100% Reserve Banking — The History

April 26, 2014

So both John Cochrane and Martin Wolf are advocating 100% reserve banking. If these two agree on anything, it’s worth taking seriously! (It’s pretty amazing how advocates for narrow banking come from across the political spectrum.) We have some thoughts on banking and private money creation, but you’ll have to read our book to figure out what they are.

Instead, we wanted to provide some history behind the idea. One of the greatest economists of the 20th century (indeed, in our view, perhaps the greatest), Irving Fisher was a strong supporter of the so-called Chicago Plan which would implement 100% reserve banking. Here is a link to the one of the original documents from 1939. The Chicago Plan economists were living in the shadow of the Great Depression, and it had a very strong influence on their thinking.

Some of the document is a bit hard to get through, but we recommend starting on page 14 where the section entitled “The Fractional Reserve System” begins. The economists pulled no punches:

“A chief loose screw in our present American money and banking system is the requirement of only fractional reserves behind demand deposits. Fractional reserves give our thousands of commercial banks power to increase or decrease the volume of our circulating medium by increasing or decreasing bank loans and investments. The banks thus exercise what has always, and justly, been considered a prerogative of sovereign power. As each bank exercises this power independently without any centralized control, the resulting changes in the volume of the circulating medium are largely haphazard. This situation is a most important factor in booms and depressions.”

And here is the core of their proposal:

“Since the fractional reserve system hampers effective control by the Monetary Authority over the volume of our circulating medium it is desirable that any bank or other agency holding deposits subject to check (demand deposits) be required to keep on hand a dollar of reserve for every dollar of such deposit, so that, in effect, deposits subject to check actually represent money held by the bank in trust for the depositor.”

Another excellent read is from Ronnie Phillips entitled “The ‘Chicago Plan’ and New Deal Banking Reform.” He goes through the Chicago Plan and shows just how close it was to being implemented. It’s pretty amazing for many reasons. The idea had a lot of support. Henry Wallace, the Secretary of Agriculture handed the plan over the President Roosevelt in 1933 and wrote the following:

“The memorandum from the Chicago economists which I gave you at [the] Cabinet meeting Tuesday, is really awfully good and I hope that you or [Treasury] Secretary Woodin will have the time and energy to study it. Of course the plan outlined is quite a complete break with our present banking history.”

Phillips also has some quotes from FDR and others during the Chicago Plan debate that are absolute gems. Check this one out from President Roosevelt:

“I wish our banking and economists friends would realize the seriousness of the situation from the point of view of the debtor classes — i.e., 90% of the human beings in this country — and think less from the point of view of the 10% who constitute the creditor classes.”

And another one from Senator Bronson Cutting of New Mexico:

“The fight against the abolition of the credit power of private banks will be a savage one, for their power as a unit is without equal in the country.”

Sound familiar?

Phillips goes through the politics of the Chicago Plan, and why it didn’t end up getting passed. It is a fascinating read that even involves the unexpected death of a Senator that supported the plan. We won’t ruin it for you — just go read it.

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10 Responses to 100% Reserve Banking — The History

  1. Gerard Caprio on April 26, 2014 at 4:11 pmi

    A seductive idea, until you recall that (a) the entire history of banking has been a move away from this extreme; and (b) the boundary problem in finance. The implication is that as funds leave a narrow banking sector in search of higher yields, the non-bank financial sector will grow vastly larger. The likelihood is that a larger NBFI sector would be rescued — in other words, along with the funds that would migrate from the banking sector, would come the government guarantees. We were not ready to let GM or AIG fail, and the same would be the case for an AMEX that would be many times its present size. So, an attractive solution in a model, but not in the real world.

  2. Eric L on April 26, 2014 at 5:43 pmi

    So then where do debts come from? Loans can still be financed by selling their income streams as securities. Finance would look the way it was increasingly looking when the crisis hit. It’s not clear to me why that would be better. At least within the fractional reserve banking system there is a limit to the total allowed leverage, whereas the economy can become arbitrarily leveraged through other forms of finance. And the fact is the danger to fractional reserve depositors proved non-existent. The problems were for debtors and for non-fractional-reserve financiers. If any form of banking is to be banned, we should prohibit lending from anything other than fractional reserve banking.

  3. Pipo on April 26, 2014 at 6:48 pmi

    I haven’t read the Cochrane paper (Wolf talks only about normal banks which is pretty weird) but I assume he allows large banks to still have access to fed funds and the discount window (otherwise how will the Fed conduct policy?).

    But then another problem emerges with this proposal, which is that it will absolutely destroy thrifts and S&Ls, who don’t have access to the equity or long-term debt that TBTF institutions do. As such they will have to make much more expensive loans.

