Myths about the FED

Alot of people vilify it. Some think it's a great system. Others don't know what it is.

http://hiwaay.net/~becraft/FRS-myth.htm

This site covers a good bit about it; however, it misses one central point. Check out this section:

COMMERCIAL BANKS AND FRACTIONAL RESERVES

At the base of the s stem, of course, are banks (and credit unions and savings and loans). These institutions are intimately involved in the creation process. This involvement is criticized by some commentators who regard the creation of money as a strictly government privilege which they feel should not be permitted of private firms. However, bank involvement in money creation is almost impossible to avoid. Moreover, the benefits of banks' role in money creation go largely to the public not the banks themselves.

Banks lend out other people's money. Bank customers who borrow the money pay interest for the privilege. The interest pays for the banks' expenses of carrying on business, interest to those who have placed their funds with the banks, and profits to the owners of the banks. Hence, the bank intermediates between people who have spare resources and those who want to use those resources.

Banks (and credit unions and savings and loans) are "depository" institution. In contrast to their intermediaries such as brokerage firms (which invest their customers' money such that the customer accepts the risk of loss), a depository institution accepts funds "on deposit," i.e., on the condition that the bank will return the principal to the depositor regardless of how well or badly the institution invests the funds. Hence, a depository institution absorbs much of the risk of loss in lending out its depositors' money.

Because banks are intermediaries, only a fraction of the money that people deposit with them is kept on hand. Most is lent out. The fact that banks keep on hand only a fraction of the funds deposited with them is no secret, and is apparent to anyone who thinks about it: the lending out of money on deposit is how a bank is able to pay interest to its depositors for their funds. Otherwise, depositors would have to pay fees to the bank for safekeeping their money.

The practice of keeping only a fraction of deposits on hand has a cumulative effect for the banking system as whole. Effectively, it permits the banking system to "create" money. If a given sum of cash is deposited in bank A, and half of it is lent out, whoever borrows it spends it, and the money becomes the deposit in bank B of someone else. Half of that sum is then lent out, spent, and deposited. The process continues until the total amount of deposits is a multiple of the initial amount of cash. In this example, the cumulative total is ultimately twice the initial amount. In practice, the multiple depends on what fraction is kept in hand as reserves by the bank and what fraction is kept as "pocket cash" outside the banking system.

Thus, "fractional reserve banking" effectively permits the creation of money by the banking system to a multiple of the "base" money (typically created by the government). But while the system as a whole creates money, individual banks generally do not. Even though each bank may have in checking accounts a sum that is equal to the money that was deposited with it, as a group, total deposits in all banks are a multiple of the initial amount.

This means, of course, that for a given supply of money in the economy, the existence of money generated by banks through fractional reserve banking reduces the amount of money that the government creates. When governments create money, they profit by the difference between the cost of printing it and its face value. Hence fractional reserve banking reduces the potential income to the government from money creation (called "seignorage).

Fractional reserve banking is a natural, common, and indeed unavoidable process. It is not an artificial construct of law or of central bank-policy. Whenever and wherever bankers, goldsmiths, and traders have accepted funds deposited with them, fractional reserve banking has emerged. It quickly becomes obvious to any businessman who accepts deposits that while some customers come to withdraw money, others come to deposit it. Only a fraction of the total deposits at a bank needs to be kept on hand for normal day-to-day banking. Even an unexpected shortfall one day at a bank can be remedied by briefly borrowing from another bank. The consequence is that a portion (usually the majority) of a country's money supply is generated by the banking system.

This process of lending out deposits can come in a number of forms. Banks years past issued currency (bank notes). Now they mostly use checking accounts. Receipts for deposits have served the same role. Despite any laws that might be enacted to prevent fractional reserve banking, there is a strong incentive for the "banking" system to come up with something of its own that will serve as money because it is in virtually everyone's interest to do so. Depositors come out ahead because their deposits earn, rather than cost, money. Borrowers have access to funds at an interest rate they might not have otherwise obtained. Bankers make profits. Society is better able to channel idle resources into economically productive activity.

