Argumentation:Fractional reserve banking

The economic, environmental and social effects arising from money creation through fractional reserve banking have been subject to much heated political debate for well over two centuries.

Arguments against the practice
There are ethical, legal and pragmatic economic arguments against the practice of fractional reserve banking.

Some economists and ethicists have concluded that the practice is fraudulent and therefore immoral, in that a bank promises to redeem deposits on demand when it is aware that, through this practice, it will never have sufficient funds to satisfy all depositors. Some critics consider this fundamentally unethical, akin to counterfeiting and/or embezzlement. The simple reality is that no bank engaged in fractional reserve banking can pay its debts as and when they fall due, because a significant proportion of current liabilities (cash deposits) have been lent out and are no longer possessed by the bank. Many analysts (including Murray Rothbard) have concluded that all banks engaged in the practice are inherently insolvent. A bank run is not an "extraordinary", "unusual", or "unexpected" event in finance, but a predictable event that merely reveals the reality of banking - that fractional reserve banking is inherently unstable and that such banks are inherently insolvent.

Murray Rothbard and others have concluded that fractional reserve banking is nothing but a monetary Ponzi-scheme, relying on new borrowers (or entrants to the scheme) to remain viable. Reformist economists such as Murray Rothbard support a "full reserve" banking system and criticize fractional reserve banking as inherently fraudulent. Murray Rothbard held this view very strongly throughout his life.

Leaving aside the ethical, moral and legal criticisms against fractional reserve banking, the primary practical economic criticisms relate to Austrian Business Cycle Theory and the associated fragility of bank liquidity in a fractional reserve banking environment, the financial risk of bank runs that depositors bear when depositing money with banks, and the impact that demand deposits have on the stock of money, and on inflation (that is, the implicit expansion of the money supply and its associated impact on prices and the exchange rate). An alternative to fractional reserve banking is full-reserve banking.

Some conservationists and environmentalists believe that fractional reserve banking creates the necessity for indefinite economic growth which leads to environmental destruction and depletion of natural resources especially when coupled with population growth.

Exacerbation of the business cycle
Adherents of the Austrian School claim that fractional-reserve banking, by expanding the money supply, will lower the interest rates compared to a hypothetical full-reserve banking system, although this idea has been criticized within mainstream economics. Austrian adherents argue that this discrepancy will affect the role of the interest rate in guiding investment decisions and will therefore necessarily create malinvestments throughout the economy. One of the proponents of aspects of the business cycle theory, Friedrich von Hayek, shared in the Nobel Memorial Prize in Economic Sciences in 1974.

Effects of an increased money supply
Fractional reserve banking involves the creation of money by the commercial bank system, increasing the money supply. According to the quantity theory of money, this larger money supply leads to more money 'chasing' the same amount of goods, which leads to a higher price level. Austrian economists state that this expansion of the broad money supply (demand deposits and notes) caused by fractional reserve banking is a cause of price inflation.

Arguments for the practice
Noted gold-standard supporter Antal E. Fekete has argued that full reserve banking is impractical and fractional reserve banking is the only viable banking system - provided it is non-inflationary and is stabilized through the re-introduction of a gold standard.

A few Austrian School economists, such as Pascal Salin also suggest that a full-reserve banking system should not be enforced legally, and dispute Murray Rothbard's characterization of fractional-reserve banking as a simple form of recursive embezzlement, and rather advocate the abolition of central banking, and suggest that free banking replace the current system. Austrian monetary theorist George Selgin has also argued in favor of fractional reserve banking as the true free market position.

F.A. Hayek accepted that bank credit and fractional reserve banking, even if they contributed to business cycles, were necessary as "the price we pay for a speed of development exceeding" that which would otherwise be possible, and that "financial institutions have never been prohibited from holding fractional reserves."

By increasing the capital available for investment, fractional reserve banking may speed economic development, allowing the economy to enjoy a higher level of investment than would exist in a full reserve environment.

Finally, by concentrating economic and financial power within the banking system, the economy is more amenable to control and "fine-tuning" (or manipulation) by central governments. In a full reserve banking environment, there would be no need for a central bank, as there would be no need for "monetary policy" and there would be no "multiplier effect" of liquidity injections into the banking system by the central bank. To some economists, especially those believers in Keynesianism and/or socialism, this is a significant disadvantage when compared to a fractional reserve banking system.

Spurious Arguments
There are a number of spurious arguments that are sometimes used in favor of fractional reserve banking and against its rival, full reserve banking.

The first spurious argument is that full reserve banking would prohibit banks from lending at all, due the fact that the savings of depositors in "at call" or "demand" deposit accounts would have to be stored at the bank awaiting possible withdrawal. This argument ignores the fact that "time" or "term" deposits could still be used for lending purposes in a full reserve banking environment and this would still allow more patient depositors to obtain interest on their savings, even if the money from demand deposits could no longer be lent out for extended periods.

The second spurious argument is that fractional reserve banking "pools" small deposits and allows small depositors to receive interest on their savings from the on-lending of this money to borrowers. Fractional reserve banking does not involve the "pooling" of deposits (sometimes called financial intermediation). It involves maturity transformation - lending out money for longer periods than you received it. "Pooling" of small deposits can occur independent of the practice of fractional reserve banking.