General Questions
Banking
 

1. What is monetizing debt?
2. What is fractional reserve banking?
3. Are banks loaning other depositors’ money?
4. If bank loans are lawful and legitimate, then what is so awful about fractional reserve banking?
5. Does fractional reserve banking cause inflation?
6. How would a bank loan be created in a 100% commodity money system, no paper at all, no monetizing of debt?
7. How does a Freddie Mac or Fannie Mae loan work?
8. I’ve read numerous examples that with fractional reserve banking, paying off the interest for the whole system is mathematically impossible. Therefore, everyone who borrows is basically competing in a game of “Old Maid.” True or false?
    

What is monetizing debt?

The term monetizing debt or monetization is the act of creating and introducing currency into circulation through debt. The currency created is used to buy goods and services. People repay that newly created currency through their future labor of creating goods and services. Goods and services are traded for goods and services, but with the amounts of currency being borrowed, do so only through long periods of time.

Banks today have a special government license to create currency by monetizing debt. Banks create currency out of thin air, but once introduced into circulation, the currency is very real. By monetizing debt, banks increase the quantity of currency in circulation. Since the supply of goods and services typically continues to rise, so must the quantity of currency in circulation increase to maintain a stable exchange value.
 

What is fractional reserve banking?

The phrase describes the amount of currency a bank can loan. Banks are restricted by law to loaning currency based both upon the amount of funds a bank has on deposit with the Fed and the amount of funds customers have on deposit. The Fed establishes the reserve ratio for all banks in America.

Each bank is limited to loaning an amount up to total excess reserves. Excess reserves are defined as the amount of deposits in excess of reserve requirements. For example, with a reserve ratio of 6% and with $1,000 in deposits, the minimum amount to be counted as reserves is $60. The remaining $940 is considered excess reserves. That bank can loan up to $940.

If that borrowed $940 was deposited at another bank, excess reserves at that second bank would be 6% of $940, or $883.60. That sum would be the maximum amount that could be loaned.

To determine the maximum possible ripple effect throughout the entire banking system, first calculate the reciprocal of the reserve ratio. This number is often referred to as the reserve multiplier. For example, with a reserve ratio of 6% the reserve multiplier is 16.667.

Then multiply the reserve multiplier by the amount of excess reserves of the first bank.

The total amount that can be loaned throughout the entire system is the result of multiplying excess reserves by the reserve multiplier. In our example, that total would be $940 times 16.667, or $15,667. This is the amount that conceivably could be created throughout the entire banking system, not just at one bank. Each bank is limited to loaning an amount up to the total amount of excess reserves.

The term “fractional reserve banking” can be misleading. Many people believe the “fractional” part of the term implies that the bank keeps on hand only a fraction of all deposits and loans the remainder of those deposits according to the fractional reserve requirements. In other words, people believe that with a 6% reserve ratio, bank’s keep 6% of all deposits in the vault and loan the remainder to borrowers.

In today’s world of banking, what banks typically do is determine how much currency they could create. In other words, if $1,000 are on deposit with a 6% reserve ratio, mathematically the entire banking system could create up to $15,667. Because banks have a government license to create funds out of thin air (monetizing debt), banks have no need to loan other depositors’ funds, but merely create new currency.

Unlike hard currency, today’s fractional reserve system is not referring to actual hard currency on deposit. Approximately 95% of the currency supply today is electronic—ones and zeroes in a computer. In more familiar terms, “checkbook money.” Much of today’s currency is mere bookkeeping entries.

Nonetheless, the reserve ratio calculations work the same. That is, each bank must count all funds on deposit and then using the reserve ratio mandated by the Fed, calculate how much currency it may conceivably create and loan. Whether those deposits are hard currency or bookkeeping entries is irrelevant to the method of calculation. Just remember that there are two approaches to using excess reserves. Banks could loan other depositors’ funds or they can create currency out of thin air.

By the way, in our example that reserve multiplier is most certainly only a theoretical number. Analysis shows that the actual reserve multiplier rate varies between 2.5 to 4. Costs, overhead, dividends to stock holders, etc., all take a bite out of the theoretical limits.
 

Are banks loaning other depositors’ money?

Sometimes yes, sometimes no.

With some timed deposits, such as certificates of deposit, the contracts are quite clear that deposited funds are not held at the bank.

However, fractional reserve banks have no need to loan their depositors’ funds, because they can create currency out of thin air.

There are several elements to this confusing issue.

