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Fractional Reserve Banking is not what most people think it is.

This is not a technical post. This is a basic post intended to clear up an important point of confusion that, I believe, exists in the minds of many people.

When people hear the term “fractional reserve banking” they think (if they think about the term at all) something like the following……

“I see – a bank takes in savings and lends out a proportion of them (perhaps as high as 90% of them) for interest, and keeps the rest as a reserve (a “fractional” reserve of, say, 10% if it is lending out 90% of the savings) to deal with people comming for the money they entrusted to the bank”.

A risky line of business (if a lot of people, all at once, want the money they have entrusted to the bank), but an understandable line of business. Certainly it would be absurd to suggest that such “fractional reserve banks” created massive credit money bubbles [please note that I say "credit" money bubbles - I am NOT claiming that banks create real money], totally distorted the capital structure of an economy, and created boom-busts. Only a silly person could suggest any such thing.

The trouble is that the above is not a description of how “fractional reserve banking” really works.

If you want the historical and legal background (as well as economic theory) then read de Soto’s “Money, Bank Credit and Economic Cycles”, and if you want what is happening (in some depth) right now then read “Paper Money Collapse” by Detlev Schlihter – but there is something basic that many writers from Ludwig Von Mises (“Theory of Money and Credit” – 1912) to Murry Rothbard (“The Mystery of Banking” – 1983, if my memory is correct) have tried to get to the public – but the public, for the most part, has still not got the message. The following is, again, not a technical account – it is an effort to get a basic truth in a form that people can understand it.

Banks do not lend out a “fraction” of savings, they lend out far more than real savings. That is how real savings can be very low – but lending (borrowing) very high. For example, a bank may have 100 Pounds (in real savings) put in it – so a 10% franctional reserve means that 90 Pounds will be lent out? NO – it means that 1000 Pounds will be lend out.

How can this be possible?

It is possible because a bank (and other such) does not treat a “loan” as a transfer of money between real saver and borrower.

Please think about that. The fundemental principles of basic economics (such as time preference determining interest rates) depend on loans being a transfer of money from savers to borrowers (either directly – or via a bank or other such). Yet that is NOT how the “finance economy” defines a “loan” (or other such).

So what do they think a loan is? They think a loan is the creation of NEW MONEY (from NOTHING). One  way of doing this is to “credit to the account of borrower” the amount of the loan.  [People have objected to this on the grounds that banks prefer such book keeping tricks as treating cheques, from other banks, as if they were deposites (without waiting for notes and coins to be physically moved from the other banks) - and crediting this "deposit money" to the account of the borrower. I could not care less what form of book keeping tricks are most popular with the credit bubble bankers at the moment, what I care about is that the bankers create credit bubble boom/bust events - but people have complained so here you are].

“And that means that money is transfered to his or her account” NO it NEED NOT.

No notes or coins will be moved to the account of the borrower (unless they specifically ask for notes and coins) – no account of any saver will be held to be any less because of the loan. The loan is considered “new money”.

This is why “broad money” – bank credit (loans and other such) can and does become much bigger than “the monetary base”. And this (NOT the banks lending out most savings and keeping a “fraction” in reserve) is the cause of boom-bust events.

OF COURSE (in reply to possible objections) I know that banks can NOT create a long term increase in the money supply on their own (I have known that for DECADES) – but banks can (and do) create increases in the credit money supply (they create credit bubble boom/bust events) thus giving governments a choice of allowing the “bust” to run its course (i.e.  for bank credit to fall back down towards the monetary base), or increasing the REAL money supply to back up the credit money. Thus creating the vast inflation (the increse in the real money supply, not just temporary credit bubbles in boom/bust events) that we have seen in the 20th an 21st centuries.

It is why, for example, there can be boom-bust events without any Central Bank – for example the United States had no Central Bank before 1913 (had not had one since the early 19th century) – yet it still had, terrible, boom-bust events which brought “captialism” into disrepute and led to demands for various forms of government interventionism (just as boom-bust events do now).

Canada had no Central Bank till after 1935 – yet it still had a credit money “boom” in the late 1920s and a terrible “bust” at the end.

Was this just due to trade with the United States suddenly collapsing? No – it was due to a credit money expansion in Canada itself.

Defenders of Canadian banking, quite rightly, point out that no Canadian banks went bankrupt in the Great Depression (unlike American banks – and unlike Canada itself only a few years before when there had been the real bankruptcies) – but this misses the basic point.

