How fractional reserve banking is a free market force
Nov 30, 2009

How fractional reserve banking is a free market force

As the financial overhaul bill starts it's way through the US congress the question of precisely how much the government should limit the ability of banks to fractionally reserve arrises and one feels compelled to consider the origin of such a system. In our world control over the money supply is monopolized by the central banks and their policy of money creation is often, and correctly so, blamed as influencing things like the current crisis. My argument is that money creation would also exist and comes about in the free market via fractional reserve banking.

Consider a purely free market currency where the currency is determined by market demand for a common, reproducible, divisible, long lasting medium of exchange such as gold. The need for warehousing and safekeeping of this medium of exchange results in the creation of banks. A reputible bank can exchange a peice of paper as a redemption slip for a certain amount of say gold in the bank. As the bank and paper notes grow in reputation they can be traded much like current money backed by the gold physically inside the bank in what would be called a fully reserve system. Now, other than governmental legislation there is no reason why a bank can not print more notes than it has money in the bank. While there is some risk that everyone would try to reclaim the notes at once and there would not be enough gold to go arround, the risk is small enough such that the market desire to aquire credit and for warehousing fees to be lowered and then even reversed so one can make interest from depositing in the bank would compel banks to lend in such a fractional reserve system. Because the notes have real value in terms of their purchasing power and ability to pay debt when a bank lends in a fractional way it is creating money.

Barriers to entry for a currency are high as their is little added value for consumers of a currency in having more than a couple which is why such alternatives to the central banks currencies like the USD or CDN don't form. However there is no reason to suspect such a fractional reserve system would not have been created by purely the market forces mentioned above it is merely that the government beat banks to the punch by using their authority to aquire the legitimacy that is slow to develop from a large collection of individual banks trying to introduce their own common currencies.

The point of all this is not to ignore the problems that printing money creates nor all the virtues that having avaliable credit creates for an economy the point is to acknowledge that printing money is not just a result of government intervention it would occur in a free market economy as well unless the government actively regulated against such things.

Thoughts on this post? Comment below!

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Anonymous said...

While it is possible for a free market gold bank to print more receipts then there is gold backing them, you must remember that if this is a true free market bank, then people would also be free to take their money from the bank. There also wouldn't be an FDIC because gold can not by mined as fast as paper can be printed, in the event of a run on the bank who is holding the currency. In history, when the very scenario you gave took place and people found out, a run on the bank occurred and the institution went out of business. This is a far better way of dealing with the issue then deeming what the institution does as "legal" and printing money on top of it all. There were also times, though, when a government would step in and say what the bank was doing was legitimate. These nations faced severe inflation.

bazie said...

A run on the bank MAY occur when people realize(perhaps upfront by a genuine and honest banking institution that says this is precisely what they are going to do and people can choose to deposit in it freely) that they are not getting 100% backed it is not guaranteed that it WILL occur. Most of the historical examples I think you are referencing came about because they hid the fact they were not 100% backed from customers - a clear violation. While not a perfect comparison, today bank runs on modern, fractional reserve banks part of our fiat currency do occasionally occur when a question of solvency arises. However, for the most part when their is good reason to expect the status quo to continue these don't exist and there is little reason to suspect it would not be the same in any other financial system. Stability is the key.

Anonymous said...

I just think a critical error is made that by thinking just because fractional reserve notes could be made, that they will be popular with customers and used as money, even when people find out that their money really isn't with the bank. As I mentioned before, when customers realized this, a run on the bank would occur. So there is very little incentive for this type of banking due to this very fact.

Now, we could assume that there would be separate institutions who would lend depositors money (which are being paid an interest rate) while charging the borrower a higher interest rate. This could be done with CD deposits for example. The depositor would agree to not demanding redemption of their money for a period of time, giving the lender the opportunity to find a borrower. Of course, this isn't fractional reserve banking, as the supply of money never changes.

In today's legalized system, a depositor can make claim on something that really isn't there. This is one of the reasons why a Federal Reserve system was created and also the FDIC. So in conclusion, fractional reserve banking would never be seen in a free market as legitimate because put simply, it's fraud.

On a side note to your comment "Barriers to entry for a currency are high as their is little added value for consumers of a currency in having more than a couple which is why such alternatives to the central banks currencies like the USD or CDN don't form." We can safely assume that if legal government tender didn't exist, markets would go right back to using metals as their form of exchange. There would also be many mining companies who would coin their metals that are to be circulated in the market. You would see plenty of different types of mint marks on these coins, just like you see all of the different types of mints on today's bullion and rounds. So you would absolutely see many different types of coins floating around, just like they did in the past as well.

bazie said...

Oh doombot, of all my recent posts you dig out the single one from like a year ago that deals with austrian issues. The goal of giving you the blog link was to talk about some of the OTHER issues so we didn't just talk about role of state things:D

As to your comments. Now it is true as you say, I think I have layed out how fractional reserve could form, but this doesn't guarantee that it would necessarily form. That said there is a very powerful incentive on all parties for it, quite the contrary of the little incentive you claim (one assumes full disclosure would be required, otherwise it would be fraudulent) For the depositor, he gains interest (or at least lowered warehousing fees) which should he believe the institution is well run and unlikely to have a bank run would be a good motivator. For someone searching for credit it increases the availability of credit if the banks notes are reputable. And for the bank it increases the amount of net transactions it can profit from. Win-win-win, as it were. All this is offset by the risk of bank runs, depreciating of the value of the banks receipts and the likes. The point of this isn't to say categorically that a fractional reserve system would absolutely dominate, but to decouple it from the notion that the only theoretical way it could exist is via a government monopoly. Quite the opposite, the demand for such a thing both positive and negative comes from many market forces and while one could argue it would not be prevalent, one can't argue it is exclusively a government concept. Unless you mandate that 100% backing MUST happen, we ought to expect that there will be cases (indeed, perhaps they will become very widespread) where 100% backing won't happen.

As for competing currencies, there are very natural advantages to having only a handful of used currencies in some regional area. Namely, one does not constantly having to be doing conversions, keeping change from a hundred currencies etc. A common medium of paper (and now electronic) currency is far simpler and more efficient. This doesn't minimize the freeness of it. There could be many valued underlying currencies...(gold, silver, platinum, various fiats, baskets of commodities as some countries use, all with 1:1 correspondence, but the common currency is likely to reduce to just a couple. As we have seen in the past while things like bimetalism has been prevalent, having a huge variety of currencies in a given region is not.

bazie said...

Oh regarding the FED and the FDIC, one of the things they do is to delocalize the risk. The risk of a bank run on any given bank goes down because it can get additional FED loans or it can go under and be insured via the FDIC. So locally the risk is lower. But the risk gets centralized and becomes systematic. Now one can argue for or against the merits of this, but it doesn't actually change the underlying market nature of a fractional reserve system as being something a priori that operates according to market pressures. In a totally free market system, it may well be that a large insurer like the FDIC comes into play which would profit by charging fees for banking insurance. Institutions that purchased the FDIC-equivalent insurance would be naturally more reputable.

Likewise, institutions (and hence the market) would set their own fractional reserve rates. They do this today actually, although the government mandates that the fractional reserve rate can't be too big. Some max out the cap, others don't.

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