My earlier piece on Rothbard and Social Credit sparked off a long thread on another blog. One of the arguments made over there was that, in the absence of much other regulation, “fractional reserve”, as Rothbard understood it, simply could not be effectively banned.

Rothbard’s (and the Social Credit mob) saw fractional reserve as an evil thing as it allows banks to create money, as it is commonly defined – in that accepting a call deposit and then making a loan from the funds deposited effectively creates money. Both the deposited funds and the loan funds are money – so the bank has created money. I explored this a bit further on the earlier thread and so will not go into it here.

The point I would like to raise here is whether, in the absence of much other regulation, it can just be banned. My point is this. Say a government (for some odd reason) decides to agree with Rothbard and then bans the maturity transformation of call funds. I believe there will be a couple of major problems with this:

1. Firstly, the legislation would have to define “call” precisely. Once you think about this is becomes, to me at least, a tricky thing. How long a call period, and under what conditions, means that a deposit remains “money”? Is it only instant call, 1 second call, 1 hour call, 24 hour call, 11am call or what? Additionally, would a term deposit (of, say, 12 months) that has a call option with penalties remain a  term deposit or does the call option render it a call deposit? If so, what penalties would be needed to make it a “term” deposit?

2. Would the banks not just walk around this anyway? Say the call period decided upon was one week. Could the customer not just deposit funds on one week term and the bank then just grant a revolving line of credit up to the value of the deposited funds, effectively allowing the customer full access to the total value of their deposit (and creating the same effect as an instant call deposit) without breaking the legal definition of “call”?

To me, the only things keeping banks within any mandated ratios that they could walk around are:

1. The ratio is set at a point where the bank would keep it anyway, such as a typical 7% reserve asset ratio (or 9% HQLA in Australia); or

2. The regulators have lots of other tools that the banks fear so they do not bother to try.

Rothbard imagined a world where the “fractional reserve” could be banned and then other regulations become unnecessary.  I cannot see how he c

ould be right.