Due to ongoing changes in banking laws and rules, many financial institutions now perform functions similar to those traditionally handled by banks. Qualified Financial Holding Companies (FHCs) may now engage in a broad range of financial activities such as: dealing in securities; dealing in insurance in any state; lending, exchanging, transferring, investing for others or safeguarding money or securities; and acting as a financial or investment advisor. In addition FHCs may engage in related activities including making “merchant banking” investments. This allows an FHC to own a company engaged in activities not otherwise permissible for an FHC.

Another element of confusion arises partly because of the nature of today’s fiat paper currency. The paper is no longer considered “receipt money,” that is, paper currency exchangeable in specie (gold or silver coin). The confusion also rests partly in the fact the few people realize that banks have a license to create currency “out of thin air.” Thus, under such a misconception, people tend to believe that other depositors’ money is always being loaned.

More confusion arises in that most people misunderstand fractional reserve banking. Although banks today operate under this mechanism, most people wrongly assume that all paper currency is represented by gold or silver. In America, paper currency stopped being exchangeable in gold in 1933, in silver in 1968. The confusion is further complicated because most people believe that money only can be gold and silver when, in fact, anything can serve as a medium of exchange.

Then there is the confusing legal element of making a deposit with a financial institution. Once you sign that deposit slip and hand over your money, who actually owns that money?

Therefore, without understanding these elements, the appearance seems to be that other depositors’ money is always being loaned.

In today’s world of electronic-checkbook currency, fractional reserve banks do not need to loan their depositors’ funds. In the days of hard currency, banks sometimes actually loaned their depositors’ funds. Yet, even then, lenders usually created funds out of thin air. Of course, with a hard currency, that receipt currency is not exchangeable in hard currency because there is no longer a one-for-one ratio. With a hard currency, such practices tend to be inflationary. However, this practice nonetheless often worked well because lenders had observed that rarely did all depositors demand their funds.

Nonetheless, there must be some kind of legal limit to how much currency a bank can create. If there was no limit, the banker could just loan his brother-in-law $1 million every day at lunch. Both people could then enjoy an expensive meal and take the rest of the day off. Under such a system, why would banks need any clients at all other than those brothers-in-law?

With that all said, however, some institutions today such as Savings and Loans do make loans with depositors’ funds (recall the panic scene in the classic movie with Jimmy Stewart, “It’s A Wonderful Life”). Loaning other depositors’ funds is largely what caused the 1980s S&L crisis. The worst of the S&Ls offered the highest interest rates to keep money coming in and continued to invest recklessly; after all, their own money was not at risk and depositors’ funds were insured against loss by government regulation. (Such activities are a strong argument against any federally-backed insurance program.)

NESARA offers the S&Ls a chance to make use of the fractional reserve system and places S&Ls under the same rules the banks must observe. At the same time, the S&Ls are limited to investing in the local community, part of their original charter.

There is another thing to remember regardless of whether you deposit funds at a bank or a Savings and Loan. When you make a deposit, the money you deposit at those institutions becomes “their” money. You have an equitable interest in total deposits only up to the amount that you deposited. Although most people view deposits as bailment, the courts unfortunately through the years have opined that deposits are actually loans. Therefore, banks may use those funds as they see fit: as reserves or to promote their credit cards, which can cause those banks serious losses in an economic downturn. This skewed and incorrect opinion of the courts has caused much havoc in the world of banking. That is one reason why NESARA prohibits commingling of funds.

One of NESARA’s main objectives is to limit a bank’s ability to place its depositors’ funds at risk, particularly when those funds are in the new gold and silver accounts. The new rules also make bank failures almost impossible which greatly reduces the risk for all depositors.
 

If bank loans are lawful and legitimate, then what is so awful about fractional reserve banking?

Depends upon the circumstances.

In a hard currency system, if the bank issues “claim checks” against the same stack of currency, then there could be fraud. If that stack of currency includes depositors’ funds, then under certain circumstances, the bank might not be able to honor its contractual obligations to pay on demand.

If the bank loans (creates) currency that is represented by no goods and services, then the issuing of that currency is inflationary, and robs all currency holders of their expected exchange value of that currency. Banks themselves sometimes do this when they buy government debt. Such actions do nothing to reserves, but are nonetheless inflationary. That is immoral and inequitable. Or as your children often say, “That’s not fair!” That is one reason why NESARA prevents institutions from holding government debt as reserves.

The actual process of fractional reserve banking is not evil or fraudulent. Obviously, when commodity currency is used, such as gold and silver coin, banks must exercise caution that all demand accounts can be honored. This would be true even with a paper currency.

