A paper entitled "Fractional Reserve Banking and the Interest-bearing Money Supply" given at a meeting of the Association of Muslim Social Scientists, London School of Economics, London, October 1999.
This paper expands upon previous summaries by the author on the topic of fractional reserve banking and the interest-based money supply. The context here is one of resource utilisation, the incentive to undertake financial leverage and levels of public and private debt. The discussion adopts a theoretical rather than empirical approach, with basic quantitative analysis illustrating each of the key points.
Summary of Key Points
The conventional explanation of the business rationale behind commercial banking has commercial banks acting as intermediators between depositors and borrowers of cash. It is proposed here that the true business rationale of commercial banks is the less benign activity of manufacturing money itself. Commercial banks manufacture money in the process of making loans and by a technique widely termed 'fractional reserve banking'. For every amount of money that is brought into existence by the banking system there is a corresponding and equal amount of debt. Under such a monetary system, since debt grows at a rate of interest, money supply displays a similar tendency. It is in this sense that there now exists, more or less globally, an interest based money supply.
One impact of the interest based money supply is to encourage substantial resource depletion. This fact is demonstrated using a simple discounted cash flow analysis. This model examines the attempts of borrowers to repay debt that grows at compound interest by investing in physical assets that display precisely the opposite tendency, namely that of compound decrement. Secondly, the process of money creation is shown to encourage the practice of leverage in the modern economy, which in turn results in what has been termed elsewhere 'business gigantism'. This term describes the increasing dominance of large scale commercial enterprises at the expense of small scale enterprise and all that this entails at the cultural and social level. Thirdly, again using a quantitative model, the continued existence of a monetary system that is based upon fractional reserve banking is seen to depend upon growing levels of debt at the private and, or, public level. In the long term, unless this debt continues to expand, economic recession ensues. Furthermore, the cyclical nature in which the commercial banking system expands and contracts money supply, by first increasing and then decreasing the rate of lending, is a prime factor in encouraging a 'boom-bust' cycle in economic activity.
Since the development of the first modern banks in Europe, the layman has been encouraged to believe that commercial bank borrows money from person A and lends it to person B. The bankers argue that they pay person A, the depositor, less interest than is charged to person B, the borrower, and that in this way they make a profit. But this is an argument that camouflages a very different business process.
In the early years of banking,the banker would issue a receipt in return for gold coins deposited by a customer. The receipt would be issued in 'bearer form', meaning that any person bearing it could reclaim the underlying gold from the bank on demand. When the general public began to pay for goods and services using these receipts instead of the gold itself, the bankers were in a position to make substantial profits.They did this by printing receipts, which were by now being used as money, for lending at interest. This was a process that cost the bankers practically nothing to engage in. Other informed individuals, realising this to be the case, would soon open their own banks in order to exploit the new business opportunity.
If it were indeed the case that the banker had the power to manufacture money, surely a more financially rewarding approach would be for the banker to spend them on his own consumption? But such a course of action had a commercial flaw in that the spent receipts would in due course return to the bank for redemption in gold -gold which never existed in the first instance. By lending the receipts instead, the banker could charge interest on the amount lent. Upon repayment,the receipts could be destroyed as easily as they had been manufactured, but the interest charge would remain as revenue.
It would of course be necessary for the banker to keep sufficient gold coins on hand so as to satisfy requests for redemption of paper receipts on any one banking day. The proportion of gold coins thus held against receipts outstanding became known as the 'reserve ratio'. In England the subject of how large a reserve ratio was required for safe operation was soon one of fierce debate. Some argued in favour of a 100%reserve on the basis that if the banker had issued £100 of receipts promising redemption on demand, then he should keep £100 of gold in the vault to honour this promise. Others foresaw the lucrative possibilities of holding a'fractional' reserve ratio. They proposed that since the coins withdrawn on anyone business day would usually be offset by new deposits, there would normally be little net change in reserves from day to day. In most circumstances a small reserve ratio would therefore suffice. A banker operating with a 20% reserve ratio could, for example, issue £100 of receipts in return for a deposit of£100 of gold and thereafter print a further £400 of receipts to lend at interest.
