Debt-based monetary system
Encyclopedia
Criticisms of fractional-reserve banking
have been put forward from a variety of perspectives. Critics have included mainstream economists
such as Irving Fisher
, Frank Knight
and Milton Friedman
. Within the economics profession today, most criticisms are from non-mainstream economic theories
such as those of the Austrian School
. There are also critics from outside the economics profession.
emphasize the role that credit
plays in the current monetary system
. These terms are not in general use, and economists generally refer instead to the money supply
, broad money
and the money multiplier
when discussing the mechanism by which the commercial banking system expands the quantity of money in an economy. The study of monetary theory in the economics profession is referred to as monetary economics.
requires loans from the banking system, people are required to go into debt in order for any new money to be created. They assert that this can debase the means of exchange. While there is no controversy over the fact that the commercial banking system expands the money supply, critics find it problematic that banks "create money out of nothing."
One criticism posits that since debt and the interest on the debt can only be paid in the same form of money, the total debt (principal plus interest) can never be paid in a debt-based monetary system unless more money is created through the same process. For example: if 100 credits are created and loaned into the economy at 10% per year, at the end of the year 110 credits will be needed to pay the loan and extinguish the debt. However, since the additional 10 credits does not yet exist, it too must be borrowed. This implies that debt must grow exponentially in order for the monetary system to remain solvent. This was the argument of the Social Credit
movement of the 1930s, who proposed to remove the job of money creation from banks and give it to governments.
Other criticisms relate to the potential fragility of bank liquidity
in a fractional reserve banking environment, the financial risk of bank run
s that depositors bear when depositing money
with banks, and the impact that demand deposits have on the stock of money, and on inflation
(that is, the implicit expansion of the money supply and its associated impact on prices and the exchange rate). An alternative to fractional reserve banking is full-reserve banking
. With full-reserve banking, some monetary reform
ers, such as Stephen Zarlenga of the American Monetary Institute
, support the concurrent issuance of debt-free fiat currency from the Treasury
, while others such as Congressman Ron Paul
and some economists from the Austrian school, call for a commodity currency as existed under the gold standard
.
Some commentators, like debt-focused critics including Stephen Zarlenga, Lew Rockwell
and Murray Rothbard
, link together fractional-reserve banking
, central banking, and government-enforced "paper" or fiat currency as negative features of modern monetary systems. They argue that fiat money
and the practice of fractional reserve banking does not impose a natural limit on the growth of the money supply
, and that this causes inherently unsustainable bubbles in asset and capital markets, which are vulnerable to speculation. These commentators often use the term "debt-based monetary system" to refer to an economic system where money
is created primarily through fractional-reserve banking techniques, using the banking system.
Mark Anielski, and other political thinkers such as Michael Rowbotham
, argue that this system of money supply has characteristics similar to a pyramid scheme
, where the newly indebted are compelled to induce others into debt to pay off their own debts.
There are individuals, even within such groups as the Austrian school, that reject the notion that fractional reserve banking is inherently destabilizing and that full-reserve banking
is the appropriate solution. One such Austrian thinker, Steven Horwitz, argued that full-reserve banking would impose similar costs of price adjustments in reaction to growth (through a reduction in the overall price level) as would inflation
, and hence offer no inherent advantages over fiat currencies and fractional reserve banking.
, will lower the interest rates compared to a hypothetical full-reserve banking system, although this idea has been criticized within mainstream economics. Austrian adherents argue that the presumed discrepancy will affect the role of the interest rate as the price of investment capital, guiding investment decisions. One of the proponents of aspects of the business cycle theory, Friedrich von Hayek, shared in the Nobel Memorial Prize in Economic Sciences
for 1974. Hayek accepted that bank credit and fractional reserve banking — even if they contributed to business cycles — were necessary.
Pascal Salin
argues that a full-reserve banking
system should not be enforced legally, and dispute Murray Rothbard
's characterization of fractional-reserve banking as a simple form of recursive embezzlement
, and rather advocate the abolition of central banking, and suggest that free banking
replace the current system. Austrian monetary theorist George Selgin
has also argued in favor of fractional reserve banking.
, this larger money supply
leads to more money 'chasing' the same amount of goods, which leads to a higher price level. Austrian economists state that this expansion of the broad money supply (demand deposits
and notes) caused by fractional reserve banking is a cause of price inflation. By contrast, Real bills doctrine
argues that creation of money by fractional-reserve banks does not affect the price level as long as the bank retains balance-sheet solvency.
s and environmentalist
s believe that fractional reserve banking creates the necessity for indefinite economic growth
which leads to environmental destruction and depletion of natural resources especially when coupled with population growth.
Fractional-reserve banking
Fractional-reserve banking is a form of banking where banks maintain reserves that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction of the quantity of deposits as reserves...
have been put forward from a variety of perspectives. Critics have included mainstream economists
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
such as Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...
, Frank Knight
Frank Knight
Frank Hyneman Knight was an American economist who spent most of his career at the University of Chicago, where he became one of the founders of the Chicago school. Nobel laureates James M. Buchanan, Milton Friedman and George Stigler were all students of Knight at Chicago. Knight supervised...
and Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
. Within the economics profession today, most criticisms are from non-mainstream economic theories
Heterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...
such as those of the Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...
. There are also critics from outside the economics profession.
Terminology
Critics of fractional reserve banking and the related fiat paper monetary system may use the term debt-based monetary system or credit-based monetary system toemphasize the role that credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
plays in the current monetary system
Monetary system
A monetary system is anything that is accepted as a standard of value and measure of wealth in a particular region.However, the current trend is to use international trade and investment to alter the policy and legislation of individual governments. The best recent example of this policy is the...
. These terms are not in general use, and economists generally refer instead to the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
, broad money
Broad money
In economics, broad money is a measure of the money supply that includes more than just physical money such as currency and coins . It generally includes demand deposits at commercial banks, and any monies held in easily accessible accounts...
and the money multiplier
Money multiplier
In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money...
when discussing the mechanism by which the commercial banking system expands the quantity of money in an economy. The study of monetary theory in the economics profession is referred to as monetary economics.
General criticisms
Critics of fractional reserve banking claim that since money creationMoney creation
In economics, money creation is the process by which the money supply of a country or a monetary region is increased due to some reason. There are two principal stages of money creation. First, the central bank introduces new money into the economy by purchasing financial assets or lending money...
requires loans from the banking system, people are required to go into debt in order for any new money to be created. They assert that this can debase the means of exchange. While there is no controversy over the fact that the commercial banking system expands the money supply, critics find it problematic that banks "create money out of nothing."
One criticism posits that since debt and the interest on the debt can only be paid in the same form of money, the total debt (principal plus interest) can never be paid in a debt-based monetary system unless more money is created through the same process. For example: if 100 credits are created and loaned into the economy at 10% per year, at the end of the year 110 credits will be needed to pay the loan and extinguish the debt. However, since the additional 10 credits does not yet exist, it too must be borrowed. This implies that debt must grow exponentially in order for the monetary system to remain solvent. This was the argument of the Social Credit
Social Credit
Social Credit is an economic philosophy developed by C. H. Douglas , a British engineer, who wrote a book by that name in 1924. Social Credit is described by Douglas as "the policy of a philosophy"; he called his philosophy "practical Christianity"...
movement of the 1930s, who proposed to remove the job of money creation from banks and give it to governments.
Other criticisms relate to the potential fragility of bank liquidity
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
in a fractional reserve banking environment, the financial risk of bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
s that depositors bear when depositing money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
with banks, and the impact that demand deposits have on the stock of money, and on inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
(that is, the implicit expansion of the money supply and its associated impact on prices and the exchange rate). An alternative to fractional reserve banking is full-reserve banking
Full-reserve banking
Full-reserve banking, also known as 100% reserve banking, is a banking practice in which the full amount of each depositor's funds are kept in reserve, as cash or other highly liquid assets...
