of zero value in such cases, for the seignorage is no longer a matter of sovereignty (see Greece’s debacle with the euro) coming soon to a bank near you, the Bank of China is a lead shareholder/creditor in many main street financial institutions in the US… they have a say in the Fed’s operations, no-one elected them, no-one can stop them… other than to elect not to sign on for any further Yuan denominated inflationary impoverishment of the holders of the current legal tender, or a general strike refusing to abide by the legal tender restrictions imposed on free exchange of goods and services and elect instead to tender a scrip of one’s own subjective marginal utility (pace Austrians…)

A huge historical oversight of the author is the difference in the legal doctrines underpinning the fiduciary media in circulation in the West – the newer lax Anglo-Saxon ethics has sadly supplanted the much older and more precise Roman code of demand deposit jurisprudence, The author fails to make this point clear. Only in recent decades has the law in Spain succumbed, formerly there was no FIAT fractional reserve banking there, as they followed precedents similar to those of Roman Catholic Canon law. For more read Jesus Huerta de Soto’s “Money Bank Credit and Economic Cycles”

avatar John Médaille May 12, 2010 at 10:01 am

Clare, Seignorage may be serfdom, but it is also a fact, especially a fact of metallic money, unless you are willing to assert that the value of a coin is always equal to its mining and minting costs. Is that your assertion? But if there is a difference, there is seignorage. The question is not whether it exists, but who has the rights to it, some private cabal like the banks, or is it the common property of the people.

As for “non-fiat” money, can you give us a single example in all of human history?

avatar Albert May 17, 2010 at 3:19 pm

Tony, Mr. Medaille may have answered your question of me, or perhaps not. Here’s my take.

I’m unsure how the distinction isn’t clear: the distinction is between A) a bank being able to lend out money (Use #1) which a demand depositor can also use to buy other goods (Use #2) by, for example, writing a check; and B) a bank not being able to lend out money that is in a demand deposit account that can be used by the depositor at will (or alternatively, the bank being able to lend out the money as long as the depositor cannot use it). Use #1 or #2, but not both.

Your example is correct, but I don’t see how it conflicts with full reserve banking, and maybe the “so what” is where the confusion lies.

Full reserve banking cannot prevent banks from becoming financially unsound; I’m not sure where that idea comes from. Even full-reserve banks can go out of business if people don’t pay back loans. What it does do is prevent banks from creating money through the double use of deposits. In the terms of your example, it’s not that full-reserve banking prevents a bank from having $200 in liabilities and assets on a balance sheet, but that it prevents a bank from lending Joe Borrower the $100 and allowing him to spend that $100 via a check so that if Joe writes a check and also spends the loan money, there is now $200 out in the economy instead of just the original $100 in a bank with $200 in assets and liabilities.

In other words, the problem isn’t that I can lend you $5 and get an IOU for $5 back, and then you lend me the $5 and give me an IOU, and then we keep lending the $5 back and forth to each other a hundred times until we both have $500 in IOU assets and liabilities. We can’t stop people from playing silly games like that… but you’ll notice that there’s still just the $5 in real money there, despite our larger assets and liabilities, and the real money is what matters for the real economy.

In the end, it’s not a miraculous panacea that will prevent all unsound dealings, but instead a system which conforms the money supply to the reality of the economy of goods and services instead of allowing the equivalent of $200, $2000, $20,000 or somewhere in between of money into the economy for $100 in deposits, which is what we have today and which, due to the rampant multiplier effect, eventually leads to a disconnect between the price of goods (like houses) and their informed value to individuals and communities.

avatar John Médaille May 17, 2010 at 4:04 pm

Albert, good example. I think it is self-evident to say that if the customers won’t pay, the business goes broke, a fact which applies to both banking and non-banking businesses. But the real issue is whether the business should be creating conditions which prevent the customers from re-paying. A fractional reserves system, where all money creation carries an interest rate, creates the conditions for failure. New money must always be created just to pay the interest on the old loans. Further, the banks make money whether the loan is productive or not, so their is no incentive to limit loans to productive uses; speculation works just as well–and much faster–from the standpoint of the bankers. Economic failure is built-in to the heart of a FRS; it is in its DNA.

Lending out deposits means that the bankers will be more cautious, because it is their own capital that stands as a loss reserve. My experience with life tells me that people are a lot more cautious with their own money than with someone else’s.

There are of course events that would prevent a large enough portion of the people from re-paying their loans: famine, war, pestilence. But these are common tragedies that affect everybody; the banks go down with everybody else. But no business should be in a position to cause disasters. Perhaps we cannot kill the locusts and stop a famine, but we should be able to discipline the bankers.

avatar Tony May 18, 2010 at 12:10 pm

Albert & Mr. Médaille, thanks for your latest comments – I was hoping to plumb the depths a bit further on this, but was distracted for a time by final exams.

Albert, when you say “prevents a bank from lending Joe Borrower the $100 and allowing him to spend that $100 via a check . . .”, is the “him” referring to the person who deposited the $100 with the bank? In other words, the depositor can’t write a check against his account or otherwise withdraw his deposit, so long as his deposit has been lent out to Joe Borrower? Hence your distinction between lending out demand deposits vs. lending out CD’s? (Am I at least getting closer?)

