Classical liberals and libertarians are united in their efforts against a central banking system, fiat money and an inflationary monetary policy which turns ever more of the money in circulation into debt. Yet despite this agreement there are major cracks in the united front. Roughly speaking we can divide this into two camps: those in favor of Fractional Reserve Banking and those in favor of a Pure Gold Standard. (Referred to as FRB and PGS from now on.)
I find myself somewhat in the middle of the heated debate. I think that FRB is an outdated and unstable business model, and favor a business model based on a Pure Gold Standard. Yet I do not want to make FRB illegal, and contrary to most PGS adherents I do not think that a properly run FRB-bank is more inflationary than a PGS. Until quite recently I did not fully understand the position of those opposed to FRB. I thought that they had the same understanding of what this system entails as the adherents of FRB, but in debates with fervent opponents of FRB I have learned that there is probably a major misunderstanding of FRB among most FRB opponents. In this article I plan to clear up that misunderstanding by proving that when properly run FRB can be fully emulated on a 100% reserve system. Thus, I am able to prove that if FRB is inflationary and causes a boom/bust cycle, then the same problems plague the PGS.
Let me first start with a few definitions in order to avoid misunderstandings. From now on, when I talk about Fractional Reserve Banking I am only referring to a world in which there is no central banks, no bank regulations and where gold is the standard measure of value. In other words, I am referring to a gold standard FRB under laissez-faire free banking.
Furthermore the term saving is generally used in an ambiguous manner. Therefore I will partition the concept into two components which I will refer to as hoarding and investing. If you have a gold coin, there are two ways for you to save it for future consumption: 1) you can put it under your mattress or equivalently let a bank store it for you in its vaults – hoarding it, or 2) you can lend it to someone you trust or let a bank lend it out for you for future repayment and interest – investing it.
Hoarding is generally considered bad for the economy because it is de facto deflationary. Deflation means reducing the money supply, and when you put money under your mattress you are effectively reducing your consumption of trade and the corresponding money in circulation, which is deflationary. Therefore if you choose to hoard your gold, then as a consequence the demand for goods in the economy will go slightly down causing the businesses to reduce the prices of their goods and of wages ever so slightly until demand picks up again. At this point the purchasing power of the gold has slightly increased. Therefore everyone else will be able to buy a little bit more with their gold due to your hoarding. In practice you have therefore lent your gold to all the other consumers in the economy.
In contrast investing your money is considered good, because by lending your money to an entrepreneur instead of hoarding it you achieve two things: 1) the money stays in circulation. Your reduction in consumption is matched by an equal increase in consumption by the entrepreneur who borrows your money. Therefore lending instead of hoarding is neither deflationary nor inflationary, which is good. 2) When you hoard you de facto lend your money indiscriminately to all people in the economy, including to unproductive alcoholics and drug addicts, but when you lend your money out you most likely lend it to someone who is more productive than the average. Thereby your investment not only keeps your money in circulation but actually puts it in the hands of someone who is able to use it in a way that is very beneficial for the economy. You benefit directly from the interest you receive, and everyone else benefits from the fact that the money is kept in circulation and placed in the hands of the most productive.
FRB vs PGS
Under a pure gold standard we distinguish sharply between hoarding and investing, which is made clear by separating banking into deposit banking and investment banking. Deposits are where people hoard their gold. A deposit bank is required to have 100% of the gold that is deposited in its vaults. If you want your gold to be immediately available to you at any time then this is where you should put your gold. An investment bank, however, lends out your gold and you are only gradually over the course of many years repaid that money with interest. This money is not available to you on demand at any time, and you should therefore make sure you do not need the money in many years before you invest it.
Fractional Reserve Banking does not distinguish between deposit accounts and investment accounts. They are blurred into one, and the bank then uses its large customer base to manage the money supply in such a way that to the customer it looks like there is always readily available money on demand in the bank at all times, even if most of the money is locked up in loans. It is this blurring of deposits and loans that creates all the confusion surrounding FRB and which fools many economists into believing that sound FRB expands the actual money supply and thereby causes inflation.
Fractional reserve as a business model
In order to remove the confusion we need to look at banking as an ordinary retail store, with an inventory of goods (in this case gold) and with a large customer base. Like in any retail store, the goal of the fractional reserve bank is to be able to supply its customers with the goods they demand while at the same time maintaining as small an inventory of goods as possible. A store, for instance, knows that even though it has 100 customers, on average only 30 of them comes in to buy a loaf of bread per day. Therefore it would be wasteful for the store to have much more than 30 loafs of bread in its inventory every day.
In banking terms we could then say that the store is running a fractional reserve bread scheme, with a 30% reserve of bread. It tells its customers that there is always fresh bread available, but if all of the customers actually came demanding bread all at once it would run out, but this very rarely happens. Because it is able to keep the inventory of bread low, it is able to keep the inventory costs down and therefore provide cheaper bread to its customers.
