Saturday, June 26, 2010

Fractional Reserve Banking: An Evil?

Hostility to fractional reserve banking is ubiquitous. The Austrians hate it and regard it as a type of fraud. There are even a good many people on the left who despise fractional reserve banking as an evil institution. However, a careful look at fractional reserve banking suggests that it is not necessarily a problem with modern fiat money, a well-regulated financial system, deposit insurance and a central bank ready as the lender of last resort. Fractional reserve banking without these safeguards can be extremely destabilizing and has often led to disastrous bank collapses and depressions.

I have to admit that every time I hear some Austrian complain about fractional reserve banking I laugh. The Austrians are adamant that fractional reserve banking is an evil fraud, yet since the early 19th century this system was a fundamental characteristic of modern Western capitalism. Fractional reserve banking was a major invention of the free market. What government ever forced banks or the public to engage in the practice? For example, from 1836 until 1913, the US had no central bank, yet fractional reserve banking was the norm (see G. B. Grey, Federal Reserve System: Background, Analyses and Bibliography, p. 90). The practice has continued today, yet Austrians reject the idea and have proposed two alternative systems (with a return to the gold standard), as follows:
(1) Free banking. This was Ludwig von Mises’ suggestion. There would be no bank regulation, no central bank monopolies, no bank licensing, and no legal barriers to entry.

(2) 100% reserve banking. Banks would not be allowed to issue more receipts for gold or silver than they have on deposit. This was Murray Rothbard’s solution.
These ideas are of course justified by the idea that fractional reserve banking is fraud, a view held by Murray Rothbard and modern Austrians like Hans-Hermann Hoppe.

But the libertarian scholar Michael S. Rozeff (2010: 497–512) has clearly demonstrated that the Austrian view of fractional reserve banking as fraudulent is wrong. If you take a pro-free market, neoclassical, or libertarian view of economics, then in fact you have no good reasons to reject fractional reserve banking (and even those on the left can accept it, with the limits I described above).

The reasons are as follows. The Austrians have a false and indefensible view that bank deposits remain the property of the depositor. They fail to understand that, when a depositor places money in a factional reserve bank, the depositor has exchanged one set of property rights for another.

By contrast, if you put your money or gold into a warehouse, then the owners or managers of the warehouse have no property rights with respect to your money stored there (such money is legally known as a “depositum,” which means “something given or entrusted to another for safe-keeping”). The identical deposit must be returned to the owner or, in legal terms, it must be returned in specie (“in its own form”).

But when a modern fractional reserve bank takes money for a new deposit this is actually a personal loan to the bank, which is why the bank pays interest for it. The money in the deposit becomes the property of the bank. The money is a loan, or legally a “mutuum,” which means “a contract under which a thing is lent which is to be consumed and therefore is to be returned in kind” (the modern sense of the English word “deposit” is thus misleading when it refers to money in fractional reserve banking). The depositor who lends the money gets a credit (or IOU) from the bank and a promise to pay interest: “the very essence of banking is to receive money as a [m]utuum” (MacLeod 1902: 318). The money has been “sold” to the bank as a mutuum and is to be returned in genere (“in general form”), which means you do not necessarily get the same money back, but just an equivalent amount with interest.

In demand deposits, you have lost your absolute property rights to the money when you lent it to the bank, and instead have entered into a contract with the bank to allow them to use it, even though they are obliged to return to you on demand money to the same amount in whole or in part from their other reserves and deposits (MacLeod 1902: 324). This can also be expressed in this way:
“General deposits are obligations of the bank to pay money. They may be payable on demand or at a stated time in the future. The great bulk of commercial bank deposits are payable on demand. They create between the bank and the customer the relation of debtor and creditor, the title to the deposit passing to the bank, while the depositor acquires a right to receive a stated sum of money” (Johnson 1911: 117).
It is certainly true that many members of the public may be ignorant of these facts above. Yet it is also true that, if people did not understand the basic facts behind fractional reserve banking, there would be no such thing as a bank run. Yet bank runs were very frequent before the 1930s when modern fiat systems and deposit insurance generally became the norm. In order for such bank runs to have occurred many people must have understood at some level that the banks do not operate on a 100-percent-reserve basis. Perhaps a good many were ignorant of this, but the fact remains that modern fractional reserve banking required a legal contract between depositors and banks, specifying that the property rights to the money had passed to the bank and in return an IOU or credit had been granted to the depositor. This is not fraud. This is a free contract.

As Selgin and White argue, even if some members of the public do not understand that fractional reserve banks do not have 100% reserves,
“[i]f any person knowingly prefers to put money into an (interest-bearing) fractional-reserve account, rather than into a (storage-fee-charging) 100 percent reserve account, then a blanket prohibition on fractional-reserve banking by force of law is a binding legal restriction on freedom of contract in the market for banking services” (Selgin and White 1996: 88).
Furthermore, as long as members of the public were informed of the facts of fractional reserve banking and freely entered into the contract with the bank, then fractional reserve banking is not inherently fraudulent or immoral.

