Hayek’s Original View of Fractional Reserve Banking

Hayek’s original view of fractional reserve banking can be found in Hayek’s essay Monetary Theory and the Trade Cycle (1929; English trans. 1933 by N. Kaldor and H.M. Croome; see Hayek 2008: 1–130):

“It follows particularly from the point of view of the monetary theory of the trade cycle that it is by no means justifiable to expect the total disappearance of cyclical fluctuations to accompany a stable price level—a belief Professor Lowe seems to regard as the necessary consequence of the monetary theory of the trade cycle. Professor Röpke is undoubtedly right when he emphasizes the fact that ‘even if a stable price level could be successfully imposed on the capitalist economy the causes making for cyclical fluctuations would not be removed.’ But to realize this, as the preceding argument shows, is by no means ‘equivalent to a rejection of a 100 percent monetary Trade Cycle theory.’ On the contrary, on this view, we must regard Professor Röpke’s theory, which coincides in the more important points with our own, as itself constituting such a 100 percent monetary trade cycle theory.

Once this is realized, we can also see how nonsensical it is to formulate the question of the causation of cyclical fluctuations in terms of “guilt,” and to single out, e.g., the banks as those ‘guilty’ of causing fluctuations in economic development. Nobody has ever asked them to pursue a policy other than that which, as we have seen, gives rise to cyclical fluctuations; and it is not within their power to do away with such fluctuations, seeing that the latter originate not from their policy but from the very nature of the modern organization of credit. So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles. They are, in a sense, the price we pay for a speed of development exceeding that which people would voluntarily make possible through their savings, and which therefore has to be extorted from them. And even if it is a mistake—as the recurrence of crises would demonstrate—to suppose that we can, in this way, overcome all obstacles standing in the way of progress, it is at least conceivable that the non-economic factors of progress, such as technical and commercial knowledge, are thereby benefited in a way we should be reluctant to forgo.” (Hayek 2008: 101–102).

Two points emerge, as follows:

(1) This passage appears to have been written before the first edition of Prices and Production (1931; 2nd edn. 1935), and is quite compatible with Hayek’s view of business cycles in those works. Fractional reserve banking is not fraudulent, nor are fiduciary media. Fractional reserve banking is a product of free market exchange. Thus, even if we were to accept the Austrian business cycle theory, cycles would be an endogenous outcome of market processes where voluntary fractional reserve banking exists.

Robert Skidelsky has a relevant insight into the reception of Hayek’s Austrian trade cycle theory in the 1930s:

“Hayek, like Keynes, hoped to prevent a slump from developing by preventing the credit cycle from starting. But his method was very different. It was to forbid the banks to create credit, something which could be best achieved by adherence to a full gold standard. He was quite pessimistic, though, about this being practical politics, so his conclusion, like Keynes’s, was that a credit-money capitalist system is violently unstable – only with this difference, that nothing could be done about it. One can understand why Hayek’s doctrines attracted a certain kind of socialist: they seemed to reach Marx’s conclusions by a different route. Because of the Austrian school’s close attention to the institutional and political setting of a credit-money economy, Hayek’s picture of the capitalist system in action was altogether more sombre than that of conventional Anglo-Saxon economics, with its story of easy adjustments to ‘shocks.’” (Skidelsky 1992: 457).

The Austrian trade cycle theory requires that real world capitalism has been severely flawed for over two centuries, and serious entertainment of the theory also leads to the conclusion that the history of modern capitalism has been nothing but an endless series of unsustainable cycles.

(2) But even this passage shows Hayek’s flawed thinking: capitalist economies have many periods where resources are idle and international trade allows the importing of scarce resources. Under such circumstances, fractional reserve banking is a highly efficient way of inducing investment by creating credit. Furthermore, the unique Wicksellian natural rate of interest – which underlies Hayek’s theory – is a non-existent, non-operational concept outside of equilibrium. Nor is the time preference theory of interest used by Austrians in their expositions of the Austrian business cycle theory sound.

Hayek’s assumption that fractional reserve banking results in extortion of real resources from savers is not true when the economy has significant idle resources and unused capacity. And even when relative scarcity for some commodities exists, economies can obtain goods by international trade.

BIBLIOGRAPHY

Block, W. and Garschina, K. M. 1996. “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process,” The Review of Austrian Economics 9.1: 77–94.

Hayek, F. A. 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, Ludwig von Mises Institute, Auburn, Ala.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1935. Prices and Production (2nd edn.), Routledge and Kegan Paul.

Skidelsky, R. J. A. 1992. John Maynard Keynes: The Economist as Saviour, 1920–1937 (vol. 2), Macmillan, London.