The Mystery Of Banking

by Murray N. Rothbard

  What of the dread bank run? Cannot a bank still be subjected to drastic loss of confidence by its clients, and hence demands for redemption, either in gold or in Central Bank notes? Yes, it can, under the gold standard, and bank runs often swept through the American banking system until 1933. But under central banking as contrasted to free banking, the Central Bank stands ready at all times to lend its vast prestige and resources—to be, as the Englishman Walter Bagehot called it in the mid-nineteenth century—a lender of last resort. In the tradition of central banking, the Central Bank always stands ready to bail out banks in trouble, to provide them with reserves by purchasing their assets or lending them reserves. In that way, the Central Bank can help the banks through most storms.

  But what of the severe free market limits on the expansion of any bank? Won’t an expanding Bank A quickly lose reserves to Bank B, and face bankruptcy? Yes, as in free banking, one bank’s expansion will meet a severe shock by other banks calling upon it for redemption. But now, under central banking, all banks can expand together, on top of new reserves that are pumped in, across the board, by the benevolent Central Bank. Thus, if Bank A and Bank B each increase their reserves, and both expand on top of such reserves, then neither will lose reserves on net to the other, because the redemption of each will cancel the other redemption out.

  Through its centralization of gold, and especially through its monopoly of note issue, the Central Bank can see to it that all banks in the country can inflate harmoniously and uniformly together. The Central Bank eliminates hard and noninflated money, and substitutes a coordinated bank credit inflation throughout the nation. That is precisely its purpose. In short, the Central Bank functions as a government cartelizing device to coordinate the banks so that they can evade the restrictions of free markets and free banking and inflate uniformly together. The banks do not chafe under central banking control; instead, they lobby for and welcome it. It is their passport to inflation and easy money.

  Since banks are more or less released from such limitations of free banking as bank runs and redemption by other banks by the actions of the Central Bank, the only remaining limitation on credit inflation is the legal or customary minimum reserve ratio a bank keeps of total reserves/total deposits. In the United States since the Civil War, these minimal fractions are legal reserve requirements. In all except the most unusual times, the banks, freed of all restrictions except reserve requirements, keep “fully loaned up,” that is, they pyramid to the maximum permissible amount on top of their total reserves. Suppose, then, that we aggregate all the commercial banks in the country in one set of T-accounts, and also consider the Central Bank T-account. Let us assume that, in some way or other, total bank reserves, in the form of demand deposits at the Central Bank, increase by $1 billion, that the legal minimum reserve ratio is 1/5, and that the banks make it a practice to keep fully loaned up, that is, always pyramiding 5:1 on top of total reserves. What then happens is shown in Figure 9.8.

  We have not finished the Central Bank balance sheet because we have not yet explored how the increase in commercial bank reserves has come about. But whichever way, the banks’ fraction of total reserves to demand deposits is now higher, and they can and do expand their credit by another $4 billion and therefore their demand deposits by a total of $5 billion. They do so by writing out new or increased demand deposits out of thin air (as fake warehouse receipts for cash) and lending them out or buying IOUs with that new “money.” This can be seen in Step 2 (Figure 9.9).

  FIGURE 9.8 — INCREASING BANK RESERVES

  FIGURE 9.9 — PYRAMIDING ON TOP OF NEW RESERVES

  Thus, an increase of $1 billion in total commercial bank reserves has led, over a short period of time, to a $5 billion increase in demand deposits, and hence in the total money supply of the country.

