The Austrian Business Cycle Theory focuses on the errors of the exponential expansion of credit caused by the fractional-reserve banking system, and therefor artificial low interest rates, created by central banks. Though, despite these flaws in the economy, many free-banking proponents still support banks practicing the fractional-reserve banking. I am among these proponents. However, when we say fractional-reserve, one must remember we mean that, while the banks can practice it, the reserves of the banks must be much higher than the current 10%. This raise in the reserves would be inevitable in free-banking, due to market forces.
But I see that some of these fractional-reserve system supporters support it not merely because a full-reserve system would offer too little credit, but because they believe that a full-reserve system offers no credit at all! This is a fallacy: one mainly proposed by Keynesians. There would be credit available in this system, and it’s pretty simply to explain how it develops.
From here on out, I will be speaking as if we have a full reserve system in place:
In a full-reserve system, there are two types of deposits (similar to banking under the Federal Reserve system): demand deposits and time deposits. The demand deposits are simply a warehousing service of money for depositors. These deposits are in 100% reserves (naturally) and offer complete liquidity to the depositor as they retain the right to take their money when they want it. This warehousing service comes at an interest rate price; people desire to have their money safe, and this is where it would be stored. There is absolutely be a demand for this (contrary to Keynesian belief).
The time deposits, by contrast, are “investments” made by people to the bank so the bank can lend money out for a larger profit. The reason this is called a time deposit is because there is a set time that the depositor can withdraw their money. The bank takes it, lends it out (most likely with a payback-date), and gets the money back in time for the depositor. Now suppose there is no payback-date for the borrower (because the bank wanted to take the most out of the debtor’s interest payments): the bank could simply take money from somewhere else and pay it back to the depositor (perhaps from the interest payments of the demand-depositors, or any of the bank’s assets). To give incentive to people to put money in time-deposits, an interest payment to the depositor is be offered; this is cut from the overall interest payment paid by the borrower.
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, credit would still expand.
My problem with this system is that it simply creates too little credit in the aggregate. For instance, interest rates would fall closer to 0 as the supply of credit increases for borrowers. Banks, at some point down the road, would make the call to stop accepting time deposits, therefor halting credit expansion. And even if they didn’t stop accepting time deposits, one would make the argument that the mere time deposits wouldn’t generate enough credit! And I would agree. Entirely.
Banks can practice whatever they want by my books, but most banks would still only keep a fraction of their reserves in the interest of making money off of credit. In a full-reserve system, the economy would still see booms and busts but extremely mild ones. And that’s what I love so much about full-reserve systems: credit is still offered while having relatively no recessions.
Though, again, I would take the trade off for a bit of a bigger bust (but not nearly what we see today) in return for more credit and a more functional economy under a free-market fractional-reserve system.
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