Why do some people state that fractional reserve banking does not increase the money supply?

[InterestedObserver]

So, I've been looking into fractional reserve banking and how it increases the money supply over the past few years. I have seen on some documentaries and videos examples of how the money supply expands due to fractional reserve banking processes. These examples helped show the idea, but it was not until I read this book that I understood WHY fractional reserve banking expands the money supply. It even provided data that showed a way to quantify how much fractional reserve money has been created by the banking system (without relying on the money multiplier as it is called). After reading it, I firmly understood and "believed" in fractional reserve money expansion.

Anyway, after learning all of this, I've been talking about it with others and hopping onto forums. Throughout this, I have been surprised by how many people express their opinion that fractional reserve banking does not actually increase the money supply. Someone even accused me of being a "Ron Paul crazy" just because I was bringing it up...which brought me to your delightful site.

I was hoping you guys could help me out.

What reasons do people give for fractional reserve banking not expanding the money supply?? Are there some "go-to" arguments that are put up? Any links to articles or other books professing this would be greatly appreciated!!

 

[Zippyjuan]

What happens in a fractional reserve bank? Let's take a bank with a ten percent reserve requirement. That means of course that they are required to keep ten percent ( a certain "fraction") of all money deposited "on reserve" and not lend it out. The idea is that they have a cushion of money on hand to meet withdrawl demands without running into problems (and a possible "bank run").

Let's send Adam into the bank with $100 to make a deposit. He is actually loaning the bank his money and they promise to pay it back to him later. (they may or may not pay interest- we are going to ignore any interest to keep from complicating things too much). Here is where we stand: Adam has zero dollars, the bank has all $100.

OK- the bank has funds they can loan out. But with the fractional reserve requirement, they have to keep ten percent of that- which means they can loan out 90% of that or $90.

Fine so far? Ok. Next we send in Bill. Bill wants to take out a loan. The most they can give him is $90 based on their deposits so he says fine and both he and the bank agree to terms. Now Bill has $90. How much does the bank have? $10 (they loaned the rest to Bill). How much does Adam have? None- he loaned his $100 to the bank and doesn't have it anymore. On the other side, we have Bill owing the bank $90 and the bank owing Adam $100. Debt has risen from zero when Adam had all the money to $190.

Another step. We Bill doesn't need the money right away so he opens a bank account to park it. He gives the bank back the $90 he borrowed. Now he owes the bank $90 but the bank also owes him $90 on the deposit he just loaned back to them. Since the bank has a new $90 in deposits, they can now loan out 90% of that or $81. Let's send in Charlie to borrow that. The bank agrees to loan him $81. Where is all the money now? Adam has zero. The bank has $19 ($10 on reserve from Adam's deposit and $9 on reserve from Bill's deposit). Bill has zero (he borrowed $90 from the bank and loaned it back to them). Charlie has $81. Total money in the system? Still $100. How much has been created? Zero. We still have the same actual money we started with.

What about debt? Adam owes nobody- in fact, he is owed money. The bank owes Adam $100 and owes Bill $90. Bill owes the bank $90. Charlie owes the bank $81. money is still the same but debt is growing. Debt is up to $271 from that original $100.

Is money being created? Or is debt being created?

What happens if people want their money back? Say Adam wants to take out his deposit. Can he? The bank doesn't have $100 to give him. They have some of it- and gave the rest to Bill and Charlie. So they need to get they money from someplace else. Either they borrow by attracting more deposits or from another bank or they get Bill and Charlie to pay back the money they owe. Adam taking out $100 means that the bank's balance sheet is out of balance- they have too many loans out for the amount of deposits they have. They need to either call in their loans (reduce the outstanding debts) or get a new deposit from somebody else.

What are alternatives to fractional reserve banking?

1) A zero- reserve or no- reserve banking system. In such a system, banks are allowed to loan out as much of their deposits as they want to- up to 100%. They could have loaned out all of that $100 Adam put into his bank account (or any smaller portion- how much would be completely up to them).

2) A full reserve banking system. In this system, a bank is required to keep 100% of all deposits in reserve which means they cannot loan out a single penny of deposited money. How do they stay in business and pay for buildings and salaries? Fees to store you money for you or other financial services. Anything in between (like say a full or partial reserve on some types of accounts and no reserve on other types) are variations of fractional reserve banking.

 

[ClydeCoulter]

Yep, Zippy,

So, they offer you a "cut" of the loot. And since almost everyone would like to get something for nothing, it's sound great. The money supply, therefore, increases causing a devaluation of everyone's money. So those keeping their cash protected by their natural right to self defense, put it into banks and hope that the "interest" keeps up with inflation/devaluation.

If there were no inflation/devaluation, keeping your money in a mattress, or other more clever device/location, would not be a problem, because once you do decide some years later to pull it and use it, you can buy just as much with it as when you hid it.

You could also, without devaluation/inflation, pay someone else to protect your money, whether in a bank or a body guard. The payout to a bank/stronghold would probably not need to be as much a loss as inflation, since it isn't a compounded loss.

 

[InterestedObserver]

Great reply Zippyjuan, thanks for the depth and example to form a conversation around. This is a good post.

Not sure if you are claiming fractional reserve banking does not increase the money supply, or if you are trying to provide a common argument that someone else would provide. So, I want to unwrap it a bit.

People in the economy make economic decisions (what to purchase, what to invest in, how much money to spend) based on the amount of money that they own. At the start of the example, Adam was wandering around the economy making economic decisions based on the $100 he owned. Bill and Charlie do not have any money to make economic decisions with at this point.

After the bank (which never claimed ownership of the money) loaned $90 to Bill, he went out into the economy and made economic decisions based on the $90 that he now owns. And truly, he does own that money. While at the same time, Adam continues to own $100 and make economic decisions based on the amount of money he owns. So, out there in the economy, Adam and Bill are making economic decisions and engaging in transactions using the $190 that they own.

The same is eventually true for Charlie. Before the loan, he owned $0. After the loan he became a participant of the economy that owns $81, out there in the economy making decisions based on the amount of money he owns.

So, at the start of the day the amount of money owned by participants of the economy was $100. At the end of the day, the amount of money owned by participants of the economy was $271.

When banks use depositor money in fractional reserve banking, the amount of debt increases and the amount of money owned by participants of the economy increases.

Or, as you stated it: "Is money being created? Or is debt being created?" The answer is both.

 

[erowe1]

So, I've been looking into fractional reserve banking and how it increases the money supply over the past few years. I have seen on some documentaries and videos examples of how the money supply expands due to fractional reserve banking processes. These examples helped show the idea, but it was not until I read this book that I understood WHY fractional reserve banking expands the money supply. It even provided data that showed a way to quantify how much fractional reserve money has been created by the banking system (without relying on the money multiplier as it is called). After reading it, I firmly understood and "believed" in fractional reserve money expansion.

Anyway, after learning all of this, I've been talking about it with others and hopping onto forums. Throughout this, I have been surprised by how many people express their opinion that fractional reserve banking does not actually increase the money supply. Someone even accused me of being a "Ron Paul crazy" just because I was bringing it up...which brought me to your delightful site.

I was hoping you guys could help me out.

What reasons do people give for fractional reserve banking not expanding the money supply?? Are there some "go-to" arguments that are put up? Any links to articles or other books professing this would be greatly appreciated!!

I don't know. That's weird. I still have my Econ 101 textbook that has a section on this. It's not like it's a controversial claim.

 

[Chester Copperpot]

well to be specific, fractional reserve banking does NOT increase the supply of money.. It does however increase the supply of currency.

 

[Chester Copperpot]

I don't know. That's weird. I still have my Econ 101 textbook that has a section on this. It's not like it's a controversial claim.

I agree.. It seemed like an odd claim to me.

 

[chronicaust]

Everyone owes somebody money. #TheAmericanDream

 

[Zippyjuan]

Great reply Zippyjuan, thanks for the depth and example to form a conversation around. This is a good post.

Not sure if you are claiming fractional reserve banking does not increase the money supply, or if you are trying to provide a common argument that someone else would provide. So, I want to unwrap it a bit.

People in the economy make economic decisions (what to purchase, what to invest in, how much money to spend) based on the amount of money that they own. At the start of the example, Adam was wandering around the economy making economic decisions based on the $100 he owned. Bill and Charlie do not have any money to make economic decisions with at this point.