  If banks remain fully loaned up, then the amount that, in the aggregate, they will pyramid on top of reserves can be precisely known: It is the inverse of the minimum reserve requirement. Thus, if the legal reserve requirement is 1/5 (total reserves/total deposits), the banks will be able to pyramid 5:1 on top of new reserves. If the reserve requirement is 1/10, then the banks will be able to pyramid 10:1 on top of total new reserves. The amount banks can pyramid new deposits on top of reserves is called the money multiplier, which is the inverse of the minimum reserve requirement. In short,

  MM (money multiplier) =1/reserve requirement

  If the banks remain fully loaned up then, we can alter our equation for the nation’s money supply to the following:

  M = Cash + (total bank reserves x MM)

  Since banks earn their profits by creating new money and lending it out, banks will keep fully loaned up unless highly unusual circumstances prevail. Since the origin of the Federal Reserve System, U.S. banks have remained fully loaned up except during the Great Depression of the 1930s, when banks were understandably fearful of bankruptcies crashing around them, and could find few borrowers who could be trusted to remain solvent and repay the loan. In that era, the banks allowed excess reserves to pile up, that is, reserves upon which they did not pyramid loans and deposits by the legally permissible money multiplier.

  The determinants of the money supply under central banking, then, are reserve requirements and total reserves. The Central Bank can determine the amount of the money supply at any time by manipulating and controlling either the reserve requirements and/or the total of commercial bank reserves.

  In the United States, Congressional statute and Federal Reserve Board dictation combine to fix legal reserve requirements. Let us see what happens when a reserve requirement is changed. Suppose that the Fed cuts the reserve requirement in half, from 20 percent to 10 percent—a seemingly extreme example which has, however, been realistic at various times in American history. Let us see the results. Figure 9.10 assumes a hypothetical balance sheet for commercial banks, with the banks fully loaned up to the 5:1 money multiplier.

  FIGURE 9.10 — BANKS, RESERVE REQUIREMENT AT 20 PERCENT

  The banks are fully loaned up, with total reserves of $10 billion in legal reserve requirement at 20 percent, and demand deposits therefore at $50 billion.

  Now, in Figure 9.11, we see what happens when the Fed lowers the reserve requirement to 10 percent. Because of the halving of reserve requirements, the banks have now expanded another $50 billion of loans and investments (IOUs), thereby increasing demand deposits by another $50 billion. Total demand deposits in the country are now $100 billion, and the total money supply has now increased by $50 billion.

  FIGURE 9.11 — LOWERING THE RESERVE REQUIREMENT

  One way for the Central Bank to inflate bank money and the money supply, then, is to lower the fractional reserve requirement. When the Federal Reserve System was established in 1913, the Fed lowered reserve requirements from 21 percent to 10 percent by 1917, thereby enabling a concurrent doubling of the money supply at the advent of World War I.

  In 1936 and 1937, after four years of money and price inflation during an unprecedentedly severe depression under the New Deal, the Fed, frightened at a piling up of excess reserves that could later explode in inflation, quickly doubled bank reserve requirements, from approximately 10 percent to 20 percent.

  Frightened that this doubling helped to precipitate the severe recession of 1938, the Fed has since been very cautious about changing reserve requirements, usually doing so by only 1/4 to 1/2 of 1 percent at a time. Generally, true to the inflationary nature of all central banking, the Fed has lowered requirements. Raising reserve requirements, then, is contractionary and deflationary; lowering them is inflationary. But since the Fed’s actions in this area are cautious and gradual, the Fed’s most important day-to-day instrument of control of the money supply has been to fix and determine total bank reserves.

  X.

  CENTRAL BANKING: DETERMINING TOTAL RESERVES

  The crucial question then is what determines the level of total bank reserves at any given time. There are several important determinants, whi
ch can be grouped into two classes: those controlled by actions of the public, or the market; and those controlled by the Central Bank.

  1. THE DEMAND FOR CASH

  The major action by the public determining total bank reserves is its demand for cash.1 We saw (in chapter IX and in Figures 9.1–9.7) how the public’s increased demand for cash will put contractionary pressure on a bank, while decreased desire for cash will add to its inflation of the money supply. Let us now repeat this for the aggregate of commercial banks. Let us assume that the public’s demand for cash in exchange for its demand deposits increases. Figure 10.1 shows a hypothetical banking system, and Figure 10.2 shows the immediate effect on it of an increase in the public’s demand for cash, that is, their redeeming some of its deposits for cash.

