Banking | Jonathan Newman

[00:00:00]Hello everyone. Good afternoon. Uh our topic is banking and I guess this is going to be a common theme on the first day because both Dr. Klein talked about how their topic was put on the first day of the schedule and how it might be a little bit counterintuitive with entrepreneurship or with money. How that shows how important it is. However, I would argue that putting banking at the beginning of Misesu is even more counterintuitive because we don't have any sort of lectures in the first few days about a particular industry. It's not like it's not like you know at the beginning of uh Tuesday there's going to be a lecture on the shoe industry right but bank banking is a particular industry so it's it's sort of intriguing as to why we would be talking about banking so early uh in Mises University but also I just want to point out that it's also very important to Austrian economics and the way Mises University has has been run in the past keeping with the theme of of throwback pictures I noticed this picture in in the album of Dr. Solerno giving this talk on on banking around the origins of money somewhere back in in that time period. I don't know. [laughter] Uh so yeah, you see he's got the the balance sheet up there with gold and warehouse receipts and we'll be getting into that in this lecture. Uh so we just saw a lecture from Dr. Sandy Klein about money and uh we didn't see this typology of money but what she was focusing on was the stuff that's at the top of this list. So this is Mises's typology of money. I've borrowed it. It was broken out like this by Dr. Hollesman in his biography of Misesus and elsewhere. Um, but she was she focused on commodity money where where it comes from, how we think about the value of money. Uh, but she also talked about uh fiat money and how we don't we wouldn't expect people to be trading uh pieces of paper like that wouldn't originate on the market.

[00:01:46]However, in this lecture, we're going to be focusing on the the bottom half of this typology. So, what what are money substitutes? what is fiduciary media?

[00:01:55]What are money certificates? So, this is it's a part of the money supply. But, uh there's new and interesting things that happen once we start giving banks our money and then there are things going on inside the bank that change the money supply. Uh and banks are acting as financial intermediaries. They're issuing out these banknotes.

[00:02:13]Things get sort of funky.

[00:02:15][clears throat] Okay. So, but first let's see what what are banks saying about what they do. So when they offer you a checking account, if you read the fine print, you'll find stuff like this.

[00:02:25]So I'm actually sort of interested in the in the fine print of banks because there's a lot of debate over what's actually going on when we're interacting with banks and opening checking accounts. Most people don't read it, but let's see what they're saying. So these are the three largest banks in the United States. Their names aren't that important, so I'll just call them bank A, Bank B, and Bank C. But one bank says, "Your available balance is the amount of money in your account that you can use right now." So this is a a promise, something that's told to all of their depositors. It's money that you can use right now. One thing that you might be interested in doing with that money is making purchases. So you can use your debit card that participating merchants to purchase goods and services at bank two. And a part of their fine print, a part of their depositor agreement is that they say our deposit relationship with you is that of a debtor and creditor, which is a little bit of a should raise a red flag. It's a little bit interesting like why would they why would they say that they are a debtor or why is there a debtor or creditor uh relationship going on if they're just sort of holding on to your money for safekeeping and offering you access to to uh payment services? They also say in the same from the same bank they say the deposit money is your money. So they're making a claim about who owns the money in this account. And at bank three they say your account's available balance is our most current record of the amount of money in your account available for your use or withdrawal. And also they make a claim about ownership similar to what bank 2 says. Each co-owner has complete control over all the funds in the account. So like they're saying this is all your money. we're just holding on to it for safekeeping. You can use it for making purchases. However, if you look at their balance sheets, if you look at their uh financial records, their annual reports to their stockholders, then you'll see that there's there's a discrepancy.

[00:04:16]They're making these claims about your access to the money, your ownership of the money, your ability to make purchases with it, and then what they're actually doing with the money. So, in bank one, I guess I changed it from 8 B and C to one, two, and three accidentally. In one bank, they have $620 billion in the checking account uh type deposits, but they're only holding on to $343 billion in reserves. So, what that means is they're not able to redeem everyone's uh uh redemption requests if they all came at the same time. So, they've made this promise. This is all your money.

[00:04:54]You can use it. you have complete control over it. But by the way, if everybody comes to get their money out at the same time, we're going to come up dry. And the same thing is happening with bank two and bank three where there's a difference in the deposits that people have made and how much how much these banks are keeping in reserve.

[00:05:11]So you can see that at the bottom the difference. So what are they doing? How is it possible? Well, you'll notice another item on their balance sheets is all these loans. They've made huge amounts of loans to the government, to businesses, and to consumers. So, it seems like they're they're taking money that we've deposited there and then they're making loans to to others. And so, that's why they're not able to redeem everybody's deposits uh if everybody came at at the same time. So, we can legitimately ask what's going on here. Banks call money in your checking account your money. They say it's available for withdrawal and purchases at par on demand. So, at par meaning 100% of it, all of it not at a discount.

