Academic journal article Independent Review

Should We Let Banks Create Money?

Academic journal article Independent Review

Should We Let Banks Create Money?

Article excerpt

You've heard the joke before: If you laid all of the world's economists end to end, they still wouldn't reach a conclusion. Side-splitting, isn't it? In truth, we economists do reach conclusions, and we agree with one another more often than our detractors appear to realize. Yet a certain amount of disagreement among us is actually a good thing. It suggests that economics is an ongoing scientific enterprise rather than a body of blindly accepted dogma.

Disagreement is healthy even within a particular economic school of thought. One case in point is an ongoing debate among academics associated with the Austrian School of economics. This debate concerns whether commercial banks ought to be allowed to continue their commonplace practice of generating redeemable IOUs, including checkable bank deposits and (less commonly nowadays) circulating bank notes, in amounts exceeding their available reserves of standard money. Because Austrian-School economists generally favor a gold standard over an irredeemable paper or "fiat" standard, the debate can be framed as one between defenders of fractional gold bank reserves on one hand and their critics who favor one hundred percent gold reserves (so that all bank-issued exchange media are fully backed by gold) on the other. I, together with Lawrence H. White, have been among the defenders of fractional reserve banking (see Selgin and White 1996), whereas Hans-Hermann Hoppe (1998) and the late Murray Rothbard (1962) have been two of the more prominent advocates of one hundred percent reserves.

Both sides in this debate have devoted much effort to determining whether the great Austrian economist Ludwig von Mises himself favored fractional reserve banking. The truth seems to be that Mises saw both advantages and disadvantages to the arrangement, so that both sides have been able to quote him in their favor. Perhaps Mises's views on this subject changed over time. But what Mises did or did not believe is largely beside the point. However much one respects Mises's contributions to economic science, the merits of fractional reserve banking must ultimately be assessed by means of rational argumentation and not by an appeal to authority.

Arguments against Fractional Reserves

The critics of fractional reserve banking condemn it for at least three reasons. First, they claim that the practice is practically or even inherently fraudulent: although some critics admit that fractional reserve banking would not be fraudulent if banks were to write contracts expressly indicating to their customers their intention to invest most of their gold deposits, these critics insist, nonetheless, that fractional reserve banks have never been explicit about their reserve-holding policy. According to this view, fractional reserve banking has survived up to the present only because of bankers' dishonesty and (in more recent decades) government-mandated deposit insurance.

Second, critics of fractional reserve banking claim that, under a gold standard, any issue of bank-created exchange media unbacked by gold ("fiduciary media") will fuel the business cycle. They maintain that bank loans funded by outstanding bank notes and demand deposits are ultimately financed by "forced" savings: in issuing spendable IOUs to borrowers, banks reduce interest rates below their "natural" levels, promoting investment at the expense of other producers and consumers who find themselves bidding against bank borrowers for scarce resources. Eventually this bidding war will force up prices and interest rates, restoring the purchasing power of the money stock to its pre-expansion value. But by that time, resources will already have been improperly invested in projects that are not sustainable given the amount of voluntary (as opposed to forced) savings available from the public. The collapse of unsustainable projects, followed by the consequent restoration of a pattern of resource use something like the pattern that preceded the issue of fiduciary media, marks the bust and recovery stages of the business cycle. …

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