Thin Air Fallacy

There is a theory that fractional reserve banking inherently gives banks the ability to create money at no material cost. The theory does not depend on the state privilege of seigniorage. It is considered a consequence of the accounting practices of free banking. This is sometimes referred to as creating money ex nihilo or "out of thin air".

Adherents describe two competing views on money creation:

Naive View

Money is created by miners at a material cost, potentially sold to people, and eventually lent to people. This theory holds that the lender is lending only money he owns. As such the lender is operating at full reserve and cannot engage in the practice of fractional reserve, which is considered fraudulent. As an honest lender he is only able to issue claims (money substitutes) against money in his possession, preventing credit expansion and therefore general price inflation.

Practical View

Money substitutes are created by banks, at no material cost, as a consequence of fractional reserve lending. The supply of these substitutes expands with every loan, contracting only as loans are settled. Given the implied lack of constraint on credit expansion, overall debt grows without bound, creating general price inflation.

In a free market people can perform the same operations as banks, without necessarily calling themselves banks. Therefore the distinction between these two possibilities must be based on obscuration of the supposed fraud. The theory holds that this obscuration is accomplished using an accounting trick that is not widely understood. So let us investigate the difference. Any money will suffice in this investigation of the money substitutes created in either case, including Gold, Bitcoin or monopoly money.

In the naive view, the potential lender has saved both the liquidity required for personal consumption (hoard) and the amount intended for earning interest (investment). All lending in this scenario originates from money savings.

Person	savings	hoard	asset	liability
amount	100oz

In the naive view of personal lending, Person hands over 90oz of gold to Borrower. Borrower accepts an obligation to repay Person with interest at loan maturity. To simplify the accounting we will assume zero interest and no accounting for repayment risk. In all cases, savings includes the sum of the hoard and the amount that asset exceeds liability: [savings = hoard + (asset - liability)].

Person	savings	hoard	asset	liability
amount	100oz	10oz	90oz

Borrower	savings	hoard	asset	liability
amount	90oz	90oz	90oz	90oz

Notice that Person has actually lent to his own enterprise (i.e. lending business) a fraction of his savings for the purpose of earning interest, which is accounted for below.

Lender	savings	hoard	asset	liability
amount	100oz	10oz	90oz

Business	savings	hoard	asset	liability
amount	90oz		90oz

Borrower	savings	hoard	asset	liability
amount	90oz	90oz	90oz	90oz

Notice that the lender's business is operating with no reserve. All of his deposited money is at risk of default. Projecting this into the naive view of banking, we need only rename "Lender" to "Depositor" and "Business" to "Bank". There is no need to assume that these are distinct individuals.

Depositor	savings	hoard	asset	liability
amount	100oz	10oz	90oz

Bank	savings	hoard	asset	liability
amount	90oz		90oz

Borrower	savings	hoard	asset	liability
amount	90oz	90oz	90oz	90oz