Wednesday, November 23, 2011

Fractional Reserve Banking

Ever since I found out how our money supply works a few years ago I have been fascinated by the process of fractional reserve banking.  I (like the majority of people) assumed that the government printed money and that banks just had huge stocks of money in their vaults to lend out.  Finding out that 95% of all Canadian money is in fact created from nowhere by private banks was ... unsettling.

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”
- Henry Ford

Clearly society can trundle along for quite some time with private institutions generating massive amounts of interest off money they created themselves and in fact I figure it can do so indefinitely.  The question is what alternatives do we realistically have given our much our current economy is integrated with this system?  I found a long but informative video on US Presidential candidate Ron Paul's website talking about the US Federal Reserve which made a case for returning to the gold standard and eliminating the practice of fractional reserve banking immediately.  The idea behind this is to disallow any money creation that is not tied directly to gold deposits, ending much of the activity of current banks.  Banks could still take deposits, lend money out at interest and perform all the basic economic functions they do now but with money creation gone I don't see a way for current mortgages to exist - the banks simply would not have the cash to lend out.

Mortgages aren't the only thing that would go away if we returned to the Gold Standard though.  Easy credit for businesses would be a thing of the past since lenders would have to actually scrape together the money to create the loan rather than simply creating money to loan to anyone who seems like a decent bet.  It would have a tremendous impact on government finance too since governments could not rely on printing money to get out of debt and the steady inflation that comes from private institutions adding to the money supply would be gone.  Of course Ron Paul and others paint this as a return to the Good Ole Days where people were honest, government was good and the bankers didn't control everything but that seems like an overzealous application of rose coloured glasses.  On the other hand even though their portrayal ranges from dishonest to delusional they might actually be right that this is a far better way to run a country.

There is no denying that under the Gold Standard the crazy government bailouts of banks would not be necessary and that the tendency for people to get in over their heads in debt would be less.  Question is, what other terrible pitfalls await us there that demagogues like Ron Paul don't know about or talk about?  How destructive would such a transition be?  I suspect that even slow measures designed to change our current system gradually would cause a catastrophic crash.  In the very long run I believe that eliminating fractional reserve banking would be a real boon to our economic system but the pain of getting there from here would be severe indeed.


  1. I think there is a big problem with being the only major world economy to use the gold standard. There is a lot of gold in the world - gold that is not really all that important to anyone. What happens when a big US bank partners with a European bank who invents Euros out of nothing to buy gold to lend to the US bank to lend to someone. Sounds like the same system, just with more hands touching the money as it goes from pocket to pocket.

  2. Part of the Gold Standard idea is that there is a government controlled central bank (unlike the privately controlled Federal Reserve) that can create currency and no other institution can do so. A US bank could put a lot of gold into its vault but it still would be unable to create money to loan to someone. It could only lend out money it has accumulated, all of which is created by a central government bank.

    The involvement of gold in the Gold Standard is just to prevent the government from printing money for temporary expenses. It is a limitation on the federal government's ability to inflate the currency and doesn't have any direct effect on the private banks. I don't know that this would work necessarily but looking at the past in the US suggests that when fiat currency is introduced the government does create currency to spend far beyond its means and cause massive inflation.

    You are right that the US government could buy gold and then use that gold to justify printing more money. However, part of the Gold Standard is that anyone can turn in US dollars for a fixed amount of gold. This means that they can't just increase the money supply arbitrarily, they actually need to buy a huge amount of gold without driving the price up above what people can turn in their dollars for.

  3. The reason Fractional Reserve was allowed was because the gold standard did not expand the money supply fast enough to keep up with increasing productivity and trade.

    There are rational Democratic alternatives for money creation and a stable, fair, truly free enterprise economy. Monetary Reform Act HR 6550 has been introduced in the US Congress. But until the public is educated, the politicians who all really work for the banks will ignore it.