Fractional Reserves and Economic Instability

[Testimony before the Subcommittee on Domestic Monetary Policy and Technology of the Committee on Financial Services, US House of Representatives "Fractional Reserve Banking and Central Banking as Sources of Economic Instability: The Sound Money Alternative," June 28, 2012]
by Dr. John Cochran
Fractional-reserve banking has historically been viewed by some economists and most monetary cranks as a panacea for the economy — a source of easy credit and new purchasing power to quicken trade. Better economists, however, recognized fractional-reserve banking with its ability to create credit, Mises's (1971, pp. 268–69) circulation credit or Rothbard's (1994) deposit banking, as a major source of financial and economic instability. The establishment of a central bank was often, when not driven by fiscal priorities of government, an attempt to achieve the first while mitigating or eliminating the second. For the United States, in particular, the effort was perhaps misguided. Per Vera Smith (1990 [1936], p. 166),
A retrospective consideration of the background and circumstances of the foundations of the Federal Reserve System would seem to suggest that many, perhaps most, of the defects of American banking could, in principle, have been more naturally remedied otherwise than by the establishment of a central bank; that it was not the absence of a central bank per se that was at the root of the evil … there remained [even with a central bank] certain fundamental defects which could not be entirely, or in any great measure, overcome by the Federal Reserve System.
Rothbard (2002) covers the history of money and banking in the United States and amply documents periods of instability generated by banking panics associated with fractional-reserve banking sans an explicit central bank. However, compared to this earlier era, fractional-reserve banking supported by "scientific" management of the currency by a central bank has failed to provide the promised stability. Besides the continuing instability, the Fed has guided a significant (massive) decline in the purchasing power of the dollar. The dollar currently has a purchasing power less than 5 percent of a 1913 dollar. Selgin, Lastrapes, and White (2010), "Has the Fed Been a Failure?" summarize:
Drawing on a wide range of recent empirical research, we find the following: (1) The Fed's full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed's establishment. (2) While the Fed's performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I. (3) Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.
During a period known as the Great Moderation, roughly 1983–2000, the US economy experienced a period of apparent relative stability and prosperity. The US economy was then buffeted by two boom-bust cycles tied directly to credit expansion and low interest rates driven by fractional-reserve banking supported by central-bank activity (Garrison 2012 and 2009, Salerno 2012, Ravier and Lewin 2012, and Cochran 2011). The most recent recession and slow recovery rivals or exceeds the instability of 1970s and early 1980s in severity and is arguably the most significant crisis since the 1930s. While much of the discussion following the recent crisis has focused on why the recovery has been so slow, a lesson that should have been learned is that the economic growth driven by money and credit creation is short term only; an artificial boom cannot last. Ultimately credit creation is a major destructive power that misdirects production, falsifies calculation — even in a period of relatively stable prices — and destroys wealth (Salerno 2012, pp. 32–36). An economy with a complex financial system like the present banking system, which in turn depends on a government monopoly of the supply of money, is prone to cycles and crises even with the best of either discretionary or rule-based management. Under our current system of interest-rate targeting, "Policy-induced booms tend to piggyback on whatever economic development is underway" (Garrison 2009). This would be true whether the central bank followed a single (rather than the current dual) mandate, such as a policy goal of price stability or adopted nominal GDP targeting (Garrison 2012, pp. 435–36). Under fractional-reserve banking supported by a central bank the interest rate brake which would normally stop such events before they turn into bubbles or booms is effectively neutered (Hayek, 1941, pp. 406–10). Because of this neutering, booms and busts remain a significant threat in a "learning by doing" policy framework (Garrison 2009). Without a foundation of sound money, a market-determined money, cycles are inevitable and destructive not only of short-term economic well-being but potentially destructive of long-term freedom and prosperity. It is urgent then that policy makers take seriously Hayek's proposal, developed during the economic crisis of the 1970s, for drastic monetary reform, for a "denationalization of money." This call is echoed by Garrison (2012, p. 436) who argues future prospects for "achieving long run sustainable growth can only rest on the prospects for decentralizing the business of banking."

Sound Money[1]

After the decline of former socialist countries and under the influence of the apparent prosperity in most market economies during the Great Moderation, most economists recognized the importance of markets and private property for long-term economic prosperity.[2] But markets and private property generate prosperity because only in such an order can monetary calculation facilitate rational economic planning. But for monetary calculation to operate in a way most consistent with consumer sovereignty, calculation and prices must be embedded is a sound monetary system. As expressed by Salerno (2010 [1998], p. 468),
While there is now a basic recognition by economists that rational allocation of resources necessitates institutional reforms that return resources to private hands and restore genuine markets for productive inputs, there is no such comprehension of the importance of sound money to the processes of economic calculation.
Salerno (p. 473) continues: "Sound money, then is simply one which does not lead to systematic falsification of or nullification of economic calculation." Economic calculation requires money prices, but for calculation to most adequately achieve the goal of solving the economic problem, the money prices used for calculation must reflect the valuations of producers/consumers that are based on their individually unique preferences, knowledge, and resources. Sound money then is money whose purchasing power and quantity are determined by consumers' and producers' valuations, preferences, knowledge, and resources — that is, a market-determined commodity money absent government intervention. As expressed by Mises (1998, p. 225),
Economic calculation does not require monetary stability in the sense in which this term is used by champions of the stabilization movement. The fact that rigidity in the monetary unit's purchasing power is unthinkable and unrealizable does not impair the methods of economic calculation. What economic calculation requires is a monetary system whose functioning is not sabotaged by government interference. The endeavors to expand the quantity of money in circulation either in order to increase the government's capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation...  
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