Space colonies and monetary systems. Part 2

Introduction Part 2: Full reserve banking

This post is the second part of our series on Space colonies and monetary systems. In the previous part we discussed the idea of debt free money of the corner-stone of the monetary system we propose. In this part we will discuss full reserve banking and why this is a necessary condition of a debt-free monetary system. First we will discuss the current system of fractional reserve banking, and why that system is problematic.

2.1 What is fractional reserve banking?

Nowadays most money is created as credit money by either central or commercial banks. How central banks can create money is quite straight forward: with a few keystrokes the employees of the central bank can create money, they can subsequently lend to the commercial banks. More people have difficulties to grasp how commercial banks can create money, and the non-banking citizens are not to blame. Bankers tend to make use of technical jargon, which might not be understood even by the bankers themselves.

Most people, who have never studied banking in any detail, will utter that it’s illegal for everyone, except the government, to create money, aka counterfeiting. For many centuries counterfeiting was considered such a severe crime, it was punishable by death in almost every country. People used to believe that the coining of money was a god given privilege of the king, Save for a few countries, counterfeiters are no longer be executed nowadays, but in many countries counterfeiters can face years of imprisonment for crime.

However, banks are privileged institutions, unlike ordinary members of the public, the government allows banks to create money. Before we can continue, we have to keep in mind that only cash money, i.e. coins and notes, are legal tender. For matters of law bank money is not “real” money, that is accepted nevertheless, is due the fact that if you want to have cash money you can go to the ATM: there you can convert your “bank money” into legal tender. If Alice owes Bob some money, then Bob is obliged to accept any sufficient cash payment as settlement of debt. However, Alice has all her money on the bank and she doesn’t want to go to the ATM, instead she transfer money from her account to Bob’s. Now Bob is able to convert Alice’s “bank money” into cash.

In real life there is much more bank money than cash, either in circulation or stored in bank vaults. If all clients of a bank would try to remove their money from the bank, most clients will be empty-handed because there is not enough cash to meet such demand. A fundamental question, is how it can be that there is much more bank money than cash? The story goes that in earlier times, when only coins were legal tender, people deposited their coins at a gold smith. If you carry large amounts of gold coins, you are taking great risks. Not only you could lose your money (and your life) by robbery, it is also quite cumbersome to carry heavy coins all the time. When you deposited your coins at the goldsmith you received a note, which stated the value of your deposit. Now if you want to buy something, you could give the seller your note(s). Subsequently the seller was able to redeem this at the goldsmith.

However, the smiths soon discovered that people did not redeem the notes, instead the notes went into circulation: Alice used her notes to pay Bob, Bob to pay Caroline, Caroline to pay David and so on. Meanwhile the smiths had large deposits of gold in their possession. Knowing that only a few note holders would claim their money, the smiths came with the idea to lend the money to people against interest. Of course, lenders got the loans in notes. Now we have more notes than is back by deposits: the depositors have notes equal to the deposits, whilst the lenders have additional notes.

Of course, the smiths, now bankers, learned they could do this a multiple times. A certain amount of deposited money could be lend multiple times. Replace gold with coins and bank notes, and notes with bank money, and we get what is called fractional reserve banking. This system has certain benefits, but creates several risks. The two most important risks related with fractional reserve banking are: 1. Uncontrolled increase of the money supply; 2. Bank runs.

The problem of bank runs has been described above, unlimited growth of the money supply induces the risk of (hyper)inflation. In order to combat these two problems, most central banks impose minimal reserve requirements on the commercial banks. The ECB or the Fed might say to the banks in their jurisdiction, that they should have minimal reserves of 25%. For every hundred euro or dollar the banks keep, they should have 25 in reserve. By regulating this requirement central banks has to influence money creation by commercial banks.

Though this seems a great tool, but there two problems with these methods: First, the reserve requirements are usually quite low, sometimes as low as 1%. Second, banks are interpreting the reserve requirement creatively. As explained by economist professor Richard Werner if we have, for instance, a reserve requirement of 1%, then a bank should be able to lend of every 100 pounds only 99 pounds. But in reality the following happens:

Suppose that Alice deposits 100 pounds on her bank account. In theory her bank could only lend 99 pounds from it, since they should have 1 pound as reserve. But the bank will usually claim that the 100 pound is their 1% percent, now they can lend 9900 pounds instead of 99 pounds. The result is that 9900 pounds has been created by the bank.

2.2 Why fractional reserve banking is problematic

The money created by commercial banks is created as credit, as debt. This means that the money created in this manner, has eventually to be repaid to the bank. The following example will illustrate why this is problematic: suppose that Bob is a plumber, and he needs a new van. Bob has at this moment not enough money to buy the van, so he goes to the bank for a loan of 9900 pounds. He gets the loan, and inclusive interest Bob has to pay the bank 12,000 pounds. Now I am a factory owner, and I need to maintain the plumbing of my factory. Bob and I agree that he would to this for 15,000 pounds. For this necessary investment I get a bank loan, and eventually I has to pay back 18,000 pounds.

Since nowadays governments do not create debt free money, almost any money is created as credit. And has been illustrated in the previous example, in order to repay your debt, someone else has to become indebted. Because of interest, the total debt has to grow. Under the current financial system it’s impossible for all debtors to pay off their debts simultaneously. Every time someone pays of his or her debts, the debt has to be shifted to someone else.