Fractional reserve banking in some form or other is virtually impossible to prevent. But this difficulty in preventing the creation of fractional reserves also helps ensure that institutions do not profit excessively from it. Although, in essence, fractional reserve banking confers money creation powers on the private banking sector, the loss to the government primarily goes to the benefit of the public, not the banks. The potential profits from money creation through account expansion gives banks an incentive to expand their activities. This expansion can only come from attracting more deposits. The primary means of attracting deposits is by offering higher interest rates or more services. As a consequence, the banks tend to bid away the excess profits, and the benefits go to customers. Fractional reserve banking is therefore a means of reducing the public's sacrifice of interest earnings to the government. The public, not the banking system, is the ultimate beneficiary of fractional reserve banking.

There is a huge flaw in this logic. It measures wealth in nominal terms. Of course the public is benefited by a system that creates lots of money exponentially when the measure of public benefit is the amount of money everyone has.

But what is money worth? Quickly, the nominal illusion vanishes. The fractional reserve system in America typically grows the money supply by about 8% annually, perhaps higher (I am using True Money Supply data from Mises.org). At this rate, the money supply doubles every 9 years.

The principle point the author misses is that for money, value is inherently related to supply. It may take some time for the value to change in response to money being entered into circulation. And observations of market prices (used to gauge price inflation) don't tell the whole story about how much value is actually disappearing (better technology and economic growth decrease prices without any change in money supply). It is a law of economics, however, to say every additional unit of money created devalues every other existing unit in terms of its former value. Thus, your average savings account at 2% nominal interest actually loses 80% of its would-be value.

Keep in mind, value is abstract. It is a subjective opinion of something's worth, dependent upon an endless complexity of conditions. For example, if you had 2,000 sandwiches and weren't hungry, a single sandwich would seem less valuable than if you only had one sandwich and hadn't eaten in weeks. Value is more complex than simply comparing one thing to another, or one market price in time to another, but for purposes of calculation, that's often what we have to resort to doing.

Logically, it seems simple to understand how increasing the number of monetary units will decrease each of their values. First, most people are not creating money. They are creating work, in the form of services or goods. They ultimately trade this work for the work of others. How much of one person's or one type of work is required to acquire some other person or type's yields an exchange rate. What glues these exchanges together, throughout the whole economy, is money. By determining the exchange rate of one's own work through the public market using money, one discovers his work's exchange rate with every other person and type of work available on the market. Money allows us to find relative value. Increasing money supply does nothing to increase one's relative value, as relative value is ultimately expressed in exchange rates of work, not monetary units.

Money cannot do anything else. It cannot make someone more productive. It cannot transform itself into work. It can only be used to attempt to coordinate work and exchange according to what individuals desire.

The simplest way to express this is supply and demand. If the supply of money goes up and the demand remains constant, its price, or value, goes down. Demand for money is expressed in terms of work. The only means for demand for money to increase is if everyone started working harder (or started using machinery that made them more productive...or the population grew).

More work could be said to benefit society, but if that were true, why would society not choose to benefit itself by working harder in the absence of an inflationary money supply? Leisure and consumption are valuable. Thus, production and consumption ratios are determined by the will of individuals, not the money supply. Just as money supply cannot change relative value, it cannot change production:consumption ratios. Even if it could, why would this be considered a benefit to society? Essentially, such an ideology promotes slavery.

Well, can increasing the money supply help create new, more productive machinery? Again, the answer is no. By devaluing others' savings, the banking system does enjoy a wealth transfer when it creates new money (commonly seen as loaning out demand deposits). By loaning this money out to investors, it can be said that inflating the money supply forces the value of cash and bank savings into investments. The problem here, besides there being a forcible transfer of wealth, is that this causes a business cycle. Given that government often tries to correct the bust portions of business cycles and prolongs them, on the whole, more resources are mis-allocated according to what people actually want. This does not benefit society.

And as people begin to notice that their savings accounts are losing 80% of their value over 9 years, they will cut back on such forms of saving. Since other methods are taxed, it is safe to assume that there is less saving than would have otherwise been. This means generally that capital investment which would result in greater production from less work is exchanged for consumption. In the long run, this makes us poorer, against our will (unless you cater to the idea that government actions are the direct expression of societal will...I do not). Again, this does not benefit society.

The final swan song of fractional reserve banking is that it presided over some of the greatest American economic growth. I believe this is true, but completely coincidental. It follows that every time period should have greater economic growth than the time period before it, so long as there are no huge natural disasters or wars. This is due to increases in science and technology as well as population, which the money system are pretty fairly removed from. A decent money system would show consistent growth. Instead we have seen some serious crashes, such as Japan in the 90's and America's Great Depression...and there may be many more to come.