Here in the OTP pub, Windy and ~Z~ got to a discussion about `fractional reserve banking`.
It is always tricky to paraphrase what other people were saying, but I think Z’s main gripe is that banks should not be able to lend money they do not have (extend credit they have not earned).
I am not sure why Windy was insisting that the US does not run a fractional reserve banking system; but it was clear he must have something in mind, or he would not deny that that is generally known by everyone.
Not a Fractional Reserve System
My second observation is that we don’t live under a Fractional Reserve System at all; we live under a private banking system in which there is a Central Bank that once sort-of attempted, unsuccessfully, to regulate private lending by imposing a ratio requirement between private bank money creation and government-created reserves.
I say “once sort-of attempted” because the Fed long ago amended its reserve requirements (see Table 12 in O’Brien, Y.-Y. J. C., 2007. Reserve Requirement Systems in OECD Countries.) so that they apply only to household deposits, and because there is a lag between deposits and reserves of 30 days: reserve requirements are based on loans and deposits existing 30 days earlier. This means that, as the European Central Bank recently politely put it in relation to its system:
“In fact, the ECB’s reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers.” (ECB 2012, p. 21, emphasis added)
I say “unsuccessfully” because, as a sensible New York Fed Vice-President admitted decades ago, the actual practice of banking, combined with the lagged nature of the reserve requirement, means that loans determine deposits and reserves follow relatively passively afterwards—the reverse of the argument that people who believe we live in a fractional reserve banking system actually put (ranging from Milton Friedman in the 1960s to critics like Mish today):
“The idea of a regular injection of reserves … also suffers from a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later… the reserves required to be maintained by the banking system are predetermined by the level of deposits existing two weeks earlier.” (Holmes 1969, p. 73)
Mish (~Z~ and Windy) all know and understand the above, so why does Keen think it important enough to split hairs over this~?
In my opinion, it is because the fractional reserve explanation, although maybe correct, is a very clumsy way of thinking about the how the banking system works.
The next section in the Keen post talks of how to do the accounting if a bank were to make a loan from reserves………….
Money creation by private banking
There’s a fairly simple way to show from double-entry accounting that banks can’t lend from reserves, and that a system of pure private banking can result in banks creating money
….. and Keen goes on to boggle my mind with all sorts of technical explanations, but the bottom line is, `that banks can’t lend reserves` (from an accounting view-point).
The next step would be to ask if loans can be made out of customer deposits …… and I am not at all sure that the answer will be `yes, of course`~!
Same for borrowing from the central bank, or any individual bank, or private person via CD’s etc.
The only money that I can see, that could be said to be lent from, would be IPO type capital.
When looked at analytically, like Keen is doing, I can only see that all loans are made from `fresh-air-money`, because any other way would throw the accounts out of whack.
Even in countries with large (20%) reserve requirements, it is not practical to call their systems `fractional reserve`, because that is just not how banking works.
The premier criteria is that `the books must balance` ….. anything after that is just pushing and shoving numbers around by the bean counters.