After the bank (which never claimed ownership of the money) loaned $90 to Bill, he went out into the economy and made economic decisions based on the $90 that he now owns. And truly, he does own that money. While at the same time, Adam continues to own $100 and make economic decisions based on the amount of money he owns. So, out there in the economy, Adam and Bill are making economic decisions and engaging in transactions using the $190 that they own.

The same is eventually true for Charlie. Before the loan, he owned $0. After the loan he became a participant of the economy that owns $81, out there in the economy making decisions based on the amount of money he owns.

So, at the start of the day the amount of money owned by participants of the economy was $100. At the end of the day, the amount of money owned by participants of the economy was $271.

When banks use depositor money in fractional reserve banking, the amount of debt increases and the amount of money owned by participants of the economy increases.

Or, as you stated it: "Is money being created? Or is debt being created?" The answer is both.

They can't spend any money if it is on deposit at the bank. The bank can't loan any money out if it isn't deposited at the bank. Thus they cannot all spend $271. If they try to, the bank has to borrow that money from somebody else- taking it away from another person who could have spent it. The total sum of spendable money doesn't change in my example. The numbers on the bank accounts grow and debt grows but actual money (what can be spent) does not.

Charlie can only spend $81 if Adam doesn't spend $100 (and puts it into the bank) and Bill doesn't spend $90 (and redeposits the money he borrowed). If either spends their money, there isn't any to get to Charlie.

Interestingly, as the number of deposits increases, the amount of money the bank must hold (its reserve) goes up so the money available to spend goes down since they have to keep ten percent of every account. Adam could have spent $100 if he had kept it. By the time it got to Charlie, he could only spend $81 and the bank had to hold onto $19 of it so rather than increasing the money supply, the fractional reserve actually reduces the money supply.

 

[Danke]

What happens in a fractional reserve bank? Let's take a bank with a ten percent reserve requirement. That means of course that they are required to keep ten percent ( a certain "fraction") of all money deposited "on reserve" and not lend it out. The idea is that they have a cushion of money on hand to meet withdrawl demands without running into problems (and a possible "bank run").

Let's send Adam into the bank with $100 to make a deposit. He is actually loaning the bank his money and they promise to pay it back to him later. (they may or may not pay interest- we are going to ignore any interest to keep from complicating things too much). Here is where we stand: Adam has zero dollars, the bank has all $100.

OK- the bank has funds they can loan out. But with the fractional reserve requirement, they have to keep ten percent of that- which means they can loan out 90% of that or $90.

Fine so far? Ok. Next we send in Bill. Bill wants to take out a loan. The most they can give him is $90 based on their deposits so he says fine and both he and the bank agree to terms. Now Bill has $90. How much does the bank have? $10 (they loaned the rest to Bill). How much does Adam have? None- he loaned his $100 to the bank and doesn't have it anymore. On the other side, we have Bill owing the bank $90 and the bank owing Adam $100. Debt has risen from zero when Adam had all the money to $190.

Another step. We Bill doesn't need the money right away so he opens a bank account to park it. He gives the bank back the $90 he borrowed. Now he owes the bank $90 but the bank also owes him $90 on the deposit he just loaned back to them. Since the bank has a new $90 in deposits, they can now loan out 90% of that or $81. Let's send in Charlie to borrow that. The bank agrees to loan him $81. Where is all the money now? Adam has zero. The bank has $19 ($10 on reserve from Adam's deposit and $9 on reserve from Bill's deposit). Bill has zero (he borrowed $90 from the bank and loaned it back to them). Charlie has $81. Total money in the system? Still $100. How much has been created? Zero. We still have the same actual money we started with.

What about debt? Adam owes nobody- in fact, he is owed money. The bank owes Adam $100 and owes Bill $90. Bill owes the bank $90. Charlie owes the bank $81. money is still the same but debt is growing. Debt is up to $271 from that original $100.

Is money being created? Or is debt being created?

What happens if people want their money back? Say Adam wants to take out his deposit. Can he? The bank doesn't have $100 to give him. They have some of it- and gave the rest to Bill and Charlie. So they need to get they money from someplace else. Either they borrow by attracting more deposits or from another bank or they get Bill and Charlie to pay back the money they owe. Adam taking out $100 means that the bank's balance sheet is out of balance- they have too many loans out for the amount of deposits they have. They need to either call in their loans (reduce the outstanding debts) or get a new deposit from somebody else.

