Money Systems 4.32 Fractional reserve money creation

Keep in mind there have been no 100% commodity money systems in primary, widespread use for at least 700 years – if ever. And, keep in mind how easy and how prevalent it has been to think money is a commodity, when it has mostly been an account of ownership of a commodity or a receipt for a commodity, or a promise to come up with a commodity in the future, or a tally measured against a commodity and settled in kind. It appears to be very easy to confuse people – including the so-called experts!

And, remember people have been using forms of IOUs for money for all of recorded history. Depending on the trustworthiness and authority of the issuer of the IOU, people have probably been demanding some sort of guarantee the IOU would be good in the future. Various commodities have been set aside as guarantees of trustworthiness: grains, cattle, land, precious metals and other kinds of assets. However, the fact these assets have been set aside to guarantee money does not make them money.

Picking up our history of money, a significant development came in the 12th–14th century, with the rise of the international merchant class. Money creation became linked to banking. The power to create new money shifted from people with authority (generally monarchs), to people with the biggest and strongest banks – often connected to merchant empires.

And, while some actual commodity money remained in active use, most money shifted from being a receipt for gold in storage, to accounts and IOUs that promised to settle with gold in the future. When a receipt for a gold coin, or a promise to pay one in the future, serves as well as the gold coin itself, a temptation is born. Why not make a few extra promises? If you juggle your promises well, no one will know the difference, right? At some time in history, giving in to this temptation resulted in either the greatest financial innovation or the greatest con, depending on your values. When only a portion of the actual gold promised was kept readily on hand by the one making the promise, this new financial innovation was called, fractional reserve banking, though it is actually a form of money creation.

The story of goldsmiths

Stories about the invention of fractional reserve banking/money creation often go back to the goldsmiths of the 12th–14th century. This is probably a teaching story, rather than an historical fact, since as we have seen in Chapter 4.30, money that is an IOU of future value has probably been around longer than this story credits. But, this story does offer an explanation of how commodity money and IOU-future-value money became a hybrid, preserving the trustworthy image of commodity money, while allowing the banking sector relatively free rein to create new money for society.

Here is the story. Gold coins were used as money by those who had enough wealth to warrant a coin of such high value. Poorer people used a variety of other moneys. People with lots of gold, could afford to hire the staff to protect their store of wealth. A rising merchant and middle class, who had enough to store and protect, but not enough to hire their own security, would take their gold to goldsmiths for safekeeping. Goldsmiths had a vault and security since gold was the material they used for their creations.

When someone gave the goldsmith gold for safekeeping, the goldsmith would give them a receipt, or IOU, for the amount of gold. Now, it was a bit of a nuisance to go back to the goldsmith to take out your gold to buy something. People found they could give someone else the IOU-receipt for the gold in lieu of the actual gold. The IOU-receipts became the money in use – the monetizing of a receipt. The money is a commodity (gold), but the gold itself is not being used for money. A receipt has been issued for the gold money, and the receipt is being used for the money token. This is commodity-backed money (Chapter 4.28). But, wait…

Introducing fractional reserve money creation

The goldsmiths discovered if they had 100 coins in their vault belonging to others, the owners rarely came to take them out. The paper receipts were easier and more practical as money. They discovered they only needed to keep about 10 of the gold coins on hand to meet the demands of people who wanted to take out their gold. This 10 percent was called a reserve.

The goldsmith-bankers discovered they could take about 90 of those hundred coins, and make a loan of them to someone else, and then collect interest on this loan. Because there was already a receipt for the 100 coins circulating as money, when the bankers loaned out another 90 they were increasing the supply of money from 100 to 190. Of course, the borrower as often as not, re-deposited the 90 borrowed coins with the banker, taking an IOU-receipt for their own deposit. Now there were 190 IOU-receipt monies circulating and only 100 gold coins in the vault. The banker could keep about 10 percent of the 90, which was 9 more coins, and make another loan of 81 gold coins by issuing new receipt money. The banker could keep doing this until he needed to keep all 100 coins on reserve for 1,000 in receipt-IOU money out circulating through his fractional reserve money creation process – all collecting interest for the banker-lender-money creator. As each round of money creation is smaller, this charts as a pyramid, with the initial deposit as the base (Chapter 4.34).