[00:05:51]and on demand, meaning whenever you want to. And they say that you have complete control over it. However, on the flip side, what makes this weird, something funky is going on. Banks do not keep all deposits backed by reserves. Instead, they make loans, as I said, to Uncle Sam businesses and consumers. And we can look at a time series of of some of these figures in the aggregates. So, the green line at the top is deposits. The blue line at the bottom is their reserves. And then the brownish line it is actually measured on the right hand axis that shows the ratio of deposits to reserves. And you'll notice that they're right now they're keeping it close to a little above 15% of reserves uh is backed excuse me deposits are backed by reserves. Okay. So how can we make sense of this? What's what's going on here?

[00:06:41]Well, I'm I'm glad that Dr. Klein mentioned the mystery of banking by Rothbart in the previous lecture because a lot of what I'm going to tell you in this lecture is just based on what Rothbart does in that book and one thing that he does is he separates banking into two different functions. We can think about banks doing two different things. There's deposit banking and there's loan banking. Under deposit banking, the bank is acting as a money warehouse. So you come in, you give back in the gold standard days, you give uh them a certain uh amount of gold and they give you a little bank note. They give you a little slip of paper that says this this person has deposited this amount of gold. They can come back and and get that gold back or the same amount of gold back whenever they want to. So they give a little paper receipt and as we'll see later, Rothbart refers to them as warehouse receipts. We might more commonly refer to them as as banknotes. Of course, we don't use banknotes these days. We use debit cards. We use We don't even use checks anymore. In fact, a lot of times people are just sort of like tapping their phone on a little device that it works the same way as a debit card. But when if you have a checking account and you're spending money out of that checking account, it's working the same sort of way. The you're sending instructions to the bank to send money from your bank to to the the vendors or the merchants bank. Rothbart says, "As in the case of any warehouse, the depositor placed his goods on deposit or in trust at the warehouse and in return received a ticket or warehouse receipt stating that he could redeem his goods whenever he presented the ticket at the warehouse." So here the the money warehouse, the the bank that's a pure deposit bank is functioning in the same way as a as a coat check. So like you go to some fancy party somewhere and they're they'll take your coat from you at the door and they give you a little slip of paper. when you come back, you can give them the ticket that they gave you and they'll match that with your jacket, your coat, and they'll give it back to you. So, here Rothbart is saying that a pure deposit bank works like that. Not exactly, because when you deposit money, you're not as concerned about getting the exact same coins that you deposited. The other function of money that we'll look at is uh or excuse me, function of banking that we'll look at is loan banking. So, here banks are acting as a financial intermediary.

[00:08:52]They're taking in the savings from their customers and then they're using those savings to make loans to to others.

[00:09:01]Rothbart says the bank is borrowing money from some in addition to investing the savings of the owners and lending money to others. So here there's there's an actual relinquishment of being able to use the money. You're you're parting with it for a specific time period.

[00:09:14]You're telling the bank, hey, here I'd like to purchase a certificate of deposit. I'll lend you the money. I'll buy a a bond from this bank. And so now the bank has that money that's been saved. It's been relinquished to them and then they're using that to make loans to others. And so that's loan banking. So let's look at uh the balance sheets or the mechanics of of what's going on with pure deposit banking and pure uh loan banking. With uh pure deposit banking, here we have a a balance sheet of a bank. We've got assets on the lefth hand side, equity and liabilities on the right hand side.

[00:09:46]The what you should be picturing in your mind is somebody comes in and gives $15,000 worth of gold. Remember from the uh previous lecture, the dollar referred to a specific weight of gold. So somebody gave a specific weight of gold to the bank and said, "Hey, I'd like to I'd like for you to keep this safe for me. I don't want to have to keep guarding it. It's a little bit too risky for me to keep it under my mattress or whatever. It's too heavy for me to carry around. And so maybe I would like access to the nice convenient payment systems that you offer. like I can tap my phone to to spend it. Those sorts of those sorts of considerations lead people to to be willing to pay for this service of having a bank a money warehouse uh hold on to their money uh for for safekeeping. So the bank in this case issues warehouse receipts for gold. So this person they come into the bank with a certain weight of gold and they leave with these warehouse receipts that are claims. They're certificates. They allow them to come back to the bank and get the money out if they want to. It's like a little piece of paper that says, "Here's your coat back. Here's here's the amount of gold that that you want back based on how much you deposited earlier." Okay? And so the bank is is able to uh redeem this person's deposit when they want to by holding on to the gold.

