Money creation in a fractional reserve banking system (beginner's question)

Economics Economics Questions
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1

I’m trying to get my head around fractional reserve banking and had a couple of questions about this…

So as to avoid rewriting something that’s already been quite well explained, I’ll use the following as a starting point:

http://en.wikipedia.org/wiki/Fractional-reserve_banking

OK, so basically if we have a reserve requirement of 10% and the central bank “creates” $100 worth of central bank money, the commercial banks then use this to “create” a further $900 of money that various people in this economy now have at their disposal to conduct their day to day affairs (buying and selling goods and services from one another).

That $900 represents both the total amount of deposits and the total number of loans in the system… however the deposits will be earning an interest rate which is inferior to the that of the loans - so to keep things simple, imagine that deposits are earning 0% and loans are made at 2%. Also to keep things simple, imagine that the only thing that the loans were used for was to buy widgets.

In order to pay back all of their loans, the various people in the economy (let’s call them the villagers) need to come up with $900 + interest, or $900 x 1.02 = $918… which you will note is more more money than they have at their disposal. If all the villagers pooled together all of the cash at their disposal then they’d only be able to scrounge together $900, so they’d still fall short of their loan repayments by $18. As such and failing the injection/creation of new money, a certain percentage of the villagers MUST necessarily default on their loans (regardless of how hard they’ve worked, saved or how many widgets they’ve all made).

So basically, my questions is one of money creation. From what I can tell, the only point at which new money can be injected into the system is the central bank. However we have the central bank at one end of the system , the commercial banks in the middle and the villagers at the other. Injecting cash into the system at the central banking end of the the system will only excacerbate the problem. The only kind of “money creation” which could alleviate this problem would be the kind of money creation that injected money into the system at the other end - i.e. money “created” by the villagers.

So my question is, how can the “villages” in this system create the money that they need to pay back the interest on the loans that they HAD to take out in order for there to be any money in the system at all? From what I can tell, this is a mathematical impossibility. The villagers have been hobbled right from the get go and there’s nothing they can do about it???

2

The villagers can buy money from the bank in exchange for goods and services, thus the amount of money that can be paid back to the bank is theoretically limitless.

3

Let’s say Bob takes out a loan for $100, and pays Joe with the money, and then Joe deposits $100 in the bank. The bank can then loan out another $1000, which Bob borrowes and pays to Joe, and then Joe deposits $1000 in the bank, who can now lend out $10,000. . . .

Can this process be repeated forever, with the bank’s generated money expanding without bound?

4

No, you’re confusing two fundamentally different types of reserve ratios. The one which allows a bank to multiply $100 by 10 to create $1000 only applies to central banks. The commercial banks however are only allowed to loan out 90% of their money, so on $100 deposited they can only lend out $90. Once this money is once again deposited, $81 is lent out, and so on as the amount approaches $0. So central banks multiply by the ratio (in this case 10) while commercial banks divide by it. This is also why onbooks it appears as though commercial banks always have 10% mroe deposits than loans, creating the myth that they actually loan out their deposits.

In effect, if a central bank has $1000, with a reserve ratio of 10:1, the central bank can create and lend out $10,000. This 10,000 isthen re-deposited in a commercial bank which lends out $9,000, then $8,100, etc. In the end money initially owned by the central bank is multiplied by 100 times, giving us $100,000. That is if the cycle isn’t interrupted (by hoarding). Of course, if the reserve ratio is larger, and in some countries such as the UK and Canada it is no longer present at all, then a lot more money can be created.

5

Technically I don’t believe the banks have reserve requirements anymore, so there is no limit to how much they loan out so long as they manage to supply cash when demanded.

The problem is sometimes people demand all their cash at once, but that is just one of those 25-sigma events.

6

However, if the only way to reverse the perpetual default of debt by the villagers is to sell goods and services to the bank, won’t this create a perpetual transfer of wealth to the banking system to avoid perpetual default? If the villagers are only selling products and services to the bank to counteract the excess interest due relative to the total money in circulation, they are still losing value to the banks to keep the system functioning, so the system still ends up with the banks owning everything and/or the system collapsing… is that accurate?

7

Yes that sounds right to me. This is why banking, together with inflation is usually equated to theft.

The biggest question is not how the system works, but whether this came about naturally, or whether it was a big scheme all along. I don’t think we’ll ever know, but I can tell you that the media’s 300 year silence is not helping the widespread ignorance of what FRB is.

8

I suppose you ought to expect that if you never pay down the principal of your loan.

9

If the only source of money is a loan that is not accompanied by the creation of the interest needed to retire the loan, then a system of perpetual debt is created. There is not enough money to pay back the loan and the outstanding interest. This is the basis of fractional reserve banking. This is why it is inherently unstable - it creates perpetual insolvency (if all all callable loans were demanded, there would not be enough money in the system to pay them back). When fractional reserve banking is combined with an inelastic money supply, there will be panics as the money supply will not be able to be altered fast enough to cover the instability. This is why we have abandoned the gold standard. It is thought that gold is too inelastic. This is a mistake - it is not gold that is too inelastic, but that fractional reserve banking is too unstable.

In a true free-market, one would be able to use either a fractional- or full-reserve bank. The fractional-reserve banking customer would be responsible for his decision to use a cheaper, yet more volatile, business to store his money. Unfortunately, this option is unavailable because our democratic system allows citizens to steal from others when they make poor choices about future risk. As a result, the citizenry has used the government to subsidize and institutionalize fractional reserve banking, and they have institutionalized a monetary system that is ‘flexible’ enough that the risks that some take are spread over the dollar holding public at large. This spread of risk makes it cheaper to feed at the public trough than to engage in responsible behavior - when risk is removed from the decision-making process, the decisions become increasingly risky.

The moral course of action would have been to criminalize fractional reserve banking, instead of criminalizing gold - but the public was not aware that it was the instability of the fractional reserve system and not the inelasticity of the money supply that was causing the banking panics before the Federal Reserve Act.

10

Well put.

It seems as if the problem does not lie in the system itself, but in we the people who have authorized it through the outsourcing of personal consequences to a communal pot, creating a system where we cannot feel the pain of our poor decisions today (which initiates immediate positive behavior change to mitigate the pain), but instead we can make years of poor choices blithely ignorant of the eventual boiling point of a society that does not feel direct consequences…

The problem is that we the people wanted more than we could have in a balanced system, so we demanded an unstable system that could give us more now. The source of the problem is “we,” not “they.” Look how fervently we the people are demanding universal health care and increased minimum wage standards; we don’t want to know the eventual consequences; we want the goods, and we want them now.

With that said, an education system bent on the indoctrination of we the people to depend on the mainstream media and government for our every need and pleasure certainly plays its part, but if we were a proactive people, there could be no hidden deceit. We are responsible, whether or not we acknowledge it. If we change us, the system will change too.

11

It is an interesting question whether the usurpation of wealth from the people to a centralized banking system is intentional and planned by an “elite,” or whether it is simply a natural consequence of Darwinistic Capitalism and the selfish orientation of that economic system. I expect we can know the answer if we stop watching the mainstream news as if its journalistically balanced and start asking the right questions, scrutinizing every decision of the banking system and the government.

One thing I do know for sure, and it is not commonly acknowledged, is that those institutions are comprised of fallible people that could easily be acting in their own interests rather than in the public interest. Considering the system of power we currently have and the importance of money in the political system, I would say it is more likely than not that the majority of public “servants” are actually self servants. Money and power are more than enough motive to deceive.

With that said, when the government makes a big decision, or the mainstream media begins to focus on a particular movement or issue, consider, “What advantage is this decision or focus for the agents of that decision or focus?” There is usually a much more reasonable answer to that question than the one given.

But, like I said, the question still stands, and I don’t whether it is premeditatively planned and executed or a simple matter of chance. You would think that the most experienced and best educated economists in the world would be able to see what we simple-minded amateurs can see plainly, but perhaps they are just too blinded by their own lust for power and wealth to ask the right questions. On the other hand, perhaps that same lust is what drives them to use their knowledge to carry out such an evil plan.