  FIGURE 10.1 — A HYPOTHETICAL BANKING SYSTEM: ALL COMMERCIAL BANKS

  The hypothetical banking system is depicted as one with a 20 percent reserve ratio, fully loaned up. “Reserves” in the commercial banks’ asset column are of course exactly equal to “Demand deposits to banks” in the central Bank’s liabilities column, since they are one and the same thing. The asset side of the central Bank balance sheet is not being considered here; in our example, we simply assume that central Bank notes outstanding in the hands of the public is $15 billion. Total money supply in the country, then, is Demand deposits plus Central Bank notes, or

  $50 billion + $15 billion = $65 billion

  Now let us assume that the public wishes to draw down its demand deposits by $2 billion in order to obtain cash. In order to obtain cash, which we will assume is Central Bank notes, the banks must go to the Fed and draw down $2 billion worth of their checking accounts, or demand deposits, at the Fed. The initial impact of this action can be seen in Figure 10.2.

  FIGURE 10.2 — INCREASE IN THE DEMAND FOR CASH: PHASE I

  In short, depositors demand $2 billion in cash; the banks go to the Central Bank to buy the $2 billion; and the Central Bank, in exchange, prints $2 billion of new notes and gives them to the banks.

  At the end of Step 1, then, the money supply remains the same, since demand deposits have gone down by $2 billion but Central Bank notes outstanding have increased by the same amount. The composition of the money supply has been changed but not yet the total. The money supply is still $65 billion, except that there is now $2 billion less of demand deposits and $2 billion more of Central Bank notes in the hands of the public.

  But this is only the first step, because the crucial fact is that bank reserves have also gone down by $2 billion, by the same amount that Central Bank notes in the hands of the public have increased.

  But since reserves have gone down, and the banks keep fully loaned up, this means that banks must contract their loans and demand deposits until the new total of deposits is again brought down to maintain the legal reserve ratio. As a result, bank loans and investments must contract by another $8 billion, so that the fall in reserves can be matched by a fivefold fall in total deposits. In short, the $2 billion drop in reserves must be matched by a total of $10 billion drop in demand deposits. At the end of the completed Step 2, therefore, the balance sheets of the banks and of the Central Bank look as follows (Figure 10.3).

  FIGURE 10.3 — INCREASES IN THE DEMAND FOR CASH: CONCLUSION

  The eventual result, then, of an increased demand for cash by the public is a drop in demand deposits of $10 billion, resulting from the drop of bank reserves of $2 billion. The total money supply has gone down by $8 billion. For demand deposits have fallen by $10 billion, and cash in the hands of the public has risen by $2 billion, making a net drop of $8 billion in the supply of money.

  Thus, an increased demand for cash causes an equal drop in bank reserves, which in turn has a money multiplier effect in decreasing total demand deposits, and hence a slightly less intense effect in cutting the total amount of money.

  If the public’s demand for cash drops, on the other hand, and it puts more of its cash in the banks, then the exact reverse happens. Suppose we begin with the situation in Figure 10.1, but now the public decides to take $2 billion out of the $15 billion of Central Bank notes in its possession and deposits them in exchange for checking accounts. In this case, demand deposits increase by $2 billion, and the banks take the ensuing extra cash and deposit it in the Central Bank, increasing their reserves there by $2 billion. The $2 billion of old Central Bank notes goes back into the coffers of the Central Bank, where they are burned, or otherwise retired or liquidated. This situation is shown in Figure 10.4.

  FIGURE 10.4 — DECREASE IN THE DEMAND FOR CASH: PHASEI

  In short, the immediate result of the public’s depositing $2 billion of cash in the banks is that, while the total money supply remains the same, only changing the composition between demand deposits and cash, total bank reserves rise by $2 billion.

  Receiving the new reserves, the banks then expand credit, lending new demand deposits which they have created out of thin air. They pyramid deposits on top of the new reserves in accordance with the money multiplier, which in our stipulated case is 5:1. The final result is depicted in the balance sheets in Figure 10.5.

