Friday, January 1, 2016

Confusion about Fractional Reserve Banking

By Robert Wenzel

I note excitement in a number of Austrian school economics quarters over news that Switzerland will hold a referendum on the Vollgeld initiative.

The initiative, promoted by the Swiss Sovereign Money movement, calls for private banks to hold 100 percent reserves against their deposits.

Some see this as an important battle against fiat currency. I would argue it is not such and is simply misdirection that will accomplish nothing good.

How far has this confusion spread? I suspect very far. When discussing another topic with an Austrian fellow traveler, he responded to me in an email:
I did not say anything about the central bank. I don’t think that the [Austrian Business Cycle] theory requires a central bank, it requires fractional reserve banks. 
But is fractional reserve  banking really the key to money distortions that result in misdirected funds into the capital sector? I think not.

Murray Rothbard in The Mystery of Banking writes:
In short, under free banking, banks are totally free, even to engage in fractional reserve banking...Propagandists for central banking have managed to convince most people that free banking would be banking out of control, subject to wild inflationary bursts in which the supply of money would soar almost to infinity.
To be sure, there are plenty of debates around fractional reserve banking and whether it would be allowed in a truly free market society, given that it is possible that it could be viewed as a broken contract, but that is not the question here. The question here is: "Is fractional reserve banking fundamental to the cause of the business cycle?"

Admittedly, at present, central banks do use fractional reserve banking in their calculations of how much money they are pumping into the banking system. But this is because we do have a fractional reserve banking system and it is a method by which money can be pumped into the economy, especially when coordinated by a central bank, but it is only a method. Take fractional reserve banking away and central banks can still pump funds into the commercial bank sector all day long.

Note what the  Swiss Sovereign Money movement says:
Banks won’t be able to create money for themselves any more, they’ll only be able to lend money that they have from savers or other banks.
But what prevents a central bank from being one of these "savers"? That is, why can't a central bank buy term paper from banks, the funds of which the banks could then lend out since it isn't part of demand deposits (where 100% reserves would be required)?

Indeed, in a Telegraph report, it appears clear that it is understood that the central bank would still be in  charge of money printing, with input from the government:
If successful, the sovereign money bill would give the Swiss National Bank a monopoly on physical and electronic money creation, "while the decision concerning how new money is introduced into the economy would reside with the government," says Vollgeld.
In other words, it is entirely possible that the  Swiss National Bank could fund the credit sector even without fractional reserve banking. or it could be instructed to print money for other sectors.

But there is nothing here fundamentally that puts fractional reserve banking at the center of capital-consumption structure distortions. It can occur without fractional reserve banking if a central bank is involved and it would be extremely difficult to pull off in a free banking system even if fractional reserve banking were allowed.

It is the central bank that is the problem Rothbard again:
Free banking, then, will inevitably be a regime of hard money and virtually no inflation. In contrast, the essential purpose of central banking is to use government privilege to remove the limitations placed by free banking on monetary and credit inflation.

There is nothing in the Vollgeld initiative that should be exciting for those who want government out of the money printing business. Ending fractional reserve banking won't do it, ending central bank operations will.

End the Fed!

Robert Wenzel is Editor & Publisher at and at Target Liberty. He is also author of The Fed Flunks: My Speech at the New York Federal Reserve Bank. Follow him on twitter:@wenzeleconomics


  1. HOORAY! Welcome to the club, Wenzel. Perhaps you have written on this before, but this is the first I have seen.

  2. I wrote on this topic about a week ago, with the same conclusion (though, I provided far less analysis). Giving more power to central bankers is not beneficial to the common folk. To me, the referendum is even worse than doing nothing, as it cloaks statist platforms in populist rhetoric. It gives the people the impression they're finally sticking it to the bankers, when in actuality the reverse is true.

  3. Great comments by RW. I will only add that in a free banking non-fed system, the risk to depositors by banks that leverage via reserve ratio methodology will (or may) be graded just like the restaurant health and safety grading system found in many states. A private consumer reports like" group, can inspect the various banks, where grades of A, B, C, and D, will be issued. The scores can be posted outside the bank entrance. Certainly an A grade score would likely be proudly posted by the institution, or available online.

    People will accept the risk they desire, foolish or not. Furthermore, it is reasonable to hope that a reserve ratio of 100%, qualifying for an A score by the bank, would cost the depositor a fee to maintain, and of course yield no interest appreciation. Likewise, a lower reserve ratio, like the 5% to 10% some institutions pay would be graded a D, but yield dividends appropriate for the market climate and demand for loans. Indeed, some institutions may have multiple type savings accounts: A thru D, so the consumer chooses their risk vs appreciation, within the same bank. Provided the accounts from different bank risk activities were kept completely separate, even if a bank were to fold.

    AND lastly, by all means, END THE FED. But the average consumer loses interest in that complex discussion. Rather, I've found, "End High Food Prices", and "Protect our Children's Future", is the way to gain the public's attention, and interest.. that is the disease, and symptom. But, the cause of the disease,is monetary meddling by the FED. The it will more likely be understood, that the proper treatment/cure is ENDING THE FED.

    1. Of course you would have a choice of what type of bank to put your money in. Investment banks or simply security type banks. The investment banks would yield a return variable upon the different banks risk or loan portfolios. Security banks may very well charge the customer for the simple security of their money. There also would not be FDIC to hedge the depositer's risk but there may be private insurance companies that may be created to provide some type of risk insurance. Certainly all 'free' banks would have to carry some sort of insurance (and be in good standing) to provide legitimacy, security, and integrity of the business, and also various types of rating services to keep the public informed.

  4. For an excellent article by Larry White confirming the confusion about central banking among Austrians as being the failure of Hayek to follow the position of Mises, see:

  5. Rothbard nailed it in RW's last quotation from the Mystery of Banking. The point at issue is a "regime of hard money". Central banking, fractional reserve banking, legal tender laws, crony corporatist capital structures...these are all manifestations of fiat currency controlled by a cartel. Hard money is everything.

    1. And this is why crypto currencies such as Bitcoin, imo, fail the hard currencies test UNLESS these electronic 'fiat' currencies also peg themselves to a defined WEIGHT of specie (still currently the best peg being grams of gold) rather than wildly fluctuating and speculative quantity of dollars.