Haha! Nice one. I’m borrowing that if you don’t mind. 
joke
There are not 2 parties involved. Your explanation is too simply. With the fractional reserve of many the banks are able to take money from individual (c,d,e,f,g,h,) and their reserve to repay both the 100 to (a) and 90 to (b)
yes, it takes a large pool of depositors to maintain the illusion. central banking attempts to lift another constraint, by essentially pooling all deposits to some degree.
Thanks to everyone who has participated in this thread. After having a chance to think this over some more, I wanted to reply again to summarize what I think are two fundamentally different answers to my question.
(1) When a bank lends money it doesn’t have in reserve, it is automatically expanding the money supply. Two people now have a claim on the same dollar, which is like saying there are two dollars.
As I mentioned in a post last night, I now get this, at least to a point: I can see how it double claim does result in money of some sort. But it also seems not quite the same as a dollar that actually exists in two locations (whether a federal reserve note, or two distinct deposit accounts) that can be spent simultaneously without further intervention.
(2) Credit expansion only occurs because banks can deposit loan checks in each other simultaneously, thereby never being called on to produce the money that they loaned out.
I get this, at least in principle – the T-accounts work out. However, it seems like a brittle model in a society with over 20,000 banks (I think that’s right, but I can’t find a figure online). If your credit expansion depends on the money you lend out being deposited in a bank that also lends out an identical amount of money that gets deposited at your bank…well, it would be rare for that to happen. Even considering that we’re counting in the aggregate, it still doesn’t seem likely.
That’s where I want to bring in Rothbard’s book, to which I have referred in this thread. It is The Mystery of Banking, and you can read it online here: http://www.google.com/url?sa=t&source=web&ct=res&cd=1&url=http%3A%2F%2Fmises.org%2Fmysteryofbanking%2Fmysteryofbanking.pdf&ei=WTviSOz2Npyw8ASE57yyDg&usg=AFQjCNFacTwwUwnU3OmOpQdHG7_hoEGPQg&sig2=LIYG150nbYVg9cFMfuzVZQ. On pp.118-9, he clearly states that money does not get created if it isn’t deposited in the same bank from which it was borrowed. Which would seem to rule out case (1) above, although, now that I have been convinced that it should count, I’m not sure what to think. 
In the next chapter, he goes on to argue that a central bank gets around this limitation; unfortunately, he doesn’t explain how. The discussion is on pp.132-3, with the crucial part the last full paragraph on p.133. There he asserts that a central bank allows all banks to expand at the same time, but he doesn’t show how.
Assuming Rothbard is right, the question is: can anyone demonstrate how the Federal Reserve allows credit expansion? In other words, how is it different than the two banks described in case (2) above?
One more comment about the supply of money and hoarding. I seem to recall that von Mises calls the amount of money that people are holding the “demand” for money, and the amount of money that they are spending the “supply” of money (counterintuitive, but logical). This would seem to reinforce the point that money held in a checking account is fundamentally different from “circulating” money, although I’m not sure how to apply it to the case at hand.
Sincerely,
Derek
Hey, Derek. Yes, this is confusing - purposefully so. The FED doesn’t want everyone to understand clearly how it works.
The simple answer is that 1 & 2 are no different from each other. Most money is not physical notes - it is bank credit - it is the size of your bank account. The FED is the banks’ bank. Rather than have banks settle up by demanding physical currency in return for checks against accounts from another bank, they simply debit/credit their account balances with the FED. If the banks experience heavy withdrawals and need more notes, they borrow “reserves” from other banks or the FED itself.
The FED has no problem securing these notes from the Treasury Dept because they only cost the FED about $.12 per note, regardless of whether it is a $100 bill or a $1 bill. For the FED to lend these notes to banks, it must first issue them into circulation, which means it must hold collateral against them. It usually does this with government debt, but it also uses gold, and now it uses all kinds of debt, through its new “facilities”. The FED will “buy” debt by crediting the seller with a larger balance in its federal reserve bank account.
The government has one of these accounts, as well as all of the member banks. Essentially, the FED monetizes debt to create new money - that is it buys debt with previously non-existent money. When a bank goes to cash a government check, the FED debits the government account and credits that bank’s account at the federal reserve.
The term “reserve” is confusing. It used to be that account balances and bank notes were not reserves - only gold was. Today, reserve simply means liquidity. A bank’s reserves are the amount of cash in their vault + their account balance at their regional federal reserve bank. They can only create illiquid money - in the form of loans due to them. If they need liquid money, they have to borrow it.
This means for every $10 you have in YOUR account, your bank has $1 in either cash or its FED account. Should depositors run on the bank, demanding to cash out their account, several things allow this to happen without bankruptcy. First, the bank can convert its FED account to cash (but if it allowed its reserves to deplete below reserve requirements, the FED could regulate it and take it over). Second, the FED is designed to enable easy lending of funds from one bank to another. It does this by lowering interest rates by creating new money. Third, one of the reasons that depositors do not run on banks is deposit insurance - if they fail to run to the bank before it runs out of cash, they will be repaid by the federal reserve. Finally, the FED can monetize debt, raising its own loanable funds able to be borrowed through its discount window, which typically carries a higher rate than inter-bank borrowing, but provides a lender of last resort.
Without a central bank, fractional reserve banking is limited by several factors - the size of the bank’s clientele, competition with other banks, and the willingness of people to use the bank’s notes instead of gold. The more customers the bank has, the more likely these customers would pay each other than someone outside the bank, allowing the bank to simply debit and credit accounts rather than producing the gold. The less competition the bank has, the less likely another bank will demand gold for its bank notes or to settle a check. And the more willing people are to use the bank’s notes in place of gold, the less gold the bank will have to produce.
