On 100-Percent Reserves, Milei, and Argentina

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Philipp Bagus
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Unsurprisingly, Javier Milei´s monetary reform plans are discussed intensively in libertarian circles. For the first time, a real libertarian reform of the monetary and financial system is in sight. One of the main issues of contentions is Milei´s plan to introduce a 100% reserve banking system. Such a move would be truly revolutionary. The Argentinian banking system would be sound and stable. Harmful credit expansion would be ruled out. Unfortunately, but perhaps not surprisingly fractional reserve bankers have come out to criticize Milei´s plan.

In this context, we find a video by the Spanish economist Juan Ramón Rallo which he has produced in response to a brief note by Jesús Huerta de Soto, responding in turn to another video Rallo where Rallo criticizes the 100% reserve ratio. Huerta de Soto has declared that the debate is settled, and he will not continue to respond. Above all, because all of Rallo´s arguments are dealt with in detail in Huerta de Soto´s well-known book "Money, Bank Credit and Economic Cycles" (fourth edition).

However, I would like to briefly comment on Rallo's video.

Rallo, following his Feketian liquidity theory, argues, for example, that credit expansion driven by fractional-reserve banks is limited, when there is no central bank that can bail the banks out, because banks are careful not to let their liquidity deteriorate too much. This shows, once again, how the liquidity approach obscures the view on what is most important, namely the effects of the credit expansion generated by the fractional reserve banking system on the capital goods structure. In fact, the Austrian theory of capital is completely absent in the video and in the whole of Rallo's theory, and yet capital theory is crucial.

Thus, in the first place, the video does not take into account the Austrian theory of capital and the Austrian business cycle theory developed by Mises and Hayek at all. It overlooks the fact that any creation of fiduciary media through the credit expansion of fractional reserve banks artificially lowers interest rates. This injection of fiduciary media by fractional reserve banks always distorts the structure of production because the relative decrease in the interest rate makes investment projects appear profitable that would not be profitable with higher rates. More ambitious projects are undertaken that are unsustainable with society's scarce savings. After the artificial boom driven by credit expansion, inevitably a recession sets in. And in the recession, banks' investments and assets suffer heavy losses. Non-performing loans are on the rise. At this point, customers lose confidence in banks and go en masse to withdraw their deposits. That's when bank runs arise in the absence of a central bank that can bail banks out. Ignoring the theory of capital and that all credit expansion causes business cycles is the same mistake that George Selgin makes, and that Professor Huerta de Soto dismantles in detail in chapter 8 of his book. Therefore, the fact that the banking systems of dollarized countries such as Panama and Ecuador have survived so far does not mean that they will survive indefinitely, since they are subject to the chronic risk that their banks will begin a credit expansion (in unison or not). The same chronic risk is also faced by the Tether company mentioned by Rallo, which is nothing more than a shadow bank that operates with a 10 percent reserve ratio and although it has been able to survive its runs so far, given the liquidity of the assets in which it invests, there is no guarantee that it will not vanish in the future, since its business model is always on the razor's edge.

Secondly, Rallo wants to scare Argentines with the risk of deflation and chronic recession that 100 percent of reserves would supposedly generate. The fear of deflation is used precisely to justify a "flexible" money supply, that is, a banking system with fractional reserves; a system that creates large amounts of money (in the form of fiduciary media) for its own benefit without anyone's knowledge or control (taking advantage of a "seigniorage" identical to that of the counterfeiter).

In my book "In Defense of Deflation" I have dedicated myself to dismantling all the arguments against deflation in a free market, and that are usually employed to justify inflation. On the one hand, price deflation as a result of increased productivity is a wonderful thing. It is akin to a growth dividend that is given to the entire population. On the other hand, price deflation as a result of an increase in the demand for money is the solution to the desire to increase the real cash balances of economic agents. And as the marginal purchases and sales that individuals make to achieve this goal vary, so do relative prices, as a natural consequence of their subjective valuations. Finally, after a credit expansion and an artificial boom, and if there is no central bank to inflate the money supply, there is usually a credit contraction that generates strong price deflation. This credit crunch is a market reaction to the previous monetary aggression of fractional reserve banks and accelerates recovery by purging malinvestments more quickly.

