Tuesday 28 June 2011

The problem is central banking not fractional reserve banking

or so argues Steve Horwitz at the Free Banking blog. Some economists, especially Austrian economists, see fractional reserve banking as one of the great evils of the world. Murray Rothbard being an obvious example. But not all economists, even Austrian economists, see it that way. Horwitz looks at arguments against fractional reserve banking and finds them wanting.

He opens by noting,
In some free-market circles fractional reserve banking (FRB) is blamed for everything from business cycles to bad breath. Defenders are seen as apologists for inflation and fraud. Thankfully these views remain a minority because they are gravely mistaken. As I, and other Austrian monetary theorists, such as George Selgin and Larry White, have argued, there’s nothing wrong with FRB that getting rid of a central bank can’t cure. Fractional reserve banking works just fine in a free market.
And here, in a few words, is the point. The problem isn't with FRB as such, it is more to do with having a central bank. Get rid of the central bank and move to free banking and FRB would work just fine.

The whole Horwitz piece is worth reading.

1 comment:

Tel said...

Paper money represents a promise. Just like an IOU notes. When banks create money by putting loans on their books they effectively issue more of the same IOU notes. When governments run a deficit, they also create IOU notes.

Thus we have a certain number of people who are enjoying something today that they have promised to pay for in the future, and a certain number of people who are waiting for future enjoyment that they believe they are entitled to.

So if I make a personal promise to someone else and I promise something I know I can deliver (e.g. 3 hours of labour), then I'm safe because I know I can deliver and the other person is safe too. But if I make a promise to a bank in money, then my promise is bound up in the pool of other people's economic activity and I never really know whether I can deliver of not -- I would need global understanding on the financial system to know how easy or difficult it would be to pay back what I owe.

The real problem starts when dodgy promises get into that global financial pool -- things are promised that can never be fulfilled. In this case *SOMEONE* must lose. It is simply not possible to fulfill everyone's expectations. Inflation is one way of watering down everyone's promises and thus curbing expectations. Having a bank crash and writing off some people's savings is another way.

The real deep problem here is that governments have attempted to tell people that the above situation simply cannot happen... which is not an encouraging sign in the light of the observation that it has happened.