Central banking attempts to eliminate the clientele size and competitive bank constraints, fiat currency the last one.
The way central banking does this is by forcing all banks to use a common bank note and hold reserves at the central bank. With a common bank note, average banks usually do not redeem the notes for gold, nor are they required to. The central bank is the one who insures redemption for some fixed quantity of gold. Essentially, central banking turns the entire banking sector into a giant bank, as far as the constraints of fractional reserve banking go. Holding the reserves at the central bank pushes banks to work as a cartel rather than competitively. They are facilitated to loan each other money quickly, yet they cannot call out the inflationary practices of one bank. Central banking also attempts to prevent bank runs by depositors by collecting deposit insurance.
Ultimately, there can still be a run on the central bank - this is what happened in 1933. This is where fiat currency comes in. It attempts to prevent the people from favorably using any other bank note or gold itself while simultaneously refusing to redeem the bank note for its gold backing.
Yet, the people can still reject the currency as a whole, although this is very difficult. Most simply reject the currency as a means of saving money, instantly buying precious metals, investments, etc. with their income, yet convert back to the notes (or bank account credit) for exchange on the market.
Thanks again for everyone’s response. I’m still unresolved on this issue, but I don’t want to bother everyone further; I’m just grateful that I’ve had a chance to discuss the issue with people who understand it. (There aren’t many people who realize that debt is money.)
I will leave with some parting thoughts. If cases 1 & 2 that I provided are not fundamentally different, why is a central bank needed? If (fractional reserve) lending by itself creates money, I don’t see the need for banks to cover their reserves as they do in case 2. What I would really love to see is a t-account showing how the central bank fundamentally changes things. Rothbard asserts it, but doesn’t show it. Whenever I try to do it, it ends up looking no different from a multitude of banks holding their reserves locally. (Except, of course, when the central bank lends money – that is, I think, clearly a different case, because it doesn’t need reserves.)
The more I think about Mises’s definition of the “demand” for money as money held, and the “supply” of money as money spent, the more I become convinced that case 1 does not represent an expansion in the money supply, and hence doesn’t affect prices. It has been a while since I read Human Action, and it is a long book, so I may not be remembering correctly. I also remember being unsatisfied with his explanation of money creation via debt, but I can’t remember any details, unfortunately – perhaps I will have to read that section again.
I’m still operating under the assumption that I am missing something fundamental that I just can’t wrap my brain around, but I will keep plugging at it, and maybe I will understand some day.
Sincerely,
Derek
Money is an interesting thing. In America’s Great Depression, Rothbard uses time deposits as a part of the money supply, because at the time they were widely used identically to demand deposits, being withdrawn without the time limitation being enforced.
This website actually records a money supply figure known as “True Money Supply” that varies from M1, M2, and MZM. I’m not sure of the technical qualifications it uses to define money.
I’m not entirely sure I know the answer to your question myself. I would assume it would have something to do with the central bank using central bank notes, which the member banks must hold as its reserves…or on account at the central bank, denominated in the same units. Thus, any member bank to the central bank would be encouraged to lend to temporarily troubled banks, because if they didn’t, that bank would have to take credit from the central bank, which would effectively debase both the reserves and outstanding loan returns of the other banks.
Check out chapter 4 of Money, Bank Credit, and Economic Cycles - Huerta de Soto covers this in detail.
I’ve heard that the banks nowadays can actually lend someone $900 from $100 worth of reserves legally, why do all people have examples where the banks nearly duplicates money (10:9) when I’ve heard they can lend 9 times more than they have reserves of actual paper money. (1:9)
Have I been wrong for all these years? I’ve read so many articles on Austrian Economics I didn’t there was a fundamental I had missed.
Is it really so that they only almost duplicate money?
Arvin, I’m almost 100% sure that banks can only lend <= 100% of their “reserves”. The reason why you hear the 9x figure rather than 9/10 is that if a bank loans out 9/10 of its money and that 9/10 gets put in another bank, that money is now “reserves” for that bank. Thus, 9/10 of that 9/10 can be reloaned out. The eventual result after reloaning fractions to infinity is 10x the original amount of money, so 9x when you subtract the original amount.
This is also why it takes a long time for the money supply to grow once the FED has created a large “liquidity injection”.
The amount of total money in circulation as the result of fractional reserve banking relies on the reserve requirement.
100 / req = money multiplier. 100 / 10% = 10x. 100 / 3 = 33.3333x.
meambobbo, thanks for the information, if one explains how it works in 1 line though, could one just say “One bank can make $900 from $100 possible”? To be more clear, the bank doesn’t actually expand the paper money 9x ex nihilo? It’s the thing they start that expands the money ex nihilo 9x?
Yes, one bank can make a new $900 from $100, but it would require far more than a single deposit of $100 - it would actually require $1000 worth of deposits - with fractional reserve banking, you cannot create more money than is deposited; however, the newly created money can be deposited.
Here is an example of the process from wikipedia (note this is with a 20% reserve requirement).
If a FED member bank were to actually make credit greater than their deposits, the FED would take regulatory actions to control and/or dissolve the bank.
If there were only one bank, and everybody used it, it could make $900 out of thin air from a $100 deposit, with a 10% reserve ratio. But if there are other banks, any single bank can’t do that; but the entire system can.
Seriously, read ch4 of MBC&EC; he explains it all in excruciating detail, for single banks, multiple banks, a central bank, what happens if some people keep their money under their mattresses, etc.