Understanding Money Destruction in Repaid Bank Loans: A Fundamental Concept in Fractional Reserve Banking

"Why is money destroyed when loans are repaid and doesn’t this go against the function of storing value that money should have?" This question often arises from individuals who do not fully grasp the intricacies of modern banking systems, such as the fractional reserve banking model.

While it’s true that when you repay a loan, the moneyrsquo;s existence on a balance sheet may be withdrawn, this does not mean that the money itself is annihilated. Instead, it becomes available for the bank to lend to another borrower.

For those unfamiliar with the functioning of modern banking, the idea of money being ldquo;destroyedrdquo; when it is repaid can seem absurd. However, this is a simplified view of a complex financial system. In a fractional reserve banking system, the money you withdraw from a bank is backed by only a fraction of physical cash reserves. The remainder is considered virtual or created money that exists only in digital form on a bankrsquo;s ledger.

Fractional Reserve Banking Explained

Under a fractional reserve banking system, banks only keep a fraction (typically 10%) of their deposits in reserve. The rest is reinvested into the economy and used to issue new loans. Herersquo;s how it works:

When a customer deposits money into a bank, the bank holds a small fraction of it in reserve. The remainder, known as the monetary base, is lent out to other customers. When the loan is repaid, the process of withdrawing the money back into the same bank essentially removes it from circulation. The bank, however, still holds the loan amount in reserves, as the borrower now has more money to spend or invest, thus keeping the economy dynamic. This cycle repeats, allowing banks to create and destroy money, albeit in a limited and controlled manner.

Where Does the Concept of Money Destruction Come From?

The ldquo;destructionrdquo; of money when loans are repaid can be confusing for people who think of money as a fixed quantity. However, the concept stems from the balance sheet perspective of a bank. When the debt is repaid, the liability on the bankrsquo;s books is removed, which can give the appearance that the money has been destroyed. In reality, the money becomes available again for lending.

The Absurdity Argument Debunked

It's important to recognize that claiming that money is destroyed is contrary to how we operate. In the context of the U.S. and many other modern economies, this is a fundamental principle of how money functions in a fractional reserve banking system. The stored value of money is based on the trust placed in the banks and financial institutions to manage and back it.

The Illusion of Money Value

Lastly, it's worth noting that the value of money is largely a social construct. While the physical object (like paper money or coins) has some intrinsic value, the digital or electronic currency is fundamentally based on trust and the economic system. If, hypothetically, the entire world collectively decided that money was useless and cat pictures had value, the stored value of the current monetary system would indeed be nothing.

Understanding the concept of money destruction in repaid loans is crucial for anyone interested in the mechanics of modern banking and the economy. It clarifies the role of banks in creating and destroying money in a fractional reserve system, and helps dispel the notion that money is a static, fixed quantity.