A Price Deflation Might Bring Down a Fractional Reserve Banking System as the Real Burden of Debt Increases

A price deflation might bring down a fractional reserve banking system. This is so, because a price deflation can lead to bankruptcies as the real burden of debt increases. Especially in a recession after an artificial boom, a credit contraction and bankruptcies due to the malinvestments occurs. As a consequence of the bankruptcies that are induced by the price deflation, loans that banks gave out will turn bad. The stocks of the bankrupt companies that other banks hold will lose value, perhaps even to the point of becoming worthless. In general, the assets of banks will fall in value. In order to preserve solvency banks will restrict credits and put pressure on its corporate partners and other banks. The decline in one bank’s assets’ values might induce doubts in the solvency and liquidity of other banks. Due to the credit restriction, corporate partners might go bankrupt. Other banks also financing these corporations get into financial difficulty as well. Bank runs might occur. In a fractional reserve system, by definition, the bank cannot pay out all demand deposit claims that exist. The bank will go bankrupt. If one bank collapses this instability might spread to other fractional reserve banks due to their interconnectedness. The bankruptcy will induce fear about the solvency of other banks, further reduce the value of their assets’ value, and lead to systematic bank runs. A bank panic ensues. This might bring the whole fractional reserve banking system down if the central bank fails to bail out the banking system. This possible consequence of price deflation is beneficial as it purges the old banking system making place for a 100% gold standard as Rothbard points out.

—Philipp Bagus, In Defense of Deflation, Financial and Monetary Policy Studies 41 (Cham, CH: Springer International, 2015), 90.