Is fractional-reserve banking inflationary?

A question asked by George Selgin at the Free Banking blog. Some members of the Austrian School, with the larest group being followers of Murray Rothbard, see three reasons for opposing fractional reserve banking:

1. They claim that banks resorting to it defraud people,
2. that they bring about business cycles, and
3. that their activities cause inflation.

Selgin's article addresses the last point. Selgin writes,

The “Rothbardians,” as I’ll refer to them, recognize two distinct meanings of the word “inflation.” One meaning—which they prefer—defines it as any increase in the nominal stock of money, including fractionally-backed bank deposits and notes (which they, following Ludwig von Mises, prefer to call “money substitutes”). The other, which is in common use today, defines it as any ongoing increase in the general level of prices, that is, as a positive rate of change in one or more broad price indexes, such as the CPI. In calling fractional reserve banking “inflationary” Rothbardians often seem to have the latter, more conventional definition of inflation in mind, and my arguments are mainly aimed at responding to their complaint so interpreted. However, in doing so, I also hope to clarify the extent to which fractional reserve banking does or doesn’t promote “inflation” in the less conventional and more strictly Rothbardian sense of encouraging growth in the (broad) money stock.

Perhaps the simplest way to assess the price-level consequences of fractional reserve banking is to first imagine an economy in which such banking is prohibited, as many Rothbardians insist it ought to be. Such an economy would admit 100-percent reserve or “warehouse” banks only. To simplify the comparison further, let’s assume that all exchanges are conducted using warehouse bank certificates: in other words, the reserve medium itself—let’s assume it’s gold—doesn’t circulate. The price level adjusts so as to equate the supply of and demand for gold, including bank reserves.

Assuming fixed levels of demand for both money and non-monetary gold, there can be no inflation in this system, in either sense of the term, so long as the gold stock also remains unchanged. That stock could increase, however, as a result of gold mining. For the sake of argument, though, let’s assume that available gold mines have all been exhausted, and that no new discoveries are forthcoming. By assuming that available gold is not consumed—in the sense of being gradually used up—by industry, we can rule out deflation as well.

Suppose next that fractional reserve banking is legalized and that, Rothbardian warnings notwithstanding, it becomes so popular that all the old warehouse banks embrace it. Will inflation result? Of course it will—but only for a time. As fractionally-backed notes (or deposit credits) take the place of their 100-percent reserve predecessors, the demand for monetary gold, and hence the demand for gold in general, declines, causing the value of gold to decline with it. Because prices are expressed in terms of an (unchanged) gold unit, the price level has to rise. But as the demand for gold doesn’t drop to zero—banks still hold some reserves, and there is still a non-monetary demand for gold—the price level eventually reaches a new equilibrium. All this assumes, by the way, that the switch to fractional reserves is worldwide: if the switch was limited to a single, small country, then banks in that country would export their unneeded gold reserves to the rest of the world, and worldwide price level changes would be negligible.

The overall extent of the increase in prices, and of the underlying expansion of fractionally-backed bank money, will depend on the reserve ratio banks settle on. The lower the ratio, the higher the rise in prices. But whatever the ratio turns out to be, the system will eventually reach a point at which inflation ceases. The move to fractional reserves results, in other words, in a permanent, once-and-for-all price level change, but not in any permanent change in the inflation rate.

What’s to keep the banks from further reducing their reserve ratios? The answer is that, so long as they all compete on an equal footing, as in a free banking system, each will be inclined to routinely return claims, such as checks or banknotes, received from rival banks. The uncertain flow of such interbank “clearings” generates a demand for reserves for settlement, which (in the presence of positive costs of default) will vary with the volume of outstanding bank liabilities, even if bank customers never bother to withdraw gold. Although optimal reserve ratios are unlikely to remain perfectly constant over time, and may decline gradually as more efficient settlement procedures are discovered, for the most part the rate of inflation under an established and mature fractional reserve arrangement is unlikely to differ substantially from the rate that would prevail under 100-percent reserves.

Admittedly this conclusion depends on the assumption of an unchanged real demand for money. If the demand for money grows over time, as it does in most healthy economies, that growth will in fact have different implications for inflation under the two regimes. Yet it still won’t promote inflation in either case. On the contrary: in the 100-percent reserve case, growth in money demand must cause prices to decline at a roughly corresponding rate (“roughly” because there may be some shifting of available gold from non-monetary employments to bank reserves). Under fractional-reserve banking, in contrast, there will be greater scope for monetary expansion, depending on how free banks are from legal impediments. Under free banking, for example, banks can “stretch” their reserves somewhat as the demand for money increases, provided that the increase takes the form of a fallen velocity of money. This happens because the fall in velocity translates, ceteris paribus, into a fall in both the volume of bank clearings and the demand for reserves. In other words, in the presence of economic growth, a free fractional-reserve banking system, although it won’t promote inflation, will be somewhat less deflationary than a 100-percent reserve system.

Selgin ends by saying,

So it’s time to dump the rhetoric linking inflation to fractional reserves. Fractional-reserve banking may have its drawbacks, but a tendency to fuel inflation isn’t one of them, and the chief beneficiaries of claims to the contrary are none other than the world’s central bankers and their apologists.