Index

Chapter XI
The Fractional Reserve Banking System

What is the fractional reserve banking system? Banks are private institutions or corporations established for [p. 102] the purpose of rendering services to the public with the hope of making a profit for the owners (stockholders) of the bank. A commercial bank is a bank that accepts checking accounts. Checking accounts are also called demand deposit accounts. Many people believe that when a commercial bank makes a loan it lends its cash. A commercial bank may lend cash but in practice it seldom does. If a prospective borrower wishes to borrow cash in any quantity, he is apt to be asked to open a checking account and then the banker will enter his loan as a demand deposit in his checking account. Nearly all commercial bank loans are made in that manner. Cash is seldom given to the borrower.

People may believe that the loan is made as a demand deposit for the convenience of the borrower and it is true, of course, that a checking account is convenient for the borrower but with our present shortage of currency (cash), the banks do not have enough currency to make all their loans in currency. There is not enough currency in existence. The main reason for the checking account loan system, however, is that it is the most profitable way for a bank to make loans. If enough currency existed, there would be no need for banks to make loans of bank credit.

As an example, we had on July 1, 1971, about 210 billion dollars' worth of purchasing media in circulation. Of that amount, about 6 billion was in coins and about 50 billion in Federal Reserve notes. The other 154 billion were in the form of demand deposit accounts of bank credit.

Let us give a brief description of how the fraction reserve banking system works in the making of demand deposit loans. The First City Bank has $50,000 worth of currency in its vault. Tom, a local business man, enters the bank and asks for a $10,000 loan. If the bank gave Tom the loan in currency, the bank then would have only $40,000 worth of cash left. But if, instead of giving Tom the $10,000 in cash, the bank had Tom open a checking account and then wrote in his account a bookkeeping entry (a credit) of $10,000 as a demand deposit [p. 103] loan, the bank would thus make the loan and still have the $50,000 worth of cash in the bank. In addition, the bank would now have Tom's $10,000 deposit and Tom's note for $10,000 as an extra asset.

Thus we see that when a commercial bank makes a loan as a demand deposit, it has, after the loan is made, the same amount of cash it had before it made the loan. Also, its assets increased by the amount of the loan.

One may say, yes, but when Tom writes a check to Peter for the $10,000, the bank would have to give Peter the cash when Peter comes in to cash the check. That is true only if Peter asks for the cash. But usually when Peter comes in to cash his check, he does not take out currency. He deposits the $10,000 check in his checking or savings account. The First City Bank then would debit Tom's account by $10,000 and add a $10,000 credit to Peter's account. So, the First City Bank would still have the $50,000 in currency.

Of course Peter might cash and deposit the check at the Second City Bank. In that event, the First City Bank would have to transfer the $10,000 worth of currency to the Second City Bank. But James, a new customer, may come in and deposit a different check for $10,000 made against the Second City Bank. That would bring the $10,000 worth of currency back again. So, in practice, all banks operate nearly as one bank. That is why it is possible for a bank to make loans as demand deposits and still keep its cash.

The above examples show that the checking accounts and the demand deposit loans are not just a convenience; they are needed as a substitute for currency so long as we do not have an adequate supply of currency.

When a loan is made as a demand deposit, that bookkeeping entry represents a claim for currency which is supposed to be in the bank. Usually enough currency is in the bank for each loan at the time the loan is made, but there is seldom enough cash in the bank for all the loans taken as a whole.

Demand deposit accounts are checking accounts. A [p. 104] check made out by the drawer is an order to the bank to pay currency to the payee of the check. The bank is able to pay currency for such checks only so long as a small percentage of the holders of the checks ask for currency. There is, at the present time, just not enough currency in the country to equal all demand deposit accounts.

Because of the shortage of currency, the banks have adopted the system whereby they make loans as demand deposits (bookkeeping entries) and keep a fraction of the amount of the loan in currency (cash) in the bank as a reserve. Such a banking system is called a fractional reserve banking system. This is the system used in the United States and probably in all other countries as well.

