July 28, 2011 Reading Time: 3 minutes

Fractional reserves is an important component of financial stability. Most of the financial regulation is aimed to control this aspect of banking practice such that banks do not become insolvent and a contagious set of bank runs gets into the financial markets. It is as if banks were unable to control themselves and regulation coming from the government or a central bank were needed. If banks are expanding too much, won’t that cause a bubble and provoke distortions in the real market (i.e. housing) and prepare the next crisis?

These worries are not absent in the case of free banking with competitive bank issuers. If the competition that reigns between issuer banks makes them be more careful on how much they expand, doesn’t fractional reserves expand money supply beyond its demand causing a bubble and distortions as well? If investment should be carried out with real savings, isn’t fiduciary media a problem because it is not backed on real savings?

Even though this is a common critique of free banking, a clear distinction is needed between (1) hoarding and (2) saving. Hoarding is when the individual keeps a given amount of money in his pocket, under his mattress, etc. Simply put, is when the individual takes money out of circulation. Hoarded resources are not lent to someone else for investment or consumption, it is out of the market. Because hoarded resources do not go into the market of loanable funds, hoarding does not affect interest rates, but does affect the level of prices by taking money. The inverse is the price of money. When hoarding takes place, less money in circulation will push prices down, which will make the price of money go up.

Saving, on the other hand, is to take the hoarded resources out of the wallet and to offer them in the market of loanable funds. The individual lends the money to someone else for consumption of investment. Because the aggregate supply of credit has increased, savings have an effect on the interest rates downward, but does not affect the level of prices because money is still in the market.

If an hypothetical Robinson Crusoe who lives alone in an island keeps his production of food constant but decides to reduce his consumption, he can hoard the extra food in a shelter. Let’s say that, because he eats less, he has an extra hour every day. If he decides to spend that time walking on the beach, Robinson Crusoe did not reduce total consumption, he just changed his bundle of consumption from food to leisure.

However, if Robinson Crusoe uses his hoarded food to spend less time fishing and use that time to produce something else (i.e. a net), then he is financing himself. There’s no intermediary. But in this case he didn’t reduced his consumption, he reassigned time in the production of food to something else. Hoarding does not become investment if its not used to finance an activity.

If a person spends 100USD less in consumption goods, the 100USD do not become available for investment until they are offered in the market of loanable funds. In a society with multiple individuals, a person can lend his resources to another one. Let’s say a person, Mr. Lender, lends 100USD from his hoarding to Mr. Borrower. When this occurs, Mr. Borrower gives Mr. Lender a signed contract saying that he will pay to the bearer of the note the 100USD plus interests. As long as Mr. Borrower is well respected, Mr. Lender may be able to use the signed contract for exchanges himself. If we do this in a bank that has the freedom to issue its own banknotes, this is called a banknote or IOU.

Therefore, to move resources from my wallet or under the mattress to the bank is not just a mere shift in location, it is a change from hoarding to saving. Until I perform that change, hoarding is not available for investment. Not every deposit in a bank account, then, increases the money supply through secondary expansion, it has to be a deposit that is new in the financial market. If the deposit is a transfer from another bank account then there are no changes in the total money supply, just an internal shift of were reserves are located.

On the other hand, banks can only increase their banknotes as long as their customers are willing to keep a higher amount of reserves on their accounts. Namely, only when individuals decide to spend less and save more (rather than hoard) can a bank lend more to borrowers. The bank is just an intermediary between the above example of Mr. Borrower and Mr. Lender.

This distinction is important for the critique of free banking. If saving and hoarding are treated indistinguishable, then this aggregation conceals the difference and fractional reserves seems to imply an over-expansion of money supply.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Image: Grant Cochrane / FreeDigitalPhotos.net

Nicolás Cachanosky

Nicolas Cachanosky

Nicolás Cachanosky is an Assistant Professor of Economics at Metropolitan State University of Denver. With research interests in monetary economics and macroeconomics, much of his recent work has focused on incorporating aspects of financial duration into traditional business cycle models. He has published articles in scholarly journals, including the Quarterly Review of Economics and Finance, Review of Financial Economics, and Journal of Institutional Economics. He is co-editor of the journal Libertas: Segunda Época. His popular works have appeared in La Nación (Argentina), Infobae (Argentina), and Altavoz (Peru).

Cachanosky earned his M.S. and Ph.D. in Economics at Suffolk University, his M.A. in Economics and Political Sciences at Escuela Superior de Economía y Administración de Empresas, and his Licentiate in Economics at Pontificia Universidad Católica Argentina.

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