From IOU-receipt to IOU-future value

The moment the bank loaned out the gold coins for which they had previously issued IOU-receipts, these receipts ceased to be true receipts and became promises to come up with that value of gold in the future; they changed from IOU-receipt money to IOU-future-value money. Fractional reserve money creation pretends it is issuing an IOU-receipt money, when in fact it is issuing an IOU-future-value from the bank itself. The banker-goldsmiths pretended they were issuing a receipt for gold that would be stored, when in fact, they were issuing a promise to come up with gold in the future, when a demand was made for it.

This is how fractional reserve banking was born. It is a form of money creation. It was not born of honest dealing. The goldsmiths did not say to the people who left their gold for safe keeping, “We will only keep about 10 percent of your gold on hand, and the rest we will use for our own ends, because we have found we can get away with that.” They evolved into banks and called their customers deposits, demand deposits, or book money, or sight money . Most people using these banks assumed all their gold was in the bank’s safe keeping, and it was theirs to have on demand. And, in good times, it certainly functioned that way. Few people realized the bank was actually lending out what they deemed excess deposits and only keeping on hand a small reserve. Today, this is often referred to as the money multiplier function of banks and a 10 percent reserve requirement.

It was easy to muddle people’s thinking, because some people would genuinely leave their gold with the bankers expecting them to loan it out to others on their behalf. It was easy enough to imply all the money being lent out represented the savings of someone. It has apparently also been easy to muddle people’s thinking about what constitutes excess money in the bank.

The tale of the goldsmiths may be mostly story; the truth is likely more nuanced, complex and has much deeper roots in the shadows of history.

Broken promises

When the bankers grew careless and kept too little gold or other reserves on hand, making them unable to meet the demands of depositors, or when depositors lost confidence in their ability to meet demands and more than 10 percent of them came calling for their money, this was called a run on the bank. In a run on the bank, only the 10 percent who were first to withdraw got their money, the rest lost it all. During the Great Depression an estimated 9,000 banks failed. In 1933 alone, people who had money deposited in banks lost approximately $140 billion. Somehow, people have been convinced this is just how banks work.

Because fractional reserve money creation requires deception, there is really no way to know exactly when the practice began. It possibly began in the 12th–14th century Italian merchant houses or European market faires. Then in the 14th century, the Medicis of Italian

Renaissance fame and fortune brought the practice of fractional reserve money creation to an eminence that, with the cover provided by their development and use of double entry bookkeeping, made them the wealthiest and most powerful family in Western civilization. However, on a smaller scale, the practice could have begun any time, decades or even millennia earlier. Monetizing IOU-future-value money has been around for a very long time, and fractional reserve money creation is a hybrid that begins with a small seed of IOU-receipt money, and then swings into true IOU-future-value money. Those who have always known how fractional reserve money creation works have often argued that if the creation of new money is tethered to at least some quantity of a valued commodity, it will somehow constrain the creation of new money; it will keep the supply growing at the right rate, and keep the value stable. There is no historical evidence this is true. The evidence says commodity money leads quickly to commodity-backed money, and commodity-backed money quickly becomes fractional reserve IOU-future-value money, which is inherently unstable, volatile and almost guaranteed to collapse.


A fractional reserve money creation-banking system has never been stable, and is not stable by its very nature. Bankers are human. Like bears to honey, they are attracted by the promise of high returns on low investment. And, what a deal: create new money by making loans and collect interest on it. Or, create new money, loan it to yourself, and play the stock market, where rewards can be extraordinarily high — especially on borrowed money with no skin of your own in the game. It’s a high stakes game of playing your promises and collections right, and when, inevitably, big financial gamers lose their bets, the burden falls on the general public.

The banks get to pick who gets the loans, and every bit of historical evidence shows bankers are prone to favor family, friends and powerful people in high places who will do them favors. Uncurbed by rules, regulations, oversight and accountability, the power of new money creation goes to bankers’ heads and they get carried away. Every time.

In fairness, in a fractional reserve money creation system, it is hard for a bank to judge how much to keep on hand: one day nobody may want access to their money, and the next day there might be a high demand for it. When a banker misjudges and loans out too much of his depositors’ money, or someone comes in wanting an unusual amount of their deposit back, the bank will not have their money on hand to return. The bank would have to tell someone to wait to take their money out. This could cause a panic. People will stampede the bank to get their money, rightfully fearing they will lose it all.

