Unit 1 Lecture Notes

But if a fractional reserve banking system is not necessary, how can we explain its prevalence everywhere in the world today? In particular, how can we explain that economies that have utilized it seem to prosper? The answer lies in the fact that central banks that act as a lender of last resort to banks. Fractional reserve banking is inherently unstable without a lender of last resort that can increase the money supply. This guarantee allows banks to create more liabilities for the monetary unit than they have assets. Historically, fractional reserve banking was unsustainable in a free market, and the creation of central banks was primarily due to banks seeking government protection from the inevitable bank runs of fractional reserve banking.

In a free market, a bank that engages in fractional reserve lending will find itself with a mismatch between its assets and liabilities. For instance, it may owe a depositor $100 available to them on demand, but will simultaneously loan out a fraction of that money to a borrower. Should the depositor request all their money when the borrower still has it, the bank has a problem. But since the bank of course has more than one borrower and depositor, it should be able to return the money back to the depositor by giving him some of the other depositors' cash. As the amount of lending increases (and the fraction of deposits lent out increases), the bank's position becomes increasingly precarious and vulnerable to a bank run. To make matters worse, once depositors and borrowers discover the increasing amount of unbacked credit issued by the bank, they become more concerned about the safety of their deposits and thus more likely to demand their withdrawal. If the amount of deposits suddenly demanded by depositors exceeds the bank's reserves on hand, the bank has a 'liquidity problem' (which is viewed as distinct from a solvency problem, because the bank does have enough assets to meet all the withdrawal demands of its depositors, but does not have them on hand). The liquidity problem is precipitated by a bank run: as depositors begin to realize their deposits might not be safe, they rush to the bank to demand them. But the bank can only satisfy a fraction of them.

There are a few different ways to address this problem: the bank can simply satisfy the withdrawal requests of the first depositors to demand it (until the bank runs out of reserves). Another way is for the bank to enact a percentage haircut on each depositor's balance until the bank's total reserves match the total of all depositors' newly adjusted balances; This method essentially transitions the bank to full-reserve banking, which then allows all depositors to withdraw their total (and newly reduced) balance simultaneously. Both options imply bankruptcy of the bank, as its assets are liquidated to meet its liabilities to depositors and lenders. While these options can be devastating for both the bank and its depositors, they are in fact the healthiest way to deal with this problem; at a bare minimum, both depositors and bankers learn not to engage in such activities again. An alternative option introduced over the last century is the creation of a government-mandated central bank to ‘inject liquidity' into the struggling bank and allow it to meet its obligations to depositors. Now, with a monopoly on the issuance of money, the central bank can effectively monetize the obligations of the bank and offload the risk of the banks' reckless actions onto all the holders of the nation's currency, not just the bank's depositors. It's bad enough that the conscientious banks and individuals who did not engage in fractional reserve banking now have to subsidize the irresponsibility of the ones who did, but even worse is that these banks can continue to operate with an ongoing subsidy from society at large; Full reserve banks then become unprofitable in comparison, as they bear the burden of responsible risk management which limits their upside relative to their fractional reserve counterparts.

As Guido Hulsmann put it:

The emergence of central banking cannot be understood separately from the problems caused by fractional reserve banking. To a historically unprecedented extent, central banks allowed governments to take control of the monetary, financial, and economic systems of their countries. Eventually, this nationalization of money and credit snowballed into the nationalization of other parts of the economy, as the government had recourse to a money printer it could abuse.

In the United States, the Federal Reserve was created as a response to the crisis of 1907, in which overextended fractional reserve banks faced a liquidity crisis that required J.P. Morgan to gather the bankers and play lender of last resort. Instead of understanding this event as a lesson for banks to reduce their fractional reserve banking, it led banks to create a government agency to protect them as they overextend credit. The two reasons given for the creation of central banks were: the protection of the banking system from bank runs or financial crises, and the stabilization of the Dollar's value. That these two goals were directly contradictory is the obvious kind of fact that was only noticed by economists like Friedrich Hayek, in his enormously important and widely unread Monetary Nationalism and International Stability:

Inevitably, the goal of protecting the value of the "cash" was to conflict with the goal of protecting banks from bank runs, and central banks almost always favor the financial system at the expense of reserve currency's value. After a world war, mass death and destruction, and many terrible economic mistakes1, the US could no longer maintain the Dollar's redeemability to gold; Most of the world's economies defaulted on their notes' promise of redemption in gold, and ended up revaluing their currencies in terms of gold. Although many economists discuss this episode, few call it by its true name: sovereign default.

What history shows is that fractional reserve banking can only function with a lender of last resort, and only when the lender of last resort has the capability to increase the money supply at will. In other words, fractional reserve banking can only survive with easy money. Given the modern availability of hard money options like gold and Bitcoin, the only way fractional reserve banking can survive today is through legal tender laws and a government-enforced monopoly on the issuance of money. This is why the banking system of most western economies needed the abandonment of gold redeemability in the 1930s to survive.