A useful fraud

It’s entirely true that fractional reserve banking is a fraud, a Ponzi, it’s simply outrageous how credit, or wide money, is created. Murray Rothbard was entirely correct:

In The Mystery of Banking (1983), the anarcho-capitalist economist Murray Rothbard called fractional reserve banking “a shell game, a Ponzi scheme, a fraud in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts.”

Nowt wrong with that statement.

That is not, however, the end of it. What we actually want to know is whether fractional reserve banking is a useful fraud. Which it is.

As we all know all economics is either footnotes to Adam Smith or wrong. And Smith touches upon this in Wealth of Nations. It’s an exercise for the reader to find the exact passage but there’s a bit about commercial banks issuing a bit more paper than their capital or deposit bases would justify. This being a rather useful thing they’re doing.

So, that’s that then, Smith says it’s fine and we need think no more.

There are those occasional reprobates who do not understand that all economics is only footnotes to Smith or wrong. So, for those who are proven to be hard of thinking as a result of that mistaken belief, an explanation.

The big thing that fractional reserve banking does for us is maturity transformation. Yup, dontcha’ just love the jargon?

So, think about a world without it. 100% reserve banking as it’s called. A bank can only lend out the money that it has on deposit (plus it’s own capital of course). Further, it can only lend it out for the same period of time that the depositor has lent it to the bank. That’s what the absence of fractional reserve does mean.

There’s going to be a hell of a shortage of mortgages in this world, isn’t there? We desire to borrow money for 30 years to pay for that des res. How many people save money in a bank account for 30 years? OK, now qualify that, how many not mad people leave money in a bank account for 30 years?

What fractional reserve allows is the bank to collect up all of the short term deposits that we put in there and then lend it out in long terms loans. Bercause they’ve not got to have deposits which exactly match the loans they make. Sure, this creates problems:

A fractional reserve system is subject to the possibility of bank runs. And that’s what 2008 was, it was a wholesale bank run.

Another way to put this is that fractional reserve banking allows banking. As Brad Delong continually points out, if you borrow short and lend long then you’re a bank. If you’re not doing that maturity transformation then you’re not doing banking. Maturity transformation requires fractional reserve. And yes, we really, really, want to have maturity transformation.

So, there’s a simple enough answer to this debate question:

Does fractional reserve banking endanger the economy?

Yes and it’s worth it.

Fractional reserve banking means the entire financial system is at risk of falling over. The very same bug that gives us this also delivers maturity transformation – that second making the first risk reasonable.