Will fractional reserve banking create hyperinflation?

Everyone knows banks are in the business of taking money from savers and lending it out at a higher interest rate to borrowers. They make money from the difference in interest rates between the two parties. That's all right? Nothing else to see here. Wrong.

There is actually much more than meets the eye. People are becoming more aware every day that the Federal Reserve creates money out of thin air with the stroke of a keyboard to buy up Treasury bonds. This is called monetization or quantitative easing, but few appreciate the way banks create money as well. It is well disguised to the public. Banks create credit over and above the original amount of money deposited until the money and credit combined is 10 times the amount of money originally deposited.

Abe makes a deposit at his local bank of $100. According to current lending rules, the bank can lend out 90% of the money and must keep on hand $10 in its vault for day to day operations. The bank lends out $90 to Bill. Bill takes the money and buys a bicycle with it. The bike shop owner, Carl, deposits the $90 in his bank. Of that $90, $81 is lent out to Derek. He spends it with Ethan, who deposits it in his bank. They lend it out 90% or $72.90 to Frank. Frank buys something from George. George deposits the money and 90% of that, or $65.61 is re-lent. The process completes over and over again until the original $100 of bank deposits has resulted in an additional $900 of credit creation.

This money is created by the magic of credit creation. There is a certain amount of currency issued by the Federal Reserve, this is called base money. Fractional reserve banking then takes that money and converts it to 10 times its original amount.

Why is this important? Take a look at the following graph from the Federal Reserve's website:



The monetary base has more than doubled since the financial crisis of 2008. What does this mean in layman's terms. The Fed has created money out of thin air to buy all that undesirable junk mortgage debt and who knows what other toxic nonsense the Wall Street banks were holding.

Under normal circumstances this money would multiply 10 fold out into the economy and we would be looking at hyperinflation. Why have we not had hyperinflation given this astounding increase in the monetary base? Simple, The Fed is paying banks interest not to lend. Banks are logically choosing to keep their cash deposited at the Fed and collecting a risk free return as opposed to lending the money out to borrowers in the economy.

Will the Fed continue this policy of paying interest on deposits forever? Will banks ignore the safety and start lending their money out to customers at a higher rate of interest and kick off hyperinflation? Will the Fed reduce the monetary base if banks start lending again?

These are questions that will determine if we end up on a hyperinflationary path that will lead to the destruction of the currency, or in a deflationary debt collapse where bad loans are worthless and the credit losses domino though the economy.

One thing is for certain, the Fed cannot simply sell off its reserves to shrink the monetary base. This is because they exchanged Treasury Bonds for junk assets at equal value. The process went like this. 1) Government bailout issued 100s of billions of dollars in new debt. 2) Fed bought the government bonds with newly created money. 3) The Fed exchanged those bonds to banks for their toxic bad assets. If they tried to sell those toxic assets into the market they would only fetch their market value which is far less than they paid for them.

4 comments:

  1. Amazing insight into Fractional Reserve.. Great Examples.. I salute your knowledge...

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  2. I have a question though on liquidity soak operation. by raising interest rate. for 1 Unit of base money which becomes 10 Units in market. while soaking .. Do Central bank need to Soak all 10 Units to keep system in equilibram?

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  3. When the Fed sells bonds the money supply shrinks and the process works in reverse. The base money is reduced and as a result the fractional reserve lending will shrink by 10 times that amount. This scenario would be under normal market conditions in the past. Now that the Fed is paying interest to banks to keep their reserves at the fed and not lend them out there would only be a one to one reduction in money + credit supply.

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  4. Thanks for your reply so In short it will be too tough now.

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