Fractional reserve lending - do banks create money out of thin air?
I know banks are allowed to lend out more than their deposits (like 10x), but exactly how does this work? Do they simply create a debt out of thin air ? Trying to understand this process abit better.
If I was underwater on my mortgage and learned that the bank created the debt out of nothing - I'd seriously question whether I needed to pay it back. What a racket.
I'm not an expert but basically banks are allowed to not hold all of their deposits for demand deposits (checking accounts).
So if I put a $100 bill in the bank they are allowed to lend out up to $90 to someone but I still "have $100" in my checking account when I look at the entry online.
It makes no sense to me, it fraud.
But don't count on getting anything back on those grounds though.
Originally Posted by matt0611
I think it's worse than that. My understanding is that they can lend up to 9x the amount you deposit - so they make up $900 for every $100 on deposit. I may be wrong but am hoping to clarify here if that is the case and where that $900 comes from.
No, a $100 deposit means they can lend $90.
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Exactly. Let's say the bank finds out that at no point more than 10% of the money in sight deposit accounts is actually demanded by the owners of the accounts. So it lends out up to 90% of every sight deposit to others. Those people eventually spend that money to people who will deposit it themselves, etc., etc.
Mathematically, Y*[(1-x)/x], where x is the reserve ratio and Y is the initial deposit, is the maximum amount of money created out of thin air. [(1-x)/x] is called the money multiplier. So with a 10% reserve requirement, you can end up with up to 9 times the amount of money created out of thin air. Well, actually 8 times out of thin air + the original deposit.
The alternative would be to disallow the lending out of money in sight deposit accounts, so that the capital would just wait in your bank account idle, while 90% of it will not be used at a given time. And also higher interest rates for borrowing money, but negative interest rates for sight deposit accounts (you'd have to pay the bank for that service).
Personally I'd have no problem with fractional reserve banking in a free banking environment. As long as everyone is aware of it. By depositing money in a fractional reserve bank you basically agree to not get all your money back in the case of a bankrun.
And yes you'd have to pay the mortgage back. You agreed to. Nobody forced you to make that contract.
But that 90$ can be deposited again, and from that 81$ can be lent out again, and so on.
thanks for clarifying - i knew it was created out of thin air but unsure of the method/amount. so... it really is created out of thin air - isn't it? so it may be safe to say that 80% of the economy is riding on an air pocket ?
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First of all, I've been a little wrong. The amount of money maximally created out of thin air would be 9 times the amount of the deposit, not 8.
The multiplier, including the initial deposit, would be 1/reserve requirement. In our case with 10% it would be 1/0,1 = 10. Or a nine-fold of the initial deposit out of thin air.
No. That would only be the case, if all the physical bank notes and coins would be deposited in sight deposit accounts and all but the reserve would be lent out and so on and so forth. This multiplier only shows you the maximum amount of money created by commercial banks would be (1-reserve rate)/reserve rate times the amount of cash. However, the real multiplier is also determined by other factors. Not all of the cash is deposited. Even if everybody wanted to deposit all the cash, it's not necessarily the case, that there is demand for such a huge amount of loans, nor willingness to lend out so many loans (as is currently the case). In this case banks wouldn't even let everybody deposit their cash, or at least there wouldn't be any interest on those deposits.
Currently, according to those graphs:
the real multiplier is actually smaller than 1. The money base, M0 (money created by the central bank, or cash and bank reserves at the Fed) exceeds M1 (cash and sight deposits). I just realized that this is the case since late 2009 and it really surprised me. What that means, if I'm not totally wrong here, is that the amount of reserves the commercial banks hold at the Fed exceeds the amount of cash deposits, since cash is part of M0 and M1. That's really amazing. For the last 2-3 years if the Fed increased M0 by X, the amount of money in circulation (M1) increased by less than X.
Last edited by Danan; 01-06-2013 at 11:15 AM.
isn't that because the fed is paying money on those deposits and the banks will just take it without the risk? i knew the banks created 9x or so money from the deposit... wasn't sure how exactly and should have reviewed that crash-course vid first. but i believe this whole economy is smoke and mirrors and that we are operating in a matrix movie-like existence. add derivatives to this and we are really in Wonderland.
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