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Free Banking and Economic Development, Part 2

(Both parts of this article originally appeared, under the title "Fractional Reserves and Economic Development," on the short-lived Free Market News Network.)



When Adam Smith first drew attention to the benefits of fractional-reserve banking, those benefits were but a glimmer of far more impressive gains to come. In 1776, the year of the appearance of Smith’s Wealth of Nations, Scotland had only 10 note-issuing banks, the two oldest of which, the Bank of Scotland and the Royal Bank of Scotland, were but 81 and 49 years old, respectively. The note-exchange and settlement system was still in its infancy, so metallic reserves still accounted for about a fifth of issuing banks’ liabilities. By the time of the passage of the Scottish Bank Act of 1845, which placed restrictions on further Scottish note issues, Scotland had almost twice as many note-issuing banks, with coin reserves often amounting to less than two percent of their liabilities. Scottish banks’ had thus achieved a substantial improvement in their ability to invest Scotland’s money holdings productively, and had done so without engendering the least loss of public confidence in their notes.

Although Scotland offers an especially impressive example of the gains to be had from fractional-reserve banking, such banking has also played a crucial role in worldwide economic development. Persuasive evidence of this can be found in two collections of studies, Banking in the Early Stages of Industrialization (1967) and Banking and Economic Development (1972), both edited by economic historian Rondo Cameron. Surveying the findings of the first volume, Cameron concludes that banks, through their “substitution of various forms of bank-created money for commodity money,” played an essential part in fostering industrial development, and that they were most effective in so doing in places, like Scotland in the early 19th century, where they were least hampered by government regulations, including regulations limiting banks’ right to issue circulating notes.

More recent research has reinforced Cameron’s conclusions by showing how “repressive” financial regulations—meaning regulations that prevent banks from functioning as efficient savings-investment intermediaries, such as statutory minimum reserve requirements—have impeded economic growth in less-developed countries. Oppressive banking regulations are especially harmful to poor countries, where money holdings represent are large portion of available savings. Of such oppressive regulations the monopolization of paper currency by central banks is perhaps the most oppressive of all, for it means that a substantial part of the public’s monetary savings is diverted from the private sector, which might employ those savings productively, to the government, which tends to squanders them instead.

As nations become wealthier, the relative importance of fractional-reserve banks diminishes, because the public becomes increasingly able to afford financial assets other than money, including stocks and bonds. Industry can then rely, to some extent at least, on funds acquired by selling securities, instead of having to borrow from banks. Yet bank loans remain a major source of business funding, and of small-business funding especially, even in wealthy nations with well-developed securities markets. In the United States, for instance, businesses today get more than twice as much credit from banks as they get by issuing their own bonds, and many times as many funds as they get by selling shares. In Germany and Japan bank loans account for a still larger share of business funding. And although commercial banknotes have been legally suppressed in most countries, demandable bank IOUs, in the form of demand deposits, remain banks’ own principal source of funds. Without fractionally-backed bank money, in other words, most businesses would have to go begging for credit—as they were forced to do, temporarily, during the banking crisis of the 1930s.

I realize that claims concerning how fractional-reserve banks promote prosperity will carry little weight among those who insist that such banking necessarily entails fraud. It would be tragic indeed if they were right, for then we would confront a stark choice between condoning fraud on one hand and enjoying economic prosperity on the other. Fortunately, though, we face no such dilemma: as I hope to make clear in a later essay, the claim that fractional-reserve banking involves fraud is just as untenable as the claim that it has contributed nothing to the wealth of nations.