Some thoughts on free-market banking

First of all there are many misinterpretations about what fractional reserve banking actually is. So lets being with sorting out some of our terminology.

A lot of people claim fractional reserve banking isn't fraudulent because everyone can agree on it. Well that is just the thing, they can't. A fractional reserve bank is by very definition a deposit bank which breaks it's promises. A deposit bank takes your money and promises you cash-on-demand, you can have them back anytime you want. If they then don't actually keep that money availiable on demand, but go and lend it to other people, they have broken the contract and it is a fraudulent operation. Most of the time this wouldn't be noticed much but the bank can in fact not keep it's contracts with all of it's client at the same time.

If you on the other hand agree on the bank lending the money to someone else and accept the risk that it may not be availiable if too many people demand money from the bank at the same time, then this is no longer a fractional reserve bank. It is simply a savings & loans bank with a very loose withdrawal policy. The receipt you get for your savings balance in such a bank is not money. It is an IOU or what we call near-money, it will always be traded at a discount (however small) compared to real money.

One interesting question here is if the will be any demand for full reserve banks in a free-market. After all having your money in a full reserve will cost you a storage fee and free-market short-term savings & loans banks will probably be very efficient at making there IOUs redeemable into cash most of the time so they will trade at a very small discount.

I think that in the beginnings of a free-market system there will be plenty of demand for full reserves. This is simply how bills will be issued so that people don't have to carry around gold coins where ever they go (any commodity can be used, but I will go with gold as the most likely example). These bills issued by deposit banks will be the first step money takes from being the actual commodity. They can be used in shops or deposited in savings contracts or whatever. Eventually though savings & loans banks may reach the efficiency and trust level necessary for shops to start accepting IOUs on savings deposits as payment, and the discount could be so small that it costs more to calculate it then the value of the discount. Making these IOUs de facto equal in value to money. This is when it starts getting really complicated to define what money actually is.

We also have several other services which interfere with the demand for real-money. Insurances, promises of credit when I need it (like on most credit cards) and so forth also reduces the amount of real-money that people will need to hold to be 100% sure that they can cover emergency expenses and so forth.

However I think that this isn't really that much of a problem. Even if savings & loans banks reach the extreme levels of trust and efficiency required to have there IOUs trade at the same value as real gold it is not likely that this will cause the same fluctuations in the money supply and subsidised prices on credit that we see today in our State run system. The two main factors behind the destructive business cycle according to Austrian theory.

More likely is that when these banks have reached peak efficiency the money supply will remain fairly constant. They will adjust there interest rates according to the demand and supply for credit to keep there lending levels at the same maximum. As long as only a very small amount of new gold is inserted into the economy the total balance sheet for all these banks should also remain fairly constant. Instead it is the interest rates that will fluctuate but they will do so according to the actual demand and supply of capital (some central banks may be attempting this today but they are in a terrible position to succeed). This will prevent the massive mal-investments that we see during boom cycles today when credit is too cheap and demand for goods overestimated and a lot less capital will be destroyed.

All in all as long as we remove the governments control over the currency, interest rates as well as removing deposit guarantees that remove trust as a competitive advantage for banks it should all work out pretty well. As long as we don't allow fractional reserves, because it is impossible for the market to compensate for the phenomena of money that looks like money but are IOUs.

This subject deserves a much more lengthy analysis naturally. The main purpose of this text is just for me to sort out some of my first glance reflections.