Schumpeter on Fractional Reserve Banking

Joseph Schumpeter had this to say about the modern credit system:

“In this sense, therefore, we define the kernel of the credit phenomenon in the following manner: credit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power. The creation of purchasing power characterises, in principle, the method by which development is carried out in a system with private property and division of labour. By credit, entrepreneurs are given access to the social stream of goods before they have acquired the normal claim to it. It temporarily substitutes, as it were, a fiction of this claim for the claim itself. Granting credit in this sense operates as an order on the economic system to accommodate itself to the purposes of the entrepreneur, as an order on the goods which he needs: it means entrusting him with productive forces. It is only thus that economic development could arise from the mere circular flow in perfect equilibrium. And this function constitutes the keystone of the modern credit structure” (Schumpeter 1983 [1934]: 107).

Schumpeter has put his finger on the essence of fractional reserve banking, and one of the secrets of how capitalism in the 19th century provided a much faster growth rate than in previous centuries.

And we can add: when a capitalist system is in an underemployment disequilibrium, underemployment equilibrium, or moving from one underemployment equilibrium to another, there are real resources available for entrepreneurs to use in capital goods investment. Or, as Steve Keen, argues,

“contrary to the neoclassical model, a capitalist economy is characterized by excess supply at virtually all times: there is normally excess labor and excess productive capacity, even during booms. This is not per se a bad thing but merely an inherent characteristic of capitalism—and it is one of the reasons that capitalist economies generate a much higher rate of innovation than did socialist economies … The main constraint facing capitalist economies is therefore not supply, but demand.”
Steve Keen, “Dude! Where’s My Recovery?,” Debtwatch, June 11th, 2011.

When the credit flows to speculators who use the money on asset price speculation, capitalism faces severe problems: asset bubbles and debt deflation. In unregulated or poorly regulated financial systems, asset price inflation funded in part or even significantly by private debt is a plague causing business cycles.


BIBLIOGRAPHY

Schumpeter, J. A. 1983 [1934]. The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle, Transaction Books, New Brunswick, N.J. and London.