How I Learned to Stop Worrying About Fractional Reserve Banking and Start Hating the Fed Even More than Ever

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How I Learned to Stop Worrying About Fractional Reserve Banking and Start Hating the Fed Even More than Ever

The Current Consensus:

It is the widely accepted opinion, and I'll admit it was mine too until I thought about it some more, that there is something inherently wrong, immoral even, with Fractional Reserve Banking.

I hope to show here why there is nothing wrong with Fractional Reserve Banking and how the real troubles stem from something else which I will call, "Fictional Reserve Banking".

What is Fractional Reserve Banking

First we must define what Fractional Reserve Banking is.  The simplest definition I can think of goes something like this:  

The practice (by banks) of holding less cash in reserves than the total deposits owed to creditors.  

If that was all, FRB certainly seems not only dangerous but also downright fraudulent.  "Where is my damn money?" is my initial reaction.

However, that is just not how it works.  If depositors deposit $100,000 in a bank, then that banks' balance sheet looks like this:

Assets                          Liabilities

$100,000 (cash)             $100,000 (owed to depositors)

If the bank turns around and uses $90,000 on a loan for someone to buy a house, the balance sheet then looks like this:

Assets                          Liabilities

$10,000 (cash)               $100,000 (owed to depositors)

$90,000 (asset-backed loan)

The total assets and liabilities add to zero in each case.  The bank has not decreased its asset position, it has merely converted 90% of its cash assets to a real estate loan.  The depositor's claims have not lost any value  - they still have every right to take all their $100,000 out.  So what happens if they all rush the bank at the same time, say FRB critics?  The answer is the bank borrows the $90,000 from some other bank in the meantime, until it can find $90,000 from depositors again.  If the bank is following sensible lending standards (like, for example, requiring the borrower to put at least 20% down, making sure they have a steady job and a good credit history) they should have no problem finding another bank to lend them the money.  Alternatively, they could sell the loan to another bank who might be interested in buying the cash flow inherent in the loan.

One could argue there is some risk to the depositors having immediate access to their cash, but even if true, that's as far as the criticism can go.  There is nothing immoral or fraudulent about the practice as the bank has not done anything except convert one asset (cash) into another (real estate backed loan).  

Central Bank and Government Role

The real problems stem from something else entirely.  Our government, in yet another effort to manipulate markets, had a "great" idea.  The idea as we all know was to encourage home-loan originations by creating artificial demand for those loans in the secondary markets.  The purpose was to increase home-ownership in America, because the American dream shouldn't just be a dream if the government can have anything to do about it.  The secondary markets are where banks buy already-made loans from one another, as I alluded to above in showing how the bank could liquidate its loan if needed.  

Part of the problem with this idea is that the money to purchase these loans in the secondary markets had to be borrowed from foreigners or worse, created into existence.  That means our Asset in the above example goes from being cash, to being a home loan, back to being cash (for the depositors), but now reappearing as an Asset for Fannie or Freddie.  So the question is, where did Fannie or Freddie get the money to buy the Asset that went to the bank that made the loan that originated from the original $100,000 depositors?

The answer is the money was created out of thin air or borrowed from foreigners by our Treasury, who then lent it to Fannie and Freddie.  Did our Treasury make sure it was borrowing the money at a lower rate than that which was being used to make the loans?  I doubt it, but I will give them the benefit of the doubt just for kicks. 

Were Fannie or Freddie enforcing responsible lending standards?  It is a demonstrable fact that that answer is a resounding NO.  In fact, Fannie and Freddie lobbied congress, and congress obliged, to lower standards so that more and more Americans could achieve the American Hand-Out (oops - I meant "Dream"). This happened first in 1999 and got worse in subsequent years.  As we all know, this also provided fodder for an irresponsible and greedy Wall Street machine, cloaking itself in the example set by government, to do much of the same.  The only difference is they couldn't create money out of thin air, but that thin-air money did set the conditions which otherwise could not have existed by which Wall Street set its standards and by which lenders to Wall Street measured their own standards.

The other problem is that since the money being used was controlled by the government, money's cost (interest rates) would be fixed arbitrarily with the government acting as the ultimate price-fixer.  When the price of money or anything else is fixed arbitrarily, rather than by market forces, normal supply and demand forces go out the window and bubbles are formed.

Fictional Reserve Banking

The ultimate cause of our credit bubble has nothing to do with Fractional Reserve Banking.  It has to do with what lies underneath FRB.  That is, where is the money that is funding Fannie and Freddie, that then went to buy all these loans from your local fractional reserve bank come from?  It came from pure Fiction - loans from foreigners made to our Treasury which is itself based on nothing, or worse yet, loans made from the Federal Reserve with money - you guessed it - printed out of thin air!

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Hello Mr. Brown-

I think we should worry about the FRB system, though I’m not sure if I’m able to explain the worries in a brief and understandable way. I’d be glad if some of the worries get broken up in a following dialogue…

I sense a society can only grow on existing surplus. E.g., if a society needs 100% of its efforts and resources to maintain its existence, it cannot grow. It also cannot grow now on future surplus which is available if it grows but not available at this point. That may be a subtle distinction from the FRB system.

