Fractional Reserve Banking: Engine for Economic Growth or Fraud?

The cornerstone of our monetary is based on fractional banking. This, along with the Federal Reserve (I will discuss the Federal Reserve in another article) play an important role in the value of our money, the dollar. It also has a significant impact our wealth (both personal and as a nation). To make better investment and business decisions, and to steer our nation to prosperity, we really need to know how both of those systems work.

  

Fractional Reserve Banking

The way a bank operates is like this: You deposit your money into a checking account, say $1,000.00. The bank then shows the deposit on the asset side of the balance sheet (I'll go into how a balance sheet works in another article. Suffice it to say here that it means the bank views your money as their money. You can read about it here: Murray Rothbard: The Mystery of Banking, page 92.). This is the bank's reserves. The bank then can (and does) take that deposit and lends 90% of it to businesses, individuals, and whoever the bank deems credit worthy. In the process the bank charges interest on the money lent, and it is usually a very long term note, such as 15 or 30 years in length. Below is an example:

                                                                              Bank

Deposit: $1,000.00                                                                  Loans: $900.00
                 

Because the bank has $1,000.00 of hard money (money earned by the depositor through the sweat of his brow or his investments. In the beginning and to a certain extent now, it is gold...hard money), and will then lend out up to $900.00, leaving $100.00 in reserves. So far, so good. There is still $1,000.00 in the banking system. What happens next? The borrowers of the $900.00 will then deposit it in a bank and spend the money they borrowed into the economy to buy items for their business (or if it is a consumer loan, to buy a car, vacation, etc..). The deposits made into these banking institutions will then be lent out as well leaving 10% in reserves, whereby these loans are then deposited as well. So following the line of money a little bit looks like this:

• First deposit:                                $1,000.00               Loans: $900.00
• Next set of deposits:                     $900.00                  Loans: $810.00
• Next set of deposits:                     $810.00                  Loans: $729.00
• Next set of deposits:                     $729.00                  Loans: $656.10      

This can go on for quite a while. Here is what happened. After the initial $1,000.00 deposit, the banks added another $2,439.00 in the system. How? It created money out of thin air. The banks created "notes"  to represent a claim. On what? That is a good question. It used to represent a claim on gold or other precious metals (although the gold above a certain amount does not exist from fractional banking), but now that we are off the gold standard (Thank you Richard Nixon. He took us off of the last remnant of that in 1971), it is simply a claim by the U.S government that it has value. At close view, the money system seems a little funny. After all, essentially creating money out of thin air just because a bank has some hard assets to back it up? Doesn't make a lot of sense, does it? How did it come into being?

A Little History

I will come back to modern fractional banking and the pros and cons of it below. But let's first take a look at how it developed in the first place.

Fractional reserve banking started around the 17th century in both Britain and the Netherlands. People during that time used the goldsmiths to store their precious metals, and in return would be issued a receipt for the metals they had deposited. Over time, these receipts would be used literally as money itself, for it was easier than having to go to the goldsmith to get the gold, then go and pay for items with said gold. After all, the receipt represented the actual gold itself. The goldsmiths observed that, at most, 10 to 20% of the receipts were ever redeemed at one time, so they started printing more receipts than they had in gold. This they used for lending out to people as loans whereby they would charge interest. Thus was the beginning of fractional reserve banking. It would seem to be an illegal operation because by printing more receipts for gold than they had in gold is fraud. The receipts are basically worthless. So how did it become the legalized institution it is today? By court order. There was a case called Foley v Hill and Others in England in 1848 that actually legalized it. Here Murray Rothbard lists the exact verbiage:

Money, when paid into a bank, ceases altogether to be the

money of the principal; it is then the money of the banker,

who is bound to an equivalent by paying a similar sum to

that deposited with him when he is asked for it. . . . The

money placed in the custody of a banker is, to all intents and

purposes, the money of the banker, to do with it as he

pleases; he is guilty of no breach of trust in employing it; he

is not answerable to the principal if he puts it into jeopardy,

if he engages in a hazardous speculation; he is not bound to

keep it or deal with it as the property of his principal; but

he is, of course, answerable for the amount, because he has

contracted.

So there you have it. The general origins of fractional reserve banking and the legacy of our monetary system. There is quite a lot of controversy as to whether it is or isn't a good system for economic growth. Let us examine the pros and cons.

The Case for Fractional Reserve Banking

The main argument for the use of fractional reserve banking is the multiplier effect. This, in essence, means that by increases in the money base above the stated reserves, the overall wealth of a country increases. The rational is that by adding more money or credit to the system, more loans can be made to businesses and new start ups that can create more and better products. As an example, a farmer can approach a bank and get a loan to buy a machine that can harvest 1000 plums as compared to the farmer only able to pick 100 plums in the same amount of time. By increasing the plum output, we as a nation are better off...more wealthy. By persuading individuals to store their earnings in a bank (as mentioned above, it first meant the the storage of gold and later on, dollars), the banks are now able to use it to increase wealth. This argument also states that if someone holds onto their gold (say that the person is a hoarder and buries it), it is not wealth. That it really represents nothing, and it certainly is not put to good use.