  4. fresno dan on April 26, 2014 at 7:28 pmi

    Let me ask an obtuse question:
    If 100% reserve banking means a loan must be backed by a deposit (money in the bank) where does the excess money to loan come from?
    (if I deposit 100$, than the bank must keep it ‘in the bank’ – the bank can’t lend any portion of that deposit elsewise there would not be 100% reserve – correct? If the bank buys bonds and uses that interest to finance loans, wouldn’t a run on the bank put the bank in a position of taking losses on the bonds if forced to sell at an inopportune time?)

    • Kieth on April 27, 2014 at 10:43 pmi

      It’s only demand deposits (checking, savings, and anything having to be paid “on demand” to depositors) that have to be reserved 100%. Time deposits like CDs would create the funds to be loaned out.

      The biggest immediate impact to the individual bank depositor is that demand deposits would no longer pay interest, but would cost you money. No more free checking, but then it wasn’t free anyway. This creates no desire to hold excess cash in a demand account. To earn any interest on a bank account you’d have to put the funds into a time deposit account.

      With a system like that there is only one way for anyone to earn money on demand deposits. That’s if the Fed would accept deposits of bank reserves and pay interest on them.

  5. jck on April 26, 2014 at 8:37 pmi

    It should be called fractional capital banking because reserve requirements are backwards looking and in no way are a constraint to bank lending at least since basel 1.

  6. The Bogan on April 26, 2014 at 9:28 pmi

    Warren Mosler (who has a firm grasp of the monetary system) has commented on the Martin Wolf article: http://moslereconomics.com/2014/04/25/comments-on-martin-wolfs-banking-article/

    Marshall Auerback also had a piece on the Chicago Plan a while ago too: http://macrobits.pinetreecapital.com/the-chicago-plan-does-not-deserve-to-be-revisited/

    So, basically, it would cause massive deflation.

  7. csissoko on April 27, 2014 at 2:43 pmi

    The 100% reserve solution fails to take into account the economic function of banks.

    I have a theory of money, banking, and economic performance, expressed in this paper, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2392098, which argues that modern economic growth was made possible by the maturing of banking in late 18th c. Britain. This evolution created an environment where incentives were carefully aligned to enable the private sector to issue “safe” assets abundantly, and allow a vast number of individuals to overcome the liquidity constraints that characterize most of our economic lives. In short, I argue that the existence of a functional banking system is what makes neoclassical economics (with its complete absence of liquidity constraints) imaginable.

    In my view, the problem with modern banking is the destruction of the incentive structure that made the issuance by the private sector of “safe” assets incentive compatible. This destruction has taken the form of legal and regulatory changes, most of which took place from the 1980s on – and included dramatic changes to the concept of a “lender of last resort” and its duties. The “shadow” banking system is an outgrowth of these changes.

    While I can agree that continuing with our current financial system is a recipe for disaster, like the previous commenter, I have profound doubts that this solution is consistent with the rates of economic growth to which we have become accustomed in recent centuries.

  8. Carl on April 28, 2014 at 3:57 pmi

    It’s 100% reserve on demand deposits, not savings deposits. Savings provides the pool from which loans are made, and that’s why they pay interest. An initial creation of about $8 Trillion, cash, to cover both demand and savings deposits, then let the markets handle the allocations. Couple this with alternative currencies, to include the ‘Real Bills’ doctrine and you have dynamic monetary markets of choice.

    The point is achieving elastic economies of scale, curtailing predatory over production in order to capture markets and profits with its attendant misallocation of resources which is the inherent flaw of Capitalism fueled by fractional reserve lending (creating currency out of thin air).

  9. LetUsHavePeace on April 29, 2014 at 6:53 ami

    It might help to start at the beginning. What exactly are Reserves to be? Throughout American history there have been two basic answers: (1) Gold and silver Coin – which the Constitution itself specifies as Money and (2) Government Debt. Under the second system the bank’s obligation to pay out legal tender on demand only requires it to hand over a paper note (or digital representation) that says the Federal Reserve has issued and the U.S Treasury has printed a bill that is “legal tender for all debts public and private”.

    When banks and other businesses were obligated under the law to pay out coin on demand, the question of the level of reserves had meaning. Since the banks’ and other businesses’ notes were both understood to be promises to pay money and not money itself, the natural question was how solid was the promise? That question was asked and answered by discounting.

    In a world where all legal tender in every country is now a form of government debt, discounting becomes a circular chase. No wonder trading volumes have exploded. We already have 100% reserve banking in the sense that, ultimately, any bank with sufficient importance can assure the public that its relations with the central bank are sufficiently solid that people can have, on demand, as much paper as they desire (subject, of course, to the national security state’s oversight on dealings in cash).