Is Greg Mankiw Against the Fractional Reserve System?

One of the aspects of the financial industry that I feel is most ignored and yet most responsible for the financial mess we are currently in is the fractional reserve system. I don't understand how it makes sense for banks to lend money they don't have have. Honestly, if you think about it, all the fractional reserve system does is allow banks to borrow money from their customers and not pay them for it. Unfortunately, it has been around so long that some people can't even imagine a financial system without one. As if having people pay to securely store and transfer their money would suddenly become unprofitable. It makes me pretty happy then to see someone who isn't an Austrian Economist discuss the Fractional Reserve System. Not that I don't like the Austrians, Frederich von Hayek is my favorite economist. It's just good to see someone in the mainstream raise some concerns.

Mankiw vs. Greenspan: How Much Leverage Do Banks Need to Be Useful?

The conversation between Alan Greenspan and some of then nation’s most prominent economists at the Brookings Panel on Economic Activity on Friday was deemed “not for attribution” by the organizers. But Greg Mankiw, the Harvard economist, has posted his response to Greenspan on his web site. You can read it here.

He largely agrees with Greenspan, but differs on one key point: “The issue concerns the importance of leverage to the viability of a financial intermediary, Mankiw says. “Alan proposes raising capital requirements and reducing leverage, but he suggests that there are limits to how much we can do so. If we reduce leverage too much, he argues, financial intermediaries will be not be sufficiently profitable to remain viable. He offers some back-of-the-envelope calculations that purport to show how much leverage the financial system needs to stay afloat.”

Comments on Alan Greenspan's "The Crisis"

Indeed, I think it is possible to imagine a bank with almost no leverage at all. Suppose we were to require banks to hold 100 percent reserves against demand deposits. And suppose that all bank loans had to be financed 100 percent with bank capital. A bank would, in essence, be a marriage of a super-safe money market mutual fund with an unlevered finance company. (This system is, I believe, similar to what is sometimes called “narrow banking.”) It seems to me that a banking system operating under such strict regulations could well perform the crucial economic function of financial intermediation. No leverage would be required.