Rethinking Paradigms

Fractional-Reserve Banking: Not Fraud, Not Folly

by Wendy McElroy

bankingFractional-reserve banking is a contentious issue within libertarian theory. This is confusing because I do not consider it to be part of libertarian theory at all.

The practice of fractional-reserve banking has been variously defined. A standard and neutral definition is: the practice by which a bank maintains readily available reserves that represent only a portion of its customers’ deposits while lending out or investing the rest. At the same time, the bank stands by its obligation to redeem demand deposits upon request. Fractional-reserve is often viewed as an aspect of centralized banking or government regulation but it is an entirely separable practice that has functioned within free banking systems. Indeed, fractional-reserve was standard in the 18th century Scottish free banking system which economist Lawrence H. White described in his classic work Free Banking in Britain – Theory, Experience and Debate 1800-1845.

The iconic Austrian economist Murray Rothbard offered a different definition. In an article published by The Freeman (September and October 1995), he described his view of how fractional reserve operated even in the absence of a central bank. Rothbard explained, “I set up a Rothbard Bank, and invest $1,000 of cash (whether gold or government paper does not matter here). Then I ‘lend out’ $10,000 to someone, either for consumer spending or to invest in his business. How can I ‘lend out’ far more than I have? Ahh, that’s the magic of the ‘fraction’ in the fractional reserve. I simply open up a checking account of $10,000 which I am happy to lend to Mr. Jones. Why does Jones borrow from me? Well, for one thing, I can charge a lower rate of interest.” Rothbard called this “counterfeiting” because money is created “out of thin air.”

Additionally he viewed fractional-reserve as a fraud perpetrated on the original depositors. Why? If “the American public…in unison, demanded cash. What would happen? The banks would be instantly insolvent, since they could only muster 10 percent of the cash they owe their befuddled customers.”

Rothbard’s depiction encounters some practical objections. For example, he is assuming all deposits could be demanded in unison – that is, he assumes they are demand deposits and not term ones. Moreover, the same sort of logic could be used to discredit insurance companies. If all (or a significant enough number of) insurance holders filed claims in unison, the insurance companies would go bankrupt. And, yet, I am not aware of insurance companies being similarly viewed as fraudulent.

Instead of dwelling on side issues, however, I accept the description of fractional reserve offered by Rothbard and various other Austrians. I will disagree with them on their own terms.

What Is NOT Being Debated

Both libertarian defenders and opponents of fractional-reserve reject a state monopoly of money or banking; most of them reject any state involvement at all. Instead, both sides advocate privately issued currency that enjoys no legal privileges beyond those enjoyed by individuals. They argue for banking and currency by contract, by voluntary acceptance.

The disagreement on fractional-reserve banking is twofold. Is it fraud? Is it economically prudent? Only the first question is a libertarian one.

Libertarianism can be loosely defined as the political and social philosophy based on the right of every person to the peaceful use his own body and property. Stated in a ‘negative’ manner: libertarianism opposes force and fraud; the latter is a form of theft because it is the wrongful assumption of a property title.
Thus, if fractional-reserve banking is fraud, then it falls squarely within the realm of libertarian theory, and it would be outlawed by a free-market system. But if it is not fraud and merely imprudent, then it falls outside of libertarian analysis however interesting or useful an economic issue it may be. In other words, if fractional-reserve banking is voluntary and non-fraudulent, then a libertarian society would not outlaw the practice even if it proved to be a foolish one.

Is Fractional-Reserve Banking Fraud?

Theft is the non-consensual use of another person’s property. The owner relinquishes some or all control of his property in exchange for a described value. If the value is not as described, then no legitimate exchange or contract has occurred. As economist Bryan Caplan stated, “If you offer me a Mitsubishi 5500 projector in exchange for $2000, and hand me a box of straw instead, you are using my $2000 without my consent (which was contingent, of course, on you giving me the projector).”

The issue upon which fraud hinges is “informed consent.” If depositors at a fractional-reserve bank are fully informed of the bank’s policies and practices, then fraud is not possible. With full knowledge of the terms and the risk, the depositors are entrusting their money to the bank in exchange for an interest rate. (By contrast, a 100%-reserve bank that would not have the benefit of using most of the money deposited would presumably charge a storage fee rather than offer interest. Indeed, this is what happens with the 100%-reserve storage called safe deposit boxes.) Otherwise stated, an informed depositor may make a poor choice with whom or where to entrust his money but the free market and libertarianism does not prohibit even stupid choices.

To maintain the accusation of fraud in the presence of informed consent, some Rothbardian economists expand the definition of ‘fraud’ itself. As a counter to Bryan Caplan’s arguments in defense of fractional reserve, for example, Walter Block responded, “But, lying is only sufficient for fraud, not necessary. There are other ways to commit fraud besides an outright lie. For example, it is fraudulent for a bank or anyone else to try to sell you a square circle, even if they do not lie about it. Why? Because there is no such thing as a square circle, and, in order for a contract to be a valid one, not only must both parties agree to it (neither lies to the other), but, also, the contract must be in accordance with LOGIC.”

This is a strange requirement. It means a 3rd party would be able to invalidate a contract in which there is full disclosure and with which the contracting parties are satisfied. As with insurance policies that cannot be paid out if there is a ‘run’, there are quite a few contracts that may well involve what some Austrians see as a breach of ‘logic’. For example, a man might well pay a priest to hear confession and absolve his sins, or a psychic to tell his future. As long as both parties accept the logic of the exchange, it is not the business of an atheistic 3rd party to intervene and invalidate the contract. Just as the free market and libertarianism do not outlaw stupidity, neither do they prohibit a breach of logic. And a 3rd party has no business substituting his logic for that of the contracting parties.

The 19th century individualist anarchist Benjamin Tucker wrestled with much the same issue as the “illogical” contract. Like many contemporaries, Tucker believed that charging interest or rent was “usury” – an unethical or immoral monetary practice. He thought such practices were sustained by the state and would naturally disappear in a free market. When confronted with the possibility of people choosing to pay interest in a free market, Tucker agreed that such contracts would be valid. They would be immoral, unwise, and worthy of scorn but they would be valid because they would be voluntary.

Equally, contracts that seem illogical to a 3rd party are valid nonetheless.

Is Fractional-Reserve Banking Foolish?

The work of the libertarian monetary theorists White and George Selgin long ago convinced me that fractional-reserve banking would thrive in the free market, as it has done in the past.

The free market is well able to manage the problems perceived by fractional reserve opponents. Banks would rest increasingly upon their reputations as good managers; those with impeccable records of redemption would probably offer the lowest available interest on deposits. Defaulting banks would not be bailed out except in a free-market manner – e.g. by an insurance policy or buy-out. Perhaps insurance would be an optional purchase for individual depositors as well. Moreover, a bank that diluted the value of its own notes through an ‘inflation’ of supply would be ‘corrected’ with a loss of reputation and customers.

Opponents of fractional reserve would disagree, of course. But the important point here is that the disagreement is no longer libertarian but utilitarian. The question has become “Which is the best banking system: fractional or 100% reserve?” My answer: let the free market decide. Let individuals choose for themselves.