Note: This is the latest entry in the Acton blogging series, “What Christians Should Know About the Economy”. For other entries in the series, see this post.
The term: Fractional reserve bank
What this means: Understanding fractional reserve banking is easier if we separate what it is (which is quite simple to explain) and the effects of the system product (which is a bit more complicated).
Let’s start by taking the term fractional reserve bank and working backwards.
First, there is the banking part. For our purposes, we must mainly focus on two services provided by banks. The first service is to provide a safe place for people to store change (cash and coins). This is called a “deposit”, or foreign currency deposit, and there are two main types, a demand deposit and a term deposit. With a sight deposit, you can withdraw the money you have deposited in the bank at any time without notice (like with a checking account). With a term deposit, you can only withdraw your money from the bank after a specified period (3 months, 6 months, etc.) and / or after giving the bank notice (as with a certificate of deposit ( CD)).
Second, there is the reserve, or bank reserve. It is simply the amount of a deposit – 0 to 100% – that the bank is required to keep on hand so that when people ask for their repayment, the bank has the currency to give them.
Finally, there is the “fractional” part. It just means that the bank only has to keep a “fraction” of the reserve and is not required to keep a 100 percent reserve. (Technically, the fraction can range from 1 to 99%, but the amount required is usually determined by the Federal Reserve.) To earn money, banks usually lend the amount they are not required to keep in reserve. .
Although it sounds simple, the effect is rather surprising (and often controversial): because the bank is allowed to lend the part that is not required to hold in reserve, commercial banks create new money.
To better understand this point, watch this one-minute video:
If you only go with one takeaway from this post, it should be this: The fractional reserve system allows commercial banks to increase the money supply in the economy by creating money. (This will be important to know for future articles in this series.)
Other things you might want to know:
• How much money can banks add to the money supply using fractional reserve banking? We can get a rough estimate, although usually accurate, by using the formula called “money multiplier”. This formula says that the monetary multiplier, m, is the inverse of the reserve requirement, R or m = 1 / R.
For example, if the reserve rate is 20% (that is, the Federal Reserve requires banks to hold 20% of all deposits in reserve, or 20 cents on every dollar), the rate reserve, R, would be 1/5 or 0.20. So when we put that into our equation, we get: m = 1 / 0.20 = 5. So if a bank receives a deposit of $ 1,000 and the reserve rate is 20%, the money qu ‘it lends will add a maximum of $ 5,000 to the money supply.
• The primary alternative to fractional reserve banking is full reserve banking (also known as 100 percent reserve banking). This is the requirement that banks must keep 100 percent of demand deposits in cash. Since they could not lend the money held in demand deposits, banks would likely charge customers a higher fee for storing these deposits. This system was favored by many free market economists, such as Milton Friedman and Murray Rothbard. (Some Austrian economists even claim that, “In a free market system, the practice of fractional reserve banking would be illegal by its very nature.” “)
• Fractional reserve banking predates government control / supervision of the banking system. Some economic historians claim that federal reserve systems were put in place by nation states precisely to provide some control over the money supply. This is also the reason why some economists still support the banking system with full reserve. Irving Fischer, whom Milton Friedman called “the greatest economist of the 20th century”, written in 1935 that “100 percent banking […] would give the Federal Reserve absolute control over the money supply.
• Some Christians argue that the fractional reserve system violates Bible principles. For example, the theonomist Gary North says, “The Bible is clear on three legal principles. . . (2) Multiple indebtedness, which is the basis of fractional reserve banking, should not be allowed (Exodus 22:26). North sets out his argument for this claim in his free book, Honest money. Personally, I do not find North’s argument consistent or convincing. I think he engages in a creative eisegesis to argue that Scripture agrees with his own preference for economic policy. Like John W. Robbins says,
[Exodus 22:26] is the only Bible passage North has found that he says condemns fractional-reserve banking. Unfortunately, the shift has little to do with banking, and nothing to do with fractional reserves. North himself admits that “the context of this verse is the general prohibition of interest taken from a poor believer…. It is not a business loan ”(80). Therefore, at North’s own premises, the biblical model for money and banking does not include any condemnation of fractional reserve banking.