Fractional Reserve Banking, or, “Why George Selgin is Wrong about Banks and Inflation”

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I am dedicated to an ideologically pure form of anarcho-capitalist thought in the libertarian style, following the mold of great thinkers like Murray Rothbard.

Since I’ve been working on some freelance projects and editing my forthcoming book, I want to post a little update just to show something, and I have just had a perfect Twitter argument that can help to show the Rothbardian view of money.

Of course, everyone knows Austrian economists for their preference for specie money over fiat. That’s not exactly a secret, and if you asked a random person what they know about Austrian economics they’ll probably say “oh, they like gold, don’t they?”

Okay, so they’d probably look at you like you’re from Mars. But if they just had the mainstream understanding of Austrian economics, that’s what they’d say.

However, one thing that most of us Austrians (though I am a layperson and not a professional economist) are quite opposed to is the idea of fractional reserve banking.

Historically, the role of banks is to take money, hold on to it, and then return it to depositors. This was a security function, and sometimes a convenience, since you could use notes instead of metal coins and the banks would just clear the balances between themselves.

Since the banks looked at relative balances between them and moved all the money at once, this clearance process was much more efficient than everyone carrying around their business’s money or their life savings when going from place to place.

However, this obviously had fees attached, and people like to get stuff for free. Since banks have operating overhead, you would have to pay them for their services.

The Birth of Fractional Reserve Banking

This is the draw of fractional reserve banking. Instead of simply having your money sit in their vaults, a fractional reserve bank lends out a portion of their money and just keeps some.

During COVID, the Federal Reserve in the US removed the legal requirement to hold any cash reserves, though they obviously keep some cash in the teller’s register.

This will probably have basically apocalyptic effects if people lean on this, but I’m trying to avoid talking about potential apocalypses today and I’ll address it briefly in a moment.

The upside of fractional reserves is that if the banks make successful investments—and because they just need to cover the expense of security, maintenance, and administrative overhead this doesn’t need to involve turbo-geniuses who get everything right—they can cover their expenses and even offer interest to people who have (fractional) deposits in their institutions.

Three Austrian Critiques of FRB

Fractional reserve banking has three main issues from the Austrian perspective. The first of these is that FRB can be an act of fraud, the second is that it imposes a risk upon depositors, and the third is based on the monetary supply alterations brought forth by FRB.

Fraud

One is that consumers are defrauded if they believe their reserves are sitting in the bank.

Of course, most consumers understand the bank will not return their money directly from the same deposit they made. And, of course, no bank would pretend otherwise. Only a safe deposit box or similar private vault guarantees the exact return of a deposit, and that’s still got fees associated with it.

Assuming that money is fungible—which is an inherent quality of money—this does not matter.

But the depositor assumes that there will be enough money for them to withdraw all their accounts at any point, unless a bank clearly tells them it cannot through the use of a time deposit or bond (which is not really a fractional reserve but an agreement to invest with the bank as a middleman).

Further, the fraction of the fractional reserve may be important to a depositor. If a bank changes the fraction it withholds in reserve, depositors may choose to go elsewhere. But how many banks guarantee a static reserve rate for a depositor, and how many of them even reveal their current reserve status?

This is where the fraud occurs.

It is possible, of course, to have FRB systems without fraud. It does not resemble the current conditions, and would be more likely to result under a free banking system rather than the current system with its government interventions (for reasons we’ll discuss in the next section).

Risk

Second, the fractional reserve system is vulnerable to bank runs. This is not just a result of lost confidence in banks—though this is usually the case in bank runs.

Instead, shifts in demand for money can cause excessive withdrawals. However, it is not really the money demand so much as time preference that hammers deposits, since money demand plays out in prices on the market.

If there is reason to expect that money will lose value or people need to spend money now to pay immediate expenses, this raises their time preference and leads to withdrawals.

