THE FEDERAL RESERVE Fractional Reserve Lending (Banking 101)

"All the perplexities, confusion and distresses in America arise not from defects in the Constitution or confederation, nor from want of honor or virtue, as much from downright ignorance of the nature of coin, credit, and circulation." [1]

Ignorantia juris non excusat (ignorance of the law does not excuse) is a well established principle dating back thousands of years. Roman and English law, precursors of the American system of jurisprudence, both recognized the maxim.

Be it not forgotten – justice excuses not the law. The laws of the land are to be made in pursuance of the Constitution. The Constitution has precedent. Any law not in pursuance of the Constitution is null and void, as if it never occurred. So the court has ruled.

"And there is virgin Justice, the daughter of Zeus, who is honored and reverenced among the gods who dwell on Olympus, and whenever anyone hurts her with lying slander, she sits beside her father, Zeus the son of Cronos, and tells him of men's wicked heart, until the people pay for the mad folly of their princes who, evilly minded, pervert judgement and give sentence crookedly." [2]

No man is above the law – not even the King. No law is above the Constitution – not even the King’s. All men are created equal. All men are judged accordingly. He without sin cast the first stone.

The ignorance of coin, credit, and circulation is unfortunately, a widespread occurrence – causing perplexities, confusion, and distress, all tearing at the social fabric of our nation. But who is guilty of these defects – who has caused them to be?

Is it the fault of the common man that he cannot understand the complexities of a monetary system that moved Lord Keynes to say that not one man in a million understands money?

No, the common man is not at fault, the blame lies elsewhere: it rests with those who have purposefully made the monetary policy so bizarre that even its keepers have a hard time understanding the delusion they have created.

John Kenneth Galbraith clearly understood the illusionary nature of the elite’s monetary economists when he stated that they:

“use complexity to disguise or to evade the truth, rather than to reveal it.” [3]

The most dishonest monetary illusion is the shadow cast by fractional reserve lending.

"Because of 'fractional' reserve system, banks, as a whole, can expand our money supply several times, by making loans and investments." [4]

Let’s take a closer look at the sword of State the magi use to create their tricks of prestidigitation – the scepter of fractional reserves.

What is meant by fractional reserves? It would seem that reserves are reduced to a fraction, but a fraction of what? Perhaps we should seek the wise counsel of the Federal Reserve, as this is their raison d’etre.

“Required reserve balances are balances that a depository institution must hold with the Federal Reserve to satisfy its reserve requirement. Reserve requirements are imposed on all depository institutions – which include commercial banks, savings banks, savings and loan associations, and credit unions – as well as U.S. branches and agencies of foreign banks and other domestic banking entities that engage in international transactions.

Since the early 1990s, reserve requirements have been applied only to transaction deposits, which include demand deposits and interest-bearing accounts that offer unlimited checking privileges. An institution’s reserve requirement is a fraction of such deposits; the fraction – the required reserve ratio – is set by the Board of Governors within limits prescribed in the Federal Reserve Act.” [5]

According to the above, the Board of Governors set required reserve balances within limits as prescribed by the Federal Reserve Act that depository institutions must hold on account.

The required reserve ratio is clearly stated to be a fraction of demand deposits and interest-bearing accounts that offer unlimited checking privileges.

Notice the wording “since the early 1990s, reserve requirements have been applied only to transaction deposits”, as such language demonstrates that previous to the early 1990’s reserve requirements were applied to a larger composite – according to the usage of the word “only.”

Which in fact is true, as reserve requirements have been reduced several times since the Fed took control in 1913? A closer look at reserve requirements is in order.

The Federal Reserve has the following to say in regards to reserve requirements:

“Reserve requirements have long been a part of our nation’s banking history. Depository institutions maintain a fraction of certain liabilities in reserve in specified assets. The Federal Reserve can adjust reserve requirements by changing required reserve ratios, the liabilities to which the ratios apply, or both.” [6]

Once again, we see the use of the word “fraction” when discussing reserve requirements, however, we now have the further clarification of reserves in “specified assets.” Obviously, these “specified assets” are critically important, as they are the reserves of our monetary system.

“A depository institution satisfies its reserve requirement by its holdings of vault cash (currency in its vault) and, if vault cash is insufficient to meet the requirement, by the balance maintained directly with a Federal Reserve Bank or indirectly with a pass-through correspondent bank (which in turn hold the balances in its account at the Federal Reserve).” [7]

Now we see that depository institutions satisfy their reserve requirements by holding cash (currency) in their vaults, or if short, they get some help from the Fed or a correspondent bank. The next logical question is: how much cash are they required to have on reserve in their vaults.

