So I’ve got 100% reserve banking on my mind. 100% reserve banking is best described as the polar opposite of our current banking system, which I’ll go ahead and explain first. The system we have today is based on fractional reserve banking, fiat money and the Federal Reserve.

Fiat money simply means that our money isn’t backed by anything. We can’t go to our bank and trade it in for gold or silver; it holds value simply because everyone accepts that it holds value; value which is determined by the amount of money in the economy relative to the overall productivity of the economy.

Fractional reserve banking means that banks only have to keep a certain percentage of their deposits on reserve. Let’s say that you deposit $100 at a bank and the reserve requirement is 10%. This means the bank keeps $10 and can loan out the other $90, thus, creating $90 out of thin air, as both the depositor and the borrower have claim on that $90. That $90 will presumably be deposited in another bank and the process repeats itself as $81 will be created, and so on. In the end, for every $100 initially deposited, $900 new dollars will “magically” appear in the form of bank credit.

The Federal Reserve acts as a lender of last resort, in case bank runs threaten to destabilize the system. The Fed is also in charge of managing the banking sector and maintaining the “optimal” amount of money in the economy. That we believe there is an “optimal” amount of money to be had, the economy is a bit odd in the first place. It lead famed economist Murray Rothbard to ask, “How come, after all… no one addresses the question: what is the “optimal supply” of canned peaches today or in the future?” (1) Regardless, the Fed sets the reserve requirement and controls the money supply through a host of other different methods I need not discuss here.

The Fractional, I mean, Federal Reserve

Two things immediately strike me as strange about this arrangement. First, that banks create money whenever they make a loan (or the Fed can create it at a whim, usually by monetizing government debt). Second, that two, or more, people have claim to the exact same asset. If you put your $100 in the bank, you presumably hold title to that $100. However, $90 of it (assuming a 10% reserve requirement exists) will also be “owned” by whoever borrowed your money from the bank as well. This situation has no parallels that I’m aware of. It’s true that there can be complex ownership structures: say I buy a piece of property with two loans, a first for 80%, through Bank of America and a second for 20%, through a private lender, then put that property in a trust that is part of a larger partnership based in the Cayman Islands, which I co-own with several other people. I then lease that property out to someone with an option to buy in two years. He, in turn, subleases it to someone else, who rents out the extra rooms to his friends. Yeah, that’s a tangled mess, but eventually, if you work your way through said mess, I am still the sole-owner of that property. Not true when it comes to bank deposits.

The reason banks can do this, legally speaking, is rather strange. Way back in the day, when there was no real legal precedent, bankers just figured fractional reserve banking would be a good, if morally dubious, way to make extra money. The idea permeated its way throughout banking all over the world, but only became codified as law after the British case of Carr v. Carr in 1811, in which the judge stated that deposits were essentially loans to banks and as long as they repaid their depositors, they could do with those deposits as they wished (bet you didn’t think of your checking account that way). This definition is in stark contrast to, what is legally called, a bailment. Or in plain English, if deposits were considered bailments, the bank would act as a warehouse for your money.

The difference between a loan and a bailment, for all intents and purposes, is the same as the difference between fractional reserve banking and 100% reserve banking. In 100% reserve banking, banks simply act as warehouses for capital. For simple checking accounts, bank customers would probably have to pay a small fee to keep their money in the bank, instead of receiving interest. It would be like putting your money in a safe deposit box. Bank’s primary purpose would be to invest people’s money for them, in the form of loans to others and then charge a fee or percentage of the interest for the service of bringing the lender and borrower together. Since the bank must maintain 100% of the money entrusted to it on reserve, it could not allow customers to withdraw their funds on demand. Instead, customers would likely have to sign contracts that prevented them from getting their money back for a certain period of time.

All this may sound like a big headache and make fractional reserve banking sound more appealing, despite its many questionable aspects; however, there are major advantages to 100% reserve banking. Right off the bat, banking panics are simply impossible. Since every bank has all its money on hand (or its customers aren’t contractually entitled to it at that time), there is no way that a run on the bank will cause a bank to go under. And therefore, large banking crises, such as the one we are seeing today, or saw in the Great Depression, or in the panics of 1819, 1837, 1857, 1871, 1893, 1907, etc. would never happen.

