Real Bills, Phony Wealth
by Robert Blumen
by Robert Blumen
He who sells what isn't his'n buys it back or goes to prison.
The Real Bills Doctrine was left for dead over 100 years ago. But modern prophets Antal Fekete and Nelson Hultberg have recently attempted to revive it. Their version of the doctrine consists of two elements: the issuance of bills of exchange by clearing houses and the monetization of such bills by banks. My prior articles on this topic (1 2 3 4 5) have dealt with the first part of the doctrine, namely the issuance of bills of exchange. This article concerns the second plank of the doctrine, namely, the monetization of Real Bills through fractional reserve banking.
I will show that advocates of the doctrine misrepresent the Austrian school's banking theory; that their arguments on this subject do not prove their conclusions; and that, far from offering any benefit, the institution of fractional reserve banking is always harmful and pernicious. A sound monetary system is based on the use of gold as money and the elimination of bank credit expansion.
I should mention that, in analyzing Fekete's doctrines, I consider the issue of fractional reserves to be of secondary importance to the problems in his theory of savings. The need for banks to hold Real Bills follows from his theory that the bills of exchange are an economic substitute for saving. I have criticized this theory extensively elsewhere (3 4 5). The bank credit monetization issue is somewhat of a diversion because once the fantasy of paper claims as a substitute for real savings is discredited, the entire doctrine falls apart whether or not banks monetize the bills.
Austrian Banking Theory
Before discussing Fekete's critiques, I will first offer a brief summary of Austrian banking theory. The interested reader should consult Jesús Huerta de Soto's Money, Bank Credit, and Economic Cycles. This magisterial work contains an exhaustive discussion of the legal, historical, and economic aspects of 100% and fractional reserve banking. Any discussion of fractional reserve banking should start from a thorough understanding of the information presented in this book. His treatment of the issue is far in excess of what can be conveyed in a short article.
Professor de Soto explains that, throughout the history of banking, across many cultures, times and places, the relations between bank customers and banks have been governed by a consistent set of legal principles, what might be termed a common law of banking.
The common law of banking recognizes two types of banking contracts. When a customer hands gold coins over to a bank, either the gold is given to the bank for safekeeping only, or it is loaned to the bank. In the first case, the contracts is called the irregular deposit contract and in the second case, a loan contract. Professor de Soto gives a detailed legal and historical analysis of these two types of banking contracts in Chapter 1 of his book.
Under the irregular deposit contract, the immediate availability of the funds is not transferred by the depositor to the bank. On the contrary, the bank is obligated to maintain availability of the funds for the customer on demand, at all times. In order to do so, the bank is required to keep the entire amount of all of the deposited coins for all customers on hand for immediate redemption. Under this type of contract, the customer pays the bank a fee for storage.
When a customer enters into an irregular deposit contract with a bank and the bank issues bank notes or a demand deposit for the same quantity of gold that was deposited, no money creation takes place. Bank notes and demand deposits are ways of representing the depositor's ownership of the gold.
Under the loan contract, availability of the funds is transferred to the bank, for a defined period of time, at some rate of interest. The bank takes on the obligation to repay the principal amount plus some interest at a later time. Note that in contrast to an irregular deposit, in which the customer pays the bank, under a loan, the bank pays the customer. The willingness of the bank to pay for a loan follows from the services provided to the bank by full ownership of the funds.
Under traditional law, loan banking is an entirely different business than deposit banking. When a bank has borrowed funds at interest, it must invest the funds in order to earn a return greater than its cost. The bank legally has full use of the funds, therefore the bank is entitled to lend the funds. The loaned money is not available to the bank customer on demand, although in some types of credit contracts, a bank might agree to make a best effort to liquidate part of their loan portfolio if the depositor wants to cash in part of the loan on short notice.
Under the irregular deposit contract, the bank may not loan out the funds because if the bank did so, the funds would not be available for immediate return to the customer. Fractional reserve banking occurs when a bank violates the irregular deposit contract. The reason that fractional reserve banking is inherently fraudulent is that it is a violation of the irregular deposit contract.
There is always a temptation for deposit banks to become fractional reserve banks because of the interest they could earn on their customers' money. There are several ways this transformation could be carried out. One would be for a bank to loan out funds that it was holding to satisfy an irregular deposit contract. Another would be for the bank to create additional demand claims against its existing gold without having accepted any new gold to satisfy those claims. For example, a bank purchases some asset — say a Real Bill or other debt security — and issues new bank notes (or creates checking accounts) to pay for them.
