Fractional reserve banking
Or: Stop finger-pointing
There is a lot of criticism around fractional reserve banking. That it is an unsustainable way. That basically we need to get loans to pay off interests of the previous loans and that this leads us into a spiral where we cannot escape from. That it creates money out of thin air.
Let’s look at that in more detail.
Please note
This document is oversimplified. It has no right to completeness or correctness.
This document just tries to get an idea across that the world is complex and that not everything which seems bad is bad overall. That indeed most things have both sides of the medal, it just depends on the perspective. This documents intends to educate in the way that it’s totally inappropriate calling (as an example) fractional reserve banking is bad. Fractional reserve banking also has positive effects. Thus ones needs to take a deeper look at things.
This document tries to stimulate, you the reader, to question common “facts”. Question these informations you receive, question their reliability their trustworthyness, question them from different perspectives, question them for their sources.
Example:
If you want me to convince that Rothschild family controls all central banks in the world you cannot present me a list you found on the internet. Cause I could state right here: not one central bank is controlled by Rothschild family. You read this document on the internet as well, right? So my statement must also be true.
Constant vigilance is required.
So many fake or misleading news out there, just do not believe every piece immediately.
Please note also
Most links and excerpts in this documents state just facts or mechanisms. They do not judge if something is good or bad. These articles try to educate the reader about how something works, not if it is good or bad.
Economists, those who try to get it right, learn over years in universities, working at central banks etc. how all works together. But also economists make mistakes and are not Gods, they cannot satisfy all needs we have. Again: every action has both sides of the medal, it’s just a matter of perspective.
Let’s dig into the main content now of this document.
Monetary and Fiscal policy
First we need to understand at a very high level what a government, usually, tries to achieve.
Usually a government tries to find a certain equilibrium between these 4 aspects:
-economic growth
-full employment
-price stability
-balanced trade
These are also called the “Magic Square of economic policy”
http://www.economicpolicyresearch.org/econ/2017/NSSR_WP_022017.pdf
As you may realise pulling on one end reduces on the other sides.
Are we sure that these 4 are really the factors economic policy should achieve?
I am pretty sure that it is a good selection of objectives and has served us (globally) quite well in the past 70 years.
And sure enough a government has other objectives as well:
-good education for all citizens (low illiteracy rate etc.)
-good infrastructure (public transportation, telecommunication, roads, utilities etc.)
-good security (low crime rate etc.)
-etc.
However those other objectives cannot be influenced directly by fiscal or monetary policy. They might have effects on the 4 quadrants of the magic square though. Or the other way around, that we can only achieve better education in a growing economy.
Example:
If a country decides to build more schools, more people may want to become teacher. Thus the constructors of the schools and the teachers will be employed and thus reduce unemployment.
On the other hand if constructors had to lay off all their employees due to recession, not being able to pay salaries, then it might take a good while longer until all schools are built. Companies would first need to start employ people, eventually educate them about latest construction techniques etc.
Who would argue “economic growth” did not help us get better in these other objectives the countries have? Better healthcare would not be impossible at high unemployment rate, nor would improved medical treatment (cures for cancers, AIDS, etc.) be possible without economic growth.
A government, as traditional knowledge tells us, has 2 possibilities to influence the 4 factors from the magic square of economic policy:
-Fiscal policy
-Monetary policy
https://www.theclassroom.com/objectives-of-monetary-fiscal-policy-13657223.html
Fiscal and monetary policy represent two approaches by which governments attempt to manage their nations’ economies. Fiscal policy uses the government’s taxation and spending powers to influence the economy, while monetary policy uses interest rates and the money supply to ensure stable economic growth. Although monetary and fiscal policy have differing effects, both strive to ensure economic stability.
By affecting interest rates and the nation’s money supply, monetary policy impacts the ability of consumers and firms to obtain credit.
https://www.thebalance.com/what-is-fiscal-policy-types-objectives-and-tools-3305844
https://www.thebalance.com/what-is-monetary-policy-objectives-types-and-tools-3305867
As this document tries to dig a bit deeper on the monetary side, let us just skip the fiscal policy part for the moment. Most people anyway do not understand the macro economic effects of fiscal policy. And this document tries to soothe the souls of those who constantly rant: Fractional reserve banking will lead us to dooms day.
Fractional Reserve banking
Fractional reserve banking directly affects one of the tools of monetary policy: money supply.
What is fractional reserve banking after all?
In fractional reserve banking a bank can loan out deposits from their customers. Thus keeping only “fractions” of the deposits as a reserve.