Why were Canadian banks so unpopular in the 1930s? Why was there a vast political movement for “Social Credit” (and other crackbrained monetary crank ideas)?

This was because Canadian banks had called in a lot of their loans (and they were right to do so – otherwise the banks would have collapsed) – indivduals and business enterprises found themselves having to pay lots of money, or lose their home or their business.

This is the answer to the question that so many people ask during a bust. “Where did the money go?” (people confuse money and real wealth – in spite of the efforts of the Classical Economists to deal with this fallacy – both the fallacy that money is real wealth, and the related fallacy that increasing the money supply leads to a long term increase in real wealth).

When people cry out “where did the money go” (and then go on to blame “the Jews” or whoever is the local hate target – and, yes, antisemitism did greatly increase, even though very few of the leading bankers were Jews) they never ask themselves DID IT EVER EXIST IN THE FIRST PLACE?

Because, of course, IT DID NOT EXIST.

It was an ILLUSION of prosperty – based on a credit bubble (“crediting to the account” and other book keeping tricks) which was bound to collapse.

This does NOT mean that the Great Depression was inevitable – the Great Depression was mostly not a credit money bubble collapse (such as the one that happened in the United States in 1921 and many other times) it was mostly the POLICY RESPONSE to the credit money collapse – preventing markets (particularly labour markets) clearing by preventing the free movement of prices and wage rates.

For example, if someone says “nominal incomes must never be allowed to fall” because “demand” (or some such thing) will be damaged. What they are really saying in the conditions of a credit money bust is “mass unemployment must be maintained – markets must not be allowed to clear”. People such as Herbert, The Forgotten Progressive, Hoover (who, contrary to the myth, was an interventionist – indeed a fanatical one) may not know that what they are doing will create and maintain mass unemployment – but that is the effect their actions will have. Whether it is done by pro union laws (see W.H. Hutt “The Strike Threat System” for how this system is really the result of the undermining of the Common Law), or by direct government interventionism (as with Herbert Hoover) if wages are MADE “sticky downwards” then, in a time of a credit money bust, mass unemployment will be the result.

And the credit money bust is INEVITABLE once the credit money “boom” has been created – the false prosperity can not last (it is based on book keeping tricks – smoke and mirrors) it is an illusion (a fairy castle in the air) and must come crashing down.

The “broad money” (the book keeping trick created bank credit) must come back down towards the “monetary base” – with a massive liquidation of the “malinvestments” generated by the credit money bubble. And efforts to prevent such a correction (including the correction of wage rates) turn a bust into a catastrophe. No quick recovery (as with the bust of 1921) – but a prolonged period of MASS UNEMPLOYMENT.

It is much the same with goods as it is with human services. Preventing prices going down (dramatically down) means that one has such terrible things as hundreds of thousands of houses and apartments standing empty (neither sold or rented) whilst (at the same time) great numbers of people are homeless (even sleeping in the streets).

Markets only clear, a price system only works – if it is ALLOWED to do so. Otherwise you get houses standing empty (and decaying), goods (including food) rotting unsold – and, at the same time, vast numbers of people without work and without shelter (and so on).

All of this is driectly related to fractional reserve banking (in the real sense of the term – not what people think the term means). The panic response to the bust is due to people NOT UNDERTANDING WHAT IS HAPPENING.

They do not know that there was an inflationary increase in the money supply (especially if prices were not “going up in the shops” – as they were not, much, in the late 1920s and in the 1990s and 2000s the basic truth that the word “inflation” does NOT mean “price rises”, as the false books claim, is unknown to most people). So when the, inevitable, bust comes they scream “where has the money gone?” – not understanding that it was a credit money bubble (the money did not exist). And then they panic – as do politicians and so on.

Prices should FALL in a period of real prosperity (i.e. if people really are finding better ways of doing things). If prices are NOT falling, and yet everyone is saying it is a period of prosperity……. Then something is very, very wrong. There is an inflation of the money supply – and people saying “but prices are not going up in the shops” is to miss the point.

The Role of Central Banking.

Whilst the true cause of credit bubble boom-busts is fractional reserve banking itself – Central Banking does indeed have a very important role. It MAGNIFIES and EXTENDS the size and scope of the credit mony bubble.

For example, J.P. Morgan (back in the early 20th century) is said to have lent out about three Dollars for every one Dollar in real savings he had (entrusted to banks he controlled) – and the other New York based “National Banks” (so named because of the national banking Acts of the Civil War era). This lending out of more money than he really had caused Morgan sleepless nights – he knew he was riding a tiger and sometimes has to resort to desperate methods to prevent everything collapsing around his ears.

