Musings on Fractional-Reserve Banking in a Bitcoin Age; Physicalist Shock Absorber Metaphors

I’ve been fascinated with the inter-Austrian debate on fractional-reserve banking for years.¹ My view has long been that fractional reserve freebanking (FRB) is not inherently fraudulent and should not be illegal; but that economically it makes no sense. I think Huerta de Soto’s Roman legal analysis of irregular deposit warehouse banking is correct,² and that there is a distinction between the savings/warehousing function and credit intermediation. (Thus, our UK banking system reform proposal from a few years back.)³

I believe gold or commodity money is closer to ideal money than fiat, and better in many ways. I also think that a 100% reserve gold standard is superior (economically and financially) to a FRFB gold system. I also think that we are likely to have a digital money in our future since it is, like gold, better than fiat, as money, and it’s even better than gold in most respects; it is even closer than gold is to an ideal money. I also think there will only be one winner standing in the digital money competition, and that it’s likely to be BTC. In a 100% reserve BTC world I suspect both types of banking would largely disappear, or at least change radically.

For instance, custodial or savings would no longer needed since self-custody will be easy. Even if custodial storage of one’s BTC is used for convenience, the cost is basically nil so the custodian would likely do it for free, instead of charging the warehousing fees that FRFBers argue would have to be charged and thus would necessitate FRFB so that interest could be earned to offset this cost. Thus, there would be no need or temptation for a BTC custodian to start resorting to lending and rehypothecation. As an example, Coinbase doesn’t charge a storage fee, I believe, and is also 100% reserve.⁴ Moreover, while Coinbase seems to operate on a digital version of the irregular deposit model (in which funds are commingled), it is not so clear BTC custodians really need to do that. In a world of physical money such a gold, the cost of regular deposits—basically, safety deposit boxes—is higher than irregular deposits so customers and banks would tend to prefer the latter. But with digital money perhaps a BTC custodian could segregate all its customers’ accounts so that there is no commingling, a regular deposit approach that is basically the same near-nil cost as the commingling approach Coinbase uses now. But the point is it’s easy to image that any BTC custodial services would remain 100% reserve, whether employing irregular or regular deposits, and would have extremely low or near-zero fees and costs. So if the warehousing or storage function of banks persists in a BTC world, it will be different than what we are used to.

As for credit intermediation, with the change in character and habits that will accompany a deflationary world, where people save more and are less spendthrift, and also much richer, it’s easy to imagine the entire institution of lending and credit radically shrinking, or possibly almost disappearing. Instead of borrowing money to buy a home or car, people might just rent and save up first and then pay cash. People would hold some of their wealth in the form of money (BTC), since its value would appreciate over time (price deflation), with a growing economy and a fixed stock of money; but not everyone would want to keep all their money in cash—they would want some of their wealth in other vehicles, either for diversification, or in hopes of earning returns greater than the default deflation rate. If businesses and individuals stopped borrowing money and selling bonds, as suggested above, then people seeking to reduce their cash holdings could not loan it as there would be no takers. But you could invest in productive assets: buy stocks, real estate, invest in local business ventures, and so on.

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In any case. This is not really what I had intended to talk about, but I wanted to set the stage. A few months ago I had a thought and sent it off to a prominent freebanker. I didn’t hear back, but have polished those comments a bit and post them here.

Dear X—

I thought of a physicalist metaphor for an aspect of the argument for FRFB. Imagine a rigid car with solid wheels (metal or wood, say). It would be very stiff since it has no shock absorbers, and would respond violently to shocks like potholes. Now, when you have shock absorbers, the car has to be raised off the ground a distance, the travel, so that the wheels/tires can go up and down in response to fluctuations on the pavement. But in a rigid car since there are no shock absorbers, you need no travel. Thus there is no reason to raise the chassis high off the ground. It could be very close to the ground, like 1″, since there is no travel.

So it’s clear that if you don’t like the bumpy ride, and you want to add shock absorbers, you need to raise the car body up a foot or two for the travel of the shock absorbers. You need clearance. Now raising the car up has some costs: it is more complicated, takes more material, raises the center of gravity and thus makes the car less stable, and so on. But it’s generally considered to be worth those costs for the smoother ride and better road traction and handling.

The FRFB system conceived as Dali’s Giraffe-elephants

It occurs to me that the shock absorbers in this physical vehicle system are analogous to how freebankers conceive of the function of the FRFB system, which can expand or contract the money supply (analogous to the upward or downward movement of the shock absorber) in response to demand changes (analogous to potholes or bumps). But to do this you need clearance from 100% reserve level. Otherwise you could only expand the money supply, but you could not contract it. So to transition from a 100% reserve system which is too rigid to response to shocks to the economy (or so freebankers and Keynesians seem to think) to a functioning FRFB system that has the flexibility to more better handle changes in the demand for money, you have to have an initial inflationary period when you go from 100% to, say, 10% reserves. Instead of raising a car 18″ off the ground for its suspension travel, you expand the money supply by a factor of 100. That’s an awful lot of travel. Reminds me of Dali’s elephants.

So now we have a system that is elevated off the ground (it’s not fully 100% backed) so as to allow for shocks to be absorbed. This allows in the case of the car a better ride or more efficient running and in the case of the economy/financial system, it allows various efficiencies too since it permits money demand to be more efficiently accommodated–without having to change money prices, instead you just quickly inflate or deflate the money supply by changing the reserve ratio up and down around some more steady state rate (say, it fluctuates between 12% and 8%, around a natural level of 8%, which is akin to how a wheel on a shock works–it goes up and down for bumps or potholes but the car keeps an average clearance distance from the road). Now—and here is where the metaphor breaks down—though I do think shock absorbers serve a real need, I am not persuaded that there is any “problem” faced by a 100% reserve system that a FRFB needs to solve, or that it could solve even if it were a problem. But I think perhaps this mechanical metaphor might help explain what its proponents see is the good it does. Just a thought.

1. See The Great Fractional Reserve/Freebanking Debate (Jan. 29, 2016); Fractional-Reserve Banking, Contracts of Deposit, and the Title-Transfer Theory of Contract (Aug. 12, 2009).  [↩]
2.  Huerta de Soto, Money, Bank Credit, and Economic Cycles. [↩]
3. UK Proposal for Banking Reform: Fractional-Reserve Banking versus Deposits and Loans (Sept. 14, 2010). [↩]
4. On Coinbase, Bitcoin, Fractional-Reserve Banking, and Irregular Deposits (July 12, 2022). [↩]