Fractional Reserve Banking and "Austrian" Business Cycles, Part I

Austrian Business Cycle Theory, banking theory, central banks, fractional reserve banking, money supply
Austrian Business Cycle Theory, banking theory, central banks, fractional reserve banking, money supply
Source: Marginal Revolution University

Several times on these pages (e.g., here and here), and elsewhere (e.g., here and here) I've tried to refute the claim, championed by certain Austrian-school economists and their many fans, that fractional-reserve banking is inherently fraudulent, because whenever the sum of readily-redeemable bank deposit balances and (when they exist) redeemable commercial banknotes exceeds the quantity of bank reserves, the difference must consist of so many fake "warehouse receipts" or "property titles."

Although the popularity of the "fractional reserves equal fraud" (FR=F) thesis seems to be on the wane, many still remain in thrall to it, and I'm pretty darn sure that no further exertions by myself, Larry White, or anyone else will ever suffice to change all of their minds. Although I wish this weren't so, I worry less and less about it. After all, there are still several Flat Earth societies, complete with dues-paying members, yet reputable geographers don't seem to be losing any sleep over it.

There is, however, a second "prong" to the Austrian* attack upon fractional-reserve banking which has also won many adherents, and which hasn't been so thoroughly debunked as to make one wonder about those adherents' powers of ratiocination. I mean the argument that fractional reserve banking inevitably causes business cycles by allowing banks to finance levels of investment exceeding those warranted by voluntary savings, at interest rates driven below their equilibrium of "natural" levels. The ensuing "malinvestment" boom, financed by "forced" rather than voluntary saving, inevitably leads to a bust, when unsustainable investments are liquidated, and economic activity is painfully redirected along sustainable paths.

In fact this second "fractional reserves equal Austrian business cycles" (FR=ABC) prong of the Austrian assault on fractional-reserve banking is just as unfounded as the first. The difference is that, while trying to win over the last, staunch adherents to the FR=F thesis may be futile, getting many who now believe that FR=ABC to see the error of their ways may not be so difficult, because the counterarguments haven't been aired as often.

Those counterarguments are, on the other hand, more involved than the ones that can be brought to bear against the against the FR=F argument. Consequently I've chosen to devote several posts to them. I begin this first post with a review of conventional "Austrian" arguments concerning the meaning of excessive monetary expansion. I then consider the bearing of fractional reserves on an economy's rate of monetary expansion. In two follow-up posts I use this background information to  critically assess the claim that fractional reserve banking is an important cause of Austrian-style boom-bust cycles.

Monetary Expansion and the Austrian Theory of Business Cycles

To asses the claim that fractional reserve banking is an important cause of booms and busts of the sort described by the Austrian theory of the business cycle, we have, first of all, to recognize at least two popular versions of that theory that supply grounds for this claim. Both versions attribute cycles to excessive monetary expansion. But each defines "excessive" monetary expansion differently. According to one version, a constant money supply alone is capable of averting cycles. As Murray Rothbard explains, in summarizing Austrian monetary theory,

once any commodity or object is established as a money, it performs the maximum exchange work of which it is capable. An increase in the supply of money causes no increase whatever in the exchange service of money; all that happens is that the purchasing power of each unit of money is diluted by the increased supply of units. Hence there is never a social need for increasing the supply of money, either because of an increased supply of goods or because of an increase in population. People can acquire an increased proportion of cash balances with a fixed supply of money by spending less and thereby increasing the purchasing power of their cash balances, thus raising their real cash balances overall… .

A world of constant money supply would be one similar to that of much of the 18th and 19th centuries, marked by the successful flowering of the Industrial Revolution with increased capital investment increasing the supply of goods and with falling prices for those goods as well as falling costs of production. As demonstrated by the notable Austrian theory of the business cycle, even an inflationary expansion of money and credit merely offsetting the secular fall in prices will create the distortions of production that bring about the business cycle (my emphasis).

The other version of the theory maintains instead that cycles are caused, not by growth in the money stock per se, but by growth in the supply of unbacked ("fiduciary") bank money. According to Frank Shostak, one of several adherents to this view, what sets in motion these cycles is not fluctuations in the growth rate of money supply as such, but the fluctuations in the growth rate of money supply generated out of “thin air.” By money “out of thin air” we mean money that is created by the central bank and amplified by fractional reserve lending by commercial banks.

An increase in the money supply out of “thin air” provides a platform for non-productive activities, which consume and add nothing to the pool or real wealth. Money out of “thin air” diverts real wealth from wealth generators to non-wealth generating activities, thus weakening the wealth-generating process.

In this alternative version of the theory, what matters is whether new money is either made of or backed by some commodity, like gold, or not. In a gold standard system, growth in the stock of gold, no matter how rapid, can never set off a cycle; in contrast any decline in the ratio of gold reserves to readily-redeemable bank liabilities can set a cycle in motion. In the case of a fiat money system, the two versions of the Austrian cycle theory coincide, for in this case there is no question of any "commodity-money" driven growth in the total quantity of money, whether that growth is due to central bank expansion or to a reduction in commercial banks' reserve ratios.

Fractional Reserves and Monetary Expansion

The next step in countering the FR=ABC thesis consists of showing that a banking system's reserve ratio and its rate of monetary expansion are largely independent of one another. One might have a banking system that rests on slimmest of reserve cushions, in which the monetary supply doesn't grow at all. Alternatively one could have a 100-percent reserve system in which the money stock grows at a rapid rate.

