Fractional Reserve Banking

Fractional Reserve Banking There are three key parts of the modern banking system. 1. Fiat currency and legal tender laws. 2. Fractional reserve. 3. A central bank to centrally coordinate everything. Fractional Reserve is a system where banks accept demand deposits and loan out the depositors’ money, and keep only a fraction of the deposits as a reserve for withdrawals. Banks tell depositors their money is available to be withdrawn at any time, when in fact the money has been loaned to other people. The banks can not meet their obligations. It is a very clever form of a ponzi scheme. This is unique to banks – grain silos and other warehouses don’t do issue counterfeit warehouse receipts backed by other people’s deposits. If they did it would be considered fraud by the courts – however Banks are exception to the legal principle. The reason why counterfeiting is illegal is because it is fraud. People counterfeit because it benefits them. As believers in liberty we are against force and fraud. Historical Fractional reserve has a long history going back to the beginnings of banking. Courts treated all banks as fractional reserve banks – banks had no contractual obligation to be 100% reserve. Depositors were at the mercy of the bankers.h In the past circulation of paper money backed by fractional reserves of gold led to temporary increases in the money supply which created business cycles. There would be more paper money in circulation than actual gold, which distorted prices. Bankers wanted hard money backed by gold. They understood that continual increases in the money supply would wipe them out. (By contrast manufacturers and farmers with debts wanted more money in circulation so they could repay loans with less valuable money.) On the other hand they would make more money by loaning out via a fractional reserve system. The long term successful establishment bankers would keep things in balance, but would face periodic crises from the business cycles that threatened to wipe them out. The net gainers of the process are the banks and the people they loan to. The losers are everyone. Bankers setting up central banks understood that fractional reserve systems are unstable and require a central bank to keep the establishment bankers afloat. Today

Today we have fiat currency backed by nothing. Fractional reserve allows the banks to expand the amount of quantity of loans and credit in the economy. Expansion of credit distorts prices and creates a business cycle or runaway inflation. The value of fiat currency has decreased by 95% or more in pretty much all countries. Most money is kept in banks. Banks loan out your deposits, putting money in to an account for the borrower. The borrower spends the money, and the recipient of the money usually puts the money back in to another bank account. Money continues to circulate within the banking system and it isn’t withdrawn as cash. If it was withdrawn the system would promptly run in to problems. When the banks run in to trouble they can get the federal reserve to bail them out. This is the explicit purpose and social function of all central banks – to bail out banks by being the lender of last resort. There is nothing controversial about this. The banking system is considered sound by many precisely because there is a central bank. By contrast I’d say the system is worse as we have business cycles and paper money is worth less year after year. There’s no limit on inflation. Bankers setting up central banks understood that fractional reserve systems are unstable and require a central bank to keep the establishment bankers afloat. Replacement The replacement is a 100% reserve system. The bank must keep 100% of the money on hand necessary to meet its obligations. Money would be whatever the market decides is money. Historically this has been gold. The key problem with Fractional Reserve is that the time structure of the banks’ liabilities (obligations to depositors) are much shorter than the time structure of their assets (the borrowers obligations to the banks.) Banks borrow short and lend long. Depositors can withdraw their money at any time while borrowers have more time to repay the bank. This means that banks are inherently bankrupt – they can’t pay their obligation if asked. No other business or person can run its books so it runs out of money if it pays its obligations. Rothbard suggested that the time structure of banks obligations should match that of their loans. Rothbard would have no problem with depositors giving banks money for 90 days and banks lending the money at 90 days or less. This wouldn’t create temporary increases in the money supply. People can do this today with CDs. Money market funds are also useful for short term credit. For longer term loans savers could invest in something like a mutual fund for loans. They might not be able to redeem their deposit until the loan is over – but they could sell their share on the open market.

There are a variety of free market banking mechanisms which would replace fractional reserve banking.