Fractional reserve banking, where the Austrians went wrong

Like I’ve said before, I’m a big follower of the Austrian school of economics, which is light years ahead of all the conventional economic wisdom. However, there are a couple of issues where they go wrong.

The first, is trying to use ABC theory to explain every crisis. For example, Austrians might use this theory to explain the 1930s depression. But like I explained in yesterday’s post, the causes were fiscal, and there was no illicit tampering with the money supply, since the gold standard was still in place.

The second issue I have with the Austrian school, is their attack against fractional reserve banking. Fractional reserve banking is the state by which banks only hold a fraction of what they loan out at the bank. So from a deposit of 100 euros, they will lend out 90 and keep 10, these 90 then end up in another bank, from which 81 euros are loaned, and 9 remain as reserves.

The Austrians would then say, that this process, is creating money out of “thin air” and that banks are, by nature, insolvent institutions, because at any point, if all depositors were to go and redeem their deposits, the bank wouldn’t be able to give everyone their money back.

Let us have a closer look, by analysing the following table.

Individual Bank Amount Deposited Lent Out Reserves
A 100 80 20
B 80 64 16
C 64 51.20 12.80
D 51.20 40.96 10.24
E 40.96 32.77 8.19
F 32.77 26.21 6.55
G 26.21 20.97 5.24
H 20.97 16.78 4.19
I 16.78 13.42 3.36
J 13.42 10.74 2.68
K 10.74 0.0 10.74
Total Amount of Deposits: Total Amount Lent Out: Total Reserves:
457.05 357.05 100

This shows the process I was describing before. You can see how 100 euros deposited, can turn into much more. However, look at the end result. You will notice that total reserves plus the money lent out amount to the total deposits. In fact, no money has been created. The bank may be in trouble if someone defaults on the loans they gave out, but that’s a problem in any business. The reason that it seems like there is more money, is because that money has been loaned out. But that’s money being used, nothing more.

In reality, it’s not that banks are by nature insolvent. The confusion stems from the fact that what banks have to do is manage liquidity. We must distinguish insolvency from illiquidity. Banks do two things, they loan out money and they hold deposits which are redeemable on demand. What the bank needs to do is manage this situation optimally. Of course, this balance could be easily upset during a bank-run, when everyone rushes to take out their deposits. In this case, the bank may not be able to return the money on demand, since they still have loans waiting to mature, but when they did mature, the money is there.

The important point to be made from this, is that regular banks don’t create money out of thin air. The central banks create money out of thin air, but that is another issue.

Again, I think much of the Austrian confusion might come from the fact that there is something inherently wrong in today’s banking system, but they are not pointing the finger at the right place.


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