Wednesday, December 29, 2010

The Trouble with Fractional Reserve Banking

Thorsten Polleit, Honorary Professor at the Frankfurt School of Finance & Management, has an excellent piece on briefly explaining "The Faults of Fractional-Reserve Banking." Among the problems of fractional-reserve banking he cites are the following:
  • It violates property rights. It does so because it asserts two people have exclusive ownership rights over the same piece of property.
  • Contrary to popular belief, fractional reserve banking is not the result of the natural workings of a free market.
  • The fact that, in our current system, the central bank can bail out a fractional-reserve bank that is in financial trouble by creating additional fiat money does not make fractional-reserve banking any more legitimate.
  • It generates inflation via credit expansion and, hence, sets in motion the business cycle
Polleit's essay is a response to Martin Wolfe's "Could the World Go Back On a Gold Standard?" Wolfe says that we will not and we should not. (Incidentally Wolfe cites a recent article on privatizing money, by my graduate money and banking professor, Leland Yeager).

One of Wolfe's assertion that Polleit responds to is that 100 percent reserve banking is wasteful, because most of the time depositors do not need the money they have in their deposit accounts. Forcing the bank to hold onto that money would force society to do without the productive forces unleashed by lending out that money to a productive entrepreneur.

Polleit does a good job responding to Wolf's assertions, however, I would like to add one more bone of contention. People do not hold money in demand deposits because they don't "need it." People purposely choose to hold a specific quantity of money in their cash balance. Demand deposits make up part of that cash balance. People hold money because the future is uncertain and it is impossible to know exactly how much money will be needed when to fulfill all of the various transactions that will be undertaken. People purposely decide to hold a specific amount of currency and money in their checking accounts as they deal with uncertainty. It is simply wrong to assert that people hold money in a checking account because they do not need it.


  1. I need every dollar in my checking account! I keep it there partly because I will need it later and mostly because my house is not nearly so protected against unwanted intrusion as a bank, and because I don't feel quite badass enough to carry all my cash (or gold) around with me and protect it against all possible threats.

  2. I wouldn't sell your self-protection abilities short. You wield a pretty mean broadsword.