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Money: Fractional Reserve Banking Is Fraudulent

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Your mistake was assuming FBNs would be worth as much as gold. The FBNs would be worth whatever fraction of gold they had backing them, or worth their amount as paper, which ever is higher.

There are at least three different notions of VALUE:

1. Intrinsic: According to this (most simplistic) view, value is inherent in objects independent of their relationship to people. This is the view of Platonists and some religionists. It is apparently also the view of nimble.

2. Subjective: According to this view, value is relative to the valuer, but it is determined by his whims. So value is arbitrary. This is the view of VonMises and many other "modern" people.

3. Objective: The value of something depends on who is evaluating it and on what he intends to do with it. Value is not a matter of whim nor is it arbitrary. It is determined by what that person actually needs in order to live. This is the Objectivist position as I understand it.

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There are at least three different notions of VALUE:

1. Intrinsic:  According to this (most simplistic) view, value is inherent in objects independent of their relationship to people.  This is the view of Platonists and some religionists.  It is apparently also the view of nimble.

2. Subjective:  According to this view, value is relative to the valuer, but it is determined by his whims.  So value is arbitrary.  This is the view of VonMises and many other "modern" people.

3. Objective:  The value of something depends on who is evaluating it and on what he intends to do with it.  Value is not a matter of whim nor is it arbitrary.  It is determined by what that person actually needs in order to live.  This is the Objectivist position as I understand it.

Not every active person in the economy has Objectivist morals, so I would have to agree with Von Mises on this one. If everyone were Objectivists there wouldn't be a big market for porn, yet it still has value in our economy. This means that people do assign value to things I do not consider valuable. Although I would not call that arbitrary.

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I'm afraid I don't have sufficient knowledge on this subject to make a contribution to the discussion. I am planning on reading a lot this summer to make up for it. However, I'd like to say that as an econ major I've thoroughly enjoyed this thread and would like to thank Nimble for starting it and AWest, pi-r8 and everyone else for providing great information. This is why I come to this forum! =-)

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I'm somewhat confused here. Are you guys talking about the current American system of Fractional Reserve Banking? I didn't see anything that specifically stated that this discussion was about another country's system or a theoretical system, or a historical system, but everyone seems to be talking about money backed by gold...which doesn't exist in America anymore.

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We are talking about two cases: the hypothetical case of a gold-backed fractional reserve money, and the hypothetical case of a non-backed fiat fractional reserve money. The former, incidentally, is US past, and the latter is US present.

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I did some historical research, and during the 1830-50s when banking in the US was relatively free. The banks with higher fractional reserves would not accept notes from banks with lower reserve fractions at the same price as theirs. This lead to an inequality of bank notes, which lead to exchange rates from bank to bank even though they each were on the gold standard. This proves my point that in a free market, participants in a fractional reserve bank would lose some of the value of their gold if they were to deal with banks that had higher reserves or full reserves. I said earlier that the market would not value the note of a fractional reserve bank as highly as one that came from a full reserve bank.

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I... in a free market, participants in a fractional reserve bank would lose some of the value of their gold if they were to deal with banks that had higher reserves or full reserves. ...

A.West's post in this thread made this point, as did my post. However, if one gets away from 100% backing, then the % of gold reserves becomes only one part in figuring the rational rating of a bank note. The other factor is the quality of the assets that cover the % that is not backed by gold.

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I'm sorry, I guess I did not catch that you agreed with me in some aspect of this debate. Plus it's been a while since I posted on this topic.

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(Moderator's note: The issue of Fractional-reserve banking arose in another thread. I have moved the post to this existing thread that has that subject as its main topic. - softwareNerd)

If Trudy Cool means that any fractional reserve system is intrinsically harmful, I would think that would be pretty easy to refute.

Could you do that for me. Also Include an explanation as to how you believe fractional reserve systems would work in a proper economy.

I think there exist 2 different views regarding what it is and that might be part of the confusion.

1- A bank owns $100 and can loan out $90

2- A bank owns $100 and can loan out $900

I understood fractional reserve banking to be #2 but I'm not an economist.

