I know this isn’t exactly breaking new ground, but I’m going to blog about something I don’t really understand. What would the world be like without fractional reserve banking (FrRB)? I’ve been meaning to write about this for a while, because I am on the libertarianish wing of politics and some of the things I’m most dubious about this branch of thought concern currency and banking. There are frequent criticisms of fiat money (paper money, basically), demands for a return to the gold standard and attacks on FrRB, like this one from Austrian School economist Murray Rothbard. Being a sceptic, I like to question received wisdom, even when it’s my own, or that of a group I generally agree with such as the Austrian economists.

The FrRB system is normally described as one in which banks need by law only keep a fraction of deposits in their possession, and can lend out the rest. In fact, I believe it’s more a matter of how much a bank needs in very liquid assets versus liabilities, wherever the assets might have come from. They don’t have to be deposits, a bank can also use its own capital to back loans.

The effects of these two ways of backing loans seem to me to be rather different. Let’s assume banks in a particular country have to hold 20% of their loans in liquid assets like gold, cash or publicly traded stocks. If a bank takes £1,000 in deposits it can lend £800 and has to retain £200. That doesn’t strike me as particularly inflationary and while you can reasonably say new money has been created, you can also – it seems to me – equally reasonably say it hasn’t. The money was there in the first place, but the bank has taken a risk that the deposit won’t be withdrawn in full abruptly before the loans are repaid. Different measures of money supply reflect this: M0 doesn’t include any multiplier effect from FrRB, whereas M1-M3 do.

But to put £200 of capital into the bank, then to lend £800 does seem clearly inflationary and can reasonably be described as creating money from thin air.

The alternative, full reserve banking (FuRB), would not require banks never to lend, but rather demand that they lend on the same timescales as the deposits they have accepted.

To expand on this a little, under the present system banks accept deposits on mainly short terms, redeemable on demand or after very short periods of notice like a month or two, but then lend out most of this money on far longer terms, often measured in years. This means that if every depositor wanted to withdraw their money in full before the loans were repaid, the ban would have a liquidity problem. It needn’t be a catastrophic one: the loans are assets and could be borrowed against elsewhere. The recent banking crisis had, I believe, a lot to do with a contraction of inter-bank lending, which limited the ability of banks to borrow elsewhere when there was a run on deposits. Part of this contraction was an uncertainty about the value of assets that were composed of complicated packages of loans which were hard to value, but that’s a failing of the complicated packages of loans rather than of the system per se.

FuRB would require that deposits repayable on demand be retained in full, deposits repayable on 30 days notice be lent on terms that average 30 days and so on. Plainly, longer term loans would be much harder to finance, though not impossible.

No doubt, like me, most readers of this blog generally borrow from the bank to finance cocaine and prostitute binges in the Bahamas, and having to repay in 30 days might be a useful discipline. But some people and businesses, I am told, borrow to pay for new cars, houses or plant and equipment. In these cases, longer terms are desirable.

So I can see two consequences of an abandonment of FrRB. One is that if the supply of people wanting to have cocaine-fuelled orgies in the Bahamas dries up, it would be very hard for a bank to pay interest on bank deposits repayable on short terms, that is, most bank deposits. Instead, people would have to pay the bank to store their money safely. So, no point at all in saving money as money, if you want to see an appreciation of savings, you’d have to invest them directly in a business and take the consequent risks, which are much higher than those encountered on average in bank deposits, especially for people less able than professional bankers to judge risk in a given business investment.

The second is that businesses wanting to borrow to expand would find it very hard to do so from banks and would have to turn to private investors.

That does rather cure the first problem, though. Fewer people would be employed, earn enough to save, and so the impact of the inability of banks to pay interest on normal sort-term deposits wouldn’t matter so much.

While FrRB might be inflationary, it also fuels growth. The alternative, so far as I can see, would be both deflationary and cause economic contraction.

I think I’d like to stick with Fractional Reserve Banking. If banking regulators required that assets, however packaged, remained transparent enough to be valued clearly, we’d be able to continue to have jobs, and even sometimes save – and be paid interest by banks when we did so. That recently this seems not to have been the case was perhaps less a matter of weak bank regulation, and more one of crap bank regulation.

NB: I know it’s a lot more complicated than this, that there’s a difference between Northern Rock and an investment bank. But this is a blog, not a book, and I’m keeping it as simple as I can – for my own benefit, apart from anything else.