A History of Fractional Reserve Lending vs Bitcoin
The Art of Banking — the bank loans you money that someone else has deposited for the bank to safeguard and store. In return for that initial deposit from the original person, the bank safe-holds the money, guaranteeing that anyone who stores their money at the bank will be able to withdraw into fiat whenever requested. Using that deposit, the bank is able to lend this lump sum of money from the deposit to someone else and get paid the interest. Prior to 1913, the promise a depositor could simply pull out their deposit could not be kept consistently. Bank runs “bankrupted” banks, leaving customers with a savings account of $0 that used to have $100,000 before they left for vacation. There was no money left to be given out. All of the money had already been taken from the bank by depositors. Those that arrived late were financially destroyed.
The culprit was fractional-reserve banking. Banks are not legally obligated to be able to pay out 100% of deposits at any given moment. Instead, banks take your money and lend it out to others at a profit. They then use that profit to lend out to other people, so on and so forth. Loans are an important part of the economy, but they come at a cost when the bank uses your money instead of its own for lending. This is where risk is introduced. Lending money that the bank did not own is how the Stock Exchange Crash of 1873 and other hiccups in the early 1900s were born.
Because of fractional-reserve banking, if enough people wanted to withdraw all of their money at once, the bank would no longer have enough money to hand to the depositors who simply want their money back. Fractional banking is a beautiful thing, but only when it works. This brings an end to the money making machine that is modern day banking.
So what is the solution to the liquidity problem fractional-reserve banks face? Germany and Great Britain back in 1920s had their own central reserve system — the means to provide liquidity to banks in the case of a panic from customers. US citizens looked around the world and saw that other stock markets were stable. They requested the creation of a government bank.
The Federal Reserve was created December 23rd, 1913. Its role since then has been to print money and offer it to large banks at a very low rate such that they can handle any surges in demand for cash. This allows banks to maintain profitability, at the cost of inflation being introduced into the money supply. How does the Fed slow down the creation of money?
The Fed does this by buying back treasury bills from large banks while simultaneously lending to these banks at a higher interest rate — making it more expensive for banks to borrow money from the Fed (because the profitability margin decreases as a result of this increased interest rate). The banks respond by raising their own rates, reducing the amount of loans that will be created due to the increased risk of this additional cost for your every day customers.
For many decades we have seen The Federal Reserve attempt this balancing act between high and low interest rates. But have they actually done so? Interest rates have been raised only a couple of times in a significant way, usually when it’s too late. Raising interest rates can literally cause economic depressions (The Federal Reserve has on record taken credit for causing the Great Depression).
“Regarding the Great Depression, … we did it. We’re very sorry. … We won’t do it again.” Ben Bernanke (Chair Of The Federal Reserve). November 8, 2002
Thus, we are stuck with an entity that can print as much as it wants, reducing the overall scarcity of the precious dollars you own. All without your permission or consent. Sure, liquidity can now be provided and the loans can continue. But if trust falls apart, what is left? Two year interest rates are at 0.25%. They can go no lower. The means to stimulate the economy by providing liquidity to create low interest rate loans that are (in theory) supposed to generate real economic growth is no longer possible as a backup band aid solution if trust falls apart. The only way to continue is by “stimulating” the economy by massively dumping money into the system. The Federal Reserve is playing with fire, as they always have.
This is where bitcoin enters the picture. There are no fractional reserves with bitcoin. There will never be a “bank run” on the bitcoin ledger if everyone rushes to retrieve their bitcoin because your bitcoin is never lent out by the blockchain protocol. It’s the equivalent of a bank that never lends; only holding your currency for you. Oh, and this bitcoin bank (a decentralized ledger everyone has access to) doesn’t charge you for simply holding your bitcoin. Finally, the scarcity of bitcoin is predetermined. There is no entity that can expand the monetary supply of bitcoin.
What are the implications?
(1) Bitcoin will never be the ideal currency for a fractional reserve system — — liquidity cannot be created. If you bump into an exchange or bank that ever uses Bitcoin in a fractional reserve system, proceed at your own risk. The bank may “cheat” you, but the protocol never will.
(2) The scarcity of bitcoin is predetermined such that if trust is ever widely adopted surrounding bitcoin, scarcity will never be the “problem” when it comes to bitcoin’s valuation. It will be dependent on a variety of other factors.
(3) The monetary velocity of bitcoin will play an enormous role in its end valuation
As we continue to move into the unknown that is 2020, we would all do well to take a step back and look at the role of The Federal Reserve. How is the dollar being propped up, and how long will it continue? Is bitcoin an alternative solution? Is it an effective hedge? The jury is still out.
In this article series, I share excerpts and stories from my book, Building Confidence In Blockchain — Investing in Cryptocurrency and a Decentralized Future. I hope you enjoyed this post — if you enjoyed it and want to connect you can reach me here via email firstname.lastname@example.org or connect with me on social: (twitter) https://twitter.com/l_woetzel or (LinkedIn) https://www.linkedin.com/in/carter-woetzel-16936b136/ .
Also, you can also find my book on Amazon — here is the link to buy it: [Link goes here]