Best of the Week
Most Popular
1.Spain Ignores Scotland Lesson as Catalan Independence Referendum Could Spark Civil War - Nadeem_Walayat
2.Used Car Buying From UK Dealer Top Tips, CarMotion.co.uk Real Customer Experience - N_Walayat
3.Spanish New Civil War Begins as Madrid Regime Storm Troopers Quell Catalan Independence Rebellion - Nadeem_Walayat
4.Virgin Media Broadband Down, Catastrophic UK Wide Failure! - Nadeem_Walayat
5.Are the US Markets setting up for an Early October Surprise? - Chris_Vermeulen
6.The Pension Storm Is Coming To Europe—It May Be The End Of Europe As We Know It -John_Mauldin
7.Stock Market Crash 2018; Will it Prove to be Another Buying Opportunity - Sol_Palha
8.The Profoundly Personal Impact Of The National Debt On Our Retirements - Dan_Amerman
9.Stock Market as Good as it Gets; Like 2000 With a Twist -Gary_Tanashian
10.1987 Stock Market Crash 30th Anniversary Greatest Investing Lesson Learned - Nadeem_Walayat
Last 7 days
Bitcoin Hits $6,000, $100 Billion Market Cap As Helicopter Ben and Jamie Demon Warn The End Is Near! - 22nd Oct 17
Time for Caution in Gold Miners - 22nd Oct 17
“Great Rotation” Ahead; Will it Be Inflationary or Deflationary? - 21st Oct 17
The Trigger for Volatility, Rates and the Next Crisis - 21st Oct 17
Perks to Consider an Agent for Auto Insurance - 21st Oct 17
Emerging Megatrends Hurting Consumers - 21st Oct 17
A Catalyst of the Stock Market Bubble Bust - 21st Oct 17
Silver Stocks Comatose - 21st Oct 17
Stock Investors Ignore What May Be The Biggest Policy Error In History - 20th Oct 17
Gold Up 74% Since Last Stock Market Peak 10 Years Ago - 20th Oct 17
Labour Sheffield City Council Employs Army of Spy's to Track Down Tree Campaigners / Felling's Watchers - 20th Oct 17
Stock Market Calm Before The Storm - 20th Oct 17
GOLD Price Creates Bullish Higher Low - 20th Oct 17
Here’s the US’s Biggest Vulnerability in NAFTA Negotiations - 20th Oct 17
The Greatest Investing Lesson Learned from the 1987 Stock Market Crash - 20th Oct 17
Stock Market Time to Go All-in. Short, That Is - 19th Oct 17
How Gold Bullion Protects From Conflict And War - 19th Oct 17
Stock Market Super Cycle Wave C May Have Started - 19th Oct 17
Negative Expectations, Will the Stock Market Correct? - 19th Oct 17
Knowing the Factors Affect your Car Insurance Premium - 19th Oct 17
Getting Your Feet Wet In Crypto Currencies - 19th Oct 17
10 Years Ago Today a Stocks Bear Market Started - 19th Oct 17
1987 Stock Market Crash 30th Anniversary Greatest Investing Lesson Learned - 19th Oct 17
Virgin Media Broadband Down, Catastrophic UK Wide Failure! - 19th Oct 17
The Passive Investing Bubble May Trigger A Massive Exodus from Stocks - 18th Oct 17
Gold Is In A Dangerous Spot - 18th Oct 17
History Says Global Debt Levels Will Lead to Another Crisis - 18th Oct 17
Deflation Basics Series: The Quantity Theory of Money - 18th Oct 17
Attractive European Countries for Foreign Investors - 18th Oct 17
Financial Transcription Services – What investors should know about them - 18th Oct 17
Brexit UK Vulnerable As Gold Bar Exports Distort UK Trade Figures - 18th Oct 17
Surge in UK Race Hate Crimes, Micro-Racism, Sheffield, Millhouses Park, Black on Asian - 18th Oct 17
Comfortably Numb: Surviving the Assault on Silver - 17th Oct 17
Are Amey Street Tree Felling's Devaluing Sheffield House Prices? - 17th Oct 17
12 Real-Life Techniques That Will Make You a Better Trader Now - 17th Oct 17
Warren Buffett Predicting Dow One Million - Being Bold Or Overly Cautious? - 17th Oct 17
Globalization is Poverty - 17th Oct 17
Boomers Are Not Saving Enough for Retirement, Neither Is the Government - 16th Oct 17
Stock Market Trading Dow Theory - 16th Oct 17
Stocks Slightly Higher as They Set New Record Highs - 16th Oct 17
Why is Big Data is so Important for Casino Player Acquisition and Retention - 16th Oct 17
How Investors Can Play The Bitcoin Boom - 16th Oct 17
Who Will Be the Next Fed Chief - And Why It Matters  - 16th Oct 17
Stock Market Only Minor Top Ahead - 16th Oct 17
Precious Metals Sector is on Major Buy Signal - 16th Oct 17
Really Bad Ideas - The Fed Should Have And Defend An Inflation Target - 16th Oct 17
The Bullish Chartology for Gold - 15th Oct 17
Wikileaks Mocking US Government Over Bitcoin Shows Why There Is No Stopping Bitcoin - 15th Oct 17
How to Wipe Out Puerto Rico's Debt Without Hurting Bondholders - 15th Oct 17
Gold And Silver – Think Prices Are Manipulated? Look In The Mirror! - 15th Oct 17

