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:

"If 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.

"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 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 owner?

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!

Notes

  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.

November 17, 2008