Reply To: Is fractional reserve banking more efficient?


Your example illustrates the first step of the business cycle, not efficiency. The issue of fiduciary media by banks leads to malinvestments during the boom which must be liquidated during the bust. Likewise, during the housing the boom the additional houses produced (and the additional capital capacity produced to support housing production) was not efficient.

It is only better for society to have another restaurant built if it proves to produce goods more valuable to people in society than the alternative production facility that could have been built with the same resources. That the restaurant owner pays back his loan is not a sufficient condition to prove social benefit. Lots of homeowners were paying back their mortgages during the housing boom.

In the market, profit and loss calculations reveal when the use of resources in one line of production have greater value than in another alternative line of production. An enterprise earns profit if the revenue generated by the sale of its output exceeds the costs incurred from the purchase of its inputs. The revenue generated is determined by the demand people have for its output. The costs incurred is determined by the demand other entrepreneurs have to produce their output which, in turn, is determined by the demand people have for their output. An enterprise earns profit by compensating the input owners for the loss of value they cannot receive from other entrepreneurs and then uses the inputs to produce output that people value more highly than that which would have been produced by other entrepreneurs.

Now apply these general principles to banking. If a bank intermediates credit, then they compensate savers by paying interest to borrow funds from them. Because they have lent money to the banks, the savers must reduce their demands for goods. But they have willingly entered into an agreement to do this. If the bank issues fiduciary media, then it pays no opportunity cost to obtain command over these funds. And yet, when it lends the funds out to borrowers, they are able to bid resources away from other people without anybody agreeing to such restrictions in their command over resources. Such activity is inefficient on these grounds alone.

We can come to the same conclusion about fiat money. If the government prints more fiat money and spends it to build three more bridges is society better off? Clearly not. All such spending of the government is inefficient by the nature of how the resources are transfers out of the hands of some people and into the hands of other people. Unless this is done in voluntary exchange under the guidance of economic calculation, then the activity is socially inefficient.