What are Fractional Reserves?
The US Federal Reserve, or Central Bank, is the banking system’s bank. It is the lender of last resort.
It is through the Central Bank that banks settle their accounts with each other. The central bank serves as a clearinghouse for checks written by depositors, and it holds the commercial banks’ reserves.
Bank reserves (vault cash, and deposits by banks at the Central Bank or the Fed) are monies held out of circulation by banks to satisfy the Fed’s reserve requirements and the currency demand by the public. Excess reserves are those held above the legal reserve requirements to handle uncertain demand. Bank deposits not held in (required plus excess) reserves are used to make loans and earn interest.
When banks make loans, they do not actually lend out the equivalent in cash but instead create on their balance sheet a loan asset and an equal liability called a demand deposit. Such lending by banks is limited only by reserve requirements (set by the Fed) and the cash they need to satisfy cash withdrawal demand by their customers.
As these loans are then re-deposited by the borrower, the multiplier process continues as fractional reserves are held back and the balance is “lent” out again.
Learning from Dogs 
The most important point about the fractional reserve system is that it allows banks to create most of the money. However weird that sounds…
Creating the public’s money ought to be a strict prerogative of the state, because money is a public utility, and it cannot be the reserve of a few private individuals, (motivated by their personal profit, or not).
Conclusion: a strict functional ethic in accord with a deontology and a ferocious supervision and penal system should be created to oversee bankers, because they are just, in truth, officers of the state, thus making their present activities akin to corruption (because they use for private profit money that was created for everybody, or then create money out of thin air.)
Really private banking should have a multiplier of one: you invest what you have, not a dime more.
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Patrice: I probably should have clarified that I posted this piece in response to a request from a reader to explain the fractional reserve system. I was not drawing any conclusions or making any inferences.
In any case, in your comment, you confuse money with profit (or income). Both are measured (in the U.S.) with dollars, but they are not the same thing.
Income is the value created by labor and capital.
Money is liquidity. It, too, is denominated in dollars, but that doesn’t make it income.
The Federal Reserve creates money. It controls the money supply. Individuals, through money demand, and banks, through excess reserves and lending, do have a marginal impact on the equilibrium level of the money supply, but the Fed can offset any and all actions of either group.
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You say that I “confuse money with profit (or income)”? I really do not see where I did get so confused. I have got to be real stupid.
You say “Income is value”. Then you say it is measured in dollars. So “value” is measured in dollars? I guess, a point I have been trying to make, precisely, is that “value” is greater a concept, and has greater public utility than “income measured in dollars”.
You say: “The Federal Reserve creates money. It controls the money supply.” True, sure. But the central bank “controls” money only INDIRECTLY.
The relationship of the central banks to money is just as that of the admiralties to privateers, a little way back.
Most of the money is created by private banks. Under normal reserve requirements, about 4/5. Central banks (it’s not just the Fed!) control the money supply through the reserve requirements, or, otherwise said the multiplier.
This is the big dirty secret bonus bankers and the hyper rich do not want the People to know, worldwide. Because, if the People understood this, People would realize that they are not in People-rule (demo-cracy), but in pluto-cracy (Money-rule).
Thus, I fully expect the upper class and its devoted helpers to absolutely not understand what I am talking about: their income depends upon it. And, of course, they would have little value otherwise… And no money, besides…
This is getting to be fun…
PA
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Patrice,
Here is where, in my view, you confuse money with income, referring to banks:
” …because they use for private profit money that was created for everybody, or then create money out of thin air.”
The money supply, which is controlled by the Federal Reserve, which is the Central Bank, is not income, or profits, or earnings, or command over goods and services (which are the closest objective though admittedly incomplete measure we have of “value”). Money is the oil in the engine of value creation. The engine is composed of capital and labor, and its output is the goods and services that people use to survive and enjoy. The engine would still be there, it would still produce, producers would still have profits,and people would still consume and survive, all without MONEY.
So, again, you confuse money and income.
And notice I did not have to accuse you of being from a particular class of people who speak not the truth but who twist the facts to try to protect my position.
So what is the fun part? Clarifying things? Trying to incite class warfare? Insinuating other peoples’ motives? Never mind — that’s a distraction from what this cite is supposed to be about.
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It was of course highly ironical that you informed me that I confused income and money. Verily, this is exactly what I accuse the banks of doing. They create our money, from a government mandate, and they view it, basically, as their income.(through a few trivial manipulations.)
They have several ways of doing that. Oone of the simplest is this. Right now they get money from the Fed at roughly 0% and they buy government bonds with that, at 3.5%…
PA
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There is nothing “ironical” with a bank earning income from providing a service.
Banks do not earn an income from “creating money.” Let me try to explain my point. I distinguish the multiplier from the base, because an increase in the money supply through the multiplier is impossible unless the fed creates an increase in the monetary base in the first place. The fed controls the multiplier as well, either directly through reserve requirements, or indirectly through reacting to money demand by the public. If the Fed changed the rules of THEIR game, and required essentially 100% reserves, the money multiplier falls to 1, and the increase in the base — entirely controlled by the Fed — is the increase in the money supply.
