Summary. Assume a pure fractional reserve banking system. Also assume the simplest and most extreme case of banking collapse: all banks go bust. In this scenario the money supply vanishes: not too clever.
In contrast, under FULL RESERVE, where deposits are taxpayer guaranteed that encourages the misuse of depositors’ money. Plus when all banks go bust, and assuming government reimburses all depositors, the money supply initially doubles which is liable to be inflationary, until that supply is withdrawn via tax. Also not too clever.
The best system is full reserve plus the “Kotlikoff / Werner” condition that where depositors let their bank use their money in a commercial fashion, and it all goes belly up, depositors lose their money.
Take the simplest possible pure fractional reserve system. There is just one private bank with no assets or liabilities. It creates $P out of thin air and lends it to X to enable X to build a house. X pays the money to Y to build the house. The house turns out to be worthless. The words “Spain” and “Ireland" should spring to mind. That means X is bust. The bank is also bust, and Y’s money vanishes into thin air.
As Irving Fisher put it in his paper “100% Money and the Public Debt” (1936), “The most outstanding fact of the last depression is the destruction of eight billion dollars - over a third – of our “check-book money” - demand deposits.”
Full reserve plus taxpayer backing for deposits.
Take a second scenario: full reserve with taxpayer guarantees for depositors regardless of what use banks make of depositors’ money.
Initially the central bank / government spends $P into the economy, and that money ends up in the hands of A,B & C, and they deposit the money in the private bank, and the private bank in turn deposits that money at the central bank (private banks always keep their monetary base at the central bank).
As in the above fractional reserve example, X applies for a $P loan from the bank, and pays Y to build a house. The house again turns out to be worthless. And as in the above illustration, the private bank is bust. Or to be more accurate, the bank has $P at the central bank, but it owes $P to A,B & C, plus it owes $P to Y (i.e. the bank owes a total of £2P).
However, deposits are taxpayer guaranteed, so the government / central bank machine graciously gives $P to the private bank.
But that means the money supply has doubled.
Notice how we’ve had a ballooning of monetary base / reserves over the last three years?
Alternatively, government does NOT FULLY reimburse private banks: but that just leaves banks in a precarious position – ring any bells?
Full reserve with no taxpayer backing for all deposits.
Lawrence Kotlikoff and Richard Werner advocate banking systems which have in common the characteristic that depositors must decide how much of their money they want to be 100% safe, and how much they want their bank to use in a commercial fashion: that is lend on to businesses and mortgagors.
Incidentally, citing the above two individuals here should not be taken to imply their agreement with this post.
Anyway, forcing depositors to make that choice means that depositors will put money they are likely to need in the coming months into their safe accounts. While money which they think they won’t need and/or which they are prepared to risk will go into “risky” or “investment” accounts (under a Werner system), or into “non cash mutual funds” to use Kotlikoff terminology.
Let’s assume everything is the same as the illustration just above (except of course that there is no taxpayer backing for depositors’ money in investment accounts). I.e. the private bank lends to X, who pays Y with the house turning out to be worthless.
In this scenario, the private bank does not go bust: it is depositors, i.e. A, B & C who lose out.
There is not too much of a deflationary effect because A, B & C still have the money they intended spending in the near future (in their safe accounts).
There is no need to double the money supply.
It is true that something has disappeared: the investments made by A, B & C. However, the disappearance of an investment does not have anywhere near the same deflationary effect as the disappearance of the same amount of money: a fall in the value of the Dow Jones or FTSE does not influence the weekly spending habits of the wealthy by all that much.
I vote for the third option. That’s the full reserve plus making depositors decide how much of their money they want to be, 1, instant access, 100% safe, but not earning any / much interest, and 2, how much of their money they want to earn a significant amount of interest, while not being instant access and not 100% safe.