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It’s been awhile since I’ve written a juicy “Conspiracy Theory Thursday” post, so it must be time for another one…

We left off with our story of money earlier this week with people having progressed from using coins made of precious metals to using receipts for these metals. Precious metal coins were wonderful, but they had two major problems:

  1. They were heavy and cumbersome to lug around in any sort of quantity from home to merchant, and
  2. You had to guard them at all times to protect them from thieves

(We’ll set aside the third problem for the moment of unscrupulous governments, merchants, and buyers scraping or “clipping” bits of gold or silver from the coins thus decreasing their worth…that’s a story of “debasement” for later!)

With the first “banks”, these two problems were solved; people could safely store their precious metal coins at a safe vault guarded by a trusted member of the community (usually a gold or silver smith who already had a vault of his own and was accustomed to safeguarding his own metals) and receive a receipt for how much money they had stored.

When purchasing something, the buyer simply handed the seller his receipt and the seller deposited the receipt at his own “bank”. The seller’s “bank” then talked to the purchaser’s “bank” and they each made the appropriate entries in their books to reconcile the transaction.

This worked swimmingly for years, but eventually these banks noticed that they had a lot of gold and silver piling up in their vaults as more and more trade was conducted. They quickly realized that most people didn’t actually need to withdraw the metals very often, and decided that they could make more money by lending out these precious metals rather than by storing them.

Which brings us to…

Fractional Reserve Banking

Let me briefly tell you what fractional reserve banking is, and then we’ll get into what I think is the more interesting question…is it evil and nefarious or perfectly legitimate?

Supposing for the moment that it’s a perfectly fine practice, let’s take a look at how it works:

Our “bankers” from our example above, upon noticing that fully 85 – 90% of the coins remained in the vault at all times with only 10-15% being used in commerce, decided that the remaining coins ought to be “put to work” rather than sitting idly in the vaults collecting dust.
The bankers then decided to lend out these coins to borrowers, and earn interest income on the coins that would otherwise just be collecting dust.

So, let’s take a look at an example:

You deposit 100 coins at your bank. Your banker says “thank you very much”, hands you a receipt for your 100 coins (say for $100, $1 per coin), and promptly looks around for someone to make a 90 coin loan to, knowing it is highly unlikely that you will return tomorrow and demand all 100 of your coins back.

He finds John, the cobbler, who wants to expand his shoe-making business but needs 90 coins to purchase enough leather to make a lot of shoes. Your banker issues John 90 of your coins, knowing you “most likely” will not need them yourself. John, however, does not want to lug around and safeguard 90 gold coins himself, so he just keeps them at the bank and instead gets a receipt for the 90 coins, a $90 receipt.

That simple explanation is really the heart of fractional reserve banking. Do you see what just happened? Your banker has become a magician and has “magically” created $90 worth of money out of thin air (or rather, out of DEBT).

Now there are two receipts out there, one for $100 and one for $90, both backed by the same 100 gold coins in your bank. Therefore the same coins that were once $1 per coin are now effectively only worth 52.6 cents each. The coins backing the receipts is now only worth a fraction of the face value of the receipts, so these receipts became known as “fractional money” and the process by which they were created is called “fractional reserve banking”.

Let’s see what happens next…John takes his $90 receipt and gives it to the leather man, Steve, to buy the leather to make his shoes. Steve takes the $90 receipt and deposits it at his bank.

Steve’s bank talks to John’s bank and they make the appropriate entries in their books… the 90 coins are “transferred” from John’s bank to Steve’s bank and everyone is happy.

You haven’t asked for your coins back yet, John is happily making his leather shoes and paying off his loan to your bank, and Steve is the proud new owner of 90 shiny coins (well, his bank is…he has a receipt for $90 from his bank that shows that the bank owes him 90 coins).

Now at this point you would think that your and John’s bank would be sweating it a little (I would be, but then, I am honest…) but lo and behold, your bank is happy—it still owns 10 coins and is comfortable in the fact that you will “most likely” not want your 100 coins back (at most you’ll ever want 10), and John is busily paying interest on his loan so the bank is making money.

And now Steve’s bank gets into the action…it has 90 new coins just begging to be loaned out to a prospective borrower! Steve’s bank “knows” it can loan 90% of those 90 coins out to a borrower without Steve being bothered in the slightest. So Steve’s bank makes a loan to Sara for 81 coins to help her start her new bakery.

Magic money!

Now there are three receipts in circulation for the same 100 coins:

  1. Your original receipt for $100
  2. Steve’s receipt for $90 (this was originally John’s, but he gave it to Steve in exchange for leather)
  3. Sara’s receipt for $81

Now the value of the original 100 coins has been reduced again…If my shaky old math skills work correctly each coin is now worth 100 coins / ($100 + $90 + $81 receipts) = $0.37 per coin.

This lovely little process continues until either:

  1. The bank runs out of money to loan (90% of smaller and smaller amounts eventually reaches 0…72.90, 65.61, 59.05, 53.15, 47.83, 43.04, etc.), or
  2. You (or Steve or someone along the way) decide that you want your coins back

Fractional Reserve Banking Today

This is still how fractional reserve banking works today, except thanks to President Nixon in 1971, our U.S. dollars (“receipts”) are no longer backed by anything of value. You cannot exchange your dollars for gold or silver…Nixon took that ability away on August 15, 1971, and ever since then the U.S. dollar has been backed by nothing other than “the full faith and credit of the United States Government”.

I’ll let you draw your own conclusions as to whether that’s worth anything or not!

Now that you know what fractional reserve banking is, you have a decision to make:

Is it evil and nefarious, or perfectly legitimate?

Some historical accounts portray it as evil and nefarious, saying that bankers broke the original contract between the depositor and the bank, and that the precious metals stored at the bank weren’t truly available to lend. They further state that sharing the interest income from the loans with the original depositors was never part of the plan (and we all know that banks currently pay us less than 1% on our deposits and yet charge borrowers upwards of 4 and 5% for a home and dramatically more for credit cards!) and that bankers only did so after the depositors became outraged at learning this was happening (the depositors had naively thought that the bankers were lending the bankers’ own money, not that of the depositors).

However, other historical accounts (and all mainstream news media today…) remove the “nefarious” angle and simply state that the bankers decided that the money ought to be “put to work” rather than sitting idly in vaults “collecting dust”, and that more money expands economic opportunity for everyone.

We will return to this question next week with a deeper look at both sides, but for now, what do you think about fractional reserve banking? Evil and nefarious or good for society?

To your financial success,

— Kung Fu Girl