Guest Post: Nature and Roles of Money and Banks

Flattr this!

By Geoff Davies

[This arti­cle is based on extracts from The Nature of the Beast: how econ­o­mists mis­took wild hors­es for a rock­ing chair eBook]

Any dis­cus­sion of the nature and role of mon­ey in mod­ern economies typ­i­cal­ly brings out a pletho­ra of con­fus­ing or con­flict­ing the­o­ries, claims and counter-claims about what mon­ey is, what role it plays, what dys­func­tions it might be respon­si­ble for and how they might be fixed.  One com­mon set of claims is that mon­ey is a unit if account, a medi­um of exchange and a store of val­ue.  I argue the first prop­er­ty is a triv­ial one and the last is only true if the mon­ey is whol­ly or in part a real com­mod­i­ty, like a pig or some tobac­co.  The mon­ey we com­mon­ly use is a token that has no imme­di­ate val­ue, but rather an implied promise of future val­ue.  If the world pro­ceeds as expect­ed then that val­ue may be deliv­ered, but if unex­pect­ed things hap­pen you may be left with worth­less paper and your per­ceived val­ue will not have been stored.  Indeed many retirees are find­ing the val­ue of their retire­ment fund is not as assured as they had wished.  Many argue pas­sion­ate­ly that mon­ey should be backed (in whole or in part) by gold, but gold is just anoth­er com­mod­i­ty and its val­ue fluc­tu­ates wide­ly with lit­tle ref­er­ence to the needs of an econ­o­my for a medi­um of exchange.

Banks, too, elic­it great con­fu­sion.  One key ques­tion is whether bank loans increase the mon­ey sup­ply, and anoth­er is whether cen­tral author­i­ties can con­trol the mon­ey sup­ply.  Even eco­nom­ics text books show that bank loans do increase the mon­ey sup­ply, yet neo­clas­si­cal econ­o­mists argue they do not, and that pri­vate debt is there­fore not impor­tant.    To dis­en­tan­gle these con­fu­sions we need to con­sid­er some sim­ple cas­es of exchange and cred­it, from which the nature and role of mon­ey and the mys­tery of its cre­ation can be clar­i­fied.

Bet­ter under­stand­ing could lead to major improve­ments.  If token mon­ey (i.e., mon­ey that is not a com­mod­i­ty) is prop­er­ly under­stood, and if a soci­ety is a sta­ble and trust­ing one, then it can func­tion well as a medi­um of exchange.  Token mon­ey is an implic­it social con­tract, involv­ing a debt and a cred­it.  If this is prop­er­ly under­stood then a bank­ing sys­tem can be designed that does not desta­bilise the econ­o­my with exces­sive accu­mu­la­tions of debt and risk, and that facil­i­tates exchange with min­i­mal dis­tor­tion.

The fun­da­men­tal act of eco­nom­ic activ­i­ty is exchange.  If Jane is good at rais­ing pigs and Tom is good at grow­ing wheat, then they might each do what they’re good at and then exchange a pig for some wheat.  They could do this with­out the use of mon­ey, or in oth­er words they could barter.  This sim­ple exam­ple illus­trates the point of all eco­nom­ic exchange, which is to increase val­ue.  Jane could grow her own wheat, and Tom could raise his own pigs, but they work more effi­cient­ly if they each do what they’re good at and then exchange.  Being able to exchange gives them more val­ue for the work they invest.

To put it anoth­er way, Jane and Tom gain more val­ue if they spe­cialise and then exchange.  This is a found­ing prin­ci­ple of eco­nom­ics, famous­ly expound­ed by Adam Smith.  The sto­ry of the indus­tri­al rev­o­lu­tion, and indeed of civil­i­sa­tion, is as much a sto­ry of spe­cial­i­sa­tion as it is of tech­ni­cal inno­va­tion.  Or to put it in Eric Beinhocker’s terms, it is as much about social inno­va­tion as tech­ni­cal inno­va­tion1.

