By Mises. Originally published at ValueWalk.
By Frank Shostak, Mises
The so-called multiplier arises as a result of the fact that banks are legally permitted to use money that is placed in demand deposits. Banks treat this type of money as if it was loaned to them, thus loaning it out while simultaneously allowing depositors to spend that money.
RELATED: “Austrians, Fractional Reserves, and the Money Multiplier” by Robert Batemarco
For example, if John places $100 in demand deposit at Bank One he doesn’t relinquish his claim over the deposited $100. He has unlimited claim against his $100.
However, let us also say that Bank One lends $50 to Mike. By lending Mike $50, the bank creates a deposit for $50 that Mike can now use. Remember that John still has a claim against $100 while Mike has now a claim against $50.
This type of lending is what fractional-reserve banking is all about. The bank has $100 in cash against claims, or deposits of $150. The bank therefore holds 66.7 percent reserves against demand deposits. The bank has created $50 out of “thin air” since these $50 are not supported by any genuine money.
Now Mike uses that $50 to buy goods from Tom and pays Tom by check. Tom places the check with his bank, Bank B. After clearing the check, Bank B will have an increase in cash of $50, which it may take advantage of, and lends say $25 to Bob.
As one can see, the fact that banks make use of demand deposits whilst the holders of deposits did not relinquish their claims sets in motion the money multiplier.
A case could be made that people who place their money in demand deposits do not mind banks using their money. But, if an individual grants a bank permission to lend out his money, he cannot at the same time also expect to be able to use that money.
Regardless of people’s psychological disposition what matters here is that individuals did not relinquish their claim on deposited money that is being also lent out. Once banks use the deposited money, an expansion of money out of “thin air” is set in motion.
Although the law allows this type of practice, from an economic point of view, it produces a similar outcome that any counterfeit activities do. It results in money out of “thin air” which leads to consumption that is not supported by production, i.e., to the dilution of the pool of real wealth.
The legal precedent to fractional-reserve banking was set in England in 1811 in the court case of Carr v. Carr, in which the courts established the legality of fractional-reserve banking. The legality of the situation, however, is different from the economics of the matter.
According to Mises,
It is usual to reckon the acceptance of a deposit which can be drawn upon at any time by means of notes or checks as a type of credit transaction and juristically this view is, of course, justified; but economically, the case is not one of a credit transaction. … A depositor of a sum of money who acquires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to, has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him. The depositing of money in no way means that he has renounced immediate disposal over the utility that it commands.1
Similarly, Rothbard argued,
In this sense, a demand deposit, while legally designated as credit, is actually a present good — a warehouse claim to a present good that is similar to a bailment transaction, in which the warehouse pledges to redeem the ticket at any time on demand.2
Why an Unhampered Market Will Curtail Fractional-Reserve Banking
In a truly free market economy the likelihood that banks will practice fractional-reserve banking will tend to be very low. If a particular bank tries to practice fractional-reserve banking it runs the risk of not being able to honor its checks. For instance if Bank One lends out $50 to Mike out of $100 deposited by John it runs the risk of going bust. Why? Let us say that both John and Mike have decided to exercise their claims. Let us also assume that John buys goods for $100 from Tom while Mike buys goods for $50 from Jerry. Both John and Mike pay for the goods with checks against their deposits with Bank One.
Now Tom and Jerry are depositing received checks from John and Mike with their bank — Bank B, which is a competitor of Bank One. Bank B in turn will present these checks to Bank One and will demand cash in return. However, Bank One has only $100 in cash — it is short $50. Consequently, Bank One is running the risk of going belly up unless it can quickly mobilize the cash by selling some of its assets or by borrowing.
The fact that banks must clear their checks will be a sufficient deterrent to the practice of fractional-reserve banking in a free market economy.
Furthermore, it must be realized that the tendency of being “caught” practicing fractional-reserve banking, so to speak, rises, as there are many competitive banks. As the number of banks rises and the number of clients per bank declines the chances that clients will spend money on goods from individuals that are banking with other banks will increase. This in turn will increase the risk of the bank not being able to honor its checks once the bank begins the practice of fractional-reserve banking.
Conversely, as the number of competitive banks diminishes, that is as the number of clients per bank rises the likelihood of being “caught” practicing reserve banking is diminished. In the extreme case if there is only one bank it can practice fractional-reserve banking without any fear of being “caught,” so to speak.
Thus if Tom and Jerry are also clients of Bank One then once they deposit their received checks from John and Mike, the ownership of deposits will be now transferred from John and Mike to Tom and Jerry. This transfer of ownership, however, will not cause any effect to Bank One.
We can then conclude that in a free market if a particular bank tries to expand credit by practicing fractional-reserve banking it is running the risk of being “caught.” Hence in a truly free market economy the threat of bankruptcy will bring to a minimum the practice of fractional-reserve banking.
Central Bank and Fractional-Reserve Banking
While in a free market economy the practice of fractional-reserve banking would tend to be minimal, this is not the case with the existence of a central bank.
By means of monetary policy, which is also labeled as reserve management by the banking
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