Reserve banking

Ron Paul, fractional reserve banking and the myth of the money multiplier

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There is a saying in the banking industry that for a badly run bank no reserve requirement is strict enough, and then for a well run bank any reserve requirement is positively draconian. Basically, good bankers know how much or how little cash they need, but incompetent bankers always seem to be in trouble.

This is important in light of comments of recent years – even by great thinkers of the John Cochran variety – that a good banking solution would involve regulations forcing bank reserves up. It sounds so easy, but it would be more realistic to completely destroy the banking industry. Well-run banks would suffer reduced profits and severe talent leakage on the way to irrelevance, so that they would ultimately need government help, while mismanaged banks would inevitably make mistakes that would render them irrelevant. any reserve deemed powerless in the way of a similar need for government assistance.

And then there are those, including Rep. Ron Paul, who believe that no reserve requirement is enough. Their view is that fractional reserve banking – through which banks lend the vast majority of their deposits on hand – is the height of moral hazard such that banks should operate under 100% reserve requirements.

Paul’s intellectual mentor in this area is the late Murray Rothbard who proclaimed that “Fractional reserve banks… create money out of thin air. Essentially, they do it the same way as the counterfeiters.

About Rothbard’s claim, underlying is a fanciful belief that the so-called “money multiplier” is fact as opposed to fiction. It is the latter. Indeed, wise minds should quickly understand that there is no such thing as a monetary multiplier that bank A can take $ 1,000,000 and lend $ 900,000, then bank B can lend $ 810,000, then bank C can lend $ 729,000 so that $ 1 million in deposits miraculously turns into almost $ 2.5 million.

Indeed, just as there are no sellers without buyers, there are no borrowers without savers; thus rendering the very notion of a monetary multiplier irrelevant. A million dollars does not multiply into 10 million dollars if it changes hands enough times; rather for someone to borrow someone else has to be willing to stop using short term money so they can do it. That such an absurd piece of witchcraft has so long pierced so many brilliant minds is one of the great mysteries of life. So, while banks may make all kinds of mistakes – capitalism is both a question of failure and success – the fact that they lend the funds entrusted to them does not make them counterfeiters.

Thinking more broadly of the fractional reserve bank, denouncing it is like shouting at the sun that it is setting in the west. Okay, sorry, but the sun is setting in the west and the banks are loaning out the vast majority of the funds entrusted to them. Pretty straightforward fractional IS reserve bank.

It is certainly true that banks could keep 100% of deposited funds, but if they did, it would not be banks. Instead, they would be warehouses for money, and those warehouses would charge depositors a fee for the right to deposit with them. Basically, the money saved would decrease day by day and year by year; essentially compound interest on the reverse. Banks would systematically “cut the ball.”

Of course, if the banks were warehouses, therefore not banks, they would quickly go bankrupt given the desire of individuals to be compensated for sums that they do not need to consume immediately. Banks pay them the right to lend money they do not need immediately, and they are able to compensate them through loans to others in immediate need of credit; thus the fractional reserve bank.

In the above sense, if fractional reserve banking did not exist, wise minds would soon invent it given the desire of most individuals to be remunerated for their savings. If in doubt, one would think that people absent from banks would be happy to simply store their money under a mattress or in a safe. Unlikely, which is why fractional reserve banking is the business rule. It is because consumers want banks and banks can open their doors precisely because they lend money deposited for the sake of profit.

It is certainly the case that sometimes banks fail to keep enough cash on hand necessary to meet the desires of depositors, but far from being a problem, banks or any financial institution can simply borrow from others. institutions that are not currently experiencing a lack of liquidity. If the assets in their books are healthy, that’s okay. If that’s a problem, they, in a normal world, can be acquired. And while this is unfortunate, the Federal Reserve also exists as a lender of last resort when banks are strapped for cash, and they theoretically lend to them at a penalty interest rate so that banks can meet all the demands. requests from applicants.

There is, however, an area of ​​agreement between this author and fractional-reserve skeptics, and it has to do with the bailouts. Those who denounce bank deposit lending do not like government safety nets in the form of the Fed as a lender, nor do they like federal deposit insurance. They are right, but the logical conclusion from this should not be that banks should have 100% reserve requirements.

Instead, the Fed’s role as lender of last resort should be abolished (and while we’re at it, abolish the Fed, but that’s for another article). If this were the case, private market players would quickly assume the role of the Fed with ease, and they would do so much more efficiently to lend only to banks with good balance sheets that are simply experiencing short-term cash deficits.

As for deposit insurance, the markets could also take care of it quickly. Basically, depositors would buy insurance on their deposits from private financial companies. Depending on the level of risk taken by the banks, they would either pay dearly or little for insurance. It would be really simple.

As for fractional reserve banking, its critics must be serious. Businesses are in the business of profits, and the path to bank profits is to lend as much money as possible with the greatest possible caution. Very confused critics do not hate fractional reserve banks; instead, they don’t like bailouts from banks that don’t effectively lend the money entrusted to them. That’s good, but they would be wise to educate their eyes on what really is the problem rather than yelling at the dashboard.


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