Examples with multiplier effect
https://www.thebalance.com/what-is-fractional-reserve-banking-4590236
One thing is for sure: Without fractional reserve banking, your banking relationship would look different. Instead of paying you interest on your deposits, banks might charge you (or charge significantly more) for their services. In fact, banks earn revenue by putting your money to work and keeping the difference between what they charge borrowers and what they pay you as the depositor.
https://www.learningmarkets.com/understanding-the-fractional-reserve-banking-system/
Easy to understand explanation
https://quickonomics.com/fractional-reserve-banking/
At first glance, the fractional reserve banking system probably seems too good to be true. How can it be possible for banks to create money out of thin air? At this point, it is important to note that they create money, not wealth. Money in this context is only a medium of exchange. It has no intrinsic value. By taking on a loan, borrowers get more money, but at the same time they are also taking on more debt. So at the end of the day, they are not richer than before. In other words, an increase in money supply only results in a higher level of liquidity, but it does not make the economy wealthier at all.
The critics of fractional reserve banking may now argue: Exactly! Money out of thin air!
They may continue: That is so unfair!
Please do not make me go into a philosophical discourse on what is fair and what is not fair.
I rather would ask the critics: What exactly is “unfair”? Cause others have more “money”?
If the answer is “Yes”, then rest assured that fiscal policy can help in “redistributing wealth”. Of course also fiscal policy has its limits and is not perfect.
Economical explanation
https://www.investopedia.com/terms/f/fractionalreservebanking.asp
Fractional reserve banking has pros and cons. It permits banks to use funds (the bulk of deposits) that would be otherwise unused to generate returns in the form of interest rates on loans—and to make more money available to grow the economy.
…to grow the economy, now where did we read that just now? Ah.. it’s one of the quadrants of the magic square of economic policy!
See? Already we start to see the other side of the medal. While “money out of thin air” seems totally “unfair” (and maybe unsustainable), it (fractional reserve banking) on the other hand addresses “growth of the economy”.
Do you, the reader, see already that a thing like fractional reserve banking is not just about “money out of thin air”, that it has other aspects which are actually helping other objectives?
Side note
As a matter of fact all those who criticise fractional reserve banking should not be fans of CBDSs. Why? Cause with CDBCs, as its name says, money will be digital only, no possibility to cash out paper bills anymore.
Basel III
The Bank of International Settlements (BIS) is kind of like the global regulator. They work closely with the International Monetary Fund (IMF) and the Worldbank. BIS is owned by the central banks around the world.
BIS’ main focus is
Promoting global monetary and financial stability through international cooperation
https://www.bis.org/about/profile_en.pdf
Basel III is a regulatory approach to try to reduce the risk of economic crisis around the globe.
What is Basel III?
Will Basel III have an effect on fractional reserve banking?
From the Bank of International Settlements (BIS)
https://www.bis.org/bcbs/basel3.htm
For Systemic Important Banks (SIB, or G-SIB) or domestic systemic important banks (D-SIB) even higher standards are introduced.
List of SIBs
https://www.fsb.org/wp-content/uploads/P221119-1.pdf
Side note for XRP investors and Ripple fans
Take note of the names in this list, a good 30% are RippleNet customers. Coincidence?
Easy to understand
https://www.investopedia.com/articles/economics/10/understanding-basel-3-regulations.asp
Key take away is that
Banks must hold more capital against their assets, thereby decreasing the size of their balance sheets and their ability to leverage themselves.
However, please not also
While banking regulations may help reduce the possibility of future financial crises, it may also restrain future economic growth. This is because bank lending and the provision of credit are among the primary drivers of economic activity in the modern economy. Therefore, any regulations designed to restrain the provision of credit are likely to hinder economic growth, at least to some degree.
So we learned up to here that Basel III may help reduce risks of fractional reserve banking, BUT, and this is a big BUT (which everyone should be aware of), it may also come with the effect of reduced economic growth.
Deflation or Inflation?
Let’s look at some other factors as well. I assume most of you know that money is just a medium of exchange of value and as long as both sides trust that value all is fine!
If I can convince you that my old sock I give you for a service you provided will be accepted in the bakery to buy bread, then you will be willing to accept my old sock as “medium of value exchange” (or money if you so will).
https://www.bankofengland.co.uk/knowledgebank/why-does-money-depend-on-trust
When money is issued by a central bank, people are able to trust the value of the notes as they are all coming from a single, trusted source.
https://www.thoughtco.com/why-paper-momey-has-value-1146309
Our system of money operates on a mutual set of beliefs; as long as enough of us believe in the value of money, for now, and in the future, the system will work.
The value of money, usually, is not stable. Money can gain in value or lose in value.
Value of money
-Deflation
-Inflation
What are the effects of deflation?
https://www.investopedia.com/articles/personal-finance/030915/why-deflation-bad-economy.asp
As you can see deflation is usually accompanied by recession and all other effects which come with it. It, deflation, impacts negatively all 4 quadrants of the magic square of economic policy.
