When hard money becomes standard, fractional reserve lending will simply not be possible. This will have a major impact on lending for large assets like real estate, financeable assets (automobiles, industrial equipment, etc.), and business loans. First, let us consider what happens to a community when fractional reserve banking (FRB here on) is introduced:
A town exists with a stable supply of currency to begin, assuming imports and exports balance to make things easy. People for the most part live, work, and spend inside this community. Banks lend money to build homes, grow businesses, etc. Normal stuff. Then, currency backing is abolished and FRB becomes standard; what happens?
- Banks lend money to build homes, grow businesses, etc., and keep cash reserves equal to their deposits. They back every dollar with a hard asset like precious metals.
- Currency backing goes away and now can be borrowed without a complete reserve.
- One bank starts lending at half interest rate and they lock up $1 for every $3 they lend, thus enabling them to lend more currency for lower interest (customer happy) and earn 1.5x more interest on their reserves (depositors happy).
- Because other banks start following suit, people are able to borrow more and thus buy more at an increased price. Additionally, the banks in which the borrowed currency is deposited lend out those dollars too, multiplying the currency supply. Eventually, FRB results in a 4x increase to currency supply.
- Increased supply for borrowed currency reduces its value, especially against those things for which the loans are made.
- The price of other goods versus the currency rise to equilibrate the new supply-demand dynamic.
- Wages did not increase proportionately because they are not paid with significantly borrowed currency (except for big business loans).
- Assets for which dollars are lent are disproportionately and artificially favored in the new economy.
- Currency is funneled into these artificially favored investments, and those who learn the game profit extraordinarily.
- Short term gain caused long term suffering.
Now, this was a 1:3 FRB, but in today's USA FRB is at 1:9. There are up to 10x as many dollars in circulation than actually exist officially in the system.
This is simply not possible in Bitcoin, because the funds would actually have to leave lender A to go to borrower B and would no longer be considered in circulation on A's books. The depositors for A would see the funds leave and object (not your keys, etc.). In essence, what would end up happening is an escrow account in which A actually owns the asset, and B would incrementally purchase the asset from A. In this sense, lending will still occur, but not FRB. It is simply not possible to effectively create a world in which 210M-BTC exists, even virtually.
One way in which this may work for larger peers is A opens a lightning channel to B and pays C through it. A would effectively be purchasing the asset through B from C, and B would then repay A through the channel. This does require the borrower to have sufficient outgoing liquidity, which could be achieved in a custodial B with unequal peers, that is A≃B≃C, but A≫b≪C, so b uses B custodially.
This causes an equalizing effect to investments and consumptive products, such as food. Shelter would no longer be an "investment" strategy for the upper-middle class and above, but rather something achievable by the average person yet again.
Now, let's consider the radical effect on a society which loses its ability to lend in fractional reserve. The first major effect would be a sharp loss in "price" of many assets (those mentioned at the beginning of this article), and secondarily the loss of many professions which rely on those assets being easily and cheaply financeable.
The effect will not be immediate, but quite dramatic after a short delay. This pain will be short lived, likely on the scale of a couple years, because the value of the rapidly deflated currency would sharply increase against real assets to meet the decreased supply. The demand would slowly rebound if confidence in the reverted banking system was not destroyed, a real possibility. Many other societies experienced one or more changes to accepted currency, and we can look to their histories as to what might happen.
What may be more realistic is a rival state issued currency which cannot be lent with a fractional reserve. As a phase-out method, it is possible to incrementally increase the minimum reserve current 1:9 to 1:6, then to 1:3, 1:2, 2:3, etc. until the fraction reserved is 1:1 over the course of several years.
- FRB is standard, and the circulating supply is multiple times greater than what was minted by the central bank.
- The voting population begins to reject FRB, the society reestablishes a backed currency as a replacement (thinking the Texan digital gold project).
- The backed currency slowly gains usage.
- Path #1: the unbacked currency collapses before being phased out, and many people experience marked loss.Path #2: the unbacked currency becomes fully phased out as the backed currency gains prominence.
- The supply-demand dynamic in the lack of cheap borrowed money causes a rebalance in the economy between assets that were formerly purchased with borrowed money and those not.
- Wages and borrowed money equalize, and those even in the lower earning brackets begin to thrive once more.
The one issue I see with this scenario is that the average businessperson is addicted to cheap borrowed money, and it is unlikely that they will voluntarily give up their advantage, as this would require a level of virtue not common in today's world. Until the day in which fractional reserves are unacceptable, investors will favor the unbacked currencies. It seems the only option is a currency collapse and replacement with hard money.