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The Fractional Reserve Banking System
The Consequences of the System

Peter Joseph produced two informational exposés, Zeitgeist the Movie and Zeitgeist Addendum.  Subjects covered in these movies are the Jesus myth hypothesis, contemporary religion, the US Federal Reserve Bank and Fractional Reserve Banking System, what role the US plays in the global economy and a few conspiracy theories.  I was amazed to learn how the fractional reserve bank system worked at it's simplest level and that is what this paper is for.  I did a little research to get a better understanding of the system at its root level.  How the system works is simple and fairly obvious after looking into it.  The problems that are inherent in this system have a major negative impact on people in it.  These inherent problems are not as obvious by simply understanding the basic idea of the system.  After spending time thinking about the various aspects of this, I thought it would be worth while to get some of my thoughts on paper.  The intent of this paper is to explain the basic idea of the fractional reserve banking system (the easy part) and attempt to clearly explain some of the inherent negative aspects of the system.

Where Money Comes From

Money did not magically appear in everyone’s pocket.  Although we already know this we seem to loose track of this fact.  Sure we know money is printed somewhere but do we understand it wasn’t given to us for free?  Money is printed by the Federal Reserve (a private institution).  Bonds are printed by the Government.  The Federal Reserve loans the Government the money while holding the Bonds as collateral.  Essentially the Government and Federal Reserve trade money for bonds.  It is important to note that at this point the Government is now in debt to the Federal Reserve (a private institution).  Under this system once money is created the nation is in debt.

The Government has a Central Bank which is used to introduce the money to the nation.  The newly created money is not given out and evenly distributed among the citizens of the nation.  The new money is not given to special people.  The Government is in debt for this money and wants to be sure it can get the money back to one day pay off its debt.  So the Government loans the money to people.

Money is borrowed from the Central Bank by people, businesses, institutions etc.  The money is borrowed so it can be used to purchase something (goods, services, etc.).  Anyone that gets money from the Central Bank does so with a loan and is now in debt.

Money comes from debt.  Money is debt.  From the very start and all the way down the chain money cannot exist without debt.  When dealing with money in our everyday lives it is easy to overlook this.  For the system to work we need debt, since debt is what made the money.

Economic Activity, the Flow of Money

In the simplest form a bank loans money to a “Borrower”.  The Barrower gives money to a “Merchant” in return for desired goods or services (the money is spent).  The Merchant deposits the money into another bank.  The other bank then has money to loan and the process repeats.

Sometimes it is more convoluted than the above simplest form but the outcome is the same.  A Borrower or Merchant may decide to keep some cash on hand which would temporarily remove it from the normal flow.  The money will eventually need to be spent or put into a bank in order to put it to use.  Doing so will put the money back into the normal flow; it just took longer to get there.  A Borrower or Merchant may decide to put some money into a bank and spend other money in multiple places.  In any case the money still eventually ends up in a bank.

Some people may think their money is kept outside of this normal flow from bank to bank if they take their pay check and pay cash for everything.  The money given to them by their employer still originated from the Central Bank and therefore exists because of debt.  When these people spend their money on things they need, the money goes to various merchants or service providers.  These Merchants are businesses and exist to make money.  As the Merchants collect money they deposit it into a bank.  If a person pays cash for everything the money still ends up in a bank; it just took a few more steps along the way.

Economic Activity is the flow of money from a bank (loaned out), through a series of purchases then deposited to another bank.  The steps may take more time or be more complex, but the money starts in a bank and eventually ends up in a bank.  Economic activity is what happens between banks.

The Fractional Reserve Banking System

Before the 1800’s people used to store their gold and silver coins with goldsmiths.  In turn the goldsmith would issue a note for their deposit.  After these notes became trusted they were traded among people and the early form of paper money was born.  Goldsmiths noted that usually people would not redeem all of their deposits at one time.  The excess gold or silver was left sitting with the goldsmith.  The goldsmiths decided to invest a portion of the deposits they were holding.  They held on to a fraction of the money they actually owed people.  The investing generated income for the goldsmiths.  The goldsmiths then became active in earning money with the gold and silver they were holding for people.  This is how the Fractional Reserve Banking System came into existence.