With any currency, a mechanism must exist to continually increase the currency supply to match the increased availability of goods and services. When that mechanism is the monetizing of debt, that is, banks are allowed to create currency out of thin air, then there is no need to loan other depositors’ funds. Whenever debt is monetized, the new currency is created, not loaned from depositors’ accounts. There is still danger, however, of depositors losing funds if the bank makes bad business decisions (investing in derivatives for example), extends credit too far, or if reserve ratios are too low. Such losses are normally, but not always, covered by FDIC (another reason why federally-mandated insurance creates problems—banks should be forced to honor all demand deposits and contracts, or be forced to go out of business).

In a world of hard currency, fractional reserve banking could be dangerous since depositors’ funds are being used. When using hard currency, the great fear of fractional reserve banking is bank runs. That is, if people believe a bank to be insolvent, people would rush to the bank to withdraw funds. Of course, in a hard currency system, the funds are not immediately available. Therefore, word would spread and panic would result.

In today’s world of electronic-checkbook currency, the issue is rendered moot. Because much of the currency in circulation today is electronic-checkbook currency, bank runs are more easily quashed than in the days of hard currency. Under normal conditions, the aggregate demand for old-fashioned physical cash is easily met by the banks. However, should some event cause a run on the banks and the aggregate need for physical cash exceeded the available quantity, banks initially would be unable to immediately honor their contractual obligations. The Fed would no doubt order the printing of more currency (via the Bureau of Engraving and Printing), but human nature has shown that once the people realize their cash is “safe” they would no longer demand the actual cash.

In fact, the Fed had tons of currency printed in anticipation of bank runs for the Y2K problem, runs which never occurred. That currency never went into circulation, but could have. Would such an event have been inflationary? No. There is no direct effect in swapping paper currency for checkbook currency one for one. Both represent the same amount of purchasing power in the hands of the public, which should roughly match the amount of goods and services immediately available. The Fed would supply banks with paper currency to cover a run, but only on a dollar for dollar basis. The Fed would require the bank’s commercial paper to back their advances or would collect interest on any loans made to the bank. If people re-deposited their cash, the banks would return the cash to the Fed for their commercial paper to recover the income.

However, indirectly those cash withdrawals lower bank reserves and restrict the amount of currency a bank can create and loan. If account holders did not soon redeposit the cash, the overall effect would be deflationary. To counter the deflation, the Fed would likely cut interest rates, at least on the currency banks borrow overnight, and maybe cut rates overall, in their usual tactic of “leaning against the wind.”

Nonetheless, many people today believe that banks always loan other depositors’ funds when in fact they do not. This incorrect belief about fractional reserve banking causes many people to call for the end of all such practices. Those who dislike such a system often fail to realize that even when local banks create currency through debt, that currency is represented by local goods and services in the market. All currencies are fundamentally backed by goods and services. Currency exists for the sole purpose of exchanging wealth (goods and services) and can be backed by nothing but goods and services. The problem today with fractional reserve banking is not that banks create currency out of thin air. At the local level, that currency is backed by goods and services.

A problem with fractional reserve banking is the currency inflation pyramid effect caused by central banking, and in particular, the central bank’s authority to create funds out of thin air when backed by no goods and services. The central bank does not serve the general public, but serves as the government’s bank. When the government cannot raise sufficient funds through taxation and borrowing of currency already in circulation, they then borrow from the central bank. Because such newly created currency is being used to fund existing commitments of government (largely welfare and wealth redistribution schemes), that newly created currency is rarely backed by goods and services.

This is not a statement that the current Federal Reserve System cannot work, only that when the Fed creates currency backed by no goods and services, that action is inflationary. If the Fed created funds only to buy true goods and services, the system would have greater credibility.

When government debt is purchased by the central bank, that check is deposited at larger commercial banks. That deposit increases reserves, which subsequently increases that bank’s ability to loan. From that point on, there is a ripple effect through the entire banking system as borrowed funds are deposited at other institutions. At the local level this is not a problem as those newly created funds are backed by goods and services (usually in the nature of virtual wealth).

The actual currency inflation is introduced at the initial creation point at the central bank.

Although the currency inflation mechanism of central banking is a problem, that particular inflationary problem can be cured. NESARA provides such reforms in that the new Treasury Reserve Board of Governors has no authority to buy and hold debt (to later sell). Under NESARA all purchased government debt paper must be exchanged with the Treasury for new Treasury credit-notes, and by law the Treasury must then cancel (destroy) that debt paper. The newly obtained credit-notes are placed into the new Treasury Reserve Account and are not placed into circulation.

