Weaknesses of Fractional Reserve Lending

There are some negative features in this system.

  1. It is not stable. The banks say your money is safe and it is your money, so is available to you, but that is not fully true. Banks lend out a sizable amount, so do not have all of your money available to you. The government does not have direct control over the money they issue, but can implement some rules to somewhat manage the money.                                  Say one of the banks makes a bad investment, or worse, some money is embezzled, so now they cannot pay out the money you ask for.  You do not have faith in the bank anymore, you read about it in the newspaper and other people start to demand their money, too. Even though the other banks are solid, people start to question those and start taking out money from there as well. That is where the FDIC comes in. It is a government agency which steps in and provides insurance to banks. The money a bank client asks for, will ultimately be provided through this insurance policy.
  2. Bad incentives. Because the bank is insured by this FDIC policy, the customer is not too concerned with how the bank invests its money, so there is no accountability necessary toward the customer, as to whether the bank is making good loans or bad loans.             Banks can issue sub-prime loans to people who cannot really afford that house. It is not just the sub-prime loans that cause financial problems, but more so the ease with which the banks “offer” all kinds of incentives so people will buy whether it is wise or not.
  3. Lending money. The banking system has a lot of control over the money. When the economy is doing well the banks will distribute more money into the lending supply. The opposite is true as well: when the economy is weak it can turn into a recession. Businesses will ask for less money in the form of loans, etc. But in a recession the economy really needs more money so people will buy more again. The Federal government will print more money. However, that is only half of the equation, when in fact, the banks provide less lending, being scared because of the recession. In reality, when you want to get more money into circulation the opposite is happening. When there is a boom and you want to slow down the economy, the opposite is also happening. Because of the boom, more money is entering the market place. To temper an overheated economy, the government can sell more securities and take the money it receives for them, out of circulation.

This is not some law of economics. It is a system, but not the only system, although the most common in many countries.

Sal really explains this very well with a diagram in The Monetary System class of the Khan Academy:


My challenge to you:    Take time to study this diagram, and see if you can explain it to a friend!

Fractional Reserve Banking

How does our banking system work, and why bring that up? The most common banking system used by most countries is the Fractional Reserve System. This is explained very well in the Khan Academy class of the monetary system. It is not a perfect system but needs to be explained for understanding because national debt is related to it. Here is a diagram again from the Khan Academy:


How does the money, that the Central Bank prints, get circulated? For simplicity, say the Central Bank prints three dollars, or three units, if you will. We have a system whereby the government sells securities, often in the form of bonds. Whoever has those securities can sell them and deposit that money in a bank. The money can also physically or electronically be transferred to a bank. Say, someone owns securities (the 3 yellow rectangles on the borrow left), sells those and deposits the money in a bank, or the bank obtains dollars from the Central Bank. I will skip the details of that process for now. The bank, let’s say receives $3 (the green rectangles in the diagram) from someone who sells securities. So now the individual can access his / her money from the bank (the “bank” with the 3 dollar bills). But the bank does not keep all $3, because it assumes the individual will not access all $3 at once, so it reinvests most of that money, even though it will tell the depositor that his money is safe and will be accessible. In reality a bank only has to keep about 10% available to its customers. This % fluctuates.

Whoever buys those securities may not use all of it, or buy a car and the dealership deposits that money in a bank. This is shown as the second “bank” with two dollar bills. That bank reinvests, say, $1 and the same thing happens all over again. So, the three dollars, or units, printed by the Central Bank now have multiplied to six dollars (fractional).

The bank issues checks. Say I want to buy an apple which costs $1. I can write a check for $1 (Yellow rectangle left of the apple) and give that to the vendor, who in turn deposits that back in the bank into his account. Only a paper transaction has taken place: my account has been reduced by $1 and the apple vendor’s account, increased by $1. So the original $1 printed by the Central Bank does not even come into play!

The point of this exercise, is to show that the government has limited control over the money it prints. To reduce the $$ in circulation, the government can sell the securities, and keep the money they receive out of circulation to reduce the money supply, thus reducing the amount of lending by the banks. The government can also buy securities and take that money and put it into circulation, so the banks can increase their lending portfolio.

There are also some drawbacks about the system, but that will be for another blog.


Emotional Economics

The business cycle can also be expressed in an emotional format. The Khan Academy came up with the diagram below:


When we believe things are looking up economically, we get a sense of optimism which gives us confidence everything will be all right. That turns into excitement when things keep going well. Gas prices drop, we hear that there is less unemployment, and other factors. That turns our excitement into thrill and that increases our confidence. We start looking what our contribution may have been to this movement, or how we can contribute. Now we can buy that dining room set we always wanted, or maybe even that car as advertised on TV! Our thrill turns into euphoria. Companies start investing capital in more tools and machines to expand production. Then we see prices rising, first because production cannot keep with demand, followed by an overheated economy. The Fed already has reduced interest rates to almost 0% and now is redirecting it upwards again to take the steam out of the economy. People are laid off here and there, causing some anxiety among the rest of us. It becomes clear that we have an overproduction and people are getting into more debt. Industry and governments are still in denial if we have to believe the fervent advertisements: “Now is the time to buy your dream house before interest rates go up again!” is the slogan. “Don’t worry if your mortgage payments are a bit high, your home value will only go up, so you’ll be ok.” But more people are losing their job and gas prices are creeping up. The population is getting  fearful. People are pulling back and delaying that couch set purchase. Production is decreasing a bit more with all the consequences that come with it. People who lost their job can barely keep up with their mortgage payments and are becoming desperate. Banks are starting to issue notices for those who are 2-3 months behind in their mortgage payments. All of a sudden housing values are not so important anymore because no one can afford to “upgrade.”  The richer among us also stop paying mortgages, because those prices “were ridiculous to begin with”. The banks don’t dare evacuate them for fear of property being destroyed or stolen so they can stay in their “castle” even if they do not pay the mortgage for 6-8 months, or longer!  Panic sets in, interest rates drop to zero % and housing prices start to drop. More foreclosures. Some capitulate, just leave their home and drop off the key at their bank. Despondency sets in and the homeless are becoming more visible. The editorial pages have more articles about depression. The Fed buys up mortgages to keep the economy going, banks get all kinds of relief. No matter that the banks contributed to this mess in the first place by offering mortgages to just anyone at the peak of the cycle, they are not held responsible; no CEO’s are fired!

Gradually we see a glimmer of hope. Companies have cut back enough to survive the recession, Wall Street is showing some growth again and international markets are following. We may not like it, but China’s economy is surging because they don’t want to lose the dollar value, since they have a lot of them. They can now invest them in California properties 🙂 Relief sets in followed by optimism, and the cycle starts all over again.



      Realtors are telling us the housing market is “booming” again. The graph on the left of new housing construction does not seem to support that. Ever since coming to the USA in 1967, realtors always say: “Now is the best time to buy!”

What emotional stage do you believe we are in, at the end of 2014?

Principle I: Teach your children the difference between (National) Debt and cultural habits.

That is easy to say, but how do we do it in a society where we are bombarded with offers to buy, and where many households are far in debt, teaching children that debt does not matter?


Before 2009 48% of households carried debt. Then it dropped and came back up again to 47%. The average debt dropped from $29,000 to $25,480 but not because people were paying off debt at a faster pace, but because banks closed out accounts. With these kind of statistics, how do we have a chance of teaching children the difference between debt and cultural habits?

By teaching our children economics, and how politics plays a role.

 Let me recap where we have been so far in the search of whether national debt is a big issue or not:

  1. Is debt a bad thing? I have given examples of debt in business, government, and individual debt.
  2. Government debt is twofold: a city can go bankrupt and so could a state, but the national government can stay afloat a bit longer by printing money.
  3. Social Security is not part of the budget, but is an entity of its own, getting financed separately. But it is an entitlement, which puts it high on the moral list in the American culture.
  4. I touched on aggregate demand, and where foreign exchange fits in.
  5. A business cycle is not very difficult to understand. It is based on how confidence in the market (Wall Street) and government fluctuates.
  6. How National Debt has  been on an astronomical increase, regardless of which political party was in office, either the Presidency and / or Congress.
  7. How culturally we have changed to the price-someone-is-willing-to-pay from cost-plus-reasonable-profits-to-stay-in- business, and regarding personal debt as being “normal” without worrying too much about the consequences.

I’ve described the business cycle, but not yet how emotions follow that.

What kind of banking system do we use? Are there more than one?

More about all that in the next weeks!


Should you help your children stay out of debt?

“In my day if we earned a quarter, we spent 15 cents and saved a dime. Your generation earns a quarter, spends the quarter and then borrows another quarter at 25% interest!”

I really identified with that saying by Jeanette Pavini in Market Watch. Wondering why it spoke to me so profoundly, I drilled deeper and came to the following conclusions:

  1. The thought processes are totally different between generations. When I was a kid, the concept still existed, that you can spend only what you have and no more. I would receive an allowance each week, but only after I showed the balance, and how the difference with last week was spent. It was not a matter of “checking up on me” as to how I spent my money and whether is was done wisely. My dad never evaluated the wisdom of my decisions, only the record keeping: that my physical amount of money matched my records. To give an example: A 10-year-old’s version of “living within one’s means” might include financial decisions like choosing whether to buy a new video game or saving their money so they can eat at the concession stand with their friends at the next field trip.
  2. Today’s generation is taught that you can have it all now. To sweeten the deal, the idea is that you pay-for-it-as-you-go, enjoying both your new video-game and a good time with your friends. This concept is permeated throughout our society: with lower interest rates you refinance your house, as your family grows you purchase your next bigger house, when you get a loan the payment plan conveniently shows the “minimum payment” (because the longer you draw out the payment the more interest your friendly banker makes!). Immediate gratification comes with a price, but “oh well, the house price will go up anyway, right?”

“Our financial habits rub off on our children and influence their relationship with money later in life. But what may be surprising is just how young children start to form financial habits. Adult money habits are set by the age of seven, according to a study by behavior experts at Cambridge University and published by Money Saving Advice.

