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Guido Hülsmann's "Revolutionary Essay" on Fractional-Reserve Banking

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In a must-read post on Zero-Hedge, Tyler Durden highlights Guido Hülsmann’s neglected 2003 article “Has Fractional-Reserve Banking Really Passed the Market Test?” Durden lauds the article and predicts that it “may prove to be the most revolutionary essay in the history of monetary economics and banking, if only it receives the level of appraisal and promotion it deserves.”

The central–and brilliant–insight of Hülsmann’s article is that in a market completely free of legal restrictions on money production, money certificates, that is, genuine titles to money actually on deposit, would drive fractional reserve bank (FRB) notes and deposits out of monetary circulation. The reason is that the latter are not titles to present money but credit instruments that “promise to pay” money at some point in the future on demand. In the case of a title to money, the holder of the deposit title, whether in the form of a note or checking account, retains ownership of the money and therefore the depository institution is legally obligated to maintain the full amount of the deposit in storage. In contrast, under a credit or financial contract, the ownership of the money legally passes to the debtor for the length of time specified in the contract. Thus, for example, a FRB is free to lend out or invest the money as it pleases, given any constraints specified in the contract. The only legal obligation is that it have the money available at the moment that the “depositor” demands it.

Now as Hülsmann points out, under these arrangements in an informationally-efficent market, default risk would be priced into the FRB financial instruments and they would therefore circulate at a discount to genuine money titles. Furthermore, in the absence of deposit insurance and a central bank operating as a “lender of last resort,” FRB notes and deposits would be dehomogenized and recognized as distinct brands of their issuing institutions. Thus the discounts of the different brands of FRB credit instruments against money certificates would vary according to the reputation of the issuing institution, its reserve ratio, the perceived riskiness of its asset portfolio, and the degree of the maturity mismatching between its liabilities (notes and deposits) and its assets (loans, investments and reserves). Furthermore these discounts would fluctuate unpredictably over time as a result of alterations in reserve ratios, the risk and average maturity of asset portfolios, etc. The constantly fluctuating exchange rates between each brand of FRB notes and deposits and all other brands and the standard money would make economic calculation all but impossible. For these reasons, Hülsmann concludes that FRB financial notes and deposits would lose out to money certificates in the competition to serve as a general medium of exchange on a truly free market, although they may still be demanded as a highly liquid component of one’s financial portfolio.

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