The Myth of “Fractionalization”

-- Or “Fun with calculators” by Tom Redfern

There is a myth circulating amongst the ranks that Commercial banks can create money through some process. Often, this process is referred to as “fractionalization”. There are may proponents of this myth, and equally as many are the variations.

We can dismiss them wholesale without investigating them in their singular characteristics simply by inspecting the natural, and in fact inevitable consequences of any bank (and therefore all banks) being allowed to create money in the process of making loans. A simple example follows.

Bank A is a lending institution and holds on behalf of some depositor 50 dollars. When Bank A lends that money to some borrower, that money will, in most cases, be deposited in some Bank B on account for the seller who is the recipient of the money. To understand the impossibility of Bank A being allowed to create money, we need merely understand the interests of Bank B in this process.

If Bank A were allowed to lend, by any mechanism, more money than it had available in its accounts at the time of the loan, that increased amount would be used to make a purchase from some seller who would then deposit that new or increased amount in his Bank B.

To be clear; if Bank A could lend 100 dollars upon that 50 dollars held in deposits, Bank B would now have claim against Bank A for 100 dollars, 50 dollars more than Bank A held on its accounts.

We could not logically argue, as some might, that bank B would allow Bank A in any way to fail to make good in its obligation to pay Bank B as this would cost Bank B a loss in potential profits, a violation of the rules of common sense. So we can be confident that money will be transferred to Bank B in due course through the normal check clearing process such that Bank A satisfies its obligation, and must therefore somehow either come up with the money on its accounts or it must create it. The question of where the opportunity to create this money might arise is a question for another day, but continuing with the current model, Bank B now becomes the holder of a deposit on account of the seller, and has those 100 dollars available to lend.

Now, we must be consistent. If Bank A was not an illegal counterfeiter of money, and created that extra money by some legal means, that is, if A were allowed to lend more money than it had available on deposit, common sense and hard logic require that Bank B could do the same. So, whatever mechanism allowed Bank A to lend 100 dollars on 50 dollars held on deposit, Bank B now uses that same mechanism to loan 200 dollars on that 100 dollar deposit to some other borrower to make a purchase. The seller now becomes a depositor in turn at his Bank C of that 200 dollars. Bank C now holds the 200 dollars on deposit and, by the same mechanism, lends 400 dollars to some borrower who, again in turn, deposits that 400 dollars in some Bank D, and so on.

In this model, each loan doubles the amount of money available in the system based on that original 50 dollars. This is not an unreasonable amount to create through “fractionalization” by some advocates, who claim as much as 10 fold increases per cycle (100 dollars loaned on every 10 dollars on deposit).

Now, it is true that banks generally will minimize the amount of time money will be held without drawing interest on it, as making interest on money is their business. So it is that we say that a bank will have applications for loans and will be ready to make a loan as soon as the money is available. I would suggest that 24 hours is a reasonable period of time for a bank to hold a deposit before the money is loaned and drawing interest. Juggle this as you might, whatever the period, every cycle increases (in this case, doubles) the supply. In this model, the equation which describes this situation would be (50 X 2^n) where n is the number of 24 hour cycles.

This is to say, based upon our initial 50 dollar deposit, and after propagating through the industry for one year (that is, 261 business days) we would have 50 time 2 to the 261^st dollars in circulation. We have a number which is approximately 1.8 with 79 zeros following behind it, a number so large, we don't have a name for it, and is more money than there would be grains of sand in our solar system if the sun and all the planets were made of pure sand. The monetary system would certainly have collapsed by the 7^th day, something detrimental to the industry as a whole.

You can juggle numbers as you please, and reduce or raise the amount held in reserves and you can save the worlds economies from destruction for only days. Do the math. It is ridiculous and impossible that a bank can be allowed to create money by any mechanism or in any ratio.

One could argue that the real mechanism in place that now limits the amount of money banks are allowed to loan (a formula based mainly on their capitalization) would serve to stop the demise and, yes, it is possible that it would slow the time of death, but not by much as it would be impossible to make a case that banks won't immediately begin increasing their capitalization out of their new found profits based on money for which they pay no interest. Ultimately, there can be no barrier to the expansion that all the newly created money will not defeat.

Simply put, if banks were allowed to create money, there could be no possible check on the ensuing inflation. Money would cease to be a useful measure of value or medium of exchange and such a process would completely collapse our monetary system, and with it, our entire economic system.

Commercial banks could never be allowed to create money for the same reason that counterfeiters cannot be allowed to crate money. Further, due to their position of trust in our communities, the penalties for a banker attempting to create money would necessarily be far more sever than any mere counterfeiter, and therefore I would suspect that bankers would be among the least likely to try. The historical evidence certainly supports this.

Central Banks create money. Given this power, they are the most corrupt institutions and corrupting force known to man. Patriots must come to understand this process and attack the real problem and not expend themselves shadow boxing non-extant targets or chasing red herrings placed before them by such crackpots as might make such claims.

As important to modern commerce as banks are, and as well regulated an industry as banking is, (regulations which, by the way, protects the industry, if not the consumer), it would be difficult to imagine a scenario whereby any bank could find even the opportunity to counterfeit, or in any other way, create money.

As the creator of money, the Central Bank of the United States (the Fed) inflates the supply over time in a controlled and linear fashion. It must maintain exclusive control over this privilege such that any banker attempting to create money would very necessarily be jailed. It could be no other way.

Please use your sense, people.