There are few things more misunderstood than the practice of fractional reserve banking and its impact on our economy. There are reputable Austrian economists on both sides of this issue. Most, like myself, believe fractional reserve banking to be fraud and injurious to the efficient and ethical working of the economy. (Read Jorg Guido Hulsmann’s excellent The Ethics of Money Production, available at the online bookstore at Mises.org.) Others, such as Ludwig von Mises himself, would not ban fractional reserve banking but would allow the market to regulate it. Mises was more concerned with the prospect of government intervention in the monetary system and feared that laws against fractional reserve banking would be the camel’s nose under the tent mitigating in favor of more regulation.
It is difficult to understand fractional reserve banking without understanding some of the history of banking and how fractional reserves originated, for our current system maintains a fiction that has long since been made irrelevant. That irrelevancy is that something of lasting value backs our money; that is, something that would exist even if the nation/state that issued the monetary unit ceased to exist. Think of the difference in value between a gold coin of ancient Rome and the Confederate dollar, for example.
Fractional Reserves and Bank Runs
Historically banks came into existence as warehouses for gold and other precious commodities. Gold has always been a universal medium of exchange, even when other commodities competed with it for acceptance in the market. The first bankers were goldsmiths, who owned safes in which to store the raw materials of their profession. Wealthy individuals paid goldsmiths a fee to store their gold, and goldsmiths issued them receipts. Eventually these individuals started using the warehouse receipts as fiduciary media; meaning that rather than go to the goldsmith and redeem one’s gold in order to purchase something, these individuals started endorsing over their warehouse receipts. Thusly, the warehouse receipts circulated in the economy rather than the gold itself. Over time the goldsmiths realized that they could issue warehouse receipts in excess of the gold held in their vaults and reap a profit, because at no time did all the people who owned warehouse receipts for gold travel to the bank at the same time to redeem their certificates for gold specie. Now, the goldsmiths did not simply spend the excess receipts on consumer goods; rather, they lent them to borrowers and earned interest. (Doubtless the goldsmiths and even some economists today do not consider this practice to be fraud.) Since there now were more warehouse receipts for gold circulating in the market than gold in the vault to back them, it was said that the gold reserves amounted to only a “fraction” of the outstanding claims. Notice that two things had happened. One, the goldsmith gains from his fraud; that is, he made a profit (if the loan was repaid on time) from the use of goods that he did not own. Two, the money supply increased by the amount of the excess warehouse receipts. However, the money supply could not increase by very much, as we shall see.
The goldsmith, now transformed into a banker, was limited by the market in how many fractional reserve receipts he could issue. All would be well until the public became concerned that the bank had over-issued certificates. (Sometimes rumors were started by his competitors.) Then the holders of the certificates would “run” to the bank to redeem them for gold. A bank run had been born. Then the bank’s only course of action was to call in its loans, get paid in gold, and then pay its depositors in gold. If his borrowers could not repay, the banker would be forced to declare bankruptcy.
Sound Money and Credit Money
Notice that the certificates backed 100% by gold could always be redeemed without any difficulty. Thusly, such money could never be the source of inflation or deflation. But the excess certificates were not back 100% by gold; they were backed by the promise of the borrower to repay--that is, this money was backed by DEBT! If the debt could not be repaid, these excess money certificates could not be redeemed for gold. The money supply—composed of indistinguishable certificates, some backed 100% by gold and some backed only by debt—had been expanded when the goldsmith issued the excess certificates. Now the money supply shrank back to its former, sounder level.
Of course, money certificates today are backed by nothing—not gold, nor silver, nor cockleshells. The money we use is fiat money, and yet governments everywhere maintain the fiction that banks must hold reserves in some small percentage amount in order to cover their customers’ deposits. But what are these reserves? These reserves are debt, too. Let me explain.
