Fractional-Reserve Banking: An Analysis from an Ethical and Economic Standpoint - Part 1: Introduction and History

(This is part 1 of a 8 part series on Fractional-Reserve Banking)

Fractional-Reserve Banking: An Analysis from an Ethnical and Economic Perspective

Our current system of banking, a centralized system of money production and control, is one of mystery and will be discussed for this essay. This system of money creation and its implications will be analyzed for their ethical dexterity and economic effects. The modern system of banking, where a Central Bank controls the entire money supply of a country, must be understood and explored since money is the lifeblood of any economy. However, our monetary system is not well-understood and met with confusion and ignorance rather than curiosity and knowledge. The fractional-reserve system will be the focus of this paper as I examine its history, process, legality, economic and ethical rational and criticisms, and also present a discussion on possible alternatives.

History

The beginnings of fractional-reserve banking go as far back as 8th century China1
(Rothbard 91) but the emergence of standardized practices did not exist till around the seventeenth century. While the practice was not the same everywhere the basic story follows this pattern: Gold and silver coin were the prevailing currency at this time and people would carry their coins around with them and keep their stores somewhere in their home. Goldsmiths would keep their extra gold in vaults at their shops and customers would ask to keep their extra currency in there as well for safe keeping. The Goldsmiths would charge a fine for the service and in return for the deposit of gold would issue deposit receipts to the customers for the amount of gold placed in the vault (typically one note per ounce of gold). As more people began using these “money warehouses” the more people began having deposit receipts. As a result, it was found that by just exchanging deposit receipts for goods and services, instead of the actual gold, transactions could be made easier in the marketplace. The exchange of notes proved much more convenient instead of having to carry around gold, or transfer large amounts of precious metals.

The Goldsmiths realized this trend and decided to take advantage of the situation. Since very few customers actually took their gold out of the vaults and instead used the deposit notes as a medium of exchange, the Goldsmiths were able to issue more notes than actual deposits as loans with interest. Thus the Goldsmiths moved from 100% reserves to fractional-reserves since they could not redeem all the notes from the gold reserves. They justified these actions by calling the extra notes an IOU liability that they would pay back to the depositors’ accounts. However, these money warehouses (becoming the equivalent of modern banks now that they lent out depositors money) still recognized depositors’ right to redeem their gold on demand. It is not hard to see as Murray Rothbard put it, “But the legal claims issued by the bank must then be fraudulent, since the bank could not possibly meet them all” (ibid 99). These practices continued and soon became legalized banking practices and are the base to the modern system that exists here in America and around the world.

Here in America our Central Bank, the Federal Reserve, controls monetary policy and the supply of money in the economy. The Federal Reserve (commonly known as the Fed) conducts monetary policy through tools such as open-market operations and the required reserve ratio. The Federal Reserve controls the operations of commercial banks by changing this reserve ratio, thereby affecting the amount of credit, or new money, that can be created. This process of making new money, of how money is created out of thin air, will be detailed in this next section.
First off, it is important to understand why a Federal Reserve is needed in a fractional-reserve system. Since banks cannot possibly redeem all deposits at the same time (the phenomenon know as a “bank run”) the system is inherently unstable. Recognizing such instability, bankers pushed for, and got, the Federal Government to establish a central bank to act as “lender of last resort”. The purpose of the central bank is one of providing liquidity to banks during times where the banks would have otherwise become insolvent and declared bankruptcy. Having such a power allows banks to continue fractional-reserve practices without the worry of going out of business.