How Finance Capital


How Finance Capital Cripples Industrial Capital: The Role of Fractional Reserve Banking

[Published in Briefing Notes in Economics, Vol. 4, Issue No. 26 (January 1997).]

Huge amounts of debt have plagued the economies of the United States and many less-developed countries during the last two decades. Despite the heavy toll that the debt burden is taking on these economies, mainstream economic theories have been pitifully inept in explaining the causes or developments that led to the proliferation of the debts thus accumulated. According to these theories, whether Keynesian or monetarist, the supply of credit is determined by two factors: (a) the savings by households and businesses, and (b) the Federal Reserve policies that determine reserve requirements and the money supply—the so-called fractional reserve banking (FRB), which will be discussed later in this essay.

But the huge sums of credit that financial intermediaries extended to a variety of borrowers during the last two decades went far beyond the boundaries set by the amount of savings or Federal Reserve money supply regulations. For example, in the United States alone the amount of domestic lending during the 1982-90 period exceeded the amount of household and corporate savings by 23% (Citicorp Economics Database, as cited in Pollin, 1992:22).

Neither do the standard theories explain the demand side of the debt overhang (i.e., the demand for debt financing). For example, neoclassical economists attribute the rise in the debt financing since the mid-1960s to the low cost of borrowing in the 1960s and 1970s—the high inflation rates of those years made the real interest rates very low, sometimes even negative. But this explanation is inadequate in light of the fact that deficit spending continued through the 1980s—indeed, it speeded up during the 1980s—despite the drastic rise in the cost of borrowing during that decade, especially in the first half of the decade.

The view of the Post-Keynesian economists of the debt overhang is similarly inadequate. Based on Hyman Minsky’s “financial fragility hypothesis” of mature market economies, this view maintains that during long expansionary business cycles both lenders and borrowers tend to base their lending/borrowing decisions more on positive expectations of the upswing of the cycle than on realistic calculations of returns on investment against which they accumulate debt claims, or debt burdens—this tendency to base lending/borrowing decisions on optimisitic expectations of the expansionary of cycle is called “boom psychology.”  Under the boom psychology even the less secured and less competitive businesses embark on a borrowing binge in an effort to expand their market share. Partly due to this boom psychology, partly due to competitive pressure, banks discard their hesitations to extend loans to less and less-secured borrowers. Eventually as the expansionary cycle reaches its peak and a fall in sales and/or profits occurs, businesses in weaker financial positions fail to meet their payment commitments. The lenders then retreat form extending additional credit. The credit crunch that replaces the prior credit boom will subsequently lead to a crisis of illiquidity and indebtedness (Minsky, 1978 and 1982).

Implicit in this theory is that there is a positive correlation between real investment (i.e., capacity buildup), on the one hand, and debt financing, on the other. That is, investment in plant and equipment during the upswing of the business cycle is associated with debt financing, and a decline in real investment on the downside of the cycle is accompanied or followed by credit crunch and a decline in deficit expenditure. This theory is valid as far as it goes (i.e., to the extent that it explains  such developments in real world). In other words, it is an empirical explanation, not a scientific theory. For example, it does not explain the rise in U.S. business/corporate debt financing since the mid-1960s as this rise has in fact been accompanied by a relative fall in real investment.Nor does it therefore explain the broader global debt overhang that has tormented the economies of the United States and many less-developed countries during the last two decades.

Within these two major views of the debt crisis there are a number of less known explanations of the problem. Despite the fact that these secondary explanations are distinct from one another in many respects, they all tend to be based not so much on scientific theories or factual evidence of the debt or credit crisis as they are on exogenous or psychological hypotheses such as rational expectations, the moral hazard problem, a principal-agent dilemma, uninformed bankers, overborrowing thesis, and so on (see Darity, 1985, pp. 15-49, for example).

Thus, orthodox economic theories, whether Monetarist or Keynesian, do not provide adequate explanations of the ongoing crisis of global debt, or credit. Here are a number of brief suggestions and arguments that I hope will go some way to rectify these inadequacies.

