During the 2008-2009 credit crisis, we witnessed the near collapse of the global financial system. Several years later, it’s easy to reflect on how our fractional reserve banking system contributed to the crisis. In this writing, we’ll discuss precisely what it is, how it works, and the benefits and risks it presents.
Stable Prices: The Fed’s Balancing Act
One of the most important duties of the Federal Reserve Board is to maintain an environment of stable prices, which today is an inflation target of 2.0%. To achieve this, the Federal Reserve Board must maintain adequate control of the U.S. money supply.
If the production of money fails to keep pace with the output of goods and services then,
1) prices will fall
2) the labor force, factories and other production facilities will not be fully employed/utilized
3) some combination of the two will occur.
If the money supply expands too rapidly, the reverse would be true. Hence, the inverse relationship between the money supply and prices is an important concept to grasp. Now let’s examine the metrics used to measure the U.S. money supply.
The Money Supply
There are several ways to measure the money supply. These include the monetary base, M1, and M2. The Federal Reserve discontinued publishing the M3 monetary aggregate in March 2006. The monetary base is the sum of the currency in circulation plus the amount of reserve balances held by depository institutions at the Federal Reserve.
M1 is defined as the sum of currency held by the public and transaction deposits at depository institutions (which are financial institutions such as commercial banks, savings and loan associations, savings banks, and credit unions). M2 is defined as M1 plus savings deposits, small-denomination time deposits (less than $100,000), and retail money market mutual fund shares.
It should be noted that actual currency (i.e., coins and bills) comprise a relatively small part of the overall money supply.
What Makes Our Currency Valuable?
What gives our currency its value? For example, why is a $20 dollar bill worth $20 or a dime worth 10 cents? There is absolutely no intrinsic value in paper money and very little in coins. The value of our currency is based solely on the promise that it can be redeemed for an equal amount of goods and services or other financial assets. In essence, its value is based strictly on confidence and yet is still affected by supply and demand.
Centuries ago, people would leave their extra gold and coins on deposit with the local goldsmith until it was needed. Years later, deposit receipts were used since they were easier to carry. However, because the majority of bank deposits would sit idle until needed, and to avoid charging a fee to depositors for safeguarding their money, banks began to use deposits to make loans. Outstanding loans, however, are much greater than total deposits. This is the genesis of our fractional reserve banking system.
How Money Is Created and Leveraged
In America’s fractional reserve banking system banks are required to keep a fraction of their deposits in reserve but may loan or invest the rest of the money (i.e., excess reserves) for a prudent business purpose. This leverage explains how $10,000 in new deposits can ultimately generate as much as $90,000 in additional capital.
The table below illustrates more precisely how this process works. To begin, let’s assume the Fed purchases $10,000 in newly issued government securities. The Fed would deposit this money in the securities dealer’s bank account, which we’ll refer to as Bank A.
Assuming a 10% reserve requirement exists on all deposits, Bank A would allocate $1,000 to reserves ($10,000 x 10%) which would leave $9,000 to loan or invest. Therefore, in Expansion Stage 1 (see Table A below), the $10,000 would be reduced by $1,000, leaving $9,000 as free capital or excess reserves. Eventually, the $9,000 would be loaned and deposited by the borrower.
Again, after accounting for its reserve requirement, the bank receiving the deposit would have excess reserves of $8,100 (see Expansion Stage 2). This process is repeated approximately 74 times until the final stage occurs and the excess reserves are at zero.
Again, the initial $10,000 which entered the monetary system as new money can generate about $90,000 in additional capital.
How much leverage is possible using the amount of Treasuries actually purchased by the Fed? Using data from 2013, the Fed bought $759 billion in U.S. Treasuries. Assuming the same 10% reserve requirement, the total monetary expansion would be in excess of $6.83 trillion ($759 billion x 9).
Of course, this assumes banks are eager to lend and borrowers have an appetite for borrowing. It’s rarely this simple.
Current Reserve Requirements
It should be noted that cash in the vault plus reserves held by the Federal Reserve Bank constitute bank reserve requirements. The Federal Reserve Board announced its 2015 reserve requirements on November 14, 2014. They are listed in the following table.
In addition to reducing interest rates and expanding the money supply during the 2008-2009 financial crisis, the Fed also reduced its reserve requirements to make additional capital available for lending. Since late 2008, the Federal Reserve has been paying interest on required reserve balances and excess balances.
The Federal Reserve has many tools at its disposal to help guide the U.S. economy. We’ve just discussed one which is lesser known but vitally important. Even though potential monetary expansion may be large in a fractional reserve banking system, if banks are unwilling to lend and borrowers are unwilling to borrow, the benefits would be negligible. Therefore, next time you make that bank deposit, multiply it by nine and consider that this is the approximate amount of additional capital your deposit will facilitate.