. With full-reserve banking, some monetary reform
Monetary reform
Monetary reform describes any movement or theory that proposes a different system of supplying money and financing the economy from the current system.Monetary reformers may advocate any of the following, among other proposals:...
ers, such as Stephen Zarlenga of the American Monetary Institute
American Monetary Institute
The American Monetary Institute is a non-profit charitable trust organized in 1996 for the "independent study of monetary history, theory and reform."...
, support the concurrent issuance of debt-free fiat currency from the Treasury
Treasury
A treasury is either*A government department related to finance and taxation.*A place where currency or precious items is/are kept....
, while others such as Congressman Ron Paul
Ron Paul
Ronald Ernest "Ron" Paul is an American physician, author and United States Congressman who is seeking to be the Republican Party candidate in the 2012 presidential election. Paul represents Texas's 14th congressional district, which covers an area south and southwest of Houston that includes...
and some economists from the Austrian school, call for a commodity currency as existed under the gold standard
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...
.
Some commentators, like debt-focused critics including Stephen Zarlenga, Lew Rockwell
Lew Rockwell
Llewellyn Harrison "Lew" Rockwell, Jr. is an American libertarian political commentator, activist, proponent of the Austrian School of economics, and chairman of the Ludwig von Mises Institute.-Life and work:...
and Murray Rothbard
Murray Rothbard
Murray Newton Rothbard was an American author and economist of the Austrian School who helped define capitalist libertarianism and popularized a form of free-market anarchism he termed "anarcho-capitalism." Rothbard wrote over twenty books and is considered a centrally important figure in the...
, link together fractional-reserve banking
Fractional-reserve banking
Fractional-reserve banking is a form of banking where banks maintain reserves that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction of the quantity of deposits as reserves...
, central banking, and government-enforced "paper" or fiat currency as negative features of modern monetary systems. They argue that fiat money
Fiat money
Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...
and the practice of fractional reserve banking does not impose a natural limit on the growth of the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
, and that this causes inherently unsustainable bubbles in asset and capital markets, which are vulnerable to speculation. These commentators often use the term "debt-based monetary system" to refer to an economic system where money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
is created primarily through fractional-reserve banking techniques, using the banking system.
Mark Anielski, and other political thinkers such as Michael Rowbotham
Michael Rowbotham
Michael Rowbotham is a political and economic writer and commentator based in the UK who is best known for his two books The Grip of Death and Goodbye America...
, argue that this system of money supply has characteristics similar to a pyramid scheme
Pyramid scheme
A pyramid scheme is a non-sustainable business model that involves promising participants payment or services, primarily for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services to the public...
, where the newly indebted are compelled to induce others into debt to pay off their own debts.
There are individuals, even within such groups as the Austrian school, that reject the notion that fractional reserve banking is inherently destabilizing and that full-reserve banking
Full-reserve banking
Full-reserve banking, also known as 100% reserve banking, is a banking practice in which the full amount of each depositor's funds are kept in reserve, as cash or other highly liquid assets...
is the appropriate solution. One such Austrian thinker, Steven Horwitz, argued that full-reserve banking would impose similar costs of price adjustments in reaction to growth (through a reduction in the overall price level) as would inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
, and hence offer no inherent advantages over fiat currencies and fractional reserve banking.
Exacerbation of the business cycle
Adherents of the Austrian School claim that fractional-reserve banking, by expanding the money supplyMoney supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
, will lower the interest rates compared to a hypothetical full-reserve banking system, although this idea has been criticized within mainstream economics. Austrian adherents argue that the presumed discrepancy will affect the role of the interest rate as the price of investment capital, guiding investment decisions. One of the proponents of aspects of the business cycle theory, Friedrich von Hayek, shared in the Nobel Memorial Prize in Economic Sciences
Nobel Memorial Prize in Economic Sciences
The Nobel Memorial Prize in Economic Sciences, commonly referred to as the Nobel Prize in Economics, but officially the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel , is an award for outstanding contributions to the field of economics, generally regarded as one of the...
for 1974. Hayek accepted that bank credit and fractional reserve banking — even if they contributed to business cycles — were necessary.
Pascal Salin
Pascal Salin
Pascal Salin is a libertarian French economist, professor at the Université Paris-Dauphine and a specialist in public finance. He is a former president of the Mont Pelerin Society ....
argues that a full-reserve banking
Full-reserve banking
Full-reserve banking, also known as 100% reserve banking, is a banking practice in which the full amount of each depositor's funds are kept in reserve, as cash or other highly liquid assets...
system should not be enforced legally, and dispute Murray Rothbard
Murray Rothbard
Murray Newton Rothbard was an American author and economist of the Austrian School who helped define capitalist libertarianism and popularized a form of free-market anarchism he termed "anarcho-capitalism." Rothbard wrote over twenty books and is considered a centrally important figure in the...
's characterization of fractional-reserve banking as a simple form of recursive embezzlement
Embezzlement
Embezzlement is the act of dishonestly appropriating or secreting assets by one or more individuals to whom such assets have been entrusted....
, and rather advocate the abolition of central banking, and suggest that free banking
Free banking
Free banking refers to a monetary arrangement in which banks are subject to no special regulations beyond those applicable to most enterprises, and in which they also are free to issue their own paper currency...
replace the current system. Austrian monetary theorist George Selgin
George Selgin
George A. Selgin is a professor of economics in the Terry College of Business at the University of Georgia, a senior fellow at the Cato Institute in Washington DC, and an associate editor of Econ Journal Watch...
has also argued in favor of fractional reserve banking.
Inflation
Fractional reserve banking involves the creation of money by the commercial bank system, increasing the money supply. According to the quantity theory of moneyQuantity theory of money
In monetary economics, the quantity theory of money is the theory that money supply has a direct, proportional relationship with the price level....
, this larger money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
leads to more money 'chasing' the same amount of goods, which leads to a higher price level. Austrian economists state that this expansion of the broad money supply (demand deposits
Demand account
A transactional account is a deposit account held at a bank or other financial institution, for the purpose of securely and quickly providing frequent access to funds on demand, through a variety of different channels....
and notes) caused by fractional reserve banking is a cause of price inflation. By contrast, Real bills doctrine
Real bills doctrine
The real bills doctrine holds that issuing money in exchange for real bills is not inflationary. It is best known as "the decried doctrine of the old Bank Directors of 1810: that so long as a bank issues its notes only in the discount of good bills, at not more than sixty days’ date, it cannot go...
argues that creation of money by fractional-reserve banks does not affect the price level as long as the bank retains balance-sheet solvency.
Environmental degradation
Some conservationistConservationist
Conservationists are proponents or advocates of conservation. They advocate for the protection of all the species in an ecosystem with a strong focus on the natural environment...
s and environmentalist
Environmentalist
An environmentalist broadly supports the goals of the environmental movement, "a political and ethical movement that seeks to improve and protect the quality of the natural environment through changes to environmentally harmful human activities"...
s believe that fractional reserve banking creates the necessity for indefinite economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
which leads to environmental destruction and depletion of natural resources especially when coupled with population growth.
See also
- Criticism of the Federal ReserveCriticism of the Federal ReserveThe Federal Reserve System, known colloquially as "the Fed", has faced various criticisms since its conception in 1913. The system was created as a third attempt at central banking in the United States...
- Austrian Business Cycle Theory
- Monetary reformMonetary reformMonetary reform describes any movement or theory that proposes a different system of supplying money and financing the economy from the current system.Monetary reformers may advocate any of the following, among other proposals:...
- List of monetary reformers