Fractional Reserves, Legal Tender, and Central Banking


If you ever want to see a furious discussion break out among libertarians influenced by Austrian economics, just start talking about money and banking. Despite their agreement on so many things, they often have a variety of views on the ideal banking system and how to best understand terms like “inflation” and “deflation.” The debate over the morality and efficacy of fractional reserve banking is one of the most divisive issues. I have addressed that topic in an earlier column, but here I want to tie it into some broader issues that enter into this debate.

This discussion is prompted by Larry White’s testimony on the history and practice of fractional reserve banking before Rep. Ron Paul’s subcommittee on monetary policy in late June. White’s testimony is a concise yet thorough discussion of why fractional reserve banking came to be and why it is not at the root of monetary problems. As he points out, “[A] fractional-reserve banking system is not unstable when the banking system is free of hobbling legal restrictions and free of privileges.” U.S. history illustrates this point.

No Branch Banking

Until only the last few decades, U.S. banks faced severe legal restrictions on their ability to open branch offices, both across state lines and in some cases even within a given state. These restrictions led to highly under-diversified banks that were more prone to failure and whose troubles would be exacerbated by fractional reserve banking. In the post-Civil War era, regulations that required banks to purchase certain government bonds before issuing currency made them vulnerable to bank runs when the demand for currency rose and they were unable to meet it. Again, fractional reserves combined with this legislation led to recurring panics.

The “solution” to those panics was the Federal Reserve System. It, however, replaced those old regulations with both new regulations and new privileges that combined with fractional reserve banking to create problems. In particular the Fed was given the power to change the quantity of currency and the level of reserves banks hold on deposit at the Fed by either printing more currency or buying government bonds from banks and paying them by crediting their accounts. That power enables it to change the “monetary base,” the foundation from which the banking system can multiply its lending. This privilege belongs to the Fed because it is the only institution allowed to produce currency, which allows that currency to serve as reserves and enables the Fed to create new reserves out of thin air.

Monopoly–not fractional reserve–is the problem. As I’ve said before, there’s nothing wrong with fractional reserve banking that getting rid of central banking wouldn’t cure.

Read More at The Freeman. By Steven Horwitz.


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