Recently, the State Bank of India chief questioned the need for banks to maintain 4.50% of their deposits with the central bank as reserves – Cash Reserve Ratio (CRR) – a restriction not applicable to NBFCs and insurance companies.
To have an informed debate, we present a holistic perspective, drawing mostly from the work of Murray Newton Rothbard in “What Has Government Done to Our Money?”, available free of cost at http://mises.org/money.asp.
Transactions between members of primitive communities were through the direct exchange of goods / services (barter). However, the barter system had limitations.
A butter producer wanting to buy wheat could do so only if she found a wheat seller, who in turn wanted to buy butter (double coincidence of wants). Furthermore, a farmer wanting to sell his cow to buy 1) a set of dress, 2) provisions and 3) tools for his farm, had to find sellers of all these three items at the same time for the transactions to materialise (indivisibility).
Addressing these limitations, physical markets and indirect exchange of goods emerged. The seller exchanged her good(s) for a commodity (like cowrie shells, salt, metal, grains and the like) and later on exchanged this commodity to buy her desired good(s). Over time, metals having higher marketability, divisibility, durability and portability emerged as the medium of exchange.
Among metals, people across the globe, unconnected by modern transportation and communication, chose gold and silver as medium of exchange and hence money. Governments or economists had no role to play in this!
Gold coins needed to be assayed by the recipient (goods seller) in each transaction. To overcome this limitation and avoid the physical risk of carrying metal in person, traders / merchants in medieval Europe placed them with goldsmiths for safe keeping, who in turn issued receipts for the gold deposited.
Alternatively, these warehouses also maintained accounts for traders instead of issuing receipts for gold. By simple debit of one account and credit to another client’s account, upon written request, warehouse facilitated payment between its clients without physical movement of gold precursor to cheque payment). Thus, receipts and deposit accounts were mutual substitutes for gold.
Over time, realising that gold held in their custody was very rarely redeemed, some devious goldsmiths started issuing receipts without backing of gold. An illustration would make this clearer.
Let’s say person A produces goods worth Rs30,000 and exchanges it for 10 gms of gold and in turn deposits it with a goldsmith. A gets receipt(s) with which she can buy goods worth Rs30,000; i.e. the supply of money is Rs30,000, which is backed 100% by gold.
Now, if the warehouse additionally issued receipt worth Rs10,000 to person B, without corresponding gold deposit, then the money supply increases to Rs40,000, which is backed by only 75% gold (Rs 30,000 / 40,000). In other words, Rs30,000 (75%) is real and Rs10,000 is counterfeit receipt or the amount lent.
Importantly, while person A has produced goods to have Rs30,000, person B has Rs10,000, without producing any output or rendering any service!
As ‘civilisation progressed’, these warehouses became ‘banks’, and their receipts became bank notes, which later on became currency. The book-keeping accounts maintained by warehouses for clients became deposit accounts. Issuance of fake receipts is the not-so-respectable origin of banking lending. Thus, banks are ‘already and always insolvent’. When all depositors demand their gold, bank’s insolvency is revealed (bank ‘runs’).
Enter the Central Bank. Smaller banks held correspondent accounts with the larger bank (banker’s bank), which enabled the former to make payments to clients, with minimal physical movement of gold. During ‘bank runs’, the largest bank usually bailed out the smaller bank, thus emerging as the lender of last resort or the central bank. However, to avail this protection, banks had to deposit their customer’s gold with the central bank as reserve and also accept restriction on lending.
Illustratively, if the central bank prescribes gold reserves at 4.50%, then Bank X depositing 10 gms of customer’s gold (Rs30,000) with the central bank can issue notes up to Rs6,66,667 (Rs30,000 / 4.50%). Of this, Rs6,36,667 is the bank lending (fake receipts) on which it earns an interest income. Apparently, some bankers find this ‘restriction’ stifling and discriminatory!
Even without changing the reserve ratio, central bank can create money by lending to banks. In the above illustration, if the central bank lends Rs15,000 to Bank X, then Bank X’s deposit with the central bank increases to Rs45,000. Bank X can now issue notes up to Rs1,000,000 (Rs 45,000 / 4.50%).
Under fiat currency, banks have to deposit, say 4.50%, of their deposits with the central bank as reserve (CRR of 4.50%).
Under gold standard, only producers had money. If this money was lent, the lender could not spend it. Under fractional reserve banking, both the depositor and the borrower get to spend the same money, thus creating money unhinged from real output, with disastrous consequences.
First, it immiserises producers. The lower the reserve ratio, the higher the immiserisation.
Second, money once created gets spent. Thus, fake money leads to needless consumption, which is not possible under real money. Excess consumption (labelled as ‘growth’) has led to unsustainable exploitation of natural resources. Sadly, the link between fake money creation and the ensuing ecological destruction has not been fully appreciated, even by the otherwise diligent environmentalist.
As money is only a medium of exchange, the civilised society ought not to allow its fake creation. Hence, a well-informed question ought to be, ‘Why continue with fractional reserve banking’? As credit without money creation is the norm, returning to the norm or to gold standard would be logical.
Rothbard has made a persuasive case for gold standard while simultaneously demonstrating that economics can coexist with common sense. Fortunately, for the critiques of gold standard, ignorance is not a disqualification.