Since preferences are the domain of the individual, the conditions for a run rarely occur without fears of bank insolvency added to the mix. However, a FRB still has some point at which normal market demand for immediate money (as opposed to future money) exceeds the current supply in its reserves.

In the United States, the solution to this has been to insure deposits at a federal level. However, this simply means that the taxpayer is footing the bill for the risk—depositors do not care about whether their bank is being a good steward of their money. Since the government will bail out a failing bank so depositors don’t get soaked, we wind up with more failing banks.

On the free market, of course, there would be no such institution and depositors would have to consider the reserve ratio of a bank and would be more likely to choose to even pay fees on a deposit to ensure its safe return at a later date.

Now, of course, people could choose to risk their money, but we already have a term for this—investment. An investment firm can accept money from people to invest, and it may even offer the return of shares.

The distinction here is that the combination of the bank’s actual role (at least using the traditional definition of a bank) is to hold reserves and engage in the clearance process to transact with other banks on behalf of its clients.

This function requires deposits. The investment function requires liquid money. While banks may have the equipment to both hold deposits and invest in ventures, this imposes additional risks.

Inflation

A potential issue with fractional reserve banking is that it serves as a source of money inflation.

This is the process by which additional currency enters the supply and has the effect of improving the relative economic condition of the borrower at the expense of non-borrowers through the Cantillon effect. This is how any inflation works.

A particular hazard of inflation with fractional reserve banking occurs if borrowers deposit the money. This would lead to a hall of mirrors effect as “ghost” money winds up deposited and lent again. This hall of mirrors effect is unlikely to occur in the free market or in practice in a significant amount, since the rate of return on deposits is low and most borrowers are taking money to convert into real assets instead of placing it in banks.

However, there will be inflation in the market reversely proportional to the reserves after banks lend out money, since there is both the original claim to the deposit and the bank’s claim to the money they lent. The larger the reserve, the lower the inflation.

The critics of Austrian concerns regarding inflation and fractional reserves either argue that inflation is good—even though the easy money effect of fractional reserves encourages malinvestment and creates scenarios like the margin buying of stock that was a major factor in the Great Depression—or that the inflation is essentially negligible.

Right now very few people are pro-inflation, and talking about the hazards of monetary inflation deserves its own treatment. However, the notion that fractional reserves have only a minimal impact on inflation needs to be addressed.

A Response to Selgin

When I mentioned the effects of inflation on Twitter, someone responded to me with an article by George Selgin of the Cato Institute. In an essay, Selgin argues that contrary to Rothbardian assertions, FRB-induced inflation would be minimal.

Barring the fact that the Cato Institute ought to be leveled and the ground it sits on should be salted so that nothing can grow there, this deserves a response.

So without further ado, here was what I pointed out. Take a moment and go read his article before reading my answer, because it depends on understanding his argument.

My issues with Selgin probably extend to dogma, and since he doesn’t explain how he came to some of his conclusions at length and I’m not familiar with his work to know how he reached them, I can only really look at issues I see with his claims.

Would Rothbardians ban FRB?

Selgin presumes that any FRB is “illegal” under the Rothbardian scheme.

FRBs with full disclosure are not immoral or fraudulent, though they are hazardous.

We would more likely think of them as investment firms, akin to… retirement fund managers, and as a result they might be fraudulent if they used the term bank, but there is nothing to stop someone from engaging in lending collectively or individually.

Since Selgin seeks to answer the Rothbardian critique of inflation within the FRB system, it’s worrying that he has made these initial errors in his assumption of how Austrians in the Rothbardian tradition view FRBs.

Monetary and Price Inflation

Although Austrians never say prices inflate except as a slip of tongue or shorthand, Selgin engages in the classic endeavor of muddying the waters between monetary and price inflation. At least he has the decency to say that he is doing this, but he will use the two interchangeably when it benefits his case.

If we wanted to discuss price inflation, I could argue that the increased efficiency of resource exploitation and industrial processes may reduce prices to the point of being negligible, but that’s not relevant to money.

