Full-reserve banking

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Full-reserve banking (also known as 100% reserve banking, or sovereign money system) is a system of banking where banks do not lend demand deposits and instead only lend from time deposits. It differs from fractional-reserve banking, in which banks may lend funds on deposit, while fully reserved banks would be required to keep the full amount of each customer's demand deposits in cash, available for immediate withdrawal.

Contents

Monetary reforms that included full-reserve banking have been proposed in the past, notably in 1935 by a group of economists, including Irving Fisher, under the so-called "Chicago plan" as a response to the Great Depression. [1] [2]

Currently, no country in the world requires full-reserve banking across primary credit institutions, although Iceland's legislature considered it in 2015 after the 2008–2011 Icelandic financial crisis. [3] [4] [5] In a 2018 Swiss ballot initiative, 75% of voters voted against the Sovereign Money Initiative which had full reserve banking as a prominent component of its proposed reform of the Swiss monetary system. [6] [7] [8]

Concepts

Full-reserve banking requires banks to maintain 100% reserves against demand deposits. This is a significant change from fractional-reserve banking, [9] where only a small percentage of deposits must be on reserve. [10]

Basic Principles

Full-reserve banking effectively splits banks into two distinct functions, described by Benes and Kumhof (2012) as the "separation of the monetary and credit functions of the banking system." [11]

  1. Custody and Transaction Services: Banks hold deposited currency as 100%-reserve deposits, transferable to third parties. [12]
  2. Investment Intermediation: Banks would become true intermediaries, transferring from savers to borrowers. Jackson and Dyson (2012) argue this separates transaction accounts and investment accounts. [13]

History

In the early 20th century, classical economics was widely accepted. In the 1930s, Keynesianism gained prominence as policymakers sought solutions for the Great Depression. [14]

Economists proposed various strategies to address financial stability, including the Chicago Plan's full-reserve banking. [15] Irving Fisher's "The Debt-Deflation Theory of Great Depressions" (1933) [16] analyzed how debt cycles contributed to economic instability. [17] Fisher proposed in his 1935 "100% Money" [18] disconnecting money and credit. [19]

Albert G. Hart detailed in 1935 [20] how to maintain economic stability during the transition to 100% reserves. [21] William R. Allen recounted in 1993 how Fisher's proposals influenced banking reform discussions. [22]

Full-reserve banking did not become law.

Views

In favor

Economist Milton Friedman at one time advocated a 100% reserve requirement for checking accounts, [23] and economist Laurence Kotlikoff has also called for an end to fractional-reserve banking. [24] Austrian School economist Murray Rothbard has written that reserves of less than 100% constitute fraud on the part of banks and should be illegal, and that full-reserve banking would eliminate the risk of bank runs. [25] [26] Jesús Huerta de Soto, another economist of the Austrian school, has also strongly argued in favor of full-reserve banking and the outlawing of fractional reserve banking. [27]

The financial crisis of 2007–2008 led to renewed interest in full reserve banking and sovereign money issued by a central bank. Monetary reformers point out that fractional reserve banking leads to unpayable debt, growing economic inequality, inevitable bankruptcy, and an imperative for perpetual and unsustainable economic growth. [28] Martin Wolf, chief economist at the Financial Times , endorsed full reserve banking, saying "it would bring huge advantages". [29]

Martin Wolf, Chief Economics Commentator at the Financial Times , argues that many people have a fundamentally flawed and oversimplified conception of what it is that banks do. Laurence Kotlikoff and Edward Leamer agree, in a paper entitled "A Banking System We Can Trust", arguing that the current financial system did not produce the benefits that have been attributed to it. [24] Rather than simply borrowing money from savers to make loans towards investment and production, and holding "money" as a stable liability, banks in reality create credit increasingly for the purpose of acquiring existing assets. [30] Rather than financing real productivity and investment, and generating fair asset prices, Wall Street has come to resemble a casino, in which trade volume of securities skyrockets without having positive impacts on the investment rate or economic growth. [24] The credits and debt banks create play a role in determining how delicate the economy is in the face of crisis. [30] For example, Wall Street caused the housing bubble by financing millions of mortgages that were outside budget constraints, which in turn decreased output by 10 percent. [24]

Money supply problems

In The Mystery of Banking , Murray Rothbard argues that legalized fractional-reserve banking gave banks "carte blanche" to create money out of thin air. [31] Economists that formulated the Chicago Plan following the Great Depression argue that allowing banks to have fractional reserves puts too much power in the hands of banks by allowing them to determine the amount of money in circulation by changing the amount of loans they give out. [32]

Fractional-reserve banking fraud issues

Deposit bankers become loan bankers when they issue fake warehouse receipts that are not backed by the assets actually held, thus constituting fraud. [31] [ page needed ] Rothbard likens this practice to counterfeiting, with the loan banker extracting resources from the public. [31] However, Bryan Caplan argues that fractional-reserve banking does not constitute fraud, as by Rothbard's own admission an advertised product must simply meet the "common definition" of that product believed by consumers. Caplan contends that it is part of the common definition of a modern bank to make loans against demand deposits, thus not constituting fraud. [33]

