ZoneBitcoin EditorialThe fractional reserve system is a banking approach that has generated much discussion and controversy among economists until today. This system, which allows banks to lend more money than they actually have in reserve (thanks to writing games), has played a crucial role in the economic development of many countries. For many economists, it is a solid and reliable engine of growth, which has enabled the emergence of many industries. For others, it is above all a system vulnerable to financial crises which prevents the development of a stable economy.
While the subject divides experts in the field, Bitcoin has emerged as a detonator in that it radically calls into question the fractional reserve system.
In this article, we will take a detailed look at what the fractional reserve system is, how it works, and why Bitcoin goes against how it works.
What is the fractional reserve system?
The fractional reserve system is a banking system where banks only need to keep a fraction of their customers' deposits as reserves, and can use the rest to make loans. To summarize, it is thanks to this system that banks can generate profits.
Example of how the fractional reserve system works
Let's imagine that a bank has 1000 euros on deposit. If the required reserve rate is 10%, the bank must keep 100 euros in reserve and can lend the remaining 900 euros. If the borrower then deposits these 900 euros in the same or another bank, the latter can in turn lend 810 euros (90% of 900 euros). This process can repeat itself infinitely, creating an amount of currency far greater than the initial deposit.
History and evolution of the fractional reserve system
In economic history, it is accepted that the first central bank operating on the fractional reserve system was the "Sveriges Riksbank" created in Sweden in 1668. However, there were already more rudimentary forms of this system, notably through the usury activities that some people practiced. In fact, let us recall that the Church prohibited usury based on the Holy Scriptures on the one hand and on the criticism of interest-bearing loans denounced by Aristotle (cf. Chremastic).
Lending against interest was then considered an unfair practice that takes advantage of the weakness of the poorest to enrich themselves. In fact, Islam and Christianity strongly rejected the use of usury although forms of it could be found during the 16th and 17th centuries in Europe, with financial and commercial centers like Florence, Venice or Amsterdam again. These places which favored monetary exchanges played an important role in the development of the banking sector.
Then, as early as the 16th century, the idea that money deposits could increase and stimulate the economy through loans quickly became popular. After the first bank was established in Sweden, two central banks were established in the United States, the first in 1791 and the second in 1816, which were later replaced in 1913 by the "Federal Reserve Bank", which is now the American central bank.
Advantages and Criticisms of the Fractional Reserve System by Economists
The fractional reserve system has advantages and disadvantages. On the one hand, this system plays a crucial role in financing the economy by allowing banks to lend more money than they have in reserve. Authors like John Maynard Keynes supported this system, warning it as a relevant and adequate tool to regulate the supply of money and stabilize the economy. Likewise, Milton Friedman, who was opposed in his vision of the economy to Keynes, nevertheless also supported this system by considering it as a guarantor of intelligent management of the money supply. Other authors have insisted on the fact that the fractional reserve system can also facilitate access to credit for businesses, and thereby contribute to the growth of a country.
Contrary to these thoughts, this system has been strongly criticized and questioned by many economists, including many belonging to the Austrian School. One of the most notable critics is the Austrian economist Ludwig von Mises, notably in his work " The theory of money and credit " published in 1912. He believed that the fractional reserve system could lead to economic cycles of expansion and contraction, which fueled credit bubbles that eventually burst into financial crises.
Other economists, such as Murray Rothbard (a member of the Austrian School) have also expressed similar criticisms of the fractional reserve system. These criticisms often stem from the belief that this system contributes to financial instability.
The phenomenon of bank panics
One of the main problems with fractional reserve banking is that it can lead to financial crises. If all depositors demand to withdraw their money at the same time, a bank may not be able to meet these demands because it does not have enough reserves. This is called a "bank run." The financial crises of the Great Depression in the United States are a notorious example of the catastrophe that can be caused by a mass withdrawal.
More recently, we have been able to see with the Silicon Valley Bank that such phenomena continue to wreak havoc on the economy. Even if states generally choose to carry out bailouts to stem the crisis, the fact remains that they cannot prevent them from taking place.
Bitcoin and the fractional reserve system
Bitcoin inventor Satoshi Nakamoto wrote a few lines in the Bitcoin genesis block that echoes the headline of the newspaper on January 3, 2009, namely: Chancellor on brink of second bailout for Banks. This echoes the second bailout plan decided by the British government to "save" a bank hit by the 2008 crisis.
It is then admitted (although this may be subject to debate) that Satoshi Nakamoto saw bitcoin as a currency exempt from this type of crisis.
Unlike the traditional fiat currency system, Bitcoin was created as a fixed supply currency (21 million units) giving rise to an alternative economic framework that operates in an entirely different way.
More so, Bitcoin is managed by a distributed network of nodes called the blockchain, which does not require a single entity to control the network. This means that there is no need for a central bank and there is no authority in charge.
These two elements combined (fixed supply and no controlling authority) make Bitcoin a system diametrically opposed to central banks and the fractional reserve systems they use.
Why does Bitcoin not include a fractional reserve system?
Bitcoin is not suitable (in absolute terms) for a fractional reserve system for several reasons. First, Bitcoin was designed to be decentralized, meaning there is no central authority like a bank that controls the currency. It would be extremely difficult technically to imagine a system in the current functioning of Bitcoin which would allow the creation of units of bitcoins based on existing bitcoins. This would be a sort of antinomy to the proof-of-work mechanism which supports the network.
Second, the issuance of Bitcoin is limited to 21 million units, meaning that no new units will be generated once this limit is reached. It is then impossible to change this ceiling, without risking destroying the key principle of Bitcoin, namely a limited supply over time.
In a nutshell, Bitcoin defeats the whole idea of the fractional reserve system. For many supporters of this cryptocurrency, this is also the guarantee of a strong and solid economy which cannot print money on simple demand.
Final Thoughts
Thinking about the merits of the fractional reserve system is an eminently complex task. Different socio-economic factors must be considered to make a judgment. In certain situations and at certain times, the fractional reserve system has played a determining role in the economic development of certain countries. The industrial revolution certainly took full advantage of this system, which allowed many countries to become rich and achieve rapid economic growth.
However, some economists attribute the crises to the fractional reserve system, which can be like a sword of Damocles over the people, who must expect to go through crises perpetually, as Nobel Prize winner Paul Krugman reminds us (cf. Why seizures always come back").
And, this is also where Bitcoin gets interesting. By completely eliminating the fractional reserve system, it offers us a new window of thought where we can imagine a system that would do without monetary creation ex nihilo and its consequences on the economy….
Disclaimer: The opinions expressed are personal and solely those of the author of the article and do not necessarily reflect those of Zonebitcoin magazine.
