Saving Part 3 – Fractional Reserve Banking

Last week we added Fractional Reserve Banking to our “engine”, where the bank acts as an intermediary between savers and borrowers, keeping a fraction of the savings deposited with it in reserve, and lending the rest out.  I pointed out that this model bears no relationship to how banking and money creation work in practice, quoting the Bank of England on this point, but it’s still interesting to think about how the engine works, particularly the saving component, if we connect the banking component in this incorrect way!

The first implication of this model is that saving is a good thing that stimulates the economy.  Far from causing the paradox of thrift, saving is a virtuous act that provides the source of credit so essential to the economy.  Indeed, textbooks will generally point to saving as the source of funds for investment.

The second implication with the way this model is presented is that national saving is the sum of this individual saving.  While this is rarely explicitly stated, I’ve found that it clearly underpins most economic writing about saving and investment – they are simply not thinking carefully enough about what saving is.

While I am at pains not to turn this blog into a polemical attack on mainstream economic thought – I want every post to be moderate and well-reasoned – at some point in the future it will be necessary to present the textbook description of macroeconomics more fully, along with an analysis of its flaws.  These flaws seem to become subtlely embedded in the way anyone with a bit of knowledge of mainstream economics thinks (from academic economists, to journalists, to politicians, to the man on the street).  So we need to be very clear what these flaws are so that we can spot when they are inclining someone (including ourselves) to error.  It’s often not obvious and on the surface it can seem that what they say makes sense.  In fact, the reason I’ve started my blog with all of these weird models is to try and introduce the foundational concepts in a completely different way to the textbooks, to avoid you becoming infected with these errors.  (It’s something I now regret as I’m finding this a bit of a slog, and think many of my readers are too, but in a few weeks we’ll take a new track and liven everything up.)

So let’s think logically about saving in this model, without jumping to the conclusion that individual saving is funding investment or is contributing to national saving.

The first point to realise is that there is no compulsion in this model for banks to lend for investment.  Business is inherently risky, and if a business is unsuccessful the bank will not get its money back.  It makes far more sense to make a “secured loan”, where the loanee owns some collateral that can be repossessed by the bank if the loan isn’t repaid.  It should come as no surprise, therefore, that mortgages are banks’ favourite type of loan.  We haven’t added financial assets to the model yet, but these provide another form of collateral, and much lending in the real world economy is for the purchase of financial assets.

If, in our Multiplyland model, the banks mainly made loans to consumers rather than businsesses, this would cause inflation if businesses are not able to correspondingly increase their productivity.  Similarly, if banks in the real world are mainly making loans for the purchase of property or financial assets, and if supply can’t keep up, this will simply cause inflation in these specific markets – we would expect to see house and asset price “bubbles”.

So you see that the impact of all these loans depends on the what they are for.  And thus we come back to the foundational concept I first introduced two weeks ago:

“Decisions about who to allocate credit to, and how much credit to allocate, are absolutely fundamental to the path the economy takes in the future.”

Now let’s explore this further in the context of Multiplyland.  Suppose a new fashion develops:  buying fine art becomes the way to show how with-it you are.  So as not to get left behind, people start taking out loans to join the latest trend.  As there is a limited supply of artists, and as it is a field that requires a lot of training, and as it takes time to create new works of art, supply cannot keep up with the new demand, and prices rise.  You get inflation in the specific market of fine art.  So people need to take out even bigger loans to buy this art.  So rather than funding investment, or consumer demand in other areas of the economy, new credit is being diverted to this one specific market and away from other markets, and as people start paying off these loans they have to reduce their expenditure on other items.   So saving can, in fact, give rise to the paradox of thrift in this model:  the growth in the fine art market is at the expense of contraction in the economy elsewhere.  Of course, those working in the fine art sector are now much richer, which will compensate to some extent, but it depends what they choose to spend their money on.

And once again we thus find that individual saving does not necessarily lead to national saving, it all depends on how those savings are put to use.  If the savings are loaned to others for use in specific markets, it can cause inflation in those markets (this will be a major theme of this blog in the future).  We can only save as a nation through investment (in its strict economic sense).

Secondly, this example highlights another fundamental concept.  The distribution of wealth is critical to the future path of the economy, because what influences the direction of that path is how those who have the wealth choose to spend or save it.  Let’s say that again, and highlight it:

The distribution of wealth is critical to the future path of the economy.

There is an obvious point about distribution – if a few people are extremely rich, and many are in poverty, one way to alleviate poverty is to re-distribute the wealth.  This is not, in any way, what I am talking about here.  There are huge implications when you start considering how you will redistribute, and my point here is nothing to do with the rights and wrongs of redistribution.  I am making the technical point that the way wealth is distributed is a major factor influencing the future direction of the economy, because of the different ways in which different people spend their money.  Two economies of the same size, based on the same industries, will advance on completely different paths if they have different distributions of wealth.

This blog is about how we create an economy that provides enough for everyone, and the introductory posts highlighted that maintaining and improving productivity is key to this, and hence so is investment and saving.  This post is pointing out that the distribution of wealth is another critical factor that has to be considered.  It will be some time until we come back to consider this further, but when we do it will be linking back to this post.