Banking and Morality: 100% Reserve versus "Fractional" Reserves
October 20, 2008 by Paul McKeever
In written pieces (see here, here, and here, for examples) and in videos, I have advocated a 100% reserve requirement for banks. I am hardly original in doing so. A 100% reserve was advocated by the Chicago professors who advised Roosevelt during the banking crisis of the 1930s (see Ronnie Phillip’s excellent article on the topic); it is and was advocated by several economists of the Austrian school, including, according to Gary North, Ludwig von Mises; it was most famously advocated by famous American economist Irving Fisher; it was even advocated by Milton Friedman before he concluded that it was politically difficult to achieve, and settled, instead, for monetarism (see his “A Program for Monetary Stability). However, unlike some of those economists, my reasons are founded on ethics, not on economics: a 100% reserve prevents inflation of the money supply and, thereby, prevents non-consensual wealth redistribution.
Over at YouTube, a vlogger by the name PortfolioManager1987 has posted a video singing the praises of our current, fractional reserve, system of banking. He suggests that Objectivists, like myself, are wrong to support a 100% reserve, and suggests we embrace the current fractional reserve system.
I’ve heard and considered the arguments he makes many times in the past, because they are the same ones used by libertarian advocates of “free banking”. With all due respect to PortfolioManager1987, he – like the others – (a) appears not to understand 100% reserve banking, and (b) misses what it is about fractional reserve banking that makes it immoral. He having mentioned me by name in his video, I responded to his video as follows:
I advocate a 100% reserve system. You appear to suggest that, with a 100% reserve, banks do not create credit, that banks do not lend out credit for productive investment, and that banks do not receive interest. None of those things are true in a 100% reserve system. In a 100% reserve system, banks create $1 of credit for each dollar of currency, and they lend out that dollar of credit for interest.
In a 100% reserve system, the depositor is paid interest on his deposit if he agrees to let the bank use his money. To do that, he agrees that, for a fixed period of time (e.g., one year), he will have no right to withdraw the money that is being loaned out. That system allows the bank to create only $1 of credit for each dollar on “time deposit” (e.g., GICs).
In contrast, in a fractional reserve system, the depositor retains the right to withdraw all of the money he has on deposit with the bank. The bank then creates more than $1 of credit for each dollar on deposit: $1 for the depositor, and some fraction of $1 (e.g., 95 cents) that is loaned out to a borrower. For example, with a 5% reserve, the depositor holds $1 of credit, the bank holds $1 of currency (e.g., a $1 central bank note), and a borrower holds 95 cents in credit. The same dollar, in other words, is simultaneously owed to the original depositor, and to anyone who holds the 95 cents of credit. Usually, that 95 cents gets deposited in another bank and, when that happens, it is treated the same as currency. The receiving bank issues a 95 cent credit to the depositor, holds 95 cents of credit issued by the first bank, and issues approximately 90 cents in additional credit to another borrower. The process continues as such. Ultimately, with a 5% reserve, the first $1 of currency results in the creation of about $19 in credit ($19 in credit if one excludes from the count the amounts issued by a given bank to a given depositor). With zero reserve requirement – as in Canada – there is no legal limit to the number of dollars that can be created and loaned out by a bank.
The issue is not fraud. The issue is theft. From the perspective of a saver or earner, there is no difference between the government inflating the money supply, and a private entity doing it. Expanding the supply of dollars makes every other dollar less valuable than it otherwise would be.
In a growing economy, each dollar becomes more valuable unless someone inflates the supply of dollars. Whoever does inflate that supply seizes the value of the increased productivity. Under current monetary policy, banks do so more than fast enough to prevent dollars from increasing in value: they actually cause prices to rise during periods of economic growth that would otherwise cause prices to fall and the standard of living to rise.
The fact that there is additional material wealth ‘backing’, in some sense, all of the additional credit misses the point. There’s nothing immoral about lending money that one has earned. There’s nothing immoral about paying interest to encourage people to deposit their currency, and then lending out that currency that is held on a time deposit. The immorality is in creating the dollars out of thin air without first earning or borrowing them. The interest earned on the lending of the unearned is interest that rightly ought to have been paid to those who earned or borrowed the loaned-out amount.
At the end of the day, the fractional reserve system is a system for the massive, immoral, redistribution of wealth: from those who earn dollars to those who merely print them.
With a 100% reserve, the banks would have to earn or borrow the dollars they lend out. Lending to productive businesses would continue, but all wealth, including the banker’s, would be earned. There would still be risk, because even a time deposit needs to be honoured by the bank when it expires. The bank would pay for the use of the money deposited, and would profit if it loaned out money to sufficiently productive borrowers.
There would be no shortage of money as the economy grew because prices would fall over time, which means that, over time, less money would have to be borrowed for the same given purpose.
As for central banks: eliminating them, alone, would not make the fractional reserve system moral. In fact, it was the fractional reserve system that led banks to want to form a central bank, so that they could borrow currency from one another if they found themselves facing depositors who wanted to withdraw more currency than the bank actually had. Eliminate the government-owned central bank, and bankers will simply form a private one. Eliminate fractional reserves, and nobody will need one.
“In defense of fractional reserves”, by PortfolioManager1987
“Understanding Money and Banking, Part V: Inflation, the Gold Standard, and Fractional Reserve Banking”, by Paul McKeever