The Fatal Flaw of 100% Reserve Banking

In: Economics • August 4, 2014

  

There is a huge divide between theorists of two allegedly opposed monetary doctrines: the 100% reserve bankers and the free bankers. Although I do contend that both postures have more in common than many at first sight think, the fatal flaw of 100% reserve banking can be boiled down to one very simple error. When we take this fatal flaw away, nothing stands in the way to reconcile both doctrines.

Demand Deposits versus Time Deposits

Defenders of 100% reserve banking vehemently oppose the concept of demand deposits. Demand deposits are simply deposits that can be withdrawn at any time without any advance notice. Demand deposits are sometimes called different — callable loans, demand loans, et cetera — because they are applied in a different context, although their essence for all practical purposes remains the same.

The whole problem with arbitrarily labeling some loans — bank deposits are a specific type of loan — as good and others as bad, is that it is fruitless. Since if we assume that a demand deposit is illicit, evil, bad, immoral or damaging, than one should also be able to provide a logical answer to what the practical difference between a demand deposit and a very short-term time deposit is.

In other words, should a time deposit, or loan, callable after five minutes be considered just as evil as a demand deposit? What about time deposits with a maturity of an hour, two hours, or even a day? At this point, theorists have to draw an arbitrary line in the sand as to what period actually comprises a demand deposit. No satisfying answer can be given: some define it as three months, others define it as two weeks. Whatever they may answer, there is no way to bring the debate to a satisfactory conclusion.

Not Necessary for People to Know

Although I suspect that few of us actually think a bank stockpiles its demand deposits in stacks of paper federal reserve money in some giant bank vault, it would still be unnecessary for people to consider their cash balances a loan (or bank liability) instead of cash. Cash in a bank is not cash. It is one of the most liquid assets next to cash, but it does carry a counterparty risk. But don’t we all know that?

Would there be any difference if people know that their cash balances are not money, but bank liabilities? Didn’t the recession of ’08 took away all doubt (if any) about bank deposits being bank liabilities rather than money? Is it a lie that 100% reserves gradually died out after the vanishing of the Bank of Amsterdam? You can probably imagine what my answers to these questions would be.

Fractional Reserves Not a Problem, Central Banks Are the Culprit

In some sense, the Federal Reserve is a pyromaniac firefighter. It carries within it the seeds of its own destruction by creating the necessary circumstances that enable commercial banks to expand more credit than justified by the increase in demand for cash, eventually leading to an unsustainable boom followed by an inevitable bust as Ludwig von Mises brilliantly laid bare in his superb work on the business cycle.

But a system-wide credit expansion is impossible in a mature banking system without the intervention of a central bank, as the functioning of clearing houses will put a drain on banks that expand more than the actual demand for cash balances (bank liabilities) warrants. With a central bank as lender of last resort, this healthy, regulatory market process is disrupted, and commercial banks are able to expand credit on top of what consumers actually save. The solution is straightforward: let markets work, also in banking.

100% Reserves Will Not work

Prohibiting commercial banks to issue demand deposits or short-term time deposits makes the system rigid. Whenever the demand for money increases, the price adjustment process will depress commerce to an unnecessary extent. As such, the 100% reserve bankers are wrong in condemning demand deposits or short-term time deposits.

The problem of today’s banking system is not that ‘money is created out of thin air’, but rather that commercial banks are able to get ‘bank reserves created out of thin air by central banks’. There is no such thing as a ‘money multiplier’ in the real world. Banks compete for scarce reserves and bank reserves, in turn, depend on our decisions to hold cash balances at the bank or get rid of them by buying goods or paying bills. The foremost thing messing up the scarcity of reserves is the main culprit of our banking sorrows: the central bank.


  

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