#2 seems inherently fraudulent to me by nature in any system. Especially when applied to a country size scale.

Edited by softwareNerd

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I'd love to.

The simplest example of fractional reserve I can think of would be Adam loaning money to Bart on the condition that Adam can ask for his money at any time, and receive it within a specified time frame (say, an hour.) Even though Bart may or may not have the total amount of loaned money at every possible instance, Adam benefits if there is some advantage in letting Bart hold his money (e.g. interest or security) and Bart obviously benefits from a loan.

I believe fractional reserve works, because

  • fractional reserve is no different from any other loan with an unspecified due date
  • (in the case of non-fiat fractional reserve) any bank notes have a specific redeeming value.

I think there exist 2 different views regarding what it is and that might be part of the confusion.

1- A bank owns $100 and can loan out $90

In terms of fraction reserve, I wouldn't say the bank "owns" a deposit of $100. But otherwise, I'd consider this fractional reserve.

2- A bank owns $100 and can loan out $900
You mean a situation in which a bank has deposits of $100 and loans out a sum of certificates they agree to redeem for $900? Fractional reserve is when you keep only a part of money entrusted to you (investing/spending the rest,) not when you create certificates that have a redeemable value more than one can redeem. This too is being presented as a problem, but it isn't significant so long as these certificates have a specified redeemable value. If someone presents more certificates than can be redeemed, he can't get his money, no different from being defaulted for any other loan.

#2 seems inherently fraudulent to me by nature in any system. Especially when applied to a country size scale.
After reading this thread (thanks, softwareNerd!) the simplest reply is that *only in a fiat system* is a person required to accept certificates as legal tender. thus a person who used only hard currency is not fraudulently affected, and a person who volitionally used certificates is harmed only to the extent that his certificate's reserve institution is ultimately unable to redeem its certificates (i.e. he can only used 100% backed certificates.)

Lastly, Mises took [an anti-fractional reserve] stance... And Mises was who Rand recommended for economics. I like how an Objectivist forum ignores Rand's advice on economics.
I didn't/don't know that Rand was anti-fractional reserve, but that still wouldn't make a valid anti-fractional reserve argument in and of itself.

If Mises was against it, that just means there's room for improvement in the best of the known economist's theories :worry:

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I know Rand's stance about an "only gold" montary system, but need an economy only have currency backed by gold? Any other thing of value would do nicely, any kind of property that is physically transferable. So, if choose to offer a currency backed by corporate stock (assuming a productive company) it would be just as valid as one backed by gold. Of course gold is almost always in demand, therefore making it a good store of value, but how can it account for ALL of the value in an economy? Why not just balance the currency against all of property and real value in an economy. But because having a complete list of goods and services borrowed against would be inane, we just call the total "debt."

This is the nature of fractional reserve banking. Ideally, any money going into a bank is loaned out to finance the expansion of property and value, making a new business, or reinvesting in an old one. This loan is repaid by the new value generated by the business, therefore backing the the currency generated. Of course, this system is not perfect, so there will be some "inflation" in the economy if the money is not loaned out wisely, but this is covered by the gains made by the first savers by having an interest rate equal to or greater than the rate of inflation. An unfortunate result is that now all savings needs to be inside the system to retain value.

Granted this is a fickle beast to be tangling with, a great Pandora's box, but the potential for large expansions in real value is almost impossible to ignore. Inflation must be constantly fought, the job of the Fed, or less the beast would fly out of control. As long as inflation is kept under control, (that is less than 8%, anything higher and the nightmare scenarios start cropping up) Fractional Reserve Banking is a good tool in the management of a modern economy.

I wanted to give a reasoned counter arguement. But have at it!

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I'd love to.

The simplest example of fractional reserve I can think of would be Adam loaning money to Bart on the condition that Adam can ask for his money at any time, and receive it within a specified time frame (say, an hour.) Even though Bart may or may not have the total amount of loaned money at every possible instance, Adam benefits if there is some advantage in letting Bart hold his money (e.g. interest or security) and Bart obviously benefits from a loan.

I believe fractional reserve works, because

  • fractional reserve is no different from any other loan with an unspecified due date
  • (in the case of non-fiat fractional reserve) any bank notes have a specific redeeming value.

In terms of fraction reserve, I wouldn't say the bank "owns" a deposit of $100. But otherwise, I'd consider this fractional reserve.

You mean a situation in which a bank has deposits of $100 and loans out a sum of certificates they agree to redeem for $900? Fractional reserve is when you keep only a part of money entrusted to you (investing/spending the rest,) not when you create certificates that have a redeemable value more than one can redeem. This too is being presented as a problem, but it isn't significant so long as these certificates have a specified redeemable value. If someone presents more certificates than can be redeemed, he can't get his money, no different from being defaulted for any other loan.

After reading this thread (thanks, softwareNerd!) the simplest reply is that *only in a fiat system* is a person required to accept certificates as legal tender. thus a person who used only hard currency is not fraudulently affected, and a person who volitionally used certificates is harmed only to the extent that his certificate's reserve institution is ultimately unable to redeem its certificates (i.e. he can only used 100% backed certificates.)

I didn't/don't know that Rand was anti-fractional reserve, but that still wouldn't make a valid anti-fractional reserve argument in and of itself.

If Mises was against it, that just means there's room for improvement in the best of the known economist's theories :)

Ok...so I have no problem with fractional reserve banking as regards to #1. And after reading some more on it(your post included) I am tending to think there would not be a serious problem with it except in the context of a single supplier of bank notes. If you actually had a choice in banking in other words, you could deposit your money in a bank who offerred you the best deal. You would have to weigh the interest they were offering against the risk your money was under. So if they operated on a really thin fraction of reserves, their liklihood of bankruptcy would be higher.

The problem then currently seems to be that because of a privately owned national bank that also controls the money supply, we have a system balanced on the edge of disaster which allows banks to make rediculous percentages of interest in a very underhanded way. If $100 existed in the whole economy, which was primarily held in accounts with a national bank, and the bank could loan out $900 at say 12.5% and still maintain 10% fractional holding, then after 1 year they would have made the entire $100 of the whole economy's money in interest payments for that year off of money(in the sense of created value) that they don't actually possess. In other words, they would earn 100% interest per year.

This is what strikes me as fraudulent. To be able to loan out money you don't possess and have not either earned yourself or had deposited in your bank. Of course by telling everyone and allowing everyone to do the same, it is no longer fraud. So, theoretically in a free market everyone could loan out 10Xs what they possess. Even if it is not fraud per se, still seems like there is something wrong with the notion.

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No one is able to do that, not even under the current fiat system.

hmmm...maybe I misunderstood, but that was what I thought trudy was explaining on the debitism post-that they were fabricating money and earning interest off of the fake money. If the federal reserve does not do that, then who is getting the interest off of the fiat money initially?

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hmmm...maybe I misunderstood, but that was what I thought trudy was explaining on the debitism post-that they were fabricating money and earning interest off of the fake money.

No, that would be a crime, even under the current legal system.

What is not a crime under the current legal system is for the government to take away taxpayers' money. The government can use this power in two ways:

  • It can tax you right now;
  • It can borrow money and promise to repay it with interest from the taxes you are going to pay. Then it tells the Fed to inflate the money supply, decreasing the value of the money you have--and also decreasing the value of the debt it owes.

Both of these are based on the government's power to tax you. The first one is blunt and direct; the second one is more "sophisticated." But the blame for it lies with the government all the same; it is a statism issue, not a banking issue.

Edited by Capitalism Forever

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Granted this is a fickle beast to be tangling with, a great Pandora's box, but the potential for large expansions in real value is almost impossible to ignore. Inflation must be constantly fought, the job of the Fed, or less the beast would fly out of control. As long as inflation is kept under control, (that is less than 8%, anything higher and the nightmare scenarios start cropping up) Fractional Reserve Banking is a good tool in the management of a modern economy.

