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.