Balance sheet fundamentals

Furthermore, Rothbard argues that fractional reserve banking is fundamentally unsound because of the timescale of a bank's balance sheet. [34] While a typical firm should have its assets be due prior to the payment date of its liabilities, so that the liabilities can be paid, the fractional reserve deposit bank has its demand deposit liabilities due at any point the depositor chooses, and its assets, being the loans it has made with someone else's deposits, due at some later date. [34]

Against

New fees

Some economists have noted that under full-reserve banking, because banks would not earn revenue from lending against demand deposits, depositors would have to pay fees for the services associated with checking accounts. This, it is felt, would probably be rejected by the public. [35] [36] However, in economies where central banks enact zero and negative interest rate policies, some writers have noted depositors are already paying to put their savings in fractional reserve banks. [37]

Shadow banking and unregulated institutions

In their influential paper on financial crises, economists Douglas W. Diamond and Philip H. Dybvig warned that under full-reserve banking, since banks would not be permitted to lend out funds deposited in demand accounts, this function would be taken over by unregulated institutions. Unregulated institutions (such as high-yield debt issuers) would take over the economically necessary role of financial intermediation and maturity transformation, therefore destabilizing the financial system and leading to more frequent financial crises. [38] [39]

Writing in response to various writers' support for full reserve banking, Paul Krugman stated that the idea was "certainly worth talking about", but worries that it would drive financial activity outside the banking system, into the less regulated shadow banking system. [40]

Misses the problem

Krugman argues that the 2008 financial crisis was not largely a result of depositors attempting to withdraw deposits from commercial banks, but a large-scale run on shadow banking. [41] As financial markets seemed to have recovered more quickly than the 'real economy', Krugman sees the recession more as a result of excess leverage and household balance-sheet issues. [41] Neither of these issues would be addressed by a full-reserve regulation on commercial banks, he claims. [41]

