Full-Reserve Banking Goes Mainstream

March 27th, 2013

Imagine that all bank deposits — the dollars in your checking account — were 100% backed, one-for-one, by your bank’s reserve holdings at the Fed (the modern, fiat-money-world equivalent of gold reserves). Runs on bank deposits would be impossible, because the outfit that issues reserves and currency can’t run out of reserves and currency — any more than a bowling alley can run out of points. You could always take your money out of the bank.

Meanwhile all lending would come from actual investment funds, in which the investors (via equity or debt) are explicitly putting their funds at risk in hopes of getting better returns.

As pointed out by Matthew C. Klein — recently transplanted from The Economist to Bloomberg View — this notion…

…has a long and distinguished academic lineage. Luminaries such as Irving Fisher, Milton Friedman and James Tobin have all advocated it.

For instance, the “Chicago Plan” was developed in the 1930s by Fisher and Henry Simons. Friedman later endorsed it as well. Two researchers at the International Monetary Fund have written an up-to-date appraisal — and the proposal, in theory, does everything its designers claimed 80 years ago. The first 20 pages of this paper are an excellent primer.

Tobin explained the essence of the idea in 1987 at the Federal Reserve’s annual economic symposium in Jackson Hole:


“I think the government should make available to the public a medium with the convenience of deposits and the safety of currency, essentially currency on deposit, transferable in any amount by check or other order…The Federal Reserve banks themselves could offer such deposits, a species of ‘Federal Funds.'”

More recently, Boston University economist Larry Kotlikoff has argued that we need to completely separate money from credit by introducing what he calls “limited purpose banking.” It’s basically the same idea.

Matthew says “This is the remedy advocated by Bloomberg View’s editors.” That’s pretty mainstream.

I’d go even farther and recommend Steve Randy Waldman’s idea of “starter savings accounts,” in which you could get a guaranteed 0% real return — no matter the level of inflation — on up to $200,000 in deposits. This would insulate the real economy from the vagaries of the financial system’s floods and droughts. Got confidence?

These ideas are not as simple as they sound — there are institutional and incentive issues to address. But separating the mundane business of administering holdings and payments from the ever-more-arcane business of lending and investment is not some wacky internet econocrank idea. It’s downright conservative.

Cross-posted at Angry Bear.

  1. Oliver
    March 28th, 2013 at 09:06 | #1

    The real problem that needs addressing in my opinion is not the fact of what a deposit is backed with ex-post, but by which mechanism it is created. In the current world deposits are the accounting record of an investment, which creates the spread, which in turn is the raison d’être of banks. 100% reserves means the creation of deposits and investments become separate events. So, instead of the supposed limiting factor of capital requirements and demand for loans determining the growth of the money supply, one is left with having to invent a separate growth rule for deposits. This is why I think 100% reserves, at least in its intent, is not compatible with endogenous money and very much a monetarist project. But I gather JKH is of different opinion. I’ll go through his piece again.

  2. Oliver
    March 29th, 2013 at 02:22 | #2

    On second thoughts, that’s a bit confused. Consider it writing therapy :-).

  3. March 31st, 2013 at 14:57 | #3

    So would mortgage backed securities be banned, or would investors still buy them?

    As far as I can see, fractional reserve banking has come out of the crisis looking at least as good as any other sort of finance. Biggest financial crisis since the FDIC system was put in place and… depositors of the sort you’re trying to protect were just fine. This is still interesting as a way to address the problem of too much finance generally, but framing the problem as one of fractional reserve specifically confuses the issue.

    Meanwhile the crisis has exposed the naivete behind the hope that investors will explicitly put their money at risk — they want their FDIC guarantee too, and if the government doesn’t provide it they will create a private industry to assess risk and insure against it, but no private actor can insure the economy, so that will fail and then they will make a persuasive case that economic survival depends on the government stepping in to bail them out.

  4. April 4th, 2013 at 01:14 | #4

    This is just another iteration in the old debate between Bailey Park and Pottersville. The only advantage to the Pottersville scenario (full-reserve “banking”) is that the people making investment decisions bear the full cost of the risks they incur. The disadvantage, though, is that no one else shares any of the returns from investment.

    There is an existing line of mechanism-design literature on markets where households are highly heterogeneous in their abilities at making investments. The optimality result is basically this: we want to design the markets so that people who are good at investing (and therefore rich) bear as much of the risk as possible, but where the people who are bad at investing (hence, poor) still make decent returns while bearing as little risk as possible. That means we want a situation where the poor, bad investors lend their money at a guaranteed rate to the rich, good investors, who then make the investment and pocket whatever the remaining returns (or losses) on the investment. That is an awful lot like fractional reserve banking, especially in a world that has deposit insurance.

    So, I would posit that the existing literature says that full-reserve banking is sub-optimal from a distributional perspective. The poor are better off when they can have savings accounts, and the rich not much worse off.

  5. April 4th, 2013 at 10:43 | #5

    As an advocate of full reserve, I don’t mind deposit insurance if it’s entirely self-financing. And that obtains in the case of FDIC and small banks.

    Big banks are different: only the state (i.e. taxpayer) can provide the insurance. But that equals a subsidy of banks, and subsidies are generally accepted in economics as being “sub-optimal”: i.e. they involve a misallocation of resources.

    So I think the poor have just got to accept risk if they put their money into big banks. And if they don’t like that, they can put their money into some sort of ultra-safe and “derisory rate of interest” account as advocated by Tobin and Kotlikoff.

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