Summary. Assume a full reserve bank system: that’s a system where the only form of money is government issued money. If private banks are then allowed to print money (which is what fractional reserve consists of), interest rates fall and borrowing, lending and debts rise. For every dollar of new borrowing (aka debt) there’s a dollar of new money (private bank created money). That new money will be inflationary unless government implements some sort of compensatory deflationary measure like raising taxes and robbing the private sector of its existing stock of government created money.
To put that the other way round, switching from a fractional reserve system to full reserve (i.e. doing the switch in the opposite direction) reduces lending and borrowing, which is deflationary. But the solution is easy: have the state print money and spend it into the private sector. I.e. private sector, so to speak, gets back the above money that was robbed from it.
Which of the two systems, full and fractional reserve, most closely resembles a genuine free market and is thus most likely to maximise GDP? The answer is full reserve because under full reserve, borrowers have to pay the full cost of borrowing: they are not subsidised by private money printing.
Assume a full reserve banking system: that’s a system or economy where the only form of money is state issued money. It’s also a system under which those who want their money loaned out bear the risks involved – which is actually perfectly normal in simple economies. E.g. if Robinson Crusoe lends a fishing rod to someone in a desert island economy and the borrower loses the rod and cannot recompense Crusoe, the reality would probably be that Crusoe would bear the loss rather than the loss being born by the economy as a whole (which would be the equivalent an FDIC type deposit insurance system).
Also, under full reserve, the fact that lenders bear risks means that if they lend via a bank, then those lenders are effectively shareholders in the bank rather than depositors.
Fractional reserve is then allowed.
If fractional reserve banking is then allowed, that means there is private bank created money as well as the central bank created money, and in the case of private banks, they LEND out that money rather than, as is the case with central banks and governments, simply spend the money into the private sector.
Fractional reserve bankers get their scheme off the ground by making depositors a “too good to be true” offer, which is: 1, you deposit $X with us, we lend some of that out so that you get interest, and 2, we guarantee you’ll get your money back (maybe instantly or maybe, in exchange for more interest, after a delay). That offer is too good to be true because lending money is risky and that flatly contradicts the promise by banks to depositor that they’ll get their money back.
The net effect of introducing fractional reserve is a big increase in loans and hence deposits, and private banks can easily make those extra loans because they haven’t had to pay for the new money they’re lending out: they just print it! So the net effect is that loans and hence deposits rise and interest rates fall. But that fall in interest rates means people will want to hold FEWER, not more deposits. So they’ll try to spend away their increased stock of deposits. In short, inflation ensues, unless government takes some sort of deflationary counter measure, like raising taxes and robbing the citizenry of part of its stock of base money.
George Selgin actually set out the latter scenario (switching from full reserve to fractional reserve) in an article entitled “Is Fractional-Reserve Banking Inflationary” published by “Capitalism Magazine”. Start at his third paragraph if you like. As he explains, the effect is inflationary, at least for a while. To be exact, he says inflation reduces the real value of base money to the point at which the amount left is only just enough to enable private banks to settle up with each other.
He assumes that no “deflationary counter measure” is taken, which means that inflation rips, and the citizenry are robbed via inflation rather than via extra tax. But the effect is the same. (Incidentally that is not to suggest Selgin would agree with the basic thrust of this article: it’s just that as it happens he made the same point as is made here about the switch from full to fractional reserve being inflationary)
Having said that the switch from full to fractional reserve is inflationary, there are actually several details in that narrative that are missing above. So let’s now fill in some of the details (which Selgin also missed out).
I’ll take it stage by stage, starting with a full reserve scenario. So having assumed full reserve, let’s assume private banks are allowed to go for fractional reserve. The first thing that happens before any new loans are made is that those shareholder / depositors find things have changed a bit. That is, instead of being shareholder / depositors, they are now bog standard depositors: i.e. instead of carrying any risk themselves, they pay deposit insurance. But if those shareholder / depositors and the new insurer both gauge the risks correctly, they’ll charge the same for covering the risks. Ergo the charge made by banks to relevant borrowers remains unchanged.