1. The credit system in mature market economies is not much constrained by domestic savings or central bank regulation of money supply. The institutional structure of the monetary/financial system which gives the commercial banks the power of creating money many times the amount of their reserves—by virtue of the so-called fractional reserve system—makes the supply of money much more flexible than the domestic savings or formal central bank regulations permit. Commercial banks and other financial intermediaries are quite resourceful in expanding their lending capacity beyond their legal limits. The apparent idea behind these limits is that, based on the amount of their loanable deposits as determined by reserve requirements, the commercial banks first determine their lending capacity and then go around for customers. But the realities are quite the other way around. Half of all new business loans are made to big corporations under credit lines the companies have negotiated with their bankers, legally entitling them to borrow agreed-upon amounts. As one officer of the New York Federal Reserve has put it, “In the real world, banks extend credit. . . and look for reserves later. In one way or another, the Federal Reserve will accommodate them.” (as cited in Heilbroner and Galbraith, 1990, p. 383).

There are a number of ways through which financial intermediaries find reserves beyond their formal or legal lending capacity—ways that have come to be known as  “liability management.” One way is the use of unutilized reserves (i.e., unutilized lending capacity) of other financial intermediaries. Within the well developed financial markets of today, funds can easily be moved from financial intermediaries with excess reserves to those with shortages. Another way of expanding their lending capacity is for the financial intermediaries to convince depositors to hold their financial assets in higher yielding forms of deposit which carry lower reserve requirements—certificates of deposit are a good example of this strategy. Financial intermediaries can also draw upon foreign sources in order to expand their lending capacity, either their own offshore branches or other institutions. The increasing use of this practice was in fact a major impetus for the explosive growth of the Eurodollar market since the mid-1960s, and it has become a major source of United States loanable funds. (For a detailed account of the Commercial banks’ “liability management” see Pollin, 1987:148-149, for example.)

With so much resourcefulness of commercial banks in augmenting their lending capacity and creating money—debt money, to be sure—their drive for speculative loan pushing in order to expand their interest earnings by creating ever more debt money becomes understandable. This explains why, for example, in 1987, out of a total of $3350 billion of national deposits in the United States, only $65 billion (or barely 2 percent) were kept as reserves and the rest were all loaned out, despite the fact that the official required reserves were supposed to be over 20 percent! Equally surprising was the ratio of debt money, money created by commercial banks, to real or legal tender money, money created by government—that ratio was between 12/1 and 13/1 (Hixson, 1991: 246.)

2. Contrary to the standard views, demand for credit is not limited to industrial and/or commercial credit (i.e., to debt financing of real investments and sales). In the era of well developed stock markets, futures markets, real estate markets, and similar markets for speculation, a large part of credit is demanded for speculative debt financing, or speculative investment—investment in buying and selling of existing assets with the expectation of capital gain. This clearly explains the rise in mergers and takeover of the 1980s, along with the corresponding strategies of debt financing such as the so-called “junk bonds.”

3. The Keynesian monetary policy, that was largely inspired by the experience of the Great Depression, and the consequent financial arrangements that were institutionalized in many advanced capitalist economies have greatly contributed to the protracted global debt crisis. Prior to Keynes (and/or the Great Depression),  the use of debt money (via government deficit expenditure) as a policy tool to avoid periodic crises and depressions was unacceptable. Such financial injections were considered irresponsible as they would lead to a disequilibrium between the productive capacity and the (monetarily) effective demand, and would artificially prop up inefficient enterprises, thereby preventing periodic “cleansing” of inefficiencies that resulted from crises and depressions. Thus, despite their brutality, periodic crises of overproduction usually led to a fresh start, marked by higher productivity of labor and higher rates of profit, through the destruction of a lot of value and a lot of debt during the period of crisis.

The experience of the Great Depression and the Keynesian financial prescriptions and policies changed all this. Since then, governments have regularly used deficit expenditure and debt money to prevent high unemployment rates and deep recessions. But while this has prevented cataclysmic crises of the type of the 1929-33, it has created a number of side effects. One such side effect has been the long-term monetary instability and the protracted (and accumulating) global debt. As the Keynesian monetary policy of government deficit spending contributed to the long expansionary cycle of the post-World War II period, it also contributed to the accumulation of huge financial assets in the hands of major commercial banks, both here at home as well as abroad, largely in the form of the so-called Eurodollars.