What are alternatives to fractional reserve banking?

1) A zero- reserve or no- reserve banking system. In such a system, banks are allowed to loan out as much of their deposits as they want to- up to 100%. They could have loaned out all of that $100 Adam put into his bank account (or any smaller portion- how much would be completely up to them).

2) A full reserve banking system. In this system, a bank is required to keep 100% of all deposits in reserve which means they cannot loan out a single penny of deposited money. How do they stay in business and pay for buildings and salaries? Fees to store you money for you or other financial services. Anything in between (like say a full or partial reserve on some types of accounts and no reserve on other types) are variations of fractional reserve banking.

Only two choices? How about commodity backed money for the bank. And loans that pay interest to finance the banks?

 

[Zippyjuan]

Only two choices? How about commodity backed money for the bank. And loans that pay interest to finance the banks?

Commodity backed or not backed money is distinct from your banking system. You can have a commodity backed fractional reserve banking system or a commodity backed zero reserve (or full reserve) system.

And loans that pay interest to finance the banks?

If any of the money you lend out comes from deposits, it is a fractional or no- reserve banking system. If the money being lent out comes say from the money of those who own the bank and not from any deposited funds, that could be a full reserve bank. Yes, a bank can (and does) earn money by charging interest on loans but a full reserve bank is not able to make loans (unless it is from their personal funds) so they need other sources of income.

 

[Danke]

Commodity backed or not backed money is distinct from your banking system. You can have a commodity backed fractional reserve banking system or a commodity backed zero reserve (or full reserve) system.



If any of the money you lend out comes from deposits, it is a fractional or no- reserve banking system. If the money being lent out comes say from the money of those who own the bank and not from any deposited funds, that could be a full reserve bank. Yes, a bank can (and does) earn money by charging interest on loans but a full reserve bank is not able to make loans (unless it is from their personal funds) so they need other sources of income.

If they are earning income from assets and loans, the can make loans and still back up the loans without fractionalizing.

 

[Zippyjuan]

The important factor is where they are getting the money to loan out.

 

[InterestedObserver]

They can't spend any money if it is on deposit at the bank. The bank can't loan any money out if it isn't deposited at the bank. Thus they cannot all spend $271. If they try to, the bank has to borrow that money from somebody else- taking it away from another person who could have spent it. The total sum of spendable money doesn't change in my example. The numbers on the bank accounts grow and debt grows but actual money (what can be spent) does not.

Charlie can only spend $81 if Adam doesn't spend $100 (and puts it into the bank) and Bill doesn't spend $90 (and redeposits the money he borrowed). If either spends their money, there isn't any to get to Charlie.

Interestingly, as the number of deposits increases, the amount of money the bank must hold (its reserve) goes up so the money available to spend goes down since they have to keep ten percent of every account. Adam could have spent $100 if he had kept it. By the time it got to Charlie, he could only spend $81 and the bank had to hold onto $19 of it so rather than increasing the money supply, the fractional reserve actually reduces the money supply.

Indeed. They cannot all spend the money that they own at the same time. If they tried to do this, the bank would experience a reserve depletion issue. This is the major weakness that fractional reserve banking introduces into a monetary system.

But, just because they cannot all spend their money at the same time, does not diminish the fact the Adam, Bill and Charlie own a total of $271 and they each make economic decisions based on the amount of money that they own. Banks increase the amount of money owned by participants of the economy, and it is their job to make sure the scheme does not collapse or unravel.

 

[Zippyjuan]

does not diminish the fact the Adam, Bill and Charlie own a total of $271

Actually Adam owns the money. The others just want to use it while he doesn't need it.

He is trading consuming (spending his money) today for consumption in the future. The borrowers are trading future consumption for consumption today. They may have more money to spend now from their loans while Adam has less (because he lent it out) but they will have less money to spend in the future when they have to pay back the loans. Then their personal money supply will shrink and Adam's will rise.

 

[Danke]

The important factor is where they are getting the money to loan out.

Initially from investors, then loans and other assets.

 

[Zippyjuan]

As long as it isn't from deposits, they can be a non- fractional reserve bank. What you describe is how the Export/ Import bank runs. They were initially funded by Congress but now get the money they loan out from interest and fees on the loans they make- no longer needing Congress to fund it (and having no depositors).

