Fractional Reserve Banking

This page will describe the fractional reserve banking system, and explain why our monetary system, and our entire modern society, are 100% dependent on ongoing economic growth.

Many people today do not understand this. And among even those who do have some understanding, it seems that very few are aware of how deep and far-reaching are its implications.

Basically, it works like this:

Fractional Reserve Banking - Step 1

The banks create new money in the form of debt.

Imagine that you are given a car loan, or home mortgage. Before you took out the loan, generally this money did not "exist" in the ordinary sense (that is, in the way you would naturally imagine it, without thinking about it in detail). That is, it didn't come from anybody else's bank account or wallet—it's not like somebody else originally deposited this money into the bank and then the bank lent it to you.

Only a very small part of the money did once belong to someone in real life. This is the basis of the term fractional reserve. Typically, something like 1/10th of your loan may exist in actual deposits that the bank has in its coffers (or, actually, as numbers in its account records).

This is not like how in school you learned that the bank does not have the actual physical (paper and coins) cash money to add up to the total amount of money it has. In primary school I learned that in reality, the bank keeps most of the people's money just as numbers in its account records, and that compared to this there is only a small amount of notes and coins in circulation. Most people know this.

What most people do not seem to know about is the concept of the fractional reserve. (Although it is taught in senior high school economics, it is usually presented in a form not easily translated to real-life understanding by most students). That is, not only does the bank not have enough physical notes and coins to cover all of the money that it "has", but it does not even have enough "numbers-in-the-computer" money to cover the total amount of money it "has".

Adding to the confusion is the fact that in financial-people-speak, cash usually means this "numbers-in-the-computer" money, that is immediately available, not only physical notes and coins (although notes and coins would be also be counted as cash). As an analogy, an investor's wealth can be broken up into such categories as stocks, real estate, term deposits, and "cash", where "cash" would include not only the notes and coins in their wallet but also all the money in their savings account(s) available for immediate withdrawal. I will avoid use of the word "cash" on this page, to avoid this confusion, but keep this in mind if you look up "fractional reserve banking" in other places.

Practical example

Say, for example, that in the beginning there was originally $1 billion in the whole economy, that was all the money that existed, and there were no banks, everyone had the money in their pockets or under their pillows. Then, banks come onto the scene, and everyone deposits their money into the bank. So there is now in total $1 billion in the economy, in bank deposits.

Now, under the fractional reserve system, the banks are able to lend out more money than actually "exists". Lets assume the ratio ends up as 10 to 1. (In actual practice it is more complex than this, but I think this is example is accurate enough to explain the overall effect.)

So now, the banks lend out $10 billion to people in the economy.

Fractional Reserve Banking - Step 2

The debt has to be paid back, eventually, plus interest.

For simplification, let's assume that all of the loans are housing loans, and they are all 25 years, and the interest charged to the borrowers/homeowners is the same. Let us assume the interest rate is such that by the end of the term of the loan, each borrower will have paid back exactly three times the initial amount borrowed. The actual values I have used do not matter much—I have just chosen these as nice round numbers that will (hopefully) make the example easy to follow.

So, in 25 years, the bank needs to be paid back $30 billion.

Now let's think about this for a minute. We started with just $1 billion of actual money, and now the bank is going to be paid $30 billion at the end of 25 years. The bank has lent out $10 billion to people (to pay for all the houses, in this example). So there is $10 billion circulating in the economy. And in 25 years, people need to pay back $30 billion to the banks, so as not to default on their loans. But there is not $30 billion of money in the whole economy. There is only $10 billion (and of that $9 billion only exists as loans and not as "real" money).

Lets assume that most of the borrowers are not going to default on their loans. (That is, they will pay back the entire amount they owe, reasonably well on time). This is how things have operated in our economy for at least a few decades, so we know that it is possible for this kind of banking system system to work, and not collapse, for at least long enough for some of these kind of loans to be paid out.

The "million dollar question", then, is—where is the extra $20 billion going to come from?

Fractional Reserve Banking - Step 3

New loans are required to pay back the interest on existing loans.

The answer is really quite simple. New loans are being created all the time, on an ongoing basis. (Out of money which does not "really" exist)—and these new loans allow the total money supply to grow, in exactly the same way that the original $10 billion of loans was created out of $1 billion of deposits.

If this sounds a lot like getting a third credit card because you can't make the payments on your first two credit cards, then you are understanding this article quite well. In fact, if you could just keep getting a new loan every time you couldn't afford the interest on the older ones, you would never have to pay any of them back. Or (and this is more like how it works in the real economy), you could completely pay out your first credit card, and then close the account, keeping just cards number two and three. And then when card three is clocked up to its limit, get a fourth one. With the bigger limit on card four, now you can completely pay out card two, and still keep increasing your spending and improving your lifestyle. As long as you are able to keep growing, and therefore are able to continuously increase your debt, you will be okay.

