The fatal flaw in maturity transformation and fractional reserve banking. Part II.

This is the second part of a mini series of articles on maturity transformation and banking. Part I was here.

The basic point made in Part I was that maturity transformation (MT) achieves nothing because while MT does increase liquidity, the state then has to confiscate that extra liquidity in order to keep inflation under control.

A similar apparent merit seems to be part of the existing bank system (sometimes called “fractional reserve banking”). And that merit seems to give fractional reserve the edge over the alternative, namely so called “full reserve banking”.

Full reserve is a system where the only form of money is base money (which was the starting point for the hypothetical economy set out in Part I). Under full reserve private banks do everything they currently do, but they don’t actually create money. And full reserve has had numerous advocates and for a long time. For example Irving Fisher said in response to the hundreds of bank failures in the 1930s, “We could leave the banks free…. to lend money as they pleased, provided we no longer allow them to manufacture the money which they lend”.

An apparent problem with full reserve is the fact that it involves relatively large amounts of base money doing nothing which might seem to be a waste. Indeed, the UK’s Independent Commission on Banking (ICB) echoed that sentiment when it said (section 3.21): “If . . banks were not able to perform their core economic function of intermediating between deposits and loans, the economic costs would be very high.”


Money costs nothing.

The first flaw in the idea that unused base money is some sort of waste is that it costs nothing to produce such money! It’s produced simply by the central bank making a book keeping entry (done on computers nowadays). As Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”*

Thus the ICB’s claim that unused base money is some sort of waste, is beginning to look debatable.


Switching from full to fractional reserve.

But suppose a hitherto full reserve system DOES SWITCH to fractional reserve. Let’s quickly run thru the hypthetical scenario set up in Part I again which involved a country called “Hypoland” where creditors had net assets of $120k and debtors had net assets of $110k.

The fractional reserve private bank sets up in Hypoland and announces: “Deposit your money with us, and we’ll put it in instant access accounts, PLUS you get some interest”.

So instead of the private bank or banks in Hypoland being funded by shares, they are funded by deposits (aka money).

But as in Part I, where loans were initially done on a direct person to person basis and were then done via a bank and hence were turned into a form of money, the shares that fund full reserve banks in Hypoland are turned into money. I.e. those shares are “liquidised”.

As in Part I, demand then rises, so the state has to deal with inflation by confiscating that extra liquidity. As in Part I, we’re back were we started: not much is achieved by switching from full reserve to fractional reserve (or vice versa).

Indeed, George Selgin’s similar hypothetical scenario (mentioned in Part I) produced much same result, namely that private bank created money DISPLACES base money: it does not ADD to it.

And therein lies a second flaw in the above ICB claim about full reserve involving loads of unused base money. That is, if an economy switches from full to fractional reserve, it might seem that loads of unused base money can then be usefully employed as claimed by the ICB. In fact that’s not true because the introduction of fractional reserve involves DISPLACING base money with privately issued money – or put another way, to prevent the introduction of fractional reserve being inflationary, that unused money has to be confiscated.