Fractional reserve banking is the process you described. Give the bank $100, it is then legally obliged to only keep X%, let's say 10%. Hence, why most - if not all - banks today are vulnerable to a 'run on the bank', because banks never have 100% of outstanding liabilities immediately liquid.
However, that being said, you make it sound as if those banks are lending/giving that money to rich Saudi princes who squander it. They are not. They are lending it to entrepreneurs that have built a business to X point that want to expand. Those entrepreneurs take that money at a relatively low interest rate (in America anyway) and invest it into their company, believing that the return they can generate is higher than the interest they pay.
Those entrepreneurs in turn hire people and when they are successful, they pay themselves a lot of money. They can also sell the business at some point in the future.
All the while, they pay back the bank the principal + interest and they have their business. This is the way it should work and this is the way it works about 80% of the time.
The other way fractional reserve banking works is that those same banks, end up using some of those funds to invest. They invest in a diversity of assets - stocks, gov't debt, etc.
They also invest in an asset class known as 'Alternative Assets'. You know what type of fund is a major beneficiary of raising money from banks and large financial institutions by fulfilling the alternative asset type category? Venture Capital funds.
Sure, you can argue that there is a bubble in Silicon Valley, but VC funds have been - undoubtedly - a major part in the major creation of MANY things we take for granted today. From Fairchild Semiconductor to Apple to Intel to Facebook, Twitter, Microsoft (eventually), Cisco to FedEx, UPS, McDonalds, Burger King, to many others in between.
Guess who got rich along the way? All those founders + many employees. Not just in earning good wages, but also in stock options and experience for their next job.
So let's just cut this crap about fractional reserve banking being the bane of society.
Sure, fiat currency, can and does lead to inflation - but inflation is the cost of technological advancement.
If there was no fiat currency, we (the ENTIRE world) would have gone through the worst depression we have ever seen - rather than just a 'Great Recession'. It would make the 1930s look like a blip in the radar.
It is precisely because the fiscal and monetary authorities were able to take those drastic measures to save the global economic system, that we can even be discussing this today.
It's also easy to dismiss the crisis as being caused by Wall Street, but...again...progress and advancement comes with a price.
Also, if you hate fiat currency so much and you think the world would see less recessions as a result of going back to the gold standard or backed by some finite amount of money, how about you take a look at history for a sec: http://en.wikipedia.org/wiki/List_of_recessions_in_the_Unite...
As you can see, the list of recessions before 1960 is pretty extensive.
America 'broke' the Bretton Woods system in 1968 - http://en.wikipedia.org/wiki/Bretton_Woods_system - and that essentially marked the end of using a reserve currency backed by a physical good (gold). Since then, there have been recessions but they haven't been as severe as many before the great depression.
The 1800s were absolutely BRUTAL when it comes to economic recessions. Going through that list, it feels as if almost every year was a recession. Kinda insane.
I apologize if this reply comes across as very terse and perhaps facetious, but I am SICK and TIRED of people bashing the current fiat system when there is no other viable alternative in sight. Every system has it's drawbacks, and has its pros. The fiat system is one where the global economic systems evolved into it - not because bankers wanted to get rich, but because policymakers realized that by being able to print more currency on-demand, it would soften economic pullbacks. What this 2008 credit crisis has shown us, is that they were DEAD right. We can debate the causes of the crisis until the cows come home, but what cannot be debated is that the policymakers (from Hank Paulson, Geithner, Bernanke, Sheila Beir, Jean-Claude Trichet, Mervyn King, and everyone else around them in their jurisdictions) made the right choices and used the right tools - because the world economy has truly been saved from possibly the worst recession we have ever seen. The only thing worse than what could have been, is what could have been had America defaulted on it's debts - but that's another argument for another day.
Oh, and when the Fed prints new money and earns interest on that new money, if they earn any profit you know who gets that? You. The taxpayer. It's called seigniorage - http://en.wikipedia.org/wiki/Seigniorage . At the end of the Fiscal year, if the Fed has profited from it's monetary activities during the year, it writes a fat ass check to Uncle Sam. Sometimes in the $50B range. Imagine ANY corporation paying a tax bill that large.
Edit 2: Here is a nice summary of the Feds performance and how much it paid over to the US Treasury in 2009 and 2010 if anyone wants to debate their performance, oh and this is ON TOP of them saving the world economy (basically single handedly) - http://www.marketwatch.com/story/the-feds-annual-profit-surg...
