This is an issue that has raised a lot of attention, misunderstanding, and misinformation in recent years. And so a primer.
Modern banking can get very complicated. But in traditional terms, banks have two sides to what they do. They take in deposits and make loans.
Why? What role does that fill? Banks are part of the industry called "financial intermediaries". That is, middlemen. Depositors have more money than they have a use for at current. They want to earn some money putting their money to work. Borrowers need more money than they currently have. And they are willing to pay to use someone else's money.
Banks make the connection between these two groups of people.
They reduce the risks and the transactions costs to both borrowers and lenders. And by doing so, they make capital for businesses cheaper and more available. And that allows a greater creation of wealth to the society.
Banking of this sort has been with us a long time. It's not a new thing in the world. English kings explicitly allowed goldsmiths to engage in banking at least 400 years ago. It may well date to the early 13th century in Italy. I'm not aware of it existing older than that. But wouldn't be surprised if it did.
It has been around for all of the modern era. And has largely made the modern era possible. To attack something that all of our prosperity rests on in nonsensical. It demonstrates an ignorance of how the world works that is dangerous to all of us.
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Someone want to chime in with the Marxist critique of banking? As I understand it, making money work is not work, and so does not deserve an income.
But as I just showed, making money work is work. And so does deserve some sort of an income for doing so.
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So banks make the connections between savers and borrowers. What else do they do and how do they do it? Banks have two primary kinds of depositors. Checking accounts and savings accounts. Simple version, savings accounts earn interest for the depositor, checking accounts make the depositors money quickly and easily available for a variety of purposes.
The money to pay for all of this comes from the loans the banks make. All those loans charge interest, which is the primary revenue of the bank. Out of that revenue, the bank has to pay the interest on deposits, and cover all the costs of the checking accounts, plus all the costs of running the bank and some rate of return to the bank's owners.
But banks can't loan out all of the money that is deposited with them. Because they never know when their depositors are going to want their money back. And so they have to keep a
fraction of it in reserve to cover what their depositors are going to want on any given day. Now in the US we normally talk about a 10% reserve ratio. Why? Well it makes the math easy
But really, because it's dictated by law. It doesn't have to be 10%. Some nations have gotten away from mandatory reserve requirements. They can do that because they have more properly regulated and run banks, and so can safely run with a lower reserve.
You see, the higher the reserve requirement, the less money the bank has to loan out. But the lower requirement, the more the banks can loan. Lower reserves mean lower interest rates and more loans to the economy, and so more economic growth. Higher reserves, higher interest rates, less growth.
Contrary to current political myth, fractional reserve banking in and of itself does not push inflation. Because all the money "created out of thin air" when loans are made is destroyed again when the loans are repaid. It is not an ever expanding quantity of money. It is a stagnant amount of money until the monetary base is expanded again, or the slow but inexorable velocity of money speeds up a bit.
The thing is, that most of the danger that comes out of finance does not come out of conventional banking. Conventional banking is actually very well understood and easy to deal with. The problems come when finance is allowed to be creative. When it is allowed to take chances.
The fundamentals of money and banking are among the simplest and most basic in economics. There's really no disagreement about the principles. And so there's really no reason for anyone who has had high school AP economics or a few college courses to get it so fundamentally wrong as we hear in some of the political debate today.
) explanations for the predictive deficiencies already observed with that theory. And they are wrong, because they do not accurately describe the issue, they're just consequences of what is really wrong with any "rational" be-all model for economics. These are just unknowns about the behaviors of other people, but what matters is why those unknowns ("costs", as some economists with a warped world view like to call them) exist.They exist because people all have individually different goals and preferences. No one is exactly a clone of someone else. No one is motivated by exactly the same combination of stimulus, of desires. There is no average consumer, no average producer, no average trader. And it that does not exist, there can be no rational theory of the market, because no one can add and average together the actions of all its participants. You can't average different things!
