The State, nor private entities such as Capitalist banks, can engage in fractional reserve banking. Any money that is issued by the State must be fully convertible into gold or silver. However, private institutions are permitted to take deposits and/or transfer money.
Fractional reserve banking, as the name suggests, means that the banks only need to keep a small fraction of the deposits and are allowed to loan out the rest. The banks can effectively expand the “base money” provided to them by the central bank into “broad money”. For example, if the reserve requirement is 10% and the Central Bank loans $100 to Bank A, then Bank A can issue $1,000 worth of loans. In this example, the bank creates $900 out of thin air. The following diagram, taken from a Bank of England publication, explains this process (we will get into the counter-Propaganda section below)
As noted in this Khan Academy video, the fractional Reserve Banking system is advantageous because it:
Expands economic activity: as there is greater availability of the medium of exchange, there is a greater ability for people to invest in the economy.
Enables greater investment now to produce more goods and services in the future: More goods and services, e.g. apples, will be produced.
Reduces prices across the economy: The increased production makes goods more affordable because the goods have a lower price.
Production depends on science and not the economic system: As previously refuted in this post, Capitalist policies are not a prerequisite for production. The number of apples a land will produce is purely driven by science. For example, tree thinning increases the yield of apples over the long run. The implementation of such an approach to apple farming is not dependent on the existence of a fractional reserve banking system.
Growth in production does not “automagically” improve the standard of living: As noted on my post “Let them eat GDP," GDP from 2007 to 2014 grew from $14.4 trillion to $16.6 trillion. During the same period, the number of poor people didn't fall. Instead, it rose from 37.3 million people in 2007 to 46.5 million people in 2014. So even though the GDP rose by over $2 trillion, there were 9.2 million more poor people. Consequently, those trillions of dollars added to the economy for seven years did not improve the welfare of at least 15% of Americans.
Investors will invest in the production of goods and services: The video assumes that the money created would be invested in an irrigation canal (thereby increasing apple production) or a factory to make the apple harvesting more efficient or faster. However, that’s not what the rich are actually investing their money. In reality, there is no reason for the wealthy to invest in the production of apples, when they can make more money from speculating on real estate, the stock market, derivatives or other paper oriented (aka fictitious) wealth that is out there. Sony makes 63% of its operating profits from finance with “[l]ife insurance has been its biggest moneymaker over the last decade, earning the company 933 billion yen ($9.07 billion)”, so why would they choose to invest in the production of goods – computers, TVs, and other electronic equipment – when it can make more money betting on the death of people?
I also noted this point in the post on fiat currency. Before 1971, only 10% of foreign exchange transactions were speculative. However, only two decades after 1971 (i.e. when Nixon closed the gold window) “those percentages are reversed, with well over 90 percent of all transactions being speculative”. George Soros is infamously known for the massive bet he took on the British pound in 1992. According to the NYT, “[t]he trade made $1.5 billion for Quantum, and Soros, whom the British tabloids dubbed “the man who broke the Bank of England” became a household name. The bimetallic standard will, therefore, restore price stability and prevent people from getting rich through such transactions. The point is that the more money produced by the banks will lead to more production of real goods and services is false.
The reduction in debt will cause the money supply to shrink: What happens to the debt if the apples are wiped out due to inclement weather (as it happened in Ontario in 2012)? The debt would have to be wiped along with the medium of exchange. In contrast, such an event in a full reserve banking system (i.e. a loan is made based on the existence of a deposit), the debt is written by the lender but that medium of exchange would still exist in the system. Of course, in an Islamic economy there would be no bank-based loans. Instead, there would be investments made based on the partnerships structures where the capital would absorb the loss, but the medium of exchange (i.e. gold and silver) would still exist.
Points to consider:
How does Fractional Reserve Banking work?
Some cite the alleged saying of Henry Ford about how there would be a revolution tomorrow if the people understood the banking system. I couldn't find any reliable source that attributes this saying to him, but it is nonetheless bewildering to realize that society gives banks the ability to conjure money out of thin air through the fractional reserve banking system.
Most of the explanatory materials out there, such as this YouTube video, focus on the multiplier effect. That is, the central bank creates what is known as “base money”, and then this expands into broad money. However, this requires a bit of nuance. A Bank of England publication explains the process a little differently:
“Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves. While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.
In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England. The rest of this article discusses these practices in more detail.” [Emphasis was retained from the original article].
The bank also produced a video on the topic, which summarizes some key points:
For me what clicked is how the bank operates like any other company. When a manufacturing company sells something, it analyzes the markets, assesses what products to sell, then it buys the raw materials, processes them, and then sells them as finished goods to the public. In a sense, banking works similarly. The bank analyzes the current economy and assesses the amount and number of loans they want to issue. The central bank, in effect, decides how much the “raw materials” are going to cost for the bank. In other words, it prices the raw materials through the interest rate mechanism, which in turn becomes the "cost of goods sold" for the bank. By driving up the cost of these raw materials, the central bank still determines the limit of what the banks can lend – the “cost of goods sold” becomes too expensive thereby preventing the banks from offering loans to some of its customers. The key here is that the central banks set the ultimate limit. However, the banks can choose to lend less and thereby cause the economy to crash because they are not providing enough liquidity in the system. This is what happened with the banks in the 2008 Financial Crisis. They didn't respond to the stimulus offered by the central banks and decided not to lend money to companies like SRC Holdings.
And this is where quantitative easing comes into the equation.
