This post is a response both to several of Ron Paul's arguments against fractional reserve banking and a series of tweets between David Andolfatto and I. I'll take his invitation and tell him, and everyone else, what I think informed citizens should think.
The way the banking system works is not a secret. Banks loan out their deposits. They use the interest they charge on these loans to pay interest to their depositors, to fund their operations, and to make a profit. Banks are required to retain assets that exceed their obligations.
Depositors cannot really lose money if a solvent bank encounters a liquidity crisis. So long as the bank is solvent, their capitalization can compensate depositors for the loss of use of their funds until loans are repaid. So long as the bank does not make too many bad loans, the depositors will be fine, even without insurance.
Some Libertarians have argued that all fractional reserve banking is inherently fraudulent and have even argued that any fair society would prohibit the practice entirely. This is nonsense. The system is not a secret. Anyone who does even a small amount of research can learn how banks work. The idea that two people who want to enter into a particular financial arrangement should be prohibited from doing so is entirely un-Libertarian.
Another argument is that fractional reserve banking is fraudulent in practice because banks don't disclose what they do with deposits when people open an account. This argument is, frankly, silly. When McDonald's sells a cup of coffee, they don't explain the precise risk of burns that it creates and what types of burns it can create with what type of exposure. Just as McDonald's can't include a medical education with a cup of coffee, banks can't include a financial education with every bank account.
Even in an ideal world, people wouldn't need to understand every detail of the contracts they enter into and the agreements they make. It's a common Libertarian objection to laws that we are all presumed to know them all, something that would be everyone's full time job were we to actually try to meet that presumption. The more a system can "just work" without people needing to understand how it does things the better, so long as that information isn't hidden from those who really do want to know. Those who wish to do so are free to distill this knowledge into convenient to digest form and provide it to anyone who wants to know more.
A more moderate position is that fractional reserve banking is a bad practice and that in an ideal society it would not exist. I've never found this argument persuasive. There exists a continuum from stuffing your money into a mattress to giving seed money to a new startup. It seems to be an inherent rule that greater returns are possible with, and only with, greater risk. Zero risk might be right for a few people some of the time, but I can't see how it would be the norm that most people would prefer most of the time. Fractional reserve banking seems to be a pretty good point on this continuum.
I don't mean to argue that we have a perfect system and there's nothing we should change. If you've read my War on Cash series, you know that I am definitely not happy with many aspects of our financial system. But fractional reserve banking is not the problem.
