Why do we need banks, anyhow?

Previously, I've pointed out that we need a (small amount) of inflation to drive money into banks rather than having money sit under mattresses, and that we cannot allow the banking system to fail because banks create and destroy money via the process of fractional reserve lending and allowing the banking system to collapse would collapse the economy into a deflationary spiral that would have an end game of food riots and probable revolution. At which point the question becomes: If fractional reserve banking has such risks, why should we allow it in the first place?

First thing: If you do not have fractional reserve lending -- if banks are not allowed to loan out a portion of the money on deposit with them -- then we do not have a banking system. Period. You would have to pay banks to hold your money if they weren't allowed to lend it out and get some interest on it from borrowers. The interest you get from having your money on deposit in a bank is paid by lenders, not because the bank feels like being charitable. The reason the bank is paying you interest is to attract your money to their bank so that they can then lend it out to borrowers, not because they like giving money to you.

Now, okay, you say. Let's just go back to the gold standard so that the amount of actual physical currency can't change (thus eliminating the need to earn interest on our money), and ban fractional reserve lending. Lending can exist without banks, right? And because the number of goods and services in the economy are almost always inflating but the amount of gold is not (or is inflating very slowly as more gold is mined), that means prices will deflate over time and we'll be able to get more goods for our money!

The problem with deflation is as I've mentioned earlier -- it drives money out of the economy and turns it into mattress stuffing. Rather lumpy mattress stuffing, in the case of gold, but still mattress stuffing. The economy, starved of the lubricant of commerce (money, whose sole value is as a token of exchange to make it easier to conduct commerce), collapses into a barter arrangement. This actually happened in large parts of the United States during the Great Depression, my grandmother distinctly remembered bartering milk for peas and corn for corn milling at the general store and teachers being paid with eggs because the county couldn't collect any money for property taxes and, rather than foreclose in a tax auction (which would have been useless because nobody in the county had any money to buy the land at a tax auction), accepted whatever the person had as barter goods in lieu of taxes and traded it to their employees for their services. Thing is, that's a very inefficient way to conduct an economy. If you can figure out some sequence of barters that will arrange for all 50,000 components of a typical modern computer system to come together into a new computer, more power to you, because I can't -- that computer system simply won't be built if the economy collapses into a barter economy.

So deflation is bad, but let's say we *don't* go to a gold standard, but instead closely monitor the actual amount of money we print so that it grows exactly as much as the number of goods and services grow, so that there's no incentive to keep it under mattresses for later. But, we also ban fractional reserve banking. Well, as has been pointed out, there is a such thing as lending without fractional reserve banking. Finance companies lend out money, for example, money that is invested in them by investors. Thing is, this results in a much smaller pool of money available for lending than in the case of fractional reserve banking, because your paycheck is going to live under your mattress for most of the month as you spend it, rather than sit in a bank where it can be used as collateral for loans.

A fractional reserve banking system, by allowing banks to pay interest and thereby attract deposits, results in basically the sum total of the capital of the nation being available as collateral for loans, as vs. the alternative, which allows only a small portion of the capital of the nation being available as collateral for loans. By and large, this is a good thing, because loans are how future income gets turned into current assets that can be used to produce that future income. Loans are how that empty storefront in downtown San Jose gets turned into a thriving candy store. Loans are how that order for a new computer at my computer shop gets turned into a new computer, as I take out a loan on inventory to buy the parts to build the new computer, then pay back that loan (plus take some profit) once I actually ship and get paid for the new computer. Without a financial system capable of providing loans on a massive scale, capitalism slows dramatically, because you must then wait until you accumulate sufficient excess assets in order to purchase capital goods that can be used to produce that future income. By using future income to purchase the capital goods that will produce that future income, you no longer need to wait, and capitalism can thus move faster.

The Muslim world basically outlawed fractional reserve banking by barring loaning money at interest, and as a result became a stagnant backwater of use only for the oil extracted from under its sands, whereas before the West invented fractional reserve banking, the Muslim world threatened the very existence of the West. If you cannot leverage the current capital of the nation into future income, your economy is in the same dire straits as the typical third-world economy that lacks a functioning banking system (in most third-world nations, capital assets either live under mattresses, or flee to outside the country to banks that are perceived as more stable) -- incapable of the fast innovations and fast responses to market conditions necessary to be competitive. In short, you can have an economy without fractional reserve lending. But you cannot have a modern economy without fractional reserve lending, because without fractional reserve lending, you simply don't have enough capital assets in your financial system in order to move sufficient volume of loans for your businesses to be agile enough to meet changing conditions and fulfill changing customer demands. In short, a functional modern capitalist economy requires a working system of banks that incorporate the majority of capital assets of the nation and leverage that into future income. Any society which does not have such a system is at dire disadvantage economically.

-- Badtux the Economics Penguin