Fractional Reserve Banking – Why A National Bank is needed – part 1 of 2

By Emilio Kalmera

“We can have democracy in this country, or we can have great wealth concentrated in the hands of a few, but we can’t have both.”~ Louis D. Brandeis.

Emilio Kalmera

Emilio Kalmera

170782_ennia_web-banner_sxm-talks_2500-fm_468x60px_eng

It is no secret that our present Minister of Finance supports a National Development Bank. For the record I support this endeavour as well. But there are some that don’t and I am having a debate on Facebook about this.

Some of the fundamental arguments received on Facebook are as follows: “Local commercial banks and institutions (SZV, APS) are willing to finance certain Government projects and with an approved budget by CFT, SXM is even able to borrow on the international market. So access to competitive credit is there both locally and internationally. So why spend the scarce public funds to create another Government entity that SXM in essence does not need? Why do we need a Development Bank that will take lots of tax dollars to set up and operate while SXM has local and international access to very competitive credit?” I will debate these arguments in part 2, but for now I want to build up the foundation for my arguments for a National Bank or National Credit Union.

Fractional Reserve Banking, a unique attribute of the banking business discovered many centuries ago, started with goldsmiths. Goldsmiths were not bankers, but were jewellers. The “unique attribute” discovered by the goldsmiths was that they could issue and lend paper receipts for the same gold many times over, so long as they kept enough gold in “reserve” for any depositors who might come for their money. This was the sleight of hand later dignified as “fractional reserve” banking.

Trade in seventeenth century Europe was conducted primarily with gold and silver coins. Coins were durable and had value in themselves, but they were hard to transport in bulk and could be stolen if not kept under lock and key. Many people therefore deposited their coins with the goldsmiths, who had the strongest safes in town. The goldsmiths issued convenient paper receipts that could be traded in place of the bulkier coins they represented. These receipts were also used when people who needed coins came to the goldsmiths for loans.

So imagine you sweat hard and earned 1 ounce of gold and decide to deposit it at the goldsmith and receive a receipt worth $35 for the 1 ounce of gold. Then someone comes along and wants to borrow $35 by the Goldsmith. So the Goldsmith writes out a receipt for $35 and lends it to this individual. The problem is, however, that the lent receipt has the same rights to claim the 1 ounce of gold that the original depositor deposited. In other words there was no distinction between the goldsmith’s receipts.

The mischief began when the goldsmiths noticed that only about 10 to 20 percent of their receipts came back to be redeemed in gold at any one time. They could safely “lend” the gold in their strongboxes at interest several times over, as long as they kept 10 to 20 percent of the value of their outstanding loans in gold to meet the demand. They thus created “paper money” (receipts for loans of gold) worth several times the gold they actually held. They typically issued notes and made loans in amounts that were four to five times their actual supply of gold. At an interest rate of 20 percent, the same gold lent five times over produced a 100 percent return every year – this on gold the goldsmiths did not actually own and could not legally lend at all!

If they were careful not to overextend this “credit,” the goldsmiths could thus become quite wealthy without producing anything of value themselves. Since more money was owed back than the townspeople as a whole possessed, the wealth of the town and eventually of the country was siphoned into the vaults of these goldsmiths-turned-bankers, while the people fell progressively into their debt.

If a landlord had rented the same house to five people at one time and pocketed the money, he would quickly have been jailed for fraud. But the goldsmiths had devised a system in which they traded, not things of value, but paper receipts for them. The system was called “fractional reserve” banking because the gold held in reserve was a mere fraction of the banknotes it supported. ~ Adapted from Brown, Ellen (2011-06-21),Web of Debt: The Shocking Truth About Our Money System and How We Can Break Free (p. 27-28). Third Millennium Press, Kindle Edition.

If you did not get above don’t feel bad. As one of the greatest economist once stated: “The process by which banks create money is so simple that the mind is repelled.” ~ John Kenneth Galbraith.

I will try to break down above mentioned to you in more layman terms. Someone comes to a goldsmith, Party A, with jewellery worth a $100 dollars and deposit it for safekeeping and receives a goldsmith’s receipt (could also view it in light of a pawn shop receipt) showing that he deposited this jewellery. This $100 worth of jewellery will be used as the bases to create new receipts. So let us say party B comes in and wants to borrow $80 by the goldsmith. The goldsmith makes up a receipt of $80 to party B as a loan. So no cash was issued to party B.

The receipts circulate as good as money would. Let us say for some reason that party A and party B did not spend their receipts and decide to redeem their receipts for the jewellery. Party A would be entitled to receive the $100 worth of jewellery he deposited and party B would be entitled to receive $80 worth of jewellery less interest charges of say $5 thus net $75. So the goldsmith owes party A and B $175 worth of jewellery whereas only $100 worth of jewellery is in the vault.

In the case of commercial banks today, those receipts that I mentioned above are actually depositors’ accounts. So when commercial banks create a loan, they debit their books with a loan asset and credit a depositor’s account if the person is an existing client or create a new account where the credit will be written to (computer account entry of debit and credit) if the person is a new client. The loan proceeds at the time of the computer transaction do not come from the vault as no cash is given out to you upon executing the computer loan creation transaction.

Only an accounting entry of debiting the bank’s loan asset account and crediting your bank account for the same amount is done in a computer. In the case of a non-commercial bank (e.g. Pay-Day loans, Island Finance, etc.), however, the loan proceeds do come from the cash reserves from as you either get cash once the loan is approved or a check to cash the money later. So commercial banks are hybrids as they have two roles: they act both as “depositories” and as “banks of issue.” And as banks of issue they create new money as loans, out of thin air using computers, which is backed by existing customer deposits.

Ironically, interest is charged on this new money created out of thin air without having to exert any work for its creation, which makes such institutions more powerful than God who at least worked to create something (the earth) out of nothing.

Stay tuned for part 2.

Source: 721 news Fractional Reserve Banking – Why A National Bank is needed – part 1 of 2

1 COMMENT

  1. Good article. It would also be good to know for full disclosure purposes that the writer of the article is at present working for the Ministry of Finance, a Ministry under the authority of Minister Gibson who is a staunch supporter of a National Development Bank.

LEAVE A REPLY