The principle was thus established that the greater the risk incurred (in reducing the reserve ratio),the greater the expected profit. It is a principle which stills rules in the world of finance today. But on those occasions when requests for redemption were in excess of reserves, the bank would collapse if it could not quickly source extra reserves from elsewhere. The nineteenth century 'Note Wars' in the United Sates saw one bank collecting the note issue of another for simultaneous presentation and redemption. This precisely in order to drain the competing bank of its reserves and thus force its demise.1 In the less wildcat European states, an interbank market for reserves had already developed, allowing bankers to cope with unexpected peaks in demand for redemption of receipts. Today, the central bank stands ready to act as the ultimate provider of these reserves, a 'lender of last resort', effectively allowing the commercial banks to practice fractional reserve banking with impunity.
In seeking to protect their loans of receipts, it became common for banks to avoid profit sharing investments altogether and to concentrate instead upon interest based loans supported by collateral. The use of interest assured to the greatest extent possible under law that the profit available from the money manufacture process could be realised. The collateral would act as security, assuring repayment of the banker's loan plus interest in the event of the borrower's default. Such criteria for extending loans naturally biased the lending of funds towards wealthy individuals, explaining the quip that "bankers are people who lend you money if you can show that you don't really need it". Wealth would therefore tend to by-pass poorer individuals, whose business ideas might nevertheless have been worthy of receiving finance. This was a feature that would over time encourage substantial wealth inequalities in society, evidenced perhaps by the fact that, today, the world's richest 358 human beings own more wealth than the poorest 2,500 million.2
On occasions, a speculative boom would arise as a result of the bankers' art in action. Those who wished to buy particular asset, be it company shares or tulip bulbs, might do so by taking a bank loan. Thereafter the asset would be pledged as collateral. As the newly manufactured 'bank money' was spent, the price of the asset in question would begin to rise. Others, noticing the trend, would join the game to borrow bank money and buy into the rising market. But the speculative bubbles that arose in this manner would often burst as reserve ratios fell and the bankers became nervous of creating further bank money. With less new money being created,fewer new buyers would enter the market and prices would begin to fall. Some borrowers, who had relied on making speculative profits in order to pay their interest costs, would default. Their bankers would then seize and sell the collateral on the market, pushing prices down still further.
A still greater problem was to arise under fractional reserve banking, one that perhaps most of all contributes to the problems of the modern economy. The bankers charged interest on money that only they could create. How then could borrowers hope to repay loans of the manufactured money plus the interest charges? Imagine that,initially, the total amount of gold coins in existence is £100. If bankers now create £400 of paper money there will be a total money supply of £500. Let us further imagine that the £400 of bank money is loaned for three years at 10%interest per year, and that an amount of £532.40 will therefore be due for repayment. Now, if the total money supply at the beginning of the loan period is only £500, where will the extra £32.40 come from?
The required new amount of money could come from one of only two sources. Either the bankers would have to expand the supply of bank money, in other words lend yet more paper money, or the state would have to increase the supply of its own 'state money'. If new money were not forthcoming from either source, widespread bankruptcy would ensue among borrowers.
Over time, the state would come to prefer monetary expansion over bankruptcy since the political implications of the former were generally seen as more palatable. In order to achieve this monetary expansion, the state had two direct options open to it (the indirect option was simply to encourage the bankers to expand once more their lending).The first direct option was to step into the market as a risk-free borrower to whom the banks could lend with confidence, thereby taking the place of those private customers to whom the banks were no longer lending. The bank money thus borrowed could then be injected into the economy, perhaps through public works.This, in essence, was the Keynesian solution to the monetary recessions of the thirties3. It was a largely effective short-term solution, but one that did nothing to address the root cause of the problem.
During those times when state money existed as gold and silver, money manufacture was necessarily restricted by the availability of bullion for minting into coins. The King might of course cheat by instructing his mignons to mint coins with base metal at the core4,a form of debasement that was often obvious to those who were accustomed to handling the coins of the realm. But once the state adopted the banker's art of manufacturing money as paper notes, its debasements were achieved by the less obvious means of increases in quantity rather than decreases in quality. Given the ease with which the modern state could manufacture money, it is unclear to many commentators why that state would ever prefer to borrow money manufactured by the commercial banking system at interest. President Lincoln knew this well and proceeded with the issuance of Greenbacks in the United States during the Civil War5. This was a measure so politically and economically successful that it earned him the hatred of senior figures in the American banking community, men whose ruse had been uncovered.
There is however another twist to the tale. Nowadays, even the manufacture of state money often requires that the state first borrows from the banking system6. The result is that,whichever of the two options it selects in order to achieve the required monetary expansion (expansion of bank money supply or expansion of state money supply), the state becomes a frequent borrower and 'national debt' becomes entrenched7. In the meantime, where new amounts of state money find their way into the economy, they provide a larger base of bank reserves upon which the cycle of bank money supply expansion may resume.
The authorities in England long ago acted to counter the dangers posed to the health of an economy in which numerous private issuers of paper money were active. Under the 1844 Bank Charter Act, the right to issue most kinds of paper money was restricted to the Bank of England. But the Act did nothing to prohibit the growing reliance of bankers upon the newly developing cheque and account statement system. Once more, public confidence was essential to the successful operation of the new system. Where once the public felt sure of its ability to convert receipts into gold, it had now to be persuaded that the figures printed on bank account statements could be withdrawn as state money using a cheque.
Imagine customers A and B who each have a zero balance on their current accounts at the only bank in town.Customer A now gives customer B a cheque of £100 in payment for goods, and customer B deposits this cheque with the bank. The banker credits account B with £100 and debits account A with the same amount. B is now in credit and A in overdraft to the amount of £100 and the goods have been paid for. The amount of new (bank) money in existence is the £100 in customer B's account, whilst customer A is now paying interest. Notice that one group of bank customers must always be in debt to an amount that equals existing bank money supply. Notice also that if A now repays his overdraft by depositing a cheque of £100 drawn on Customer B, then the bank money transferred from B to A simply vanishes. Under fractional reserve banking, debt repayment destroys money - an act which if practised widely enough leads directly to economic depression. In complete contrast, gold coins are never destroyed in the act of repaying a loan.
In the battle to control inflation, it has become an almost unchallenged idea that interest rates must rise. The effect, it is assumed, is to restrain bank lending, thus reducing demand for goods and services and thereby reducing upward pressure on prices.But by increasing interest rates, account balances held at commercial banks,both credit and debit, are forced to increase faster in line with the higher interest rates imposed upon them. Since bank money supply equates with debt owed to the banking system, bank money supply may therefore increase faster as interest rates rise, securing precisely the opposite inflationary effect to that intended by the policy makers.
Of the interest charged on bank money, some is passed on to depositors and the rest belongs to the bankers. The amount of the bankers' profit is therefore largely determined by a) the difference between the interest rate paid to depositors and that charged to borrowers, the 'interest spread', and b) the amount of money manufactured. The actual level of interest rates is often immaterial in influencing either of these variables.
The inevitable result of allowing commercial banks to manufacture money is that they will from time to time manufacture as much as they can, since in the process of so doing they can earn more interest and make more profit. According to the Bank of England's own figures,in the United Kingdom today there is currently in excess of £28 billion of state money (notes and coins) in circulation. Meanwhile, even a conservative measure (M2) of total money supply is in excess of £250 billion,from which one may imply that the banks have created at least £220 billion of bank money8. This is the scale of money manufacture by the banking system in our modern world.
We live in an age when fractional reserve banking is at the heart of the monetary system in every national economy. Hence, the deficiencies of that system now apply globally. By making money itself an interest based entity, the shadow of interest is cast across all real world processes. In its effort to repay the unrepayable debts created by the banking system, the debt of humanity must grow. The necessity for economic growth is in fact the necessity to repay this debt and thus humanity has entered into an unwinnable race with compound interest.
