Tag Archives: Fractional Reserve Banking

Follow-up on the CAD question – Value of a currency, gold reserves and FRB

In response to my previous article, Aditya Sood had asked the following question.

Sir, I have a question. From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past. The fractional reserve is a new thing. So who decided that value of a currency should be de-linked from an underlying commodity? Was it that all countries saw some flaws in that system and decided to shift to a new one ? Or is it that one particular country/group of people enforced it upon the rest ? If yes, how did they manage to convince all the countries about shifting to a new system?

Also, when this delinking took place, did anyone (economists etc.) see any alarm bells ringing?

Aditya’s question contains so many clues to the kind of misunderstanding that exists among ordinary people and the extent to which education is required to enable ordinary people to understand the varying grotesqueries of the prevailing system of money and banking.

Misunderstanding No. 1

Aditya asks

From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

The important point to understand is that in the not too distant past, commodities like gold and silver were money. There was no such thing as a currency independent of coins of these precious metals and there was therefore no question of the value of a currency being linked to its gold (or silver) reserves.

The clue to understanding these lies in understanding how some of the important modern currencies got their name. Take the British Pound, for instance. Ever wondered why it is called the Pound, or more specifically the Pound Sterling? Simply because the unit of money in England in the 1600’s was 1 lb (by weight) of Sterling Silver. 1 lb being a large weight (453.592 gms to be precise), there were other smaller units such as the shilling and the pence that served as the unit of money in smaller value exchanges. Each of these units stood for a definite weight of the same money commodity – Sterling Silver.

The concept of monetary unit is important to understand while we understand money. The monetary unit is a conveniently chosen quantity of the underlying money commodity. Money is a good like any other good and is one of the commodities exchanged in any trade transaction, it being the generally accepted medium of exchange. Every good in every exchange is exchanged in a certain quantity and so is money. The concept of the monetary unit is a method to specify and identify the quantity of the money commodity involved in an exchange. When the price of a good is quoted as 10 shillings, it means the quantity of sterling silver contained in, say, 10 coins marked 1 shilling each. In this sense, the monetary unit is similar to the unit of measurements like the metre, the kilogram and the litre.

So, in response to Aditya’s question, it is not that the value of the Pound Sterling was fixed as 1 pound of sterling silver. It was simply that the Pound Sterling was defined as 1 pound (by weight) of sterling silver.

Misunderstanding No. 2

Taking the same part of Aditya’s question

From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

the second important misunderstanding that is visible is that there was no such thing as the currency of a country. There was money, which was largely coins of specific weight and purity of metals like gold and silver, and there were different such units, each of a specific weight and purity and minted at a particular mint. In any economy, multiple forms of money were simultaneously in circulation and there even existed exchange rates among the different currencies depending on their defined weight and purity, the age of the coins and their wear and tear, and, last but not the least, the reputation of the mint itself.

In America in the 1700’s, for instance, Spanish silver coins were the most popular form of money. The most popular coins of all were the thalers. The name thaler is a shortened form of the longer Joachimsthaler which in turn stood for coins minted at the mint of a Count Schlick from the Joachimsthal or Joachim’s Valley region of Bohemia (modern day Czechoslovakia). These coins flowed into America thanks to the robust trade with Spain, what with large tracts of America then being Spanish colonies (Does The Mask of Zorro remind you of something related?). The reliability of these coins soon made them the most popular coins in trade. Even the Joachimsthaler was later to be upstaged by the even more reliable Maria Teresa Thaler. At the time of American Independence, a choice had to be made as to the unit of money of the newly independent States of America. The unanimous choice was the already prevailing thaler renamed as the Dollar.

The thaler stood for 371 ¾ grains of pure silver and the dollar too was chosen to stand for the same quantity of the same metal. In effect, it was just a formal acknowledgement of what was already the market’s choice of the money commodity and the monetary unit.

In addressing Aditya’s question, what we therefore see is that different regions ended up using different monetary units of one or the other of precious metals like silver and gold and that in each region one of these monetary units ended up being predominant due to various market factors.

Misunderstanding No. 3

I apologise for quoting the same bit from Aditya again, but it is interesting to note how many misunderstandings are revealed by just 1 sentence. He asked

From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

The notion of gold reserves being linked to the amount of money in circulation is an outcome of certain banking practices that started becoming prevalent in the late 17th and early 18th centuries. I am referring primarily to the emergence of paper money and demand deposits a money substitutes. The point is simple – paper money as we know it is a relatively recent phenomenon. For a large part of history, gold and silver coins served as the money.

Paper money emerged in the form of receipts issued by warehouses that stored money proper (gold and silver coins). Over time, these receipts started circulating in lieu of the money proper, the coins in storage. This evolved further into the concept of savings banks which accepted deposits of coins against which they issued bank notes. Savings banks, like their predecessors, the warehouses, charged their clients for the storage of the coins.

By the 16th and 17th centuries, these bank notes had become widely accepted as money substitutes that could, on demand, be redeemed in the money proper. However, savings banks observed that only a small fraction of their bank notes actually returned for redemption at any point in time. This served as a great temptation for the savings banks to in a practice that is today known as Fractional Reserve Banking.