Furthermore, Austrian economists, such as Nobel Prize winner F.A. Hayek, argue that the artificial increase in bank credit (through the Federal Reserve and fractional reserve banking) causes the boom/bust cycle most people think is just an unfortunate side effect of a market economy. The theory, summarized briefly, states that as credit is increased artificially, the market starts off on an uncontrollable boom. People, flooded with cheap credit, start more projects than available resources can complete. Once it becomes evident that many of these projects are unfeasible, the boom shifts rapidly to a bust and the economy goes into a recession. This theory is by no means accepted by all, or even most economists. Paul Krugman equated it to “phlogiston theory of fire” (3) and Milton Friedman said, “It is, I believe, false.” (4) Both of them have also won the Nobel Prize in economics.

I’m not going to do a detailed analysis of which side is right (I personally lean toward the Austrians), because the case for a 100% reserve requirement doesn’t need it. And the big key in my opinion is that a 100% reserve requirement would end the credit/consumption based economy and replace it with an economy based on savings. One extraordinarily important problem with a fiat money, fractional reserve banking system is that all new money is created as debt!* A 100% reserve standard would, presumably, come with a gold standard (each dollar could be redeemed for a certain amount of gold). This means that new money would arrive on the scene attached with no debt. It was simply mined out of the ground. A fiat, fractional reserve system, to the contrary, attaches debt to every single new dollar since new money is created through bank loans. Every dollar introduced into the economy is a dollar that someone owes to someone else, usually a bank.

Furthermore, since fractional reserve banking creates a lot more money than could be mined out of the ground, it naturally has an inflationary effect. Inflation is a major disincentive for saving, since savings become less valuable as a currency depreciates; inflation acts as an incentive to spend now. And finally, with so much credit on the loose, credit cards and the like become more available and those damned impulse purchases become that much easier to justify. Thus, it is no surprise that Americans, for most of the decade, have had a negative savings rate (5) and a grand total of almost 14 trillion dollars in debt. (6) Its also safe to say this would not be the case in a 100% reserve system.

Household Debt - Source: Federal Reserve Bank of St. Louis

This system should obviously have an appeal to conservatives who long for the days when thrift was a personal value held in high esteem. It should also appeal to liberals who often chastise corporations and banks for shackling the poor and middle class with debt and call for government intervention on these people’s behalves.

Indeed, these liberals should ask if the banking system itself is fatally flawed. When thinking about what would happen if a 100% reserve standard were implemented, something that should interest every liberal comes to mind; namely, corporations would get smaller! Obviously, banks and major financial institutions would shrink because there would be much less credit available to lend out. However, I believe, companies would become smaller throughout the entire economy.

It would work like this: right now, credit is cheap (due to fractional reserve banking and the Federal Reserve). Therefore, the best long-term investments for individuals are usually not in the credit market, but in the equity market; namely stocks. The vast majority of individual’s retirement savings exist in mutual funds, 401K’s, IRA’s and other stock portfolios. All this provides capital to corporations, usually big corporations hedge fund managers believe to be safe investments. These corporations can then use this flood of capital to expand. However, if credit were tightened by implementing a 100% reserve standard, interest rates would go up significantly. This would drive capital away from equity purchases (stocks) and toward lending money. I imagine investment banks pooling people’s savings into bundles, which they would loan out to home buyers, entrepreneurs and other businesses. To compete for this capital, large corporations would either have to use debt to finance expansion or sell their stock cheaper or offer higher dividends, to attract investors. Thus, it would become more difficult for big businesses to attract capital, thereby spreading money more evenly throughout the rest of the economy.

If that’s not enough to peak the common liberal’s interest, it must be noted that since fractional reserve banking is inflationary, it acts as a regressive tax. Inflation is a tax because new money adds no wealth; it simply takes away from the purchasing power of existing money. The reason inflation is regressive is a bit more complicated. When new money is created, it doesn’t create inflation until it has had a chance to circulate throughout the economy. For example, say there are $10 dollars and 10 widgets in an economy. Each widget costs $1. If I pump in $10 more dollars, the widgets will be worth $2. However, since the economy isn’t some giant computer, it has no idea new money has been pumped in until after that money is spent. The widgets will still cost $1 until after they’ve been bought. So those who get the $10 I pumped in will be able to buy the widgets for $1, when they should have had to pay $2. In other words, those who get the money first get to buy at below market prices, while those who get the money last buy at above market prices.

Now, while everyone takes out a lot of debt these days, big businesses still take out much more credit than regular folks. Therefore, inflation acts as an almost perfectly regressive tax, redistributing wealth upwards. The poorest of the poor take out very little debt (aside by credit card debt, usually spent on consumables), the middle class take out a fair amount of debt (albeit, much more than they should) and the rich take out a lot of debt (mostly to invest in profit seeking ventures). Furthermore, this credit, whether loaned to the poor or rich, is paid back with interest to the banks, even though much of the money the bank loaned out was created out of thin air; receiving interest on nothing in some sense. Thus, the banks and government (which gets to spend new money immediately, usually in the form of monetized debt), benefit the most from this regressive tax. A tax that would be eliminated with a 100% reserve standard since bank loans would not create new money and inflation would be significantly curbed.

This is not to say 100% reserve banking (presumably with a gold standard and no Federal Reserve) is a perfect system. That it surely is not. Credit would certainly become more expensive and make it more difficult to buy a house. Deflation would probably set in too, since so much less money would be created. Most economists are scared to death of deflation; however, while major deflation destroys the incentive to lend, modest deflation isn’t a bad thing. It means nothing more than everything is getting cheaper, which should be a good thing.** Still, there’s no fool proof way to make sure every banker plays by the rules. Since some probably won’t, a bank here or there could still go under if they cheat. And since people would probably have to pay to keep their money at a bank, many could choose to hold onto their money, putting their savings at the mercy of thieves and disasters.

Some of these issues could be addressed with the proper regulation or even by market forces. Others might be worth the cost, given the advantages. 100% reserve banking is done, after all, in private lending all the time. The most common examples are “hard money” lenders who lend on real estate or venture capitalists who lend to start-ups. The Bank of Amsterdam even successfully used a system of 100% reserve banking from 1609 until the late 1800’s. (7) If nothing else, given our current financial mess, 100% reserve banking is at least something to think about.

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*For those more interested in this topic, I recommend the video “Money as Debt.” The whole series is about 50 minutes. I have a couple of reservations about it though. It dismisses the gold standard almost out of hand and recommends the government takes over credit, which is about the worst idea I’ve ever heard. It also assumes that because all money starts as debt, people will become more and more indebted until the banks own everything. This, however, neglects to account for increases in productivity. By productivity increasing, dollars gain what could best be described as equity, even though they started out as nothing more than debt. Regardless, it’s still a worthwhile video. You can find the first part here:

http://www.youtube.com/watch?v=vVkFb26u9g8

**Major deflation is certainly bad. It destroys the incentive to lend. Say if deflation was so out of hand, that market interest rates would be below 0%. No one would lend at this rate though, because it would be better to simply hold their money. Major deflation is especially bad if the government tries to implement wage or price controls which will throw the economy out of equilibrium and cause high unemployment and shortages (this is what happened in the Great Depression). However, the United States experienced modest deflation from 1870-1900 and saw massive economic growth during that time. Furthermore, in 2004, the Papers and Proceedings of the American Economic Review published a study of deflationary episodes in 17 countries over 100 years and found that, excluding the Great Depression, 90% of deflationary episodes did not result in a depression. (8)

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(1) Murray Rothbard, The Case Against the Fed, Pg. 18, Ludwig Von Mises Institute, Copyright 1994

(2) Ibid., Pg. 40-45

(3) Paul Krugman, “The Hangover Theory,” Slate, December 4^th, 1998

(4) Milton Friedman, “The Monetary Studies of the National Bureau, 44th Annual Report”, The Optimal Quantity of Money and Other Essays, Chicago: Aldine. pg. 261-284

(5) “Our Savings Rate Is (Still) Negative: Should We Worry,” My Money Blog, 2/4/07, http://www.mymoneyblog.com/archives/2007/02/our-savings-rate-is-negative-should-we-worry.html

(6) Series: CMDEBT, Houshold Sector: Liabilities: Household Credit Market Debt Outstanding, Federal Reserve Bank of St. Louis, retrieved June 11^th, 2009, http://research.stlouisfed.org/fred2/series/CMDEBT

(7) Murray Rothbard, The Case Against the Fed, Pg. 44n, Ludwig Von Mises Institute, Copyright 1994

(8) Quoted from Tom Woods, Meltdown, Pg. 138, Regnery Publishing Inc., Copyright 2009