Fractional reserve banking is as clever as legalising drunk driving and making it compulsory to insure against resulting injuries.

 
 

 

Prior to the introduction of deposit insurance, our bank system (fractional reserve banking) was essentially fraudulent. Reason is that banks told depositors or at least suggested to them that their money was safe, while at the same time, granting loans. Those two activities are plain incompatible because if a bank makes enough silly loans, and banks do just that far too frequently, then they are not able to repay depositors their money.

Anyway, governments eventually decided to do something about that. But instead of simply banning the above practice, they decided, if anything, to encourage it by introducing deposit insurance (in the early 1930s in the US, for example). That is, banks could continue to engage in the above fraud, but depositors were shielded against loss when the fraud resulted in disaster.

Unfortunately, though, that did not deal with all the fallout from the above mentioned “disaster”: i.e. banks going bust. That is, deposit insurance, while it protected depositors from loss, did not stop banks going bust.

So in 2007/8 for example we had a major bank crisis, as a result of which various banks faced going bust, though of course the majority were saved thanks to taxpayer funded largesse. But even that taxpayer funded largesse did not prevent the bank crisis causing a ten year long recession and tens of millions worldwide losing their jobs, and hundreds of thousands losing their homes.

In other words, to repeat, deposit insurance does not deal with all the fallout from bank crises.
 
The alternative to deposit insurance would have been to ban the above mentioned fraud. And doing that would have involved forcing banks to abstain from putting depositors’ money at any risk whatever: in other words banks would have been forced to keep money which depositors wanted to be totally safe in a totally safe manner (shock horror). That is banks would have been banned from lending out depositors’ money, or even from having the same entity or bank subsidiary engage in both accepting deposits and making loans.

As for loans, banks would have been forced to fund those via equity, not deposits. And what d’yer know? That’s what full reserve banking consists of.

So deposit insurance has distinct similarities to legalising drunk driving while making up for that sloppy attitude by forcing all car  drivers to be insured for medical expenses and loss of earnings if they crash their cars while under the influence of alcohol. That is, that insurance deals with SOME OF the problems of drunk driving, but it does not cover all the fallout from that anti-social activity.

And just to repeat, deposit insurance deals with SOME OF the consequences of the above fraud, but it does not deal with all the fallout from that activity.

In particular, bank failures under full reserve banking are plain impossible: as for safe money, that’s safe. And as to banks which lend, or the subsidiaries of banks which lend, they’re funded via equity, thus if they make silly loans, all that happens is that the value of that equity falls. The bank or subsidiary does not go bust.
 

Of course that is not to argue that full reserve puts an end to all booms and busts. But it does remove or at least ameliorate one cause of boom and bust.

And as for any idea that any cut in lending and indebtedness caused by full reserve is a problem, that is hard to reconcile with never ending complaints we get from a long list of worthies to the effect that there is too much private sector debt.

Plus the fact that more lending increases GDP all else equal DOES NOT prove that more lending is desirable. One reason is that increasing GDP, i.e. imparting stimulus when unemployment is higher than it need be, can very easily be done WITHOUT any specific attempt to increase lending and debt. For example a helicopter drop basically just increases consumer spending, though doubtless a finite amount of extra lending will accompany that.

Moreover, the conventional assumption in economics is that externalities should not be allowed. And a bank system which imposes ten year long recessions on an economy is clearly a system which is guilty of imposing an externality. 

________________

P.S. (14th Dec). I’ve just realised there’s a bit of a mistake / omission from the above article, as follows. Supporters of the existing / fractional reserve bank system would argue in response to the above points that bank problems NOT DEALT WITH by deposit insurance are dealt with via bank regulation, e.g. imposing minimum capital requirements.

My answer to that is that the latter idea is fine in theory, but the problem is that bankers always find it easy to get their way with politicians and roll back bank regulations. Witness the claim by Sir John Vickers (chairman of the main UK government inquiry into banks in the wake of the 2007/8 bank crisis) that bank regulations are still not adequate.

And it’s not just POLITICIANS who do banksters’ bidding: Mervyn King, former governor of the Bank of England, appears to be just as willing to do banksters’ bidding. In Ch7 of his book “The End of Alchemy” he argues against full reserve banking on the grounds that “banks would lobby hard against such a reform”. Perhaps he also thinks theft should be legalised because thieves are not too keen on anti-theft legislation.

Conclusion: in practice, it is very debatable as to whether bank regulation actually solves the problem, though clearly there is more to this argument than appears in the above article and this “P.S.”.