Wednesday, April 10, 2013

Compromises between full and fractional reserve banking.


One element of full reserve is requiring depositors to choose what their bank does with their money. If just that element of full reserve were applied to a fractional reserve system, there’d be a benefit as follows. Money deposited in a bank is not regarded by depositors as money that is at risk. Thus they’d demand that their bank invested or loaned on their money in relatively conservative ways, e.g. to mortgagors with decent equity stakes. And that in turn would leave banks short of money to devote to the sort of risky activities that tend to bring banks down.

Milton Friedman claimed that switching to full reserve more or less overnight would not be technically difficult. In Chapter 3 of his book “Program for Monetary Stability” he said “There is no technical problem of achieving a transition from our present system to 100% reserves easily, fairly speedily and without any serious repercussions on financial or economic markets.”

However, the switch could easily involve political problems because the change would be a big one. There’d be winners and losers.

Full reserve involves requiring depositors to choose between having their money kept in a 100% safe manner and secondly, letting their bank lend on their money. And under Laurence Kotlikoff’s version of full reserve, depositors would have a choice as to how their money was loaned on or invested.

However, requiring depositors to make the latter sort of choices is perfectly compatible with FRACTIONAL RESERVE. Thus if the decision is taken to implement full reserve, an initial first step – one that would not lead to instant full reserve – would be to require depositors to make the above choice.

And that would have a distinct advantage, as follows.

Money deposited in a bank is not regarded by the depositor as being a risky investment: either the depositor intends spending the money in the near future or (where the money is put in a deposit or “term” account) it is a very conservative sort of investment.

Thus if under a fractional reserve system depositors had to make the above choice, about 99% of them would instruct their bank to use their money in a relatively safe or conservative manner. E.g. the money might fund just mortgages where relevant home owners had a decent equity stake.

And that in itself would solve about half the problems that have plagued banking. That is, banks would find it much harder to use money that was supposed to be safe (i.e. backed by government guarantees) to fund the sort of risky activities that have brought banks to their knees in recent years, and throughout history.

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