Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

The Mirage of GDP Growth

“From now on, depressions will be scientifically created.”
- Congressman Charles A. Lindbergh Sr., 1913
 
In medieval England the vast majority of people used gold and silver coins for every day transactions.  But carrying out heavy gold and silver for every transaction was certainly a burden even for the strongest of men. So many enterprising entrepreneurs of the day, mostly the goldsmiths, offered to safely store the gold and silver for people and issue them paper receipts for a claim on their gold and silver. They charged a small fee for storage and the happy customers could walk off with their paper receipts and a lot less weight to carry around. It appeared to be a win-win situation. And it normally was until the safekeepers of the gold and silver began to realize that only a very small percentage of the depositors ever came in at the same time to demand their property. Some of them decided that they could make a little extra money by loaning out some of the gold and silver that they were holding for their customers. As long as there was enough on had to pay out those who came in demanding their property, nobody was the wiser. But if customers demanded more of their gold and silver than the goldsmith had on hand, there would the equivalent of a bank run and the goldsmith would most certainly have gone to jail for fraud.
The preceding illustration is of course a historical example of fractional reserve lending. The goldsmiths were lending out more than they had on hand, keeping only a fraction of the gold and silver in their vaults. This practice was initially illegal. But countries around the world soon came to find out that they could massively expand credit and short-term economic growth if this practice were legalized throughout the banking system.
 Fractional reserve lending became entrenched in the United States in the early part of the 20th century. Banks lent out more than they had on hand. There was no Federal Reserve System to be the lender of last resort and there was no Federal Deposit Insurance Corporation (FDIC) to guarantee deposits. In 1907 a bank run ensued where large depositors went to the bank window demanding their money. Because the banks had lent most of it out, they could not provide the depositors with all of their money. This in turn led to more fear from other depositors and the “Panic of 1907” commenced.(1)
Under the guise of halting bank runs that naturally occur when fractional reserve lending exists, a special entity was created in 1913 that would lead to an enormous expansion of the banking system and all of the problems that come with it. This entity is the Federal Reserve System.  Created by Congress under the Federal Reserve Act, the Fed was to serve as the central bank of the U.S. and would be the lender of last resort when bank runs occurred. Rather than reduce or eliminate the root cause of banking panics, that is fractional reserve lending, the Fed would now see to it that this scheme would shift into overdrive. Knowing that the Fed was there to bail them out with loans, banks had little to fear in a bank run. But the results of the Fed eventually became much worse than just the moral hazard effects of being the lender of last resort. The Fed was and still is allowed to print our money. They print money to buy treasury bonds from banks, thus increasing the amount of money in the banking system. This is called Open Market Operations. Recently the Fed has become even bolder by printing money and buying all sorts of impaired securities from banks, government agencies, other countries, and other places they won’t disclose. This is what they’re calling Quantitative Easing.
Since the Great Depression, the mark of excessive credit has been felt many times. Most recently we have seen this with the tech bubble and the housing bubble. But the question remains: How does fractional reserve lending create bubbles and a mirage of growth? There is a simple example that illustrates how this system can turn a million dollars into ten million. If I deposit $1000 into a bank and that bank has a 10% reserve ratio, meaning that it must keep 10% of deposits on hand, then it is free to lend out $900 of my money. That $900 goes out and likely eventually gets deposited into the banking system again. Of this $900, 90% can be lent out again. So $810 goes back out. Taking this to the limit, we find that my $1000 becomes $1000*(1/Reserve Ratio)=$10,000. This is how money is created in the banking system and the formula above is known as the money multiplier.(2)
There have been countless arguments over the years as to whether this type of money creation is just another form of a giant ponzi scheme. But recently I received an interesting twist on that question. The question put to me was, why is this money creation any different than a person spending $1000 at the local store, then the owner of that store spending 90% of that $1000, and so on ad infinitum. Wouldn’t this multiplier effect be the exact same as the money multiplier effect in terms of how it impacts GDP growth? I thought this was a very interesting question and I set out to show why it is indeed different and how the Federal Reserve plays a part in amplifying the effects of money creation.
In this example we have three depositors and a 10% reserve ratio in the banking system. Person A has $100. He can either spend it or deposit it in a bank. He chooses to deposit it at the local bank.
Person A
Owns
Spends
Deposits
100
0
100
 
The bank can now lend our $90 of this deposit. It is lent out to person B who spends $10 of this money and eventually redeposits $80 of it.
Person B
Borrows
Spends
Deposits
90
10
80
 
The bank now lends out 90% of this $80 to person C.
Person C
Borrows
Spends
Deposits
72
10
62
 
Now person A comes back a few months later and asks for his $100 back. Of course, the bank has lent 90% of his money out. But never fear, the bank can simply go to the Federal Reserve’s discount window for a loan to cover this amount. The bank can also go to other banks for a loan at the federal funds rate to cover it. Because the Fed can print money at will, these banks will rarely if ever have to worry about their reserves on hand.  So person A gets his $100 back and spends the money, thus increasing overall GDP.
 
Person A
Withdraws
Spends
Deposits
100
100
0
 
Now let’s look at the total amount of money spent in our hypothetical economy using the table below.
Time
Period
  Person A       Person B       Person C       Person A  
  Owns Spends Deposits   Borrows Spends Deposits   Borrows Spends Deposits   Withdraws Spends Deposits
1 100 0 100                        
2         90 10 80                
3                 72 10 62        
4                         100 100 0
 
Reserve Ratio
Total $ Spent
 Without FR Lending
0.1
100
Total Bank
 Lending
Total GDP
That is Not Real
162
20
Total $ Spent With
 FR Lending
Total Deposits at The End
120
142
Total $ Spent
Required Reserves
120
14.2
 
I want to highlight the entry Total GDP That is Not Real. What does this mean exactly? This means that $20 has entered the economy that is backed by no assets. This is the difference between what would have been spent in the economy without fractional reserve lending and what was spent in a world with fractional reserve lending. Some would say that even with fractional reserve lending, every dollar lent out is usually backed by a dollar’s worth of assets somewhere. This of course assumes these assets have not declined in value and each loan has some type of collateral. For the sake of argument let’s assume this to be true. But with the Federal Reserve involved, this is no longer the case. Banks are using money created out of thin air by the Fed to amplify the effects of fractional reserve lending on the economy. To make matters worse, the Fed is constantly using Open Market Operations and Quantitative Easing to print money and feed it to the banking system, which in turn uses fractional reserve lending to multiply the amount of money sloshing around at least tenfold.
The bottom line is this. In a world of fractional reserve lending with no Federal Reserve, there is always the possibility of bank runs as well as there being more money lent out than there are assets to back that money. In a world with the Federal Reserve thrown into the mix, we are guaranteed that there is more money than there are assets to back it. This is because the Fed can print money with impunity since the dollar is backed by nothing except faith. It is no surprise then that we have ongoing bubbles created as too much money is chasing too few goods. And much of our GDP growth, as we have seen in the past decade, was merely a mirage created by a massive increase in debt.
 
 
 
 
(1)    “The Financial Crisis: Perhaps It’s Not Different This Time, Afterall”, by Chris Leithner, http://www.quebecoislibre.org/08/080415-11.htm