One can also make the point that, if people had really wanted to put their money into non-fractional reserve warehouses to keep their money completely safe, then one wonders why 19th and early 20th century capitalism never developed a large business sector providing just this service.

Fractional reserve banking before the 1930s thus allowed the creation of fiduciary media (a type of money substitute), including banknotes and bank deposits (which could be drawn on by check or withdrawn). It also allowed the creation of credit money in the form of bank deposits and banknotes. Mises defined fiduciary media as money substitutes where the issuer of the fiduciary media maintains less than 100% reserves in commodity money (gold or silver).

Modern Austrians reject fiduciary media that are not backed by commodity money.

Another libertarian scholar called George Selgin argues in response to this as follows:
“In a recent twist on the [fractional reserve] ... fraud argument, Hans-Hermann Hoppe and his co-authors … argue that holders of fiduciary media are, in fact, not victims of bank fraud at all but co-conspirators who assist bankers’ fraudulent undertakings by misrepresenting themselves “as the owners of a quantity of property that they do not own and that plainly does not exist” … Apart from begging the question of who are the victims, this novel fraud argument is based on a simple failure to recognize that redeemable banknotes and deposit credits are not “titles,” as Hoppe and his co-authors claim. They are instead IOUs, so there is nothing inherently fraudulent about there being more of them in existence at any moment than the total stock of what they promise to deliver. (If all IOUs had to represent existing property in order to be non fraudulent, most loan transactions would be fraudulent.) A person who deposits gold in a bank in exchange for a redeemable banknote does not retain ownership of the gold, but instead gives it up, albeit for an indefinite period of time … The bank, in issuing IOUs against itself, is not analogous to a counterfeiter, as Hoppe and his co-authors claim, for the simple reason that the bank acknowledges its own debts, whereas a counterfeiter issues IOUs with someone else’s name on them” (Selgin 2000: 93–100).
Banks keep reserves to meet their obligations to the depositors (the people to whom they are obliged to return money on demand). In ordinary circumstances, this system functioned adequately. But, if all depositors wanted to withdraw their deposits at the same time, the bank would experience a run and collapse, because a fractional reserve bank does not have enough reserves on hand to pay everyone.

This is because the banks were creating credit money (a type of fiduciary media) from deposits and the people to whom they loaned the money had used it.

Credit money was vitally necessary for investment and expansion of output. One can note that, even at the beginning of the 19th century, bills of exchange (a type of money substitute) constituted roughly 70% of the money in circulation. Only 30% consisted of banknotes and precious metals (see U. van Suntum, The Invisible Hand: Economic Thought Yesterday and Today, p. 74).

The truth is that, to see anything like a 100%-reserve-banking world, we would have to go back to the 16th to 18th centuries.

Once banks started to issue banknotes against gold deposits that were already used to back bills of exchange, the banks were creating new money (fiduciary media). Capitalism in the 19th century was based on fractional reserve banking and increasing use of fiduciary media.

Since the gold standard simply did not provide enough commodity money to meet the demand for credit in a growing economy, the 19th century was marked by deflationary periods (e.g., from 1873–1896). In particular, from 1814 to 1913, prices declined by 44% in the US, 44% in the UK, 22% in Germany, and 24% in France (Triffin 1985: 150–151).

In the face of rising demand for money, 19th century nations created credit money:
“[the] reconciliation of high rates of economic growth with exchange-rate and gold-price stability [in the 19th century] was made possible … by the rapid growth and proper management of bank money, and could hardly have been achieved under the purely, or predominantly, metallic systems of money creation characteristic of the previous centuries. Finally, the term ‘gold standard’ could hardly be applied to the period as a whole, in view of the overwhelming dominance of silver during its first decades, and of bank money during the latter ones. All in all, the nineteenth century could be far more accurately described as the century of an emerging and growing credit-money standard, and of the euthanasia of gold and silver moneys, rather than as the century of the gold standard.” (Triffin 1985: 153).
Triffin (1985: 152) estimates that in 1800 bank money or credit money probably constituted less than 33% of the money supply. But by 1913 paper currency and bank deposits accounted for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10%.

Thus growth rates in the 19th century were only sustained by a massive expansion of credit money, and what economic growth that did occur was not achieved under the type of “pure” gold standard that existed in previous centuries.

The only way to have ended the fractional-reserve system that allowed this credit money creation would have been by government intervention. But that would have choked off economic growth.

Are there arguments against fractional reserve banking from the perspective of the left? Indeed there are. The 19th-century fractional reserve system was not usually regulated (or regulated very poorly), had no deposit insurance, and sometimes no central bank as a lender of last resort. This meant that the 19th century saw repeated and endemic financial crises and panics that set off severe recessions or depressions. Thus the 19th-century business cycle was frequently marked by speculative asset bubbles in boom times that collapsed in bank runs and crises setting off contractions in the real economy. Fractional reserve banking requires careful financial regulation, separation of commercial and investment banks, and a central bank. Without these interventions it is a potentially dangerous system.


