Posts Tagged ‘Fractional-Reserve’

(Note from author: I have recently been convinced that fractional-reserve banking, though it’s a bad idea, should not be outlawed.  The government should not outlaw bad ideas unless fraud or another for a violating rights is involved.)


In order to understand the Federal Reserve (FED), you need to understand credit expansion and the banking systems, which is full reserve and fractional reserve banking.  In order to understand the banking systems, you need to understand the nature of wealth and money, and their differences.

Money does not equate to wealth, or put slightly differently, money is not wealth .  If money was wealth, then why does printing money not increase the total amount of wealth in our society?  Sure, money can be traded for items that satisfy our needs or wants of utility, but as is, the paper is not useful — it’s only potentially useful.  What money represents — e.g., things that satisfy our needs and wants of utility — is useful, which is money’s source of value.

Money is simply a tool of exchange and a means of saving — i.e., the postponement of consumption.   Wealth is the goods you have at your disposal, which will satisfy your needs or wants of utility — i.e., wealth is your standard of living.  The wealthier you are the more you have at your disposal.

The implications behind the meaning of money — as a tool of exchange and a means of saving — are that to possess money you must have produced something of value and passed on your disposal of it to someone else in exchange for an IOU on society — the trade isn’t complete until you trade that IOU for something you need or want.  In essence, you’re bartering and exchanging what you produced for something you haven’t produced — money is simply the median or the “middle-man.”  Money has value but it doesn’t represent a static standard of wealth.

Think of the errors that one might conclude if one equates wealth to money consistently to that end:

1.  Wealth can be produced by reproducing money

2.  Wealth is only as static as the amount of money that exists, which leads some to assume wealth is static

3.  Since wealth is static, then it’s only fair to redistribute it evenly (a common argument)

4.  Profit is exploitation and wealthy people must have exploited the poor (another common argument)

5.  The exchange of money means one benefits at another’s expense

6.  Exporting is good because it brings in money, and therefore, wealth (another common argument)

7.  Importing is bad because it sends money out, and therefore, it drains our wealth (another common argument)

8.  Money just sitting on a table does not multiply; therefore, lending money cannot multiply wealth; therefore, lending money at interest is charging for something money has no ability to produce — more money; therefore, money should be lent at no interest, otherwise it’s exploitation (not an uncommon argument)

People in our society also tend to equate the dollar value of an item as its worth — another error.  Let’s say an item produced was originally $8 per unit.  Now let’s say that half of the items were destroyed — the unit may now be closer to $16.  Instead, let’s say that the money supply reduces by half — the item may now be closer to $4.  In the first case the item’s value relative to demand went up, and in the second case the value stayed the same relative to demand, but the price went down — the value of money fluctuated.  (We are assuming of course that the effects of inflation were instantaneous).

There are many reasons for the value of money to fluctuate.  For example, we could create more money, it can be destroyed, people’s interest in it could change, more things are produced, fewer things are produced, and probably more variables have a play (like foreign currency) than what I have listed.  (A speculator’s sole purpose is to predict these fluctuations and act on those predictions).  People’s desire is hard to predict, which means desire would be hard to predict for any kind of currency whatever; therefore, let’s limit the scope of our study to the aspects that cause fluctuations that can be predicted — like production and the creation of money.

Let’s first analyze what different effects that fluctuating currencies has on wealth.  Gold is a great place to begin our study because, compared to fiat money, gold has a relatively static quantity.  We’ll then shift our focus to fiat money because it contains a lot of the same principles as gold, but in addition to those, fiat money can rapidly multiply.

Given our study, the only real means for gold’s value to fluctuate is a change in the production of goods.  If production increases, then deflation takes hold, which means the value of gold goes up (relative to goods) because you can buy more with the same amount of gold.  If goods and production are destroyed, then inflation takes hold, which means the value of gold goes down (relative to goods) because you are able to buy less than before.

What happens to the treatment of gold as its value decreases? People tend to exchange more of it for goods because a certain amount of gold does not go as far as it used to; therefore, people pay more to receive the same about of goods.  The less gold is worth, the more people prefer goods over gold.  One can anticipate a threshold for the use of money — i.e., men in society have to reach a certain level of production, which isn’t much, to warrant the use of money over barter.

