My paper delivered at the Mises Canada Conference on Prices and Markets

Toronto Prices and Markets Conference

November 7 - 9, 2014

The First Step to Returning to Sound Money:

requiring 100% reserves on bank demand deposits

by Patrick Barron

The most important characteristic of sound money is that it is backed one hundred percent by reserves. Let us acknowledge that the fiat money that we all use is comprised of pieces of paper in our pockets and demand accounts in banks. We may access our demand accounts in banks via paper checks, electronic debit cards or some other means.

Two Ways for New Money to Enter the Economy

In the fiat system we currently live in there are two methods by which new money enters the economy. In the first method, the Fed conducts open market operations in which it buys an asset with money it creates out of thin air. It pays for these assets with money that it creates out of thin air.

Once created, most of these new fiat dollars end up as reserves in the banking system and will remain there until the Fed sells some asset in a reversal of its prior open market operation. It can sell the asset only by offering it at a price low enough to entice buyers, which may mean raising the interest rate.

The second method by which money can enter the economy is via bank lending. Under the present fractional reserve banking system, one dollar of new reserves can be pyramided into around ten dollars of new money.  The bank credits a demand account when it makes a loan. This money was created out of thin air by the banking system. Historically, banks have created more money via their lending operations than the Fed has via open market operations, because each dollar of new reserves can create multiples of new money via bank lending

The Explosion of Excess Reserves

Prior to the Fed's unprecedented expansion of base money in 2008, there were very few excess reserves in the banking system. The banks quickly expanded lending--and, thus, the money supply--to convert any new, Fed produced excess reserves into required reserves. Banks simply used their reserves to the fullest in order to make more money.

 Unique Opportunity to Mandate One Hundred Percent Reserves

To stop inflation in the Austrian sense--i.e., stop the increase in the money supply--requires two things. First, the Fed must stop increasing reserves. Second, the banking system must stop pyramiding these reserves into new money. Both must be stopped, but ending fractional reserve banking addresses the most immediate danger, because the banking system capacity for increasing the money supply is many times that of the Fed's capacity for manufacturing new reserves.

However, there is a new, bigger danger now. Whereas in the past total reserves were very low and there were almost no excess reserves in the banking system, today the numbers are growing each month. As of October 15, 2014 excess reserves amounted to $2.693 trillion.  The ratio of required reserves ($.132 trillion) to bank demand accounts ($1.615 trillion) was 8.2%.

If the banking system utilizes these excess reserves as efficiently in the future as it has in the past, checking balances could increase by twelve fold for each dollar of excess reserves.  But it gets worse.

Checking balances could go from $1.615 trillion to $34.456 trillion (($2.693 trillion/8.2%) + $1.615 trillion). If we add the $8.619 trillion of savings, money market accounts, and small certificates of deposit to the mix of reservable liabilities, the ratio (i.e., required reserves/reservable liabilities) drops to 1.29% (($.132 trillion/($1.615 trillion + $8.619 trillion)) from 8.2%.  Total bank deposits that effectively can be withdrawn upon demand would increase by 77.5 fold for each new dollar of reserves!!!! This means that total reservable liabilities could go to $219 trillion (($2.693 trillion/1.29%) + $1.615 trillion +$8.619 trillion).  Therefore, excess reserves of this proportion are a ticking time bomb of monetary inflation.

The Realization Rothbard's Deposit and Loan Banks

The obvious way to end fractional reserve banking is to raise the reserve from its current, multi-tiered, complex system to requiring one hundred percent reserves. Fortunately, the Fed's expansion of excess reserves has given us an opportunity, that may be fleeting, to divide the banking system into deposit banking and loan banking and require one hundred percent reserves on deposit banking.  Total bank reserves are greater than bank demand deposits...$1.615 trillion of demand deposits and $2.825 of total bank reserves.  The Fed could require that the new deposit banks maintain one hundred percent reserves on their current level of demand deposits without creating more reserves. The deposit banks would not be allowed to lend their demand deposits. Demand deposit customers would pay the deposit bank for money transfer services. The banking system's other deposits of savings, money market, and certificates of deposit would move onto the liability side of the loan bank.  The loan banks assets would be its loans and investments.  The deposit bank's assets would be fiat money reserves.  The deposit bank would make its money through fees alone. It would not be allowed to  invest its customers' deposits. Customers' savings, money market, and certificate of deposit accounts at the loan banking side would be backed by its loans and securities, the size of the bank's capital account, and the banker's reputation. These non-demand, savings and time accounts would be seen for what they really are: loans made to the bank.

Enforcing 100% reserves on bank demand deposits would mean that the banking system would be defined by the following equation:

Bank demand accounts = Bank reserves (cash in bank vaults plus reserve accounts at the Fed)

Adding "cash held outside bank vaults" to both sides of the above equation gives this result:

M1  = The Monetary Base

  

Transition Issues

The transition from our current system--in which demand accounts are mixed with time accounts and both are lent or used to purchase securities, which results in multiple owners of demand funds--will require some time to sort out. Here are five such issues:

1. Currently the public expects that savings, money market, and some short term certificates of deposits may be redeemed upon demand with no loss of principle and some insignificant loss of interest, just as it expects to redeem checking deposits upon demand. This will not be the case when these deposits are moved to the loan bank. There may be some overnight financing of trade, for which the depositor might earn interest, but most deposits in the loan bank will carry a longer maturity, so that the banker can conduct proper asset/liability management; i.e., ensuring that his loans are being repaid at approximately the same time as his deposits mature, so that he can meet his depositors' possible withdrawal of funds.

