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Honest Money
What It Is and What It Isn't

Money Part VIII - Fractional Reserve Lending

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 Reserve Notes).

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 with silver.

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.

Fed Speak

According to the Federal Reserve:

"Reserve requirements 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 following chart:

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 dollars.

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 $100.00 dollars.

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.

They Knew

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:

"Congress shall have the power to coin money, regulate the value thereof and of foreign coin, and fix the standard of weights and measures."

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.

Money Creation

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.

Step One

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 asset.

The liability that the Fed creates is a Federal Reserve check. It gives the Treasury the check in payment for the Treasury bond.


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 accounts.

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.

May, 2006
-Douglas V. Gnazzo
email: Douglas V, Gnazzo
website: HonestMoneyReport

Honest Money: What it is and what it isn't
Part I : Part II : Part III : Part IV : Part VI : Part V : Part VII : Part VIII

Douglas V. Gnazzo 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).

©2006 Douglas V. Gnazzo. All Rights Reserved.

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