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.

Money = Debt

This is quite a hard subject to address concisely but I will try my best to explain this system: the system of modern money. A system where money = debt.

Most every modern nation operates under what is called "fractional-reserve banking" in which a Central Bank controls the supply of a nation's money. In our country we have a Central Bank know as the Federal Reserve, but more on them later. To understand our 'modern' money system one must understand what fractional-reserve banking is.

When a commercial bank receives a deposit (e.g. you take your paycheck to the bank and put it into your savings account) the bank will add those funds into their reserves. Now many think the money is saved inside the banks vault and you can access that money at anytime. This is false. A bank does keep some money inside of its vaults but only the amount of reserve it is required to have on hand. This "reserve requirement" is set by the Central Bank, and is typically set around 10%. What does that mean? It means that for every $100 you deposit in the bank they will only keep $10 in their reserves.

So what happens to the the other $90? Well that money then becomes available for the bank to loan out, hence the name "fractional-reserve banking"--they only keep a fraction of deposits as reserves. The $90 can now be lent out as a loan since it is considered "excess reserves" and the bank is not required to place it in their reserves. Now for our example let us say the bank lends out the $90. What happens next? Well here is where the story gets interesting and complex so please pay close attention.

One would reasonably assume that $90 comes from the actual deposit of the $100, where $10 is keep in reserves, and the remaining $90 is lent out. But this is not the case. The bank actually keeps all $100. When it lends out the $90 it simply writes the money into their books and becomes new credit *tada!* in the form of $90 is suddenly created out of thin air. Now this is where most people become lost. How can the bank just write the $90 into their books if it does not exist? It is because the Central Bank grants commercial banks the power of money creation called the "money multiplier" or "multiple deposit creation" (link to federal reserve sheet). This process continues on as the person receiving the loan will then deposit the $90 in their bank, where they keep 10%, or $9, in their reserve, and can then loan out $81, and so on for theoretically infinity, until about $900 dollars, or 9 times the original deposit can be created from this system out of thin air. So again, the bank does not loan out the actual $90 it is not required to keep in reserves, it merely uses that money as a liability to back the creation of a new $90.

So here's the crux, here's where money actually equals debt. Because banks create this new money based off the promise of the debtor to pay back his debt, they do not actual loan out people's savings. New money is given value only by a debtors promise to repay the loan. Hence, money = debt. Let's continue to see the full effects of this.

The $90 from the original deposit is actually used by the bank for their own investments. This way if everyone decided at once to remove their money from the bank, the bank would default and fail. This is called a "bank run" and happened various times in history (most notably during the Great Depression). This happens because the bank only holds about 10% of all deposits in their holdings. The rest becomes invested in various funds or assets and would have to be liquidated (meaning sold off so the bank can receive cash for them) for the bank to recover all deposits. Considering the trillion dollar balance sheets of major banks, such a process is impossible. This is way such an institute as the Federal Reserve has to exist. Called the "lender of last resort" the Federal Reserve was established to prevent such disasters as bank runs, by being given the power to create their own money.

Take a look at a dollar bill. At the top you will see the words "Federal Reserve Note". You will also notice the words "This bill is legal tender for all debts public and private". What this means is that you are required by law to repay any debts in court with only these Federal Reserve Notes. The Federal Reserve controls the supply of money in the economy through the use of "Open Market Operations". These operations include the buying and selling of government securities, also known as bonds. Bonds are loans made to firms or institutions based off their debt. So in order for the Federal Reserve to introduce new "credit" into the financial system it buys and sells government bonds, aka government debt. So again we see the same formula, money = debt. The Federal Reserve prints up (or more specially enters into a computer a new entry) Federal Reserve Notes in exchange for Government Bonds. Debt for Money, Money for Debt.

What does this mean for me and you, normal everyday people? What this means is that we can never, never get rid of debt. Our entire monetary system is based on the application of debt in order to create money. The banks create money out of thin air, out of liabilities, and we wonder how in just a matter of days last Fall we "lost" trillions of dollars of wealth. And since the Federal Reserve inserts money into the economy through the purchase of government bonds, the United States will always be in debt--to it's own central bank. Money (like everything) has no reason to be controlled by the government. But first we must understand what money is to understand this.

Money has three functions: it acts as a store of value (you receive compensation for you work in the form of money as physical value), a unit of account (goods and services are quoted in terms of money), and a medium of exchange (it functions as a common good in use of market exchanges instead of straight barter). Money itself is a commodity--it is a good by itself-- but a commodity that is used as a medium of exchange. Examples of money have included: tree bark, seashells, wooden sticks, and most notably gold and silver. The reason people accepted these goods as a common medium of exchange is because they found value in them. The coinage of gold and silver throughout history has shown to be one of the most effective and accepted mediums of exchange, but anything can act as money as long as people find value in it and can effectively use it as a medium of exchange. In our Central Bank monetary system our money is pieces of paper. These pieces of paper themselves are so cheap in real terms that they are essentially worthless. The only reason our dollars have value is that people have faith in the Central Bank to keep the supply of currency in balance with the demand for goods and services. My question is then: why would we place such power in the hands of so few people?

Well, there is only two answers to such a question: our leaders are delusional and believe in faulty economics such as Keynesian, which tell them they have the power to fix entire economies; the other option is that they want power-- they want to control our lives in every way possible and controlling our money is one of the most potent ways to do it.

I could go on explaining how our system is both UnConstitutional and unethical but I have written quite enough. It is so important to understand this system, the effect it has on your life, and how broken it has become.

Further Study:

Zeitgeist Video explaining monetary system (I don't agree with this whole movie but their explanation of the monetary system is extremely well put together)

Money As Debt Video (great history behind our current system)

The Creature from Jekyll Island (overview of the Federal Reserve)

What Has Government Done to Our Money? (great book by the amazing Murray Rothbard)
please read as much as you can on Mises.org, it has an enormous amount of information available for free.

Zimbabwe - Destruction by the Government

Gold For Bread - Video

This video just breaks my heart, especially the part with the small child scared and broken because he has no food to eat. This is what happens to a country whose government destroys the economy through monetary destruction. Twenty years ago Zimbabwe actually had a stronger dollar than the U.S. dollar. Today the money is as worthless as the paper it is printed on. There is no change in the countries people, or their production, but their money is worthless. They have to mine and pan for gold all day long just to buy a loaf of bread. This country has gone from developed to third-world overnight, all because of their central bank. A central bank that inflated the currency into a hyperinflation spiral.

Here's the scary part: inflating (or printing money) is exactly what our central bank (The Federal Reserve) is doing at an alarming pace.

What this chart shows is the unprecedented increase in Federal Reserve holdings of assets (namely AIG and other financials). But when the Fed buys these assets it doesn't use a store of cash from its vaults, it prints the money (or more specially enters the transaction on a computer) out of thin air. What happens is a major increase in the money supply, and according to the law of supply and demand this means the value of dollar has to drop due to the major increase of supply and no change in demand. Simply put, the Fed is causing every dollar in your wallet to lose its value. And with its recent actions, the possibility of a Zimbabwe like hyperinflation is becoming increasingly high.