Mon, 26 Nov 2007

Fractional Reserve Banking

I'm trying to figure out whether derivatives have the potential to create inflation. In order for them to do that, they would need to be able to create new money where none exists. A lot of people agree with the Wikipedia article on Fractional-reserve Banking. That article says that new money is created when a bank makes out a loan. They're allowed to loan out a large fraction of a new deposit, as long as they keep a fraction on reserve. They make this loan by creating a new account with the loan. That loan can itself be loaned as, as it's considered to be a deposit. And so on and so on until the loan has been multiplied several times.

The problem with that theory is that when somebody takes out a loan, they do so for a reason. Since banks want to be paid more than they pay out, nobody makes money by taking out a loan and leaving it in the bank. No, people spend that money by withdrawing it from the bank. This fellow agrees with me.

So, fractional reserve banking cannot persistently create new money -- no more than can kiting a check create persistent new money. Within a few days, the kite falls to the ground, and what looked like new money was seen to be no money.

So my question is whether a complex derivative can cause money to be in two places at the same time, for a long period of time? I still don't know.

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