Fractional Reserve Banking

I’d like to expose or explain a banking mystery: fractional reserve banking.

Let me go back to the time when gold when used as currency.  Goldsmiths would hold onto people’s gold, and give them a paper certificate to redeem their gold.  People with these certificates found them “as good as gold” and so began exchanging them with others.  After all, it is easier to exchange paper than gold.  This was a full reserve system.  Every exchange of paper money was physically backed by a real gold deposit.

Some goldsmiths decided to try and put more paper in circulation than they had gold available.  The problem is that if enough depositors (people with paper certificates) wanted their gold back (by redeeming their paper certificates), it wasn’t available.  The actual reserves on hand were some fraction of the total reserves accumulated.  How did this happen?  Some goldsmiths gave out redeemable certificates in exchange for some other item or service (not gold), or possibly as a handout.  They may have also decided to invest some of the gold they had on hand in some venture.  These are all possibilities.

In any hand, the banking system we have today is descended from this idea: people deposit money.  That money is lent out to individuals so that at any given time, if enough depositors asked for their money back, they would not get it all.  Banks kept on hand only a fraction of the reserves (hence “fractional reserve”) lent to them.  Before government regulation and central banking, the threat of “bank runs” (remember those scenes in “Mary Poppins” or “It’s a Wonderful Life”?) were a voluntary check on bank spending habits.

Central banking has changed this.  Instead of the banks setting the interest rate and reserve rate, the government-backed central bank (i.e. the Federal Reserve System in the U.S.) sets it.  They amass a huge amount of data, measuring all sorts of things like inflation, GDP, unemployment, economic growth, etc.  Based on the data, they set the fractional reserve and interest rates, essentially dictating to banks what interest rates and reserve rates to use.  The government (or government-backed central bank), rather than the (privately-owned) banks, set a monopolistic banking standard for all to follow.

This leads to problems with inflation: one of those problems is that costs increase for all of us.  Another is the business cycle: those first recipients of the new money spend it, resulting in an infusion of cash.  Hence bubbles in certain markets, like housing.  Bubbles are also linked to government involvement.  For instance, govenrment policies tended to guarantee loans to underqualified individuals in the housing boom.  The emphasis was on helping all to be homebuyers.  Many individuals unqualified by market standards of risk (individuals acting freely with their own money) were qualified by government standards of risk (bureaucrats using someone else’s money).  This type of malinvestment (unsustainable investment) leads to a necessary correction (hence the bust).

And to solve the problem of bank runs, the government has an insurance program.  The insurance program is pure silliness and not feasible, and would lead to hyperinflation if it ever had to be used.  Let’s hope it never need be.  But that’s another story for another day.

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Filed under Austrian Economics, Libertarian, politics

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