Posts Tagged ‘Fractional reserve’


June 18, 2010


I’m going to try to explain the hat trick by which money in banks appears out of nowhere.

This may seem crazy to non- economists, but this “pulling money out of thin air” is the cause of the business cycle, the boom and bust and depressions which make the supposedly free market fail and cause periodic misery for millions: companies that fail and the unemployment that scares us. Understanding the hat trick points the way to end that misery. And it’s not enough for the economists to understand it; unless we all understand it, we can’t muster enough political power to stop it.

The hat trick is built into the system all businesses use to keep track of their financial condition. It’s called “double entry bookkeeping”. Each money transaction is recorded in two columns, as either an asset or a liability. The columns are supposed to balance at all times.

When the bank lends me $1000, it opens a checking account in my name. It enters $1000 on the liability side of the ledger. The liability is the new checking account. The bank owes me $1000. I can write checks on my new account and the bank is obliged to redeem them right away.

The entry on the asset side of the ledger is my IOU to the bank. I have promised to pay back the $1000 in 1 year (with interest, but let’s ignore that). So now the balance sheets show additions of $1000 debit and $1000 credit. The book balances, right? Not really. The amounts balance, but the reality doesn’t.

$1000 cash in hand is not at all equal a $1000 IOU to be paid in one year. I can spend the $1000 now. The bank can’t spend my IOU. I assure you that my word is as good as gold, but you can’t know that. So nobody but the bank will accept the IOU as money

The bottom line is that the bank has converted my IOU into temporary cash, $1000 for 1 year. At the end of the year I’ll pay my debt. The $1000 will disappear by way of a pair of entries in the bank’s books, and the interest I pay will be added to the bank’s assets.

Bankers are convinced that this is open, honest, and above board. It’s all down in the book, for anyone to see. It just doesn’t mention that the $1000 asset won’t be a real asset until next year. So for the next year, an extra $1000 will be added to the supply of money in circulation.

Honest or not, it’s a time honored tradition of banking. It’s legal. OK, it’s a gamble. If I spend the borrowed money and then die penniless, it’s a dead loss for the bank. That’s partly what the interest is for, to compensate for such risk. If one out of 20 such loans fails, the bank will still be earning 5% interest on all of the money they pulled out of the hat.

Someone has said that double-entry bookkeeping is one of the greatest inventions. I’ve always found it confusing enough to make me suspect smoke and mirrors- a hat trick.

But– what the banks give, the banks can take away. Aside from the banks making money out of their hat trick, they cause the amount of money in circulation to rise and fall, causing the distorting oscillations of the business cycle.

Why get excited about this hat trick? Practiced by many banks, coordinated by the Federal Reserve, and protected by deposit insurance, the practice of fractional reserve banking gives us a sick dollar, with alternate fever and chills, and most painfully, periodic mass unemployment.

The hat trick causes the humps and hollows in the economy, such as the frenzy of the stock market boom and crash of the 1920s, the depression of the 1930s & 1940s, the stagflation of the 1970s and the Housing bubble and plunge into depression of 2008. And each time, we have spells of unemployment. That’s serious business.

100 years ago, very few people had bank accounts. Workers received their pay in cash or checks. They promptly cashed them at a bank or currency exchange. Banks worked for years to gain our trust, so now nearly everyone has a bank account. We trust the banks and the dollar. It’s only because of that trust that we can be so easily fleeced by the banks and government. The banks need our money in their bank accounts as a base for a pyramid of temporary money called credit. For every dollar that we keep in a bank account, banks can maintain $10 of temporary money (credit), earning interest.

This is all legal. Some judge long ago decided that your deposits in a bank are not deposits for safekeeping, but a loan. If the bank gets in trouble and can’t pay you back, that’s just your tough luck.

The rules of honest banking wouldn’t allow this. Every dollar in a deposit account (Payment on demand) should be backed by a dollar of cash in the vault.