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Banks, Central Banking and Economic Instability

June 30, 2012

Oral Argument at Hearing entitled “Fractional Reserve Banking and the Federal Reserve: The Economic Consequences of High-Powered Money” Thursday, June 28, 2012
Domestic Monetary Policy and Technology by John P. Cochran. Full testimony and video of proceeding at http://www.financialservices.house.gov/Calendar/EventSingle.aspx?EventID=300542 .

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, as a major source of financial and economic instability. Credit created by fractional reserve banks, credit extended beyond what could be supported by actual savings, while initially appearing beneficial ─output and employment increase in areas supported by the expanding credit─is unsustainable and will end in a bust. A secondary consequence of the bust is a financial and banking crisis─the bank run and associated panic. 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 misguided. Per Vera Smith (1990 [1936], 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, …

Recent research supports her conclusion. Compared to the pre-Federal Reserve era, the Fed has failed to provide the promised stability and 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% of a 1913 dollar. Selgin, Lastrapes, and White 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 ….

Fractional reserve banks developed from two separate business activities: banks of deposit or warehouse banking offering transactions services for a fee, and banks of circulation or financial intermediaries. Circulation banking if clearly separated from deposit banking, reduces transactions costs and enhances the efficiency of the capital markets, leading to more savings, investment, and economic growth. Fractional-reserve banking combined these two types of banking institutions into one—a single institution offering both transaction services and intermediation services. With the development of fractional reserve banking, money creation, either through note issue or demand deposit expansion, and credit creation became institutionally linked.

Banks create credit if credit is granted out of funds especially created for this purpose. As the loan is granted, the bank prints banknotes or credits the debtor on deposit account. It is creation of credit out of nothing” (Mises pdf p. 194). Created credit is “credit granted independently of any voluntary abstinence from spending by holders of money balances.”


The existence of a central bank with the ability to create high-powered or base money is a necessary prerequisite for excessive credit creation and the resultant boom–bust cycle. While 100% reserves could eliminate or reduce boom-bust cycles and eliminate the threat of bank runs and panics, boom-bust business cycles are really a phenomenon of central banking, not of fractional-reserve free banking per se.

Without a central bank, credit creation by fractional reserve banks would be limited in extent. Large misdirection of production caused by credit creation require either newly created base money or the promise to create new base money in the event of a crisis by a central bank.

During a period known as the Great Moderation, roughly 1982-2000, the U. S. economy experienced a period of apparent relative stability and prosperity. The U. S. economy was then buffeted by two boom-bust cycles tied directly to credit expansion and low interest rates. While much of the discussion following the recent crisis focused on why the recovery has been so slow, a lesson that should have been learned is that a credit driven artificial boom cannot last. High-powered money driven credit expansion enhanced by the money multiplier is a major destructive power that misdirects production, falsifies calcu­lation, even in a period of relatively stable prices, and destroys wealth. Policy-induced booms tend to piggyback on whatever economic development is underway. The interest rate brake which would normally stop such events before they turn into bubbles and booms is effectively neutered by credit creation, thus booms and busts remain a significant threat in the current policy framework.

Central bank response to the most recent crisis has moved in the direction of greater, not lesser central bank involvement in the economy. Recent trends are troubling. John B. Taylor recently reported that the Federal Reserve purchased 77% of the net increase in the debt by the Federal government in 2011. The Fed is moving from monetary policy to a “Modustrial Policy, a policy environment that is not a monetary framework. It is an intervention framework financed by money creation. The current Fed is engaged in picking winners and losers, crony capitalism, and thus becoming a gigantic financial central planner.

These trends make a return to sound money which “involves abolishing central banking and paper fiat money and restoring a commodity money chosen by and totally subject to the market” (Salerno, Money: Sound and Unsound, p. 474) imperative.

Fractional reserve banking supported by a central bank is the cause of boom-bust business cycles. Both the 2000 dot.com bust and the 2007-08 financial crises and Great Recession were policy induced boom-busts. Elimination of this source of instability requires monetary reform such as H.R. 1094 which is most consistent with reforms recommended in the written testimony. H. R. 4180 would be a strong improvement over current Fed operations as would H. R. 245, but both of the these would while improving monetary policy, still leave the economy subject to boom-bust cycles as monetary policy would still not prevent boom-bust which piggy-back created credit driven unsustainable growth on top of productivity driven sustainable growth.

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