The origination of the idea:
Where does the idea of fractional-reserve banking come from? The short answer is goldsmiths implemented the idea to depart from full-reserve banking. Back when gold and silver coins were the primary means of currency, goldsmiths kept deposits of gold in their safe for a small fee. In return the depositor would receive a receipt for the exact amount of their deposits. After a while, the receipts grew in popularity and were circulated just as much as the physical metals were themselves -- after all, they were as good as gold. The deposits in the goldsmith’s safe were collecting dust and the smith realized that very few people came back to collect their deposits because they were using their receipts instead. The goldsmith would then lend out the deposited gold at interest while keeping some in reserve just in case someone returned for it. The depositors didn’t mind too much because they received their gold when requested (more or less) and because instead or paying for the storage fee, they would receive interest for their deposits; thus, the birth of the fractional-reserve banking process.
Money To Be Made With Little Risk:
Who is making the money? In short, the bankers are. They are earning interest on money that is not theirs. Getting back to our previous example, let’s say for the sake of argument that the bank makes 8% interest for money on loan and pays 3% interest for deposits. Given our example, there is $9000 loaned out and $10,000 in deposits—or $9000 loaned out, and $9000 + $1000 in deposits. To simplify, that means the bank is making 5% on $9000 (8% on $9000 — 3% on $9000) and paying 3% $1000. $9000 is $1000 times 9; so to simplify even further, that means the bank is making 45% (5% times 9) on $1000 and paying 3% on $1000. And to go the rest of the way, the bank is earning (when all is said and done) 42% (45% — 3%) on that original $1000, which was not originally theirs. There is a ton of money to be made off of money that doesn’t belong to you. Is this process sustainable?
The Sustainability Of This Contradiction:
Continuing with our example, one can see that eventually the bank will own at least $1000 on record—only about two iterations of interest payments is 86% of $1000. There is still $9,000 on record for loans and $10,000 for deposits. Ok let’s assume the bank makes $1000 and withdraws it out of the system (the most extreme scenario) and puts it into an off shore hedge fund leaving everyone else to pay back $9000 in loans with zero money available. This will create an infinite demand for money and no means to quench it. Or in the case of a bank run instead, where everyone pulls out at the same time leaving those last in line with lint in their pockets. The only result of either scenario is deflation (in this case by 10 times), leading to a depression.
Ok, this obviously cannot be sustained given my little example, but what about on the scale of an entire country (or the world)? Macroeconomic effects are made of microeconomic events; therefore, if something cannot work at the micro level, then how can it possibly work at the macro level? The answer is it can’t. The part cannot contradict the whole. The best you can hope for is to patch it up the best you can temporarily, and they do, until the system ultimately fails—like in 1929 or any end to any bubble.
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