Some Muslim commentators cannot understand why the deferred price is at a premium to the spot price and why the so-called Islamic banks focus so dearly upon this fact in effecting their business. They do not see that the commercial banks survive only by fixing their financial rates of return in advance and that the interest based money supply is the cause of the deferred price premium. Discourse on Islamic banking and money tends to ignore the single most essential issue that is fractional reserve banking and instead searches for a way of implementing commercial banking on Islamic lines. But the grand and original plan of commercial banking was to defraud society of its wealth and there can never be an Islamization of this activity.
Model 1 - Resource Depletion
Under this model, several borrowers compete for the right to purchase a resource from a seller. In general, the seller of that resource will sell to the highest bidder and, again in general, the highest bidder will be the one who believes he is able to generate the highest monetary return from the utilisation of that resource. In quantifying this belief, each bidder undertakes discounted cash flow analysis.Here, the yearly operational cash outflows and cash inflows are first estimated. These amounts are then netted, and the net amounts are restated in terms of present value using the bidder's cost of capital. (Where the project will be financed by a bank loan, the cost of capital will be the interest rate on the loan required to finance the project). A high net present value for the working of the resource can arise either due to an aggressive plan for the utilisation of the resource or due to access to a lower rate of interest than is available to other bidders.
Where large numbers of banks compete to offer loans to corporate bidders of similar competence, the tendency will be for interest differentials to be minimal. It is therefore the difference in utilisation methods proposed for the resource that accounts for the bulk of the difference in net present value estimates among bidders. The more aggressive the bidders utilisation plan, the higher the present value he will estimate, and the higher the price he may therefore be prepared to pay for the resource.
As an example we can examine a forest resource yielding timber for logging. A large pool of potential bidders exists, each capable of raising interest bearing finance and at similar terms from the banking system, using the resource as security for the loan. The discounting analysis of three such bidders, A, B and C, is shown. For each bidder, the forecast profit stream resulting from utilisation of the resource is shown. The present value of each years net cash-flow is then calculated assuming an interest rate on the financing of 15% annually for each bidder. The price that each bidder can pay for the resource has an upper limit equal to the summation of the present values of each year's net cash-flow. It is not economically worthwhile to borrow more than this amount from the bank since the resource would not, according to the bidder's own forecast, return sufficient net cash-flows to repay a loan any greater than this amount.
| || A || || B || || C || |
| Period || Utilisation profit ($) per annum || present value ($) for period || Utilisation profit ($) per annum || present value ($) for period || Utilisation profit ($) per annum || present value ($) for period |
| || || || || || || |
| 1 || 100 || 87.0 || 150 || 130.4 || 200 || 173.9 |
| 2 || 100 || 75.6 || 150 || 113.4 || 200 || 151.2 |
| 3 || 100 || 65.8 || 150 || 98.6 || 200 || 131.5 |
| 4 || 100 || 57.2 || 150 || 85.8 || 200 || 114.4 |
| 5 || 100 || 49.7 || 150 || 74.6 || 200 || 99.4 |
| 6 || 100 || 43.2 || 150 || 64.8 || 200 || 86.5 |
| 7 || 100 || 37.6 || 150 || 56.4 || 200 || 75.2 |
| 8 || 100 || 32.7 || 150 || 49.0 || 200 || 65.4 |
| 9 || 100 || 28.4 || 150 || 42.6 || 200 || 56.9 |
| 10 || 100 || 24.7 || 150 || 37.1 || 200 || 49.4 |
|11 + || 100 || 164.8 || 150 || 247.2 || 0 || 0 |
| TOTAL PV || || 666.7 || || 1000 || || 1003.8 |
Here, C is seen to forecast the highest present value for the utilisation of the resource and is therefore willing to borrow the highest sum in bank financing. Hence, 'C-type' bidders tend to acquire resources in preference to A and B-type bidders. (Note that C depletes the resource entirely after year 10). Any interest rate in excess of15% increases the commercial bidding advantage in favour of C, whilst lower interest rates destroy this advantage in favour of B. In most 'real world' examples that are constructed, the higher the interest rate, the more the commercial advantage in favour of aggressive utilisation. The future outcome(desertification, pollution etc.) is irrelevant to the bidder since the contribution of cash-flows at distant dates does not impact substantially upon the present value calculation. Hence, C does not worry about the loss of the entire resource after year 10 under his utilisation plan (yields after this date are forecast at 0).
