End fractional reserve banking and fix the economy

Home » Blog » 2013 » September » 17 » End fractional rese…

When you ask the man in the street how money works, they will suggest that it’s a system of tokens that circulate forever. That system is called full reserve banking. Money could work like that. Money should work like that… but money doesn’t work like that.

To be more accurate, a tiny slither (3%) of our total money supply is indeed made up of tokens that circulate forever, but the vast majority (97%) is made up of a completely different kind (technically known as broad money) which is a kind of temporary money, continuously being created and destroyed. It gets created when banks make loans and destroyed when those loans are repaid.

The result of this strange arrangement is that the total amount of money that exists in the economy is always fluctuating. At any one time, thousands of people may be creating new money by taking out loans while at the same time thousand may be destroying money by repaying existing loans.

Screen Shot 2013-09-17 at 18.31.21The total amount of money in the economy is therefore rather analogous to the amount of water in a bath when the plug has been removed, letting water pour out, and there is a tap running with water flowing in. The water flowing out corresponds to money destruction as existing loans are repaid, and the running tap corresponds to new loans being made. If these two rates are exactly the same then the total amount of money we had would remain constant, but that’s rather tricky to arrange.

The problem comes when there are large changes in the rates of borrowing… Imagine for a moment a period in which there was great enthusiasm for borrowing, say for example in the years running up to a housing bubble. The tap has been gushing, pouring water in the bath. People are borrowing like crazy because they think that house prices can only ever go up.

Then the bubble bursts, people are sceptical that house prices can go any higher and suddenly the enthusiasm for new borrowing reduces dramatically. This is like turning the tap off or at least, turning it down dramatically. But the water carries on pouring out the plughole at just the same rate because all that earlier borrowing still has to be repaid. If the government did nothing then the water level would start to fall.

This is exactly what happened in the US in the great depression in 1929. In the run up to the depression people were borrowing like crazy, not to buy houses, but to buy stocks and shares – because they thought the price of them could only ever go up. Then suddenly the bubble burst, people no longer believed that share prices were going to rise and they stopped borrowing. The tap got turned off, the water was still going down the drain and governments did nothing.

During the years of the great depression, the total amount of money in the US economy shrank by a third. Note that the money wasn’t “going somewhere else” it wasn’t ending up in somebody else’s hands… it was actually disappearing out of existence. A decreasing money supply is agonising for an economy. People go round scratching their heads, wondering why everyone seems to have less money than they used to.

Now fast forward to 2007. We had an almost exact replay of 1929. Except this time all the borrowing was for housing. When the bubble burst, the government thought “oh my god, how do we stop the money supply collapsing?”… but within the current money system, the only thing they could think of doing was to desperately try and get the tap running again. So they put interest rates down to near-zero, made hair-brained schemes trying to get people to take out more mortgages and they did a whole load of borrowing themselves. All these things are very harmful to an economy, especially the near-zero interest rates. It puts retired people into poverty because they are attempting to live on the interest from their savings. People who had been saving all their lives for a decent retirement, suddenly find their pensions shrink to almost nothing.

Now imagine for a moment that all of the money in the system was converted to everlasting tokens. Under this system there is simply no such thing as a collapsing money supply! If we switched to this system, then virtually overnight we could have normalised rates of interest, we could scrap the hair-brained mortgage schemes and the government could do less borrowing. The advantages are simply enormous.

You might ask: “That all sounds good to me, but what are the arguments against?”

People who are against our proposals are almost invariably only against because they don’t understand the system. There are no coherent arguments against, that I know of, from people who properly understand both the existing and our new proposed systems.



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  • EconomicsStudent

    Well okay let me present you with a hopefully coherent argument against your proposed system. I know private banks create money in the form of deposits which are promises to pay cash and cash is created as a liability of the central bank. I also know that that your proposal would allow the government to create money as a liability that does not have to be repaid.

    I agree with a lot of what you guys in saying that speculation is bad and causes bubbles and that it is bad that there are just a few big banks in the UK. However………..

    What you guys propose is a fixed money supply (that rises and is set by a committee) and I do not think this is wise. The benefit of a properly managed debt based money supply is that it can both expand and shrink when needed. I favour a flexible money supply above a fixed one and I favour a system where money can be created for those in need (entrepreneurs that take out a loan) and not just by government spending.

    • reissgo

      “The benefit of a properly managed debt based money supply is that it can both expand and shrink when needed” – You say “when needed” as if someone was in control of it… but right now (without extraordinary government behaviour), the money supply would be shrinking when *not* needed… there are strong forces shrinking the money supply, which is not desired by anyone. The water pouring down the plug hole is out of anyone’s control.

    • Simon

      The existing system is not flexible, and entices more people into debt.
      it is a manic depressive system, creating too much money in the boom, and too little in the bust.
      If I refuse to take on extra debt to increase the money supply because it is deemed good for the economy at the moment, then the government will do it for me by borrowing more, and burdening the tax payer with the interest and debt repayments.
      The existing system prefers to lend more for speculation on assets like property, and less for business. If I was a bank making lending decisions, this is what I would prefer to do too, because I would have property as collateral for the loan, and I would not have to work out if your business was going to be a success or not. At the same time, the banks can increase the price of the assets they have lent money for by increasing their lending together, until the level of debt is seen to be unsustainable, as happened in 2007/2008.
      Increasing debt in society enriches a few (especially banks who issue debt), at the expense of the many, so we need more money and less debt. We could issue new debt free money, to replace the money that is lost when existing debts are repaid.
      As for man made climate change, I am sceptical about it (much more sea ice in the Arctic this summer for example), but I am pleased that the Green Party has adopted monetary reform and I hope the bigger political parties see sense too.

      • plainmoney

        As I understand it, UK government borrowing does not directly increase the money supply. The bank balances of non-bank purchasers of new gilts decrease.

        • Simon

          Where did these purchasers get the money to buy the gilts ? Many of them will be our pension funds. The Bank of England now owns a third of all gilts after Quantititve Easing.

          • Simon

            Further to previous post, I think the point plainmoney makes above should be made clearer on the Positive Money site. I can see if I invest heavily in gilts, then my bank balance will reduce, and similar if my pension fund invests more in gilts and less in shares for example. I don’t think the government should borrow to fund it’s expenditure anyway, but that is a separate issue.

        • reissgo

          Not directly, I agree. But indirectly. When gov. sell bonds, the bonds may be purchased with existing money – but when the central bank then buys those bonds back, they do so with freshly created money. Its a rather convoluted process.

          • plainmoney

            Under QE, when the BoE buys an extant gilt from a non-bank, equal amounts of central bank money and commercial bank money are created in parallel.
            Prior to QE, under Open Market Operations (suspended since QE), commercial banks could exchange their proprietary gilts with the BoE for new central bank money. Inter- bank liquidity was thus eased but no increase in commercial bank money was directly entailed.
            When a commercial bank buys an extant gilt from a non-bank then new commercial bank money is created.
            There are three variables for a gilt transaction – who sells, who buys (government, BoE, commercial bank, non-bank), and new or extant gilt, though only some combinations make sense.
            How the relevant balance sheets and the aggregate money totals change can be specified exactly, case by case.

          • Simon

            Good, detailed response, worth a blog page on it’s own. The gilts market is more complicated than first appears.

    • plainmoney

      PM advocates publicly issued money, as far as I know not necessarily 100% debt-free. For example:

      This flexibility is explained further on page 214 of Modernising Money.

      • EcoStudent

        Yes you are right and I know. But this directly contradicts most of their PR outings like this post.

        Because yes the positive money proposal wisely does allow for debt based money side by side the equity based money. So do not pretend that all your money is debt free and that debt or credit is some form of evil.

        Reasonable requist right?

  • Robert

    “People who are against our proposals are almost invariably only against because they don’t understand the system. There are no coherent arguments against, that I know of, from people who properly understand both the existing and our new proposed systems”.

    How comforting it must feel to know, with absolute certainty, that one has discovered the truth and that anyone who disagrees with one does so only out of ignorance of it! And how suspiciously closely such a position resembles that of the religious believer to whom has been vouchsafed a mystical revelation of the divine! (It also uncannily resembles that of the Austrians, incidentally).

