The Case for Free Banking

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FRACTIONAL
RESERVE BANKING

Most people
are aware of the basics of the current system of banking that we
have in place. Joe Average takes his savings to Steve’s Bank, and
gives it to them as a deposit. They credit his account with the
amount of money he has given them. They then take the majority of
that money, we’ll say 60% as an example, and loan it out to borrowers,
charging an interest rate. If Joe should return to collect on his
deposit before the bank collects on the loan, they will pay it out
to him either through their takings from interest on other loans
or from the accounts of other customers of the bank. This system
is why economists say that savings and investment are so closely
linked. Without savings, placed in the hands of fractional reserve
banks, there could be no loans, and without loans, there could be
no large-scale investment, at least, under our present system.

This system
does not work too badly (we’ll get to that later) in the absence
of a federal bank and fiat currency. However, in our current system,
it is an inherently inflationary process that serves to distort
the structure of production and cause what economists call the business
cycle
.

Suppose that
there is a sudden increase in the demand for loans in our current
system. Banks, of course, oblige this desire for loans. However,
since the supply of money has remained the same, they react by raising
interest rates.
Interest rates, are, essentially, the price of borrowing money.
So of course, they obey the laws of supply and demand like any other
price mechanism. However, the government has in place a price control
on interest rates. It takes the form of the federal reserve, which
will respond to rising interest rates through pumping money into
the economy, in an attempt to keep rates at what the fed has set
as its target. The result of this is of course, inflation. Anytime
the demand for loans is increased, money is simply taken out of
thin air and placed into the economy by the fed!

Like any
policy that refuses to let markets clear, the fed’s policy of trying
to control the interest rate is misguided and has ill effects. By
refusing to allow interests rates to function properly, and keeping
them artificially low via the creation of new money, the fed encourages
malinvestment. Investors who believe that interest rates will always
be (relatively) low have much less reason to invest carefully. Why
not take big risks? After all, you can always take out more loans,
it’s not as if the price of loanable funds is liable to change just
like the price of anything else in a market. Of course, eventually
this malinvestment boils over, and the demand for loanable funds
begins to skyrocket as poorly made investments go bottom up. Sometimes,
the fed responds by bailing out banks (remember that they keep only
a fraction of actual savings) through loaning them large amounts
of money. The result is large-scale inflation. Sometimes it chooses
not to, believing it is best to stick to a tight money policy. The
result is bank runs. With the federal reserve in charge, you are
damned if you do and damned if you don’t!

FREE BANKING

So, clearly,
this is a problem. It traps us in a constant state of boom-bust
capitalism, the business cycle always nipping at our heels. Is there
nothing we can do? There is an answer, however politically infeasible
it seems currently. The answer is a complete end to government monopoly
of the money supply. We should instead institute a system of free
banking, whereby banks print and compete with their own notes.

Before
we discuss this, it is important to understand the nature of money,
and what it really is. Everybody knows how a primitive, barter-based
economy works. If I have wheat, and I want meat, I take my wheat
and I find someone who A.) Has meat in the quantity I want, and
B.) Wants wheat in the quantity I have. We can then trade. For obvious
reasons, this gets very inconvenient very fast, especially when
more complex trade enters the scenario. The result is that some
good appears in the barter economy, which is widely traded enough,
that it actually becomes the standard of trade itself. Everyone
is confident that everyone else will be willing to accept it in
trade. In the history of the west, and indeed of all advanced economies,
this has near universally been gold. So let us assume that, in the
absence of the dollar, gold becomes our standard of trade (though
really it could be anything). Of course, just as nobody wants to
lug all of their dollars around with them in cash, nobody wants
to lug all of their gold around with them. That would be even more
inconvenient!

So people
pay to have the gold deposited in banks, and are issued receipts,
in the form of bank notes, to use as trade. Now, obviously, banks
are going to want to compete to have the best notes. After all,
banks want to get the most deposits. The result will be that banks
will try to minimize the risk a consumer takes by depositing with
them of a run on
the bank
. This could spell the end of fractional reserve banking
altogether, and the creation of a separate market for loanable funds
independent of banks. It could also mean that fractional reserve
banking will continue, but, in the absence of a price control (federal
reserve), interest rates will set themselves according to the actual
demand for loanable funds. It will likely be some mix of the two,
with some banks engaging in fractional reserve, but using other
perks to get savers to deposit with them instead of with other banks.
In any event, it is the end of inflation, and it minimizes the risk
of bank runs (since investors will be much less likely to malinvest
if they know that interest rates might change rapidly). Fractional
reserve banking with a central bank structure is the cause of the
business cycle and of boom-bust capitalism. Free banking is the
cure.

May
2, 2007

Ben
Tansey [send him mail]
is an undergraduate at UMass Dartmouth, majoring in economics.

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