On 3/31/09, me and a few dozen of my economics professor colleagues tuned in to a webcast by Karl Case, co-creator of the Case-Shiller Home Price Index. He told an interesting story of how the housing market came to be constructed, how home prices became collateral for all kinds of other assets, and how the smartest statisticians on earth could have been wrong about default rates on subprime mortgages, since they were deceived by a 30-year long real estate boom. I liked his story of the real estate bubble, though I think he missed the primary cause, the only logical reason why housing could become hideously overvalued: money creation.
I questioned him on the connection between fractional reserve banking and the housing bubble. His response showed how little he had thought about banking. "There's no need to destroy the entire credit system and bring lending to a halt," he replied.
I understand that response, for I thought much the same a few years ago, before I began to research the issue. Banks are a major conduit through which savings become investment. It is an economic necessity that such a conduit exists, but it is far from the only one. When corporations issue stocks or bonds, for example, savings become investment. (Assuming the corporation uses the money it raises for investment and not some other purpose.)
If we insist that banks are honest and do not permit them to engage in fraud, it does not mean that there will be no credit system and no lending. It simply means that lending will be done on a basis that is absolutely solid and does not involve the fraud and instability of the fractional reserve system.
The great American economist Irving Fisher showed this quite clearly in his 1935 book 100% Money. Murray Rothbard argues for the same thing in his article The Case for the 100% Gold Dollar. A full reserve system would not destroy banking, nor would it end credit. Banks would be restricted to lending only from bonds they would issue specifically for the purpose of investment. People who bought such bonds would know that they are taking a risk, sacrificing liquidity for a return. No lending from demand deposits (checking and savings accounts) would take place.
Full reserve banking would not end credit, it would simply make the credit system rational, functional, and morally sound.
