The Faults of Fractional-Reserve Banking

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In a November
1, 2010, blog post titled "Could
the World Go Back to the Gold Standard?,"
Martin Wolf,
the Financial Times chief economics commentator, comes to
the conclusion that "we cannot and will not go back to the
gold standard."

Among a number
of mainstream-economics arguments leveled against the desirability
and feasibility of the gold standard, Mr. Wolf puts forth a line
of reasoning that can serve particularly well as a starting point
for debating his position. Mr. Wolf writes,

Economists
of the Austrian school wish to abolish fractional reserve banking.
But we know that this is a natural consequence of market forces.
It is wasteful to hold a 100 per cent reserve in a bank, if depositors
do not need their money almost all of the time. Banks have a strong
incentive to lend some of the money deposited with them, so expanding
the aggregate supply of money and credit.

Austrians
Do Not Call for Establishing a Gold Standard by Decree

To get the
ball rolling, Austrian economists (in particular those in the Misesian-Rothbardian
tradition) uncompromisingly call for replacing fiat money
with free-market money – money that is produced by the
free interplay of the supply of and demand for money.

Such a recommendation
has a firm economical-ethical footing: free-market money is the
only monetary order that is compatible with private-property rights,
the governing principle of the free-market society.

The focus on
private-property rights does not only follow from natural-rights
theory (in the Lockean tradition), but it can be ultimately
justified on the basis of the self-evident, irrefutable axiom
of human action, as Hans-Hermann Hoppe has shown.[1]

Austrians therefore
argue for privatizing money production, shutting down central banks,
and letting the market decide what kind of money people want to
use. Government wouldn’t have to play any active role in the workings
of a free-market monetary system.

One may hold
the view that precious metals – in particular gold and silver,
and to some extent copper – would be the freely chosen, universally
accepted means of exchange. In other words, they could become money
once people have a free choice in monetary matters.

However, Austrian
economists wouldn’t call for establishing a gold standard, let alone
a gold standard with (government-sponsored) central banking: they
would argue for free-market money, under which, presumably,
gold would become the freely chosen money.[2]

Fractional-Reserve
Banking Violates Property Rights

Now let us
turn to fractional-reserve banking. It means that a bank lends out
money that clients have deposited with it. Fractional-reserve banking
thus leads to a situation in which two individuals are made owners
of the same thing.[3]

Fractional-reserve
banking thus creates a legal impossibility: through bank lending,
the borrower and the depositor become owners of the same money.
Fractional-reserve banking leads to contractual obligations that
cannot be fulfilled from the outset.

As Hoppe, Block,
and Hülsmann note, "any contractual agreement that involves
presenting two different individuals as simultaneous owners of the
same thing (or alternatively, the same thing as simultaneously owned
by more than one person) is objectively false and thus fraudulent."[4]
A "fractional reserve banking agreement implies no lesser an
impossibility and fraud than that involved in the trade of flying
elephants or squared circles."[5]

The truth is
that fractional-reserve banking amounts to violating the nature
of the law of property rights. And so the argument that fractional-reserve
banking represents sensible money economizing – an argument
that Mr. Wolf brings up against a gold standard – doesn’t hold
water.

Arguing in
favor of fractional-reserve banking would in fact be tantamount
to saying that it is legal (or rightful or even lawful) that Mr.
A does whatever he wishes with Mr. B’s property – without requiring
Mr. B’s consent.

What, however,
if the bank and the depositor both agree voluntarily that money
deposits should be used for credit transactions via the issuance
of fiduciary media? Even such a voluntary agreement would be in
violation of the law of property rights.

While bank
and depositor benefit from such a trade (or expect to), what about
those who receive fiduciary media? They would be falsely lured into
exchanging goods and service against an item (fiduciary media) that
is already claimed as property by others – something the seller
presumably wouldn’t agree to if he had only known the very nature
of the trade.

What if all
market agents voluntarily agreed to engage in fractional-reserve
banking? The conclusion above wouldn’t change: voluntarily accepted
fractional-reserve banking would represent a monetary system that
is, by its very nature, in violation of the nature of the law of
private-property rights. It would produce economic chaos on the
grandest scale.

Fractional-Reserve
Banking Has Not Emerged "Naturally"

To be sure,
fractional-reserve banking is not, as Mr. Wolf notes, "a
natural consequence of market forces." It is a result of, and
has been upheld by, government law.

In a free-market
system, the practice of fractional-reserve banking would be illegal
by its very nature. And so fractional-reserve banking would be ended
(sooner rather than later) under the auspices of a functioning law
of private-property rights.

The reason
that fractional-reserve banking has been around for quite some time
is due to government law – which, of course, must be distinguished
from the natural law of property rights. Of course, government can
make fractional-reserve banking legal in a formal sense. However,
even government law does not change the nature of things. As Murray
N. Rothbard puts it succinctly,

fractional
reserve banks … create money out of thin air. Essentially
they do it in the same way as counterfeiters. Counterfeiters,
too, create money out of thin air by printing something masquerading
as money or as a warehouse receipt for money. In this way, they
fraudulently extract resources from the public, from the people
who have genuinely earned their money. In the same way, fractional
reserve banks counterfeit warehouse receipts for money, which
then circulate as equivalent to money among the public. There
is one exception to the equivalence: The law fails to treat the
receipts as counterfeit.[6]

Fractional-Reserve
Banking under Commodity Money versus Fiat Money

In a commodity-money
regime – such as the gold standard – fractional-reserve
banking is, as Austrian economists show, in effect a form of counterfeiting.
However, what about fractional-reserve banking under a system of
fiat money?

Under fiat
money, banks’ liabilities vis-à-vis clients (as far as demand
deposits are concerned) are payable in the form of base money,
or central-bank money – a type of money that can only
be produced by (government-sponsored) central banks.

Central banks
hold the monopoly over the production of base money. They can increase
the base-money supply at any one time at any amount deemed politically
desirable. It is the central bank that eventually determines whether
or not banks can meet their payment obligations.

It may well
be that the central bank decides, once a bank is called upon by
its clients to pay out demand deposits in cash, to provide sufficient
amounts of notes – by loaning them to the bank and/or by purchasing
part of the bank’s assets.

The essential
point is, however, that banks that engage in fractional-reserve
banking in a fiat-money regime create contractual obligations they
cannot fulfill from the outset. Rothbard notes that

it doesn’t
make any difference what is considered money or cash in the society,
whether it be gold, tobacco, or even government fiat paper money.
The technique of pyramiding by the banks remains the same.[7]

The Uncomfortable
Truth about Fractional-Reserve Banking

Austrian economists,
and Ludwig von Mises in particular, have shown that fractional-reserve
banking under commodity money necessarily causes economic problems
on a grand scale. This is because banks then engage in circulation-credit
expansion – that is, they issue money through lending that
is not backed by real savings.[8]

Circulation
bank credit is inflationary, and it causes economic disequilibria
and overindebtedness of the private sector – in particular
on the part of governments. It is also the very cause of the "boom-and-bust"
cycle.

The latter,
in turn, opens the door for ever-greater doses of government interventionism
– regulations, nationalizations, price controls, etc. –
that, over time, erodes and even destroys the very principles on
which the free-market society rests.

This conclusion
doesn’t change when there is fractional-reserve banking under fiat
money. Fiat money – or, to be more precise, its production
– is already a violation of the free-market principle; and
fractional-reserve banking amounts to leveraging the economic consequences
of fiat money.

For the sake
of preserving prosperous and peaceful societal cooperation, the
very opposite of Mr. Wolf’s conclusion must hold true: namely that
we can and will return to sound money, and the gold standard is
one particular form that is fully acceptable from an economical-ethical
perspective – if and when it is freely chosen by the people.

Notes

[1]
Hans-Hermann Hoppe, "On
the Ultimate Justification of the Ethics of Private Property,"
in The
Economics and Ethics of Private Property: Studies in Political Economy
and Philosophy
, 2nd ed. (Auburn, Alabama: Ludwig von Mises
Institute, 2006), pp. 339–45.

[2]
Murray N. Rothbard called for a return to a 100% gold dollar. However,
this doesn’t contradict the statement given above, as Rothbard’s
recommendation rests on the precondition that "if people love
and will cling to their dollars or francs, then there is only one
way to separate money from the state, to truly denationalize a nation’s
money. And that is to denationalize the dollar (or the mark
or franc) itself. Only privatization of the dollar can end the government’s
inflationary dominance of the nation’s money supply." See Murray
N. Rothbard, "The Case for a Genuine Gold Dollar," in
The
Gold Standard: Perspectives in the Austrian School
, Llewellyn
H. Rockwell, Jr., ed. (Auburn, Alabama: Ludwig von Mises Institute,
1992), p. 5. Rothbard’s recommendation for defining the dollar once
again as a weight of a market commodity, namely gold, rests (i)
on the suitability of using precious metals, especially gold, as
money and, even more important, (ii) the fact that the US government
confiscated gold in 1933 – so that a re-defining of the dollar
in gold would be the natural choice.

[3]
For a thorough discussion see Jess Huerta de Soto, Money,
Bank Credit, and Economic Cycles
(Auburn, Alabama: Ludwig
von Mises Institute, 2006), esp. chapter 3, "Attempts to Legally
Justify Fractional-Reserve Banking," pp. 115–65.

[4]
Hans-Hermann Hoppe, with Jörg Guido Hülsmann and Walter
Block, "Against Fiduciary Media," in the Quarterly
Journal of Austrian Economics, vol. 1, no. 1, pp. 21–22.

[5]
Ibid, p. 26.

[6]
Murray N. Rothbard, The
Mystery of Banking
, 2nd ed. (Auburn, Alabama: Ludwig von
Mises Institute, 2008), p. 98.

[7]
Ibid, p. 100.

[8]
Circulation credit (or Zirkulationskredit) means that
banks, when extending a loan to a consumer or firm, increase the
money stock. In contrast, commodity credit (or Sachkredit)
means that a bank extends a loan to a consumer or firm by merely
transferring already existing money from the saver to the investor.
For a more detailed explanation, see Ludwig von Mises, The
Theory of Money and Credit
(Indianapolis: Liberty Fund,
1981), pp. 296–310.

Reprinted
from Mises.org.

December
27, 2010

Thorsten
Polleit [send him mail]
is Honorary Professor at the Frankfurt School of Finance & Management.

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