I will walk us through some basic exam­ples of exchange in order to bring out key fea­tures of mon­ey.  Some­times we don’t think much about famil­iar things, just because they are so famil­iar, so we must make a spe­cial effort to exam­ine them afresh.

Thus, sup­pose Tom would like a pig from Jane but Tom’s wheat crop is not yet ready to har­vest.  If Jane trusts Tom she might be will­ing to give him the pig now and have Tom give her the wheat when it’s ready.  But sup­pose Tom is a stick­ler, and he writes a for­mal lit­tle note that says “Tom owes Jane one pig’s worth of wheat” and gives it to Jane in exchange for the pig.  Lat­er, at har­vest time, Tom deliv­ers the wheat to Jane and she gives him the note in exchange, since she doesn’t want to claim any more wheat from Tom.  Tom can throw the note in the fire, because he has ful­filled his promise and the note has no more pur­pose.  Fig­ure 10.1 is a lit­tle dia­gram of the two-part exchange.  Tom’s note is depict­ed as IOU (I owe you: Tom’s promise to Jane).

Figure 10.1

Fig­ure 10.1  A split barter.  (a)  Jane accepts Tom’s promise (IOU) in exchange for one of her pigs.  (b)  When the wheat is ready, Tom exchanges some of his wheat for the IOU that Jane has held.

I’m belabour­ing this sim­ple exam­ple, and a cou­ple to fol­low, because we’re on our way to clar­i­fy­ing exact­ly what role mon­ey plays, and some dif­fer­ent forms it can take.  You could even say that Tom’s note is a rudi­men­ta­ry form of mon­ey.  Now here is a key point:  Tom’s note allowed Tom and Jane to break their exchange into two parts, as is spelled out in Fig­ure 10.1.  In the first part, a pig is exchanged for an IOU.  In the sec­ond part, the IOU is exchanged for some wheat.  E. C. Riegel2 called such a two-part exchange split barter.

How­ev­er this exam­ple does not yet bring out the full pow­er of Tom’s IOU, and of split barter.  We can do that by look­ing at a three-way exchange, like the one depict­ed in Fig­ure 10.2.

The well-known prob­lem with barter is that you have to find some­one who has what you want, and who wants what you have.  Har­ry has a pig, but he doesn’t want Tom’s wheat, he wants Dick’s pota­toes.  Dick wants Tom’s wheat (which is not ready yet), but Tom doesn’t want Dick’s pota­toes, and so on.  Now it hap­pens there’s a three-way match here, and if they’re patient and trust­ing they might do the three-way barter, with delay, as depict­ed.  Notice, by the way, that Dick has to wait for Tom’s wheat, and if he’s already giv­en Har­ry some pota­toes then for a time he has less val­ue:  Tom owes him a debt, just as Tom owed Jane a debt in the first exam­ple.

Figure 10.2

Fig­ure 10.2  A three-way barter, with delay.

A sec­ond pos­si­bil­i­ty would be to do an indi­rect barter.  Even though Dick doesn’t want a pig, he might accept it from Har­ry in exchange for the pota­toes that Har­ry wants, as depict­ed in Fig­ure 10.3(a).  Then, when Tom’s wheat is ready, Dick could exchange the pig for some wheat with Tom (Fig­ure 10.3b).  The pig would then have func­tioned as mon­ey.  Pigs are actu­al­ly used as mon­ey in some cul­tures.  We can call the pig an exam­ple of com­mod­i­ty mon­ey.  In this case there is no debt: Dick always has full val­ue, in the form of either pota­toes or a pig.  This is because the pig, the medi­um of exchange, has intrin­sic val­ue.

Figure 10.3

Fig­ure 10.3  An indi­rect barter.