U.S. banks use the Fractional Reserve Banking System.  This means banks only keep a fraction of their deposits as a “reserve”.  The remainder of the deposit can be given out as loans.  For example let’s assume a bank receives $100.00 as a deposit and the legal reserve percentage is 10%.  The bank is legally bound to hold 10% ($10.00) in reserve.  The bank has the option to give the remaining 90% ($90.00) in the form of a loan.  At the same time the bank is still obligated to immediately pay back the $100.00 to the depositor if they should decide to withdraw it.  This system works when the amount of deposits continues to exceed the amount of withdrawals.  The bank can fail if too many people withdraw money.  If the reserve is not sufficient to pay for the withdrawals, the bank is in forfeit.

The Benefit of the Fractional Reserve Banking System

The fractional reserve system is said to benefit the economy by creating more money for trade then actually exists.  This is accomplished through a series of loans from banks, purchases made with the money and the money ending up back in another bank ready to be loaned out again.  The money created is not real but a calculation of money movement through banks over time.  Time is often an over looked element when trying to understand how money creation happens.

How Money is Created

The illustration below helps explain how the process of money creation happens.  The arrows in the illustration represent the flow of time.  The blocks labeled “B - M” represents what was explained in the section Economic Activity, the Flow of Money.  The B and M in the boxes represent the Barrower and Merchant outlined as the simplest form of money flow.    For the illustration below, an original amount deposited in the Central Bank is $100.00 and the fractional reserve rate is 20%.  The number of loan / deposit cycles is set at 9.  This can continue to a theoretical limit but 9 cycles illustrates the point well.   The flow of money as shown by the illustrations below will be referred to as the “money chain”.

Fractional Reserve Illistration 1

The illustration is straight forward showing the normal flow of money over time.  Following it every step of the way is simple and logical.  The money flows through borrowers and merchants from bank to bank.  Each bank retains 20% and passes the rest on in the form of loans.  From the start of the chain the loans are large.  As the money works its way down the chain the loans get smaller since each bank along the way holds a reserve.

What was difficult for me to grasp at first was how $100.00 could give $346.31 dollars to spend in the economy and still have $100.00 left in the banks.  $346.31 spent and $100.00 left over adds up to $446.31.  It would appear that $100.00 was multiplied over 4 times to a total of $446.31.

The money left over in the reserves of various banks, add up to the original $100.00.  That is the original money that was deposited in the Central Bank.  This is referred to as Central Bank Money.

The amount people spent, adds up to more (depending on the reserve percentage and the number of cycles from bank to bank).  This money was loaned out by commercial banks then spent through economic activity.  This money is referred to as Commercial Bank Money.  Commercial Bank Money is not real physical money; it is a calculation of how much was spent as the money trickled down the money chain.  It happened over time.  In effect the same money was counted over and over again.  An example of this would be for you to spend $10 on a book.  That counts as $10 spent.  Now the person you bought the book from takes the $10 you gave them and spends it on a candle.  They also spent $10.  Together both of you spent $20.  So $10 gave $20 dollars of spending in the economy.

Here is another way to see that Money = Debt.  The Commercial Bank Money is the calculated amount spent in the economy over time, $346.31.  This is equal to the amount of debt in the economy.  Each borrower received money from a bank loan, spent that money and is now in debt for that amount, $346.31(cumulative).  The Central Bank Money is the amount of real money sitting in the reserves of various banks, $100.00.   This is equal to the amount of the original deposit made into the Central Bank by the Government.  The Government is in debt to the Federal Reserve for $100.00.  Look at these two debts together.  The Government is in debt to the Federal Reserve for $100.00 and there is $346.31 of debt within the economy.  These two added up show the total debt in the system, $446.31.  Adding up the total of all deposits made to the banks is $446.31.  Any way you slice it money cannot exist without there being an equal amount of debt.  Debt = Money and Money = Debt.

The next illustration is the same as the first but situated in a row and column format so amounts are easily added for computational purposes.  The economic activity blocks have also been removed.

Fractional Reserve Illustration 2

Although Commercial Bank Money is not real money it cannot be ignored.  Money is traded for products and services.  Those products and services are what make our lives better.  Since money changing hands (Central Bank Money) is what makes things happen in our society, this false calculation of money does represent how active the economy is.  In the example above the original $100.00 sits in banks.  The Commercial Bank Money was responsible for moving $346.31 of products and services around.  That is why they say money is Created.