The U.S. money supply is NOT the U.S. level of GDP or income. They are different animals, come from two entirely different processes, but do interact and do both happen to be measured in dollars.
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Happy Christmas, Sherry:
We agree about several points, such as full reserve banking would be 100% controlled by the Fed. But please notice that this means that in the present system, increase in the money supply is not controlled by the Fed, but by private individuals, the private, unelected, unsupervised bonus bankers.
Let me be a bit more precise. When the banks lend, as they are supposed to, they do create money, multiplying the one given by the central bank. So far, so good. I am NOT against the fractional reserve, per se. My objection, which I tried to make extremely clear is that banks lend the money to whoever they please. That, per se, is not a problem either. It is a problem as implemented now, because bonus bankers are mostly driven by profit for their ilk.
And that is where I part with the present system. A strict deontology, backed up by stiff penalties is necessary to prevent this sort of venality and nepotism, plus political influence peddling. I noticed that you yourself have mentioned that some of the activities of government are akin to this, and that you deplored it.
As it is banks lend to a particular class, allowing the later to be the only one with money that they thereafter can turn into profits. To describe this by a logical hyperlink, that means banks are allowed to create not just money, but profits for themselves, at the exclusion, possibly of the productive entrepreneurs in the economy.
Big bank loving Obama himself has complained recently that “fat cats bankers” are not lending to the real economy. But why would they? No deontology force them to.
If I were Big bank Bonus Banker, the Fed would come, lend me a billion, or more. Then I could put it back with the government at 3.5%, and make a profit of 35 million in a year, with zero risk. Would that be class warfare? Sure.
I could also play derivatives, like Goldman Sachs, and, if I won, I would claim a profit and giant bonuses, whereas, if I lost, the government would replenish me with 50 billion dollars or so. Class warfare? You decide.
Lending to what looks as the most profitable projects for the real economy is OK with me. That is what I want to see big banks do. But I do not want to see Big banks lending to friends, just because they are friends, or belong to the same ilk. Nor should it be OK to lend to the casino in the sky somewhere on another planet of derivatives.
Thus I claim that because fractional system, non unity multiplier bankers create the money that end up circulating in the general economy, they are de facto civil servants, and a deontology ought to force them to behave as such.
The old class warfare was about having a small part of society forcing the rest to work miserably for them. What we have now is different, and is more reminiscent of Antique Rome, when the plutocracy removed employment from the core of the empire to ensure power on the People. The outcome may be different this time, because many Europeans, who are more invested in history, are fully aware of the mistakes of the past. The Germans and French, at least, are firmly determined to not de-industrialize and decerebrate too much. Britain seems to recognize its error, and is backing away from the excess of short term monetary profiteering.
Having an economy means more than a few making profits. It’s about managing a house, and, implicitly, doing it well.
As somebody who tried to make some profitable investments in the past, I felt personally alarmed when I was told I got confused between money and income. Sorry if you felt offended by what you viewed as class warfare and personal insinuations. Methinks only Goldman Sachs and its ilk practices class warfare, and I am sorry to say I do not have that sort of income, money, or whatever.
And please be assured that I appreciate your time and effort to address my financial ignorance.
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And, in turn, I am enjoying the way this exchange explores areas that are not familiar to me – part of the justification of the Blog in the first place.
Also, I have been remiss in not offering Christmas greetings to you and your family and for thanking you for the support you have shown to us authors over the last few months.
I sense 2010 may be a year of more interest that many of us would want! But at least we can have healthy commentary! 😉
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Hello Patrice,
That is clearer, thank you. But I maintain that banks do not create money; they cannot take something that wasn’t there yesterday, and make it appear today. Only the Fed can do that.
A bank takes the new reserves created by the Fed, let’s say $100, and lends the fraction that is not held back as currency (to satisfy check cashing activities of the local community), required reserves as dictated by the Fed, and excess reserves as a sort of insurance policy against uncertain demand for currency (except now the Fed is paying the banks for their excess reserves, in income, not money supply).
So now this bank has an increase of $100 in liabilities on the right-hand-side of its balance sheet (reserves created by the Fed, injected into the banking system as deposits), and an equivalent increase of $100 in assets (currency, reserves, and loans) on the left-hand-side of its balance sheet. So, no, the bank does not create money. The balance sheet balances. Accounting is odd that way.
Because of the fractional reserve system set up by the Fed, once that first loan is eventually deposited into another commercial bank, it too becomes part of the money supply (forgive the details — I know you know this but I have to lay it out to try to refine my point). But that second bank does not create money either. It takes in the deposit (from existing funds, not newly created funds), holds back enough to cover currency demand and reserves then, we hope, lends out the balance. Its balance sheet balances, too.
