Episode 14: Unexpected Insights On Fractional Reserve Banking


Our previous episode on “money printing” veered into fractional reserve banking at a few points, so this week John Flaherty and Monetary Metals CEO Keith Weiner dive into that topic.

In this episode, you’ll discover:
    • 4 traits that determine legitimate credit, versus counterfeit credit
    • What many alarmists incorrectly presume about this system
    • The concept of ‘ceiling’ vs an absolute multiplier
    • How nearly everyone today suffers confusion between money and credit
    • A similar multiplying effect that occurred in gold…without any banks at all



Episode Transcript

John Flaherty: Hello again and welcome to the Gold Exchange podcast. I’m John Flaherty and I’m here with Keith Weiner, founder and CEO of Monetary Metals. Last episode we talked about the concept of money printing and we established that the Fed is not actually printing, but borrowing. Who are they borrowing from, you ask?

Well, pull out your wallet and look at the green piece of paper that you see there. It says Federal Reserve Note. Congratulations, it’s you! Anyone who holds dollars effectively is a creditor to the Fed. Keith, you’ve written a lot about this. You call the Fed notes counterfeit credit. Why is it counterfeit?


Keith Weiner: That’s a good question. And it’s one of those things people don’t think about that much. I would say there are four criteria for what makes legitimate credit, proper credit. Two of them have to do with the lender, and two of them instead of the borrower. On the lender side, number one, it should go without saying, but it isn’t being said anymore…the lender should be aware that he is lending. And he should realize there’s a credit operation.

And to your point about, you know, you don’t know who the borrower is, it’s you…people aren’t even really aware. They think that the dollar is money. When you hold a money balance, you’re not actually a lender, versus holding a bond. But if you think of the Federal Reserve note as kind of a bond of zero-day maturity and zero interest, then you realize, yeah, you’re actually lending. You’re lending to the Fed so that they can on-lend to the government and to the major banks.

So, number one is the lender knows that he’s lending.  Number two, the lender agrees. The lender approves of it.

We don’t know whether lenders approve or don’t approve. The right to approve or disapprove was taken away from them in 1933. So if you don’t approve of lending, and you want to withdraw your money, there is no withdrawal. There is no money in the monetary system today. The Federal Reserve note is irredeemable. That means you’re a creditor and you will like it.

It’s like in the Soviet Union, you know, infamously, they have elections there. People are sometimes surprised to hear that. They went to vote. And there was there was one name that you could vote for you. You could vote for Stalin. And so Stalin had, you know, was reelected with over 99.9% popular majority. Now, was he really that popular? There’s no way to know. There was no other box to check. And even if there were, everybody wouldn’t be that stupid because that was a place where they cheered you for looking wrong, let alone voting wrong.

So the lender has to know. The lender has to approve. And both of those criteria are not true today. And then there are two on the borrower side. And on the borrow side, the borrower has to have the intention to repay. And if you look at debates….the borrower obviously being, you know, the 800 pound gorilla borrower in the room, being the US government…the government can’t even stop increasing its debt, let alone make any credible show, any credible pretense even, of intending to repay.

And then finally, the borrower has to have the means to repay. What that means is you have an income that matches against the amortization schedule of the debt and certainly in commercial debt that means you’re borrowing to finance a productive asset. If you borrow to buy a house and the house rents for a thousand dollars a month and your mortgage is eight hundred dollars a month, you have a thousand dollars a month income against eight hundred dollars a month’s expense. And so you have the means to repay.

But if you borrow in order to go on a gambling binge to Las Vegas, then the asset is gone. There is no assets anymore and there is no income that was created. You just simply have a liability. You don’t have the means to repay it. Now, you may have some spare income out of your salary that’s going to go towards that to many years to be repaying it. Pretty unpleasant. And most people don’t have that discipline. Certainly the government doesn’t.

So those are the four criteria: the lender is knowing and willing, the borrower has means and intent. And in the case of the government borrowing, whether it’s directly from the Fed or directly from buyers of its bonds, all four of those – through the Fed, anyway – all four of those criteria fail. And so I call if counterfeit credit.