The Cons of Fractional Reserve Banking

There are, however, some serious issues one must consider in relation to fractional reserve banking. First of all, it is fraud. If you deposit your money into an account, it is a demand deposit, meaning that you should be able to withdraw all or part of it whenever you want. After all, it is your money. But in reality only 10 or 20% on average is actually in your account. The rest is loaned out. It is not there. Second, it is inflationary. Arguments go back and forth as to whether inflation is good for economic growth or not (I'll address this another time), but suffice it to say that inflation in and of itself eats into your savings. Your savings will lose value over time, thus lowering your personal wealth. Third, the banks almost from the moment they open their doors are insolvent because of fractional reserve banking. If everybody decides that they want their money at the same time, the banks will go out of business. The depositors will lose their money. This is known as a bank run. It happened very often before the advent of the Federal Reserve. Why doesn't it happen today? Because the Federal Reserve will lend banks money to pay depositor demands. How? Printing money out of thin air. This in an of itself seems a bit funny to me. It certainly makes one question the real value of the dollars they are holding on to. Fifth, the banks are taking your deposits and using it for loans on their books. They are putting your money at risk, but you get no return. In other words, your money is working for the bank. It gains profits, and if they lose money they get bailed out by the federal reserve. You do not. Sixth, it creates distortions between economic growth and actual wealth. Increasing the money supply will inspire entrepreneurs to take on more risk to grow businesses, but if the individual's savings and personal wealth doesn't keep up, it eventually leads to excess businesses closing and a contraction of the money supply (in a nutshell, a recession and potential depression).

The Alternative

Economic growth can happen in a sustainable way without fractional reserve banking. For one thing, demand deposits should be treated as demand deposits. They should not be lent out. The banks can make money by charging a monthly fee for the checking account. In truth, it is similar to an institution that stores gold for an investor. They store it for safe keeping and charge the appropriate fees to run at a profit. Now what banks can do to get investment capital for loans is offer investment vehicles for customers whereby the customer will lend their money for a given period of time to a bank for rate of return. This way a bank can lend out that money and make a profit for itself and the the individual that lent his money to the bank. This is what a CD is for. Banks and investment institutions can design any number of investment vehicles to suit market needs.

Denouement 

There are many other aspects of our monetary system that must be addressed for our prosperity. For example, it would be very beneficial if we allow free banking and get back to a gold standard for our money supply, but the fractional reserve money system needs to be changed as well. As explained above, there are many problems with fractional reserve banking. Left unchecked it plays a major role with inflation, recessions and depressions.
On a personal level, we can keep most of our wealth out of the banking system. At the very least, one can keep low balances in their checking accounts. This makes it harder for the banks to leverage up their balance sheets. We can also store our wealth in precious metals. The value of gold and silver will not go down due to inflation like the dollar will. I believe that if the majority of people get into gold and silver, the money system will have to be changed. It can bring back a gold standard. And finally, if we all do a better job of researching investment vehicles and other opportunities, we will be better off as a nation.

Nobody Understands Debt?

Paul Krugman is a well known economist that writes for the New York Times. He has recently written an article about how nobody really understands debt, and that the leaders of the United States may well make bad policy decisions because of it. Common sense tells us that when we take on debt, we have an obligation to pay it back. Furthermore, making payments on that debt takes money away from something else we can spend it on. Makes sense, doesn't it? If I buy a car and take on payments of $300.00 a month for 5 years, that is $300.00 less a month I could allocate elsewhere. If I take on too many loans, my monthly obligations can get very hard to make. By servicing these loans, I cannot spend that money elsewhere, or more importantly, save a good portion for a rainy day. I would be treading on thin water. Would it be any different for a government? Paul Krugman says yes. Here he explains it:
    

First, families have to pay back their debt. Governments don’t — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.
Second — and this is the point almost nobody seems to get — an over-borrowed family owes money to someone else; U.S. debt is, to a large extent, money we owe to ourselves.

Point 1. Families have to pay back their debt, but government does not? Why not? The people holding those bonds...those pieces of paper saying the government will pay them back are expecting to get paid back. The real difference is that the government has tools, nay trickery to pay back the debt instruments that a family does not, mainly the printing press. If worse comes to worse, they can print up more money to pay the debt. If a family tried to do that, they would get arrested and thrown in jail for fraud (BTW, the government printing money without backing and using it to buy things is also practicing fraud...the difference is it is legal for them to do it). So, in essence, the lenders to our beloved government will get paid back in dollars that are worth less than they bargained for.  
Point 2. An over borrowed family owes money to someone else, but the U.S. debt we owe to ourselves. Boy, to this day I have a hard time wrapping my head around that. How can you "owe it to yourself"? Let's say a family decides to borrow $10,00.00 from itself to buy a car. How would the family do it? The only way it can be done is if the family had the $10,00.00 in the first place. In essence, from it's savings and investments. Then the family could "borrow" the money from itself by writing a promissory note for the amount, monthly payments and interest over a given period of time. How is it different with the government? It isn't. The government borrows from individuals (you and me and whoever buys the bonds). It borrows from people who saved their money. These people expect to get it back, plus interest. Otherwise they would not have lent it to the government. What is important to make clear is that "we" do not owe it to ourselves. The government owes it to individuals and other institutional investors. There is no "we" in that mix. 
Paul Krugman is a Keynesian (an economist in the 1930's that basically says the government needs to go into debt to "prime the pump" when the economy is in recession, and that national debts do not really matter). Keynesians think that you can get something for nothing. All it takes is for the government to step in go into debt or print money to keep things going. This is flawed thinking. It does not matter if we are talking about an individual, family, business, or government. Economic fundamentals still apply. Debts do matter. They are easy to understand both on a micro and macro sense. Do not let someone like Paul Krugman talk you out of your common sense.

His full article is here. Nobody Understands Debt.