Guest Post: Fraction … Er … Fictional Reserve Banking

Washington’s Blog.

As the New York Federal Reserve Bank explains on its website:

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+…=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+…=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

Of course, many Austrian economists have criticized fractional reserve banking. For example, Murray Rothbard wrote:

Let’s see how the fractional-reserve process works, in the absence of a central bank. I set up a Rothbard Bank, and invest $1,000 of cash (whether gold or government paper does not matter here). Then I “lend out” $10,000 to someone, either for consumer spending or to invest in his business. How can I “lend out” far more than I have? Ahh, that’s the magic of the “fraction” in the fractional reserve. I simply open up a checking account of $10,000 which I am happy to lend to Mr. Jones. Why does Jones borrow from me? Well, for one thing, I can charge a lower rate of interest than savers would. I don’t have to save up the money myself, but can simply counterfeit it out of thin air. (In the 19th century, I would have been able to issue bank notes, but the Federal Reserve now monopolizes note issues.) Since demand deposits at the Rothbard Bank function as equivalent to cash, the nation’s money supply has just, by magic, increased by $10,000. The inflationary, counterfeiting process is under way.

“Unfortunately, while banks depend on the warehouse analogy, the depositors are systematically deluded. Their money ain’t there.”

The 19th-century English economist Thomas Tooke correctly stated that “free trade in banking is tantamount to free trade in swindling.” But under freedom, and without government support, there are some severe hitches in this counterfeiting process, or in what has been termed “free banking.”

First, why should anyone trust me? Why should anyone accept the checking deposits of the Rothbard Bank?

But second, even if I were trusted, and I were able to con my way into the trust of the gullible, there is another severe problem, caused by the fact that the banking system is competitive, with free entry into the field. After all, the Rothbard Bank is limited in its clientele. After Jones borrows checking deposits from me, he is going to spend that money. Why else pay for a loan? Sooner or later, the money he spends, whether for a vacation, or for expanding his business, will be spent on the goods or services of clients of some other bank, say the Rockwell Bank. The Rockwell Bank is not particularly interested in holding checking accounts on my bank; it wants reserves so that it can pyramid its own counterfeiting on top of cash reserves. And so if, to make the case simple, the Rockwell Bank gets a $10,000 check on the Rothbard Bank, it is going to demand cash so that it can do some inflationary counterfeit pyramiding of its own.

But, I, of course, can’t pay the $10,000, so I’m finished. Bankrupt. Found out. By rights, I should be in jail as an embezzler, but at least my phoney checking deposits and I are out of the game, and out of the money supply.

Hence, under free competition, and without government support and enforcement, there will only be limited scope for fractional-reserve counterfeiting. Banks could form cartels to prop each other up, but generally cartels on the market don’t work well without government enforcement, without the government cracking down on competitors who insist on busting the cartel, in this case, forcing competing banks to pay up…

Hence the drive by the bankers themselves to get the government to cartelize their industry by means of a central bank.

Similarly, Ron Paul wrote in October:

Whenever instability turns up, we see efforts to socialize the losses, but rarely do people question the source of instability. Economist Jesús Huerta de Soto places the blame on the institution of fractional-reserve banking. This is the notion that depositors’ money in use as cash may also be loaned out for speculative projects, then re-deposited. The system works as long as people do not attempt to withdraw their money all at once. In the face of such a demand, banks turn to other banks to provide liquidity. But when the failure becomes system-wide, they turn to government.

The core of the problem is the conglomeration of two distinct functions of a bank. The first is warehousing, whereby banks keep money safe and provide checking, ATM access, record keeping, and online payment, services for which consumers are traditionally asked to pay. The second service the bank provides is a loan service, seeking out investments and putting money at risk in search of return.

The institution of fractional reserves mixes these functions, such that warehousing becomes a source for lending. The bank loans out money that has been warehoused—and stands ready to use in checking accounts or other forms of checkable deposits—and that loaned money is deposited yet again in checkable deposits. It is loaned out again and deposited, with each depositor treating the loan money as an asset on the books. In this way, fractional reserves create new money, pyramiding it on a fraction of old deposits. An initial deposit of $1,000, thanks to this “money multiplier,” turns into $10,000. The Fed adds reserves to the balances of member banks in the hope of inspiring ever more lending.

As customers, we believe that we can have both perfect security for our money, withdrawing it whenever we want and never expecting it not to be there, while still earning a return on that same money. In a true free market, however, there tends to be a tradeoff: you can enjoy the service of a warehouse or loan your money and hope for a return. The Fed, by backing up fractional-reserve banking with a promise of endless bailouts and money creation, attempts to keep the illusion going.

The history of banking legislation can be seen as an elaborate attempt to patch the holes in this leaking boat. Thus have we created deposit insurance, established the “too-big-to-fail” doctrine, and approved schemes for emergency injections to keep an unstable system afloat .

