WEALTH AND MONEY PART VIII: FRACTIONAL RESERVE BANKING
It started with goldsmiths. As early bankers, they initially provided safekeeping services, making a profit from vault storage fees for gold and coins deposited with them. People would redeem their “deposit receipts” whenever they needed gold or coins to purchase something, and physically take the gold or coins to the seller who, in turn, would deposit them for safekeeping, often with the same banker. Everyone soon found that it was a lot easier simply to use the deposit receipts directly as a means of payment. These receipts, which became known as notes, were acceptable as money since whoever held them could go to the banker and exchange them for metallic money.
Then, bankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money. More notes could be issued than the gold and coin on hand because only a portion of the notes outstanding would be presented for payment at any one time. – – Modern Money Mechanics – The Federal Reserve Bank of Chicago
And fractional reserve banking was born. It is standard practice throughout much of the world and is sanctioned by government regulation. Banks are typically required to possess only 10 percent of the funds they actually lend. This is called the reserve ratio. Ninety percent of the money banks lend is created out of thin air on a computer screen. Tracing the process is enlightening.
Suppose a person named Tom deposits $1000 in a bank with a reserve ratio of 10 percent. The bank is required to keep $100 of Tom’s money in reserve, but is free to make a $900 loan to Mary. Analyzing this situation, Tom still has $1000 in purchasing power should he choose to use it, but Mary also now has $900 dollars in purchasing power. Money was just created out of nowhere. The original purchasing power of $1000 has become $1900.
But let us take this process even farther. Assume Mary pays her $900 to Cathy who then deposits it back into the bank. The bank considers this $900 a new deposit and is free to lend out all but 10 percent or $90. So the bank loans $810 to Sam, and the original purchasing power of Tom’s $1000 deposit has grown to $2710 ($1000 + 900 + 810). Sam spends the $810 on a used boat from Fred, who again deposits the money in the bank. The bank is free to lend all but $81 of this new deposit, so a loan of $729 is made to Tammy. Tom’s original deposit of $1000 has now grown to a purchasing power of $3439 ($1000 + $900 + $810 + $729).
If the bank continues this process to its logical and mathematical end, Tom’s deposit of $1000 eventually becomes ten times the original amount, or $10,000 of purchasing power. This is obviously a form of Ponzi scheme, but it is legal and does serve to keep money flowing in the economy. As long as few people default on their loans or demand their deposits back at the same time, the Ponzi scheme works. But if too many people default or demand payment on deposits creating a run on the bank, the Ponzi scheme fails.
The Federal Deposit Insurance Corporation (FDIC ), of course, was created to protect depositors from bank defaults resulting from fractional reserve banking. But in effect it is part of the Ponzi scheme. Because of the FDIC, the government – – the public – – is forced to pay the bill if a bank fails. The bank is let off the hook and moral hazard abounds.
But perhaps the most destructive aspect of fractional reserve banking is that it is inherently parasitic. Returning to Tom’s $1000 deposit that allowed $9000 in loans, all of this money was created out of nowhere and all of it was issued as debt. In other words, all of the borrowers of the $9000 are now paying the bank interest on money it never had in the first place. It is a game on a computer screen, but it extracts the real wealth of the community and gives it to the banker.
There are many arguments for and against fractional reserve banking, but most of the problems arise because it places money creation and rent extraction in the hands of the private banking cartel. If we were to make banking a public utility as discussed in previous articles in this series, all of the advantages of fractional reserve banking could be used to benefit the community. Assets could be leveraged and money could be kept flowing in the economy, but interest and profits would be returned to the community. The process would add rather than extract wealth from society.
“The few who understand the system will either be so interested in its profits or be so dependent upon its favours that there will be no opposition from that class, while on the other hand, the great body of people, mentally incapable of comprehending the tremendous advantage that capital derives from the system, will bear its burdens without complaint, and perhaps without even suspecting that the system is inimical to their interests.” – – The Rothschild bankers of London writing to associates in New York, 1863.
Part IX will discuss: Fractional Reserve Banking and the Free House
The Goldsmiths Tale: A short video on the evolution of fractional reserve banking: