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A couple of additional points:

1) The fact that people panic at the possibility of a bank "run" suggests that, like your daughter, they understand (and have understood for over a hundred years) that not everyone's money is held continuously at the bank.

2) Presumably, the emphasis (in the pre-moral-hazard days) on conveying an image of conservative management practices in bank marketing also derives from the public's understanding of fractional reserve banking (doesn't it?).

Wow, did you shed a pride-filled tear?

Please tell us: on a scale from 1 to 10; how proud were you?!

*Sniff* -- you've restored my faith in the Miley/Jonas generation.

btw, "teachable moment" is now banished:

@Geoffrey: The central planning of language is hereby banished.

And my daughter's intuitive economics has been on display before:

I regard most of your articles deep and enlightening. In the spirit of Rizzo's appeal I believe that you took a cheap shot by illustrating how even an adolescent undertand the mechanics of fractional banking. Even if that can be extrapolated to larger audiences it does not prove that it is beneficial.
How to sell the Austrian message is the issue.

Actually Guillermo, the point was not the validity of FRB per se, but whether or not people understand the nature of the contract they are entering into. My point was that even a 14 year old understands how FRB works. That doesn't necessarily make it desirable, but it does mean that she's not being fooled somehow, which was the original context for the post. If people understand FRB, it's hard to claim it's fraudulent, whether or not it's beneficial.

Gulliermo, you are correct that this post does not establish it is beneficial. However, it is a point of controversy whether people actually know what they are getting into when they deposit their money at an FR bank. I was recently in some discussions at the Mises blog (I thought I had been banned all this time, but turns out I'm not) where people said that disclosure would result in all customers patronizing 100% reserve rather than FR banks:

Can you point to any 100% reserve advocates who claim that "the public really doesn't know how fractional reserve banks work and that current banks don't make it clear enough that one's deposit is really a loan to the bank which it, in turn, will loan out to others (most of it anyway)" or that "their money is sitting in the bank in the equivalent of a drawer with their name on it"?

I did my own tiny survey once, calling the bank call centres asking them what the depositor gets in exchange for cash deposited. The results varied very widely. One told me that all I got was a record on a computer, which is pretty accurate, i.e. implying no form of safe-custody obligation. Others will swore the bank held the money as strictly yours, and that the bank finances its lending operations with 'commercial paper' and not customer deposits.

I asked a teller a few weeks ago about it, and she said I got a receipt. What happens to the cash? I put it in my drawer. Then what happens to it? I might pay it out to someone else. This middle age female teller obviously wasn't the best person to explain it, but then again the contract is not made when you deposit the cash with the teller but when you open the account.

I have also obtained the account agreements of the major banks in NZ and looked through them to see if they detail that the balances are debts of the bank, repayable on demand. Not one made this explicit, they apparently, along with the lawyers, consider it an implied term: necessary for the contract to work and so obvious it goes without saying, and capable of uncontroversial exposition.

Where you find the explicit detailing of these things is in the financial statements: 'Deposits include substantial customer deposits which are repayable on demand. However, historical experience has shown such balances to provide
a stable source of long term funding for the Banking Group.' (ANZ National Bank, maturity analysis, note 34 of )

Also, this is where you find the unsecured nature of bank deposits: 'Deposits from customers are unsecured and rank equally with other unsecured liabilities of the Banking Group. In the unlikely event that the Bank was put into liquidation or ceased to trade, secured creditors and those creditors set out in the Seventh Schedule of the Companies Act 1993 would rank ahead of the claims of unsecured creditors.' (note 21 of

Just to turn the crank a bit, I can relate that my SEVEN year-old daughter gets the concept of fractional reserves.

Sometimes I think one-hundred-percenters have never seen the movie "It's a Wonderful Life" when they claim people expect their money to be stored in bags. Everyone else in the country has seen George Bailey's explanation of how banks work dozens of times, and know that is not the case.

Thanks Steve - for those interested here's a video of a talk on the data that we found:

If anyone sends me an email I'll happily send the lecture slides

Will publish the findings more publicly soon

I am not getting into the merits or lack thereof of fractional reserve banking. However, in another aspect of the Rizzo spirit, let me point out the following. My classical liberal and Austrian friends sometimes point out the insights their children have which are consistent with their own views. I'd like to see sometime a parent lambast his kid for believing something dumb and statist. Even one of those "Italian" he/she-is dead-to me-things would be quite interesting. I feel I must add an emoticon: :)

Don't hit me.