    That resemblance alone ought to give anyone who finds himself un-selfquestioningly taking up such a position (in relation to something as earthbound and freighted with moral ambiguity when all is said and done as money and debt is) pause for thought – long and careful thought at that. But no sign of any such self-examination here – only absolute certitude. Fine, if you count yourself already among “the saved” (it seems to come to that, I’m sorry to say), unacceptably facile if you don’t.

    “People who are against our proposals” include some very formidable intellects indeed – not least Keynes who (whilst possessing a deeper understanding of money than most of us will ever be able to lay claim to) evinced no disapproval of fractional reserve banking, considering arguments about it to be beside the point. (So do I, as it happens). Since the dawn of civilisation banking has been about the creation of credit and its consequential monetization – “money (as the saying goes) is debt”. As Steve Keen put it:- “we don’t live in a fiat-money system but in a debt-money system which has had a relatively small and subservient fiat-money system tacked onto it”. Fractional reserves have been inherent in its functioning from the start and has never yet withered-away even in the face of religious condemnation and the threat of condign punishment. Significantly, islamic banking practice does not, if I understand correctly, preclude fractional reserves. Neither of course do mutuals, which owe their origins not to profit-seeking but to societally-benign purposes and self-help.

    Anything less that 100% reserves must mean that money is created when loans are made. Positive Money proposes to make this practice impossible and to replace the money now being created by loans with money issued directly into circulation by government. In doing so it proposes that the judgment as to what quantity of money to issue be entrusted to technocrats, instead of to bankers. I think (as do many others) that this would be a change for the worse, not least because it aims to put into reverse 5000 years or more of human history which – I happen to think – makes King Canute look like a hard-headed realist in comparison. I also think that people whose business is money who – like the Medici – have shown themselves throughout history to be supremely proficient in managing it (which I for one never could have been because I just don’t have the head for it) are the best-fitted to go on doing what they do best – not technocrats who (if they could do it better) would have been bankers themselves.

    I think PM has got its priorities wrong; the focus ought to be on the means whereby the continued exercise by bankers of the functions they have always performed can best be prevented from serving only their own interests and instead be caused to benefit society in general. That’s a difficult enough task in itself, without getting distracted by irrelevant theological arguments. In my opinion, target number one ought to be the abolition of deposit insurance (which PM’s proposals would achieve, but only as an incidental by-product not as a cardinal aim). The prerequisite for this would be that the payments system cease to be a private-bank monopoly which – IMO – is unconscionable and deserving of sustained attack. In other words:- “Bring back the National Giro” (ritually slaughtered by Thatcher in obedience to neoliberal doctrine having nothing whatever to do with the national welfare). A revived national giro would be exactly analogous to the transaction-account model proposed by PM (except that participating in it would be optional) and, given that once the option of that BoE-backed transaction-account facility had been made available there would cease to be any justification for free mandatory deposit-insurance (underwritten by the taxpayer) to be provided to holders of private-bank accounts (whether transaction accounts or any other kind), the split aimed-for by PM between transaction accounts with a 100% reserve and interest-paying but risk-bearing private-bank accounts would de facto have been brought about. That the banks would continue to hold only fractional reserves (without which, incidentally, maturity-transformation is made impossible) would be for them to decide given that they not the taxpayer would be bearing the attendant risk, likewise those who choose to be their account-holders.

    • reissgo

      “In doing so it proposes that the judgement as to what quantity of money
      to issue be entrusted to technocrats, instead of to bankers.” – well there is your first mistake. The banks are not really in control of the money supply under the current system. In 2007/8 the private banks would have *liked* the money supply to carry on heading upwards, but it headed downwards causing them (and us!) much pain.

      • Robert

        @ reissgo
        You may be right in describing this as a mistake.

        However, I would counter that to base (as PM does) the whole new system upon control over the money-supply is about the biggest mistake that could be made. All attempts (by Nigel Lawson for instance) to do just that failed abjectly and in the end complete defeat had to be admitted, whereupon the metric was shifted to RPI, where it remains.

        The banks in fact decide how much credit to issue which isn’t necessarily synonymous with “the money supply” anyway. I’m suggesting they’re best left to get on with that – subject to over-riding constraints such as govt-imposed credit-squeezes, cyclical factors, interest-rate trends, fiscal policy, etc..

        PM opposes this because its dogma (that fractional reserve banking is evil) forces it to, regardless of its merits.

        • reissgo

          ” All attempts (by Nigel Lawson for instance) to do just that failed abjectly” – attempts to control the money supply while leaving fractional reserves in place will always be problematic because the only control is using interest rates to encourage/discourage the flow of water into the bath. With the current system, nobody is in current control of the water flowing down the plug hole, because the repayment schedules were written into the loan contracts in the past. If there was a sustained period of too much lending (leading to a huge amount of money scheduled to go down the plug hole over the coming years), then, under the current system, the only way to stop the money supply falling is to attempt to achieve that overly high rate of lending all over again. I say that’s no control at all.

          • Robert

            But, once again, you are erecting money-supply as your totem.

            PM habitually – it seems to me – ignores (or at best underplays) the role of fiscal policy, yet talks all the time as if its proposals nevertheless embrace the whole field of economic management. Money-supply is only one way of injecting/withdrawing demand into/from the economy. Running budget deficits or surpluses is at least as important. Furthermore fiscal policy measures can be targeted more selectively and be implemented more immediately.

    • Johnj

      This system suits the elite this is why they invented it. One day everything will collapse then enter our so called elite saviour to bail the world out and then instal the nwo it is all part of the masterplan

  • PeterM

    ” Money should work like that” ?? Should it?

    This looks like another quantity theory of money. Economic activity in any economy is determined by spending not by the amount of money in existence.

    A $trillion dollar economy needs a trillion dollars of spending to keep it at full capacity. Any more and there is inflation. Any less there is deflation and unemployment.

    Governments role should be to spend more when the private sector are spending less and vice versa.

  • PeterM

    “Note that the money wasn’t ‘going somewhere else’ it wasn’t ending up in somebody else’s hands… it was actually disappearing out of existence. ”

    This is a valid point. However, it is easily corrected by governments creating money, as only they can, to compensate.

    The supply of money, in a sovereign fiat based system, can be considered a variable to be adjusted at will. A key concept is that all currencies like the $ and £ ( but not quite the €) are essentially government IOUs. Governments can’t possibly borrow back their own IOUs. Think about it! So there’s no need to pay it back! There’s no need to even pay interest – except to define interest rates in the economy.

    Too much unemployment/lack of purchasing power? Increase the money supply. Increase government spending, and/or reduce taxation.
    Inflation too high? The opposite of the above.

  • Walter

    Just a small point. The comment that pensioners are impoverished by near-zero interest rates can only apply to a small minority. Very few pensioners in the UK attempt to live directly on the interest on their savings. The vast majority of those who receive a pension in addition to their state pension have either an occupational pension, which will probably be indexed to the inflation rate, like the state pension, or an annuity, which may either be fixed, or, again, is indexed to inflation, but at any rate will not decline.

    • African Jesus

      Fractional Banking is worldwide – so the pensioners in the UK would fall under the wealthy 1% of global population, leaving the rest relying on Government pensions. and saving $10 a month for 40 years wont keep you alive passed 70 without interest. you wasted your time typing a load of crap that helps fuck all. good luck with life dude :) peace

  • Ralph Stokes

    What about the interest? Surely we want zero interest because money doesn’t exist to pay it back which means people are always in debt

  • Milton

    It is crucial to understand the underlying monetary system. Only with a solid foundation of knowledge can these topics be discussed. The best source I have found for establishing knowledge of these topics is found in the book Debt Inflation. No joke…read the book, and then come back and read this article. It will make all the difference in the world.

  • Cheeky Bugger

    Getting rid of the corrupt central banks would go a long way towards solving the world’s economic problems. These people are parasites, living off the hard work and endeavour of others.

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