And the real point here is, as long as it looks to the banks like you are still moving up in the world, still making positive profit from your job/investments/whatever, (that is, it looks like your capacity to produce is still growing), they will keep lending you more money, and you will be okay.

In the personal analogy above, the implication is that eventually you will earn enough money from your job (or whatever) to pay back the debt. That is where the similarity ends between your individual financial affairs, and those of the whole economy. When considering the whole economy, there is no "elsewhere" that is going to provide the extra money. It has to come from somewhere else, and when you are considering the entire economy, there is no somewhere else. (Actually, there is the international financial scene, the world bank and all that, but as I understand it the same principles apply also at the world level, and when you put it all together, the entire world economy consists almost entirely of debt-based money, and requires continuous growth to forestall economic collapse.)

I always used to wonder how it could seem that every country was miles deep in debt, and who actually "had" the money that all these countries seemed to have borrowed it from. The answer is that nobody ever "had" the money, it was created as debt, to be repaid plus interest. Thus it is not just a vague idea that there seems to be much more debt in the world than actual money—that is really how it is, and it is how the entire system has been set up to work.

What If There Was No More Growth?

What if there were to be no more growth at all? Surely some day we will have to stop growing, since our country, and the planet, does not have an infinite capacity to support more and more people using more and more energy and resources per person.

From what we have discussed above, if there was no more monetary growth, then there would not be enough money in the economy for all of the people (and companies, etc.) to pay back all of the loans that have been taken out. It's not a matter of needing to do more work, or sell more stuff—there is simply not enough money in existence to pay back all of the debt that is in existence. So, people would start to default on their loans. If we consider the ratio of debt to "real" money, there is a lot more debt than there is "real" money that actually exists. Therefore almost all of the loans that have been taken out are now never able to be paid back.

As an example, imagine that you can't keep up with your your mortgage payments anymore. Neither can almost everyone else. Your boss can't pay your salary, because that too is debt-based money, he is too busy trying to pay the interest on his own loans (commercial and personal), and dividends to the shareholders, etc., which he can't pay, nobody can pay, because there is simply not enough money in existence for more than a small fraction of the existing loans to be repaid. The more you think about it, it, the more you can see that eventually it would become meaningless who had money and who didn't.

The end result is that the entire financial system breaks down.

Now you know why, when you watch the evening news, they talk about economic growth as if their life depends on it. Their life (and your life, until you are able to survive without reaping any of the fruits of the modern economy) does depend on it.

In the case that you find any or all of this material hard to believe, try doing a Google search on "fractional reserve banking".

How Long Can We Continue Without Growth?

This can be understood, in an overall non-numerically-precise way by thinking back to our original example of the $30 billion worth of 25 year loans. How long can this system hold together, without new money being created to keep up the repayments on the original $30 billion of debt? You can get a "gut feel" of this by thinking about it. Perhaps a few (like, a small single digit number of) years—I'm not sure exactly. But probably more than one year, given that there is going to be some "slack" in the system. Definitely not 20 or 30 years. Perhaps not 10 years.

But the real answer, for our real economy, is going to be based on things like what are the time lengths (terms) of most of the loans that most of the "pretend" (debt-based) money was made from. That, and the rate of interest being charged on those loans, will determine how much money in total needs to be paid back to the banks, and how soon. Once economic growth stops, after some amount of time the total amount of these repayments will exceed the total amount of money in the economy available to service the debt. This length of time is not going to be more than 10 or 20 years, and probably less than that. Consider also that one of the effects of a failing economy is for interest rates to rise (and often to rise dramatically). Since many of the loans are variable interest loans, this will have the effect of increasing the amount that must be repaid—just at the very time when people's ability to repay is continually shrinking.

Think back to the "depressions" we have had in your lifetime, that you can remember from the news. After even just a couple of years of zero (or negative) growth, things would be starting to get strained. And even then, new loans are still being made on the understanding that eventually the economy would turn around. What if it were to become common knowledge that the economy was no longer able to turn around—that there could be no more growth, at all? Clearly we are back to the situation of financial breakdown.

Another way you could look at it is to think about this: No more growth means, effectively, no more return on investment. You buy your house and land rather than rent because you know it it going to be worth more (and generally, a lot more) in the future. What if, as in a theoretical flat no-growth economy, you knew that house/land would never be worth any more than it is now? And no more business investment? No new jobs, (other than replacement of retirees etc.)?

And what about a permanently contracting economy? What if you knew your real estate, your share portfolio, was going to be worth less in the future, and still less and less the longer you held on to it? You would try to sell it all of course, but who would want to buy it?

As another example, a question: How many children would you have if you knew that all your children, and their children, and their children, would have to live with you in the same house?

As you can see from just a couple of examples, the idea of a zero or negative growth economy (in the permanent long-term) violates much of what we have gotten used to in our modern way of life.

So Why Not Just Change The Monetary System Then?

As money is just a medium of exchange, a symbol for actual material wealth, so too the organisation of our monetary system is just a reflection of actual, real forces that form, shape and drive our modern society. Beyond the configuration of the monetary system there are deeper, more fundamental reasons why our culture and economy are dependent on continuous and everlasting growth.