[00:11:06]the the person at the coat check is able to give people their coats back by holding on to their coats, right? So, they keep the gold in reserve. They put it in a vault in the back so it is being kept safe and it's ready to be given back to this person when they come back with the with the warehouse receipts demanding withdrawal, demanding redemption of the of these claims. So, as Rothbart says that nothing exceptionable has happened. I I left that part of the screenshot in there because it's important. Nothing nothing weird is going on. This is just a it's just a swap. Some gold has come out of one person's pockets or their safe at home or their under their mattress and now it's sitting in uh the vault at the bank. But this person can still spend the gold. They can still use it as long as other people in the economy are willing to accept these warehouse receipts. As long as other people say, "Yeah, I trust this bank to be able to give uh to give me the gold if I come in with this warehouse receipt." Then other people would be willing to accept it in exchange. So, it's like that person is spending the gold. The ownership of the gold that's sitting in the vault is changing even while the gold is sitting still in the vault. So, people can still spend the gold while it's sitting still.

[00:12:22]Now, at the beginning of this sentence that I highlighted where Rothbart is saying nothing exceptionable has happened, Rothbart does point out that as there's like a a caveat here, aside from the fact that the bank is actually considering the gold as an asset, right?

[00:12:37]So, like the fact that they've put this on their on their balance sheet to maybe give an example. Suppose your friend is going out of town and they have a a a pet dog and suppose it's a purebreds valuable and so while they're away on vacation, they ask you to take care of the dog for them and they bring it over to to your house and you're watching the dog while they're away. You would not consider that dog your asset, right?

[00:13:05]That would not go into your net worth calculation. I mean, unless you're underhanded and a bad friend, that would not that would not become one of your assets while you're holding on to that person's dog for them, right? So, Rothbart says something weird is already going on. As soon as we're putting the the gold and the warehouse receipts on the balance sheet of of the uh of the bank here, but aside from that, nothing as as Rothbart said, nothing exceptionable has happened.

[00:13:29]Specifically, what what's not happening?

[00:13:31]Well, there's no expansion of the money supply. As I said, the the warehouse receipts are they're they've sort of taken the place of the gold. So, people could have held on to the gold. They could have transacted it, but they decided they like the convenience of the payment systems offered by offered by the bank. They like that the the gold was sitting safe in the vault at the bank. [snorts] And so, they've they've decided, I'd rather use my money in this form as opposed to holding on to the physical gold. But since there was a one forone swap, there's been no expansion of the money supply. The gold in depositor's hands is replaced by warehouse receipts. Instead of moving gold to make purchases, people trade the receipts. So people are still trading gold. They're still using gold as the money. They're just trading ownership of gold that's sitting still in in a vault.

[00:14:19]So there's a one to one correspondence of gold and vaults to the warehouse receipts. And so here's a new term for that. The reserve ratio is 100%. So, if you take reserves and divide it by the warehouse receipts in this in the previous example I showed you, $50,000 worth of reserves and that's backing $50,000 worth of of uh warehouse receipts or the deposits. And so, the reserve ratio is is 100%. You can see that here just by comparing those items on this pure deposit 100% reserve bank's balance sheet. Okay. Now, moving on to uh loan banking. So loan banking as I mentioned before uh when banks are engaged in pure loan banking they they are acting as financial intermediaries.

[00:15:02]So if you see on this bank's uh on this bank's balance sheet they've got some bonds that they've sold. They've offered CDs to to people who want to relinquish their money for a specific time period.

[00:15:15]So like you buy a one-year CD and what you're saying is here bank here's some money. I'm not going to touch it for a year. do with it what you will make some loans and give me a cut of the interest.

[00:15:26]So you're it's a it's a savings vehicle.

[00:15:28]You're part you're relinquishing the use of that money and for that particular time period and and bonds do the same thing. So you're lending money to the bank. You're purchasing a CD. You're relinquishing money for a specific time period. But there's also shareholders.

[00:15:42]They they've given money to the bank.

[00:15:44]And where they get in exchange is is uh equity. They get partial ownership of the assets of the bank.

[00:15:52]And the what does the pure loan bank do?

[00:15:54]Well, if they want to make money, they're going to they have to uh give their CD holders some return for them to be willing to purchase the CDs. They owe their bond holders interest, right? So, they can't just sit on the money. They can't just put all that money in the vault because if they did that, they would lose money. So, they what do they do? They make loans. They take the money that was saved, that was relinquished, and then they they turn around and they make loans to others to to uh maybe consumption loans by offering credit cards, uh helping people finance the purchase of a home. So, they offer mortgages, business loans. So, businessmen come in and they say, "Hey, I've got this great idea for a business.

