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Why We'll Still Never See a 100% Reserve Economy

Blinder: Leave credit creation to the banks
Blinder: Leave credit creation to the banksPhotograph by Joshua Roberts/Bloomberg

“I’m going to start with a model of a perfectly safe 100 percent reserve economy,” said Robert Lucas, “…which looks better and better to me.” Lucas, a Nobel Prize-winning economist at the University of Chicago, was speaking two weeks ago at a panel in San Diego to mark the 100th anniversary of the Federal Reserve. It’s a fairly radical place to start.

Monetary economists distinguish between “inside” and “outside” money. Outside money is what you might think of as “money,” a volume of dollars managed by the Federal Reserve and backed by the full faith and credit of the United States Treasury. But that’s not the only money in the economy. Private banks, too, create money through leverage. They lend more than they have, keeping only a percentage as a reserve. The credit this creates functions as real money: A business can spend the dollars it takes out via a loan. This money—credit—is called “inside” money. The Federal Reserve manages the supply of outside money in attempting to spur the economy or keep inflation in check. Private banks manage the supply of inside money—again, credit—by lowering their reserves (increasing the credit they can offer and consequently, their profits) or raising their reserves, which reduces their risk. When politicians complain that banks aren’t offering credit, they’re asking, essentially, for banks to goose the economy by expanding the supply of inside money.