Giving Credit Where Credit is Due: The Benefits of Letting Banks Issue Money

Abstract

Economists have long debated the relationship of bank to the business cycle. The attribution of economic cycles to the inherent of fractional-reserve has been advanced not only by Austrian scholars in the tradition of Murray Rothbard, but also by a number of prominent economists historically including Irving Fisher and University of Chicago icons like Frank Knight, Henry Simons, and a young Milton Friedman. The recent financial crisis has reignited these calls to abolish fractional reserve through narrow banking or sovereign money proposals. This paper rejects this notion and argues that the pyramid of credit plays a fundamental role not only in stabilizing economic activity but also in fostering economic development. The instability commonly attributed to pyramiding can be largely mitigated by policy changes far less drastic than the abolition of bank money, and any residual instability is almost certainly worth the dramatic benefits in normal times.