This is a two-part article in response to this video. Before reading these posts, please go and watch that video. It explains the fractional reserve system without using much jargon and highlights some alleged problems with that system.
I write these posts with an aim to defend the fractional reserve system as it stands today. While I do believe that not all of it is perfect, I do believe that a complete overhaul of the system is unnecessary and that the video over dramatizes the issue.
Clarifications and notes on terminology followed
Wealth and money: I am treating money as different from wealth. Wealth in my post would mean any additional goods or services produced from raw, and otherwise unusable, materials available in nature. Creation of goods or services of zero demand would result in no wealth creation. Money these days has become synonymous with currency. In my post, by money I mean an abstract or real object that can be bartered for goods and services. Thus, money also has an extrinsic value determined by the market.
Enterprise: Any economic activity that seeks wealth creation is an enterprise by my definition. And because it seeks wealth creation it has to aim to produce more resources by consuming fewer resources (less and more measured by the demand in the society). Even your day to day office work will fall under this category. Ultimately you consume oxygen, water, food, entertainment, etc. and charge yourself to work the next day and transform these raw materials into presentations, tractors, flour, clean gardens, cooked food, sold pizzas, blog posts, iPad applications, bank spreadsheets or whatever else your trade demands you to produce.
Section 1: Why create money before wealth?
Let’ say there was no fractional reserve banking system in your society. All money would then eventually come from either the government mint (henceforth, the mint) or through someone else. The government mint in such a scenario would mint the money to account for the wealth that has been created. How it figures out the value of the wealth created will be discussed in section 3. And why it needs to be would be discussed in section 2. For now let us examine why it needs to create money even before the economic activity has begun.
Say you are a poor but talented entrepreneur and you come up with an idea of producing electricity from your local spring. You estimate that this project, when completed, would allow your society to create more wealth. But to begin this project you need to raise some capital. Consider the extreme scenario where even if everyone emptied their pockets you would not get enough capital to fund this project. Therefore, if the government does not mint more money and loans it to you, your project would never start and the net result would be a possible loss to the society. Therefore, for the society’s good, the government would have to intervene and mint more money. In a more practical example, the society will have enough money but it will come at a cost in terms of foregone opportunity. The best way to avoid such a loss of opportunity would be to conjure money out of thin air and to return it back to thin air when it has served its purpose.
Regardless of how the government determines the amount of money to mint, this process would create additional money before the wealth would be created. Because this money has to be conjured from thin air it needs to be abstract –meaning that its nominal value (market value) should be greater than its real value. For example, the cost incurred to mint a €1 coin should be less than €1. If it were not, then the mint would simply be playing a zero sum game with the society and our objective won’t be met. You would of course be obliged to pay back to the government. But at least you will get started with your enterprise.
This idea is essential to equal opportunity –skilled or talented people should not be left behind just because they have no resources or capital to command.
You would pay the government back when your project generates sufficient money for you. In an ideal scenario, the government should then destroy this money and thus bring the abstract money amount back to zero. But in practice, it would instead put this money in a reserve and would bring it out again when it runs, once again, into a similar situation. Note that the net effect of this approach would the same as destroying that money now and minting new money when the need arises.
The other scenario would be if your project fails. In this case, the abstract money would have been consumed in the form of services or goods to no effect. You will default in this case. I will revisit this point in more detail in section 4. For now, I have given arguments for why money needs to be created before the wealth itself has been created.
Section 2: Distributing the created wealth
Suppose you succeed with your project and your customers do create goods and services using the electricity that your plant produces. How do we know they have created wealth? First and foremost, whatever they create should be in demand by the society. But of course, whenever someone will pay for the goods or services produced by your customers they will have to forego some other good or service. It is easy to see that this demand cannot be internally met with the existing money in the system because there is a surplus of wealth. If it were to be met internally it would mean that something else dropped in value (lost demand) –thereby bringing the net wealth created by the activity to zero. In short, the government needs to mint an equivalent amount of money (note that by our definition, money is abstract) to account for this surplus wealth. How it determines this amount is very critical and will be discussed in section 3.