Let us give another example to show in greater detail how the fractional reserve banking system works. Let us suppose that the First City Bank opens up for-business with $50,000 worth of currency in its vault. Tom comes in and borrows $10,000. It is given to him as a demand deposit in his checking account. The bank keeps the $50,000 in currency.

Dick comes in and borrows $15,000 in the same manner as Tom did. Harry, too, comes in and borrows $25,000 in the form of a demand deposit, just as Tom and Dick did. The bank has now made loans of $50,000 but it still has the $50,000 worth of cash in its vault.

Now let us have ten other borrowers come in, one at a time, each one borrowing $10,000 in the form of demand deposits.

Another ten borrowers come in consecutively and again each borrows $10,000 in the form of demand deposits.

The bank has now made $250,000 worth of loans, but it still has only the $50,000 in cash in its vault. The $50,000 is the fraction which the bank holds in cash as the reserve for the $250,000 loans made in the form of demand deposits. When we divide the $250,000 into the $50,000 it equals 20%. So this bank would say that it held 20% cash reserves for its demand deposit accounts. [p. 105] The legal requirements for demand deposits are from 7% to 22%; for time and savings deposits, from 3% to 10%.

If this bank wishes to keep a 20% reserve for its demand deposit accounts, it cannot make any more loans until someone makes a payment or a deposit. But soon a lady enters the bank and deposits $1,000 in a savings account. If the bank's policy requires a 10% reserve for that $1,000 savings account, the bank will set aside $100 of that $1,000 for that reserve. The bank now has $900 which it can use as a 20% reserve for additional demand deposit loans. With that $900 as a 20% reserve, it can make an additional demand deposit loan of $4,500. (20% of $4,500 = $900) That in essence is how the fractional reserve banking system works.

Bank Credit

When a bank makes a loan or an investment in the form of a demand deposit, it is considered to be extending bank credit. A student was once asked, "What is bank credit?" He answered, "Bank credit is nothing." Who could say that he was wrong!

To define bank credit we might say that it is a loan or an investment (a bank makes an investment when it purchases a bond) made by a commercial bank, not by giving out any of its cash, but by making a bookkeeping entry as a credit in the payee's demand deposit account.

Bank credit in this form could not exist if the fractional reserve banking system did not exist. Bank credit is a verbal promise by the banker that he will payout currency on demand. A bank does not and cannot pay out bank credit. A verbal promise cannot be paid out. It is not something to be put in a purse. But a verbal promise can be transferred from one person to another person. That is how bank credit is used as a medium of exchange.

The bookkeeping entries in the demand deposit accounts are the evidence of those verbal promises and they are the evidence of the transfer of those verbal promises. [p. 106]

The bank may and sometimes does pay out currency to fulfill its promises, but in most cases, when a bank is ordered to pay currency to a payee by means of a check, it simply transfers its verbal promise to pay currency to the payee by bookkeeping entries, that is, by debiting the account of the writer of the check and by crediting the account of the payee of the check. The verbal promise is thus transferred from one person to another person.

Under the fractional reserve banking system, the banks have enough currency to fulfill only a fraction of those verbal promises. If a 100% reserve banking system were established for demand deposits, the banks would have enough cash on hand to fulfill all of those verbal promises on demand.

It has been said that money (meaning the purchasing media) will not manage itself. What this really means is that given the fractional reserve banking system, the extension of bank credit (the banks' verbal promises to payout more cash than they possess) must be managed or controlled.

But who is to control the controllers, especially when their decisions to increase or decrease the money supply .are made in secret meetings? The actions of the Federal Reserve Board are not made public until weeks after they have been taken. It should be noted that whoever controls the money supply controls the prices of the goods and services exchanged with that money supply.

In other words, if people wish to be employed in the production, distribution, and exchanging of their goods and services, they will have to raise or lower their prices and wages to correspond to the increase or decrease of the money supply. If, when the money supply is increased, prices and wages are not increased, shortages of goods and services will result. If, when the money supply is decreased, prices and wages are not decreased, unemployment will result. Remember what we learned in chapter VI in the story about Peter Meyer and Count Schlick!

