This week, I’m planning to bore the pants off everyone with a small rant about Basel III. It’s affecting my life. It’s affecting your life. And even if I understand why people like Bernie Sanders want banks to be “better”, I doubt that we grasp the real cost of all that “better”.

But before I get there, I need to talk about fractional banking. In case you’re new to this: it’s a hot topic for the conspiracy theorists. It’s up there with “powerful families that control the Federal Reserve” and “income taxes are actually illegal” and “illuminati”.

Here is how fractional banking works:

• I deposit money at the bank.
• The bank keeps a bit of my money in reserve, and lends the rest of the money out.

The system is “fractional” because of that “bit of my money in reserve”. And the part that freaks people out is:

• The person who borrowed the money pays someone else.
• That someone else deposits that money at the bank.
• The bank keeps a bit of their money in reserve, and lends the rest out.

And so on, in ever smaller amounts. A diagram:

So if you start with $100, and there’s a reserve requirement of 10%, then hypothetically, that $100 will keep getting lent out until all of it is back at the bank as the “10% reserve”, and there will be $900 in loans floating about in the economy.

Of course, what conspiracy theorists forget is that this is not really “un-repayable”.

Why?

Because, in addition to $900 of loans, there’s that $1,000 of deposits. Which is, you know, the important part. The money is just a medium of exchange – it’s not the exchange itself.

There’s an old joke/riddle that I want to use here (taken from this site):

It’s a slow day in some little town……..
The sun is hot….the streets are deserted.
Times are tough, everybody is in debt, and everybody lives on credit.

On this particular day a rich tourist from back west is driving through town.
He stops at the motel and lays a $100 bill on the desk saying he wants to inspect the rooms upstairs in order to pick one to spend the night.
As soon as the man walks upstairs, the owner grabs the bill and runs next door to pay his debt to the butcher.
The butcher takes the $100 and runs down the street to retire his debt to the pig farmer.
The pig farmer takes the $100 and heads off to pay his bill at the feed store.

The guy at the Farmer’s Co-op takes the $100 and runs to pay his debt to the local prostitute, who has also been facing hard times and has had to offer her services on credit.
She, in a flash, rushes to the motel and pays off her room bill with the motel owner.
The motel proprietor now places the $100 back on the counter so the rich traveler will not suspect anything.

At that moment the traveler comes down the stairs, picks up the $100 bill, states that the rooms are not satisfactory, pockets the money & leaves.

NOW… no one produced anything…and no one earned anything…however the whole town is out of debt and is looking to the future with much optimism.

Is the real economy here the $100? Or is it:

• The meat that the butcher sold to the hotel owner;
• The pig that the farmer sold to the butcher;
• The pig feed that the Co-op sold to the farmer to raise his pig;
• The “services” that the prostitute offered the Co-op store manager;
• The hotel room that the hotel owner rented to the prostitute.

The truth is that the town didn’t need the $100 bill – they could all have offset their IOUs between them. But a system with money made it easier.

The other important message: money does not give rise to a system of credit. Rather, the system of credit can conceivably pre-date the rise of money. Which turns out to be closer to the historical truth.

Early barter economies apparently operated on a system of IOUs: “I’ll take these eggs, and I’ll pay you back in fish when I’ve caught it.” or whatever. That’s credit! It may not be as efficient as having a credit card, which gives one the ability to trade favours/work with almost anyone – but it’s still a line of credit.

And it’s why many of the concerns around fractional banking seem a bit silly (to me, at least). The message seems to be “if you don’t have $1,000 of hard cash in the bank to cover the $1,000 of deposits, then that’s monopoly money.”

Of course, what is actually being said is that the economy should not have $1,000 worth of goods and services being exchanged through the banking system. Instead:

• the original depositor should put his $100 in a bank, and it should stay there until he needs it; and
• the other $900 worth of goods and services should get settled in other goods and services, or those exchanges should happen a lot slower and in cash (when the depositor buys something, like if the rich tourist actually stayed the night in the hotel, and injects a little cash into the economy, and then that can circulate).

I’m not saying that fractional banking can’t give rise to bank runs, when everyone wants to hold their claim on everyone else’s goods and services in hard currency.

But I’d rather the occasional bank run than an economy where everything happens in cash (which means that a lot less happens)…

Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.