I'm amazed you didn't teach your daughter about FRB by the age 14. I always imagined econ teachers reading "The Road to Serfdom" to their kids as a bed time story.

Also, our current system isn't really fractional reserve; it's a bizarre hybrid. Because of the existence of the FDIC, all deposits are (practically) 100% backed by the printing power of the treasury. Imagine the mother-of-all bank runs. If literally everyone in the country removed their money, the government would simply print the difference between currency and deposits. M0 would skyrocket, but M1 and M2 would remain unchanged, and I don't think it would be all that inflationary.

Depositing money at the bank is, in a sense, depositing it at the FDIC who in turn lends it back to banks so that the banks can make loans.

James, You are right, and very few people understand that. In fact, even without FDIC, as long as the central bank can invest in bank obligations, the entire stock of deposits can run off into central bank notes without starving the banks of funds. Deposit insurance or state guarantees of bank debt only put bank deposits on par with central bank notes as far as credit risk goes.

Steve, I think my 5 year old gets it too :) see this video.

Your daughter's comments go only to the fraud issue, however, but not to economic issues. Perhaps she thinks it's okay for the banks to loan her money out since there is FDIC insurance standing behind it.


Your daughter is well ahead of me. I have an undergrad degree in economics and still (I cannot believe I am admitting this in public) did not truly understand the fractional reserve system until recently. I knew banks lent out our money, of course, but I did not realize that banks create money out of thin air.

The loan "money" that we get when we borrow is the result of a magical bookkeeping entry. I erroneously thought that banks took my $100, kept some fraction thereof to cover withdrawals, and lent out the rest at a higher interest rate than they pay me. In fact, they take that $100 and CREATE new money to the tune of roughly $800, depending on the reserve requirements.

When I first researched this, I thought some hacker had redirected me to The Onion. No such luck. It's true, though my treatment above is simplistic. The money supply (fiat money, that is) goes up when loans are made. It does not take a genius to figure out that something has gone horribly wrong with a financial system based on such smoke and mirrors, as ours is today.

Unfortunately this is much more than an academic quibble. Because our money is not real, as are gold and silver, we risk suffering at the hands of a government that prints money to solve every financial crisis. When hyperinflation results, all bets are off. We will see an economic crisis that makes the Great Depression look like a beach party.



Don't misread my post: I have no problem at all with fractional reserve banking and the fact that my daughter understands it doesn't make me proud of her because she sees through some sort of fraud, but for precisely the opposite reason: she understands it why it's good.


Banks do maturity transformation. If you borrow at 1 month and lend at 6 months, every month you need to find another lender (debt roll-off). If you borrow at 1 second and lend at 6 months, every second you need to find another lender. There is nothing created out of thin air, just that a credit with zero duration is called money, as the future becomes "present".

Of course banks do not work precisely in this way: the credit line is automatically renewed. So, it would look like being indebted at 1 month with the tacit acknowledgement that if the depositor doesn't do anything, the loan is automatically renewed.

Banks are inherently at risk of instability because of this, but there is nothing more than entrepreneurial risk in this endeavor. I think I wouldn't sleep very well if I had demand liabilities, but maybe I'm too risk averse. Ah, no, I forgot: with bailouts, deposit insurance and base money creation at demand, so I would sleep if I were a bank because of government backing. :-)

The creation of money out of thin air is a false description of the process. The bank merely creates a credit/debit position with mismatched maturities, its profits depend on the interest rate spreads (and operating costs) and risks on the event of early withdrawals in excess of normal reserve coefficients.

I am too very pessimistic about the long run, but my worries about money are just a subset about my fear of everything that stinks of politics.

Hyperinflation can be kept under control because financial crises have a countercyclical effect on prices (like in Japan) and because recessions reduce the output-inflation trade-off (like during Volcker's disinflation). A long run slump is a more likely outcome of monetary interventionism than a crack-up boom, as long as banks are used as channels of monetary transmissions and some healthy inflation-resetting recession occurs here an there. Markets' agony may last for a long time.

