One wants the money supply to expand to match a growing economy. One way is to permit fractional reserve banking. Bank deposits can grow beyond the amount of gold, both increasing the money supply and creating the possibility of a bank going bankrupt. An alternative is fiat money: the King prints a limited amount of extra money to match the money supply to the growing economy and avoid deflation.
This is nice for the King because he benefits from the seigniorage. (But also potentially fatal, as he gives in to temptation to print too much and then some more, leading to hyper-inflation and the guillotine.)
Fiat money can be combined with fractional reserve banking. Now the monetary authorities can create extra money to overcome banking crises. Notice that society has a trade-off to make. Perhaps high reserves, so that the banks do not create much money, in which case the King/President will have to print extra fiat currency. Perhaps low reserves, and a small base of fiat currency. Now the banks create most of the money in circulation and get to charge interest on it, as an kind of on going seigniorage.
Which is best for the country? One off seigniorage accruing to the national treasury (due to printing), or the recurring seigniorage of interest paid to the banks on the money created by the fractional reserve system? There is something to be said for fractional reserve banking, as a kind of automatic stabilizer. If the economy contracts, there is a credit squeeze and the money supply contracts. Pick the reserve ratios and minimum lending rates correctly and it contracts the correct amount for price stability. And this works in reverse, expanding the money supply as the economy recovers, avoiding needless restrictions on growth due to deflation.
Experience shows that reserve ratios are too low, leading to economic instability. Why do we ignore this experience? Follow the money, low reserve ratios are profitable for bankers. We could have have a much more stable economic system with a two part strategy of 25% reserves and the monetary contraction implied by raising reserve rate being countered by printing the right amount of money.
This is nice for the King because he benefits from the seigniorage. (But also potentially fatal, as he gives in to temptation to print too much and then some more, leading to hyper-inflation and the guillotine.)
Fiat money can be combined with fractional reserve banking. Now the monetary authorities can create extra money to overcome banking crises. Notice that society has a trade-off to make. Perhaps high reserves, so that the banks do not create much money, in which case the King/President will have to print extra fiat currency. Perhaps low reserves, and a small base of fiat currency. Now the banks create most of the money in circulation and get to charge interest on it, as an kind of on going seigniorage.
Which is best for the country? One off seigniorage accruing to the national treasury (due to printing), or the recurring seigniorage of interest paid to the banks on the money created by the fractional reserve system? There is something to be said for fractional reserve banking, as a kind of automatic stabilizer. If the economy contracts, there is a credit squeeze and the money supply contracts. Pick the reserve ratios and minimum lending rates correctly and it contracts the correct amount for price stability. And this works in reverse, expanding the money supply as the economy recovers, avoiding needless restrictions on growth due to deflation.
Experience shows that reserve ratios are too low, leading to economic instability. Why do we ignore this experience? Follow the money, low reserve ratios are profitable for bankers. We could have have a much more stable economic system with a two part strategy of 25% reserves and the monetary contraction implied by raising reserve rate being countered by printing the right amount of money.