Critical question of Rothbard's "The Mystery of Banking" and fractional reserves

Economics Economics Questions
1

I am about halfway through The Mystery of Banking right now and so far think that it is an excellent work in many ways, notably his description of how banks in a truly free market should compete to keep fractional reserve inflation low and how a central bank is a cartelization of the industry that has given way to unchecked inflation. Great stuff.

My concern and question, however, comes with his description of how fractional reserve banking works. It does not seem correct to my knowledge.

On page 115 Rothbard says: “Rothbard bank has had $50,000 of gold coin or government paper deposited in it, and then proceeded to pyramid on top of that $50,000 by issuing $80,000 more of fake warehouse receipts and lending them out to Smith. The Rothbard Bank has thereby increased the money supply in its own bailiwick from $50,000 to $130,000, and its fractional reserve has fallen from 100 precent to 5/13.”

Now, to my knowledge this is not how fractional reserve banking works. If someone made a $50,000 deposit in a bank and the reserve ratio was indeed 5/13, than the maximum loan based upon that deposit would be $30,770. Once this $30,770 has been loaned out, $19,230 (the 5/13 of $50,000) is held on reserve.

Rothbards assertion that the bank can issue $80,000 out of thin air based upon a deposit of $50,000 seems totally unfounded to me and I am having trouble finding the truth in this.

I am a relatively new student to the Austrian school and have been totally absorbed by their theories of pure and unhindered free markets and business cycle theory, but the descriptions I see coming from Rothbard on the nature of fractional reserve banking seem off base.

What am I missing here? What do you think is the correct picture?

2

This is correct. If 50,000 dollars are deposited in the bank, and 50,000 dollars are kept in reserve, then the bank is holding 100% reserves. But if 50,000 dollars are deposited in the bank, and the bank issues 80,000 dollars, then the banks reserve ratio is 5/13. For every 13 dollars lent out by the bank, only 5 dollars are hold in reserve.

You are right, but this is not what Rothbard was saying. In Rothbards example, the reserve ratio was not 5/13 to begin with.

3

In the 19th century and before, banks would issue paper certificates representing their reserves. For example, if I have $100 in reserves, I could issue certificates worth more than $100. That is the defacto creation of money, largely the same how central banks create money today.

4

Ok. On page 137 Rothbard makes the case that lowering reserve requirements from 20% to 10% at a bank that has $50 Billion in assets, $40 Billion in current loans and $10 Billion in reserves will lead to a doubling of the money supply with $100 Billion in assets, $90 Billion in loans while the $10 Billion in reserves stays the same.

This doesn’t seem right to me. Rothbard changes the number for the assets and current loans instead of changing the amount held on reserves, therefore arbitrarily creating money. If reserve requirements where changed from 20% to 10% percent wouldn’t the bank end up still having $50 Billion in assets and now have $45 Billion in current loans (instead of $40 Billion) and $5 Billion held in reserves (instead of $10 Billion)?

Why does Rothbard assert that the bank will magically create 50 Billion more dollars so that the numbers align with the new lowered reserve requirement? His new numbers do indeed align with the new reserve requirement, but it involves magic money creation. The way I explained also meets the new reserve requirement in a more logical way that did not involve doubling the money supply. It seems to me like the bank would just shift more money from its reserves into loans rather than doing the rather absurd sounding notion that Rothbard suggests.

I’m not looking to disprove Rothbard in any way. I highly respect all of his writings, but am having a hard time with his explanations on this.

Is, heaven forbid, Rothbard wrong? What am I missing here.

5

It is a different way of analyzing the process of credit expansion, but it is fundamentally the same as the incremental process. Rothbard is essentially assuming that in granting a number of loans beyond the amount of reserves, the reserves will not be drawn down by the borrower. The reason for this assumption is that deposits and withdrawals within a banking system are constantly taking place in a simultaneous matter, and so therefore a decrease in one’s reserves are you usually compensated for simultaneously by a fresh deposit of one its members (as other borrowers are also with drawing from there lenders).

Rothbard’s “Mystery of Banking” is very good but if you really want to have a comprehensive understanding of the process of credit expansion under various assumptions you should really read Huerta de Soto’s “Money, Bank Credit, and Economic Cycles”, especially Ch. 4 which explains all of this in a very clear and extensive way.

Since it only came out rather recently it’s more up to date and thus subsumes nearly everything important with regard to banking (he doesn’t go as much into the specific of the US Federal Reserve System as Rothbard has). Huerta de Soto even addresses your very question with reference to Rothbard’s book (pg. 232).

6

a banks Assets are what it has out on Loan plus its Reserves.

lets say

you have 10Billions reserves. (like the bank in your question before the law on reserve ratio changes)

if you want to have nothing out on loans; you would find yourself with only 10billion assets (what is in your reserves)
but this means you are at 100%reserve ratio, and there is money to be made loaning money and earning interest.

lets go the other extreme and try loaning out crazy money and marking that up as our assets.
to have 200billion out on loans you would have 210assets and with your 10reserves, this means yor are at 10/210=5% reserve ratio.

you have been too reckless creating loans and writing them up as assets, and you will loose your a bank license if the government finds out.

assets are loans plus reserves. A = L + R (or rearranging) L = A-R

lets substitute in for our reserve requirement, (the smaller the reserve the better for us, but the legal limit is the condition we must meet given we arent allowed to got to a 0%reserve)

R/A=1/10 (10%) therefore 10R=A
therefore from L=A-R we have L=10R-R=9R … L=9R

in words, you will have 9times w your reserves out on loans when you are trying to do the most possible loaning on the reserves you can muster.
for 10billion reserves, which is what our bank started with, it would have 90 loaned out, and 100 as assets, mainting the 10% ratio.

7

There is something I fail to understand. Why are some forms of credit creation out of thin air? And why are others not?

8

i think when we are talking about fiat money, all money creation is ex-nihilo , out of nothing

9

This thread is about fractional reserves, fiat money or not.

Fiat money is made out of paper and ink anyway. And copper for coins?

10

its costs no more to print up 100trillion in hard cash paper currency than it does 1(single) unit of currency. so that says something

11

Face value. I stand corrected.

12

Yes, I think you are missing something. $30,770 out of $50,000 for a 5/13 ration is maybe what the bank clerk thinks is happening, but that is not the case. Rothbard will explain this in Chapter XI: “Central Banking: The Process of Bank Credit Expansion”. After the Credit expansion process, the bank will have issued $80,000 on top of the $50,000. You can trust the master (Rothbard).