Fractional Reserve Banking Considered

More than anarchy vs. minarchy and Austrian vs. neoclassical economics, the most common subject of debate that I observed at the Mises University program was the institution of fractional reserve banking in a free banking system. The simplest objection to it is the moral objection that it surely must constitute fraud if a bank promises to hold your money and then loans it out in your absence. Of course, if A, the customer, and B, the bank agree by contract to the practice, one could argue the bases are all covered. I think this leaves out an important party, C, the seller of goods that A buys with private money tickets from B. If A passes off money to C as being worth $10 that could not be redeemed for $10 in gold, this must also be fraud. If A notifies C that B's money is not 100% backed, B might reject it but the fraud question is settled.

One reason why this is not the best objection to use is that should a private money system ever return, it's likely that a majority of the population, or even as much as a plurality will not be libertarians who are dead-set against a practice they consider fraud. Most people could care less about inflation and the business cycle because they won't need to redeem their money receipts from their banks most of the time and because there are other more immediate concerns to worry about.

The better argument for convincing people (hence, the one we should use) is the economic one that 100% reserve banks will outcompete fractional reserve banks; the problem is this might not be true. I suspect that banks with a reserve ratio close to 100% will outperform other banks for the reason I mentioned earlier, that sellers might not accept the less-valuable money. However, this question will have to be settled when we get there. Even if the practice persists, it must certainly be less inflationary than the present system whereby banks only need to have enough reserves to cover 10% of their accounts.

If we believe that "anarchy in production" will produce the greatest utility with regard to consumer goods, surely "anarchy in banking" will produce the greatest utility with regard to money.

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I find it hard to believe

I find it hard to believe that a full-reserve bank could outcompete a fractional reserve one. Consider the simplest fractional-reserve bank: one which invests its deposits in some broad portfolio of safe, interest-bearing, liquid commodoties. (Say high-grade corporate bonds). Essentially its lending its deposits to corporations. Now the depositors are pretty much guaranteed their money back, as the bonds are liquid, so even if there is a run on the bank, they can get money. By combining the bonds with other investments, the possibility of the whole portfolio declining dramatically are very low.

So now instead of being charged to use the bank, depositors (or noteholders) receive a few percent interest. They have some tiny chance of losing their money in a global financial meltdown. I might bury some gold coins in the backyard as a hedge, but I'll take the interest-bearing account (or note) any day!

The bank can invest (lend out) its assets, and still pay all its noteholders, just by liquidating those investments. What is so important about instant payment in gold that is worth giving up all that interest?

The problem with the

The problem with the fractional-reserve banks is the credit creation process- $1.00 of real assets go in, $1.00*(1/fraction) goes out. The whole "money multiplier" thing.

The people operating with the fractional-reserve bank are getting signals that there are more resources available than is true in reality, which distorts signals.

The thing is that absent some sort of coordinating mechanism, all banks can't inflate at the same time/rate, and competition will tend to drive reserve rates higher. I remember reading a paper a while ago comparing the US, Canadian, and Hong Kong banking systems based on the type of deposit insurance they had (US with DI and the Fed, Canada during the period of comparison was half DI, half not, and Hong Kong until 1969 or so was no insurance free banking). US banks had a higher rate of bankruptcy/insolvency than either Canada or Hong Kong, which had almost no bank runs in its entire history of free banking.

THe Hong Kong example had the various banks in a constant mexican standoff, looking to stab each other in the back at any opportunity. Any whiff of fiscal impropriety led the other banks to aggressively target their opponent's banknotes, which would force the opponent to repair their deposit situation or be ripped the shreds. Whereas the more cartelized and guaranteed the banking system, the more unstable it became (the US system being backed by deposit insurance and the lender-of-last-resort).

Bringing it back home, even though fractional banking is inherently inflationary, the discoordination in "fraud" will most likely put checks on the formation of a general credit boom. New England bankers used to do that all the time in the first half of the 19th century in response to wildcat bankers (the 1/infinity fractional bankers...) and while panics washed over the "west" all the time (i.e. the midwest and deep south), New England's stingy bankers stayed lucid and liquid. New England's banks often kept the monetary system from going into full tilt precisely because they were stingy.

In a world with highly developed financial markets, though, the threat posed by individual fractional reserve banking is not so great. At least in the US, there are zillions of ways to disperse risk. At some point, the risk of default falls into the negligible range (within the noise of everyday random risk) and so even a fractional reserve bank will be able to act with the same level of security as a 100% reserve bank, and as Patri said in those cases the fractional bank will outcompete the 100%.

Sound money aside, it is

Sound money aside, it is really hard to see how 100% reserve banks could out-compete banks of the sort that we know and love today, since the single biggest source of income for retail banks is the profit made on their loan spread. 100% reserve banks (such as, I suppose, E-gold and their ilk) have only fees for their incomes, and consumers may be loathe to pay exhorbitant fees for a mere checking account.

