"Most people are in arrested development and cannot use logic." Jacob.
"Competition and capitalism are hated to-day because of their tendency to destroy poverty and privilege." William Hutt
"America is unique in that our economy is totally dependent on global charity." Peter Schiff

Monday, May 23, 2011

Does fractional reserve banking really increase total spending?

Someone over at the Mises forums asked this.
I know the theory is that fractional reserve banking increases total spending. But does it increase spending over time? I don't see how it can. Suppose John Smith earns 1 million dollars over his adult lifetime. If he borrows 500k and spends it when he is 18 then that means he is going to spend 500k less over the rest of his life. In other words the ability to borrow money does not increase the net amount you can spend over your lifetime. All it does is shift the time horizon. So I would think that all fractional reserve banking would do is shift the spending forward in time, not change the net amount.

I liked my own answer so much I'm posting it here.
Very good question. Shows an active mind.

1. What about businesses? They don't die. What about dying with debt? It happens.

2. Let us move aside the curtain of money and see what is happening behind the scenes. First we will talk about businesses.

Absent FRB [=Fractional Reserve Banking], the money available to borrow comes from people saving their money and putting it in a bank. This is called under-consumption, meaning there are going to be resources that will not be consumed right now. The banks lend that money to businesses, who use it to buy those unconsumed resources to make tools etc. and increase production. With their increased production, which is hopefully a higher percent than the interest and principal they are paying on the loan, they pay off the loan. Society benefits from the increased production, since the wealth of a nation is it's goodies.

If we introduce FRB, there is money available to people that did not get into the bank from depositors, and so does not represent underconsumption, and so there is no increased supply of resources to draw from. Thus the businesses will have to compete for the existing few resources. They have plenty of money to spend, having borrowed it from the banks, so that prices for those resources will rise. In other words, enter inflation.

Some businesses will lose money because of this change in prices. Rather than paying off the loan with their new profits, they will go bankrupt, because there are no profits.

So that FRB does more than shift the time horizon. It inflates the money supply, a very damaging thing.

As for a consumer borrowing from the bank to consume, he shouldn't be there in the first place. He will have to repay that money with interest, but will not be using the borrowed money to increase his wealth. FRB allows the banks to increase their pool of suckers.

EDIT: Not sure why, but I can't post comments. So I'll say right here that Jack's comment is spot on, and is what I meant.


  1. Unless you qualify the deposits in the paragraph starting with, "Absent FRB", as time-based deposits, you are perfectly describing FRB. A bank that loans out its deposits, that is, does not keep 100% of its deposits "in reserve", is practicing FRB. A fraction of the total deposits is kept "in reserve", and a fraction is lent out.

    In a full reserve system, a bank lends out the bank's own assets, not deposits.

  2. Yes, That's what I meant, Jack. TY for clarifying.