Banks started issuing bank notes of cumulative face value far greater than the actual number of units of money proper in storage. The actual reserves of money proper they held was a fraction of the total face value of their own bank notes that they had put into circulation. This is the concept of the fractional reserve underlying the concept of Fractional Reserve Banking.

Operationally, every Fractional Reserve Bank is fundamentally insolvent. It has made promises that it just does not have the ability to keep. If a bank has a reserve ratio of 10%, any number more than 10% of the total notes emitted coming in for redemption at a time means that the bank has to make public its insolvency and shut down.

But why did banks risk such insolvency? The reason was that the money could be loaned out at interest and the bank could earn an actual profit in money proper. Basically, banks were getting to earn easy money by lending out other people’s property that had been given to them for safekeeping.

This system of Fractional Reserve Banking, while temporarily profitable, is not without its consequences. Bank notes emitted thus were offered as loans to producers. Thus, they were injected into the production system as credit expanded beyond the actual pool of available real savings. This was, as is to be expected, accompanied by interest rate depression below the free-market level. In simple terms, as explained out here, this is precisely how the inflationary boom is created. However, as explained by ABCT, the seeds of the inevitable economic depression are sown during the inflationary boom. The economic depression would start with a spate of bank runs, leading to widespread closure pressures on highly inflationary fractional reserve banks.

Unfortunately, the Fractional Reserve Banking system was also a convenient way for governments to raise resources for their ever-burgeoning spending plans. Fractional reserve banks were therefore able to lobby governments to protect them from the effects of their own irresponsibility. This close, symbiotic relationship between governments and the banking system grew ever stronger through a series of boom-bust cycles throughout the 18th and 19th centuries eventually leading to a system of governments taking control of the system of money by instituting Central Banks and conferring on them a monopoly over the issue of the fiat money and control over the banking system.

The biggest step in this process was the setting up of the Federal Reserve Bank of the US in 1913 with a monopoly over the issue of US Dollars. The inflationary practices of the banking system under the Federal Reserve’s watch led to the Crash of 1929 and the Great Depression of 1929-1945. Under the pretext of the Great Depression, the US government moved the monetary system further from a linkage to real money such as gold through policies such as outright gold confiscation and devaluing the dollar from 1/20.6 oz of gold to 1/35 oz of gold. The argument cited was that the demand to hold gold was responsible for the Depression. The reality was that the government wanted to put an end to the commodity-based monetary system and free itself from the strict limits imposed on government spending by the laws of economics.

The US thus moved from a gold standard to a notional gold exchange standard where US citizens could not redeem dollars in gold but foreigners and their governments could. By 1971, however, the situation worsened on account of further inflationary fractional reserve banking and the US was about default on its obligation to redeem dollars in gold to foreigners. That was when the then President Nixon repudiated all obligations of the US government to redeem dollars in gold, thus putting the entire world on a pure fiat standard. The UK had already done so in 1931 leaving the Dollar as the sole global currency.

This, in short, is how the monetary system of the world transformed from a pure commodity-based monetary system to a pure fiat monetary system controlled by governments through Central Banks and the rest of the banking system. Basically, the banking system followed practices that landed them in trouble and created economic depressions. The blame was steadily and repeatedly placed on precious metals, especially their scarcity, eventually leading to a government takeover of the system of money and the banishment of silver and gold from their market anointed role as money proper.

What do we learn from this deviation into history?

It is incorrect to make statements like value of a currency being linked to the reserves held by the government or a monetary authority like a Central Bank. The monetary system of today is essentially the outcome of a systematic though protracted government takeover of a market determined system of money.

Addressing the rest of Aditya’s questions

Aditya then asks

The fractional reserve is a new thing.

It evolved basically as a way to earn money from nothing and grew by lobbying support from governments that benefited from FRB.

So who decided that value of a currency should be de-linked from an underlying commodity?

If one person or entity should be blamed, it is the US government. At a more general level, it is the banking system, Central Banks and governments that, through their machinations, moved the monetary system off a commodity base into a pure fiat system.

Was it that all countries saw some flaws in that system and decided to shift to a new one?

No. The commodity-based system of money had no major flaws. In fact, it is precisely the scarcity of precious metals that makes them good monetary materials. Rather, it was that governments and the banking system the world over saw a commodity-backed monetary system as a serious limitation on their inflationary and extravagant ways and foisted an FRB system on the markets. When their system failed (as it is expected to), they blamed the failure on the commodity and used it as an excuse to take control of the monetary system and change it to something that was more beneficial to them.

Or is it that one particular country/group of people enforced it upon the rest ?

Not exactly, various governments, in their own ways, encouraged, fostered and finally acted to enforce a pure fiat monetary system.

If yes, how did they manage to convince all the countries about shifting to a new system ?

No one had to convince any one. Every government and every fractional reserve bank wanted this system. Since governments were ready to use the power in their hands to make this happen, they did.

Also, when this delinking took place, did anyone (economists etc.) see any alarm bells ringing?

There were economists of the Austrian School like Ludwig von Mises who cautioned against these moves but they were largely ignored.

