How to avoid future encounters with financial meltdown

Cobden Centre Advisory Board member and Chief Executive of Tyler Capital, James Tyler, sets out the case for 100% reserve banking.


In October 2008 the Federal Reserve briefed a secret congressional committee that the US economy had, at one stage, been only a few hours away from a total meltdown in the financial system.

How did this come to pass, and how can we prevent it again?

The Problem

Fractional Reserve Banking (FRB) is an inherently unstable complex system.

Each and every bubble and crisis has some kind of link to FRB, going back thousands of years.

Even where financial crises are caused by natural disasters (the San Francisco earthquake of 1906 being a prime example), the financial crisis only followed because banks did not have enough reserves to pay out worried depositors – due to fractional reserves.

In a nutshell, depositors wanted what they thought was their property back, only to find it did not exist.

Over 70% of people in the UK believe that money placed in an instant access account remains their property.  This is not the case.

Fractional Reserve Banking

  1. Person ‘A’ deposits £100 of cash into his instant-access bank account.
  2. At this point, he signs over property rights to the bank – the bank gives him a promise to return on demand
  3. The bank retains a small reserve (say £3), and lends out £97 to Person ‘B’
  4. Both ‘A’ and ‘B’ both have a claim to instant access on this money.
  5. In one move, the bank has turned £100 into £197 of useable money
  6. ‘B’ buys a Widget from WidgeCo for £97
  7. WidgeCo deposits the £97 with his bank ‘Z’.
  8. Bank ‘Z’ now lends out around £94 to person ‘C’ keeping just under £3 as a ‘reserve’
  9. Person ‘C’ borrows to buy computer, and pays £94 to ‘D’
  10. Money supply has started its process of mushrooming:
    • ‘A’ Has the right to £100
    • ‘B’ has spent his claim to £97, and owns a widget
    • WidgeCo has a claim to £97
    • ‘C’ Has spent £94 and owns a computer
    • ‘D’ has a claim to £94
  11. This process continues until there is no more money to lend
  12. If any one person with a claim to their money exercises their right, the inverse pyramid collapses.
  13. If person ‘A’ claims any more than £3 of his money, the inverse pyramid collapses.

In 2007/8 this money pyramid almost collapsed.

What causes the problem?

The problem comes from the banks’ book keeping entries.  Each step in the fractional reserve process creates a new book keeping entry.

This book item represents a real increase in the money supply, as there is a claimant who has the legal right to use it.

As long as people do not reclaim (what they think is) their property, there is no problem.

Unfortunately history proves that, at times, people do wish to reclaim (what they consider is) their property, and bank runs, like Northern Rock, occur.

The solution

  1. Sound money
  2. Property rights
  3. Transparency

How to achieve it

  1. Turn each bank’s deposit from a book keeping entry (i.e. credit) into hard cash.
  2. Remove the property rights to this cash from the bank and give them back to the depositor.
  3. Extinguish the liability the bank has to the depositor.
  4. The banks will now (unfairly) have a huge number of assets, but zero liabilities – that is not just.
  5. In order to square the banks’ accounts, remove all these assets (all existing loans made) from the banks and place into a mutual fund.
  6. Each borrower still has a liability, and has to continue paying interest and capital.
  7. These repayment flows are diverted towards paying back the government debt.
  8. Via legislation, enforce property rights of depositors over demand deposits (i.e. instant access accounts).
  9. Any instant access deposit must be backed by 100% cash: in this instance, the bank becomes a storage facility, and charges a fee
  10. All new credit must be fully matched, like for like.  A suggested form of saving would be the widespread use of certificates of deposit (CDs).
  11. If people wanted top lend at higher risk, and earn higher rates of interest, money market funds could be set up to facilitate.  Investors could buy shares in the fund, and redemption would be repaid via selling shares.  In adverse circumstances (i.e. credit losses), shares could be sold at less than par thus these funds would not constitute part of the money supply/cash used in the economy.
  12. Auditors can be charged with uncovering any FRB activity within banks.

