Fractional Reserve Banking: The Original Sharing Economy Invention

 

At first thought, it’s kind of funny that people pay so much for cars given that they mostly just sit parked. But thinking about it a bit harder, maybe a car sitting in a garage or parking lot most of the day actually serves a greater purpose. If it is the cheapest price to pay for on-demand transportation, then it actually makes a lot of sense. People own cars not because it’s a perfect deal, but because it’s perceived by car owners as the best achievable deal — the best possible option of traveling. Likewise, owning a cottage seems wasteful if it is only occupied a couple days a week, but if that is the most convenient way to have an on-demand place for weekend getaways, then it too makes a lot of sense. In both examples, the opportunity costs of idle resources are outweighed by their benefits.   

The reality is that uncertainty and the problem of coordinating with others plague most of what we want to do in life. I may know I want to travel in the future, but I may not know exactly when and where. I could hope to use a bus, or to borrow my friends car, but I can’t be certain the bus goes where I want, and that my friend won’t need his car at the same time. Likewise I may want to swim and fish, but I don’t know when I’ll have the free time to do so. I could hope to borrow strangers cottages for a price, but how do we coordinate a time that works for both of us, and how do they know to trust me?

These are the problems the sharing economy are currently solving: on-demand vehicles and housing, coordinated in a way which I could not do on my own, and with rating systems that achieve a level of trust I could not get on my own. Companies like Uber and Airbnb have made possible the benefits of on-demand travel and on-demand housing while drastically lowering the idle resource costs.

But this is only the beginning. Driverless cars should have many benefits which will only amplify these effects. While someday it’s likely most people would no longer own a car per se, they’d still own the right to a car whenever needed. There will be no more spending all that money to have a car sit in your garage all night just to get a ride to work in the morning. When driverless cars lower the cost of Uber sufficiently, there can be significantly less garages, parking lots, and significantly less cars. What an awesome world we could soon find ourselves in!

But my goal here is more than just getting excited for the future, I want to show that one industry has been giving society these type of benefits for centuries — Banks. Like Airbnb has done with homes, and Uber is doing with cars, banks long ago found a way to lower the opportunity costs of idle resources. For the same reason we keep cars sitting in the driveway, we hold money because of coordination problems and uncertainty. 

Fractional Reserve Banking and the Sharing Economy

Fractional reserve banking allows banks to issue notes of redemption for base money (outside or government money), but in such a way that not only are there more notes than base money, but also these notes circulate as a medium of exchange (not literal paper notes anymore, think any money created by banks, i.e. what’s on your debit card). Fractional reserve banking is a process which allows customers to have on-demand money redemption, while reducing heavily the amount of money that sits idle. (Larry White give a more more detailed account how fractional reserve banking came about and how it works here)

It may seem wasteful to hold money under the bed or in a storage warehouse, but before fractional reserve banking it wasn’t. It’s just like keeping a car in the garage or a cottage for only the weekend. Sure it’s idle most of the time, but it’s there when you need it. Nonetheless, it’s costly. Fractional reserve banking then should be seen as having solved the problem that Airbnb and Uber are trying to solve now – Idle resources stemming from the high transaction costs of coordination and uncertainty.

This reduction in transaction costs provided by a fractional reserve system, like in all sharing economies, tapped a new and impressive source of revenue which makes both the banks and its customers better off. A fractional reserve system is preferred by customers because they get to share in the profits of the money loaned out by the banks. It is this practice which allows interest and other beneficial services (instead of warehouse fees) on accounts without sacrificing liquidity. Indeed, this brings on some new risk, but under competition, market forces will have companies eventually strike a balance between actual profit and projected risk. We can say that if people prefer future driverless Ubers to owning a car, or fractional reserve banks to storage warehouses, then the opportunity cost of idle resources is greater then the costs associated with risk (the net benefit is higher).

The sharing economy makes for a more elastic supply, where supply quickly changes in response to demand. The supply of hotel rooms in any given city was pretty inelastic until Airbnb came along. Now, when hotels are all booked people can rent out their extra bedrooms in their homes, and this allows the supply to increase instead of the price, which is great for consumers!

Ride sharing companies like Uber can use their fancy algorithms to decide the size of the fleet it needs and the size of the customer base it can credibly promise on-demand rides to. They are smart, they can figure out an equilibrium of customers to fleet ratio. If driverless cars become the dominant means of these systems, then their ratio can be where almost no car sits idle but no one is waiting long times for ride. If societies tastes change such that people are demanding more car rides, Uber simply needs to increase its fleet size and/or decrease the amount of customers using the service. They can do this by raising their price (surge pricing). If societies tastes change the other direction and demand less rides, then Uber can either shrink its fleet and/or simply increase their amount of customers by lowering the price.

Likewise, banks are smart too. Based on their gross clearing activities, desired risk etc., they can figure out an equilibrium ratio of the notes they create to base money, such that almost no money is sitting idle but no one is denied redemption such as their contract states . If societies tastes change such that people demand to spend more notes (demand to hold onto notes falls), banks would need to either increase their total number of reserves, or cut back on the amount of notes in circulation, so as to maintain the new higher rate of redemption. One way they could do this would be by raising their interest rate on loans. If people start to want to spend less, and therefore increase their demand to hold notes, then banks could either hold less total reserves, or simply increase the amount of notes they create by lowering their interest rate on loans. (George Selgin gives a more technical explanation of these processes here).

Thus supply can be more responsive to demand. Like all other aspects of the sharing economy, fractional reserve banking means people can get more for less. With Uber, there’s more traveling with less total cars; with Airbnb there are more roofs over our head without there actually being more roofs; with banks there’s more investment and less total base money sitting in vaults. Loans that would have been too costly (not just in monetary terms, but other transaction costs as well), can be reduced to a more attractive price as banks solve coordination and uncertainty problems for us.

It’s hard to know the counterfactual, but without fractional reserve banking, its seems reasonable to assume therefore, that economic activity would be reduced dramatically. I may want to lend out my gold under my mattress or in a storage warehouse, but only a well functioning bank can let me do so without me sacrificing my liquidity. They can then safely lend out a big fraction of the idle money, and still guarantee on-demand money for those who wish. Furthermore, they can conduct things like credit checks and get a better picture of trustworthiness than I ever could if I were to try and lend out my money alone. Fractional reserve banking either lets my money make money for me, or it lets me borrow someone else’s money without having to overcome the transaction costs myself. As is signature with the sharing economy, it puts resources to work.

The future has a lot of potential awe inspiring inventions coming down the pipeline. But while daydreaming about these, we shouldn’t forget to be in awe the invention of fractional reserve banking. Long before fancy apps, and indeed long before the internet even, it was solving our problems and making our lives better.

 

 

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