[00:16:35]Will you help finance this endeavor?"

[00:16:37]And they'll look at the the business plan and they'll say, "Sure, yeah, that sounds like a good idea." Uh and they come up with an interest rate. So they they do all this research and investigation of the people who are asking to borrow money from the bank and the bank is able to lend them money that has first been lent to them. And in this example, Rothkart has the pure loan bank sitting on a little bit of cash as well perhaps as a as a safety buffer.

[00:17:03][snorts] And I also left a part of the uh this the text from the book in the screenshot here on purpose because notice Rothbart is talking about how the bank here is is performing the important service of channeling the borrowed savings of many people into productive loans and investments. The bank is expert on where its loan should be made and to whom and reaps the reward for this service. So here uh what the bank is doing is they're they're doing that research and investigation that would be difficult for all of us to do individually. So suppose I' I've got a little bit of money that I I don't want to spend. I'd like to invest it maybe earn a little bit of return on it. But it would be very cumbersome for me to go out and investigate people who want to buy a house or to start a business and look at their business plan and look at the the value or yeah appraise the house myself. It'd be difficult for me to go through that whole process to find potential borrowers and select them so that I can earn return. Instead, what I can do is I can I I would suffer a little bit of the total return because I'm using a middleman here, but I can offer the money to this bank. So, I can purchase a CD and then the bank will do that service for me. They'll investigate.

[00:18:15]They'll also in case a a loan goes bad, they'll take it to collections and they'll try to get the money back. I don't really want to be in that sort of business, right, of of getting money back from people. But hey, the bank uh can special the pure loan bank can specialize in in performing this sort of service. So that's what Rothbart is saying. It's performing the important social service of channeling many people's savings into uh productive investments.

[00:18:41]Once again, nothing really exceptionable is happening here. There's no expansion of the money supply. And the reason why is because the bank is lending money that was first saved and relinquished.

[00:18:53]So when when the bank sells a bond and you purchase that bond, the money leaves your account. It leaves your cash balances and enters the bank's cash balance. When when you purchase a CD, you're telling the bank, I'm not going to touch this money. I don't need this money for the particular period that the CD applies. Right? So you're you're relinquishing this money to the bank.

[00:19:19]Not the same thing when you open up a checking account where you're saying I would like immediate use of this money.

[00:19:26]So this very different thing going on with with a deposit. So the owners invest and creditors lend money to the bank and then that money is lent to borrowers. So the money is leaving some people's pockets going through the bank as the intermediary and going into other people's pockets. Those are the ones who are borrowing from the bank.

[00:19:44]So you might be wondering how does the bank earn money on this? Well, you saw the lecture on the [snorts] uh division of labor. So the bank has this comparative advantage. They they have computers. They have the people who specialize in investigating the business plans of various businessmen who want to start a new business. And so and so the the bank is able to economize. they're able to uh produce this service efficiently and they can earn whatever spread exists between the uh amount that they owe their lenders and the amount that they receive from their borrowers.

[00:20:20]So for example, if the bank offers CDs at 10% and then lends at 15% well there's a 5% spread there in the rates and if as this is this example is from the mystery of banking as I said be relying on that. Uh Rothbart says if the administrative expenses of operation are say 2% then that leaves 3% profit on the entire transaction. So that's how the bank is able to make money. Now, they wouldn't be able to do that. If you think back to when we were talking about uh pure deposit banking, a a bank would have to charge a fee for you to have a checking account, which is something that we're not really used to. And we'll talk about why in a little in a little bit, but in that case, the the you're you are the bank's customer. If you open a checking account, you're the bank's customer. You've got to pay the bank a fee for keeping your money safe, for offering you access to those payment systems. But in the case of loan banking, they earn the interest spread.

[00:21:22]And as somebody who lends to the bank by purchasing a CD, for example, you can earn a little bit of that as well. And that's something that's promised upfront when you purchase the C the CD.

[00:21:32]Now, a lot of people say this is too hard for banks. They they can't do it this way. Uh in order for them to make some money, they need to uh borrow short and lend long. That's the only way for them to make money. And that's not true.

[00:21:48]They it it's certainly feasible for them to have that the time structure on both sides of their balance sheet be the same. So here and I' I've got an example that shows how they can do this. The the the way that they do it, by the way, is on this slide. They offer CDs at an average of 10% and they lend at 15%. But there's nothing there that says any anything about how the the loans that they make have to be of a certain maturity. And when they borrow from others, it has to be of a shorter maturity. There's nothing about that.

