Yet few people not versed in banking ever dream that their money ‘in the bank’ is not in the bank; and few people versed in banking ever dream that the money which is not there ought to be there, or that it is practical to have it there.
— Irving Fisher, Economist, 193612
An anchor provides stability or confidence in an otherwise uncertain situation. Money created by fractional reserve is inherently uncertain and unstable. Yet, this has been the prevailing system for hundreds of years. What anchors this money has shrunk over time. The next sections look at this evolution from money creation partially collateralized with a reserve, to partially collateralized with banker equity, to no meaningful collateralization.
By definition, in a fractional reserve money creation system there is some money in reserve that anchors the promises made. This reserve is there to make the money in circulation more trustworthy. Reserves are defined as a portion of the money deposited by customers. This is true whether the money is an IOU-receipt for a commodity or an IOU-future value promise. In a true fractional reserve system, these reserves anchor and constrain the money creation of the private bankers. Bankers must first have deposits before they can create new money. Then, they must gauge how many reserves they must keep on hand to satisfy the demands of their customers and avoid a run on their bank.
These deposits become the base of the money creation pyramid described in Chapter 4.32. You deposit $100, the bank puts $10 on reserve and loans out the other $90. The borrower deposits the $90 and the bank puts $9 on reserve and loans out another $81. The borrower deposits the $81 and the bank adds $8.10 to its reserves and loans out another $72.90. It keeps doing this until it has created $1,000 in new money that is circulating with only $100 on reserve. The required reserve ratio limits the amount of new money that can be created and earn interest for the bankers. In a truly fractional reserve money creation system, the deposits from customers serve as a control on how much new money can be created. The reserves are generally small in proportion to the money banks create anew.
Some authority decides what the ratio of reserves must be to the new money created. It may be that a private, independent bank judges from its own experience that keeping 20 percent on hand will protect it from any run on the bank. It may be that a private central bank demands its cartel members maintain a certain reserve to assure all members are sound. It may be a government that says all the nation’s banks must maintain a reserve of a specific amount. Historical reserves have ranged from almost nothing to almost 90 percent.
In a fractional reserve money creation system, the reserve ratio determines how much new money a bank can create. For example, if banks must maintain a 10 percent reserve, then they can create 10 times the money they have from depositors. If they must maintain a one percent reserve, then they can create 100 times the money they have from depositors. Whatever the ratio, a fractional reserve money creation system requires some money be deposited by the public to anchor the creation of new money, and some of those deposits must be held on reserve.
NOT OUR SYSTEM
In practice, this is not the bank system we currently have, especially for the five or six big banks that control most of the banking business. We have a fractional reserve system in name only. Smaller, local and regional banks, which overall have a small share of the money creation business, practice this model to some extent. But the big banks have been able to manipulate the laws to the point that, for all practical purposes, they keep nothing at all on reserve. Overall, our banking sector’s creation of new money is not anchored by a need for customer deposits that they multiply.
For all intents and purpose, a true reserve money creation system is a story of the past. The money multiplier affects less than 10 percent of the money supply (in the US), and, “the tight link suggested by the multiplier between reserves and money and bank lending does not exist.” Federal Reserve, 201013