Giving Credit Where Credit is Due: Defending Bank-issued Money Against the Resurgent Calls for 'Narrow Banking'

Abstract

Economists have long debated the relationship of bank credit to the business cycle. The attribution of economic cycles to the "inherent instability" of fractional-reserve banking has been advanced not only by Austrian scholars in the tradition of Murray Rothbard, but also by a number of prominent economists historically including Irving Fisher and University of Chicago icons like Frank Knight, Henry Simons, and a young Milton Friedman. The recent financial crisis has reignited these calls to abolish fractional reserve banking through "narrow banking" or "sovereign money" proposals. This paper rejects this notion and argues that the "pyramid of credit" plays a fundamental role not only in stabilizing economic activity but also in fostering economic development. The instability commonly attributed to pyramiding can be largely mitigated by policy changes far less drastic than the abolition of bank money, and any residual instability is almost certainly worth the dramatic benefits in normal times.

Keywords: Fractional Reserve Banking; Narrow Banking; Chicago Plan; Milton Friedman; Sovereign Money; 100 percent Reserves

JEL Classification: E42, E44, E58, G21, N11, N12, N21