Economist Larry White at George Mason University submitted a thought-provoking written testimony the other day. Discussing the issue of fractional reserve banking before the House Subcommittee on Domestic Monetary Policy and Technology, he made the following claim:
For payment by account transfer, FRB offers a more economic way of providing payment services. A money warehouse or 100% reserve institution could also offer payments by account transfer, but its services would be significantly more expensive. The other bank payment instrument, redeemable banknotes circulating in round denominations, simply cannot exist without fractional reserves. Banknotes are feasible for a fractional-reserve bank because the bank doesn’t need to assess storage fees to cover its costs. It can let the notes can circulate anonymously and at face value, unencumbered by fees, and cover its costs by interest income. An issuer of circulating 100% reserve notes would need to assess storage fees on someone, but would be unable to assess them on unknown note-holders. There are no known historical examples of circulating 100% reserve notes unemcumbered by storage fees.
I admit I have not read enough economics to be conversant on the topic of free vs. full-reserve banking. My initial thoughts are that the deposit contract with a fractional reserve bank cannot really be called a contract (more of a gamble). But I do not doubt, as Dr. White proposes later in the testimony, that fractional reserve banks would be fully capable of discovering and adjusting the level of reserves necessary to ensure full redemption on demand.
But regarding the quote above, I cannot find reason to disagree with White in that banknotes are not feasible without fractional reserve banks. However, I do not understand why banknotes need to exist at all.
In other words, why cannot individuals simply carry around coins with which to make transactions, keeping the bulk of their funds in full-reserve warehouses? When they want to make a major purchase, they write a check, thereby informing the warehouse that they have transferred funds. This form of “account transfer” would not be expensive as White suggests. It can easily be done electronically in a matter of seconds. Indeed, we do it every day at the ATM.
Of course, individuals would only pay a fee for what they have in the warehouse, and not other money that they possess. This removes the difficulty with assessing storage fees for money warehouses and retains a full reserve system that I suspect (at the moment) is the only system that retains the legitimacy of the deposit contract.
White cites this as a defense of fractional reserve banking. But if it is not the case that the banknotes created by fractional reserve banks are any ‘easier’ than carrying around a few coins, does his defense fall apart? Yes, banknotes make transfer of funds easy once you presuppose the existence of fractional reserve banks. But that presupposition is what I am questioning.
It is possible that I am missing some important relevant points. It wouldn’t even surprise me that I am making some gross oversights. But these are my initial thoughts, and ones that I will try to develop further in the future. I welcome any input, questions, or corrections.