[amluto]

That 10% reserve number is interesting. I learned about the 10% reserve ratio in macroeconomics class, where I also learned that there's this thing called the money multiplier. See, if banks are required to hold a fraction r (10%) of their deposits in reserve, then obviously they'll lend out the rest, which will in turn be held or spent by the borrower, and one way or another it'll end up back in a bank. So a (1-r) fraction of the actual cash and Fed-issued money ends up lent out and redeposited. But the banks can loan out a (1-r) fraction of /that/, ad infinitum. So the total amount of deposited money is 1 + (1-r) + (1-r)^2 + ... = 1/r of whatever money (cash and things actually deposited at the Fed) the Fed created in the first place. Since r = 10%, the multiplier is 10.

The official page AFAICT is here:

http://www.federalreserve.gov/monetarypolicy/reservereq.htm

The effective ratio is actually under 10% these days.

Edit: Fixed an inconsequential typo.

[nostromo]

Here's a great article that describes exactly this phenomenon in more detail.

http://www.theguardian.com/commentisfree/2014/mar/18/truth-m...

> There's really no limit on how much [money] banks could create, provided they can find someone willing to borrow it. They will never get caught short, for the simple reason that borrowers do not, generally speaking, take the cash and put it under their mattresses; ultimately, any money a bank loans out will just end up back in some bank again. So for the banking system as a whole, every loan just becomes another deposit.

> What this means is that the real limit on the amount of money in circulation is not how much the central bank is willing to lend, but how much government, firms, and ordinary citizens, are willing to borrow.

...

> Just consider what might happen if mortgage holders realised the money the bank lent them is not, really, the life savings of some thrifty pensioner, but something the bank just whisked into existence through its possession of a magic wand which we, the public, handed over to it.

[jayfuerstenberg]

The documentary "Four Horsemen" (link below) goes into these topics at length, especially money creation. Most people's jaws drop when they learn that 97% of all money in the world isn't in paper/coin form but rather 0s and 1s in a database and that it is all willed into existence as debt by a bank.

https://www.youtube.com/watch?v=5fbvquHSPJU

[amluto]

I don't see any inherent problem in having the sum of all deposits far exceed the actual amount of cash in existence. I do find it odd that the Fed and Congress permit the banks to exert strong control over the total money supply by adjusting how much cash they hold in reserve rather than having the Fed itself control the money supply.

[carsongross]

Of course there is an inherent problem with it: it's fraud. Just because it's fraud we are used to doesn't make it any less so.

Demand deposits should be covered via reserves. Loans by banks should be duration-matched to financial instruments offered to the public. Presto, no bank runs and the interest rate is driven by a market expression of societies time preferences.

Economic stimulus is done via government spending, rather than jamming money into an already bloated financial sector. I would favor a universal citizens dividend for this, to minimize corruption.

[irln]

This is not an indictment of the Fed, but with respect the Federal Reserve == the banks.

[irln]

Some have argued that the reserves no longer exist in practical terms. [1]

[1] http://www.ny.frb.org/research/epr/02v08n1/0205benn/0205benn... tl;dr "They attribute the diminished force of the requirements largely to the spread of "sweep" arrangements—a banking innovation that allows depository institutions to shift funds out of customer accounts subject to reserve requirements."

[jhulla]

This is an excellent paper by the Bank of England about how money is created in modern economies:

http://www.bankofengland.co.uk/publications/Documents/quarte...

[carsongross]

With sweep accounts, the reserve ratio is far, far worse than 10%. This is why we are screwed: we've been expanding the fractional ratio for 60 years and it's finally starting to matter as the U.S. economy slows and stops growing fast enough to paper it over.

There is no exit. The Fed cannot raise rates.

[jayfuerstenberg]

Keep in mind also that the 10% reserve doesn't mean physical money (paper/coins). When a bank loans money, it can create $9 out of thin air for every real $1 it holds (be it in paper or in DB entry). When loans are being paid back, the banks count that payment as "real" money against which they can loan 9x the value again. In theory at least, this process can repeat to infinity.

I wonder if anybody unit tested this design for flaws.

[dragonwriter]

> This is why we are screwed: we've been expanding the fractional ratio for 60 years and it's finally starting to matter as the U.S. economy slows and stops growing fast enough to paper it over.

If the above was the problem, then the below wouldn't matter:

> There is no exit. The Fed cannot raise rates.

Because the Fed wouldn't be considering raising rates. If the US economy is growing too slowly, the Fed generally seeks to lower rates, not raise them.

[irln]

Why is having a lower reserve ratio far worse?

[carsongross]

See above.

Or, ask yourself: why is there any reserve ratio at all?

[irln]

As long as a loan is collateralized by an asset that a reasonable market would value at or above the amount of the loan, the only issue is liquidity...right? So whether the ratio is 10%, 2%, etc. is kind of irrelevant. If folks want their money all at once, no reserve requirement would be sufficient. But at least the idea here (not that it has been followed) is to keep things stable enough so no large group runs for the exits and so long as conditions are maintained that don't foster those runs, the system should work.

[carsongross]

That is not correct. For demand deposits there should be a 100% reserve requirement. No bank run is possible: if everyone shows up and wants the money they are legally able to demand at a given moment, it's all there.

Loans are then (strictly) duration matched with financial instruments offered to the public. Collateralization provides the banks with assets to offset the inevitable bad loans, but "investors" can't demand their money back earlier, and the banks had damn well better be on point when it comes to making and managing the loans, or they are out of business. There would be a secondary market for these instruments, of course.

It's pretty straight forward when you just think in terms of contracts. Its a testament to how fucked up (or, perhaps, effective) our education system is that smart people like yourself can't see these problems straight away.

[irln]

> Loans are then (strictly) duration matched with financial instruments offered to the public.

So loans are funded by the public?

> It's pretty straight forward when you just think in terms of contracts. Its a testament to how fucked up (or, perhaps, effective) our education system is that smart people like yourself can't see these problems straight away.

Why are folks like you so afraid of discussing issues that might challenge your worldview? I would argue that only by being able to articulate answers to these questions (some of which you claim have such obvious answers) can we obtain a better understanding. Maybe your schooling encouraged a blinders mentality, but I humbly suggest you be open yourself to provide answers and not insults.

[chinathrow]

Well written, thank you. It's beyond my understanding why the fractional reserve banking is allowed by western societies. Why should banks be able to do this, but not other companies or even private persons?

[forgetsusername]

>Why should banks be able to do this, but not other companies or even private persons?

Companies and individuals are most certainly able to create "money" on their own. You can issue all the debt you want, as long as you find a willing counterparty and sign your own name to it. It's balance sheet expansion.

For example, you go to purchase a new car, and sign a note telling the dealer that you will pay the price of the car, plus interest, over five years. You've created an asset out of nothing, for which the bank is more than willing to pay the dealer cash for. People and companies create such assets every day. There is no magic to issuing your own liabilities, which is what the Fed does when it prints money.

[leaveyou]

Unions and monopoly is bad. Competition is good. Except for lending and money creation. Banks must have monopoly on that, because.. shut up and go to work.

[dragonwriter]

> Why should banks be able to do this, but not other companies or even private persons?

Other companies besides "banks" (savings and loans, credit unions, etc.) can. Other other companies and private individuals only can't in the sense that there are rules governing this to prevent abuse, and if you jump through all the hoops required to do that, you have become a bank, savings and loan, credit union, or some other entity allowed to do it. Banks, etc., are just the name given to entities that have met the requirements to engage in particular activities.

[irln]

The fractional reserve system on its own is not necessarily the issue so long as those making the loans fairly value the assets that collateralize the loan. Which also dictates that the loans be collateralized in the first place :)

[throwaway1967]

They do it without asking (the Federal Reserve Act was passed Christmas Eve 1913 - around the same time the IRS came into being, what a coincidence) and most people do not understand the harm in it (even here on HN).