In yesterday's post, I discussed an example of how the American dollar as a fiat currency has been systematically devalued since the removal of the Gold Standard in 1971. The next item it's crucial to understand is the concept of fractional reserve banking.
The way that our banking system works is that a bank has to keep a 'reserve' of money on deposit, ostensibly to ensure that it can give depositors access to their money on demand. This reserve is a fraction of the actual amount it has taken in on deposit--hence the name fractional reserve banking. Currently in the U.S., banks must keep in reserve 10% of transaction deposits like checking accounts or other forms of accounts where the owner is allowed to do more than six transactions a month. Banks must keep 0% reserve--no reserve at all-on time deposits like CDs or other deposits like money market accounts, where the number of transactions are limited to 6 per month.
Ok, so--at the most, a bank has to keep 10% of the money on deposit in reserve. Reserves include money kept in their vault and money on deposit with a central bank--the Federal Reserve. Let's see what this means in practice.
Let's pretend I make a deposit of $100 to my checking account at 1st Bank. According to the rules, the bank must keep 10% of my money in reserve. The rest it can lend out to other customers. So, to make this easier, let's assume my bank keeps a crisp $10 bill of my money in their vault. The other $90, they loan to customer A. Customer A uses that money to buy something from Merchant Z. Z deposits the $90 in his bank, 2nd Bank.
2nd Bank now has a deposit of $90, and it puts 10% or $9 in its vault. It then lends the remaining $81 to Customer B. B buys something at Merchant Y, and Y puts $81 in her bank account at 3rd Bank.
3rd Bank now has a deposit of $81, and puts 10% or $8.10 in its vault. It then lends the remaining $72.90 to Customer C. C buys something from Merchant X, who deposits $72.90 into his account at 4th Bank.
4thBank now has a deposit of $72.90, and puts 10% or $7.29 in its vault. It then lends the remaining $65.61 to Customer D. D buys something from Merchant W, who deposits $65.61 into her account at 5th Bank. And on down the chain.
If you carry this on down, the result is that the banks, collectively, lend almost $1000, based on my one little $100 deposit. And there is a total of $90 on reserve in all the banks combined. Not even as much as my original deposit, much less all the other deposits that have been made down the line.
The fractional reserve system means that for every dollar deposited, ten dollars are 'created' by lending. And in order for people to get paid back, the chain of 'debt' has to keep going forever. It's a Ponzi scheme, where more patsies have to play in order for the first patsies to get paid. If the system stopped, everyone on the chain has to pay their loan fully, or someone is going to come up short. And, of course we know that not all loans get paid back fully.
This is, for example, why they try to make it hard to withdraw your money from a bank in cash--they haven't got it. They have computer entries, not cash. And they have the ability to borrow money from the Federal Reserve (which also are banks, so they borrow from themselves) if their computer entries come up short.
So now it's easier to see why the bursting of the American housing bubble caused such a global crisis. Housing values going down meant that: 1) fewer people were buying houses (and borrowing to do so), which seriously slowed the deposit, lend, deposit, lend cycle that keeps the system able to pay back people's deposits; and 2) more people concluded that it wasn't worthwhile to pay the loans, and defaulted on their mortgages, which the banks knew meant that they were short to pay the deposits.
Hence the bank bailouts, in which the Federal Reserve made up some all new imaginary money to give to the banks to delay the day when it would become apparent they don't have anywhere near enough assets to actually meet their obligations.
But not for long.