Home > Economics > Why do we have fractional reserve banking in a fiat currency world? (speculative, blue-sky thinking, tell me why I’m crazy)

Why do we have fractional reserve banking in a fiat currency world? (speculative, blue-sky thinking, tell me why I’m crazy)

January 29, 2012 Leave a comment Go to comments

UPDATE: I have a new post here, arguing that this post is wrong.

If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated – David Hume

OK guys, you’re going to have to bear with me on this one because I’m in blue-sky thinking mode – so usual caveats on speculative thinking apply double for this one. What would happen if the central bank just said “We’re implementing a 100% reserve ratio, but don’t worry we’re just going to create all those reserves in your account with us at a click of a button”? I can’t see how anything would happen at all. It wouldn’t be inflationary, because it would make no difference to people’s decisions or ability to use their money to chase goods and services – ‘the coin be locked up in chests’. But it would mean there are no bank runs, because ‘the money is always there’.

So, why can’t we just do this? The central bank can control the money supply as before to maintain a certain policy target, the only difference is there are now tons of new reserves sitting in accounts with the central bank that aren’t allowed to ‘go anywhere’ due to the 100% reserve requirement. The new reserves are created by the central bank as needed, and everything just goes on as before. Except that old-fashioned bank runs would not happen.

Am I crazy? What else would happen to the banking sector if we did this? How would it affect the natural rate of interest? This smacks of WAY-too-good-to-be-true, and I thought the most efficient way for me to find out where I’ve gone wrong here is to open myself up to public humiliation for having missed something totally obvious.

FWIW, the way I ended up at this conclusion was wondering as to what would happen if we increased or decreased reserve requirements, which seemed to me to be precisely nothing – as the central bank (if it was doing it’s job) would just offset the deflationary/inflationary effects caused by a massive reduction/increase of supply in the market for excess reserves. So long as the central bank controls the price in that market, then I can’t see why reserve requirements matter at all. Except that less reserves means more bank runs.

This is by way of saying that I can’t think of any objections to the full-reserve position that are not general objections to the marginal cost of funds being the key instrument of monetary policy, which would apply no matter the regulatory reserve requirement ratio.

Categories: Economics
  1. January 29, 2012 at 6:05 pm

    Great question. I’ve been trying to wrap my brain around full-reserve banking (making government the monopoly supplier of money) for a while. Hoping to see good comments here.

  2. Max
    January 29, 2012 at 6:06 pm

    This would expand the central bank balance sheet, which is fine as long as there are politically non-controversial assets available to buy (i.e. government bonds).

  3. January 29, 2012 at 6:19 pm

    Steve: thanks. Really hoping for some good comments too. And ‘nationalizing’ the money supply is basically what I’m talking about.

    Max: Very good point. The trick is obviously around how the central bank can soak money back up if it needs too (I do get the MMT idea about how this can be done through taxation, I just have a very strong aversion to the integration of ‘monetary’ and ‘fiscal’ policy for basically political economy reasons).

  4. January 30, 2012 at 5:13 am

    “strong aversion to the integration of ‘monetary’ and ‘fiscal’ policy for basically political economy reasons”

    I think fiscal would be a far better monetary stabilizer because it injects money nearer or at the bottom. But it has to be via automatic formulas because obviously you can’t rely on feckless and shiftless politicians to make those kind of discretionary judgments well. Unemployment, EITC, etc are good examples of stabilizers but the JG would also serve that purpose.

    Even then, some discretion is probably necessary, and much as I might hold my nose, I have trouble thinking of any practical method superior to bonds and the Fed BOG…at least any that might happen in my childrens’ lifetimes…

  5. January 30, 2012 at 9:20 am

    The key reading here (even though it appears to be about a different subject) is Milton Friedman’s “The optimum quantity of money”.

    Foregone nominal interest payments is a tax on holding currency. The optimum long run monetary policy is to create deflation at a rate equal to the real interest rate, to push the nominal rate of interest to 0%, so that people are satiated in holding currency. (This ignores the cost of producing currency and replacing worn out notes etc.) This eliminates a distorting tax on holding currency.

    Suppose for some reason governments choose to have a positive inflation rate, so nominal interest rate is above 0%. So there is a tax on holding currency.

    The question of required reserve ratios is then a question of whether this tax should be extended to chequing accounts. 100% required reserves mean you impose the same tax on chequing accounts as you impose on holding currency. 0% required reserves means no tax on chequing accounts.

    • January 30, 2012 at 12:36 pm

      @Nick: “Foregone nominal interest payments is a tax on holding currency. ”

      Just because people (“the market”) want risk-free holdings that pay interest does not in any way imply what seems to be the unstated assumption here: that the government is obligated to provide them, or that failing to provide them is a “tax” — a “taking” of something that they own or deserve by some natural right.