There is no case in which the FRB does not result in an increased money supply, because both a deposit and a loan exist where previously only a deposit would exist. That this is a bookkeeping trick doesn’t change the fact that it gives both the depositor and lender claims to the same money, and therefore makes it easier to secure money at the potential expense of the depositor (besides all the ordinary Cantillon effect derived phenomena).

Banking and the Circulation of Money

Selgin explicitly presumes that actual currency/specie does not circulate, and only warehouse notes do. This is spherical cow thinking and bypasses Cantillon’s observed redemption of banknotes, which is a process that we would fully expect to happen in any FRB system.

Further, FRB actually increases the demand for clearance between banks and withdrawing money from unfamiliar banks, since it is only partial reserves that are untrustworthy. An arbitrary enforcement of 100% reserves by state force would reduce the demand to withdraw currency and specie, since people would know that anyone who didn’t have deposits ready to present upon demand would face criminal penalties.

Even under the current system of insured deposits, people might still want to get their money from a bank rather than the government, because even if the deposit would eventually be paid out it would involve a headache while the FDIC process takes place.

The Specie Supply

Selgin assumes a static supply of specie to make a point about how money works as a medium. This is not terribly problematic by itself, and the trade-off is usually worth it because it makes the case easier.

It’s also never going to happen, and he unfortunately makes a blunder that would only occur once one makes this assumption.

This blunder is that he assumes that the demand for money on the market shifts from specie to claims on reserves.

While seemingly plausible, this is the exact opposite of what we would expect from Cantillon’s work and the Austrian understanding of money.

Banknotes have their own economic utility, but it is based on the ability to make withdrawals from reserves, either directly or following a clearance process.

The actual value of banknotes as he describes them (which is essentially similar to a paper check) on the market comes from the fact that my account will have the money in my own bank, not from me holding a note from a bank I don’t use.

At some point someone actually wants the money, not just a guarantee of money. Even in a perfectly reliable system, someone may have a demand for the gold itself.

This is how he argues the market would set fractional reserves, since the reserve would include a consideration for the people who wanted specie (i.e. gold) for non-monetary purposes.

However, some people will still want gold or paper money as money itself, since it bypasses the bank middleman clearance process, which involves fees and the potential for surveillance.

Negligible Effects

Selgin often hand-waves away certain impacts as “negligible” when talking about market shifts.

Negligible means a different thing to an econometrician than it does to a marginal consumer.

If I have $1, I can buy a $1 loaf of bread. If easy money increases the cost of the loaf of bread to $1.05, I can no longer buy the bread.

I will need to find more money myself—which may involve renegotiating labor contracts or dipping into savings—or plead for the clerk to have pity on me.

As someone who has been in this situation, I do not consider any effect of market shifts negligible.

FRBs on the Free Market

Selgin correctly argues that FRBs will probably keep a high reserve ratio so they can redeem on demand.

However, miscarriage of investments will still occasionally result in people getting soaked, and unless the bank merely debits everyone’s account (e.g. imposing a negative interest rate) when it takes a loss, a bank run can still wipe out an account-holder’s whole savings if they are late to withdraw.

Of course, time deposits and other mechanisms help to prevent bank runs, but they are also undesirable.

Once again, we see that this problem would not exist if the term used were not “bank” but investment firm and there was an understanding that someone was really engaging in a share of an enterprise, rather than a monetary deposit.

Money Demand

Selgin talks about increases in money demand and static money demand.

I question some of his assumptions but recognize that he refers to observations and is not trying to make an axiomatic case for a direct relationship between money demand increases and a healthy economy.

However, he relies on the idea of a velocity of demand to develop his point that a fractional reserve bank could adjust its fractional reserve rate to reflect the demand for withdrawn money compared to the demand for deposited money.

The problem is that he has no mechanism for explaining this velocity of demand, and that all he really argues for is the idea of money supply meeting money demand.

