Fractional Reserve Banking
by Jacob McCartney on 2017-06-08
Under our current banking system, it is possible to create money out of thin air.
Fractional reserve banking is a system in which only a small amount of the money circulating in the economy are backed up by actual cash. The rest of this money, while still counted in individual bank accounts, is free to be loaned out to others. The economic theory behind such practices are that this loaning stimulates and expands the economy through investment in profitable ventures.
The government requires most banks hold reserves, which is 10%. If a bank has $1 billion in assets across its accounts, it would only be required to hold $100 million. This system relies on the assumption that customers will not ask to withdraw significant amounts of their money all at once. If this happens, and the banks do not have the cash in reserves to withdraw all the money people demand, this causes what is called a run. Everyone rushes in to get their money before it runs out.
This is part of what happened during the Great Depression in 1929. The original cause of this depression was over-speculation of stock prices, which led to more investment. Massive amounts of people took out loans to get starting capital for investing. The wealth of the nation increased drastically during this time, while the real money supply kept in reserves only increased by a little. Investments in the real estate and stock markets shot up. Equity prices rose in multiples of over 30, and Dow Jones rose 500% in just a few years. Then, on October 24, 1929, the bubble popped, as the nation came to realize that most of their money could not be withdrawn from the banks. People watched, helplessly, as their wealth dropped to nothing.
Had there been money to back up the increase in assets, a) assets could not have risen to the levels they did, and b) the wealth would all still exist. The Great Depression would have been avoided.
Austrian economist Murray Rothbard wrote the following:
fractional reserve banks … create money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, which then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails to treat the receipts as counterfeit.
This is the issue with fractional reserve banking. This practice is also called circulation-credit expansion. A bank with circulation credit puts money that does not exist into the marketplace, and as a result inflates the currency and the markets.
Ending fractional reserve banking, however, is not simple, however. This is because loans happen to be one of the ways banks make money. Without it, a bank would simply be a warehouse or a safe. The money just sits there.
Ron Paul has stated in the past that despite the problems with fractional reserve banking, a reserve requirement is not needed, the underlying principle being that a bank in a competitive market with other banks must either be safe with their lending practices or risk the almost inevitable possibility of a run. Basically, a bank must face the risk of giving out loans.
While fractional reserve banking ultimately has a negative effect on economies, ending it is unrealistic. The best alternative, for now, is to open banks up to the brutal jungle that is the marketplace and let them suffer the consequences of irresponsible lending practices, should they choose to take said risks.
“Fractional Reserve Banking – An Economist’s Perspective (Transcript).” Federal Reserve Bank of Atlanta. N.p., n.d. Web. 7 May 2017.
Investopedia Staff. “Great Depression.” Investopedia. Investopedia, 09 Mar. 2017. Web. 7 May 2017.
Mises, Ludwig Von. “20.” Human Action: A Treatise on Economics. Indianapolis: Liberty Fund, Incorporated, 2014. N. pag. Print.
Murray N. Rothbard, The Mystery of Banking, 2nd ed. (Auburn, Alabama: Ludwig von Mises Institute, 2008), p. 98.
Tamny, John. “Ron Paul, Fractional Reserve Banking, and the Money Multiplier Myth.” Forbes. Forbes Magazine, 11 Aug. 2012. Web. 7 May 2017.