I agree, but lets examine the effects of a series of long-term bonds and loans in terms of three numbers: circulating money, bonds, loans 1a) Start with c in circulation and the opening of a bank 1$) c, 0, 0 (c in circulation, 0 long-term deposits, 0 loans) 2a) Someone deposits x in a long-term bond 2$) c-x, x, 0 3a) The bank lends x to a borrower 3$) c, x, x 4a) The first borrower buys a car, and the seller deposits x in a long-term bond 4$) c-x, 2x, x 5a) The bank lends x to a second borrower 5$) c, 2x, 2x 6a) The second borrower buys a car, and the seller deposits x in a long-term bond 6$) c-x, 3x, 2x 7a) The bank lends x to a third borrower 7$) c, 3x, 3x 8a) The third borrower buys a car, and the seller deposits x in a long-term bond 8$) c-x, 4x, 3x 9a)The bank lends x to a forth borrower 9$) c, 4x, 4x ..... Rinse & repeat! The amount in circulation stays constant, but the amount of long-term bonds (and loans) can grow without bound in this example because the reserves are 0%. It's not money creation because the total money stays constant (the loans outstanding always counterbalance the bonds in the bank). If we make the reserves 10%, then the lending is diminished in each cycle, but the total loans will grow to 9x backed by 10x in long-term bonds. If we insist on full reserves, then no loans can be made at all. All lending (including from bonds) is FRL. To the extent the bond-holder money is circulated back to create more bonds, the amounts in the bank can grow. To the extent that debtors might default (and their collateral prove insufficient), then the system can collapse. In contrast, if the bank must keep 100% of all short-term and long-term money in reserve in the bank (full reserve), then it can lend 0%. I agree and that is why FRL is so widespread. In the U.S. (and Italy, too) I'd bet people stopped putting their money in "safe" accounts because nobody wanted to pay a monthly fee to a "safe" bank when they could earn interest instead at an FRL institution. Besides, one can avoid the FRL banking by only using cash and gold.
Good point. But but isn't there one little difference between your case and FRL? If something goes wrong, and a huge amount of lending do not return back, only bonds are affected, not circulating. So deleveraging affect savings, but not directly real economy, because circulating is unaffected. Instead, in a FRL system, you are reducing circulating (the banks are needed to regain their reserves) and thus affecting real economy, choking economy by making money not anymore available to its first intended use, ie moving means of exchange. Do you agree on this?. Why you think reserves are 0%? Seems to me that reserves are 100%, because circulating money do not change, and circulating is completely separated by lending. No choking effect when something goes wrong. No banking runs, because you can lose all your bond-invested savings, but not your deposit. Business can continue, no shut-downs (really, no shut downs by means of (reduced) circulating, if people reduce consumption for reverse wealth-effect, that can affect business, of course, and interest induced choking could, too). Sure the lending is diminished, but what happen to circulating? Grows at each cycle. And when lends default? Evaporate. This is the instability: your're evaporating the "means of exchange", so no more exchange is possible, and inactive people will starve to death. Of course, this vicious cycle is self-powered, once started grows without control. Example (circulating, reserves, loans): c, x, 10x one loan of x is defaulting. Assuming bank loses x/2. Then his reserves are x-x/2 = x/2 c, x/2, 9x But bank is not allowed to have 9x loans with a reserve of x/2, so they have to reduce circulating to regain reserves to 0.9x. They need to reduce circulating by 9/10 x - x/2 = 4/10 x. So we have: c-4/10 x, 9/10 x, 9x Now less means of exchange, assuming speed costant, means less exchanges, thus choking real economy. And that could means more defaults. Moreover, keep an eye on volumes. There is a good chance c is a lot less than 10x. Amplificating the effect. Thus the instability. Sure, but they can't claim in case a downturn their capital is reduced. That is the downside of interest, the risk. And all is crystal clear. With FRL it is not, moreover unstability due to choking effect is not widely understood, IMO, still real. Sure. But we're forced to use banks, instead. Because to make (and receive) payments bank accounts are needed. In my country even the state do not pay directly, but always by passing to bank accounts (I'm including post offices in banks), including wages and retirement monthly payments. No account? No payments (some exceptions apply, but is a minority). Moreover, probably you know the slogan of banks and credit card companies "war on cash". I attended to a lot of events where the most used slogan was "war on cash". Sadly, I believe it is a risky choice (my country will be less affected, because 40-50% of the economy is black market, but what about more "advanced" countries? This is one of three-four reasons because Italy is less affected by this crisis than most people expect. Others are very limited foreign debt (italian treasure bonds are owned by italian people) , a credit less spread than other countries (banks here were requesting a lot of collateral until very recently) and high savings. Sadly, we have some very italian problems, as humongous and very inefficient state and an industrial system too targeted to low technology (even if our best researchers are quoted between best of world, no money for them). Aging is our tickling time bomb, too. But I'm starting to wandering too much.
There are many variables the FED and other "quants" have a hard time incorporating into their models, two of which, most importantly in my opinion, are FEAR and TIME. The psychology of fractional reserve banking is very misunderstood, or not understood at all. "God doesn't roll dice" Read this: http://en.wikipedia.org/wiki/Fractional-reserve_banking#cite_note-17 Exacerbation of the business cycle Main article: Austrian Business Cycle Theory Austrian School economists claim that fractional-reserve banking, by expanding the money supply, will lower the interest rates compared to a full-reserve banking system. They argue that this will affect the role of the interest rate as the price of investment capital, guiding investment decisions. In their view, the natural (free of government influence) interest rate reflects the actual time preference of lenders and borrowers. Government's monopolistic control of the money supply through central banks and regulations insuring fractional-reserve banking activities disturbs this equilibrium such that the interest rate no longer reflects the real supply of and demand for investment capital. Austrian School economists conclude that, if the interest rate is artificially low, then the demand for loans will be higher than the actual supply of willing lenders, and if the interest rate is artificially high, the opposite situation will occur. This misinformation leads investors to misallocate capital, borrowing and investing either too much or too little in long-term projects. Periodic recessions, then, are seen as necessary "corrections" following periods of fiat credit expansion, when unprofitable investments stimulated by fiat credit creation are liquidated, freeing capital for new sustainable investment. One of the proponents of aspects of the business cycle theory, Friedrich von Hayek, was awarded the Nobel Prize in Economics,[28] but the theory is not generally accepted as an adequate refutation of Keynesian economic theory.[29] A few Austrian School economists, such as Pascal Salin, also suggest that a full-reserve banking system should not be enforced legally and dispute Murray Rothbard's characterization of fractional-reserve banking as a simple form of recursive embezzlement, and rather advocate the abolition of central banking and suggest that free banking replace the current system.
I am familiar with this theory from Austrians. This is the best theory explaining bubbles, burst, money supply and banking. BTW Austrians are too liberal............extremists!!!!!!!!