If the point of full reserve banking is not whether it tends to make banks remain financially sound, then you’re right – my confusion stems at least in part from the “so what” aspect. If a bank is able to make productive loans that do lead to real goods and services (however those might be defined), and is able to judge correctly how much cash it might need on hand to cover any withdrawals its saving/depositing customers might want on any particular day, then what difference does it make whether the bank is practicing fractional reserve or full reserve banking? Or, to ask the reverse, how would full reserve banking lead banks to make productive loans rather than engage in speculation? I can see how full reserve banking would lead to fewer loans; I’m not sure I see how it would lead to “better” ones. (It seems to me that fewer loans is, at heart, exactly what Mr. Zencey’s essay is arguing for – a variation on the “there are just too many people doing too many things” position, that seems to start out well-meaning enough, but often degenerates into the insidious “there are just too many people.” But, perhaps I’m just being ungenerous.)

Mr. Médaille, you confuse me – earlier you said that under full reserve banking, bankers would lend deposits by acting as brokers between savers and borrowers; yet, in your latest comment, you say that under full reserve banking, bankers would be more cautious because it would be their own capital at risk. Isn’t this a contradiction?

More importantly, doesn’t any interest-bearing loan inherently carry that same problem of an expanding money supply? Again, if the money supply is supposed to reflect the real economy, then if a loan is productive and results in real wealth being created, shouldn’t there be more money in existence when the loan is repaid? You seem to argue that this additional money should be created by the government, and not by the banks – am I understanding this correctly? How would the additional money be put into circulation, and how would it be tied to the productivity of any particular loan, if it had no connection to interest on a loan?

avatar John Médaille May 18, 2010 at 12:40 pm

Tony, very sound questions. What makes bankers cautious is using there own funds as a reserve against losses, which is the only justification for making a profit at lending (well, that and the service provided). As it is, the depositor’s money serves as loss reserve, and only when the losses get high enough is the capital endangered. The result is that the bankers create too much money in good times (since profits depend on the amount of loans) and too little in bad times (since their capital is at risk.)

Expanding the money supply is not a problem; the supply of money needs to expand (or contract) along with the supply of goods and services for sale. The question is whether all the money is created at interest. Currently, there is no necessary connection between the productivity of a loan and its interest rates. In fact, the rate in inverse. Loans of no productivity (consumer loans) carry the highest interest rates, and loans of the highest productivity carry the lowest. This is the reverse of a sound system. Rather than interest of any kind, there should merely be fees for lending, a premium for risk insurance, plus participation in the profits generated by the loan. This means that the more productive a loan is, the higher its return. While non-productive loans could only collect fees for service and risk.

avatar Samuelson May 22, 2010 at 3:41 am

First, I want to say how enlightening this discussion has been. I have been reading about this question (starting with Murray Rothbard’s The Mystery of Banking) since the banking crisis erupted a couple of years ago and I have read nothing on this subject as crystal clear as this article and the subsequent posts. No one who really understands it can fail to be astonished at how private banks appropriate so much public value whilst claiming to be bastions of the free market. Many thanks to all comments and to Mr Medaille in particular for sharing his thoughts. I do have a couple of follow up questions however which I hope Mr Medaille can answer.

1. How much is the public subsidy given to banks from seigniorage? Mr Medaille said that it is the value of interest plus the value of the original loans when they are repaid. But in a fractional reserve banking system, loans in aggregate are not, and cannot, ever be repaid, because this would cause a contraction of the money supply. So how much is the value of seigniorage appropriated by banks? Is it “just” the interest?

2. Isn’t there another source of value to those who create money, namely the ability to spend it before its inflationary effects have cascaded through the economy? If so, who appropriates this value? Is it the banks through the interest payments they receive by anticipating inflation, or is it the first borrower who takes the new money and spends it?

3. Why is deflation so bad? If the quantity of money is fixed and the economy is growing at a certain rate then money will simply increase in value. If everybody knows this and it is built into expectations then value will not be transferred from borrowers to lenders as deflation will be built into the interest rate. I see no reason why negative interest rates (the borrower pays back less than he borrowed in nominal terms but more in real terms) can’t exist if the growth rate of real goods and services is high enough. Or does deflation itself cause a contraction in economic activity?

avatar John Médaille May 22, 2010 at 10:33 am

Mr. Samuelson (any relation to the famous economist?), I agree completely with point 1; the loans cannot be repaid in full, and so there are credit crises built into the DNA of the fractional reserve system. And yes, the precise value of the seignorage is difficult to measure. Suffice it to say, “a lot.” #2, I suspect the answer is “all of the above.”

The interesting question is 3. Deflation is a killer of the young and of small businesses, because the money they repay is worth more than the money they borrowed. Deflation is a transfer of wealth from borrowers to lenders over and above the contracted amount. Inflation is a reverse movement, however the interest rates usually anticipate some level of inflation. Why not a similar negative anticipation for deflation? Why bother? The money “earns” an interest rate without doing anything. Why take on risk when just holding money is profitable? Further, lenders are loath to grant a negative interest rate because for both economic and psychological reasons.

A growing economy is always inflationary to a some degree because the money must be injected into the economy before the growth takes place. To increase production you must first borrow money (assuming the borrowing creates money) before the goods are added to the economy.

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