Fractional reserve banking means that the money supply is not in fact determined by the central bank (or by gold miners, politicians or economists, etc) but mostly by lenders. The problem is the fragility of any such a system to liquidity crises. If 10% of investors decide to withdraw funds at the same time, banks will quickly be illiquid. If 20% of investors do, bank failures will usually pile up. The system’s stability is contingent on society’s ability to not panic.

It is my belief that this fragility has been totally overlooked. Many have fallen into the lulling notion that the only thing we have to fear is fear itself — and that that fear can be conquered by rationality. This is to ignore man’s animal nature: the unforeseen, the unexpected, and the wild (all of which occur very, very frequently in nature and markets) make humans fearful, and panicky — not by choice, but by impulse. This is the culmination of millions of years of evolution — primeval reality is unconquerable, immutable and obvious. More than half a century after Roosevelt and Keynes markets still crash, fortunes are lost, and millions of grown men and women still tremble in irrational, primitive fear.

Fractional reserve, of course, still has its defenders.

From Paul Krugman:

I thought I’d say a word about one particular idea that sounds plausible to some people but is actually quite wrong: banning fractional reserve banking.

I know that’s a popular theme among some Austrians. But it’s actually neither a good idea nor even feasible.

The crucial thing is to understand what banks do. And it’s not mostly about money creation! Instead, what banks are for is helping to improve the tradeoff between returns and liquidity.

Like a lot of people, my insights draw heavily on Diamond-Dybvig (pdf), one of those papers that just opens your mind to a wider reality. What DD argue is that there is a tension between the needs of individual savers — who want ready access to their funds in case a sudden need arises — and the requirements of productive investment, which requires sustained commitment of resources.

Banks can largely resolve this tension, by offering deposits that can be withdrawn on demand, yet investing most of the funds thus raised in long-term, illiquid projects. What makes this possible is the fact that normally only some depositors want to withdraw funds in any given period, so it’s normally possible to meet those demands without actually having liquid assets backing every deposit. And this solution makes the economy more productive, providing more liquidity even as it allows more productive investment.

Now I’m not going to dispute the idea that, at least superficially, fractional banking improves the tradeoff between returns and liquidity. But we must look at what kind of system that entails. The fractional system system is a classic example of fragility.

Debt is by nature fragile — fragile to deflation (which increases the value of debts, but makes them harder to repay so increases defaults) and fragile to inflation (decreases the value of debt). This means that when the system is stressed or shocked the stressor increases the stress on the system, multiplying small problems up into much larger ones. 

The greatest danger of a debt-based system, though, is the default cascade — one insolvent institution defaulting on its obligations, and leading to write-downs at other institutions, which can ultimately lead to systemic collapse via contagion. Post-crisis, the ongoing spectre of deleveraging (contracting the money supply) can keep growth, and prices depressed, even with huge washes of new central bank liquidity. As we saw first in Japan, and now in the West quantitative easing has not been a powerful enough tool to reinvigorate the economy after a burst debt bubble and financial zombification. Clearly liquidity backstops are still not enough to counteract the underlying business cycle.

Amusingly, this entire paradigm was foreseen by Thomas Jefferson:

I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.

Fractional banking — and the inflationary-contractionary business cycle described over two centuries ago by Jefferson — is for now at least here to stay. In the boom years it is beloved of consumers, who can remortgage their house and consume their equity on consumer goods. In the bust years it is beloved of the monied who can purchase productive assets at far below fair-value.

Additionally, transitioning from a highly indebted globalised debt-based banking system to a full-reserve one, is basically impossible without debt forgiveness (not happening unless things get significantly worse). Like with austerity the money supply hugely contracts, and so in the short term GDP often collapses and unemployment soars.

Krugman concludes:

The fractional reserve thing exhibits a characteristic common to a lot of what I see in the Paulist camp: they have an oddly antiquated notion of what money and finance are about, one that misses the “virtualness” of the modern world. They still think of money as being pieces of green paper, rather than what it mostly is now, zeroes and ones in some server somewhere. They still think of banks as being those big marble buildings, in a world in which most banking is a lot more abstract than that.

This is, after all, the 21st century. Things have moved on a bit.

But without all of that abstraction — if money could not be fractionally multiplied — the system might be significantly more stable, because the money supply would not contract due to liquidity runs . Perhaps there would not be such great profits for speculators, there would be fewer free lunches, and less arbitrage. Economic health is based on human beings wanting and needing things, and using their labour and capital to obtain them — very material and earthy concerns. Abstraction does not in itself make a system better — and if it increases systemic fragility to shocks and panics, it can make it significantly worse. On the other hand, banning fractional reserve banking (and its corollaries like shadow banking) might be impossible or even exacerbate the business cycle, as a ban might just drive it into the totally unregulated black market. And historically, a lack of a liquidity backstop has never stopped bankers from practicing fractional lending, either.

So in the end, perhaps I am railing against something I cannot stop or control.