Full Reserve Banking Pros & Cons
The advantages of the full reserve banking system, when compared to the current fiat system, will become all too clear to students of monetary economics in the years ahead, but you might not hear much about it until our current financial system collapses.
Our predicament of unserviceable debts, insatiable government spending programs, and ever-increasing budget/trade deficits are all terrible omens of a forthcoming global financial crisis the like of which we have never before seen.
The full reserve banking system will not prevent the coming collapse, but it may emerge from it as a better way forward once the collapse is upon us.
As the name implies, a full reserve system would force our banks to hold in reserve all of their customers’ current account deposits (also called ‘demand-deposits’ i.e., not including savings deposits or ‘time-deposits’).
The system would be initiated by the central-bank printing new money with which to purchase interest-bearing assets from the commercial banks. This process would continue until the banks had raised enough money from the sale of these non-liquid assets that they have enough money to backup their entire demand-deposit liabilities.
They would be prevented from loaning out a single penny of this backup money, and they would need to maintain a 100% backup in future in order to cover any increase in the size of their customers’ current account money.
What is the main benefit of 100% reserves?
When the economy enters a growth period, and both consumer & business confidence improve, our current fractional reserve system encourages banks to rapidly accelerate their lending in an unsustainable way. This lending is fueled by loaning out a larger multiple of the money deposited in current accounts.
As history has repeatedly proven, this leads to a rapid expansion of the entire money supply, with inevitable overheating that leads to the boom-bust business cycle. See my page about the money multiplier for more explanation on this.
Keep in mind that savings deposits are excluded from the 100% reserve requirement. This is because any increase in aggregate spending by borrowers is completely offset by reductions in aggregate spending by savers. Money saved in time deposits cannot be loaned out multiple times, because it does not circulate multiple times, it is tied to investments.
In a full reserve banking system, it is only when person A saves more (and thereby spends less) that person B can borrow more (and thereby spend more). Total spending remains the same, the total money supply is unaltered, and therefore this type of lending creates no impetus for a new boom-bust cycle to begin.
A near elimination of the business cycle would result, because no malinvestment during boom-periods, and no increase in unemployment or bankruptcies during bust-periods, can occur.
Another pleasing side-effect is that there can be no excessive profits for greedy bankers, or huge golden-handshake pension rewards, as they walk away from the catastrophic recessions that they themselves cause.
The full reserve banking system is a much fairer system.
Similarly, with no business cycle caused by periodic excessive bank lending, it would be virtually impossible to ever have another serious financial crisis. Even if a bank-run were to somehow begin, with people rushing to get their money out of the banks, those banks would be able to immediately repay every single penny that they owe – because everything that they owe, at any point in time, is held in reserve!
What is the major disadvantage?
A full reserve banking system has never been tried before… and so there is significant risk and uncertainty involved.
We can’t be sure that the banks would not be able create excessive credit via some other means. People are extremely resourceful and the free-market has a way of creating supply whenever there is a demand.
For example, some other medium of exchange, one that’s outside of government and the banking system’s control, might be used to increase lending when economic circumstances are primed for a new boom-bust cycle.
Perhaps cryptocurrency could somehow fulfill this role, although it is difficult to see how this could happen without a complicit government.
For the full reserve banking system to work, it is an absolute necessity that the authorities are wholly committed to making it work. The simplicity of the system would make it much easier for the government to avoid its customary incompetence with such matters, but no system can succeed without a firm commitment towards making it work.