Reasons why the requirement for growth is built into our current culture

All agricultural societies (as opposed to hunter-gatherer societies, in general) have the capacity to store and concentrate wealth. There are psychological and social reasons that emerge from this:

City/states are organised in such a way that the most powerful, aggressive, or wealthy individuals rise to high positions, whereas those with little power, wealth, or willingness to be aggressive sink to low-status and low-power positions. This type of internal social organisation is one of the engines which drives city/states to constantly expand, as the most powerful and wealthy individuals aggregate and consume more and more of the resources available to the city/state. This leaves progressively less and less for those on the bottom, driving the demand for growth to avoid unrest or revolt.
Thom Hartmann, The Last Hours of Ancient Sunlight, p179 (of the original edition).

A more direct reason follows from a basic fact about all current and previous agricultural societies. By using agriculture, what happens is in effect the natural carrying capacity of the land—that is, the number of humans it can support—is greatly increased compared to not using agriculture (that is by hunting and gathering). However the use of agriculture has always led to the eventual degradation of the land (and in historical cases, the eventual collapse of the society).

This is in contrast to hunting and gathering, where the maximum human population per area of land is much smaller than with agriculture. Furthermore, with hunting and gathering, if the land is degraded it does not take long for the food and other outputs of the land to reduce, which directly reduces the population of the hunter-gatherers. Individual examples of hunter-gatherer societies may last for tens of thousands of years, and collectively they have supported humanity for hundreds of thousands, or millions, of years.

The agricultural process can in this context be seen as a kind of "loan"—the "borrowing" of natural resources in order to extract more food and other immediate benefits from them. This allows for a higher human population than possible with hunting and gathering, while at the same time the natural resources of the land are being used up faster than with hunting and gathering. If we assume that in a hunter-gatherer society, the human population will stabilise at approximately the limit at which the local environment can sustain. This is regulated naturally, since if this limit is exceeded, the environment is depleted, reducing the food supply and therefore also the human population. In this way it is very difficult for the hunter-gatherer society to drastically deplete the environment, since as soon as it begins to, it reduces its own population and therefore reduces its ability to deplete the environment. Without other changes (such as natural disasters), the society can continue indefinitely with its population level at the limits of the carrying capacity of the land.

Agriculture is a means of concentrating food and other resources, which allows this carrying capacity to be exceeded. However, it does this at the expense of the natural resources, which are in the long term depleted (trees are cut, soil is eroded, rainfall decreases, and so on). This is very much like a bank loan with interest, where you are able to obtain an amount of money in the present, but in the future you will need to pay back more than what you borrowed. Provided that you are able to get more money (from somewhere else) than you have now, you are able to pay back the loan. In an agricultural society, once the population has increased beyond the original carrying capacity of the land, and the land begins to degrade, it is not possible to go back to the original state. The current, larger, population needs to be fed (since people do not generally submit willingly to starvation and death). And now the only way to do this is with even more and more intensive agriculture. Thus the process is self-sustaining. A critical point here, that drives the whole process, is that humans are able to reproduce faster than the effects of the environmental degradation become apparent. And similarly, agriculture itself is able to provide resources faster than the effects of its environmental degradation become apparent. Because increasing the human population, in the short term, allows for more agriculture (there are more workers), then to make up for a shortage of resources there is the incentive to have even more children (and more agriculture), because this will solve the problem in the short term.

This is once more very much like the requirements for growth that are built into the financial system. At any point after the beginning of the agricultural system, there is a greater population than can be sustained without depleting the environment. Because the environment is continually being depleted, it is not possible for the society to exist in a stable state - it would need to reduce its population, move elsewhere (expand its territory), or find alternative means of sustenance. If it is possible to "borrow" even more from natural resources, such as by doing more agriculture, then this option will always be taken by the society. This is in many ways analogous to the situation of a modern home borrower who takes out an extra loan to refinance previous loans.

Because this entire system allows for the continual "borrowing" of natural resources, and the "leverage" of agriculture to support a higher than otherwise possible human population, the system will continue until there is no more left to "borrow". At this point you have a population many, many, times higher than the natural carrying capacity of the land—and at the same time you have land that is drastically degraded (in terms of its ability to produce useful resources) as compared to its original natural state. Clearly this is a highly unstable state, and one in which it is not possible for the society to continue on (utilising existing methods of food production, etc) at its existing level of population—in a "flat" state, without further growth, or even in a gradually declining state.

How Long Can We Keep Growing?

An implication of the need for continual and ongoing growth is that under this requirement it is impossible to conserve anything in any meaningful way.

That is, the various environmental groups may have all the best intentions, but it is simply not possible for our modern economy and society to stop growing (and to still hold together in the form that we know it). The inevitable consequence of this is that the "rape of the earth" will continue, until the natural resources that we still do ultimately rely on are sufficiently depleted that further growth of our economy is no longer possible.

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