And at least some people claim that the fractional reserve banking system is guaranteed to create unsustainable levels of debt.

From Fractional to Fictional Reserves

But whatever you think about fractional reserve banking, whether or not you agree with its critics, the truth is that we no longer have it.

As the above-linked NY Fed article notes:

In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels.

And as Steve Keen notes – citing Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Requirement Systems in OECD Countries”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2007-54, Washington, D.C:

The US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.

So huge swaths of loans are not subject to any reserve requirements.

With the repeal of Glass-Steagall, deposits have been used to speculate in every type of investment under the sun, using insane amounts of leverage. Instead of the traditional 10-to-1 ratio, the giant banks and hedge funds were using much higher levels of leverage.

For example, Congresswoman Kaptur told Bill Moyers that while – on paper – there are 10-to-1 reserve requirements, banks like JP Morgan were using 100 to 1 leverage. She said that, with derivatives, leverage might be much higher.

And remember that most of the credit in our economy is actually through the shadow banking system, not through traditional depository banking.

As the Washington Times wrote in February 2009:

“Before last fall’s financial crisis, banks provided only $8 trillion of the roughly $25 trillion in loans outstanding in the United States, while traditional bond markets provided another $7 trillion, according to the Federal Reserve. The largest share of the borrowed funds – $10 trillion – came from securitized loan markets that barely existed two decades ago. . . .Mr. Regalia [chief economist at the U.S. Chamber of Commerce] said … 70 percent of the system isn’t there anymore,’ he said.”

Bernanke, Summers, Geithner and the boys have been working as hard as they can to re-start the shadow banking system, and traditional loans to individuals and small businesses have plummeted. So the percentage of shadow banking system lending to the all lending has probably skyrocketed again.

The NY Fed continues:

Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.

In other words, as we’ve repeatedly written, reserves can be obtained once a binding loan commitment is made.

As William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, said in a speech last July:

Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference.

Bernanke has proposed the elimination of all reserve requirements:

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

And – according to Steve Keen – about 6 OECD countries have already done away with reserve requirements altogether (Keen confirmed that Australia requires no reserves; I know that Mexico doesn’t require reserves; and Canad, New Zealand, Sweden and the UK supposedly require no reserves as well).

How Can An Insolvent Company Have Any Reserves?

Everyone knows that banks are required to have reserves, and that the giant banks supposedly have massive sums of excess reserves.

But does that really mean anything when everyone who runs the numbers says that the giant banks are (once again) insolvent?

Specifically, if we took away mark-to-the-moon valuations, forced the big boys to put their SIV off-sheet liabilities back onto their balance sheets, and stopped all of the fraud, spinning and other hanky-panky (of which Lehman’s Repo 105s were just a tiny part), it would be obvious that the too big to fails were deeper into the hole than Wiley Coyote after he fell of the cliff and hit the ground.

So any “reserves” that the TBTFs have are fake, courtesy of the taxpayer, Uncle Sugar, and plain old puppetry .

We no longer have a fractional reserve banking system. Reserves are just a fiction.

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About George Washington

George Washington is the head writer at Washington’s Blog. A busy professional and former adjunct professor, George’s insatiable curiousity causes him to write on a wide variety of topics, including economics, finance, the environment and politics. For further details, ask Keith Alexander…


  1. campbeln

    Full disclosure: I’m a programmer, not an economist (so logic may be getting in the way understanding this economy thing ;)

    I would really like to know how this jives (jibes?) with the following Billy Blog post:


    So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

    The only person who hasn’t got a clue is obvious here. The US economy is in a giant mess but the change in reserve requirements will have a zero impact on whether it gets worse or better.

    The idea that you maintain financial stability by regulating the liabilities side of the banking system is erroneous. That is how monetary policy operated during the convertible currency days when central banks had to maintain a tight grip on monetary growth to ensure it was compatible with the need to defend the parity in the foreign exchange markets.

    In a non-convertible currency system, there is no applicability at all to liability side management. All the regulation has to be put on the asset and capital side of the bank balance sheets, which is the current international approach – albeit poorly formulated.

    Now, I can’t say I subscribe to what Billy Blog is saying (as it seems more dogma then substance, see the “Keynesian-monetarist nexus on economics” diatribe…) but I’d like to hear a few logical counter points to this opposing view. I have to say I’ve read little from the Keynesian perspective (of which Billy is an obvious subscriber), but while the Austrians make since (such as your post) I cannot seem to reconcile the differences in my programmers brain.

    Thanks in advance!


    1. Tao Jonesing

      “If reserves are just a fiction, then why do banks pay interest on deposits?”

      To maintain the illusion that we have a fiat money system. Google “the roving cavaliers of credit” to see Steve Keen’s discussion. (To be fair, he does not discuss the “illusion” to which I allude, but economics always boil down to a shared delusion: nothing is worth anything unless we agree that it is.)