Who are the winners and losers if the devaluation of gold occurs?  The wealth in savings decreases along with gold — savers lose.  The total amount of goods decreases, and therefore, so does the standard of living  — everyone loses.  Because the standard of living decreases, people are less able to store their money in banks — the banks lose.  Does anyone win in this case?  I don’t think so; I can’t think of anyone who benefits.  Maybe those who take out loans benefit by paying back the loan with less valuable money than they borrowed, but that’s isolating a particular situation of the borrowers whole life; his standard of living will decrease with everyone else’s.  Even if someone ends up better off than before, they would be even better off if devaluation did not occur.

What happens to the treatment of gold as its value increases?  People tend to exchange less of it for goods because a certain amount of gold goes farther than it used to; therefore, people can buy the same things with less gold leaving them with change in their pocket.  The more gold is worth, the more people prefer gold over goods.

Who are the winners and losers if the value of gold increases?  The wealth in savings increases along with gold — savers win.  The total amount of goods increases, and therefore, so does the standard of living — everyone wins.   People are able to save more money and borrowers pay back loans with more valuable money — the banks win.  (Sure, borrowers need to work harder to pay back the loan, but that’s no different than paying interest).  Some people will lose, but only on their own efforts and risk to capital.

To sum up, a gold currency will tend to guide self-interest people towards production and savings making everyone a winner.

Shifting our attention towards fiat money; it has all the fluctuations of gold (as mentioned above) except in addition to those fluctuations, its value can fluctuate easily by reproducing or destroying it.  Since the destroyer of fiat money is the sole loser, however, we can assume no one is that self destructive; therefore, we can limit our focus solely on situations covering the production of fiat currency.  In order to isolate the effects of printing money, we need to consider a scenario with static production, meaning the same products are produced every year.

To begin, as one spends freshly printed money, he removes from society the product of their labor without reciprocating.  This causes more money to exist than what goods have been produced; therefore, the more money you print and spend, the lower its value will become due to inflation.

Inflation is not instantaneous because it takes awhile for its effects to propagate.  The information only propagates as the money exchanges hands.  For example, one can print a pile of money in their basement, but until they spend it the effects will be contained in his basement. Why is this?  Because the printer of money hasn’t made a claim on society by spending that money; it’s not until he removes goods from society without producing goods that society finally begins to realizes there are less goods than before (relative to money).  T he first recipient of freshly printed money may not know the money he’s receiving is printed, but after several exchanges people will adjust their prices when more demand for goods (relative to money) increases.  On the other side of the exchange, the first user of freshly printed money extracts its full value before inflation, but as the exchanges continue, the value extracted decreases as inflation increases.

Who are the winners and losers when money is printed?  The printer of money obviously benefits by being able to consume goods without producing them; however, this causes a strain on everyone who does produce equal to or more than they consume because the printer of money consumes what they have produced — everyone else loses.  The individuals who save money lose wealth in their savings as the value of their money is redistributed into the new total of money — they lose.   Those who take out loans benefit more than savers in the short run because the money they use to pay off the loan is worth less than the money they borrowed; however, in the long run their standard of living decreases with everyone else’s.   There is a point where the standard of living suffers so much that one is unable to pay off a loan and buy sustenance — i.e., their life is no longer self-sustaining. These borrowers go bankrupt, thus consuming the goods of society (spending the loaned money) without producing (not paying off the loan) — they join a similar status as printers on money.  So those who benefit the most are the printers of money and the borrowers of money  (for the short term) — neither of which produced anything for the privilege of spending money– while everyone else suffers.

We now know the different causes of fluctuations in the value of money that can be controlled, which means we discovered enough context to continue onto the banking process; and after that, the Federal Reserve.

Given a static value for currency, let’s see what purposes or value a bank provides.  If men had the ability to keep all their money on their person, then the necessity of banks goes down.  If men could secure their money better than banks, then the value in using a bank goes down.  Since men have trouble keeping all of their money on them securely, banks have value.  This is why men uses banks; for security and ease of use.