Many children are growing up in debt-ridden households. As of September 2014, the average household owed $7,281 on their credit cards, according to NerdWallet.com’s analysis of Federal Reserve statistics. Looking at just indebted households, that number rises to $15,607 in average credit card debt per household. That’s a collective $880.5 billion in credit card debt that American consumers owe.” (from an article by: Jeanette Pavini’s Buyer Beware, in Market Watch).

Bob Parrish 10 days ago:

       I got my first credit card at 18, a BankAmericaCard, the precursor of Visa.  I started using it for everything…and still do a half-century later!  But I NEVER carry a balance, instead using credit cards for the float they offer, for tracking my expenses, for frequent flyer miles, for enabling car rentals and hotel stays, etc.

Credit cards aren’t the enemy.  DEBT is the enemy and credit cards that are paid in full each month don’t generate debt.


Teach your children the difference between (National) Debt and cultural habits. 

The Business Cycle

Business cycle sounds very educational or professional, but is really an everyday concept. Imagine that the population of a country increases over time, which is the case for many countries in the world, that technology makes it possible to produce widgets more efficient, and that new inventions reduce the cost of production. This happens in many western countries today and in many non-western countries as well. As a result the GDP will increase over time, but not in a straight line. There are many ups and downs and these are not the same each time. Sometimes GDP will increase for a longer period of time than other times, or the other way around.

We can graph that as follows, according to another lesson of the Kahn Academy:

business cycle

On the vertical side we have the real GDP and the horizontal line expresses time. Assume population is growing and productivity goes up because of technology, the discovery of new resources, and the development of new processes. This results in an up going slope of GDP over the long run. In the short run we see ups and downs around this graph. The ups and downs are not as evenly spread as shown in the graph, but it gives the idea. In the short run we see expansions when things are going well and recessions when not so well. During an expansion more jobs are needed, people will buy more because they feel the economy is doing well, and more will be produced to meet that demand.

There comes a time when producers find themselves stuck with a bigger inventory, or they are using their equipment to the limit and cutting corners on repairs. They hire more people than are really needed. This results in a smaller profit and manufacturers will start scaling back. Everyone is still optimistic that it is only temporary or only affects some businesses. Even economists remain optimistic. But as it continues, people get a bit nervous. The standard saying applies here: “If my neighbor loses his job it is a recession, but when I lose my job it is a big depression.” Things start to improve and gradually people become more optimistic again. Then we get to the top and a new cycle starts. Not all cycles are the same. We saw this with the 2009-2010 recession, which was at its lowest point since the Great Depression in 1933. Currently, there are more job openings, gas prices are going down, but incomes still remain level so not everyone is convinced yet that the economy is improving.

1950-2014 GDP

Here is the real graph showing how GDP has been growing since 1950, but this is a “sanitized graph” not showing the ups and downs. It is interesting to see the 2008-09 recession as just a “blip” in the overall picture. Below are the details of National Debt:

Screen Shot 2014-11-13 at 2.47.53 PM


Screen Shot 2014-11-13 at 2.48.23 PM

Note how under Clinton the National Debt only increased 3.9 %, but the trend started under the old Bush!

What makes it a bit more complicated is when the government artificially lowers the interest rate, as it is doing now.

 The basic story is that when the government artificially lowers the interest rate, it gives the appearance of the prosperity that would accompany a genuine influx of new savings, but this apparent prosperity can’t be genuine since it is fueled by nothing more than pieces of paper (fiat money) . 

Technically, it’s not correct to say that the economy can finance an increase in output of both consumption and capital goods, by ignoring depreciation . this is because the way the economy deals with depreciation is to produce more capital goods . For example, if a particular entrepreneur engages in maintenance on his factory by buying ball bearings and lubrication oil, and by slowly building up a new machine to replace his current one once it wears out, then these actions are all acts of investment in the creation of new capital goods , so really what happens during the unsustainable boom period is that entrepreneurs produce the “wrong” kinds of capital goods, and yet they erroneously think that their total output has increased .  (from: Lessons for the Young Economist, Robert P. Murphey)

Since the government is keeping interest rates artificially low it appears we are in such a situation.  How long will this last?

Aggregate Demand and Foreign Exchange

One more component for aggregate demand is foreign exchange. Let’s look at another screenshot from the lesson of the Kahn Academy:

Screen Shot 2014-11-02 at 5.08.01 PM

Look at the three bar graphs in green and purple in the top left. The middle graph reflects the amount of GDP spent in green and the purple represents investments. If price goes down (upper bar graph) there is more available for investments, assuming everything else remains equal. Thus, the interest rate can drop. When the interest rate drops it is / can be advantageous for a foreign country to invest and / or purchase from you, rather than produce it themselves.

Say the exchange rate starts out with $10,000 = ⎳5,000 (British pounds). When the exchange rate drops because Americans have more to invest, let’s say it becomes $10,000 = ⎳4,000. It will become cheaper for the British to purchase an American good. In other words, the $ becomes weaker.

Should American companies move their banking overseas when it is economically more advantageous?