Tuesday, 13 July 2021

A common mistake by defenders of fractional reserve banking.




A common claim by defenders of the existing bank system (fractional reserve) is that the alternative, full reserve, would restrict credit and thus reduce GDP. That claim is of course true if one assumes “all else equal”. However, the all else equal assumption is nonsense because any cut in demand resulting from credit restriction would result in government and central bank implementing more stimulus, and thus returning, or at least attempting to return demand to its “pre credit restriction” level, with the result that there’d be less lending / debt based economic activity and more non debt based activity.  Thus this above “common claim” by defenders of fractional reserve is false logic.


A common claim by defenders of the existing bank system  (fractional reserve) is that were banks to be prohibited from lending out money at the same time as accepting deposits (which essentially amounts to lending out depositors’ money), credit would be restricted, which would cut GDP. (Incidentally any readers wanting to claim that banks under fractional reserve create money rather than lend out depositors’ money, which is sometimes claimed to be what this Bank of England article says, please see Appendix 2 (p.12) here. That BoE article actually says (quite rightly) in its second sentence that banks BOTH created money AND act as intermediaries between depositor / lenders and borrowers.

There’s a selection of economists who make the “credit would be restricted” claim listed in the reference section below.

The answer to the latter “credit would be restricted ergo GDP is reduced” argument is that clearly the argument is true ALL ELSE EQUAL: i.e. assuming that upon credit being restricted, forms of economic activity not reliant on credit don’t expand to compensate.

But the latter is a totally unrealistic assumption because governments and central banks are constantly trying to keep demand up, and unemployment down to the level where unemployment is minimised in as far as is consistent with not letting inflation rise too far. Thus WERE full reserve implemented and credit restricted, government and central bank would simply implement some stimulus so as to bring unemployment back down to the latter minimum possible level.

Thus the above “credit would be restricted” argument falls flat on its face. Put another way, the IMPORTANT question is as follows. Which scenario maximises GDP: the fractional reserve scenario where credit is “maximised” (so to speak), or the full reserve scenario where there is less lending (and less debt)?

Well there’s a simple answer to that, which is that under fractional reserve, government (i.e. taxpayers) stand behind money lenders via deposit insurance and bank bail outs. I.e. governments stand behind (aka subsidise) two types of money lender: depositors (who lend to banks) and banks themselves. And GDP is not maximised where government subsidises any particular form of economic activity, whether it’s money lending, car manufacture, restaurants or you name it.

Put another way, government should not subsidise or even so much as hint that it might rescue firms in trouble where those firms are into COMMERCIAL activity, like money lending.  The merest hint that government might rescue incompetents in any industry constitutes a subsidy of that industry because those lending to firms in that industry will know their money is safer, if only marginally safer, than in the absence of that sort of government hint.




Coppola, F. (2012). Full reserve banking: the largest bank bailout in history. Coppola Comment. She refers to “a serous restriction on the nature and scope of bank lending.”

Kregel, J. (2012). Minsky and the narrow banking proposal. Levy Economics Institute of Bard College, Public Policy Brief, No.125, 2012, passage starting “In a narrow banking system….”.

Van Dixhoorn, C. (2013). Full Reserve Banking. Sustainable Finance Lab, p.21.

Vickers, J. (2011). Independent Commission on Banking Final Report, para 3.21.

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