Fractional Reserve Banking: Creating Money Out of Thin Air

Savings and lending

Before we discuss fractional reserve banking, it is important to understand the essence of savings and lending. The first myth to dispel is that money is wealth. Money is not wealth; real wealth is tangible physical goods.Your house, your furniture, your car, your golf clubs — those are real wealth. Money, as the medium of exchange, is a claim on real wealth. Therefore, the act of saving is the expression of an individual’s preference to relinquish his claim on wealth today for a future date. It is very important to understand this. Money is a convenience that arose to facilitate trade. Before money, every trade was an exchange of real wealth (barter). With the introduction of money, every trade is still an exchange of real wealth, just temporally disconnected because the receiver of the money doesn’t complete his side of the trade (receive his goods) until he spends the money he received in exchange for his goods.

This is true of lending as well. Jones borrows $1000 today to purchase goods and services. Tomorrow he repays $1000, but is actually repaying what the money can purchase. He borrows real wealth, and returns real wealth. Therefore, lending entails a transfer of real wealth from lender to borrower. The existence of money tends to obfuscate this insight, but does not change it.

Fractional reserve banking

Historically, gold warehouses (or was it goldsmiths?) found that their customers rarely withdrew their deposits; mainly because the receipts to the deposits were as good as the deposits themselves and thus came to be traded in their lieu. Therefore, much of the gold remained in the vaults untouched. Lending this gold at interest, they could make a good profit with repercussions only if more gold was demanded for withdrawal than was currently in the vault. Thus the practice of fractional reserve banking was born. Today, this basic scheme is operate on a large-scale by all banks in a government regulated environment. The government establishes a reserve ratio, which sets the fraction of deposits that must be held at the bank. Thus, if the reserve ratio is 0.1, then 10% of all deposits must be held at the bank and 90% are free to be lent out. This has the net effect of allowing 9 times the deposited amount to be lent out. Here is how the process works:

Jones deposits $1,000 at bank A. With a 0.1 reserve ratio, bank A can lend out $900 of that deposit and keep $100 on hand as reserves. Let us say they lend out $900 and it makes its way to Smith – either he borrowed it, or the real borrower used it to pay him. Smith now has $900 that he deposits at another bank, B. Bank B, in turn, keeps $90 as reserve (10% of $900) and lends out $810 to someone else. This $810 is spent and deposited at bank C, which keeps $81 as reserves and lends out $729 to someone else. As this process continues, the total amount lent out by the various banks in the system adds up: $900 + $810 + $729 + …. The sum of this series is $9,000. The total held in reserve also adds up: $100 + $90 + $81 + $72 … = $1,000. Thus $9,000 of lending is supported by $1,000 in reserves. This is why most commentators will state that fractional reserve banking allows the lending of multiples of reserves. Technically, it is not the bank that received the initial deposit that can lend out a multiple, but rather the system as a whole creates it through the process described above.

Having described the mechanism, let us examine it more carefully. When Jones deposits $1,000 in his checking account, bank A issues him a receipt stating that he has $1,000 on deposit. This is a promise to pay $1000 dollars on demand. If bank A lends out $900 of that $1000, then they are no longer capable of honoring their liability to Jones. What they are banking on (excuse the pun), is that Jones will not attempt to withdraw his money before they are paid back on the loan they made. With a single customer, Jones, this is a reasonable risk. However, with hundreds of customers, it becomes far less risky since they can siphon funds between accounts and repay Jones with someone else’s deposit. What they fear then is a run on the bank where a critical mass of customers simultaneously demands withdrawals in excess of total reserves, making them insolvent.

It should be apparent to the reader by now that this is fraud, plain and simple. Some commentators will describe it as counterfeiting, but I think fraud is a more appropriate term as counterfeit bills are not at the root of the fraud. Far more important, however, are the consequences of fractional reserve banking on the economy.

The practice of fractional reserve banking expands the money supply (cash and demand deposits) beyond what it would otherwise be. Due to the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country’s central bank.

Fractional-reserve banking really does “create money out of thin air”.

Expansion of Debt through Fractional Reserve Banking & Government Bonds:

Stage 1

Government needs to create some more money so it draws up Government Bonds, for the sake of this example, to the value of 10 billion monetary units (dollars, pounds, euros, yen).

The government then enters into agreement with the Central Bank (remember the Central Bank is a privately owned bank – it is not part of the government) who then print off 10 billion worth of standard currency notes. So far there is no money only paper. In real terms these days there is no paper either, this is carried out inside a computer. The Government Bonds are swapped for the physical money, the cash you carry. Only 3% – 4% of money actually exists in terms of coinage and bills.

Stage 2

The government then deposits the 10 billion in another bank. This money (which doesn’t exist in reality) becomes part of the banking resources of that bank. At this point the nations’ monetary supply has been raised by 10 billion out of nothing. The Government Bonds are in reality promissory notes to the Central Bank, “I owe yous” which the government has to pay back with interest.

The 10 billion is now part of the bank’s reserves. This bank is now free to lend money against this new reserve of 10 billion and is only required to keep (usually) 10% or 1 billion. The 90% or 9 billion is considered “excessive reserve”. 9 billion is now loaned, and this is where it gets interesting and the money from thin air is created. This bank doesn’t lend the actual 9 billion. What it does is it keeps the whole original investment (10 billion) but it lends 9 billion on paper to a further client who deposits it in a second bank. The second bank’s reserves have now grown by 9 billion.

The cycle repeats. Bank No. 2 now keeps 10% on reserve (9 hundred million) leaving free 8·1 billion to lend. This cycle can in theory repeat infinitely. The table below will show the expansion of the money supply out of thin air. This system is legal because the bank always maintains 10% on deposit.

In theory about 90 billion can be created out of the initial investment of 10 billion. Put another way – nine times as much money can be created on each loan deposit cycle.

So what gives this money value? Existing money. This practise leads to price rises and diminishing value of each monetary unit. This is called INFLATION and it is built into the system as we shall see. Fractional Reserve Banking is by its very nature inflationary. Without a proportional increase in goods and services in the economy it will always lead to a lowering of the value of the monetary unit.

For example: in the USA $1 in 1913 was the equivalent of $21·60 in 2007 or put another way there was a 96% devaluation in 94 years because of the banking practises of the Federal Reserve.

A different way to look at it would be MONEY = DEBT through LOAN

The last time the United States’ national debt was nothing was in 1835. This is because President Andrew Jackson closed down the previous Central Banking fraud scheme. 1913 saw it re-emerge as the Federal Reserve Bank.

Stage 3

Borrowed money is repaid with interest. Almost every single monetary unit must be returned to a bank at some time INCLUDING interest on that money. But… the original 10 billion was expanded under the fractional reserve system by numerous bank loans. So the original money loaned to borrowers (called the “principal”) must be returned to the bank along with interest on the principal. Where does this extra money, the interest, come from? Nowhere. I simply doesn’t exist. This means that the money owed to the banks is always greater than the money in circulation. This is inflation, and new money is always needed to keep pace with the in-built deficit.

This cycle leads to foreclosures and bankruptcy which are built into the monetary system from the word GO. The system always transfers true wealth, property etc. to the bank in the form of mortgage defaults. The bank will repossess the house, business premises and so forth. The thing to remember here is that the money that was loaned to the individual facing bankruptcy never existed in the first place. It was brought into creation on the signing of the mortgage agreement.

From this it can be seen that the system in which we live is financial slavery. We have to chase money to make the repayments on money that never existed in the first place. The difference between physical slavery and financial slavery lies in the fact that a physical slave is provided with housing and food, the financial slave has to provide those for themselves.

This system is the biggest scam on earth and is perpetuated by greedy, power hungry bankers in collusion with your government. The self elected élite amass more power and wealth at our expense. Imagine what the consequences of a New World Order and a centralised banking government system would bring. The appointees of President Barak Obama bear scrutiny. Nearly all are from the financial institutions.

Inflation and the business cycle

It should be clear that fractional reserve banking is highly inflationary because it is nothing but an increase in the money supply. This, of course, is accompanied by all the attending ills of inflation, but none more so than the business cycle.

Recall that money is only a claim on real wealth. When Jones deposits his $1000 in his checking account, he does not relinquish this claim; he is merely choosing not to exercise it. When his money is lent out and spent on goods or services, those goods and services are diverted to individuals who would not have otherwise received them. Had Jones instead stuffed his mattress with the cash, he would have maintained his claim on real wealth and not lent out his money. However, placing it in a bank, he has unwittingly been defrauded into relinquishing his claim on real wealth and lending out his money. This is known as forced savingsand is vitally important in understanding the business cycle. It is demonstrable that forced savings along with other related factors causes market dislocations that result in booms and busts. The business cycle is not an inherent instability in the free market caused by “animal spirits”. To suggest so betrays a highly superficial and childish understanding of the macro economy. 


Sources – Austrian Economics ExplainedFractional Reserve Explained