I thought my followers would be interested in reading this:
A question on full-reserve banking:
The Austrian business cycle focuses on the errors in the exponential expansion in credit caused by the fractional-reserve banking system and artificial low interest rates created by central banks.
However, couldn’t this same problem with speculative bubbles, boom and bust cycles, and lowered savings occur in a free-market (full-reserve) system?
For instance, there would be two types of deposits in this system: demand deposits and time deposits. The demand deposits are simply a warehousing service of money for depositors. These deposits would be in 100% reserves (naturally) and would offer liquidity to the depositor as they retain the right o take their money when they want it.
The time deposits are “investments” made by people to the bank so the bank can lend them out. To give incentive for people to put money in time-deposits, an interest payment to the depositor would be offered as a cut of the total interest to the borrow of this money.
So as more and more people put money in time-deposits and the banks lend them out, even though all of the assets remain the same and the money supply remains constant, wouldn’t credit expansion be an issue?
Interest rates would fall closer to 0 as the supply of credit increases for borrowers. We would be buying on credit all over again. The only way I could see this being okay is that there would still be a stable money M1 money supply, but I’m still confused as to where I’m either a) thinking about it wrong or b) thinking about it correctly and we would actually still have boom and bust cycles.
number1hoodrat (Logicallypositive) answers:
Finally got around to this question. Forgive me for taking a while to answer, like I said I was at a music festival the past 3 days and was way too tired to formulate a decent response.
Just like any economic system, the free market certainly has its drawbacks. As you stated, booms and busts will always occur. However, what you have to keep in mind is that although booms and busts will occur, the intensity of the booms and busts will be far, far lesser than they would be under an inflation-induced bubble. Furthermore, there is an excellent book by Douglas French I reccomend you check out, titled Speculative Bubbles and Increases in the Monetary Supply. Basically Mr. French makes the case that, throughout history, all bubbles can be linked to expansions in the monetary supply. Granted this isn’t always induced by a central bank: one of his examples (I forget which country, I believe it was Denmark though I could be mistaken) was an expansion of the money supply brought about by the discovery of a silver mine. The mined silver was pumped into the money supply which in turn sparked a bubble. But since precious metal mines aren’t very common (to that degree anyways) anymore, and also since industrial demand for those metals is far greater, we don’t necessarily have to worry about that anymore. So the moral of the story here is that the horrible boom/bust business cycle you fear is caused precisely by a central bank-induced expansion of the monetary supply.
Credit expansion is certainly one issue that must be addressed under 100% reserve banking. It is indeed a true fact that credit does not expand nearly as much as it does under a fractional reserve banking systme, which can in turn lead to periods of harmful deflation and stagnant economic growth. However, if you examine history you will see that for one, those periods are nowhere near as long as the depressions induced by the bursting of a bubble, nor as severe. And second of all, with 100% reserves you truly avoid such speculative bubbles which I argue are far more harmful to an economy than temporary bouts of deflation.
I hope that answers your question. Thanks for asking, it was a good one!
Good information about free-market credit creation, free-market interest rates, and a free-market business cycle. All of which is not induced by central banks and doesn’t benefit giant bank executives nearly as much as today’s corporatism does.
Follow up here. Later, it’s briefly discussed that even if banks couldn’t repay loans on time-deposits, the bank could easily tap into its own assets (such as interest payments received both on demand deposits and loans) to pay off its debt.
This wouldn’t pose an issue because time-deposits wear off at various points all year round. People will have to wait before their specific duration of their CD was up to retrieve any money. This gives the banks time to recover from bubble pops that would be less significant and time to pay off debts at according times.
That contrasts to the fractional reserve system, where the money is lent out but the depositor is still legally entitled to it on demand; when masses go for retrieval of their deposits, the banks have no money to give back because it’s all out in loans and so many people are demanding money that isn’t there anymore. Thus, the bank runs.
Also: Any of my followers not following Logicallypositive (number1hoodrat) should do so now. Great economic explanations and some funny posts daily.