  FIGURE 10.5 — DECREASE IN THE DEMAND FOR CASH: CONCLUSION

  Thus, the public’s depositing $2 billion of cash in the banks increases reserves by the same amount; the increase in reserves enables the banks to pyramid $8 billion more of deposits by increasing loans and investments (IOUs) by $8 billion. Demand deposits have therefore increased by $10 billion from the reduction in the public’s holding of cash. The total money supply has increased by $8 billion since Central Bank notes outstanding have dropped by $2 billion.

  In short, the public’s holding of cash is a factor of decrease of bank reserves. That is, if the public’s holding of cash increases, bank reserves immediately decrease by the same amount, whereas if the public’s holding of cash falls, bank reserves immediately increase by the same amount. The movement of bank reserves is equal and inverse to the movement in the public’s holding of cash. The more cash the public holds, the greater the anti-inflationary effect, and vice versa.

  The public’s demand for cash can be affected by many factors. Loss of confidence in the banks will, of course, intensify the demand for cash, to the extent of breaking the banks by bank runs. Despite the prestige and resources of the Central Bank, bank runs have been a powerful weapon against bank credit expansion. Only in 1933, with the establishment of the Federal Deposit Insurance Corporation, was the government of the U.S. able to stop bank runs by putting the unlimited taxing and counterfeiting power of the federal government behind every bank deposit. Since 1933, the FDIC has “insured” every bank deposit (up to a high and ever-increasing maximum), and behind the FDIC—implicitly but powerfully—is the ability of the Federal Reserve to print money in unlimited amounts. The commercial banks, it is true, are now far “safer,” but that is a dubious blessing indeed; for the “safety” means that they have lost their major incentive not to inflate.

  Over time, one powerful influence toward a falling demand for cash is the growth of clearing systems, and devices such as credit cards. People then need to carry less cash than before.2 on the other hand, the growth of the underground economy in recent years, in order to avoid income taxes and other forms of government regulation, has required an increase in strictly cash transactions, transactions which do not appear on the books of any government-regulated bank. In fact, it is now customary for economists to try to gauge the extent of illegal, underground transactions by estimating the increase in the proportion of cash transactions in recent years.

  The major movement in the public’s demand for cash is seasonal. Traditionally, the public cashes in a substantial amount of demand deposits before Christmas in order to use cash for tips or presents. This has a deflationary seasonal effect on bank reserves. Then, in January, the cash pours back into the banks, and reserves rise once again. Generally, the Fed keeps watch on the public’s demand for cash and neutralizes it accordingly, in ways which will be e
xplored below.

  2. THE DEMAND FOR GOLD

  As in the case of the demand for cash in the form of Central Bank notes, an increase in the public’s demand for gold will be a factor of decrease in lowering bank reserves, and a fall in the demand for gold will have the opposite effect. Under the gold standard, with a Central Bank (as in the U.S. from 1913 to 1933), almost all of the gold will be deposited in the Central Bank by the various banks, with the banks getting increased reserves in return. An increase in the public’s demand for gold, then, will work very similarly to an increased demand for Central Bank notes. To obtain the gold, the public goes to the banks and draws down demand deposits, asking for gold in return. The banks must go to the Central Bank and buy the gold by drawing down their reserves.

  The increase in the public’s demand for gold thus decreases bank reserves by the same amount, and will, over several months, exert a multiple deflationary effect over the amount of bank money in existence. Conversely, a decrease in the public’s demand for gold will add the same amount to bank reserves and exert a multiple inflationary effect, depending on the money multiplier.

  Under the present fiat standard, there are no requirements that the Central Bank redeem in gold, or that gold outflows be checked in order to save the banking system. But to the extent that gold is still used by the public, the same impact on reserves still holds. Thus, suppose that gold flows in, say, from south Africa, either from outright purchase or as a result of an export surplus to that country. If the importers from south Africa deposit their gold in the banks, the result is an increase by the same amount in bank reserves as the banks deposit the gold at the Central Bank, which increases its gold assets by the same amount. The public’s demand for gold remains a factor of decrease of bank reserves. (or, conversely, the public’s increased deposit of gold at the banks, that is, lowered demand for gold, raises bank reserves by the same amount.)