A third pos­si­bil­i­ty is for Tom to write an IOU.  The exchanges could then pro­ceed as illus­trat­ed in Fig­ure 10.4.  Tom and Har­ry exchange a pig for Tom’s IOU.  If Dick knows and trusts Tom, he might be will­ing to accept Tom’s IOU from Har­ry in exchange for giv­ing Har­ry some of his pota­toes.  Lat­er, when Tom’s wheat is ready, Dick can present Tom’s IOU and get some wheat in return.  In this exam­ple, Tom’s IOU will have cir­cu­lat­ed as mon­ey.  (Tom might have rephrased his note “Tom owes the bear­er wheat to the val­ue of one pig.”)

Figure 10.4

Fig­ure 10.4  A three-way split barter.

We can now begin to see the full pow­er of split barter, because if oth­er peo­ple know and trust Tom, then his note might not pass just from Har­ry to Dick, it might cir­cu­late around the local com­mu­ni­ty, facil­i­tat­ing oth­er exchanges, before even­tu­al­ly return­ing to Tom at har­vest time. Tom’s note is token mon­ey, mon­ey with no intrin­sic val­ue of its own:  it is just a piece of paper with some words on it.  The role of token mon­ey is to per­mit split barter, and the pow­er of split barter is that peo­ple doing exchanges don’t have to have match­ing wants.  Tom can do half of an exchange with Har­ry, and lat­er he can do the oth­er half with Dick (or who­ev­er bears his note).

Now it’s time to draw out some impor­tant prop­er­ties of token mon­ey.  Tom’s note has facil­i­tat­ed exchange, so clear­ly it is a medi­um of exchange.  Tom’s note may appear to be backed by a com­mod­i­ty, name­ly a quan­ti­ty of wheat, but the wheat did not exist when the note was writ­ten.  Tom’s note is only use­ful if oth­er peo­ple trust Tom’s word, so Tom’s note is real­ly backed by Tom’s promise.  Tom’s promise has val­ue only in a com­mu­ni­ty or soci­ety in which mutu­al trust exists.

In the first exam­ple, with Tom and Jane, we can see more clear­ly that Tom’s note is real­ly the expres­sion of a social con­tract between Tom and Jane.  Because it is a con­tract, it was cre­at­ed when the agree­ment was made and it can be destroyed when the agree­ment is ful­filled.  (With this per­spec­tive, we don’t have to be hor­ri­fied that mon­ey is some­times destroyed — Tom burnt his note, and a bank de-issues or destroys mon­ey as a loan is payed off).  To the giv­er of the note, it rep­re­sents a promise to deliv­er a ser­vice – as has been explic­it in our exam­ples.  On the oth­er hand to the bear­er of the note it rep­re­sents a claim on some­one else’s ser­vice (in this case, Tom’s).

We now come to an espe­cial­ly impor­tant prop­er­ty of Tom’s note.  Tom’s note rep­re­sents a claim on future ser­vice.  The con­tract between Tom and Jane links the future to the present, because Jane must agree to hold her wish for some wheat in abeyance, expect­ing the agree­ment to be ful­filled in the future.  This link­ing of the future to the present is fun­da­men­tal­ly impor­tant for under­stand­ing the dynam­ics of an eco­nom­ic sys­tem, as it means, in the lan­guage of cal­cu­lus, the pri­ma­ry sig­nalling mech­a­nism in the sys­tem involves time-deriv­a­tives.  The neo­clas­si­cal the­o­ry deals with a sta­t­ic equi­lib­ri­um that excludes time, so it excludes this cru­cial prop­er­ty of token mon­ey and can­not describe the way economies devel­op over time, nor prop­er­ly describe the role and influ­ence of mon­ey.

In the mean­time Tom owes a debt to Jane and Jane is owed a debt by Tom.  Thus the note rep­re­sents a debt.  With the intro­duc­tion of debt comes risk.  The risk aris­es from the link­ing of the future to the present, because we can’t be sure what the future will bring.  If Tom’s crop is destroyed by a hail­storm, Jane will lose – she gave a pig but got noth­ing in return.  This high­lights anoth­er crit­i­cal prop­er­ty of token mon­ey, that it intro­duces debt and risk.

Final­ly, if Tom’s note func­tions as mon­ey, then obvi­ous­ly his issue of it increas­es the mon­ey sup­ply.

So far the dis­cus­sion has been in terms of Tom’s note, which may not seem much like nor­mal mon­ey, despite my asser­tion that the note func­tioned as mon­ey.  To make the con­nec­tion clear­er, sup­pose the peo­ple in Tom’s com­mu­ni­ty like the way his note helped them to exchange things, but they realise it would be more use­ful if they could use a stan­dard­ised form of note, or promise.  So (mov­ing the sto­ry right along) they get the local print­er to print up some notes that say “The bear­er is owed goods or ser­vices to the val­ue of one dol­lar”, and they agree that one dol­lar stands for the val­ue of one kilo­gram of wheat.  They also ask the print­er to keep track of how many notes are issued to each per­son who wants some, in oth­er words to keep track of each person’s promis­es.  The print­er decides to set up a side busi­ness to per­form the note-print­ing and account­ing, for which he will of course charge an appro­pri­ate fee.  The print­er decides to call this busi­ness Com­mu­ni­ty Bank.

These stan­dard­ised notes should be more recog­nis­able as the kind of mon­ey we are used to, yet they still have all the prop­er­ties that Tom’s IOU had.  Thus the offer­ing of a stan­dard­ised note implies a con­tract involv­ing the promise of deliv­ery of a ser­vice.  The exchange also implies a debt, it links the future to the present and it there­by involves risk.

If you have a ten dol­lar note, the note express­es a debt owed to you by your com­mu­ni­ty.  You may not be used to think­ing of it this way, but think about where your mon­ey comes from.  If you are employed, then you con­tribute your ser­vices to your employ­er and in return he gives you some pieces of paper, or some num­bers in a com­put­er.  You are def­i­nite­ly owed!  The debt can be redeemed if you take your notes (or your deb­it card) to a store and buy some gro­ceries.  On the oth­er hand if Tom, rather than earn­ing mon­ey, sim­ply with­draws some new mon­ey from the bank and issues it in exchange for a pig, then Tom is cer­tain­ly tak­ing on an oblig­a­tion.  His oblig­a­tion is to return to the com­mu­ni­ty equal val­ue in goods or ser­vices.  He can do this by pro­vid­ing wheat in exchange for mon­ey, which he then deposits and extin­guish­es his debt.

Seen in this form, it is clear that token mon­ey has no intrin­sic val­ue, nor is it backed by any spe­cif­ic com­mod­i­ty.  Rather it is backed by the promise of the com­mu­ni­ty to deliv­er val­ue in goods or ser­vices in exchange for the mon­ey.  The val­ue of token mon­ey thus depends on the exis­tence of a trust­ing com­mu­ni­ty.

We can dis­pose of the claim that mon­ey should be backed by gold, as it used to be (or was alleged to be) before the “gold stan­dard” was dis­card­ed.  Token mon­ey, in a trust­ing com­mu­ni­ty, does not need to be backed by gold or any oth­er com­mod­i­ty.  It’s true that in order to main­tain a steady val­ue the mon­ey sup­ply must be care­ful­ly man­aged, but that is a dif­fer­ent issue.  Any­way the val­ue of gold is also volatile, depend­ing as it does on arbi­trary fluc­tu­a­tions in sup­ply as gold dis­cov­er­ies are made, on hoard­ing, and on peo­ples’ high­ly sub­jec­tive val­u­a­tion of gold as an orna­ment, as an imper­ish­able com­mod­i­ty or even as a sym­bol of immor­tal­i­ty.

Not all exchange occurs in a con­text of trust, such as in low-trust soci­eties or in inter­na­tion­al deal­ings.  In sit­u­a­tions where trust is lack­ing it does make sense for mon­ey to be backed by things of real val­ue.  Bernard Lietaer3 has there­fore pro­posed a backed cur­ren­cy, which he calls a Ter­ra, backed by a ‘bas­ket’ of com­modi­ties that can be stored in ware­hous­es.  It could be ben­e­fi­cial espe­cial­ly for poor­er coun­tries whose cur­ren­cies may be vul­ner­a­ble to glob­al forces.  The par­tic­u­lar mix of com­modi­ties would be deter­mined by each coun­try using those of its prod­ucts that best retain their val­ue.

