Four Arguments in Favor of Fractional-Reserve Banking
Among economists related to the Austrian School, there is a disagreement regarding whether banks should retain all their deposits as cash (full-reserve banking) or not. Some of them, such as Rothbard, Mises and Huerta de Soto, believe that this ought to be the case. They assert that only through full-reserve banking will we eliminate the recurring business cycles that we suffer in the form of rising rates of unemployment and, in general, economic stagnation. Contrary to this position, fractional-reserve banking supporters argue, through four basic arguments that we will dive into, that keeping all their deposits in cash will lead to a malfunctioning monetary system. It must be said that most of the economists have abandoned this debate, as there is no reason –fortunately– to believe that fractional-reserve banking will be abolished.
Let’s, for the sake of the explanation, explain the difference between full-reserve and fractional-reserve banking with balance sheets of assets and liabilities. In this hypothetical situation, α is looking for financing and tries to acquire it to β in exchange for a promissory note that β can claim at any moment:
Now, thanks to financial liabilities that are not backed at a rate of 100% by real assets –α has liabilities whose market value is higher than his liquid cash reserves–, α can turn β’s savings into investment. However, β can turn to cash his promissory notes at any point in time –because it is a short-term asset– whilst α will not have enough cash for β until his long-term investment does not produce consumer goods that are sold in the market.
This is the example that most of the full-banking defenders use to criticize fractional-reserve. This is clearly a case of a maturity mismatch between the assets and liabilities of α. But this is a reckless practice that should not take place. Long-term assets ought not to be equal or higher than short-term liabilities. Fractional-reserve banking does not necessarily imply maturity mismatch –other examples when this does not occur are disregarded by those who vouch for fractional-reserve banking.
The real function of banks
The first question that arises from this debate is about the role of banking. Full-banking economists have a worrying misconception about the role of banks. As they only approve the existence of demand deposits 100%-backed by cash reserves, financial intermediation would cease to exist. The banking system does not consist of money storages but of creating extremely complex connections between creditors and debtors. Financial intermediation, as irrelevant as it may seem, has played an essential role –mistakenly overlooked by most economists– in the development of modern economies. It has enabled the emergence of extensive orders characterized by immense interconnections that go far beyond the complete comprehension of human reasoning. In real terms, the availability of savings that can be converted into investment through banking intermediation would be reduced in an enormous scale if fractional-reserve banking were forbidden.
Fractional-reserve banking does not cause business cycles
Although this is an extremely complex and profound environment, many orthodox Austrian economists (most of them full-banking economists) misconceive the role of fractional-reserve banking in business cycles. The premise of the Austrian theory of business cycles is well-known: the artificial credit expansion. Full-banking economists argue that only fractional-reserve can result in that, as not all bank notes are backed are redeemable in real assets. The Austrian economists that defend fractional-reserve, although, claim that the root cause is not credit expansion –natural in every modern and adaptive monetary system– but the decrease of liquidity in the financial economy. It is true, indeed, that the decrease of liquidity can be caused by credit expansion. It has been pointed out as well that credit expansion can only take place in fractional-reserve banking. But that does not imply that fractional-reserve banking necessarily leads to business cycles. If there is no maturity mismatch in the banking system and liquidity is preserved across the economy, these cycles would either not occur or occur to a little extent.
The importance of the elasticity of the money supply
In a world where monetary demand and the real productions are dynamic and changing, monetary supply must adapt to these circumstances. In a full-banking system, the economies would be condemned to deflation and economic incoordination. Huerta de Soto, for instance, claims that this phenomenon is not a concern, as relative prices would adjust without any inconvenience. The truth, however, is that not all prices are elastic and not all prices are equally elastic. That means the velocity with which the prices adjust to shifts in demand is different. That is because wages and interest rates are not negotiated every day, thus some prices considerably more elastic than others depending on each situation. Even if relative prices were all elastic, differences in elasticity would cause relative prices to vary. Price variations are not a concern if they are the consequence of the shift of subjective individual preferences. Consequently, not allowing monetary supply to grow as much as demand would lead to monetary distortions that affect the real economy and the allocation of resources.
The case for consent and contractual freedom
As surprising as it may appear, most defenders of full-reserve banking are libertarian, such as Mises, Rothbard, Huerta de Soto and so on. How can it be that the most fervent defenders of individual freedom are in fact in favor of forbidding a type of banking that has spontaneously emerged from human interactions in a free market? The answer is simple: the depositor has been deceived. Therefore, in the view of full-banking economists, there is in fact a lack of liberty when agreeing to lend the money to the bank in form of bank deposits. However, if A lends money to B, and this money can be claimed at any time –supposing that there has been no coercion in this contract–, what lack of contractual freedom is there to find? There are others that argue that the possibility of not accessing the money whenever you claim it invalidates de contract itself, but the possibility of not fulfilling the contract does not invalidate it at all. In every contract, that possibility –in a shorter or larger scale– exists and is unavoidable. For instance, C can have a contract that entitles them to a monthly wage, but that company might go broke before C receives their pay bill. No full-banking supporter would dare to question the validity of this contract for the same reason that they ought not to question the validity of a debt contract.