      “The amount paid for deposits is very little these days, but isn’t the main benefit of having deposits to a bank is that the deposits get converted into reserves?”

      No. The main benefit of having deposits is that you get paid interest for allowing the bank to lend out that money to other people. The hope is that the interest rate you get paid is greater than the inflation caused by the banks lending out your money.

      “Are we moving to a world where banks will no longer have an incentive to pay interest on deposits?”

      As a practical matter, we’re already there. How much interest income did you earn last year? This is temporary, though, at least until the current set of bankers realize that they’ve set up a situation where it is either your money or their lives. They’re a venal crowd, so they will choose their lives, if the choice is presented to them.

      Of course, these are just my opinions. If I didn’t help answer your questions, I hope I provoked further questions.

      Good luck.

    2. Tao Jonesing

      Billy is channeling Steve Keen.

      The single best explanation to be found is Steve Keen’s “Roving Cavaliers of Credit” post, which may be found here (as I recall, Yves cross-posted it on NC):

      Keen (and Billy, I believe) is actually a “Post Keynesian,” in part because they view what has become known as ”
      Keynesianism” as a bastardization of what Keynes actually meant and said. Having read Keynes, I agree with them. (This is where the “nexus . . . diatribe” you refer to comes into play.)

      To be fair, GW is not, I believe, ascribing to an Austrian point of view per se. Rather, he is relying on the agreement between the Austrian school and the Post Keynesians to reinforce the notion that their agreement on the point of “fiction” is meaningful.

      Based on what I’ve seen GW say for the last couple of years, he is a tweener. Personally, I view the Austrian school and Post Keynesian school as completely incompatible (and the Austrian school disgusting), but GW has a lot more tolerance for emotionally stunted individuals than I do.

      In closing, as a programmer, economists should be apologizing to you, who actually contributes something to our shared illusion beyond a reach-around for the wealthiest among us and an “attaboy” for everybody else.

      1. john

        The thing that has always disappointed me about economists is that you guys don’t seem to have any models that make any attempt whatsoever to describe technology. You have models for currency movements and what have you, but your supply and demand models always seem to start with some generic, homogenous widget.

        It’s hard to take you guys seriously when your economic models never predict anything accurately; the ultimate sign of success in your profession is to work for some large, criminal bank; and your supply-and-demand models only work for commodities like hay or a cord of wood. What gives?

        1. toby

          Hi John,

          if you haven’t already, check out Debunking Economics by Steve Keen. I’m about a third of the way through, but by my reckoning he’s already pointed out amply that economics, particularly the neoclassical flavour, is a busted flush. It does not have a logical leg to stand and needs to be completely rewritten, from the ground up.

        2. Gordon

          I second that. Steve Keen’s Debunking Economics is a must read for anyone trying to understand how we’ve gone so badly wrong.

          What is clear is that the ‘neoclassical’ economics of the mainstream is no more than a cult based on epic levels of self-delusion. A bona fide opiate of the people in fact.

        3. Tao Jonesing

          “The thing that has always disappointed me about economists is that you guys don’t seem to have any models that make any attempt whatsoever to describe technology.”

          Actually, Paul Romer has developed models that account for technological change and its effect on economies, but his theories have not been mainstreamed by the neoclassical orthodoxy. Here is a link to one of Romer’s earlier papes on “endogenous technological change”:

          David Warsh wrote a book on the topic that is an easy and interesting read, which may be found here:

          As a non-economist with a degree in electrical engineering, I have found that economic models are not in the least bit scientific, primarily because when economists discover that their models don’t work, they assume away the bad fact that makes the models crash as being “exogenous” (i.e., outside of the model). Steve Keen’s book and the blogpost above do a lot to expose this ugly fact.

          The key to understanding “what gives” is that what we call “economics” today used to be called “political economics.” They dropped the “political” because doing so helps the con of economics work better.

  2. john

    If reserves are just a fiction, then why do banks pay interest on deposits? The amount paid for deposits is very little these days, but isn’t the main benefit of having deposits to a bank is that the deposits get converted into reserves? Are we moving to a world where banks will no longer have an incentive to pay interest on deposits?

    1. rumor

      Why do banks pay interest on deposits?

      Well, not all banks do. Investment banks obviously only operate on the loan side of the system.

      As others have already mentioned, banks pay a pittance in interest on deposits these days, precisely because they aren’t particularly useful as reserves.

      But where interest on deposits has value for retail banking is as *incentive* to (a) get a customer in the door and (b) keep him there. Once the customer is in the door and, better, once he is a loyal customer, he is a source of fees and interest payments for all the *other* services a retail bank offers; mainly loans such as mortgages, HELOCS and small business lines of credit.

      Attracting deposits is no longer primarily for building up reserves to buttress lending, but it’s still important for lending because it brings in a customer base. It’s one aspect of being a competitive retail bank, just like customer service, or the convenience of branches and ATM locations, or flyer miles programs, or any other value-added incentive program.

  3. Dorian Gray

    Fantastic summary of the banking industry’s antics, thank you for making this subject so accessible.

  4. Alexandra Hamilton

    That explains why there were and are no real bankruptcies and liquidations of banks. They are usually taken over very quickly by a – usually larger – competitor.
    This is a wonderful way to hide the fact, that there is nothing there in the bank, no real assets no reserves. It’s just an empty hull.

  5. Skippy

    That’s why I’m fully invested in digital electronic storage…seems Tobe where all the money is…in electron form.

  6. ryanclarke

    The Fed can print money all they want to … that’s exactly why the Fed ‘bought’ $1.25 TRILLION dollars worth of junk mortgage backed securities from Fannie and Freddie. Fannie and Freddie then in turn reloaded on bad mortgage debt from the likes of Morgan Stanley and Bank of America and Citi. These banks have used the cash … not to loan to the general Joe Blow Sixpack who can’t pay his credit cards … but to juice the stock, bond, and commodity markets. The banks bought anything that was liquid and could be turned into cash in a hurry.

    So now we have exactly what Japan had in the 1990s. A banking system that will not lend into the economy and which only survives due to gov’t support. Given time, the currency will depreciate … which is exactly what Uncle Sweet wants as he’s in a ton of debt to China and Japan and would like to pay it back with a currency you can piss on.

    And that’s exactly what the U.S.currency is worth. Remember, up until the 1970s when the U.S. did away with the gold standard … your cash in your wallet was backed by gold in Uncle Sam’s bank vault at Fort Knox. From the moment Nixon went off the gold standard until March 2009 your money was backed by U.S. treasury debt … debt which the world would buy and so had value.


    On main street, we call this the shell game. On Wall Street it’s called business as usual.

  7. kssong

    lend with a heart.
    place-sumer.somewhere in iraq.
    time-3200 bc
    capital-cattle/goats/corn/sometimes coin.
    interest-calf/kid/corn/sometimes coins.
    what does the temple do with the profits?-help widows,orphan,infirm.
    therefore capital is circulated in the economy.

    lend with har vard.
    capital-out of thin air
    interest-kept by banksters.
    results-i)liquidity squeeze.
    ii)companies and nations looted/devastated.
    (tyco,mci,enron,arthuranderson,aig,lehman,e7y,s&l,’94 latin america,’97 asian tigers,’07 subprime,

  8. craazyman

    Leverage has been badly abused and strategically used to loot the public by individuals operating from pyschopathic instinct.

    It’s absolutely unconscionable that our political looters (oh gee, I meant “leaders”, slip of the tounge there) have permitted this — Demogogues and Republicons alike. But then I guess that’s what makes a “saavy businessman”. Thanks Mr. President, for that little gem.

    Fractional reserve lending seems to me a separate issue. In a tribal culture where barter is the primary means of exchange, there is no money or credit. As a result, fisherman, hunters, basket makers, cooks, doctors (or their equivalent) all subsist in an economic harmony where the optimization of the health of the tribal unit is the basic goal. Economic health depends on the harvest and the hunt. And on the ability of the tribal unit to process it’s thanatos instinct — which it rarely succeeds at in the long run — absent warfare and scapegoating and pyscopathic forms of “religious” practice (e.g. Freud’s Totem and Taboo; James Frazer’s The Golden Bough).

    The exchange of goods and services was direct and personal — taking the form of exchanges of what can be loosely called “spirit” along with the physical or labor aspect. In other words, people helped each other out of necessity. I give you three fish for dinner and you give me a basket of corn. We are bound in a relationship that transcends the physical items. We operate inside of a tribal mind.

    As tribes grew into cities, such transactions become more anonymous in the form of market places. Money arose to facilitate these, but as it arose, the spiritual element of the transcation declined. It became anonymous and impersonal. Like all thing, this brought a phenomenon (freedom) and it’s opposite (a form of debt slavery).

    Disparities in ability and the luck of the hunt, the harvest and personal health injected increasing inequalities into the situation. And the evolution of language empowered imagination to translate inchoate thoughts and feelings into ambitions to create things in circumstances unencumbered by the complex rituals — i.e. inventions, lifestyles freed from family history or clan identity, etc. Taboos and other formalized social structures inhibited individual freedom in tribal cultures. Money helped break down these social organizations.

    Money became a substitute for the matter and the spirit exchanged during the exchange of goods and services. So money became a metaphor for the spirit of the tribe. Banking became a method of extending spirit through the lending of money to those in need. Fractional reserve lending became a way to magnify the extension of spirit money and to multiply its impact on the spiritual enlargement of the community and on the imaginative possibilities of the communities’ creativity.