There days J.P. Morgan would be considered a wimp. Two to one? Three to one? How about ten to one or a hundred to one? Of course no one really knows – because trying to follow the insanely complicated modern banking system (with all the “credit default swaps” and on and on) would drive anyone insane. For example, modern “capital requirements” are largely meaningless – because very clever (but very unwise) bankers have found lots of complicated ways round them.

And modern bankers do not know that their basic principles are in any way unsound. Things have got so extended and complex that they have lost sight of simple things. They understand complex things (that would make the head of an ordinary person explode). But simple basic principles (things that J.P. Morgan privately understood – i.e. he understood he was playing a “shell game”) modern bankers have not got a clue about such things. So everything comes as a surprise to them – everthing apart from their vast incomes (agreed by friendly “remuneration committees”) of course. When things come crashing down bankers follow anyone who promises (privately) to save them – for example Barack Obama (see the book “Bought and Paid For” for how much financial support financial industy people gave Comrade Barack).

Indeed bankers develop relationships with friendly politicians in order to keep things running smoothly even in good times. And they actually concentrate their attentions on policitians who might be “anti business” (in the United States Senate not just Comrade Barack – but also former Senator Chris Dodd, and in the House the fairly open socialist Congressman Barney Frank).  Such a policy of subsidy does mean that very bad people (“Progressives” – as Americans call them) gain great political power (leading to orgies of regulations – such as Barney Frank’s support both for the Community Reinvestment Acts and for the government controlled “private” entities Fannie Mae and Freddie Mac, all of which pushed money into the housing bubble), but bankers do not see that far ahead. As long as the subsides (the “Discount Window” and the friendly loaning out of [freshly created] money and borrowing the money back again (at a higher rate of interest)  continue , they do not look further (why should they?). And so they are totally astonished when someone like Comrade Barack Obama (and his political associates) organizes mobs to shout for their blood. “But he is our friend – he talked so nicely to us (in private) and we gave him so much money……” Perhaps they will continue the bankers will continue to be astonished till Comrade Barack has them (and their families) hacked to pieces, or perhaps they will switch their support to Mitt Romney (the Republican candidate who is most flexible when it comes to ethical matters), who knows?  I have to get back to what I am trying to explain.

Every step of the way in the late 1990s and 2000s (indeed in 1987 also) Alan Greenspan PREVENTED the credit money bubble antics comming to an end. Every time there looked like there might be a serious “correction” he came in with extra credit money to “save the world” – i.e. to make the credit money bubble BIGGER, to delay the bust but also to make it WORSE.

This is why modern fractional reserve bankers are able to do things that J.P. Morgan would neve even have considered. Indeed if someone working for him had done them, Morgan would most likely have killed them – with his own hands (like most of his generation – Morgan was no stranger to physical violence). Yet modern bankers do not even know they are doing anything wrong (and have not got a clue of how violent human beings can be) – because Central Banks encourage them (every step of the way). Including the European Central Bank – which people demand should be buying debt (with money it creates from NOTHING) – as if the “ECB” has not already been doing that (and it has been).

All this is not understood. For example,politicians demand that the Central Bank do something to prevent “bubbles”, not understanding that the basic point of Central Banks (why they were created in the first place – not just the Federal Reserve in 1913 with the meeting on the island, but also the Bank of England in 1694, and all the other Central Banks) is to INCREASE lending (for example – to governments) – to make credit money bubbles BIGGER than they would be otherwise.

A related absurdity is to demand that “regulations” prevent money going into a certain “bubble” area (such as housing) – this ignores both the fact that regulations tend to push the credit money INTO the bubble area, and that even if the extra money did not go into that area, it would go somewhere else. Another area of the economy would be hit by malinvestments – the capital structure would still be twisted.

If you want to prevent the bust you must prevent the credit money boom. A basic truth – but one that is totally ignored. People love the “boom” – and they do not see that it (not “the Jews”, one third of Europeans are said to believe “the Jews” are at least partly to blame, or “deregulation” the endless claim of the British and American left – even though regulations, as Peter Schiff and others have pointed out, have never been worse) is the cause of the bust.

I hope the above (which, yet again, I repeat is not a techical account) has cleared up some confusion, but I must make a final point.

One must be careful not to say any of the above is “fraud” – as court judgements and statutes clearly mean that none of the above is legal “fraud”. Which is why I have not used the term.


