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Crisis is a Cost of Growth

Megan McArdle summarizes my resistance to one tenet of the Austrian School’s economic philosophy. The Austrians prefer “sound money”, with currency tied to gold and no fractional-reserve banking.

The Austrians seem correct that banks lending out 90¢ of every dollar on deposit, then lending 90% on that 90¢, ad infinitum will be inflationary. Essentially, money is being created from thin air. And inflation means that real assets lose value over time.

So what are the reasons to favor fractional reserve banking? Threefold:

1) Stopping it would require a huge regulator to keep people from doing what they naturally want to do, which is lend short and borrow long.

2) Fractional reserve banking vastly increases the supply of savings available for investment.

The less affluent have to have a reasonably large cushion they can get their hands on in case of emergency, such as car repairs or a really good deal on a jet ski. Without fractional reserve banking, that would be dead money, sitting in a vault somewhere. Indeed, they'd probably end up paying someone to guard it for them.

3) The financial market can still have big crises.

Borrowing and lending money are risky endeavors. They are unfortunately necessary in a society where the people with the good ideas aren't always the people with the money.

If one could enact an Austrian utopia, perhaps economic troubles would be few and small. If there had been no Federal Reserve, we wouldn’t be in the current banking crisis. But we would have experienced some other crisis, at some time. There’s no perfect system which relies upon imperfect human agents.

But the periodic stability of Fed-backed fractional-reserve allows us to become richer faster. The richer we are, the better we can endure those inevitable crises.