Token mon­ey, whether it is backed by com­mu­ni­ty trust or by a com­mod­i­ty, is not itself wealth, it is a token of wealth.  We might also think of it as poten­tial wealth.  It has no imme­di­ate val­ue in itself, but it holds the poten­tial of being con­vert­ed into wealth.  Wealth, as I defined it ear­li­er, is the val­ue to a per­son of real things, be they food, a house, an axe, a fac­to­ry, or a piece of land close to ser­vices or acces­si­ble to many poten­tial cus­tomers.

Most of our mon­ey comes from banks, who cre­ate it out of noth­ing accord­ing to their per­ceived needs.  Banks are not well under­stood by most peo­ple.  There is a gen­er­al idea that banks accept deposits and make loans, but banks’ oper­a­tions are much more com­plex than that.  Banks do oper­ate under gov­ern­ment-imposed rules, but the rules have been changed and loos­ened over the past sev­er­al decades.  The rules now are so com­plex and jar­gon-laden that it is dif­fi­cult for any but the most expert to real­ly under­stand them.  What the banks do with­in those rules, and how close­ly they remain with­in them, are even hard­er to fath­om.  Nev­er­the­less some key under­ly­ing fea­tures can be dis­cerned, and they have a large effect on the behav­iour of our econ­o­my.

Banks devel­oped from the prac­tices of mon­ey chang­ers and mon­ey lenders in the Mid­dle Ages, who learned that they could loan promis­so­ry notes to a val­ue greater than the reserves of coin they held, so long as every­one did not want to redeem their notes for coin all at once.  An exam­ple will be giv­en short­ly.  There is a text-book ver­sion of how mod­ern banks issue mon­ey, and the sys­tem it describes is called frac­tion­al reserve, reflect­ing its sim­i­lar­i­ty to the par­tial reserves held by mon­ey chang­ers.  How­ev­er bank­ing has devel­oped beyond this in at least two impor­tant ways.  One is that in some coun­tries sim­ple reserve require­ments have been replaced with “cap­i­tal ade­qua­cy guide­lines”.  The oth­er is that empir­i­cal evi­dence indi­cates that banks first loan mon­ey, then look for ade­quate reserves, rather than reserves lead­ing loans.  Fur­ther­more the amount of debt is sev­er­al times greater than the amount of cir­cu­lat­ing mon­ey, con­trary to what the frac­tion­al reserve sto­ry pre­dicts.  The net result is that banks are a lot freer to cre­ate mon­ey for loans than neo­clas­si­cal the­o­rists typ­i­cal­ly assume.

The frac­tion­al reserve sys­tem can be con­fus­ing at first, and you have to step care­ful­ly through the details to see its results.  It is spelt out by Heil­broner and Thurow4, and in The Nature of the Beast (Appen­dix A).  I will just give the take-home mes­sages here.  In the text-book frac­tion­al reserve sys­tem, if the reserve frac­tion is 10% then banks, col­lec­tive­ly, can loan out about nine times what they have in deposits.  In oth­er words they have to keep in reserve only about 10% of what they loan out.  The reserve frac­tion varies quite a lot among dif­fer­ent coun­tries, but that is a fair­ly typ­i­cal val­ue.  So banks don’t just loan mon­ey that has been deposit­ed with them.  Instead, every time they make a loan, about 90% of it is new mon­ey, cre­at­ed out of noth­ing.

There are two impor­tant con­se­quences of frac­tion­al reserves.  First, every time a loan is grant­ed the mon­ey sup­ply increas­es, and con­verse­ly as the loan is paid off the mon­ey sup­ply decreas­es.  Sec­ond, because new mon­ey is issued as part of a loan, the bank charges inter­est on it.  Each of these fea­tures affects how the larg­er econ­o­my behaves.