[00:22:16]Notice here, look, they can offer uh one-year loans in the amount of $10,000, threeear loans, 20,000, fiveyear loans, the amount of 40,000. Just I just came up with these numbers arbitrarily. And then that's matched by not only the same size liabilities, but the same duration of the liabilities. So they that could be financed by people purchasing CDs of 1, three and five years in the same amounts 10 20 and $40,000. So there's no maturity mismatching required. Okay. So that's pure deposit banking 100% reserves. There's no change in the money supply. Nothing as Rothbart said nothing exceptionable happening. And that's also pure loan banking where there's also no expansion of the money supply. money is go going from all the money is accounted for. There's no extra claims on money.

[00:23:07]There's no expansion of of purchasing power, people's ability to to purchase things. However, things get funky, things get fishy when we start to mix these two functions. When you mix deposit banking with loan banking, you get this scary thing. You get this uh fractional reserve banking arrangement.

[00:23:27]And I like the way Rothbart described it. he said or how how it would come to be about. He said the irresistible temptation now emerges for the goldsmith or other deposit banker to commit fraud and inflation to engage in short and fractional reserve banking where total cash reserves are lower by some fraction than warehouse receipts outstanding in elsewhere in uh Rothbart's writing he sometimes refers to this as uh the fractional reserve bankers engage in profitable hanky panky it's a great it's a great term now what happens here as we'll see is we get a new subtype of money so remember I showed you the typology of money. Uh, and the new subtype uh that we get is the unbacked money substitute or cue the dramatic music fiduciary media. Chose that font on purpose.

[00:24:15]Okay. So, what's happening in in fractional reserve banking as I said is the bank is combining these two functions. They they are taking in deposits.

[00:24:24]So people are depositing money and they have a a checking account at the bank and then the bank is using that as a basis for extending loans to people. So they're not taking in savings. They're not taking in money that's been relinquished for a certain time period and then using that to fund loans. And they're also not taking in deposits and then keeping all of that ready to redeem the depositor's requests whenever they want to at par on demand. They're mixing them. So they've got the they've got the deposits on the on the liabilities side and they got the loans on the on the asset side. So Rothbart goes through this example. He says the Rothbard bank has issued $80,000 of fake warehouse receipts which it lends to Smith, thus increasing the total money supply from $50,000 to $130,000.

[00:25:12]So, originally there was $50,000 worth of deposits and the bank was keeping $50,000 in reserves. But then the bank created new warehouse receipts and lent it to Smith. Now Smith has these warehouse receipts which as you remember is being used as money. Pe people uh trust this bank and so people will accept it in exchange. So the the total spendability, total purchasing power has increased. it's gone to Smith, right? So now this Smith person who has received this loan uh also you saw in the previous lecture from uh Dr. Klene, there's this uh canon effect or this uh non-neutral changes in or uneven effects of an increase in the money supply.

[00:25:57]Smith is in this early spender, this early receiver category who can benefit at the expense of the later receivers.

[00:26:04]So the money supply has expanded. So the total money supply increases from $50,000 to $130,000. The money supply has increased by the precise amount of the credit, the $80,000 expanded by the fractional reserve bank. 100% reserve banking has been replaced by fractional reserves. The fraction being 50,000 over 130,000 or 5 over 13. So here we're comparing these two things.

[00:26:31][clears throat and cough] And what's happening is you take that the gold coin the cash that's being held in reserve that goes in the numerator and then the deposits the warehouse receipts total total amount that exists uh goes in the denominator and you get that 5 over13.

[00:26:47]More [clears throat] on why why I'm pointing this out. We'll see we'll see why in just in just a little bit. Okay.

[00:26:52]So Rothbart says in short the deposit banker has suddenly become a loan banker. The difference is that he is not taking his own savings or borrowing in order to lend to consumers or investors.

[00:27:02]Instead, he is taking someone else's money and lending it out at the same time that the depositor thinks his money is still available for him to redeem. So that's the that's the important aspect.

[00:27:13]This depositor still considers his checking account balance as his money, his complete control. He can use it for purchases. It's a it's a part of his balance sheet. his net worth calculation includes the the money that he's deposited in this bank. However, now there's been additional claims on the same reserves, the same base money uh that's been issued that's been lent to Smith. And so now there's an increase in there's overlapping claims on the same base money [clears throat] or rather and even worse the bank issues fake warehouse receipts and lends them out as if they were real warehouse receipts represented by cash.

[00:27:51]Okay, so here's why I was emphasizing the calculation of the reserve ratio earlier and that's because something really interesting happens when Smith takes that money. Actually, let me go back.