In a similar way a fractional reserve bank observes that 90% of the money that people deposit is unused most of the time. On average people only demand 10% of the money they have in the bank for payments. The rest of the money is simply lying there – hoarded. The bank then gets the idea that it can lend out the remaining 90% of the money for interest since that money is just hoarded and unused. Just like the retail store the bank is then able to give the impression that all of the money is available at all times, even if it only has a 10% inventory.
This is called 10% fractional reserve banking for the following reason: The depositors have a claim for 100 ounces of gold in the bank, and at the same time 90 ounces of gold are lent out. The bank is able to service the customers on demand because it knows that statistically the depositors only demand 10 ounces of gold at a time.
Notice that as long as the bank does its job well then no more than 100 ounces of gold will be in circulation at the same time. In other words, when fractional reserve banking is done carefully it is not any more inflationary than full reserve banking because it is using hoarded money that would otherwise be deflationary. The confusion arises by the fact that all the depositors have a total claim of 100 ounces of gold while at the same time it has lent out 90 ounces, making it a total claim of 190 ounces. This leads the critics of FRB to conclude that the bank has expanded the money supply by 90%, but this is no more the case than to claim that the retail store has expanded its bread supply when running its fractional reserve bread scheme. The fact of the matter that only 30 loafs of bread are demanded and therefore the bread supply is only 30 loafs of bread, not 100 even though it caters to all its 100 potential bread customers. In a similar manner only 100 ounces are in circulation at the same time because even if 90 ounces have been lent out the depositors only on average demand 10 ounces. Therefore, even if the depositors have claims to 100 ounces of gold, only 10 of them are kept in circulation by the depositors and therefore counts as part of the money supply. Thus, sound fractional reserve banking in itself is not inflationary and it does not expand the money supply. FRB does however create a false impression that the money supply is greater than it actually is.
FRB emulated in a PGS
Many people find this explanation daunting or unconvincing and I will therefore prove it by showing that sound fractional reserve banking can be perfectly emulated on a pure gold standard.
On a pure gold standard you cannot blur hoarding and investment into one. You need to keep them separate. Therefore in your bank you will need to have two accounts, one for hoarding, which is your safe deposit of cash, and one for investment which is money that will (potentially) be unavailable to you for a very long time, until it is repaid with interest.
Even if most people only need 10% of their money at all times, some people sometimes need to have all their money quickly. That is a real bummer when 90% of your money is locked up in an investment. How does the bank solve this problem? By creating an internal market for investors (money suppliers) and divestors (money demanders).
Every day many of the bank’s customers want to put more of their money into the bank and invest them for interest. (They save some of their salaries) At the same time some of its customers who already have invested their money want to divest them for cash. Rather than lending out this new money to completely new borrowers the bank can as a service to their customers let the new lenders take over the existing loans of other investors who want to divest and get cash.
With a sufficiently large loan market (which need not only be internal to the bank) the effect is to make the loans almost as liquid as the cash itself. In other words, if a bank customer needs to convert his investment into cash he can sell it in a heartbeat to another bank customer. Thus even though only 10% of the cash is 100% guaranteed to be available as cash hoarded in the bank, it feels like 100% is liquid and available at all time due to the high degree of liquidity of its loans. This is in most cases so reliable that most customers can put all their money into investments and still enjoy the benefits of cashing out their money on demand at any time. In this way a 100% reserve bank is able to fully emulate sound fractional reserve banking in detail.
This proves that sound FRB is no more inflationary than a pure gold standard. If sound FRB somehow causes boom/bust cycles then this should happen equally much on a pure gold standard as well.
Some may now object that during crises full reserve and fractional reserve banks have very different outcomes. In both cases there may be a liquidity squeeze. In fractional reserve banks it results in bankruptcy, whereas under the full reserve alternative described above it would simply mean that the bank temporarily cannot provide the service of divesting loans on demand, which would be inconvenient, but no catastrophe. This is true and certainly argues in favor of a pure gold standard, but it does not undermine the general argument made in this article. During normal operation FRB and the PGS can be made identical and hence anything that is wrong with one must also be wrong with the other.
The bullwhip effect
If fractional reserve banking in itself is not the cause of the boom/bust cycle, then what is? With the advent of the industrial revolution came a radical deepening of the division of labor. The work that was previously performed by one person was divided into smaller tasks which were performed by many different people who had specialized in these tasks. This resulted in dramatic improvements in productivity, but it also resulted in longer supply chains, i.e. longer times in production and more intermediaries. The field known as Supply Chain Management has long studied the dynamics of supply chains and it has identified a principle that seems to be true for all supply chains: the further removed from the customer in time and number of intermediary steps, the greater the variations in demand. Thus, longer and deeper supply chains amplify volaitiliy. This principle is known as the bullwhip effect and it alone can explain most of the economic cycles.
