-1
$\begingroup$

I come from a layman perspective, but I've been trying to understand macroeconomics and finance. Currently I'm struggling with the current topic. Here I'm not worried about the system transition just arguing about the consequences of two different systems.

I accept that lending capital that is not being used is great for growing the economy, and banks seem a great and impersonal way to intermediate between borrowers and lenders. I understand fractional-reserve banking in it's current form, but I disagree with it, it makes the good times better and the bad times worse and than we need monetary policy to smooth it out. Wouldn't it make more sense to smooth banking in the first place? But expanding the money supply by lending money but still keeping it available in a deposit account seems to lead to financial bubbles. I argue that we could avoid this by being transparent about deposits in the following way:

  • When you open an account you settle how much you're comfortable to loan out and must be made aware of the risks implied.
  • When you check your balance, the funds that have been loaned out or are marked to be loaned out are displayed but are not available to use.
  • This makes intuitive sense to me because if I lend 100\$ to my friend, than I'm short of those 100$ and I'm aware of that, I can't use them. Why shouldn't banks be held up to this standard?

I argue that this would avoid bank runs, because you can clearly check how much is available and won't fear that you'll lose everything, while still having the benefits of borrowing albeit with slower growth but also milder recessions. This might be argued to be impractical, but dealing with the consequences of the current system seems to me to be even more impractical.

Would this be a realistic alternative, and if so what would be the effects on the economy, comparing to the current system?

$\endgroup$
  • 1
    $\begingroup$ The problem with this question is that it is opinion-based, which is counter to the rules of this website. I think you need to eliminate the part of the question asking whether this is a better system (and probably your opinions on fractional reserve banking as well). It should focus on your proposed system, and what the effects would be. $\endgroup$ – Brian Romanchuk May 12 at 11:21
  • $\begingroup$ For many years commercial banking has not operated in the "fractional reserve banking" system you are thinking about, if it ever did $\endgroup$ – Henry May 12 at 11:27
  • $\begingroup$ @BrianRomanchuk Thanks for the feedback and the answer, I tried to edit my question accordingly. $\endgroup$ – davidbrown May 14 at 9:39
0
$\begingroup$

As mentioned by @BrianRomanchuk which system is "better" is matter of opinion as that includes value judgement. For a radical ascetic a system which forces people to live on a subsistence level is the best system possible. However, what you propose is most likely not optimal from economic perspective.

What you propose here is basically transitioning to some sort 100% fractional reserve system. There have been proposals for such system in the past - it is called 'the Chicago plan'. The idea first gained some traction in 30s at the University of Chicago (hence called the Chicago plan) and few years back the plan generated a bit of a buzz when Jaromir Benes and Michael Kumhof (IMF economists) published their paper Chicago Plan revisited where they tried to revive the idea. However, the idea was not really embraced by the profession. There are several reasons why.

  1. You are right that if there would be 100% reserves and banks could lend only money that are in investment accounts (what you call setting aside), it would prevent the chance of bank runs (at least for the deposits itself). But evidence shows that deposit insurance by government does this equally well. You might not know that but in most developed countries including US all banks are by law required to have insurance for their deposits. Hence, even though your deposit money are technically being lend out you will not loose them if bank goes bust (at least up to certain limit, in the US the limit on deposit insurance is \$250.000, see here). Hence unless you are very high up in the income distribution you never have to make bank run as your money is safe, only if you are quite rich you might worry about it, but if you are rich enough to have such balance on your deposits there are other ways that you can protect yourself from this, and generally you would probably have some wealth manager who actually invests money for you. The only advantage of Chicago plan would be that there are always some 'shadow banks' that try to get around the deposit insurance rules by disguising themselves as other types of financial institutions, but it is generally believed this problem can be controlled by appropriate regulation.

  2. Fractional reserve system has many advantages relative to the full reserve system. In a fractional reserve system money supply can expand and contract more flexibly based on what is the demand for loans in the economy and consequently government through the central bank can easily manage money supply just by setting interest rate instead of actually changing monetary base. However, in your system that would no longer be possible and central banks would have to manage money supply through changes in monetary base which is much harder to do with the same precision as when you just play with interest rates. Managing quantity of money in economics is extremely important for mitigating the boom-bust cycles. Hence, even if we would agree for the sake of the argument the Chicago plan could help mitigate some financial crises it could make non-financial crises more difficult to cope it.

  3. Under the 100% reserve plan there would be, in the most likelihood, an overabundance of sterile deposits. Money that are just deposited but never lent out to help finance investment which is extremely beneficial for firm creation, job creation and economic activity in general. In such system firms would have tougher time to invest into new factories R&D and so forth as most national savings would not be put into productive use.

Hence, generally mainstream economists are not very cordial to the 100% reserve system and it is believed such system would be worse for the economy as it has some serious drawbacks and only some tentative possible advantages.

The only country brave enough to try to implement such plan was Iceland, but to the best of my knowledge even though they announced in 2015 they want to implement it they did not really do it yet. According to most recent source I managed to find on their reform from 2016 it is still being reviewed by the committee set up to examine such system.

However, let me reiterate that again what system is a best is a matter of opinion. A system that delivers the highest possible level of material welfare might not be the best system for everyone. You might oppose fractional banking on moral grounds etc. but most of the profession supports the fractional reserve system, or at least does not really endorse any alternative as better. In fact as an undergraduate economist the only other monetary system you will hear about is the gold/silver standard and even that probably in history class - by this I am just trying to show that among mainstream economists fractional reserve is really taken so for granted that alternatives are often, for better or worse, considered not worth to even mention to undergraduates.

| improve this answer | |
$\endgroup$
0
$\begingroup$

Just responding to a few points.

When you open an account you settle how much you're comfortable to loan out and must be made aware of the risks implied.

This can be achieved in the current system, as people are free to buy Treasury bills, which are effectively default risk-free.

Also, small depositors have no default risk associated with bank deposits, as they are covered by deposit insurance.

I argue that this would avoid bank runs, because you can clearly check how much is available and won't fear that you'll lose everything, while still having the benefits of borrowing albeit with slower growth but also milder recessions.

You believe that recessions will be milder, but there is not much evidence for that theory. The non-bank financial system collapsed in 2008, and there is no obvious mechanism for lender-of-last-resort operations in non-bank finance. Whereas banks are under a strict regulatory regime, which allows the central bank to have some confidence when acting as a backstop to the liquidity of the banking system.

| improve this answer | |
$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.