[00:28:04]Notice [clears throat] here when the bank issued the uh loan to Smith and created those warehouse receipts in the process and gave them to Smith that the bank put it on their balance sheet.

[00:28:18]However, Smith is not just going to sit on those warehouse receipts that he received as a loan. If you go to the bank and you get a loan, your intention is to go out and spend it, right? Your intention is to go buy a house to go, you know, pay for factors of production if you got a business loan or if you got a consumer loan to go buy consumer goods, right? So, your intention is to is to take those warehouse receipts, take the the liabilities that the bank has given you and spend it elsewhere.

[00:28:46]and these other people who receive those notes, they might not bank at the same bank that you do. And so this uh that $130,000 there uh that was created, excuse me, the 80,000 that was created and given to Smith is not likely to stay on the uh this bank's reserves because now this bank is going to have to clear with the other bank.

[00:29:12]Okay, just want to point out. So here what what's going on is somebody comes in, they deposit $1,000 in the First Bank of Auburn and immediately if nothing else happens, that means that this bank now the First Bank of Auburn has $1,000 in reserves. But then somebody else comes in and requests the the 9 the $900 uh uh loan from this from this bank and they get it. And then when they spend it, their reserves go down to $100. So, I sort of skipped a a step there, but you'll see why just to make it simpler here. So, step one, the money supply is $1,000.

[00:29:51]When they make the loan to this other this next person, maybe the next person in line at the bank, they make the loan of $900. Now, this first person thinks that they have $1,000 and the second person receives a loan of $900. So, if you add up how much money everybody thinks that they have, then you get $1,900.

[00:30:12]But then this person who takes the $900 loan, they spend it and they spend it on goods that were sold by people who bank perhaps at the second bank of Auburn.

[00:30:23]And so that $900 that was issued by the first bank ends up over at the second bank of Auburn. And so there's a deposit made at the second bank. If this bank also keeps 10% reserves, then now they have the ability to issue additional warehouse receipts, issue new loans, create new fiduciary media, unbacked money substitutes. Uh, however, notice that the amount that they create is smaller than the than the first step.

[00:30:50]So, somebody deposited, do I have a pointer? I've got a pointer. Somebody deposited this $1,000.

[00:30:56]This bank is seeking to maintain a 10% reserve ratio. So they want to hold on to 10% uh in in in their vaults. They make the $900 loan to somebody else. And so 900 goes over here. And so the increases get smaller and smaller as we go on. So this person who receives the $810 loan, they spend it on people who bank at other a third bank, the third bank of Auburn. So that 810 loan from the second bank ends up in as a deposit in the third bank of Auburn.

[00:31:30]And you'll notice that as we go on and we keep track of what's happening to the money supply, it keeps increasing because each bank receives this additional deposit, which is an increase in the amount of reserves that they have, which allows them to to to be more able to create more uh claims on themselves. It allows them to create more warehouse receipts, issue more loans. So, they have an increase in their reserves. it's higher than their desired reserve ratio and so they're able to create more loans to others but then those loans end up as deposits in other banks in the same banking system and if everybody's keeping 10% reserves then there's an upper limit so I just showed you two steps three steps here but this can keep on going over and over again and at the limit once you get to you know just keep cycling around in this banking system over and over Again, you get up to $10,000, which is the [clears throat] upper limit on how how much the money supply can grow as a result of this interbank lending.

[00:32:37]If all these banks are keeping fractional reserves, money starts as a loan from one bank, ends up as a deposit in the next bank, that bank issues another loan, the increases get smaller and smaller. It's a geometric series.

[00:32:48]And the limit is given by the inverse of the reserve ratio, which is why I was emphasizing the reserve ratio earlier.

[00:32:55]So if the reserve ratio is 10% 1 over 0.1 is 10. So you take that original deposit amount of $1,000 multiply it by the inverse of the reserve ratio or the money multiplier and that gives you multiply yeah multiply that by the original deposit amount that gives you the upper limit. How how much can this money supply grow as a result of fractional reserve bank operations which is just you know mind-blowing.

[00:33:23]Okay. So now let's think about um how central banks might influence this process. And so we've got um an example from Rothbart here. This example starts off with uh the Federal Reserve purchasing US government securities from Jones and Co. So Jones and Co. has government bonds. They sell it to the Fed. And so when the Fed purchases the these assets, they do it with money that didn't exist before. They have been delegated authority by Congress. one can question whether that was legitimate or not to to create money so they can create US dollars. And so when Jones and Co receives this um receives that uh $1,000, that's money that didn't exist before. So that's new cash. It's new money in in the system when the Fed purchases uh when they add the government securities to their to their asset side of their balance sheet. So now Jones and Co. has $1,000 supposedly deposited at bank A. Bank A in this example will say that uh the banks are keeping 20% reserves as opposed to to 10%. So bank A wants to keep at least $200 uh 20% of that deposit in reserves.