Lending, as you clearly know, is the income-generating activity of the bank. The banks provide a service to the economy, as do savers and venture capitalists and angel investors and so on. This service is an integral part of the capital formation process of the economy. Fundamentally, all banks (and the other lenders) do is enable businesses and homeowners to move their resources around through time. And they charge interest for doing that, to compensate them for intervening expected inflation and for the risk that the borrower may not pay them back. There is nothing evil or suspect or wrong with charging interest for lending. And if you think there is, then I’m sure you’d have no trouble lending me $100,000 at zero interest?
There is a difference between creating money, increasing the money supply, and earning income or profits. They are each distinct and each serve a specific purpose. I think that what you were saying is that creating money and increasing the money supply are essentially the same thing, and that banks should not earn a profit for lending money. And I have tried to respond to those assertions.
Merry Christmas to you, too.
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Sherry: we are working through Christmas! Thanks for your answer. It seems that our differences involve philosophy of the very practical type.
I am not saying that banks should not be paid for lending money. That idea comes from the Bible, and was a trick to give a preferred treatment of Jews for Jews, later adopted by Christians for Christians, and then Muslims for Muslims. So the three of them could not ask interest to their kind, but anybody else was fair game. It may explain was “Muslim” Spain, was so superior, because the three variants of Judaism were co-existing , and could lend to each other (the Franks allowed the Jews too, and never forbid Islam per se).
Anyway, lending money for interest is a legitimate business as far as I am concerned. Not only I am not anti-capitalist, but I view capital as a good thing, just as I view as a good thing that capital go out and be used in society.
Using a balance sheet approach to demonstrate that only the central bank creates money, which annihilates my argument that bankers are civil servants in drag. However, I am undaunted. My point is that FRACTIONAL RESERVE BANKING CREATES MONEY THROUGH DEBT.
First, if the central bank gives ten billion dollars to Patrice Ayme, Patrice Ayme will have ten billions, right. Then Patrice can give parts of these ten billion dollars throughout society, end of the story.
It is very different if the central bank gives a billion dollars to JP Morgan. Let’s fix the context by saying the reserve requirement is 10%. JP Morgan will then keep one billion (in reserve), and lend nine billion to Goldman Sachs. Then Goldman will keep nine hundred million dollars, and lend eight billion one hundred million dollars to City, which will keep in reserve 810 million in reserve, and lend 7.290 billion to Bank of A, and so on.
In truth, if the Fed gives ten billion to ONE bank, up to around 47 billion dollars can be lent by banks to actors in the financial world.
At this point we are facing a quasi-metaphysical question: if I am lent a million by a bank to buy a 1.2 million dollars house, was that million dollars created or not? I say it was created.
This touches to the problem that caused the crisis of 2008: banks lent money to financial operators (often themselves), to make pure bets. Now the money created above is limited according to the multiplier. With a 10% requirement, it’s a bit less than 5.
So banks, by creating (nearly all the) money and then sending (way too much of) it to the DERIVATIVE WORLD, instead of the real world, starved the real economy, of capital, as I have argued for years.
My latest essay on this being at thttp://patriceayme.wordpress.com/2009/12/23/fractional-reserve-gouging/.
This is not an anti-capitalist argument. It’s rather an anti-nihilist argument. When those rogue creators of public money, the big bankers, have invested enough in the derivative world, they may discover that the real economy has fallen into ruins.
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typo above, of course: I meant that the central bank would give TEN billion dollars to JP Morgan, as the rest of the reasoning showed…
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But you are completely wrong. You are creating a story with a little bit a fact and a lot of assumptions, and it simply does not hold together.
You say “First, if the central bank gives ten billion dollars to Patrice Ayme, Patrice Ayme will have ten billions, right. Then Patrice can give parts of these ten billion dollars throughout society, end of the story…It is very different if the central bank gives a billion dollars to JP Morgan.”
No, you are wrong. First, money is created when the Fed purchases new assets with new reserves. Period. For example, if the Fed sold an asset, like foreign exchange, to get the funds, no money would be created.
Second, if you gave the money to anyone who then deposits any fraction of it in a bank, the money multiplier process would begin, whether the original infusion went to you or to a bank.
Third, you say “If I am lent a million by a bank to buy a 1.2 million dollars house, was that million dollars created or not? I say it was created.” No. Again, it depends on whether the bank’s loan was funded by new reserves from the Fed. And then it depends on what the home seller does with the proceeds — buys another house?
And you seem to directly contradict what you say above: you get a loan in each case, but in the first case you give it a way, and say that no money is created; in the second case you buy a house, but say a million dollars is created.
Third, the only way any portion of the million loan used in the $1.2 million purchase of the home creates more money is when a deposit is that then generates more loans and deposits through the fractional reserve system.
So the fed only creates money when it creates new deposits (we are ignoring changing reserve requirements as a monetary policy tool here), and the banking system creates new money when deposits are lent that then get deposited again.
You and I need to have a common, factually correct understanding of money creation before we can tackle what I hope is a clear, correct discussion of derivatives. It might help to define any terms used!
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The Socialist Anti-Semitic Myth of the Creation of Money out
of Thin Air (Link here)
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Thank you for leaving your comment.
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Thank you very much for your hospitality
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