He argues that a fractional reserve banking system could have monetary inflation that directly counteracts price inflation, as far as I can tell.

This is just the act of increasing both demand and supply so that they stay equal. However, this assumes that the ideal price is steady—an assumption that would need to be proved and which relies on an allergy to price changes.

It is neither relevant to the idea that fractional reserve banks don’t cause monetary inflation—in fact, it relies on it—nor is it particularly interesting as a point because it’s a strict hypothetical and Selgin does nothing to rule out alternate outcomes, such as monetary inflation from reduced fractional reserves leading to price inflation.

Selgin also never considers the idea that the demand for money could decrease, though this is unlikely to have much of an effect.

Living in Fantasy

A fundamental issue with Selgin’s argument is that it starts with the presumption of specie. This, of course, would be ideal, but as an Austrian and Rothbardian who faces the criticism of living in a world of idealism rather than realism, this is a step too far for me.

Of course, a bank with a limited supply of gold would have a hard time pulling off extremely low fractional reserves. When banks are using paper money that they can get from the government on loan to secure their deficits, as is true in the current system, failing to consider the fact that a 0% reserve bank—as is currently the case—could actually contribute significantly to inflation is a disqualifying error.

He also goes off on a tangent to argue that specie mining could lead to inflation even under 100% reserve banking under a specie currency. Austrians have never denied this, but at least the resource investment involved in finding new deposits of (presumably gold, but also silver or other potential backings for specie and commodity currency) will provide a measurable limit to the ability to inflate the supply.

Further, this is another case of Selgin seeming to care about prices even though there’s no obvious reason to do so under an Austrian understanding of economics. There is no “fair” price—prices reflect what consumers will pay.

If they are not willing to pay enough to satisfy all demand, there will be “too little” supply, but in reality this will be a consequence either of these resources simply being unavailable or being less desirable than alternatives at the price they are available at.

Fed-Blaming

It is certainly correct, as Selgin notes, that most monetary inflation can be laid at the feet of the Federal Reserve.

However, this is like arguing that because a counterfeiter makes a potentially infinite amount of bad bills, we should overlook a small proportion of bad bills coming from fractional reserve banks.

Once again, FRB has an absolute limit in ways that printing money does not—a 0% reserve bank lending made-up money is just a Ponzi scheme—but there is no guarantee that the fractional reserve will be as high as he argues under all market conditions.

In short, the idea that a fractional reserve may only cause a particular amount of inflation and only over the initial deposits is based on assumptions that Selgin never examines.

Conclusions

Since Selgin does not consider time preference and its effects on deposit and withdrawal, he has significant issues. Low time preference is the only reason people deposit in the first place, since they want to retrieve money they currently have at a later date—and a sudden increase in time preference will lead to withdrawals.

Combine this with the potential for fractional reserve banks’ investments to fail, which is actually made more likely by the very inflation their lending causes, and you wind up with some good reasons not to discount the inflationary effects simply because they are small.

Failing to consider time preference means that a major service provided by banks—the savings, though not the transfer, related to deposits—never gets a mention.

We can forgive this as it relates solely to the idea that FRB may have only a “negligible” effect on inflation. But it is an important part of how reserve rates will arise on the market—a society with low time preferences will have a lower fractional reserve requirement, but the inflation will create countervailing high time preferences for expenditure because of cheap loans, leading to additional hazards.

When we compare FRB to printing money, the effects of FRB are minor. But the easy money of FRB is precisely akin to the circumstances surrounding the bust portion of the business cycle, and aggressive reserve policies contribute more than their weight because they correspond with catastrophe in the event of a bank run.

This is, of course, a potential hazard for investors, but investors do not withdraw their deposits in the same way a bank client does. Even if we view them as “savers” for retirement (as opposed to profit-seeking investors like day traders), they know that what they are really getting are shares of enterprises, not placing a deposit.