Fractional reserve makes for instability. Full reserve is more stable.

One of the sources of instability which exacerbated the credit crunch is the freedom that the private banking system has to create money. The commercial or private bank system tends to greatly expand its money creation activities exactly when it should not: in a boom. Plus the money creation system slows down or goes into reverse exactly when it shouldn’t: in a recession.

This ability of the private banking system to create and extinguish money stems from the fractional reserve system; and a solution to the problem would be full reserve banking (or perhaps 90% reserve banking). Full reserve is a system under which the only money is the “state’s money”, i.e. monetary base.

Milton Friedman advocated this system, and specifically so as to bring better stability. This was in a paper in the American Economic Review in 1948: “A Monetary and Fiscal Framework for Economic Stability”. There is also a small political party in the UK devoted to this end: the Monetary Reform Party. The latter quotes from various historical figures who advocated full reserve banking, e.g. Abraham Lincoln.

Friedman repeated his views in 1975 to a US House subcommittee (US House, 1975, 2156-57)

Full reserve is also advocated by a German academic: see paper by Claude Hillinger (p. 29).

There is another long article here on the subject.

Beware of the large number of nutters who advocate full reserve banking because they think that fractional reserve is some sort of fraud. The basic merit of full reserve is as set out by Milton Friedman: better stability.

Obviously were fractional reserve banking to be abolished, a much larger monetary base would be needed.

Equally obvious is the fact that if full reserve were seriously mooted, the goons and the cowboys running existing commercial banks would fight it tooth and nail. Banksters want casino type activity: so much more fun than providing boring old basic banking facilities for Mr and Mrs Boring Average.

And even better than casino type activity is casino type activity with taxpayers picking up the bill when things go wrong. Who can possibly object to a “heads I win, tails you lose” scenario?

Can fractional reserve be suppressed?

Fractional reserve banking is free market activity that arises naturally, thus the question arises as to how difficult it would be to suppress were it outlawed. For example would banks and/or non-bank institutions not still try to engage in “fractional” activities?

There are several answers. First, there is little temptation to create additional currency where the state already provides an adequate volume of currency. For example, take those very small scale currencies that individual towns sometimes create. There is only significant room for these currencies given significant unemployment. That is, if half the people in your neighbourhood are unemployed, they will (by the very definition of the word “unemployed”) be seeking to engage in some form of economic activity. Being unemployed, they will be short of conventional money. Solution: have the neighbourhood create its own money to help those in the neighbourhood trade with each other.

However, given full employment and an adequate supply of conventional money, there is little demand for some other form of money.

Second, fractional reserve systems nearly always involve a legal maximum “fraction”. That is banks have to keep some minimum by way of reserves (10% of loans and deposits, or whatever). This has never proved difficult to enforce. Thus if the fraction happens to be 100% rather than 10%, it is hard to see where the big problem is.

Third, it would be very difficult for small, back street, or non-bank institutions to get into the fractional reserve business in a big way. (And if any institution which did get into this activity in a big way would automatically come to the attention of the authorities).

Fractional reserve banking involves creating debt which is then passed from hand to hand in exchange for goods and services. Now if you are given a cheque drawn on a well known bank, you trust it ( assuming you also trust the person writing out the cheque). But suppose you live in the North of Scotland and the cheque is drawn on a “bank” recently set up by Joe Bloggs, the well known firm of plumbers in the east end of London (but unheard of in Scotland): would you trust it?

Isn’t better bank regulation superior to full reserve banking?

Could be. But the world economy has just take a multi trillion dollar hit as a result of poor bank regulation. And do we have better bank regulation as a result? I don’t think so.

Bank funded lobbyists are crawling all over Capitol Hill. Plus “better regulation” is inherently complicated, which means that banks will arguably always outwit politicians on this one.

The beauty of full reserve is that it is a nice simple rule, and as Milton Friedman makes clear, it is a substitute for a variety of detailed regulations: the legislative and bureaucratic costs are arguably lower.

Afterthoughts (1st Jan 2011). Others with doubts about fractional reserve:
Monetary Reform Party.

American Monetary Institute

Prof Jesus Huerta de Soto.

Also I changed the title of this article from “Full reserve banking helps stability.” To “Fractional reserve makes for instability. Full reserve is more stable.” today.