The first banks that were used kept money in a vault, and they never lent any of that money out; that type of system is called full reserve banking where 100% of the deposits are kept in their reserves (AKA their vault).  Banks were able to stay in business because they earned money for securing its members’ money — people would pay the banks to secure their money.  The banks would also lend out money that they owned at interest.  At times, they even acted as middlemen between one of their depositors and a borrower and earned some sort of commission on that money.  Full reserve banking does not cause the value of money to fluctuate because it doesn’t reproduce money nor does banking in and of itself produce enough goods to change the value of money — it just secures the principle of property rights ensuring property owners keep their property.

A second system of banking is called fractional reserve banking, and, as the name sounds, the bank is able keep less than 100% of their deposits in reserve, which means the banks can lend out depositors’ money at interest without their knowledge.  The depositors no longer have to pay banks to secure their money because the cost is paid by the interest earned on the lent money; in fact the bank earns so much money that they pay the members for storing their money in their bank.  This banking system causes the value of money to fluctuate, so this warrants further analysis.

The essential difference between the two systems that causes the value of money to fluctuate under fractional reserve banking, but not under full reserve banking, is that for full reserve banking the lender losses access to their money when a loan is created.  For fractional reserve banking, however, loans are made without any lender losing access to their money .  It is important to understand this difference and its full implication because without doing so would mean increasing your risk of making bad evaluations in your conclusions based on this information — like people often do after they equate money to wealth.  First let’s further understand the difference before we get into its implications.

For full reserve banking, when a loan is made the lender sees the money leave his account along with a place holder (or an IOU) for that money; the person taking out the loan has the money along with a negative place holder.  Each place holder and money, or lack of money, counter balances each other — i.e., money with a negative place holder, and lack of money with a place holder cancel each other out.

For fractional reserve banking, however, the bank sees the lack of money along with a place holder, while the person borrowing the money sees the money along with a negative place holder — seems equivalent to full reserve, doesn’t it?  Well, not quite.  Where does the bank get the money to lend?  Is that their money?  It can be, but more than likely that money comes from a depositor.  (It doesn’t matter if the bank uses $100 from one depositor or 10,000 pennies from 10,000 depositors — the essentials are the same regardless of the break down).  What place holders or money transfers do the depositors see?  The answer is none — they see 100% of their money in their account.  Is this a problem?  You bet it is — it’s the root contradiction which causes secondary and tertiary effects down the road.

A contradiction follows the formula of something that is and is not at the same time in the same respect.  Well in the fractional reserve bank’s example, the depositor’s money is his (as displayed in his account) and is not his (as displayed in someone else’s account) at the same time (from the initiation of the loan until it’s paid off) in the same respect (as seen in an account) — the very definition of a contradiction.  It is inessential that the banks have not named one depositor they’re taking from when they take from the pool of money in their vault  — that money came from somewhere and doesn’t eliminate the contradiction.  It is inessential that the lender puts collateral up against the loan to counteract the risk of default — it doesn’t eliminate the contradiction.

The contradiction is the single piece of essential information because contradictions cannot exist and every attempt to bring a contradiction into existence has resulted in some sort of annihilation.  For example, think of the results of carrying out polices based on equating money to wealth — e.g., you seek to print more money, you wage war to confiscate money, you eliminate trade as people attempt to sell their products and boycott yours and vice versa, etc.  It eventually results in the annihilation of whatever value you were trying to create — i.e., money and societies lose their value.  In the case of fractional reserve banking, as we will discover, the results are the same — i.e., the retardation of wealth at best and destruction of wealth at worst.

(This particular contradiction within fractional reserve banking is also a violation of property rights, where property is necessarily singular ownership — i.e., one thing one owner.  For fractional reserve banking, multiple owners exist for a single thing — i.e., depositors and borrowers own the same dollar.  Of all the economic reasons I’ll go over in explaining the perils of fractional reserve banking, it is the argument for securing property rights that should be sufficient to a free society, that has any interest in remaining free, in ceasing the act on moral grounds and making it illegal).