What we can learn from this

Most of us carry a number of misconceptions that distort our view of the working of the world. A lot of what we hear from most common sources needs to be questioned if we are to make sense of what is happening in the world around us. History shows us that those who are in charge of the system of money and banking are themselves responsible for the key monetary and economic problems of the day. Unless we grasp this fundamental issue, we will find it very difficult to comprehend true and lasting solutions to serious economic challenges.

What sense do we make of bad news?

It seems to be the season of bad news. Here, here, here, here and here with some honourable exceptions here and here, various sectors of industry led by the automobile sector seem to be facing slow or negative growth in the last financial year. What sense do we make of these disparate bits of data coming from different corners of the market?

Why are auto sales falling?

Before answering this question, it is important to understand that what we are witnessing is a broadbased fall in sales across the automobile industry, not just in one or two firms. This means that people have, in general, chosen not to buy new automobiles, which in turn means that they have chosen to retain their existing mode of transportation, which could be private or public transportation.

Second, a significant proportion of automobile purchases (2 and 4 wheelers) in India happens with a bank financing the purchase, usually paying a large chunk (70-80%) of the price. The buyer of the automobile pays for it on a 3-5 year EMI schedule. That people are not ready to borrow in order to finance automobile purchases indicates that either funding is not available as easily as before or has become too costly, or the borrowers perceive greater uncertainty regarding their future income and are therefore reluctant to take up the responsibility of paying for a new vehicle under a scheme of EMIs.

So, if automobile sales are indeed falling, it must be a combination of these factors
1. People choosing to retain existing modes of transportation
2. Funding not as easily available as before
3. People not ready to borrow now and pay EMI later due to fundamental uncertainty over their own income
that underlies the problem. But then that raises the further question of why such an outcome should occur, that too across the entire automobile industry after so many years of spectacular, non-stop growth? The answer lies not in an analysis of the automobile industry and its markets but in understanding the broader economic climate in which the auto industry currently operates.

The economic climate

Since 2007, the global economy and the Indian economy along with it have been muddling through what is today called The Great Recession and is being recognised as one of the longest periods of economic growth challenges since the Great Depression. On paper, the recession started in December of 2007 and while there are debates about the official end date, the problems that started in 2007 are far from over. Every now and then, a new crisis pops up and there is a mad scramble to contain it. It was Greece a few months ago and it is Cyprus now. Heaven knows what it will be in the near and distant future.

Like any depression, The Great Recession is just a period of correction that consists of identification of a cluster of entrepreneurial error. In simple terms, a large number of businesses suddenly and surprisingly find that they are and have been producing things that people do not need and are therefore staring at deep losses and capital erosion. As Austrian Business Cycle Theory explains, this cluster of errors is created during the preceding inflationary boom (in this case by the boom of 2001-2007) and is caused by a combination of misleading interest rate signals given to producers, credit injection into the production system and monetary inflation, causing intertemporal discoordination, i.e., a mismatch between consumers’ consumption decisions and producers’ corresponding production decisions.

That producers en masse suddenly find far fewer takers for their goods, as automobile manufacturers currently do, is a result of this intertemporal discoordination. When this happens, what a sensible producer should do is to understand the economic climate, try to develop a better forecast of what the future, medium and long-term, is likely to look like and adjust production decisions accordingly. This could mean, in some cases, producing less of the good. It could even mean completely ending certain lines of production, i.e., shutting down certain businesses.

Such decisions are usually accompanied by a lot of pain as many people are put out of employment and, in many cases, will need to reskill themselves to the requirements of the new production structure. This puts further strain on many already struggling businesses leading to more business failures and more people being out of unemployment. While this sounds painful, it is just the market’s way of clearing past production decisions that are not in line with consumer preferences.

This process goes on till the market clears out all such poor decisions and leaves the production system in sync with consumer preferences. Capital is taken out of the hands of those who made poor forecasts of the future into the hands of better forecasters, i.e., from failed entrepreneurs to successful entrepreneurs. This is the proper point of economic recovery. Further economic expansion would, under a free market, be triggered by fresh decisions to save and add to the capital available to be advanced for production for a more distant future.

An alternative, equally or more likely in today’s FRB system, is that the banking system interrupts the market’s cleaning up process and initiates a fresh round of interest rate depression through credit expansion and monetary inflation, thus flooding the market with cheap money and cheap loans. This time, however, one would also have to contend with the possibility that such measures are not guaranteed to work like they have in the past. Experiments in the Western world indicate that such attempts have not really led to an economic recovery this time round.


What the auto industry is going through today could very well be one of the manifestations of the bursting of the bubble created from 2001 to 2007. If people are not buying as many cars as they are producing, it is probably because they do not wish to see producers produce as many cars as they are producing. It is possible that the market is crying for a correction and that producers need to cut-back production to the level customers are ready to support. This is clearly one of the possibilities for any producer. Alternately, producers could place their bets on the RBI, through the banking system, inflating a new bubble through a fresh round of credit expansion and monetary inflation. In this case, they need to hold their horses for the recovery to happen while being prepared to profit the most by being at the vanguard of the recovery.

