Fractional Reserve Banking
See Also: Arithmetic, Population and Energy Video.
This page will describe the fractional reserve banking system, and
explain why our monetary system, and our entire modern society,
Many people today do not understand this. And among even those who
do have some understanding, it seems that very few are aware of how
deep and far-reaching are its implications.
Basically, it works like this:
Fractional Reserve Banking - Step 1
The banks create new money
in the form of debt.
Imagine that you are given
a car loan, or home mortgage. Before you took out the loan,
generally this money did not "exist" in
is, in the
detail). That is, it didn't come from anybody else's bank account
or wallet—it's not like somebody else originally deposited
this money into the bank
and then the bank lent it to you.
Only a very small part of the money did once belong to someone in
real life. This is the basis of the term fractional reserve.
Typically, something like 1/10th of your loan may exist in actual
the bank has in its coffers (or, actually, as numbers in its account
This is not like how in school you learned that the bank
does not have the actual physical (paper and coins) cash money
to add up to the total amount of money it has. In primary school
I learned that in reality, the bank keeps most of the people's money
just as numbers in its account records, and that compared to this
there is only a small amount of notes and coins in circulation. Most
people know this.
What most people do not seem to know about is
the concept of the fractional reserve. (Although it is taught
in senior high school economics, it is usually presented in a form
translated to real-life understanding by most students). That is,
not only does the bank not have enough physical notes and coins to
cover all of the
money that it "has", but it does not even have enough "numbers-in-the-computer"
money to cover the total amount of money it "has".
is the fact that
in financial-people-speak, cash usually means this "numbers-in-the-computer"
money, that is immediately available, not only physical notes
and coins (although notes and coins would be also be counted as
cash). As an analogy, an investor's wealth can
up into such categories as stocks, real estate, term deposits,
and "cash", where "cash" would include not
only the notes and coins in their wallet but also all the money
in their savings account(s)
available for immediate withdrawal. I will avoid use of the word "cash"
on this page, to avoid this confusion, but keep this in mind if
you look up "fractional reserve banking" in other places.
example, that in the beginning there was originally $1 billion
in the whole economy, that was all the money that existed, and
there were no banks, everyone had the money
pockets or under their pillows. Then, banks come onto the scene,
and everyone deposits their money into the bank. So there is now
in total $1 billion in the economy, in bank deposits.
Now, under the fractional reserve system, the banks are able to
lend out more money than actually "exists". Lets assume
the ratio ends up as 10 to 1. (In actual practice it is more complex
than this, but I think this is example is accurate enough to explain
the overall effect.)
So now, the banks lend out $10 billion to people in the economy.
Fractional Reserve Banking - Step 2
The debt has to be paid back, eventually, plus interest.
For simplification, let's assume that all of the loans are housing
loans, and they are all 25 years, and the interest charged to the
borrowers/homeowners is the same. Let us assume the interest rate
is such that by the end of the term of the loan, each borrower will
have paid back exactly three times the initial amount borrowed. The
actual values I have used do not matter much—I have just chosen
these as nice round numbers that will (hopefully) make the example
So, in 25 years, the bank needs to be paid back $30 billion.
Now let's think about this for a minute. We started with just $1
billion of actual money, and now the bank is going to be paid $30
billion at the end of 25 years. The bank has lent out $10 billion
to people (to pay for all the houses, in this example). So there
is $10 billion circulating in the economy. And in 25 years, people
need to pay back $30 billion to the banks, so as not to default on
their loans. But there is not $30 billion of money in the whole
economy. There is only $10 billion (and of that $9 billion only
exists as loans and not as "real" money).
Lets assume that most of the borrowers are not going to default
on their loans. (That is, they will pay back the entire amount they
owe, reasonably well on time). This is how things have operated in
our economy for at least a few decades, so we know that it is possible
for this kind of banking system system to work, and not collapse,
for at least long enough for some of these kind of loans to be paid
The "million dollar question", then, is—where is
the extra $20 billion going to come from?
Fractional Reserve Banking - Step 3
New loans are required to pay back the interest on existing
The answer is really quite simple. New loans are being created all
the time, on an ongoing basis. (Out of money which does not "really"
exist)—and these new
loans allow the total money supply to grow, in exactly the same way
that the original $10 billion of loans was created out of $1 billion
If this sounds a lot like getting a third credit card because you
can't make the payments on your first two credit cards, then you
are understanding this article quite well. In fact, if you could
just keep getting a new loan every time you couldn't afford the interest
the older ones, you would never have to pay any of them back. Or
(and this is more like how it works in the real economy),
you could completely pay out your first credit card, and then close
keeping just cards number two and three. And then when card three
up to its limit, get a fourth one. With the bigger limit on card
four, now you can completely pay out card two, and still keep increasing
your spending and improving your lifestyle. As long as you are able
to keep growing, and therefore are able to continuously increase
will be okay.
And the real point here is, as long as it looks to
the banks like you are still moving up in the world, still making
positive profit from your job/investments/whatever, (that is, it
looks like your capacity to produce is still growing), they will
keep lending you
more money, and you will be okay.
