I’m always surprised how few people know about this. The banks are literally gaining interest on money they never had. It should be illegal.
Well, they have it in the sense that somebody deposited it with them, and they have some fraction of it held in reserve to cover withdrawals.
Edit: Well, in the form of capital, so that’s actually the wrong terminology.
Yes, they still have it. It’s just not in cash.
Fractional reserve banking works because most people don’t need all their money as soon as they get paid. Most businesses keep some money in the bank too. Banks have a required percent of deposits that they must keep on hand to allow these withdrawals. And if they run low on cash, they just borrow money for a day from other banks (literally just one day). The US government can adjust the percent of required reserves or the overnight lending rate to keep banks from lending too much money out.
Banks use this money to loan to businesses or people buying houses. It works well because whenever the money is loaned out it is used for a purchase and just redeposited in another bank. A percentage of that money is retained by the bank and the rest is loaned out again. And again and again. This way money is “created” when people buy things in the economy.
This seems like an already failed banking model which places lenders at the front of the pack and will lead to only larger asset bubbles. Japan’s Kiretsu system of banking led to banks taking out loans to cover up their own investment losses as they had put their money into an asset bubble which collapsed. Banks then committed wholesale fraud by disguising such losses on their books. The Japanese government then used quantitative easing. They create money ex nihilo, swap the money for a t bill, then they bought the toxic assets by giving t bills to the bank. The bank doesn’t sell the t bill, they merely collect interest on it.
The main effect is a system in which bubbles are never popped and consumers suffer a declining standard of living in order to keep asset prices high.
It’s a little more complicated than that. Without fractional reserve banking, the economy would be more difficult to control. I would recommend a quick macroecon video or something.
I myself took quite a while to really understand why this was legal even during my macroecon credit. It actually makes sense when you think about it.
I’ve been thinking about it and it still doesn’t make sense. I’m a scientist, not an economist, so it’s wildly out of my wheelhouse. Would you mind pointing me in the right direction?
Here’s where I’m hung up. Let’s assume a 10% fractional reserve and, for the sake of simplicity, just one bank and a dramatically simplified deposit/loan scenario, just to minimize the number of hypothetical people and transactions.
Person A deposits $1000. Bank lends $900 to person A which is sent to Person B.
Person B deposits $900. Bank lends $810 to person B which is sent to Person C.
Person C deposits $810. Bank lends $729 to person C which is sent to Person D.
Person D deposits $729. Bank lends $656 to person D which is sent to Person E.
Let’s stop there. So we have one initial deposit of $1000, which has resulted in an additional $2,493 in deposits ($3,493 in total) and $3,095 in loans. The bank is now receiving payments, plus interest, on over 3x the amount of actual money it was actually given. To me, it seems like the bank is figuratively “printing money” and gaining interest on it. Nothing I’ve read on fractional reserve lending has suggested this is incorrect.
Halp!
I’m a scientist, not an economist
I’m neither lmao. We just had a macroecon credit in my degree program, which is where I learnt about this.
Halp!
Now onto this… You’re kinda right but kinda wrong in that fractional reserve banking “creates money”. Here’s a way to think about putting your money in a bank. By opening a bank account, you are not putting your money in a vault. You are loaning it to the bank. The bank then loans it out to another person, who then “loans” it to another bank. Hence, fractional reserve banking is a natural side effect of this logic. What would happen if we had a 100% fractional reserve? Well, the bank wouldn’t be able to loan your money to anyone then. It would essentially become a vault.
Therefore, fractional reserve banking is necessary to make loaning money possible. Loaning money is necessary for obvious reasons.
Now to the “creating money” part. Sure, at the macro scale, you get a lot of virtual money in the economy. At the micro level though, individual banks aren’t creating money. They still have to get the money that they’ve lent out back. If they fail to do so, they’re going to go bankrupt. Banks would never go bankrupt if they could print money on a micro scale, right?
Okay, so now let’s zoom out back at the macro scale. Now, you can accelerate or decelerate the economy by controlling the ratio of money that is in circulation vs money that is out of circulation. It’s simple- more money in economy = more demand = more profits = more investments in increasing supply to be competitive = more work done. If this demand however drops, profits drop, and increase in supply drops. This is very bad as no work will be done. However, if demand increases too much for essential goods (like food, housing, etc.), it is bad as it can cause problems for people till the supply can catch up. The economy is going too fast in such cases.
Now, you can slow the economy down by many ways- by increasing interest rates, increases the fractional reserve and so on. This way, less people are going to borrow (you just reduced demand by this simple technique). You now reduced demand in your economy and slowed it down. The opposite can be done to speed the economy up.
