John Tamny and the Problem with Fractional Reserve Banking

John Tamny of Forbes is one of the more informed contributors in the increasingly dismal state of economic commentating.  Tamny readily admits he is on the libertarian side of things and doesn’t give into the money-making game of carrying the flag for a favored political party under the guise of a neutral observer.  He condemns the whole of the Washington establishment for our current economic woes and realizes that government spending is wasteful in the sense that it is outside the sphere of profit and loss consideration.  In short, Tamny’s column for both Forbes and RealClearMarkets.com are a breath of fresh air in the stale rottenness of mainstream economic analysis.

Much to this author’s dismay however, Tamny has written a piece that denies one of the key functions through which central banks facilitate the creation of money.  In doing so, he lets banks off the hook for what really can be classified as counterfeiting.  In a recent Forbes column entitled “Ron Paul, Fractional Reserve Banking, and the Money Multiplier Myth,” Tamny attempts to bust what he calls the myth that fractional reserve banking allows for the creation of money through credit lending.  According to him, it is an extreme exaggeration to say money is created “out of thin air” by fractional reserve banks as Murray Rothbard alleged.  This is a truly outrageous claim that finds itself wrong not just in theory but also in plain evidence.  Not only does fractional reserve banking play a crucial role in inflationary credit expansion, it borders on being outright fraudulent.

So what exactly is ethically wrong with fractional reserve banking?  In his book Money, Bank Credit and Economic Cycles economist Jesus Huerta de Soto explains that the clear distinction between what would be considered demand deposits and savings available for loans has been enforced in banking history dating all the way back to ancient Greece.

Demand deposits were considered those deposits which banking customers believe they have direct access to at any time.  Because of the fungible nature of currency, identical gold coins did not have to be redeemable to the original depositing parties.   Deposits which were used to lend to entrepreneurs for a fixed amount of time were understood to be off limits by the patrons who provided them.  Typically the saver who placed his money in a bank for a specified period of time would do so to profit from a predetermined rate of interest. Under this system of strict separation between demand deposits and deposits used for lending, a duration mismatch, or a bank not having enough money on hand to pay all demand deposits, will not occur.  Back in the days of Ancient Greece and Rome, it was always considered fraudulent for bankers to lend out money put in their possession for safekeeping though that didn’t stop some who couldn’t resist earning a nice profit…

by James E. Miller

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