We cannot know the value of bank credit until there is a bank run

When people try to understand Fractional-reserve banking they generally spend considerable effort speculating on what actions the central bank (and the Government) would take in the event of a bank run. The reason they do this is that they need to know if the banks themselves will have sufficient "money" to pay out the exiting depositors. Without extra cash being created, the banks clearly will not have enough money to satisfy everyone. So if we think that credit is valuable today, it suggests an expectation that the cash required will be created when there is a run on the banks.

But this is only speculation, since we cannot ever know what will happen in that occurrence and comments by central bankers and Government officials make no difference (to the fact that we don't know) beyond offering an insight into what their actual actions might be. Even if they promise to print the money this is not (sufficient) evidence that they will (actually do so).

If they do actually print the money ahead-of-time then the banks will have enough cash in their vaults to pay everyone and this is no longer Fractional-reserve banking, but instead Full-reserve banking. If the central bank does this, they will also need to make it available to the banks as a loan, not an outright gift. It would still be necessary for the banks to repay the central bank when their loans are repaid... Or are we to assume that the loans made by the banks will never be (can never be) repaid?

There is no way to find out if the value of bank credit should be equivalent to cash, or if it is zero. Just as there is no way to find out if a bet on a horse race is worth something or nothing. The price of bank credit in the market suggests that the consensus opinion is that the required cash will be printed... If you disagree with this view there are plenty of people who will purchase your bank credit for cash.


It is a contradiction to think that, in the event of a bank run the Authorities will refuse to print the quantities of cash required (to compensate depositors) and yet also value bank credit... If you value bank credit you must also expect that the cash will be printed, unless it is only valuable to you because you expect to be able to sell it... to someone who either expects printing, or who values credit for some other (irrational) reason.

Unless we only value bank credit for its resale value, then to value bank credit and not expect that the Authorities will (be required to) print significant sums of cash in the event of a (systematic) bank run is a contradiction, because you will get no "money" for it.


If we imagine that bank credit cannot be sold until after the (inevitable) bank run, and also that we do not expect that the Authorities will print huge amounts of extra cash in response to a bank run, then why would bank credit have value? Some might claim that (in spite of these caveats) it still retains value because of the value inherent in the loans made by the bank and that holding credit presents the ability to receive the proceeds of these loans when they are repaid... But this is not a valid position because in that case you would not be owning credit but the loans themselves... Which won't ever be repaid because if the person borrowing the money was concerned with the need to repay the loan, it would not cause higher prices in the market, because the person would (rather than (feeling that they are in a position to be) spending the cash) pay down the loan.

So the pertinent question for someone who thinks that bank credit is (genuinely, not merely to sell to ignorant people) valuable not because of the chance that extra money will be printed, but instead because of the value derived from the loans made by the bank, is this: "Why does bank lending result in higher prices?" and more specifically, why does it cause higher prices when loans made outside the banking system do not result in higher prices... If they claim that loans made outside the banking system do result in higher prices, this must be demonstrated by them because there is no evidence to say that it does, why would it?

Bank lending causes higher prices because the depositor retains use of the money that has been loaned out...

If you think that bank credit is (genuinely, not due to the ignorance of other people resulting in a resale value) valuable for reasons not derived from the likelihood of extra money being printed, why then does bank lending result in higher prices (when lending made outside the banking system does not result in higher prices)?

Monday 4th May 2009