French toast for breakfast! Who doesn’t love the appetizing aroma and delicious flavor? Of course we need a few ingredients before we can have our pile of steaming goodness in the shape of French toast. Bread, eggs, and milk – later on, butter and syrup – all need to be available for our ideal breakfast, and in the right quantities. When was the last time you were able to create ten slices of French toast out of one slice of bread? For that matter, when was the last time you were able to use one of anything to produce ten of the same? You may not have that kind of power but, surprisingly, there is someone just around the corner who does. When a bank accepts a deposit and then loans it out, it actually creates additional money out of nothing! This practice (which we will explain in more detail in the next paragraph) is called fractional reserve banking. But creating money with a few clicks of a mouse is a power that does not come without strings attached. It has economically undesirable consequences and even moral implications that need to be considered. Sadly, these often go completely under the radar.
What is fractional reserve banking? Before we can answer that question, we need to grasp the concept of fiduciary media – bank notes that are promises of payment upon demand. Since these notes can be redeemed at any time, they can ironically take the place of a society’s monetary commodity and be passed from hand to hand without ever being redeemed. If I have a promise for a certain amount of money whenever I want it, that promise is just as good to me as the money itself (as long as it is accepted as trustworthy, of course).
Once banks caught on to this, they realized that it was possible to issue more notes – more promises to pay – than there was money in the bank’s vault. To be sure, the process might be considered illegal, but banks were able to get around that by convincing legislatures that money deposited in a bank should no longer belong to the depositor (the only thing he has left is the bank’s promise of repayment) but become part of the bank’s assets (Ritenour 333). That means banks can use money deposited in their system as though it were lent to them (Shostak). Banks are able to issue promises of payment (often simply numbers on a screen) without any physical money actually backing their promises. As a bank issues more promises by lending your deposit to others, money is literally created out of thin air, because “the act of lending creates deposits” (McLeay, Radia, and Thomas 2). In other words, you deposit money and it is credited to your account. Then along comes the guy in the next apartment and borrows your money, and that loan is credited to his account. Then along comes the next guy, and the money credited to guy number two is loaned to him. So now three people have the same exact physical money in three different electronic accounts!
Most people are familiar with the fact that the government prints money. But money creation is much broader than that. In fact, “most of the money in circulation is created… by the commercial banks” (ibid 12). As long as the bank has enough cash on hand to pay up demand for redemption, they can issue more promises of payment without receiving more actual money into their vaults. In short “customers have more money on deposit, than the bank has cash in the vault” (Murphy 386). When Joe decides to borrow money for those three acres he has always wanted, Bright Bank does not have to hand over so much cash, but can simply type in a few numbers. Then, Joe pays the owner of the land, Sam, and as long as Sam also has an account with Bright, the bank merely has to transfer the numbers from one account to the other. Although there are limits on how much money a bank can create, fractional reserve banking is in fact just that – banking with only a fraction of the money remaining in reserve.
The immediate economic consequence of fractional reserve banking is a greater supply of money. As we have already noted, “when banks extend loans to their customers, they create money by crediting their customers’ accounts” (Mervyn 3). More money! Hurray! Isn’t that great? However, it is important to remember that just because there is more money in the world does not mean that there is more wealth in the world. You can’t eat cash for dinner, listen to music on a dollar bill, or use a buck as a golf ball. Instead, you use money to accomplish those things.
So, now that there’s more money, you can get that pro golf club you’ve always wanted! That means that the demand for professional golf clubs just went up. Predictably, the price goes up too. This applies not only to golf clubs, but to everything people are interested in buying more of, and prices of all those things will go up. Maybe you won’t be able to get that golf club after all. So are we back where we started?
As you may notice, not all these changes happen simultaneously. Ritenour points out that the inflation caused by more fiduciary media is not “dropped uniformly out of a helicopter hovering over the nation” (337). Whoever gets the money first can spend it before prices go up, and so on. As this continues and prices begin to rise, those who have not got the extra money yet (and perhaps never will) have to pay extra regardless. It’s a zero-sum game: if anyone benefits from new fiduciary media – new money-on-a-screen, someone else has to pay. In the long run, fractional reserve banking results in a redistribution of wealth and a distortion of the economy (rather than in the desired consequence of greater wealth), without the consent or perhaps even the knowledge of the majority of the participants.
Note that it is the borrowers and spenders who benefit, because they borrow the money and get it first. It’s the responsible people who spend wisely, don’t go into debt, and save some of their income, that end up on the losing side of the spectrum when fractional reserve banking is practiced. Who’s the biggest borrower and spender in the American economy? I’ll let you figure that one out.
However serious the economic consequences might be, the moral and Biblical problems connected with fractional reserve banking are even more alarming. God’s clear command, “Thou shalt not steal,” is broken in two ways (Exodus 20:15).
First of all, when bankers accept a deposit under a promise of repayment without having any way to repay fully, they have in essence stolen that money. Although a bank may be able to repay some of its customers, there is no way it can repay them all!
Secondly, the monetary inflation caused by fractional reserve banking leaves the people who receive the new money after prices have already risen with less in terms of purchasing power – less real value – than they had before. This rearrangement has been without their consent or any type of reimbursement.
But the problem is not confined to theft. As Ludwig von Mises reminds us, “It is permissible to call a policy of intentional inflation dishonest as the effects sought by its application can be attained only if the government succeeds in deceiving the greater part of the people about the consequences of its policy,” and this applies to inflation caused by banks as well (230). If everyone knew that a bank was unable to pay out all the deposits, that bank would be unlikely to last long. Plus, if everyone realized that the redistribution that comes from a fractional reserve policy penalizes investors – those who save over the long term – the system would quickly be recognized as a danger to the future of society. Fractional reserve banking will only keep from imploding if the majority of people are deceived as to the consequences (or even its existence).
The deception of fractional reserve banking goes far beyond this concealment of the truth. By issuing a promise to pay when a bank is well aware that it cannot fulfil the promise except in comparatively few cases, the bank in fact issues a lie! “Lying lips,” as King Solomon reminds us, “are an abomination to the Lord” (Proverbs 12:22a).
The system itself, and the inflation produces, are in clear contradiction to the moral law of God.
Our analysis of fractional reserve banking has helped us to see how problematic it really is. Even a simple definition raises obvious difficulties; how can an honest banker do business while keeping only a fraction of the money he should have in reserve actually in the vault? Once we delve in further and consider the economic consequences – inflation and the consequent redistribution of wealth – it becomes apparent that fractional reserve banking is in fact quite harmful. When we consider the Bible – the only legitimate moral standard – we see that the system is contrary to God’s holy law. Ultimately, it is on this that we must take our stand. Mises states, “In the economist’s eyes the main issue is not that inflation is morally reprehensible but that it cannot work except when resorted to with great restraint… for a limited period” (230). In the eyes of the Christian, however, Scripture is and ought to be the final authority. In view of the commands to “love no false oath,” and “steal no more” there can be no doubt that fractional reserve banking has no place in a society that seeks to conform itself to the only absolute standard, the law of God (Zechariah 8:17, Ephesians 4:28). How should such a society respond, through its God instituted government, to the practice of fractional reserve banking? In the epistle to the Romans we read, “…he [government] is the minister of God, a revenger to execute wrath upon him that doeth evil” (13:4). Throughout the New Testament we discover that governments are God’s agents to punish sin, more specifically sins condemned on the second table of the moral law (DeBoer, 79). As we have seen, fractional reserve banking clearly falls under this category. Government ought not only to step out of the practice itself, but also should exercise its lawful authority by punishing fractional reserve banking according to law. By avoiding debt, Christians can keep the temptation and the demand for banks to create more money down, besides fulfilling Paul’s injunction to “owe no man any thing, but to love one another” (Romans 13:8). Wise investment by Christians will contribute to the creation of true wealth in a society, and by teaching others the truth behind the fractional reserve system Christians can aid the restoration of an honest banking structure. Support for godly, upright statesmen and a government that follows the biblical patterns is also essential. Where the government fails, however, we can be sure that God will not. “A false witness shall not be unpunished, and he that speaketh lies shall not escape” (Proverbs 19:5).
If you enjoyed this article, you might also want to read:
- The Affordable Care Act, Calorie Labeling, and You
- Poverty Part I: The Modern Diagnosis
- Poverty Part II: The Biblical Diagnosis
- Suppression or Expression?
DeBoer, Louis F. Lord of the Conscience: A Defense of Religious Liberty. Saundertown, RI: The American Presbyterian Press, 2000.
Holy Bible. King James Version. Cambridge, Great Britain: Cambridge University Press, n. d.
King, Mervyn. Speech Transcript. Bank of England. 23 October 2012. December 16, 2014. <http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech613.pdf>
McLeay, Michael, Amar Radia, and Ryland Thomas. “Money Creation in the Modern Economy.” Bank of England. Quarterly Bulletin 2014 Q1. December 16, 2014.
Mises, Ludwig Von. The Theory of Money and Credit. Lexington, KY: Pacific Publishing Studios, 2010.
Murphy, Robert P. Lessons for the Young Economist. Auburn, AL: Ludwig von Mises Institute, 2010.
Ritenour, Shawn. Foundations of Economics: A Christian View. Eugene, OR: WIPF and STOCK, 2010.
Shostak, Frank. “The Money Multiplier: Myth or Reality?” Mises Institute. December 16, 2002. December 16, 2014.