In full reserve banking, the amount of claims (potential claims) on society are never greater than (and are actually equal to) the amount produced — i.e., the producer lends his claim on society in exchange for interest, which is paid by the borrower.  In fractional reserve banking, however, you have greater claims on society than what has been produced because you have producers who do not lend their claim on society, and you still have borrowers who acquire a claim; this creates a lag effect, where claims on society increases faster than what is produced.  Where did the increase in claims come from?

So how did the banks succeed in creating a contradiction if they cannot exist?  How is it that the depositor’s money is and is not his at the same time in the same respect?  I’ll I’ve you a hint, a contradiction cannot exist.  When you think you’re facing a contradiction, check your premises; you’ll find that one of them is wrong.

Our essential premises are that the depositor still has access to his money and that the money supply did not multiply.  We know that bank runs can occur, which leads one to suspect the former.  We also know that the depositor can use his money (under normal conditions), which leads me to suspect the later.  The truth is that both premises are false under different contexts, and both are never true at the same time.  The double contradiction only serves to further conceal the contradiction — it allows most to accept the lie that both premises are true, which is only half of the truth when in fact both are never true at the same time.  The reason that two contradictions seem to exist is because the respects (remember “…in the same respect”) change subtly making it hard to track.  In one respect, the money is owned on paper, and in another respect the money is owned physically.  On paper the money supply multiplies and physically it does not .  So when the money is owned in one respect, let’s say physically, then the money supply premise is true, while all depositors having access to their money is false.  If money is owned in the other respect — on paper — then all depositors having access is true, while the non expansion of the money supply is false.  (I suggest rereading the arguments surrounding the different respects of ownership until it sinks in).

A fair number of people see that both premises are false under different conditions, but fail to understand the implications or severity in accepting the contradiction.  They obviously understand from history that bank runs are bad, but think they can be avoided and see no negative repercussions for expanding the money supply.  We understand, from our discussions of inflation, why expanding the money supply is bad.

Who are the winners and losers under fractional reserve banking?  Savers find that the money they saved loses value over time more than the interest they earn on that money — they lose.  More consumers than producers exist at any one time   — everyone loses as the standard of living suffers.  Bankers are able to earn a ton of money from interest on money they didn’t own — they win, but only for the short term because their standard of living suffers more than it would have if the money supply didn’t expand.  (It’s would be difficult for bankers to understand this because they can potentially make 45 cents on the physical dollar every year).  The borrowers win in the short run by paying off the loan with less valuable money, but like the bankers, their standard of living suffers in the long run for the same reasons as bankers.  There is a point where the standard of living suffers so much that one is unable to buy sustenance and pay off their loan — their life is no longer self-sustaining.  Unlike full reserve banking, however, where the lender would lose his money along with the person he lent money to, no depositor “loses” theirs under fractional reserve banking.

A limit exists for how much banks can lend out, under fractional reserve banking, and still function.  If they keep 100% in reserves, then it’s no longer fractional reserve.  If they lend out all of their reserves, then they default on any withdrawals, which results in a bank run.  What number, between 0% and 100%, allows a bank to function and allows depositors to have access?  It really depends on how much people need money.  The ability for people to save increases as the standard of living increases; and vice versa as the standard of living decreases.  In addition, when people borrow money, they use unconsumed goods — i.e., what would become savings — to pay off the principle and the interest.   There is a point, therefore, like there is in the use of money, where the standard of living needs to reach a certain point before fractional reserve banking can exist because people need to save money in order for fractional reserve banking to function and people need to earn enough to save.

Let’s assume that we reached the limit of credit expansion, what happens when we reduce the amount of credit by paying off loans?  Deflation occurs.  Is this a good thing?  We discussed earlier that deflation is good, but in this case, it is good only under a certain context.  The savers benefit because the value of their money increases — they win.  The standard of living increases as more goods are consumed when people start to pay off loans — everyone wins.  The borrowers suffer because they need to pay back the loans with more valuable money than they borrowed — they lose, but they would pay interest anyway.

