Tuesday, April 8, 2008

Monetary Expansion and Fractional Reserves

Any increase of money supply is of concern to the cash investor, as it can cause inflation. In prior posts I mentioned the two factors that constitute money supply: cash and credit.

I also argued a recession would be typically deflationary if it corrects a credit expansion, since (1) after the event people would have to pay back what they borrowed, and that leaves less money for them to spend; (2) if loans do not originate as quickly as they are paid off, money supply diminishes through the contraction of credit; and furthermore (3) any defaulting on debt would shrink the capital base of banks, and therefore decrease the money supply created by fractional reserve banking.

Now, if you lend someone cash that you have, it doesn’t increase the money supply because the amount of cash in the system is still the same. But banks are allowed to lend out more than they have in deposits, through fractional reserves. If regulators say they need to have at least 10% in reserves, then with $1000 of your savings, the banking system can issue a series of loans up to $9,000. [Basically, the bank takes your $1000 and lends $900 ($100 must be kept in reserve), and when that is re-deposited in another account in another bank, $810 is lent (with $90 in reserve), then $729 ($81 in reserve), etc. which when all loans originating from the initial deposit are added together approaches 9k; with a thousand in reserves].

Mostly, this works out okay for banks. In effect, it can add up to nine times cash deposits to the money supply, which remits as debt is paid off. But if banks lose their capital through defaults, the fractional reserve credit lost will be nine times the capital write off, and money supply shrinks.

So, for every dollar deposited in a bank, that is $9 added to the availability of credit. For every dollar lost by the bank to defaults, that is $9 removed. Are fractional reserves a bad thing? There is some risk in the event of many defaults, but I don’t lose sleep over it. However, it will be relevant for points I raise later.

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