December 10, 2023

Murphy Baffled: Government or Fractional Banking?

In monetary economics, there have been two sides of banking, one that supports full reserve banking and the other that supports fractional reserve banking. This debate is now central in Austrian Economics which I have already discussed in my essay on this site.

The inspiring works on free banking from prominent scholars like George Selgin and Lawrence H. White received wide acceptance and praise in Austrian Economics. Free banking school made their position in Austrian Economics with much acceptance from prominent economists. But, there have been some that oppose it and one of them is Robert Murphy.

Now, there are different arguments against fractional reserve banking. Rothbardians prefer to say that it is “fraud” which is an easy escape too. With this, the argument based on economics is avoided and completely based on jurisprudence. But, Robert Murphy is different out here, he has clearly stated that he doesn’t want to argue on that basis and probably is himself not a fan of the “fraud” argument.

Murphy wants to argue based on technical economics. Primarily it is Hayek’s Business Cycle theory that he puts forth based on which Hayek too opposed Fractional Reserve Banking and so did Rothbard. But, the business cycle according to the Austrian Theory occurs when there is an expansionary policy that would artificially lower the interest rate below the “natural level”. At the natural level of interest rate, the money supply is equal to the money demand directed by market forces.

In a free banking system, there would be competition, banks can’t expand recklessly otherwise their currency would devalue and people will start preferring other banks over them. Banks in this case unlike monopoly central banks are restricted to adopt expansionary policies. The money supply will increase (supply curve shifts) only when there is an increase in money demand (shift in the demand curve). So the natural rate of interest would still be maintained with the purchasing power of the currency or the price level would remain stable.

Fractional Reserve Banking induces more economic activities that lead to more money demand than it would be if their full reserve banking. M1 in this case which is the supply of money would be equated with the demand of money and not M0 which is the total currency issued. So, the claim that fractional reserve banking would cause a business cycle is a big one and needs more justification and evidence.

After this, his next major concern is bank runs too. This is probably something many fear and maybe fractional reserve banking supporters would too to an extent. But, I had addressed this issue in the essay too saying that a bank failing because of bad management is a sign of good capitalism. The field of business studies (management, marketing, finance, etc..) cannot be mixed with the science of economics. There is indeed a risk of bank runs but that lies on the responsibility of each bank or central bank would take responsibility of all. The former case is relevant to a free market economy. Every firm will have uncertainty which is an important phenomenon of microeconomics. This lies for all sectors in a free market economy. More risk more gain.

Murphy’s other problem with FRB is that it creates money from “thin air”. With the multiplier effect, more money is in the economy than was issued. This means that there is a difference or a huge difference between M1 and M0. This is also a regular argument by those who oppose FRB. But it should have been rather acknowledged that FRB carries fewer resource costs.

Like, if we take full reserve banking backed with gold then that would carry greater cost. It would be a significant part of the national income that would be used in the monetary processing of the economy. But, same way if there is 10% reserve banking then the cost would go down by 10 times. So 100% reserve banking can consume a good part of national income, estimated at 1-3% which isn’t a small number. On the other hand, Fractional Reserve banking adds more to the economy as it induces more investment and more growth.

But, let’s assume that Murphy is right in his claim. He is not the only one to claim that FRB is unstable and giants like Fisher and Freidman have supported this. But also there is a need for a reminder to readers that Murphy is an anarchist (or more accurately anarcho-capitalist). Now, what needs to be explained is how an anarchist claims to avoid FRB in a free banking system. I have already shown in my essay that in a free market banking system with consumer sovereignty, there would be FRB that would win. Also, history says that 100% reserve banking couldn’t prevail without the imposition of government.

So the real question is how Robert Murphy would avoid FRB. Even if it’s economically unstable then what is the way to stop it? History says free societies have adopted free banking with FRB (have succeeded too). Hayek said that government should regulate but Murphy can’t do the same. So, what is the solution to this problem, so does the problem lies in the free market that Murphy has been supporting for years? This needs clarification more importantly than any further arguments against FRB.

Lastly, it would irrational to call FRB fraud too because as long as depositors are agreeing by signing the contract there is no fraud happening. Also, it’s no secret as to what banks do with people’s money, many are well aware of it but they accept it because they know that’s how banks earn revenue and survive and also give part of the revenue to depositors as interests. Or simply that banks borrow money from depositors and pay them interest for it and then further loan it to the borrower asking higher interest rate.

So, overall this argument over the banking system from a free-market perspective seems weak from full reserves or more accurately it is simply naïve. It seems like Robert Murphy is trapped in his prison but this problem would be solved easily for him if he either adopts the popular fraud argument or simply keeps aside his anarcho-capitalism ideology.

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