> However, that being said, you make it sound as if those banks are lending/giving that money to rich Saudi princes who squander it. They are not. They are lending it to entrepreneurs that have built a business to X point that want to expand.
Banks create 80% of the money and declare themselves owner of it, which they then loan out. There is nothing wrong with loaning money. But there is something very wrong with creating new money and then loaning it out, which is what banks do. They are money trolls... hijacking 80% of the money and charging a toll for using it.
> I apologize if this reply comes across as very terse and perhaps facetious, but I am SICK and TIRED of people bashing the current fiat system when there is no other viable alternative in sight.
Bitcoin is a viable alternative. (I'm aware of all the limitations of bitcoin, like the maximum rate of transactions. But the fundamentals are sound. The problems that exist can and will be fixed in time. Bitcoin will scale to be a global currency.)
> The fiat system is one where the global economic systems evolved into it - not because bankers wanted to get rich, but because policymakers realized that by being able to print more currency on-demand, it would soften economic pullbacks.
Nope. It very much is because bankers wanted to get rich. The Federal Reserve was designed by bankers. Other central banks are designed by bankers. Governments go along with it because they get to benefit from the inflation just like the bankers.
> At the end of the Fiscal year, if the Fed has profited from it's monetary activities during the year, it writes a fat ass check to Uncle Sam. Sometimes in the $50B range.
The Fed does not produce wealth. Any profits they give to the government, thus saving taxpayers a little money, are more than offset by the loss in purchasing power the taxpayers suffer through inflation.
At this point now, based on your replies, I can only assume you are trolling so I will ignore the first 2 responses and reply the to third and fourth.
>Nope. It very much is because bankers wanted to get rich. The Federal Reserve was designed by bankers. Other central banks are designed by bankers. Governments go along with it because they get to benefit from the inflation just like the bankers.
Are you a techie? Do you understand the web? Who would you want writing legislation to govern the web? Lawyers who are clueless about the web and think that the internet is a series of tubes, or people that are VERY web savvy - like Tim Berners-Lee, et. al? The same thing applies to finance, banking and everything else. Makes no sense to have people writing legislation or creating systems that don't understand what they are doing.
>The Fed does not produce wealth. Any profits they give to the government, thus saving taxpayers a little money, are more than offset by the loss in purchasing power the taxpayers suffer through inflation.
If that's the case, why has inflation been so low in the US in the last two years, when the Fed undertook the largest expansion of it's balance sheet in modern history? i.e. it has printed more money recently, than at any other time in it's mandate - but inflation AND inflation expectations are still low.
>If that's the case, why has inflation been so low in the US in the last two years, when the Fed undertook the largest expansion of it's balance sheet in modern history? i.e. it has printed more money recently, than at any other time in it's mandate - but inflation AND inflation expectations are still low.
That is because all that inflation has been exported to other countries. There are economies who have bet their growth on exports and depend on a strong dollar.
It's going to be just hilarious when China realises it can't actually do anything with all the shiny pieces of green paper we've posted them in exchange for most of their industrial output for a couple of decades, not to mention the whole Middle East.
I'm not a troll. Read my blog, my past posts here, posts on reddit, posts on the Bitcoin Forum, and my Tweets. I mean what I say.
> Are you a techie? Do you understand the web? Who would you want writing legislation to govern the web? Lawyers who are clueless about the web and think that the internet is a series of tubes, or people that are VERY web savvy - like Tim Berners-Lee, et. al? The same thing applies to finance, banking and everything else. Makes no sense to have people writing legislation or creating systems that don't understand what they are doing.
The tech equivalent of the Fed would be if the techies designed an internet where 1) all information goes through some central servers that they control, 2) they sell that information and profit, 3) everyone is legally required to use their internet and not a competing internet for sending information over long distances. This would be a corrupt, Fed-like version of the internet where some particular group of people have all the power and use it for their own benefit. This analogy isn't perfect, but it captures the basic point, that the Fed was designed in a corrupt way. It doesn't matter that the corrupt people were experts or not. If anything, being experts and using expert-jargon just allowed them to mislead everyone about the true purpose of their design - socialism for the rich.
