Monday, August 22, 2005

Why Reserve Requirements Solve a Market Failure

I tried debating some libertarians in the comments section of this Catallarchy post. For some reason, many libertarians see a gold standard and the end of "fractional reserve banking"* as an integral part of their agenda. But these are some of the most misled policies ever.

"Fractional reserve banking" is in quotes because I don't like the term: it implies that there's some good alternative. Nearly all banks make a profit by lending out the currency that people have deposited. That means that there's much less currency in the bank than there are total deposits. If everyone demands their money at once, the bank's not going to be able to let them all withdraw it. But what's the alternative? If you force banks to keep every dollar that everyone deposits in a safe, they have no way of making loans and earning money. They'll have to charge for deposits instead of paying interest on them. Moreover, where will capital for loans come from? So I don't like calling it "fractional reserve banking."

In any case, it's not necessarily good to have "fractional reserve banking" if there's no regulation of it, somehow. Unconstrained, the incentives are such that banks would like to loan out as much money as possible, keeping the absolute minimum on hand to pay everday withdrawals. That's because they don't really take bank runs into account. After all, a bank run means the bank is probably finished anyway since they will rarely be able to pay all the bank-runners. So why keep a reserve of 10% of deposits when 2% works just as well (except during that bank run)? The problem is that this sort of thing causes Great Depressions. Thus, the Fed has the ability to set a minimum reserve requirement because the efficient expected welfare maximizing reserve ratio is not the one achieved by the free market.


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