Fractional reserve banking: Understanding the nature of money

Libertarians long for a return to the gold standard and scoff at “government paper.” But maybe government paper is not all that bad.

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WASHINGTON, February 2, 2016 — Despite having the deepest and most liquid capital markets in the world, America has no free market for money. Instead, the Federal Reserve has a monopoly on money.

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Where does that monopoly come from?

While Federal Reserve is said to create money out of nothing, this is not entirely true. The mechanism by which currency is infused into the financial system is based on borrowing. The Fed purchases U.S. Treasury securities (bills, notes and bonds) and keeps them in reserve until it sees fit to convert them into “money.” Dollars are then printed at the U.S. Bureau of Engraving and Printing, but cannot be placed into circulation until the Fed converts the bonds in a process called “monetization.”

The Federal Reserve has deposit requirements for member banks, which is a fraction of their outstanding liabilities. For most commercial banks, one-tenth of total deposits must be held in reserve, though 8 percent is typically held in debt securities and 2 percent is cash in the vaults. For retail banks, treasuries are cash equivalents.

Ultimately, the Fed can place nine dollars into circulation for every one dollar of the bonds it holds, while banks can place up to nine dollars into circulation (by lending them out) for every dollar they get from the Fed. By monetizing debt, the Fed adds to the money supply. It reduces the money supply by selling treasuries, as it recently started to do when it decided to hike the overnight lending rate.

Crazy as it may seem, the bottom line is that every day, your local bank branch is printing money (albeit electronically). So are your local credit unions, pawn shops, check-cashing joints, bail bondsman and anyone else authorized to make loans. On top of all of this, the Fed can also change the reserve ratio at any time to meet its goals.

Your ability to borrow is the bank’s ability to print money, which is why credit cards are also included in capital controls. When you are visiting a foreign country, customs officials routinely ask what credit cards you carry and what their limits are, because a credit card is instant money for the purchase of goods and services.

Reserve requirements are all well and good. But what if everyone wants their money out the system all at once? The FDIC is there to back things up, but there are limits to coverage and that agency can’t rescue everybody. Need proof? Remember those 2008 images of long lines of people waiting to withdraw money out of troubled IndyMac bank in California. Such still-fresh, real-world scenarios still serve to remind us that bank runs are not a thing of the past.

On “Russia Today” in early 2016, Max Keiser compared a bank run to a stock selloff, where large institutions reap the gains and small-time investors are left holding the bag:

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“It’s like a variation on fractional reserve banking, when you say that a bank, for every dollar in deposits, they’ve loaned out a thousand or two thousand dollars,” Keiser said. “Now if those loans are all due at the same time, obviously, that one hundred or one dollar that they have in reserves would be obliterated instantaneously, and that again, going back to the crisis of 2008, we saw an implosion of the fractional reserve model and a liquidity crisis and a seizing of credit, globally.”

So in a tenuous world of fractional-reserve banking, how do we define money?

Before 1971, the Fed held gold in reserve and converted gold into paper money. At the same time, it would redeem gold for $35 an ounce. Gold was basically money, and the government could only place as much money into circulation as it could redeem in gold. In fact, at its inception, the Fed was actually prohibited from buying any government debt, much less monetizing it.

In his 2012 book “Paper Promises,” Philip Coggan wrote: “As money has broken away from its precious metal origins, it has become harder and harder to define.” According to Coggan, the Federal Reserve Bank of Chicago noted in a 1982 pamphlet that “currency has been designated ‘legal tender’ by the government – that it must be accepted.” And the term “must be accepted” means we don’t have a choice.

For all intents and purposes, money is whatever the Federal government says it is. “Money” is determined by government fiat and can be randomly and arbitrarily changed at any time. “Desperate governments have prosecuted, and executed, traders for using the ‘wrong kind’ of money,” notes Coggan, although America is not at that point. Yet.

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A cynic might say that money is just another way for governments to control people. Lately, there has been a notable rise in the number of rumors claiming that some nations are scheming to do away with cash and move to all electronic money. This would ostensibly allow them to more easily track and control people. But at least for now, cash is still king.

Libertarians long for a return to the gold standard and scoff at “government paper.” But perhaps government paper is not all that bad. Consider this: A diamond miner in Zimbabwe works for Tiffany & Company. After a day’s work he is given four choices for his labor. One: a diamond ring worth $7,500. Two: $7,500 in cash. Three: $7,500 in gold bullion. Or four, an American passport.

Keep in mind, however, that the passport is government paper.

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