For more of this type of information on the Fed, read "End the Fed" by Ron Paul and "The Case Against the Fed" by Murray Rothbard.
> If that's the case, why has inflation been so low in the US in the last two years, when the Fed undertook the largest expansion of it's balance sheet in modern history? i.e. it has printed more money recently, than at any other time in it's mandate - but inflation AND inflation expectations are still low.
The Fed publishes misleading inflation numbers. Anyone who spends a lot of their income on things like food and energy recognizes that prices are rising pretty quickly. For me one price that stands out is that a cup of coffee used to cost less than $2 a few years ago, but now costs something like $2.30. It stands out because paying $2 and receiving a nickle as change is a lot more convenient than paying $3 and receiving $0.70 as change.
However, I agree that inflation is not as high as I would expect given just how much money the Fed has printed. I'm not exactly sure where the new money has gone, but it is probably just sitting around in some bank accounts somewhere, not circulating in the economy, and that's why we haven't felt it more than we have. I suppose it is probably being used by banks to patch up their balance sheets after the crisis and that's why it is just sitting there. My bet would be that in the coming years, that money will get used, and that's when we will really start to feel the inflation. When coffee reaches $5 per cup, we will know QE1 and QE2, etc., have trickled down.
I am SICK and TIRED of people bashing the current fiat system when there is no other viable alternative in sight
Bashing something when you don't have a better option is timeless. People do it all the time. I don't blame you for getting a little warm under the collar over it. Heck, I'm currently irked by the same thing with power. Alternative power never gets to move forward because nuclear is scary, windmills kill birds, etc. Coal is the worst by far, but we're sticking with it because we haven't found the perfect free energy source.
I agree with you, but it's a better argument to say Intel, Facebook, etc. created huge consumer surpluses, so the real beneficiaries of VC investment were the consumers of the products which were created due to VC investments in companies, more so than employees and founders.
Hundreds of millions of people have benefitted from Intel CPUs; far more than have every worked for Intel or owned Intel stock.
I agree that hundreds of millions of people have benefited from Intel CPUs, McDonald's burgers and everything else by those companies.
But I was talking in strictly financial terms. The founders, employees and early shareholders benefited the most from those companies in financial terms. The economy did benefit significantly, indirectly, no doubt....just trying to bring it back to his argument about 'bankers milking the fractional reserve system for their profit'.
I have been wondering about this and you may be the person to answer it. My thought is that inflation only occurs when the increase in money supply is greater than the increase in wealth generated in the economy. So if an economies' wealth increases at 5% a year and so does the money supply then there's no inflation.
This is an interesting way to put it, but I must admit I am not sure.
The issue I have with this definition is that wealth can be generated even without new money being created - we are seeing it in Silicon Valley at the moment, where vast amounts of wealth are created largely on the back of old money being recycled.
Strictly speaking, inflation occurs when more money chases the same assets - so the prices of those assets rise to accomodate the new money. So in theory, by having the prices for those assets rising, wealth is created. i.e. if $100B in new money is injected into the economy, and half of that goes into residential real estate, then the average house prices will increase by no other reason than more money is chasing fixed supply.
So the $200,000 house is now worth $300,000 - therefore $100K has been 'created'.
But the way the economy is so complex and intertwined, that increase in wealth could beget another increase in wealth - i.e. the owner of that house could take out say $50K of that to start a business which increases his wealth even more (PG has a fabulous essay about creating wealth from nothing) out of his sweat (i.e. not related to inflation other than the fact that he used the rise in the price of his house to start the process but everything else was his own doing).
The truth is that I don't think modern economics truly understands inflation yet. For instance, America pumped a TON of new money into the economy (both fiscally and monetarily) and inflation has been subdued in America.
China pumped in a moderate amount of money, and inflation has been out of control recently. i.e. much more than the money they have pumped in, so they have been having to tighten the reins.
Suffice it to say, I don't know. I wish I could condense it to a nice nugget like that, but I can't.
Fractional reserve banking is the process you described. Give the bank $100, it is then legally obliged to only keep X%, let's say 10%. Hence, why most - if not all - banks today are vulnerable to a 'run on the bank', because banks never have 100% of outstanding liabilities immediately liquid.
