When you deposit money into your checking account at a bank, you have the justified expectation that the money you deposited will be used to honor the drafts (checks) you write against that account. You may be surprised, however, to learn that the bank does not. The bank expects to pay your drafts with money borrowed from other accounts, counting on the probability that not every account holder will write big checks all at once.
In fact, the bank believes so strongly in that probability that at any given time it has 90% of the deposits entrusted to it out on loan. If only 10% of the depositors suddenly withdrew their money, the bank would be forced to borrow money or declare bankruptcy.
Since most banks have deposits flowing in as well as out on any business day, this fractional reserve system normally works very well for banks. If more money flows out than in on a given day, however, the reserves of the bank are depleted and they must take immediate steps to replenish them.
This is illustrated annually in the United States in December. Individual depositors have a tendency to withdraw more than they deposit in December due to Christmas gift-giving. To maintain their currency reserves, the banks have to sell a portion of the securities they hold, either on the open market, or to the Federal Reserve Bank. In January, as deposits exceed withdrawals, the banks are able to repurchase the securities to draw down their reserves.
The danger of a fractional reserve banking system is that it is entirely dependent on the confidence of depositors in the banking system. If depositors were to suddenly lose confidence in the solvency of their bank, they will rush to withdraw their deposits before the bank collapses. Since the bank only has enough reserves to cover 10% of funds deposited with them, rumors of bank insolvency can quickly become self-fulfilling prophecies.
To prevent a frenzy of deposit withdrawals, termed a bank run or run on the bank, banks have developed mechanisms to insure bank deposits and borrow money from other banks and the Federal Reserve. The mere presence of these curbs speaks to the fragility of fractional reserve banking, and when the curbs go in they fuel the erosion of confidence as much as they quell it.
To prevent widespread bank panic about their pyramid scheme, banks are ultimately forced to use government guns funded by taxpayers. The government can declare a “bank holiday” to allow banks time to replenish their reserves; in effect, this makes it a crime for you to access your deposits or for a bank to give you access. The other hammer the government can use is the printing press.
Since the loans which precipitated the bank panic are still in place, when the government turns on the printing presses and begins cranking out currency the money supply becomes greatly inflated. As the new currency hits the streets the overall prices of goods and services begin to rise, meaning any deposits left in the banks are worth less in real terms than they were. This, of course, leads to a new round of withdrawals.
To be fair, as the currency becomes debased, some of the new money is used to pay off loans, thereby decreasing the money supply as long as new loans are not issued. Preventing the issuance of new loans, however, exposes the true cause of the bank panic: fractional reserve banking. That cannot be permitted so the inflation and debasement of the currency continues, eventually leading to hyper-inflation.
Since the dawn of fractional reserve banking and government issuance of fiat currency, this scenario has been replayed over and over. Just since the 1980s, Angola, Argentina, Belarus, Bolivia, Bosnia-Herzegovina, Brazil, Georgia, Israel, Madagascar, Nicaragua, Peru, Poland, Romania, Russia, Turkey, Ukraine, Yugoslavia, and Zaire have battled bouts of hyperinflation due to this fragile system. As of this writing, Zimbabwe is projected to have inflation anywhere from 11,000% to 1.5 million % in 2007.
It is important to note that no economy based on fiat currency has ever expected hyperinflation and all governments have denied the existence of hyperinflation until the currency completely collapsed. Note also that, despite the massive human suffering and disruption that result from the collapse of a fiat monetary system and fractional reserve banking, governments return to a fiat system and protect fractional reserve banking as a matter of course.
Fractional reserve banking, much as a fiat monetary system itself, is a fragile pyramid scheme favored not because of its stability, but because of its ability to rob political power and wealth from depositors and taxpayers. In no other field of human interaction is a fraud of this magnitude considered the normal course of business.