Fractional Reserve Banking Is Indeed Fraudulent

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In response
to Walter
Block’s online discussion with Bryan Caplan
regarding fractional
reserve banking (FRB), Eric
Posner has written an article
in which he attempts to justify
FRB on the basis of a supposed contractual arrangement between bank
and depositor. Posner criticizes Block for not understanding the
difference between property rights and contract rights. Block has
responded in an article called Is
Fractional Reserve Banking Fraudulent?
in which he rightly likens
the FRB contract to selling a "square circle." Let us
examine further where Posner’s argument fails, and why the alleged
FRB contract does indeed involve a logical contradiction.

The crux of
Posner’s argument can be found in this statement:

I give the bank some cash and pay it to put this cash in a safety
deposit box, then the bank can't use that cash. It can't lend
it out to someone else; it can't list it as an asset on its balance
sheet; it can't touch it without my permission. If the bank were
to do so, then it would have engaged in theft, and the relevant
employees would go to jail. Lawyers call this transaction a bailment.

if I deposit some cash with the bank, I don't retain my property
interest. Instead, I'm making a loan to the bank and I obtain
a contractual right to repayment on demand. If I demand my cash
(plus interest, if any) and the bank fails to pay me, then I can
sue it for breach of contract and demand expectation damages."

No one would
disagree with the first paragraph. A transaction, involving money
in a safety deposit box, is indeed a bailment, and the bank has
no right to use the money.

But why does
Posner suddenly change the rules of the game when the money is put
into a demand (checking) account? Posner believes that instead of
a bailment, a demand account involves a contractual arrangement
where the depositor transfers ownership of the money to the bank
in the form of a loan, and the bank grants the depositor a contractual
right to repayment on demand out of funds belonging to the bank.
According to this argument, the bank now owns the money, or the
greater portion of it, to do with as it pleases, but so long as
the bank fulfills its obligation to the depositor, there is no problem.
If the bank fails in its obligation, well that is just too bad for
the depositor; he can always sue for breach of contract.

While this
state of affairs might seem reasonable in the context of the present
law, what Posner does not seem to realize is that Block’s argument
against FRB is made from the point of view of the natural
law, as things "should be" as Block puts
it, not just as they currently are. And when looked at in this way,
the present law contains clear and obvious logical contradictions,
and glaring violations of property rights, which make contractual
arrangements like this a total nonsense.

To see why,
one has to examine what it means to own property.

A person who
has the right to use or dispose of some particular property at any
time, and in any way, without the consent of anyone else, is by
definition the owner of that property. It is the single fact that
he has the right to use or dispose of the property whenever he
wants and however he wants that makes him the owner.

If a person
possesses this right in its entirety, he cannot logically be anything
other than the full owner, and thus the only owner, of the property
in question.1 It is not possible for
a person to possess this right, in its entirety, and be a non-owner.

Thus a person
who has the right to use or dispose of a particular sum of money,
whenever he wants and however he wants, is necessarily the
owner of the money in question.2

When someone
deposits his money in a checking account, it is redeemable on demand.
That is the definition of a checking account. “Redeemable on demand”
means his money is available to him at all times, in which case
he retains the right to use or dispose of it whenever he wants.
Since the bank makes no stipulation as to what he can spend it on,
he retains the right to use or dispose of it however he wants.

This means
a person who has a checking account, cannot logically be anything
other than the owner of the money contained therein.

A bank that
offers a checking account cannot enter into a contract with a depositor,
where ownership is transferred to the bank, because if the
money really is available on demand to the depositor, it is logically
impossible for him to have relinquished ownership. If he cannot
relinquish it, he cannot transfer it. And thus if the bank declares
itself to be the owner, either in whole or in part, the bank’s claim
is fraudulent.

In contrast,
a genuine time deposit is one where ownership is transferred
to the bank. In this case, a contract involving the transfer of
ownership is made possible precisely because the depositor does
not retain an on-demand right to the money he deposits. By
so doing, he necessarily relinquishes ownership of the money he
has now, in exchange for money the bank agrees to pay him at some
specified time in the future. There is no “double ownership” problem
in such a case.

Let us look
at Posner’s statement again:

“But if I
deposit some cash with the bank, I don’t retain my property interest.
Instead I’m making a loan to the bank…”

There is nothing
wrong with this statement if the deposit is in fact a genuine loan
such as the time deposit discussed above. But it is clear there
cannot be a loan to the bank if the next statement Posner makes
is true:

“…and I
obtain a contractual right to repayment on demand."

The contractual
right to repayment on demand means the bank grants the depositor
full control of the money, to use whenever and however he wants.
If the depositor has this right, whether it is contractual or otherwise,
he necessarily owns the money.

And since his
ownership of the money is determined by the fact he has the right
to use his account whenever he wants, that is at all times, the
bank cannot claim he is an owner only at those particular times
he spends or withdraws the money. It is the possession of the right,
not merely the exercise of it, that signifies him as the owner.

Thus we are
faced with a glaring contradiction. If the depositor continues to
own the money, how can he make a loan to the bank? To do so he has
to forgo his property interest. And how can he forgo his property
interest, that is forgo his ownership, when he continues to be the

In short, how
can a contract exist which lets the bank claim ownership, on the
one hand, while the depositor keeps ownership, on the other?

Posner’s contractual
contrivance in defense of the banks makes no sense. Indeed a contract
such as this is a complete phony. Block is entirely correct. When
banks use this argument in order to justify their immoral practices,
they are indeed selling a square circle!


  1. Or in the
    case of joint ownership, if a group that has the right to use
    a particular sum of money, whenever and however it chooses, it
    is necessarily the owner.
  2. In the case
    of joint ownership by a couple or a group, individuals within
    the group do not have full rights of ownership individually.
    (They cannot logically each have an independent right to use or
    dispose of the property whenever and however they please.) They
    can have partial rights individually, but they can only
    have full rights of ownership collectively. Therefore
    it is the group, as a single entity, that has full rights of ownership.

17, 2008

Davidson [send her mail]
is originally from England and in her spare time is a dedicated
student of Austrian economics.

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