Yglesias tells us that some Occupy Wall Street protesters have picked up Ron Paulish monetary ideas — although some know better. I thought I’d say a word about one particular idea that sounds plausible to some people but is actually quite wrong: banning fractional reserve banking.
I know that’s a popular theme among some Austrians. But it’s actually neither a good idea nor even feasible.
The crucial thing is to understand what banks do. And it’s not mostly about money creation! Instead, what banks are for is helping to improve the tradeoff between returns and liquidity.
That’s a very quaint notion. But were it true there wouldn’t be any such thing as systemic risk!
Simple: If you only loan against actual asset values there is no systemic risk possible; if you get in trouble you simply sell down the assets until you no longer are. Since you’ve never “created money” there’s no systemic risk that can arise. Ever.
Of course this isn’t how it works in the real world today. That’s the “Bailey and Biddle” model from It’s a Wonderful Life, but pretending that we live in that world today is beyond fanciful.
For proof one need only look at the Credit Card in your wallet – or, for that matter, the student loan. If you wish to get more esoteric you can look at the Credit Default Swap.
None of these are backed by capital in today’s banking system, but all should be – dollar for dollar. Why? Because all are claims on something that does not, today, exist!
That is functionally the precise same act as a naked short. You put into circulation that which does not exist “on the come” that it will in the future. In the case of stock that is naked shorted you’re counterfeiting the stock of the corporation in question – you’re representing that you have something to deliver (the stock) but only the company in question has the right to create (by issuance in exchange for capital) that stock.
In the case of naked credit creation unbacked by an asset the bank is effectively naked shorting the currency, betting “on the come” that production will in the future cause the government to issue actual currency with which to make the bet good!
That’s an outrage! It’s also how we get massive asset inflation.
Krugman knows this, of course. After all, he has a Nobel Prize and a PhD, right? He can’t possibly be so ignorant as to claim that banking as currently practiced actually encompasses (mostly) lending against actual assets – that is, liquidity matching for a price – can he?
After all, were this the primary function of banks these days there could never be systemic risk, since lending against assets can’t cause it, as if the person who borrowed doesn’t pay you simply seize the asset and resell it into the market, extinguishing the debt without systemic consequence (the borrower, of course, goes broke by such a process, but that’s the risk of borrowing that which you can’t pay back!)
The claims of charlatans must be matched against the factual record of not only what has occurred before but what threatens to occur now.
PS: This is why I support – strongly – a “One Dollar of Capital” LAW for banks, and why you should too.