I’m about to kick a dead horse, but every once in a while you see the horse’s ghost gallop about the internet. The notion that fractional reserve banking is “fraudulent” and “unstable” is a “brain worm” that deserves to be extinguished.
Part of what a bank does is intermediate between savers and borrowers. When you put your money into a savings account, the bank will lend it out. Fractional reserve banking works the same way, but deals with relatively liquid type of deposits. There’s nothing fraudulent about it.
I’m relatively young and I don’t make a big income, so I keep a good amount of money in a demand deposit. If I ever unexpectedly need it, it’s there. Most of the time, it just sits there. Anything not being presently consumed is being saved for future consumption, so those dollars are savings — just like a savings deposit, but (given regulatory rules) with no interest and greater liquidity. The bank will lend these savings out.
Are there two claims on the same money? In a sense, yes, but that’s true with just about any savings vehicle. The money you’re lending is yours, you’re just not currently spending it, so it can be lent out. You might argue that the problem with fractional reserves is when depositors go to the bank to withdraw their money. This isn’t an issue unique to deposit banking. It’s called a maturity mismatch and it can happen with any kind of asset. In fact, it’s something that is inherent to banking: banks borrow short and lend long.
The “trick” is to manage these different assets and rely on the law of large numbers to make sure you always have the sufficient liquidity to pay-off short-term liabilities. That’s what successful banks accomplish. Without the ability to juggle assets of different term lengths, the intermediation industry is going to be very inefficient.
What’s the relationship between fractional reserves and economic crises? Some see that many financial crises are preceded by bank runs, so they conclude that it must have been the maturity mismatch that was at fault. It’s strange, actually, that some Austrians would believe this, because they’re the ones always stressing about their peers mistaking the symptoms (the crash) for the cause (credit expansion). Business cycles are caused by excess supplies of money, which change the distribution of profits. When money supply growth begins to slow down this distribution changes — thus, the sudden loss in profitability for large swaths of industry.
Just because too much sugar is bad for you doesn’t mean all sugar is bad. There’s nothing inherently destabilizing with fractional reserve banking as long as excess money is minimized. What’s the difference between “excess money” and lending on fractional reserves?
Like with any other economic good, there is a point at which demand and supply are equal. Unlike many other economic goods, money has to clear in multiple markets. When the demand for money increases, ignoring for a minute the ability to increase supply, the prices of other goods that exchange for money have to decrease in order to clear against the higher relative value of the currency. If prices don’t clear and exchange suffers, we call that a shortage of money. On the other hand, if there’s more money than people are willing to hold, this is called excess money. It will continue to circulate (the “hot potato” effect) until it returns for redemption or the price level increases, the relative value of money falls, and demand and supply are again equal to each other.
That a bank lends on fractional reserves doesn’t really say anything about whether there is excess money. When the demand for money increases, the volume of deposits might swell (the amount of liabilities returning to the bank for redemption will fall) and it will allow the bank to issue credit. In this case, the banking system is increasing the supply of money to meet the heightened demand. That’s why, if you’re worried about the business cycle, blaming fractional reserve banking is the wrong way to go. What you should really be worried about is surplus money.
How do we accomplish limiting the ability of banks to create liabilities, without enforcing full reserves? Through coordinating monetary institutions (rules or constraints), which may include:
- In a competitive banking system, banks holding other banks’ liabilities will send them in for redemption, draining on the issuing bank’s assets. If a bank over-issues money, it will suffer from illiquidity. If a bank under-issues money, they will be foregoing the revenue they could have earned had they maximized the use of their assets.
- If banks could pay competitive interest on demand deposits, they’d have to raise this rate to attract new deposits to fund their lending. But, as the supply of loanable funds increases, the rate of interest on these loans will fall. If the latter rate (on loans) falls below the former (on deposits), the bank is making a loss.
That’s why it pains me when I read Austrians cheering for recent IMF studies and old Chicago research papers supporting 100 percent reserves. They’re worrying too much about the symptom and they don’t realize that they’re supporting the cause: bad monetary institutions (after all, it’s not like these IMF and old Chicago School economists are advocating for free banking).