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Why You Should Care About Fractional Reserve Banking

Commentaries & Views

(Kitco News) - Modern day fiat money is an abstract concept. Sure, money is the medium of exchange that allows you to pay your mortgage, go out to dinner and load up on groceries at the store. But, at its base, money is a scorecard system that bypasses the need for bartering. It is a social construct that facilitates activities in our highly developed economy.

In today's world, money is largely digitized and made up of via electronic records and numbers in computer systems. Your bank account is comprised of numbers in a computer file, not gold or silver bars in a vault.

Taking this a step further: the majority of modern day money is credit, which represents money created through the loan creation process. Central bankers call this: fractional reserve banking. This process allows banks to take in deposits, then loan out that same money and theoretically create new money, via credit expansion.

Here's how the Federal Reserve Bank of Atlanta explains the concept:

"The story that's usually told about the origin of fractional reserve banking is told about ancient goldsmiths. Goldsmiths stored precious metals in their vaults and people came to them to store precious metals on their account. And, over time, the goldsmiths realized, you know, if I lent this gold out and put it out there in the community in some sort of an investment, then I could made a profit and return the gold to the vault before anybody is the wiser."

Setting the Current Stage

Former Federal Reserve Chairman Ben Bernanke spearheaded a massive effort to prevent the U.S. economy from sliding into another Great Depression after the 2008 global financial crisis imploded. Bernanke unleashed the powers of the central bank to create money via quantitative easing and balance sheet expansion, commonly referred to as money printing.

Despite his critics, Bernanke – a keen student of Great Depression economic history – probably saved the country from another depression with his bold and unconventional actions. Yet, the U.S. economy has still not fully healed. Gross domestic product growth is positive, but has failed to hit its pre-2008 stride.

Most importantly – Federal Reserve monetary policy has not even come close to normalization. In March 2017, the federal funds rates stands at a still historically ultra-low 0.75-1.00%. It is nearly nine years since the Fed dropped the funds rate to zero-0.25% in December 2008 to stave off economic depression. The path to policy normalization has been shepherded along in a slow pace by Fed Chair Janet Yellen, as central bankers didn't want to spook, consumers, markets and businesses and trigger a renewed economic downturn.

As a reference point, in 2006, the fed funds rate stood at 5.25%. In 2000, the fed funds rate stood at 6.50%. Admittedly, that is on the high end in recent monetary policy tightening cycles – but it is important to remember what occurs during "normal" tightening cycles.

That brings us back to fractional reserve banking. Bill Gross, fund manager at Janus Capital Group, recently highlighted this issue in a note to clients:

"It still mystifies me…how a banking system can create money out of thin air, but it does. By rough estimates, banks and their shadows have turned $3 trillion of "base" credit into $65 trillion + of "unreserved" credit in the United States alone – Treasuries, munis, bank loans, mortgages and stocks too, although equities are not officially "credit" they are still dependent on the cash flow that supports the system."


            Chart source: fred.stlouisfed.org

Running On Credit  

Gross highlighted current credit conditions noting that: "the global economy has created more credit relative to GDP than that at the beginning of 2008's disaster. In the U.S., credit of $65 trillion is roughly 350% of annual GDP and the ratio is rising."

Gross issued this warning:

"Our highly levered financial system is like a truckload of nitro glycerin on a bumpy road."

He went on to say that one mistake could trigger a credit implosion where investors
"all rush to the bank to claim its one and only dollar in the vault." When this happened in 2008, Bernanke had the tools available to him to cut rates to near zero and create trillions of dollars via quantitative easing to prevent a "run on the system."

With Fed rates at 1.00% and balance sheets still historically swollen, the central bank is out of bullets.

The moral of Gross's story? He points to Will Roger's famous quote: "I'm not so much concerned about the return on my money," he wrote, "but the return of my money."

Gold has always served as the ultimate safe-haven and capital preservation vehicle. Have you taken the time to properly diversified your portfolio?

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.

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