Man, Economy, and Liberty

3

Fractional Reserve Banking: An Interdisciplinary Perspective

Walter Block

Freshman economics students are taught to understand the miracle of fractional reserve banking: it can create money out of thin air! Kindergartners are encouraged to save their pennies at institutions based on this system. Fractional reserve banking (FRB) is a pillar of our community, the underpinning of our entire banking system. There are even many libertarians who favor the arrangement. Professor Murray N. Rothbard, a staunch critic of FRB,1 has been widely attacked on his stance, even by libertarians.2 I think it is no exaggeration to characterize FRB as almost universally beloved, defended by people from virtually all shades of political opinion. Yet, as will be shown in this paper, FRB is a fraud and a sham, whose intellectual pretensions of honesty deserve to be exposed once and for all.

What, exactly, is fractional reserve banking? Since we are dealing here with a classical case of “The Emperor Having No Clothes,” FRB can perhaps best be explained by the use of a fairy tale:

Once upon a time, in a land far, far away, at a time long, long ago (when the gold standard was in its infancy) there lived a goldsmith, humble, meek and pure.

Since the goldsmith had the strongest safe in town, the people were accustomed to leaving their jewelry, gold, and other valuables with him. The goldsmith, for a small fee, would give the townsfolk a receipt for leaving their deposits with him. The receipt would say that: “Jones has deposited ten (10) ounces of gold with Humble, Meek, and Pure Goldsmith to the trade; Humble, Meek, and Pure Goldsmith will, therefore, pay to the bearer of this note, ten (10) ounces of gold, on demand.”

The citizens of the town, lazy by disposition, though highly aware of the cost of goods like shoe leather, food, hay for their horses, etc., would rarely go to the goldsmith to withdraw their gold before making a purchase. Rather, they would merely hand over the receipt for gold to the tanner, the food supplier, or the merchant at the stable. The merchant would accept this note for his goods knowing that he, too, could trade it for something else, or return it to Humble, Meek, and Pure Goldsmiths, and receive his 10 ounces of gold, on demand.

All was well with this tranquil tale until the Wicked Witch of the West cast a spell over the goldsmith’s wife and made her covetous, dissatisfied, and consumed with a passion for expensive living. She, in turn, “leaned” on her husband. She gave the goldsmith not a moment’s peace until he concocted a “brilliant” scheme for “earning” more money. The goldsmith realized that most of the villagers were content to leave their gold permanently on deposit, and that those few who withdrew gold spent it in such a way (on local merchandise) that it would eventually reach him again. So the goldsmith took some of the hard earned gold that had been entrusted to him and gave it to his wife to spend on fripperies. Other funds that did not belong to the goldsmith were, nevertheless, lent out by him, the proceeds going to his good lady.

Noticing that his previous financial manipulations went undiscovered, the goldsmith escalated. Now, not content with seizing the gold belonging to others, he manufactured receipts for gold that had never been given to him; he thereupon turned these notes over to his favorite charitable cause, and she went out and spent them.

This particular fairy tale ends happily—for the goldsmith and his wife, that is. Their financial irregularities are never discovered, and the townspeople remain content to leave their valuables with the goldsmith and to use his ever increasing bank notes to transact business.

The question we are faced with is: How is fractional reserve banking to be evaluated? (We formally define FRB as a system where some fraction less than 100% of the assets is kept on reserve against the deposits outstanding).

The goldsmith’s first method, giving his wife gold that had been entrusted to his care, is a rather straightforward case of embezzlement. (Webster defines embezzlement as “to appropriate property entrusted to one’s care fraudulently, to one’s own use.”) It may well be true that such a great amount of trust and goodwill had been built up in the business that none of the townspeople would be suspicious of the malappropriation. If this is so, then there will be no ruinous run on the bank. But this means only that the embezzlement will not be discovered, not that it did not take place.