A summary of what will have happened

  1. The money supply will remain the same as before – there is no inflation
  2. Credit has been converted into cash.
  3. All persons who have outstanding loans still have a liability to pay but to the mutual fund, and from there on, to repay government debt.
  4. Lending will be made either by fully maturity-matched CDs or via money market mutual funds
  5. Banks are left with their true capital – buildings, reputation and so on, and will have divested themselves of artificial credit as an unfair revenue generator.  Banks will henceforth become boring and safe again.
  6. Speculation will not be allowed by banks that take in demand deposits; speculation becomes the realm of pure investment firms (better known as hedge funds – not banks).

Benefits of a 100% reserve banking system

  1. Prevents banking crises:
    • Most agree that 100% reserve banking would end banking crises
    • Liquidity crises are impossible – this is distinct from credit crises, which are a separate phenomena
    • If a bank ’fiddles’ the books to maintain FRB, then this is simple fraud, and can be picked up at audit.
  2. Prevents cyclical economic crises:
    • Credit expansion ‘fans the flames’ of natural economic cycles.
    • Whilst central banks have had some success at reducing the frequency of bank crises (although not their magnitude), they have not been capable of ending recessions.
    • It is impossible to imagine how the productive structure could be distorted by the behaviour of economic agents who purely save and/or invest.
    • If money remains state manufactured and legal tender laws exist, it is only government that will be able to trigger economic cycles, but at least this would be a transparent process.  Once money is fully privatised, this unfortunate influence disappears.
  3. Most in tune with private property:
    • Stamps out legal corruption.
    • The whole banking process becomes more transparent to customers.
    • The recklessness of banks is severely curtailed when they become responsible for the property of others.
  4. Promotes stable, sustainable economic growth, reduces market transaction costs and reduces strains on labour relations:
    • Inflation due to credit expansion corrupts the cohesiveness of society.
    • People fail to see that rapid, frenzied expansion is likely to have an artificial cause, and is likely to end badly.
    • We have become conditioned to accept the manic/depressive nature of stop-start economic growth.  There is a large economic cost to the stress an economy must endure in this process.
    • Constant or increasing purchasing power negates the need for continual salary increases to keep a relatively constant purchasing power.  This will take the sting out of employer/employee relations.  The interventions of unions to protect employees would be less easy to justify as it would be harder for employers to deceive workers into lower real incomes
    • The credit squeeze that follows every boom will be eliminated as a natural course of events
  5. Put an end to feverish financial speculation:
    • Banks were at the heart of the recent crisis – hedge funds have not caused systemic risk.
    • Banks have used FRB backed by tax payer guarantees to engage in risky behaviour not explicitly sanctioned by depositors.
    • The peculiar diminution of property rights for depositors and the opaque nature of FRB creates incentives to tempt individuals towards unscrupulous behaviour.
    • Wild stock market speculation, funded by loans, would be much harder to facilitate, lower in frequency and magnitude and therefore cease to have a large effect on equity valuations.
    • Hostile takeovers, whilst harmless in themselves, could only go forward on sound economic principles.
    • In the market, the creation of financing without equivalent savings generates its own demand, to the detriment of all other citizens apart from those fortuitous enough to use the newly created credit first.
  6. Reduces economic function of the state:
    • There would be no need for a central bank or a lender of last resort.
    • Public choice theory indicated how privileged groups are able to exploit the fiduciary  money system by exploiting government favour and patronage.
    • Reduces the ability for politicians to ‘buy’ votes by tampering with the economic cycle.
    • FRB allows excessive government spending without resorting to unpopular taxation, thus ‘hiding the pain’.
  7. Most compatible with democracy:
    • The financing of government activities should open for debate and discussion and the costs should be transparent.
    • Voters would have a greater clarity of information in order to make clearer choices under a sound money system.
    • Governments would have to consider long term implications of spending decisions, rather than hide the effects and ‘hope for the best’.
  8. This proposal fosters peaceful cooperation amongst nations:
    • Wars have been greatly facilitated by FRB.  Many wars/acts of aggression would not have been possible.
    • Wars have been very costly in two respects, first the immediate damage, but secondly, FRB has imposed a long term ‘tax’ on citizens in terms of inflation and reduced economic growth.
    • 100% reserve banking will prevent the hostile act of ‘competitive devaluations’ – economic war in all but name.
    • Transparency in a nations’ financial system fosters trust with international partners.

