#51 Fractional Reserve Banking

Many people mistakenly blame our current financial crises on fractional reserve lending. I believe this is an incorrect position. By definition, any lending institution is to some degree under-collateralized. This simply must be the case.

The current arcane financial system has abstracted away the ideas of debt and capital. Lending requires previously accumulated capital. This is crucial to understand. This is abstracted away under the current paradigm because lending creates new money from nothing, but this still expropriates existing, accumulated capital. There is no such thing as a free lunch.

If I have 10 apples, and I loan you 5, I now only have 5 apples and a promise to be repaid my other 5 apples (plus some interest) from you. I an now under-collateralized on my stock of 10 apples. This is essentially fractional reserve banking in concept and must happen in order for lending and investment to take place.

In addition, I cannot lend you 11 apples if I have only accumulated 10.

Both of these principles, the extent to which lending is limited by previously accumulated capital and the nature of lending, are abstracted away by the fiat financial system. By effectively creating new money out of thin air with new loans, collectively accumulated capital in the form of fiat expansion is utilized to the finance the loan. Banks typically have had reserve requirements (money set aside and not lent) set in place by the federal reserve, although recently this requirement has been reduced to 0.

This means that even though I only have 10 apples, I can now lend you 50 claims to paper apples despite not having those apples to lend. Additionally, I may have already lent my 10 physical apples to someone else and effectively have 0 physical apples on hand.

Ordinarily, in a free market, lending of such a voracious nature would result in liquidation of my assets. Chances are, enough people would attempt to claim their paper apples or some of my lending would fall through (remember that lending is investment) and default. My business of apple lending would collapse and I would suffer the consequences by losing all of my accumulated and deployed capital to mal-investment.

This is where the lender of last resort steps in to make any institution failing from their bad investments whole. The federal reserve provides any and all amounts of liquidity necessary to shore up bad debt with new money. This new money, again, comes at the expense of extraneous capital from the greater economy.

Fractional reserve banking (or fractional reserve lending) are not the cause of societies ills. A world without fractional reserve banking is a world without lending. Certainly, fractional reserve lending and full reserve custodial banking could be separated out, and in some cases already are. However, what the layperson now thinks of as a custodial agreement for their funds are actually lending agreements with a bank.

This relationship and the difference between the two should be made more clear to the consumer. Personally I tend to find equity solutions to financing are preferable over debt and interest, however, Accredited Investor laws make this nearly impossible for all but the wealthy. Preventing a great number of people from restricting their investments to markets they understand with their own accumulated knowledge. With all of that said, it is important to remember that blaming fractional reserve banking for the economic ills of society is a misappropriation of cause and effect.

It is the lender of last resort and the governments ability to indefinitely create new money at the expense of others, to make bad debt whole, which debases society. It is, as is typical, the postponement of the liquidation of mal-investment on which you should shine a light.

Book of the Month:

The Price of Tomorrow: Why Deflation is the Key to an Abundant Future

-“It took $185 trillion of debt to produce about $46 trillion of GDP growth over the last twenty years.”

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