As the division of labor deepened during the industrial revolution it took longer or more intermediaries to finish a product and the bullwhip effect predicts that increases the uncertainty and creates greater variations in the demand further down the chain – boom/bust cycles.
This deepening of the division of labor was not limited to physical production. With improved banking came a deepening of the division of labor in money usage. Lending is a form of division of labor. Previously the money was kept by a single customer. Banking allowed the usage of money to be divided and subdivided through lending. Money lent out to entrepreneurs could be lent out by new banks and thereby creating a long monetary daisy chain with further and further division of monetary usage. Thus, not only did the industrial revolution itself create a boom/bust cycle for consumer demand, the improved banking system also created a purely monetary cycle, where small changes in the actual or de facto money supply rippled through the monetary supply chain causing greater variations. This would most likely have happened even if FRB had never seen the light of day.
The solution to the boom/bust cycle
So how do we fix this problem? Keynesians claim to have solved the mires of the boom/bust cycle through the central bank and an active monetary policy, and point to the last 60 years of depression free growth. Sure there have been recessions, but they have not nearly been as large as in the past. Economic growth has been a fairly smooth ride, and it is all due to Keynesian politics, they claim.
But is this true? The fact is that the bullwhip effect has been radically reduced especially in the last 20 years due to improved supply chain management, which in large parts has been enabled by the commercialization of the PC and later the internet. This has allowed businesses to dramatically shorten the distance, both in time and in intermediaries, between customer and manufacturer. The result is less volatility and therefore reduced inventories.
Improved information percolation and faster and shorter supply chains must take the credit for reduced market volatility, not Keynesian policy. Keynesian policies have if anything distorted the market and thereby creating false information signals that has contributed to the bullwhip effect. If we were to return to the gold standard today the result would not be the kind of volatility seen in the 19th century due to technological improvements that have much reduced bullwhip effect.
The solution to the boom/bust cycle then seems to be almost entirely technological in nature, namely improved supply chain management. A stable monetary value as achieved under a gold standard surely contributes to reducing market volatility, but the inherent volatility generated by limited and imperfect information about the future is best handled by improving the supply chains. This is certainly true for production but it is also true for banking, for what is banking if not monetary supply chain management?
Picture a bank as a business in which customers (the depositors) order the production of interest, and the bank outsources this production to productive companies and individuals (the borrowers). The bank’s mission is to be able to satisfy customer money demand (cash withdrawal) with as little cash inventory as possible. Obviously this is just a standard supply chain management problem to which there are lots of good solutions.
The 19th century solution was fractional reserve banking, which allowed the banks to reduce inventories to as low as 10% or less of potential customer demand, but added the additional risk of bank runs and bankruptcies. As shown previously in this article modern electronic technology has enabled us to step out of the era of mass production into the era of mass customization. Within the boundaries of a pure gold standard it is easy to customize the preferred solution for each individual bank customer. Does she want a 0% or 5% or 30% cash reserve with the remaining money locked up in interest production? No problem. It can be achieved with the click of a button in an internet bank.
But even more interesting is the possibility of using these electronic tools to improve the supply chain management. The bullwhip effect is essentially an information distortion effect. The further into the future one has to look and the more intermediaries one has to go through, the more information becomes distorted and hence more volatile. Therefore improving the information flow reduces the bullwhip effect.
Amazingly this too could be available at the click of a button. Each customer is an expert on her own life, and usually has more information about her future plans than any other people in the world. Will she travel around the globe next year? Is she planning a wedding in two years? Kids in five? Her information is probably far more accurate than some average statistics. In a 21st century bank she could plan her own financial future while at the same volunteering her plans (anonymously) to the bank and to the market. She does this by creating saving projects. Saving for her globe trip in one year, saving for her wedding in two years, saving for her kids in five years. By committing to such a saving plan she is telling the bank important information about her future – information that helps the bank improve money supply management, reduce cash inventory and increase interest.
When myriads of bank customers share their plans about the future the result is less market volatility and less risk of boom/bust cycles. Today the banks simply have to guess based on statistics what the demand for money will be three years from now, but with consumers volunteering their future consumption plans the bank can know that there will be a spike in demand for cash ahead of time and prepare by temporarily increasing the inventory of money during that period.
With such technological improvements economic volatility can be significantly reduced. It can even be done successfully in today’s central banking system, but would be even better on a gold standard.
There is of course much more to the story of money than what I have told in this article. The purpose of this essay was merely to show that under a gold standard fractional and full reserve banking are not so different, since the transactions of fractional gold reserve banking can be emulated in minute detail by a properly designed pure gold standard bank. But it should also be clear that the discussed concepts have great significance for monetary theory at large. In particular it is an acknowledgement of key elements of the Austrian business cycle theory, while at the same time delivering a sharp criticism of it in its present form. This critique deserves a much more comprehensive exposition than is provided in the current essay, and is left for another article. However, I do hope that by clearing up some of the misunderstandings regarding fractional reserve banking that the debate can move forward into more fertile land.