Fractional reserve banking has been criticized by numerous schools of economic thought since its inception. These criticisms are not without merit. Quite the opposite. They are criticisms that should be taken note of and used as the foundation for a movement advocating for full-reserve banking.
Members of the Austrian school are probably the most ardent critics of fractional reserve banking. Specifically, Ludwig von Mises criticized fractional reserve banking as being the main underlying cause of business cycles in capitalist economies and believed that full-reserve banking could stabilize economies and possibly eliminate business cycles altogether.
Von Mises identified two types of credit: Commodity credit and circulation credit. The former is a type of credit where money is loaned to investors but the total supply of money in the economy remains unchanged as actual savings are used to fund the investment. The latter is what we know as fractional reserve banking. Fractional reserve banks also loan out savings to borrowers but the total money supply does not remain unchanged. Both the saver, who still has a demand deposit for the total amount of money they deposited in the bank even though not all of it is actually there anymore, as well as the borrower hold demand deposits for the same property. If R100 was initially deposited and R90 loaned out, the total money supply is now R190, even though the actual available cash is still only R100. The money has just been created out of thin air through a process called the credit multiplier.
Usually, in a relatively stable system of fractional reserve banking, the savings of millions of depositors are pooled and used to fund loans. As long as the depositors of savings do not withdraw all of their deposits at once, the system remains functional. However, once there is a crisis of confidence in an economy and clients all want to withdraw their deposits simultaneously, we are left with a situation known as a ‘bank run’. Because fractional reserve banks created multiple demand deposits for the same stash of money, they effectively ‘overbooked’ that money. Creating two demand deposits for the same stash of money creates a fraudulent system of double ownership; both the saver and the borrower lay claim to the same property and, by legislation, both claims are ‘legitimate’ exercises of property rights. When a bank run is initiated in an economic crisis, banks do not actually have the necessary cash to satisfy all the demand deposits they created (insurance against economy-wide bank runs are also not sufficient).
In an article for the Mises Institute, Robert Batemarco explained how this fraudulent system of double ownership leads to economic crises and credit crunches:
“What is controversial about the money multiplier is not its existence, but whether or not it creates distortions in the economy. The distortions introduced into the economy by fractional reserve banking, and to an even greater extent by central banking, comprise the central element of Austrian business cycle theory. The basic idea is that the creation of money (which is also credit, since that new money is loaned into existence) increases the supply of loanable funds and lowers market interest rates without increasing the supply of voluntary saving. This misleads investors into believing that more resources have been made available by savers for investment projects than actually have been made available. Thus, projects are started on too big a scale since many investors try to exercise a claim on the same productive resources. In so doing, they will bid up the resource prices, slashing the profitability of many of these investment projects. This is the real goods sector counterpart of bank runs in the monetary sector. Since there is no real goods sector counterpart to deposit insurance, firms will run short of the resources necessary to profitably complete their investment projects, exposing them as malinvestments and turning boom to bust.”
It can be argued, and indeed is argued, that depositors of savings consent to the system of double ownership and therefore the system is justifiable since it relies on voluntarism. Yet it is not that simple. Fractional reserve banking leads to a legal impossibility since contractual obligations are created through the extension of fraudulent demand deposits that simply cannot be fulfilled. It is entirely illogical and indeed contrary to the very nature of property rights to create a situation where persons A and B can simultaneously lay 100% claim to object X. Such a contract, even if all parties consent, still violates the nature of property rights as it creates an insolvable dispute. The contract is rendered unenforceable due to the mere illogical nature of it.
In a system of full-reserve banking, banks would merely act as protectors of people’s savings for a small fee. They would not act as intermediaries between savers and borrowers through a system that creates demand deposits out of thin air for cash that doesn’t actually exist. The money supply would stay stable. If investors require capital, they would not be able to borrow it from a fractional reserve bank. Instead, they would simply need to convince savers to invest their actual savings into entrepreneurial ventures. There are numerous ways of funding investment in the absence of fractional reserve banking such as buying private bonds or even putting money into fixed deposit accounts where the depositors do not have a demand deposit awarded to them for a certain period of time and those monies deposited then being loaned out (the total available money supply thus remains unchanged). Fractional reserve banks would most likely be replaced by full-reserve investment banks. In such a system, investment is still possible. The way it is funded is just simply not fraudulent.
Jacques Jonker
Latest posts by Jacques Jonker (see all)
- The Case for Full-Reserve Banking - February 18, 2020
- Exploring Le Grand E Day’s Theory of Multigovernment – Part 2 - December 1, 2018
- Exploring Le Grand E Day’s Theory of Multigovernment – Part 1 - November 26, 2018
