Two flaws in fractional reserve banking.

The first flaw is as follows - I’ll explain the second in a day or two. Incidentally this article, and part two of this mini-series are in larger than normal font because I think this is an important point, and I want to make it especially easy to read, because I doubt that even 1% of economists understand it. 

Fractional reserve banking is risky if not actually fraudulent. The risk stems from the fact that under fractional reserve (FR), banks’ liabilities are fixed in value because they’ve promised depositors that depositors will get $X back for every $X deposited (maybe plus interest and maybe less bank charges).

In contrast, banks’ assets can fall dramatically in value if it turns out (as indeed it does, regular as clockwork) that a bank has made silly loans. At that point the bank is bust, or at least may be.

And therein lies the reason for saying FR has for most of its history been fraudulent: to promise someone, or even to suggest to them, that they’ll get their money back, when they may not, is fraud. Indeed, when any of the many other lenders apart from banks make that promise, what they’re doing is classed as illegal, if not fraud. By “other lenders” I mean stockbrokers, mutual funds, unit trusts. At least it’s true to say that FR has been fraudulent for the hundreds of years it has existed, up to relatively recent introduction of deposit insurance.

But the latter fraud point is not the central issue here, so I’ll move on.

The above risky nature of FR banking means that if depositors’ money is really going to be safe, banks have to be backed by taxpayers: in the form of taxpayer backed deposit insurance and billion dollar bailouts for banks when things go wrong.

But the above mentioned “other lenders” enjoy no such luxury. “Other lenders” in addition to the above mentioned mutual funds / unit trusts and stockbrokers, include peer to peer lenders and trade credit lenders (that’s firms which allow their customers an extended period of time before paying for goods delivered). And as for the total amount loaned by those “other lenders” the total exceeds the amount loaned by banks.

Ergo FR as presently set up, involves privileged treatment for a particular type of lender: banks. Put another way, it involves a non level playing field as between banks and other lenders. And as is widely accepted in economics (and indeed by anyone with some common sense), non level playing fields equal a misallocation of resources.

Put another way, GDP is not maximised where a playing field is not level, unless there is a very good reason for the field not being level. (Or if you don’t like the idea of GDP being maximised because of environmental concerns, let’s say “output per hour is not maximised” (in the hopes that people use the extra output to work fewer hours)).

As for the excuses offered for the latter privileged treatment of banks, probably the most popular is that if banks’ liabilities are indeed totally fixed in value (inflation apart) then those liabilities become a form of money, which all else equal increases the money supply, which is stimulatory.

Well the problem there is that central banks can create any amount of money they anytime and at zero cost simply by pressing buttons on computer keyboards.  Indeed given that private banks are utterly and completely hopeless at issuing the right amount of money at the right time because their money creation activities are pro-cyclical rather than anti-cyclical, central banks absolutely have to issue money so as to compensate for the latter incompetence.

The conclusion is that fractional reserve banking is badly flawed. Or put another way, the excuses for having private banks create money do not stand inspection, which is exactly what dozens of economists have been saying for decades, and indeed centuries. See here for a small selection of those economists.

There is a fuller explanation of the above point here.