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What Is Fractional Reserve Banking? Everyday People Explanation

Fiat Currency Chronicles: Fractional Reserve Banking

U.S. Economy's Biggest Gross Domestic Product: Debt

by Pruthvish Patel

In the first article for this series, we learned that the Federal Reserve bank printing money contributes significantly to inflation in the U.S. Peeling the onion one more layer, we see that other banks follow suit and also print money on top of what the Federal Reserve bank prints. Fractional Reserve banking is the tool that allows banks to print money out of thin air. The U.S. banks have done this at an alarming rate leading to finance being the No. 1 sector in our Gross domestic product (GDP). The product is debt.

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What Exactly Is Fractional Reserve Banking?

Fractional Reserve system (also known as Fractional Reserve banking) is a policy that banks must keep a certain percentage of cash in deposits to fulfill withdrawals from customers. The role of Fractional Reserve banking is twofold. The first role is to make sure people’s hard-earned money stays with them for times of need. The other is to allow growth of an economy through lending, also known as debt creation.

Figuratively, let’s say you play in a league of 12 fantasy football players. The pool for the league is $25, which is deposited on LeagueSafe. The $300 in the account is subject to Fractional Reserve banking, which is set at 80%. So, by policy, LeagueSafe must keep $240 ($300 * 80%) cash at all times to pay out to the league mates. However, LeagueSafe can take $60 ($300 * 20%) and use it to lend a loan to some other league that cannot pay cash for the league pool. That extra $60 does not exist. They are “creating” (or printing) money out of thin air. This tool is provided to them by the fractional reserve system policy.

The Problem With Federal Reserve Banking

The Fractional Reserve system doesn’t inherently carry negative connotations. Allowing banks to generate loans from stored cash deposits drives the bank within an idealistic framework. Fueling the economy happens through lending money to businesses or homeowners, preventing economic stagnation. Challenges arise when the policy encounters mismanagement or displays signs of fraudulent behavior.

As of 2020, the Fractional Reserve percentage stands at 0%, showcasing a prime example. Yes, you read that right. The bank doesn’t have to keep any cash in reserve to meet your checking account withdrawals. This scenario becomes less important if the bank participates in sensible investments that yield profits. Nevertheless, issues arise when the bank undertakes risky investments or if the economy falters and loans default. In such cases, the bank finds itself without the funds necessary to honor your cash withdrawal. Consequently, this triggers occurrences of bank runs, as was witnessed in 2023.

Fractional Reserve banking is like a team turning players into future draft picks. They are creating fiat assets based on current players. But if that team manager makes bad choices with those future draft picks, the team would keep digging a hole. Usually, that means that the team becomes an orphan. This is similar to defaults and bankruptcies by banks we have seen recently.

US Economy GDP Leader: Finance

This policy of low federal reserve percentage has caused the finance industry to be the No. 1 sector in the U.S. GDP, as seen in the chart below.

Statistic: Share of value added to the gross domestic product of the United States in 2022, by industry | Statista
Find more statistics at Statista.

The U.S. economy is reliant on financial services at a 20% rate. So, as banks profit, the U.S. economy grows. As banks lose, the U.S. economy loses. What is more alarming is that the top 45% of the GDP is reliant on service industries. The causes of this scenario are multi-fold, but a key contributor is Fractional Reserve banking. This over-reliance is also why banks get bailed out time and time again.

A simple view is that the biggest bank and the biggest business is the U.S. government. The U.S. dwarfs other countries in total debt at $24.5 trillion! That is a third of the world’s debt. So if the biggest business survives on debt, they want to keep making more debt. Hence, the current economic climate.

Understanding Fractional Reserve banking is key to understanding money.

Thanks for reading my analogy and breakdown of Fractional Reserve banking! Find me on Twitter @ThePruPatel for more financial and fantasy football advice!

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