When a bank purchases debt securities using funds that were held on deposit, the asset is "monetized": the bank has created money out of nothing with which to pay for the asset. The bank could pay by the creation of new deposit accounts offering immediate availability for which no gold actually exists. Or the bank might pay the seller with physical coins looted from existing deposits. This would cause other deposits to be in default of the availability requirement. In either case, new fictitious demand deposits have come into being. These deposits are illegitimate claims against the bank's existing base of irregular deposits.
In relation to the two types of banking contracts, the term "fractional reserve" applies only to the irregular deposit. The term "fractional reserve" simply does not apply to loan contracts because there is no reserve requirement per se. When a bank has entered loan contracts, it might hold some reserves against loan defaults, but only as a practical matter, not a legal one.
Credit banks are free to offer legitimate financial instruments based on a loan contract, such as CDs, money market funds, and short-term bond portfolios holding bills of exchange. These securities are issued when the bank customer loans funds to the bank. All of these exist now and are not problematic under the 100% reserve requirement. Banks could also agree to make a "best effort" to liquidate shares in their underlying bond portfolio for as close to their principal value as possible should a customer wish to withdraw a loan.
Within a 100% reserve banking system, there is no legal problem with banks offering money market mutual funds subject to the loan contract. These accounts might hold high-quality short-term credit instruments, including bills of exchange. When a customer wishes to liquidate shares in a MMF, the bank could not guarantee immediate payment in gold on demand because most or all of the gold would have been loaned out. However, the bank could make a best effort to sell a portion of the fund's underlying credit portfolio in the credit market, for some amount of gold. After the sales of securities had settled (a process that currently takes one to three days for most securities in US markets) the funds would be available for the customer.
However, it must be emphasized that Money market funds, CDs, or other credit contracts are not money. They are not money for the same reason that all debt is not money. Debt is a promise to repay money at some time in the future. The measure of whether something is or is not money is that money enables the final settlement of a transaction of loan. A loan that is repaid with another loan is not really repaid; it is still an outstanding loan. While bills of exchange are collateralized debt contracts, collateralized debt is still debt.
I have provided a more fully worked-out argument to the effect that debt is not money in my article on Charles Holt Carroll. Carroll was one of the most astute banking theorists in history and was a source of great wisdom on this topic. For those seeking an understanding of the difference between money and debt, his writings are unmatched in their clarity and the vigor of his attacks. Carroll properly identified fractional reserve banking as "the organization of debt into currency," that is, the creation of "fictitious currency" out of what is actually debt.
Carroll wrote on the topic of bills of exchange:
Some writers have placed promissory notes and bills of exchange in the category of currency, but it is altogether a mistake; their affinity is with circulating property, not with money. They may be exchanged for property, and so might the property upon which they are drawn; and if offered for sale for money they are still more like property; they are exchanged against money, and are more likely to have the effect of increasing the exchange value of money than of reducing it, as they would if they were of the nature of currency. They are, however, neither money, nor currency, nor property, but more records of an unfinished bargain; the purchase money is not paid, and these are memoranda or written evidences of what the debtor is to do to complete the contract. One species of property exchanges for another; this is barter, the fundamental principle of trade; and when promissory notes and bills of exchange are exchanged for money, they take the position of property as essentially different from money as the goods that were delivered for them, or for the fund upon which they are drawn.
Fekete's Attack on the Austrian School
Now I will return to an analysis of Fekete's doctrine. Fekete presents his doctrine as a remedy for alleged deficiencies in one hundred percent reserve (irregular deposit) banking. He and Hultberg makes a series of arguments against one hundred percent reserves (the irregular deposit contract): that without credit expansion, investment could not be financed on a sufficient scale and economic stagnation would result; that it has never existed in practice; that bank notes are inherently credit transaction; that bank contracts deal with flows rather than stocks; that irregular deposit banking is not compatible with clearing systems; and that the historical existence of clearing systems proves their theory.
Deposit Banking Never Existed?
Fekete charges "The first thing to be observed about the '100 percent gold standard' is that nothing approximating it has ever been tested in practice."
On the contrary, de Soto, in Chapter 2, gives numerous examples of deposit banks throughout European history. I cite one example here. The interested reader should consult de Soto for more detail.
The last serious attempt to establish a bank based on the general legal principles governing the monetary irregular deposit and to set up an efficient system of government control to adequately define and defend depositors' property rights took place with the creation of the Municipal Bank of Amsterdam in 1609. It was founded after a period of great monetary chaos and fraudulent (fractional-reserve) private banking. Intended to put an end to this state of affairs and restore order to financial relations, the Bank of Amsterdam began operating on January 31, 1609 and was called the Bank of Exchange.103 The hallmark of the Bank of Amsterdam was its commitment, from the time of its creation, to the universal legal principles governing the monetary irregular deposit. More specifically, it was founded upon the principle that the obligation of the depository bank in the monetary irregular deposit contract consists of maintaining the constant availability of the [deposited funds] in favor of the depositor; that is, maintaining at all times a 100-percent reserve ratio with respect to "demand" deposits. (p. 98)
According to Rothbard, deposit banking as a business was destroyed by a series of bad court decisions in the Anglo-Saxon world. In court cases brought by depositors against banks for violation of their deposit contract, courts ruled that whenever money changes hands between a bank and its customers, it is necessarily a credit transaction. This legal development destroyed legal protection of the irregular deposit contract and opened the way for the widespread development of fractional reserve banking and eventually, central banking.
Professor de Soto provides extensive evidence that the deposit contract has received the protection of law throughout most of the history of banking. As he writes (page 70, note 52):
…bankers always carried out their violations of general legal principles and their misappropriations of money on demand deposit in a secretive, disgraceful way. Indeed, they were fully aware of the wrongful nature of their actions and furthermore, knew that if their clients found out about their activities they would immediately lose confidence in the bank and it would surely fail. This explains the excessive secrecy traditionally present in banking. Together with the confusing, abstract nature of financial transactions, this lack of openness largely protects bankers from public accountability even today. It also keeps most of the public in the dark as to the actual nature of banks. While they are usually presented as true financial intermediaries, it would be more accurate to see banks as mere creators of loans and deposits which come out of nowhere and have an expansionary effect on the economy.
All Banking Is Credit Banking?
Fekete argues that the bank notes can not represent irregular deposit contracts. In his opinion, when someone accepts a banknote they are necessarily entering a loan contract:
My position is that the holders of gold certificates and, for the stronger reason, holders of bank notes are in fact (voluntary or involuntary) grantors of credit. What they hold is a promise to deliver a present good, not the present good itself. In other words, paper currency such as a gold certificate or a bank note is a future good.
Fekete rules out a priori the possibility that the bank and customer intend to enter an irregular deposit contract. Fekete does not provide any explanation of why banks and their customers should not able to execute irregular deposit contracts, nor why these contracts should not receive legal protection. In any case why should Fekete's position take precedence over the intentions of the parties involved? What if the bank customer wishes to enter into an irregular deposit contract and the bank agrees? The issue should be decided entirely between the bank and the bank customer.
In Lecture 12, Fekete again confuses the deposit contract with the credit contract:
Some sound-money theorists such as Murray Rothbard see the solution to the problem of credit abuse in the so-called 100 percent gold reserve banking. They suggest that banks should maintain 100 percent gold reserves against all their outstanding credit.
Fekete is again ignoring the distinction between deposit banking and credit banking. If the traditional system of contract law as described by de Soto were enforced, then banks would only be required to hold available reserves against irregular deposit contracts but not against credit contracts. When a bank receives funds through a loan contract with a bank customer, the bank is free to loan out these funds again. There is no reserve requirement in the sense that the term is used regarding deposits.
Confusion of Stocks and Flows?
In his Lecture 8, Fekete advances another argument against the reserve requirement: that it confuses stocks and flows.
The notion that the bank's promise, if it is to be honest, forces it to have a store of gold on hand equal to the sum total of its note and deposit liabilities stems from a fundamental confusion between stocks and flows. The promise of a bank, as that of every other business, refers to flows, not stocks. The promise is honest as long as they see to it that everything will be done to keep the flows moving.
On the contrary, it is not the case that the promise of every other business refers to stocks. Rothbard in Mystery of Banking (chapter 7) gives the example of bailment law. A bailment law is a promise to hold a fungible good for safekeeping. This is a promise referring to a stock, not a flow. An irregular deposit contract is a banking bailment contract.
More fundamentally, money, in distinction from all other goods, is always a stock. Every unit of money is held by someone as part of their stock of money. Unlike other goods, money is not consumed as such, it is always held. When the owner of one unit of money spends it, the buyer of that money becomes its new holder. The purpose of the irregular deposit contract in banking is to maintain integrity in the holdings of gold so that each ounce of coin can be properly transferred when the owner wishes to do so. Once a deposit is loaned out, it is no longer available to the owner to transfer.
Deposit Banking not Compatible with Clearing?
