Bitcoin and Fractional Reserve Banking

What would happen if Bitcoin became the base money of a fractional reserve banking system? Would it spell disaster for the anonymous crypto-currency? To answer this question, we have to look at the history of banking and the role government has played in both exacerbating and concentrating its risks.

In a previous post on the future of money, I looked at Bitcoin, a cryptographic peer-to-peer currency. Bitcoin’s core innovation, which sets it apart from any other digital currency, is the lack of a central authority to issue new money or to keep track of transactions. Instead, these tasks are handled by a distributed network over which nobody has total control.

There are currently 5.8 million BTC in existence, and one Bitcoin trades at $0.78 on the exchange market. Close to BTC 100,000 are sent in transactions every hour, and there are between 5,000 and 10,000 nodes connected to the network at any time. The total processing power of the Bitcoin network now rivals some of the most powerful distributed computing networks, such as SETI@home (8057 TFLOP/s according to BitcoinWatch.)

The Rise of the Bitcoin Banks

We are seeing the rise of one of the first viable internet currencies where nobody is control. The growth in size, payments and goods and services offered are evidence of this. However, the future of Bitcoin may look quite different to its origins as a cypher-punk geek project. One possible future was alluded to by Gavin Andresen, Bitcoin’s technical lead, in a recent interview for CIO Magazine:

In the future the Bitcoin payment network might be used only by major banks and financial institutions, with large-value payments made to “settle accounts” periodically through the day. Small transactions might be bundled up by the banks over proprietary payment networks, as is done now with Visa and MasterCard or bank debit-card payments.

However, this future scenario seems quite at odds with the stated goal of Bitcoin. According to Bitcoin.org, a reason to use Bitcoin is to:

[b]e safe from instability caused by fractional reserve banking and central banks. The limited inflation of the Bitcoin system’s money supply is distributed evenly (by CPU power) throughout the network, not monopolized by banks.

This might seem paradoxical: one the one hand, Bitcoin presents itself as an alternative to the global fiat-money banking regime, and on the other, it could be used to enable a version of fractional reserve banking by itself. My view of this is that the paradox is superficial: the kind of fractional reserve banking which might arise around Bitcoin is fundamentally quite different from the kind we have in the banking system today.

However, before I explain why, it’s worth taking a detour to examine the nature of the fractional reserve system today, and precisely why it is unstable, exploitative and unsafe for society.

The Fiat Fractional Reserve Banking System and its Discontents*

The heart of any fractional reserve banking system is the ability of depositors to withdraw their cash at any time, while banking institutions have simultaneously lent out this money as long-term loans. This fundamental tension within the banking system is possible only insofar as the majority of bank depositors don’t try to withdraw their money at the same time. The system can, under those circumstances, maintain the illusion that its customers’ deposits are “in the bank,” whereas what they really have is a promise by a bank to pay the depositor a certain sum of money, on demand.

With the rise of digital banking, electronic payments became more common, reducing the need for cash. This meant that it became even easier to transact in bank credit – the bank’s promise to pay money – rather than money. In fact, the two are so interchangeable nowadays that the distinction is hardly noticed. What’s more, banks can simply settle the differences between their accounts at the central bank, further reducing their need for actual cash at any given moment.

The folly of this system has been noted by no less than Mervyn King, the governor of the Bank of England, who called it a “poor advertisement for human rationality”:

“Eliminating fractional reserve banking explicitly recognises that the pretence that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not co-exist with risky assets.” (BBC)

The fractional reserve system’s alchemy enables it to extend credit to businesses, rather than use up a scarce supply of funds. The banks’ ability to lend is constrained only by its reserve requirements, and the market’s perception of its financial strength. This has certain advantages to businesses, who enjoy an abundant supply of credit in the good times, limited only by their ability to productively invest it. However, the system has some less fortunate consequences, as evidenced by the most recent banking crisis:

