Financial basics - Banking Part 2

Fractional reserve banking (unique item.)

It's an almost cast iron rule in banking that the name of the subject concerned is exactly the opposite to what is occuring, or has nothing whatsoever to do with what's really going on. oh, and I know that people get very worked up about this stuff but don't worry, nowhere actually still uses FRB these days but we'll get to that soon to. Just fyi before we begin. :)

Let's start with our first sort of fractional reserve banking - unique item fractional banking.

If we remember our piano from the previous blog - we left it in the care of the banker and paid him a fee to look after it for us, but then found out that he had loaned it to someone else - a pianist. Now...why could the banker do that?

Well, pianos are kindof hard to move and if we store them it's not all that likely we will be coming to check on them or want them back anytime soon. The banker can therefore be reasonably sure that he can loan our piano to someone, charge them a fee and still give us our piano back when the time comes for us to collect it.

In a fractional reserve system, the banker lends the piano to several other people for a fee. The piano is the reserve and the fraction is the amount of people he can lend it to before some external constraint like being found out by the original owner or running out of people who want to borrow limits the lending. One crucial constraint is the amount of time it takes to move the piano about. The faster that piano moving can occur, the more times the piano can be loaned.

If the banker has 1 piano and lends it to 20 people, the fractional reserve is 5%

Lets say he lends Bob the piano in January and Bob pays him a violin for doing so.
In Febuary, he lends John the piano and John pays the banker a flute for this service.
In March, he lends Linda the piano and Linda hands over a bassoon as payment.
And so on...

We can see that pretty soon the banker has a whole orchestra worth of instruments (but no idea how to play them.) What can he do? All the banker knows is lying, storing and lending....so it's pretty easy to imagine that he will try to lend out the other instruments he has gathered if he can - not being able to play them for one and saving on storage for another, plus he can get still more fees from those loans.

In fact, by lending the piano out, he pushes the cost of looking after the piano onto others. Each pianist is paying the banker to do the bankers job for him.

Of course, this isn't quite as simple as I make it appear - the piano can be damaged, it can be stolen, it can go missing. However, it's worth noting that if, say, Linda loses the piano when she is borrowing it, it's up to Linda to replace it. If she can't, the banker can take her to court and make a very good show of having lost "his" piano. All the paperwork will certainly show that and Linda herself will almost certainly think that this is what has occured. Linda will be paying for a replacement piano, have to find the instrument as fee and will probably be paying the bankers court costs as well.

A fractional reserve system as regards a unique item, therefore, is a recording of who has been loaned what, where and when from the bankers perspective but without the global perspective that will reveal him as a fraudster.

The banker has 1 piano but receives a whole orchestra on the back of apparently carefully looking after it for someone else. As long as the banker selects his pianists reasonably carefully, he has absolutely zero risk. All he need do is loan the piano to people who already have more in assets than the piano is worth and he can never, ever lose.. Worst case is he has to write off the piano because someone has damaged it, pay the original borrower back (in fiddles?) while apologising and keep all the instruments he has gathered in the meantime. Win/win/win for the banker.

Now we can see why a banker is a man who lends umbrellas when it's sunny and wants them back when it is raining.....

The next question to answer is what happens when there are two bankers......which I will cover tomorrow.

Financial system basics

Well, right now we are in the middle of an economic crisis, a credit crunch, the start of the next depression, a housing bubble going pop and a whole lot of other economic difficulties that I will have a look at going forward.

This time, however, I am going to talk about the basics of the financial system, specifically the answer to this question -

What gives pieces of paper with dead presidents, monarchs and other various famous people any value?

When you think about it, the trading of bits of paper with people printed upon them (they aren't even naked!) shouldn't really have all that much value. You can't eat them, you can't write on them all that well, you cannot do very much with them at all.

So..why so valuable?

First of all- taxes.

You have to pay your taxes or some rather nasty things will happen to you (assuming you are caught of course.) You have to pay your taxes using the "legal tender" banknotes of the country that you are living in.

The simple act of threatening people gives fiat money, legal tender, paper currency or whatever you want to call them their value. They are, in effect, "get out of jail free cards." Without taxation paper currency has no value.

A simple analogy is this -

A large, heavily armed group of men are demanding that you provide them with pictures of someone who used to lead their gang. Luckily for you, there is another group of men called "bankers" (who apparently have nothing to do with the first group) who are willing to loan you the pictures (at interest) if you provide them with collateral in the form of promised future labour, your assets such as cars, houses and so forth. There is also a third group of men who are giving out pictures of ex-gangleaders in exchange for a days work, these people also seem to be an entirely different group to the gang which is threatening you.

So...you pledge your assets or work for a day to acquire the pictures of old gang leaders and give them to the heavily armed gang, who seem pleased and tell you they will leave you alone for the rest of this year but will be back next year for another payment of pictures and every year after that.

As soon as the heavily armed gang leave you, pictures in hand, they drive straight around to the workmaster and give him some of the pictures, and then drive to the banker to give them some of the pictures so that when you need some more you can pledge more of your assets or do more work for yet more pictures. This is happening to all of your neighbours, all of your friends, to your family all at the same time and so it seems kind of ..well..normal. People trade the "get out of jail free cards" amongst themselves even, because they have value - what's more important than your liberty and your unmolested health?

Now, I don't know about you, but this looks a lot like slavery to me. It's more complicated than an outright master/slave relationship but it pretty much amounts to the same thing.

The second thing you can do with the paper is to cancel debts as far as the heavily armed gang is concerned. They have a court system where one of their number settles disputes by using the gangs might on one party in a disagreement (usually the one who has least to offer the gang.) If you offer the gangleader pictures to pay a debt, then the courts will back you up even if the other person wants some other substance instead. All legal means of restitution are lost if the paper currency is refused.

So, people accept them for this reason.

Again, I don't know about you, but this doesnt seem to me to be the most equitable arrangement. it looks a lot like one man getting another to work for him for free by using force.....which is again a kind of slavery. It's almost an embarassed slavery though, not the old, open kind - a veneer of legitmacy has been placed over it and the obvious coercion has given way to a game of plausible deniability where it could even be argued that one hand really doesn't know what the other is doing.

I doubt that the average worker in any of these spheres (or the average tax/debt payer) has this global view of events. Higher up the food chain the truth will be known of course.

And so we have this blog, within which I shall aim to put how our systems work as simply as possible, without terminology or jargon as far as possible and hopefully by using easy to understand analogies and stories to illustrate what actually goes on.

Thank you for reading and have a good one!