The question then becomes to whom should the government give this money? May be it has no need for the goods and services that were actually produced in which case it would have no reason to give money to the person who produced them. But for the money to trickle fairly into the system the government would ultimately have to purchase some goods or services from the society. Thus, the government in this case would always be external to the society. That, by the way, is why government spending is so critical in sustaining the economic growth. The spending is usually for a common cause such as national defence. Government spending is not a magical bullet to solve all growth problems –the society has to take the first step by creating this wealth.
But what if your customers fail to produce any wealth? Then your project though successful in implementation would fail in its end result of being beneficial to the society. Whether it fails at the implementation stage or at the consumption stage would be immaterial. The net effect would be a loss to the society. I will revisit this further in section 4. In summary, I have argued that any wealth creation has to be backed by an increase in the money supply.
Section 3: How much money? Who decides?
Now to the critical question I’ve avoided so far. How much money should the government mint out? Who decides the fair value of the new wealth? It is essential to determine the price because that will ultimately guide government spending. If your society were an island of 1000 people, the government might have no problem monitoring every economic activity and determining the amount of money to mint. However, most modern societies are simply too large for this model to succeed. Take the case of United States with millions of people under its boundaries or India where there are billions of people going about their daily lives. An extreme example is the EU where multiple countries are served by a single central bank. The government could in theory appoint several agencies tomonitor a certain geographical region and report the economic activity in that region. The government could then compile all this data and determine the amount of money to mint.
However, there are cheaper alternatives to this. A free market approach would be to let the people in the society determine the price for their own consumption. The government would intervene at a stage when it shall become necessary to pump more money into the system or take some out of it. This could be monitored by the price index of key items in the economy. In this scenario, the government would not mint the money as soon as the wealth would be created. Rather, it would observe the demand for this money.
Let’s again go back to our example. Consider that your project succeeded and your customers were able to create additional goods or services which were in high demand in your society (thus, they created wealth). In such cases, the demand for something else would ultimately have to fall because the net money in the system would not have yet increased. This existing demanding could be monitored by monitoring the market price of that good or service and more money could be minted and introduced into the system. Conversely, if the project failed, it would have consumed raw material that could have otherwise been used in a successful enterprise. This therefore would drive the prices of something in the economy up. That something may not be the raw material in question. In this case, the government would have to step in to take some money out of the system.
Section 4: Why is it necessary to take money out of the system?
If either the project fails or if the customers fail to create wealth (that is they have consumed something from the society but have not given anything back), the price of something else will ultimately rise. This point is important so allow me to illustrate it with the following examples.
Consider that a customer has decided to convert wood, stone, sand and clay into houses using that electricity. She shall consume all these materials from the society, driving their prices up. But in return she would have produced a house of zero net worth (net demand). And thus, the society would be left with little material for use in other endeavours (foregone goods). Assume further that the demand for wood was met for by foregoing furniture. Then the price of furniture would rise and the price of wood itself would remain at more-or-less the previous levels. The point I am trying to illustrate is that it does not matter price of which good or service would rise. The point is that something in the system will become dearer.
Regardless of what prices rise the situation is that you have extra abstract money in your system and even lesser wealth to back it up. Therefore, the government needs to take some money out of the system and restore economic equilibrium. This is a logical conclusion of the failure of the enterprise –a net shrinkage of the economy. What happens when an economy keeps consuming raw materials but does not create wealth? Well of course, it goes bust. A great example would be a fictitious society that instead of turning wood into furniture simply burns it down.
To summarize, I have argued why a society needs to create abstract money to support enterprises and economic growth. I have argued why the government needs to spend and what happens when it does not. I have also argued as to what governments should do when enterprises fail or succeed.
In the next part, I shall build upon these arguments and tackle the questions and concerns raised in the video. The next part will go public on 9th August 2011.