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Downside Leverage -- an often overlooked positive attribute of "fractional reserve banking".
One good but often overlooked thing about having bankers run the money system is that if they lose money on bad loans -- that money theoretically comes out of the banker's pockets (because the bankers own the banks). If the government ran the system and owned the banks -- all losses would come out of the pockets of the taxpayers. Of course what happened in the financial and real estate price meltdown of 2008 shows that in any case -- the taxpayers will probably pay the bill for the losses caused by unpaid debts. In that 2008 case -- the government basically pumped taxpayer money into private banks and corporations, thus shielding them from losing money.
Many people understand that the fractional reserve system (the underlying system we use now) gives the managing or owning institution -- whether the Fed or Congress -- a system that has enormous leverage built into it. For every dollar of capital invested by the owners of the system - those owners can make loans adding up to ten times (or much more) the amount of the invested capital. In other words -- if a Federal Bank opens its doors with one million dollars of invested capital -- it has the right to lend out $10 million at whatever interest is currently in vogue.
And they actually have much more leverage than that. If a depositor deposits another $1 million with the bank -- the bank can lend out another $10 million. It turns out that there is no limit to how much the entire system can lend out.
I know that sounds impossible -- but it is the way the system works.
What is not so well understood is that leverage in any system almost always works both ways -- In this case, it (a) magnifies the opportunity for profit -- but it (b) also magnifies the opportunity for loss if the loan goes bad. The (b) part is very good, in my opinion.
Under the present system, The Fed has been able to escape the penalties for bad loans. The establishment of Freddie Mac and Fannie Mae (such cute, benign-sounding names) allows the Fed to sell off whatever loans they consider risky.
I don't think there is any hope of stopping the fractional reserve system -- but I do think it is possible to have it work for the common good -- by making sure that unpaid loans AUTOMATICALLY penalize the banks who are the original lenders. There should be a natural control built into the system. Such a control would almost guarantee that inefficient lenders would be driven out of the system. This control can be accomplished only by passing laws that demand the banks hold onto all loans they make for the duration of each loan.
Originally, it was probably thought that the enormous leverage would work to keep the Bankers prudent, conservative and cautious because for every dollar of bad loans they made, they would have to call back TEN dollars of loans and they would therefor lose the continuing interest on that 10 dollars -- a worse fate can hardly be imagined.
Somewhere along the line, it appears that bankers forgot the downside of the leverage and thereby took chances that were not prudent.
But then, they covered themselves by gulling the government into setting up Freddie and Fannie; patsies that would buy up the shaky loans, thus shielding the Fed's banks from the downside of the leverage. See #6 at Intro-6.
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Fight Greed with Fear ... "When the banker who loses his or her bank also loses his or her shirt, greed will be tempered. At least for a while." (Eduardo Porter -- in a NY Times article on 9/29/08).
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