How Modern Banking Works

This post is meant to be educational so that everybody knows how our monetary system works. Knowing how the system works is the first step to identifying the problems and considering solutions.

How modern Fractional Banking works:

line 1 Bank Starting Capital………………….1,200

line 2 Reserve for Bank working capital……………………………………. ..200

line 3 Private Loans……….1000…….1000……..1000…….. ..1000

line 4 Int + Prin……………..2000……..2000……2000… ….2000

Total Principal + Interest on Line 4= $8,000

Line 1 Starting capital is only $1,200

Line 2 The bank keeps only 200 in reserve.

Line 3 The bank has lent out $4,000 on $1,000 and expects to get paid back $8,000. The bank has lent the same $1,000 out to four people at the same time. They can do this because the money never really leaves the banking system. It is just being transferred around from one account to another.

The money to be payed back, the total of Interest + principal on line 4 ($8,000), does not exist because on line 1 they only started out with $1,200.

More money must be created (printed) to pay back the Int + Prin… or the borrowers will default. The system depends on more borrowers coming in after and create more money through debt borrowing.  Factional Banking is a legalized Ponzi scheme, but there is nothing better that would scale to a growing economy that has been thought of yet.

The system is designed so that all new money must be borrowed into existence. More money must be constantly created or else the borrowers will default because at any given time there is not enough money in existence for ALL borrowers to pay back their debt. The Church understood this and tried to ban the practice of Fractional Banking. Andrew Jackson, the 7th US president, knew this too and fought hard to destroy the Second Federal Bank of the United States. The charter of the First Federal Bank was allowed to expire. The point is that there are costs and benefits to this system that have been known for a long time.

The system is good because it allows for the money supply to scale to a growing economy. The system requires that all borrowings are backed by collateral. So if allowed to work properly, it is a very good system with a built in control on inflation. The money created at the local level IS backed by something. It is backed by real assets which have an intrinsic value much greater then gold. Gold is not good for much except art. The down side of debt based currency is a situation when there are not enough new loans coming in.  When there are not enough new borrowers coming in to borrow more money (create new money), some people will default (recession). This is the built in control on inflation. The Federal Reserve has traditionally used interest rate adjustments as the throttle control on this debt based money creation system. With lower the interest rates there is more borrowing, hence more money creation. If there is too much money creation the Fed raises interest rates to slow the rate of new borrowing, which slows the creation of new money.

If this system is confusing let me put it another way. If you want to borrow money from a bank to buy a house, the rules allow the bank to create electronic money out of thin air as long as the house is used as collateral. No money is ever really exchanged today in large transactions. Neither the buyer, nor the seller of the property ever see hard cash. The money is moved electronically from one account to another. Since all US bank are chartered by the Federal Reserve, all the banks that seem independent really function as one giant bank. It will also surprise people that in all likely hood they have never held real money in their hands there entire lives. If you look at a one dollar bill you will see the words “Federal Reserve Note”. A Note is a Payable. Those words say that the Federal Reserve OWES you a one dollar. So what you think is money in your hands is really just an IOU from the Fed to you.

The system can work.  I can’t think of a better system that would satisfy the needs of a modern economy. The problem with this system is the Government. The government has given itself the ability to borrow as much money as it wants without putting up real assets as collateral. The Treasury just prints up paper bonds and sells them to the Fed Reserve for new cash. The govt basically gives itself an IOU for new money. This is proof that anything that government touches… turns to shit.

It is false to say that our money is not backed by anything, it is infact backed by real assets that borrowers use as collateral. The only problem in this system is the Government borrowing which is not backed by anything of value other then its “power” to tax and confiscate property almost at will.

As the government borrows more and more, its debt becomes a bigger percentage of ALL the Outstanding debt. As that Government percentage goes higher, it means that a greater percentage of our money is NOT backed by real assets.

There is only one possible solution to this problem at this point. The national debt can never be paid back, since in this system the money to pay it all back never exists at any point in time. The amount not actually owed to anyone can be written off. That should be balanced by proportionally decreasing the private debt and the money supply. The effect of this is “Deflation”. The problem of this is only psychological as people will have to get use to the idea of taking a pay cut every year. That however would be offset by lowered living expenses. People with savings would benefit from an appreciation as the value of the dollar increases.

(Note: Permission to reprint and link with credit to Bill Tsafa is hereby granted)

About Bill Tsafa

Swordman, Gunman, Scholar, Accountant, Patriot
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6 Responses to How Modern Banking Works

  1. Bill Tsafa says:

    I have been considering for a long time if debt based currency is good or bad. I am troubled by the fact that any replacement system would be subject to even greater abuses. Gold backed currency for instance is subject to manipulation by those who mine it. It would be impossible to determine the exact rate at which gold should be mined. Mining too much would lead to inflation, mining too little would lead to recession. It simple is too hard for any government to be able to determine and manage the currency needs. The “capitalist” way is for the market to self manage its own needs.

    In our current system, the management of money is partially managed at the local level as local banks are able to create money as debt backed by assets put up as collateral. The new money is backed by real assets held by the borrower. The total debt consisting of principal plus interest acts as a control on inflation, since the borrower now has to come up with the money to pay back… which in aggregate across the entire economy does not exits yet… hence the control on inflation. I have come to think of this phenomena as the “Invisible Carrot”. The Invisible Carrot is debt bondage. It is however voluntary… and I do not believe that Liberty means that the people have a responsibility to protect their brothers from their own stupidity. People should be free to succeed or fail on their own.

    As I mentioned in the article … I do believe that the biggest flaw in the Federal Reserve System is that the Federal Government can borrow as much money as it wants without real collateral. I believe the Federal Reserve Governors should be replaced with the 50 governors of each state and that a 2/3 vote be required for an action.

  2. Pingback: Debt Ceiling Hocus-Pocus Illusions | Liberty Thinkers

  3. Shawn Kelly says:

    Great article Mr Tsafa!

    I am having a little trouble seeing, as you said above, how a gold backed currency could be manipulated worse than one of fiat. To increase a given amount of fiat, all that is really needed is a button to be pushed. (Oversimplifying here…)

    To increase the amount of gold would require far more work. It would take up labor and capital that needs to be paid for. Any increase in supplied gold would only come about with an increase in the demand for it, and as long as demand matches (or surpasses) the supply, you will not see price inflation. (According to the laws of supply and demand)

    I would also disagree that mining too little would lead to a recession. If the money supply stayed the same, but production stills continues and there are more available goods in circulation, you would see an increase in the purchasing power of the currency.

    No one person should “determine” the amount of gold that “needs” to be produced, those signals will be sent and interpreted through the price mechanism. Like the production of all other goods the market will spontaneously balance it.

    Keep your articles coming! I enjoy reading them, not many here write much on economic issues.

  4. Bill Tsafa says:

    Hi Shawn. I am delighted that you enjoy my articles. I started writing a few things here in a reply and then realized I was writing a whole article. I will be posting Gold Standard- Myths and Fact- Part 2 shortly.

  5. Billy says:

    I dout there is any “Gold”in Fort Knox!.The Crooks in Congress at one time or other stole it!.The Federal Reserve is not needed.Have you ever watched Star trek.A Moneyless Society.Based on the betterement and GROWTH of the Human Race!.And our only Home,One planet.In an endless Megaverse!.

    • Bill Tsafa says:

      The USA functioned for many periods in history without a central banking system, so you are correct in that it is not needed. The only purpose that it seems to have is that it gives the US Govt the ability to continuously print its own money without control.

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