An Austrian School Solution to the Problem of Fractional Reserve Banking

You never want a serious crisis to go to waste. And what I mean by that is an opportunity to do things that you think you could not do before. — Rahm Emanuel at the Wall Street Journal’s CEO Council, 2008

Because fractional-reserve banking is an unstable house of cards, governments see the need to regulate banks, provide deposit insurance, set up a lender of last resort, and adopt a too-big-to-fail doctrine.

Given that the inflation genie cannot be bottled up indefinitely, the Fed should not let a federal funds market in crisis mode go to waste. It has an opportunity to do things that it could not do before. It should use this opportunity to switch to a less risky and less costly free banking system advocated by Austrian economists.

Free banking is inherently more secure and stable, but not as profitable as its ugly cousin, fractional-reserve banking. The lent-into-existence money and leverage examples in part I illustrate the fragility of fractional banking. Unlike free banks, fractional-reserve banks can play fast and loose with depositors’ money because bad decisions are backstopped by government interventions.

Even with backstops in place, the house that leverage and lent-into-existence money built can crumble in a heartbeat. A senator’s careless remarks on June 26, 2008 triggered the collapse of IndyMac Bank. Less than two weeks later its customers had withdrawn $1.3 billion in deposits. Because money evaporates when scared depositors stuff demand deposits into mattresses, politicians, too-big-to-fail banks, other crony capitalists, and orthodox economists convince us that the Fed’s lender of last resort role, FDIC, TAG, and the too-big-to-fail doctrine are necessary.

In the absence of a banking safety net, a free bank’s reputation and desire to remain in business are all the regulations that are needed because depositors are unmerciful regulators. In either system, banks that assist people in buying homes and cars need to be sure that these people are credit worthy, and able and willing to pay back loans. However, free banks would have to have more stringent credit standards, require non-leveraged down payments, and be more diligent in the approval of credit.

The financial collapse was triggered by just the opposite. Interest rates and credit standards were low, and borrowers could lie on liar-loan applications and leverage down payments.

In a free-bank system, deposits are the property of depositors. So free banks must secure mortgages by enticing depositors to convert demand deposits to time deposits that mature over similar lengths of time. This reduces net interest margins, which is a competitive disadvantage that thwarts free banks in a fractional-reserve system.

According to Fed data released in August of 2012, excess reserves are nearly twice that of demand deposits. Given this large difference, I suspect reserves exceed demand deposits at too-big-to-fail and other large banks. Hence, the Fed could change the reserve ratio for these banks to 100%. This would convert excess reserves to required reserves, and restore depositors’ property rights.

I suspect only Austrian economists would celebrate ending fractional-reserve banking and eliminating all backstops including the Fed. I’d also wager that some of my colleagues, nice guys who are true believers in the faith, might want to lock me up in a broom closet after bringing much shame upon us for daring to suggest the Fed is not needed. Too-big-to-fail banks might also lobby politicians to fly Black Hawk helicopters over my home at 2am to sweep me away to an indefinite luxurious Gitmo vacation.

At one time, my past-self would have grabbed a pitch fork with that frankensteinian monster, my present-self, afoot. However, after years of teaching macroeconomic principles, my orthodox indoctrination gave way. Fractional bankers, like Bailey and Drysdale, are villains because they view demand deposits as theirs, want depositors to provide them with high net interest margins, and want taxpayers to bear all risks.

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