    There is nothing inherently evil in this. In fact, it can be an amplifier of personal liberty and a driver of broader and wider prosperity. But like any form of drug or medication or spirit (e.g. whiskey), its essential energy needs to be respected and it needs to be used in a way that nourishes instead of destroys. Money backed solely by a physical asset is subject to hoarding and fails to have a multiplier quality that enlarges the general distribution and allocation of “spirit.” As such, it is inherently undemocratic and fosters a privileged aristocracy.

    It’s all a balancing act, like most things in life. The Lord demands an active conscience as well as an active consciousness. Or all hell breaks loose.

    This is a sort of disorganized and choppy short-form note of a very long-form theme.

    Language has a way of unconsiously revealing ideas along with it’s conscious narrative aspect. The title of the book about the Fed “Secrets of the Temple” is revealing of all this. Where is a community’s spirit “located” except in it’s religious edifices.

  9. winstongator

    The two things we look at in banks – warehousing & loans – have different signs of the costs! Warehousing would cost consumers money. It is paying someone to guard your money – you cannot generate a positive return from that. Also, the money has no use sitting in a vault.

    The fed has dual mandates of stable prices & low unemployment. Let’s say a scare causes depositors to stuff their money under matresses. Unemployment goes up and money supply goes down. The fed would simply print more money, achieving nearly the same thing as banks using deposits to make loans.

    To those that want gold or a fixed money supply, consider a nation with only one good – a widget. Money supply is 100Z, and there are 100 widgets in the nation. Next year, 10 more widgets are made. What happens to the price of widgets? Goes from 1Z/widget to 100/110, or about 0.9Z/widget. A productive economy with a fixed money supply will by definition produce deflation. Will that be helpful?

    If you think a bank holds nothing, then move out of your house and live on the street, because the bank holds a mortgage on where you’re living. That house is that asset on their balance sheet. The problem is that, in many cases, the loans backing the houses are larger than what the homes are now worth. Bad loans were written, and those bad loans begat more bad loans. The making of bad loans does not mean that you should not make any loans. Home values started falling 3 years ago, and we still do not see banks fully accounting for their nearly real or potential losses.

    Banks should have funding sources in addition to deposits. A fed president recommended 10 year bonds making up some significant portion of bank’s borrowing base. If a bank couldn’t roll a portion of those 10yr’s it would have to shrink its balance sheet. Which is the action that is needed.

    I believe real banking reform could have prevented much of the excess seen in the naughties (00-09), and we should at least try that before crying for a banking revolution. We had panics when we were on the gold standard, so that will not be a panacea.

  10. Toby

    Steve Keen’s been mentioned a couple of times already, and rightly so. He, and a handful of other economists, are exposing economics for the Emperor’s New Clothes it is. Combine this excuse for a scientific discipline with fractional reserve lending, which is a state sanctioned ponzi scheme — the system leaks, people become saturated with debt, new blood for the hungry debt beast dries up, and systemic collapse occurs — and you have a recipe for repeating disasters. But even acknowledging this systemic problem does not go far enough.

    Perhaps the fundamental assumption of economics is the permanent and unchangable presence of scarcity, often characterised as unlimited wants versus finite resources. Certainly resources are finite, but can anyone actually prove that wants are unlimited? There is plenty of evidence to suggest otherwise, for example at the end of a talk given by Daniel Kahneman here:

    where a Gallup survey is mentioned which show a flat line measuring happiness to income after $60,000 annually. More money, goods, and other material acquisitions do not make you forever happier. Data brought to our attention in The Spirit Level is equally damning of the infinite wants meme.

    What this suggests is that scarcity is a solvable problem, should we want to think of scarcity as a problem, which I think we should, considering the global harm done by hoarding, suspicion of others wanting your stuff, war, poverty, crime etc. Technically we are capable of feeding and housing the world, and with a move to renewables, properly managed and accompanied by a redesign of transport, cities, houses etc., we can abundantly power the world too. This is never going to happen while the presumption of scarcity persists. This key element of economic theory needs to be addressed, as well as all others. Until that takes place, money will continue bedevil us since all money-types exist to distribute via the price mechanism scarce goods and services. As we all know, air, abundant everywhere, has no value economically speaking.

    Additionally important is our ever improving ability to replicate technically what humans do as labour in the economy. By some estimates we have until around 2042 until all our functions are replicable by machine/computer means. This presents the current model with an enormous challenge, since purchasing power will pretty much disappear.

    Put briefly, our world is changing so rapidly the current status quo/system cannot keep up, and neither can we culturally. The ramifications of the changes underfoot are almost to big to properly digest, and yet they certainly require of us a global rethink on how we conduct our affairs. Fractional reserve banking is one part of a multi-level problem and must not be forgotten, but there is far more to address than this. By my reckoning only a resource-based economy addresses all of these issues cohesively. Sadly it represents such a radical departure from current orthodoxy and consensus I fear collapse must occur before it stands a chance of being taken seriously.

    1. Mickey Marzick in Akron, Ohio


      If “scarcity” is the underlying rationale for capitalism and productive forces [means versus potential] exist to eliminate scarcity then capitalism as a socioeceonomic system is now obsolete. The material means may exist but the spiritual/intellectual wherewithal leaves much to be desired.

      Right now, deleveraging and austerity are the means with which to induce “scarcity” [artificial] and make the world safe for capitalism. Telling the other 5 billion or so other earthlings that it’s necessary to cut production because there’s too much excess capacity reveals the moral bankruptcy of this economic system. It’s about profit – not human needs.

      No, I doubt if the planet can sustain six billion or so human beings with the consumption patterns of most Americans, West Europeans, and Japanese, but giving a little bit more and taking a little bit less by the already obese wuld go along way toward mitigating the appalling poverty that exists outside of these regions. No amount of economic growth predicated on the illusion of scarcity is going to resolve this. Of course, it is not intended to!

      1. Toby

        Absolutely. The immensely frustrating thing is that profit and money are both less important than human beings, since humans are the only animals on the planet that can even begin to make any use of such concepts. To prioritise costs and profits above human concern is to put the cart before the horse, and in this particular instance of that folly the consequences are horrible. To say we can’t afford to put the human world on a surer footing for lack of funding, when we have both the know-how and resources to do so, is an ugly admission of failure I have a hard time stomaching. But in the end it is our own ignorance and cultural inability to deal with the new which is holding us back. Change is difficult and painful. These things take time, and urgency is only recognised when the wheels are well and truly off.

    2. jake chase

      To those who have finally realized economics is bunk I recommend the one economist of the past two hundred years who told the unvarnished truth. Thorstein Veblen’s Theory of Business Enterprise is as true and complete today as it was when he wrote it in 1904. The only things which have changed are the vastly increased role of government spending (and interference) and the federal reserve system, each of which has only accelerated the inflationary trend, enhanced the racketeering potential and delayed and magnified the inevitable crises, while making suckers out of anyone locked out or refusing to participate in the business game (which is now a business/government game).

      Veblen understood that the business system was a profit seeking orgy dependent upon perpetual sabotage and derangement of an industrial system created by science, technology, engineering. His analysis explained everything and the only response a toadying economics profession could do make was to ignore him and discredit him personally for attaching himself indiscriminately to available females.

      1. Tao Jonesing


        Thanks. I have some of Veblen’s stuff. I’ll make sure to track that one down and read it.

  11. joebhed

    The most-majorest contribution from this GW post is the reminder of the oft-lost fact that it is NOT the commercial banks under the Fed – those with a wisp of a reserve requirement – that have created most of the “money” over the past generation or so, but rather the “shadow” bankers on the unregulated side of the non-bank scorecard that have done so.
    They have never had the wisp of a reserve requirement that the CBs have had, being the unregulated – don’t want to stifle innovation – financializers of the American economy.
    So, what IS banking?
    What IS money?
    Whose money system IS it, anyway?
    Is it OURS?
    We the people?
    Who lost the Trillions due to the unregulated financializers with the money power?
    Wake up America.
    Repeal the Fed Act and put the government in charge of creating the money, and let bankers get back to full-reserve banking.
    The Money System Common.

  12. Gordon

    The continued existence of fractional reserve banking routinely reduces bloggers to near apoplexy. But is is such a bad thing?

    Sure it comes with risks as we have seen recently but then so do many other things in life – like crossing a busy road. No-one would not let a four-year old loose on the highway yet, as Steve Keenhas pointed out, bankers and their government overseers seem to have as little understanding of the realities of the system they operate and its risks as does the average four-year old. Disasters are inevitable.

    If I deposit $1,000 in ABC bank and it then lends it out many times that would be foolish in the extreme if I am the only depositer. But if I am only one of 100,000 depositors then queuing theory suggests that lending it out many times over is sensible, provided that it’s not on bad loans and that the multipe is not too high – i.e. not more than about 10x. Money works harder, enterprises are funded and we all benefit.

    The trouble is that it’s hugely profitable for banks to somehow convince themselves that they can lend more than 10x and this seems to correlate with bad lending.

    So the solution is regulation that targets this temptation. Abolishing fractional reserve banking would be akin to shooting the messenger – it’s where the problem shows up, not the problem itself. A banking system reduced to warehousing would be an expensive overhead for the economy.

    In practical terms this might involve:
    1) Enforcing a ‘plain vanilla’ strict limit of 10x lending backed by shareholers’ capital with no separate pots for property or other special asset category. Any permitted complexity will merely provide loopholes to jump through.
    2) A levy on lending in any category which starts looking bubbly (as property periodically does).
    3) No limited liability for bank directors in the event of a bank failure to concentrate their minds. (I think I read somewhere that this was the case in the UK until 1868)
    4) No bank to be TBTF.

    1. fresno dan

      good points.
      I note that our FED regulators have a belief that credit is the be all and end all of our economy. When one looks at the far greater than 10X leverage, one has to ask:
      die they not know how much leverage there was?
      Or did they know not care (or think that it was in fact desirable)?

  13. fresno dan

    O how I wish I had saved a graph of the historic GDP for each dollar lent. Something along the lines of 4 dollars in the forties, 3 dollars in the fifties, 2 in the sixties…until now, when it is negative. Which would make sense looking at the tremendous amount of real estate investment that went bust. Not every investment makes money, and it seems we have reached the point where none will.
    I was taught that economics is derived from a Greek word meaning scarcity …but now, we don’t have scarcity. We have more housing than we need, and very low interest rates (just one question, if banks are GIVEN free money, why are home loans 5% at the very best rate, and more typically for the average person 6%???).

    Theoretically, with such a low cost of money, things should be booming. But we have 10% unemployment (and far higher than that, according to other interpretations of the flaws in how employment is measured).
    I read a quote from Walter Bagehot where he noted the rather strange idea, if you ponder it, that merely depositing money should provide you with a real 5% return. If central banks can merely make money, which seems more and more evident, that certainly strikes me as true. In time scales, human civilization is very young, nation states mere toddlers, and modern economics newborns. Teething is gonna be a b*tch.

    1. fresno dan

      Thank you!
      I found it also this morning. I have seen it in sundry forms on various blogs.

      Do people think this is an accurate reflection of the return on borrowed dollars?
      Why or why not?
      Is it important? One could argue that the excessive past returns were a reflection of an inefficient economy. I would argue that its good to have some reserve, and its better to have one thousand dollars of debt versus one hundred thousands dollars of debt.

      1. Gordon

        Clearly it’s vitally important even if exactly why is a matter of some debate.

        Steve Keen argues that with each business cycle the proportion of new debt flowing into Ponzi investments – most commonly property but also dot.bombs and other bubbles – increases. By definition this Ponzi investing is not productive so the overall productivity of the new debt falls.

        Over time as the burden of repayments increases it will, at the level of the whole economy, act as a drag on productivity.

        Moreover, as certain asset values are bid up by Ponzi investing, price signals are increasingly distorted. ‘Austrian’ economists object to the Fed’s interference with interst rates but the fact is the market can muddy price signals all by itself and this must have at least some effect though I can’t begin to quantify it.

      2. joebhed

        It only matters if the productivity of the capital resource matters to the success of an economy to improve the standard of living of the people.
        As laborers and machines have become more efficient and productive, this has masked the decline in capital(debt) productivity.
        To me the tragedy of the money is that it is all created a s a debt.
        So, the result of the failure of debt-money to maintain its productivity – more and more money goes just to pay for the older money that was created – is the hallmark of the failed, debt-money based economy, and that, again to me, covers everything from Bretton Woods on forward.
        To me, this is well-illustrated in Steven Lachance’s paper here:
        It is the debt-money system itself that is broke, broken and insolvent – witnessed by the most important chart of the century since we created the private debt-money system of fractional, or fictional, reserve banking.
        My favored solution is found at .

  14. canuck

    I’m glad that this excellent blog is discussing reserve requirements. I think they are a an excellent way to control leverage in the banking system in addition to capital requirements. Capital requirements are complicated and continually under revision. But if you have a reasonable reserve requirement on deposits (say 20 per cent) you limit the money multiplier in the banking system to 5 times. I think it would be appropriate for the core banking system. It would also be cheaper than paying banks to keep reserves at the Fed. Banks hate the idea of going back to this type of a system. I believe that reserve requirements in Canada have been phased out completely in the past 40 years, but countries such as China still use them as an instrument to control the money supply in addition to the interest rate. In most other countries RR are so low they aren’t really effective at restraining leverage. Banks regard reserve requirements as a tax and don’t want to know about them. This doesn’t address the problem of insolvency in the banking system currently, but may help avoid a subsequent crisis.

  15. scharfy

    Banks create money. They do not take money in- and then lend out 90% of it.

    They issue new loans. New loans. Credit Creation. In its deepest sense.

    Money that did not exist. Upon loan approval at your bank, now does.

    A totally new checking account is …. generated.

    They need reserves/deposits only to satisfy legal reserve requirement law, further they borrow reserves on the interbank market at price set by the Fed, if they ‘need’ them.

    They are only constrained by their capital structure (i.e. how much liquid assets they have backing them (not deposits)) and their view of credit/lending conditions/pricing.

    Think about it. The Fed is using the banks to effect monetary policy. Its the preferred mechanism. The money supply is not static. Banks add and subtract to it – by creating loans.

    The Fed is the universal balance sheet for all these loans.

    Thus, most or all NEW money enters the system in the form of debt. The banks are the allocating devices. The fed sets the price/amount of money, and the banks issue it. Maybe it will come into the system in a car loan, or a mortgage, or a student loan – that is up to the banks.

    The sum total of al this debt – is your functional money supply.

    The current system is just the old system evolved.

    I mean they don’t actually print dollars anymore. Where to you think the ability to purchase goods with electronic ledger balances come from?

    How else could money come into and out of our system?

    This isn’t conspiracy theory mumbo jumbo. Its how modern banking works. Most of the stuff out there isn’t WRONG, its just old.

  16. Ned Baker

    I’m pretty sure the original post is wildly off base, but I’m not really informed enough to critique it. All I can say is that if my bank bought a treasury bond with 90% of my deposit, then George would call that a gross injustice, but I wouldn’t.

  17. flow5

    All mainstream economists know that the current reservable liabilities and their associated reserve ratios are not “binding” because increasing amounts of vault cash (including ATM networks) plus retail deposit sweep programs have wiped aside such binding requirements.

    Legal reserves are a credit control device. The FED is the lender of last resort (supplies the banking system’s liquidity). Without legal reserves, the money supply will become uncontrollable, and the FED’s inflation mandate — unachievable.

    Take as an example, one of the Federal Reserve Act of 1913 objectives: to prevent the “pyramiding” of reserves.

    Under the National Banking System all assets classified as “cash & due from banks” constituted a part of the legal reserves of the banks.

    Under the National Banking System the banks could create a multiple volume of reserves with a given amount of currency by the process of redepositing currency with correspondents. Thus the original amount of currency would be made to create reserves equal to the original volume of currency plus the number of times that the currency was redeposited in successive banks.

    Since the liquidity of the banks necessitated that the banks be able to covert deposits into currency upon demand…crisis conditions developed…

    The Reserve Authorities are counting on the banks needing central bank deposits for clearing checks and making other interbank payments. The hypothesis is that this gives the central bank leverage over the money and bond markets.

    However, the commercial banks buy their liquidity, they don’t store their liquidity. Trying to manage the money supply with attempts to control the cost of credit was what the Treasury-Federal Reserve Accord was all about. I.e., the effect of tying open market policy to a remuneration rate is to supply additional (and excessive legal reserves) to the banking system when loan demand increases. I.e., it feeds the fires of inflation.

  18. kevinearick

    the efficient machine becomes both the means and the end, short-circuiting the human economy:

    “the running maintenance of interstitial adjustments between the several sub-processes or branches of industry, wherever in their working they touch one another in the sequence of industrial elaboration … an unremitting requirement of quantitative precision, accuracy in point of time and sequence, in their proper inclusion and exclusion of forces affecting the outcome .. This requirement of mechanical accuracy and nice adaptation to specific uses has led to a gradual pervading enforcement of uniformity..

    It compels the adaptation of the workman to his work, rather than the adaptation of the work to the workman …
    (ke: the point of the utility becomes its own end in a one-way relationship, when the grid serves as the supply circuit instead of humans)

    the largest effects are to be looked for among those industrial classes who are required to comprehend and guide the processes, rather than among those who serve merely as mechanical auxiliaries of the machine process… the machine has become the master of the man who works with it and an arbiter in the cultural fortunes of the community into whose life it has entered… It is a matter of common notoriety that the modern industrial populations are improvident in a high degree … compared in this respect with the class of handicraftsmen whom they have displaced, as also with the farming population of the present time, especially the class of small proprietary farmers. The trouble seems to be of the nature of habit rather than reasoned conviction… the canon of conspicuous waste. Under modern conditions a free expenditure in consumable goods is a condition requisite to good repute. The working population is required to be standardized, movable, and interchangable … he is discouraged from investing his savings … in any of the impedimenta of living. The machine is a levelleler, a vulgarizer, whose end seems to be the extirpation of all that is respectable, noble, and dignified in human intercourse and ideals. Realty to a superior installed by law or custom suffers under the discipline of a life which, as regards its most formative exigencies, is not guided by conventional grounds of validity.

    1. kevinearick

      Realty in the last sentece replaced with fealty.

      the economy of humans serving machines doesn’t work, and dumbing down education to accept the outcome doesn’t work.

  19. Ingolf

    “Bernanke, Summers, Geithner and the boys have been working as hard as they can to re-start the shadow banking system, and traditional loans to individuals and small businesses have plummeted. So the percentage of shadow banking system lending to the all lending has probably skyrocketed again.”

    The shadow banking system contracted a fair bit in 2009. Combining GSEs, Agency and GSE-backed Mortgage Pools, Issuers of ABS and Security Brokers and Dealers the total was $14,674.4 billion at the end of 2008 and $13,885.8 billion at the end of last year (down $788.6 billion or about 5.4%).

    The commercial banking sector grew about 1%, although the growth certainly wasn’t in traditional lending.

    (All figures from Fed Z.1 report).

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