Saturday, September 20, 2008


(Week 8 - Saturday, Sept. 20)

Two columns ago I described how the goldsmith banker of the 15th century initiated the practice of keeping a quantity of gold in reserve in his vaults which represented a fraction of the outstanding receipts that he had issued against that gold (and which now effectively circulated as money). This fraction was determined by the size of reserve he deemed necessary to be reasonably certain that in the normal course of business (apart from a "run on the bank") he would have enough gold on hand to redeem any receipt for it that was presented at the teller window.

Yesterday I described the first steps of the "fractional reserve" mode of money creation used in modern banking, and asserted that it is superficially similar to the fractional reserve method of the goldsmith banker in that it requires the banker (in the language of the profession) to keep in "reserve" a quantity of money that is at minimum a certain "fraction" of what he is giving out as "loans," as a hedge against the bank becoming "insolvent" (going broke). Anything "reserves" beyond that level are called "excess" (i.e. "reserves" upon which new money could be created, but has not yet been).

Note that in each of these processes the banker is essentially creating new money; the goldsmith when he is writing out multiple claims against a reserve supply of gold in his vault, and the modern banker when he is writing out a check against a "reserve" supply of paper or electronic deposits of money in his bank.

Despite what may seem like close parallels between these two processes, they are fundamentally different, and have opposite effects.

The goldsmith banker is in possession of an actual reserve supply of something (the quantity of gold in his vault) that can be dipped into to stave off catastrophe in a time of emergency (much like a reserve of grain can stave off starvation during a drought). Catastrophe in this case would be defined as the goldsmith running completely out of the precious metal, with the result that he could no longer redeem at his teller window a promissory note he had issued that said the bearer was entitled to receive his (the note bearer's) gold. In this event, public confidence in his operation would collapse, notes still outstanding would become worthless paper, and his business would be declared "insolvent" or "bankrupt." It should be noted, however, that this would not have transpired until his reserve of gold was completely exhausted.

The modern banker is not in possession of any such reserve supply of something that he can dip into to stave off catastrophe in a time of emergency. His "fractional reserve" is a bookkeeping illusion. In yesterday's column I described how if a banker has $10,000 in "reserves" on deposit in his bank reserves, he is allowed to create $9,000 in new money to "loan" out.

In the idiom of the banking profession, of this $10,000, the banker has loaned out $9,000, and kept $1,000 "in reserve." Note, however, that none of the original $10,000 of "reserves" on deposit is actually loaned out. It all remains on deposit. The status of the $10,000 has changed only in the sense that this particular $10,000 has now been spoken for as the baseline of money on deposit that the banker could use to create $9,000 in new money. To speak as if $9,000 was loaned (as if some money on deposit was lent to someone and left the bank), and $1,000 kept "in reserve" (as if it were in any way comparable to the tangible reserve of the goldsmith banker) is to mutter nonsense.

According to the rules of "fractional reserve" banking, if the person who had that $10,000 on deposit came to the teller window and withdrew it, the $9,000 that had been created using it as a baseline would now be unsupported. If the owner of the $10,000 withdrew even a small part of it, say $100, that would mean that 9/10 of $100 ($90) would be unsupported in their formula, and a way would have to be found very quickly to either "call in" (cause to be repaid) $90 of that loan, or find $100 dollars in new "reserves" (money that was not yet designated as supporting newly created money on top of it).

If a modern bank dips into its "fractional reserve" for even a single dollar, the formula by which it is governed is violated, and the whole fragile structure by which it creates "credit money" comes undone. This singular fact transforms what should be among the social order's most stable institutions (banking), into a game of brinksmanship by which, in the pursuit of their mandate to maximize profits, bankers are obliged to come as close to "needing" to use their "fractional reserve" as possible, while knowing that if they miscalculate and step over that line their bank will instantly "fail" (be declared "insolvent"). The banking system as a whole has been moving ever closer to the "fractional reserve" tipping point, has gone past it, and can no longer stop its own fall. That is why the Federal government is, in people's perceptions, being obliged to step in.

Richard Kotlarz

The complete set of columns from this series is posted at the following websites: