Lawrence White Tries to Argue for Fractional Reserve Banking

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Lawrence White is Professor of Economics at George Mason University. In testimony for the U.S. House Subcommittee on Domestic Monetary Policy and Technology he argues for fractional reserve banking. His arguments are flawed: and that’s putting it politely.

He starts with a history of banking – goldsmiths and all the usual historical material with which those who have read a little about banking will be familiar.

However, his argument starts to go astray in the following passage. He says, “For payment by account transfer, fractional reserve banking offers a more economic way of providing payment services. A money warehouse or 100% reserve institution could also offer payments by account transfer, but its services would be significantly more expensive.”

And the reason White gives for claiming that “payment services” are cheaper in the case of fractional reserve is that fractional reserve banks can pay interest to depositors while full reserve banks cannot. (That’s on his definition of the words “fractional” and “full”).

In fact there is no reason to suppose that “payment services” provided by a fractional reserve bank are any cheaper or “more economic” than those provided by a full reserve bank. That is, the ACTUAL COSTS (clearing cheques, issuing bank statements, etc) are the same in both cases. However, fractional reserve offers depositors interest on their deposits. And if you deduct that interest from the costs of payment services, then of course the cost of those services could be said to be reduced. But the reality is that this is just cross-subsidisation of one bank activity by another.

Also it leaves unanswered, or begs the basic question addressed by Prof. White later in his testimony, namely whether the benefits of fractional reserve are real, or whether they derive from subsidies in the form of the too big to fail subsidy and occasional trillion dollar mega bail outs.


Fiat versus rare metal currencies

Next, Prof. White claims that “Under a gold or silver standard, the introduction and public acceptance of fractionally backed demand deposits and banknotes means that the economy needs less gold or silver in its vaults to supply the quantity of money balances (commonly accepted media of exchange) that the public wants to hold. Thus money is supplied at a lower resource cost…”

Not true. Prof. White is of course right to say that a currency which is paper based involves “lower resource cost” than one based on a rare metal: there is no need for people to sweat their guts out underground digging up metal ore, etc. But that merit is a merit of a FIAT CURRENCY (full or fractional reserve), as distinct from a metal based currency. It is not a merit specifically in fractional reserve.

Indeed, White himself all but says as much in his next paragraph. He says, “Under a fiat money standard, as we have today with the Federal Reserve dollar . . . .there are no mining or minting costs…”


Full reserve banks CAN lend

Prof. White then claims that, “For commercial banks to hold 100% reserves in the form of fiat money issued by the federal government would, however, change drastically the function of the banks. Instead of funding productive enterprises, the banks would instead only fund the federal government. Fewer loanable funds would be available to the private economy, and more to the government. Private investment would be suppressed, and public spending enlarged.”

Wrong again. “Lending to productive enterprises” can perfectly well take place under full reserve, as long as a bank can find a depositor who (in exchange for getting some interest) is willing to have their money lent on, AND WHO is willing to give up the right to instant access to that money for some period, AND WHO carries the loss when the loan (or some bundle of loans) goes wrong.

The latter set up is the one proposed by the main advocates of full reserve (e.g.  Laurence Kotlikoff, Richard Werner and Positive Money).

Alternatively, where depositors want 100% safety (under a Kotlikoff / Werner regime) they can have it, but they have to pay the penalty correctly identified by Prof. White, namely that they’ll get little or no interest, and will have to pay bank charges which may easily come to more than any interest earned.


Stopping bank lending would be pointless

In fact it would be senseless to prevent banks lending under full reserve because there is nothing inherently wrong with borrowing and lending. Plus borrowing and lending will always take place, not just by banks, but between individual people, between non-bank firms, and so on. So if  organisations which called themselves banks were barred from lending, the demand for loans would just be met by people or organisations pretending not to be banks.

As regards Prof. White’s claim that “Fewer loanable funds would be available to the private economy..”, quite right. That would certainly be the case to a finite extent.  But the above advocates of full reserve propose having the deflationary effect of that reduced borrowing countered by having the government / central bank create and spend more money into the economy.

The net result would be that private sector entities would have more cash at their disposal, thus they would not need to borrow so much. No doubt banks (and the politicians they have bought) would cry their eyes out at the prospect of a reduced need to borrow. But personally I don’t see very much wrong with someone being able to pay cash for a personal computer rather than having to go begging to some bank for some or all of the relevant funds.

As for the final few words in the above quote from Prof. White’s testimony where he says that “public spending” would be “enlarged”, that is just nonsense: the decision as to what proportion of GDP is taken by the public sector is COMPLETELY INDEPENDENT of the decision as to whether to have a fractional or full reserve system. That is, under both a full and fractional reserve system, government can easily raise or lower taxes (and thus public spending) any time it wants.


You can easily improve fractional reserve by making it – er – full reserve

Next comes a section in Prof. White’s testimony entitled “The problems of financial instability, bank runs, and crises.”  Here he questions the claim that fractional reserve banks are prone to bank runs. And Prof. White points out that this problem can be solved if banks have the option of refusing to pay depositors on demand, and instead promising to pay them in 60 or 90 days’ time.

Well hang on. That 60/90 day delay constitutes a significant move in the direction of full reserve banking. That is, full reserve banking, at least as proposed by Kotlikoff, Werner, etc is a system under which (to repeat) depositors who want to earn interest from their money, cannot have instant access to their money.

Moreover, Prof. White than advocates ANOTHER improvement that could be made to fractional reserve banking which is just another move in the direction of full reserve. He praises a practice adopted by banks before banks’ behaviour became much more lax and sloppy in recent decades. He points out that banks used to invest  “primarily in short-term, high-quality, liquid business IOUs…”.

Well now, if a bank stipulates that where a depositor wants interest, they can’t have their money back for 60 or 90 days, plus the bank puts the relevant money into investments or loans with a 60 or 90 day maturity, the bank is not creating money (and creating money is of course the hallmark of fractional reserve).

Put another way, the latter 60/90 day regime equals full reserve.


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