Real Bills, Phony Wealth
Debtor’s Prison
by
Robert Blumen
by Robert Blumen
DIGG THIS
He
who sells what isn’t his’n buys it back or goes to prison.
~ saying
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.
Fekete is wrong
on all counts. Regarding the first argument, the interested reader
should consult my articles (3
4 5).
I will address the other two here.
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.
Conclusion
 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.
Copyright
© 2006 LewRockwell.com
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