[Jthomp76]

If we did away with fractional reserve banking and banks could only lend out what they had in reserves, would economic expansion be severely limited? As it is now so many people/entities have access to funds only because banks can lend out more than they have in reserves. What would,the repercussions be of abolishing fractional reserve banking?

[jmherbener]

One 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

[Jthomp76]

If we had a full reserve banking system would not financial innovations resembling fractional reserve banks spring up a la the shadow banking system?

[jmherbener]

Entrepreneurs will offer any financial product, which conforms to the rules of private property, that they anticipate will be profitable enough to justify their investment in it. If they think that savers’ time preferences are such that they will make nearly instantaneous loans at the lowest interest rate on the yield curve and that borrowers will take out and roll over extremely short term loans on such lending so that savers can be paid back without disruption, then they may choose to offer such deposits to savers. But these deposits are no different than any other certificate of deposit at longer terms on the yield curve. Banks are inter-mediating credit in all such cases. There is no credit creation in such inter-mediation. Moreover, such deposits would not be chosen by people at large in an unhampered market economy as a superior medium of exchange to money proper and money substitutes, i.e., 100-percent-reserve claims to money.

[Jthomp76]

Dr. Herbener,
I’ve been taking an online class on money and banking with Columbia’s Perry Mehrling. I relayed your response above (not the most recent one but the one before) and here is what he says. I think I know what you’ll say but am curious if you have any thoughts I could chew on. Below is his response:

The “credit from thin air” that Herbener emphasizes is, in my view, the essence of banking, but I think of it differently. As I say repeatedly in the course, all banking is a swap of IOUs. The bank makes a loan to me, which concretely means creating an asset (the loan) and a deposit at the same time, these entries then being booked for me as an asset (the deposit) and a liability (the loan). No real resources change hands, just a swap of IOUs. But at the end of the day I have purchasing power that I did not have before, which I can then spend.

When I spend, and only when I spend, income is created for the person receiving the deposit, as well as saving at that very instant. If my spending was for an investment good, then both investment and saving go up in the aggregate. If my spending was for a consumption good, then my dis-saving wipes out my counterparts saving. Consumption goes up but not saving.

I don’t think 100% reserve banking is possible; indeed, according to my way of thinking, it is not really banking. I think central banking is a natural organic development that arises in all banking systems, it is nothing more than banking for bankers. I don’t think it is possible to eliminate central banking.

[jmherbener]

Professor Mehrling defines banking as financial intermediation (swapping IOUs). Thus, by definition, for him banking cannot be money warehousing, or, for that matter, foreign currency exchange, or financial advice, all traditional activities of what are called banks. That’s fine, he can define terms as he likes. It doesn’t change the reality of institutions called banks that perform functions in addition to swapping IOUs, including providing a money warehouse.

The substantive issue he raises is whether or not so-called instantaneous-term IOUs (i.e., demand deposits) are in fact financial intermediation. Otherwise, I agree with what he said about swapping IOUs and the transfer of command over resources. There is a sizable literature on the question of whether or not demand deposits are financial intermediation. Huerta de Soto’s book is an example:

http://mises.org/books/desoto.pdf

Professor Mehrling’s view that it’s not possible to eliminate central banking is ahistorical. Setting aside the recent experiments with currency boards in some countries, there was banking in the western world long before the first central banks arose in the 17th century. It’s not only possible to have 100 percent reserve banking, such banks existed for long periods of time in Europe.

I agree that central banking is a natural outcome of a particular legal treatment of banking. The development of central banking is a natural outcome of following the logic of granting legal sanction to demand deposits as financial intermediation. As professor Mehrling puts it a swap of IOUs, the borrower issuing a term IOU to the bank and the bank issuing an instantaneous-term IOU to its customer. But it begs the question to assume that such a legal treatment merely extends financial intermediation to a hitherto overlooked realm. In any case, once this swap is given legal sanction, then central banks follow logically. Murray Rothbard’s book chronicles this development and its consequences:

http://mises.org/books/historyofmoney.pdf

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