Full reserve banking

Full-reserve banking is a banking practice in which the full amount of each depositor's funds are kept in reserve (as cash or other highly liquid assets) when each depositor has the legal right to withdraw them. In other words, deposits available for immediate withdrawal would not be lent out for extended periods but rather would be retained by the bank to allow the depositor immediate access to the funds. Only certificates of deposit (or term deposits) would be used for normal lending activity. Full-reserve banking was practiced historically by the Bank of Amsterdam and some other early banks but was displaced by fractional reserve banking after 1800. Proposals for the restoration of full-reserve banking have been made, but are generally ignored or dismissed by mainstream economists, who believe that the costs of such a change would outweigh any benefits.

Debate over full-reserve banking
The debate over the benefits and costs of full-reserve banking trace back over centuries. During the Great Depression, a number of Chicago economists suggested monetary reforms, which included some calling for the ending of fractional-reserve banking in two 1933 memoranda that came to be known as the "Chicago plan". After an apparent recovery in the mid-1930s, America was again in recession and in 1939 a number of economists circulated a draft proposal entitled A Program for Monetary Reform calling once more for an end to fractional-reserve banking.

With the advent of the Financial crisis of 2007-2010, some monetary reform advocates are again calling for an end to fractional-reserve banking and a return to full-reserve banking. One proposal is being put forward by Stephen Zarlenga and the American Monetary Institute; this is known as the American Monetary and Financial Security Act.

Mainstream economists seldom discuss the merits of full-reserve banking. However, monetarist and Nobel Prize winning economist, Milton Friedman once supported a 100% reserve requirement for checking accounts. And, well known for his advocacy of similar reforms, economist Laurence Kotlikoff has also called for an end to fractional-reserve banking. In April 2009, Kotlikoff and Professor Edward Leamer called for the implementation of Limited Purpose Banking, which would turn banks away from fractional-reserve banking activities and permit them only to conduct "pure" financial intermediation, in a manner similar to pooled mutual funds.

Most recently, in late 2010, two British MP's, Douglas Carswell and Steven Baker, sought to introduce legislation into the British Parliament that would allow depositors to decide if their money should be lent out and for what period. If this legislative reform were to pass, British depositors would have the option to elect to save their money in full-reserve bank accounts.

Active debate regarding the merits of full reserve banking have occurred amongst Austrian economists for decades, and Austrians such as Murray N. Rothbard and Jörg Guido Hülsmann support full-reserve banking and hold that fractional-reserve banking is immoral, inherently "fraudulent and inflationary" and is a form of legalized embezzlement that is analogous to a government-supported Ponzi scheme.

The case for full reserve
This would eliminate (or at least greatly reduce) the financial risks associated with bank runs, as the bank would have all the money in reserve needed to pay depositors - regardless whether depositors actually claimed their money.

Proponents argue that this form of banking would also eliminate the need for a lender of last resort (such as a central bank), which is normally needed to support the banking system in times of systemic risk or financial contagion, as these financial risks would not exist in a full-reserve banking environment. This simply requires that the resources available to the banks issuing credit money and demand deposits would be sufficient to convert all currency at once if so required. It was a central component in Social Credit proposals.

Were the United States to adopt full-reserve, all currency would be created by the federal government, and as a result all seigniorage revenue would also accrue to the federal government. This is in contrast to the current US system, where a large proportion of the currency supply is in the form of demand deposits created by private banks. When the Federal Reserve creates currency and uses it to buy treasury bills, it collects seigniorage revenue in the form of interest payments which it then returns to the United States (for example, in 2002 the United States earned $24.495 billion in this manner). When a private bank creates currency, the government cannot collect any seigniorage from it. Since the Federal Reserve has a target for the size of the currency stock, any currency created by private banks is currency that is not created by the Fed and thus constitutes lost seigniorage. Some consider this an illegitimate "privatization" of what should be a public good, with these profits being retained by the government to finance essential social services and capital works.

It is argued by these economists that, in contrast to fractional-reserve banking, full-reserve banking guarantees a stable money supply, which ensures that the means of exchange is not debased over time. This improves the efficiency of the price mechanism, promotes saving and the deferral of consumption, provides much greater confidence in the financial system and in the integrity of all commercial transactions and therefore encourages sustainable, non-speculative, productive investment.

Advocates of full-reserve banking do not necessarily advocate that the government lay down regulations stipulating a full-reserve system. In fact, some economists, such as Murray Rothbard (of the Austrian School) believe that government intervention sustains fractional-reserve banking, as governments have formalized the practice by making it legal and supporting it through the creation of central banks. Murray Rothbard argues that in doing this they have prevented periodic bank runs and other natural checks that would otherwise be placed on banks by astute customers, anti-fractional-reserve consumer groups, and other such organizations. Rothbard expresses this concern, and argues the case for 100% gold or silver-backed money, in his book What Has Government Done to Our Money? and other published works.

Criticism
The most common criticism of full-reserve banking, and by contrast, argument for fractional reserve banking, is the need for financial intermediation and capital formation. F. A. Hayek accepted that bank credit and fractional reserve banking &mdash; even if they contributed to business cycles &mdash; 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." Austrian monetary theorist George Selgin has argued: "Those self-styled Austrian economists, mostly followers of Murray Rothbard, who insist on fractional-reserve banking's fraudulent nature or inherent instability are, frankly, making poor arguments. I don't think the evidence supports their view, and that they overlook overwhelming proof of the benefits that fractional reserve banking has brought in the way of economic development by fostering investment."

Under full-reserve banking, deposits available for immediate withdrawal would sit idle ready for depositors to claim they money, while entrepreneurs went without this potentially usable capital. This would be likely to significantly reduce the capital available to borrowers and therefore reduce total spending and aggregate demand in the economy.

Full-reserve banking would also, by definition, lead to severe reductions in the growth of the money supply and liquidity. Transitioning to a full-reserve banking system would therefore be likely to cause significant economic dislocation and possibly a severe credit crunch.

Pascal Salin, former professor at the Université Paris-Dauphine and former Mont Pelerin Society president, opposes such regulation of banking and disputes Murray Rothbard's characterization of fractional-reserve banking as a simple form of recursive embezzlement. He argues that a situation of perfect certainty doesn't exist even in a full-reserve banking system. He also argues that in a perfectly free banking system any customer must be free to choose the kind of notes and the system of payments for services he prefers since optimality cannot be defined independent of the wants of the individual.

Criticisms of full-reserve banking combined with a gold standard
Central banks currently control the growth of the money supply. Full-reserve banking removes the need for setting prudential or reserve requirements, as the effective reserve fraction is one. Some supporters of full-reserve banking also support a gold standard. The combination of the two would eliminate the need for open market purchases and related policy tools by central banks, as the money supply would be fixed by the amount of the metallic commodity in circulation; the value of money would also be tied to the value of one commodity. This creates additional implications that do not necessarily apply to all full-reserve banking proposals, as it would render the central bank's functions largely redundant.

Among criticisms of a full-reserve banking system combined with commodity money (e.g. a gold standard) is that it implicitly means that there is no government-controlled "monetary policy" at all. Critics also argue that full-reserves, commodity money system leaves the economy with an inelastic money supply, not able to be manipulated by a central bank. Proponents argue that the lack of a government-manipulated money supply (the lack of a "monetary policy") and the presence of a sound currency (as opposed to an "elastic" one) are advantages, not disadvantages. More subtly, since full-reserve banking combined with commodity money means that during periods of high demand for money, the prices of other goods must fall, the broader real economy may bear adjustment costs that are (in principle) no different from those it would bear during periods of moderate inflation (that is, if the cost of adjusting to absolute prices is low or negligible, moderate inflation should be no more problematic than moderate deflation). However, this subsequent deflationary effect is likely to have deleterious consequences if some prices are stickier than others; in particular, wages are often significantly stickier than other prices. Most mainstream academic economists believe that given wage stickiness, the adjustment costs of deflation are significantly higher than an equivalent inflation.

Current examples
There are currently no examples of full reserve banking with an established history of operation. However, a variety of organisations aspire to provide full-reserve banking or claim to do so.

Islamic banking
In theory, Islamic banking is often synonymous with full-reserve banking, with banks achieving a 100% reserve ratio. In practice, however, this is not the case, and no examples of 100 per cent reserve banking are observed. According to Islami Bank Bangladesh: "The fractional reserve system versus 100% reserves would have different policy    implications. Under the former system, banks would have the ability to draw profits on funds that they have exerted no productive effort. Such earning is against the original spirit of Islamic banking. One solution may lie in the nationalization of commercial banks, which has already occurred in most of these countries. As regards the latter, we have a fair amount of theoretical insight from the western literature but do not have any valuable empirical    observations on the operations of 100% reserves even in countries that have adopted Islamic banking. These Islamic banks are still operating under fractional reserve system. Hence, the operation of monetary policy under 100% reserves system needs further research."

Digital gold or silver
Since 1996, a form of private currency called digital gold currency has been in circulation. Many of these currency providers claim to act like full-reserve "private banks" with a one-to-one ratio of the currency they issue and the hard asset, usually gold or silver, that they store as reserves. The most prominent examples are GoldMoney and e-gold, with the latter encountering various issues. Also available are physical gold exchangers and storage providers, such as BullionVault.

Some monetary reformers believe a new free market will emerge in money production and distribution, as the Internet allows renewed decentralisation and competition in this area, eroding the central government's and bankers' old monopoly control of the means of exchange. Some monetary reformers believe that in a genuine free market, where government did not impose a monopoly currency on the populace, a predominantly full-reserve banking system, backed by a gold standard or silver standard monetary system, would arise spontaneously out of the free market.

Links

 * Free Banking and Fractional Reserves: a Comment (Pascal Salin)
 * Alternatives to Conventional Banking Products By Maryam Ayaz
 * In Defence of Fractional Reserve Banking (Pascal Salin)
 * Money upside down
 * Transforming Money
 * Free Banking FAQ
 * Greening the Dollar Reclaiming our democratic Values Through Monetary Reform