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Fractional Reserve Banking

This essay by Tommas Graves and Henry Law does not reflect the views of the Campaign but it is published here in an attempt to shed light on issues which have come to the fore in recent months and are likely to continue to receive attention in the immediate future.



Official money originated as money issued by governments to pay their expenses. This money then had to be collected again through the tax system. To ensure that the gold and silver was of a standard quality, it was impressed with an image of the head of the state eg the emperor and taxes could only be paid with this money. As a result, this money was trusted by traders and circulated as a medium of exchange.

All official money is fiat money to the extent that its face value is higher than the value of the material used. This is true even of pure gold currency. Precious metal coins were often debased with other, less valuable metals; many times in history, governments who were short of funds would issue currency with a face value much higher than the value of the metal. Paper currency is the end point of this state of affairs. In all circumstances, if excess currency is not withdrawn from circulation through the tax system, the result is that the value of the money drops relative to the value of goods ie inflation occurs. Paper currency is inherently vulnerable because it can be spent into circulation under the guise of government generosity, which wins votes in a democracy and keeps populations quiet under tyrannies.

Governments like people to believe that inflation is due to anything apart from their own actions in producing money for spending and not subsequently withdrawing it from circulation. This deception generally succeeds, as one can see from comments in the media. The effect of persistent inflation is to reduce the value of holdings in the currency eg savings. Thus it is a form of robbery of people’s savings – in other words, a hidden tax.


Credit money arose from the practice of fractional reserve banking which developed in the later Middle Ages. People would deposit their gold money with goldsmiths for safe keeping. The goldsmiths would then give the depositors a receipt for the deposited gold. These deposit notes, if issued by a trustworthy goldsmith, were considered as good as money and circulated in the same way. This process was the origin of modern banking.


Jews were often involved because the goldsmiths’ trade was one of the few in which Jews were allowed to engage. It was also often the case that Jewish families were far flung and a receipt issued in, say, Venice, would be accepted in Munich. In this way the practice enabled and facilitated international trade.

The proto-bankers, both Jewish, though mostly Christian, soon realised that the depositors would leave their gold in their vaults for long periods and that they could safely lend it out again, or even write notes of credit for “money” loaned. It was discovered that a safe ratio of loan to deposit was about 8:1. At a higher ratio, the situation could arise when rumours got around that the bank was unstable. Depositors would rush to get their money out, money that the bank did not have. There were many examples of banking collapse over the centuries.

Here, then, is the principle behind fractional reserve banking: a bank can safely create credit up to about 8 times the amount deposited. It is a necessary part of the economic system as it enables the transfer of purchasing power. As will be explained later, interest is no necessary part of the fractional reserve banking system.


Since Christians were forbidden to charge interest, the Jewish bankers were at an advantage, at least for a while, since they were outside the jurisdiction of the Catholic Church and could charge interest on the credit they had created. This advantage did not last long, as, by the fifteenth century, the Catholic Church was turning a blind eye to the practice of usury.


It was Sir William Petty who discovered that the interest rate is approximately equal to the ratio between rent and land price. It used to be generally reckoned that 20 years’ harvest bought the field, and so the interest rate tended to settle at around 5%.


The proper use of credit is to enable production. The farmer, for example, must pay to plant his crop and must sustain himself until the crop is harvested and sold. The credit gives the farmer access to goods previously produced eg last season’s crop.

A good example of credit would be for building a ship. Materials have to be purchased and the workers paid, but nothing is earned until the ship has completed its first voyage and the goods sold. At that point the credit can be repaid. The credit had been used to create a productive article.


Credit used for land purchase eg a mortgage, is an improper use of credit, since it results in no production and adds nothing to productive capacity. It is simply a “release fee” paid to an owner to enable a pre-existing resource to be brought into productive use. It should be noted that most credit today is used for land purchase in the form of loans for mortgages. The use of credit for consumer ie end user purchases is also an improper use, since nothing was added to productive capacity. There is a fine line to be drawn here. Borrowing money to buy a car to get to work would be a legitimate use of credit, but borrowing money to buy a pleasure boat would be a reckless act on the part of both borrower and lender. Such purchases should, prudently, be paid for out of savings.