As can be seen from the above chart there isn’t a heck of a lot of reserves on reserve. Three of the five categories listed in the chart have zero (0) reserve requirements. One of the five categories has three (3%) percent reserves, and the remaining category has approximately ten (10%) percent reserve requirements.

So, what are the ramifications of the above listed reserve requirements? From the Fed’s publication, we find the following:

“The supply of balances can vary substantially from day to day because of movements in other items on the Federal Reserve’s balance sheet. These so-called autonomous factors are generally outside the Federal Reserve’s direct day-to-day control.

The largest autonomous factor is Federal Reserve notes. When a depository institution needs currency, it places an order with a Federal Reserve Bank. When the Federal Reserve fills the order, it debits the account of the depository institution at the Federal Reserve, and total Federal Reserve balances decline.

The amount of currency demanded tends to grow over time, in part reflecting increases in nominal spending as the economy grows. Consequently, an increasing volume of balances would be extinguished, and the federal funds rate would rise, if the Federal Reserve did not offset the contraction in balances by purchasing securities. Indeed, the expansion of Federal Reserve notes is the primary reason that the Federal Reserve’s holdings of securities grow over time.” [8]

Federal Reserve notes are those little green pieces of paper we all carry around in our wallet or purse and refer to as cash. A dollar bill is a Federal Reserve note, as are fives, tens, twenties, fifties, and one hundred dollar bills.

From where does the Fed get the Federal Reserve Notes? Good question. Let’s try and find the answer.

Notice in the above quote the last sentence, which reads, “Indeed, the expansion of Federal Reserve notes is the primary reason that the Federal Reserve’s holdings of securities grow over time.”

With the Fed’s holding of securities entering the picture, we now have two questions to answer: Federal Reserve notes come from where; and what securities is the Fed holding due to the expansion of Federal Reserve notes?

The Treasury has a role to play in this monetary game of musical chairs. The Fed has this to say regarding the Treasury:

“Another important factor is the balance in the U.S. Treasury’s account at the Federal Reserve. The Treasury draws on this account to make payments by check or direct deposit for all types of federal spending. When these payments clear, the Treasury’s account is reduced and the account of the depository institution for the person or entity that receives the funds is increased. The Treasury is not a depository institution, so a payment by the Treasury to the public (for example, a Social Security payment) raises the volume of Federal Reserve balances available to depository institutions.” [9]

From this we see that the Treasury has an account at the Federal Reserve, and that the Treasury draws on the account to make payments by check and direct deposit. Where did the Treasury’s account at the Fed come from? Rather than finding answers, we are discovering more questions.

“Open market operations are the most powerful and often-used tool for controlling the funds rate. These operations, which are arranged nearly every business day, are designed to bring the supply of Federal Reserve balances in line with the demand for those balances at the FOMC’s target rate.” [10]

The more we look, the greater our task becomes. That is good, as often times its not just the answers that matter, but asking the right questions as well. We are getting warmer by the minute.

“In theory, the Federal Reserve could conduct open market operations by purchasing or selling any type of asset. In practice, however, most assets cannot be traded readily enough to accommodate open market operations. For open market operations to work effectively, the Federal Reserve must be able to buy and sell quickly, at its own convenience, in whatever volume may be needed to keep the federal funds rate at the target level. These conditions require that the instrument it buys or sells be traded in a broad, highly active market that can accommodate the transactions without distortions or disruptions to the market itself. The market for U.S. Treasury securities satisfies these conditions.” [11]

United States Treasury securities are the main market the Fed uses to conduct open market operations. As the money supply continually grows, the buying of Treasury securities by the Fed occurs more often then selling.

Fractional Reserves refers to monetary reserves required to be on deposit in banks. The reserve requirements go from zero, to 3%, to 10%. Federal Reserve notes (cash) are the predominant reserve deposit. When banks need cash, they go to the Fed. The Fed holds U.S. government securities in its accounts. The U.S. Treasury has an account at the Fed. The Fed conducts open market operation of buying or selling Treasury securities. The remaining questions before us are:

Where does the Fed get the ever-increasing supply of Federal Reserve notes? Where did the Treasury account at the Fed come from? Where The Money Comes From

Trillions of dollars are said to be everywhere. I remember as a kid that a million was a big number. Today billions of dollars are tossed around from computer to computer without the blink of an eye. Trillions are now the topic de jour.

Budgets, deficits, and international money flows are all described using trillions or parts thereof. We have come a long way. The financial wizards circle high above the common man. But perhaps the way so chosen is the wrong way, for the good of all of the people – not just the elite few who control the strings of the purse, and profit thereby.

Let’s go within the Temple of the Wizards of Finance, to see what arts the conjuring is done by, to see what potions and spells are cast within fortune’s cauldron, and what strange brew precipitates there from.

On that fateful day when Federal Reserve Notes were first issued, it is obvious that a huge number of dollar bills had to be printed. Now, the printing press is pretty much obsolete; the only money that actually gets printed is used to replace old and worn Federal Reserve notes already in circulation. In vogue today is electronic money – fast food style.

The process actually begins with the Treasury Department printing a piece of paper called a bond, which is done electronically. Treasury bonds are debt obligations (liability) of the government to repay a loan - with interest.

The Treasury sells bonds to the public. The bonds the public does not buy, the Treasury deposits with the Federal Reserve. When the Fed accepts the bond from the Treasury, it lists the bond on its books as an asset.

The Fed assumes the government will make good on its promise to pay back the loan. This is based on the belief that the government’s power to tax the people is sufficient collateral.

Because the Fed now has an asset that it didn't have before receiving the Treasury bond, the Fed can now create a liability that is offset by its new asset.

The liability that the Fed creates is a Federal Reserve check. It gives the Treasury the check in payment for the Treasury bond.

The Federal Reserve check is endorsed by the Treasury and is deposited in one of the government's accounts at the Federal Reserve. The government can use the deposits to write checks against, to pay for government expenses.

This is the first new money flow to enter the system. Various government contractors, vendors, etc. receive these checks as payment for services rendered, and they take the checks and deposit them in their commercial banks.

This is when the wizards of finance perform their greatest feats of magic. The deposits in the commercial banks take on a sort of split personality or dementia, brought on by a preponderance of delusional thinking.

On the one hand, the deposits are the bank’s liabilities, as they owe the total sums to their depositors.

However, because of FRACTIONAL RESERVE lending, the bankers get to lend out 9 times what they have on deposit.

In other words, FRACTIONAL RESERVE lending allows the commercial banks to create 9 times more money then they have on reserve. The banks lend money they don’t have, and:

As the newly issued money is put to work by borrowers, they then spend it and the receiver then deposits it in their bank account, and the bank starts the reserve lending policy all over again. This is why the

If it didn't, the debt would not be able to be serviced. There is no money created without creating debt, they are one and the same. Wealth is not created by creating money by fiat – only debt. As the Fed has admitted:

"Commercial banks create checkbook money whenever they grant a loan, simply by adding new deposit dollars in accounts on their books in exchange for a borrower's IOU." [12]

Fractional reserve lending invokes the moral hazard of fidelity of contract. Banks have on deposit (reserve) at most 10% of the “money supply.”

This means that if more than 10% of depositors go to the bank at one time to withdraw “our” money – there isn’t any money to withdraw beyond the 10% reserves.

Which means that 90% of the money supply is non-existent, nothing more than a fleeting illusion.

The bank’s solvency stands on the faith that no more than 10% of depositors will want their money at the same time. This means that although

Fractional reserve lending insures and guarantees that banks cannot possibly be liquid.

Banking is the only type of business that is allowed to function this way. If any other business used a similar modus operandi it would be subject to censor, arrest, court, and possibly imprisonment. Banks cannot fulfill all of their contracts if demand occurred at the same time. Thus, the banks are illiquid.

Why the double standard? Why the dishonesty? Why are they afraid of gold and silver money as the Constitution mandates? Because it would make them tow the line or go bankrupt. Less they forget - be ever mindful - even Zeus cannot deny Destiny.

Coming Soon – Open Letter To Congress Seeking Redress For The Return To Honest Money

[1] John Adams in a letter to Thomas Jefferson [2] Hesiod, Works and Days [3] John Kenneth Galbraith Money: Whence It Came, Where It Went [4] Federal Reserve Bank, New York The Story of Banks, p.5. [5] The Federal Reserve System Purposes and Functions The Implementation of Monetary Policy [6] Same as above [7] Same [8] Same [9] Same [10] Same [11] Same [12] Federal reserve Bank of New York, I Bet You Thought, p.19

Ya but I think your missing something, or maybe I am.

I think the story is that the banks can borrow ten times their deposits from the fed, and only have to keep a tenth of the deposits on hand.

