Fractional Reserve Banking on Wikipedia

The fractional reserve banking page on Wikipedia has long been a source of edit-warring. It has generally presented the, now thoroughly discredited, "money multiplier" theory as if it was gospel. But now in the light of this new Bank of England document, the money multiplier defenders on Wikipedia have few arguments left. Today I posted on the discussion page a new opening section (below) which I hope to have accepted.

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Fractional reserve banking is a monetary system in which there are two types of money with one type constituting a fraction of the total, hence the name. The first type is known as central bank money or base money which is created by the central bank. The second type, known as broad money or demand deposits, is both created and destroyed by private banks as they make loans, or their loans are repaid. Broad money is essentially an IOU, from the private bank, of central bank money.

Central bank money can be further subdivided into two components, reserves and cash. Reserves are electronic and do not circulate outside of the banking sector, whilst cash takes the form of notes and coins which may be used by the public.

Banks typically loan out IOUs totalling more central bank money than they posses. This makes them vulnerable to a phenomena known as a bank run. Governments often have guarantees and or other policies to protect bank's customers in such circumstances.

There are regulations that require that a bank holds a minimum amount of capital and or reserves for any given amount of IOUs it has loaned out. The exact nature of these regulations may be different between different countries and at different times.

Fractional-reserve banking is the current form of banking in all countries worldwide.

What's wrong with MMT

I'm writing this blog entry as a discussion point. Please don't take it as definitive.

I have long been dissatisfied by MMT'ers. Listening to them just hasn't rung true. And I've never quite been able to work out why... but now I have a hunch... its all to do with the difference between "base money" and "broad money", or as I like to think of it "everlasting tokens" and "spendable IOU's". If you are not familiar with these concepts, please watch this.

MMT'ers appear to believe that the world revolves around base money (everlasting tokens), despite the fact that over 95% of the money in the economy is broad money. The reason for this they would say is that when man A buys $1000 worth of stuff from man B, then the transaction is not complete until $1000 of base money is transferred from A's bank to B's bank. But this is (mostly) untrue. If for example A and B both are with the same bank, then no base money need get transferred anywhere. It would be purely the bank's spendable IOU's or broad money that would be transferred from A to B. Even if bank A and bank B were different, so long as they are reasonably large, then any base money settlement between the banks will be done at the end of the day and will involve a sum corresponding to the net balance of transfers between them. If there were thousands of transactions between bank A and bank B some in one direction and some in the other, then the net transfer of base money will likely be only a tiny fraction of the total amount exchanged.

People's propensity to spend money (and therefore the overall demand) depends critically on the amount of broad money that they earn and/or possess in the bank. Therefore, unlike what MMT'ers would have you believe, it is the amount of broad money that dominates the behaviour of the economy. And don't forget it is perfectly possible, at least in the short and medium term, for the amount of base money and the amount of broad money to be quite uncorrelated, one can rise as the other one falls and vice versa.

Feel free to leave comments. I will read them carefully and may write a followup blog addressing whatever comes up.