Since money itself is created as part of an interest bearing loan under fractional reserve banking, the shadow of interest is cast across all real world processes that involve the use of money. Resource depleting utilisation and other 'short-termist' investment patterns are but one form in which this shadow appears. Another is in the pricing of commercial transactions. An example of this that is particularly relevant to Islamic banking is the emergence of a forward price at a premium to the current (or 'spot' price) for many commodities.
Imagine that the spot price of commodity X for cash payment is $1000 per ton and the annual interest rate is10%. To store one ton of the commodity, a charge of $10 per annum in advance is incurred. A commodity dealer is now asked by a client to supply one ton of commodity X in one year's time with payment being made in one year's time. In order to supply one ton of the commodity at year 1, the dealer must buy it today and store it for one year. In order to buy the ton of commodity X today,the dealer must borrow $1010 at 10% interest (sufficient to pay the purchase price and the advance storage costs) and repay $1111 at time one year. The minimum price at which the dealer can agree to sell the commodity to his client for delivery in one year is therefore $1111. This is the one year arbitrage free forward price for commodity X. Any lower a price would incur a loss for the dealer. Any greater a price and the dealer will lock in a profit on the transaction. By way of comparison, were the annual rate of interest to be 0% in this example, the one year arbitrage free forward price would be $1010 per ton.Notice that the rate of interest is a crucial determinant of the arbitrage free forward price.
Islamic banks conduct what is essentially the above transaction under the murabahah contract. Such a bank might buy commodity X at $1000 per ton and thereafter deliver it for payment by the client of $1111 in one year's time. Where interest based dealers borrow money from the money market to finance a forward transaction, the Islamic banks finance the operation by drawing on their depositors' funds at a 'profit sharing' rate. In this case, the difference between the spot price and the forward price is $111. The Islamic bank might keep $10 of this difference, pay$10 to the storage agent, and return the remaining balance of $91 to the depositors. Nonetheless, it is demonstrably the case that were interest rates to be zero, market forward prices would be very close to spot prices in many cases, and therefore the profits to be had from this kind of commodity murabahah would be minimal, if anything. In other words, the commercial success of murabahah substantially depends upon the continued existence of the interest based financial system.
Model 2 - Leverage
Financial leverage, or gearing,arises in the adoption of a financing pattern that comprises both debt and equity. Commonly the debt component will form the most substantial part of the overall financing amount. Hence a business venture may be financed using $100 of equity and $900 of debt at 10% interest per annum. Or in another form, a speculator may purchase $1000of a given commodity in the market paying a deposit of $100 with the balance of$900 to be paid at a later date. In both of these examples, the motivation of the individual undertaking leverage is the same, namely to make a rate of profit on a large pool of assets ($1000) that more than meets the interest charges (if any) on the accompanying debt. The surplus of the rate of return on assets above the interest charge remains as profit for the one who undertakes leverage. Where such a surplus is identified, the larger the pool of assets that are mobilised, the larger the resultant profit. This search for largeness in business transactions is a feature of the leveraged business process, one that leads to the replacement of small equity based business enterprise by large debt financed enterprise. It is proposed here that this 'business gigantism' is substantially encouraged by the practice of fractional reserve banking.
The business rationale under leverage is substantially different to that undertaken by the non-leveraged entrepreneur. The leveraged businessman examines with great concern the difference between the forecast return on assets and the interest cost. Where this difference exists, the larger the amount of funds applied to the project,the greater the profit. The non-leveraged entrepreneur does not undertake such an analysis since he is not attempting to access the difference between interest cost and expected return on assets. He is concerned instead with identifying the most profitable application of funds already in his ownership.