Um, inflation is created by the government’s printing presses. That’s why governments hate the gold standard – it prevents them from looting the public by inflating the currency.

Fractional banking does affect credit expansion, but it cannot inflate the currency beyond the marginal reserve of the bank. For example, if the bank has $100 in deposits, and a reserve of 10%, then it can create $90 of currency. Some argue that the ability for banks to rapidly inflate the investment base is a good thing in a growing economy; others argue that it leads to business cycles.

The danger of fractional banking is that the public will perceive savings accounts as a guaranteed form of savings due to government regulations (like the FDIC and Fed lending). However fractional banks are not savings accounts – they are investment accounts. In a free economy, consumers would decide whether to risk their funds in a fractional savings account in exchange for interest or pay to store 100% of their funds in a vault. Unfortunately, our government has made 100% savings impossible by mandating fiat money, bailing out failing banks, and making private gold holdings illegal when it hyper-inflates, as in the 70's.

The answer of course, is to get the government entirely out of the economy, and let the market establish an equilibrium between investment and savings banking.

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How can [gold] account for ALL of the value in an economy? Why not just balance the currency against all of property and real value in an economy?
As I understand things, non-fiat currency tends to do its own balancing (though not as quickly as may be liked.) Since goods added/removed in a market cause the prices of other goods to correspondingly decrease/increase (generally speaking,) there really is no particular need for new currency in order for a limited amount of gold to represent all the exchanged goods/services in a market.

I am tending to think there would not be a serious problem with [fractional reserve] except in the context of a single supplier of bank notes.
[being]able to loan out money you don't possess and have not either earned yourself or had deposited in your bank [strikes me as fraudulent.] ...Even if it is not fraud per se, still seems like there is something wrong with the notion.
Take this from the sense of a single certificate-issuing entity initiating force, and a certificate-issuing entity not initiating force. If the original (non-issued) currency is fiat, then that's the problem (and not fractional reserve itself,) so I'll assume that the non-issued currency is gold.

Suppose Pokecorp sells Pokemon cards, which are so highly valued that a card which costs 2 gold cents to make goes for 1 gold dollar on the market. They may create as many cards as they can, or a limited number. The potential devaluing of Pokecards in terms of gold is avoided by not accepting Pokecards for goods. The potential devaluing of gold in terms of Pokecards is avoided by accepting Pokecards for goods. A "wrong" choice can be detrimental, but one has a choice.

Pokethugs Inc. also sells Pokemon cards at a similar cost and selling price. But Pokethugs realizes that their bubble can burst by traders no longer valuing their cards. So what Pokethugs does is forcibly restrict Pokecards from becoming devalued, thus forcibly restricting individuals' capacity to avoid repercussions of the Pokesystem.

If the first scenario were changed to a lending (instead of buying) scenario, there would be no fraud problems for the given reasons. The second scenario doesn't involve lending, though the same problems being attributed to fractional reserve apply to it. The problem isn't the quantity of suppliers of bank notes or fractional reserve itself (or even taxation or inflation per se,) but force.

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Fractional reserve banking is not fraudulent.

When the depositor puts his gold in a fractional reserve account in Bank A, he knows that the bank does not hold 100% in reserve. He is not being defrauded.

When Bank A gives out a part of the deposit as a loan, the loaner also knows that the bank notes he recieved are not a 100% reserve.

When Joe buys bread at Sally's bakery and pays her with a Bank A bank note, Sally knows that that note is not from a 100% reserve bank. She is not being defrauded either.

If Bank A passes off full reserve notes and proceeds not to hold the full value in reserve, that is fraud. This is not inherent to fractional reserve banking.

If Bank A prints out full reserve bank notes for gold it does not have, that is fraud. This is not inherent to fractional reserve banking.

If Joe passes a Bank A note to Sally saying it is a 100% reserve note, he is defrauding her not Bank A.