Objections and replies

  1. Banks would disappear as they would lose their main source of income:
    • All they would lose is the possibility of making loans without voluntary saving.
    • Legitimate activities remain unchanged.
    • It would actually mean an evolutionary change to more sustainable model.
  2. It would reduce credit, pushing interest rates higher and hindering economic development:
    • Present system is hardly extending credit.
    • During boom times there is an over supply of credit leading to large scale mal-investment in unsound projects.
    • In the long run, credit is always deferred consumption – this process will not be impinged.
    • The idea that loans exceed voluntary savings is a fallacy.
    • If obstacles were put in the way of unsound, speculative schemes then this may be a good thing.
    • Large-scale borrowing by corporations is transacted by methods such as share placements and bond issues
    • Interest rates depend upon time preference: to consume or save?
    • There is no theoretical basis at all to indicate higher interest rates – indeed research points to lower rates than we have been traditionally used to in the long run.
  3. Would penalize those who profit from the banking system:
    • Does not take into account those who will profit from the new arrangements.
    • Would stop governments from financing its expenditure by opaque and undemocratic methods – i.e. credit expansion.
    • Would stop bankers from profiting from the very same opaque process.
    • It is debateable whether the majority of banking profits come from increased economic value or whether it is in fact the redistributive effect of credit creation.
    • Savings would remunerated by interest and the gradual increase in the purchasing power of money.
    • So called ‘free’ banking services, such as ATM withdrawals, cheques etc do in fact represent a cross subsidy from the profits generated by fractional reserve banking.  This stifles innovation and acts as a barrier to entry into the banking services market.
  4. 100% reserves are a state intervention that limits contractual freedoms of willing participants:
    • 100% reserves represent the application of property rights to money.
    • Surveys have shown that over 70% of people currently believe that money in instant access banking accounts remains their property.
    • Current banking arrangements create large barriers to entry, thus reducing competition and preventing free choice in society.
    • Apply Gresham’s law to banking.  Imagine a customer has a choice of two accounts, both delivering exactly the same benefits.  One has fees, one does not.  When genuine money titles are offered in competition to the IOU’s of fractional reserve banking, the latter will tend to drive out the former.
  5. Financial innovation will inevitably lead to a return to fractional reserve banking:
    • Peel’s act of 1844 outlawed the expansion of bank notes to prevent the pyramiding of notes on specie, but the role of book-keeping entries was not foreseen or understood.  The error in the Peel Act was a narrow application of problem solving rather than a generic expression of the principal of property rights.  Economists at the time just had not developed a theoretical framework describing the relationship and equivalence between bank notes and bank deposits.
    • In prosecuting many criminal activities, it is hard to apply principals to complex technicalities but it is not permissible to allow the proscribed activity merely because the criminal will find a way around it.
    • Fractional reserve banking is incompatible with contract law when compared on a like for like basis with all other activities.
    • Recent experience has shown that financial innovation merits careful examination, and a 100% reserve system coupled with property rights would expose any machinations to study more easily.
  6. Would not allow money supply to grow at the same rate as economic development, thus hindering growth:
    • Currently economic agents are conditioned by inflationary expectations; they would adjust to an increasing purchasing power of money rather than declining.  Inflation complicates the accounting process leading to book profits but muddying the water with respect to replacement costs.
    • ‘Deflation’ in terms of prices is not the same as deflation of the money supply.  The boom-bust cycle creates periods of money creation followed by money destruction.  This continuous cycle of credit would stop.
    • This system does not guarantee a unit of unchanging purchasing power – that is impossible in any system.  To believe it possible misunderstands the role of money and its historical development.
    • Increasing purchasing power of money would stimulate consumption.
    • A relatively static money supply (as represented by a classical Gold standard) has not hindered economic growth, indeed there is evidence to suggest that a move to ‘elastic’ money supply has in fact lowered the rate of real economic growth.
  7. Cannot be achieved by a single country, international agreement difficult:
    • Overlooks comparative benefits of areas adopting early.
    • The recent credit crisis provides the perfect backdrop to expound the benefits of sound money, now that the pitfalls of FRB are clear to see.
    • The creation of the Euro disproves the idea that new monetary arrangements could not be created.


A move to 100% reserves on demand deposits does not represent ‘something new’. It is the opposite of radical: it is conservative.

The proposal represents a return to classical legal principle. It offers a chance to resume the natural path of the development of money and society. Such a path can be expected to enjoy an elevated rate of economic growth such as accompanied the development of money in the free market.

Further reading

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