We should always keep in mind that this is what freedom means: the banks are not obliged to lend in those circumstances because they are free to do what they want. Consequently, it was up to the central banks to step in and stimulate the economy by buying assets. As the same Bank of England publication explains, the Central Bank bought assets from the end consumers and skipped the banks altogether. Since they purchased the assets themselves (e.g. bonds or troubled assets), this ended up in the pockets of the insurance companies, pensions funds, etc. and not the banks per se (i.e. unless the central bank was buying from the bank as an “asset holder”). Therefore, this didn't expand “base money” that the banks use to expand the money supply. Instead, it is injected liquidity directly into the system by giving money to the other institutions who then, in turn, could use that money to engage activities that could either expand the money supply (e.g. depositing in the account of another bank, raising the prices of bonds, stocks, etc.) or contract the money supply (e.g. by paying off debt).
The Debt-Money paradox: What is interesting about the way the money supply is generated is that it only comes into existence once there is a liability that is issued. That is, the money exists in the economy because a loan has been issued by a commercial bank (who in turn borrowed from the central bank). So what happens if somehow everyone pays off its debt? All the money in the economy would disappear! This is, of course, a paradox as that money (used to pay off all the debts) would only be generated by liabilities that are on the central banks or commercial banks’ balance sheet – meaning the debt exists somewhere in the system.
Islamically, debt is a burden that one seeks to be free of. That is, the objective is to be debt-free. Prophet Muhammad (saw) used to pray:
“O Allah, I seek refuge with You from sin and heavy debt” [Bukhari, Muslim]
Also, to die with debt means one’s soul is stuck in the grave till that debt is paid off:
“The soul of the believer is suspended because of his debt until it is paid off.” [Tirmidhi]
The Prophet (saw) refrained from offering the funeral prayer for one who had died owing two dinars, until Abu Qataadah (may Allah be pleased with him) promised to pay it off for him. When he saw him the following day and said, I have paid it off, the Prophet (saw) said: “Now his skin has become cool for him.” [Ahmad]
What this illustrates is how diametrically opposed the Islamic system is to Capitalism. In Capitalism, the monetary system is dependent on people taking on debt perpetually. In Islam, in contrast, a person must get out of debt as fast as possible. Consequently, a gold-silver standard enables this objective, whereas the current debt-based monetary system does not.
Why give banks this much power?
It's incredible how much power rests in the hand of Capitalists, where society gives powers to private actors to create the medium of exchange out of nothing. This is a testament to one of the principles of propaganda articulated by Samuel Huntington that "Power remains strong when it remains in the dark; exposed to the sunlight it begins to evaporate." It is difficult to take and read about fractional reserve banking because the system is designed to amuse us to death. This is no accident. In fact, we are being seduced with what Harold Lasswell called “the chains of silver”. But if you are reading this, in sha Allah, you are well on your way to breaking through the barrier they have set upon us!
And those who do question, like the Occupy Wall Street Movement, are marginalized by the media and brutally repressed by the institutions of ‘law and order.' For example, the New York Times dismissed Occupy as a fad that fizzled, when in reality the movement was repressed through coercive political means as evidenced by the 8,000 arrests of protesters. Keep in mind a conviction in America reduces you - especially as a poor person of colour - to a “lower caste". This accomplished by a number of means, including the fact you have to check the box that you are a felon and thereby unable to get gainful employment.
What will it take for the fiat-fractional-reserve-currency bubble to pop?
With the price drop in bitcoin at the end of 2018, the financial press felt safe to term the rise and fall as a bubble. The real issue, however, is that there is nothing really behind bitcoin – they are just digital tokens that can’t be double spent. That is, the underlying innovation of bitcoin was that it introduced a network technology that enabled a token to be sent from one party to another, where the receiving party can be assured (after waiting 10 minutes) that those bitcoins have not been spent anywhere else. Regardless, there are actual no assets or mineral linked to this token.
Similarly, there is nothing backing the fiat-fractional-reserve-banking-backed US dollar that runs the world today. So doesn’t that make the US dollar a bubble as well?
The truth can be painful, but the plain reality is that the move to fiat-fractional reserve banking system is a disaster waiting to happen because it ultimately is a bubble: there is nothing behind the currency that is issued by the US – other than the nuclear-flex.
We have seen the hyperinflation in Germany in the 1920s wreak havoc on the economy – only to be resolved by replacing the currency with a new one.
The current system is propped by belief – the petrodollar was established because of the slavish agents in the Muslim world who dutiful agreed to such an irrational agreement to sell oil for USD. But what happens when the Muslims wake up and realize the political and economic system – one that mandates the gold-silver standard – brought by Prophet Muhammad (saw) is superior to Capitalism?
What happens in the case of an environmental catastrophe so large that it wipes out a significant amount of assets from the US economic balance sheet? For example, Hurricane Michael impacted up to 17 planes worth $377 million each. If only 3 of them were destroyed, that would be over a $1 billion in damage. I am thinking something like the Big One – a massive earthquake known as Cascadia” – hits the west coast and cause is anticipated to cause $32 billion worth of damage in Oregon alone. In 2008, Capitalism couldn’t handle a downturn in housing prices because (a) it made loans to people who couldn’t afford it and (b) these loans get spread everywhere because they were sold as AAA “mortgage backed securities” to other financial institutions. The point is that the Capitalist economic system is fragile.
That being said, Capitalism is flexible and seems to be able to, if you pardon the pun, paper over the issues. When interest rates where no longer useful, they used quantitative easing or negative interest rates to stimulate the economy. Billionaire Ray Dalio notes that the next step could be “helicopter money”, where the central bank puts money straight in the hands of people because buying assets from the billionaire class – aka quantitative easing – failed to do the trick. And there could be other tricks that continue to bolster confidence or “iman” (belief) in the US dollar.
But, despite this flexibility, Capitalism is not immune to reality. Eventually the – Muslim world, the Americans or someone else – will eventually (by Allah’s (swt) Permission) see through the dollar deception, demand a better system and the bubble will burst.