The Dubious Logic of the Case for Full Reserve Banking

I was planning to do a long post full of maths and models about the practicality of 100% reserve banking, but it struck me that the issue can be dramatically simplified.

Unlike the Rothbardian wing of Austrians Post-Keynesian critics of fractional reserve banking rarely make the dubious claim that it is inherently a fraud.

Both Austrians and PKs accept that credit can have an effect on effective demand and so on price.  Austrian’s make the claim that this is inherently inflationary, PKs would deny this but focus instead on the growing burden of debt over time and the impact of credit on asset price inflation. (see my previous piece debunking the concept of forced savings in the Austrian argument)

Thankfully we are hearing less of arguments that there is somehow a debt virus – that interest creates an inherent ‘gap’ in demand which requires to be plugged – as in some dodgy animations on You Tube.  Monetary Circuit modelling largely discredits this idea though there may be an element to the proposition that the rent of money is an extraction from production and drag on the productive sector – of dangerous proportions what the size of the financial sector gets too large and the burden of debt unpayable – Michael Hudson’s argument.

But credit of course is necessary in all financial systems unless you have a society with no maturity intermediation and all investment is made in small doses by small savers, not very efficient.  If you have to have credit then there is in Full Reserve Banking a solution in term deposits – as our previous post and model discussed.  There are some Austrian thinkers, such as Hulsmann, who with ruthless logic state that all maturity transformation is also a ‘fraud’.  Laying the emotion aside they have a point for two reasons:

1) Term deposit lending is still likely to generate a credit cycle

2) With liquidity risk there is always a risk of a bank run.

But given that a modern financial system requires an inefficient mechanism to close maturity mismatch/durability gaps in asset/liability portfolios.  So what then is the case against fractional reserve banking?

If it is the case that fractional reserve banking creates credit too rapidly then it is a matter of degree not principle, as full reserve banking has the same problems, only it creates credit more slowly.

If the ancillary argument is made that the problem is what credit is spent on rather than credit per-se – for example speculation on assets rather than production – then again it is a problem of degree.  Opponents are saying that time runs too fast slow it down rather than saying the fractional system is flawed per-se.  Indeed this begs a question, can you use trigger mechanisms for slowing down the rate of credit creation (credit accelerator).

You could have a rule for example that ties statutory minimum reserve levels to asset price inflation (such as house prices).  Hong Kong have benefited from such a system for many years.

Indeed there is an argument to say that speculation would be higher under full reserve banking as as (without state intervention) it creates credit more slowly (as you are removing leverage of equity and excess reserves to enhance ‘lending power’ and with reduced lending there is reduced profits from lending and so the ‘revolving fund of credit’ grows less slowly – see my previous model), which will require higher interest rates to attract savers in forcing loanable funds, then investors will require high return ‘sure things’ not risky innovations.

The liquidity shortage under full reserve is the key problem.  If you had a period of capital destruction such as a war or natural disaster a free banking full reserve model would struggle to create capital quickly enough, also in cases where there needs to be rapid capital replacement, such as where an innovation renders capital stock in an industry or a class of consumer goods obsolete.

In a free banking full reserve model then the money supply is fixed, in each of the above cases the demand for money would be increasing, and if the supply of money was fixed you would get deflation, depression, and yes potentially debt deflation.

Defenders of full reserve free banking such as De Soto claim that with a stable price level caused by a fixed money supply (you don’t need a gold standard in such a system except to lock together international fixed exchange rates – why nowadays would you want to do that!) then there will not be cyclical liquidity shortages, but this omits the structured deflationary tendency of 100% reserve banking, and that as demonstrated  term deposits can generate credit cycles.  The free bankers know this and are right to stress that full reserve banking has always required state intervention.

Such is the system as proposed in the Chicago Plan by Fisher and others as well as its modern variants such as Positive Money, the AMI etc.  This plan would have many benefits, the state could more easily generate liquidity at times of crisis,  and with state owned banks (not a feature in all proposals) there is no societal rent of money as a factor return.  These potential advantages (and there are disadvantages and possibly better ways of achieving these advantages) however do not stem from any structural advantage of full reserve banking but from improvements to distribution and ‘inside’ (state) money creation whatever the banking system.

Therefore I do not think the advocates of full reserve banking have made their case at all.

The best advocates of full reserve are Richard Werner and his colleagues at the University of Southampton in their submission to the independent banking commission.  Much as I admire Werner I think there are many technical flaws in the paper – but that will require a much more wonkish follow up.

I therefore am with Hayek, Minsky and Freidmann, initially sympathetic but after examination rejecting full reserve banking on theoretical and practical grounds.

5 thoughts on “The Dubious Logic of the Case for Full Reserve Banking

  1. Well argued. You’ve pretty much covered all the objections to full reserve banking. For me the really enormous objection to it is its inflexibility and inability to respond to a sudden need for increased liquidity. In this it is much like gold standard currency and the end result is the same – deflation and depression.

  2. Andrew,

    You claim, “If it is the case that fractional reserve banking creates credit too rapidly then it is a matter of degree not principle, as full reserve banking has the same problems, only it creates credit more slowly.”

    That implies that credit creation is a “problem” even when done at a modest pace. What problem? Indeed, you yourself suggest there is no problem there when you say “credit of course is necessary in all financial systems”. Quite right. In other words you are saying in the latter phrase that credit creation at modest pace is NOT A PROBLEM. I agree.

    Rapid credit creation just prior to the crunch was a fundamental cause of the crunch. Have a look at the expansion of M4 relative to the monetary base on the chart here (scroll half way down):

    Next, in the paragraph starting “The liquidity shortage…” you claim that given a big rise in demand for loans, full reserve won’t provide the necessary credit. I have to admit that when it comes to creating savings out of thin air and lending them out for legitimate or illegitimate purposes, fractional beats full reserve hands down. Prior to the crunch, the fractional system created money like there was no tomorrow and lent it out for NINJA mortgages, liar loans, property speculation, etc: pure genius. Now we’re paying the price.

    In contrast, under full reserve, and given a rise in demand for borrowed funds, those funds WILL MATERIALISE, but at a price. Increased demand for borrowed funds will interest rates which in turn will induce people to save: that’s where the funds come from. I see nothing wrong with the price of something rising when demand increases.

    Your next paragraph starts, “In a free banking full reserve model then the money supply is fixed…” I’m baffled. I’ve always taken the phrase “free banking” to mean what it says: a system that arises in a free market – i.e. fractional reserve. That’s certainly the sense in which George Selgin uses the phrase in his book “The Theory of Free Banking”.

    However, you seem to be referring to full reserve here, and you say “if the supply of money was fixed”. Well the money supply is NOT FIXED under full reserve: government and central bank expand it (and/or contract it) depending on whether the economy needs stimulus or damping down. Certainly that’s what happens under the full reserve system advocated by Positive Money, Prof. Richard Werner and the New Economics Foundation here:

    Click to access NEF-Southampton-Positive-Money-ICB-Submission.pdf

    Next, you claim that “full reserve banking has always required state intervention..” True. But unless I’m imagining things, over the last five years we’ve had “state intervention” of a truly astronomic magnitude to rescue the fractional reserve banking system. And thanks to that system, we’ve had a credit crunch, mass unemployment, soaring home re-possessions, and so on.

    According to Andrew Haldane of the Bank of England, the subsidies dished out to the present banking system come to several times bank profits over the last decade or so. I.e. any idea that the present banking system is commercially viable is a joke. See:

  3. You write on the Fisher, Chicago type approach – “These potential advantages…do not stem from any structural advantage of full reserve banking but from improvements to distribution and ‘inside’ (state) money creation whatever the banking system.”
    Could you please expand on what you mean here? It is hard to see why a Chicago Plan approach can’t achieve these and other things with much greater stability and transparency. You deal mainly with Austrian topics, then seem to sort of like a Fisher type approach, but don’t give much detail on why you then reject it.
    You also like the Werner/Southampton approach but suggest you have technical objections. Can you somehow put them in a nutshell to at least have an idea what they may be based on?
    Kind regards,

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