But, what's more, in the dollarization system in Argentina with a 100% reserve ratio proposed by Milei, prices would not even fall. The Argentinian money supply would increase with the inflow of dollars that would flood Argentina when the Argentinian demand for money increases. There would be no need for artificial and significant downward price adjustments, because immediately foreign dollars would flood the country.

Rallo highlights this supposed deflationary risk to justify neutralizing it with the issuance of fiduciary media, concealing the fact that the fiduciary media´s introduction as loans artificially lowers the interest rate and generates malinvestments.

Moreover, only the 100% reserve ratio immunizes the system from the sudden contractions of the money supply that the fractional reserve cyclically generates, forcing much sharper and more painful deflations and recessions (although these credit contractions accelerate the recovery by liquidating malinvestments more quickly).

Third, Rallo's interpretation of the creation of central banks is wrong. It conceals the well-documented and paradigmatic case of the creation of the Federal Reserve in the US, which arises at the behest of the private bankers themselves (J.P. Morgan and Rockefeller) to achieve a lender of last resort.[1]

Fourth, Rallo improperly extends the 100 per cent reserve ratio to money market mutual funds when they pose no problem from the point of view of the proponents of a banking system with 100 per cent reserves.[2] Money market mutual funds only guarantee the return of what was invested at its market price, not at its face value. Therefore, monetary mutual funds cannot be equated with operations that, in fraud of the law, conceal a demand deposit with a return at any time of its nominal value (with a repurchase agreement, etc.).

Fifth, it is also worth mentioning Professor Huerta de Soto's recommendation to consider loans with a term of less than 30 days as deposits. A self-renewing "loan" with a one-second term is equivalent to a demand deposit and therefore is also required to have a reserve ratio of 100%. The same goes for a one-hour, two-hour, or one-day automatically revolving loan. Now, the question is where is the time limit at which the financial instrument that replicates the demand deposit becomes a genuine loan? And the practical and conservative solution applicable to private banks proposed by Professor Huerta de Soto is terms of less than 30 days, where the demand for commercial bank loans usually begins. On the other hand, individuals are already subject to the penalties of the penal code for misappropriation of deposits and equivalents at the expense of the interpretation by the courts of the particular circumstances of each case. And in a pure anarcho-capitalist system, practice and custom would establish the temporal boundary between deposits and loans.

The paradoxical conclusion is that fractional reserve banking induces the creation of lenders of last resort (central banks) which in turn make fractional reserve banking much more damaging. Proponents of fractional reserves naively believe that by eliminating central banks, fractional reserves and credit expansion suddenly becomes a good thing. But, while the elimination of central banks improves things for fractional reserve banking by raising reserve ratios, it would still not eliminate its original sin: the creation of fiduciary media always generates destabilizing cycles as demonstrated by the theory of the Austrian School (Hayek and Mises) that Rallo overlooks. At the slightest crisis, which sooner or later always results from the malinvestment induced by the creation of fiduciary media, there arises again the popular demand to create a central bank to save the bankers and depositors affected, and so on, and so on, all over again. Fractional reserve banking creates an unstable and paradoxical situation that can only be definitively and completely solved with the 100 percent reserve ratio and the elimination of central banks. Finally, I want to point out that anyone interested in the debate, before taking a position, should read "Money, Bank Credit and Economic Cycles" which is in its eighth edition and my own book "Full Reserve Banking versus the Real Bills Doctrine," which will be published shortly by the Ludwig von Mises Institute.

1 See, for instance, Murray Rothbard’s “The Case Against the Fed.”

2 See, for instance, Bagus, P., Howden, D., & Gabriel, A. (2015). "Oil and water do not mix," or: "Aliud est credere, aliud deponere." Journal of Business Ethics, 128(1), 197–206; or Bagus, P., Howden, D. & Gabriel, A. The Hubris of Hybrids. (2017) Journal of Business Ethics 145, 373–382.