There are two factions within Austrian Economics: There’s the “full reserve banking” faction, and the “fractional reserve banking” faction.

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I wanted to write a primer on what fractional reserve banking is, why it exists in the first place, and how that relates to bitcoin.

Thought Experiment: Let’s say you go to a bank and you now have a gold coin. You don’t want to store it in your house — it’s cumbersome to carry gold around — so you ask the bank to store it for you. They give you a certificate saying you have X amount of gold.

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Paper, as it turns out, is much more convenient than carrying gold -- it’s more easily divisible, it’s much better for commerce, storage, security.

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So bankers, sitting on all this gold, realize something: most people don’t need most of their gold most of the time….why don’t we create more certificates than we have gold?

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In other words, people are using these certificates as money, why don’t we make more certificates, lend them out, and earn interest on them - lend them to businesses. In this world, as long as there isn't a bank run, everything is fine

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So fractional reserve lending is lending more money out than you have in reserve, in your bank. Full reserve banking is the opposite — only lending out what you have.

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Back to our two factions within the Austrian School of Economics:

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The full reserve banking faction thinks this is fraud. The fractional reserve banking faction (or free banking school) says that as long as you’re open about it, it’s okay.

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In fact it may be a good thing to make interest, because if the bank makes interest, then they don’t have to charge as much fees for storage.

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The full reserve banking school would say that banks lending out money they don’t have is the entire cause of the boom-bust business cycle. Just look at the bank runs in the US in the 1930s, which led to a depression and creation of FDIC insurance.

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The free banking school would counter that banks could figure out what is optimal lending rate so it’s safe, or keep storage costs low.

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Will we have Fractional Reserve in a bitcoin world?

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Saifedean believes that fractional reserve banking will be tried, but it won’t work.

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Due of the decentralized nature of bitcoin, and the fact that the final ledger of bitcoin settlement is public and open for people to access, the bank’s ability to do things like borrow short & lend long, roll over maturity, have mismatch in reserves---is going to be hampered significantly.

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Banks that do this, in fact, will have their notes discounted at the percentage to which they discount their backing by bitcoin. That’s how markets will correct for fractional reserve banking-- naturally and without interference.

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Indeed. Firms that engage in fractional reserve banking will have liquidity problems. Without a lender of last resort -- government bailing out a bank because it’s too big to fail -- fractional reserve banking won’t work long-term. Eventually it’ll come falling down and there will be no Fed or FDIC to bail out the despositors.

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Liquidity needs of the bank will be too expensive to roll over on the market. In a world with fractional reserve banking -- but no lender of last resort -- a liquidity problem becomes a solvency problem. If they can’t roll over short term debt to cover long term obligations, they’ll be insolvent.

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Which is why it’s unlikely it’ll become sustainable on top of bitcoin. The reason fractional reserve banking emerged on the gold standard, however, was because gold was centralized, and, since banks do enormous amount of transactions of gold, and because they had monopolies, they could impose effectively what was seigniorage by issuing reserves that were backed by gold.

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This was somewhat sustainable because it was expensive for people to have a way to audit banks, and people couldn’t easily find alternative banks. Indeed: Banks effectively had natural monopoly or duopoly because the centralization of reserves.

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Not so in a bitcoin world, however.

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What bitcoin does is transform central banking from being a centralized model -- because it had to rely on moving gold bars around -- into being a decentralized model that is verified by processing power and electricity.

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Quoth Saifedean: “As if we took out the horse, and all the horse shit from our street by getting rid of horse and horse carriage, we take out central banks and their shit from the managing of running their money. It’s amazing. Instead we burn electricity, run all these massive farms on hydroelectric dams all over the word, harnessing energy towards running these miners to register a block every 10 minutes.”

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Thus, it will be hard for any bitcoin bank to have a value proposition that lets it get away with any type of maturity mismatch on capital markets for any long-term period of time.

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Thanks to Alex Hardy for contributing to this piece.

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Author

Erik Torenberg
Co-founder @Villageglobal, @tokendaily https://t.co/NnuJs4N1hU