John: We talked about this counterfeit credit and why we’re all forced to use it a little bit in the in the last episode. You want to just reiterate that?


Keith: Well, they passed a legal tender law that says any creditor is obliged to accept tender, which is payment of the debt, in Federal Reserve credits. And it’s not that it’s, you know, I mean, two parties can agree on whatever they want. But, you know, normally if you owe money and the creditor takes your court, the court’s going to say, well, the debtor tendered this in payment and you’re not going to get anything else, take it or leave it.


John: Right. So we literally have no choice in the matter. Even if we understand, like you said, this is rigged. The creditor is unwilling to extend the credit, and the borrower neither has the means nor intent to repay. Because of government fiat were forced into the system.


Keith: Just to underscore that you have the right to buy gold today. And a lot of people do, obviously. But with gold comes the price risk. So, to get out of the frying pan, you get into the fire in a way. And for people who cannot take the price risk, then they’re trapped in the dollar. Most people don’t want to take price risk.

They don’t understand the forces that drive the price of gold up or down. And so they’d rather just not take that risk. So by divorcing the dollar from gold, it makes gold significantly less attractive.


John: But what’s hidden perhaps is the risk that they’re taking in holding dollars. As opposed to the risk, the price risk of gold. And that’s hard to weigh.


Keith: Of course.


John: So, again, we talked a little bit last time about how the Fed borrows money. You know, the printing narrative. I want to get to kind of part two of this money printing story, which is fractional reserve banking that occurs at the commercial bank level.

So in the movie, It’s a Wonderful Life. We see the run on George Bailey’s bank.

He has a crowd of customers in there demanding their deposits back. And of course, George is there saying “Now, wait a minute, Bob, your money’s in Bill’s house. And Bill, your money is in Larry’s house…” and trying to convince them that they just need to hold out for the banks to reopen. That Old Man Potter down the street is offering 50 cents on the dollar for George’s shares…anyway, it’s a it’s a well-known scene.

As I understand it, these bank runs were used in part to justify the creation of the Federal Reserve in 1913, which enabled banks a more elastic capital supply via the Fed, the Federal Reserve System, and thus prevent these situations. And so when I go to Investopedia…I’ve referred to this source a few times on our show because it generally is the first source that pops up on Google when you search for any major financial topic.

Here’s what it says under the fractional reserve multiplier effect: Fractional reserve refers to fraction of deposits held in reserve. For example, if a bank has five hundred million in assets, it must hold 50 million, or 10 percent, in reserve. Now, I want to note real quick, as of March of last year, these requirements were slashed to zero. So as I understand it, correct me if I’m wrong, there is no current reserve requirement on commercial banks.


Keith: So, yeah, so the money supply goes to infinity. Just kidding.


John: So part two of this multiplier effect description: analysts reference an equation referred to as the multiplier equation when estimating the impact of the reserve requirement on the on the economy as a whole. The equation provides an estimate for the amount of money created with the fractional reserve system and is calculated by multiplying the initial deposit by one, divided by the reserve requirement. Using the example above, the calculation of five hundred million multiplied by one, divided by 10 percent, or five billion.

So essentially, if I understand it right, five hundred million in deposits leads to five billion dollars potentially as a ceiling in circulated currency via the lending practices of these banks. So with this description, I think we see a lot of infomercials sort of demonstrating this exponential growth of the money supply and ultimately contributing to an inflationary environment and ultimately ending in a hyper-inflation. So, Keith, help break this down for us.

Are these just like we sort of debunked that the Fed was not actually printing, but borrowing? What is going on here at the commercial bank level in terms of these fractional reserves?


Keith: So many, so many things to unpack there. I’m going to try to do my best on a brief comment.