  1. Current says:

    I think your position is contradictory you say:

    > As I have already said (several times), I have no objection to
    > you lending out 90% of your money (or the money entrusted to
    > you – to be lent out), or a 100% of it for that matter.

    That’s fair enough. But then you say:

    > I also have no objection to PRIVATE NOTES (as long the person
    > or organization issuing those notes actually has the commodity
    > those notes represent – i.e. can SHOW ME the commodity in their
    > vault).

    As far as I can see that means you want to ban all types of private money except for 100% reserved notes. I think that’s a very unlibertarian point of view.

    I don’t care if my bank actually has a pot of base money that matches my balance at any time. All I want is my bank to pay *when I demand it*. That means my bank can keep a fractional reserve. I don’t mind the fact that my balance is a debt my bank owes me rather than a bailment. There is no fraud if I and my bank agree to this arrangement.

    Now, you may not be satisfied with that you may demand a “warehouse bank”. In that case you can go to a different bank. But why should you be able to interfer with the operations of my bank?

    You complain about the word “deposit”. To some extent I agree. Way back in the 17th century (before modern banking) courts decided that a deposit of money was to be considered a loan. That is a bit confusing. I think it would be a good idea to ban the word “deposit” from association with fractional-reserve bank accounts, doing that would make the situation clearer. But it is unlikely to affect what would actually happen even in a free market. Bank customers would have no strong reason to pick fractional reserve banks.

    > My objection is to the form of “fractional reserve banking”
    > that rests on lending out money that DOES NOT EXIST.

    How do banks lend out money that doesn’t exist then? You still haven’t explained how. As I’ve mentioned many times in this thread once a loan is made it will be quickly withdrawn, so bank need to have monetary base as soon as they make a loan. Once a bank has done this it register the loan as an asset and raises more funds by borrowing from customers. That’s how over time a banks balance sheet comes to be dominated by current account liabilities on one side and loan based assets on the other, with only a very small portion of reserves.

    Bank accounts are of-course different to loans. If my bank has only £50 in base for my £5000 account balance then it has done nothing wrong. That’s because the bank *owes me* £5000 it hasn’t agreed to hold £5000 for me. The bank has only done something wrong if it fails to pay up when I ask for base money.

  2. Paul Marks says:

    Current I have, for some time, suspected that you are not fully sincere. And I think your latest comment proves that to be the case.

    However, I could be wrong – so I will reply to you.

    As you know perfectly well I do not wish to “ban” any commodity that people choose to use as money.

    Gold, silver, copper (of an agreed purity) – if buyer and seller agree that is up them.

    Fiat notes?

    Well that is a government matter.

    But IF you have these government notes of course you can lend them out – and if you have NOT then you can lend them out.

    “How can banks lend out money that does not exist” – it is called a “credit bubble” Current and it has consequences (boom/bust).

    “What about private notes”.


    You lend out a note that says “Current” upon it – just that, a bit of paper with your name (naught else).

    If someone will accept that – I am fine with it.

    BUT if you claim that you have one hundred POUNDS you better have those fiat notes in your vault.

    Just as (if we had a commodity money) if you produced a note saying “one hundred ounces of gold” you had better have that one hundred ounces of gold in your vault.

    Pounds – as long as you have the Pounds.

    ounces of gold (or whatever) as long you have them.

    “But I neither have fiat Pounds or any commodity”.


    Then lend out “one hundred Currents” – a note with the words “one hundred Currents” upon it.


    But do NOT put “one hundred POUNDS” on that note IF YOU HAVE NOT GOT THOSE ONE HUNDRED POUNDS.

    Otherwise you are a fraudster and you should go to prison.

    Understand now?

  3. Paul Marks says:

    Alas! I meant to type ….

    If you have NOT [if you do not have have the fiat notes] you can not lend them out.

    Without being a credit bubble fraudster who is pretending to “lend” what he does not have.

    Of course you could still lend out “Current” notes, but do not call them “Pounds”.

    Any bank could print up notes, with their name written on them (and naught else), and lend them out to whoever wanted them.

    Of course these notes could not be used to pay taxes, and would not be “legal tender”.

    But I am sure you would be fine with that.

    But do not call what the banks lend out “Pounds”, “Dollars” (and so on) because – as you yourself have pointed out, they do not have enough of these to match their desire to lend out.

    “But we do”.

    Then (I repeat) SHOW ME THE MONEY.

    Show me the notes and coins in your vaults.

    You can lend out what you have – but not what you do not have.

    But you can still print up some “Currents” and lend them out.

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