This difference in motivations between leveraged and non-leveraged individual leads in turn to substantial differences in resource allocation. Since the profits under leverage are directly related to the size of the project undertaken, leverage encourages large scale enterprise to dominate business activity within the economy. Such processes are sometimes referred to as the 'leveraging of value' from an idea,in order for example to allow one corporation to establish a dominant market position before the competition can establish its own manufacturing processes in a new product.
The following model describes the commercial logic behind the process of leverage. Notice that the entrepreneur has invested funds into a project whose return on assets is 20% per annum.However, due to the use of leverage, the return on his own capital is 110%.
|Entrepreneur's equity ||100 |
|Debt financing at 10% interest per annum ||900 |
|Total project assets ||1,000 |
|Return on assets at 20% per annum ||200 |
|Total asset value after one year ||1,200 |
|Repayment of debt at end of year 1 ||990 |
|Entrepreneur's equity at end of year 1 ||210 |
|Return on entrepreneur's equity (increase in equity / equity at time 0) = 110 / 100 ||110% |
The next model demonstrates the application of leverage to a competitive equilibrium. Here, three competing businessmen, A, B and C, each have equal amounts of capital at their disposal and these amounts are fully invested within their businesses. The total revenues earned by the three businesses combined are $3,000 per annum, which are shared equally among A, B and C. All three businessmen experience a rate of return on assets of 20% per annum. C now approaches a banker and negotiates aloan at 10% interest in sufficient amount to purchase the businesses of A and Bat book value. Note that the possibility of achieving economies of scale need not impact C's business logic. It is sufficient that a lender of funds should be prepared to lend to C at a sufficiently low rate of interest. Neither is it disadvantageous to C that the return on assets drops from 20% to 13.3%. C's motivation is to maximise his return on equity which rises from 20% to 40% per annum as a result of the leveraging operation. The following tables demonstrate:
| || A || B || C |
|Before C undertakes leverage || || || |
| Annual revenue || 500 || 500 || 500 |
| Annual total costs || 300 || 300 || 300 |
| Annual profit || 200 || 200 || 200 |
| Equity || 1000 || 1000 || 1000 |
| Return on assets || 20% || 20% || 20% |
| Return on equity || 20% || 20% || 20% |
| After C undertakes leverage || || || |
| Financing Structure || || || |
|Equity || || ||1000 |
|Debt at 10% per annum || || ||2000 |
|Total Assets / Liabilities || || ||3000 |
| Operations || || || |
|Annual revenue || || || 1500 |
|Annual non-interest operating costs || || || 900 |
|Annual interest cost || || || 200 |
| Annual profit || || || 400 |
| Return on assets || || || 13.3% |
| Return on equity || || || 40% |
Leverage underlies the commercial logic behind many corporate take-overs in the world today. The frequency of leveraged take-overs would be greatly reduced were it not that the banking system is able to create the huge sums of money required for them through loans at interest. Historically, the emergence of banking has largely been attributed to the commercial requirements of the Industrial Revolution. It may be at least as true that the emergence of the Industrial Revolution was largely attributable to the money creating activities of the newly developing banking system. Leverage is a key factor here. The dark Satanic mills that once bore the ire of Victorian writers, have today been replaced by the vast warehouses and monocultured housing estates of the large conglomerate. The village butcher, baker and grocer have disappeared from the high street to reappear as employees of a few dominant retailers who have leveraged the value in their brand name. Thus does the individual move from empowered small businessman to disinterested employee, from member of a world rich in variety to a world of sameness. We may see PC World, Dixons and Currys competing in the high street for our business, but in reality they all belong to the same holding company.Because all sides in the leveraging process (bank, businessman and take-over target) see benefits from its operation, leverage has become a common feature of the interest based economy. If left unbridled, it will have a far-reaching social impact upon society.
