Well, your money's in Joe's house...that's right next to yours. And in the Kennedy House, and Mrs. Macklin's house, and a hundred others. — George Bailey (played by James Stewart) in It’s a Wonderful Life (1946)
I suspect only Austrian economists would correctly identify George Bailey as the villain of Bedford Falls. George Bailey, not a hero? He helped members of his community achieve the American dream, but as a fractional-reserve banker.
In the U.S. fractional-reserve banking system, the Fed requires banks to back up just 10% of demand deposits with cash called required reserves. Demand deposits in excess of this that are not lent out are referred to as a bank’s excess reserves. Thus, a bank is presently allowed to lend out up to 90% of their depositors’ money because the system essentially strips away their property rights.
Fractional-reserve banking is lampooned in a season seven Seinfeld episode with the fractional reserve parking lot analogy. In this episode, George and Kramer discover their cars are being lent out by Jiffy Park. Although a procurer had been selling tricks out of George’s car, it was mostly available upon demand. Kramer wasn’t so lucky. When he demands his car, the attendant meets it by supplying a pink Cadillac. Of course the analogy is overly simplistic because cars are neither identical nor divisible. Nonetheless, if demand deposits are the property of depositors, allowing banks to lend this money is as sound as Jiffy Park lending cars to adult service provider procures.
Fractional-reserve banking is inflationary because money is lent into existence. To demonstrate, consider Bill who withdraws $100 from his mattress to deposit it in his checking account. Because the reserve ratio is 10%, Bill’s bank can lend $90 of his money to Jill. If she uses the money to buy DVDs from Buy-Mart, it deposits the proceeds in its bank. Buy-Mart’s bank keeps $9 in reserve and loans Jack $81 to buy a printer. After just two rounds, banks lend $171 into existence. After 100 rounds, the $100 deposit is two cents shy of $1,000.
Because proponents of fractional-reserve banking do not expect depositors to withdraw more than 10% in a given day, the money that is lent into existence can collapse like a house of cards at any moment on the slightest bad news from a bank.
The past widespread and continued narrow use of leverage in the U.S. compounds the aforementioned risks. Leverage is enticing. It boosts returns as asset bubbles inflate. However, it represents poor stewardship of depositors’ money. In an indefinite expansion, which is not possible, leverage is not problematic. Money is plentiful because it is being lent or printed into existence. Governments backstop bad practices with a safety net of deposit insurance, bailouts for too-big-to-fail banks, and central banks that are lenders of last resort.
To understand how leverage compounds the risks inherent in a fractional-reserve banking system, consider a home that is currently valued at $200,000, is held for a year after its value increases by $20,000, and is financed at 5%. If it is purchased with no leverage, a 10% return is realized. If it is leveraged with a 20% down payment, the return is 42%. The return is a whopping 168% if leveraged with 1% down. However, when the housing bubble slows, returns on heavily leveraged homes shrink. When it pops, as it did in 2007-2008, returns are negative, and the difference between returns on non-leveraged and leveraged assets increases in leverage.
The customers of Bailey’s bank were rightfully upset, and so too were the Beverly Hillbillies in a season three episode. Unlike Bailey’s depositors, the Hillbillies in this episode fired Millburn Drysdale after the President of Merchants Bank informed them that Drysdale had stolen their money. In Drysdale’s defense, he had merely lent out his bank’s reserves. This seemed funny years ago because the Hillbillies were hillbillies who could not comprehend the necessity of fractional-reserve banking.