Economics Professor: Don’t Let A Crisis Go To Waste, Use It To End Fractional Reserve Banking

By Hal W. Snarr

10/2/2012

I suspect only Austrian economists and other proponents of a free-banking system would correctly identify Jimmy Stewart’s George Bailey as the villain in the 1946 film, It’s a Wonderful Life. George Bailey, a villain? How can a man who devoted his life to helping the people of Bedford Falls achieve the American dream of owning a home be the villain in such a heartwarming tale? Well, he and Milburn Drysdale, the Beverly hillbillies’ banker, are fractional-reserve bankers.

In fractional-reserve banking, demand deposits can be lent out or held. The reserve ratio is the percentage of demand deposits banks must hold. The Federal Reserve, the central bank of the U.S., set this ratio at 10% in 1992. This policy means banks only have to back up 10% of their customers’ demand deposits with cash. This cash is called required reserves. If this is less than reserves, the difference in the two is referred to as excess reserves. For example, required reserves equal $1 billion at a bank with $10 billion in demand deposits. If such a bank has $2.5 billion in reserves, it has $1.5 billion in excess reserves because it has lent out $7.5 billion. So, fractional bankers like Bailey and Drysdale are legally allowed to treat most of their customers’ money as their own.

In episode 18 of season seven of Seinfeld, fractional reserve banking is lampooned with the famous Austrian fractional reserve parking lot analogy. In this episode, George and Kramer discover their cars are being lent to others by Jiffy Park. Although a procurer had been selling tricks out of George’s car, it was mostly available upon demand. Kramer wasn’t so lucky. When he demands his deposit, the parking lot meets this demand by supplying another’s pink Cadillac Eldorado deposit. Regulating parking lots like banks in a fractional reserve system means lots can lend cars to people other than their owners. George and Kramer agreed to this because Jiffy Park spaces were just $75 a month, and they didn’t read the fine print. Of course the analogy is overly simplistic because cars are not homogenous. Nonetheless, if you think of your money as your money, allowing a bank to lend it to others makes as much sense as allowing Jiffy Park to lend your car to adult service provider procures.

Fractional-reserve banking is also inflationary because banks lend money into existence. With the reserve ratio at 10%, a $100 deposit in Bill’s checking account can metastasize into as much as $1,000 in new money. To see this, imagine Bill’s bank lending out $90 of his money to Jill, a student who needs to buy a graphing calculator. By law, the bank can lend up to this amount because it must keep at least $10 in reserve. If Jill buys the calculator from Buy-Mart, the store deposits the sale in its bank. Buy-Mart’s bank keeps $9 in reserve and loans Jack $81 to buy tickets to a Broadway show. The ticket office deposits the sale in its bank, which lends $72.90 to a borrower to buy a used lawnmower. After just three rounds, banks create an additional $243.90 by lending it into existence. After 100 rounds, the $100 deposit is two cents shy of $1000.

Fractional-reserve banking is inherently unstable because its proponents assume depositors will not withdraw more than 10% in a given day. In addition, the bank lending example above illustrates that demand deposits are a house of cards, which can implode at any moment. This is why fractional-reserve banking is prone to bank runs and failures. In order to mitigate this risk, a government regulates and oversees commercial banks, and provides deposit insurance. Because these activities are not sufficient, a central bank is set up to be a lender of last resort. To better understand why central banking is deemed necessary in a fractional-banking system, one must grasp how our central bank, affectionately known as the Fed, functions under various scenarios. In the macroeconomic principles course I regularly teach, I refer to these as historic, normal, emergency, and crisis modes.

Prior to 2003, the federal funds market was in historic mode. This is characterized by downward sloping reserves demand crossing over reserves supply, which is a vertical line representing the sum of borrowed and non-borrowed reserves. Their intersection determines the federal funds rate. Historically, the discount rate was set between 25 and 50 basis points below this ‘market’ rate, which encouraged banks to borrow at the discount window rather than from other banks. To dissuade banks from overusing the discount window, the Fed required banks to exhaust all other lending sources and explain their credit needs. In the absence of this regulation and discount lending stigma, reserves supply would have kinked horizontally at the discount rate.

