The fractional reserve way of creating money means a lot of people are at risk of losing all or part of their savings and pensions.
If there is too much money supply in the economy then we have inflation and people with savings or pensions lose some of their purchasing power and those who owe money benefit because they repay their loans with less purchasing power. Now you know why governments and the people who speak on their behalf promote mild inflation. This is at least unauthorized taxation if not theft.
If you have deflation, then people who are owed money win because they are repaid with more purchasing power than they loaned. The borrowers lose because they have to repay with more purchasing power.
To be fair to everyone we need to manage the economy so that just the right amount of money is available at all times. At a time when the economy is on a down trend, this is very important as too much money puts us in danger of hyperinflation.
Getting this amount right has long been a challenge to central banks although the common sense answer is fairly simple. The money supply should vary with the quantity of goods and services we want to exchange and it should be flexible up and down.
The wrench in the simplicity is the fractional reserve way of creating money. When banks make loans they must (or should) keep a fraction of the amount on reserve for when the depositor wants his/her money returned. As the amount is only a fraction banks are at risk of a “run” if depositors lose faith. And because of the fractional reserve there is a multiplier effect involved. Does not this sound like a set up for a crisis? The mechanics of this process are a little complex although I have always found it easy to understand. To figure it out I suggest you Google “fractional reserve” or look at my free e book Funny Money: Adapting to a Down Economy or look at the essay Going to Market on this weblog.
The other end of the wrench is that interest is charged on the loans made by the banks. Mainstream economists have given little or no thought to the consequences of this. Because all of our money is created by the making of loans, if all the outstanding debt were to be paid off at one time there would not be enough money to repay it all because of the interest. The charging of interest on the debt/money means there is never enough money available to repay all outstanding debt. Inflation is built into the fractional reserve way of creating money.
The system works only so long as the economy and the money supply continues to grow. An upset in either means crisis of which we have had many.
The relationship between money supply and economic output is expressed in a formula, MV=PQ, some times known as the quantity theory of money. Money times the velocity at which it circulates in the economy is equal to a price index times the quantity of goods and services produced.
I get ticked off because this is frequently taken to mean there is a direct, proportional relationship between the money supply and the inflation rate or price level. Can’t people see there are four variables in this formula? Total output is an important part of this formula. If it should happen to go down something needs to happen to another variable.
Our society has a strong commitment to economic growth and a need to keep it growing so that people will not suffer from unemployment. Some desperate people are trying to stimulate growth by increasing the money supply. This may increase inflation but it will not lead to growth unless we can find inexpensive energy and mineral resources to support it. I suspect the new American president has his eye on parks and reserve lands to encourage more economic activity. He will probably succeed in the short term to be followed by a major economic collapse.
This blogger thinks we need some major economic reforms, not only in our financial system but in our commitment to economic growth. We need to minimize our production and exchange of goods and services so we are using fewer energy and mineral resources.
A lot of people operate on faith in our financial system and ignore suggestions we need reform. I think the risk is so great that prudent people will at least give some thought to these issues. It is your savings and your pensions and your future that is at risk.
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Filed under: Economics | Tagged: banks, deflation, economic growth, Economics, fractional reserve, fractional reserve banking, hyperinflation, inflation, money, money creation, pensions, purchasing power, savings, taxation | Leave a comment »