However, even if such controls were implemented today without NESARA, another real danger still would exist today with fractional reserve banking, and that danger is not easily resolved under today’s system. That danger resides with credit cards, where people can create currency on the spot and at whim. The credit card itself is not currency, but allows the card issuer to create currency. Using credit cards increases the quantity of money in circulation, which tends to raise prices. If something happens to the economy and people need immediate purchasing power, out come those credit cards. The total available credit through credit cards is extremely inflationary, even hyperinflationary because that available credit adds to the checkbook currency already in circulation. Doesn’t matter if the cost of bread increases to $20 per loaf, the kids need to eat so the bread gets purchased.

If such a scenario occurred today, we would see hyperinflation before the Fed could react.

However, notice under NESARA that such a hyperinflation example would immediately bump into a 14% national sales tax (for taxable items). Although the percentage remains constant, increasing the overall cost of taxable goods and services through hyperinflation automatically increases the total sales tax collected. With the new Treasury Reserve Account, the Treasury Reserve Board of Governors can impound currency at a steady rate and stabilize the situation without any knee-jerk step-changes in interest rates.

Adjusting interest rates as a control mechanism is a big problem. The mechanism works, but transfers real earned wealth from the workers to “unearned” wealth for the moneyed elite. Shades of Karl Marx!
 

Does fractional reserve banking cause inflation?

Depends.

All currencies, regardless of substance, are always represented by goods and services. There is nothing evil or fraudulent about fractional reserve banking as long as the total supply of goods and services continues to rise, matching the volume of currency in circulation.

Many people believe that fractional reserve banking causes currency inflation. The overall practice of fractional reserve banking is not the cause. The direct cause of currency inflation is increasing the quantity of currency in circulation faster than the amount of available goods and services increases.

Within the aggregate, this does not happen at the local level. Loans at the local level are represented by goods and services and are not inflationary.

The cause of inflation is with a government that borrows against no goods and services. Government borrows by selling debt instruments, that is, bonds and securities (IOUs), which in today’s system is often purchased by the Fed with funds created out of thin air. (Public debt purchased by individuals is purchased with existing currency and is not inflationary.) Once those funds are deposited in commercial banks, that action builds reserves and the ripple effect throughout the entire banking system begins. Therefore, fractional reserve banking itself is not the cause, but allowing the Fed to participate with funds created out of thin air that are not backed by true goods and services.

This ripple effect would still exist under NESARA, but the rules are changed dramatically to avoid the negative effects. Under NESARA, the new Treasury Reserve Board of Governors can buy government debt instruments, and that action introduces currency into circulation. However, the new Treasury Credit-Note Exchange-Value Index will greatly control when the Board buys that debt. Essentially, the Board would buy that debt only when the Index drops below 1.00. The Index also greatly limits government borrowing. Although government can continue the social welfare state, under NESARA the government cannot easily sell debt to fund those wealth redistribution payments. The Index would discourage the Treasury Reserve Board from buying debt instruments if the Index exceeds 1.03.

Governments are consumers, not producers. The problem with the currency supply is not fractional reserve banking, but a legal plunder system that has become a monster. That legal plunder system creates great pressures for public servants to create currency out of thin air.

Furthermore, when governments print currency to fund a war or military action, that currency initially funds goods and services directly supporting that war or action. Unfortunately, wars are destructive and a large part of the goods and services purchased are destroyed. As this destruction occurs, the currency remains in circulation backed by no goods and services. The currency becomes inflationary. To compound the problem experienced by war, lives are lost. Lost lives means reduced production of good and services, further worsening the inflation problem. To further compound that problem, during the war period, people tend to hold on to their currency, which tends to decrease the rate of circulation of currency as well as total volume. This action somewhat negates the inflationary effects of the government. However, when the war ends, people then start spending which increases the volume and rate of circulation, which tends to raise demand which raises prices.

Even when the goldsmiths started the practice of fractional reserve banking, those goldsmiths were not always loaning other depositors’ money, but were creating currency. Originally, the goldsmiths simply created token claim check receipts for any gold on deposit. Then the goldsmiths, after realizing few people stopped by to withdraw gold on deposit, began creating extra claim checks—through bank loans. However, although initially these extra claim checks were not represented by gold on deposit, the claim checks were not inflationary because the claim checks were represented by the virtual wealth of the property being purchased with the loans. Such a practice is not evil or fraudulent. All money must be represented by material wealth—goods and services. Specie and paper currency are merely different forms of claims on wealth.

