FRACTIONAL RESERVES AND THE FED

Joseph T. Salerno

Mises Institute, The Free Market 30, no. 6 June 2012, republished March 9, 2019, 8 pgs.

Reviewer Comment:

This article publishes the testimony of the author at the U.S. House Committee on Financial Servics, Subcommitee on Monetary Policy, which was chaired at that time by Ron Paul. Not surprising since Dr. Paul shares the same views of 'fractional banking' as Dr. Salerno. In this testimony and article Dr. Salerno describes what 'fractional banking' means and his opinion about the monetary problems that result from this.
Dr. Salerno, and Congessman Paul are engaging in the continual theoretical debate and controversy between those who denounce 'fractioncal banking' and those who claim it is important and support it. This article, then, is an example of the arguments the opponents of 'fractional banking' regularly advance. In addition he contends that the 'free market' banking system he proposes would return to making 'money' gold - or making gold 'money'. There has been no reaction from Congress to consider implementing his proposals.

A fascinating aspect to this entire 'free banking' concept with exclusion of the govenment from performing a central function in the money supply is that it is the very opposite to the MMT proposals now gaining support from radical progressive politicians.

Summary:
"A bank is a business firm that receives a deposit of cash and then issues a claim to this fixed sum of 'money'. These claims can be in the form of checks or savings deposits. The 'cash' consists of Federal Reserve Notes of various denominations. "Fractional banking' takes place when the bank then lends or invests some of the depositors' funds while retaining only a 'fraction' of the original deposit in cash as its reserve. The result is that the bank then still has 'liabilities' of the total of the deposits. It has financial assets in the sum of the loans and the retained reserves. These will balance but the 'liabilities' are immediate - they can be withdrawn on demand. While the assets are in forms that have longer times for payment. This is called 'term structure risk' meaning that the bank may have on hand only 10% of its liabilities in ready cash and its assets are in long term forms that are not normally immediately available. Dr. Salerno points out that the fundamental problem is that the deposits if withdrawn in mass will exceed the available cash to honor them until it can sell off some of the long term assets. The result of this may be significant losses to the bank, even causing bankruptcy.

But Dr.Salerno believes there is a greater danger. This is because when the bank loans 'money' it is expanding the total money supply. The process continues to expand because those who receive the money as a loan then spend it and it is deposited in other banks where it, in turn, is loaned and on and on. He claims this expansion of the total money supply creates inflation as more money is spent in acquiring goods and services.

Dr. Salerno sees another significant problem steming from "fractional banking'. He claims that the banks in order to attract consumers and businesses to ask for loans "must lower interest rates below market equilibrium level determined by the amount of voluntary savings in the economy." But he also writes that businesses are eager to obtain loans with lower interest rates and this results in their investing in less viable endeavors. They expect that the interest rates will remain low. And individuals take on larger mortgages to buy larger homes or vacation places. The result is that there is a 'false' boom in the economy. Then inflation - meaning higher prices for basic goods - increases and that causes individuals to need more credit to buy necessities. Banks then increase their interest rates and reduce their loans. This then causes the boom to end and a recession to begin. By the time the full cycle of expasion in the boom and contraction in the bust the individuals and businesses are left poorer than they were at the beginning.

He continues by describing what he believes the government and central bank does to make the cycle (situation) even worse, by "interfering" with the banking industry. The FED uses its open market actions to create even more bank reserves from nothing. It uses 'phony reserves' to 'bail out' failing banks and the FDIC insures depositors' money in the banks. Thus the public considers the banks to be trust worthy and their deposits safe. This enables the banks to engage in even more risky loans.

Dr. Salerno recommends that the solution to the problems created by 'fractional banking' and government intervention is to change the banking industry. That means eliminating all the above mentioned conditions and placing the banks to operate in the 'free market' with other industries. He wants to FED to be forbidden to engage in creating banking reserves 'out of nothing'.

Next he gets to the core of 'free market' financing theory. He proposes that the monetary system be based on a 'genuine' gold standard. Gold coins would be used for market transactions and would also be held as reserves in banks. Banks would also be able again to issue their own bank notes as they were prior to the Civil War.

He expounds further: "Once this mighty rollback of government intervention in banking is accomplished, each fractional - reserve - bank would be rigidly constrained by public confidence when issuing money-substitutes. One false step - one questionable loan, one imprudent emission of unbacked notes and deposits- would cause instant and extinction of is money subsitutes, a bank run, and insolvency." With his new system in place, he predicts that this 'ever-presen threat of insolvency' would 'compel' banks to refrain from further lending of their deposits payable on demand.

Nice to contemplate, but that is not what happened in the 19th century when the 'wild cat' banks issued their own bank notes - people did not realize the bank was insolvent until it was too late, and millions of dollars of investments and deposits were lost. Worse yet, the failure of one or two such banks triggered the 'run' he applauds on many other perfectly solvent banks because the public lost faith in all banks.

In conclusion he describes the process of bank lending under the conditions he would enforce. It would drastically reduce the ability of entrepreneurs to obtain loans for investing in new, untried, industries. It would greatly reduce the ability of individuals to finance new or existing homes. (He proposes mortgages of only 5 to 10 years duration, which would greatly increase the required down payments and make the monthly payments much larger.)

As I noted in the comments above, this is the opposite of the MMT concept. And both are pure fantasy.