See also

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References

  1. ↑ A banking revolution Jeremy Warner, UK Telegraph
  2. ↑ Weisenthal, Joe. "BAN ALL THE BANKS: Here's The Wild Idea That People Are Starting To Take Seriously". Business Insider. Retrieved 2020-11-30.
  3. ↑ Sigurjónsson, Frosti (2015-03-01). "Montary Reform - A Better Monetary System For Iceland" (PDF).
  4. ↑ "Iceland's daring raid on fractional reserve banks". Financial Times . 2015-04-09.
  5. ↑ "Iceland looks at ending boom and bust with radical money plan". The Daily Telegraph . 2015-03-31.
  6. ↑ Switzerland's 'Vollgeld' banking overhaul: how reform would work
  7. ↑ Atkins, Ralph (10 June 2018). "Swiss voters reject 'sovereign money' initiative" . Financial Times. Archived from the original on 2022-12-10. Retrieved 2020-11-30.
  8. ↑ swissinfo.ch/sb. "Vote survey shows no generation gap but misunderstandings". SWI swissinfo.ch. Retrieved 2020-11-30.
  9. ↑ Phillips, Ronnie J.; Minsky, Hyman P. (2016-09-16). The Chicago Plan and New Deal Banking Reform. Routledge. p. 46. ISBN   978-1-315-28663-1.
  10. ↑ Goodwin, Neva; Harris, Jonathan M.; Rajkarnikar, Pratistha Joshi; Roach, Brian; Thornton, Tim B. (2024-09-25). Essentials of Economics in Context. Taylor & Francis. ISBN   978-1-040-11400-1.
  11. ↑ Benes, Mr Jaromir; Kumhof, Mr Michael (2012-08-01). The Chicago Plan Revisited. International Monetary Fund. p. 4. ISBN   978-1-4755-0552-8.
  12. ↑ Tobin, James (1985). "Financial Innovation and Deregulation in Perspective" (PDF). Bank of Japan monetary and economic studies 3: 25.
  13. ↑ Jackson, A.; Dyson, B. (2012). "Modernising Money: Why Our Monetary System is Broken and How it Can be Fixed". Modernising Money. p. 265. Retrieved 2025-01-28.
  14. ↑ Wapshott, Nicholas (11 October 2011). Keynes Hayek: The Clash that Defined Modern Economics. W. W. Norton & Company. ISBN   978-0-393-08311-8.
  15. ↑ Phillips, Ronnie J. (1994-12-15). The Chicago Plan & New Deal Banking Reform. M.E. Sharpe. p. 3. ISBN   978-0-7656-3267-8.
  16. ↑ Fisher, Irving (1933). "The Debt-Deflation Theory of Great Depressions". Econometrica. 1 (4): 337–357. doi:10.2307/1907327. ISSN   0012-9682.
  17. ↑ Dimand, Robert W. (2019-03-29). Irving Fisher. Springer. p. 177. ISBN   978-3-030-05177-8.
  18. ↑ H., R. G. (1936). "Review of 100 Per Cent. Money". Journal of the Royal Statistical Society. 99 (2): 388–390. doi:10.2307/2980591. ISSN   0952-8385.
  19. ↑ Lagoarde-Segot, Thomas (2023-04-13). Ecological Money and Finance: Exploring Sustainable Monetary and Financial Systems. Springer Nature. ISBN   978-3-031-14232-1.
  20. ↑ Hart, Albert G. (1935-02-01). "The "Chicago Plan" of Banking Reform: I A Proposal for Making Monetary Management Effective in the United States". The Review of Economic Studies. 2 (2): 104–116. doi:10.2307/2967557. ISSN   0034-6527.
  21. ↑ Phillips, Ronnie J. (1994-12-15). The Chicago Plan & New Deal Banking Reform. M.E. Sharpe. p. 147. ISBN   978-0-7656-3267-8.
  22. ↑ Allen, William R. (Oct 1993). "Irving Fisher and the 100 Percent Reserve Proposal". The Journal of Law and Economics. 36 (2): 703–717. doi:10.1086/467295. ISSN   0022-2186.
  23. ↑ Solow, Robert M. (March 28, 2002), "On the Lender of Last Resort", Financial crises, contagion, and the lender of last resort, Oxford University Press, p. 203, ISBN   978-0-19-924721-9
  24. 1 2 3 4 Kotlikoff, Laurence J.; Leamer, Edward (April 23, 2009). "A Banking System We Can Trust" (PDF). Forbes. Archived from the original (PDF) on June 4, 2011. Retrieved September 14, 2010– via Boston University.
  25. ↑ Rothbard, Murray N. (2008), The Mystery of Banking (PDF), Ludwig von Mises Institute, ISBN   978-1-933550-28-2 , retrieved September 14, 2010
  26. ↑ The Case for a 100% Gold Dollar, Murray Rothbard
  27. ↑ Jesús Huerta de Soto (2012). Money, Bank Credit, and Economic Cycles (3rd ed.). Ludwig von Mises Institute. ISBN   978-1-61016-388-0 . Retrieved 4 August 2013.
  28. ↑ Jackson, Andrew; Dyson, Ben (2012). Modernizing Money. Why our Monetary System is Broken and how it can be Fixed. Positive Money. ISBN   978-0-9574448-0-5.
  29. ↑ Weisenthal, Joe. "BAN ALL THE BANKS: Here's The Wild Idea That People Are Starting To Take Seriously". Business Insider.
  30. 1 2 "Martin Wolf: Banking, credit and money". CORE. 2013-11-11. Retrieved 2020-03-11.
  31. 1 2 3 Rothbard, Murray N. (2008). The mystery of banking (2nd ed.). Auburn, Ala.: Ludwig von Mises Institute. ISBN   978-1-933550-28-2. OCLC   275097518.
  32. ↑ "100% Reserve Banking — The History". House of Debt. 2014-04-26. Retrieved 2020-03-17.
  33. ↑ Caplan, Bryan (2011-05-12). "The Morality of Fractional Reserve Banking". Econlib.{{cite web}}: Missing or empty |url= (help)[ unreliable source? ]
  34. 1 2 Rothbard, Murray N. (2008). The mystery of banking (2nd ed.). Auburn, Ala.: Ludwig von Mises Institute. ISBN   978-1-933550-28-2. OCLC   275097518.
  35. ↑ White, Lawrence H. (Winter 2003). "Accounting for Fractional-Reserve Banknotes and Deposits—or, What's Twenty Quid to the Bloody Midland Bank?" (PDF). The Independent Review. 7 (3): 423–41. ISSN   1086-1653. Archived from the original (PDF) on 2015-04-29. Retrieved 2012-11-30.
  36. ↑ Allen, William (October 1993). "Irving Fisher and the 100 Percent Reserve Proposal". Journal of Law and Economics. 36 (2): 703–17. doi:10.1086/467295. JSTOR   725805. S2CID   153974326.
  37. ↑ Texan Gold Depository
  38. ↑ Diamond, Douglas W.; Philip H. Dybvig (Jan 1986), "Banking Theory, Deposit Insurance, and Bank Regulation", The Journal of Business, 59 (1): 55–68, doi:10.1086/296314, JSTOR   2352687, In conclusion, 100% reserve banking is a dangerous proposal that would do substantial damage to the economy by reducing the overall amount of liquidity. Furthermore, the proposal is likely to be ineffective in increasing stability since it will be impossible to control the institutions that will enter in the vacuum left when banks can no longer create liquidity. Fortunately, the political realities make it unlikely that this radical and imprudent proposal will be adopted.
  39. ↑ Diamond, Douglas; Philip Dybvig (Winter 2000). "Bank Runs, Deposit Insurance, and Liquidity" (PDF). Federal Reserve Bank of Minneapolis Quarterly Review. 24 (1): 14–23. Retrieved 29 August 2012.
  40. ↑ Krugman, Paul (April 26, 2014). "Is A Banking Ban The Answer?". New York Times . Retrieved September 18, 2015.
  41. 1 2 3 "Is A Banking Ban The Answer?". Paul Krugman Blog. 2014-04-26. Retrieved 2020-03-11.
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