What is Fractional Reserve Banking?

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The Federal Reserve is an extremely interesting bank. It's a fascinating organization that does fascinating things. I've always been interested in how certain people create certain things and keep them operational. I've also always loved learning about different business models. It's the latter I'll discuss in today's post. Read on below because you might learn something you never knew. And you might love it as much as I do.

The Federal Reserve bank was created in 1914, after the Federal Reserve Act was passed in 1913. The bank took over the currency creation responsibilities from U.S. government. The U.S. government no longer prints money. The Federal Reserve does. That's why you'll see "Federal Reserve Note" printed on the cash in your pocket. The way the bank primarily "prints money" is through the issuance of loans. So basically, here's how it works. The U.S. government needs some money to cover its expenses. Since the money they need isn't in circulation, they turn to the Federal Reserve. With the press of a button, the Fed fills the U.S. treasury with a set amount. That amount is equal to the loan amount. So in case you weren't aware, the U.S. government borrows the money it needs from a private bank. Now, this is where it gets interesting. Every dollar the Fed loans, they do so with interest. So if the Fed loans the government one million dollars at 3% interest, that's what the government needs to pay back. Since its inception in 1914, the Fed has loaned money to not only the government, but to all sorts of institutions as well. Each and every one of these organizations owes the Fed what they borrowed, plus interest.

I want you to read those last few lines again. Yes, the Fed loans these organizations money at interest. If this is the case, how in the world would the U.S. government and these organizations ever pay the Fed back the entire amounts they borrowed? After all, the Fed has loaned all of the money the government has ever used. If interest is to be paid on the loan amount, where is the government supposed to come up with not only the principle, but the interest as well? Here's the answer - it's not possible. It's theorized that as the monetary supply grows and as governments and organizations around the world begin to default on their loans, the banks will begin taking assets from these nations. Assets such as land, bridges, highways, tunnels, ports, etc...

To pay back the interest that's owed, more money needs to be borrowed. It's actually impossible to pay back the debt because the debt keeps on rising in order to pay back the interest on the debt. Now that's a business model I like!

What's better is this: when the Fed issues loans, they do so with nothing backing those loans up (as far as I know). They can issue them from what people love to refer to as "thin air." After the loan is issued, the borrower must pay the loan back, plus interest. If the borrower can't pay it back, they must pay some collateral and that collateral is what I just mentioned above. So as you see, hard assets aren't necessary to issue the loans, but there may come a time (if not already) that hard assets are required to pay back the loans. This is how real wealth is created. Through hard assets.

Now, to be fair, neither I nor anyone I know is on the inside. We don't really know how any of this works. Borrowers all over the place get away with defaulting on their loans and never paying any collateral. So yes, currency does just disappear and never gets paid back to the lending institutions that lend it. Without additional debt, the economy shrinks and no one wants that. So while we all like to beat up on the bankers, they're the one who are making our lives so cushy.

Fractional Reserve Banking​

The idea of having banks reserve a certain amount of currency on hand has been changing over time. Banks used to have to hold a percentage of all deposits on hand to use for withdrawals. This amount is referred to as their reserve requirement. If $1,000 was deposited on the very first day a new bank opened its doors and if the reserve requirement of that bank was 10%, that bank would need to keep $100 on hand for withdrawals and would be allowed to loan out the remaining $900.

It gets a little confusing here. When it comes to lending, the bank doesn't actually lend out the $900 that was part of the $1,000 that was deposited. The $900 is borrowed from the Federal Reserve to lend out. So the Fed loans the money to the bank at interest and the bank loans the money to the consumer at interest. The $900 that the Fed loans is borrowed into existence. That money never existed before. When a consumer borrows that $900 from their bank, it usually gets deposited into another (if not the same bank) bank account somewhere. Once that deposit is made (wherever it may be), the bank it's deposited into now has a new deposit, which it's allowed to lend 90% of. Do you see the cycle here? Let me give you an example.

Jake and Sally want to buy a new house. The house costs $300,000, so they go to their bank to borrow some money. The bank borrows the money from the Fed and lends it to Jake and Sally. Jake and Sally take the money and pay for their new house with it. The seller of the house takes the payment and deposits it into their own bank account. The bank in which this new money is deposited says, "Ooh, we get to make new loans now!" and lends out 90% of that deposit amount. If you've ever wanted to know why banks offer savings accounts and CDs, this is why. They want to have as much an amount of currency stored in their banks so they can lend out more and more at interest. It's like a giant merry-go-round.

The Income Tax​

What's the biggest payer of the interest on the national debt? Yes, you guessed it. The income tax. Before 1914, there was none, but after 1914 (1913, really), the Sixteenth Amendment to the Constitution was added, which created the income tax both you and I love so much. Apparently, the U.S. government didn't make enough in revenues to cover the interest on the debt.

Again, this isn't meant to beat up on anyone. Debt is necessary for growth. Everyone knows this. Without debt financing, we'd live in a stagnant world that wouldn't be nearly as advanced as it is today. Covering the income tax is a very small price to pay for all that's come out of the debt we've incurred through the ages. We'd likely have very few vaccines, houses, parks, airplanes, etc...without any debt. What I'm sharing here is merely some simple history.

Here's a link to the Sixteenth Amendment. It's a rather short amendment.

Passed by Congress July 2, 1909. Ratified February 3, 1913. The 16th Amendment changed a portion of Article I, Section 9

"The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."

Fascinating, isn't it?

This post is part of a series: Guide to Investing in Gold & Silver by Michael Maloney
 
What is Fractional Reserve Banking? was posted on 06-03-2021 by CaptainDan in the Economics Forum forum.
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