What It Is and What It Isn't
Money Part VIII - Fractional
Douglas V. Gnazzo
May 19, 2006
One of the best-kept secrets
is fractional reserve lending. Ask the average guy in the street
what it means and you will get a shrug of the shoulders. Ask
the manager of any small town bank what it means and you'll get
a "well, um, I'm not sure."
Ask ten different financial
advisors and you will get eleven different answers. Most do not
know what it means, and those few that do are usually members
of the corpus elite - and they will not tell. It is one of the
secret passwords to the inner sanctum of the temple.
As we have seen in previous
papers, the Constitution mandates that silver and gold coin are
the currency of the United States - not paper notes of debt-obligation
as are the present day Federal Reserve Notes, commonly referred
to as dollar bills.
The winds of war always stir
up a devil's brew - the civil war was no different, bringing
with it a scourge that has lasted to the present day: paper bills
of credit - debt obligations that circulate as the currency (Federal
For a short time the paper
notes of the government were redeemable in gold and silver, but
this too came to pass quite quickly. By 1933 President Roosevelt
had made it illegal for any private citizen to own gold - the
same gold that the Constitution states is legal tender along
The photo below clearly illustrates
that at one time paper money was redeemable or backed by gold
held on reserve in the banks. The year on the note below is 1882.
Courtesy of the Federal
Reserve Bank of San Francisco
A Brief History of Money
As the note clearly states,
it is repayable to the bearer on demand $500 dollars in GOLD
COIN. Our money is no longer backed by gold and silver - it is
backed by nothing but promises and good faith. And the sad truth
of the matter is that the money doesn't even really exist.
According to the Federal Reserve:
have long been a part of our nation's banking history. Depository
institutions maintain a fraction of certain liabilities in reserve
in specified assets. The Federal Reserve can adjust reserve requirements
by changing required reserve ratios, the liabilities to which
the ratios apply, or both."
So, in the Fed's own words
our money is maintained by a fraction of reserve requirements.
The obvious question is: by what fraction? The Fed provides the
The largest amount listed is
10% percent, which means that the banks get to loan out 10 times
the amount they have on reserve. This is the crux of the meaning
behind fractional reserve lending. Now let's get a bit more specific.
How It Works
John Doe decides that he is
going to deposit in the bank the sum of $100 dollars. The bank
gladly takes the $100 dollars from Mr. Doe, and in return gives
him a receipt (passbook) that states that the bank owes him $100
If you read the fine print
on any deposit agreement you sign with the bank, you will notice
that you have actually loaned your money to the bank. In return
you get an i.o.u. from the bank (deposit receipt or passbook),
which stipulates the principal owed to you, and an amount of
interest to be paid to you for the loan of money you just made
to the bank. For simplicity, let us say you are paid 1% interest.
The bank has a 10% reserve
requirement that means that on the $100 dollars you just loaned
to them, they only have to keep on reserve 10% x $100 = $10 dollars.
That leaves them $90 dollars to loan out to someone else.
When they loan out the $90
they have to keep on reserve 10% x 90 = $9 on reserve. They then
can loan out $82.
Now stop and think about it.
You "loaned" the bank $100. In two loan transactions
subsequent to your "deposit" the bank has already loaned
out $90 + $82 = $172 dollars.
By the use of fractional reserve
lending, the bank has already loaned out $172 dollars using your
So where do they get the extra
$72 dollars to loan out. They do not get it from anywhere's -
they just create it out of thin air as entries on a ledger. The
money does not actually exist.
Granny Smith comes into the
bank and wants to take out a loan for $90 dollars. No problem
says the bank; John Doe just deposited $100 so we have plenty
of money to lend you. Granny gets a loan for $90, and a loan
agreement that says she owes the bank $90 dollars plus interest
of 3% percent.
What this means is that the
bank owes John Doe the $100 dollars he deposited with them, yet
they only have $10 dollars on reserve, as they have lent the
other $90 dollars to Granny Smith. How can the bank possibly
meet its obligations?
Solvent Versus Liquid
As long as no more than 10%
percent of all total depositors demand their money at any one
time the bank remains solvent, as in aggregate they have that
amount held in reserve. This is the dark side of fractional reserve
lending: the seamy side - the moral hazard that borders on fraud.
If a number of depositors greater
than the 10% held in reserve demand their money at the same time,
the bank will be in a bit of a bind, as they do not have that
amount of money on deposit. They will have to call the Fed as
the lender of last resort.
The Fed will have no problem
in supplying the money - as long as no more than 10% of the total
of ALL DEPOSITORS in the banking system don't want their money
at the same time, because if they do - it ain't there. This is
a banker's worst nightmare - it's called a run on the banks.
To the bankers, a run on the
bank is sacrilegious and immoral, showing no faith in the system.
What system? - The system of fractional reserves. The system
of make believe.
To the depositors, a run on
the banks is the simple and honest act of withdrawing their deposits
on demand, as they are supposed to be able to do.
The bankers consider it immoral
because fractional reserves themselves are immoral, they are
the epitome of moral hazard - they allow contractual obligations
to be placed in harms way, in default's way.
All it takes to start the refusal
to meet contracted obligations is more than 10% of depositors
wanting their deposits at the same time. Then the system of fractional
reserves will be seen for what it is - a straw man - an illusion
- what some would call a fraud.
The banking system appears
to be solvent - but it is not liquid - it cannot be - it is impossible
because of fractional reserve policy. Banking is the only type
of business that is allowed to function this way. If any other
business used a similar modus operandi, it would be subject to
censor, arrest, court, and possibly imprisonment.
This is one of the reasons
why the words "emit bills of credit" was removed by
the Founding Fathers from the original draft of Article 1, Section
8, Clause 5 of the Constitution:
have the power to coin money, regulate the value thereof and
of foreign coin, and fix the standard of weights
They knew the inherent evils
in allowing the issuance of paper debt-money or promises to pay,
which ultimately were never meant or honored.
This is why they stipulated
a system of honest weights and measures - of silver and gold
coin - of Honest Money. They knew from whence they spoke. They
knew of what they spoke.
Fractional reserve lending
has been shown to be a fleeting specter of illusion - inherently
weak and diseased, yet projecting the appearance of strength
and fortitude. Such is the powerful scepter the wizards of finance
wield to delude their fellow man into a life of debt-servitude
to their unknown masters.
The magic number is ten - ten
times the amounts of deposits the wizards are allowed to conjure
up and then loan out. But wait - what of the ten percent, where
did it come from?
The secret is more powerful
than that of fractional reserves: it is the power to create,
and to seemingly create something - out of nothing.
It all begins at the Treasury
Department. The Treasury prints up a piece of paper called a
bond, which presently is done electronically. Treasury bonds
are debt obligations or liabilities of the government to repay
a loan - with interest.
The Treasury deposits bonds
with the Federal Reserve. When the Fed accepts the bond from
the Treasury, it lists the bond on its books as an asset. The
Fed assumes the government will make good on its promise to pay
back the loan. This is based on the belief that the government's
power to tax the people is sufficient collateral.
Because the Fed now has an
asset that it did not have before receiving the Treasury bond,
the Fed can now create a liability that is offset by its new
The liability that
the Fed creates is a Federal Reserve check. It gives the Treasury
the check in payment for the Treasury bond.
THERE IS NO EXISTING
MONEY IN THE FED'S ACCOUNT TO COVER THIS CHECK.
The Federal Reserve check is
endorsed by the Treasury and is deposited in one of the government's
accounts at the Federal Reserve. The government can use the deposits
to write checks against, to pay for government expenses.
This is the first new money
flow to enter the system. Various government contractors, vendors,
etc. receive these checks as payment for services rendered, and
they take the checks and deposit them in their commercial bank
The Second Step
This is when the wizards of
finance really earn their keep. The deposits in the commercial
banks take on a sort of split personality or dementia, brought
on by a preponderance of delusional thinking that wizards are
prone to have.
On the one hand, the deposits
are the bank's liabilities, as they owe the total sums
to their depositors. The commercial banks, however, list
the deposits as RESERVES. Because of FRACTIONAL RESERVE lending,
the bankers get to lend out that which they do have.
In addition, they
get to charge interest on it.
As the newly issued money is
put to work by borrowers, they then spend it and the receiver
then deposits it in their bank account, and the bank starts the
reserve lending policy all over again. This is why the
Money supply must
expand by the amount of interest owed on the debt.
If it didn't, the debt would
not be able to be serviced. There is no money created without
creating debt, they are one and the same. Creating money by fiat
does not create wealth - only debt.
-Douglas V. Gnazzo
email: Douglas V, Gnazzo
Honest Money: What it
is and what it isn't
I : Part II : Part
III : Part IV : Part
VI : Part V : Part
VII : Part
is CEO of New England Renovation LLC, a historical restoration contractor
that specializes in restoring older buildings that are vintage historic
landmarks. He writes for numerous websites and his work appears
both here and abroad. Just recently he was honored by being
chosen as a Foundation Scholar for the Foundation for
the Advancement of Monetary Education (FAME).
V. Gnazzo. All Rights Reserved.