Clearly, therefore, each entrepreneur will have to decide which scenario is likely to play out and what is the most appropriate course of action for him. It’s not easy, but no one ever said that operating a business in an environment of uncertainty created by endless meddling in the market would be easy. The times sure are challenging and let’s hope many entrepreneurs do make their way heroically through this economic fog to do what they do best – meet customer needs in the best possible way.

What we need to take home, and what this article seeks to emphasise, is the point that in many circumstances, having sound economic understanding can help us understand business situations far better than those economically uninformed or ill-informed can. We can also see that cutting through the fog and making sense of complex situations is made possible by a good grasp of sound economic principles. The situation created by falling sales of the automobile industry in India only highlights the point that learning sound economics is a critical prerequisite for any aspiring business manager seeking to create a career out of making effective business decisions in a complex economic environment.

Understanding the impact of RBI’s Repo and Reverse Repo Rate Cut

It has happened as expected. RBI has announced a 25 basis point cut in the Repo and Reverse Repo rates. For the less exposed, this means that the Repo Rate has fallen from 7.75% to 7.5% while Reverse Repo Rate has fallen from 6.75% to 6.5%. What does this mean to different people? The segments we cover in this article are Banks, Industry, ordinary people and the broader economy.

Impact on Banks

To understand the impact of a cut in Repo and Reverse Repo Rates on banks, it is important to understand the role they play in banking. Repo and Reverse Repo are basically instruments used by the RBI to influence the total monetary base of banks.

To get a grip on this, it is important to understand how banks work and what the term monetary base means. Banks engage in a practice called Fractional Reserve Banking (FRB). As explained in the linked article, under FRB, a bank lends many multiples of the actual cash in hand. This cash they have is what I mean by monetary base. Clearly, any addition to the monetary base adds to the bank’s ability to make loans by creating money from nothing (as explained in the linked article).

In India, banks’ monetary base takes 2 forms – CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio). CRR is the amount of actual cash that banks need to hold with the RBI. SLR refers to the amount (by value) of approved securities (government bonds, gold and approved, privately issued financial instruments) that banks are mandated to hold. Currently, CRR is 4% and SLR is 23%. Together, they constitute the monetary base of the Indian banking system.

However, what CRR and SLR do not cover is the extent to which the RBI can lend to banks. That is covered under the Repo and Reverse Repo. In a Repo or a repurchase agreement, the Repo seller (the bank) sells an approved security to the RBI with the understanding that at a certain date in the future, the bank will buy the security back from the RBI. The bank gets cash and the RBI the security.

One would expect that this would not influence the monetary base because while the bank gets cash and adds to its CRR base, it loses possession of the security and falls behind on its SLR base and can therefore not lend more. The interesting part is that this problem in the way of expanding bank lending is eliminated by the way the Repo system works.

Very interestingly, during the term of the Repo, the bank is allowed to count the security thus sold to the RBI as part of its investments to fulfil the SLR requirement. So, the net effect of a Repo transaction is an addition to the bank’s cash reserves without falling behind on SLR requirements. With this, the bank can now engage in much more lending.

At the end of the term of a Repo, the bank buys the security back from the RBI at a price higher than the original sale price. The difference expressed as a percentage of the original sale price is the Repo Rate. Thus, Repo Rate is used to calculate the price at which the security is bought back by the bank. It is the equivalent of an interest paid by the bank to RBI.

It might seem that at the time the bank buys the security back, its cash reserve falls. However, the bank can then enter into a fresh Repo transaction and sell the security back to the RBI, bringing the cash reserve back to the higher level. In this manner, Repo becomes a means for the RBI to maintain a steady level of lending to banks.

But all this additional lending would mean more purchases of securities to meet SLR requirements. This would mean the need to deploy cash for the same. That cash would go outside the system of lending and reduce the system’s lending potential. This problem is solved by what is called the Reverse Repo.

In a Reverse Repo, the RBI sells an approved security to the bank with the understanding that it will buy it back at a future date at a higher price. The difference between the 2 prices expressed as a percentage of the original selling price (per annum) is called the Reverse Repo Rate. The Reverse Repo Rate thus becomes the interest rate received by the bank for lending cash to the RBI.

The important point for us to note is that a bank may show securities bought from the RBI through the Reverse Repo window as part of its SLR commitments. Further, as in the case of the Repo, at the end of the term of the Reverse Repo, the bank can enter into a fresh Reverse Repo with the RBI.

Summarising the understanding

Bank XYZ hits its lending limit based on its CRR and SLR. It sees potential for more lending. It offers RBI a portion of the securities it holds as part of a Repo transaction and gets cash. It deploys 23% of this new cash to obtain securities under the Reverse Repo window from the RBI, thus keeping the cash within the system. The bank now gets to create new money amounting to 1/(CRR+SLR) times the money borrowed under the Repo window and lend it out at interest. The Repo window thus becomes a cheap source of borrowing for banks.

The impact of a cut in Repo and Reverse Repo Rates

A cut in Repo and Reverse Repo rates basically reduces the bank’s cost of borrowing from the RBI to add to its reserves. It enables banks to either increase the interest rate spread on loans made by the bank or offer borrowers lower rates of interest without eating into its own interest rate spread. Thus, a cut in Repo and Reverse Repo Rates increases the banking system’s potential by expanding more loans in a profitable manner.

