A Short Word on Fractional Reserve Banking

I think I have said all I need to say about fractional reserve banking, and I do not want to repeat myself. (Here is a collection of my blog posts on the subject.) But the subject does not quite go away.

There are a couple of prominent economists – George Selgin and Lawrence White – who regard themselves as “Austrians” and who argue that fractional banking in the old days of relatively free banking was beneficial and that 100% reserve banking would have resulted in those beneficial effects not taking place. They give lots of examples.[1] I am not an economic historian and I cannot judge the accuracy of their historical examples. But I do think there is a logical (or praxeological) flaw in this reasoning.

Any policy of “easy money” – of inflation and credit expansion – will have some initial good effects on the economy. But those won’t last, and there will be repercussions later – the well-known “boom-bust” cycle. It is often said (and I have certainly said it myself) that credit expansion creates an illusion of prosperity. But strictly speaking, the initial good effects are not an illusion; the illusion is that they will last and that there will be no repercussion, no bust following the boom.

And I think history bears this out. There were repercussions even in those “good old days” of relatively free banking. Let me quote George Reisman:

Again and again, when banks did fail, the government stepped in and allowed them to suspend payment in specie, in flagrant violation of their agreement to pay their depositors specie on demand. This prevented the wiping out of fractional-reserve banks and enabled such banks to return to issue still more fiduciary media. – Capitalism: A Treatise on Economics, p. 515.

A more extensive criticism can be found in Murray Rothbard’s essay The Myth of Free Banking in Scotland.

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Another argument that keeps popping up is that it is a myth that fractional banks are fundamentally insolvent. But how could it be otherwise? If a bank lends out more money than it actually has in its possession, this means that it is not fully solvent and won’t be able to meet a bank run. To say that such a bank is actually solvent is tantamount to saying that fractional banking is not fractional at all, but non-fractional.

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I also sometimes see people defending “fractional” money (fiduciary media) by showing it can be entered into balance sheets. I do not contest that. (Murray Rothbard – who is dead against FRB – also does this in The Mystery of Banking.) But entering counterfeit money into a balance sheet does not make it less counterfeit.

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And while I’m arguing about fractional banking under a gold and/or silver standard, fractional banking based on fiat money just goes on and on and on…

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I remind you of my comment rules: don’t try to convert me to this, that or the other idea. If you think I am wrong – or that you know much more about the subject at hand than I do – there is nothing I can do about that, anyway. And I do not have the time – nor the inclination or even the stamina – to engage in endless debates. (Or read the very first sentence of this blog post.)

[1]) See George Selgin, Free Banking and Economic Development, Part 1 and Part 2. There is also a lengthy discussion on Detlev Schlichter’s blog.


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