Economics Professor: Don’t Let A Crisis Go To Waste, Use It To End Fractional Reserve Banking [libertariannews]

I suspect only Austrian economists and other proponents of a free-banking system would correctly identify Jimmy Stewart’s George Bailey as the villain in the 1946 film, It’s a Wonderful Life. George Bailey, a villain? How can a man who devoted his life to helping the people of Bedford Falls achieve the American dream of owning a home be the villain in such a heartwarming tale? Well, he and Milburn Drysdale, the Beverly hillbillies’ banker, are fractional-reserve bankers.

In fractional-reserve banking, demand deposits can be lent out or held. The reserve ratio is the percentage of demand deposits banks must hold. The Federal Reserve, the central bank of the U.S., set this ratio at 10% in 1992. This policy means banks only have to back up 10% of their customers’ demand deposits with cash. This cash is called required reserves. If this is less than reserves, the difference in the two is referred to as excess reserves. For example, required reserves equal $1 billion at a bank with $10 billion in demand deposits. If such a bank has $2.5 billion in reserves, it has $1.5 billion in excess reserves because it has lent out $7.5 billion. So, fractional bankers like Bailey and Drysdale are legally allowed to treat most of their customers’ money as their own.

In episode 18 of season seven of Seinfeld, fractional reserve banking is lampooned with the famous Austrianfractional reserve parking lot analogy. In this episode, George and Kramer discover their cars are being lent to others by Jiffy Park. Although a procurer had been selling tricks out of George’s car, it was mostly available upon demand. Kramer wasn’t so lucky. When he demands his deposit, the parking lot meets this demand by supplying another’s pink Cadillac Eldorado deposit. Regulating parking lots like banks in a fractional reserve system means lots can lend cars to people other than their owners. George and Kramer agreed to this because Jiffy Park spaces were just $75 a month, and they didn’t read the fine print. Of course the analogy is overly simplistic because cars are not homogenous. Nonetheless, if you think of your money as your money, allowing a bank to lend it to others makes as much sense as allowing Jiffy Park to lend your car to adult service provider procures.

Fractional-reserve banking is also inflationary because banks lend money into existence. With the reserve ratio at 10%, a $100 deposit in Bill’s checking account can metastasize into as much as $1,000 in new money. To see this, imagine Bill’s bank lending out $90 of his money to Jill, a student who needs to buy a graphing calculator. By law, the bank can lend up to this amount because it must keep at least $10 in reserve. If Jill buys the calculator from Buy-Mart, the store deposits the sale in its bank. Buy-Mart’s bank keeps $9 in reserve and loans Jack $81 to buy tickets to a Broadway show. The ticket office deposits the sale in its bank, which lends $72.90 to a borrower to buy a used lawnmower. After just three rounds, banks create an additional $243.90 by lending it into existence. After 100 rounds, the $100 deposit is two cents shy of $1000.

Fractional-reserve banking is inherently unstable because its proponents assume depositors will not withdraw more than 10% in a given day. In addition, the bank lending example above illustrates that demand deposits are a house of cards, which can implode at any moment. This is why fractional-reserve banking is prone to bank runs and failures. In order to mitigate this risk, a government regulates and oversees commercial banks, and provides deposit insurance. Because these activities are not sufficient, a central bank is set up to be a lender of last resort. To better understand why central banking is deemed necessary in a fractional-banking system, one must grasp how our central bank, affectionately known as the Fed, functions under various scenarios. In the macroeconomic principles course I regularly teach, I refer to these as historic, normal, emergency, and crisis modes.

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