The first is that you said…you had an interesting way of framing it. You said that’s a ceiling on the amount of money that can be created. Typically, it’s taken as that’s the amount of money that’s created. So if you have a 10 percent reserve requirement, the system will multiply the base money times 10 or you have a five percent reserve requirement, the system will multiply base money by 20.

And that’s obviously false, because now that we have a reserve requirement of zero, we don’t have infinity as a money supply. And so ceiling is probably a better concept versus just absolute multiplier.

Now, as soon as you say ceiling, doesn’t that raise a question that’s now hanging…I think of it as questions that are hanging in the air, screaming out, demanding to be answered.

OK, if it’s a ceiling, then is there any other force, is there any other rule, is there any other constraint that limits the creation of this so-called money, below whatever the reserve requirement would be? And the obvious answer is yes, which is, there is something today that is holding the money supply to be less than infinity. Right. And what is it? And so what these alarmists do and the reason why they lose all credibility with mainstream, that is with anybody who’s really studied banking and the Federal Reserve, look down upon the gold bugs that come across with this alarmism, is that they’re taking for granted something you cannot take for granted.

And that is there is a whole process involving countless different people that all have to play along in order to get that maximum expansion. Right. So, I deposit one hundred dollars in the bank. OK, fine. The bank doesn’t lend a thousand, the bank lends 90, under 10 percent reserve requirement.

Now, what everybody is taking for granted is that, well, I deposit a hundred, the bank lends 90. The borrower, let’s say you’re the borrower, you borrow 90 dollars to do what? To buy something. The seller of whatever it is you bought could choose to deposit it back in the bank and then the bank would then have the right to lend 81 out of that 90. And then that borrower spends it, and that merchant or whoever deposits it and then the bank lends 72. And so if you add up the series, you know, 90 plus 81 plus 72…you end up with a thousand.

And that’s that money multiplier equation that you’re talking about. But that presumes that every step along the way, every bank that’s got the deposit and every borrower that wants to borrow and every recipient of that borrowed spending, deposits it. There’s three parties involved in every step of that iteration. And that iteration has to be iterated countless times. And if any of those parties choose not to do that for whatever reason, then the chain ends.

And that’s why, number one, you can’t just – I call it teleporting – you can’t just go from “Oh, well, that would allow the bank to lend 10 times. Therefore, if I deposit one hundred dollars, the bank is lending a thousand.” That’s an invalid way to frame it because it just takes for granted all these decisions of all these economic actors. So that’s the first issue. Let’s look at now, a very primitive gold standard system where there’s literally no banks.

Say the economy hasn’t evolved yet to the point of having banks. So lending is completely private. Now, the bank is the market maker in lending. The bank is the one who makes it efficient that everybody with any bit of savings, no matter how small and matter how unsophisticated they are, can deposit at the bank. And every entrepreneur who qualifies can get it. So the bank, narrows the spread between lender and borrower. And if there are no banks, then the spread is going to be wide.

Most people will not be lenders. Most people will be hoarding their gold, which historically is exactly what happened. But sophisticated parties who happen to know entrepreneurs may end up lending. Notice that the same multiplier occurs even without banks at all.

Suppose I have 100 gold coins and I’m not depositing them in the bank now, I’m just simply lending them to some young entrepreneur who spends those hundred coins to hire carpenters to build a workshop for himself. And then he buys some equipment and tools and he hires some people and he buys some more materials. He spends the 100 coins and those coins disperse out into the population, obviously.

But let’s say some of those folks, let’s say the contractor who builds the workshop building gets the lion’s share of those coins. That workshop builder could then choose to lend some of those coins as well. And so you can still get a credit expansion of more total ounces of gold and credit than there is total quantity of gold coins in circulation.

Because, I lend the gold coins to somebody who spends it, a recipient of that spending lends it again. The recipient of THAT spending lends it again. And so you can end up with…obviously it’ll be lower. It’s much less efficient. There’s so much friction in the system, it’s not going to go to anywhere near its theoretical maximum capability. You’ll still get an expansion. And so this this really brings home the point that today almost everybody suffers from a confusion between money and credit.

So in the gold coin example, without banks, it’s pretty clear what the difference is between a gold coin and a piece of paper signed by John Flaherty that says, I promise to pay you a gold coin. The difference between those two is stark. It’s night and day. So what you can expand is, of course, not a quantity of money – a quantity of gold coins is not expanding as a result of this process. The only way for that to expand is gold mining.

But what can expand is gold redeemable credit. There’s no particular limit to the ratio of gold credit divided by gold coins. Today, that distinction is all but obliterated. First of all, by our rotten education system, but by the fact that there is no money in the monetary system and everyone is struggling to try to figure out what’s the definition of money and what’s the definition of the money supply. And there are ongoing arguments for decades about what’s the right definition of the money supply is. Is it M zero? Is it M1? Is it money of zero maturity, MZM? Is it Austrian money supply, AMS? Is it true money supply, TMS?

All of these debates underscore that nobody can really define what money is. And the reason is that they’re struggling to draw a line based on not on a difference in kind, but a difference in degree. What’s the difference between the dollar bill and the 30 year Treasury bond, its duration and interest rate?

Fundamentally, they’re the same animal. It’s just one’s a bigger, older animal than the other. And if you’re trying to draw the line between animal and vegetable, and there are no vegetables in the universe, it’s pretty hard to draw that line.

And so anyways, that confusion added on top of the idea of money printing and then, of course, the other one being inflation. So it’s taken practically as an article of faith that if you increase the quantity of what is called money, which I’ve now just argued is credit, then that means that consumer prices will inevitably follow by some proportion. And so they feel that all this lending dilutes the purchasing power of the currency. And so you’ve got a lot of people that are pretty angry about the whole process.


John: So, let me just restate to make sure I understand. In a gold standard, you would still get this expansion of credit commensurate with the demand for that credit. The the main difference, though, is that at the end of the day, there is something real, i.e. money, that stands ready to extinguish that credit when it is satisfied. Do I have that right?


Keith: That’s right. I mean, if there’s no demand for credit, it’s not going to expand…also supply. So in lending, there is a distinct asymmetry between the guy who has the gold coin and the guy who wants a gold coin. The guy who has the gold coin is in charge of the negotiations, because he has many alternatives. The guy who needs the gold coin does not. So both parties have to have to agree to it or have to be willing to do it.

And you’re right. When you have a debt and then you pay the gold coin, the debt is extinguished. A whole other topic for another day. In the dollar system if you owe a dollar and you pay a dollar, the debt is not extinguished, it’s merely shifted to another balance sheet.


John: Right. So you had brought up the inflation topic. Again, that might be another topic for another day, but in brief, what then does cause inflation in a fiat money system, if it’s not the expansion of the credit supply?


Keith: In very brief- rising interest rates and increases in mandatory useless ingredients. So everybody understands that it costs money to add ethanol to gasoline. And when they first do that and then everyone sees that that adds 20 cents or twenty five cents a gallon or whatever that is, everyone is screaming mad at the environmental regulators for that, as they should be. But then six months later, that’s all forgotten. And people look at the consumer price index and they say “The cost of fuel has gone up. It’s inflation. It’s the Fed. It’s the quantity of money.”

And meanwhile, it’s mandatory useless ingredients, which are things that the consumer doesn’t value and may not even know is even…I mean, ethanol, everyone knows is in the gas or MBTE.

Most cases with useless ingredients, but consumers don’t even know what’s in there and they don’t care. And they assume that the price rise due to the mandate of the useless ingredient is a monetary inflation, because Milton Friedman famously said, “Inflation is everywhere and always a monetary phenomenon.” And so based on that axiom, then every time the regulators come along and mandate something new and that drives prices up, well, that’s “inflation”.


John: Gotcha. So does it have anything to do at all with velocity? That’s another one that you hear quite a bit in the mainstream. You know, “The supply of the money is only half the equation. The velocity is sort of the other half.”


Keith: I’m laughing because I was a science major originally in school and can distinctly recall, particularly chemistry lab, sometimes in physics lab, you knew what you added, you know, this many grams of this to this many grams of that. And you put it under heat, in solution. And you knew how many grams of whatever, aspirin or whatever it was you’re synthesizing. That you’re supposed to get, you know, usually especially with with undergraduates in a relatively primitive lab, the amount of output you got was way off from what you calculated was supposed to be.

And so we always used to joke about the fudge factor, and that is, this tour de force that caused the result to be wrong. And that’s why, you know, the answer is supposed to be one, but it came out 17.3. And velocity kind of strikes me as that. Everyone assumes that, well, if you double the money supply to double the price level generally, yes there are leads and legs and yes, there’s maybe proportionality, it hits this part of the economy first before going to that part later or whatever. But there should be this doubling.

And then when it doesn’t happen, everyone says, “Well, you see, what had happened was…velocity went down.” Well, yeah, that’s the first factor that makes your equation work. No different than the chemistry lab, and it’s supposed to be this many miles of this and this many moles of that equals this and then when it  doesn’t work, then you have to put a fudge factor in your math. Well plus, you know, whatever, 16.3 in my example. And then that’s what makes it work.

And the same thing with velocity. It’s not an actual real thing. It’s just a term to make the equation balance.


John: Got it. Well, we’ll promise our listeners here and now to dive deeper into this inflation mystery. And like you said, why it hasn’t materialized when all the predictions have promised it would. That’s all the time we have today. Keith, thanks again for your insights. Thank you for joining us on The Gold Exchange.

2 replies
  1. Old Brit says:

    Credit expansion with and without banks is not the same. One feature of a genuine loan that Keith didn`t mention is that the lender has to do without the money so that the borrower may have the use of it. With Keith`s gold coinage example, the money-supply does not increase, because the gold can only be in one place at one time. With a bank loan, the bank does without nothing, since the loan is a book-keeping entry that creates a deposit in the borrower`s account, and in the bank ledger is recorded as a liability and an asset. When the borrower spends his loan, it takes its value from the community`s money, like counterfeiting does. The difference is that the bank gains interest on the loan until it is repaid and the money goes out of existence again. Thus banks control the money-supply according to their own business model, which is not the same as the community requires. For an honest money system, the purchasing power of the currency needs to be maintained constant, and new money should not be created as interest-bearing.

  2. cowboyup1234 says:

    He’s probably right that velocity is a fudge factor to make the equation work. But practically or in reality velocity seems real. Jim rickards gives an example of velocity when talking about it. Like Jim would normally go out and eat once a week. He’d go to a restaurant, take a cab and maybe the cab driver would fill up with gas. He spent money for food, a cab and the cab driver took his money and spent it for gas. Maybe velocity is sometimes used as the multiplier effect.

    If Jim during the lockdown couldnt go out or the restaurant was closed because Uncle Sam knows best and the prophet faucci will save us then Jim would have stayed home and cooked. If that’s the case he didn’t spend any money. In Weimar Germany when people got paid in fiat money and they rushed to buy things cause prices go up everyday well that seems like velocity does have an effect or does exist in some form as a real idea to describe things. Obviously if a dozen eggs go up every single day and their wages didn’t go up as much and people are not holding on to their pay checks but spending it all the day they get paid ya gotta think there’s some validity to the idea of velocity cause there’s enough examples. Or they say velocity goes down when debt to gdp is so high. It makes sense bank reserves don’t matter if all that currency creation is stuck between a players and is hardly used. Ya got that example of bank reserves trapped or having low velocity and then ya got Weimar Germany and everyone spending their paychecks. Maybe you could do an episode explaining why velocity is a fudge factor or is fake when you can see there’s different rates of people spending their fiat currency. Like lacy hunt points out. The federal reserve notes or bank reserves are trapped. But if MMT or CBDC makes it so everyone banks At the fed then fed notes or the currency the fed makes out of thin air will be legal tender.

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