2.7  Dysfunctions of fractional reserve banking

In MMT, there is no concern about dysfunctions of fractional reserve banking. Rather one will find approving remarks about how well the system is run and how smoothly it works. This stands in contrast to NCT's thesis of loss of control in the two-tier fractional reserve system and its capture by self-serving banking interests. This is highly relevant since, as expounded in chapter 1, money governs finance, as finance governs the economy. 'The root cause' of banking and financial crises, as Ferguson also concludes, 'must lie in the evolution of money and the banks'.[1] Money creation, the quantity of money in proportion to GDP and the basic pathways of newly created money are decisive for what happens in finance and the entire economy.

MMT never questions if today's banking privilege of creating money 'almost out of nothing' is really as functional or efficient as banking doctrine would have it—not to mention questions of constitutional law and moral legitimacy. The list of dysfunctions of fractional reserve banking include
- non-safety of bank money. In a banking crisis and ensuing bank runs, money can literally disappear because of the dysfunctional identity of bank credit and money.
- inflation and asset inflation through recurrently overshooting credit creation, and periodically impending deflation caused by shrinking credit and money supply in a crisis.
- thus pushing up, or depressing, business and financial-market cycles far too high above, or below, critical levels through direct leveraging of specu­lative investment, and through subsequently deleveraging any investment in order to pay back debt incurred. /36/ Banks' credit and money creation recurrently ends up trapped by over-investment and over-indebtedness with too many actors involved, particularly government and MFIs themselves.
- distorting income distribution to the benefit of financial income and to the detriment of earned income through disproportionately building up financial assets, whereas a realignment of such assets in times of crisis again hurts the real economy and earned income.

These functional shortcomings were already discussed in the literature on 100% banking of the 1930s, as well as in related contemporary follow-up literature.[2] They are being analysed and empirically documented in a growing corpus of NCT litera­ture.[3] Many aspects of this are also present in the literature on credit bubbles and finan­cial crises.[4] From 1970 to 2007, 425 financial crises have haunted the world, of which 145 have been systemic banking crises, 208 currency crises and 72 sovereign debt crises.[5]

MMT of course does not deny financial problems and crises. It nonetheless has had a marked tendency to neglect them as a 'topic beyond our scope'. The immanent crisis-proneness of fractional reserve banking is actually not part of MMT. Instead, MMT has depicted an almost idyllic bank world. 'Default risk on a bank's IOUs is small', 'banks know well how to assess creditworthiness', banks master risk management, render good service etc.[6] Banks quite often render good service indeed, and this is also the case in a fractional reserve regime. But much too often they do not, and turn out to be a burden on the common good.

MMT's benevolent belief in banks was already present in the 19th century banking school, as well as in the thinking of MMT's forefather, Mitchell-Innes, in 1913. /37/ He praised fractional reserve banking and honourable merchant bankers: 'Banking shall be carried on by honest people … and the note issue may be left to take care of itself. … No law is required; the whole [banking] business regulates itself auto­mati­cally'.[7] So, in spite of MMT's endorsement of a state theory of money and what it takes to be 'sovereign currency', MMT clearly does not stand for a contemporary currency paradigm. Quite to the contrary, MMT attests itself as an almost unreserved banking doctrine, adding to this a peculiar thesis of banks as willing 'intermediary' hands helping the government to create and spend its own currency (3.8).

Ongoing criticism of MMT, as well as the realities of the banking and debt crisis since 2007/08, obviously had an impact. MMT has begun to refer to Minsky's disequilibrium theory of financial markets and declared Minsky to be another 'forefather'.[8] The crucial point in this, however, is that credit bubbles are not traced back to their monetary origin, i.e. near-free and overshooting credit and debt creation by the banks who 'co-operate' in creating all sorts of bubbles―real estate, stocks, derivatives and, not least, sovereign bond bubbles. When it comes to explaining financial crises, MMT refers to the same explanatory patterns as mainstream economics, for example referring to deregulation having gone too far, a lack of 'institutional ceilings and floors' such as supposedly inadequate equity requirements (Basel rules), reckless risk-taking (misbehaviour) and others.

