Criticisms of fractional-reserve banking have been put forward from a variety of perspectives. Critics have included mainstream economists such as Irving Fisher,[1] Frank Knight[2] and Milton Friedman.[3]
Chief among economic theories criticizing this form of capitalism, where almost all of the money supply is an interest-bearing-debt created through banking debt-multiplication, is the Austrian School of economics.[4] Within the economics profession today, most criticisms are from non-mainstream economic theories such as those of the Austrian School.[5] There are also critics from outside the economics profession.
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Critics of fractional reserve banking and the related fiat paper monetary system may use the term debt-based monetary system[6] or credit-based monetary system to emphasize the role that credit plays in the current monetary system.[7] These terms are not in general use, and economists generally refer instead to the money supply, broad money and the money multiplier when discussing the mechanism by which the commercial banking system expands the quantity of money in an economy. The study of monetary theory in the economics profession is referred to as monetary economics.
Critics of fractional reserve banking claim that since money creation requires loans from the banking system, people are required to go into debt in order for any new money to be created. They assert that this can debase the means of exchange. While there is no controversy over the fact that the commercial banking system expands the money supply, critics find it problematic that banks "create money out of nothing."[8]
One criticism posits that since debt and the interest on the debt can only be paid in the same form of money, the total debt (principal plus interest) can never be paid in a debt-based monetary system unless more money is created through the same process. For example: if 100 credits are created and loaned into the economy at 10% per year, at the end of the year 110 credits will be needed to pay the loan and extinguish the debt. However, since the additional 10 credits does not yet exist, it too must be borrowed. This implies that debt must grow exponentially in order for the monetary system to remain solvent. This was the argument of the Social Credit movement of the 1930s, who proposed to remove the job of money creation from banks and give it to governments.
Other criticisms relate to the potential fragility of bank liquidity in a fractional reserve banking environment, the financial risk of bank runs that depositors bear when depositing money with banks, and the impact that demand deposits have on the stock of money, and on inflation (that is, the implicit expansion of the money supply and its associated impact on prices and the exchange rate). An alternative to fractional reserve banking is full-reserve banking.[9] With full-reserve banking, some monetary reformers, such as Stephen Zarlenga of the American Monetary Institute, support the concurrent issuance of debt-free fiat currency from the Treasury, while others such as Congressman Ron Paul and some economists from the Austrian school, call for a commodity currency as existed under the gold standard.[10][11][12]
Mark Anielski, and other political thinkers such as Michael Rowbotham, argue that this system of money supply has characteristics similar to a pyramid scheme, where the newly indebted are compelled to induce others into debt to pay off their own debts.[13]
Some commentators, like debt-focused critics including Stephen Zarlenga, Lew Rockwell and Murray Rothbard, link together fractional-reserve banking, central banking, and government-enforced "paper" or fiat currency as negative features of modern monetary systems. They argue that fiat money and the practice of fractional reserve banking does not impose a natural limit on the growth of the money supply, and that this causes inherently unsustainable bubbles in asset and capital markets, which are vulnerable to speculation.[14][15][16][17][18][19] These commentators often use the term "debt-based monetary system" to refer to an economic system where money is created primarily through fractional-reserve banking techniques, using the banking system.[6]
There are individuals, even within such groups as the Austrian school, that reject the notion that fractional reserve banking is inherently destabilizing and that full-reserve banking is the appropriate solution. One such Austrian thinker, Steven Horwitz, argued that full-reserve banking would impose similar costs of price adjustments in reaction to growth (through a reduction in the overall price level) as would inflation, and hence offer no inherent advantages over fiat currencies and fractional reserve banking.[20]
Adherents of the Austrian School claim that fractional-reserve banking, by expanding the money supply, will lower the interest rates compared to a hypothetical full-reserve banking system, although this idea has been criticized within mainstream economics.[21][22][23] Austrian adherents argue that the presumed discrepancy will affect the role of the interest rate as the price of investment capital, guiding investment decisions. One of the proponents of aspects of the business cycle theory, Friedrich von Hayek, shared in the Nobel Memorial Prize in Economic Sciences for 1974.[24] Hayek accepted that bank credit and fractional reserve banking — even if they contributed to business cycles — were necessary.[25]
Pascal Salin argues that a full-reserve banking system should not be enforced legally, and dispute Murray Rothbard's characterization of fractional-reserve banking as a simple form of recursive embezzlement, and rather advocate the abolition of central banking, and suggest that free banking replace the current system. Austrian monetary theorist George Selgin has also argued in favor of fractional reserve banking.[26]
Fractional reserve banking involves the creation of money by the commercial bank system, increasing the money supply. According to the quantity theory of money, this larger money supply leads to more money 'chasing' the same amount of goods, which leads to a higher price level.[27] Austrian economists state that this expansion of the broad money supply (demand deposits and notes) caused by fractional reserve banking is a cause of price inflation.[28] By contrast, Real bills doctrine argues that creation of money by fractional-reserve banks does not affect the price level as long as the bank retains balance-sheet solvency.
Some conservationists and environmentalists believe that fractional reserve banking creates the necessity for indefinite economic growth which leads to environmental destruction and depletion of natural resources especially when coupled with population growth.[29][30]