Now even in an economy that’s as well off as ours, the individual concern is still primarily one of money and finance. With great uncertainty about the future because of prices, inflation, debt, and unpredictable investments, we want to provide a “new” perspective on where money, banking, and life insurance institutions come from, how they work, and the impact they have on our financial potential.
In our last article, we began considering the root of our financial afflictions and left off with the problem of inflation (an increase in amount of money that’s available). It’s all too easy for inflation to occur when our money isn’t backed by anything valuable.
The full scope of the problem however, doesn’t start with our money system. It encompasses the banking system also, and people going into debt.
SO WHERE DOES BANKING COME FROM?
Centuries ago, when gold became more common, it became a generally accepted medium of exchange. The problem was the very attributes that made it the ideal currency, also made it difficult to keep safe in large quantities outside a warehouse or bank.
Because banks didn’t yet exist, if you wanted to store your gold for safekeeping, the most common place to do so was the goldsmiths, for they already had a facility that was capable of keeping quantities of gold on hand.
The introduction of goldsmiths as bankers was revolutionary indeed. Goldsmiths would charge a fee for storing the gold in their facilities. This small action would lead the way to what we now consider fractional reserve banking, and has become rooted in our culture.
Throughout history there has typically been two kinds of banking:
- Loan Banking: before deposit banking there was loan banking. A “depositor” would loan their money to a bank owner with the expectation of being paid back with interest at a reasonable rate. The bank owner would then loan that money to a somebody else with the expectation of being paid back with interest, this time at a higher rate. The bank owner would keep the difference as profit for themselves. Loan banking began in the 1300’s in Florence, Italy and was a system that was replicated by the Dutch, English and Swedes later. Important to note is loan banking is non-inflationary.
- Deposit Banking: This form of banking was initially practiced by the goldsmiths. In true form, deposit banking is a warehouse (or bank) that acts as a 100% reserve for money. As it happens, goldsmiths recognized that people were no longer retrieving gold every time they made a purchase… the bank note they received from the goldsmith was as good as the gold itself, and, leaving the gold on deposit, began trading bank notes instead. Important to note is that pure deposit banking is also non-inflationary.
Fractional reserve banking is a distorted form of deposit banking, and it is inflationary. It took hundreds of years for the evolution of the banking system to get to the point where we could transfer money electronically and without the backing of gold.
From Deposit (100% Reserve) Banking to Fractional Reserve Banking
The Bretton Woods Agreement wasn’t the first time we were influenced by our southern neighbours. Nearly 200 years ago, we experienced one of those moments that would determine the course of history.
The moment was a court ruling in America. In the case of Foley v. Hill and Others:
‘The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount because he is contracted.’
With this ruling, US banks were no longer held to the original bailment contract they had for safely storing gold. US banks were now bound to a debt contract, and could do with the money as they pleased (including lending it out) until time of redemption by the consumer.
The English had already gone through this court ruling, and the Dutch and Swedes had very similar banking systems also in place.
What the Federal Reserve and Central Banking systems did with the permission of the debt contract, was allow real money to become unhinged, diluting the value of the dollar, by proceeding with the legal means to create more money, fiat money, out of thin air.
The standards of the banking industry were set so long ago that we forget why and how this happens.
HOW DOES FRACTIONAL RESERVE BANKING WORK?
We left off with deposit banks and goldsmiths, who we will now call bankers, charging a fee for having consumers gold on deposit (like a chequing account), and leading the way to the fractional reserve banking system and the rise of debt and inflation.
When consumers started trading bank notes in lieu of gold, it left room for bankers to take advantage of the gold on deposit. Because most of the gold on deposit would remain in the warehouse at any one given time, bankers could create additional bank notes that looked and acted the same as a consumer’s bank note (meaning they were redeemable for gold at any given time).
Bankers knew that the redemption of these new bank notes was unlikely, and would loan them out to other people.
It was this action on behalf of bankers that injected a surplus of bank notes (paper money) into the economy, giving rise to debt and inflation.
Bankers, using this new business model, made a profit from the interest paid. It was a new income stream that came from falsely advertising more gold available than the gold reserves the bankers had on hand.
Out of all the bank notes circulating at the time, nobody knew which ones were backed by gold, and were valuable, and which ones were not.
Its like nowadays when we deposit money into a bank, the bank is required to keep a percentage of our deposits in it’s reserves. If the reserve ratio that the bank is required to keep is 10%, they keep 10% of the deposit on hand and can lend out 90%.
When we go back to the bank and apply for a mortgage, once approved, the bank is now legally within it’s right to loan 90% of the original deposit for the mortgage.
As the depositor, we can redeem our full deposit at anytime, and yet there is still a 90% loan amount circulating in the economy.
Deposits = $100,000
Reserve @10% = $10,000
Loans @90%= $90,000
Total = $190,000
As this process repeats itself, when the $90,000 loan is spent and deposited at another bank, the money is once again multiplied.
An oversimplified example of the multiplied effect is a total of $1,000,000 worth of money potentially circulating in the end.
When gold was the value standard, inflation (an increase in the quantity of money IE. printing more money than gold) was held on a relatively steady course. In 1971, when the gold standard was removed, it removed our natural check and balance.
For so long we’ve been accustomed to borrowing money because it’s available. And because it’s been rooted in our culture, nobody stops to ask where it comes from. It’s easy to borrow money. It allows us to buy homes, vehicles, go to school, go on vacation… Anything we want to do, we can do because the money is there. But now we’re experiencing great uncertainty about the future because of prices, inflation, debt, and unstable investments.
WHAT IMPACT DOES FRACTIONAL RESERVE BANKING HAVE ON OUR FINANCIAL POTENTIAL?
Central banks and the Federal Reserve hold the necessary means to create new money. However, it is the action of individual people going into debt that initiates the process.
- Debt: There is a market for cheap* money and so banking exists to provide that money.
- Inflation: Fractional reserve banking creates new money (but not wealth) and dilutes the value of the dollar.
- Debt: Because the value of the dollar is worth less, we need more, and we go further into debt.
- Inflation: The cycle continues to repeat itself.
*Interest payments are the “cheap” cost for using money that’s borrowed. It’s easy to become overloaded with interest payments when we go into debt.
As you read through The Wise Bankers Program, please be reminded of Albert Einstein. He understood the idea of compound interest and said; “Compound interest is the eighth wonder of the world. He who understands it, earns it…. He who doesn’t… pays it.”
More than that though, is the sheer volume of debt that’s incredible, especially in comparison with our savings and investments.
When we look at our current economy as one that’s being run by a culture of debt, with Canadian’s now spending $1.68 for every dollar they earn in 2016; it seems obvious that people are inadequately preparing for their financial success.
It’s the volume of debt that really matters, not the interest rate.
There is however, a non-inflationary solution to the problem of debt that’s been around for over 100 years and it requires, as Nelson Nash says, “imagination, reason, logic and prophecy”, to turn things around. At The Wise Banker, we’re here to say that you can redirect your interest payments to a pool of money you are in control of using a specially designed, dividend paying, life insurance contract. It systematically allows people to finance purchases with cash flow – not credit – and build wealth that’s designed to last for generations.