Loans are what make our economy flourish since it creates money out of thin air.  We use loans to buy cars, houses, start businesses, go to college, and many other things.  With a little money trickling down the fractional reserve banking system, a lot more money is “Created” which gives way to a stimulated economy.  The down side is when things begin to settle toward the end of the money chain.

When the Money Chain reaches the End

As the chain settles toward the end of its cycle, the flow of money in the economy dwindles and eventually stops.  When the chain settles to the end there is only one person that has money on hand that can be spent.  That person is whoever is at the bottom of the chain. 

If the chain ended with a borrower or merchant they would have money.  That money is no good unless it is used.  It will eventually be spent or deposited in a bank.  If it is not put in a bank but is passed from person to person through purchases it would eventually be eaten up in taxes.

For the sake of keeping the discussion in its simplest form we will assume a bank is the last one in the chain.  That bank will have money that can be spent or loaned out for spending (minus the reserve of course).  Although they have money that can be used, that money is still owed to someone.  The bank owes that money to the person that deposited it.  This brings back our recurring theme.  The money exists but is owed to someone.  If the bank gives the money to the depositor the debt is paid but the bank will not have any money.

With the money chain settled at its end money movement is not possible except by the last one in the chain (who is still in debt).  Borrowers have spent their money and owe money to the bank.  Banks cannot loan money or pay money out when a depositor withdraws money.  They are only storing the reserve amount and legally cannot dip into it.  Merchants have money but it is stored in a bank so it cannot be withdrawn.  Money movement (the economy) has come to a halt.  Everyone in the chain either owes money but cannot pay the debt or is owed money but cannot collect.

How to Pay Back the Debt

The way this can be undone is to reverse the cycle.  The bottom bank (Bank J) would pay the money back to the person that deposited it (who in our example was referred to as a Merchant).  Note the bottom bank would no longer have money.  The Borrower above the merchant in the chain could provide a service for the Merchant (say work for them).  The Merchant would pay the Borrower the money.  Note the Merchant would no longer have money, since it was paid up the chain to the borrower.  The Borrower would pay of his debt to the bank above him.  Note the Borrower would no longer have money, since he paid the bank with it.  The cycle would continue all the way up the chain until all debt was paid off and all real money is back in the Central Bank.  At this point there is no debt in the economy but there is also no money in the economy.  The only debt is what the Government owes to the Federal Reserve.  If the government decided to pay of the national debt and give the money back to the Federal Reserve, there would be no money left at all.  Here is that pesky recurring theme again, Money = Debt.  If there is no debt there is no money. 

If this were to happen how would we continue to operate as a society?  There would be no money.  We have grown so used to money being used; it is hard to imagine another way to do it.  The subject of money is similar to religion in that it is accepted on pure unquestioning faith.  It is so widely and unquestionably accepted that most people cannot imagine there being another way and are uncomfortable even thinking about it.  If the subject is brought up other people look at them like they have lost their minds.

How Does the Economy Continue

How does the economy continue if the money chain reaches an end?  The simple answer is debt.  Increasing debt is the only way to keep the system alive.

As the money chain comes to the end (and along the way for that matter), debts are owed among the people playing the game.  If someone (person, bank, business, institution etc.) cannot make payments on their loan they lose something.  They lose a house or car, a bank goes under, a business closes down etc.

It is inevitable that along the way someone will have to pay when they have no access to money.  It is an inescapable fact of the system.  That is why there are home foreclosures, failing businesses and other things of that nature.  These things are literally built into the system.

As the chain settles toward its end there are more and more people caught in a situation where they cannot pay a debt.  Seeing higher rates of bankruptcy, house foreclosures, business failures, etc, is a sign the money chain is getting closer to its end.  Trying to reduce spending when caught in the financial crunch, businesses will lay people off.  Unemployment rates are also a sign of the chain coming to its end. 

If this is true and the chain will come to an end, how does the economy continue to operate?  It cannot continue on the same money that started it all.  As the chain comes toward its end it is said that the economy is slowing and needs to be stimulated.  Stimulating the economy is how we keep the system alive.  Stimulating the economy means adding more money to it.  Remember money = debt.  To add more money to the system to keep it going means adding more debt to the system as well.

To add more money to the system means we need to create more money so we have it to add.  Again the Federal Reserve prints more money and trades with the Government for a set of bonds equal to that value.  So the national debt just went up.

