Could you elaborate on this? Are you saying that there is going to be a vicious cycle of reducing reserves?
It’s a matter of actually following the physical process of what happens to the gold during the multiplying up of credit, as identified in any respectable book on the subject. Every time the bank lends out money (as gold or as claims to gold) the borrower eventually spends it. That spending becomes someone else’s income, which that person then deposits back into the banking system. Some is kept as reserves, and some is forwarded to another borrower. From that borrower the process repeats, to yet another’s income and back as deposits into the banking system again. Each time it cycles around the amount lent out gets smaller and smaller, until the total amount kept as reserves is - surprise surprise - pretty much the same amount of physical gold as existed before the banking system went fractional. Grand total reserves remain the same in absolute - which is the refutation of the fallacy of the idle gold - but they go down as a proportion of what they are reserves for when the fraction the banking system keeps is pushed down.
There is a minor complication, not often discussed in the basic treatments in the textbooks. This is the discussion I had with Adrock. In LFC the process is limited, and so it truly is a ‘pretty much the same’ as above because the increase in total money supply is minimal, which in turn doesn’t devalue gold all that much. In non-LFC the process goes much further, can devalue the monetary component of the value of gold considerably, and cause notable reductions in total gold held in vaults as reserves because it’s cheapening increases its non-monetary use. Happiness at the prospect of that, and pursuit of government intervention to do so, was one of Adam Smith’s more notable deviations from laissez-faire.
As for central banking and fiat money, the theory appears to be assuming that the mechanism by which the central bank lowers interest rates is the same kind of “credit expansion,” right? The difference being that here there is no check against it. Again, my view is different: the operation of the central bank is based on the confiscation of gold and on treasury bonds–both of which take capital away from productive enterprises and move it into the hands of the government. This is a contraction of “credit,” not expansion. When the Fed is lending its assets at low interest rates, it’s acting like a robber offering to sell you back the stolen goods at a cheap price. When it demands high interest rates, it’s like the same robber demaning a high price.
…
Which part of what I wrote do you disagree with?
First, you’re confusing what the Treasury does with what the Central Bank does. It is Treasury that borrows by issuing government bonds, where all the Central Bank does is act as an auction house. Via the central bank, the Treasury borrows from various institutions (predominantly banks and insurers etc, and in the US also Social Security as a constituent of that alleged lock-box, and so on) by selling them fixed-interest debt assets. So far, that much isn’t credit expansion, just an example of lending for consumption. If that were all that happened then, yes, this action would act as credit contraction because it is reducing the amount of credit available for business lending. But, this is separate from the issue of the central bank changing interest rates.
Second, you’re getting the sequence of cause and effect wrong as well as totally misunderstanding how Central Banks operate. Credit expansion by central banks is exactly that, an expansion. But, it does not lower rates by pursuing credit expansion - it generates credit expansion by lowering rates, and it lowers rates by inflating the money supply.
Central banks don’t seek to lower interest rates in general, but usually are aimed at one in particular: the overnight cash rate that banks lend to each other at. Normal banks all have accounts with the Central Bank in its capacity as a clearinghouse, called Exchange Settlement accounts (in Australia anyway, maybe named differently elsewhere), which are used by the normal banks to settle up with each other on their customers’ net drawings and deposits of cheques and transfers etc at the end of the day. If a particular bank doesn’t have enough to settle up all that it owes to other banks that night it can borrow the shortfall from other banks on an overnight basis (banks can also borrow directly from the Central Bank itself, but banks try to avoid that because it is onerous and is a trigger to the Central Bank raising awkward questions).
Central banks lower this interest rate by printing money (today, in the form of book-keeping entries) and using it to buy (*) assets from the normal banks at above-market prices in Open Market Operations. As it happens, the assets so bought by the Central Bank are the private banks’ holdings of Treasury bonds. This puts more money in the banks’ ES accounts, which lowers their demand for overnight credit, and so puts downward pressure on the overnight cash rate. The Central Bank keeps on throwing in more and more book-keeping money, continually buying assets, until the overnight rate is at its official target as set by Board policy in those infamous rates-setting meetings they have. The net result, in a disgustingly convoluted manner, is that the Central Bank monetises Treasury debt and the extra money becomes additional funds for private banks to lend. There is thus increased lending in total (ie credit expansion), both of lending to the government (the purchase of T-bills and bonds) and to the private sector.
(* Technically, it is not buying but a more complicated transaction called a repurchase agreement, repo for short, but it works out to be the same thing with churn thrown in)
In the more uncommon event that is genuine credit contraction, the Central Bank does the opposite. It sells assets back to the banks who have excess amounts in their ES accounts (at below-market prices), which puts upward pressure on the overnight cash rate. The Central Bank keeps on soaking up money from ES accounts by selling assets until, again, the actual overnight cash rate becomes the target rate. The banking system as a whole then has less left over to lend to the private sector. This is what is true credit contraction, but it is associated with rising rates rather than falling rates.
None of this is about the Central Bank setting any interest rates by direct diktat. They used to do that, but not so much any more. Today it is the jawboning of the market and the flashing of cash as required so as to lower interest rates to suit Treasury’s desires not to pay high rates. As I said, it is now done by the manipulation of market mechanisms, via OMO’s. The force involved is still there, but is at the much deeper level of the damn capital adequacy rules that give special preference for Treasury debt. It is because of those capital adequacy rules - the Basel I and Basel II accords - that the private banks (and others like insurance companies) will ‘voluntarily’ buy Treasury debt in the first place even though the returns are very low. A bank can choose not to buy those debts, but it is penalised for it in its ability to lend and also misses out on the opportunity to sell them to the Central Banks for capital gains. Those who toe the line will have more freedom and more opportunities to make money.
JJM