The Magic of Fractional Reserve Banking
Ever since I read Trey Given’s post, A Pile of Money, I’ve had an earworm called “Fractional Reserve Banking.”
Imagine having that term dancing around in your head everywhere you go. I’d look at my house, or the cars on the street, or some business in town or the local Bank of America and think fractional reserve banking. I was dreaming about fractional reserve banking.
I remembered that it is the process by which banks loan out many more dollars than they actually have in deposits. But this article, written by Murray Rothbard, does into much more detail and describes the role that the Federal Reserve plays in the process.
If you wonder why the price of everything keeps going up, up up, which is the same thing as the value of your money going down, down, down, read the article. It’s good!
Wikipedia also offers a detailed definition of fractional-reserve banking plus a calculation for how much money is created through the chain of events that occur after a “primary” deposit. In contrast, there is full-reserve banking, which is not used, and greatly reduces a bank’s ability to loan money and pay interest to depositors.
This link to the Federal Reserve Bank of New York goes into a detailed explanation of how reserves work. I learned a number of things from this page: time deposits like CDs don’t have a reserve requirement, reserve requirements are an expense to the banks because the Federal Reserve Bank doesn’t pay interest on deposits it keeps to meet the reserve requirements that it sets, the current reserve rate of 10% is historically very low:
Current reserve requirements are low by historical standards. From 1937 to 1958, for example, the rate on demand deposits was always at least 20% for banks in New York and Chicago, which were “central reserve cities” — a term now obsolete.
It would be really interesting to look at graphs that plot various economic variable (like GDP, inflation, deficits, etc.) from 1937 to 2004. The Federal Reserve has made a number of changes to its policies during Alan Greenspan’s term. He has been an inflation hawk but also presided over a stock market bubble and crash that was similar to the 1929 crash, except that the aftermath–at least so far–has not produced a depression largely because he has used Fed policy to stimulate the economy.
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