In the personal analogy above, the implication is that eventually
you will earn enough money from your job (or whatever) to pay back the debt.
That is where the similarity ends between your individual financial
those of the whole economy. When considering the whole economy, there
is no "elsewhere" that is going to provide the extra money.
It has to come from somewhere else, and when you are considering
the entire economy, there is no somewhere else.
(Actually, there is the international financial scene, the world bank and all
but as I understand it the same principles apply also at the world level, and
when you put it all together, the entire world economy consists almost entirely
of debt-based money, and requires continuous growth to forestall economic collapse.)
I always used to wonder how it could seem that every country was
miles deep in debt, and who actually "had" the money that all these
countries seemed to have borrowed it from. The answer is that nobody
ever "had" the money, it was created as debt, to be repaid plus interest.
Thus it is not just a vague idea that there seems to be much more
debt in the world than actual money—that is really how it is,
and it is how the entire system has been set up to work.
What If There Was No More Growth?
What if there were to be no more growth at all? Surely some day
we will have to stop growing, since our country, and the planet,
does not have an infinite capacity to support more and more people
using more and more energy and resources per person.
From what we have
discussed above, if there was no more monetary growth, then there
of the people (and companies, etc.) to pay back all of the loans
that have been taken out. It's not a matter of needing to
do more work, or sell more stuff—there is simply not enough money in
existence to pay back all of the debt that is in existence. So, people
would start to default on their loans. If we consider the ratio of
debt to "real" money, there is a lot more debt than there is "real"
money that actually exists. Therefore almost all of the loans that
have been taken out are now never able to be paid back.
As an example, imagine that you can't keep up with your your mortgage
payments anymore. Neither can almost everyone else. Your boss can't
pay your salary, because
too is debt-based money, he is too busy trying to pay the interest
on his own loans (commercial and personal), and dividends to the
etc., which he can't pay, nobody can pay, because there is simply
not enough money in existence for
more than a small fraction of the existing loans to be repaid. The
more you think about it, it, the more you can see that eventually
would become meaningless who had money and who didn't.
The end result is that the entire financial system breaks
Now you know why, when you watch the evening news, they talk about
economic growth as if their life depends on it. Their life (and your
life, until you are able to survive without reaping any of the fruits
of the modern economy) does depend on it.
In the case that you find any or all of this material hard to
believe, try doing a Google search on "fractional reserve banking".
How Long Can We Continue Without Growth?
This can be understood, in an overall non-numerically-precise way
by thinking back to our original example of the $30 billion worth
of 25 year loans. How long can this system hold together, without
new money being created to keep up the repayments on the original
$30 billion of debt? You can get a "gut feel" of this by thinking
about it. Perhaps a few (like, a small single digit number of) years—I'm
not sure exactly. But probably more than one year, given that there
is going to be some "slack" in the system. Definitely not 20 or 30
years. Perhaps not 10 years.
But the real answer, for our real economy,
is going to be based on things like what are the time lengths (terms)
of most of the loans that most of the "pretend" (debt-based)
money was made from. That, and the rate of interest being charged
on those loans, will determine how much money in total needs to
be paid back to the banks, and how soon. Once economic growth stops,
after some amount of time the total amount of these repayments
the total amount of money in the economy available to service
the debt. This length of time is not going to be
Consider also that one of the effects of a failing economy is for
interest rates to rise (and often to rise dramatically). Since
many of the loans are variable interest loans, this will have the
effect of increasing the amount that must be repaid—just
at the very time when people's ability to repay is continually
Think back to the "depressions"
we have had in your lifetime, that you can remember from the news.
After even just a couple of years of zero (or negative) growth,
things would be starting to get strained. And even then, new loans
are still being made on the understanding that eventually the
would turn around. What if it were to become common knowledge that
the economy was no longer able to turn around—that there
could be no more growth, at all? Clearly we are back to the
situation of financial breakdown.
Another way you could look at it is to think about this: No more
growth means, effectively, no more return on investment.
You buy your house and land rather than rent because you know it
it going to be worth more (and generally, a lot more) in the future.
What if, as in a theoretical flat no-growth economy, you knew that
house/land would never be worth any more than it is now? And no more
business investment? No new jobs, (other than replacement of retirees
And what about a permanently contracting economy? What if you knew
your real estate, your share portfolio, was going to be worth less in
the future, and still less and less the longer you held on to it?
You would try to sell it all of course, but who would want to buy
As another example, a question: How many children would you have
if you knew that all your children, and their children, and their
children, would have to live with you in the same house?
As you can see from just a couple of examples, the idea of a zero
or negative growth economy (in the permanent long-term) violates
much of what we have gotten used to in our modern way of life.
So Why Not Just Change The Monetary System Then?
As money is just a medium of exchange, a symbol for actual material
wealth, so too the organisation of our monetary system is just a
reflection of actual, real forces that form, shape and drive our
Beyond the configuration of the monetary system there are deeper,
more fundamental reasons why our culture and economy are
dependent on continuous and everlasting growth.
