Fractional Reserve Banking
I’d like to take this opportunity, here on my Hemp.com soapbox, to introduce our readers to a friend that conveys an important insight on economics. The following essay, and subsequent postings by Carl Sanko are intended help you expand your knowledge of money and the monetary systems we live with, for better or worse. It’s what we as a world community do or don’t do that will promote change through understanding. So enjoy Part 1 as a primer, and hold on to your hats for Part 2 – a thought provoking insight on the inner workings of our financial system!
With the advent of modern banking came creative ways to steal money from the unsuspecting public. Perhaps other than government use of force and legal tender laws to require fiat paper as money, a more devious thievery has never been developed than fractional reserve banking. In the late 1500′s, gold was money, and its owners would park their holdings with a goldsmith who was known for safekeeping. The depositor would get a receipt from the goldsmith for his gold deposit, and could return at any time with his receipt to claim the stored gold that had been allocated to his account. So far, so good. Then it was realized by holders of the notes that business vendors and other sellers would treat their gold notes as equivalent to gold. The notes were less cumbersome and discretely more safe to conceal and carry than gold, and yet had the value of gold since the vendor receiving them for his goods could then go to the bank and receive physical gold on demand for the amount represented by the note. This was the creation in history of paper money, and the paper of that time was “as good as gold”. Still, so far so good. Such banking operations were honest, and an important public service; a convenience and a worthy business.
Then a hideous idea occurred to the goldsmiths. They found that paper being only paper, the amount of notes could easily be made into some amount greater than the amount of gold deposits entrusted to them by their depositors. They could, for instance, create double the amount of notes than they had in redeemable gold, and no one was likely to figure out their scheme. Assuming that as long as there was not a run on the gold deposits, there would be sufficient gold to back those who came to trade in their notes for gold. After all, the notes were easier to use as currency than gold and thus the deception was likely to remain undiscovered. Other men had to toil to make a living, but the alchemist goldsmith could create extra notes just from the paper he had on hand. Having thus enriched himself, he could do one of two things with his newly developed treasure. He could commit blatant fraud by using the extra notes for his own personal purchases and investments (effectively spending his customer’s gold), or he could take the more surreptitious route of appearing as an honest business enterprise that made loans with the notes to other needy merchants, with interest. This latter way served to make the goldsmith a highly valued member of society. Under either approach, the goldsmith was secretly risking his customers’ deposits to conceal an illegitimate creation of his own wealth. Having in possession gold that was only a fraction of what was represented by outstanding notes, we mentioned that the crafty goldsmith was jeopardizing his client’s wealth should there be a bank run in which everyone tried to claim their gold at the same time. Yet, even this was not all, for the extra notes created increased demand on goods and services which causes their prices to rise. In effect, the goldsmiths had also created inflation, which spoils the purchasing power of those who had worked and sweated to earn their gold.
Eventually, however, things got much worse when the goldsmiths became even more greedy. With insatiable desire for greater wealth, they brought down their entire system, financially ruining many depositors. Those who were the first to redeem their notes got their gold back, while those late to the goldsmith found his vault empty. The expanded supply of money that spurred an inflationary economy quickly contracted. Rapidly, there was a shortage of money to purchase goods and services, to pay off loans, to invest and save; the money bubble popped and price deflation took hold.
More about this, and how it relates to our current monetary system, in Part 2 next week.
Continue reading part 2 of Fractional Reserve Banking by Carl Sanko