As the low profit rates of the late 1960s and early 1970s replaced the earlier high profits, corporate or industrial demand for investment and expansion declined accordingly. And as the demand for credit by their reliable traditional customers thus softened, commercial banks turned toward Third World countries for investment outlets. By the end of the 1970s and the early 1980s, however, Third World debt exploded into a crisis that threatened the entire global financial system. As a result, the commercial banks recoiled from further lending to the Third World and, instead, reverted back to their home markets, especially those of the United States, largely in pursuit of speculative lending and investment—and hence the tidal waves of mergers and takeovers of the 1980s (Sen, 1991; Pollin, 1992; Mandel, 1972; and MacEwan 1987).

4. A radical restructuring of the financial/monetary/banking system is necessary in order to make the system less susceptible to the crises that result from the dependence of money supply on debt money created by commercial banks, from the speculative credit extension, and from overindebtedness and illiquidity. Perhaps the most important element in such a restructuring would be taking away the power of money creation from commercial banks and making it solely the prerogative of the government. This requires replacing the present fractional reserve system of banking with the 100% reserve system. The 100% reserve system means that when “people make deposits and thus think they have money in the bank,” argues William Hixson, “they would actually have legal tender money in the bank, not 94 percent (more or less) of their money loaned by the banker to himself, his relatives, his friends, or others” (1991: 242). Writing in support of the 100% reserve plan, Professor John Hotson at Ontario’s University of Waterloo notes:


[T]he 100 percent reserve plan . . . would end the debt-money. . . . [G]overnement money [legal tender money] . . . is “Good Money” because it can be spent into circulation interest and debt free, and ever after perform the useful functions of money for the minor cost of replacing worn out bills and coins. . . . [M]oney produced by commercial banks is “Bad Money” because it must be lent into circulation at interest, and it only remains in existence so long as someone is willing to pay interest and the banks are willing to continue to lend (1985:48-50).


The 100% reserve plan envisions that the present-day commercial banks would be reorganized so as to have three completely separate departments, or that they would be superseded by three independent financial institutions, none of which would have the power to create money. The first type of such institutions would be “check banks,” or the checking deposit departments. Check banks would serve as mere storage or warehouses where the public could continue to make deposits and withdraw cash or pay their bills by check at any time just as they have always done. They would receive no interest on deposits and would pay higher fees for banking services than previously. Since the check banks could no longer serve as financial intermediaries (i.e., make loans of depositors’ money), or act as creators of credit money, they would therefore have no outstanding loans that might prove uncollectable. This means that “the check banks would be perfectly safe from the point of view of bankers and depositors alike and no government insurance of checking accounts would be required,” (Hixson, 1991, pp. 241-44).

The second department or institution would be “mortgage-loan institutions” serving farmers, homeowners, and small unincorporated businesses, similar to savings and loan associations of the era before deregulations in the 1980s. The mortgage-loan institutions or departments would be required to accept only time deposits, deposits that would require a substantial waiting period before a withdrawal can be made. These institutions would be allowed to hold in cash only a fraction of their deposits. With the rest of their deposits, or excess reserves, they would make only secured loans. Thus while these can serve as financial intermediaries, they cannot create deposits or create money. “Perhaps all such institutions would obtain funds solely by issuing noncallable, nontransferable certificates of deposits (CDs) at rates of interest rising with the length of the term of the CDs. The basic idea here is to make savings deposits so illiquid that they cannot be considered a part of the money supply” (Ibid., 243).

The third department or institution would be “investment trusts,” which would exist for the purpose of assisting in the financing of corporate and large businesses. Investment trusts would obtain funds solely through the sale of equity shares on the open market and would pay dividends on the basis of returns to real investments (by nonfinancial corporations) thus involved. Real investment is key here. It means that the investment trusts would be required to finance primarily the new-issue equities and to make long-term, noncallable loans to businesses that would create jobs. These institutions or departments, would be required “by law to keep most of their assets in equity shares rather than in debt paper” (Ibid.).

It is necessary to point out here that the restructuring of the financial/monetary system thus envisioned will mitigate (or do away with) only those financial crises that are due to institutional and/or legal arrangements, such as the fractional reserve banking, or due to policy manipulations of those arrangements, such as debt money creation and speculative loan pushing by the commercial banks and other financial intermediaries. The restructuring will not do away with the financial crises that are due to fundamental or systemic properties of a market economy, such as the discordance between the constantly increasing productive capacity, on the one hand, and limited possibilities of sales and capital valorization (i.e., profitable investment of capital), on the other.



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