User:Nathaniel Tolles/Full-reserve banking

The Existing System
The Federal Reserve, being the central bank of the United States of America, sets the reserve requirement, which is the percentage of a bank's deposits that it legally must have available as funds on hand. The reserve requirement must be heeded by commercial banks, savings banks, savings and loan associations, and credit unions. By reducing the reserve requirement, the Federal Reserve exercises expansionary monetary policy, and exercises contractionary money policy by increasing the reserve requirement. Decreasing the reserve requirement increases liquidity and the velocity of money, with the intention of promoting economic growth.

In the United States, Europe, and other modernized economies, roughly 95 percent of the money supply is held privately by banks as demand deposits. Under a fractional-reserve banking system, banks are only required to keep a given percentage (currently 10% for large banks, 3% for banks with $16.9 million to $127.5 million on deposit) of deposits in reserve to deliver money to those that wish to withdraw. The Money Multiplier, being the reciprocal of the Reserve Ratio, dictates the factor by which the initial deposits can be multiplied, allowing for banks to "create" money to meet demand for loans. The most common circuit today, being initiated by the issuance of a mortgage by a bank to a lendee, may be illustrative of conspicuous consequences of such a system. With such an abundance of available mortgage capital, prospective homeowners are therefore able to adapt their willingness to pay to discount their actual ability to pay. Martin Wolf, Chief Economics Commentator at the Financial Times, argues that many people have a fundamentally flawed and oversimplified conception of what it is that banks do. Laurence Kotlikoff and Edward Leamer agree, in a paper entitled "A Baking System We Can Trust", arguing that the current financial system did not produce the benefits that have been attributed to it. Rather than simply borrowing money from savers to make loans towards investment and production, and holding "money" as a stable liability, banks in reality create credit increasingly for the purpose of acquiring existing assets. Rather than financing real productivity and investment, and generating fair asset prices, Wall Street has come to resemble a casino, in which trade volume of securities skyrockets without having positive impacts on the investment rate or economic growth. The credits and debt banks create play a role in determining how delicate the economy is in the face of crisis. Wall Street caused the housing bubble by financing millions of mortgages that were outside budget constraints, which in turn decreased output by 10 percent.

In Favor
In The Mystery of Banking, Murray Rothbard argues that legalized fractional-reserve banking gave banks "carte blanche" to create money out of thin air. Deposit bankers become loan bankers when they issue fake warehouse receipts that are not backed by the assets actually held, thus constituting fraud. Rothbard likens this practice to counterfeiting, with the loan banker extracting resources from the public. However, Bryan Caplan argues that fractional-reserve banking does not constitute fraud, as by Rothbard's own admission an advertised product must simply meet the "common definition" of that product believed by consumers. Caplan contends that it is part of the common definition of a modern bank to make loans against demand deposits, thus not constituting fraud.

Furthermore, Friedman argues that fractional reserve banking is fundamentally unsound because of the timescale of a bank's balance sheet. While a typical firm should have its assets be due prior to the payment date of its liabilities, so that the liabilities can be paid, the fractional reserve deposit bank has its demand deposit liabilities due at any point the depositor chooses, and its assets, being the loans it has made with someone else's deposits, due at some later date.

Economists that formulated the Chicago Plan following the Great Depression argue that allowing banks to have fractional reserves puts too much power in the hands of banks by allowing them to determine the amount of money in circulation by changing the amount of loans they give out.

Against
Krugman argues that the 2008 financial crisis was not largely a result of depositors attempting to withdraw deposits from commercial banks, but a large-scale run on shadow banking. As financial markets seemed to have recovered more quickly than the 'real economy', Krugman sees the recession more as a result of excess leverage and household balance-sheet issues. Neither of these issues would be addressed by a full-reserve regulation on commercial banks, he claims.

Further Reform
Kotlikoff and Leamer promote the concept of Limited Purpose Banking (LPB), in which banks, now mutual funds, would never fail, as they would be barred from owning financial assets, and their borrowing would be limited to financing their own operations. By establishing a Federal Financial Authority, with the task of rating, verifying, disclosing and clearing all LPB mutual funds, there would be no need to outsource such tasks to private entities with perverse incentives or lack of oversight. Cash mutual funds would also be created, holding only cash tied to the value of the United States dollar, eliminating the threat of bank runs, and insurance mutual funds would be established to pay off the losses of those that own part of the mutual fund, as insurance companies are currently able to sell plans that purport to insure events for which it would be impossible for them to pay off the entirety of the losses experienced by the insured parties. The authors contend that LPB can accommodate any conceivable risk product, including credit default swaps. Such proposed mutual funds are already in existence, in the form of tontines and pari-mutuel betting. However, others claim that despite being quite popular in the early 20th century, tontines fell from public prominence after several scandals. Tontines, even during their popularity, were seen by many as off-putting, as those that invested in tontines would see larger regular payments as other investors died. Tontines are also currently illegal. However, a modern tontine might still be a viable future alternative to other retirement plans, as they provide continuing payment based on the number of years the investor continues to live. Under LPB, liquidity would increase as such funds become publicly available to the market, which would determine how much bank employees would be paid.

Most fundamentally, risk would be undertaken people that take it on, rather than businesses, banks, or the taxpayer.