The second method, giving his wife warehouse receipts for nonexistent gold, is likewise a clear example of counterfeiting. (Defined by Webster’s as “copying, imitating, with intent to deceive.”) As in the easily recognized case of counterfeiting, the goldsmith passes off his unbacked gold receipts (fake money) for those that are fully backed by gold (legitimate money). This is logically equivalent to forgery (defined as, imitating falsely, with intent to deceive), or passing bad checks.

But whatever the name, the results are clear. The dishonest goldsmith diverts sizeable amounts of real resources belonging to other people to his own use. The economic effects of such a procedure are morally indistinguishable from the highwayman’s3 case; there is a bit more openhandedness, since everyone knows him as the thief he is, while the goldsmith is widely thought to be an honest merchant.

Nor will the case change when modern banking methods are introduced, with demand deposits and checkbook money largely taking the place of bank notes. The principle is still the same: with the advent of FRB, real wealth is shifted from the non-bank public to the banking industry, exactly in the same way as in the operation of the goldsmith’s counterfeiting ring.

Any institution engaging in FRB, moreover is bankrupt as soon as it begins. For as soon as it has more obligations outstanding against it than it has assets with which to pay, it is unable to meet its debts. And once an institution is unable to pay the debts which fall due, it is in a state of bankruptcy, the “moratorium” and other fancy obfuscations in the New York City financial crises of 1976 notwithstanding. Again, as in the case of embezzlement, the bankruptcy may not be discovered until a run on the bank occurs,4 but a bank is technically in a state of bankruptcy as soon as it embarks upon a policy of fractional reserve banking.

One common objection to our FRB analysis is as follows: If a FRB system is bankrupt because it cannot pay off all its debts, then virtually all businesses are bankrupt, because most of them would not be able to pay off all their debts at any given moment. It is true that most business firms have heavy mortgages, that they cannot retire for years. But any view that implies that almost our entire business community is now and always in a state of bankruptcy, must be seriously deficient.

The problem with this objection is that it misunderstands the time element. In the ordinary business case, it may be true that total liabilities often far exceed total assets on hand. Assets on hand may be virtually zero, right after a company has made a heavy investment and right before it recoups the returns. But in the usual case, not all the liabilities are instantaneous. Most are not. In the case of mortgages, there are payments which are not due for 20 to 30 years. We may then safely ignore the case where assets on hand are not sufficient to make payments that are not due for 30 years! The business is not thereby bankrupt. True, if the company cannot come up with the money in 30 years (or whenever it is due), then it will be bankrupt.

But the case of FRB is altogether different. Like other businesses, many of its assets are illiquid. Unlike them, however, its liabilities, at least as far as notes and demand deposits are concerned, are instantaneous. A demand deposit is just that: an amount of money placed with the bank which, according to the contract, the bank has agreed to pay back on demand, forthwith, immediately. Only in rare case are the instantaneous liabilities of an ordinary business greater than its instantaneous (liquid) assets. When this occurs, the business is truly bankrupt. But in the FRB system, instantaneous liabilities are always greater than instantaneous (liquid) assets. This is because the fractional reserve banking system is defined as one in which only a fraction of the demand deposits are held in reserve; the remainder is in the form of long term loans, or illiquid assets.

The same distinction holds with regard to insurance companies. Critics of our FRB analysis are often wont to point to insurance companies as examples of bankruptcy, according to our criteria, on the grounds that, if a large scale calamity occurs, the insurance industry, based on the principle of dividing risk, could not possibly pay off all the legitimate claims made against it.

Now it is certainly true that insurance is a method of pooling risks, and can only remain profitable on the assumption that a disaster does not strike all customers of any one company. That is why, other things equal, the larger company will be better able to pool risks. It therefore follows that if a nation-wide catastrophe were to strike, many, if not all of our insurance companies, would be rendered bankrupt.

But this is a far cry from allowing that they are now bankrupt, in the absence of such a calamity. The analogy fails, for banks under FRB are presently bankrupt, even assuming no out-of-the-ordinary circumstances. Just because a company could become bankrupt, in certain very extraordinary situations, does not mean that it is bankrupt at present.

A second objection concerns not so much a supposed flaw in the present critique of FRB, but rather a charge of inconsistency against the present author who, in the present paper attacks counterfeiting “as a fraud and a sham” while in a book,5 Defending the Undefendable, explicitly singles out the counterfeiter as “heroic.”

I plead “not guilty” to this charge of inconsistency. In the book I went out of my way to point out that I was opposed to counterfeiting, on moral grounds, but that the people who were commonly blamed for this activity, private, non-governmental agents, were not really counterfeiters at all. As I stated:

The justification for calling the common, private counterfeiter heroic is that there is a prior counterfeiter in action and that the money falsified by the private counterfeiter is not really legitimate money, instead, it is itself counterfeit. It is one thing to say that counterfeiting genuine money amounts to theft; it is quite another thing to say that counterfeiting counterfeit money amounts to theft.6

The case we are dealing with in the present paper is one of counterfeiting genuine money. There was nothing in Defending the Undefendable that would compel defense of this kind of activity. The goldsmith, in creating “extra” notes, for which no gold exists, and the modern banker, in lending out money in the form of demand deposits unbacked by any money, are both guilty of no more and no less than counterfeiting genuine money—and both are therefore guilty of theft.

Let us now consider a defense of FRB, not as presently constituted, but as it might be. There is a singular group of economists who concede that all FRB systems that have ever existed may have been equivalent to theft, but who nevertheless contend that voluntary fractional reserve banking (VFRB) is plausible, would be workable, and need not be fraudulent.

In the view of voluntary fractional reserve banking advocates, the chief evil of the present system is the cumulative statement on the face of the notes (or on the contract upon which the demand deposits are based) to the effect that there is more money on deposit than is actually the case. If there are 100,000 notes in existence, each with a face value of 10 gold ounces, then according to all the warehouse receipts for gold outstanding, there are 1,000,000 golds ounces. But assuming that the fraction on reserve is only 20%, this is a blatant falsehood. Actually, under this type of FRB, there would only be 200,000 gold ounces in existence.

The VFRB advocates, seeing the truth of this claim, act so as to obviate it. Given the preceding set of assumptions, they advocate something like the following statement appear on each and every 10-ounce note:

By the way folks, our policy is to keep only one-fifth of an ounce of gold on hand for each of the ounce value notes that we put into circulation. Since this here is a 10-ounce note, we’ve got only two ounces in reserve backing it. Thus, if all you people, the holders of our notes (or demand depositors, as the case may be) come into the bank at the same time, demanding your money back, only 20% of you will get your money back. We’ll pay off the people presenting the first 20% of our notes outstanding in the order that they demand their money. The rest of you suckers (depositors! a thousand pardons!) will just be out of luck. We’ll have to hold a forced sale of our assets. You’ll have to wait until our loans fall due. In the meantime, there will be a “moratorium” on payments. In other words, our bankruptcy will be evident.

Whatever else may be said, it must be admitted that at least this VFRB scheme cannot be called purposefully deceptive. It goes out of the way, to a degree probably never seen before, to make clear just what is involved in FRB. If the preceding statement appears in bold lettering, and not in “small (invisible) print” the claim to voluntariness is strong indeed.

The VFRB argument is also buttressed by the phenomena of “fractional reserve parking lots” which flourish on several college campuses. The patrons of such parking facilities are told, quite clearly and forcefully, that if they purchase a “permission” to park, it is a conditional one. The parking lot makes it clear that more “permissions” to park are sold than there are parking places on the lot. Therefore, if the demand is low (within the limits set by the number of spaces on the lot), the permission functions much the same as the more traditional parking permit: It “guarantees” a parking space. But if the demand on any one day exceeds the number of spaces, “first-come-first-served” is the order of the day. (Because of the risk, such “permissions” usually sell at a discount compared to the more traditional permits.) This, contends the VFRB advocates, is truly a voluntary fractional reserve parking lot, not in violation of any libertarian principles prohibiting fraud and theft. Why, they ask, cannot the same principles be applied to banking?