Now, the FRB system is the accepted logic to steer, control and enforce growth course. It steers and enforces subjects’ access to existing surplus for putting into action for handpicked value adding efforts. In the same way it bears a lot of trouble and worries.

The system is incredible ineffective. If one dares to calculate the ratio of the real world’s added value vs. the portion of that value that is arrogated by the named system’s financial services, the systems performance is just dreadful. The system itself doesn’t add real world value; it controls and collects it...

The systems consequences and occurrence lack serious democratic legitimating (controls and collects…). However the FRB credit system is very suitable for democratic societies, since it allows utilizing future obligations of those under age, or unborn, without right to vote;-)

Most important, the FRB system is based on (exponential) real world growth. If the real world growth cannot keep up, the FRB system gets sick and destructive with every fiber. Third stadium of sickness might be the Fictional Reserve Banking...

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Hi Patrick,

Who is the author of your post? Can you provide a link to the source? Thanks.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Jeff,

That would be yours truly.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Patrick Brown wrote:

If depositors deposit $100,000 in a bank, then that banks' balance sheet looks like this:

Assets                          Liabilities

$100,000 (cash)             $100,000 (owed to depositors)

If the bank turns around and uses $90,000 on a loan for someone to buy a house, the balance sheet then looks like this:

Assets                          Liabilities

$10,000 (cash)               $100,000 (owed to depositors)

$90,000 (asset-backed loan) 

Hi Patrick,

I think the criticism of FRB is the fact that the banks can take that $100K deposit and use it to create and additional $900K of loans, not $90K of loans. And the investment banks can take that $100K deposit and create $4 million worth of loans with it, since the Fed allowed them a multiplier of 40 instead of the 9 multiplier enforced on the mainstream banking institutions.

Am I correct with this? If so, that seems like the banks have much more of an inflationary impact than the government. What do you think?

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Hi Jeff,

My understanding of the mechanism by which the $100,000 can be turned into about $900,000 is that, in the above example, after the bank lends the $90,000 out for the home loan, those $90,000 will be re-deposited in the bank by the real estate agent, architect, plumbers, electricians, roofers, carpenters, and everyone else involved in the construction of the house - or, if it's a 2ndardy market purchase, by the sellers.

The balance sheet then looks like this:

Assets                                                                                                         Liabilities

$10,000 cash (left over from original depositors)                                               $100,000 (owed to original depositors)

$90,000 (asset-backed loan)                                                                          $90,000 (owed to depositors who recvd loan monies)

$90,000 cash (from depositors who recvd loan monies)

Again, the total adds to zero.  The bank can then take the $81,000 of the monies deposited by those who received the $90,000 from the sale of the house, and make another loan, ad infinitum, in a mathematical equation in which the result asymptotically approaches $900,000 in total loans from an initial $100,000 deposit, if a 10% reserve requirement is used.

The problem I have with the criticism is that for every loan, there must be an asset backing it up.  In theory then, there should be no problem with this except if and when banks make bad loans, or do not ensure that the assets backing them up are real, or do not require borrowers to cushion the bank's risk by putting some money down of their own. 

How did banks get to the point of not requiring money down on the part of borrowers?  Easy - the government provided a secondary-market purchaser (artificial demand) in the form of Freddie and Fannie for mortgages, so the banks no longer had any incentive to ensure the assets were in line with the loans or to require money-down.  Instead of making money off the cash flow provided by loans, they made money off of origination fees, commissions, "points", and whatever other fees can be justified besides the loan cash flow itself.  Furthermore, the Fed kept rates artificially low, making the monthly payment capable of affording a much more expensive house than otherwise.

Had people been required to put money down, much less credit would have been extended.  Furthermore, in order to put money down, people would have had to save for a while before buying that dream home.  These savings, in the form of bank deposits, would have helped keep interest rates down in a natural, free-market driven way, and would have kept a lot of money from chasing goods and services in the economy.  In short, it would have had the effect of lowering general price levels and interest rates, paving the way for a natural and valid form of home purchasing and lending. 

But no, our politicians and money regime elites couldn't wait that long.  They wanted an economy on steroids and so they created artificial markets for home loans, kept interest rates artificially low even though there was no savings in the economy to justify those low interest rates, and blew us a bubble of Perfect-Storm-wave-size proportions. 

I never knew Ben was such a surfing fanatic.  It will be one hell of a wave to ride on the way down.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Hi Patrick,

Hey, sorry about that, your right, I got confused. I just reviewed the Money Creation chapter in the Crash Course and I was mistaken. I agree with the points that you made and I'm impressed with the delivery of your thoughts (e.i. the mistaken request for a source). 

I think we all might want to learn how to tow-in surf so that we can ride the wave of financial destruction that headed our way!

Is that Ben on that wave?

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Baywork wrote:
Most important, the FRB system is based on (exponential) real world growth. If the real world growth cannot keep up, the FRB system gets sick and destructive with every fiber.

You seem to be thinking of debt-based money (money which is loaned into existance).  With debt-based money, only the principal and is loaned into existence, while the interest must come from new economic production and is therefore dependent on the continual creation of new loans.  Fractional reserve banking, however, existed for centuries before debt-based money.

Criticism of "fractional reserve banking" as a concept is academic: banks and mutual associations must be allowed to loan out at least some fraction of their deposits.  If banks were required to maintain a 100% reserve ("non-fractional reserve" banking), then they could never make any loans at all.  Not only would it be impossible to obtain a loan, but anybody who wished to put money into a bank would have to pay to do so.

The "1:10 reserve" system has proved itself adequate for centuries.  Central banks (the old fashioned, non-federal reserve kind which do not manipulate interest rates or conduct open market operations) are also a great idea. The problem is debt-based money, and the fact that modern US banking regulations have reduced the reserve requirement from 10% to nearly zero in practice.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Holy Caramba!  Can we get our in-house photo-shop expert to put Ben's head on that guy?!

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Patrick said:  I hope to show here why there is nothing wrong with Fractional Reserve Banking and how the real troubles stem from something else which I will call, "Fictional Reserve Banking"

Really good article Patrick.  I hadn't thought about it but I think you make a solid argument; FRB was NOT the primary reason for this crisis.  The money was loaned irresponsibly and then bundled and blessed as AAA securities (secondary market).  I learned something important through your explanation of how the secondary market inflated the bubble, which is as you said, a disconnect from free market forces.

I disagree with your statement "there is nothing wrong with Fractional Reserve Banking;" let me explain why.  They are creating almost all of the money that they lend on the spot, through a keyboard entry (out of thin air).

In 2006, M3 (broadest measure of the money supply) was nearly $10 trillion. Of that, treasury securities was around $1 trillion which means that banks expanded the money supply by a factor 10:1 through fractional lending.  And they are collecting interest on every penny.       

Baywork said:  Most important, the FRB system is based on (exponential) real world growth. If the real world growth cannot keep up, the FRB system gets sick and destructive with every fiber. Third stadium of sickness might be the Fictional Reserve Banking... 

In our current system, as the national wealth grows so does the national debt.  This is unsustainable and while fractional lending may increase the span, ultimately it will collapse.

Larry

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

jrf29 said: Central banks (the old fashioned, non-federal reserve kind which do not manipulate interest rates or conduct open market operations) are also a great idea.

Can you give any historical examples, or explain, what an old fashioned central bank is?

Larry

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

The problem with fractional reserve banking isn't about accounting.  It's about greed, economics, power.

Greed, along with the other depravities of man, must be controlled by designing systems that don't reward it.  Fractional reserve banking--making 10x to 40x money from doing nothing but monitoring computer screens--is the most powerful reward system for greedy people ever invented.  It's a system that will attract the "most dangerous of the criminal class" as Teddy Roosevelt defined them--the really smart ones.  

Economics:  The economic reality underlying the accounting example above is that the bank owns $900k in houses (accounting registers the loan as the asset; economics knows it's actually the houses, or other real assets) from nothing but people putting $100k cash in the bank.  

Power:  In this initial economic state, the bank owns the houses AND the future cashflows of the people working hard to pay them (as the CC says, debt is a claim on future labor).  Power differential is huge.   

Long-term economics:  One very critical lesson of economics is to evaluate the long-term equilibrium result rather than just the initial transaction.  The initial transaction only takes us to the $900k houses owned by the bank, which is bad enough.  30 years later all those people have worked dutifully to pay the bank and get the asset.  They've been good little people.  On the other side of the transaction with 30 more years of exponential fake money growth, the bank has become Bank of America with millions more good little people working hard their whole lives to pay them off for the rest of the debt they've issued over 30 years.  

Power:  Which brings us to long-term power differential--millions of good little people vs. Chase, Goldman, BoA, Citi.  This has taken us from capitalism in local community (free-market liberty), to corporate capitalism, to financial monarchy over the last 100 years with the big financial institutions now running our government, our lives and owning everything while the little people are stuck in debt to the huge financiers who have superior claims on all the capital in the world.  They used their power to massively centralize the ownership of assets by doing nothing but making loans and finding creative ways to hide the risk and multiply the gains.  The future is grim.  

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Larry wrote:

I disagree with your statement "there is nothing wrong with Fractional Reserve Banking;" let me explain why.  They are creating almost all of the money that they lend on the spot, through a keyboard entry (out of thin air).

In 2006, M3 (broadest measure of the money supply) was nearly $10 trillion. Of that, treasury securities was around $1 trillion which means that banks expanded the money supply by a factor 10:1 through fractional lending.  And they are collecting interest on every penny.    

Hi Larry,

I would like to know if you consider the money lent in my example above to have been created out of thin air.  Personally, I don't think it was created out of thin air.  "But the bank took in $100,000 in deposits, lent $90,000 for a loan, but still has $100,000 in cash" I imagine could be the criticism - and eventually it could be said the bank took in $100,000 and "created" $900,000. 

Yes, but it has assets to back up those loans.  The loans weren't created out of nothing - they were lent against real assets, the sellers of which then deposited the money back in the bank, creating a chain of ownership, claims, and liabilities that is still whole, as can be judged by the assets and liabilities adding to zero, as they should.

If you claim the $900,000 was created out of thin air, then what were the chain of assets (houses, cars, etc) that back those loans up created from?  Aren't they each dependent on one another with each "creating" the other, as the offsetting assets and liabilities on the balance sheet would suggest?  The loans in this example were not created out of thin air anymore than the assets were.  Each offsets the other.

Where I think we would agree is in what goes on at a higher level - at the level of the Federal Reserve and Treasury.  When the Fed writes a check for an amount to be lent to the Treasury, and the Fed has no funds to back that check up but rather wills the money into existence, well that money absolutely is created out of thin air!  And, as you point out, all our money has its origin in that money creating scheme which is our system.

My point however, is that Fractional Reserve Banking in and of itself does not seem flawed to me.  The fact it functions, in our society, over a foundation of debt-based, make-believe money is a different problem entirely, and it is a problem that winds up manifesting itself through our FRB system.  The problem however, is with the underlying foundation, not the FRB system itself, at least as far as I can tell.

If we used sound money - i.e, money actually backed by something, banks could still exercise FRB practices, but our government could not will additional money into existence at the drop of a hat, sending waves of excess liquidity through the system and distorting market forces.  Also, sound money would not require perpetual debt expansion or perpetual growth because sound money is based on past production and assets, not future servitude and liabilities.  The total amount of sound money in existence would be free of any debts - it would really be wealth, whereas debt money is and continues to be, on an aggregate basis, a burden and liability on our society, which as has been said time and again, requires perpetual growth (and further debt) to exist.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

patrick wrote:
chain of ownership

The only chain of ownership is everybody becoming linked to the chain by effectively handing over ownership of everything to the banks. Just look at the economic transaction if a bank didn't exist--house seller would have an asset of $100k (or say, a seller's financing note worth $50k plus a $50k down payment) and the buyer would have a $100k house.  Throw a bank in there and neither the seller nor the buyer has an asset--the bank has both--it finances the builder/seller who owes his business to the bank if he fails to pay his loans and it owns the buyer's house as well.  And then the bank MUST find other people to loan to in order to mutiply its assets according to the reserve ratio or it goes out of business and other more aggressive banks win, i.e. exponential growth of money.

patrick wrote:
 The problem however, is with the underlying foundation, not the FRB system itself, at least as far as I can tell

But the FRB system is what evolved into the foundation we have.  It's the bankers that created it via their power (described in post #11) to influence and now own the government that establishes the foundation and perpetuates the FRB bankers' greed (described above).

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Strabes & Larry:

Let's look at the example without the bank more closely:

Let's say I lend you $1,000 so you can buy a car.  You give that $1,000 to the car seller.  He then takes the $1,000 and loans it to his brother, who uses it to pay a contractor for converting a room in his house to a new baby room.  The contractor then takes the money and lends it his mother who uses it to take a vacation.

In this example, $1,000 of money has created $3,000 worth of debt.  Is there anything wrong with this picture?  What difference does it make if a chain of debts is incurred individually vs. through a bank?

Strabes wrote:
Throw a bank in there and neither the seller nor the buyer has an asset--the bank has both

Not true.  The Seller deposits his money with the bank - that asset continues to belong to the seller and is a liability for the bank.   

Larry, you cited M3 figures and Treasury debt earlier.  I do not really understand the point of this.  M3, as I understand it, also includes debt, does it not?  In the example above, the M3 for that little economy over that little period of time, was $4,000, but no money was created.  Here's how I get to $4,000:

I lend $1,000 to Strabes   - that's $1K

Car seller lends to brother - that's another $1k

Contractor lends to mother  - $1k

Mother spends $1k on vacation - $1k (that money winds up in someone else's account - part of M3)

Total = $4,000

Of course when the government prints money and injects it into the system by spending, that would have an effect on GDP because all of a sudden there are new FRNs bouncing around in all sorts of transactions.  I do not know how much this is offset by the devaluation in the currency or by the privately-held money that the newly-created money displaces in value-less adding goods and services, but that is another story.

Strabes, I wholeheartedly agree that our nation's banking system has imbued itself with powers it should never have had, powers that are unrecognized by most people yet harm each and every one of us to an extent nobody could ever measure.  However, that is not the point of my original post.  What I was driving at was that FRB in and of itself does not seem flawed to me. 

Our actual FRB system, as the sole proprietor of a mafia-like banking cartel, is without any doubt the biggest scam in human history, but that is what happens to any industry that cartelizes itself and enjoys treatments that are above-the-law. It will continue to do so until enough people understand what is really going on and demand radical change.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

I thought in FRB the banks could take that original $100,000 and for each $10,000 lend $90,000. not just one $10,000. e.g $100,000 becomes $900,000

Also add in Interest, which never existed. turning a $100,000 loan into $500,000 paid over the life of the loan. where does that come from.

Then add in AIG which insures the original loans so the banks can re lend $90,000 over and over again without any new deposits. $900,000 of which $800,000 was 'created', could turn into $8,000,000 very easily, all loaned into existence.

Jon

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Patrick,

Again, a very nice summary. For what little it is worth, as I have no banking or economic training, that is exactly my take on things. The problem is not with fractional reserve banking, but the ethereal origins of "money" from the Federal Reserve. Oh, and yes, greed plays a very big part, too.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Hey Doc,

Any complement from a surgeon is a thumbs up in my book  

For the record, I have no background in banking either.  I am only taking what has been presented in the CC, and what I've read in The Creature from Jekyll Island, The Case Against the Fed, and various blogs and examining it.

I have no dog in this fight, and as I said in my original post, I used to be of the mind that FRB was not only bad, but immoral, so I've come a long way.  I am more than open to further examination and to changing my stance again if I can be shown solid reasons why.

I did search Mish's blog extensively, and though it's obvious he is against FRB, he never explains why.  I respect Mish and think he makes loads of sense, and so I would love to see him address this and explain his stance.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

patrick wrote:
Let's say I lend you $1,000 so you can buy a car.  You give that $1,000 to the car seller.  He then takes the $1,000 and loans it to his brother, who uses it to pay a contractor for converting a room in his house to a new baby room.  The contractor then takes the money and lends it his mother who uses it to take a vacation.

In this example, $1,000 of money has created $3,000 worth of debt.  Is there anything wrong with this picture?  What difference does it make if a chain of debts is incurred individually vs. through a bank?

This is going to feel like a distraction, but I don't believe it is...there are deeper issues than the accounting.  The difference is that when the car dealer and contractor go broke because they're funneling the proceeds from car sales and construction out of their businesses and into unproductive consumption loans (vs. self-liquidating loans that are paid back based on return on capital), the Fed won't save them by giving them more M0 to keep the system inflating, and then they won't be saved by the Treasury when deflation inevitably kicks in when the propagation of M3 collapses on itself.  FRB is a system that creates inflation and debt. Fundamental characteristics of it. Within FRB, a consumption loan is not much different than a line of credit to a corporation that's self-liquidating.  It's a system that makes loans for the sake of making loans.   FRB banks make loans based on the reserve ratio (which comes from the Fed, so we really can't separate the Fed from this issue). Banks before our FRB system made loans based on business fundamentals (conservative banks could keep more than, say, 60% reserves if they wanted, just like the Swiss cantonal banks do today, which is why you should put some cash there, but the primary issue was quality of the borrower and the likelihood of payback, not the % reserves).  

It actually seems we mostly agree Patrick.  I just don't think it's as easy to assume away the systemic issues as you do.  FRB to me means by definition the Fed's established reserve system.  Your definition is I guess just the idea of loaning out X% of your cash.  I'm fine with the latter as long as the banker takes on the risk...if the borrower defaults, the bank is out of luck.  But I don't think that's within the definition of FRB.

patrick wrote:
 Not true.  The Seller deposits his money with the bank - that asset continues to belong to the seller and is a liability for the bank

Yeah, but only sort of.  The bank loans that money right back out.  So, is it yours?  It's now become a contingent liability.  You get the money only if other people pay the bank.  This is fine for any individual case during normal inflationary times, you can get your money back, but systemically nope--the money isn't there in a bank run.  And it's definitely not there in the event of serious deflation.  People will find their supposed "assets" disappearing in the next big downwave of the crash as banks go up in smoke.   It's also what caused the almost cataclysmic failure we experienced in september with every primary firm at risk of disappearing because they each had basically become a mega contingent liability for every other firm.  

But in my example that you referred to here, I got a bit messy.  I was actually refering to the fact that the home builder/seller is running his business via commercial bank loans as well (worth way more than the deposit resulting from the sale of 1 house).  So, the bank owns the house that the buyer thinks he owns, and the bank owns the builder's business (at least has the primary claim on it up to the amount of financing).  

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

patrick wrote:
Yes, but it has assets to back up those loans.  The loans weren't created out of nothing - they were lent against real assets, the sellers of which then deposited the money back in the bank, creating a chain of ownership, claims, and liabilities that is still whole, as can be judged by the assets and liabilities adding to zero, as they should.

If you claim the $900,000 was created out of thin air, then what were the chain of assets (houses, cars, etc) that back those loans up created from?  Aren't they each dependent on one another with each "creating" the other, as the offsetting assets and liabilities on the balance sheet would suggest?  The loans in this example were not created out of thin air anymore than the assets were.  Each offsets the other.

This is a muddy issue too.  Looking at the individual transactional level makes it seem very clear.  But at a macro level, the assets were in a way created "out of thin air" as well.  Ford makes far fewer cars if JPMChase doesn't extend growing credit through FRB.  Homebuilders make FAR fewer homes if they don't get inflated credit through construction loans.  We have to remember this is a closed money system.  All money in circulation on the buy side and the sell side was created through loans via FRB.  Yes, the sellers "deposited the money back in the bank" but that serves as the basis for new loans on the supply side as well...it doesn't all sit in the bank.  

Credit inflation via FRB creates the exponential growth we see on the supply side of the economy.

Credit inflation via FRB creates the exponential growth we see on the demand side of the economy.

Breakdown occurs when credit inflation stops, as it has now.  That's when we see how "thin" the air was that FRB generated to create all of our supposed wealth. 

Again, maybe we're debating over nothing because we're using 2 different definitions of FRB.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

The FRB system is based on institutions called banks that do nothing productive except multiply debt and inflation.  Meanwhile they centralize asset ownership under themselves exchanging collateral for bank money, and bank money disappears in deflation.  Who wins the game?

The system must be evaluated for long-term eq, not individual transactions.  A bank that only does an individual lending transaction dies...a bank depends on inflation and recycling the money perpetually.  The individual car salesman and home builder in your example above actually do something productive.  They can loan a bit of money from the profits they've acquired through being part of the production machine.  Banks can't because they don't produce.  They simply have a government-endorsed elite position above producers/consumers with the exclusive right to create "money" via FRB lending.  That's their business.  Their incentive is to defend that right by working with or becoming the government.  They do nothing else.  

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

I quite agree with strabes’ statements explained above.

Mr. Brown’s initial assumption was that ’The ultimate cause of our credit bubble has nothing to do with Fractional Reserve Banking.’

Excuse my poor English, but I think this postulation can be further disproved. One of the simplest arguments might be that the FRB acts pro-cyclical by design.

Pro-cyclical by design is another word for instable by design which means TSHTF.

The banking business model implies a pro-cyclical loaning and economic progress behavior. FRB is an effective money-multiplier by design. The designated counterbalance in the system is the central bank. I've got the notion that the designated counterbalance cannot work by design in the FRB system.
Even if the central bank would be able to determine the downright money expansion rate theoretically, it couldn’t deploy according measures due to their self-fulfilling prophecy / collateral damage potential to the economy. An over-optimistic/inflationary central bank policy is unavoidable.
Through, the central bank does not know the adequate money expansion rate down-to-earth. They do compute upper and lower specification limits called inflation and deflation. Well, since the perniciousness of hitting this upper and lower specification limits is not alike, which path is always safer? One can imagine that the bubbling of the money-multiplier system is inherent.

Nevertheless, in our credit economy we’ve to pretend that the dog wags the tail - unless we want to make us all look foolish:-) 

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Well Patrick,

Your argument certainly  makes sense to me. Bottom line is that if we had sound money (i.e. based on gold) and bankers that followed a conservative approach to lending we would not be in this mess.

It was a well thought out piece. Thanks for posting it.

Ken

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

KenC:  Glad you liked it.

Baywork:  If you don't mind, I would appreciate if you could expand on your thoughts.  You say FRBanking is pro-cyclical by design.  I suppose you mean that it demands growth in order for debts to be paid.  Fair enough.  Each debtor must of course produce enough income to pay back not only the principle but also the interest.

In our existing FRBanking system with a CB, we already know that our debt-based money system perpetuates an ever-growing supply of money.  And, if it were to encounter zero-growth or worse, shrinking economic conditions, it stands a very good chance of total collapse (with the only remedy being hyperinflation). I have no argument there.

What I want to know is, is there anything wrong with FRBanking in an economic system that is not based on debt-based money, but on sound money?  If there is no magical printing press, and no 4th arm of government with the capability to lend thin-air funds to member banks or to the Treasury, is there anything fundamentally unsound with FRBanking?  

It seems to me that if a loan is made, and the proceeds are re-deposited by the Seller (and for our discussion I think it's easier to pretend it's the same exact bank that made the loan even though all we're really talking about are aggregate loans, aggregate deposits and aggregate banks), then why shouldn't the bank be able to lend that money?  

Critics will say it's the same money that was originally lent.  Well, it's not.  Just like in my example in post 14, a chain of loans can be made without FRBanking - in fact, with no bank at all - creating much more debt than there is money in the system.  Is Sally not supposed to lend to Harry because Sally borrowed that from Steve and therefore the money shouldn't be re-lent?  That makes no sense.  The money was Harry's, then Sally's, then finally Steve's.  Sure, it could have been the exact same pile of $20 bills, but each pile was traded for a different asset, and that's what matters.  What would be totally wrong would be for multiple loans to be made against the same asset, resulting in a debt value much larger than the asset was worth, and possibly just as bad, creating multiple claims for the same asset in case of default.

So, I still do not see anything wrong with FRBanking, or with any group of people lending to one another in way that results in more debt than money.  In fact, I cannot even see how it would ever be possible to ever have debt in any system be anywhere close to the actual amount of money in it.  But, I am open to suggestions.  

Thanks all for your input.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Patrick Brown wrote:
What would be totally wrong would be for multiple loans to be made against the same asset, resulting in a debt value much larger than the asset was worth, and possibly just as bad, creating multiple claims for the same asset in case of default.

Even worse, as we have seen, would be for a lender to be provided with cheap "money" (hot off the printing presses) and encouraged to make bad loans in which the likelihood of default is high. Add to that the purchasing of "insurance" (a wager, really), in the event a given borrower will default on the loan, particularly when that "insurance" is purchased by any number of lenders other than the primary lender. Thus, we have the subprime lending and credit default swaps that, along with our fiat money system, seem to me to be at the heart of our current economic crisis.

I don't see a problem with fractional reserve banking, per se; it was how it banking was utilized, along with derivative financial instruments, that are the problem.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Patrick, I'm baffled at why you're not seeing what I'm saying.  And my guess is you're baffled in the same way about me because you're ignoring me!   I'll try to stick to my point and avoid talking about morality, greed, power, etc.  I recommend running the excel model of 60+ iterations so the FRB process can run its course...you don't get a sense for the charade by just looking at the first 2 accounting transactions.  

You're setting up impossible assumptions.  FRB and a completely sound money system can't coexist.  In a pure sound money system, i.e. with no debt-based money (bank debt/credit creates debt-based money), a FRB bank couldn't exist.  In a sound money system, growth comes from production, not lending and debt creation/inflation.  FRB creates debt money by definition even if the national currency is sound.  M1, 2, 3 are measures of debt-based money.  It doesn't matter if M0 is loaned into existence as it is now, or based on gold as it used to be.  FRB multiplies the base currency (whether it's gold-based or not) into debt money.  In a non-debt economy, there's no M1, 2, 3. Little banks that existed before the Fed were still mini debt-money creation machines (leverage on the base money), and they boomed/busted regularly because debt propagation (by definition what FRB is) creates more claims on the money than there is real money in existence. Suggesting that we eliminate the Fed from the picture doesn't change anything.  The Fed just increases the scale of the banks and the scale of boom/bust to mammoth proportions to the point where millions of people around the world are going to prematurely die as a result of this bust cycle.  That wouldn't have happened without the Fed because of a more natural limit on scale, but little boom/bust cycles would have been happening had the Fed not existed and been able to prolong debt inflation for 80 years since the Depression.  

Just look at your example:  based on $100k deposit in sound money even if it's based on gold, the bank recycles it through the system 50-60 times creating $900k in additional money that is debt-based...based on someone's obligation to pay ($900k in deposits, $900k in debt, $900k in cars assuming every borrower buys a car with the loan, all based on $100k in reserves which is the only sound money in the system).  That works until the little village (system without the Fed) goes into a downturn.  Then the local borrowers lose some of their debt-based money (what they think is sitting in the bank as a deposit) while the little local banker has possession of the sound money reserves (the original $100k as it has recycled through the system) plus the cars.   

Now, what if the local government said the banker could only loan 60% of the money each iteration instead of 90%?  Way safer.  Less boom/bust cycle, but the cycle would still happen because there's more claims on the money than actually exists.  Folks, bank runs and debt deflation have occurred throughout history, not just since Fannie, Freddie, AIG and the investment banks figured out ways to amp up leverage to 30x-100x.  You're making the mistake of looking at the absurd aspects of today's crash and saying those things are the only problem.  In fact, those things are just what prevented the more mini busts that would have been occurring at more natural FRB ratios over the last 80 years.   

Patrick, consider your example with Sally, Steve, Harry...  If it's so reasonable, why doesn't it happen without banks?  It's not just Sally lending $1k to Steve who lends $1k to Harry...it's Sally lending 50 times over and over to 50 different Steves lending 90% of her previous loan each time.  Why don't we have a society where people repeatedly cycle loans like that to each other and propagate their own debt without banks?  Because it does not work. It doesn't work with random individuals cycling their cash 50x through different individuals creating 10x debt on top of their original cash...it's illegal...that's why only legal banks can do it...a lawyer could write a contract for you to loan to a friend based on some collateral, but you would not be able to repeatedly iterate that money through other people to 10x your money.  The system you're proposing with individuals loaning to each other based on FRB principles only happens when the guy loaning the money is called Godfather, he charges 20+% interest, and he has a team of guys named Vinnie with bats to enforce his contracts.  

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Patrick Brown wrote:

Baywork:  If you don't mind, I would appreciate if you could expand on your thoughts.  You say FRBanking is pro-cyclical by design.

Because the FRBanking business model is based on recursive expectations.

The credit banking business model is to breed interest payments. For the not by reserve backed up part of the loan they don’t have real opportunity costs like an ordinary lender. They determine a risk premium which is related to recursive expectations. That’s why the business is pro-cyclical by design. And, of course in order to breed interest, the money base must be expanded.

In the second a bank creates a loan there’s no real value added to the world. This is the basic feature of the FRB, thin-air money is generated because only a fraction of reserves are required.
The borrower gets access to existing values, basically access to all existing values is fractionally redistributed because the banker thinks the deal is reasonable. And the money equivalents of backup asset are touched also? Well, no problem if the interest payments collected by the banker are a share of subsequent real world added value.
However the deal is also basically reasonable for the banker if the collected interest is in effect also a share of the expanded money base.

Money makes people work, it does not work. It does not add real value to the world itself.
Nevertheless, from the banker’s perspective money does work.
The banker’s business model is not to add value, the assignment is to create money so others add future value in the credit economy. But the banker’s interest breeding business is basically limited by expectations rather than real values. The mechanism is pro-cyclical up and down the wave. As mentioned, the banker’s business acts as a feed forward loop since the system provides no hardwired connection to real world added value.

If the tail manages to wag the dog, interest generation can be maximized.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Strabes:

Money is not used to create debt in FRBanking or in any other kind of lending.  Assets are what is used.

You argue that $90,000 is used to "create" $900,000 in debt but it is not.  The $900,000 in debt is lent against existing assets.  The only thing that is necessary to "create" the $900,000 is the cash flow necessary to pay it and the interest payments.

So "Aha", you might say, "so now the society must create $900,000 plus interests to pay off the debts"!  No, it doesn't.  The bank would not make a loan if the recipient did not already have the cash flow necessary to pay it, so the cash flows, that is, the excess production, the $900,000 in future payments plus interest, is presumably already in the system.  Isn't that why banks make sure your total mortgage, insurance and property taxes are not more than a certain % of your income and why you must also have a certain amount of free cash flow in your budget (total debt payments to income) in order to qualify for a loan?

I would be stupid to lend you any amount of money you did not have the ability to pay back, with the proof being in the existence of excess cash flow/ free cash flow/ excess production above living expenses on your part.

Of course, if in actuality I am lending money that comes from a second-tier lender who is really the one who is going to lend the money, and will pay me a fat commission for originating the loan, maybe I just won't be so careful at all.  In fact, I may spend most of my energy coniving how to trick the second-tier lender into think everything is OK rather than ensuring the borrower is fit to borrow.

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Patrick Brown wrote:

 Money is not used to create debt in FRBanking or in any other kind of lending.  Assets are what is used.

Yes, assets and liabilities are what is used. Simply take an ordinary stock or a tax payer (the state asset). The amount of credit you can buy for such an asset is dependent upon economic expectations which are dependent upon expectations that previous expectations were already credit inflated or not...

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strabes
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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Again you're looking micro...not at the systemic level necessary to evaluate FRB.  Do the mental exercise with a small town of 10 equal people and one declares himself a FRB bank.  Think through what happens.  Only then can we grasp FRB in our mega system. FRB hits a limit where it can't grow unless something changes since banks don't create real value.  So what changes? As you answer that question you'll repaint american history and see our 200 years of financial history evolving in your mind.

Quote:
 The $900,000 in debt is lent against existing assets.  

What makes those "assets" (a car is a drain on cash, which is a liability, yet a FRB bank is able to make money off it) worth $900k? It's because the bank created that much purchasing power in the system!  To understand FRB we need to remember what prices and money are.  Banks increase velocity... in today's terms, they make broader money (M1/2/3) off of M0 (the only money capable of being sound even though our M0 today is not).

Quote:
 The bank would not make a loan if the recipient did not already have the cash flow necessary to pay it, so the cash flows, that is, the excess production, the $900,000 in future payments plus interest, is presumably already in the system.  

"Presumably" is a big word.  If it were already in the system we wouldn't need banks.   

Quote:
 Money is not used to create debt in FRBanking or in any other kind of lending.  Assets are what is used.

Without money, FRB doesn't exist...it is a money expansion system by definition.  It's the core reserve (the asset...an asset is by definition monetizable...it has monetary value...banks convert them into money) that is the basis for the lending to start.  Then iterative lending (secured by contingent liabilities which they're able to call "assets" because they're a bank) enables them to 10x their assets. If FRB was so solid and strictly based on assets, then why wouldn't every businessperson in the world just become a banker...instant ability to make an asset into 10x the asset.  Why do real production, which is so much harder to create value?  

I'm feeling this discussion is futile.  To understand FRB you can't just look at a couple accounting transactions...that's what fools people into thinking it's fine.  It requires a fundamental understanding of money.  That's how bankers get away with what they do...nobody understands money.  

Just happened to look on wikipedia and this is a pretty good article covering most of the perspectives on the pros/cons...

http://en.wikipedia.org/wiki/Criticism_of_fractional-reserve_banking

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Re: How I Learned to Stop Worrying About Fractional Reserve ...

Hi Patrick,

Did you read Mish's article on Fractional Reserve Lending?

Case Against the Fed and Fractional Reserve Lending

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