In reality, it is very possible that Bank A would have both full reserve and fractional reserve accounts. It is possible that the bank would print two (or more) types of bank notes, according to the type of deposit. As was mentioned, fractional notes would trade for full notes at a loss.

Where is the advantage then? Time preference. I put 500 ounces of gold in the bank and get 500 fractional reserve notes, that trade for 495 full reserve notes. Of course I can simply go to the bank and redeem my notes for the 500 gold, trading for the full reserve notes would be stupid. My fractional account earns me 3% yearly, while a full reserve account costs 1% yearly (it is warehousing after all).

I win because my gold is working for me. The bank wins because it keeps part of the profit. The loaner gains because he gets capital to produce.

The key point is that the value of the bank's fractional notes is directly related to how trustworthy the bank is when it comes to redeeming notes. A bank that holds marginal reserves, has few clients or chooses poorly how to loan out money will have its fractional bank notes devalued in the market. A bank with lots of clients, that holds a healthy reserve and has good assets will have it's notes valued almost equal to gold (as in my example).

Why would bank notes from a bank that holds a 50% reserve on average not trade at 50% face value in the market, as some people seem to think would happen? Because anyone could simply take the note to the bank and redeem it for the full value. Some people might do exactly that, which is fine.

Any good bank will work hard to have it's fractional notes trade very close to face value. Any bank can only inflate it's own fractional notes - which is suicidal since it pushes customers away (why would you want to deposit your gold and get junk notes for it?) and increases the risk of a bank run that would mean liquidation of the bank (notice that in this case most likely all the customers get their money back from the bank's assets and capital).

And just to restate an important point that has already been made: a bank note is not a property certificate to a certain bar of gold, it is an IOU. The bank note you get when you put 500 ounces of gold in the bank does not mean you own those 500 ounces in the bank's vault, it means the bank promises to pay you 500 ounces of gold if you turn in that note. Likewise when a bank writes up 300 additional bank notes and gives them to a businessman, on condition that he pay back 350 a year from now and backed by the businessman's assets in effect the bank has 800 outstanding notes, 500 in the vault and a claim to 350 gold or equivalent assets.

mrocktor

Edited by mrocktor

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O.K. This is my contribution. As far as I understand it fractional reserve banking is and must be considered fraudelent (from a legal standpoint or not). I shall only consider the case of fiat money (that is money not redeemable for gold, etc. on demand) simply because this seems to be the type of money that we use at this time and will continue to do so for the forseeable future. Suppose now that we have a bank A, to which a depositior a entrusts a fixed sum x. As I see it, the majority of people do not by any chance understand that by the time they turn around (provided that the bank is efficient in its fractional reserve banking) 90% (or something thereabouts) of their money will have gone from the bank to the hands of borrowers of money (even if they should, but I personally think that the banks do little if nothing to make this point absolutely clear, probably one has to read about 500 pages worth of legal documents to come to the conlclusion on one's own and that is well too much for almost everyone, short of an economist or a person well nursihed in matters of the judicial). Most of them will think that the money will be doing precisely what they expect it to be doing - lying around doing absolutely nothing. Should they want to lend out the money they would have come to that decision themselves and would have signed a contract lending the money to some individual. They however do not desire that - what they want is for their money to be repayable to them at once and at a moments notice. For the bank to guarantee payability to its customers is absurd since it cannot meet this contractual obligatin at any given time (at least in certain cases). From this point of view the bank is making legal commitments for something, which it cannot necessarily meet - in this sense, as far as I am concerned its activity is thereofere fraudelent - it is pretending to have abilities, which it does not in fact possess. Another example: Suppose a firm would sign off on a check that it will deliver you say a sofa, if you pay them a thousand dollars. They don't. If you ask me : sue the bastards. The same should apply to banks. These (if they are doing fractional banking) must from the onset be inherently bankrupt. One's deposit (under fractional banking) becomes, in effect, less a gurantee of money but more a lottery ticket. of sorts. And just to be sure, I think there have in the past been numerous crises in several states deriving from the illiquidity of the banks.

