jmherbenerOne hundred percent reserve banks intermediate credit lent to them by savers. For example, customers buy Certificates of Deposit offered by banks. Banks, in turn, pool the funds provided by customers who buy their CDs and lend those funds to borrowers. The entrepreneurs who borrow such funds use them to buy inputs or assets or both and then use the inputs and assets to produce goods. Through their credit intermediation, banks help economize the pool of saving, directing it into the most profitable lines of production and investment. As the capital stock in the economy is built up by the investments in capital capacity, productivity rises and with it standards of living. By limiting their lending to the pool of funds supplied by savers, banks help to create a capital structure in the economy that satisfies people’s time preferences.
Fractional reserve banks have two pools of funds from which to make loans. The first is a pool is from savers as with 100 percent reserve banks. Banks intermediate this credit to borrowers. The second is fiduciary issue, i.e., the issue of fractionally backed checking accounts. The pool of credit is created out of thin air and therefore, does not correspond to people’s time preferences. The additional lending that the second pool makes possible funds some additional investment projects, However, the capital structure being built up by the new investments does not satisfies people’s time preferences. For this reason, the build up proves to be unsustainable. Credit creation by fractional reserve banks generates the boom-bust cycle. Malinvestments are made that must be liquidated later. Therefore, the capital structure, productivity, and standards of living cannot be enhanced by credit creation. In fact, they are worsened.
Eliminating fractional reserve banking would severely reduce the magnitude of boom-bust cycles. If central banking were also eliminated, then business cycles would disappear altogether.
Take a look at Murray Rothbard’s book, The Mystery of Banking:
http://library.mises.org/books/Murray%20N%20Rothbard/Mystery%20of%20Banking.pdf