In conclusion: Good question.

12

Surely the same problem exists with a full reserve banking system as well though? If the commercial banks loan money to the villagers and expects them to pay back the principal + interest, you are still left with the problem that there is not enough money in existence for the villagers to pay back the interest. Unless the villagers have some way of “creating” money, at very best, they are only able to pay back the principal.

I can see one potential (although darstedly) way around this with the current banking system. There are currently two kinds of central banks: private and public. The New Zealand central bank (the Reserve Bank of New Zealand) is an example of a public central bank, which doesn’t really offer a solution to the problem, although I should say that I see it as the better of two evils. The Federal Reserve Bank is the US is an example of a private central bank… when the commercial banks pay back loans that they’ve taken out from the Fed (+ interest) the interest represents a profit to the shareholders of the Fed, which the Fed can then pay out as fat bonus cheques to it’s employees or as fat dividend cheques to it’s shareholders… money that those shareholders and employees can then spend in the economy thus injecting the missing money back into the economy (this profit will be exactly equal to the amount of money that was missing from the equation above). So although this makes the system more “sustainable” it still results in a net transfer of wealth from the villagers to the commercial banks and then from the commercial banks to the Fed (which as it turns out, I think is owned by a consortium of commercial banks so basically we have, on the balance of things, a transfer of wealth from the villagers to the bankers).

My main problem with all of this is that it’s not credible - I can’t believe that the system could exist in this form? Surely I’m not the first person to have noticed that such a system is fundamentally broken… So I can’t believe that the system is actually like this. There must be something that I’m missing here…

13

Rhys, good post. I have a question for you though.

I understand perfectly well how a full reserve banking system would make a profit (by charging customers to safeguard money). I don’t however see a solution to the problem of offering loans.

Loans are obviously a necessary part of investment, and the only incentive to provide a loan is the interest one can gain from it, what’s more, is the interest is the only motivation for the debtor to repay his credit. Yet if this interest is not added to the overall money supply, then how does one pay off his loans? This creates the problem of insolvency, but how is this problem solved? I don’t see how you could simply inject the extra interest required into the money supply, I mean, who would you give it to?

Basically the question is, how do you create a banking system which allows loans with interest (since without there would be none) without creating inevitable insolvency?

Edit: Jimmy, didn’t see your post, and I think it fundamentally poses the same question.

14

The value of trade goods incl. money is not static.

15

That may be the case, but when you sign a contract for a loan at your bank you’re asked to repay the loan (and the interest) in dollars (or whatever currency is stipulated in the loan contract). You can’t walk in at the end of the loan contract and give him back, say, the principal in dollars and the rest in cakes and fish! And I believe the same is true of the loans that central banks make to commercial banks.

About the only thing that I found in the wikipedia article (that originally linked to in my original post) which might indicate a way out of this is that the central bank can sometimes buy “financial assets” from the commercial banks - which would be an alternative way of injecting cash into the system… and by alternative here I mean an alternative to a loan. However this depends what is meant by a “financial asset” since typically when banks refer to as assets they are referring to loans that they’ve made (or mortgage backed securities or whatever, which amounts to a complicated version of the same thing)… and loans can only be made on the basis of reserves, which can only be issued by the central bank - so I don’t see how that solves the problem for the villagers either.

If gold and silver can still be used as reserves then one way out of the dilemma would be for our villagers to start a mining company - since they could then use new gold and silver that they dig up to pay back the interest on their loans. If stocks in companies could be used as reserves then the villagers could start companies like Google and use value that they “create” (such as the goodwill in these companies) to pay off the interest on their loans… any way you look at it though, the villagers need to find something other than cash that they can use to pay off the interest on loans they take out, and commercial banks must do the same thing for the interest that they will accumulate on central bank loans.

So to rephrase the question, what are the “financial assets” that central banks might purchase from commercial banks as a way of injecting extra central bank money into the system without creating any corresponding debt?