The Basis of All Fiat Money Is Debt
In the U.S. the only money that may be used legally “for all debts public and private” is a Federal Reserve note. These notes—the money we carry in our wallets—are referred to as “standard money”. There is no recourse to anything beyond these paper notes. If a person wished to “redeem” his Federal Reserve note, he could go to the nearest Federal Reserve Bank and redeem it for…another Federal Reserve note. It might be one that was brand new off the printing press, but it would be the same type of note. If that person deposited his Federal Reserve note in a bank, the bank would create a demand deposit, also known as a checking account. The bank would send to the Federal Reserve Bank the Federal Reserve notes that it collected whose numbers were above what it deemed necessary to meet the normal needs of its customers for pocket cash. These notes would be deposited in the bank’s reserve account at the Fed. (A bank’s “reserve account” is nothing more than a checking account.) But the bank would not be required to maintain a 100% reserve account balance to match the total of all of its demand deposits. It is required to hold only a fraction in reserve--along a sliding scale, the fraction becoming greater for larger banks--to meet the withdrawal needs of its customers. The rest of his reserve account balance is “excess”, meaning not required to meet his “reserve requirement”.
Excess Reserves Become the Building Blocks of the Money Supply
So what can a bank do with its “excess reserves”? It can create a loan to another of its customers, credit that customer’s demand account, which will increase its reserve requirement and reduce its excess reserve position at the Fed by a fraction of the amount of the loan. The bank—actually, the banking system--can continue to lend and create demand deposits in this fashion until its reserve account balance matches its “reserve requirement”. This is how banks create money out of thin air, and one can readily understand the enormous ability of the banks to expand the money supply from this updated fractional reserve banking practice.
The key point is that the bank created the new demand deposit by creating a loan—the loan is an asset on the bank’s books and the demand deposit is a liability. Thusly, money in our bright new world of fractional reserve banking is backed by DEBT! In order for a deposit to be redeemed would require that the loan be repaid. If the loan cannot be repaid, the bank cannot meet its withdrawal obligations and goes bankrupt. This has been the cause of bank failures since the inception of modern banking.
The Central Bank Creates Reserves and Makes the Banks Bankrupt-Proof
But, enter a new player--the central bank. Our Federal Reserve Bank (or European Central Bank, or Bank of England, or Bank of Japan, or Bank of China) was created to prevent bank insolvency. The central bank stands ready to loan our bank unlimited funds so that it may honor its deposit withdrawal obligations. There are several ways that the central bank can accomplish this, such as purchasing bank assets or simply by a direct loan (called the discount window). It really doesn’t matter as long as the Fed can place the proceeds in the reserve account of our troubled bank. Ah, but where did the Fed get the funds to place in our troubled bank’s reserve account? Why, it created them out of thin air, too! For example, it can credit the federal government’s checking account in exchange for federal debt—called “monetizing the federal debt—or it can buy assets as discussed above, or it can lend directly to the banks at favorable terms. The central bank has become a money creation machine.
A Thing of Frightening Beauty—a Siren Song to Bankers and Politicians
Thusly, all central banks are the source of what the public calls inflation, creating money out of thin air to prop up bank credit expansion made possible by fractional reserve banking. The entire Rube Goldberg mechanism is a thing of frightening beauty, beloved by college professors who force their students to understand all the gory details, but especially beloved by bankers and politicians who can literally paper over bad debt with massive increases in the money supply. It does seem as if we have entered a new era in which it can be made impossible for banks to go bankrupt and fail to pay off their depositors. The central bank need only to invent some new rationale for replenishing the troubled banks’ reserve accounts; thus, the Troubled Asset Relief Program (TARP) and other such programs were born. The long-term harm to the economy is found on many fronts, from higher prices (perhaps even hyperinflation) to moral hazard to civic unrest as interest groups fight one another to feed at the government’s feed trough. Each dollar of new money, born of debt and not production, reduces the purchasing power of all other dollars already circulating in the economy. Nothing has been produced, not one nut or bolt, not one new car…nothing. But more money creates the temporary illusion of prosperity. One’s home increases in value. One’s 401K increases in value. Jobs are plentiful. New office buildings pop up to house all the new businesses that are born. The only problem is that nothing has been built on true savings, only debt. Yes, it is a brand new world, but it is a frightening one that cannot last.