Learning the fundamentals of economics has become a kind of a hobby, rewarded by a few glimpses here and there into the netherworld of the current hedge fund crisis and related incidents. It can be a little confusing, for sure. But after reading a fascinating article by Scott Thill, “The Crash of 1929: Are We on the Verge of a Repeat?” the light of understanding has illuminated my mind. I can finally put my finger on the economic worry at the back of my mind. I’ll call it “Fractional Reserve Brokeraging.”

Banking was invented about 500 years ago as a way of keeping money safe, providing easier transfer of ownership of real money such as gold and silver through certificates, and of course as a way of creating capital for investment.

For the few people who owned banks, things really got interesting with the discovery and invention of Fractional Reserve Banking. Bankers knew that not everyone needed all of their gold all of the time—in fact, only a fraction of the clients needed a fraction of their deposits at any given moment. Using this knowledge, bankers would extend “credit” to people by essentially offering them money out of thin air and requiring that they pay back the loan in real gold. It was a brilliant idea that helped fund many ventures, made bankers into international power brokers, and generally helped Great Britain and other European powers expand their empires. (For a fascinating historical documentary on the origin of money, banking, and its influence in wars and politics, see The Money Masters.)

But the general level of trust in the bank can rise and fall with current events, and if it falls far enough we know there can be a run on the bank. In that situation, it’s possible that if enough people want to withdraw their deposits at the same time (trade their paper money for real commodity money such as gold or silver), the bank will suddenly be caught without its cover—and without enough actual assets to be withdrawn, the result is bankruptcy. The bank is discredited and a lot of people lose their savings.

In modern investment practices, there is a kind of activity that is strangely similar to this “fractional reserve banking” that allows money to be created out of thin air. It’s called a “naked short”. Essentially, a naked short is an IOU (”I Owe You”) on a stock. Rather than paying money and getting a share in a company, you can pay money (through a broker) and get an “IOU” for that share instead. Apparently, this has permitted a huge sum of money to be created and floated through the markets via hedge funds. It’s essentially the same as a bank making a bet that only a certain fraction of gold will need to be in circulation, and so it can print more paper money than it actually has in gold reserves. Likewise, naked shorts allow brokers and investors to create more stocks than actually exist.

When traders realize that an IOU is not precisely the same thing as a share, the game turns into musical chairs and we wait to see who’s sitting in a chair when the music stops. Of the people who need chairs, only a fraction will be seated.