The Fractional Reserve Banking System
The Consequences of the System
Peter Joseph produced two informational exposés,
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
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
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
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
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
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
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.
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
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
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
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%.
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
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
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.
If the system is replaced what would it be replaced
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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