In college economics courses we all learn that under fractional reserve banking, banks can create money out of nothing. This allows private interests to circumvent the government’s monopoly on money creation, and thus to control the economy.
Fortunately, the “Keynesian money multiplier” on which this assumption is based is built on a logical fallacy. It violates the first principle of reason, that nothing can both exist and not exist at the same time and under the same conditions. That, however, is precisely what the Keynesian theory requires, and demonstrates its falsity. Its sole purpose was to attempt to discredit Say’s Law of Markets as applied in the real bills doctrine, the basis of commercial banking.
The Keynesian money multiplier is, as all the textbooks describe, where you deposit cash in a bank. The bank loans out 90% of the cash, and creates a demand deposit in the amount of the loan. The borrower draws checks on the account, and the recipient deposits the checks. The bank in which the borrower deposited the checks then loans out 90% of that, and so on, until the money supply is increased by a multiplier equal to the reciprocal of the fractional reserve requirement.
This is pure bologna, no matter how you slice it. Baron Kahn, who developed this theory, left out one or two rather significant facts. One, creating a demand deposit does not create money. There must first be something to back the demand deposit. In the case here, it is cash somebody deposited that increase the bank’s reserves. All that the bank did by creating a demand deposit was to book a claim against those reserves.
Two, checks on deposit are not reserves. Period. Checks are not a reserve currency. They can be exchanged for or converted into a reserve currency, but are not themselves a reserve currency. You can deposit all the checks you want in a bank, and it does not increase that bank’s reserves one cent.
Three, it is only by the bank in which the checks have been deposited presenting them for payment at the bank on which the checks were drawn that the checks are converted to the reserve currency. This increases the reserves of the bank in which the checks were deposited, BUT (and read this carefully) at the same time it decreases the reserves of the bank on which the checks were drawn, and which were used to back the creation of the original demand deposit. The net effect on the amount of money in the system is zero.
Nor does this change in any substantive way when a bank creates money by accepting a bill of exchange and issuing a promissory note for a loan on the bill. In that case the borrower’s bill of exchange backs the bank’s promissory note, and the bank’s promissory note backs the new demand deposit. Given that an accepted bill of exchange is money as much as anything else is money, the net effect on the amount of money in the system is zero.