How Money Disappears in a Fractional-Reserve Money System by Frank Shostak

Most experts are of the view that the massive monetary pumping by the US central bank during the 2008 financial crisis saved the US and the world from another Great Depression. On this the Federal Reserve Chairman at the time Ben Bernanke is considered the man that saved the world. Bernanke in turn attributes his actions to the writings of Professor Milton Friedman who blamed the Federal Reserve for causing the Great Depression of 1930s by allowing the money supply to plunge by over 30 percent.

Careful analysis will however show that it is not a collapse in the money stock that sets in motion an economic slump as such, but rather the prior monetary pumping that undermines the pool of real funding that leads to an economic depression.

Why the Money Supply Shrinks

Things are, however, completely different when Bank X lends money out of thin air. How does this work? For instance, Tom exercises his demand for money by holding some of his money in his pocket and the $1,000 he keeps in the Bank X demand deposit. By placing $1,000 in the demand deposit he maintains total claim on the $1,000. Now, Bank X helps itself and takes $100 from Tom’s deposit and lends this $100 to Mark. As a result of this lending we now have $1,100 which is backed by $1,000 proper. In short, the money stock has increased by $100. Observe that the $100 loaned doesn’t have an original lender as it was generated out of “thin air” by Bank X. On the maturity date, once Mark repays the borrowed $100 to Bank X, the money disappears.

Obviously if the bank is continuously renewing its lending out of thin air then the stock of money will not fall. Observe that only credit that is not backed by money proper can disappear into thin air, which in turn causes the shrinkage in the stock of money.

In other words, the existence of fractional reserve banking (banks creating several claims on a given dollar) is the key instrument as far as money disappearance is concerned. However, it is not the cause of the disappearance of money as such.

Banks Lend Less as the Quality of Borrowers Worsens

There must be a reason why banks don’t renew lending out of thin air. The main reason is the severe erosion of real wealth that makes it much harder to find good quality borrowers. This in turn means that monetary deflation is on account of prior inflation that has diluted the pool of real funding.

It follows then that a fall in the money stock is just a symptom. The fall in the money stock reveals the damage caused by monetary inflation but it however has nothing to do with the damage.

Contrary to Friedman and his followers (including Bernanke), it is not the fall in the money supply and the consequent fall in prices that burdens borrowers. It is the fact that there is less real wealth. The fall in the money supply, which was created out of “thin air,” puts things in proper perspective. Additionally, as a result of the fall in money, various activities that sprang up on the back of the previously expanding money now find it hard going.

It is those non-wealth generating activities that end up having the most difficulties in serving their debt since these activities were never generating any real wealth and were really supported or funded, so to speak, by genuine wealth generators. (Money out of “thin air” sets in motion an exchange of nothing for something — the transferring of real wealth from wealth generators to various false activities.) With the fall in money out of thin air their support is cut-off.

Contrary to the popular view then, a fall in the money supply (i.e., money out of ‘thin air’), is precisely what is needed to set in motion the build-up of real wealth and a revitalizing of the economy.

Printing money only inflicts more damage and therefore should never be considered as a means to help the economy. Also, even if the central bank were to be successful in preventing a fall in the money supply, this would not be able to prevent an economic slump if the pool of real funding is falling.

The entire article can be read here.

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