      This is no different from saying that foregone transfer payments to the poor constitute a “tax” on poverty.

      You could call either (as in Carmen Reinhart’s “pity the poh’ bondholders” perorarations) “financial repression.”

      You could certainly say that either of these things creates incentives similar to those created by taxes. As long as it’s presented as such — which it decidedly is *not* in Friedman — it can serve as a useful pedagogical conceit.

      As for checking accounts, full-reserve banking might indeed result in account holders paying banks a fee to hold their money for them securely and conveniently.

      And banks would be in the surprisingly novel situation of earning a living by providing a service in return for a fee.

      It’s not perfectly clear how that constitutes a “tax” on checking accounts.

    • Max
      January 30, 2012 at 6:48 pm

      “The question of required reserve ratios is then a question of whether this tax should be extended to chequing accounts. 100% required reserves mean you impose the same tax on chequing accounts as you impose on holding currency. 0% required reserves means no tax on chequing accounts.”

      It’s not possible to pay interest on currency. Traditionally reserves didn’t pay interest, but there’s no reason why they shouldn’t – reserves are just bank accounts for banks. And in fact, the Fed pays interest on reserves now.

      That’s not to say that banks would be happy about a 100% reserve requirement. Even with reserves paying interest, it might reduce bank profits (depends on whether the “seigniorage” banks make is greater than the deposit insurance fee, which would go away with full reserve).

  6. wh10
    January 30, 2012 at 4:43 pm

    Is there a “bat signal” for Scott Fullwiler? He’s your man on this.

    There’s a discussion in the comments section here, with Fullwiler’s thoughts (the article itself is addressing a different topic):

    http://neweconomicperspectives.blogspot.com/2009/11/what-if-government-just-prints-money.html

  7. klhoughton
    January 30, 2012 at 7:02 pm

    “Traditionally reserves didn’t pay interest, but there’s no reason why they shouldn’t – reserves are just bank accounts for banks.”

    Max – There’s a very good not to pay IOR; the reserves themselves are not being used to make money. (As noted above, they are there to make certain that the money that is allocated to making money is doing so.) Paying interest on reserves–and certainly on excess reserves–is taxing the people for making certain the fiduciaries who run the banks don’t get too optimistic.

    • Max
      January 30, 2012 at 7:13 pm

      Reserves don’t “tax the people” unless the Fed loses money on its operations. Forget reserves for a minute and suppose that banks were required to hold t-bills. Would that be a tax on the people because t-bills pay interest?

  8. January 31, 2012 at 7:06 am

    I oppose fractional reserve, but I’m not sure about Richard Williamson’s claim that “old-fashioned bank runs would not happen” under full reserve. There might be fewer, but under full reserve there’d be nothing to stop a bank making a series of bad loans and going bust.

    A better way to minimise bank runs (or more realistically, the amount of taxpayer funded support we give to banks) is what might be called the “Mervy King” system. King said, “If there is a need for genuinely safe deposits, the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets.”

    I.e. depositors must not be allowed to have their cake and eat it: enjoy 100% safe accounts at banks, while reaping the benefit of their money being invested in a risky manner. I.e. depositors should have the choice: 1, 100% safety, in which case they get little or no interest, but their money is e.g. deposited at the central banks and is thus safe, or 2, go for accounts where their money is invested in commerce, but there is no taxpayer funded bailout if it all goes wrong, and there is no instant access to the money.

    The net result is that for “1” there is no point in depositors doing a “run”. As for “2” depositors cannot have instant access to their money, so a run (or at least a fast run) is not possible.

    Next, what’s the reasoning behind your “strong aversion to the integration of ‘monetary’ and ‘fiscal’ policy for basically political economy reasons”?

    Steve Roth, Contrary to what you seem to suggest, a combined monetary and fiscal policy does not rule out “injecting at the bottom”. Abba Lerner’s idea (favoured by most MMTers I think) is simply to create money and spend it into the economy in a recession (and/or cut taxes). That system combines fiscal and monetary, and the relevant money can perfectly well be injected at the bottom.

    There is a short paper here (1,000 words) by a Prof. of computer science advocating more or less the above, i.e. he advocates that central banks should do some fiscal: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1977688

    • December 17, 2012 at 3:55 pm

      I happen to run across this, I know it’s old but quickly on the comment about bank runs – the idea of FullRB is that that branch of banking (or of a bank) does not loan that money, so no, there can never be a run on that money, at least not as long as the US legal system functions anyway. All the deposited money just sits there (ok, most as digital money, but it still just sits there). Even if the bank went bust, the money in those accounts has to be there by law (this is not like deposit insurance – the money can never have been transferred out of the account, not for any purpose or amount of time), and is returned to the owner or transferred under whatever legal proceedings to the next holder of its assets (a different bank or the gov, at any time available to the owner).
      And the details about how money would be loaned are pretty easily worked out – people who want interest would (deservedly) have to suffer risk – there would be numerous accounts like savings accounts with extremely low risk uses of the money (bonds etc) that would pay interest like current savings accounts. Of course, if you wanted higher interest gains, you would invest your money as normal

  9. January 31, 2012 at 7:51 am

    Full reserve makes bank deposits unlendable? That depends on what you mean by “deposit”.

