How Fractional Reserve Lending Makes Money Disappear

According to the popular way of thinking, it is held that banks are responsible for the expansion of lending also known as credit, and given that economic prosperity is associated with an increase in credit, they are seen as crucial to the economic well-being. But are banks the true source of credit?

Real Credit Is Backed by Real Savings

For instance, take farmer Joe, who produced two kilograms of potatoes. He requires one kilogram for his own consumption. The rest he decides to lend for one year to farmer Bob. The unconsumed one kilogram of potatoes that Joe agrees to lend is his real savings.

Remember, real savings are a necessary precondition of lending. Loans must be fully backed by real savings.

By lending one kilogram of potatoes to Bob, Joe agrees to give up ownership of these potatoes for one year. In return, Bob provides Joe with a written promise to repay 1.1 kilograms of potatoes in one year. The additional 0.1 kilograms constitutes interest.

What we have here is an exchange of one kilogram of present potatoes for 1.1 kilograms of potatoes in one year. Both Joe and Bob have entered this transaction voluntarily, because they both have reached the conclusion that it would serve their objectives.

The introduction of money does not alter the essence of what lending is all about. Let’s say that instead of lending his one kilogram of potatoes Joe first exchanges (sells) it for money, let us say for ten dollars.

Joe may now decide to lend his money to another farmer, John, for one year at the going interest rate of 10 percent. John the farmer in turn buys a piece of equipment with the borrowed money, which increases his production.

Observe that the introduction of money did not change the fact that real savings precede the act of lending. When a saver lends money, what he in fact lends to borrowers are final consumer goods that he did not consume.

Credit Unbacked by Real Savings Results In Economic Impoverishment

When credit is not backed by real savings, no real savings have been exchanged. The borrower holds empty money, so to speak, which he exchanges for goods and services.

What emerges is an exchange of nothing for something, or consumption of goods that is not backed by production. This leads to the diversion of real wealth from wealth-generating activities toward the holders of credit, who hold money generated out of “thin air.”

Obviously, this type of credit undermines the production of real wealth, and the weakening of the production of real wealth ultimately diminishes the borrower’s own ability to repay his debt.

Fractional Reserve Banking as the Source of Money Out of “Thin Air”

The existence of the system of fractional reserve banking permits commercial banks to generate credit not backed by real savings, i.e., the generation of credit out of “thin air.”

For instance, let’s say that farmer Joe sells his saved kilogram of potatoes for ten dollars. He then deposits this money with the Bank A. The ten dollars are fully backed by the saved kilogram of potatoes.

Now let us say that Bank A “lends” $5 to Bob by taking $5 from Joe’s deposit. The money hasn’t really been lent, because Joe still uses his $10 as if it it hadn’t been lent out at all. This means that whenever he deems it necessary he is entitled to take the $10 out of deposit. No additional real savings have been accumulated to back the $5 loaned to Bob.

Once Bob, the borrower of the $5, uses the borrowed money, he has in fact engaged in an exchange of nothing for something, the reason being that the $5 are not backed by any real savings—it is empty money.

What we have here is $15 that are only backed by $10 proper. The $10 are fully backed by one kilogram of potatoes—real wealth that has been saved.

How Money Disappears

Because this $5 dollars was never backed by real savings it presents a problem: when credit originates out of “thin air” and is returned to the bank on the maturity date, this leads to a withdrawal of money from the economy, i.e., to a decline in the money stock. This is because in this case we never had a saver/lender, since this credit was unbacked.

 So now when Bob repays the $5, the money leaves the economy because the bank is not required to transfer it back to the original lender. There is no original lender—the bank created the $5 loan out of nothing. When a bank generates a new deposit that is unbacked by real savings and lends it out, we have no original lender/saver.

The $5 in new money set in motion an exchange of nothing for something and provide a platform for various nonproductive activities that prior to the generation of unbacked credit would not have emerged.

As long as banks continue to expand credit out of “thin air” in this way, nonproductive activities continue to expand. But once the continuous generation of such credit increases the pace of real wealth consumption above the pace of real wealth production, the positive flow of real savings is arrested and a decline in the existing pool of real savings is set in motion.

Because what drives economic activity is real saving, the performance of various activities starts to deteriorate and the number of bad loans starts to increase. In response to this, banks curtail their lending activities, setting in motion a contraction of the money stock. (Remember, the money stock declines once loans generated out of “thin air” are repaid and not renewed.)

The fall in the money stock begins to undermine various nonproductive bubble activities, which cannot stand on their own feet—an economic recession emerges. These activities require the assistance of unbacked credit that is no longer available—credit created out of “thin air” and that had diverted real wealth from its producers to them.

According to many mainstream economists, a severe economic slump, also known as an economic depression, occurs due to the sharp fall in the money supply. This view originated with the Chicago school and was championed by Milton Friedman.

But as we have seen, depression is not caused by the collapse in the money stock as such, but by the shrinking pool of real savings on account of previous easy monetary policy.

Thus, even if the central bank were to be successful in preventing the fall of the money stock, it could not prevent a depression as long as the pool of real savings was declining.

Conclusion

To conclude, then, banks do not lend but merely facilitate the lending of real savings by wealth producers. Banks facilitate the flow of real savings by connecting the suppliers of real savings with the demanders. In the sense of fulfilling the role of intermediary, banks play an important role in the process of real wealth formation.

When banks begin to engage in lending by attempting to replace genuine lenders/savers, however, it sets in motion the menace of the boom-bust cycle and economic impoverishment.

It must be understood that it is not possible to genuinely increase credit without the growth of real savings. Unbacked credit expansion can only encourage volatile, nonproductive activities that consume real saved wealth and halt its accumulation, setting the stage for certain economic disaster.