[00:34:36]And so they feel free to make an $800 loan to to Macy's. So Macy's then takes that $800, deposits it in bank, actually purchases something from Smith. Smith deposits it in bank B and so on. It's the same sort of thing here. But notice the difference in this example and the previous one. The difference is that in the previous example, that was just cash that somebody had and decided to deposit it into this fractional reserve banking system. In this case, it was an action of the central bank that increased the amount of cash. So here we're starting to see how central banking plus fractional reserve banking mixed together can cause additional problems.

[00:35:17]So here's new base money that's being uh that's entering into the economy and in this case it's entering in through the fraction reserve banking system and it has this expansive uh money multiplier effect where there's new deposits created, new credit created as a result of the the central bank deciding to buy assets. So Joe's Diner gets an IOU. They spend that money on some goods from Robins and Robins uh banks at bank C. So that's an example from Rothbart. And notice he's he also keeps track of the increases in the money supply. And in this case, the upper limit is $5,000. Since the reserve ratio is 20%, the inverse of that is five. So five times 1,000 was the original deposit amount gives us $5,000 is the is the upper limit. So this is why Rothbart often referred to the central bank plus fractional reserve banking system as an upside down pyramid. So he was writing uh he was referring to the days when uh gold was actually at uh at the base of the system somewhat loosely and so there was a certain amount of gold and that was redeemable by some depending on the time period uh for federal reserve federal reserve notes were redeemable for gold. There was you could pyramid you can create additional Federal Reserve notes on top of a smaller base of gold. But then these commercial banks, they keep the the Fed notes and they have deposits at the Fed and they can use that as a base upon which they can expand deposits. They can extend credit to people and make new uh make new amounts of money, make new money and lend it into existence.

[00:37:02]And then so that's the member banks that are expanding on top of the Fed notes and then there's non-member banks that have accounts at these member banks and they can do a similar sort of expansion.

[00:37:10]So it's like an upside down pyramid. And so small small changes at the bottom. So if the Fed wants to change the uh amount of Fed notes or the amount of reserves in the system, they can have a very large influence very large effect on the total amount of of money in the economy.

[00:37:26]Now, some people some people hear this description of the money multiplier process and fractional reserve banking and they just for some reason they take it really personally.

[00:37:38]They just get really they get livid about it. Uh and they say don't don't you understand that it's loan uh loans come first and the loans create deposits and it's not uh it's not it's not the fact that banks are lending out reserves. they they're just creating loans and that's how deposits enter the system. And so I I would just encourage these people who have this sort of urge uh to read Rothbart. Notice he's totally accommodated this view. Sometimes this is referred to as the indogenous money critique of the money multiplier. And it it's all it all works the same way.

[00:38:14]Notice Rothbart says instead the the banker will either lend out the gold or far more likely we'll issue fake warehouse receipts for gold and lend them out. So Rothbart is not saying that when somebody comes to the bank and ask for a loan that the bank is literally going to get some gold out of the vaults and hand it to this borrower. No, what Rothbart showed in the previous examples that I showed you and what he's explaining here is that they just create new warehouse receipts. they they they create loans and he he has shown how those loans turn into deposits in the in the banking system. So it all for some pe for some reason people just get really upset about this. I'm not sure why. He said the banker issues fake warehouse receipts and lends them out as if they were real warehouse receipts represented by cash. So he's not saying that the the banks are literally taking stuff that's in the vaults in their reserves and lending them out. What's happening is they create warehouse receipts. those warehouse receipts are spent. They end up at other banks. Those other banks clear with the uh originating bank and then and then there's a reserve drain at that point.

[00:39:20]So Rothbart understands this. So to all these people, Rothbart would just you know keep on putting.

[00:39:27]Okay. So I think a lot of the misconceptions uh about fractional reserve banking and what's going on in the banking because there is a ton of debate about this stuff um not just about the economic effects but actually like what is going on inside of a bank.

[00:39:40]There's a there's a lot of debate among economists about that. And I think what's going on is that certain economists, certain people who are looking at at the banking system.

[00:39:49]They're they're like the the three blind men looking at the elephant or actually feeling the elephant, I should say, not looking at the elephant. So, one person is feeling the trunk and they says he says it's a snake. Somebody else is feeling the side. They say it's a wall.