    Consider the “two types of account” system I set out after Richard’s 29th Jan post. Under that system, money deposited in accounts which depositors agree with the bank will be loaned on is no longer instantly available to depositors. Thus a depositor’s bank statement might in effect say, “that $X you deposited with us is no longer with us – you have $0 deposited with us because we’ve loaned the money out for six months. But in six months’ time, your $X will be with us again, and will be at your disposal.”

    • January 31, 2012 at 1:20 pm

      @Ralph: “that $X you deposited with us is no longer with us… in six months’ time, your $X will be with us again,”

      That’s called a CD, no?

      • January 31, 2012 at 2:03 pm

        Steve, I take it you are saying a CD is as good as cash, thus where the bank loans out depositors’ money, the so called full reserve system has failed – i.e. it is still effectively fractional reserve.

        I’m sure CDs worth $1m and more can readily be used in lieu of cash in the world’s financial centers. But it’s entirely different for the sort of amounts typically deposited by households or small firms. So at least the two type of account system clamps down to some extent on the amount of money / credit that commercial banks can create out of thin air.

        Aren’t we into the argument as to what constitutes money here? There is no hard and fast definition of money. I gather government debt near maturity is accepted in lieu of cash in the world’s financial centres. But that debt is not much use for buying a car or shopping at the supermarket. And it is not included in any of monetary aggregates: M0, M4, etc, far as I know.

  10. January 31, 2012 at 2:09 pm

    Ralph, no, was just pointing out that money in the bank that you can’t get back for six months is what a CD is.

    “Aren’t we into the argument as to what constitutes money here? ”

    Yes indeed.

  11. Yakov
    February 22, 2012 at 12:27 am

    Steve, I am following your suit and opening myself up to public humiliation, but I think I can afford it – I am beginner in macroeconomics.
    As a beginner, I probably should have been asking questions, but instead I will try to answer yours (who knows, maybe I will learn something myself in this way). I will ignore for now the answers you’ve already gotten, I got a headache in an attempt to follow them. So let me go directly to your questions.

    1. “We’re implementing a 100% reserve ratio, but don’t worry we’re just going to create all those reserves in your account with us at a click of a button”

    First of all, I must say that the question is not quite clear. If you meant that the banks give all their customer deposits to the central bank as reserve, they do not have anything remaining to lend. This is probably not what you meant. What you probably meant is that the deposits remain in the pocession of the banks, but the central bank creates an 100% reserve, actually a guarantee at this point, no money, for each particular bank.
    I will build now a theoretical exaggerated scenario hoping to see repercussions in a more clear light. The bank lends out all the deposited by customers money. If the customers then run to the bank for their money, the bank does not have money, but the central bank supplies it from this account “reserve”. At this point the central bank has to produce this money and the only way I see it doing that is it prints it (well, with the help of Treasury). Imagine now, that all customers of all banks run for their money. The central bank must then print all this money which will add to the market additional cash in the amount of all the banks’ deposits. Imagine now that bank borrowers failed and did not return their debts. The bank customers, however, being assured that the system is intact, deposit their money again. The central bank creates the reserves again. Customers, time passed, decide to check out the system again and the same repeats again. Result – amount of real money in the market, not the fictitious money supply from the fractional reserve system, grows rapidly. As I said, it is an exaggerated scenario. But I am afraid, that in more realistic scenario the result will be the same just on a lesser scale.
    What do you think about that?

    • February 22, 2012 at 4:53 pm

      Hey Yakov, I think you’re thinking along the same lines as I am. Check out the conversation JKH and I had in the comments to this post’s update:

      https://shewingthefly.com/2012/01/30/richard-williamson-smackdown-watch-richard-williamson-edition/

      Envisioning for clarity’s sake a world where the Treasury is THE bank — both central bank and commercial bank. (The fourth scenario below.)

      I’ve been pondering a post lately, called “Looking at the Fed,” which would analyze what the monetary system looks like depending on what the Fed looks like:

      o As an independent entity separate from government and banks

      o As part of an entity consolidated with the Treasury

      o As part of an entity consolidated with all its reserve-holding banks

      o As part of an entity consolidating Treasury, Fed, and the banks

      I think a lot of confusion arises from people discussing these different views at the same time, even shifting views within their own discussions.

  12. September 12, 2013 at 1:08 am

    サンダル 激安

  1. January 30, 2012 at 2:33 pm
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  6. January 30, 2012 at 8:25 pm

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