And due to interest, especially compound interest, the total amount of debts is ever-increasing. One might ask why this is a problem. Being indebted is generally considered a bad thing, and people are almost always advised to pay off their debts as soon as possible. Not being able to pay off your debts is even worse. People who are defaulting on their debts, are risking to lose their possessions, since the creditors can by court order seize the debtor’s property in order to settle the debt. Businesses which has to default on their debts, face bankruptcy and their employees can lose their jobs, which causes even further financial problems. It’s for no reason that indebtedness is considered as negative. Therefore it’s important that governments will issue debt-free money in order to enable citizens to pay off their debts without shifting their debts to other persons.

Our commitment to government issued debt-free money is incompatible with the creation of credit money by commercial banks, even if both types of money would coexist. This because banks might create more credit money than the government will create debt-free money. Besides the negative consequences of indebtedness, fractional reserve banking has another problem. Since commercial banks are in control over the money supply, they might cause inflation by creating too much money.

Commercial banks pursue their own interests, not the public interest. For each individual bank it is attractive to create as much credit as possible, because so they can receive more interest. Simultaneously it would be better if the total money creation by banks would be limited, however no bank would rationally pursue such limit by itself. Consequently banks will create as much money as possible, this results in inflation. Also as argued by Professor Werner this private money creation causes asset bubbles, which will disrupts the functioning of the real economy.

2.3 Full reserve banking

Theoretically full reserve banking is nothing more than raising the minimal reserve requirement to 100%. However, establishing such requirement has profound effects. Most importantly banks are no longer able to create credit money at will. We see that as a good thing. Nevertheless there are people who oppose full reserve banking, and they have a few arguments to defend their position.

First proponents of fractional reserve banking argue that if commercial bank are no longer allowed to create money, the money supply will become fixed and cannot grow proportionally to the economy and therefore full reserve banking would lead to deflation. Deflation is the opposite of inflation, and is generally considered by economists as a worse phenomenon than inflation. There is general consensus among economists of different schools that recessions are often caused by deflation. However, the risk of deflation can be avoided in a full reserve banking economy if the government will create an adequate amount money, which we have defended in part 1 of this series. This government created money will also be debt-free and since the government is a single agency it can control the money supply more effective than self-interested commercial banks.

A second argument raised by apologetics of fractional reserve banking against full reserve banking, is that under a full reserve banking system banks can no longer lend money to the public. However, this argument is only partially true. This argument is based a mistaken assumption: banks are financial intermediaries, between those who want to save/invest their money and those who wants to lend money. As we have seen above this is not true, since banks are creating the money they lend. In order to see why this particular argument is flawed, we should look how full reserve banking might work.

In line with the “Chicago plan” we should distinguish between demand deposits and term deposits. Demand deposits are those bank accounts which allow the client to withdraw his or her money at any time, whilst term deposits are those savings which cannot be withdrawn for a certain period of time. Under the Chicago plan banks are not allowed to lend money deposited on checking accounts, thereby establishing a full reserve banking system. However, money deposited as term deposits can be lent by the banks, but only to sum of money deposits. If Alice has a 10,000 pound term deposit by her bank, the bank can only lend 10,000 pounds to Bob (assuming for the sake of the argument that Alice is the only term depositor). Another way for banks to raise money they can lend is to issue bonds. The benefit of bonds is that the owners can sell their bonds if they need money.

Since the money on checking accounts cannot be lend by banks, the holders of these accounts will not receive any interests from it. This raises two question: Why will people place their money on the bank? and How will bank make money from checking accounts? The answer to the first question is simple: save keeping and enabling financial transactions. The answer to the second question is equally simple: for the services mentioned in the answer to the first question, the clients will be pay a fee to the bank.

If a full reserve banking system as described in the Chicago plan, will be implemented, it reasonably to believe that there will be two types of banks: first there will be banks specializing in checking accounts and related services, secondly there will be banks which will intermediate between savers and borrowers. The first bank type will be save for bank runs, since they are forced by law to keep 100% reserves and therefore are always able to give clients back their money. Though clients of the second bank type have to face the risk to lose their money in case their bank will go bankrupt, they can reduce this risk by spreading their saving over multiple banks.

Fractional reserve apologetics might argue in response to our counter-arguments, that though the government might be able to create enough money to prevent deflation, but that the money created and allocated by the government might not get at the “right” places. If the government will create and allocate the money supply, some people will have a money surplus, whilst other will have a deficit. However, in our proposal the people with excess money can lend their money to the banks, which will lend it to those who need loans. In this manner full reserve banking will have the benefits of the current system, without its main disadvantages.

In the next part of this series we will discuss interest-free loans by the federal credit bank.

See also

A program of monetary reform  The final statement of the Chicago plan, written by Paul Douglass, Irving Fisher and others. The Chicago plan as described here is one of the inspirations of our proposals for monetary reform.

Richard Werner: Banking & The Economy A video featuring economist professor Richard Werner, who explains how fractional reserve banking works in reality.

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5 thoughts on “Space colonies and monetary systems. Part 2”

  1. Great piece my friend. It answers some of the misgivings I had about the money system in the previous post. I feel like moving to the colony now that issues of food, economy and energy have been taken care of.

    1. I am glad to have answered some of your misgivings.

      There are many different money systems imaginable, some are worse than others. I believe with the proper constraints we can deal with the negative aspects of money. For instance, in the previous post John and I discussed to possibility of issuing money with an expiration date, or as John put it: use it, or loose it. This would counter act the accumulation and self-perpetuating concentration of money.

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