Monday, February 15, 2010

Hamilton and the Desire for Fractional Reserve Banking

High school students are taught that Alexander Hamilton pushed for and won the establishment of a central bank, commonly referred to as the Bank of the United States (BUS). As Secretary of the Treasury, he sent a "Report on a National Bank" to the Congress on 13 December 1790. In the report, he lists multiple reasons for the establishment of such a bank. The first of these reasons is as follows:

"First. The augmentation of the active or productive capital of a country. Gold and Silver, when they are employed merely as the instruments of exchange and alienation, have been not improperly denominated dead Stock; but when deposited in Banks, to become the basis of a paper circulation, which takes their character and place, as the signs or representatives of value, they then acquire life, or, in other words, an active and productive quality...It is evident, for instance, that the money, which a merchant keeps in his chest, waiting for a favourable opportunity to employ it, produces nothing 'till that opportunity arrives. But if instead of locking it up in this manner, he either deposits it in a Bank, or invests, it in the Stock of a Bank, it yields a profit, during the interval..."

In this section, Hamilton describes the necessary, proper role for a bank in society; the lender of capital. In this scenario, a person deposits a sum of money for a specified term for the ability to accrue interest and receive his money back plus interest at the end of the term.

Hamilton then describes, what in his opinion is a more desirable function of a bank.

"His money thus deposited or invested, is a fund, upon which himself and others can borrow to a much larger amount. It is a well established fact, that Banks in good credit can circulate a far greater sum than the actual quantum of their capital in Gold & Silver."

This function is none other than the fractional reserve banking system, which is currently employed today. The current banking system is a system that once there is a scare in the economy or confidence in the banking system is lost, investors will attempt to recall their investments. The problem is that there is far less money in the banks than has been issued in the form of loans based upon fractional reserves.

Economist Jesus Huerta de Soto explains in detail the nature of a system of fractional reserve banking in his book, Money, Bank Credit and Economic Cycles. In the book, de Soto describes a system of 10 banks each recieving $1 million from one investor. The initial amount of money in the system is $10 million. The banks' reserve ratio is 10%. Once the banks conduct fractional reserve loans on the initial $1 million invested in it, the amount of money in the system created ex nihilo is $90 million. The total amount of money in the system is $100 million, but is only backed by $10 million in actual deposits. Now imagine this on a nation-wide basis!

Despite backing a system that would inevitbaly collapse he still attempted to persuade Congress to adopt the Bank of the United States. He too realized the fragile nature of the system.

"These different circumstances explain the manner, in which the ability of a bank to circulate a greater sum, than its actual capital in coin, is acquired. This however must be gradual; and must be preceded by a firm establishment of confidence; a confidence which may be bestowed on the most rational grounds; since the excess in question will always be bottomed on good security of one kind or another."

The fractional reserve banking system is the system in which the contemporary banking system is based. America's association with it began with the First Bank of the United States.


  1. Great explanation with primary source quotes. That is the stuff this website is based on.

    The key is that people who lend will not lend to a bank that is not careful of those who borrow from the bank and do not pay back the bank and thus hurt the profit of the bank and the initial lender. The free market protects this self interested balance and a market where the government gets in the way of this balance creates the situation where this safety net is lost. I.e. see 2010

  2. Glad you like the posts. I think when people read the ACTUAL words that these people said or wrote, instead of what the textbook or popular believe is, they will come away with a different opinion. It seems as though no one ever reads the actual works of such important figures. It is sad.