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Removing bank subsidies leads inexorably to full reserve banking

Musgrave, Ralph S. (2013): Removing bank subsidies leads inexorably to full reserve banking.

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The recent banking crisis laid bare a long standing and inherent defect in fractional reserve banking: the fact that fractional reserve is unlikely to work for long without taxpayer backing. Changing bank regulations in such a way that banks are never a burden on taxpayers leads inexorably to full reserve banking. Full reserve involves splitting the banking industry into two halves. A safe half where depositors earn no interest, but they do have instant access to their money, and a second half in which depositors do earn a dividend or interest, but instant access is not guaranteed and depositors bear the losses when the investments or loans to which their money is channelled go wrong. Whether the second half counts as “banking” is debatable. Also whether that split is within banks or involves splitting the banking industry into two different types of institution is unimportant. It is virtually impossible for a full reserve bank to fail, thus there is no implicit taxpayer subsidy of such banks. As to the safe half, deposits are not loaned on or invested, thus the relevant money is not put at risk. And as to the “investment” half, if the value of the relevant loans or investments fall, then depositors lose in the same way as investors lose given a stock market set back. And stock market set-backs do not cause the same sort of crises as bank panics. The reduced amount of lending based economic activity and increased amount of non-lending based activity that results from full reserve is an entirely predictable result of removing bank subsidies. Far from reducing GDP, removing subsidies normally increases GDP, and there is no reason to suppose GDP would not rise as a result of removing bank subsidies: i.e. switching to full reserve banking. Section I sets out the argument, and section II deals with some common criticisms of full reserve banking.

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