So they loan out their customers money, and borrow money from the fed to loan out as well.

So the banks borrow the money from the fed.

Where does the fed get it?

By holding the unsold Government bonds and listing them as assets, and printing money, using the bond as an asset of security.

But the asset is not backed by anything. It is a printed note from the government that went unsold.

Smoke and mirrors.

Without the apparent bifurcation of Fed and Gov, and the complicity of their partners the banks, the whole system would fail.

If we all decided to go down and take our cash and buy gold, or oil or land or soybeans, the cash is not there. It does not exist.

At a certain point [10%] draw down...the only thing you could get is a note from the bank that is backed by a note from the fed, that is backed by a note printed by the government that nobody wanted.

LOL...

You're right, Keynes wasn't as far out of the mainstream of classical economics as many people think. But I think he did dismiss the importance of savings, which helped push 'Keynesian' economics into overweighting the demand-side and neglecting supply side issues. Personally, I rather like Schumpeter.

The Fed "gets" its money from the Treasury, and Congress, in a fashion. In theory, the Fed could purchase the entire Treasury debt, and that's the limit of how much money it could create. But monetizing the entire debt would be inflationary, to say the least, so we wouldn't like that very much.

One of the roles of the Fed is to alter the mix of currency to debt, according to how the economy is acting. If inflation heats up the Fed can sell Treasury bonds in the open market, which serves to 'soak up' money, and hopefully that will slow down inflation. If the economy is stalling the Fed can buy Treasury bonds, 'injecting' money into the economy which could help to stimulate trade.

I have long looked for a copy of The History of Economic Analysis for a decent price. Thanks for reminding me to look again. He is a brilliant thinker.

Keynes has assumed a bogeyman role in economic discussions here because his ideas appear to be anathema for conservative government. But there is much more to them than those who have not studied him know. And he was a great writer. Some of the problems and determinants of economic changes that he illustrated are yet to be definitively settled. He clearly was very concerned with the supply side even at the highest levels of theory.

One of his greatest achievements was provoking the mind of Milton Friedman and Paul Samuelson. Two giants in the field of economic education. A field far too sparse.

Specie is the gold, 'money' the metal backed currency, and 'credit money' or 'bank money' the unbacked portion of the money supply. 'U.S. Notes', the greenback issue, were an example of credit money.

OMG!!!! There is unbacked money in a gold regime? Don't tell the goldbugs, they might stroke out!!

That's why these discussions are usually absurd. Both sides seem to think that in gold regimes all money was backed, and it isn't so. Fractional reserves are a basic feature of banking, even in the gold era. The reserves might be coin, or maybe Treasury notes, but the loans built upon the reserves aren't backed. They are credit money, bank money, which is indistinguishable from backed money until there's a run on a bank.

Some advocates of an entirely backed currency are aware that credit money is unbacked, and they would have us go to a system that outlawed fractional reserve banking. I suspect that action would make loans a bit hard to come by, not to mention money of any sort. Maybe we'd see tobacco money and private bills of credit make a return to fill the void.

The current system has its flaws, and a gold standard may or may not be an improvement, but the idea that we could have a 100% specie money system seems to me to be based on a utopian vision and a misundertanding of the gold standard we did have.

FDIC was intended to prevent the sort of loss that small depositors experienced in the 1930s. In addition to the stock market crash of 1929 which affected mostly the well to do, the Depression featured a lesser known but more pervasive disaster, the failure of thousands of small banks. When these banks failed depositors had their savings go down a black hole. No one got the money, it simply vanished. As a result the American money supply contracted a full 30% in the three years from 1930-33.

Making these people whole would have been the best course of action. Their work had been real, their savings had been real, and the disappearance of their money was not their fault. It usually wasn't the fault of the local banks, either, it was simply a phenomenon that could happen to an otherwise sound bank when it had to sell illiquid assets into a collapsing market at a time when everyone else was forced to do the same. It's a danger inherent to the banking system. The Fed might have been able to prevent some of this, but they were somewhat rudderless after Benjamin Strong died in 1928, just before the chaos of the Depression struck.

I have a copy of The History of Economic Analysis in paper, and as I recall it wasn't expensive, it was simply hard to find. Schumpeter is a very good writer who seems to have had an encyclopedic knowledge of his subject. And no nasty equations gum it all up.

What's ironic is that he had a sort of veneration for quantitative economics, which is mostly unreadable to all but math majors.

In theory, the Fed could purchase the entire Treasury debt, and that's the limit of how much money it could create.

