Fractional Reserve Banking: Do the Macroeconomic Benefits Outweigh the Costs?

Abstract

Fractional Reserve Banking (FRB), the practice whereby banks create long-term loans and short-term deposits, has existed since the early seventeenth century, and is generally considered to be economically beneficial by making money more readily available for long term investment. But it also has a sting, since it is premised on an unfulfillable promise: that all depositors can withdraw all their savings whenever they wish. This can result in panic withdrawals from banks, which have the potential to escalate into worldwide financial crises. So do the benefits of FRB outweigh the costs? Surveying the literature, I find the pre-Keynesian economists were well-attuned to the distortions that FRB produced. Two key ideas stood out: the first, known as “forced savings”, posited that the creation of bank money on behalf of borrowers leads to information asymmetry between borrowers and savers, disadvantaging savers. The second, due to Wicksell, is the “natural rate of interest”, being that rate which would prevail in the absence of money, which minimizes the influence of money per se in economic decisions and holds when savings equals investment. I posit a corollary of this is that banks will lend at the natural rate if they do not create money and the money supply is stable; however, since banks can create money costlessly, they err too low in the price of renting it. Hayek recognized this, but believed a stable-money economy was infeasible. I argue that the problems Hayek envisaged can indeed be resolved.