Is Fractional Reserve Banking Harmful?

Tom Woods recently held a debate on his podcast about whether fractional reserve banking is economically benign.  John Tamny argued that it is essentially harmless, while Jeffrey Herbener argued that it is.

First off, both men were gentlemen.  It is good to hear a civil debate where the two sides aren’t just looking to score cheap shots.  It was meant to be an intelligent debate for intelligent people.

Second, both men took the position that fractional reserve banking should be legal in a free market system, as long as the depositor has the understanding that his money may not be there upon request if a lot of other people show up before him.

I think this is the correct libertarian position.  It amazes me that there are so many anarcho-capitalists who say that fractional reserve banking should be illegal.  Who is going to make it illegal?  And who are they going to point the gun at?

If it is clear to depositors that their money will be used in this way, then it is a voluntary contract between consenting parties.  It is not fraud any more than insurance is a fraud.  Insurance companies rely on the fact that not everyone is going to make a claim at the same time, if at all.

The important thing to note is that fractional reserve lending would likely be far more limited without the existence of a central bank (the Fed) and without government deposit insurance (FDIC).  This was Mises’ view as well.

And speaking of Mises, it was funny that Tamny kept saying how much he admires Mises, yet Tamny himself basically denies the Austrian Business Cycle Theory.  This is rather peculiar given that it is one of the cornerstones of Mises’ writings on economics.

I think Jeff Herbener is one of the smartest guys in existence when it comes to economics.  The one drawback is that I am not sure that he always makes a good connection with the layperson.  If you have a group of economists at an Austrian Scholar’s conference, there is probably nobody better to listen to than Herbener.  I am just not sure he connects with people who do not specialize in economics, as sometimes he gets too technical.

Tamny made a decent analogy with leasing jets.  He also made a really bad analogy with lending money.

He compared fractional reserve banking to person A lending $3,000 to person B, and then person B lending that $3,000 to person C.  But this analogy falls flat because person A and person B cannot spend this money when it is in the hands of person C.

Compare this to fractional reserve lending, where person A deposits money in a bank, which is then loaned out to person B and person C.  All three people can spend this money at the same time.  It can be used to bid up prices.

Another issue that I don’t believe was mentioned (or at least not emphasized) is just the very existence of the Federal Reserve and how this magnifies the harm of fractional reserve lending.  If the money supply were relatively stable, then even a large degree of fractional reserve lending would have a minimal impact.

If banks have already lent out 90% of the bank deposits (assuming a 10% reserve requirement), then it is already a done deal.  If there is no monetary inflation, then there will be no more inflation from fractional reserve lending.  The problem comes in the fact that whenever the Fed increases its monetary base by buying assets, it is magnified by 10 times if the banks do not hold the new money as excess reserves.

(As a side note, this is part of the reason that price inflation has remained relatively low since 2008, despite an explosion in the adjusted monetary base.  Much of the new money went into excess reserves instead of being lent out.)

One other point in response to Tamny is in regards to his claim that demand deposits make up a small fraction of the total money that is lent out, which makes the whole issue insignificant.  I can’t verify his claims, but it still misses the point.  This money is being multiplied by as much as 10 times over, which then does make it very significant.

In conclusion, it actually doesn’t matter in terms of policy of who is right here.  The key is that we need to eliminate the FDIC, central banking, and all of the other government regulations.  We need a free market in money.  If that ever becomes a reality, then fractional reserve banking will be relatively harmless at that point, and the banks that abuse it will quickly find themselves out of business.

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