Model 3 - Debt
Most standard texts on the subject of modern banking provide a description of the creation of deposits by the banking system, the so-called deposit multiplier. In the following example, there are three Banks, A, B and C. Each operates a 20% reserve ratio,meaning that for each £100 received in deposits £80 are lent to the bank's borrowers. Initially there are £100 of modern state money (notes and coins) in circulation, none of which is deposited with the commercial banks. If the holder(s) of this state money deposit all the notes and coins with Bank A, that bank's balance sheet will read :
|ASSETS || |
| cash || £100 |
| || |
| LIABILITIES || |
| deposits || £100 |
| || |
To meet its reserverequirement, Bank A retains £20 of the deposited sum in cash and lends theremaining £80. Having done so, Bank A's balance sheet appears thus :
| ASSETS || |
| cash || £20 |
| loan || £80 |
| || |
| LIABILITIES || |
| deposits || £100 |
| || |
The borrower of the£80 now spends this sum and the individual receiving it deposits it with hisbank, Bank B. Bank B also maintains a 20% reserve ratio, and therefore lends£64 of the £80 deposited with it. Its balance sheet is then :
| ASSETS || |
| cash || £16 |
| loan || £64 |
| || |
| LIABILITIES || |
| deposits || £80 |
| || |
The borrower of the£64 in turn spends this amount and the individual receiving it deposits it withhis bank, Bank C. Bank C's balancesheet now reads:
| ASSETS || |
| cash || £64 |
| || |
| LIABILITIES || |
| deposits || £64 |
| || |
In this example, the amount of deposits outstanding in banks A, B and C is now £244. This is also the total money supply in this simple economy since it represents the amount of money that is available to fund immediate expenditure by cheque. £100 of the money supply is composed of state money with the remaining £144 comprising bank money. The process finds its limit (assuming the full expenditure of all borrowed amounts and the maintenance of minimum reserve ratios by all banks receiving subsequent re-deposits) when the total amount of deposits in the banking system reaches £500. This amount is given by the quantity of state money initially deposited, multiplied by the inverse of the reserve ratio (£100 * 1 / 0.2 = £500). Before the intermediation of the banks in the financial system, the money supply stood at£100, which was entirely comprised of state money.
The banks have reasoned that a substantial amount of depositors' funds will not be withdrawn on one day, an assumption that from time to time throughout banking history has proven disastrously wrong. This system is especially unstable in times of economic and political turbulence if large numbers of depositors wish to withdraw state money at short notice. (The printing of more than £20 billion of state money in the form of paper notes prior to the Millennium in the United Kingdom is an example of the preparations that a central bank undertakes in order to ensure the availability of reserves to depositors at commercial banks.)
The interpretation given to multiple deposit expansion is a benign one in most conventional treatments of the subject. Here, it is seen as a sophisticated form of fraud in which commercial banks manufacture money for lending at interest. Though the money manufacture process cannot be easily identified upon examination of an individual bank balance sheet, the truth is quite apparent when one examines the banking system as a whole. The following statistics illustrate.
Money Supply and Bank Lending (Amounts: 1997)
| || UK £ bn || Japan Yn trn || Malaysia RM bn |
| state money (M0 proxy) a || 31.45 || 62.09 || 82.89 |
| Wide money aggregate (M4 proxy) b || 835.86 || 578.90 || 291.80 |
| bank lending to public sector || 42.57 || 406.40 || 16.37 |
| bank lending to private sector || 973.37 || 578.79 || 445.95 |
Money Supply and Bank Lending (% Change: 1968 - 1997)
| || UK || Japan || Malaysia |
| state money (M0 proxy) a || 659 || 1298 || 7817 |
| Wide money aggregate (M4 proxy) b || 5153 || 1378 || 8834 |
| bank lending to public sector || 171 || 14841 || 1816 |
| bank lending to private sector || 10898 || 1304 || 26287 |
a and b : statistics for money supply are supplied by the country
source: IMF International Financial Statistics Yearbook 1998
Editor's note: the previously published tables for Money Supply and Bank Lending contained disaggregated data for 1992 and showed M1 in place of M0 for Japan and Malaysia. Consistent aggregated data for 1997 is now shown above.
