Keynes Transformed Fractional Reserve Bankers from Economic Villains Who Cause Depressions into Economic Heroes Who Enrich Society

Many critics of John Maynard Keynes attribute the success of his ideas to political appeal. No doubt, politicians are attracted to Keynesian economics because it can be used to justify profligate government spending. While important, political appeal alone cannot totally explain his triumph. Since Keynes’s theory is purportedly an economic theory, it could have never prevailed without the economists. So why does Keynes’s theory attract so many economists, and the most influential economists in particular? The answer is that influential economists in the banking system are attracted to Keynesian economics because it can serve as an economic justification for fractional reserve banking. The Keynesian interpretation of fractional reserve banking is an important reason Keynes’s theory conquered the economics profession.

Economists were becoming increasingly critical of fractional reserve banking in the years before Keynes published his theory. Even Alfred Marshall, the founder of the Cambridge school of economics, argued fractional reserve banking amplifies the business cycle. In 1912, Ludwig von Mises showed that fractional reserve banking is the fundamental cause of the business cycle. The Great Depression led many eminent American economists, including Irving Fisher, Frank Knight, Henry Simons, and Jacob Viner, to advocate abolishing fractional reserve banking. In fact, it was the American backlash against fractional reserves in the early 1930s that led directly to the formation of the Chicago school of economics. During the Great Depression, Senator Bronson Cutting and other politicians in the United States introduced legislation to abolish fractional reserve banking. 

Keynes’s theory was a godsend for the defenders of fractional reserves. Pre-Keynesian economics showed fractional reserve banking causes the business cycle and thereby makes society poorer than it otherwise would be. Before The General Theory of Employment, Interest and Money (1936), the defenders of fractional reserve banking had no answer to the pre-Keynesian analysis. But Keynes gave defenders of fractional reserves a weapon with which to combat the pre-Keynesian analysis. While the pre-Keynesian theory shows fractional reserve banking destroys wealth, the seemingly scientific New Economics purports to show that it is good for the economy. Rather than impoverishing society, fractional reserve banking actually creates prosperity in Keynes’s system. In short, Keynes transformed fractional reserve bankers from economic villains who cause depressions into economic heroes who enrich society. It is no wonder so many influential economists in the banking system have enthusiastically adopted Keynes’s theory.

—Edward W. Fuller, “Keynes and Fractional Reserve Banking: The NPV vs. MEC,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 40-41.