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Suppose there are two countries: $A$ and $B$. $A$ is a large, stable, democratic country with its own currency, the dollar. $B$ does not have its own currency. All prices and financial transactions in $B$ use the dollar and $B$'s citizens have a positive quantity of dollars that they hold domestically.

Country $B$ has a monopoly retail bank that is required to hold 5% of the value of its deposits as reserves in the safe keeping of an independent central bank, also located and controlled within $B$.

My question is: does this suffice for the bank in country $B$ to practice fractional reserve banking? If so, am I correct in thinking that the bank in country $B$ is exerting an externality on the people of country $A$ by devaluing their currency every time it creates a new loan? Is there anything that $A$ can do to prevent this?

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    $\begingroup$ (+1) This is an excellent idea for an international geopolitical economic thriller, by the way. $\endgroup$ – Alecos Papadopoulos Jun 16 '15 at 15:13
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It is the policy of pretty much every central bank on the planet to supply reserves on demand when private banks request (in return for assets). But a central bank in country B can not do this, it can not create new dollars. So if dollar based fractional reserve banking were to start up in country B, it would behave rather differently to everyone else's fractional reserve banking.

With regard to whether this could devalue the dollar - yes it could.

With regard whether there is anything A could do about this - well I guess it would be possible for the authorities in A to refuse to accept or process broad money (IOUs of dollars) created by banks in country B.

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When the retail bank in country B multiplies the money supply, it does so by creating an asset (money owed by the borrowers) and a liability (the obligation to honor the loan it gave to the borrowers) on its books, and an asset (money to spend) and a liability (the loan to pay back) on the books of each of the borrowers.

Now, if these borrowers are all spending their money amongst each other, this probably isn't going to be a problem. It by no means affects inflation in country A, because there's no additional demand on country A's resources.

But lets say instead all of the borrowers then go to use this money to import some goods from country A. This will be, on the face of it, inflationary. Suddenly you have all this extra demand, for no additional supply.

One of two things happens:

  1. The borrowers say to country A's exporter, 'I would like to buy some widgets, get the cash from my bank' and exporter (or rather, the exporter's bank, who is based in country A) says to the bank 'Cash please!'. Country B's bank doesn't have the cash to honor every loan they've made, so they're unable to honor the payments and the loan they gave the borrowers is essentially worthless. The exporter doesn't send the goods.

  2. The exporter in country A's bank is ok with the promise of payment from the bank in country B. Afterall - there are also exporters in country B selling goods to people in country A, and this will balance out the loan.

In this second scenario - the there is also an increase in supply because country B is also exporting to country A, so it's not necessarily inflationary.

Bottom line: The inflationary effect of multiplying the money supply will be tempered by the bank's ability to honor the loans. A bank can make all the on paper loans it wants, but unless it's able to actually honor them, they are meaningless. In our modern banking system, there's a high degree of trust which means when a bank lends us money, and we see that money in our bank account, we assume that that money is actually going to be able to buy us goods.

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It seems like a clever trick a foreign bank could pull but I'm not sure it would work.

So say 'B' acquires 1 billion dollars in base money from the USA ('A'). To import these dollars it had to send real wealth to the US (equipment, clothes, toys, services etc...) to buy these dollars initially. A heavy economic hit as they would be exporting real wealth and importing worthless pieces of paper intrinsically (dollars).

So does 'B' get its revenge when it turns one billion dollars in base money into say 20 billion dollars? I'm not sure... If somebody from country 'B' uses their account to purchase say 100k worth of farmland from an American, the transaction will clear reserves between the 'B' bank and the American farmer's bank in the states. So 'B' will be down more than 100k because it was multiplied and it would have to unleverage. If this was the case then the cost of adopting a foreign currency never outweighs the benefits.

But...if an American depositor trusts the the 'B' bank, then that changes everything and reserves don't have to leave B's banking system. In that case, yes country B did benefit.

So kind of a muddled answer, but it is hard to know if the cost or purchasing a foreign base money will be outweigh by foreigners interest in holding domestic bank accounts. You will always have conflicting pressures and it is tough to predict which will come out on top.

The scary situation for 'B' would be a confidence crisis. They don't have a central bank to bail them out. If investors get spooked and money gets pulled out of 'B' banking system there is nothing to stop a chain reaction and spectacular failure...which would happen absolutely...just a matter of when.

The moral of the story is the winner is whoever convinces everybody else that their "paper" or "1s and 0s" are worth something for real wealth. It could be base money in dollars, private money from American bank X, deposit money from say a French bank but denominated in American dollars or a central bank pegged currency. It all boils down to trust and faith in the end.

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