Wednesday 19 June 2019

Future Money

by Trevor Watkins

Initially Fractional Reserve Banking (FRB) was criticised from the perspective of the person depositing funds with the bank. Since the bank theoretically lent out multiples of their deposit, there is a potential for fraud and loss to the depositor. However, if the bank honours the terms of its agreement with the depositor (your money is available whenever you call for it), there is no fraud or loss. Bank runs are actually very rare.

Then the debate centred around the dangers to the economy of the bank creating "new" money without full backing. Leon said new money was not created, Dawie said it was. Even Von Mises warned of the dangers. I think it is patently obvious that new money is created when a bank makes a loan in excess of its reserves. However, I no longer think this is a bad thing.

My new insight is that banks are lending "future" money - money which has not yet come into existence, but will as a result of the loan. Consider this scenario:

  1. A builder wishes to erect a block of flats but does not have the necessary capital for materials and labour. The maximum credit period he will get from suppliers and labourers is 30 days. However, his bank will give him sufficient credit for the entire project for 5 years, if it judges him to be a good risk.
  2. The bank lends the builder R5 million for 5 years. This loan plus all its others exceeds its reserves (but hopefully by not more than the almost pointless statutory amount). Because the bank's credit is trusted by the suppliers and labourers, the bank makes the money available as a bookkeeping entry in the builders account. (ie, it does not have to produce actual gold or silver to convince people it will honour the demands)
  3. This is now "real" money. As soon as the labourer or supplier spends money paid from the builder, it is in the economy doing useful things. But it is only backed by trust in the bank, for now. Because the bank aggregates many deposits and loans, it can meet all demands through judicious management.
  4. This ability of the bank to stimulate new production by issuing unbacked loans is wonderful for the economy. It is a form of private Keynesianism. Through a network of trust it persuades and assists people to take risks they might not otherwise take.
  5. The builder completes his block of flats and starts receiving rent. He uses this to repay his loan from the bank, plus interest. The loan IS NOW BACKED by the funds and real asset created by the builder. The future money loaned by the bank becomes real money on the banks books. Everyone is happy - the builder has a productive asset, the bank has more money than it started with, the workers and suppliers have all been paid at profit.

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