Impact on Industry

With lower repo and reverse repo rates, industry gets to borrow more and even gets to pay lower interest rates on its borrowing. Therefore, those businesses that are in a position to secure additional lending from the banking system will benefit from lower repo and reverse repo rates.

Impact on ordinary people

The impact on ordinary people can be felt in 2 ways. In the nearer term, greater lending to businesses will lead to more business investment and employment opportunities. In the medium and longer term, however, the dominant factor influencing ordinary people will be the increased money supply (inflation), which will send prices of consumers’ goods soaring, resulting in future pressure to raise interest rates thus forcing the pricking of the inflationary bubble and the onset of the depression.

Impact on the broader economy

In the long-run, reducing Repo and Reverse Repo rates is harmful for the economy as it is just a means to lend reserves to banks, enabling them to engage in far bigger inflation to undertake much more credit expansion through FRB. While this lending will have some short-term positive effects, in the long-run, it creates and worsens the inflationary boom of the familiar boom-bust cycle. It also sets the conditions for the inevitable raising of interest rates thus pricking the inflationary bubble and triggering the depression.


Thus we see that the policy of reducing Repo and Reverse Repo rates is essentially bad for the economy in the long-run because it greatly aids the creation of the business cycle. It also hurts ordinary people by sending prices soaring. Industry and the banking system, however, benefit in the short run. This explains why a policy of lowering repo and reverse repo rates finds fairly broad-based support from the banking industry and general industry as well.

The hidden side of RBI’s push for more electronic payments

In this article, the RBI is cited to be pushing for electronic payments as a replacement for cheques for loan repayments. The obvious explanation is that ECS will eliminate all the time and effort involved in collecting, depositing cheques and then getting them cleared. This is supposed to leave the banking system more efficient.

What is not stated is the deeper reason for the move – to make people more accustomed to making electronic payments for everything to eventually make the move to eliminating cash.

Now, cash is a bothersome thing. As long as people have a concept of cash and want it for various purposes, the banking system has to keep some cash. This is the reasoning behind having reserve ratios like CRR and SLR. With these, the bank is supposedly in a position to comfortably meet demand for cash.

Why does people having a demand for cash make it bothersome?

If people did not have a demand for cash, there is no operational limit to how much money the central bank and the entire banking system can create. We will then land in Inflationist Utopia where money creation and credit expansion can go on unbridled. That also means that all limits on government spending are eliminated.

Is it possible that this Inflationist Utopia is RBI’s goal?

An economic depression is not a bad thing

Most people I speak to think that an economic depression is a problem that needs to be solved. Take a look at this article, for instance. This notion is far from correct. An economic depression is a period of necessary correction. An economic depression is necessarily and always preceded by an inflationary boom.

The real problem is the inflationary boom for which the bust is the cure

During the boom, policies targeted at interest rate depression allow the banking system to expand credit way beyond the available pool of real savings. This results in massive investments into projects that never would have been invested in on the free market. At the very least, new investments would need to be accompanied by
1. additional net saving by consumers
2. movement of capital from lines of production of other less preferred goods
These prevent the possibility of an inflationary boom. These conditions are a logical necessity for the new investment to happen.

However, an inflationary boom creates malinvestments. The process of creating the inflationary boom necessarily also includes the pins required to prick the bubble at some unexpected point in time. When this happens, the market reassesses all the investments made and sorts them into good and bad investments. This is done through the profit/loss mechanism and made explicit through the phenomenon of business bankruptcy. While this process involves pain, without it, the market cannot realign investments to be in line with consumer preferences, especially across time periods.

Economists would say that the boom causes intertemporal discoordination while the bust corrects those errors and brings about the highly necessary intertemporal coordination once again.

The free market is capable of keeping the inflationary boom in check

Even if the banking industry or a segment of it were to engage in fractional reserve banking by emitting far more paper, plastic and electronic forms of money than the real money commodity that they have on hand, the free market has a built-in mechanism to keep this under check. This is called bank failures.

Let us take, for instance, a region that uses dollars defined as a 1 ounce coin made of sterling silver as the unit of money. If a bank with $1 million in real dollars issues $10 million in paper dollars, the over-supply of paper dollars can easily be identified by the market. Further, the fact that on this market, every bank’s notes would be clearly identified with the bank (they would be printed as XYZ bank notes) and the market would easily be able to establish different rates of discounts for notes issued by different banks.

A more inflationary bank’s notes would be more deeply discounted than the notes of a less inflationary bank. Prices of goods might be quoted in dollars but one would have to fork out more $1 notes of an inflationary bank than the quoted dollar price. For instance, if an inflationary bank’s notes faced a discount of 50% on the market, a customer wishing to buy a good priced at $50 by paying in notes of the inflationary bank will need to fork out notes of $100 face value. If the discount were 75% because the bank is perceived as highly inflationary, he will need to fork out notes of $200 face value. Thus, the greater the inflationary condition that the market sees in a bank, the less valuable would be the money substitutes emitted by the bank.

Further, the more inflationary a bank is assessed to be, the more likely it is to be brought down by note and deposit holders walking into the bank’s branches and asking for real money in exchange. While this could be due to a loss of trust in the bank, it could also be because a trusting customer has issued a cheque to the customer of another bank that is asking the inflationary bank to pay in real dollars (which it does not have).

