Did US Economics Textbooks Get Fractional Reserve Banking Wrong? 2

Real Progressive‘s YouTube channel has the video The Full Stop Shutdown on Positive Money and the AMI marketing scam.

I believe in what Steve Grumbine is saying, and I have some critiques about this particular video, but first I want to concentrate on one point that he made. Here is an excerpt from the transcript.

1:41 the second thing that is really
1:43 important is to understand that the u.s.
1:46 textbooks got the idea of reserve
1:50 lending this whole fractional reserves
1:52 they they got a completely f***ing wrong
1:54 it is the wrong forever

From what I remember of what I was taught in my first economics course at MIT, Steve Grumbine is correct. Ever since I started reading about the Modern Money Model, I have been troubled by the difference in their explanation of bank created money and the explanation I learned. I thought I finally figured out how my economics text tricked me. I went back to look at the book so I could write this post.

Obviously, I cannot attest to the rightness or wrongness of all economics textbooks. Here is what I found from my copy of “Economics”, by Paul Samuelson, Fifth Edition, 1961. (Remember this book was published 10 years before President Nixon took us off the gold standard and fixed exchange rates, so some of this is bound to be just out-of-date and not wrong for the time it was written. The “sleight of hand” is “wrong”.)

Paul Samuelson went into great detail in the pages of Chapter 16, “The Banking System And Deposit Creation” of keeping track of the balance sheets of banks and tracking liabilities and assets. The point is that he is very clear that for every dollar asset the banks create, there is a balancing loan liability that they created for the people who got the created money. There was no net creation of anything.

In section B. of the Summary of the chapter he states about The Federal Reserve Bank “When a contraction of the quantity of money is in order, the Federal Reserve authorities pull the brakes. Instead of pumping new reserves into the banking system, they draw off some of the reserves. We shall see that in so doing they are able to reduce the quantity of money not 1 for 1, but (as just shown) almost 5 for 1.”

This is where you might say that the sleight of hand happened and things went wrong. If all you remember or read is this summary, you forget about all the liabilities that have to get cancelled along with the money. The change of net money (assets minus liabilities) is 1 for 1.

If you click on the book page thumbnail to see the whole page, you will notice in the questions for discussion the following statement:

Banks borrow from their depositors at zero or low interest rates and invest most of the proceeds in higher-yielding loans and investments. They use the difference to pay their expenses, to provide us with low-cost mediums for monetary transactions, and to reward their stockholders for taking on the risks of earning-asset values.

I read this in the book in 2017 after I made this point to Steve Grumbine in the critique you can read in the comment to this post. I guess I learned something at MIT. Besides that, think about what would happen to the cost of bank services to you if the banks were deprived of being able to make money on their lending out of deposits.

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2 thoughts on “Did US Economics Textbooks Get Fractional Reserve Banking Wrong?

  • SteveG Post author

    Steve Keen provides the definitive video that “explains” it all.

    The Money Multiplier Model Is Inconsistent With Accounting, And Therefore Wrong

    If you can understand what he did in this video, please explain it to me. He pulled a lot of fast sleight-of-hand, but even playing the video slowly, and at full screen, I am not sure of what he did or how it proves his point.

    I have made a number of comments on YouTube about the video that explains why his explanation went right over my head.

  • SteveG Post author

    Now for some of the critiques of the video that I made to Grumbine.

    You know I am a believer in the fact that the Modern Money Model is an accurate model of how our money works, however, I find your explanation that Banks don’t lend reserves not at all simple enough. You know your explanation is not effective, because you know you have to keep repeating it, and people are not getting it.

    I like the explanation that banks get money at wholesale prices and lend it out at retail prices. The fly in the ointment is that some of the money they get at wholesale can be taken out anytime the depositor of that money wants it back. The bank may have lent that money at retail to someone who doesn’t have to pay it back until the terms of the loan says it must.

    The reason why this usually works with no problem is that the people who give the money to the bank that the bank lends hardly ever all want their money back at the same time. The bank has reserves to give out for the people who do want their money back. There is a certain level of reserves that have proven to be adequate in normal times. When things are not normal, like a disaster that makes an unusual number of people wanting their money back at the same time, then the usual reserves are not enough. So we have a Federal Reserve Bank that was invented to pool the reserves of all the banks so that they could be shifted around to fill in for local unusual circumstances. However, things like the great depression are not local, and this can put a strain even on what the Fed used to be able to do. Since we have been taken off of the gold standard by Richard Nixon in 1971 or so, and we do not peg our currency to anything else but our own currency, the Fed can now be the source of an infinite amount of reserves. So our system can never run out of reserves. Individual banks still need to be solvent, because they cannot keep borrowing from the Fed if they keep losing money on the net transactions they make.

    If you would try to cast your explanation into something other than repetition of the words “banks do not lend reserves”, then you might have better luck getting people to understand what you are trying to say. If you keep repeating a phrase that you cannot understand why people cannot understand it, you aren’t going to get anywhere.

    You keep talking about how the economists got it wrong when they taught us in college about fractional reserve banking. I was taken in by that tricky teaching back in the early 1960s when I learned economics. The truth of what you say, and the fiction I was taught back then have been circling in my mind ever since I started reading about MMT. I think I just figured out exactly where the slight of hand happened in my economics text book of the 1960s. I just pulled out the book and am going to write a blog post, but I think I can state the issue here briefly.

    The economics book with the money multiplier only kept track of the money assets that the bank created. The books ignored the money liabilities that were created along with those assets. If you add the liabilities and the assets together as any good accountant would do, you find no net creation of money. All the liabilities perfectly offset the assets.

    I know this is what the MMT books have been trying to tell me, but this is the first time I made the connection between what MMT says and what Paul Samuelson’s book “taught” me. Before, I only had two conflicting descriptions in front of me. Now I know exactly why they conflict, and who is right, and who has been fooling me for over 50 years. Not only who has been fooling me, but also exactly how they fooled me.