2. A corollary of the above issue is the possibility that, prior to the imposition of 100% reserves on demand deposits, current holders of savings and money market accounts may choose to move some of these funds into their demand accounts in order to ensure that the deposits are backed by fiat reserves. They would conclude that the current interest rate on these funds is insufficient to entice them to leave them in the loan bank, secured by loans of unknown quality. Savings, money market, and small certificates of deposit comprise $8.619 trillion as of October 15, 2014. There are not enough excess reserves in the system at the present time to back all these deposit funds by fiat reserves. Nevertheless, the banking system would still have $1.210 trillion in excess reserves after requiring that all demand accounts be backed one hundred percent by reserves ($2.825 trillion of total reserves minus $1.615 trillion of demand accounts). So, the banking system could absorb the public transfer of roughly one trillion of its roughly eight trillion dollars of savings and money market accounts into the deposit banks. Then, the loan banks would have to entice the rest of the depositors not to switch by raising the rate paid on their deposits. It would have $10.675 trillion in loans and securities as assets (per www.federalreserve.gov/releases/h8/current/), which should yield sufficient income to entice current holders of savings and time deposits to leave their funds in the loan bank. The other way to resolve this issue would be to have the Fed create the necessary excess reserves and give them to the banking system. This remedy was suggested by Professor George Reisman at the Mises Circle in Newport Beach, California in 2009.

Regardless of the mix of demand deposits to savings deposits after the one hundred percent fiat reserve requirement becomes law, all excess reserves must be removed from the banking system and the public must understand that normal commercial law will require that only demand deposits are backed by reserves.

A demand deposit must display all of the following characteristics:

a. The balance in the deposit bank does not earn interest, because the banker cannot lend the money to someone else.

b. The depositor pays fees for the deposit bank's services.

c. The balance of the account must be instantly redeemable at full face value upon demand.

d. The redemption does not require prior notice to the bank.

The deposit bank's demand deposits must equal its reserves, whether held in the form of cash or as a deposit at the central bank. A new loan could be made at the loan bank only after repayment of an existing loan or a decision by a holder of a demand deposit to transfer some of his money to the loan bank in order to earn interest. In other words, loans must be funded out of a prior act of saving and not from fiat money creation.

3. The loan side of the banking system may sustain losses in the near term, since the interest rate charged to borrowers cannot be adjusted upward on most loan contracts in order to pay for the probable increase in deposit rates required to entice savings and time depositors to keep their funds in the loan bank. The loan banks would have some reduced costs, such as the expense of paying for the money transfer and settlement system--checks, debit cards, etc. These services would be transferred to the deposit bank, where the depositors pay fees for all services. Plus, the FDIC would be liquidated, so neither deposit nor loan banks would incur that expense or the expense of paying for periodic FDIC examinations. In the long run, after the system has stabilized, the market would determine both loan and deposit rates, and only the most astute bankers would survive and prosper.

4. Legislation is required to mandate 100% reserves on demand deposits. Such legislation would finally correct the underlying error that has plagued the banking system for two hundred years; i.e., the series of court cases in England--Carr v.Carr (1811), Devaynes v. Noble (1816), and Foley v. Hill and Others (1848)  that ruled that a deposit is a loan to the bank and not a bailment.

5. Stopping the money printing presses most likely will trigger a severe recession, as those non-wealth generating, bubble activities, which are supported by a continuing source of new money will collapse and be replaced over time by real wealth generating activity. But one should not conclude that it was the stopping of the money printing presses that created this situation. Money printing produced the bubble activities that must be purged at some point, either earlier, when we have some control over money matters, or later following a general, catastrophic economic collapse.

Conclusion

The Fed has created an opportunity to make the move to 100% required reserves on demand deposits. The banking system would be divided into deposit banks, which would hold only demand deposits and for which the 100% reserve requirement would pertain, and loan banks that would act as fiduciary intermediaries for those seeking to invest their excess demand funds. We would have an honest banking system under the same rule of commercial and criminal law as all other commercial enterprises. As long as deposit bankers kept 100% reserves, the money supply could neither shrink nor expand. Loan banks would disclose that their liabilities were held at risk, which is no different than buying a stock or bond. Reputable private auditors would ensure that deposit bankers were following the 100% reserve rule and that loan bankers were not operating a Ponzi scheme. Ordinary district attorneys would enforce the law, eliminating the need and expense for government regulators and deposit insurance. Stockholders would be subject to unlimited liability for fraud.

This proposal deals only with ending the banking side of money inflation. The next step would be to ensure that no entity can manufacture fiat reserves out of thin air.  Either the Fed itself would be prohibited by law from doing so, via its open market operations, or Congress could abolish the Fed and establish some agency to insure that the now fix supply of money is backed by the government's gold reserves at whatever price is required to back all of M1 by the Fed's 261.5 million ounces of gold. At that point anyone could take gold to this agency and get dollars at the fixed rate or take dollars to this agency and get gold at the fixed rate. Once the public understands the true nature of money as something that has legal backing to a commodity at a contract rate--such as the dollar to gold ratio of $35 per ounce, as established at Bretton Woods--it would understand that any trusted agency could produce money, not just governments. At that point legal tender laws could be abolished and money production would be privatized and governed by normal commercial and criminal law. Sound money would have returned to its rightful place in the market.