Monday, September 24, 2007

Fractional Reserve Banking

In the previous article we looked at free market banking institutions. We discussed that money is the commodity (historically gold and silver) selected by the market as the preferred medium of exchange, and that gold warehouses serve as an efficient means to store and trade gold. In this article we look at fractional reserve banking, which is the practice of banks lending out their customers deposits in multiples. This appears to be at odds with our discussion in previous articles, so we scrutinize the practice to see if we cannot reconcile the apparent inconsistency.

Savings and lending

Before we discuss fractional reserve banking, it is important to understand the essence of savings and lending. The first myth to dispel is that money is wealth. Money is not wealth; real wealth is tangible physical goods. Your house, your furniture, your car, your golf clubs -- those are real wealth. Money, as the medium of exchange, is a claim on real wealth. Therefore, the act of saving is the expression of an individual’s preference to relinquish his claim on wealth today for a future date. It is very important to understand this. Money is a convenience that arose to facilitate trade. Before money, every trade was an exchange of real wealth (barter). With the introduction of money, every trade is still an exchange of real wealth, just temporally disconnected because the receiver of the money doesn’t complete his side of the trade (receive his goods) until he spends the money he received in exchange for his goods.

This is true of lending as well. Jones borrows $1000 today to purchase goods and services. Tomorrow he repays $1000, but is actually repaying what the money can purchase. He borrows real wealth, and returns real wealth. Therefore, lending entails a transfer of real wealth from lender to borrower. The existence of money tends to obfuscate this insight, but does not change it.

Bank lending

Recall that gold warehouses are storage facilities. An individual depositing money at a warehouse does not relinquish his or her ownership of it, and more importantly, does not relinquish his or her claim on real wealth. The money is still theirs to spend, it is just being safeguarded. This arrangement is a checking account. Alternately, the depositor may instruct the warehouse to lend out their money through a savings account. Here, a depositor relinquishes his or her ownership of the money to the lending institution and thus the would-be borrower. Restated, the depositor relinquishes his or her claim on real wealth in favor of the borrower. In this manner, real wealth is saved, and lent out. The transaction is still a trade of real wealth where money is merely the intermediary.

(The restrictions on savings accounts may actually be quite lax. There is a clear precedent in how mutual funds are structured today.)

Fractional reserve banking

Historically, gold warehouses (or was it goldsmiths?) found that their customers rarely withdrew their deposits; mainly because the receipts to the deposits were as good as the deposits themselves and thus came to be traded in their lieu. Therefore, much of the gold remained in the vaults untouched. Lending this gold at interest, they could make a good profit with repercussions only if more gold was demanded for withdrawal than was currently in the vault. Thus the practice of fractional reserve banking was born. Today, this basic scheme is operate on a large scale by all banks in a government regulated environment. The government establishes a reserve ratio, which sets the fraction of deposits that must be held at the bank. Thus, if the reserve ratio is 0.1, then 10% of all deposits must be held at the bank and 90% are free to be lent out. This has the net effect of allowing 9 times the deposited amount to be lent out. Here is how the process works:

Jones deposits $1,000 at bank A. With a 0.1 reserve ratio, bank A can lend out $900 of that deposit and keep $100 on hand as reserves. Let us say they lend out $900 and it makes its way to Smith – either he borrowed it, or the real borrower used it to pay him. Smith now has $900 that he deposits at another bank, B. Bank B, in turn, keeps $90 as reserve (10% of $900) and lends out $810 to someone else. This $810 is spent and deposited at bank C, which keeps $81 as reserves and lends out $729 to someone else. As this process continues, the total amount lent out by the various banks in the system adds up: $900 + $810 + $729 + …. The sum of this series is $9,000. The total held in reserve also adds up: $100 + $90 + $81 + $72 … = $1,000. Thus $9,000 of lending is supported by $1,000 in reserves. This is why most commentators will state that fractional reserve banking allows the lending of multiples of reserves. Technically, it is not the bank that received the initial deposit that can lend out a multiple, but rather the system as a whole creates it through the process described above.

Having described the mechanism, let us examine it more carefully. When Jones deposits $1,000 in his checking account, bank A issues him a receipt stating that he has $1,000 on deposit. This is a promise to pay $1000 dollars on demand. If bank A lends out $900 of that $1000 then they are no longer capable of honoring their liability to Jones. What they are banking on (excuse the pun), is that Jones will not attempt to withdraw his money before they are paid back on the loan they made. With a single customer, Jones, this is a reasonable risk. However, with hundreds of customers, it becomes far less risky since they can siphon funds between accounts and repay Jones with someone else’s deposit. What they fear then is a run on the bank where a critical mass of customers simultaneously demands withdrawals in excess of total reserves, making them insolvent.

It should be apparent to the reader by now that this is fraud, plain and simple. Some commentators will describe it as counterfeiting, but I think fraud is a more appropriate term as counterfeit bills are not at the root of the fraud. Far more important, however, are the consequences of fractional reserve banking on the economy.

Inflation and the business cycle

If you read my articles on inflation, it should be clear that fractional reserve banking is highly inflationary because it is nothing but an increase in the money supply. This, of course, is accompanied by all the attending ills of inflation, but none more so than the business cycle.

Recall that money is only a claim on real wealth. When Jones deposits his $1000 in his checking account, he does not relinquish this claim; he is merely choosing not to exercise it. When his money is lent out and spent on goods or services, those goods and services are diverted to individuals who would not have otherwise received them. Had Jones instead stuffed his mattress with the cash, he would have maintained his claim on real wealth and not lent out his money. However, placing it in a bank, he has unwittingly been defrauded into relinquishing his claim on real wealth and lending out his money. This is known as forced savings and is vitally important in understanding the business cycle. It is demonstrable that forced savings along with other related factors causes market dislocations that result in booms and busts. The business cycle is not an inherent instability in the free market caused by “animal spirits”. To suggest so betrays a highly superficial and childish understanding of the macro economy and catallactics. The business cycle is, in fact, a direct result of inflation and government intervention as Austrian have carefully detailed beginning with the publication of Von Mises’s masterwork on money and capital, The Theory of Money and Credit. I will explore these ideas more completely in my article on the business cycle. You can read Rothbards introduction here or Gene Callahans explanation here.


It has been shown that savings and lending are voluntary acts on the part of the lender and borrower to trade real wealth now and in the future. Fractional reserve banking undermines this, creating instability in the economy, and resulting in the business cycle. Further, fractional reserve banking should be correctly identified as fraud because it enables the multiplication of money and creates counterfeit claims to the unchanged pool of real wealth. One common argument often put forth by apologists is that the bank, through fractional reserve banking, can pay interest on deposits thus benefiting the depositor. That this argument is actually accepted in debate today is testament to how badly understood the theory of money and banking is. Whatever is gained in nominal interest payments is lost -- and more -- through inflation. The creation of fake receipts does not also coincidentally create real wealth; it only dilutes claims to it. Thus if the depositor had 10% of the money supply before (a claim to 10% of real wealth), he has less than 10% after, thus commanding a smaller claim on real wealth. Even if he has more dollars, those dollars are worth less. Thus, he enjoys a nominal gain, but suffers a real loss.


Rothbard on fractional reserve banking.
Rothbards great introduction to money and banking.
Mises on money, by Gary North.
Money, Banking, and the Federal Reserve, complete transcript.

No comments: