The core of the problem is the conglomeration of two distinct functions of a bank.
<blockquote>- The first is the warehousing function, the most traditional function of a bank...
- The second service the bank provides is a loan service...
- The institution of fractional reserves mixes these two functions...</blockquote>
From the depositor point of view, this system has created certain illusions... <blockquote>"If we look back at banking history, we can see the drive for the centralization of power dates back centuries. Whenever instability turns up, so do efforts to socialize the losses. Rarely do people ask what the fundamental source of instability really is. For an answer we can turn to
a monumental study published in 2006 by Spanish economist
Jesús Huerta de Soto. He places the blame on the very institution of fractional-reserve banking. This is the notion that depositors' money that is currently in use as cash may also be loaned out for speculative projects and then re-deposited. The system works so long as people do not attempt to withdraw all their money at once, as permitted to them in the banking contract. Once they do attempt this, the bank faces a choice to go bankrupt or suspend payment. In the face of such a demand, they turn to other banks to provide liquidity. But when the failure becomes system-wide, they turn to government.
The core of the problem is the conglomeration of two distinct functions of a bank. The first is the warehousing function, the most traditional function of a bank. The bank keeps your money safe and provides services such as checking, ATM access, record keeping, and online payment methods. These are all part of the warehousing services of the bank, and they are services for which the consumer is traditionally asked to pay (unless costs can be recouped through some other means). The second service the bank provides is a loan service. It seeks out investments such as commercial ventures and real estate, and puts money at risk in search of a rate of return. People who want their money put into such ventures are choosing to accept the risk and hoping for a return, understanding that if the investments do not work out, they lose money in the process.
The institution of fractional reserves mixes these two functions, such that warehousing becomes a source for lending. The bank loans out money that has been warehoused — and stands ready to use in checking accounts or other forms of checkable deposits — and that newly loaned money is deposited yet again in checkable deposits. It is loaned out again and deposited, with each depositor treating the loan money as an asset on the books.
In this way, fractional reserves create new money, pyramiding it on top of a fraction of old deposits. Depending on reserve ratios and banking practices, an initial deposit of $1,000, thanks to this "money multiplier," turns into a $10,000. The Fed depends heavily on this system of fractional reserves, using the banking system as the engine through which new money is injected into the economy as a whole. It adds reserves to the balances of member banks in the hope of inspiring ever more lending.
From the depositor point of view, this system has created certain illusions...
...
In 1912, Ludwig von Mises wrote a book called
The Theory of Money and Credit that was widely acclaimed all over Europe. In it he warned that the creation of central banks would worsen and spread business cycles rather than eliminate them.
...
Now, knowledge of this problem was not well spread among bankers and government officials in 1913 when the Fed was created. But it wouldn't be long until it would become apparent that the Fed would bring not stability but more instability, not shorter booms and busts but deeper and longer ones. The longest one of all, dramatically exacerbated by bad economic policy, was the Great Depression.
- Dr. Ron Paul,
End the Fed, 9/3/2009</blockquote>