Monday, February 09, 2009

I had an epiphany about fractional reserve systems today

A few years ago on “24”, there was a scene where Jack was talking to one of the bad guys.   Here’s the scene:

poster70525211"24: Day 5: 12:00 a.m.-1:00 a.m. (#5.18)" (2006)

Jack Bauer: [to Christopher Henderson, who is holding Audrey hostage] Why are you doing this? Why are you protecting Logan?
Christopher Henderson: I'm protecting something much more important than Charles Logan...
Jack Bauer: What?
Christopher Henderson: The integrity of our government!
Jack Bauer: Our government has no integrity!

Here’s the thing I realized today:  fractional reserve systems rip off the middle class.  The reason is based partly on fractional reserve itself, and the other based on FDIC limits.

First, FDIC.  The limit of FDIC insurance is $100K, $250K between a married couple.   So people with more than $100K to save are going to put it into a financial instrument other than a deposit at a bank.  Maybe a mutual fund, or maybe a bond ladder.  The middle class, they mostly have savings accounts.

Now consider fractional reserve.  Banks loan that money at a 9 to 1 ratio.  So for every dollar of that $100K you’ve put in, the bank has loaned out possibly 9 dollars.

Doesn’t this sound like it’s diluting the money you’re putting in?  It is.

The fractional reserve system is purely designed to benefit one group:  banks, who can make 9x the interest they’d make if they could only loan the same money you had deposited with them.

The result is inflation, and your money being worth less.  The long term result is we have an economy that isn’t based on production.  It’s based on borrowing and consumption, because that’s the incentive built into the system.  The incentive is to grant as much credit as much as possible.

And that’s all of what we see today, almost 100 years after the Federal Reserve Act was put in place. 

  • The country is overleveraged.
  • Production has moved out of the country.
  • The middle class has no buying power left.
  • The thrifty people we borrow from are all foreign entities.

The only solution is to abolish the fractional reserve system and return to a non-fiat currency.  These frauds in Washington like to pretend we need to spend another trillion to save the country even before the last trillion has run out.  They believe currency is a confidence game.  And, you know what… it is, if it’s left to the bankrupt scam called the Federal Reserve that’s in place today.


b said...

The FDIC limit was raised to $250K per person and $500K for a married couple.

Nathan said...

Yes, the fractional reserve banking system is set up to benefit banks. I wonder if "banks hurt the middle class" is really the correct conclusion, though. It might be more general: fractional reserve banking hurts everyone who has net savings.

The pool of loanable money would be smaller in the absence of fractional reserve banking, so the interest rate charged for bank loans would be significantly higher. Deposits would be more valuable and earn a higher rate.

The flip side is that capital to grow businesses would be more expensive. This would probably give a big advantage to established companies that could fund expansion into new ventures out of existing profitable lines of business, and would be a huge disadvantage to startups.

I don't follow your argument about fractional reserve banking increasing inflation. In the absence of other manipulation of the money supply, I would expect a one-time inflationary event at the point where the reserve ratio were decreased (as long as it stays above 0%), and a similar deflationary event when the reserve ratio increased. If the reserve ratio stays basically fixed at 10%, the fractional reserve nature of the banking system does not have a lasting inflationary contribution.

Of course, the preceding paragraph does not describe the banking system we actually have. There is manipulation of the money supply through means other than the reserve ratio, and the reserve ratio for time deposits (such as CDs) is 0%, which does seem inflationary.

Trimbo said...

"I don't follow your argument about fractional reserve banking increasing inflation."

I'm an armchair economist, so here's what I was thinking:

Say I deposit $100K into the bank, and the bank loans $900K to a person to buy a house with my deposit as their reserve. That person buys the house. The person they bought the house from then deposits that $900K into another bank, and that bank can loan $8.1M on that. And so on. Even if they only deposited $100K of that $900K (and invested $800K in assets), the bank can still create another $900K off of the $100K that was created from the prior bank.

Correct me if I'm wrong about this having an impact on the money supply.

Nathan said...

"Say I deposit $100K into the bank, and the bank loans $900K to a person to buy a house with my deposit as their reserve."

That's not how fractional reserve banking works. Assuming a reserve ratio of 10%, when you deposit $100K into the bank the bank can only loan out $90K, not $900K. When that $90K loan is deposited in a bank, that bank then can loan out $81K. Continuing this cycle a large number of times results in loans equal to ~$900K based on our original $100K deposit, but there is a limit on how many times the original deposit is multiplied.

If the banking system operated as you described, then yes, it would be wildly inflationary because there would be no limit on the increase in the money supply due bank lending.

Trimbo said...

Doh! I see what you mean. My understanding of it was backwards. Thanks for clearing it up!

Ralph said...

I agree with Nathan that the fractional reserve system is not inherently inflationary. Trimbo answers Nathan by setting out a classic illustration of the fractional reserve system where $900k of credit is created from an initial $100k deposit, and claims that this boosts demand and inflation.

Nathan responds simply by setting out the 100k / 900k phenomenon in more detail (and correct detail). But this isn’t an explanation of why fractional reserve is not inflionary.

My explanation is thus. That 100k to 900k phenomenon all other things being equal would boost demand (and if demand were already excessive, then inflation would be exacerbated). But remember that bank customers all over the country are repaying loans about as fast as they take them out. In as far as the latter is the case, the net effect is zero, i.e. not demand increasing or inflation increasing.

As far as inflation goes, the crucial thing to look at is the total money supply for the country a whole. Milton Friedman’s big idea was to allow this to increase by a small amount each year (2% or so).

My fundamental objection to fractional reserve is that it is “pro cyclical”, i.e. during booms, commercial banks do exactly what they shouldn’t do: create even more credit, which exacerbates the boom. And during recessions, they do the opposite: extinguish credit or “extinguish money” or “deleverage” which makes the recession worse. This is exactly what is going on in the current 2009 recession.