Four important general features characterise the fractional reserve system as described above. Firstly, with every unit of bank money created there is a corresponding amount of debt. Repayment of this debt likewise destroys an equal amount of bank money. Hence, attempts to repay aggregate debt can cause a monetary contraction that in turn leads to an economic recession. Secondly,since debt grows at interest and balance sheets must balance, bank money supply must increase in line with the rate of interest. The £500 of bank money on deposit with the banking system at 10% for one year must necessarily increase to £550 after one year. Hence, ceteris paribus, the higher the rate of interest, the higher the rate of growth of bank money supply. The tendency towards money supply growth in an interest based economy must be contrasted with that occurring under a true profit sharing system. Here, if £500 is invested in economic activity, then whatever the outcome of the investment process (profit or loss) there will still be £500 of money supply at the end of the investment period. In other words, money supply growth need not accompany the process of financial intermediation in a monetary system where investment transactions are profit-sharing by nature and fractional reserve banking is prohibited. Thirdly, there may be insufficient money in existence to repay the debts created by the banking system. This fact places an unprecedented degree of power within the ambit of the bankers, since, again generally speaking, they are collectively able to foreclose on debtors unless new money is forthcoming. Hence the emergence of the fourth point. In order for new money to be forthcoming,the bankers or the state must manufacture it. Since the bulk of this new money is manufactured in the process of lending, both public and private debt must increase in the long run.
These points made, I wish to conclude by introducing my latest thinking on the matter of money creation, for contemplation and comment. If it is true that the banking system does not create sufficient (bank) money to repay both the principal and the interest on the loans that it makes, it is also true that new money must continually be created by either the state or the banking system in order for existing debts plus interest to be repaid. Hence I propose that if the amount of newly created bank and state money together substantially exceeds the interest due on previously created bank money, then a period of monetary boom may in due course develop.Conversely, if the amount of new money created by the state and the banking system is substantially less than that required to pay the interest sum on existing debt, then a period of widespread debtor default (in other words recession) must ensue. This implies that recession may occur even where money supply growth continues. Researchers may therefore be advised to look for a decrease in the rate of increase of money supply, and relate this to the prevailing average rate of interest, when examining monetary causes of economic recession in the interest based economy (for more on this point see here).
In all of the above I have used the terms 'general', 'approximate' and 'substantial' quite liberally. I hope that this reflects not superficiality in the treatment of the subject, but rather the essential level at which the theories of the Western financial establishment and its business schools are to be criticised. Events attributable to real factors (productivity changes for example) and more detailed monetary factors(for instance the term structure of interest rates) can of course be incorporated into any model that attempts to reflect the above ideas quantitatively.
1. A History of Money, John F. Chown, Routledge, 1994, 1st. Ed., p.189
2. The Global Trap, Martin & Schumann, Zed Books, 1997, 1st. Ed., p. 23,quoting UNDP Human Development Report (New York, July 1996)
3. The General Theory of Employment Interest and Money, J. M. Keynes, The Macmillan Press Ltd., 1973 Ed., p.128 - 129
4. A History of Money, John F. Chown, Routledge, 1994, 1st. Ed., p.46 - 49
5. A History of Money, John F. Chown, Routledge, 1994, 1st. Ed., p. 249
6. Government debt obligations issued in the course of such borrowing may be subsequently repurchased by the central bank on behalf of the state, and where these repurchases are made with newly manufactured state money, the process is given the name 'monetisation'.
7. Paper Against Gold, W. Cobett, 1812. Cobett states that England's national debt had escalated from zero prior to the establishment of the Bank of England in 1694 to£16,394,702 in 1701 and £257,213,043 in 1784. He sees a direct causation here between the legal right of the bank to create paper money and the inability of the state authorities to resist the temptation of borrowing these created amounts.
8. Bank of England, Monetary Statistics, 1998