Fractional Reserve Banking is a system where banks are required to keep a certain percentage (determined by the Central Bank) in cash as reserves. They will then loan out the balance and the process is repeated. In a system based on fractional reserve banking, the banks have the power to create money. The amount a bank is allowed to give out as loans is determined multiple of the bank's reserves. For example if the reserve requirement is 10% then for every RM100 of deposits a bank can give out RM1000 worth of loans. This newly created money is termed as “fiat” money. Fiat money has NO intrinsic value and NOT backed by any physical (valuable) asset such as gold and hence cannot be redeemed for any commodity or asset. It is made legal tender through government decree hence the value of fiat money depends on the strength of the issuing country's economy and therefore, issuing more fiat money by reducing the reserve requirement could lead to inflation.
How did this fiat money come about? Back in the old days when gold was still the medium of exchange, rich people (those with lots of gold) deposited their excess gold with the goldsmiths for safekeeping. Whenever they need to purchase anything, they will go to the goldsmith and withdraw some gold to pay for their purchases. This is how the banking industry was at that time, a custodian for excess gold. As trade increased, and to overcome the need for frequent withdrawals (there were no ATMs back then) the rich started issuing IOUs to their suppliers when making purchases whereby the supplier will take the IOU and redeem the gold from the goldsmith. Some of the traders use the IOU for their own purchases instead of redeeming it with the goldsmith, causing the IOUs to circulate as a payment mode. Subsequently, the goldsmiths (who happen to be Jews by the way) realised that not everyone redeems their gold; some kept them in the vaults for years. This made the goldsmith realise that they themselves could issue IOUs and lend them out and earn interest in the process. They were effectively making money out of thin air using other people’s money! That was how fiat money evolved and the system has been made legal and still practiced today. The only difference is the banks are playing the role of the goldsmith.
Fiat money contradicts with the economic theory of scarce resources; fiat money makes capital unlimited.
The fiat money created by the banks are given out as loans and used to purchase assets. This effectively means that assets are bought on debt using debt. Another way of saying it is, we are borrowing borrowed money. These borrowed money we are borrowing is actually created out of nothing, i.e. not backed by real assets.
So, there are effectively two levels of borrowers, the consumer (or corporation), who is the end borrower and the banks, the initial borrower. So, when the end borrower defaults, it will cause the initial borrower to default too as the initial borrower would not have funds to repay their lender i.e. depositors.
Money creation is the major cause of inflation. Increases in asset value may not have any correlation with actual asset value; it merely reflects the amount of money in circulation. My untested theory is that money creation creates economic bubbles and business cycles. It causes the economy to grow beyond it capabilities.
Shariah based financing on the other hand forbids money creation; every financial transaction must be based on actual economic activity. Money is defined by Shariah as a medium of exchange, a tool to facilitate trade, it is NOT a commodity on its own hence money cannot have a price and cannot be traded. Money should not grow through artificial creation but via productive activities.
Fiat money, excessive speculation and over leveraging are the root of the sub-prime triggered economic crisis. There is a reason after all for the Shariah prohibition of those unfair activities. So, the money we use as a medium of exchange and as a measure of wealth has no intrinsic value. Is all the paper money in our pockets worthless then? But isn’t cash supposed to be king?
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