Evan's Easy Economics: #22 What is Fractional Reserve Banking

Fractional Reserve Banking: What It Is

Many of the readers probably don't know what the title to this section means. We will explain a major part of today's banking system – Fractional Reserve Banking.

Our discussion about fiat money shed some light on how fiat money came into existence. But now we must deal with how it came to be that your money is in no way backed by gold.

Once, your money could be exchanged for gold and silver at a bank, the money of the United States' used to actually have such a promise written on it. Currently this is impossible. Fractional reserve banking, the system we'll talk about in this section, provided the basis for the removal of our paper money from gold. If we continue with our goldsmith story, we'll see how.

Around the 16^th Century, people would deposit their money, which was both gold and silver, at a goldsmiths' for safekeeping. They would then receive a bill of credit (a receipt) proving that they have a rightful claim to the gold and silver at the goldsmith's. The people began to use the receipts themselves as currency due to their light weight and because the bills could easily be redeemable for gold or silver.

As time went on in this manner, the goldsmith began to notice that, while everyone was using his receipts, hardly no one came in to demand their metals. This got him thinking “Hey... if I make just a few extra receipts, I could go out and buy a shiny new hammer, and no one would be the wiser because hardly no one comes in to demand their gold and silver!”. So he printed up a few receipts, and, indeed, no one was the wiser. He might have even decided to lend out some of these counterfeit receipts and charge interest on them so as to increase his own wealth through interest payments.

These acts of greed, lying, counterfeiting, and theft managed to go undetected and unnoticed. So, of course, the practice continued until people began to notice that the goldsmith seemed to be becoming quite rich.

When the people began to notice, they naturally went to go get their money! They got their torches, their hoes, their shovels, and went to go get what was rightfully theirs back from the goldsmith, whom they all thought was taking their gold and spending it. But, since the goldsmith was simply spending the newly created receipts, and not the gold, he was able to show the mob that he still had all their metal specie, and was not stealing the metal from them.

If and when a large group of people become worried that a bank is not properly taking care of their money and go to demand their money from a bank, we call it a bank run. Bank runs have been vilified throughout history, but, as we've shown here, they're completely understandable, reasonable, and should be commonplace: people are just simply asking for their money. Any honest and moral bank should easily be able to accommodate this demand. In fact, the only reasonable explanation for a bank run being a problem is if a bank is not taking care of money properly. And in such a case people should demand their money!

To the mob of people's amazement, the goldsmith was easily able to show them that he had all of their gold and silver. But, to their disappointment, he was unable to return all their metal when presented with the mob's receipts; there were simply too many receipts. This didn't please them, and surely more than one goldsmith was strung-up! But some crafty goldsmiths were able to work out a deal where they could continue inflating the money supply if they gave the people a cut of the action. The goldsmiths promised to pay interest on their receipts in exchange for continuing the practice. Basically the people gave the goldsmith the ability to counterfeit money, and in exchange the goldsmith would give them a small amount of money.

This system of banking and use of fiat currency became known as fractional reserve banking. The name sounds complicated, but its quite easy – the banks keep a fraction of the money as a reserve just in case there is a mild bank run.

Fractional reserve banking necessarily means that the bills of credit, or even the fiat money if that is what is being used, can not all be redeemable. It necessarily means that an economy is not on a 100% gold standard. It necessarily means that the people of an economy have less control over the value of their money.

Currently in the United States, the amount of money that a bank is required to have on hand at a bank is about 6% (2009). This percentage is called the fractional reserve limit. Astonishingly, a private group of bankers, the Federal Reserve, are the ones allowed to determine how high this number should be. This means that they can lend out the other 94% of the money in hopes of making money off of it through interest. (We'll use a 10% fractional reserve limit in this article to simplify the math involved.)

Yes, you read that right. A group of bankers get to decide how much of your money they have to keep in their reserves. This means that right now, for every 1 dollar you have in the bank, the bank is only required to actually have 10 cents ready to pay to you. But since the banks also are borrowing the money from a central bank, and the central bank is only required to keep the same 10% on hand, the total amount of money used is about 100 times the amount that is available to be reclaimed at any time. If everyone went to get their money out of every bank in the U.S. at the exact same time, only about 1% of the people would receive their money.

Let me say this one more time – you know that check for a hundred dollars that you got for your birthday that you put into the bank? Well, there's actually only $1 of it in existence. The bank tells you that you have $100, but $90 worth of that was created by the bank, and 90% of the remaining $10 was created by the central bank (the Federal Reserve).

The banks are lying to you.

Although this will be a little hard to follow, let’s watch this practice in action:

If you put $1 in the bank, they will keep 10 cents of it and lend out 90 cents in order to collect interest. The person who receives that 90 cents will then use it to buy, perhaps, apples. The person who sells the apples will then take the 90 cents and deposit it in the bank. The bank will keep 9 cents of that, and then lend out the other 81 cents. The person who gets the 81 cents will use it to buy, perhaps, bananas. The banana seller will take the 81 cents and deposit it into the bank, and then the bank will keep only 8.1 cents and lend out the other 72.9 cents. If this process continues uninterrupted, there will be $1 - one real dollar - in the bank, and $9 – created through fractional reserve banking - floating around the economy. The bank is able to turn 1 dollar into 10 dollars.

They're also able to collect interest off of $10 when there is only $1 in existence. Along with this, the interest rate that they pay you for depositing the money is much less than the interest rate that they receive from lending a dollar out. And, on top of that, the bank that you got your $1 from is borrowing that dollar from a central bank that only has 10 cents in its coffers. There is only 10 cents in existence, but there are $10 circulating through the world!!

To be sure, fractional reserve banking can take place while on a gold standard. Just replace the word “dollar” with “ounces of gold” in the preceding paragraphs. But with gold coins, the bankers can only take advantage of the system through lending the gold out. They can not directly make new money. The ability to create money out of thin air, as the Federal Reserve currently has the power to do, allows this system to go on completely unchecked. If there were to be a bank run using fiat money, they could just print the money and hand it out, but if the bank run occurred while they were using gold, then they would be in big trouble.

Remember that, although this sounds like a half-decent solution to the problem of bank runs, they are solving the problem of inflation with more inflation. This is how the Federal Reserve has reacted during the current "Great Recession", as it's being called. The amount of money created in the past year or so has been astronomical.

The people have less control over the value of their money simply because the banks can decide how much money to print. Any increase in money supply reduces scarcity and diminishes value of the money. This process of fractional reserve banking not only encourages fiat currency funny money, but it is inflation. It is the process by which inflation takes place.

It also causes bubbles and busts. We'll see why later.