Posted by: Dirk | July 8, 2009

(Book review) 100% Money

Irving Fisher presented his idea of 100% Money in 1935. Fisher understood that business cycles would be caused by fractional reserve banking. In good times, commercial banks create more credit, lending reserves ten times over (p. 36), while in bad times they are in dire need for liquidity. In the end, the government would step in and go deeply into debt, saving the banks. This would create booms and recessions, which could be avoided by using 100% money.

With the 100% system, banks have to hold reserves for all loans they hand out. This means that banks can lend out only the money they have but nothing more. Imagine a bank with $110. Under the 10% system, the bank can lend $100 and keeps $10 as a reserve in case the loan does not perform. Given that the lender returns the money to the banking system, some other bank will end up with the $100. It will loan out $90, keeping $10 as a reserve. This happens until 1100$ of loans are build on $110 of money. If, however, the people that deposited the money want to see it to make sure its still in the bank, all banks are bankrupt: the only money they can show is the original $110.

Fisher’s solution is to not allow commercial banks to create credit by requiring 100% reserves. A bank that loans out $100 has to place the money at the currency controller, either directly (physically) or indirectly (via an IOU). The borrower receives a check on the check department which he would deposit (p. 81). Banks cannot create any more credit. That role now belongs to the currency controller. The currency controller has to make sure that the unit of account would be stable. The purchasing power of the dollar should not change (too much) over time, so that expectations can be anchored. Sounds like inflation-targeting? It is. This time, without the financial market booms and busts, it might actually work.

Fisher’s 100% Money is a very interesting idea. Today, it should be understood that fractional reserve banking is part of the problem. Also, all institutions have been pro-cyclical: rating agencies, credit supply, Basel II and so on. So how should all this be regulated? At best, we will come up with second best solutions, since the real problem is endogenous to fractional reserve banking. Maybe abolishing it and replacing it with 100% Money is a good idea. Just moving away from the tiny reserves that we have now towards something bigger would be an improvement, but then why stop before we reach 100%? This will be the question to answer for policy makers.

Fractional reserve banking explained for the non-economist (I have watched only this episode and the next one – which I also recommend – and cannot guarantee for the quality of other episodes):


  1. Dirk Ehnts,

    I would like you to review my proposal for 100% reserve banking. It is a variation on Irwing Fischer’s 100% money.

    Great Banking Confusion

    The (usually) transparent process of inter-bank lending works so well that most of the time we don’t even think about it. This process has largely weaned the public away from physical paper money. Note that most money (about 90%) now exists only as entries on bank ledgers, backed by loans (debt). Also, note that possessing physical paper dollars is like having equity in the economic output of the United States of America, and has no credit risk associated to it. Physical paper money is not anyone’s liability.

    Bank deposit money, on the other hand, does have credit risk associated to it. That risk consists of the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than the theft and physical-loss risk of physical paper money. That is why we use bank deposit money more than physical money. Through this (normally) transparent process of inter-bank lending, the banking system acts like a huge clearinghouse (essentially a giant ledger) which clears payments between its customers without the physical transfer of cash, and keeps track of who has how much money. Most money in the world economy is not physical (paper cash or gold) but logical (ledger entries).

    To summarize: physical paper money is equity. Bank deposit money is backed by debt (actually that’s not 100% true–reserves at the federal reserve system are also equity, essentially an electronic version of physical paper cash).

    That difference — that physical paper money = equity in the nation’s economy, and that a bank deposit = debt (a bank obligation) causes great confusion.

    We have become very comfortable with bank deposit money, without thinking much about the credit risk we are taking. Bank failures, when they happen, create confusion and chaos because the vast majority of businesses and individuals use checking accounts for convenience (they can write checks rather than handling physical paper cash) and they don’t really think much about the credit risk that is normally associated with keeping their money (their most liquid capital) in a bank in a checking account. In fact, in most cases users of checking accounts do not want to take a credit risk. But in the current banking system there are no alternatives.

    Is There a Better Way?

    Consider the banking industry’s contribution to society. The banking industry provides three major services to the public:

    1. It provides a “safe” place to hold the public’s most liquid assets (cash).

    2. It acts like a giant clearinghouse (settling checks without physical paper cash transfer).

    3. It is a source of loan money (banks evaluate the credit worthiness of borrowers). Think of “credit worthiness evaluation” as a service to society. If bankers do a poor job at evaluating credit worthiness they will end up mis-allocating economic resources.

    What I am asserting is that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk, if banks gave people a choice between a regular account and a special “100% reserve account.” These special accounts, which are not available to the public today, would have no credit risk. The money in such accounts would not be lendable. There would still be fraud risk, of course. A bank desperate for cash might be tempted to “dip” into the reserves allocated to their 100% reserve accounts. Of course we would make such “dipping” illegal. The 100% accounts would be the electronic equivalent of storing physical paper bills in a safe deposit box at the bank.

    Such accounts would have no credit risk (like physical paper cash) but would have the benefit of being used in electronic transactions and be accessible by personal checks. Of course, a 100% reserve account would not earn interest but would most likely have monthly maintenance fees associated to it (similar to a safe deposit box; it would also be very much like the reserve accounts that banks have with the FED). Such accounts, if widely used, would lessen the impact of bank failures on the economy in terms of a contraction of the money supply, chaos and confusion–but would not completely eliminate them.

