Most people I speak to think that an economic depression is a problem that needs to be solved. Take a look at this article, for instance. This notion is far from correct. An economic depression is a period of necessary correction. An economic depression is necessarily and always preceded by an inflationary boom.
The real problem is the inflationary boom for which the bust is the cure
During the boom, policies targeted at interest rate depression allow the banking system to expand credit way beyond the available pool of real savings. This results in massive investments into projects that never would have been invested in on the free market. At the very least, new investments would need to be accompanied by
1. additional net saving by consumers
2. movement of capital from lines of production of other less preferred goods
These prevent the possibility of an inflationary boom. These conditions are a logical necessity for the new investment to happen.
However, an inflationary boom creates malinvestments. The process of creating the inflationary boom necessarily also includes the pins required to prick the bubble at some unexpected point in time. When this happens, the market reassesses all the investments made and sorts them into good and bad investments. This is done through the profit/loss mechanism and made explicit through the phenomenon of business bankruptcy. While this process involves pain, without it, the market cannot realign investments to be in line with consumer preferences, especially across time periods.
Economists would say that the boom causes intertemporal discoordination while the bust corrects those errors and brings about the highly necessary intertemporal coordination once again.
The free market is capable of keeping the inflationary boom in check
Even if the banking industry or a segment of it were to engage in fractional reserve banking by emitting far more paper, plastic and electronic forms of money than the real money commodity that they have on hand, the free market has a built-in mechanism to keep this under check. This is called bank failures.
Let us take, for instance, a region that uses dollars defined as a 1 ounce coin made of sterling silver as the unit of money. If a bank with $1 million in real dollars issues $10 million in paper dollars, the over-supply of paper dollars can easily be identified by the market. Further, the fact that on this market, every bank’s notes would be clearly identified with the bank (they would be printed as XYZ bank notes) and the market would easily be able to establish different rates of discounts for notes issued by different banks.
A more inflationary bank’s notes would be more deeply discounted than the notes of a less inflationary bank. Prices of goods might be quoted in dollars but one would have to fork out more $1 notes of an inflationary bank than the quoted dollar price. For instance, if an inflationary bank’s notes faced a discount of 50% on the market, a customer wishing to buy a good priced at $50 by paying in notes of the inflationary bank will need to fork out notes of $100 face value. If the discount were 75% because the bank is perceived as highly inflationary, he will need to fork out notes of $200 face value. Thus, the greater the inflationary condition that the market sees in a bank, the less valuable would be the money substitutes emitted by the bank.
Further, the more inflationary a bank is assessed to be, the more likely it is to be brought down by note and deposit holders walking into the bank’s branches and asking for real money in exchange. While this could be due to a loss of trust in the bank, it could also be because a trusting customer has issued a cheque to the customer of another bank that is asking the inflationary bank to pay in real dollars (which it does not have).
Such failures of fractional reserve banks would lead to a more cautious public wary of inflationary fractional reserve banks. Fractional reserve banks would then have to incentivise people to place money in their accounts, which in turn would raise the cost of their funds available for loans. In addition, being rated as a non-inflationary bank would make a bank more attractive to a public seeking greater safety of their money. In this process, the very service of getting rated on inflationary practices would become a valuable service that could be offered by rating agencies. Thus, we see that on the free-market, there exist many possibilities of mechanisms to keep fractional reserve banking in check.
If fractional reserve banking is in check, so is the inflationary boom. Thus, we see that an inflationary boom of the kind that we see today is impossible on the free market and thatit is only fractional reserve banking with no market controls that causes the inflationary boom.
When we will encounter massive inflationary booms
Massive inflationary booms necessarily require massive interventions that prevent the functioning of market mechanisms. These typically take the form of government action aimed at protecting the inflationary segments of the banking industry. Today, these take the following forms
1. Central Banking with a monopoly on money issue and bank licensing
2. Central Banking as a source of lending of last resort to failing banks
3. Deposit insurance that is politically motivated and priced
4. Legal tender laws that force acceptance of inflated money substitutes at par
5. Capital gains taxes on alternate forms of money
In the absence of these forms of protection, it is impossible for a fractional reserve banking system to become as prevalent as it has become today.
We need to stop fearing or hating the economic depression. What we really need to be wary of is the inflationary boom that forces the pain of the bust on people at large. We also need to fear all the interventions that make the inflationary boom possible and the periodic pain of the depression a “necessary” feature of our lives.
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