These conclusions follow from the simple fact that, in any banking system with a given reserve ratio, the growth rate of the supply of bank-created money (or, if one prefers Austrian terminology,  money "substitutes") consisting of readily-redeemable deposits and, perhaps, commercial banknotes, will be approximately equal to the growth rate of the supply of "basic" money or bank reserves. That will be so whether these reserves consist of some commodity like gold or of the liabilities of a central bank. Nor does it matter how low the reserve ratio is: as I'll show in a moment, although the growth rate of the money supply does depend on whether and how rapidly the banking system reserve ratio itself changes, is doesn't depend on the absolute value of that ratio.

I say "approximately" above because some basic money may also circulate outside of the banking system, in which case movements of basic money into and out of the banking system will also influence to total money supply. To simplify the discussion, let's assume that "basic" money consists of gold coins, but that instead of actually using these coins, the public prefers to hold banknotes and deposits, so that the supply of bank reserves is always equal to the supply of basic money. Let's also assume that there are no mandatory reserve requirements. These circumstance make life relatively easy for the bankers, who need never fear having customers withdraw gold, and can presumably expand their liabilities more readily as a result. The assumption is therefore meant to allow as much scope for fractional-reserve based monetary expansion as possible.

The banks still need some gold, however, to settle accounts among themselves, especially when the amounts involved are too small to cover with other assets. Consequently they must maintain some positive ratio of reserves, though the ratio may fall well below 100 percent. Letting r stand for that ratio, with R and M standing for the quantities of reserves and bank-created money, respectively. Then

(1) M = R(1/r).

Differentiating (1) with respect to time after taking logs gives

(2) M = Rr,

where the italics stand for rates of change. Equation (2) shows that the growth rate of the money supply depends, not on the absolute value of r, but on how that value changes over time. A falling reserve ratio will be associated with a growing money stock, other things equal; but a small reserve ratio, if constant, doesn't imply a more rapidly growing money stock than a high one. Instead, if the reserve ratio is constant, the money stock will grow only as rapidly as the supply of bank reserves,  regardless of the value of the reserve ratio.

Real and Pseudo Money Creation

Austrian accounts of the money-creation process often exaggerate the ability of fractional reserve banks to create money "out of thin air," even while sticking to a fixed reserve ratio, by looking at only one part of the bank money creation process. Consider the following, typical account, from a paper by Walter Block and Kenneth M. Garschina. Banks, they write,

are able to increase the money supply due to the system of fractional reserve banking. For example, if a deposit is made of one hundred dollars, the bank is only required to hold "in reserve" or "on hand" a small fraction of this amount. The rest can be granted as credit to customers who will inevitably follow the same deposit process with their newly acquired funds. In this way, in a decentralized system, money travels from bank to bank, multiplying each time it is lent out. And the original depositor, of course, is still able to draw on the funds entrusted to the bank on demand. As the process continues, the volume of money increases, lowering the money rate of interest below the natural rate.

But is it really true that a deposit to any bank in a fractional reserve system leads to substantially greater increase in the total money stock, and a correspondingly large increase the the money stock's fiduciary component, with all the business-cycle repercussions that follow from such?

Actually, it isn't, for the simple reason that, more often than not, a deposit made at one bank involves a corresponding withdrawal of funds from another bank, as when the deposited sum takes the form of a check. In that case, the process of deposit expansion that Block and Garschina describe will have as its counterpart a like process of deposit destruction, where the ultimate result (assuming the simple case in which all banks maintain the same, given reserve ratio) is an unchanged total money stock, with the only actual change consisting of a change in the distribution of bank deposits among the various banks.

In order for the total money stock to increase, as Block and Garschina suggest it will, the initially deposited sum, instead of consisting of funds transferred from a different bank, must consist of basic money, meaning either cash that had been circulating outside the banking system, or basic money that has freshly entered the economy, in the shape of newly produced or imported metallic money or, alternatively, the fresh fiat money emissions of a central bank. But in that case the fundamental cause of growth in the money stock is, not the fractional value of r, but the increase in R, just as our previous equations suggested. Provided that the system reserve ratio itself stays constant, so long as the supply of bank reserves itself remains unchanged, the total quantity of bank deposits won't change.

It follows from what's been said so far that, to assess the claim that fractional reserve banking causes business cycles, we must ask two questions. The first question is, "To what extent have historical money-fueled booms been associated, not with growth in the supply of either commodity money or central-bank supplied bank reserves, but with declining banking system reserve ratios?" The second question is, "When a banking system does manage to operate on a lower reserve ratio, does its doing so necessarily contribute to an unsustainable boom?" I'll answer these questions in subsequent posts.


*On Facebook Roger Koppl and Peter Boettke have faulted me for characterizing as "Austrian" a thesis that is in fact not held by all economists who identify themselves as members of that school, including most of those teaching at top ("R1") U.S. research universities. It's certainly true that some prominent Austrian monetary economists expressly reject the view that I criticize (Fritz Machlup, Larry White, and Steve Horwitz stand out in this regard), while many others have written nothing to suggest that they subscribe to it. I nevertheless feel justified in characterizing as "Austrian," for want of any equally convenient and descriptive label, a position taken, in at least some of their writings, by both Mises and Hayek, held consistently and emphatically by Murray Rothbard, and routinely argued by numerous other academic economists who certainly qualify as members of the Austrian school, including Jesús Huerto de Soto, Joe Salerno, Bob Murphy, Walter Block, Guido Hülsmann, John P. Cochrane, and Phillip Bagus. (Note added 8-18-2018.)