PS: This still implies a net transfer of wealth from the villagers to the bankers, but at least provides a ray of hope that defaulting on their loans is no longer an inevitability.

16

I’m in no shape or form an expert, and please excuse the english… But here my explanation goes:

Okay, so assume we have an economy where there are two people: mister Smith and mister Anderson. Say that mister Smith has $200 which he is willing to lend at an interest. Mister Anderson borrows $100 from mister Smith at a 10% interest. Smith now has $100, and Anderson has $100. So there’s still only $200 in the economy.

( And iff this were Frac-Res-Banking with a reserve rate of 10%, Smith would have $190 (200 - 0.1 x 100) and Anderson $100, which means the total amount of money would have been $290 (since you don’t need to give up 100%, but only 10% of the amount you’re lending). This means the purchasing power of the money would have dropped, making goods more expensive (inflation). )

Now, in order to pay back these extra $10, what does mister Anderson have to do? Well, of course, he needs to make $10 somehow. And in this economy of two, the only way he can make money, is either by selling goods or labor to mister Smith. So he works a bit, and sells a few things, and for this Smith gives Anderson $10. Anderson now has $110 (Anderson didn’t spend his borrowed money in this example) and Smith only $90.
Now Anderson pays back $110 to Smith. Smith now has $200, and Anderson $0. Exactly the same as before.

But wait, doesn’t this mean that Smith didn’t make anything? He still only has $200 after all. Doesn’t there need to be more that $200 in the bank account in order for Smith to have made a profit?

No. While Smith still only has $200, he has in fact gained goods and some labor from mister Anderson. So he has still made a profit, just not a monetary profit (instead he has made goods and labor).

So… What happens if Smith were to lend all of his $200 to Anderson? What if all the money in the economy simultaneously was being loaned at an interest? So, what happens when Anderson has paid back $200? He needs to make $20 somehow! He now realises that there is no more money to give to mister Smith… So in order to pay his debt, what does he have to do? Well of course, the only way for him to make $20, is by selling goods or labor to mister Smith. These goods and services would be the “collateral”.

Now you might ask… What happens if Anderson has no goods or labor to sell to Smith? Well, if there was collateral, and Anderson somehow managed to destroy it or whatever, this means Smith suffers a loss. Anderson has “stolen” these $20, since he is unable to repay it either with money or collateral.
If there was no collateral… Well, who in their right mind would lend money out without collateral? This means the risk of not getting money back is quite big. :slight_smile:

The fact that Smith knows with decent accuracy if Anderson will be able to repay him or not, determines if he is going to lend his money out or not (and at what interest). If Smith knows for sure that Anderson would be unable to pay back his money (either in terms of money or collateral), he certainly wouldn’t lend it out. And if he did, he would know for sure that he wouldn’t actually be payed any interest, and thus he would be involving himself in “charity”.

So even though the money supply isn’t changing, people can still make profits (in terms of labor and goods).
The fact that you don’t know for sure if you’re going to get all of your money back, is what gives rise to the risk-part of the interest rate.
The only real, decent reason to be able to create extra money would be to compensate Smith for his loss if he didn’t get the money or collateral back from the person he lent to. As in, the ability to reprint the “stolen money” which Anderson took from the economy in the last example.

Hope that makes sense!

17

Aha… yes that makes a lot of sense - thanks Eli. I’m sorry I already posted a reply to a previous post before reading your post.

In any case, as I mentioned in my other post, the commercial banks are in more or less the same position vis a vis the central bank and your explanation implies that these commercial banks are going to have to do some work for the central bank in order to be able to pay off the interest on loans that they’ve taken out from the central bank. This fits quite well with what I’d already posted which is that I noticed the central banks sometimes “buy” financial assets from commercial banks, which would be an alternative way of injecting cash into the system.

However, if you read my previous post, I still have some doubts about the nature of these financial assets (what sort of financial assets the central banks will buy for example)… If you know the answer to this, I’d be extremely interested to hear it!