Such failures of fractional reserve banks would lead to a more cautious public wary of inflationary fractional reserve banks. Fractional reserve banks would then have to incentivise people to place money in their accounts, which in turn would raise the cost of their funds available for loans. In addition, being rated as a non-inflationary bank would make a bank more attractive to a public seeking greater safety of their money. In this process, the very service of getting rated on inflationary practices would become a valuable service that could be offered by rating agencies. Thus, we see that on the free-market, there exist many possibilities of mechanisms to keep fractional reserve banking in check.

If fractional reserve banking is in check, so is the inflationary boom. Thus, we see that an inflationary boom of the kind that we see today is impossible on the free market and that it is only fractional reserve banking with no market controls that causes the inflationary boom.

When we will encounter massive inflationary booms

Massive inflationary booms necessarily require massive interventions that prevent the functioning of market mechanisms. These typically take the form of government action aimed at protecting the inflationary segments of the banking industry. Today, these take the following forms
1. Central Banking with a monopoly on money issue and bank licensing
2. Central Banking as a source of lending of last resort to failing banks
3. Deposit insurance that is politically motivated and priced
4. Legal tender laws that force acceptance of inflated money substitutes at par
5. Capital gains taxes on alternate forms of money
In the absence of these forms of protection, it is impossible for a fractional reserve banking system to become as prevalent as it has become today.

The conclusion

We need to stop fearing or hating the economic depression. What we really need to be wary of is the inflationary boom that forces the pain of the bust on people at large. We also need to fear all the interventions that make the inflationary boom possible and the periodic pain of the depression a “necessary” feature of our lives.

How inflationary banking creates economic depressions and recessions

In response to my post of yesterday , a student of mine, Sankalp, had asked this question to which I responded thus. Sankalp raised an important point that I am sure a lot of people believe. With a little elaboration from my side, his question becomes this

What is the problem in banks being inflationary by nature if by engaging in such inflation, they will be able to lend much more and a lot more investment can happen? Would not an economy where lending is constrained by the actual amount of cash experience highly hampered growth in comparison?

Ordinary people see no problem in this state of affairs. Those with an exposure to mainstream economics would in fact jump to a fierce defence of this system and argue that growth would become highly constrained if the banking system were to allow cash to sit idle in the bank’s vaults while thousands of investment-worthy projects gather dust and go to rust.

The Austrian School of Economics in the tradition of Carl Menger, Böhm Bawerk, Ludwig von Mises, Friedrich Hayek and Murray Rothbard takes a radically different view of this situation. Austrian School economists explain that the much dreaded economic depression (including its modern semantic avatars, the economic recession, slowdown, downturn or whatever you wish to call it) is caused by the inflationary banking system.

The explanation, known by the name Austrian Business Cycle Theory, originated in the work of Ludwig von Mises in his book, The Theory of Money and Credit (1912) and was further developed by his student, Friedrich Hayek, in his books Monetary Theory and the Trade Cycle and Prices and Production. In fact, Friedrich Hayek went on to win the Nobel Prize in Economics in 1974 for his Business Cycle Theory, the only Austrian School economist to do so till date.

The brief version of Austrian Business Cycle Theory

In an earlier post, I had presented a stylised representation of a production system in which the original means of production, labour and land, are applied across various stages of production and eventually transformed into consumers’ goods. We saw in that case that the consumers’ goods output worth 100 oz was made possible and supported by a total capitalist saving of 318 oz.

What would happen if consumers were to decide to save 20 oz? Two things happen.
1. Consumption now falls to 80 oz
2. Capitalist savings go up to 338 oz
But what is the use of greater saving being available from capitalists when people have decided to consume less? The trick is to recognise that saving is a deferral of consumption, not permanent abstinence from consumption. In simpler terms, the saving is intended as future consumption. Saving is a decision to change the time of consumption.

This decision by consumers gets communicated to producers through a fall in the rate of interest. Producers take a cue and decide to rejig their production for a more distant future. In doing so, the production system becomes longer, with more stages of production. Hayek presented this in a highly stylised form using what are today known as Hayekian triangles as shown below.

Fig 1 - Hayekian Triangles representing the effect of new capitalist saving on the structure of production

Originally, a total saving of 160 oz churned out an output of 80 oz worth consumers’ goods. Now, a total saving of 180 oz churns out an output of 60 oz worth consumers’ goods. In our 6-stage production structure, a similar outcome would occur with a corresponding increase in the number of stages of production.

Many outcomes result. The immediate fall in demand for consumers’ goods leads to a fall in their prices. This is transmitted up the production structure, but the lower consumption does not put factors out of employment. The lower interest rate causes remoter stage capital goods prices to rise on account of much lower discounting (lower interest rates) of their imputed future contribution to revenue (called their discounted marginal value product). In the long run, greater availability of savings results in increased demand for factors in remoter stages of production.

