I always have a hard time wrapping my head around the idea of money creation through fractional reserve banking. I get the general idea, but I have a hard time re-articulating that idea to other people.
I use comparisons to help me understand concepts, so I would like to know if this comparison is basically correct. Say the money used was gold, and banks issued paper receipts to gold. Paper receipts functioned as gold in the economy, used for exchange. A man deposits 100 ounces of gold. The bank gives him 100 paper receipts to it (each receipt is exchangeable for 1 ounce of gold). The bank must keep 10% of gold on reserve. When it makes another loan, it simply creates more receipts. It makes a loan to someone else, giving them 90 paper receipts to gold. The result is there are now 190 receipts, and only 100 ounces of actual gold. Hence, the money supply has expanded, because paper receipts function in the same way as money.
Currently, though, we do not use gold, we use paper. And we do not have paper receipts to paper, we have electronic receipts. Would this be basically correct? In a modern day scenario, gold is replaced with paper, and paper receipts are replaced by electronic receipts. 100 paper dollars are deposited, and the depositor gets 100 electronic dollars in a demand deposit. 10 paper dollars are held on reserve, and 90 more electronic dollars are loaned out.
Is that about right? Basically, I am asking in terms of money creation, the physical paper dollar takes the place of gold, and the electronic money in accounts take the place of the paper receipts to gold.
this article might help...
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tcostel:Say the money used was gold, and banks issued paper receipts to gold. Paper receipts functioned as gold in the economy, used for exchange. A man deposits 100 ounces of gold. The bank gives him 100 paper receipts to it (each receipt is exchangeable for 1 ounce of gold). The bank must keep 10% of gold on reserve. When it makes another loan, it simply creates more receipts. It makes a loan to someone else, giving them 90 paper receipts to gold. The result is there are now 190 receipts, and only 100 ounces of actual gold. Hence, the money supply has expanded, because paper receipts function in the same way as money.
Not exactly. A 10% reserve means that they must have 10% of every dollar on reserve. Meaning that every dollar can be loaned out 10 times. What you describe is more like a 50% reserve. So, at 10%, for every ounce one reserve, they can loan it 10 more times.
tcostel: Currently, though, we do not use gold, we use paper.
Currently, though, we do not use gold, we use paper.
It's important to realize that paper money was originally the claim receipt for the gold on deposit. Rather than going to get the gold, people began simply exchanging claim receipts (think of them as bearer bonds).
When fiat money was introduced, governments figured, hey, we don't need the gold, we just need the receipts. Essentially, fiat money is pure pretense, for it has nothing backing it.
tcostel:And we do not have paper receipts to paper, we have electronic receipts. Would this be basically correct? In a modern day scenario, gold is replaced with paper, and paper receipts are replaced by electronic receipts.
Electronic receipts are no more than machines exchanging paper money via banks. Say you have two banks. At the end of the month they tally all their receipts and find that one bank owes the other bank $1 million due to client deposits and withdrawals. They transfer that money into the other's account. But it's important to realize that when a bank loses $1m that it is relying on that $1m as a reserve for $10m worth of loans. Thus, small changes in accounts between banks can have large repurcussions. If the bank isn't solvent, meaning if it doesn't have cash on hand to pay what's being asked, then it has to call in those loans, and that's when trouble happens. You get failures and runs on banks, etc., caused precisely by the reserve requirement.
tcostel:100 paper dollars are deposited, and the depositor gets 100 electronic dollars in a demand deposit. 10 paper dollars are held on reserve, and 90 more electronic dollars are loaned out.
No! The 100 are considered a reserve and used to justify $1000 worth of loans. This system works because people rarely show up and demand to see cash. As long as banks are shuffling accounts between them, and remain solvent, all's fine. But one bank going down can hurt faith in other banks, so they try to keep each other up through cooperation and lending--which is where the Federal Reserve comes in with its discount rate. If a bank needs $100m in cash tomorrow, the Fed can make it happen--precisely so as to avoid a run. It's done things like that a few times, move $2m in freshly printed cash to a bank fearing a run, etc. It's all a sham of course. Fractional reserve banking should be illegal.
tcostel:Is that about right? Basically, I am asking in terms of money creation, the physical paper dollar takes the place of gold, and the electronic money in accounts take the place of the paper receipts to gold.
Yes, but it's important to realize what a bank is actually doing, that banks can actually create money. They do this by creating a loan.
Let's say you obtain a home-loan from a bank. Where does it get the money to lend you $300k or so? To lend you $300k it need only show $30k on deposit. If you pay on that loan for 30 years (or w/e), the loan will be good and your work at your job will have added to the economy the amount you borrowed (and then some), making the loan good. But if you default, the money's now been spent and the bank is out $300k, for which it might be able to absorb if it has cash to float but suppose it's running low.
It will most likely borrow some cash from other banks until it's fine.
But what if they're short too. If the bank has to start calling in loans to cover the cash demand of patrons, then it has to call in $3m worth of loans to give up $300k!
So, it's a bit of a house of cards.
You can talk to any banker, they usually don't really understand the nature of banking--they don't realize money is being literally created. They don't know that the bank is simply creating a new account number and putting a 3 with five zeroes after it.
What's pretty incredible is that the fractional reserve limit of 10% is there to keep the banks from going even lower! Historically, when a bank gets to a 30 to 1 ratio, a run on the bank is guaranteed (0.1% reserve).
If I were to start a bank, I'd call it Millennium Bank and our core policy would be 100% guarantee, because we'd use a 100% reserve, lending 1 to 1, and simply be fee-based instead of all the accounting gimicks banks resort to currently.
I'd agree with Isaac's article that the central bank is the main problem with the modern banking system. It should be free completely, unregulated.
We need a separation of economy and state.