Fekete advances another attack on Austrian banking theory with the claim that deposit banking is incompatible with clearing systems:
The first thing to be observed about the "100 percent gold standard" is that nothing approximating it has ever been tested in practice. All historical metallic monetary standards had a supporting clearing system, more or less developed, which limited the actual payment in the monetary metal to net trade, that is, the difference between the value of total purchases and that of total sales.
Fekete seems to think that under the common law, irregular deposit banking would require that all transactions within the economy must be settled at the time they are closed through a physical payment of coin. This is not the case. It is entirely possible to have clearing without the monetization of bills because it is not necessary for banks to monetize clearing instruments in order for clearing systems to work. In linking clearing with bank reserves, Fekete posits a necessary connection between two things that are in fact unrelated.
There are four combinations of reserve requirements and clearing systems, illustrated in the table below. Any one of the four boxes represents a possible system. The nature of bank reserves and banks and the use of clearing systems are independent issues.
Fractional reserve with clearing (Fekete — Real Bills Doctrine)
Fractional reserve without clearing
One hundred percent reserve with clearing
One hundred percent reserve without clearing
History Validates the Real Bills Doctrine?
Fekete and Hultberg frequently blur distinction between clearing as such and the Real Bills Doctrine which consists of clearing and fractional reserve banking. In order to establish their doctrine, they must show that both components are necessary. If they showed that clearing systems are beneficial, that would not be enough.
Here Hultberg tries to establish his position by referring only to the clearing part of the doctrine:
The most important mistake being made by Corrigan and the Rothbardians is that they continue to ignore the fact that in a free-market system, Real Bills will automatically spring up and be used wherever they are functional. There is nothing to stop them! They are not fraudulent; and they are not governmentally orchestrated. So they will certainly be utilized among producers, distributors and retailers if we are going to promote freedom.
Memo to Mr. Hultberg: there is absolutely no problem with clearing houses issuing Real Bills. I have covered in detail the views of Rothbard and Mises on clearing: they have no objection to it. Austrians and Feketeists are agreed: clearing systems are a fine thing.
But the spontaneous issue of Real Bills does not establish the Real Bills Doctrine. Nor does widespread use of clearing systems by itself establish a case against Austrian banking theory. What Fekete and Hultberg would have to show if they wanted to establish the truth of their doctrine is the necessity of banks monetizing the bills. Lengthy discussions of clearing systems, no matter how learned, are not enough.
Here, Hultberg suggests that the adoption of clearing provides validation by the market that more money is needed:
So is it rational to maintain, as Rothbard does, that there is "never any need for a larger supply of money?" The marketplace itself is telling us just the opposite — that there is often a definite need for a larger supply of money! If there was no need for a larger supply, why did demand for it spring up so abundantly to create the miracle of bills of exchange from the Renaissance era to the end of the 19th century?
The response to Fekete and Hultberg is a methodological point. No observation by itself can prove a theory. Only a sound theoretical argument can prove a theory. Other than for Dr. Pangloss, it is not true that anything that exists is for the good. Some things exist not because they are generally useful and good, but because they benefit one set of people at the expense of other people.
Even the existence of fractional reserve banking does nothing to prove that fractional reserve banking is generally beneficial, only that someone benefits. The motivation for lending reserves comes entirely from the banks' desire to earn a profit off their customers' deposits. The benefit goes entirely to the banks. There is no general benefit. (For a discussion of whether fractional reserve banking has "passed the market test," see Hülsmann's article on this topic.)
The observation of the existence of clearing does not go very far by itself. All that we can conclude from the adoption of clearing is that the people who adopt it derive some economic benefit from adopting it.
Business firms do derive benefits from clearing: it reduces their need to hold as much cash and enables cost savings in the settlement process. Other than a reduction in settlement costs, this does not produce any systemic benefit. Any financial innovation that reduces the need to hold cash (credit cards, money market funds, etc) results in a corresponding increase in the price level that cancels out any systemic benefit. Those who do not adopt this innovation would be at a disadvantage to those who did. Only the early adopters benefit at the expense of the late adopters.
Fractional reserve banking is the magic elixir of inflationists. To be sure, banks can create money, but in doing so, they do not create wealth, they merely depreciate the value of existing money. In spite of Fekete's protests to the contrary, the monetization of bills is no different than any other monetization of debt. Monetization of debt is the first on-ramp on the road to central banking and hyperinflation. Carroll, in one of most lucid critiques, observed, "It is marvelous what a perfect hallucination upon this subject possesses the minds of men otherwise thoroughly intelligent."
August 16, 2006
Robert Blumen [send him mail] is an independent software developer based in San Francisco.
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