There was still a lot of confusion regarding my previous article on fractional reserve banking. Nothing has changed with the argument, but I do want to expand on it a bit. I think part of the confusion comes down to a closely related topic. While fractional reserve banking does not create money, the creation and actual use of bank IOUs does. But that money is not the same money that went into the banks, or which comes out of the banks when you make a withdrawal.
I should have probably started with this at the very beginning. In order to talk about money, we need to know what money is. Money is a medium of exchange, a unit of accounting, and a store of value. Anything can be money, from gold to fabric with pictures of dead people on it, so long as it is accepted as an intermediary in an exchange. If it is not accepted as an intermediary in exchange, then it is not money.
When banks lend out your money to other people, they write IOUs in its place. Meanwhile, they continue to report that you have your total balance available. When fractional reserve banking creates IOUs, those IOUs are not necessarily money. In “Fractional Reserve Banking: The Myth of Creation of Money,” I used gold as an initial example. I want to continue with this idea, but extend upon it a bit.
Consider two banks, bank A and bank B, and three individuals, Alice, Bob, and Carol. Alice deposits 2 oz of gold into her account at bank A. Bank A then loans out 1 oz of gold to Bob. In place of that one oz, the bank places an IOU. That IOU is not money, at least not yet.They could just sit there until the debt is repaid. If however those IOUs are traded around, such as is the case in our banking system, then they become money.
For instance, suppose bank A and bank B have accounts with each other, and that Bob has an account at bank B. Now, further suppose that Alice purchases something from Bob for 1 oz of gold, using “money” from her checking account. When this happens, bank A clears the IOU for 1 oz of gold that it owes to Alice. It then writes an IOU to bank B and puts it into B’s account.
It is this use of the IOUs that turns them into money. Furthermore, that money is backed by the faith in the banks to be able to provide the base currency upon request. Essentially, these IOUs are currency derivatives that, in our case, happen to be traded around and thus become money. But it is not the fractional reserve banking itself that turns it into money, but the way in which these derivatives are used that does so. Additionally, these IOUs are only exchanged between banking institutions. It is not a currency system which is used directly by the people.
- Fractional Reserve Banking: The Myth of Creation of Money
- Gold: Reasons Why it is a Good Form of Money