This sys­tem has been extend­ed or mod­i­fied by requir­ing “cap­i­tal ade­qua­cy”, which allows banks to count a wider range of assets than just reserves to deter­mine how much they may loan.  Thus banks can still loan much more than they have in hand and, because reserves are now only part of the total cap­i­tal of a bank, a bank’s capac­i­ty to extend loans has been expand­ed.

Now to the oth­er exten­sion of the frac­tion­al reserve sys­tem, or rather beyond the frac­tion­al reserve sys­tem, which bears on the ques­tion of whether author­i­ties can con­trol the amount of mon­ey.  Econ­o­mist Steve Keen argues that banks make loans first, then look for reserves5.  Gov­ern­ments (through reserve banks) respond by cre­at­ing enough “base mon­ey”, the mon­ey used for reserves, to keep the bank­ing sys­tem func­tion­ing.  Although the US claims to run a frac­tion­al reserve sys­tem, it now only applies its 10% reserve require­ment to indi­vid­ual deposits, and it does not have a reserve require­ment for deposits by com­pa­nies.  Thus banks are free to loan busi­ness­es as much as they like.  There are also many debt instru­ments cre­at­ed by a shad­ow bank­ing sys­tem, and these are essen­tial­ly unreg­u­lat­ed.

Keen argues that the frac­tion­al reserve sys­tem is now a minor adjunct to the dom­i­nant mon­ey sys­tem, which is close to a pure cred­it sys­tem, in oth­er words a sys­tem in which banks arbi­trar­i­ly cre­ate mon­ey out of noth­ing.  Because bank prof­its result main­ly from mak­ing loans, their incen­tive is to push as much debt as the mar­ket will bear.  A fea­ture of shad­ow bank­ing is the trad­ing of so-called deriv­a­tives.  These are basi­cal­ly pack­ages of things like bonds, shares and mort­gages.  Because they are agree­ments requir­ing future pay­ments, they involve debt, and there­fore risk.  Because deriv­a­tives have been hard­ly reg­u­lat­ed, large amounts of debt have been cre­at­ed in this form as well.  The result has been an enor­mous increase in the amount of pri­vate debt rel­a­tive to the GDP.

Almost every insti­tu­tion involved in the finan­cial sys­tem is, in the jar­gon, high­ly lever­aged.  This is as true of old-fash­ioned banks with frac­tion­al reserves and main­stream banks with cap­i­tal ade­qua­cy require­ments as it is of shad­ow banks.  What does “high­ly lever­aged” mean?  It means you are bet­ting a small amount of your own mon­ey plus a lot of oth­er peo­ples’ mon­ey on a large return.  If the return is pos­i­tive, you make a hand­some prof­it.  How­ev­er if the return is neg­a­tive you lose not only your stake but poten­tial­ly every­thing you own.

For exam­ple, if you invest $1000 in an enter­prise that returns 15% a year lat­er, you make $150.  How­ev­er if you can per­suade some­one to lend you $9000 so you can invest $10,000, then the return will be $1500.  The return on your $1000 is mag­ni­fied or lever­aged to 150%.  How­ev­er the risk is also mag­ni­fied.  If the return is neg­a­tive, ‑15%, in oth­er words a loss, then you lose $150 on your $1000 invest­ment and are left with only $850.  But if you invest­ed the $10,000 then you lose $1500.  That means you lose all of your ini­tial $1000 and you still owe your cred­i­tor $500.

Some sim­ple para­bles can help us to fig­ure out who is lever­aged and who is not.

Hon­est Abe

Hon­est Abe is an old-time mon­ey chang­er and safe-deposit man­ag­er who issues paper receipts for coins peo­ple deposit with him, to be held in his vault.  Each receipt says it may be redeemed for the equiv­a­lent val­ue in coins.    Peo­ple would be able to use the receipts as mon­ey, stand­ing in for the coins.  If the val­ue of the coins in the vault is the same as or more than the val­ue of the paper Abe has issued, then there should nev­er be a prob­lem.  Any­one who wants “real” mon­ey can exchange their paper notes for coins.  Abe’s busi­ness involves no lever­age, and it does not increase the mon­ey sup­ply.

Clever Clan­cy

Clever Clan­cy offers an arrange­ment with his depos­i­tors that he can loan some of their coins out, in return for a share of the prof­it he makes on the loans.  He offers them 2% inter­est.   His loans car­ry the con­di­tion that if his depos­i­tors require the coins then he can “call in” the loan, in oth­er words require imme­di­ate repay­ment in coins.  He loans out nine­ty per­cent of the coins, keep­ing only ten per­cent as a reserve for peo­ple who need to redeem notes for coins.  His deposits, loans and reserves are sum­marised in Table 11.1, along with those of Abe, and Slick Slim (below).

This arrange­ment gives some pro­tec­tion to Clan­cy and his depos­i­tors, but less to his debtors.  If his depos­i­tors should want to redeem notes worth more than the coins he has on hand, he can call in some loans, retrieve the coins and pass them to his depos­i­tors.  Those whose loans are called in may sud­den­ly have to sell things for less than their full val­ue in order to raise the coins owed to Clan­cy.  If any debtors should be unable to repay their loans, then Clan­cy would lose and so would his depos­i­tors.  How­ev­er the risk of default should not be great if he loans wise­ly.

Clancy’s arrange­ment intro­duces some risk for him­self and his depos­i­tors, but he makes con­sid­er­ably more prof­it and his depos­i­tors also make mod­est prof­its.  So long as defaults are few, the main risk is to debtors, whose lives may be dis­rupt­ed by a call-in.  Clancy’s busi­ness can be viewed as loan bro­ker­ing.  How­ev­er the loans are made with exist­ing mon­ey (the coins), and so there is lit­tle risk of wider con­se­quences.  Clancy’s busi­ness might appear to involve lever­age, but since the loaned coins already exist­ed and can be accessed if nec­es­sary then in prin­ci­ple all the paper is still backed by coins.  How­ev­er the busi­ness does increase the cir­cu­lat­ing mon­ey sup­ply by 900.

Table 11.1.  Sum­ma­ry of deposits, loans and reserves.

Table 11.1

Slick Slim

Slick Slim starts out like Clan­cy, except he makes his loans with paper notes rather than coins.  As long as the loans total no more the 90% of the coins on deposit, his busi­ness should pro­ceed in the same way as Clancy’s.  In fact it should run bet­ter, because there will be lit­tle chance of not being able to redeem notes for coins.  This is because the paper he has issued would amount to less than the coins he has on hand, where­as Clancy’s deposit receipts would amount to ten times the coins he kept in reserve.

Real­is­ing this, Slim makes a cru­cial exten­sion.  He starts loan­ing more than the val­ue of deposits.  To do this he makes his receipts and his loans iden­ti­cal, so they both state sim­ply that they may be redeemed for coins.  Then he makes loans worth nine times the val­ue of the coins on deposit.  Slim’s deposits, loans and reserves are includ­ed in Table 11.1.  If he is care­ful, no-one need know he has loaned out more than he has.  His rea­son­ing is the same as before, that only ten per­cent of peo­ple are like­ly to want to exchange their notes for coins at any giv­en time.

In mak­ing this change, Slim has lever­aged his deposits by a fac­tor of ten.  He will make ten times more prof­it on the loans.  Unfor­tu­nate­ly he has also mag­ni­fied his risk.  Worse, he has cre­at­ed a sys­temic risk for his com­mu­ni­ty.

Slim’s scheme increas­es the sup­ply of mon­ey by a fac­tor of ten, because his notes can cir­cu­late as mon­ey.  This may for a time increase eco­nom­ic activ­i­ty in the com­mu­ni­ty, because his debtors will have spent their loan-mon­ey on what­ev­er project they got the loan for.  It may also cause infla­tion.