Reasons why the requirement for growth is built into our current
All agricultural societies (as opposed to hunter-gatherer societies,
in general) have the capacity to store and concentrate wealth. There
are psychological and social reasons that emerge from this:
City/states are organised in such a way that the most powerful,
aggressive, or wealthy individuals rise to high positions, whereas
those with little power, wealth, or willingness to be aggressive
sink to low-status and low-power positions. This type of internal
social organisation is one of the engines which drives city/states
to constantly expand, as the most powerful and wealthy individuals
aggregate and consume more and more of the resources available to
the city/state. This leaves progressively less and less for those
on the bottom, driving the demand for growth to avoid unrest or revolt.
Thom Hartmann, The Last Hours of Ancient Sunlight, p179 (of the original
A more direct reason follows
from a basic fact about all current and previous agricultural societies.
By using agriculture, what happens is in effect the natural carrying
capacity of the land—that is, the number of humans it can
support—is greatly increased compared to not using agriculture
(that is by hunting and gathering). However the use of agriculture
has always led to the eventual degradation of the land (and in historical
cases, the eventual collapse of the society).
This is in contrast
to hunting and gathering, where the maximum human population per
area of land is much smaller than with agriculture. Furthermore,
with hunting and gathering, if the land is degraded it does not
take long for the food and other outputs of the land to reduce, which
directly reduces the population of the hunter-gatherers. Individual
examples of hunter-gatherer societies may last for tens of thousands
of years, and collectively they have supported humanity for hundreds
of thousands, or millions, of years.
The agricultural process can in this context be seen
as a kind of "loan"—the
"borrowing" of natural resources in order to extract more
food and other immediate benefits from them. This allows for a higher
population than possible with hunting and gathering, while at the
same time the natural resources of the land are being used up faster
than with hunting
and gathering. If we assume that in a hunter-gatherer society, the
human population will stabilise at approximately the limit at which
the local environment can sustain. This is regulated naturally, since
if this limit is exceeded, the environment is depleted, reducing
the food supply and therefore also the human population. In this
way it is very difficult for the hunter-gatherer society to drastically
deplete the environment, since as soon as it begins to, it reduces
its own population and therefore reduces its ability to deplete the
environment. Without other changes (such as natural disasters),
the society can continue indefinitely with its population level at
the limits of the carrying capacity
Agriculture is a means of concentrating food and other
resources, which allows this carrying capacity to be exceeded. However,
it does this at the expense of the natural resources, which are in
the long term depleted (trees are cut, soil is eroded, rainfall decreases,
and so on). This is very much like a bank loan with interest, where
you are able to obtain an amount of money in the present, but in
the future you will need to pay back more than what you borrowed.
Provided that you are able to get more money (from somewhere else)
than you have now, you are able to pay back the loan. In an agricultural
society, once the population has increased beyond the original carrying
capacity of the land, and the land begins to degrade, it is not possible
to go back to the original state. The current, larger, population
needs to be fed (since people do not generally submit willingly to
starvation and death). And now the only way to do this is with even
more and more intensive agriculture. Thus the process is self-sustaining.
A critical point here, that drives the whole process, is that
humans are able to reproduce faster than the effects of the environmental
degradation become apparent. And similarly, agriculture
itself is able to provide resources faster than the effects of its
environmental degradation become apparent. Because increasing
the human population, in the short term, allows for more
(there are more workers), then to make up for a shortage of resources
there is the incentive to have even more children (and more agriculture),
because this will solve the problem in the short term.
This is once more very much like the requirements
for growth that are built into the financial system. At any point after
the beginning of the agricultural system, there is a greater population
than can be sustained without depleting the environment. Because
the environment is continually being depleted, it is not possible
for the society to exist in a stable state - it would need to reduce
its population, move elsewhere (expand its territory), or find alternative
means of sustenance. If it is possible to "borrow" even more from
natural resources, such as by doing more agriculture, then this option
will always be taken by the society. This is in many ways analogous
to the situation of a modern home borrower who takes out an extra
to refinance previous loans.
Because this entire system allows for the continual
"borrowing" of natural resources, and the "leverage" of
agriculture to support a higher than otherwise possible human population,
system will continue until there is no more left to "borrow".
At this point you have
a population many, many, times higher than the natural carrying capacity
of the land—and at the same time you have land that
is drastically degraded (in terms of its ability to produce useful
as compared to its original natural state. Clearly this is a highly
unstable state, and one in which it is not possible for the society
to continue on (utilising existing methods of food production, etc)
at its existing level of population—in
state, without further growth, or even in a gradually declining state.
How Long Can We Keep Growing?
An implication of the need for continual and ongoing growth
is that under this requirement it is impossible to conserve anything
in any meaningful way.
That is, the various environmental groups
may have all the best intentions, but it is simply not possible for
our modern economy and society to stop growing (and to still hold
together in the form that we know it). The inevitable
consequence of this is that the "rape of the earth" will
continue, until the natural resources that we still do ultimately
rely on are
depleted that further growth of our economy is no longer possible.
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