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Prophets of Gold – Part 4 – The ghost of fractional reserve

Posted by Don McLenaghen on January 26, 2012

Old fears not seen

Having discussed how the prophets of gold use government debt to promote their gilded dreams, we will now discuss a more bizarre idea that any currency that is not gold is simply debt.

Another issue regarding debt that is often brought up is the ‘fractional-reserve system’. This ‘multiplication’ of the amount of effective money in the economy is great. Now, so we don’t get confused, there are several KINDS of money. The kind we have been talking about so far is ‘hard money’, that is the actual currency in the system. In this part, we will be discussing ‘soft money’, this money is not real in the sense there are coins in your hands, but becomes the value in objects we buy. It is created via loans and the fractional reserve system.

So, when I deposit money in the bank; the bank keeps some of that money as reserve and then loans out the rest. The amount of money held in reserve varies from nation to nation; by law in Canada a bank doesn’t have to hold any money as reserve but other countries do like the USA, which has a sliding system with ledgers of assets more than 71 million having to hold 10% in reserve with the rest of the ‘major economies’ somewhere in between (Chinese banks must have 20% in reserves). Many banks, like Canadian ones, have ‘excess reserves’ (reserves beyond legal requirements) because it is financially prudent for the corporation to allow for market runs, bad loans and other vagaries of the financial system.

Note, this loaned money is not ‘real’ currency but electronic and as such it is used to buy stuff…like a car or a house (or in these times of inequality – food). Now the seller of the car takes that money and deposits it which becomes the base for the next round of loans. In this way an original $100 deposit generates $900 in economic activity. It is this (theoretical[1]) nine fold increase that the prophets of the gold standard flout as ‘money as debt’. It has nothing to do with government debt but a fundamental principle of the capitalist system and NOTHING to do with the gold standard. Fractional reserve banking has been used for a long time during periods[2] of fiat money and fixed money (i.e. gold back currency).

If this ‘soft-money’ could be eliminated by having a demand full-reserve banking; that is the bank keeps all the money people deposit there (regardless of its type – fait or fixed); this would instantly remove 90% of the economy of our country…compared to a 37% drop during the Great Depression.

OF course, there are ways to ‘fake’ it; some Chicago school advocate thought of having 2 kinds of banks[3], the full-reserve bank and another that would be seen more as an ‘investment’ company[4]. The investment company would be like a bank in that you would give it your money not as a deposit…as savings, but you would be ‘loaning’ the money to the company who would pay you interest; the company would pool these loans and turn-around and lend them to others…at interest. The investment company would make its profit in the difference between the two interest rates.

How would the market react to this? One of the main aims of the prophets of the gold standard is to encourage savings. Yet, keeping your money at a bank under ‘full-reserve banking’ would cost you money; banks will still have to provide security, buildings, staff…etc…they will likely still provide some services like chequing; the only way to pay for this is through fees. This would create a disincentive for people to use banks and an incentive to use ‘investment companies’. Of course, choice is nice but I fail to see how this would improve things besides making more explicit the existing situation.

The problem of capitalism

Now, another part of this is the belief banks can make an infinite amount of money (thanks to 0% reserves) in that they unjustly earn profit on the interest of lending out this money. Well, that is true[5]. As just demonstrated I don’t see how returning to the gold standard would solve it, nor would the damage of getting rid of the fractional-reserve system make things better. If you really wanted to prevent them from profiting, you could either turn all lending banks into crown corporations (nationalize them) or set regulations such that they make only a ‘handlers’ fee and the ‘interest’ profits either go to the government (the root of all money) or the depositors.

Now, one possible reason the prophets fear fractional reserve is that it provides another way inflation can be created and if there is anything they hate worse than ‘fiat’ is ‘inflation’.

[1] In the real world, you never get a perfect cycle. Most expects hold only a six fold increase but that’s large enough to warrant further investigation into the prophets claims.

[2] This is why banks would fail in the old days. If people demanded currency for their bank deposits, the bank would not have enough to cover everyone because of fractional reserve system. Most times, the bank has enough money to cover the everyday withdrawals.

[3] Although i see this as separate entities, it’s the ‘kind’ of account that is different. These could, I guess, co-exist in the fame firm.

[4] Douglas, Paul H.; Hamilton, Earl J.; Fisher, Irving; King, Willford I.; Graham, Frank D.; Whittlesey, Charles R. (July 1939), A Program for Monetary Reform

[5] Some claim, that the Federal Reserve makes interest from the government bonds it distributed, however any money the Fed makes is rebated back to the US Treasury. The US government does not pay any net interest to the Fed.

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