retired aviator

Fractional Reserve Banking in Pictures

Fractional reserve banking is much older than the US dollar. It originated when goldsmiths, who were keepers of a communities valuables, noticed that typically very few owners would redeem their receipts for their gold at any given time. These receipts sometimes were in the form of transferable bearer bonds (simply paper money).

Over time the idea developed that the depositors could earn interest on their idle gold by loaning it out for worthy undertakings, and the goldsmith earn fees too. Over many years of watching most of the gold sitting idle in the vault all the time earning nothing, gradually the idea appealed to both goldsmiths (bankers) and depositors to earn more interest by issuing paper notes beyond the amount in the vaults. Thus was born fractional reserve banking. By putting your money in a bank rather than under your mattress, you are inherently agreeing to be a part of the fractional reserve system. You do have a choice. In the old days when bank runs sometimes wiped out depositors, people did eschew banks and stash their cash quite often. (If inflation is your worry in stashing cash, you can exchange your mattress money for some type of durable assets. As general inflation 'lifts most boats' over the very long term, your purchasing power can be maintained in the assets.)

The notion that banks first receive deposits and then loan out those funds is not really how it works (though it can be). That is the Econ 101 version. It is not well known outside the banking industry that private banks actually can create money out of thin air for borrowers. They do not need to 'transfer' funds from somewhere to a borrower (though they can if they choose). Since banks cannot create money for themselves, obviously, but only for a borrower, the system works pretty well. In creating new money, the bank books a loan receivable (asset) which is offset by the cash paid out to the borrower - a net wash on the books of the bank, except for future interest.

So your initial $100 deposit can instantly be sufficient reserve for that bank to create up to around $900 on behalf of a borrower (only). However, the $100 came from an account held at another bank in all probability, so that bank may have to pare back new lending to the degree its reserves had just shrunk.

The real limiting factor to this type of money growth is the number of willing borrowers. That is why the Fed is so focused on setting interest rates -- to influence the amount of new borrowing and the money supply, among other things.

The Fallacy of Floating Exchange Rates

I think that many years from now world leaders may wake up and realize that having to have currency exchange between nations at all is like a ball and chain, and the numbers of different currencies will diminish as nations merge currencies, as in the euro. Ultimately, it would be best to just have as single world currency, in my opinion! Currency exchange is beset with all kinds of economic and political problems, and is essentially an unproductive waste without any benefit to the whole.

What Is the Monetary Base?

I'm finding this to be a greatly enlightening article. I thank you. I do have a problem with this statement though:

"If the private sector holds more base money than it needs, it will normally use the excess to purchase interest-earning Treasury securities, since base money earns no interest.Thus the Treasury will always be able to recapture its deficit spending through the sale of securities, since it can pay whatever interest the market demands."


There are mnay other interest-bearing vehicles and no need for the public to plow extra cash particularly into Treasuries!

What to Expect From the Dollar in 2009

"The dollar’s rally in the second half of 2008 has been largely driven by risk aversion, deleveraging and repatriation. "


Why do you say repatriation strengthens the dollar? It seems foreigners sending dollars back to the US by selling them to get their local currency back would weaken, not strengthen, the dollar.

James Grant Wants to Know: Who Will Buy Our Greenbacks?

I don't think hard asset (such as gold) currency backing is as important as the discipline in printing fiat currency it engenders. We could have more printing discipline without any backing with just the same effect.

Seems highly remote that people will be widely distrustful of "Federal Reserve Notes" because they are not redeemable for gold or some hard asset any time soon.