Is This the End of Fractional Reserve Banking?

Switzerland’s Vollgeld “Full Money Initiative”

I can pretty much guarantee you that the biggest story not being covered in the traditional business press right now is that Switzerland will hold a referendum to consider ending fractional reserve banking (!).

Yes, you read that correctly. That paragon of the banking industry is voting on whether to deconstruct banking as it has been practiced for centuries. In case you cannot read German, let me share with you some of the details:

• Swiss law requires a popular referendum on any petition that receives at least 100,000 verified signatures as affirmed by the Swiss Federal Chancellery.
• On 24 December 2015, the Federal Chancellery confirmed to finanzen.ch that it had received 110,955 valid signatures on a petition to end fractional reserve banking.
• The effort is officially known as the Vollgeld, or “Full Money Initiative.”
• The date for the vote has yet to be set. But given the complexities of the issue, and that Swiss law allows for counter-arguments, it will likely be a drawn out process before the official referendum date is set.

In the Heart of the Great Depression

How did this state of affairs even come about? The answer, it turns out, is shrouded in history. Specifically, it is hidden in the fog of the economics profession of the Great Depression. On 16 March 1933, a group of economists hatched an idea known as the “Chicago Plan,” Chief among these economists was one of the grandfathers of the profession, Irving Fisher. Their obsession was to identify the causes of the Great Depression and of the business cycle. Among the culprits they identified was fractional reserve banking.

In fractional reserve banking, banks keep only a small portion of the deposits they receive in their vaults and are otherwise free to lend out the rest. A typical ratio is 10:1 loans to reserves. What that means is that commercial banks share responsibility for money creation in an economy with central banks and that the credit and monetary functions of banking are intimately tied together.

Yet commercial banks have a varying and volatile appetite for money creation. The economists of the Chicago Plan thought that the business cycle was directly related to these appetites, with recessions (and the Great Depression) being among the consequences. Their solution? A 1:1 ratio of loans to reserves, with every $1 in loans backed by $1 in deposits. Despite generating a lot of interest at the time, the plan fell into obscurity. It resurfaced briefly several years later, following the US recession of 1937–1938, after which it again disappeared from history.

The Chicago Plan Revisited

In the wake of the Great Recession, many began reconsidering the Chicago Plan. But the greatest re-examination came after Jaromir Benes and Michael Kumhof — two economists at the International Monetary Fund (IMF) —  published a paper entitled “The Chicago Plan Revisited” in August 2012. Benes and Kumhof not only revisited the Chicago Plan, they tested it with modern econometric models of the economy. Before discussing the results of their modeling, what were the asserted benefits of the original Chicago Plan as set forth by Fisher in 1936?

1. Greater control of a major source of business cycle fluctuations, including  the unpredictable expansion and contraction of banks’ credit and, consequently, the supply of banks’ created money.
2. The complete elimination of bank runs.
3. A dramatic reduction — if not complete elimination — of net government debt.
4. A dramatic reduction in private debt since money creation is no longer tied to debt creation.

Certainly these are interesting contentions, and if you know anything about the financial system, then you also know that the Chicago Plan is nothing less than a radical rethink and redo of the global financial system. But will it work? According to Benes and Kumhof, the answer is an astounding and unequivocal “Yes”:

“We find strong support for all four of Fisher’s claims, with the potential for much smoother business cycles, no possibility of bank runs, a large reduction of debt levels across the economy, and a replacement of that debt by debt-free government-issued money. Furthermore, none of these benefits come at the expense of diminishing the core useful functions of a private financial system. Under the Chicago Plan private financial institutions would continue to play a key role in providing a state-of-the-art payments system, facilitating the efficient allocation of capital to its most productive uses, facilitating intertemporal smoothing by households and firms. Credit, especially socially useful credit that supports real physical investment activity, would continue to exist. What would cease to exist however is the proliferation of credit created, at the almost exclusive initiative of private institutions, for the sole purpose of creating an adequate money supply that can easily be created debt-free.”

Iceland Takes Up the Mantle

On 20 March 2015, Iceland published the results of an intensive study that explored the viability of ending fractional reserve banking. The report, commissioned by the prime minister, is entitled, “Monetary Reform: A Better Monetary System for Iceland.” In the words of the author, Frosti Sigurjonsson:

“[The report] proposes a radical structural solution to the problems we face. The feasibility of and merits of that specific solution need to be debated. But whatever the precise policies pursued, they must be grounded in the philosophy which the report proposes — the money creation is too important to be left to bankers alone.”

What Does It All Mean?

By now you must have many questions about the ramifications of an end to fractional reserve banking. What does it all mean? There are several good sources for necessarily speculative answers (since no one has ever lived under a full reserve regime):

• The papers from the IMF, Iceland, and Switzerland.
• Read about the Chicago Plan and assess the potential impacts for yourself.
• My colleague Ron Rimkus, CFA, is writing a follow-on piece to discuss the ramifications. So check back here on The Enterprising Investor.

Editor’s note: An early version of this article stated that the Vollgeld referendum would be held this year. That is not correct. A date for the referendum has yet to be set.

Image credit: ©iStockphoto.com/william87

Originally published on CFA Institute’s  Enterprising Investor.