Market Oracle FREE Newsletter

3 Videos + 8 Charts = Opportunities You Need to See - Free

The Fractional Reserve Banking System Explained

InvestorEducation / Global Financial System Jun 14, 2010 - 02:36 PM GMT

By: Robert_Murphy

InvestorEducation

Diamond Rated - Best Financial Markets Analysis ArticleAustrian economics is superior to Marxism in every respect, and this includes internal, sectarian squabbles. When we Austrians feel the time is ripe for another bloodletting — it keeps us strong by thinning the herd once in a while — we argue over fractional-reserve banking.

If you have never had the pleasure of watching such fireworks, I point you to Joe Salerno's recent blog post; it has enough links to bring you up to speed. In the present article, I want to walk through a simple example to make sure everyone understands exactly why some of us think fractional-reserve banking is just plain weird.


Of course, weirdness is not proof of dubiousness, let alone fraud, but bankers who engage in fractional-reserve banking really do "create money out of thin air" in a sense that I think many commentators don't fully appreciate. I offer this article to at least clarify what the ostensible problem is.

A Simple Example

Suppose a teenager, Bill, is rummaging in the attic and finds $1,000 in physical currency in an old chest. Bill is ecstatic and runs to the local bank, where he opens a checking account and deposits the green pieces of paper.

Under a 100-percent-reserve banking system, this would be the end of the story. In the act of making the deposit, Bill's currency holdings would fall by $1,000, while his checkbook balance would rise by $1,000. Putting the money in the bank wouldn't affect the total amount of money in the economy.

However, in our current system, Bill's bank would see a new profit opportunity. After the bank put the $1,000 of paper currency into its vault, its reserves would be that much higher, while its outstanding deposit liabilities would have risen by $1,000 as well (in the form of Bill's new checking account). But since banks in the United States are subject only to a reserve requirement of (approximately) 10 percent, the bank would have new excess reserves of $900. If it found a suitable borrower, the bank would have the legal ability to grant a new loan for this amount.

Suppose the bank found such a borrower, Sally, and charged her 5-percent interest for a 12-month loan. Assuming she paid off the loan in a timely manner, here is what the bank's balance sheet would look like at various stages in the process:

I. Bank's Balance Sheet after Billy's Deposit

Assets

Liabilities + Shareholder's Equity

$1,000 in vault cash

$1,000 (Billy's checking account balance)

 

II. Bank's Balance Sheet after Loan Granted to Sally

Assets

Liabilities + Shareholder's Equity

$1,000 in vault cash

$900 loan to Sally at 5% for 12 months

$1,000 (Billy's checking account balance)

$900 (Sally's new checking account)

 

III. Bank's Balance Sheet after Sally Spends Her Loan on Business Supplies

Assets

Liabilities + Shareholder's Equity

$100 in vault cash

$900 loan to Sally at 5% for 12 months

$1,000 (Billy's checking account balance)

$0 (Sally's checking account balance)

 

IV. Bank's Balance Sheet after Sally Sells Her Products for $1,000 Cash and Deposits the Proceeds in Her Account

Assets

Liabilities + Shareholder's Equity

$1,100 in vault cash

$900 loan to Sally at 5% for 12 months

$1,000 (Billy's checking account balance)

$1,000 (Sally's checking account balance)

 

V. Bank's Balance Sheet After Sally Pays Off Her Loan Plus Interest

Assets

Liabilities + Shareholder's Equity

$1,100 in vault cash

$1,000 (Billy's checking account balance)

$55 (Sally's checking account balance)

$45 in bank shareholder equity

 

As our hypothetical example[1] makes clear, with the power of fractional-reserve banking, bankers can apparently earn income out of nothing! So long as Billy leaves his money in the bank, and so long as Sally is able to earn enough revenues from her business to avoid defaulting on her loan, the bank's shareholders end up with $45 of the community's cash, free and clear.

Now, the bank didn't stick a gun in anyone's belly, and the original owners of that $45 voluntarily traded them to Sally in exchange for whatever goods or services her business produced. Still, something seems a bit fishy in that the bank created $900 in new money, earned $45 in "old" money held by the outside community, and then destroyed the $900 when Sally paid back her loan.

Incidentally, it is because of these strange machinations that many critics of our current financial system describe it as "debt-based money." In a very real sense, if people stopped taking out new loans (from banks) and paid off their outstanding loans, the total quantity of money would shrink drastically. In my opinion this would be a good thing — especially if the politicians and the Fed sat back and let it happen — but it is nonetheless a very strange feature of our current system.

Creating Money Out of Thin Air?

Some people deny that commercial banks "create money out of thin air." They agree that the Fed does so when it buys assets by writing a check on itself. However, in our example above, it seems that the commercial bank at worst is taking $900 of "Bill's money" and handing it over to Sally. Sure, that might be dubious, but it's not as blatant as when the Fed literally writes checks drawn on thin air, right?

Actually, I think this standard textbook description — in which each new bank in the sequence creates new loans equal to 90 percent of the new deposit — is a bit misleading. There is nothing in the legal reserve requirement to prevent banks from making new loans that are large multiples of a new deposit. Instead, it is prudence on the part of the banks that enforces this restraint.

To see this, let's repeat the above story but have the bank make a much larger business loan to Sally:

I. Bank's Balance Sheet after Billy's Deposit

Assets

Liabilities + Shareholder's Equity

$1,000 in vault cash

$1,000 (Billy's checking account balance)

 

II. Bank's Balance Sheet after Loan Granted to Sally

Assets

Liabilities + Shareholder's Equity

$1,000 in vault cash

$9,000 loan to Sally at 5% for 12 months

$1,000 (Billy's checking account balance)

$9,000 (Sally's new checking account)

 

Let's stop at this point and consider what has happened. The bank's balance sheet still checks out — $10,000 in assets and $10,000 in liabilities. So the accountant's head won't explode on account of the large loan to Sally.

But perhaps the bank in our updated scenario is running afoul of the 10-percent reserve requirement enforced by the Fed? Again, no — as of the moment of the new loan to Sally, the bank's total customer checking account balances are $10,000, and the bank has $1,000 in physical currency in its vault, "backing up" those accounts. So the bank is satisfying the 10-percent reserve requirement.

To understand why the bank would be foolish to make a $9,000 loan to Sally after receiving Billy's $1,000 in cash, we must look ahead one step:

III. Bank's Balance Sheet after Sally Spends Her Loan on Business Supplies

Assets

Liabilities + Shareholder's Equity

($8,000) in vault cash

$9,000 loan to Sally at 5% for 12 months

$1,000 (Billy's checking account balance)

$0 (Sally's checking account balance)

 

Now we see the problem: Presumably, Sally is not going to borrow $9,000 at interest, in order to let that balance sit in her checking account. She is going to spend the money, by writing checks on the account. The people who receive those checks are going to deposit them in their own banks; and, during normal interbank clearing operations, the original bank will receive requests to transfer out $9,000 of its reserves.

We now see why standard economics textbooks have banks only making new loans equal to 90 percent of the amount of each new injection of deposits. The assumption is that the new depositor won't withdraw his money anytime soon, but that the new borrower (i.e., the person getting the loan) will withdraw the money very soon.

Let's be clear though on the moral of the story: in this second scenario — which is not in violation of the reserve requirement (though it might violate capital requirements or other regulations) — the commercial bank is quite obviously "creating money out of thin air."

Consider: The bank received $1,000 in currency from Bill, and it then made a loan of $9,000 to Sally. This new money didn't "come from" anywhere; it existed as soon as the bank clerk changed the numbers on the ledger. Sally went from having $0 in her checking account to having $9,000, with the simple push of a button.

Conclusion

In the present article, we have walked through a simple example to illustrate the strange nature of fractional-reserve banking. In a very real sense, this process creates money out of thin air. This observation alone doesn't prove its illegitimacy, let alone its connection with the business cycle, but it should give pause to those who see nothing wrong with the practice.

Robert Murphy, an adjunct scholar of the Mises Institute and a faculty member of the Mises University, runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. Send him mail. See Robert P. Murphy's article archives. Comment on the blog.

© 2010 Copyright Robert Murphy - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2017 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife