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

Login or register to post comments Last Post 27761 reads   141 posts
Viewing 10 posts - 1 through 10 (of 141 total)
  • Sun, Jun 21, 2009 - 03:23am

    #1
    Farmer Brown

    Farmer Brown

    Status Silver Member (Offline)

    Joined: Nov 23 2008

    Posts: 158

    count placeholder

    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!

 

  • Sun, Jun 21, 2009 - 01:46pm

    #2
    Peak Prosperity Admin

    Peak Prosperity Admin

    Status Bronze Member (Offline)

    Joined: Oct 31 2017

    Posts: 1613

    count placeholder

    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…

 

  • Sun, Jun 21, 2009 - 03:13pm

    #3
    Peak Prosperity Admin

    Peak Prosperity Admin

    Status Bronze Member (Offline)

    Joined: Oct 31 2017

    Posts: 1613

    count placeholder

    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.

  • Sun, Jun 21, 2009 - 03:30pm

    #4
    Peak Prosperity Admin

    Peak Prosperity Admin

    Status Bronze Member (Offline)

    Joined: Oct 31 2017

    Posts: 1613

    count placeholder

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

Jeff,

That would be yours truly.

  • Sun, Jun 21, 2009 - 06:20pm

    #5
    Peak Prosperity Admin

    Peak Prosperity Admin

    Status Bronze Member (Offline)

    Joined: Oct 31 2017

    Posts: 1613

    count placeholder

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

[quote=Patrick Brown]

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) 

[/quote]

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?

  • Sun, Jun 21, 2009 - 06:54pm

    #6
    Peak Prosperity Admin

    Peak Prosperity Admin

    Status Bronze Member (Offline)

    Joined: Oct 31 2017

    Posts: 1613

    count placeholder

    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.

 

  • Sun, Jun 21, 2009 - 07:19pm

    #7
    Peak Prosperity Admin

    Peak Prosperity Admin

    Status Bronze Member (Offline)

    Joined: Oct 31 2017

    Posts: 1613

    count placeholder

    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?

  • Sun, Jun 21, 2009 - 07:38pm

    #8
    Peak Prosperity Admin

    Peak Prosperity Admin

    Status Bronze Member (Offline)

    Joined: Oct 31 2017

    Posts: 1613

    count placeholder

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

[quote=Baywork] 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. [/quote]

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.

  • Sun, Jun 21, 2009 - 07:48pm

    #9
    Peak Prosperity Admin

    Peak Prosperity Admin

    Status Bronze Member (Offline)

    Joined: Oct 31 2017

    Posts: 1613

    count placeholder

    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?!

  • Sun, Jun 21, 2009 - 08:44pm

    #10
    Peak Prosperity Admin

    Peak Prosperity Admin

    Status Bronze Member (Offline)

    Joined: Oct 31 2017

    Posts: 1613

    count placeholder

    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

Viewing 10 posts - 1 through 10 (of 141 total)

Login or Register to post comments