In particular, MMT now also refers to Minsky's notion of money manager capitalism and to left-wing orthodoxy on contemporary financial capitalism, i.e. global financialisation.[9] No doubt new forms of financial-market capitalism have developed and deserve critical analysis. So far, however, financialisation theories fall short of the mark, in that they misjudge the role of the monetary system. They try to explain everything on the grounds of exploitative profit seeking and cumulative effects of compound interest over long periods of time. They fail to systematically take into account that most interest-bearing claims are primarily created or purchased 'almost out of nothing' by the banking industry.

/38/ Accordingly, solutions to financial crises are looked for in re-regulation of financial markets and in fiscal measures (taxes on financial transactions, wealth and inheritance). In addition, MMT calls for compensatory government deficit spending. In taking up a Minsky new-deal type of proposal, government should act as 'employer of last resort', creating earned income for everybody and compensatorily complementing the central bank as 'lender of last resort' for the banks. Financial markets certainly need to be re-regulated in some way. Compensatory labour-market measures may also be taken, even though these do not contribute to solving underlying structural problems. But any such approach will basically be insufficient as long as it misses the root cause of banking and financial crises, i.e. fractional reserve banking. The pivotal role of money and banking in causing financial crises is blinded out, including the role of deficit-borne government bond bubbles. MMT does not see why monetary reform might be relevant.[10]

In NCT's analysis, to the contrary, it is the banks who hold the reins – and banks from around 1980 increasingly resorted to casino-style highly leveraged investment banking, disregarding 'boring banking' at the service of people and companies. If the banks want to print money or, to put it 'paperlessly', if they want to key credits into current accounts, there is almost nothing outside the banking sector to stop them, as long as they do it in collective step. In as far as the banks do this in ever growing disproportion to GDP, this will eventually result in a crisis as a result of financial over-investment and over-indebtedness. In the US during the pre-crisis decade up to 2008, broad money M2 grew by 80% but nominal GDP (including consumer price inflation) much less, by 45%; real GDP (price-deflated), meanwhile, grew by just 16%. This is to say that about one fifth of the addition to the money supply served real economic growth, while a good third went ininto consumer price inflation and the biggest part, 44% of the increase, went into asset inflation.[11] /39/ In Germany from 1992 to 2008 M1 grew by a staggering 189%, nominal GDP by 51% and real GDP by 23%. So only about an eighth accounted for real economic growth, another eighth for consumer inflation, but three quarters of the additional money supply fuelled financial-market exuberance.[12]

 

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[1] Ferguson 2008 62.

[2] Fisher 1935, Hart 1935, Simons 1948, Allais 1977, 1987, Hixson 1991, Gomez 2008, 2010, Benes/Kum­hof 2012. 

[3] Huber/Robertson 2000, Zarlenga 2002, AMI 2010, Robertson 2012, Huber 1999, 2013, Dyson/Green­ham/Ryan-Collins/Werner 2010, Ryan-Collins/Greenham/Werner/Jackson 2012, Schemmann 2011a+b, 2012, Dyson/Jack­­son 2012, Sensible Money 2012a+b, Positive Money 2011, Robertson 2012, Verein Mone­tä­re Modernisierung 2012, Yamaguchi 2012.

[4] Kindleberger 1993, 2000; Minsky 1982a+b, 1986; Ferguson 2008, Reinhard/Rogoff 2009, Schula­rick/ Tay­lor 2009, J. Galbraith 2008.  

[5] Laeven/Valencia 2008, Reinhart/Rogoff 2009, Lietaer et al 2012 49–52.

[6] Wray 2012 pp276.

[7] Mitchell-Innes 1913 405, 407.

[8] Fullwiler/Kelton/Wray 2012 9, Wray 2011 pp11.

[9] Cf. Hein et al. (eds) 2008, Windolf 2005.

[10] Wray 2012 280. Only once does Wray casually mention 100%-reserve (79) – and rejects it, en passant, for it would increase banks' refinancing costs and thus the general level of interest. This is right, but too narrowly considered for doing justice to approaches of 100% reserve. It is certainly no argument against plain sovereign money where it does not apply. See "100% reserve ..." on this website.      

[11] www.federalreserve.gov/releases/h6/hist. Also cf. Ferguson 2008 pp62.

[12] Deutsche Bundesbank, Monthly Bulletins, tables II.2. www.bundesbank.de/statistik/ zeitreihen.