Banking, Fractional Reserves and the Illusion of Money Creation

Banking, Fractional Reserves and the Illusion of Money Creation

By Mudasir Sheikh
A common perception is that money is printed by government in the form of notes and coins. It is true, but only to a point. In India, according to Coinage Act 1906, the government can issue all coins and ₹1 note. All other currency notes ranging from ₹2 to ₹2000 are issued by RBI under  the RBI Act, 1934. This process of issuing currency notes and coins has little variation from country to country. The Federal Reserve, which is the central bank of USA, has similar functions as RBI. But, the coins and currency notes constitutes only about 5% of money in circulation.  This major portion of money in supply is created by private lending corporations known as banks, through the fractional reserve system. The fractional reserve system is least understood by majority of global population. The major portion of money supply about 95% is pumped into economy by banks using this tool.
For understanding fractional reserve banking let us consider a new bank just opens its doors, and welcomes its first loan customer. The bank issues a loan of ₹10,000 to the borrower. The borrower will then purchase goods worth  of₹10,000. The seller of the goods will get ₹10,000 which he can spend or save it into a bank. In both the cases the amount will get deposited into some bank, as the whole banking system is a closed loop and acts as a one bank. When the ₹10,000 will get deposited into a bank, the bank can again lend the amount as a loan but it has an obligation to keep certain percentage as a reserve, which is called reserve requirement, which in this hypothetical case is 10%. In real situation it can be less than or more than 10%. So a bank will keep 10% of ₹10,000 i.e., ₹1,000 with itself and lend the rest as a loan. Again the second borrower will spend it into the market; ultimately the amount can once again be deposited in to the banking system. Again the bank will have to keep 10% of ₹ 9,000 i.e. ₹ 900 and lent the rest as a loan. The same process will repeat itself ten times in case of 10% reserve requirement and thus creates a multiplier effect. After the completion of ten cycles, the bank cannot lend it again according to law. During these ten cycles ₹10,000 will be converted into ₹1, 00,000. Which is now circulating in an economy? This is the fate of every loan transaction signed by borrowers. So, it can be said the rules of accounting used by banks are complex, but reality is quite simple. Banks can create as much money as we can borrow.
The footage of government printing money showed on mass media accounts only 5% of money into an economy. About 95% of money in circulation is created by banks when a borrower simply signs a pledge of indebtedness to a bank. Does it ever come in your mind that how there can be so much money out there to be lend. Actually there is not, banks does not lend money they create it from debt. As debt is potentially unlimited, so is the money supply. Mass perception is that if all the debts were paid off, economy will prosper. But it is true only at an individual level, at macro level there would be no money. As money is debt in modern economy, no debt means no money.
The consequences of this fraudulent system of money creation by banks affect every aspect of society. By controlling the money supply, bankers control the direction of society. By facilitating easy credit to a particular industry, that industry will prosper irrespective of social consequences. Bankers , for instance, facilitating easy credit to the liquor industry, casinos, gambling dents and so on because these sectors are profitable. Credit is not easily provided to hospitals, schools, non-profit organisations as they cannot pay them huge rates of interest. On the other hand, when the credit system breaks down as in the  2008 financial crisis, every one suffers. But the explanations given by experts regarding this do not hold water. They do not  discuss the root cause of the problem which is that when money is created in fractional reserve banking system only the principal amount is created. But,  the borrower has to pay principal plus interest, so this system has inherent faults. It is natural that someone has to default. Because the system is bankrupt by design people lost jobs, land, homes and other assets to bankers, who have created this fraudulent system.
The interest paid by corporations and governments towards banks, is paid by the common public, in the form of taxes charged on all goods and services we buy. When  the interest rate is increased by banks,  people start taking less loans. The rate of debt money creation falls behind debt money destruction. Debt money is destroyed when a loan is paid back. The money supply  shrinks. When money supply shrinks, there is less money as compared to goods and services available into an economy. When money is less, goods and services are more, the prices of goods and services will fall. This is called deflation. Money becomes harder to earn during deflation. For those who are heavily in debt, this situation is catastrophic. In case of a reverse situation when people are taking more and more loans due to low rates of interest, money supply will increase into the system, which results into a loss of purchasing power of a currency. This process is called inflation. Inflation steals the wealth of every person, which is then directly transferred into the pockets of bankers. Thus both inflation and deflation are caused by unsustainable and selfish practices of money lenders. As banks control the ease of credit, money supply and interest rates , they can create periods of expansion and recession, during economic downturns when most of the debtors cannot pay back their debts and have their assets confiscated by banks. This is one of the reasons why currently rich are getting richer and poor are getting poorer.The perverse irony then is that most people in the world,  who are producing real wealth are in debt to bankers,  who just fabricate money out of thin air.

The author is an MBA and M.Phil. He can be reached at:

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