Last Sunday, 1.8 million Swiss citizens voted in a landslide against a referendum to take away banks’ power to “create” money, thus preserving fractional-reserve banking, the foundation of the modern Western financial system. The Swiss rightly discerned that giving Western governments more power over finance would not solve the problems of that system. Perhaps the fact that people in a rich Western nation chose to preserve a key provision of post-medieval economics shouldn’t be surprising, but in today’s political world, any vote for the status quo is itself a bold statement.

Though you may not know it, you’re familiar with fractional-reserve banking if you’ve seen It’s a Wonderful Life. In the 1946 movie, customers of the Bailey Building and Loan Association, hero George Bailey’s family bank, have swamped the bank’s single office. In a panic common to the Depression years, during which the movie is set, they demand their money back immediately. Bailey gives a speech that explains the system well. “You’re thinking of this place all wrong,” he says. “As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others. Why, you’re lending them the money to build, and then they’re going to pay it back to you.”

Indeed, banks do not keep their customers’ deposits in-house. Instead, they lend them out, keeping only a small reserve—“fraction”—against customers who will want their cash. Right now, the government reserve requirement in the U.S. varies from 3 percent to 10 percent. Fractional-reserve banking ensures that money goes to work in the economy rather than sitting in a bank vault.

The system has always annoyed fringe elements of the economic world. First, supporters of Vollgeld—“sovereign money”—think that it gives rise to bailouts, because in a general panic, central banks step in to provide liquidity to banks facing massive withdrawal requests. Second, Vollgeld advocates say that abolishing fractional-reserve banking would substantially reduce the risk of financial bubbles and deep recessions caused by the bursting of those bubbles, and would cut down on government and private debt levels, too. Finally, critics object to the idea that a bank, rather than government, can “create” money, in the sense that it can approve a loan to a customer without having that money on hand, and the customer can then spend the proceeds of that loan in the real economy. The theory here is that only a government should create money. Supporters of the referendum derided the current system as encouraging “fake money,” noting that “when you deposit money into your bank account, it is no longer your money,” but only “the promise to pay you the money when needed . . . the promise that . . . many not be kept,” and that all of this happens “without your consent.”

None of these arguments stands up to scrutiny. First, central-government lending to banks during bank runs isn’t meant to bail them out. If a bank’s assets have suffered such severe declines as to render it unable to make good their depositors, then the bank should go bankrupt. This philosophy works in helping to maintain market discipline. The problem in 2008 was that Western central banks and governments used it inconsistently.

The second argument assumes that banks, not governments, are primarily responsible for asset bubbles and dangerous levels of debt. Yet Western governments already have an outsize role in creating and distributing money. Western central banks, such as the Federal Reserve and the European Central Bank, set the interest rate at which they lend to banks. If central banks think that private-sector banks are lending too much money, they can increase interest rates, making it more expensive for everyone to borrow, thus reducing debt levels. Regulators can also increase the fractional-reserve requirement, which reduces the amount that banks can lend relative to their deposits.

Given that central bankers are hardly expert at figuring out the optimal interest rate or fractional-reserve requirement, assuming that they could determine the optimal amount of total money within a national or global economy seems dubious. Low interest rates have enabled record levels of public and private-sector debt worldwide, with at least a nominal private-sector check—the banks—on this debt creation. It’s not clear why getting rid of this weak gatekeeper, and letting governments simply create more money directly, would improve the situation.

As for the distribution of money, much of the excess lending that contributed to the 2008 crash came from outside of the traditional fractional-reserve commercial-banking system. Investment banks, for example, bundled shoddy mortgages together and sold them to global investors, entirely outside of fractional-reserve constraints; complex derivatives that insured against price changes on other derivative financial instruments were catastrophic to the global system when the market turned, and they, too, were designed independently of fractional-reserve banking.  

In March, the Financial Stability Board, an advisory group made up of the world’s financial regulators, announced that, in 29 countries that account for much of the world’s economy, “shadow banking”—credit creation done outside traditional banks, looking similar to traditional bank borrowing and lending but also similarly susceptible to abrupt credit contractions—now totals $45 trillion, compared with $138 trillion in bank assets. Shadow banking has grown from 62 percent of these nations’ GDP in 2011 to 73 percent in 2016. A quarter of much of the world’s de facto banking system, then, now operates outside fractional-reserve rules, a greater concern than shortcomings within the system.

In the end, only 24 percent of Swiss referendum voters chose to nationalize the banking system. Perhaps the Swiss, with their long banking history, understand the complexities of finance better than most people. Or perhaps they are just not interested in shaking things up; the Swiss, after all, score among the highest on the world—higher than the US and the UK, which  have had their own radical electoral results lately—when it comes to almost any measure of quality of life. Protecting the modern banking system—or any free-market creation that has helped the world prosper—is too important to fall victim to uninformed agitation, but governments must make sure their voters aren’t so desperate that they choose agitation anyway.

Photo: swisshippo/iStock


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