When real estate is purchased through a mortgage the owner is effectively the lender’s tenant for the duration of the loan. What is labelled “interest” is in reality economic rent of land, as defined by Ricardo in his Law of Rent. In Sharia banking, this relationship is acknowledged. There is no different in principle between lending under the Sharia system and ordinary bank lending. The dominance of mortgage lending as a banking activity has turned the system into nothing more than a means of extracting economic rent. Money is created at almost no cost for the purchase of land in order for the “purchaser” ie the borrower, to pay rent to the lender. It is significant that the duration of mortgages has been steadily increasing over the past 50 years, from terms of, typically, 15 years to any up to 40 years. This is partly why land prices have risen inexorably over this period, far in excess of wages or general inflation.


The word “credit” carries the idea of trust. The lender trusts the borrower’s ability to repay the credit. In order to do this properly, the lender must investigate the borrower’s circumstances, qualifications, history, experience, and the purpose of the credit. It would be unwise to give credit to a youth who fancied trying his luck and wanted to buy a fishing boat. The same credit would be legitimate if the fisherman was mature, experienced and knew what he was doing.

Legitimate credit needs no collateral and security other than the item for which the credit has been given. Thus the security for the credit granted for building a ship is the part-finished ship itself. The security for the loan to the farmer is the ripening crop.

The only security required is some kind of insurance bond against the risk of the ship sinking or the crops failing.

In the modern banking system, collateral normally means real estate or land. Thus, the owner-occupying farmer must pledge his land against the credit. The start up business must pledge his home. This is not how the banking system should operate. It is not banking. It is more akin to pawnbroking.


This discussion has tried to show that fractional reserve banking is not in itself a bad thing. It give producers access to resources while they are themselves in the process of generating wealth for which they have not yet been paid. What would a banking system be like without collateral and interest? In the first place, it would be much smaller. Banks would not be able to issue credit for consumer purchases. Those who wanted credit would have to be genuinely credit-worthy – experienced tradespeople and artisans, and farmers, with legitimate and realistic business aims, whom the lender could have confidence in their ability to repay the loan. The lenders would have to take care who they gave their credit to. Bankers have to earn their livelihood as professionals, but they would do this as do other professionals such as lawyers and architects – by charging on the basis of their time. The risk factor would be taken care of by an insurance bond. The collateral or security, as explained above, consists of the goods for which the credit has been granted.


At the core of this problem is the private appropriation of the rental value of land, which, it should be remembered is a value created by the presence and activities of the community, first and foremost though the protection of property rights by government. If the economic rent of land is collected through the tax system as the principal source of public revenue, the problem goes away. Real estate prices would reflect the value of the buildings and other structures on the land, since the purchase would involve taking on the liability to pay the land value tax. In a region with poor economic opportunities and infrastructure, this tax liability would be small. In prosperous regions with good infrastructure, the tax liability would be correspondingly large.

In either event, the collection of rent as public revenue through a land value tax removes the possibility for using land as collateral for credit, which would compel the banks to find an alternative and less harmful system of operation, such as that outlined above. It would also make irrelevent the cult of the housing ladder and remove people’s motivation for getting onto it at all costs. Reckless borrowing and reckless lending feed on each other. However, this is the precise reason why the necessary reform verges on the politically impossible. There are too many vested interests getting in the way – the financial sector on the one hand and the voting power of the home ownerists on the other..


The banking system and the land market are fundamentally flawed, primarily due to entrenched and misguided notions of property. We have credit being used for the purchase of that for which credit ought not to be given, including land and consumer goods. In theory, a remedy is available, but nothing will or can change unless there is a catastrophic collapse. However, catastrophic collapses rarely lead to benign consequences and are not something to be wished for.