IIRC, when we had a budget "surplus" Greenspan talked about the Fed buying Fannie, Freddie and corporate debt in open market operations when Treasuries got too scarce (sounds kinda silly now).

They are credit money, bank money, which is indistinguishable from backed money until there's a run on a bank.

Sounds like what I was thinking when I said that credit can increase the money supply without the Fed creating new high powered money.

So, do you agree that a gold regime where the high powered money supply grows more slowly than the economy is deflationary?

Yes, I think you're right in seeing a connection. Purchasing fannie and freddie debt looks to be similar to the "real bills" debate early in the Fed's history. IIRC the argument against monetizing "real bills" is that it is self-reinforcing on the upside of the business cycle.

It could well be, but I don't know that it has to be deflationary. That's certainly a worry if you're a debtor. I don't know if credit money can make up the difference or not. The demand for liquidity in a tight monetary regime might allow for a substantial increase in credit on the same monetary base. As long as the public is satisfied that the money they use isn't being debased they won't be inclined to convert to gold, which in the old system didn't earn interest even on savings, according to Grant.

Bretton Woods fell apart not because of domestic problems but because of the Triffin dilemma. The U.S. dollar was becoming the world's reserve currency after WWII and there were more dollars overseas than we had gold to back them. The French repatriated dollars for gold and we either had to reign in the dollar and suffer recession, or break the last link to gold and risk inflation. Foreign policy may have trumped monetary policy in this debate.

It could well be, but I don't know that it has to be deflationary. That's certainly a worry if you're a debtor.

Or a producer. Or both (farmers).

The French repatriated dollars for gold and we either had to reign in the dollar and suffer recession, or break the last link to gold and risk inflation.

I remember reading about that. Didn't they repatriate the dollars we gave them as bank reserves after WWII? The French, screwing with America for over 200 years!!

This is a very interesting article concerning the French, the Kennedy administration, and the demise of Bretton Woods. At least one French official was our loyal ally, as you will see. I haven't read it all, I'll have to get back to it when I can:

http://www.utexas.edu/lbj/faculty/gavin/articles/giscard_ball.pdf

I think that Hayek would largely disagree even though he admired Keynes just not his theory, which I believe he thoroughly refutes.

Hayek DID foresee the Great Depression, he saw the same Govt interventionist activity in America as he had seen the Euro-socialists were up to before duped American Govt bought fully into it.

After all Hoover was actually the first New (raw) Dealer.

Hayeks biggest criticism of Keynes was Keynes statement that we would all die anyway eventually.

I suggest you do a little research on the matter at mises.org - a huge repository of Hayek & Rothbard articles there.

I'll take Rothbard and Hayek any day over all the others.

"And the reason we have SS is because the capitalist economy collapsed leaving millions destitute"

Pure BS. Capitalism NEVER failed anywhere unless Govt imposed itself upon free markets.

The responsible parties were the FED, Hoover's Smoot/Hawley and other business subsidies, and FDR, well not enough bad can ever be said about that egomaniacs abuse of office.

Since there have never been true "free markets" your stipulation about capitalism never failing on its own is mere puffery. Government has NEVER had complete seperation from the economy in ANY country ANY where at ANY time.

As to the cause of the depression SH definitely hurt, the Fed screwed up by slowing money growth and the initial fedgov moves to cut spending and balance the budget did not help. FDR was not even in office until the thing had been going for three years so he can't be blamed for it by any fairminded person.

And the last thing that a starving man wants to hear is a sermon about free enterprise. There are political realities which must be addressed or the capitalist economy will be washed away by the deluge.

Read what Paul Warburg, architect of the Fedl Reserve & the New Deal says about FDR.

http://members.tripod.com/~wwx2/hellbent.html

As Thomas Paine wrote in The Rights of Man (1792):

Great part of that order which reigns among mankind is not the effect of government. It has its origin in the principles of society and the natural constitution of man. It existed prior to government, and would exist if the formality of government was abolished. The mutual dependence and reciprocal interest which man has upon man, and all the parts of civilised community upon each other, create that great chain of connection which holds it together. The landholder, the farmer, the manufacturer, the merchant, the tradesman, and every occupation, prospers by the aid which each receives from the other, and from the whole. Common interest regulates their concerns, and forms their law; and the laws which common usage ordains, have a greater influence than the laws of government. In fine, society performs for itself almost everything which is ascribed to government.

Why do you defend what the Founders were against lock, stock and barrel?

Your handle speaks volumes

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