 

[Danke]

As long as it isn't from deposits, they can be a non- fractional reserve bank. What you describe is how the Export/ Import bank runs. They were initially funded by Congress but now get the money they loan out from interest and fees on the loans they make- no longer needing Congress to fund it (and having no depositors).

Free up banking ( no central banking system) then depositors can choose what level of reserves and interest payments are acceptable for them to do business.

 

[TheGrinch]

What happens in a fractional reserve bank? Let's take a bank with a ten percent reserve requirement. That means of course that they are required to keep ten percent ( a certain "fraction") of all money deposited "on reserve" and not lend it out. The idea is that they have a cushion of money on hand to meet withdrawl demands without running into problems (and a possible "bank run").

Let's send Adam into the bank with $100 to make a deposit. He is actually loaning the bank his money and they promise to pay it back to him later. (they may or may not pay interest- we are going to ignore any interest to keep from complicating things too much). Here is where we stand: Adam has zero dollars, the bank has all $100.

OK- the bank has funds they can loan out. But with the fractional reserve requirement, they have to keep ten percent of that- which means they can loan out 90% of that or $90.

Fine so far? Ok. Next we send in Bill. Bill wants to take out a loan. The most they can give him is $90 based on their deposits so he says fine and both he and the bank agree to terms. Now Bill has $90. How much does the bank have? $10 (they loaned the rest to Bill). How much does Adam have? None- he loaned his $100 to the bank and doesn't have it anymore. On the other side, we have Bill owing the bank $90 and the bank owing Adam $100. Debt has risen from zero when Adam had all the money to $190.

Another step. We Bill doesn't need the money right away so he opens a bank account to park it. He gives the bank back the $90 he borrowed. Now he owes the bank $90 but the bank also owes him $90 on the deposit he just loaned back to them. Since the bank has a new $90 in deposits, they can now loan out 90% of that or $81. Let's send in Charlie to borrow that. The bank agrees to loan him $81. Where is all the money now? Adam has zero. The bank has $19 ($10 on reserve from Adam's deposit and $9 on reserve from Bill's deposit). Bill has zero (he borrowed $90 from the bank and loaned it back to them). Charlie has $81. Total money in the system? Still $100. How much has been created? Zero. We still have the same actual money we started with.

What about debt? Adam owes nobody- in fact, he is owed money. The bank owes Adam $100 and owes Bill $90. Bill owes the bank $90. Charlie owes the bank $81. money is still the same but debt is growing. Debt is up to $271 from that original $100.

Is money being created? Or is debt being created?

What happens if people want their money back? Say Adam wants to take out his deposit. Can he? The bank doesn't have $100 to give him. They have some of it- and gave the rest to Bill and Charlie. So they need to get they money from someplace else. Either they borrow by attracting more deposits or from another bank or they get Bill and Charlie to pay back the money they owe. Adam taking out $100 means that the bank's balance sheet is out of balance- they have too many loans out for the amount of deposits they have. They need to either call in their loans (reduce the outstanding debts) or get a new deposit from somebody else.

What are alternatives to fractional reserve banking?

1) A zero- reserve or no- reserve banking system. In such a system, banks are allowed to loan out as much of their deposits as they want to- up to 100%. They could have loaned out all of that $100 Adam put into his bank account (or any smaller portion- how much would be completely up to them).

2) A full reserve banking system. In this system, a bank is required to keep 100% of all deposits in reserve which means they cannot loan out a single penny of deposited money. How do they stay in business and pay for buildings and salaries? Fees to store you money for you or other financial services. Anything in between (like say a full or partial reserve on some types of accounts and no reserve on other types) are variations of fractional reserve banking.

This may be true if we were only dealing with dollar bills being loaned out. Checks and electronic banking made this much simpler to get around.

The reason they can get away with creating money out of thin air, is that they have ability to just create a number in your bank account out of thin air that you owe back, something no company or person has the ability to do.

They loan you $90 of the $100 dollars Johnny deposited, then they still have $100 actual dollars in their vault, but added a promise to add $90 more from a guy who can't just create numbers in his bank account.

When repaid, you have successfully created $190 out of $100. It is that simple. You just want to make it sound complicated to confuse people, just like you always do.

 

[Warrior_of_Freedom]

I hate banks and think all banks should die. I don't care if it makes purchases more difficult.