Thanks once again. [:D]

18

This is complicated, but an example may help:

Assume that there exists one axe. Bob has the axe. He loans the axe to John in exchange for two axes a year from now. Assume axes are money, and Bob and John are the only two actors. The question is, from where does the extra axe come? The answer is, either Bob or John may produce the additional axe. If John produces it, then all is even a year from now; if Bob produces it, John will have to borrow it at a greater cost than the original loan to repay Bob. So, John may repay Bob with either profit or credit.

To ask from whence does the interest come, is to assume the supply of money is credit; that is, this question only makes sense if one assumes that borrowers cannot create the interest themselves - which is essentially true when money is debt. When money is debt, interest can only come in the form of increased debt - like when John repays the interest to Bob by with credit in the form of an axe borrowed from Bob. In that specific example, Bob would represent of the role of a central bank - slowly bleeding John dry.

Think about it - if John cannot make an axe, yet he borrows an axe before he repays an axe, than at one point in the transaction, John is borrowing an axe before he has paid the interest on the previous loan. This corresponds to a debt of two axes - one axe owed within 24 hours with its corresponding interest of 1/365th of an axe in addition to the axe owed a year from today! Which is just to say, that John will fall deeper and deeper in debt each year. His only saving grace is his ability to increase his productivity at a rate greater than or equal to the rate of his increasing debt of 1/365th of an axe per year in perpetuity - exactly the problem the US citizens face today with the parasitic Fed and its fiat inflation!

On the other hand, with free-market money, profit will be exchangable for money prior to the creation of the money by the creditor. In that specific example, John uses his productivity to save enough time and resources to make the axe he owes, and when his debt is paid it is not paid with credit, but with the profit of his enterprise.

Think about it - If John can create the axe on his own, than he will be able to use the profit of his wise borrowing to create an additional axe prior to the due date of the loan - thereby averting additional debt.

Gold is free-market money that the debtor may produce before the interest comes due, fiat currency is debt-money that the debtor must borrow before the interest comes due.

This is why fractional reserve banking requires elastic money - in a fractional reserve system, one must borrow before the interest is due. Without credit heaped upon credit, fractional reserve banking fails. But gold does not allow credit heaped upon credit. Gold must be earned - dug from the ground. Fiat currency is not earned, so it can be used as a system of practically never-ending credit and debt - two sides of the same coin. Gold can’t create a system of never-ending credit and debt because it is realized too soon, that the supply of gold is more limited than the credit extended, and recession causes liquidation of mal-investment.

Credit is a leash. On a long leash, dogs may run around the corner and do things that cause havok in civil society. On a short leash, corrections come instantly and constantly. People want the long leash, but not because it is helpful. They want it so they can ignore the punishing effects of living in civil society. Our monetary system is a fantasy built on barbarism and unreality. It is a 1980’s gay lifestyle that is ignorant of the HIV running through the society. Watch the slow decline of the ignorant. There is no savior, but for a return to compliance with reality. I hate to seem apocalyptic, but economics is unavoidable. If we would quickly take the brutal hit, we could be king again in a year or two, but alas, I am afraid socialism (compromise) will drag us down to the same level as the rest of the world…

19

Very good. [:)] That’s how it works.

There are three ways the money supply can be altered.

  • by the issue of notes and coins

  • by obtaining debt ( also known as credit) in some form

  • by the central bank performing open market opperations (OMOs) - exchanging government bonds for money and vice versa within the banking system.

Go to your countrys central bank web page and download the money aggregate figures.

You will find that notes and coins M0? make up a small fraction of the broad money supply. The rest has been created by debt or OMOs at some point.

The villager doesn’t create money. They add value to it by working off their debts.

Most are trapped in the system. The best they can do is to save for what they buy - staying free from debt.

If they get far enough in the black, they can add value to the economy (start a business) free from debt.

Owning a bank makes them masters of the system.

20

Pretty much.

The way things are set up, borrowing weakens the money supply by diluting it, causing inflation. Lenders get to keep the interest on something that’s largely created out of thin air.

How is interest justified? by inflation - the very thing caused mainly by borrowing.

Conversley:

No borrowing. No interest. Almost no inflation. Stability. Slow growth is the only downside.