Note that the better argument against fractional reserve banking is that it exists because of (i) deposit insurance, and (ii) legal tender laws. Whether depositors understand that their deposit is a loan is no longer of particular relevance (the fact that they certainly thought it was a bailment during the nineteenth century (prior to the FDIC and legal tender laws) is certainly telling. At this point, however, the primary issue is that FRB increases the amount of total credit available (to a point beyond society's preference for savings versus investment), thereby lowering effective interest rates and distorting the allocation of capital. Also, to your point that the payment of interest implies a loan, that would only make sense of deposits were not available for withdrawal on demand. Ironically, the FDIC and the Fed used to prohibit the payment of interest on demand deposits. They don't any longer, as we all know.

Further to my earlier post, let me add that it was not an argument against FRB. Rather, national deposit insurance + legal tender laws turn all banks into fractional reserve banks (by rendering 100% reserve banks superfluous - since there's no point not to earn interest on your deposit if you don't bear the risk of loss, all depositors would move their money to FR banks). Thus, in the absence of deposit insurance or legal tender laws, you would expect to see 100% reserve banks AND FR banks; depositors in the latter having assumed the risk of possible loss and being compensated by interest payments accordingly and depositors in the former not bearing any risk of loss, by definition. Finally, one last refutation of the idea that the payment of interest implies a loan. This is obviously not the case, as deposits bear no risk of loss - the rate of interest being determined by bank's competition to attract more deposits, presumably based on their respective investment/lending capabilities (i.e., their ability to earn a return greater than the stipulated interest payment).


You'd have a point if it weren't the case that we have seen FRB historically in the absence of DI and legal tender laws. And in those situations, 100% reserve banks were essentially non-existent.

DI and LT laws are bad things that create lots of problems. But those problems are due to THOSE things and not FRB. There's nothing *intrinsically* problematic about FRB, even though really existing FRB systems have had problems due to various regulations they've been burdened with.

Bottom line: the historical evidence cuts strongly against your argument.

Quick response to Steve - Actually, I've analyzed the 19th century case law only to discover that there is ample evidence to support the conclusion that most people believed they were creating bailments, but that most banks were treating ordinary deposits as loans, and courts responded by establishing default rules that said "in the absence of explicit agreements to the contrary, all deposits will be deemed general deposits." General deposits are loans (as opposed to specific deposits, which are bailments). So, the fact that most banks were fractional reserve banks in the 19th century is actually not a counterpoint to the conclusion that a market place totally lacking in 100% reserve banks is anomalous in a free market. Indeed, many bankers in the 19th century were effectively committing conversion, or, for the non-lawyers, a form of fraud, when they loaned out deposits that were understood to be bailments (pursuant to which title remains with the depositor). The second point, Steve, is that during the 19th century there was no income tax (the 16th Amendment was not passed until 1895), and there were effectively no legal tender laws. To be sure, gold and silver (or gold certificates) still constituted the primary forms of currency (in addition to post Civil War green backs and state bank note issues). Thus, there was no catalyst inducing the use of central money until (i) the income tax (which has to be paid in Federal reserve notes, by law) affected a substantial portion of the population, and (ii) deposit insurance was created in 1933 by the Glass Steagall Act. So, you are correct that there were FEW 100% reserve banks in the absence of legal tender laws and deposit insurance; however, I believe your point proves too much - there was no central currency either.

Let me clarify that I wholeheartedly agree with Steve that "there is nothing 'intrinsically' wrong [with] FRB." I add only that the argument that all banks would be fractional reserve banks in a freely operating market is a non-starter given the existence of numerous "incentives" (or compulsions) in the legal environment. That is, the default legal rule should classify deposits as bailments (IMHO), not loans. Let people specify that they want their deposits to be treated as loans, and, in the process, abandon deposit insurance (which, technically is not "insurance" in a tautological sense, since the insurable event is is completely dependent on the existence of the insurance policy (in effect, 100% moral hazard)), so that such choice has meaning. But, I digress.

Stumbled across this page whilst googling.

This example concerning your daughter - in what way has she explained how Fractinal Reserve Banking actually works?

She assumes that the money she deposits is given to somebody else who wil pay it back plus interest. No where does she mention that the banking system can use her money as a means to create loans worth roughly ten times the value of her original deposit.

Ask her this question - If you put $100 into a savings account, how much money can the BANKING SYSTEM loan out from this original deposit?

I'd be interested in her answer.

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