Ninety years after its founding, the Fed apparently discovered that markets work much better than directives. In January of 2003, it began setting the discount rate 100 basis points above its federal funds rate target. (I suspect this change had more to do with the Fed avoiding a negative discount rate as it lowered its federal funds target). The change in policy kinked reserves supply at the discount rate. When reserves demand intersects the vertical section of supply, the federal funds market is in normal mode. In this mode, the federal funds rate can be kept very near its target by the New York Federal Reserve buying and selling government securities. These transactions are called open market operations, a tool the fed discovered accidently in the post-World War I era.

Cynically, one can say the Fed believes in free markets as long as the federal funds market remains in normal mode. If a banking emergency, like the one sparked by the collapse of Lehman Brothers, increases reserves demand enough so that it intersects the horizontal section of reserves supply, the federal funds market is in emergency mode with the quantity of reserves demanded exceeding the amount supplied (the sum of borrowed and non-borrowed reserves present at the moment a banking emergency strikes). This difference is a shortage in federal funds unless the Fed fills it with discount loans. According to data published on the Federal Reserve Economic Data website (FRED), discount lending surged from a fairly constant level of $18 billion in August of 2008 to $140 billion the following month, a $122 billion increase in just one month. In emergency mode, the federal funds rate equals the discount rate because reserves demand intersects the horizontal section of supply.

Since October of 2008, the federal funds market is in crisis mode. The difference between it and normal mode is in the demand curve. When the Fed was about to purchase all of that paper from banks after TARP (Troubled Asset Relief Program) was enacted, it had to recognize that doing so would be an open market purchase of biblical proportions. This unprecedented action would have pushed the federal funds rate into negative territory unless a price floor could be imposed. The floor that was imposed is called Interest on Reserves (IOR). IOR kinks demand horizontally because banks would rather lend their reserves to the Fed at a rate equal to IOR than to other banks at a much lower negative rate. Hence, IOR is the equilibrium federal funds rate when the federal funds market is in crisis mode.

This new monetary tool allows the Fed to buy as much paper from banks as it deems necessary without changing the federal funds rate. In addition, the Fed can simply raise and lower IOR to affect changes in the federal funds rate.

Once the economy begins to grow more robustly, banks will increasingly lend more to consumers and less and less to the Fed. Some (politicians, employees of the Fed, and priests and parishioners of the economic orthodoxy) may say that this is indicative of the financial crisis being ‘averted’ by ‘wise’ fiscal and monetary policy action. Consumers and lenders will begin borrowing more, and banks will oblige because they are more confident that borrowers will pay back loans. If the Fed does not return the federal funds market to normal mode as demand for reserves builds, which is the case when GDP is growing robustly, the downward sloping section of demand will eventually cross the vertical section of supply. As this happens, $1.5 trillion in excess reserves will flow out of the federal funds market, and the federal funds rate will rise above IOR. This is akin to the Mississippi River breaching its levees. Depending on the size of currency drain, the $1.5 trillion in excess reserves could lend into existence $3 to $10 trillion in new money. This is the hyperinflation that many fear.

At some unknown future time, private sector lending will recover. The Fed knows a bank will not keep reserves bottled up earning a rate equal to IOR when it can lend to consumers and businesses at much higher rates. To keep the inflation genie in the bottle, the Fed will probably choose to incrementally raise IOR with a close eye on money supply and excess reserves. It may also want to sell off the paper it has purchased after the 2008 financial collapse. However, selling these assets in open market operations would flood the banking system with cash. Because banks can buy securities from whomever it wants, the Fed cannot simply sell securities to other central banks and corporations. If it does, then it and Treasury, which has to auction enough bonds off each year to cover those coming due and fiscal budget deficits in excess of a trillion dollars, would be competing for the same buyers. This would cause interest rates to spike.

So, it appears the Fed is between a rock and a hard place.

With the federal funds market in crisis mode, the Fed should follow the advice of Rahm Emanuel, the former White House Chief of Staff to President Obama. At the Wall Street Journal CEO Council in Washington, D.C. just after the 2008 presidential election, Emanuel said, “You never want a serious crisis to go to waste. And what I mean by that is an opportunity to do things that you think you could not do before.” According to data recently published on FRED, demand deposits totaled $828 billion in August of 2012, which is dwarfed by excess reserves totaling $1,478 billion. Given this large difference, I suspect reserves exceed demand deposits at too-big-to-fail and other large banks. Hence, the Fed could change the reserve ratio for these banks to 100% over night. Such action would convert excess reserves into required reserves in an instant, and transform fractional-reserve banking into the system that Austrian economists have been calling for. Such change is needed and implementable with the federal funds market in crisis mode.

A free banking system is inherently more secure but not as profitable as its ugly cousin, fractional-reserve banking, which is literally a house of cards. The lending-money-into-existence example above illustrates this very well. Another great example is the following illustration of how shaky fractional-reserve banking is when home owners (or investors of other assets) discover leverage. When a housing (or any other asset) bubble begins to form, increasing leverage boosts returns. Consider a home that is currently valued at $100,000, is expected to rise by $10,000 in one year, and can be financed with a 5% interest rate mortgage. If this home is purchased with no leverage, the rate of return is 10%. If instead the home is partially leveraged with a 20% down payment, the rate of return is 42%. The rate of return is a whopping 168% if the home is leveraged with 1% down. When the bubble pops, as it did in 2008, the house that leverage built implodes.

Although banks can play fast and loose with depositors’ money in a fractional-reserve system, banks in a free-banking system cannot because there are no backstops.  A free bank could be out of business in hours if they are poor stewards of depositors’ money. Even with backstops in place, the house that leverage and lent-into-existence money built crumbles in a heartbeat. A senator’s “careless remarks” on June 26, 2008 triggered the collapse of IndyMac Bank. Less than two weeks later its customers had withdrawn $1.3 billion in deposits. Because money evaporates when scared depositors stuff demand deposits into mattresses, politicians, too-big-to-fail banks, other crony capitalists, and orthodox economists convince us that the Fed’s lender of last resort role, FDIC, TAG (Transaction Account Guarantee), and the too-big-to-fail doctrine are necessary.

Banks’ reputations and their desire to remain in business becomes the regulator in a free banking system. In either system, banks that assist people in buying homes and cars need to be sure that these people are credit worthy, and able and willing to pay back loans. However, banks in a free-banking system would have to have more stringent credit standards, require non-leveraged down payments, and be more diligent in the approval of credit. The financial collapse was triggered by just the opposite. Interest rates and credit standards were low, and borrowers could lie on liar-loan applications and leverage down payments. A free bank, in the absence of a lender of last resort, FDIC, and other backstops, would also need to secure outstanding mortgage debts by enticing depositors to transfer demand deposits to time deposits that mature over similar lengths of time. This means net interest margin is much smaller for free banks than it is for fractional banks. This competitive disadvantage thwarts free banks in a fractional-reserve system.

I suspect only Austrian economists would celebrate ending fractional-reserve banking with the raising of the reserve ratio to 100% and elimination of all backstops including the Fed. I’d also wager that my colleagues, nice guys who are true believers in the faith, might want to lock me up in a broom closet after bringing much shame upon the department we work in for daring to suggest the Fed is not needed. Too-big-to-fail banks might also lobby politicians to fly Black Hawk helicopters over my home at 2 AM to sweep me away to an indefinite luxurious Gitmo vacation.

At one time, my past-self would have grabbed a pitch fork with that frankensteinian monster, my present-self, afoot. However, after years of teaching macroeconomic principles, the conditioning I received in an orthodox Ph.D. program gave way. I now have much respect for Jed Clampett and his stepmother, Granny. They were rightfully upset in episode 10 of the third season of the Beverly Hillbillies. In this episode, John Cushing, President of Merchants Bank, informs Jed and Granny that Millburn Drysdale has stolen their money. In Drysdale’s defense, he had merely lent out his bank’s reserves. This seemed funny years ago because the Hillbillies were hillbillies who could not comprehend the complexities and necessity of fractional-reserve banking. Now that I see the light, it is clear that fractional bankers, like Bailey, Cushing, and Drysdale, are villains because they view demand deposits as theirs, want depositors to provide them with high net interest margins, and want taxpayers to bear all risks.

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Thanks to Professor Snarr for providing us this excellent article.