Economic Stability under Alternative Banking Systems: Theory and Policy

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In this paper we show in a thought experiment that in an economy where: i) investors hold rational expectations, ii) output is generated by a linear homogeneous production function, and iii) real investment is allocated across sectors by the CAPM, a fractional reserve banking system is not Pareto efficient and amplifies the business cycle. The policy implication is that bank regulation should go further than the Volcker rule or the Vickers commission proposal by restricting bank investments to currency in the vault and deposit accounts on the central bank. The paper proposes that post office banking perhaps augmented with block chain technology sometime in the future is one way to implement the transition from fractional reserve banking to full reserve banking. While little academic work has been done on full reserve banking in the aftermath of the Great Crisis, it is interesting to note that it is part of banking reform proposals now before the parliament in Iceland and a special referendum in Switzerland.

Author(s):

Robert Krainer    
University of Wisconsin-Madison
United States