Rethinking Money Part 2: Our Money is Broken - Fractional Reserve Banking

Our banking system actually forces some people into poverty no matter how well they manage their money.


Most of the seemingly intractable problems in this world are created by the fact that our money itself is broken. Many people, even in money-related professions such as accounting and finance, do not know some of the basics about how our economic system works. In particular, the problems created by fractional reserve banking are not widely understood.

How Our Money Gets Created

It is common for people to think that the nation’s central bank, the Federal Reserve Bank (also called “the Fed”) creates our money. While that is not incorrect, it is not a complete picture.

Actually, banks create most of our money. And they create money through debt.

Suppose that I have somehow received $10 million from the Fed. In reality, this is not possible. But for the sake of this example, let’s pretend that this could happen.

I take my $10 million and deposit it in a bank. What does the bank do with it?

In our fractional reserve banking system, they lend out 90% of the money. They keep a small fraction, 10%, on reserve at the bank in case I want to withdraw some of the money. That’s what the “fractional reserve” part of the banking system name means.

What happens to the 90% of the money that the bank lends out? The following figure illustrates the answer to this question.

As you can see, the bank holds 10% of the initial deposit and lends 90%, which amounts to $9 million.

When someone borrows money, they inevitably deposit it in a bank. So the bank receiving the deposit of $9 million does the same thing. That is, it holds 10% and lends 90$. The amount of the new loan is $8.1 million.

Of course, the money continues to ripple through our banking system. Each time someone deposits it in a bank, that bank keeps 10% and lends 90%. In this way, the initial $10 million becomes $90 million.

What About the Interest?

Everyone knows that the bank wants to be paid back more than they lent out. For example, if you borrow money for a mortgage, you’ll probably end up paying 2.5 to 3 times what you borrowed. The extra money is interest.

Here’s a question few consider: Who creates the currency for the interest?

In our example, the Fed created the initial $10 million for the deposit. The banks created an additional $80 million to lend out. Who creates the money that we need to pay the interest?

Answer: No one.

As strange as it seems, it’s true. No one creates the cash needed to pay the interest on the loans the banks make. And remember, most of the money that people pay on their loans is interest. For example, you will probably pay 2.5-3 times what you borrowed to buy your home. So a loan for a $200,000 house may mean that you have to pay back $600,000. No one has created the currency for the extra $400,000. And that $400,000 is fully two-thirds of what you have to pay back.

So how do we obtain money to pay the interest on our loans?

Simple, we fight each other for the money that’s currently in circulation.

Consequences of Our Money Creation System

Because of our fractional reserve banking system, there must be winners and losers. Some people will fall into poverty no matter how well they manage their financial affairs. As a result, our banking system actually forces some people into poverty. And there’s nothing we can do to stop it as long as we continue to use this system.

As you might expect, money flows from borrowers to lenders. A very few lenders at the top gradually control an increasing amount of the currency in circulation. The rest of us compete for the remainder, which decreases over time. The natural result is that the competition gets fiercer and the number of losers grows. In other words, more people fall into poverty and the wealth gap between the rich and the poor grows.

We’re seeing the result of a century of fractional reserve banking here in the US today. The gap between the rich and the poor has never been higher. And it threatens the stability of our civilization.

Another consequence of fractional reserve banking is that the need to pay back debt-generated money pressures the economy to constantly grow. A growing economy creates more money. However, as the money supply grows, so does the amount of debt-generated money.

On the positive side, economic growth does bring a higher standard of living, advances in technology, and so forth. However, unending growth also consumes increasing amounts of resources. Over time, the resources become scarce in relation to the demand. National and international conflicts quite naturally increase.

The unrelenting need for growth means that businesses must constantly sell more. They need to get consumers to buy more. They do this through a variety of methods, but the result is that we consume far more than we need to in order to maintain our standard of living. Our money drives overconsumption.

At some point, we must reach the limits of the Earth’s capacity for the economy to grow. What will we do at that point? Any slowdown in the growth of the economy adversely affects all of its participants. If we were to hit a limit to growth, our economy would not only have to cease growing but it would also have to attain a steady state. This alone could collapse our economy. The consequences of economic contraction could be worse.

In a sense, our economy functions very much like a cancer. It must have unrelenting growth to survive. But in doing so, it kills the source of its survival.

Debt-generated money gives advantages to big businesses. The growth it pushes upon the economy means that businesses must become increasingly efficient over time. This is normally a good thing. However, the drive for growth forces levels of efficiency upon businesses that can often only be achieved by large businesses. For example, local businesses often cannot compete with large, big-box retailers such as Walmart and Target. Over time, larger businesses decrease economic diversity in ways that have profoundly negative effects on local economies.

It is also possible to become so efficient that a business loses its resiliency to deal with changing market conditions. Woolworth’s, Borders, Kmart, and Digital Computer Corporation (DEC) are just a few examples. These were all well-run and efficient businesses providing good products and services. But they were so focused on one way of doing business–the way that had proved most efficient until that time–that they lost the ability to deal with changes in the marketplace. They had no resiliency.

The figure below summarizes the consequences of our fractional reserve banking system.

While our money creation system has been an engine of prosperity for many, it is not without its negative effects. Those effects increase over time until they collapse the economy. There is no other outcome possible.


For more information on the consequences of fractional reserve banking, please see Rethinking Money: How New Currencies Turn Scarcity into Prosperity, by Barnard Lietaer and Jacqui Dunne, chapters 4 and 5 inclusive.

Why Do We Have this System?

Our fractional reserve banking system was invented in the 1400s. In the 1600s, the Bank of England standardized the system and propagated it throughout Europe. As European powers expanded their control over much of the world, they took their banking system with them.

In the 1600s, science in general and economics in particular were poorly understood. By way of analogy, the dominant medical treatment in the 1600s for most medical complaints was bloodletting. When a physician uses bloodletting he cuts the patient and let's the patient bleed. Or he may use leaches to suck out the patient's blood. Bloodletting was their way of releasing bad "humors" which were thought to be the causes of diseases and other maladies. They had no clue about germs.

We would no longer use medical treatments from the 1600s such as bloodletting. Why would we use their banking system-especially if we know that banking and economics were even less understood back then than medicine was?

It's important for use to know that the fractional reserve banking system wasn't designed for economic stability or sustainability. It was specifically created to enrich the money elites and the aristocracy. It still enriches the money elites to this day. And it does a very good job of what it was designed to do.

Where Do We Go from Here?

You and I have the power to completely reinvent our money and our monetary system. We can do this legally and in ways that will work hand in hand with the current system. In fact, it is perfectly possible to create parallel monetary systems that bolster each other and make each other more sustainable.

At Cognisay, LLC, we are developing tools that will help you rethink money, reinvent the economy, and create a more sustainable world where all who will work have a fair chance to prosper. Stay tuned to this blog to find out more about how this all works.


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