The argument against fractional reserve banking is very like the argument against artificial interest rate adjustments.

 

In a “base money only” system, i.e. under full reserve banking, people and firms would lend to each other, sometimes on a peer to peer basis, and sometimes via banks or similar. And under that system there is no obvious reason why the rate of interest established would not be some sort of genuine free market, or “GDP maximising” rate: after all in such a market there’d be millions of borrowers and hundreds of lenders competing for business, just as in the real world right now. I.e. in that scenario, it is difficult to set up monopolies or cartels to rig the market.

Note that under that system, banks would lend only base money. That is, letting private banks create their own home made money would not be allowed, or to be more accurate privately created and state backed money (backed via deposit insurance and bank bail outs) would not be allowed. (Privately created UNBACKED money, e.g. Bitcoin, is a different matter).

However, if commercial banks are allowed to create their own home made state backed money (as under fractional reserve banking), they can lend at BELOW the above free market rate. Reason is that they then have additional funds to lend, which will inevitably result in the rate of interest falling. Apart from an artificially low rate of interest, another effect is that there is then an artificially high level of debt.

But that fall in interest rates stems from preferential treatment for private banks: that is, there is no more reason for those banks to be allowed to create money (in particular state backed money) than for steel producers or restaurants to be allowed to. Indeed if steel producers or restaurants had the right to create money, that would cause the price of steel and restaurant meals to fall.

As Irving Fisher said in the 1930s, there is no reason why firms which LEND money should also create the stuff.

The latter point about state backing for privately issued money is important. That state backing makes the relevant privately issued money as good as base money. In contrast, there is non state backed money, e.g. Bitcoin. It is assumed here that the latter form of relatively risky money, while it will always occupy a niche market, will never be popular with the vast majority of households and small and medium size businesses, as long as totally safe state issued or state backed money is available, and thus that it can be ignored, though obviously things are developing in this area and need watching.

A final point here is that the above argument dealt with the relatively simple case of where, initially, the only form of state backed money is central bank issued money and privately issued and state backed money is then allowed. That argument can actually be made more general in the sense that having allowed a small amount of privately issued and state backed money, there are no good arguments for allowing even more privately issued state backed money and for the reasons suggested above, i.e. that any such move would simply INCREASE the preferential treatment accorded to private money issuers.

Put another way, given a need for stimulus, having the state create and spend more money into the economy is preferable to artificial inducements to private banks to create and lend out more money.

And that of course amounts to saying that where stimulus is needed, the best form of stimulus is to simply create and spend more base money (and/or cut taxes) as advocated by Ben Dyson, Richard Werner etc (p.10) here for example, rather than cutting interest rates.

Does that amount to saying that fiscal stimulus is preferable to monetary stimulus in the form of interest rate adjustments? Well not quite, if by fiscal stimulus you mean having government borrow $X and spend it. The latter Dyson/Werner form of stimulus is really a combination of monetary and fiscal stimulus, a form of stimulus with which Ben Benanke is actually sympathetic (see his para starting “A possible arrangement....”).

 

Market forces.

It might be claimed that a weakness in the above argument is that the importance attached to market forces is rather called into question by the fact that having the state issue money is not in the nature of a free market either. The answer to that is that as anthropologists and historians have discovered, in most civilisations, money comes into existence because of the desire by a king or ruler to collect taxes more efficiently, not as a result of market forces. i.e. while the market is good at some things, it is not good at setting up a form of money. As Abba Lerner put it, “Money is a creature of the state”.

Moreover, the idea that we can do without state created money is just delusional. The reality is that nowadays states are expected to do something about recessions, and the only way they can do that is by creating and spending state created money, something they have actually done on an unprecedented scale since the 2008 bank crisis.

To summarise, while money itself is arguably not a free market phenomenon, having accepted that the state should create money, it is then reasonable to make the assumption, widely made in economics, namely that the free market produces the best solution, unless there are clear reasons for thinking it doesn't.