[00:40:03]But they're all just getting like tiny little components, tiny aspects of of the elephant. somebody else feels the the tail and says, "No, it's a rope."

[00:40:11]And so I think that's what's happening when people are looking at the banking system and coming to these incorrect conclusions or these not as thorough conclusions. So they'll look at they'll look at the fact that banks do offer CDs and they can make loans and they will come to the conclusion that banks are are intermediaries or likewise they some people will say when somebody opens a checking account they're actually are saving. Some people will make this claim. I totally disagree with this claim. I think that when somebody opens a checking account, what they want is immediate spendability.

[00:40:42]It's a part of their cash balance. It's not a part of their saving. They haven't relinquished those funds to the bank.

[00:40:48][snorts] Other people will look at the act of the bank making the loan to somebody and they say this has created credit and and then they will they'll they'll see that and they'll say that's how the money supply increases. But then they'll deny that there's this money multiplier story where there's the repeated steps. And then other people just hate Rothbard and they'll say it's whatever helps me justify my hatred of Rothbard. So there's a lot of that going on. And so I think [clears throat] the the whole elephant looks like this. So it's true individual fractional reserve banks create money. They create credit X Neilo. So the the people who are saying that it's all pure credit creation, they're right in a very narrow sense.

[00:41:26]Yes, fractional reserve banks are creating credit X neolo. However, that doesn't mean that you uh have to deny the money multiplier story. How those um the loans that are issued by that fractional reserve bank, they can end up at other banks and that can be used to uh increase credit creation elsewhere.

[00:41:46]So, there's like credit creation that results in more credit creation. That's the money multiplier story. So, they're right, but it's incomplete. And it's true, banks are intermediaries to the extent that they use funds that have actually been relinquished by savers.

[00:42:02]However, as I mentioned before, I would argue that putting money in a checking account is not the same as saving. And to see the money multiplier, you do have to follow multiple steps. Okay, let me skip to the very end. I was going to go through some very specifics of what's happening from quarter to quarter.

[00:42:20]But here I'll say this is this is not as controversial as it might seem. So Rothbart is often viewed as this radical controversial author and of course he did have some radical and controversial things to say but the money multiplier story and his analysis of fractional reserve banking is not as controversial as as it might seem. I mean a lot a lot of you know US people in the US are just sort of uncertain or ignorant about what's going on in the banking system.

[00:42:47]But economists understand what what's going on. So here I just took this from the the Fred blog and this is pretty recent. It's 2023. And they're talking about how uh the ratio of M2 to M0, which is the blue line there, is often referred to as the money multiplier, a measure that describes how the supply of private money, bank deposits, response to the monetary base, what we've been referring to as bank reserves. As there's other things in monetary base, but being brief, as banks accumulate excess reserves in their account, they expand their deposits and lending activities, which is what we've been talking about. So, what I've been saying here is not some, oh, those Austrian school people are all cooks and crazy.

[00:43:24]They've got their weird theories. This is you can find this sort of thing uh even in mainstream outlets. Okay, so as I mentioned before, weird things happen when you combine central banking with fractional reserve banking. The real issue here is that fractional reserve banks are subject to runs and of course they're they're have this incentive to cartilize to come together so that they all inflate. They all create credit and issue fiduciary media proportionately so that no one bank gets out of balance and then that bank is is stuck having having a bank run that's being instigated by their competitor banks. But if they all inflate together then then that all when they clear with one another they all settle out and they're all okay. if it's if they're proportionate with one another. So it's they have an incentive for someone to manage that so that they're increasing credit proportionately and also just in case you know something bad happens there's a bank run it's nice to have a lender of last resort and hey it would be nice for that lender of last resort to be backed up by a money printer. So like they have an incentive to come together this way.

[00:44:27]And so this I think explains the emergence of of central banking.

[00:44:31]Fractional reserve banking I think uh it it's destined to lead to to central banking because of those incentives.

[00:44:39]However, as should be obvious, this does not solve the inherent problem. The way you solve the inherent problem is with 100 100% reserve banking. That's how you solve the problem. All this does is it institutionalizes it. It allows it to to proceed further and go on more and more.

[00:44:54]Uh and also it just shifts the costs away from the bank so that when a bank fails, it's not just that bank that fails and their customers that lose their deposits. In the case of a central bank with FDIC and all the stuff that we have today, if banks are making these un doing these unound practices, it's taxpayers and and the people who are holding on to dollars that are losing purchasing power because the failures of the banking system are being uh they're being bailed out by the government and the Fed. They're the ones who are incurring the cost of those sorts of things. So, it's a bad arrangement. And on that sour note, let's go eat some dinner. Thank you.

[00:45:32]>> [applause]