    Lending involves business risks (credit risks). If a customer were to choose a non-100% reserve account then he would be subject to losing his money. This would force the public to do some homework before handing money over to a bank (in essence, customers would need to consider banks’ credit ratings, quality of management, etc.). Of course in this type of setup, a non-100% reserve account would probably have to pay a higher interest rate than the fractional reserve accounts do today. In fact if the public had a choice of 100% reserve accounts, there would be no need to impose legal reserve requirements on non-100% reserve accounts. There would be a clear separation between accounts that have a credit risk and accounts that don’t. The accounts with credit risk would need to set their interest rates high enough to attract depositors.

    If our banking system were setup this way, we would avoid huge systemic risks in the future, since a major part of the money supply would likely be sitting in non-lendable accounts. Many enterprises probably should not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc.). In any insolvency or bankruptcy the 100% reserve accounts would receive priority, and unless the bank was fraudulently “using” these reserves the deposit owners of such accounts would never lose their money. If an electronic deposit account with no credit risk were available, then any individual or business choosing not to use such an account would be subject to losing their at-risk deposit. If such an alternative were available, then the depositor who chose the lendable money account would be warned that he or she could lose money if the bank became insolvent.

    Once this choice is given to the public the banks can then be allowed to fail without severely impacting the payment system which is needed to conduct day-to-day commerce. The only job of the FDIC would then be to insure smooth transfer of 100% reserve accounts to another bank.

    I will go a step further and state that the availability of such accounts (non-lendable, 100% reserve accounts) should be mandated by Congress through force of law. Each business and individual should be able to choose whether they want to take a credit risk or not.

    a) The 100% reserve accounts would just be another option that a public would have. I am in no way saying that banks should be forced to offer 100% reserve deposit accounts only just that they must provide it as one of the choices.

    b) I also propose that many institutions absolutely necessary to maintain law and order must not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc). The idea here is that civic law and order should not be disrupted even if several very large financial institutions fail at the same time.

    c) I would also remove the protection of FDIC insurance for moral hazard reasons. But I would still have an FDIC like institution to facilitate a quick and smooth transfer of 100% reserve accounts to another bank from the failing bank. The idea here is to keep the payment system running smoothly so day-to-day commerce can continue to function even if a very large deposit taking institution fails.

    d) The main objective is to preserve Adam Smith’s invisible hand in disciplining and destroying poorly managed very large financial institutions. I am not proposing that we write a more stringent Glass-Steagall Act or keep anyone from creating complex financials products (securitization, derivatives, etc.) or keep any bank from investing bank deposits in risky and/or complex financial products. In fact, I would want most banking regulations repealed, as they are unable to protect us from systemic meltdown. Doing this will greatly lower regulatory compliance costs for banks.

    e) I strongly believe that if we don’t let very large financial institutions die then they will eventually economically destroy us by mis-allocating huge amounts of capital. There should be no such business that is too big to fail. But we also don’t want to descend into total chaos after a meltdown and not be able to maintain a basic payment system to conduct day-to-day commerce.

    f) In short, our basic electronic ledger based payment system should function even if several very large financial institutions fail at the same time without resorting to physical paper cash to conduct day-to-day transactions. Deposits in 100% reserve accounts will provide a basis to build new viable financial institutions if a meltdown occurs.

    Mansoor H. Khan

  2. I have been puzzled by the continued practice and existence of fractional reserve banking because I never found a theoretical explanation for its necessity or a defense in its favor. All I ever read was a hand-waving argument about supporting ‘economic growth’ – yet most growth models do not include any money at all.

    As far as I understand it, it’s a relict and tradition: at some point the practice started and has continued to the present day.

    Do you have any references on a theoretical treatment of frb? It would help me quite a bit! Thanks!

    • Don’t like fiat currency?? How about gold backed enslavement currency??

      Feel Better??

      • Without taking a look at that website I can say that I am not inclined to support any gold-backed monetary standard. Being critical of fiat money does not mean I do not support it. The fractional reserve banking system of today and Irving Fisher’s 100% money are not so far apart. Today we have 5% money or 10% money (0% money in some offshore financial centers), and we have noticed that credit creation was too strong during the boom and now during the bust its too weak. If we decide to raise the reserve rate, then where do we stop – 15%, 20%, …? It is helpful to think about the extremes in order to get a clear picture, I believe. Irving Fisher did that 70 years ago, and why should we not do it today? I consider myself a scientist, and not a member of some dogmatic church of macroeconomics.

  3. […] with Limited Purpose Banking. Laurence Kotlikoff has revived Fisher’s 100% Money proposal (which I also reviewed) under the name of Limited Purpose Banking, which is setting the reserve ratio at 100%. The idea is […]

  4. […] an industry which has a huge influence on policy makers and the media. Their proposal of a 100% money requirement might sound radical, but to my knowledge nobody has ever been able to compute the optimal reserve […]

  5. […] Irving Fisher’s 1935 “100% money” book for a workshop in Hamburg next month. The last time I read the book I thought that fractional reserve banking is a good description of reality. I […]

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s


%d bloggers like this: