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Problems for the Fractional-Reserve Banker: The Criminal Law

A deposit banker could not launch a career of “fractional-reserve” fraud and inflation from the start. If I have never opened a Rothbard Bank, I could not simply launch one and start issuing fraudulent warehouse-receipts. For who would take them? First, I would have to build up over the years a brand name for honest, 100-percent reserve banking; my career of fraud would have to be built parasitically upon my previous and properly built-up reputation for integrity and rectitude.

Once our banker begins his career of crime, there are several things he has to worry about. In the first place, he must worry that if he is caught out, he might go to jail and endure heavy fines as an embezzler. It becomes important for him to hire legal counsel, economists, and financial writers to convince the courts and the public that his fractional-reserve actions are certainly not fraud and embezzlement, that they are merely legitimate entrepreneurial actions and voluntary contracts. And that therefore if someone should present a receipt promising redemption in gold or cash on demand, and if the banker cannot pay, that this is merely an unfortunate entrepreneurial failure rather than the uncovering of a criminal act. To get away with this line of argument, he has to convince the authorities that his deposit liabilities are not a bailment, like a warehouse, but merely a good-faith debt. If the banker can convince people of this trickery, then he has greatly widened the temptation and the opportunity he enjoys, for practicing fractional-reserve embezzlement. It should be clear that, if the deposit banker, or money-warehouseman, is treated as a regular warehouseman, or bailee, the money deposited for his safe-keeping can never constitute part of the “asset” column on his balance sheet. In no sense can the money form part of his assets, and therefore in no sense are they a “debt” owed to the depositor to comprise part of the banker's liability column; as something stored for safekeeping, they are not loans or debts and therefore do not properly form part of his balance sheet at all.

Unfortunately, since bailment law was undeveloped in the nineteenth century, the bankers' counsel were able to swing the judicial decisions their way. The landmark decisions came in Britain in the first half of the nineteenth century, and these decisions were then taken over by the American courts. In the first important case, Carr v. Carr, in 1811, the British judge, Sir William Grant, ruled that since the money paid into a bank deposit had been paid generally, and not earmarked in a sealed bag (i.e., as a “specific deposit”) that the transaction had become a loan rather than a bailment. Five years later, in the key follow-up case of Devaynes v. Noble, one of the counsel argued correctly that “a banker is rather a bailee of his customer's fund than his debtor, … because the money in … [his] hands is rather a deposit than a debt, and may therefore be instantly demanded and taken up.” But the same Judge Grant again insisted that “money paid into a banker's becomes immediately a part of his general assets; and he is merely a debtor for the amount.” In the final culminating case, Foley v. Hill and Others, decided by the House of Lords in 1848, Lord Cottenham, repeating the reasoning of the previous cases, put it lucidly if astonishingly:

The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with as he pleases; he is guilty of no breach of trust in employing it; he i s not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted.3

The argument of Lord Cottenham and of all other apologists for fractional-reserve banking, that the banker only contracts for the amount of money, but not to keep the money on hand, ignores the fact that if all the depositors knew what was going on and exercised their claims at once, the banker could not possibly honor his commitments. In other words, honoring the contracts, and maintaining the entire system of fractional-reserve banking, requires a structure of smoke-and-mirrors, of duping the depositors into thinking that “their” money is safe, and would be honored should they wish to redeem their claims. The entire system of fractional-reserve banking, therefore, is built on deceit, a deceit connived at by the legal system.

A crucial question to be asked is this: why did grain warehouse law, where the conditions—of depositing fungible goods—are exactly the same, and grain is a general deposit and not an earmarked bundle—develop in precisely the opposite direction? Why did the courts finally recognize that deposits of even a fungible good, in the case of grain, are emphatically a bailment, not a debt? Could it be that the bankers conducted a more effective lobbying operation than did the grain men?

Indeed, the American courts, while adhering to the debt-not-bailment doctrine, have introduced puzzling anomalies which indicate their confusion and hedging on this critical point. Thus, the authoritative law reporter Michie states that, in American law, a “bank deposit is more than an ordinary debt, and the depositor's relation to the bank is not identical to that of an ordinary creditor.” Michie cites a Pennsylvania case, People's Bank v. Legrand, which affirmed that “a bank deposit is different from an ordinary debt in this, that from its very nature it is constantly subject to the check of the depositor, and is always payable on demand.” Also, despite the law's insistence, following Lord Cottenham, that a bank “becomes the absolute owner of money deposited with it,” yet a bank still “cannot speculate with its depositors' [?] money.”4

Why aren't banks treated like grain elevators? That the answer is the result of politics rather than considerations of justice or property rights is suggested by the distinguished legal historian Arthur Nussbaum, when he asserts that adopting the “contrary view” (that a bank deposit is a bailment not a debt) would “lay an unbearable burden upon banking business.” No doubt bank profits from the issue of fraudulent warehouse receipts would indeed come to an end as do any fraudulent profits when fraud is cracked down on. But grain elevators and other warehouses, after all, are able to remain in business successfully; why not genuine safe places for money?5

To highlight the essential nature of fractional-reserve banking, let us move for a moment away from banks that issue counterfeit warehouse receipts to cash. Let us assume, rather, that these deposit banks instead actually print dollar bills made up to look like the genuine article, replete with forged signatures by the Treasurer of the United States. The banks, let us say, print these bills and lend them out at interest. If they are denounced for what everyone would agree is forgery and counterfeiting, why couldn't these banks reply as follows: “Well, look, we do have genuine, non-counterfeit cash reserves of, say, 10 percent in our vaults. As long as people are willing to trust us, and accept these bills as equivalent to genuine cash, what's wrong with that? We are only engaged in a market transaction, no more nor less so than any other type of fractional-reserve banking.” And what indeed is wrong about this statement that cannot be applied to any case of fractional-reserve banking?6

  • 3. See Murray N. Rothbard, The Mystery of Banking (New York: Richard-son & Snyder, 1983), p. 94. On these decisions, see J. Milnes Holden, The Law and Practice of Banking, vol. 1, Banker and Customer (London: Pitman Publishing, 1970), pp. 31–32.
  • 4. A. Hewson Michie, Michie on Banks and Banking, rev. ed. (Charlottes-ville, Va.: Michie, 1973), 5A, pp. 1–31; and ibid., 1979 Cumulative Supplement, pp. 3–9. See Rothbard, The Mystery of Banking, p. 275.
  • 5. The Bank of Amsterdam, which kept faithfully to 100-percent reserve banking from its opening in 1609 until it yielded to the temptation of financing Dutch wars in the late eighteenth century, financed itself by requiring depositors to renew their notes at the end of, say, a year, and then charging a fee for the renewal. See Arthur Nussbaum, Money in the Law: National and International (Brooklyn: Foundation Press, 1950), p. 105.
  • 6. I owe this point to Dr. David Gordon. See Murray N. Rothbard, The Present State of Austrian Economics (Auburn, Ala.: Ludwig von Mises Institute Working Paper, November 1992), p. 36.
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