Of course, when every commercial bank in the country [p. 107] can make loans of bank credit simply by making bookkeeping entries in demand deposit accounts there must be some authority that decides how much bank credit should be extended. The Congress has designated the Federal Reserve Board as that authority. Whatever its merits, the Board has been unable or unwilling to prevent the banking system from extending inflationary bank credit; and it did not prevent the deflation of bank credit and the bank failures in the 1930s. The solution will come only when people learn how to operate demand deposit accounts on a 100% cash reserve basis.

Demand Deposits: Two Types

If John Smith earned $1,000 worth of currency and deposits it in his checking account, the bank will call that deposit a demand deposit. The bank received $1,000 worth of currency and is responsible for keeping it and for paying .it out when ordered to do so by means of a check. That is one type of demand deposit. As an example of the second type of demand deposit, John Smith goes to the same bank and asks for a loan of $1,000. The bank gives him the $1,000 loan by making a bookkeeping entry of $1,000 in his checking account. That bookkeeping entry is the other type of demand deposit. Both types of deposits are recorded in the same account. Note that in the second instance the bank did not receive any currency from anyone for that deposit. In fact, the currency for that demand deposit had not yet been earned by anyone. In effect, by giving his note for that demand deposit, John Smith promised to earn $1,000 worth of currency in order to pay for that demand deposit at a later date. Surely, there is a difference between these two types of deposits, but the same term demand deposit, is applied to both types.

If all deposits were made with currency, or with checks that could be cashed for currency on demand, the banks then would be operating with a 100% reserve banking system. Then there would be only one type of demand deposit. No authority, such as the Federal [p. 108] Reserve Board, would be needed to control the reserves of the banks.

When we read a bank statement published in a newspaper, we see that the demand deposit accounts are usually several times greater than the cash on hand and the cash due from banks. That tells us the amount the bank has available with which it can pay the depositors of the demand accounts.

Note that we are not including the time and savings deposits as demand deposits because they do not have to be paid on demand.

The bankers may tell us that they can sell some of their bonds to obtain more cash with which to pay their demand deposits. But they cannot sell the bonds unless someone is willing to buy them and has the cash with which to pay for them. If the cash is taken out of another bank, then that bank will have less cash with which to pay its demand depositors.

Bank Statement

The following is a copy of a bank statement given by a bank doing business on October 15, 1974:

ASSETS

Cash and due from banks	$4,583,043.05
Obligations of Federal Financing Bank	4,054,592.07
Obligations of other U.S government agencies	698,105.42
Obligations of state and political subdivisions	3,684,605.47
Federal funds sold and securities purchased	400,000.00
Other loans	16,017,841.84
Bank premises and fixtures	1,446,974.58
Other assets	320,211.57
Total Assets	$31,205,374.00

[p. 109]

LIABILITIES

Demand deposits	11,756,466.61
Time and savings deposits	14,128,543.47
Federal funds purchased and securities sold	1,206,377.36
Mortgage indebtedness	755,768.12
Other liabilities	655,401.07
Total Liabilities	$28,502,556.63

RESERVES

Reserves for bad debt losses on loans

272,724.29

CAPITAL ACCOUNTS

Equity capital	2,430,093.08
Total Liabilities, Res. & Cap. Accounts	31,205,374.00

If a bank makes a cash loan for $1,000, the bank statement will show $1,000 less cash after the loan is made than it had before the loan was made. If a bank makes a loan of $1,000 and the bank statement shows the same amount of cash as before the loan was made, the loan was made with bank credit.

Likewise, if a bank records a bookkeeping entry of a demand deposit for $1,000 and, after the bookkeeping entry was made, has no more cash than it had before, the demand deposit was just a bookkeeping entry because no cash was received. The banker pretended that he received cash.

To determine from a bank statement the amount of loans, investments, and demand deposits the bank has made with bank credit (bookkeeping entries), take the data from the bank statement and place the figures in the following categories:

1. The total amount of its loans and investments.
2. The total amount of funds the bank received from all sources. [p. 110]
3. The total amount the bank spent for its premises, fixtures, and other assets.
4. The total amount of its demand deposits.

Now subtract the amount it spent from the amount it received. The result will be the amount available for loans, investments, and to payout the demand deposit accounts.

Next, subtract from that figure the amount of demand deposits. The balance will be the amount available for loans and investments.

Now subtract that figure from the amount of loans and investments really made. The answer will be the amount of loans and investments made with bank credit (bookkeeping entries).

To prove that the answer is correct, pretend that the bank credit is cash and add it to the amount the bank received and then finish the problem. The result will show that the bank received enough cash to make all the loans and investments with cash and that it also is able to payout all demand deposits with cash.

Another way to determine from a bank statement the amount of loans, investments, and demand deposits the bank has made with bank credit is as follows:

Subtract the amount under the headings of "cash" and "due from banks" from the amount of demand deposits and multiply by two. The answer will be the amount of loans, investments, and demand deposits made with bank credit.

Because the loans and investments made with bank credit are equal to the demand deposits made with bank credit, all we have to do is to multiply the amount of demand deposits made with bank credit by two to determine the amount of loans, investments, and demand deposits made with bank credit.

In the following worksheet we take the data from the above bank statement and show the arithmetic used to determine from a bank statement the amount of loans, investments, and demand deposits made with bank credit. [p. 111]

LOANS AND INVESTMENTS MADE:

Obligations of Federal Financing Bank	$4,054,592.07
Obligations of other U.S. government agencies	698,105.42
Obligations Of state and political subdivisions	3,684,605.47
Federal funds sold and securities purchased	400,000.00
Other loans	16,017,841.84
Total amount of loans and investments made	$24,855,144.80

AMOUNT THE BANK RECEIVED FOR ITS BUSINESS:

Cash on hand and cash due from banks (from depositors)	4,583,043.05
Capital equity (from stockholders)	2,430,093.08
Reserves (from profits)	272,724.29
Time and savings (from depositors)	14,128,543.47
Federal funds purchased (from banks)	1,206,377.36
Mortgage indebtedness (from borrowings)	755,768.12
Other liabilities (value received from others)	655,401.07
Total amount received for the bank's business	$24,031,950.44

[p. 112]

AMOUNT SPENT:

Bank premises and fixtures	$1,446,974.58
Other assets	320,211.57
Total amount spent	-1,767,186.15
Net amount available for the bank's business	$22,264,764.29
TOTAL DEMAND DEPOSITS (Amount bank must pay on demand)	-11,756,466.61
Net amount available for loans and investments	-10,508,297.68
Demand deposits, loans, and investments made with bank credit	$14,346,847.12

NOTE BELOW: The simple way to obtain the same information.

Demand deposits	$11,756,466.61
Cash on hand and cash due from banks	-4,583,043.05
Amount of demand deposits made with bank credit	7,173,423.56
Multiply by 2	2
Demand deposits, loans, and investments made with bank credit	$14,346,847.12

[p. 113]

The Bank of England

The Bank of England, a privately owned bank established in 1694, was probably the first to make legal use of the fractional reserve banking system. Since that time, with the exception of a period between 1842 and the Civil War, when the state banks of Louisiana were required to operate on a 100% reserve system, all commercial banks in the United States have operated on a fractional reserve system.

The Bank of Amsterdam

The Bank of Amsterdam was established in 1609 by the officials of the City of Amsterdam in Holland. It was established as a 100% reserve banking system, meaning it was always able to pay on demand every depositor's money in gold or silver coins or bullion. It operated for nearly two centuries-181 years-without a failure. It failed in 1790 because it did not stay on the 100% reserve system. In that final year, when the bank could not pay all of its depositors, it was discovered that some years earlier the officers of the bank secretly and illegally loaned a large part of its gold and silver to a private company and to governmental bodies. After those loans were made the bank operated on a fractional reserve system. The bank officers who subsequently took control were honest, but the bank failed because it was on a fractional reserve system. It no longer had the full amount of cash to fulfill its obligations to pay on demand.

We mention the 100% reserve banking system used in Louisiana and Amsterdam in order to point out that a 100% reserve system has worked successfully in the past.

The Consequences of the Use of the Fractional Reserve Banking System

By allowing commercial banks to practice fractional reserve banking, the banks are given the right legally to [p. 114] loan out funds they do not have available for loans. No person and no other corporation are given such a right. Not even the individual owners of the bank have such a right. Yet all the bank owners collectively are given the right legally to loan out funds they do not possess.

The idea of the fractional reserve banking system began in 1694, with the establishment of the Bank of England. Before 1694, individuals would, at times, loan out money they did not own (money they were safekeeping for others), but when they were caught they were run out of town for their dishonesty.

The following are some of the consequences that result from the use of fractional reserve banking for demand deposits:

It Is Extensively Used

Probably over 90% of all buying and selling in the United States is done with demand deposits of bank credit. The demand deposits are transferred from one person to another by means of written orders (checks) to the bank.

It Is Expensive

The fractional reserve banking system provides a convenient, but expensive, means to make up for the shortage of bona fide currency. It provides a legal opportunity for the commercial banks to charge interest on bank credit, even on inflationary bank credit.

It Allows The Federal Reserve System To Inflate And Deflate The Money Supply.

The individual banker has no way of knowing for certain whether the granting or the refusal to grant a particular loan or the making of a particular investment will cause an increase or decrease of the money supply. The result is that the local bankers and the general [p. 115] public must guess and gamble regarding future economic conditions. Only those who control the fractional reserves for the banking system know what the economic future will be because by controlling the banks' reserves, they control the money supply and create the future economic conditions. Thus, they have a great advantage over all other people. The members of the Federal Open Market Committee of the Federal Reserve System are the ones who exercise the greatest control over the reserves for the banking system.

It Provides The Means For Monetizing Debts

The use of the fractional reserve banking system as a means of creating bank credit "money" requires that the people and/or governmental bodies remain in perpetual and increasing debt. If they do not incur and maintain debts, they have no bank credit "money." If they pay off the debts, they again have no bank credit "money." If they do not pay off the debts, they lose the property they pledged as collateral for the loans. Under the fractional reserve banking system for demand deposits, people are forced into a perpetual round of going in debt, paying off the debt, renewing the debt, and paying interest on the bank credit "money" created by monetizing debts.

We must keep in mind that the "money" made out of debts is not real earned currency. It is not the evidence of a claim for goods or services. It is not a tax credit certificate. It is a substitute for bona fide currency; it is created out of nothing by the making of bookkeeping entries.

It Is A Cause of Bank Failures

Banks operating on a fractional reserve system for demand deposits will always fail when too many depositors try to convert their deposits into currency within a short period of time. When too many depositors [p. 116] are in a rush, when they run to the bank to change their deposits into currency, their action is called a “run on the bank."

Banks operating on a 100% reserve system may fail for other reasons, such as poor management, theft, and embezzlement by officers or employees. That is what happened to the Bank of Amsterdam, but those failures do not take place because of any weakness in the 100% reserve system. The failures occur because of human weaknesses. A bank is said to fail, and it must close its doors, when it is unable to pay its depositors the amount of currency the depositors have a right to claim on demand.

Its’ Consequences Are Concealed

Problems, such as inflation of the money supply, deflation of the money supply, bank failures, general unemployment, and ever increasing interest-bearing debts by governmental bodies, corporations, and individuals are consequences of the practice of fractional reserve banking for demand deposits. But this is not apparent to the people.

It Is Not Necessary

Banks operating on a 100% reserve system for demand deposits can charge a fee for servicing their demand deposit accounts. They can loan out their time and savings deposits in the same manner as the savings banks and the savings and loan associations do.

How To Change the Fractional Reserve System to a 100% Reserve System for Demand Deposits

How can the fractional reserve banking system for demand deposits be changed to a 100% cash reserve system? By cash we mean currency issued by the United States government. The currency may be issued in additional [p. 117] coins in denominations of $5, $10, $20, $50, and $100 or in certificates in lieu of coins. The following is an illustration:

Note that these certificates are to be considered representations of coins and used as coins. When they are sold by the banks to the public; they will be exchanged for coins, United States notes, Federal Reserve notes or demand deposit accounts. That is why they are issued for value received. If they are used by the U.S. government as payment for goods and services they will inflate the money supply.

These certificates are documents giving written evidence that they will be received by the government as United States coins.

The certificates are not U.S. notes. They contain no promise to pay. They are not tax credit certificates. No tax should be levied to redeem them because they will [p. 118] not be used as a payment for goods and services when they are introduced into circulation. They will come into circulation by being sold or exchanged for other currency or demand deposits. They will not have to be redeemed in anything. They will stay in circulation just as our present coins stay in circulation.

Remember that all buying and selling is bartering, or exchanging one item for another. So when we buy coins, or certificates in lieu of coins, from the government through the banks with our demand deposit accounts, we are exchanging the demand deposit account for the coins or certificates.

When all demand deposits of bank credit are exchanged for coins and/or certificates in lieu of coins, enough currency will be in circulation so that the banks can have 100% reserves for all demand deposit accounts.

Because the change from fractional reserve banking to 100% reserve banking for demand deposits should take place gradually, we suggest that the government agencies which charter the banks establish a schedule of reserve increase of 20% annually. After one year, for example, demand deposit accounts could be required to have a 20% reserve; after two years, 40%; three years, 60%; four years, 80%, and after five years, 100%. In order to enable the banks to implement this program, the demand depositors must make demand deposits of currency instead of bank credit. This can be done by writing a check to the bank for the amount of the deposit and asking for coins, or certificates in lieu of coins, and then redepositing them in the demand deposit account, with the insistence that the bank keep the total amount as a 100% reserve for the account. The bank and the depositor must agree on a just fee to be paid to the bank for servicing the account.

The time and savings deposits should require the same reserves as those in mutual savings banks and in savings and loan associations, i.e., from zero to three percent. Only demand deposits need 100% reserves. The banks will make their loans and investments from time and savings deposits. [p. 119]

We suggest that no Federal Reserve notes be used for any of the banks' 100% reserves. The Federal Reserve notes are also to be exchanged for coins or certificates in lieu of coins. Thus, they will be returned to the Federal Reserve banks to redeem the government bonds that were deposited as collateral at the time the notes were issued.

Let us suppose there is about 160 billion dollars' worth of demand deposits in the banks, and that approximately 150 billion dollars of it are demand deposits of bank credit. The other 10 billion consists of deposits of existing currency. It is the 150 billion in bank credit that should be exchanged for United States currency. When that is done, enough currency will be in circulation so that banks can operate their demand deposit accounts on a 100% reserve basis. There will be no more purchasing media in circulation than before and, as an additional benefit, the government will make from the sale of the coins and the certificates in lieu of coins a profit of nearly 150 billion dollars which should be used to reduce the debt of the United States government.

Why Is the Sale of the Coins and Certificates so Profitable?

To simplify the explanation let us use the Eisenhower one-dollar coin as an example. Newspaper reports have stated that it costs the government about six cents to make each Eisenhower dollar coin. The government sells it (deposits it for credit) through the Federal Reserve banks to the local banks and then to the public for one dollar's worth of demand deposits and/or Federal Reserve notes. Thus, it makes a profit of 94 cents on each coin. The profit the government makes in the minting of coins is called seigniorage. The seigniorage for gold coins between 1794 and 1934 was very small as was the seigniorage for silver coins between 1794 and 1873. The seigniorage for our present coins varies from about 6/10 of a cent for the one-cent coin to about 94 cents for the one-dollar coin. [p. 120]

The government declares the one-dollar coin, for which it paid six cents, to be legal tender for a one-dollar payment and it receives the coin for anyone dollar payment due the government. That is why the people will pay one dollar for it.

When the government sells or deposits the one-dollar coin for a one-dollar credit in a Federal Reserve bank, it pretends that the coin is equal in exchange value to a coin with one dollar's worth of silver. If the government made a coin with one dollar's worth of silver, it would also sell it for $1 to the Federal Reserve banks. (We assume the coin is not sold for numismatic purposes.)

A coin with a legal tender value of one dollar, containing one dollar's worth of silver, would be received, not redeemed for any payment of one dollar. It would stay in circulation. It is a full-bodied coin. Full-bodied coins do not have to be redeemed in anything. They are items with exchange value in themselves, which is equal to their market value as a commodity.

When the government declares coins to be legal tender, it pretends that the coins are full-bodied coins. It sells them, or receives credit for them, at the same price that it would obtain for full-bodied coins. Because the government and the people treat them as full-bodied coins, they circulate as full-bodied coins. And as long as the government receives them at their face value for payments due it, they will keep their face value for other payments.

Now, if the government issued certificates in lieu of coins, the cost would be much less than for coins. So the profit would be over 99% of the face value of the certificates.

Summary on the Fractional Reserve Banking System

Banks render useful services. Because of the shortage of bona fide currency, however, they are forced to make loans of bank credit through the use of the unsound fractional reserve banking system. When a bank uses a system [p. 121] in which it has to promise to payout more cash than it possesses, it certainly can be called an unsound system.

Commercial banks have two types of accounts for their customers: 1. Savings and time deposit accounts. 2. Demand deposit or checking accounts.

The savings and time deposit holder should understand that his funds are to be loaned out by the bank and that he cannot demand his funds until the date agreed upon at the time he makes his deposit. He is loaning his funds to the bank. He could and probably should demand some security for his loan. No reserves in the usual sense are needed. The important thing is that the bank must have 100% of the cash on hand only at the time the bank agreed to return it to the depositor.

The demand deposit or checking account funds are placed there by depositors with the understanding that they can be withdrawn or transferred by check on demand. In order for the bank to be able to do that it cannot loan out any of those funds. Under the fractional reserve banking system, most of the funds in the demand deposit accounts are funds of bank credit loaned to the depositor by the bank. Sometimes the bank requires the depositor, the borrower, to keep a minimum compensatory deposit balance. A compensatory deposit is a specific minimum amount of funds that the bank may require a borrower to keep in his demand deposit account, even when he pays interest on that amount.

In order for the banks to be able to payout in cash, on demand, the total amount of their demand deposits, enough new currency must be added to the currency now in circulation to equal the total demand deposits in the nation. One way to do that is for the United States treasury to issue enough coins and/or certificates in lieu of coins and deposit them in the Federal Reserve banks for credit as it now deposits newly minted coins. Then the demand depositors can and should exchange their demand deposits for the newly issued currency. The banks would then be on a 100% reserve banking system for demand deposit accounts. [p. 122]

If a 100% reserve banking system for demand deposits is adopted, there would be no reason to fear a "run on the bank." There would be no need for the Federal Reserve banks to control the reserve of the local banks. There would be no need for the Federal Open Market Committee. Legal inflation of the purchasing medium would never be caused by the banking system. There would be no booms or busts caused by commercial banks.

As a result of the profit the government would make from the selling of its coins and/or certificates in lieu of coins, it could payoff about 150 billion dollars' worth of its debts without levying any taxes for that purpose. And if Federal Reserve notes were also exchanged for coins and/or certificates in lieu of coins, another 50 billion dollars' worth of the federal debt could be paid off.

It is important to remember, that after all the banks, demand deposit accounts are on a 100% reserve system, this increase in currency would not cause any increase in the total money supply. The only difference would be that the demand deposit accounts would really be exchangeable for cash. And Federal Reserve notes, which once were redeemable for lawful money, could be redeemed for lawful coins or certificates in lieu of coins.

No Reserves For Demand Deposit Accounts

When the commercial banks make loans of bank credit by operating their demand deposit accounts on a cash reserve of less than 100%, the public has no way of knowing the percent (It could be 50%, 10%, 2%, or zero percent.) of cash reserves the banks have as long as the people use checks in lieu of currency and so long as they do not demand cash from the banks.

If the loans of bank credit were made without interest charges and limited to the financing necessary to bring goods to market (and for no other purpose) and were repaid when the goods were sold and checks were used in lieu of currency to transfer that bank credit, no [p. 123] reserves would be needed, no controls by the Federal Reserve System or any other agency would be needed, and no inflation of the money supply would result. The money supply would be in balance with the amount of goods being offered for sale.

Previous page

Next Page