Deflation is bad under fractional reserve banking, however, if it occurs rapidly.  For example, the faster deflation occurs the harder it will be for borrowers to pay off the loan and buy sustenance, which increases their likelihood of bankruptcy.  Borrowers lose the ability to pay off the loan because they now need to work several times harder (up to 10 times) to pay off loans — they lose.  The more borrowers that go bankrupt, the less money the banks will have to pay depositors their interest.  The less the banks have to pay depositors, then the more likely they will go bankrupt — they lose.  If a bank manages to avoid bankruptcy, they will still be unable to return to full reserve banking; that equates to lost value.  The bigger the gap between what the banks have in reserves and what the depositors have in their accounts, then the more value is lost — savers lose.  The more value that is lost, then the more the standard of living suffers — everyone loses — e.g., the market crash of 1929.  The trend of fractional reserve banking is to resist returning to full reserve for that exact reason — everyone loses.

So at the limit of fractional reserve banking — meaning the reserves are at their lowest and the expansion of the money supply is impossible — is it better than full reserve banking?  Under full reserve banking production matches or surpasses claims to consume, the standard of living matches advances in production, and property rights are protected.  Under fractional reserve banking at its limit, production lags behind claims to consume (remember there are more claims to consume than what people produce due the fractional reserve banking contradiction), the standard of living matches advances in production, and property rights are violated.  All being equal, if my evaluation is correct, a full reserve banking society would improve their standard of living at a similar rate to that of a fractional reserve banking society; however, there would be a period of time, for the fractional reserve banking society, when the standard of living would lag behind until the limit of expanding money is reached.  The icing on the cake (sarcasm), however, is that everyone’s property in banks are constantly at risk because they are relying on others not to make a physical claim on their money.  As our standard of living continues to drop, how much longer to you suppose people can live without making that physical claim?

We talked about the nature of money, the ways in which it can fluctuate, different systems of banking, and the implications of each; now we have a great base of knowledge to discuss the FED.  Every fact you read about the FED is true, but not the evaluations.  For example, they do control the money supply by setting the interest rate for loans, but that is not in the long term interest of anyone, and only serves the short term interests of very few people.  They don’t print money and loan it out, they simply loan money in the form of electrons, and fill their reserves with printed money that the US Treasury Department printed — essentially the same thing as loaning printed money.  They actively strive to cause inflation, between 3% and 5% every year, which continually increases the limit   of fractional reserve banking; thus, avoiding the system’s natural limit.  The FED is able to loan money even if there are no depositors to back it up.  Depositors become an old fashioned notion when the production of every dollar carrying person is backing up the freshly printed bills.  This leads us to our next question: is fractional reserve banking better than full reserve banking if the natural limit placed on fractional reserve banking is removed?  The question reduces to, is steady inflation better than steady deflation?  You have the information; you be the judge.  I suggest starting with the lagging of production behind consumption that we discussed in fractional reserve banking, which would necessarily continue and become greater.  Is that good?  Do you think there is a possibility where the increases in claims to consume would surpass the advances in production?  And finally, do you benefit?

The FED is convinced that their actions are in the best interest of the country, and therefore, in your best interest — that is their evaluation.  What is yours?


(Note from author: I have recently been convinced that fractional-reserve banking, though it’s a bad idea, should not be outlawed.  The government should not outlaw bad ideas unless fraud or another for a violating rights is involved.)

The origination of the idea:

Where does the idea of fractional-reserve banking come from? The short answer is goldsmiths implemented the idea to depart from full-reserve banking. Back when gold and silver coins were the primary means of currency, goldsmiths kept deposits of gold in their safe for a small fee. In return the depositor would receive a receipt for the exact amount of their deposits. After a while, the receipts grew in popularity and were circulated just as much as the physical metals were themselves — after all, they were as good as gold. The deposits in the goldsmith’s safe were collecting dust and the smith realized that very few people came back to collect their deposits because they were using their receipts instead. The goldsmith would then lend out the deposited gold at interest while keeping some in reserve just in case someone returned for it. The depositors didn’t mind too much because they received their gold when requested (more or less) and because instead or paying for the storage fee, they would receive interest for their deposits; thus, the birth of the fractional-reserve banking process.