One way of introducing the new money to the economy is to divide it up among the people and give it to them.  Remember those stimulus checks in 2008?  This money ends up in a bank either by being directly deposited or through spending.  The banks loan portions of the money and the chain continues a little longer.  As this money settles down the chain will again settle toward an end.

Another way to stimulate the economy with the newly created money (debt) is to deposit it in the Central Bank.  Then the central Bank loans it out down the same money chain or creates a new chain by loaning the money to other people.  People in need from the first chain can borrow money from any of the banks in the second chain and vice versa.  The chains become intertwined like a web.  Eventually all the money will settle toward the end of the money chains.

In either of the cases (stimulus check or Central Bank loans) the money will settle toward the end of the chains and the economy will begin to slow again.  At that point the economy will need to be stimulated again.  It will be stimulated again by adding more money to the system.  This new money will mean yet more debt for the Government.

For our economy to continue we must continue increasing our debt.  It is not something that can be avoided since money is debt.  Debt is not something we can figure our way out of.  Some say we have a money system.  It would be equally correct to say we have a debt system.  Money cannot exist without debt.  They are the same thing.

What seems to blind people from seeing this inevitable fact is the complex web of the money chains.  The Government watches the warning signs of a slowing economy.  As these signs (bankruptcy, unemployment, foreclosures, etc) increase they start thinking about stimulating the economy.  They introduce more money (more debt) to the system before everything comes to a screeching halt.  The new money creates a more complex web of money chains.  If you never step back to look at the big picture it seems there is always money out there.  All you have to do is figure out where you can pull it from.

While all this is happening we scream about the government messing up and continually increasing the national debt.  If the national debt was not increased our economy would come to a standstill.  Our nation would be full of debt and there would be no way for us to pay each other what we owe.

Taxes and Interest

Taxes imposed by the government extract money from all levels of the money chain.  The government spends the money where it needs to.  This spending puts it back into the chain in various places.  Some people benefit from this if the money is spent where it will trickle down to them.  Others are hurt by this if the taxes take too much money from them.

Interest is where it gets interesting.  Remember the money chain we are working with?  Our example was not based totally in reality since it did not include interest.  This was done to keep it simple.  Let’s add the concept of interest to it to reflect reality.

The Federal Reserve loans money to the Government but now wants interest.  Say the Federal Reserve loaned the Government $100.00 and charged 5% interest.  The government would then owe the Federal Reserve $105.00.  But if the Government only has $100.00 how can it ever be able to pay a debt of $105.00?  It can’t! 

Let’s assume as a nation we decided to reverse the money chains and pay off all debt.  This of course would end with all money back in the Central Bank.  Now say we decided to pay off the national debt.  We would have $100.00 in the Central Bank total.  The problem is we have a debt of $105.00.  We do not have enough to pay off the debt.  We owe the money to the same palace we got the money.  So we can’t get more money to pay off the debt since acquiring more money would carry more debt with it.  With the money system we use today the national debt cannot be paid off!

This continues all the way down the chain.  The Central Bank keeps 20% of the money ($20) and loans out the remaining 80% ($80) to a borrower and does so with 5% interest attached.  The Borrower now has $80 but owes $84.  How can the borrower pay back the $84 if they only have $80?  They can’t!

Later the $80 ends up in a bank.  20% ($16) is kept in reserve and 80% ($64) is loaned out with 5% interest.  The next borrower now has $64 but owes $67.20.  How can they pay a debt of $67.20 if they only have $64?  They can’t!  Are you seeing the trend here?

To make money banks charge interest on the loans.  People want to put their money in a bank to earn interest.  Banks make money by charging more interest on the loans than they pay to depositors.  No matter what happens there is only so much money.  Charging interest and asking for it to be paid back is not possible when you look at it from the top down.  We are blinded to this because of the complex web of the money chains.  If we provide a service for someone in another money chain and get money in return we can pay our debt and interest.  But money has now been pulled from the other chain and someone in that chain will not have enough money to pay a debt.  Somebody will eventually get the short end of the stick with this system because there simply is not enough money to pay the debt that exists.

The illustration below is the same as the one we were working with before but with the element of interest added to it.  The cycles from bank to bank is set at 3 to keep it brief.  The fractional reserve rate is still 20%, the interest charged for loans is 10% and the interest owed to depositors is 5%.  The interest the Federal Reserve is charging the government for the money is 5%.