Eventually, however, the goldsmiths/bankers got greedy and began inflating the currency supply by issuing further loans, but the new currency issued (claim checks) represented no goods or services. Mostly this was done by loaning to governments to finance wars. Wars do not create goods and services, but destroy them. Without a corresponding rise in goods and services, such currency became inflationary.

Even in non war periods, the loaning of money to governments is often inflationary because governments rarely create goods and services, they consume goods and services.

Creating currency (claim checks) is not evil, if the claim checks represent wealth created by the aggregate community. The inflation arises when the claim checks are issued against wealth that other people have already been issued claim checks, or when the money is created and not represented by wealth.

This inflating of the quantity of currency in circulation essentially creates a problem of more people holding claim checks that could be redeemed in goods and services. This tends to bid up prices.
 

How would a bank loan be created in a 100% commodity money system, no paper at all, no monetizing of debt?

Same as an individual person would loan assets. The bank would have to own the assets in order to loan the property. These assets, in an honest system, cannot be another depositor’s money as this would then create a double claim on the same money. Therefore, such loans would have to come directly out of the banker’s pockets. Just like a person would loan $10 to a neighbor.
 

How does a Freddie Mac or Fannie Mae loan work?

Same as any other loan in the current system. The only difference is that the bank serves as a middleman for the government. The government is actually monetizing the debt. The bank simply earns a commission for doing all the paper work. Those loans are not inflationary because the newly created currency is backed by goods and services (in the nature of virtual wealth).
 

I’ve read numerous examples that with fractional reserve banking, paying off the interest for the entire system is mathematically impossible. Therefore, everyone who borrows is basically competing in a game of “Old Maid.” True or false?

Depends upon how the interest is paid and how much is owed within the aggregate.

All things being equal, most “Old Maid” stories are just that—stories. What many myth chasers fail to realize is that regardless of the banks’ license to create currency, paying the interest is possible in a typical loan system because the myth chasers fail to account for natural resources and future labor, which eventually creates future goods and services. Ultimately, those future goods and services are what backs newly introduced currency.

The myth chasers usually control and rig the story so that natural resources and future labor are never included in the example they provide. This is misleading and erroneous.

Consider the following simple example.

A farmer asks his banker for a loan. The banker provides a plow, a horse, and a sack of corn seed. The banker expects the farmer to return the plow, the horse, and a sack of corn seed. The price for borrowing those commodities (the interest to be paid) is some of the future harvest. Under normal weather conditions with no natural disasters, the farmer raises a healthy crop of corn. The farmer returns to the banker the plow, the horse, a sack of seed, and some of his harvest. What is the farmer left with? His crop of corn, which he can eat, barter, trade, or sell on the market. The farmer converted some natural resources and his labor into property—corn. The farmer not only repaid the loan, he paid the interest and was even left with something extra of value. The farmer’s labor contributed to creating that value.

Yes, the interest can be repaid. However, future conversion of labor and resources must be used to pay the interest.

However, notice in this example the interest paid is simple interest. Simple interest is a straightforward rental fee. Unfortunately, in today’s financial world, compound interest is charged, and when compound interest is charged the door is then opened to those accusations of playing “Old Maid.” Determining whether the entire system eventually will collapse depends upon many elements, such as the interest rate charged, the term of the loan, the ability to convert future labor and resources into currency, etc.

Mathematically, compound interest is inherently unstable. However, if the terms of a compound interest contract are kept within physically doable limits, then all that results is a long-term stressful contract of converting future labor into currency to pay the interest. The most well-known example is the 30-year mortgage. Thirty years is certainly doable on an individual level, but when evaluated throughout all of society, what is the cost of such processes to society in general? Unlike simple interest, compound interest attempts to create something out of nothing—an act that is contrary to natural physical laws of the universe.

Compound interest is an untenable and unsustainable long-term element of society. Compound interest should be considered unconscionable. Of course, every individual possesses the right to contract, and no law can be enacted to prohibit that right. Thus, if an individual agrees to pay compound interest then that individual possesses that right. However, as long as banks possess a government-granted license to introduce new currency into circulation (after all, banks are incorporated creatures of the state), we see no issue with placing legislative restrictions on those actions. Thus, the NESARA proposal prohibits compound interest on secured loans made on a fractional reserve basis.

Overall, what is discouraging about any loan is that any loan creates a master-slave relationship out of the involved parties. In essence, this is what most people are upset about. The solution, of course, is to not borrow, or at least greatly limit how much is borrowed and when.