For background (note that this's an innaccurate "simple-minded" explanation -- see Mises.org for gorey details), fractional-reserve banking is the "modern" system of banking -- with FRB, a bank that has $100 in its savings accounts is free to lend someone $110 dollars. In our system, the Federal Reserve offers banks a Faustian deal that states that if they hold a certain amount of reserves (say, ten cents on the dollar) against deposits, the Fed will insure the deposits in case too many people all try to collect their debts at once. In the "non-fractional" system, you could only loan $110 if you have $110 to lend, and then you can't lend out any more until some comes back -- this is colloquially called the "money warehouse" school of banking. There's more to it that, but that's enough in a nutshell to get the next point, which is that fractional-reserve banking is inherently inflationary. The reason why is that if I have $100, and can lend you $110 dollars, you now have $110 and can loan someone $121 dollars -- so where did the extra $21 dollars come from? That's inflation. You now have $121 dollars representing $100 dollars of actual economic value, and thus each dollar is worth less than it was before. This is the real definition of inflation, not the commonly used proxy, "price inflation". In the absence of financial gimmics (like the Fed Funds Rate), price inflation almost instantly mirrors monetary inflation (assuming a free market). The Feds adjust the interest rate at which banks may lend each other money, which thereby adjusts the supply of money that banks can "invent" through loans. Note that the Fed Funds Rate is never negative! Go figure, huh? It all sounds like hanky-panky, and relative to true economic value (goods, services & property) it is, but so long as all countries are playing the same game, currency rates remain largely indicative of a particular state's economic performance (modulo central-bank interest-rate differences).
The big problem comes in because there's always pressure to have more money available, aka "cookies for everyone!" Too much money inexorably leads to hyperinflation, which is really, really bad (just ask the Turks -- they issue 20,000,000-Lira bank notes!). In order to avoid hyperinflation, the banks end up having to rein in the economy by raising interest rates above the pure-market "time-value of money" rate, which tends to cause recessions -- this gives rise to the "boom/bust" business cycle. The Business Cycle is completely avoidable with total-reserve banking, however, as Alexander Hamilton knew oh so well, if you're restricted to lending only "idle, unused" money, it's awfully hard to raise funds when you need them for wars and roads. Total-reserve banking makes for incredibly inflexible fiscal policy, and it's really hard to run a nation that way.
So I have a modest proposal: semi-fractional banking. Instead of having a total-reserve currency, with all its attendent virtues and inflexibility, or a fractional-reserve currency, with it's attendent vices and flexibility, why not have both? We could issue two separate currencies under different rules; let's call them Values and Credits:
- Value banking is total-reserve, money-warehouse banking. The interest rate charged over time for a bank to lend Values either to retail customers or to other banks is determined solely by the free market. Values are legal tender for property, wages and interest.
- Credits are fractional-reserve currency; the Federal Reserve controls deposit-reserve requirements, repo & funds rates, &c., just like it does for USD today. Credits are legal tender for all goods and services which are neither property, wages nor interest.
- The exchange rate between Values and Credits is determined by the free market.
- Taxes must be levied in Values.
Following this system, we're free to inflate our economy as much as we like, but our indebtedness must be financed with real money, our wages must be paid with real money and real property (land) must be purchased with real money. On the other hand, our iPods, car washes and battleships can be paid in flexibly money that we're free to invent as necessary. Our true economic situation would be apparent to everyone, as would the real cost of the things we purchase, because we'd be unable to finance our purchases with financed money. If we over-inflate the money supply, we'll either see the pain right away, or, if it's really necessary, delay the pain but see it loom ever larger on the horizon.
Semi-fractional banking would not come for free; we'd pay the piper with service-charge friction converting between the two currencies (although I suppose that, much like ATMs, your own bank wouldn't charge you if you have an account), but the stability and openness we'd get in exchange would more than make up for the friction.
It would be the best of both worlds.
