Other posts I’ve written on the subject of Fractional-reserve banking: Fiat Money is False Money and Leads to Failure, Banking and Our Inflation Problems, and Credit and Full-Reserve Banking: Not Mutually Exclusive to name a few.
Without a doubt the United States was (and according to most still is) the economic superpower of the world. Its standard of living was high, employment was up, it manufactured, served, and had what seemed to be an endless amount of foreign investors. But the question arises of how the U.S. arrived to such a position. In the early 20’s, the economy experienced the effects of the Federal Reserve Act kicking in: credit was moving in much larger amounts to a much broader base of people. This meant people were buying stocks on margin or bought appliances, products, and even cars with payment plans. This, in turn, offered everyone jobs somewhere along the line. The economy kept expanding.
This clearly ended with the October crash in 1929: the onset of the Great Depression. The boom brought an inevitable bust, and standards of living were poorer than before. Despite this crash, the 20’s foreshadowed the 1950’s regarding the growing middle class. Through the Great Depression, as the New Deal was passed, people and businesses became more “federally insured”; when the war was over and the economy was picking up again, buying-on-credit became more frequent and “safer”. Again. Thus our modern middle-class consumerism was born; if people could become debtors all they wanted then there was no stopping our economic growth!
That economic system clearly has major flaws, and I as an Austrian have pointed this out many times. But there is an argument, which I myself subscribe to, that supports a system of fractional-reserves (credit expansion). I’m going to attempt to make that same argument to all who read this.
If anyone who reads this were to observe my other posts linked at the top, they would notice I condemn inflation and the fractional-reserve system we stand by today. Many of my Austrian counterparts would state this it is so horrible, the system as a whole must be wiped out; it is absolutely fundamental for them to understand that there are certain levels of fractional-reserves that can have long term benefits.
Let me start by analyzing some of these of these numbers. The first thing to realize is the current reserve ratio set by the Federal Reserve: 10%. This means that when you deposit, say, $100 into a bank, they only keep 10% of that. You are still entitled to withdraw the whole $100, but they only have $10. The Federal Reserve has banks practice this so that the other 90% (your $90) can go out in the form of credit.
Note: It is somewhat sustainable, because the banks hope that a limited amount of depositors want their money at a certain time. This would allow the banks to simply move money around and pay you the $100 you rightfully own.
Thus $90 was just added to the money supply. But wait, we’re not done! This process now repeats with that $90, which turns into $81, etc etc.
This is known as the money multiplier, and the equation of it is:
M being the multiplier, and R being the reserve ratio. So let’s plug in our current ratio. The equation becomes m= 1/.1 = 10. What is that in a percentage? 1000%. Your money inflates 1000% in our current fractional-reserve system. That’s an astonishing amount of credit out in the markets! The liabilities of the banks must be overflowing! Why, they must feel the urge to raise those reserve ratios! Nope. Time and time again, the Federal Reserve bails them out when they start to have a bank run. Why, we just found out the Federal Reserve spent $16 trillion doing this exact thing in secret!
The Austrian Business Cycle Theory has been proven correct with every bust we’ve seen. I’d like to very very briefly go over it here. We know that there is a market for Loanable Funds, and that in a full-reserve system, Savings will always equal Investment. If people are saving more and more, we’ll notice the ability to invest increase. With more investment availability (i.e. the ability to give out credit), we’ll notice the market interest rate fall. Here is a graph of the overall economy in a 100% Real Savings economy.
We notice that there is generally more Consumption as opposed to Investment, meaning that there is less money being put into earlier stages of production. The economy has a bit of a high time preference. There is no bubble being developed.
Here is a picture of the economy when Savings does not equal Investment:
Through one of the many ways the Federal Reserve expands the money supply, we see a boost in investment with no change in real savings. In fact, savings might actually decrease with the artificially low interest rate. We now see a boost in Consumption and Investment. This greatly distorts the Hayekian Triangle, pumping malinvestments into all parts of the economy.
Note: I may make a post further explaining the Austrian Business Cycle Theory.
There are very damaging levels where this can be done. We’ve seen the effects of these damaging levels throughout world history. But are there levels of credit expansion that won’t distort the Hayekian triangle so much, and may actually help us? Yes. If we threw out every other money-creating tool the Fed has and boosted the reserve ratios to a point where banks may act autonomously, then we may reach “the perfect economy”. We may as well call this free-banking.
Now let’s backtrack and observe the following graph, showing the multiplier effect with various reserve ratios:
50% and higher doesn’t seem so scary at all. Even 40% might not seem so detrimental. Look, I’m not saying we wouldn’t have bubbles; we would, but they’d be very minor.
We need to realize that without our flow of credit in the 50’s, we wouldn’t have become the economic superpower we are. I don’t condone the risks we took doing it, how fast it took, and the woes it brought us after these booms, but the general rule still holds true: flow of credit is a positive thing. When done responsibly, that is. In free-banking, banks wouldn’t be able to keep 10% reserves like this; they would need to stay higher so long as we are not on a unified currency. There really is a point where what Rothbard regarded as “fraud” will help us.