BIBLIOGRAPHY

Block, W. “Walter Block versus Bryan Caplan on Fractional Reserve Banking,”
http://www.lewrockwell.com/block/block110.html

Johnson, J. F. 1911. Banking Principles, Alexander Hamilton Institute, New York.

MacLeod, H. D. 1902. Theory and Practice of Banking (6th edn), Longmans, Green, Reader, & Dyer, London.

Rozeff, M. S. 2010. “Rothbard on Fractional Reserve Banking: A Critique,” Independent Review 14.4 (Spring): 497–512.

Selgin, G. 2000. “Should We Let Banks Create Money?” Independent Review 5.1 (Summer): 93–100.

Selgin, G. A., and White L. H. 1996. “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians!,” Review of Austrian Economics 9.2: 83–107.

Triffin, R. 1985. “Myth and Realities of the Gold Standard,” in B. Eichengreen and M. Flandreau (eds), The Gold Standard in Theory and History, Routledge, London and New York. 140–161.

7 comments:

  1. A much needed post. However, I think you give the Rothbardians too much credit by characterizing their anti-fractional reserve position as the "Austrian" view. Even among self-styled Austrian economists (I say "economists" to make clear that I'm not counting mere "fans" of Austrian economics, many of whom know no more about it than what they read on Mises.com), it is a minority view.

    For more on the wrongheaded history behind the Rothbardian position have a look at my working paper, "Those Dishonest Goldsmiths," available online as an SSRN working paper.

    ReplyDelete
  2. Hello Professor Selgin,

    Your points are excellent and I have clearly made an error in characterizing the
    Rothbardians' view on FRB as the "Austrian" view. I will certainly read your paper on the goldsmiths.
    If you read this response, can I ask if you regard yourself as an Austrian or as a neoclassical libertarian?
    I have found what must be your website here:

    http://www.terry.uga.edu/~selgin/

    Regards

    ReplyDelete
  3. "They fail to understand that, when a depositor places money in a factional reserve bank, the depositor has exchanged one set of property rights for another."

    It's not a failure of understanding this concept, but a rejection of it. Rothbard noted the historical evolution of bailment law, whereby bank deposits came to be seen as debts, rather than a bailment. He cites the decisions of Carr v. Carr [1811], Devaynes v. Noble [1816] and Foley v. Hill and Others [1848] to explain this development.

    They [Austrians] argue that banks should perform the role of a secure warehouse, or a 'bailor'. They argue, as you noted, that deposits should remain property of the depositor.

    "The Austrians have a false and indefensible view that bank deposits remain the property of the depositor."

    The Austrians argue this position should be the case, but they are not arguing that it is currently the case. You seem to confuse the words 'should' and 'is'.

    Nonetheless, I'm interested to know, how & why is the traditional view of bailment "false and indefensible"?

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  4. First of all, there's no official "Austrian position" on FRB or 100% reserve banking.

    And I think Rothbard (as Walter Block explains) tries to make a difference between a demand deposit (which, according to Rothbard, should not yield any interest and should not be subject to FRB) and a time deposit. Anyway, I think that the Rothbardian idea of FRB as fraud is just silly. It can be established out of a voluntary order, and even the praxeological attack on FRB by Hoppe, Hulsmann and Block is somewhat silly (Against Fiduciary Media, check it on https://mises.org/journals/qjae/pdf/Qjae1_1_2.PDF).

    Also, Mises position on the subject is rather dubious, so I wouldn't put any word on his mouth about this issue. He championed the wertfrei economics, all we know is he favoured a return to the gold standard and a return to free banking (we may say we don't know nothing about reserve requirements).

    What is very difficult to say is to what extent FRB is inherently stable, there are lots of papers about it, but this is a part of empirical economics, a much more difficult way to get the "truth".

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  5. What is very difficult to say is to what extent FRB is inherently stable

    I think the evidence suggests that, in the absence of a lender of last resort and deposit insurance, FRB can be prone to bank runs and devastating financial crises.

    Some cases in point: Australia's banking crisis in the 1890s and the US banking collapses 1929-1933.

    On Australia's crisis (which occurred under the gold standard and with no central bank), see Charles R. Hickson and John D. Turner, 2002, “Free Banking Gone Awry: The Australian Banking Crisis of 1893,” Financial History Review 9: 147–167.

    Government intervention through a central bank, deposit insurance and effective financial regulation to minimize reckless lending reduce uncertainty and make a FRB system more stable and more effective in creating productive investment.

    The reason we have these interventions is precisely because people (even bankers, business people and investors) found the laissez faire FRB system too unstable.

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  6. Couldn't it be that in nowadays world, with lots of central banks pumping fiduciary media and creating bubbles anytime, any country that implements free banking FRB would be subject by those "external attacks" and make it very unstable?

    Maybe the case is now stronger for the implementation of a 100% commodity backed money.

    ReplyDelete
  7. Thanks for this article, and especially for the citations. What's always bothered me about this debate is the fact that no capitalists actually want to abandon FRB (or, for that matter, the Fed.

    ReplyDelete