Fractional Reserve Illustration 3

Every bank along the way appears to have profited except the last bank.  Since they have not loaned out money and charged interest for it, they are at a loss.  For banks to stay in business they MUST loan out money (or take money from people as service fees).   The complicated web of money chains is not the only reason we fail to see the big picture and realize money = debt.  Another reason is our one way view of the system.  Looking at this chart from the top down looks like there was a lot of profit in the banking system.  What also happened is there was more debt created than there is money to pay off.  We never look at it from the bottom up.

We already know that after the chain has settled to an end it either needs to be stimulated with the addition of more money or we can pay off the debt and make money go away.  Seeing that each bank made a profit is deceiving.  Let’s start at the bottom again and try to pay off all debt in the economy and get the money back to the Central Bank.

The bottom bank would have to pay back $53.76 to the merchant who deposited the money.  The problem is the bank only has $51.20.  The debt cannot be paid.  Let’s pretend the merchant said it was no problem and decided not to hold the bank responsible for the interest.  The merchant gives money to the borrower above him through a trade of services.  The borrower then uses the money to pay off his loan.  He owes the bank $56.32 but only received $51.20 from the merchant.  Pretend the bank says not to worry and does not hold the borrower responsible for the interest.  This next bank then owes its depositor $67.20.  The bank received $51.20 from the borrower below it and has $12.80 in reserves totaling $64.00.  Are you seeing the point?  The money to pay any of the interest does not exist!  It just plain isn’t there!  Just like the Government cannot pay the Federal Reserve the $105 it owes since there is only $100 in existence.

To pay off all debt in a system with no interest is possible, but would wipe all money out of existence.  To pay off all debt in our system that has interest, is not possible!  A lot of people would have to let go of profits they thought they made in order to pay off the debt in our system.  This goes for everyone in the economy as well as the Government and Federal Reserve.

Inescapable consequences of our money system

The idea of how money is created with the Fractional Reserve Banking system is simple.  The problems it creates are just as simple but not as obvious until you take a good look at what is happening.  It is evident most people do not understand the implications of the money system we use.  If people understood how our money system worked they would not say we should pay off the national debt, or ask to tweak the system so there are no house foreclosures.  The negative things that occur in our system are not because of poor planning.  They are because debt is an integral part of what the system is.  Debt is money so the negative impacts are inescapable.  Just as in musical chairs; just hope you are in a good position when the music stops.

With the system we use………………….
Paying that off the national debt is simply not possible.  Unemployment will rise and fall but will always be there.  House foreclosures will always be there.  Bankruptcy will always be there.  Business failures will always be there.  The negative impacts of increasing debt and an undulating economy are what the system is built on.  These things are the system at its most basic level.

Any way you slice it there is no “fix” for the system.  Money put into certain programs to help assist those in financial need is still part of a system that is built on debt.  Someone, Somewhere, Will Lose.  Unplayable debt is just as much a part of the system as becoming rich.  Both will happen.

Escaping the System

It is not possible to escape the system individually and still function normally in our society.  Our economy has been centered on money.  If we wish to obtain anything from the economy (food, water, shelter, entertainment) we need to use money.  Working for money, being paid in cash and paying for everything with cash does not allow escape from the system.  It only minimizes your role in it.  The money you are paid with, originated from a bank.  The money you spend will eventually find its way back to a bank.

If everyone decided to end the system all at once, money would lose all value and we would be free of it.  Of course we would quickly need to find another way for society to function.  Not everyone will be willing to give up the system.  Money is power and people with a lot of it will not want to give it up.  They are benefiting from it after all.

Unfortunately, in order for the system to end, it has to fail.  As the system fails it would mean hard times for a lot of people until it all got sorted out. 

What Next

If the system is replaced what would it be replaced with?

A system of trade of any kind would most likely end with the same short comings as the one we use now.  People would still ask with each transaction, “What’s in it for me?”  If money were not used something else of value would be (labor, gold, etc).  The system would just change names from monetary to something else.  A system of cooperation would be needed to replace the old one. 

This would be a drastic step for most people to conceive of.  We are so blinded by the system it is hard to think any other way of doing it is even possible.  I know a lot of people that would not believe a system of cooperation is possible.

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