However, that being said, you make it sound as if those banks are lending/giving that money to rich Saudi princes who squander it. They are not. They are lending it to entrepreneurs that have built a business to X point that want to expand. Those entrepreneurs take that money at a relatively low interest rate (in America anyway) and invest it into their company, believing that the return they can generate is higher than the interest they pay.
Those entrepreneurs in turn hire people and when they are successful, they pay themselves a lot of money. They can also sell the business at some point in the future.
All the while, they pay back the bank the principal + interest and they have their business. This is the way it should work and this is the way it works about 80% of the time.
The other way fractional reserve banking works is that those same banks, end up using some of those funds to invest. They invest in a diversity of assets - stocks, gov't debt, etc.
They also invest in an asset class known as 'Alternative Assets'. You know what type of fund is a major beneficiary of raising money from banks and large financial institutions by fulfilling the alternative asset type category? Venture Capital funds.
Sure, you can argue that there is a bubble in Silicon Valley, but VC funds have been - undoubtedly - a major part in the major creation of MANY things we take for granted today. From Fairchild Semiconductor to Apple to Intel to Facebook, Twitter, Microsoft (eventually), Cisco to FedEx, UPS, McDonalds, Burger King, to many others in between.
Guess who got rich along the way? All those founders + many employees. Not just in earning good wages, but also in stock options and experience for their next job.
So let's just cut this crap about fractional reserve banking being the bane of society.
Sure, fiat currency, can and does lead to inflation - but inflation is the cost of technological advancement.
If there was no fiat currency, we (the ENTIRE world) would have gone through the worst depression we have ever seen - rather than just a 'Great Recession'. It would make the 1930s look like a blip in the radar.
It is precisely because the fiscal and monetary authorities were able to take those drastic measures to save the global economic system, that we can even be discussing this today.
It's also easy to dismiss the crisis as being caused by Wall Street, but...again...progress and advancement comes with a price.
Also, if you hate fiat currency so much and you think the world would see less recessions as a result of going back to the gold standard or backed by some finite amount of money, how about you take a look at history for a sec: http://en.wikipedia.org/wiki/List_of_recessions_in_the_Unite...
As you can see, the list of recessions before 1960 is pretty extensive.
America 'broke' the Bretton Woods system in 1968 - http://en.wikipedia.org/wiki/Bretton_Woods_system - and that essentially marked the end of using a reserve currency backed by a physical good (gold). Since then, there have been recessions but they haven't been as severe as many before the great depression.
The 1800s were absolutely BRUTAL when it comes to economic recessions. Going through that list, it feels as if almost every year was a recession. Kinda insane.
I apologize if this reply comes across as very terse and perhaps facetious, but I am SICK and TIRED of people bashing the current fiat system when there is no other viable alternative in sight. Every system has it's drawbacks, and has its pros. The fiat system is one where the global economic systems evolved into it - not because bankers wanted to get rich, but because policymakers realized that by being able to print more currency on-demand, it would soften economic pullbacks. What this 2008 credit crisis has shown us, is that they were DEAD right. We can debate the causes of the crisis until the cows come home, but what cannot be debated is that the policymakers (from Hank Paulson, Geithner, Bernanke, Sheila Beir, Jean-Claude Trichet, Mervyn King, and everyone else around them in their jurisdictions) made the right choices and used the right tools - because the world economy has truly been saved from possibly the worst recession we have ever seen. The only thing worse than what could have been, is what could have been had America defaulted on it's debts - but that's another argument for another day.
Oh, and when the Fed prints new money and earns interest on that new money, if they earn any profit you know who gets that? You. The taxpayer. It's called seigniorage - http://en.wikipedia.org/wiki/Seigniorage . At the end of the Fiscal year, if the Fed has profited from it's monetary activities during the year, it writes a fat ass check to Uncle Sam. Sometimes in the $50B range. Imagine ANY corporation paying a tax bill that large.
Edit: Although this isn't terribly up-to-date, ehre is a nice paper explaining seigniorage and how much the US gov't made over the last 50 years up to the 90s - https://docs.google.com/viewer?a=v&q=cache:iB65wWXSx3oJ:...
Edit 2: Here is a nice summary of the Feds performance and how much it paid over to the US Treasury in 2009 and 2010 if anyone wants to debate their performance, oh and this is ON TOP of them saving the world economy (basically single handedly) - http://www.marketwatch.com/story/the-feds-annual-profit-surg...