Which is preferred?
https://www.investopedia.com/ask/answers/111414/what-difference-between-inflation-and-deflation.asp
As basically both deflation and inflation (inflation at least at high rates) are bad for an economy, governments usually tend to favour a very mild inflation.
https://www.snb.ch/n/mmr/reference/sem_2015_09_25_andolfatto/source/sem_2015_09_25_andolfatto.n.pdf
high inflation economies are associated with … a higher tolerance for fractional reserve banking systems – and hence, a greater likelihood of financial crisis.
Note: high inflation
We know that fractional reserve banking increases money supply:
https://www.economicshelp.org/blog/111/inflation/money-supply-inflation/
Increasing the money supply faster than the growth in real output will cause inflation.
As we do not see (in most countries at least) a high inflation, my logic concludes, the expansion of the money supply (partially due to fractional reserve banking) is just about at the right level. At the right level means it is rather equal to the growth in products. If increase of money supply was way out of proportion of growth of products, inflation would be way higher, but this is not the case.
https://mises.org/wire/fractional-reserve-banking-and-money-creation
So we come to the conclusion, that both deflation (at any rate) and inflation (at high rates) is not welcome. We also learned that fractional reserve banking actually helps inflation. We even saw that the mild inflation rate we see almost in all industrialised countries is just about fine. And this “fine level of inflation” was helped by? Amongst other factors: fractional reserve banking.
Velocity of money
But there is more to money than what we have seen until now. The velocity of money. Most do not understand this side of money. Let me explain.
How many people can you make happy with a 10$ bill during a day? 1? 2? 5? 10?
You pay your hairdresser with 10$. He keeps a portion as profit and buys sandwiches for his staff with the rest. The bakery store keeps a profit and buys more flour for the next day. The farmer keeps a profit and buys gasoline for his trucks. The gasstation keeps a profit …
You get the idea. The faster I can transact value (or money) the more people I make happy.
The theory is called quantity theory of money.
https://www.investopedia.com/insights/what-is-the-quantity-theory-of-money/
Formula
M * V = P * T
where:
M = Money Supply
V = Velocity of Circulation
P = Average Price Level
T = Volume of Transactions of Goods and Service
As this concept is even harder to grasp for most let me reduce it to this simple statement from Navin Gupta: https://youtu.be/wyp5Od8KeO0?t=1023
If you accelerate the money by 2-3 days, GDP will grow about x%
Let’s dig into this formula.
Let us use RTGS to increase velocity of money, ie. no need for increasing money supply anymore! Correct!
On the other hand RTGS (more specifically IoV) will increase volume of transactions multifold. To keep equilibrium either the money supply needs be inflated even more, or the velocity be increased. Let’s assume we do other stuff than just buying all the time. That means velocity of money has its limits. Which puts the supply of money as the only other factor to keep up with the rising volume of transactions.
As a matter of fact the velocity of money (only to its limits) can and will sustain fractional reserve banking, or the interests being paid on the loans.
Note
Specially for XRP investors this should be a fact they have to consider. All educated XRP investors (is this finger-pointing from my side?) do know the transaction volume will rise with IoV. Velocity of money will increase to a certain extent as well. Which factor in the equation helps levelling out the formula?
Thus, in my opinion, it is actually illogical or counter productive in believing in IoV and XRP and at the same time finger-pointing at fractional reserve banking being bad.
Summary
While there are arguments both for and against fractional reserve banking you, the reader, should now at least have the tools (changing perspectives, doing your own research etc.) to look at it from various perspectives. It should help differentiate the effects any policy can and will have.
Telling fractional reserve banking is bad is about the same as telling cars are bad.
Let me remind you next time you have an accident and there’s no ambulance around to bring you to the next hospital. Actually which hospital? We would still live in caves if the wheel would not have been invented. I don’t wanna know how many trucks delivered raw material to build your house or the hospital. Is this a bad thing? I personally am very glad to have a place to stay which protects me from nature (rain/sun/snow/wind). I also am very happy that there are hospitals where I know they can cure me.
Another example: everyone wants taxes to be reduced. I ask you, the reader, whom will maintain utilities, build roads, pay teachers and nurses and doctors? We need all these things, the higher standard we want the more taxes we have to pay.
As Milton Friedman stated (https://en.wikipedia.org/wiki/There_ain%27t_no_such_thing_as_a_free_lunch)
There is no such thing as a free lunch
Also you, the reader, should have learned by now:
Our world is complex, more than ever. More information channels open possibilities for minorities and their needs to be heard. There is no such thing as “one policy fits all”. There is also no such thing as a perfect system. Each system has pros and cons. And each system has potential to be exploited.
Finger-pointing is immature! Try to differentiate or change perspective next time you are lured into finger-pointing! I am 100% sure I can show you the other angles on the thing you finger-point!
I hope this document helped you, the reader, to mature a little, or at least smile a little, or maybe become a little bit more humble.
I hope I have opened your mind to continue/start a discussion about this (Fractional Reserve banking) and other related topics
Contact me at Twitter @iPinky77
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