As to depositors who previously sought total safety at the central bank, they can now enjoy total safety plus instant or more or less instant access to their money at the same time as having their money loaned on and hence being able to earn interest (a contradiction in terms of course).
In short, “shareholder / depositors” and “want total safety depositors” are now merged into the same group or category. But they then share the interest coming from borrowers, so there is less interest per depositor. That’s not a problem for the former “want total safety depositors” because SOME INTEREST is better than none. So that’s an incentive for that type of saver to save more, i.e. accumulate more deposits. On the other hand former “shareholder / depositors” lose out, thus they will “dis-save”: i.e. try to spend away some of their money.
Absent some sort of detailed survey into the attitudes of depositors, it is difficult to say which of those two effects predominate. However I’ll make the bold assumption that the two effects more or less cancel out, or at least that any net effect there is dwarfed by the next effects to which we now turn.
Next: banks lend more.
As intimated above, fractional reserve enables private banks to lend more, something which is easy for them to do because they don’t have to pay anything for the new money they’re lending out – they just create it out of thin air, or “print” it. I.e. private banks can cut interest rates and lend more.
That extra lending initiates another effect of the switch, namely that given that borrowers do not borrow other than to spend the money borrowed, an increase in lending means an increase in spending (i.e. an increase in aggregate demand). However, that effect is temporary, because once the additional loans have all been spent, the “extra spending” effect comes to a halt.
Clearly that would be an important point to consider given a real world switch from full to fractional reserve (or vice versa). However, given that the effect is temporary, I’ll ignore it for the sake of brevity.
The switch causes excess deposits.
As explained above, switching to fractional reserve means more loans and hence more deposits (given that “loans create deposits” as the saying goes).
Borrowers will be happy with that: lower interest rates enable borrowers to borrow more. But depositors won’t be happy: interest rates have fallen and to make matters worse, the result of private banks increased lending is increased deposits.
Depositors will thus almost certainly have more deposits than they want, thus they’ll try to spend away the excess. Hence the inflation to which Selgin refers.
As already explained, government could just let inflation rip, which is the scenario that Selgin assumes. That means savers or “money holders” are robbed.
An alternative is for government to impose some sort of deflationary counter measure, like raising taxes, i.e. robbing the citizenry of part of its stock of money.
Another possible deflationary measure is for government or “the state” to raise interest rates, and it can do that by wading into the market and offering to borrow at above the going rate of interest, and as regards interest, well the state can just send the bill to the taxpayer.
Also note that the purpose of that borrowing is NOT TO invest in infrastructure or anything like that: the sole purpose is to discourage spending by the private sector. In effect, that’s just another form of robbery or confiscation.
So which is best: full or fractional reserve?
My answer to that is: “whichever is nearer to a genuine free market”.
But there is a slight problem there namely that money is not and never has been a purely free market phenomenon: that is, there has to be some sort of nation-wide agreement as to what form the nation’s money shall take: gold coins, cowrie shells or whatever. And indeed, the historical evidence supports that: that is, in numerous civilisations, money was introduced by a ruler, king etc, not by market forces. Thus there is an inevitable element of “government monopoly” about money.
Nevertheless, there are other characteristics of free markets that different bank or monetary systems might or might not have.
In particular, a genuine free market is one in which customers normally pay the full cost of the goods and services they purchase.
A bank system where banks obtain some of the money they lend out simply by printing the stuff is not a market in which customers are paying that full cost.
There is certainly a case for printing and distributing more money from time to time (via helicopter drops or similar), but there is no reason for any sector of the economy to have preferential access to that new money.
A genuine free market is also one in which fraudulent or dubious promises are not allowed: like the basic promise that fractional reserve banks make: “deposit your money with us, and we’ll lend it on while guaranteeing your money is totally safe”.
And finally, given a perfectly functioning free market, recessions are cured essentially by helicopter drops, i.e. distributing money to a wide selection of people and institutions, not just banks. That is, in a perfectly functioning free market and given a recession, wages and prices fall, which increases the real value of base money, which in turn induces those with a stock of money to spend more – a phenomenon know as the Pigou effect.
All in all, full reserve banking shares important characteristics with free markets.