Two flaws in fractional reserve banking (Part II).

I set out one flaw in fractional reserve banking on this blog yesterday.

That flaw (to recap and summarise) is that fractional reserve is inherently risky because banks’ liabilities are fixed in value (inflation apart), while their liabilities can fall dramatically in value when they make silly loans – at which point they are likely to be bust.

To solve that problem, taxpayers have to back banks with deposit insurance and billion dollar bail outs. But that equals preferential treatment for banks relative to other lenders, which is an obvious mis-allocation of resources.

Let’s now consider the second flaw. This is actually extremely simple, yet for some reason it is largely ignored by opponents of fractional reserve.

It is simply the point that depositing money at a bank with a view to earning interest is a commercial transaction just as much as is depositing money at a stockbroker with a view to earning a return is commercial, thanks to whatever the stockbroker invests the depositor’s money in. 

Plus even, where those who deposit at a bank get no interest, but nevertheless have the cost of their bank account defrayed by interest earned by their bank, they are still effectively earning interest: i.e. they are still into commerce. And it is widely accepted in economics (and indeed by anyone with some common sense) that it is not the job of taxpayers to support commerce, except where there are very good reasons for that support.

And that all points to the wisdom of full reserve banking, which is the alternative to fractional reserve. That is, under full reserve, anyone who wants a return on their money, thanks to the fact that their bank is lending out money as well as accepting deposits is free to try to get such a return, but the policy of government towards those people is: “You’re into commerce, so you’re on your own. In contrast, if you simply want some money kept in a totally safe manner, i.e. not tainted by the risks involved in the entity that accepts your deposits also lending out money, that’s fine: well do that for you. But you won’t get any interest.”

And finally (and to repeat) the above two flaws are set out in more detail in a paper which is available here and here. The former is easier to read in that scrolling thru the paper is easier.