Plausible as the argument sounds, it does not succeed. We must question the claim that the 10-ounce bank note, even with the statement clearly visible, is really a 10-ounce note (or a demand deposit for 10-ounces of gold). What right, it may be asked, do the VFRB advocates have to the claim that 10 ounces of gold are really payable, to the bearer, on demand. All of economic reality rebels against such a claim. By the admission of the VFRB people, there is no such guarantee. On the contrary, the VFRB people admit that all the notes may not be paid on demand (if too many people make this request).

Suppose the statement were to be altered to the following, in an attempt to get around this criticism:

Ok you guys, now hear this. This is your friendly local neighborhood banker speaking. If you turn in this piece of paper which purports to be a 10-ounce gold bank note (or warehouse receipt for gold, or demand deposit for 10 ounces of gold) you have a 1 to 5 chance of getting your money back. However, if no one claims his money before you do, (or if fewer people claim their money than we have money available), then you are guaranteed to receive your money back—for sure. Cross our hearts and hope to die.

The second statement is clearly free of the claim that there is no legitimacy to calling the relevant piece of paper a 10-ounce bank note. Moreover, it places the bank note clearly in the tradition of the “fractional reserve” parking lot, certainly a legitimate institution. But note now that the VFRB position is free of the claim, at long last, that it is in any way fraudulent, or misleading, it is open to another criticism: this piece of paper is a bank note no longer; rather, it is a lottery ticket.

What, indeed, can be the justification for calling a piece of paper (or a contract, in the case of checkbook money) a bank note, when it is only offering (under certain conditions) a 1 to 5 chance of receiving money. How is such a supposedly voluntary fractional reserve banking system to be distinguished from a voluntary lottery?7 It cannot be so distinguished, and therefore VFRB if it adheres scrupulously to the dictates of honesty, must of necessity reduce itself to a lottery, and not a system of banking at all.

Let us conclude by disposing of the claim that on the market, the value of a fractional reserve banking note will tend to trade at its par value multiplied by the reserve fraction. Thus, a 10-ounce gold note, with a 20% reserve behind it, will, it is claimed, tend to trade at two gold ounces; a 30-ounce gold note backed by a 40% reserve, at 12 gold ounces.

This would be equivalent, in our lottery analogy, to the claim that lottery tickets will sell at mathematically “fair” prices. In other words, a lottery with a first and only prize of 1,000,000 gold ounces will sell no more than 100,000 chances, for 10 gold ounces each. But this would mean that the lottery entrepreneur would undertake to give out all his income from the sale of tickets to the prize winner, leaving zero profit for himself. Such a businessman could not thrive for long.

In the banking case, the 10-ounce gold “note” need not trade at two gold ounces (assuming a 20% reserve). It might sell at far less, if people do not trust the bank, and it might be worth more, if people do not fully digest the import of the second statement printed on it.7

Notes

1. See Murray N. Rothbard, Man, Economy, and State, (New York: Van Nostrand), pp. 701-03. See also his What Has Government Done to our Money? (Santa Ana, Calif.: Rampart College, 1974).

2. Exhaustive research, however, fails to uncover any published critiques in this regard.

3. Lysander Spooner, No Treason (Larkspur, Colo.: Pine Tree Press, 1966).

4. It is presently unlawful to encourage runs on banks, or to cast aspersions on their financial probity. Presumably, the better to “protect” the public.

5. Walter Block, Defending the Undefendable (New York: Fleet Press, 1976), pp. 109-20.

6. Ibid., p. 113.

7. Ludwig von Mises, Human Action (Chicago: Henry Regnery, 1949), pp. 106-16.