History has seen a very few well-managed and responsible banks that have maintained the right amount of cash on hand, made good decisions about making safe loans, and always kept the incoming and outgoing promises well matched. But there have been very, very few. Bank collapses have been the rule rather than the exception under a fractional reserve system. It is too seductive to have the power to create new money for your family, friends and people of power – not all of whom are trustworthy.

A fractional reserve money creation system requires a tight level of control to maintain any level of stability, but whoever has the ability to create new money has the power to corrupt its own overseers and decision-makers. This means in practice, controls will be eaten away until meaningless.

The less the banks need to keep on reserve, the more new money they can create, and the higher their profits. But, even the bankers recognize tiny, insufficient reserves are risky; it’s difficult to accurately predict reserve needs on a daily basis. So, fractional reserve bankers figured out strategies to smooth the demand so they can safely keep as little as possible on reserve.

Bankers have two primary strategies to meet this goal: the establishment of a cartel of individual banks (with or without a central bank); and connections to political power. These have come to be one and the same in nearly all countries.

Central bank money creation

We’ve noted in Chapter 3.25 that individual banks have a very good reason to create a central bank – it makes it easy to transfer money from their customers to the customers of other banks. This is the primary reason for a central bank in a 100% banking system. However, because a fractional reserve money system is extraordinarily unstable, the role of the central bank takes on another critically important role. It is not merely a convenience. It’s a backup system for the individual banks, reducing the likelihood they will go bust when they misjudge how much reserve cash to keep on hand.

In a fractional reserve system, bankers noticed when there was a central bank keeping the reserves for member banks, they could get away with far fewer reserves of their own. They did not need to keep enough reserves on hand to meet all of their depositors’ demands for money. They only needed to keep enough reserves on hand to meet the demand for cash and the net amount to be transferred to another bank. And, they could borrow from the other member banks when their reserves were not enough to cover the net transfer needed. Reserve requirements became smaller and smaller. This meant more so-called excess money available to lend, further expanding the money supply and their profits.

Even before central banks became government sponsored central banks, national and international banks tended to be either family operations with far-flung branches and a central office, or cartels of individual bankers with agreements to come to each other’s rescue as needed. I love the stories about the free banking era in the US (mid-1800s), when bankers in cahoots would haul a reserve of gold from bank to bank just ahead of the government examiners.7

But, when banks keep tiny reserves, what happens when there is an economy-wide quake and every single bank needs to call on all its reserves? When people are taking unusual amounts of money out of banks, or too many depositors come demanding their money from all the banks at the same time, or the banks have made a lot of bets that go sour and they must pony up cash they do not have on hand, and all the banks’ reserves in the central bank are not enough to meet these demands, what happens? The whole system collapses, bringing a nation’s entire economy with it. But, wait…

Money creator to the bankers

A central fractional reserve bank, has one more ace up its sleeve: it can be a money creator for its member banks. If none of the banks have reserves they can lend to each other, then the central bank itself can create new money in exchange for an IOU from the banks in need.

So individual banks are double protected. They have the ability to borrow from each other through the central bank to cover any minor miscalculations. And when all the member banks, or even just the biggest ones, miscalculate, and there are no more reserves to borrow from other banks, the central bank can step in and create new money for their use. This is what happened from 2007 to 2010 when the central bank of the United States, the Federal Reserve, created over $16.1 trillion to keep our insolvent banks from collapsing.8 That is trillion with a ‘T,’ and equivalent to more than all the money that changed hands in our economy in each of those years – an indication of just how badly the banks miscalculated.

With a central bank money creator, the banks can get away with multiplying the money supply nearly to their hearts content, but only for a time. (Think of the inevitable outcome of exponential growth and the algae, Chapter 2.7, and the FED’s balance sheet on Chapter 5.54.)

Central bank – Legal tender

The smaller the reserves, the riskier the gaming for the banks. And, while any IOU money system must rely on maintaining the integrity and worth to keep its promises, a fractional reserve money creation system is especially dependent on the confidence of its users. A fractional reserve system is not honest; it is a con. A con requires the marks retain strong confidence to keep the game afloat. The best way to sustain confidence is to get the money you are creating declared the legal tender of the realm. This adds a luster and puts the common wealth of a nation behind the IOUs the private bankers make when they create a nation’s money. This is important enough to warrant its own section (next).

A fractional reserve money system

Who Decides

As with any money system, the decision to choose it will be made by the greater community – in whatever way they make decisions. However, fractional reserve money creation is a con, so the decision has almost never been made with all the information out on the table. The emphasis has been on the promise to redeem a gold note for gold, rather than the reality that only a small fraction of the promises can be kept at any one time.

Bankers have been very successful at muddling the concept of how the money supply increases. Bankers and their lackeys have called their ability to create new money, the efficient use of excess reserves. “Gee, it’s awful to have money just sitting in the bank, when it could be put to good use in the economy.” This meme successfully ignores the fact excess money is already circulating; it is moving from account to account, and by putting it to good use, the bankers have increased the money supply.

Most rulers, politicians and decision-makers seem to be confused about monetary issues. After all, as money creators, private interests have had enormous power to pick and choose who would get the new money they create, including politicians who can be manipulated into agreeing to act in the bankers’ best interests. Bankers create new money for individuals, governments and businesses who then consider themselves in their banker’s debt. And, banks invest heavily in promoting monetary theories and arguments that obscure the money-creation-wizards behind a curtain. This takes the decision- making farther away from a choice made of, by and for the people of a nation.

The Token

The token in a fractional reserve money system is a written IOU. Today, about 3 percent of these IOUs are in the form of very fancy, difficult to counterfeit paper or coins that we call cash. The remainder are accounting entries.

Authentic & Trustworthy

Fractional reserve-created money gets its authenticity and trustworthiness from the reputation or power of the creator, or from a government guarantee that backs the creator’s promises. Historically, while nearly all fractional reserve money has been created by private bankers, they have often secured a guarantee for their money from the highest level of governments.

Some argue the mythical and magical invisible hand of a wise and rational free marketplace will provide the authenticity and trustworthiness for privately created fractional reserve money. Bankers are providing a public service when they pick and choose which borrowers will make good on their promises; the integrity and wisdom of the banker’s choices makes the money system trustworthy. Again, the historical evidence says this is not true.

Before a US Congressional committee on the 2007–2008 financial meltdown, former Chairman of the Federal Reserve, Alan Greenspan, admitted his lifelong faith in bankers to act in the best interest of their banks and the public was sadly misplaced.

Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity – myself especially – are in a state of shocked disbelief.

— Congressional Hearing, October 23, 20089

This man, an Ayn Rand acolyte, with the lifelong belief that if everyone acted on their personal self-interests, the outcome would benefit society as a whole, was in charge of our Federal Reserve System for 19 years! (1987–2006). I find that shocking.

Measure & Store of Value

In theory, a system that creates fractional reserve money could be a stable or elastic value money. When it has a stable or elastic and increasing value it is a good store of value. When it has a decreasing value, such as most systems today, it is not a good store of value.

However, when newly created fractional reserve IOU money carries interest, it will always be an elastic, depreciating value money system. This is because the money supply must increase beyond productivity and population needs, and beyond the normal profit-making that is a part of everyday business – even basic banking business. The money supply must be enough for ordinary business, and enough to pay the money-creators interest on their money creation activities.

Creation & Destruction

Fractional reserve money is created when a bank exchanges its own IOU-future-value money for an IOU from another party. It is a refinement of basic IOU-future value money (Chapter 4.30) in that it requires a certain collateral be set aside as a reserve to provide some guarantee the promises made will be kept. In a fractional reserve money creation system, when someone pays back a loan, money is extinguished.

While these banks can be government owned and operated, or privately owned and operated, historically, nearly all the money created through fractional reserve, up to the present day, has been created by privately owned banks or their central bank. Private bankers have introduced the new money into the economy through their choice of who gets to borrow.

who rules?

The bankers who create the new money rule.

NOTE: In recognition of the highly unstable nature of a fractional reserve banking system, some economists have promoted a 100% reserve money system, sometimes using the name interchangeably with 100% money . Economist Irving Fisher may have been the first to use this phrase in 1936 in his pamphlet, 100% Money and the Public Debt. 10 But, once the reserve is 100% and banks are only loaning out money that they have on hand in savings, it is no longer a reserve system; it is an entirely different system (Chapter 4.37). So using the term 100% reserve money can be confusing.