The addition of stages implies greater specialisation and division of labour implying more efficient production thus leading to greater volume of consumers’ goods output in the future. This leads to a further fall in consumers’ goods prices in the future. However, when the greater output of consumers’ goods hit the market, the saved funds are now available to support their consumption. For the same 60 oz of spending, consumers get to consume the greater output of the longer and hence more efficient production system. This is the normal process by which an economy advances and standard of living improves.

Inflationary credit expansion and the production structure

When the banking system inflates money supply, it does so by injecting credit into the production system in the form of loans made to producers. This injection, however, takes place without saving by consumers. An injection of 80 oz of credit makes the production structure as long as in the earlier case with the 80 oz of consumers’ goods output being supported by a total apparent capitalist saving of 240 oz.

Fig 2 - Hayekian Triangles representing the effect of credit injection through monetary inflation on the structure of production

To achieve this credit expansion, the banking system will need to depress the interest rate. This lowered interest rate raises the prices of remoter stage capital goods as in the case of real savings, shifting factors of production there. However, the greater availability of capital without a fall in the demand for consumers’ goods results in a rise in the prices of factors of production. When the greater income is spent on consumers’ goods, their prices start going up as well, though after the prices of capital goods and their factors of production go up.

A general feeling of prosperity is created all around as capital goods prices, consumers’ goods prices, wages and rents go up and profits emerge in the economy. This is the inflationary boom like the one we experienced from 2001 to 2007.

However, inflationary pressures soon catch up and the system is forced to raise interest rates. Production processes that started in the reduced interest rate regime suddenly become impossible to continue further. To make matters worse, when the greater output of the more efficient, longer production structure hits the market, savings are not available to be spent on them. Unsold inventory piles up and businesses rack up huge losses.

The result is widespread business failure including failure of financial institutions that made loans to borrowers who end up defaulting. This is what we understand as the bust, commonly known as an economic depression or recession.

What we see

The lengthening of the production structure caused by genuine saving was stable and sustainable in the long run. Lengthening fuelled by credit expansion, however, is unstable as the manner in which it is done creates pressures that force an untimely increase in interest rates resulting in the depression stage of the business cycle. We see that once the inflationary boom is triggered by credit expansion through monetary inflation by the banking system, the bust is inevitable.

Thus, Austrian Business Cycle Theory helps us understand that it is the inflationary banking system that is the primary cause of all the misery created by the phenomenon of economic depressions. The key question now is

Are these boom-bust cycles inherent to the capitalist system of production or are they a result of intervention in the economy? Is it at all possible to eliminate the business cycle?

These important questions shall be the subject of another post on another day.

Fixing Inflation

This article raises an issue very relevant to the times we live in – fixing inflation. Summarising what Mr. Subbarao says, inflation is a supply side problem. That means that according to him, inability of the system of production to keep up with the ever-rising demand for goods and services is responsible for steadily rising prices. This inability, he implies, is due to fiscal policy failures and a slow pace of reform dragging economic growth down. The responsibility for fixing the problem, as per Mr. Subbarao, lies with the government. In his opinion, there is precious little that the RBI can do to stimulate growth without stoking the fires of inflation.

Mr. Chidambaram, on the other hand, believes that he has done what he could and was expected to do, i.e., keep fiscal deficit under control, to keep inflation under control, and that the ball is now in the RBI’s court. He believes it is time for the RBI to cut interest rates and tinker with other parameters in its control (like CRR and SLR) to boost growth.

What do we, as ordinary people, make of this debate happening in rarefied environs? Let me make a beginning by focusing, in this article, on inflation.

What is inflation?

The commonly accepted definition of inflation is the steady rise in prices, which is measured through price indices like WPI and CPI. The Classical (Original) definition of inflation, however, is the increase in money supply. This might come as a surprise to many of you because all you may have heard is the commonly accepted definition given above. So here, here, here and here are some links that confirm what I am saying.

Which of these is meaningful and useful?

Only the Classical definition of inflation is meaningful and helps us understand real world phenomena like ever-rising prices while the commonly accepted definition is utterly useless.

Why is the Classical definition meaningful and useful?

Money is a commodity like any other. It has a price too. That price is determined, like it is for all other commodities, by the forces of supply and demand. When money supply increases, the price of money falls. When the price of money falls, the prices of goods and services denominated in that money rise. A steady rise in the supply of money causes a steady rise in prices. Thus, the Classical definition of inflation helps us understand the real world phenomenon of rising prices from fundamentals and is therefore meaningful.

Why is the commonly accepted definition of inflation useless?

Defining inflation as the steady rise in prices tells us nothing about what caused prices to rise in the first place. Explanations like the demand-pull and cost-push theories, and structural/built-in inflation are based on elementary economic fallacies and errors. For instance, if we say that prices are rising because demand is rising, what caused the demand to rise in the first place? If we say prices rise because costs rise, aren’t costs prices themselves? Are we then not bound to explain what caused THOSE prices to rise first? If we do not, would we not be guilty of engaging in circular reasoning by saying that rising prices cause prices to rise? And is saying that some price rise is “built-in” not a negation of economic theory itself, especially price theory, which seeks to explain prices from fundamentals?

A small point of caution while using the Classical definition of Inflation

It often happens that productivity improvements send supply of goods and services up so rapidly that we do not see rising prices but stable or even mildly falling prices. In such cases, it is important to bear in mind that in the absence of inflation, prices of these goods and services would have been much lower than they currently are. So, merely observing stable, slowly rising or mildly falling prices in the face of increase in money supply does not negate the Classical definition of inflation.

What causes money supply to increase steadily?

As explained in my previous post, the banking system that we live with is the fundamental and most proximate cause of inflation. Fractional Reserve Banking is based on creating money many multiples of the monetary base we start with. A banking system with a 10% reserve ratio can multiply every Re. 1 into Rs. 10. The Rs. 9 is addition of money supply by the banking system.

Central Banks (like RBI) make matters worse. They have reserve ratios of their own based on which they lend reserves to banks. The US Fed, for instance, has a reserve ratio of 35%. This means that the Fed multiplies the banking system’s monetary base by 1/0.35 or 2.9 times. Combined with the banking system’s reserve ratio, every $1 can be multiplied into $29. The inflationary potential of the banking system is thus magnified by Central Banks.

Government spending draws resources from the private sector through taxation and borrowing. All this leads to a pressure to keep increasing money supply.

It is these 3 factors – the Banking System, Central Banks and Government – that are responsible for causing inflation (as per the Classical definition).

What does this help us do?

At the very least, it helps us pin the blame for the phenomenon of ever-rising prices. At a deeper level, it gives a solution to the problem. All it takes to solve the problem of inflation is for the triumvirate identified above to stop engaging in inflation (as per the Classical definition).

The question is, would they? And if they would not, why is it so? These are important questions that we will find answers to in subsequent posts.

Why the SBI Chairman is calling for rate cuts

I just chanced upon this article and thought it would be helpful to explain why representatives of the banking industry frequently make such demands. This is meant as a primer for those with little introduction to banking and finance.

Here’s how the banking system works. It is called a system of Fractional Reserve Banking. Unlike ordinary people, banks can lend many times the amount of money that they actually have on hand. If you have Rs. 1000 on hand, the maximum amount you can lend to someone is Rs. 1000. A bank, however, gets to lend many multiples of Rs.1000 depending on the regulatory regime, i.e., the reserve requirements imposed by the central bank (the RBI in India).

This is made possible by a simple accounting trick. Imagine a bank with the following balance sheet

Table 1 - Balance Sheet of a Hypothetical Bank upon launch

One would expect that the bank will be able to lend a maximum of 1,000,000 and end up with a balance sheet that looks like this.

Table 2 - Expected Balance Sheet of a fully loaned up bank

We think that the bank has 1,000,000 in cash to pay all deposit holders if need be. However, under fractional reserve banking, a bank needs to keep only a fraction of the total deposits as cash in reserve. This fraction is called the reserve ratio. These days, it is usually set by the central bank of each country though prior to central banking, banks used to set their own reserve ratios.

A bank with a 10% reserve ratio needs to keep only 100,000 as reserve against deposits of 1,000,000. Conversely, a cash base of 1,000,000 can support a deposit base of 10,000,000. This means that the bank’s balance sheet can look like this.

Table 3 - Balance Sheet of a fully loaned up Fractional Reserve Bank with a 10% Reserve Ratio

Thus, we see that fractional reserve banking enables banks to lend far in excess of their actual cash holdings. They do this by adding units of money to the total money supply by adding it into new or existing deposit accounts. This is reflected in the jump in deposits held in bank from 1,000,000 to 10,000,000.

Basic arithmetic tells us that if a bank gets to borrow 1,000,000 at 8% and lend 10,000,000 at 12%, it must be enormously profitable. So, there is phenomenal incentive for banks to borrow to add to their cash base and grow by increasing the total amount they have loaned out. In order to do this, banks need a source of near unlimited lending. That source is the central bank (the RBI in India).

The Repo window of the RBI is basically a means for banks to augment their cash reserves through sale of bonds to the RBI (repo) or borrowing reserves from the RBI (reverse repo). Interest rates (Update: Please note that interest rate here stands for repo/reverse repo rates) determine how much a bank can add to its cash base through this window. Higher interest (Update: repo/reverse) rates mean lower addition to the cash base while lower interest (Update: repo/reverse repo) rates mean higher addition to the cash base. Therefore, it must be obvious that banks would prefer lower interest (Update: repo/reverse repo) rates all the time.

Lowering the reserve ratio has a dramatic effect on how much the banking system can lend out on the same cash base. A drop in the reserve ratio from 10% to 9% will leave our hypothetical bank’s balance sheet looking like this.

Table 4 - Balance Sheet of fully loaned up Fractional Reserve Bank after cut in Reserve ratio to 9%

The banking system thus gets to lend out an additional amount greater than its actual cash base. While the actual additional amount of lending possible depends on the original reserve ratio and the extent of the cut, the simple arithmetical point is that it a cut in the reserve ratio necessarily means additional lending possibilities for banks. Combined with a cut in repo and reverse repo rates, it can indeed add significantly to the banking system’s ability to create new loans.

Thus, it becomes clear why the banking industry is perpetually calling for lower interest rates and lower reserve ratios. The economic consequences of these are, of course, an entirely different matter and I shall tackle them some other time.