January 12, 2010 Special Issue

Mo money, mo problems

A full reservist strikes out against fractional reserve banking

by Clare Raspopow

Mauzy feels the fractional reserve system is as secure as a castle in the sky. GRAPHIC ELSA JABRE

Reach into your wallet and pull out a $20 bill—okay, a $5 bill—and ask yourself what it is that you’re holding in your hand. The simple answers come first: it’s money, it’s currency, it’s the thing that’s going to buy you your coffee this afternoon. But what is this thing called money we’ve all come to know and love (or hate as the case may be)? According to Steven Mauzy, it’s a fat lot of nothing.

The evolution of banking: a quick and dirty breakdown

Once upon a time, people paid for things with other things: grain for livestock, livestock for smith work and so on. When bartering and gift economies—economies where people do things with the expectation that when they need something done, someone will help them out—became unwieldy or unreliable, people resorted to transactions using small nuggets of precious things: metals, salt, shells, stones, and really anything else people have convinced themselves is inherently valuable.

The transition to commodity money—money whose value is based on the value of what it’s made of, i.e. gold—happened pretty quickly; historians peg the widespread adoption of coinage as early as the first millennium B.C.E. Instead of herding cattle long distances to buy a couple of slaves, a bag full of gold would suffice. How simple!

But even commodity money would prove too cumbersome as the size of economies increased and wealth began to concentrate. No one wanted to carry giant, heavy bags of gold around to buy things. Big piles of gold in your home made you a target for thieves. And on top of that some people were known to cut their coins with cheap base metals to make more of it and to make the cheap, pliable metal more durable.

People then began storing their gold with gold merchants (that could verify the quality of the goods), who would in turn give them vouchers for the sums they had deposited. These vouchers—sometimes small bits of leather, sometimes pieces of paper—would form the basis for a financial system of representative money.

Eventually, these gold merchants discovered that most people didn’t take their money out too often; they could lend gold out to people who needed it at an increased interest rate and their depositors wouldn’t know or care. These businesses, which were tantamount to private banks, would reserve a fraction of their deposits to cover the amount they would probably need, allowing them to, in effect, multiply the money at their disposal. This system, though crude, would become the basis for fractional reserve banking, the system that all major banks now use.

Eventually, due to the prevalence of private bank failures and political manoeuvring on a national scale, countries would adopt a central banking system. This gives one nationalized bank the authority to print a country’s currency, set the reserve rates—what percentage of their deposits the banks must retain—and control interest rates. These central banks can serve as a safety net when smaller privately owned banks run into trouble—think the United States credit meltdown—and are often charged with the responsibility of seeing that the country’s financial institutions aren’t behaving recklessly.

Fractional reserve banking

“When you loan something that isn’t yours, it’s a fraud,” explained Stephen Mauzy, a financial analyst in the U.S. and part of a minority that favours a return to the full reserve banking system. A full reserve system would require banks to keep the full amount of every client’s deposit on hand.

Mauzy writes for the Ludwig von Mises Institute, an organization created to advance the Austrian School of economic thought which says that, due to the complexities of human beings and economic systems, financial modelling is difficult to the point of being useless.
He is troubled by what he sees as the artificial inflation of wealth that fractional reserve banking allows.

“The supply of money is basically driven by loan demand,” he explained.

If one bank has $10 and the reserve rate is 10 per cent (as it is in the U.S.) that means the bank only has to keep one dollar on hand and can loan out the other nine to clients or, as often happens, other banks. A bank receiving nine dollars from the first bank is only required to keep 90 cents on hand, allowing them to loan out $8.10. In effect, most money is a guarantee on the part of the banks, a cool coercive, “you know me, I’m good for it.”

As this process continues, the multiplication of the original $10 continues to many times its real value. The more people want to borrow money, the more likely the banks are to oblige them by producing more money—which is, in effect, just producing more debt.
“When you get a [money] oversupply, assets get bid up,” said Mauzy, explaining why he thinks fractional reserve banking is harmful for economic stability. “You get a huge expansion [of available capital] and people start paying more and more for assets, more than they should. Then something happens and you find out that the assets aren’t worth that much and you get a crash.”

Mauzy sees the housing bubble as a prime example of this phenomena where houses double or triple in a few years only to crash back down to their original value, sometimes lower. People who had over-extended themselves on the bet that their houses would continue to inflate in value end up losing everything.

If the oversupply of money gets out of control, the central bank—in our case The Bank of Canada, in the U.S. the Federal Reserve—can raise the reserve rate, requiring banks to keep more of their original deposits on hand. But Mauzy doubts that something like that would happen.

“There’s too much pressure not to raise the reserve requirement,” he said. “People forget what happened [in an economic crisis] pretty quickly. When the pressure subsides from the bankers, they always want more money to lend.”

In Mauzy’s eyes, the solution to this vicious economic cycle is full reserve banking.
“[We need to] get rid of the idea of treating the money supply as a function of debt demand,” he said. “If we had full reserve [...] there would not be a business cycle anymore. You wouldn’t get these mass speculations, people would be more prudent, I think. You wouldn’t have [such dramatic] inflation either. You’d see a lot less distortions.

“It would make banks a lot safer. You wouldn’t have bank runs.”

A bank run happens when those people who have invested in a bank lose faith in its financial stability and everyone tries to get their money out at once (think It’s a Wonderful Life). If the bank is unable to call in the loans it has made to others or has lost a great deal of money in speculative investing, so many depositors requesting their money back could cause the bank to fail entirely.

But, while Mauzy believes that full reserve is the answer, he’s decidedly in the minority. Most economists think that, the world being what it is, an attempt to return to a full reserve system would be tantamount to economic suicide. Credit at the levels we have come to depend on would disappear. The money supply would drastically dry up.

In fact, some economists such as George Selgin, a professor at Terry College of Business in Athens, Georgia and also from the Austrian school, believe not only that fractional reserve banking is not to blame for the dramatic economic cycles we’ve been seeing, but that it’s the efforts of the central banks to regulate and control the money supply that cause recessions and compound economic difficulties. He advocates the dissolution of the central banking system in favour of commercial banks, whose currency—which they would have the right to produce—would be backed by their own assets.

While his view point is most definitely not in vogue, Mauzy stands behind it. He believes something is to blame for the ups and downs we’ve been seeing and that there’s a simple, but unpopular solution.

“You can’t lend what you don’t have,” he said. “[Full reserve banking] would go a long to curbing the excesses we’ve seen.”