How much money is there?
If I take this $100 to my bank, and deposit in my checking account, I still have $100, but it is safe and secure and I won't lose it at the bank.
To use that $100, I can fetch it back from the bank, use it to write a check, or use it to buy something with my debit card.
When my bank gets my $100 in cash, they list that as THEIR asset... $100 cash in their vault. At the same time, they increase my checking account balance by $100, which to me is money, but to them is a liability, since they owe it to me.
So far, so good.
What happens next is the interesting part.
Lending Out Money
According to the rules that banks in the USA must follow, the bank only has to keep $10 cash in their vault to cover my $100 in checking account deposits. Thus, the bank is allowed to do whatever it wants with the other $90.
In most cases, they want that $90 to be "working for them", earning more money... or growing.
So, what do they do?
They loan it out to somebody.
After making this loan, the bank still owes me $100, but instead of having $100 of "my" cash in the vault, they instead only have $10 in cash plus a written promise from the borrower to pay back the $90 (plus interest).
Let's stop for a moment and think about this...
I think I have $100 in the bank.
The borrower has $90 in cash.
How much money is there?
If we add what the borrower has ($90) with what I think I have ($100), it appears that there is $190 in money.
How can this be. There is only $100 in cash... but there is $190 in "money"...
What happens next is even more interesting...
Lending Out Money #2
The borrow got the $90 in cash in order to pay for something.
Once that $90 is paid, in most cases, it is again deposited in a bank.
The person who has this deposit thinks they have $90 more on deposit in the bank.
(There still appears to be $190 in money at this point.)
And now the lending happens (again)...
The bank only has to keep 10% of that $90 as cash in its vaults. It has to keep that $9 "on reserve". The bank is allowed to do whatever it wants with the other $81.
Imagine the bank lends the $81 cash in exchange for an $81 written promise from some new borrower.
How much money is there?
So, there is $100 in my checking account + $90 in the other person's checking account + $81 in the hands of the the last borrower, which adds up to $271...
How can this be?
There is still only $100 in cash, but there is also $271 in "money".
Keep Lending it Out
This cycle of depositing and lending can continue forever.
The end result, after many cycles of this, is that using that same $100 cash that I originally deposited in the bank, the bank(s) can lend out $900 in loans.
This $900 in loan money was paid to others and became $900 of deposits in other people's accounts.
How much money is there?
There is still only $100 in cash which at this point is all in the vault of the bank(s), but there is also $1,000 in "money", all of which exists as deposits in checking accounts.
This system of "fractional reserve" banking is inherently unstable. The $1000 in checking account money is "backed" by only $100 in cash plus $900 in "promissory notes".
What happens if on one day many people go to the bank and attempt to remove cash? Only $100 of cash withdrawals could be satisfied.
The bank could sell some of the promissory notes (usually mortgage papers) to get more cash... but what if they have to take a loss when they sell? The bank could end up in a position where they OWE more money to depositors than the VALUE of all their cash, promissory notes and other investments.
(Note: This is the position that many banks were in, "insolvent" I believe is the term, during 2008-2009.)
Let's take another related example. Imagine that the total value of the promissory notes is only $850. Now the bank is in the same situation with less assets than their liabilities.
How can this possibility (or likelihood) of insolvency be eliminated?
1. Change the rules so that banks must keep enough cash in their vaults so that ALL the checking accounts could be emptied in cash on the same day. In other words, the total amount of cash in the banks would have to be greater or equal than the total value of all the checking account balances.
2. Since the bank would no longer lend out the money that was backing the checking accounts, the bank would encourage everyone to move as much money as possible into savings accounts, where the money was NOT available on demand. It would be quite clear that if money is in savings, it may not be available for a while. The benefit to having the savings account would be the same... nice interest payments which would increase the size of the savings accounts.
Try It Again
Let's look at our example again.
I have $100.
I deposit all $100 in my checking account.
I have $100 that the bank owes me in my checking account. The bank now has $100 cash in the vault. The bank can not lend out any of this $100.
The bank then reminds me that if I don't need some part of that $100 for a while, then I can move some into my savings account, and that will be very carefully invested to earn the highest interest rate possible, but that, of course, it will not be instantly available.
Let's imagine that I transfer $90 to the savings account. The bank is then free to do whatever they want with this $90. I know it isn't available right away, because the bank is investing it for me.
I also have $10 in my checking account, which is backed up by $10 of cash in the bank's vault.
Imagine that bank lends out all $90 of cash which I transferred to my savings account. The borrower can take that cash and deposit it in another bank, or could spend the $90, and whoever receives that cash could deposit it.
Thus another $90 cash is deposited in a bank, and another $90 checking account balance is created.
Notice, the total cash is $100, and the total of the checking account balances is still $100. In addition, there is a $90 promissory note in the bank (from the loan) and a $90 savings account in my name... But clearly I can't access that money at the moment since it is loaned out and has yet to be paid back.
Let's go one more step to see how this plays out.
The owner of the $90 checking account decides to transfer only $50 to their savings account.
The bank now make another loan of $50, with another $50 promissory note, and the $50 in cash ends up as a $50 deposit in some other person's account.
How much money is there now?
Cash -- $100
Checking Balances -- $100
Savings Balances -- $90 + $50 = $140
Promissory Notes -- $90 + $50 = $140
As this process continues, the result might be more that $900 in lending noted above, or it might be less. It would depend on two things:
1. The percentage of money would be deposited into savings vs. checking accounts.
2. The willingness and ability of the banks to find people with whom to lend.
There are two extremes.
- No one puts money into savings accounts, in which case there is only $100.
- No one LEAVES money in their checking accounts, in which case, overtime, their is an unlimited ability for the banks to lend, and no limit to the total size of the savings accounts.
Reducing the Risk of Insolvency
What appears better in this second system (sometime called "full reserve banking") is that everyone knows that there is only enough money to back the checking accounts, and the bank should be much, much less likely to run out of money when the checking account holders come in for cash, even all at once.
Also, the bank would not get be insolvent when the investments (mortgages, etc.) lost value. Rather, it would be understood by everyone that savings accounts could, theoretically at least, lose money.
If a bank did lose money on invested from the savings accounts, the owners of those accounts would stop putting money in those accounts; would be inclined to go to another bank; to keep more in their money in checking accounts, which would lead to less available for lending; and would only deposit money into savings accounts in banks that were very, very reliable in their ability to avoid any losses on investments.
Which system is better and why?
Below is a list of Wikipedia articles and web sites which deal with the topics of this article or with monetary reform in general.
- Full Reserve Banking -- Different from what is described above in that both checking AND savings accounts would be backed 100% by cash. This begs the question: "From where would loans originate?"
- Fractional Reserve Banking
- Free Banking -- Similar but not identical to the proposal above.
- Monetary Reform -- Listing a number of different ideas for reforming money.
- American Monetary and Financial Security Act - A proposal to reform the U.S. monetary system. This proposal which may be introduced as a bill in the U.S. congress in 2009. The act is the primary subject of study of the American Monetary Institute.
- American Monetary Institute web site -- Stephen Zarlenga -- Examines a proposal to make the private Federal Reserve Bank into part of the U.S. Government by making the Fed part of the Department of Treasury, 100% reserve backing of all checking accounts, and the U.S. Government spending money directly into circulation. Hosts an annual conference in Chicago in September to discuss this proposal and related topics.
- Economic Stability web site -- Joe Bongiovanni and Peter Young -- Additional information on monetary reform and information on the AMI conference.