The Best Explanation of Fractional Reserve Banking, Ever!

[TheNcredibleEgg]

Hey u2. You'd be well served reading the following paper put out by the Bank of England earlier this year. (I read it twice. Thinking about reading it a third time.) I think it stemmed from a feud between Steve Keen and Krugman about whether or not banks actually create new money or whether or not banks just act as intermediaries. Keen argued the former. Krugman huffed the latter. Keen is right.

Anyways, the link explains cogently how economic textbooks and the money multiplier are wrong when it comes to money creation by banks. It explains how banks do create money out of thin air via loans and it explains how profitability is the restraint. Not reserves. So the OP explanation AND the video is both somewhat wrong.

In the modern economy, most money takes the form of bank
deposits. But how those bank deposits are created is often
misunderstood: the principal way is through commercial
banks making loans. Whenever a bank makes a loan, it
simultaneously creates a matching deposit in the
borrower’s bank account, thereby creating new money.

The reality of how money is created today differs from the
description found in some economics textbooks:

• Rather than banks receiving deposits when households
save and then lending them out, bank lending creates
deposits.

• In normal times, the central bank does not fix the amount
of money in circulation, nor is central bank money
‘multiplied up’ into more loans and deposits.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

 

[helmuth_hubener]

it explains how profitability is the restraint. Not reserves.

Actually, I would agree that profitability is the ultimate restraint. If worthy loan candidates cannot be found, less than the maximum legally-allowed limit of checking account balances will be created. But the reserve requirement does put an absolute cap on it.

In a "boom" time, there will be plenty of good credit risk loan-seekers. The reserve requirement will be the limiting factor.

In bad times, the lack of profitable loans to be made could well be the limiting factor.

This does not mean that Browne's explanation is "wrong" in any way. It simply means that he didn't see fit to go into this, just as there are many complications and technical wrinkles he glossed over, skipped, or didn't go into. He expected all of his readers already understood profit and loss. The new concept that required explanation was how the banking system can create money at all.