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Fractional Reserve Banking

Fractional Reserve Banking

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Published by Anders Mikkelsen
Short notes on Fractional Reserve Banking. Prepared for local discussion in NY about Fractional Reserve Banking.
Short notes on Fractional Reserve Banking. Prepared for local discussion in NY about Fractional Reserve Banking.

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Published by: Anders Mikkelsen on Oct 19, 2009
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Fractional Reserve Banking
 There are three key parts of the modern banking system. 1. Fiat currency and legaltender laws. 2. Fractional reserve. 3. A central bank to centrally coordinateeverything.Fractional Reserve is a system where banks accept demand deposits and loan outthe depositors’ money, and keep only a fraction of the deposits as a reserve forwithdrawals.Banks tell depositors their money is available to be withdrawn at any time, when infact the money has been loaned to other people. The banks can not meet their obligations. It is a very clever form of a ponzi scheme. This is unique to banks – grain silos and other warehouses don’t do issue counterfeitwarehouse receipts backed by other people’s deposits. If they did it would beconsidered fraud by the courts – however Banks are exception to the legal principle. The reason why counterfeiting is illegal is because it is fraud. People counterfeitbecause it benefits them.As believers in liberty we are against force and fraud.
Fractional reserve has a long history going back to the beginnings of banking.Courts treated all banks as fractional reserve banks – banks had no contractualobligation to be 100% reserve. Depositors were at the mercy of the bankers.hIn the past circulation of paper money backed by fractional reserves of gold led totemporary increases in the money supply which created business cycles. Therewould be more paper money in circulation than actual gold, which distorted prices.Bankers wanted hard money backed by gold. They understood that continualincreases in the money supply would wipe them out. (By contrast manufacturersand farmers with debts wanted more money in circulation so they could repay loanswith less valuable money.) On the other hand they would make more money byloaning out via a fractional reserve system. The long term successful establishmentbankers would keep things in balance, but would face periodic crises from thebusiness cycles that threatened to wipe them out. The net gainers of the process are the banks and the people they loan to. The losersare everyone.Bankers setting up central banks understood that fractional reserve systems areunstable and require a central bank to keep the establishment bankers afloat.
 Today we have fiat currency backed by nothing. Fractional reserve allows the banksto expand the amount of quantity of loans and credit in the economy. Expansion of credit distorts prices and creates a business cycle or runaway inflation. The value of fiat currency has decreased by 95% or more in pretty much all countries.Most money is kept in banks. Banks loan out your deposits, putting money in to anaccount for the borrower. The borrower spends the money, and the recipient of themoney usually puts the money back in to another bank account. Money continues tocirculate within the banking system and it isn’t withdrawn as cash. If it waswithdrawn the system would promptly run in to problems.When the banks run in to trouble they can get the federal reserve to bail them out. This is the explicit purpose and social function of all central banks – to bail outbanks by being the lender of last resort. There is nothing controversial about this. The banking system is considered sound by many precisely because there is acentral bank. By contrast I’d say the system is worse as we have business cyclesand paper money is worth less year after year. There’s no limit on inflation.Bankers setting up central banks understood that fractional reserve systems areunstable and require a central bank to keep the establishment bankers afloat.
 The replacement is a 100% reserve system. The bank must keep 100% of themoney on hand necessary to meet its obligations.Money would be whatever the market decides is money. Historically this has beengold. The key problem with Fractional Reserve is that the time structure of the banks’liabilities (obligations to depositors) are much shorter than the time structure of their assets (the borrowers obligations to the banks.) Banks borrow short and lendlong. Depositors can withdraw their money at any time while borrowers have moretime to repay the bank. This means that banks are inherently bankrupt – they can’tpay their obligation if asked. No other business or person can run its books so itruns out of money if it pays its obligations.Rothbard suggested that the time structure of banks obligations should match thatof their loans. Rothbard would have no problem with depositors giving banks moneyfor 90 days and banks lending the money at 90 days or less. This wouldn’t createtemporary increases in the money supply. People can do this today with CDs.Money market funds are also useful for short term credit.For longer term loans savers could invest in something like a mutual fund for loans. They might not be able to redeem their deposit until the loan is over – but theycould sell their share on the open market.

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