Austrian school economists universally cite the fractional reserve banking system as the primary cause of boom-bust business cycles, whereas defenders of our current fiat money/fractional reserve banking system claim that other forces are to blame, such as “shocks” to the economy like war and natural disasters, or inherent flaws in capitalism, such as periodic falls in demand.Â These Keynesians claim that periodic falls in demand which idle productive resources, including labor, must be countered by government intervention, primarily spending by government and artificial lowering of the interest rate by central banks.Â It is easy to see why this theory is so popular–it gives governments and central banks a scientific rationale for what they want to do anyway: spend and regulate.Â Despite decades of failure, this prescription still predominates the halls of governments and central banks.
For the Austrians, the cause of the boom-bust business cycle has a simple cause which brings about a complex result. The simple cause is fractional reserve banking, which leads to bank credit expansion and malinvestment.Â The complex part is the Austrian explanation of how this credit expansion distorts the capital structure of the economy, leading inevitably to the bust.Â Bank credit not financed by real savings causes the unsustainable boom, and it is fractional reserve banking that allows banks to expand credit not backed by prior savings.Â So banks manufacture money out of thin air. Â Printing more money (as central banks are doing everywhere in the world right now) and deficit spending (also the policy of choice by governments) merely leads to more malinvestment, exacerbating the problem and leading to a deeper recession later that will take longer to healâ€”if the market is ever allow to heal.
Even in the so-called “gold standard era” of the nineteenth century, banks engaged in fractional reserve banking.Â Thusly, there were periodic boom-bust cycles.Â It was the absence of a one hundred percent reserve standard for demand deposits that accounted for these cycles.Â It need not have been so.Â Fractional reserve banking–in which the banker lends out deposited funds–was challenged in England in the early 19th century when some depositors asked the courts to force bankers to repay their deposits out of the bankers’ personal funds. Â The depositors wanted the courts to treat deposit banking according to traditional legal principles.Â The banker would be required to keep ready for redemption one hundred percent of deposited funds, just as a grain elevator treats a farmer’s deposit of corn or wheat. Â The elevator cannot speculate with this “deposit”. Â But the courts ruled that the depositors had “lent” the banker the money rather than entrusted him with their money as a deposit. Â This judgment was accepted as precedent all over the Western world and led to dire economic consequences. Â The economic side is that when the bank loans money in a fractional reserve system, rather than a one hundred percent reserve system, the money supply increases without an increase in prior savings.Â There are no new real resources freed for productive investment. Â Eventually reality reveals the problem, as prices start to rise in consumer goods, forcing resources back from more time consuming investments. Â These investments never were funded with real savings, only fiduciary monetary expansion. Â This is what caused the several depressions of the late nineteenth century.
But research has shown that these depressions were not nearly as onerous as those of the twentieth and now twenty-first centuries, because the underlying reserves themselves–gold and silver–could not be inflated. This provided a limit to the expansion. Furthermore, in the absence of a central bank as lender of last resort in the U.S., banks were wary of the ever-feared bank run, whereby bank depositors descended upon a bank en-mass demanding redemption of their deposits in gold.Â This fear limited credit expansion.Â But with the advent of the Federal Reserve Bank in 1913, and the gradual demise of gold as reserves, have meant a steady increase in bank credit expansion.Â Now the reserves themselves may be expanded by the Fed to infinite amounts. Â That is one source of the credit expansion. Â Then the fractional reserve banking system adds a second source of expansion.
For example, if reserves are 1 monetary unit (m.u.) and the reserve requirement is 100%, then the money supply is 1 m.u. Â Next let’s assume that we are under a gold standard and the banks are required to keep only 10% reserves. Â Now the money supply can be inflated to 10 m.u.’s. Â But, if reserves are not gold and the Fed inflates them to 2 m.u.’s and the reserve requirement is 10%, the money supply can be inflated to 20 m.u.’s. Â So, under a gold standard with fractional reserve banking, the reserves themselves cannot be inflated, which limits the extent of money inflation. Â But when reserves themselves are nothing more than blips on a computer screen, the money supply can be inflated to infinite amounts. Â This is the worst of all monetary worlds, because there now is no institutional check on monetary expansion.Â The Fed has created new reserves in massive quantities since the subprime lending bust of 2008–over a trillion dollars in new reserves!Â Under our fractional reserve system, the banks are able to expand credit to many times this already huge amount.Â This will lead to more not less malinvestment, because none of this credit expansion will have been financed by prior savings.
So, governments and central banks are doing everything in their power to create another unsustainable bubble.Â Central banks have intervened to keep interest rates close to zero (!), and governments are engaged in successive bouts of profligate spending that they characterize under the pompous title of “quantitative easing”.Â It cannot last, and it will not last.