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Author's profile photo James Zdralek

Debt is Always Fractional Reserve (10th in the series)

What if the world ran on new classes of digital currency that are inflation resistant, create price stability, discourage bubbles and deflationary spirals? What if they could protect citizen’s savings without reducing liquidity when they save rather than spend?

This blog series examines issues and possibilities in the changing banking and monetary systems. Rapid change could occur in the near future due to the ongoing digital transformation. What are the possible outcomes? Which future will happen? How are you prepared?



Futures-backed currency, introduced in the first of this series of blog posts, is a type of currency that can pay interest direct to people holding the currency. This type of currency may address issues with sizing the money supply and controlling inflation.

This post could have been titled “The Ubiquity of Multiplicative Debt” or “The Money Multiplier is Much More Massive” or, using the click bait tease format, “Full Reserve Banking was implemented. Look what happened next!”. Is full reserve banking a solution to inflation? Proponents of full reserve banking may not like the conclusions.

The biggest issue with full reserve banking is that it creates dead money. This occurs in a similar way to digital wallets and cryptocurrency but in a more traditional way. A previous post argues why dead money is bad.

Applying full reserve banking would force commercial banks to have the full amount of deposits available and on hand for consumers. This would prevent bank runs that occur when everyone wants to withdraw their money at the same time. If we demand that all banks use full reserve for deposit accounts, the interest rate on these accounts would be zero and banking fees would be higher. The bank is there to make to make money and full reserve banking would stop them from doing that.

In a business or even a household money should be doing one of three things, expansion, function or investment. Expansion, by spending it on equipment or people to improve the business. Function by having enough on hand to conduct business, what is called the float in a retail context. Investment can be distributed between deposits in a bank, deposit certificates, bonds and strategic investment in shares of other businesses depending on cash flow planning requirements. Any cash laying around not performing one of those activities should be considered dead money. Dead money in any organization is to be avoided. As a financial manager, the objective is to only be holding the amount of cash you immediately need. Anything extra should be earning interest in a bank or invested in other financial instruments.

I would argue that what people call the fractional reserve system is a natural aspect of debt. Any debt whether it is an account balance in a bank, deposit certificates, bonds, IOUs, selling the accounts receivable of your business, these are all forms of debt that create a money multiplier effect. Most discussions of full reserve banking only focus on M1, the bank deposits. Banning fractional reserve would merely move the service to other areas within M2, M3, and M4. M4 being economists’ notation for “other forms of money”, specifically including bonds in my consideration.

If you think of a bond acting in the same way as a bank, then the description that follows will sound exactly like the process of the money multiplier effect of fractional reserve banking. It is the story of how deposits in a bank create more money but is reworded to consider bonds. Any business or government can create a bond. They accept money in exchange for it. They can use the money to buy something then pay back the bond later. Whoever holds the bond can sell it before it is due so it is almost like cash but slower moving. When a municipal government issues a bond. They sell it and accept money. Whoever holds that bond possesses a deposit at the “bond of municipal government” bank. Once the road building company has built the road they may have some money left over and want to invest. They buy bonds from “Acme Road Equipment” since they do a lot of business and trust the company. Acme Road Equipment spends the money raised from their bond offering on new factory robots. Then the “Robot Factory Ltd.” would invest some of the money left over, their profits, in buying municipal government bonds since all the new employees at the factories and road crews are buying cars and it looks like a solid guaranteed return. The money used to buy the initial bonds, M0, can now be thought of as multiplying 3 times, B1 for the initial bonds, B2 and B3 for the second and third time the money was not needed for transactions but was instead invested in debt. Each time progressively getting smaller. The ratio being referred to as the money multiplier. This pattern is recognizable to economists who study the money multiplier effect but it is usually applied to bank deposits.

Many programmers would view this as a fatal recursion problem. Fortunately, it is not something that is instantaneous and central banks can respond to overheated economies. The reserve requirement keeps the ratio in check for banks but there is no reserve requirement for bonds or other forms of debt.  The money multiplier is always observed to be lower than the model or calculated effect. This limiting effect is an aspect of trust. This can be reframed and viewed in a positive light. If you think of debt as trust, then the equation brings forward something better. Yes, there is a limit to trust but it exists and is the primary facilitator of the money multiplier. People keep a certain amount of cash, this is their distrust. The rest of their money they trust a business and buy their bonds or they deposit it into a bank and earn interest. The money multiplier is a measure of trust.

Therefore, the full reserve deposit requirement would be a failure. People will find other ways to trust one another. Using bonds. Using IOUs. Using the traded purchasing of accounts receivables. Any number of ways that people can purchase financial instruments of debt and earn interest with their money. Full reserve banking proponents should focus on a different solution, I would propose that the issue is not the money multiplier effect but inflation. The interest earned on deposits or bonds, the reward for trust, is pirated away by inflation. This issue should be addressed with a solid solution that does not merely relocate the problem like full reserve banking would.

The paper linked below describes a concept which eliminates the punitive forms of inflation and automatically stabilizes the size of the money supply. Stay tuned for additional examples of how this theory can help.



This blog series will be a forum to discuss different concepts and areas where these theories can be applied. Subscribe to stay informed.

Read more about the future of money: Full article. 



The Team

The SAP Canada Ideation Centre’s mission is to help Canadian leaders of business, academia, government and non-government organizations develop a deeper understanding of the digital forces driving the economy today. Ideation Centre members strive to bring forward made-in-Canada fact-based arguments that challenge decision makers to think about the potential of organizational shifts that were not possible in the past. The Ideation Centre is fueled by thought leaders from the Industry Value Engineering team at SAP Canada. This diverse team of industry and value advisors helps organizations of all sizes and industries take advantage of technological innovations to create incremental economic value by adopting new business models and optimizing business processes, from the back office to the boardroom, farm to storefront, mine to operating room, etc.



The Author

Over his decades-long career in the high tech industry, James Zdralek has concentrated on usability, user research and design thinking while building a reputation as a visionary innovator. Merging his expertise in product design, human behavior, and economics, and through his focus on improving accounting tools, James envisions ideas that can drive tectonic shifts in financial and monetary systems. He holds a bachelor’s degree in Industrial Design, a masters in Psychology, and a diploma in Professional Accounting.

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