• The debt imperative. Since the majority of money in circulation is in fact bank credit, the overall level of indebtedness in the economy is close to the entire money supply. It is impossible for everyone to pay off their debts, as the money required to do so has to be introduced into the system as more debt. If people stop borrowing, the money supply begins to shrink, and there is less money available to service debt.
• Misallocation of credit. Problems arise when banks misallocate credit. Bank credit can be created to fuel harmful speculation, to manipulate markets, as well as to create asset bubbles. The positive feedback loop whereby banks continued to expand credit on the basis of rising house prices, which they were also causing, can have drastic consequences for the real economy. (The 2008 sub prime debacle is an obvious example).
• Exacerbation of the business cycle. The business cycle, whereby production expands and contracts, is exacerbated by banks extending too much credit (increasing the money supply) when times are good, and restricting credit too harshly (decreasing the money supply) when times are bad. Economic performance is affected by the money supply, which is in turn a function of banks’ often foolish lending.
• Usurpation of wealth. Because banks increase the money supply when they issue bank credit, and often do so in excess of the economy’s capacity to productively invest it, they create inflation. Such inflation erodes the value of savings, and is the reason why most fiat currencies have strongly depreciated since their inception. Furthermore, banks charge interest on practically the entire world’s money supply – a huge and seemingly arbitrary transfer of wealth from the productive economy to the banking system.

Returning to Bitcoin, we can see that a future scenario in which the above system is replicated would repeat its disastrous results. However, as I have already said, there are some reasons to believe that a fractional reserve system based around Bitcoin would be much less dangerous to the economy and society. To see why, we have to go back in history to the Free Banking Era in the United States.

The Free Banking Era (1827 – 1862)

The firm paid my wages in wildcat money at its face value. – Mark Twain

The Free Banking Era was perhaps the most interesting stage of American financial history. Between 1827 and 1862, responsibility for regulating banks was dissolved to the states, many of which pursued laissez-faire strategies, allowing unchartered banks to exist as long as they adhered to basic reserve requirements, capital ratios and interest rates. In all other respects, the states treated individual banks much like any other private corporation: they did not enjoy any special guarantees such as deposit insurance (though there were some voluntary schemes.) Banks were certainly never bailed out or prevented from collapsing. Most significantly: banks were not permitted to issue Federal reserve note money. Bank credit had to be extended in the bank’s own credit notes – often derogatorily referred to as “wildcat money” because of its precarious nature. Underlying bank credit was a promise that bank notes could be redeemed in specie – namely, gold or silver.

During this period, there was a large increase in the number of banks, as well as increase in the rate of bank failures. Bank money was recognised to be inherently risky, since no Government support existed to guarantee its value if the issuing bank failed to make good on its redemption promise, or went bust. Furthermore, because bank money wasn’t legal tender, nobody was forced to use it. This imposed a further discipline on banks: their money was only as good as the market’s belief in their financial strength. It was commonplace for bank notes to trade at a discount the further they travelled from their issuing banks. An industry of middlemen arose who bought up notes out of state and brought them back to redeem them – another source of constraint on the banks’ ability to issue credit.

While the conventional view of this period is one of instability and endless banking collapses, judged as a whole it was actually more stable than the system we have today. The reason is that risk was transparent: individuals entered into voluntary agreements with banks, which they knew carried risks. They were therefore more careful about where they placed their money. Banks in turn had to be more careful about how much credit they could extend, because they lived and died by the market’s perception of their financial position. While the system saw banks collapse around the edges, the structural integrity of the system was greater – its resilience lay in its diversity. Today, the inherent risk of fractional reserve banking is assumed by the entire system, and ultimately by society, should the entire edifice need rescuing from collapse.

Incredibly, this view of the Free Banking Era is supported by another famous central banker, Alan Greenspan:

Throughout the free banking era the effectiveness of market prices for notes, and their associated impact on the cost of funds, imparted an increased market discipline, perhaps because technological change–the telegraph and the railroad–made monitoring of banks more effective and reduced the time required to send a note home for redemption. (…)

Part of this reduction in riskiness was a reflection of improvement in state regulation and supervision. Part was also private market regulation in an environment in which depositor and note holders were not protected by a safety net. That is, the moral hazard we all spend so much time worrying about today had not yet been introduced into the system.

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