How­ev­er, if for any rea­son Slim’s depos­i­tors sus­pect that he might not be able to redeem their notes, there might be a rush to redeem notes and he will run out of coins.  He may attempt to call in loans, requir­ing they be repaid in coin.  This will cre­ate a short­age of coins as debtors scram­ble to sell things to raise the coins to repay their loans.  It will also reduce con­fi­dence in the val­ue of his paper notes.  If mer­chants know Slim is hav­ing trou­ble redeem­ing his notes, they may refuse to accept any more in pay­ment for goods.  If that hap­pens the notes may become worth­less, and any­one hold­ing them will lose.  The sup­ply of mon­ey will sud­den­ly decrease, because Slim’s notes cease to func­tion as mon­ey, so the for­mer­ly boom­ing eco­nom­ic activ­i­ty will slow.


Unlike Clancy’s scheme, the con­se­quences of the fail­ure of Slick Slim’s scheme do not fall just on Slim and those deal­ing direct­ly with him.  The con­se­quences flow through the whole com­mu­ni­ty.  As he expands the mon­ey sup­ply he may trig­ger infla­tion, which affects every­one by devalu­ing the mon­ey they already hold.  If peo­ple lose con­fi­dence in his notes, then any­one hold­ing the notes los­es, but the whole com­mu­ni­ty also los­es if the drop in the mon­ey sup­ply impedes local eco­nom­ic activ­i­ty.  In con­ven­tion­al terms, Slick Slim’s paper mon­ey first trig­gered an infla­tion­ary boom, then a reces­sion.  This sequence of events occurred many times through the eigh­teenth and nine­teenth cen­turies.

Frac­tion­al reserve bank­ing is also high­ly lever­aged.  It func­tions essen­tial­ly in the way Slick Slim’s bank did, and it gen­er­ates the same kind of risk, not only for itself but for the whole com­mu­ni­ty.  If for any rea­son a lot of its loans should default, then it may not have enough reserves to cov­er the loss­es and it would become insol­vent.  The mon­ey involved with the default­ing loans would van­ish, the mon­ey sup­ply would sud­den­ly drop, and a reces­sion or depres­sion might be trig­gered.

Mod­ern banks do not prac­tice sim­ple frac­tion­al reserve bank­ing any more, but they are still high­ly lever­aged and there­fore they gen­er­ate at least as much risk.  The shad­ow bank­ing sec­tor is overt­ly one of high lever­age and high risk.  The finan­cial instru­ments they deal in are all debt instru­ments, bets on the future.  They effec­tive­ly mul­ti­ply the mon­ey sup­ply even more.  This is how pri­vate debt in the US came to be 47 times greater than “base mon­ey” in 2007.

In tech­ni­cal terms, the high lever­ag­ing of the bank­ing sys­tem sets up a pow­er­ful desta­bil­is­ing (pos­i­tive) feed­back.  Pos­i­tive feed­backs are the ones that tend to mag­ni­fy a trend.  Thus in good times the feed­back tends to dri­ve the mon­ey sup­ply up, but when bad times come the same feed­back tends to dri­ve the mon­ey sup­ply down.  Lever­aged bank­ing is a built-in gen­er­a­tor of insta­bil­i­ty in our economies.  It is a major fac­tor in caus­ing reces­sions and depres­sions.



1    Bein­hock­er, E.D., The Ori­gin of Wealth. 2006, Boston: Har­vard Busi­ness School Press.

2    Riegel, E.C., Flight From Infla­tion. 1978, Los Ange­les: The Heather Foun­da­tion, Box 48, San Pedro, CA 90773.

3    Lietaer, B., The Future of Mon­ey. 2001, Lon­don: Cen­tu­ry.

4    Heil­broner, R. and L. Thurow, Eco­nom­ics Explained. 1994, New York: Simon and Schus­ter.

5    Keen, S., The rov­ing cav­a­liers of debt, Steve Keen’s Debt­watch,, 2009. Post­ed.


Bookmark the permalink.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.