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