In any case the inflation under fractional reserve banking is most certainly gretaer than it would have been, did the latter not exist (more money, more demand, higher prices).

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If customers don't understand fractional reserve banking... why do they think banks would pay to store customer's money??

And since the government ultimately backs back accounts, for all intents and purposes, banks can meet "contractual" obligations at every given time. Whether the government should do so is another question...

I shall only consider the case of fiat money simply because this seems to be the type of money that we use at this time and will continue to do so for the forseeable future.
But you shouldn't bundle the issues. If fractional reserve is legit under, say, a gold standard, then the problem is not fractional reserve, but fiat money.

In any case the inflation under fractional reserve banking is most certainly gretaer than it would have been, did the latter not exist (more money, more demand, higher prices).
Inflation can occur through acceptable (non-forcing) means and illegitimate (forcing) means. If me 100 million other people start exchanging IOUs for services, this can cause inflation, but there is no legal problem with it, because everyone has the opportunity to similarly trade IOUs or avoid them as they see fit.

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Inflation can occur through acceptable (non-forcing) means and illegitimate (forcing) means. If me 100 million other people start exchanging IOUs for services, this can cause inflation, but there is no legal problem with it, because everyone has the opportunity to similarly trade IOUs or avoid them as they see fit.

If you and 100 million people start exchanging (emmitting) IOUs, there is inflation first (in the short run) as there is new "money", but no new products. The whole thing changes over time as they have to offer products and services to pay their debt. So after the new money is already introduced, you have a rise in products and services, but no rise in "money", hence deflation to the same degree you have had inflation before. So you have long-term price stability, even though this short boost will cause fluctuations in prices. If you also have interest payments on the IOUs, you have to offer more services and products to pay the interest, too and therefore a net deflation in the long run.

Uh oh, I started talking debitism again. :lol:

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If customers don't understand fractional reserve banking... why do they think banks would pay to store customer's money??

And since the government ultimately backs back accounts, for all intents and purposes, banks can meet "contractual" obligations at every given time. Whether the government should do so is another question...

But you shouldn't bundle the issues. If fractional reserve is legit under, say, a gold standard, then the problem is not fractional reserve, but fiat money.

Inflation can occur through acceptable (non-forcing) means and illegitimate (forcing) means. If me 100 million other people start exchanging IOUs for services, this can cause inflation, but there is no legal problem with it, because everyone has the opportunity to similarly trade IOUs or avoid them as they see fit.

My point would be that customers don't ususally think at all about what their bank is doing with their money because they find its function to be evident enough (or so it would seem). Besides if given banks which would not be allowed to do fractional banking but would be allowed to lend money if their customers allowed them to do so, then does it not seem plausible enough that these banks would want as big a customer base as possible (since these customers are not only future borrowers but lenders as well), seeing as how banks can make profit on the interests earned. So in a competitive enviroment, banks able to make profit this way would definitely be willing to pay a small interest if that mean a bigger customer base. That's one of the things that they might consider (but again my point is that they wouldn't consider, anything, at all).

I'm not sure about your country but where I come from, the state only backs the savings of any given individual to a certain fixed amount. Beyond that it's all a question of good luck.

Also, fractional resereve banking should (in my opinion) not be legit under any from of money (gold standard or fiat money).

Oh, I have another question. As far as I know there is today in circulation more dolllars than say 10 years ago. How is this possible (does it all come from banks lending more money than they have)?

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Oh, I have another question. As far as I know there is today in circulation more dolllars than say 10 years ago. How is this possible (does it all come from banks lending more money than they have)?

Depends upon what you call money. If you mean dollar bills and coins, that money is issued by the Fed. They have it printed/minted and buy either private debt or (mostly) government bonds. But that's only about 10-20% of what counts as money, the other 90% are created by fractional reserve banking (lending money until they have reached the limit of 10% required "reserves" (= Fed paper)). I've heard that this reserve ratio has been lowered, but I have no source for that claim. But whatever the ratio is, the principle remains the same.

Edited by Felix

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