Banking on a Bitcoin Standard

Last month in Free Banking in Bitcoin, I responded to the criticism regarding bitcoin’s volatility, addressing downside risk and the misconception that bitcoin is deflationary. This week, I begin the next chapter about banking in bitcoin by introducing what banking would look like on a bitcoin standard.

The traditional view embraced by Austrian economists is that fractional reserve banking is fraudulent, inflationary, and sinister. But this holds only if the customers were to believe their deposits were fully redeemable all the time. If instead customers were to know that banks were lending out their deposits to earn revenue and stay in business, they might be more open to placing their deposits in a fractional reserve bank. After all, the bank must survive, and there is nothing immoral or untoward about charging a higher interest rate on loans and capturing income between loans and deposits to stay profitable. Banking on bitcoin will prevent banks from lending at will, since they cannot manufacture bitcoin out of thin air the way they can with fiat money. This will impose natural discipline on banks and constrain the amount of lending (and therefore leverage) in the financial system, absent oversight from a well-intentioned but ultimately misinformed bank regulator. In sum, fractional reserve banking will exist outside of a central bank. To understand how, we need to consider a free market of banks.

What will banking look like on a bitcoin standard? How will it be different from banking on a fiat standard, and what needs to happen to make it work?