In any case, I really don't see the case for "fraud" when we're talking about retail banks issuing specie. Your third-party argument is somewhat compelling, but I think that it can be dealt with simply by saying that a payer in specie issued from a traditional (i.e. not 100% backed) bank is implicitly guaranteeing the value of that currency. To the extent that the currency does not wind up being worth what he says it will, his payee will have recourse against the payer and not the bank, and then the payer could well have legal recourse against the bank.

Which, of course, counts for nothing if the bank is bankrupt. But, then again, a completely free market with fairly transparent financial markets would significantly reduce the chances of this. :smile:

my total objection lies

my total objection lies solely in the fact that 'im legally forced to use a fractional money system. why o why cannot we have a choice? its obvious fractional reserve banking is a useful tool for controlling the fools only, and thats about it. gold eliminates the scumbags like Jude Wanniski from the equation. problem solved.

Um, qwest, as far as I know,

Um, qwest, as far as I know, gold is still legal to buy and legal to use as a commodity. I think FDR banned gold for consumer and commodity use at some point, but that ban was lifted a long time ago.

Brian, I mentioned the


I mentioned the inflation angle to the Mises Profs and they didn't seem to mind. After all, a fully-backed reserve system is inherently deflationary, as the money supply remains relatively constant while productivity and economic growth increases. The real problem, they said, is not with inflation or deflation, but with the power to inflate or deflate concentrated in the hands of one extremely large entity.

"The problem with the

"The problem with the fractional-reserve banks is the credit creation process- $1.00 of real assets go in, $1.00*(1/fraction) goes out. The whole “money multiplier” thing.

The people operating with the fractional-reserve bank are getting signals that there are more resources available than is true in reality, which distorts signals."

No, not really. That process is only a problem during a transition from 100%-system to fractional reserves. Then it becomes a inflationary process. Under the 100%-system, the monetary base is the money supply, so when you increase the monetary base, the money supply will increase as well. Under FRB, holding the reserve ratio and the velocity of money constant, an increase in the monetary base by 3 percent will increase the money supply with 3 percent as well. So there's no difference when it comes to distortion.

The problem is that ceteris is not always paribus, both the reserve ratio and the velocity of money will change. And that may pose a problem under FRB, but also under the 100%-system. The velocity of money reflects the demand for money. If the demand for money changes, the money supply should change as well and that is difficult under the 100%-system and may distort the signals.

No, under FRB, increase the

No, under FRB, increase the monetary base by 3% and you necessarily increase the money supply by the 3% times the reciprocal of the reserve rate. So that is a big difference.

Ex: Money supply of $100. I add in $3 to the bank. Bank has a 20% reserve requirement. It loans out 80% of the 3% to other people, who'll deposit it again, who'll deposit it again, fractionally until ultimately there is $15 of new deposits in the system. Which is spectacularly different from merely increasing the total metallic monetary base by $3.

"Velocity" is not meaningful in this situation.

Micha- I agree with them;


I agree with them; the problem in general is with coordinated inflation. Thats what I was clumsily trying to get at in the last parts of my other comment- that individual inflations won't seriously distort the economy due to other banks' counteractivities. When they're forced into collusion by a central bank, then inflation proceeds apace and causes mischief.

I pretty much agree with

I pretty much agree with Brian, above.

Fractional reserve banking in and of itself, is not necessarily a problem. It could be seen as a form of gambling. "This '10 units' bill, is it going to get me ten units when I try to redeem it, or not?"
It is the institutionalization of that form of banking, by government, that is the problem. The Hong Kong situation would develop in a "free banking" world. In fact, private depositor insurance would probably arise, with insurance companies doing major diligence on banks, and refusing to insure accounts in "wildcat" operations.

(Of course, any bank that claims to be full reserve and is fractional, that is a fraud.)
If all notes are allowed to compete, the more stable will win. The only overdrafts will be those necessary to fund the operations of the bank and provide a natural rate of interest.

Brian: No, there is no


No, there is no difference. In your example, the monetary base was from the beginning $20. Add $3 and your monetary base increased by 15 percent. The money supply increased from $100 to $115, which is also an increasement by 15 percent.

The whole deal will pan out

The whole deal will pan out only if you are in a state of constant mild deflation. This is when 100% fractional banking should come into its own. If you are in no inflation or low inflation of course the banks that don't keep 100% reserves are going to outcompete the ones that do.

The Gold standard without 100% reserve is a big problem. Because you are going to have this constant switch between low inflation and low deflation and its at this crossover point that you are likely to get these big behaviour changes in the way folks will hold money and in the behaviour of the banks.

Everything comes together with 100% fractional reserve when you have this constant deflation. So there is very little incentive of banks to cheat and so behavioural norms as far as the demand for money should be more or less stable. Forget about 100% fractional reserve with a low inflation environment. Its constant deflation or we should just get used to the Fed. In fact if we got used to this constant deflation and then we had a massive gold strike and we went into inflation I would go so far as to say we would have to take action to stop this from happening since we would be risking the whole system unravelling.