Money To Be Made With Little Risk:

Who is making the money? In short, the bankers are. They are earning interest on money that is not theirs. Getting back to our previous example, let’s say for the sake of argument that the bank makes 8% interest for money on loan and pays 3% interest for deposits. Given our example, there is $9000 loaned out and $10,000 in deposits—or $9000 loaned out, and $9000 + $1000 in deposits. To simplify, that means the bank is making 5% on $9000 (8% on $9000 — 3% on $9000) and paying 3% $1000. $9000 is $1000 times 9; so to simplify even further, that means the bank is making 45% (5% times 9) on $1000 and paying 3% on $1000. And to go the rest of the way, the bank is earning (when all is said and done) 42% (45% — 3%) on that original $1000, which was not originally theirs. There is a ton of money to be made off of money that doesn’t belong to you. Is this process sustainable?

The Sustainability Of This Contradiction:

Continuing with our example, one can see that eventually the bank will own at least $1000 on record—only about two iterations of interest payments is 86% of $1000. There is still $9,000 on record for loans and $10,000 for deposits. Ok let’s assume the bank makes $1000 and withdraws it out of the system (the most extreme scenario) and puts it into an off shore hedge fund leaving everyone else to pay back $9000 in loans with zero money available. This will create an infinite demand for money and no means to quench it. Or in the case of a bank run instead, where everyone pulls out at the same time leaving those last in line with lint in their pockets. The only result of either scenario is deflation (in this case by 10 times), leading to a depression.

Ok, this obviously cannot be sustained given my little example, but what about on the scale of an entire country (or the world)? Macroeconomic effects are made of microeconomic events; therefore, if something cannot work at the micro level, then how can it possibly work at the macro level? The answer is it can’t. The part cannot contradict the whole. The best you can hope for is to patch it up the best you can temporarily, and they do, until the system ultimately fails—like in 1929 or any end to any bubble.

(Note from author: I have recently been convinced that fractional-reserve banking, though it’s a bad idea, should not be outlawed.  The government should not outlaw bad ideas unless fraud or another for a violating rights is involved.)


The Basics:

Law of Identity: A is A

Law of Excluded Middle: Anything is either A or non-A

Law of Contradiction: Nothing can be both A and non-A at the same time in the same respect

Law of Causality: The relationship between cause and effect

The Problem:

Fractional-reserve banking is a fraudulent process because it violates the law of contradiction. Because it is a fraud it is incompatible with the free-market; therefore, free-market laws should prohibit such frauds and protect individuals from it. Our whole financial system, however, is designed around concealing that fact and it’s designed around sustaining its operation besides. The motive for maintaining this particular contradiction (as far as I can tell) is that there is a ton of money to be earned and because it’s lasted this long thus far (i.e., status quo). It will soon be coming to an end, as most contradictions eventually do, one way or another; either by choice or by the implacability of reality rearing its head — I sincerely hope for the former.

Why fractional-reserve banking is a fraud:

What is fractional-reserve banking? Fractional-reserve banking is what allows banks to lend part of its deposits (AKA assets) while maintaining a small fraction (in this example 10%) in reserve; thus, the term “fractional-reserve banking”. That doesn’t sound so bad, that is until one carries it out to its logical conclusion.

Let’s say for the sake of argument that only $1000 exists in circulation, only one bank exists, and there is only one depositor (so far) at this bank, who deposited the existing $1000. The bank can now lend $900 while maintaining $100 in reserve. That $900 gets spent and then deposited back into the bank. Because banks do not care about the source of their deposits, that $900 is counted as an asset. The bank can now lend 90% of $900 while maintaining 10% in reserve. That lent money gets spend, it’s deposited back into the bank, and it’s counted as an asset which the bank can now lend 90% of again. This cycle can continue until the very last penny. The result being that $1000 is in the reserve (the original $1000), $9000 is on the books as lent out, and $10,000 is on the books for deposits. That should raise a few eyebrows, but it gets worse.

Here in lies the contradiction; that $1000 is claimed to be owned by several people. People will spend their deposit as though they own it. People will assume that their money exists in full. Keep in mind that nothing can be A and non-A at the same time in the same respect – that would be a contradiction. In this case, that $1000 belongs to the first depositor and not to the first depositor at the same time in the same respect — that is a contradiction. Any one or all of its many owners may go the bank to claim “their” money — you better be the first one in line though because only $1000 exists.