The so-called multiplier arises as a result of the fact that banks are legally permitted to use money that is placed in demand deposits. Banks treat this type of money as if it was loaned to them, thus loaning it out while simultaneously allowing depositors to spend that money.
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For example, if John places $100 in demand deposit at Bank One he doesn't relinquish his claim over the deposited $100. He has unlimited claim against his $100.
However, let us also say that Bank One lends $50 to Mike. By lending Mike $50, the bank creates a deposit for $50 that Mike can now use. Remember that John still has a claim against $100 while Mike has now a claim against $50.
This type of lending is what fractional-reserve banking is all about. The bank has $100 in cash against claims, or deposits of $150. The bank therefore holds 66.7 percent reserves against demand deposits. The bank has created $50 out of “thin air” since these $50 are not supported by any genuine money.
Now Mike uses that $50 to buy goods from Tom and pays Tom by check. Tom places the check with his bank, Bank B. After clearing the check, Bank B will have an increase in cash of $50, which it may take advantage of, and lends say $25 to Bob.
As one can see, the fact that banks make use of demand deposits whilst the holders of deposits did not relinquish their claims sets in motion the money multiplier.
A case could be made that people who place their money in demand deposits do not mind banks using their money. But, if an individual grants a bank permission to lend out his money, he cannot at the same time also expect to be able to use that money.
Regardless of people's psychological disposition what matters here is that individuals did not relinquish their claim on deposited money that is being also lent out. Once banks use the deposited money, an expansion of money out of “thin air” is set in motion.
Although the law allows this type of practice, from an economic point of view, it produces a similar outcome that any counterfeit activities do. It results in money out of “thin air” which leads to consumption that is not supported by production, i.e., to the dilution of the pool of real wealth.
The legal precedent to fractional-reserve banking was set in England in 1811 in the court case of Carr v. Carr, in which the courts established the legality of fractional-reserve banking. The legality of the situation, however, is different from the economics of the matter.
According to Mises,
It is usual to reckon the acceptance of a deposit which can be drawn upon at any time by means of notes or checks as a type of credit transaction and juristically this view is, of course, justified; but economically, the case is not one of a credit transaction. ... A depositor of a sum of money who acquires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to, has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him. The depositing of money in no way means that he has renounced immediate disposal over the utility that it commands.
Similarly, Rothbard argued,
In this sense, a demand deposit, while legally designated as credit, is actually a present good — a warehouse claim to a present good that is similar to a bailment transaction, in which the warehouse pledges to redeem the ticket at any time on demand.
Why an Unhampered Market Will Curtail Fractional-Reserve Banking
In a truly free market economy the likelihood that banks will practice fractional-reserve banking will tend to be very low. If a particular bank tries to practice fractional-reserve banking it runs the risk of not being able to honor its checks. For instance if Bank One lends out $50 to Mike out of $100 deposited by John it runs the risk of going bust. Why? Let us say that both John and Mike have decided to exercise their claims. Let us also assume that John buys goods for $100 from Tom while Mike buys goods for $50 from Jerry. Both John and Mike pay for the goods with checks against their deposits with Bank One.
Now Tom and Jerry are depositing received checks from John and Mike with their bank — Bank B, which is a competitor of Bank One. Bank B in turn will present these checks to Bank One and will demand cash in return. However, Bank One has only $100 in cash — it is short $50. Consequently, Bank One is running the risk of going belly up unless it can quickly mobilize the cash by selling some of its assets or by borrowing.
The fact that banks must clear their checks will be a sufficient deterrent to the practice of fractional-reserve banking in a free market economy.
Furthermore, it must be realized that the tendency of being “caught” practicing fractional-reserve banking, so to speak, rises, as there are many competitive banks. As the number of banks rises and the number of clients per bank declines the chances that clients will spend money on goods from individuals that are banking with other banks will increase. This in turn will increase the risk of the bank not being able to honor its checks once the bank begins the practice of fractional-reserve banking.
Conversely, as the number of competitive banks diminishes, that is as the number of clients per bank rises the likelihood of being “caught” practicing reserve banking is diminished. In the extreme case if there is only one bank it can practice fractional-reserve banking without any fear of being “caught,” so to speak.
Thus if Tom and Jerry are also clients of Bank One then once they deposit their received checks from John and Mike, the ownership of deposits will be now transferred from John and Mike to Tom and Jerry. This transfer of ownership, however, will not cause any effect to Bank One.
We can then conclude that in a free market if a particular bank tries to expand credit by practicing fractional-reserve banking it is running the risk of being “caught.” Hence in a truly free market economy the threat of bankruptcy will bring to a minimum the practice of fractional-reserve banking.
Central Bank and Fractional-Reserve Banking
While in a free market economy the practice of fractional-reserve banking would tend to be minimal, this is not the case with the existence of a central bank.
By means of monetary policy, which is also labeled as reserve management by the banking system, the central bank supports the existence of the fractional-reserve banking and thus the creation of money out of “thin air.”
The modern banking system can be seen as one huge monopoly bank which is guided and coordinated by the central bank. Banks in this framework can be regarded as branches of the central bank. For all the intents and purposes the banking system can be seen as one bank. (As we have seen a monopoly bank can practice fractional-reserve banking without running the risk of being “caught.”)
Through the ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks could engage jointly in the expansion of credit out of “thin air,” through the practice of fractional-reserve banking. The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out.
By means of the monetary injections the central bank makes sure that the banking system is “liquid enough” so banks will not bankrupt each other.
Whenever the Fed injects money into the system this will result in an increase in a deposit of a particular bank. This bank, based on its portfolio strategy, will decide how much of this increase in deposits it will lend out and how much it will keep in reserves. (Even in the modern banking system banks would have to keep certain amount of reserves in order to settle transactions.)
Now, if a bank decides to keep 20 percent in reserves against the new increase in deposits then it will lend out 80 percent of these new deposits.
For instance, as a result of the Fed’s monetary injections Bank One deposits increased by $1 billion and the bank lends $800 million whilst the rest is kept in reserves. Let us assume that the borrowers of $800 million are buying goods from individuals that bank with Bank B who in turn presents checks for clearance for this amount to Bank One. Since Bank One has in its possession $1 billion it would have no problem to clear the check.
Consider however, a case where Bob deposited $100 with Bank One. The bank decides to lend 80 percent to Mike whilst the rest is kept in cash reserves. A problem could emerge if both Bob and Mike were to decide to take their money out. Then there is a risk that Bank One will not be able to honor its checks. In the event of such an occurrence, the Fed is ready to provide Bank One with a loan to prevent bankruptcy. (Furthermore, by making sure that the banking system has enough money the central bank enables the bank that encounters difficulties to honor its checks by borrowing in the so-called money market.)
Also, note that fractional-reserve banking is inherently unstable. The time structure of banks assets is longer than the time structure of its liabilities. Banks demand deposits — liabilities — are due instantly, on demand, while its outstanding loans to debtors are for a longer period. (Additionally, note that the presence of the central bank encourages banks to fund long-term assets with short-term money thereby running into possible financial difficulties once short-term interest rates rise above the long-term interest rates).
According to Rothbard,
A bank is always inherently bankrupt, and would actually become so if its depositors all woke up to the fact that the money they believe to be available on demand is actually not there.
Finally, not only does fractional-reserve banking give rise to monetary inflation it is also responsible for monetary deflation. Since banks by means of fractional-reserve banking generate money out of “thin air” whenever they do not renew their lending they in fact give rise to the disappearance of money.
This must be contrasted with the lending of genuine money, which can never physically disappear unless it is physically destroyed. Thus when John lends his $50 via Bank One to Mike the $50 is transferred to Mike from John. On the day of the maturity of the loan Mike transfers to Bank One $50 plus interest. The bank in turn transfers the $50 plus interest adjusted for bank fees to John — no money has disappeared.
If however, Bank One practices fractional-reserve banking it lends the $50 to Mike out of “thin air.” On the day of the maturity when Mike repays the $50 the money goes back to the bank, the original creator of this empty money, i.e., money disappears from the economy, or it vanishes into “thin air.”
