Wednesday, November 2, 2011

Is Fractional Reserve Banking Fraudulent?

Issue 29 of The Voluntaryist has a very detailed article titled “Free Banking and Fractional Reserves.” The article is basically a back and forth discussion between Carl Watner and Lawrence H. White over points White makes about fractional reserve banking in an essay titled “Free Banking and the Gold Standard.”

Carl’s intent was to investigate whether or not fractional reserve banking would play a part in a free banking system. If fractional reserve banking is fraudulent, the practice would be excluded in a free market.

One point White and Watner discuss is the idea of freely contracting on the matter. Some consumers may want to negotiate 100% reserves and others would go ahead and accept fractional reserve banking, perhaps as a way of avoiding fees for every service. Watner agrees that explicit contracts, even for fractional banking, would be legitimate but he also discusses what might happen in regards to property ownership if there is no explicit agreement between the parties.

So…much of the discussion centers on who actually owns the funds that are deposited in a bank. Is there such a thing as conditional ownership on funds deposited or held by a bank? Should a bank be able to hold less than 100% in that case? Or does that mean they are taking and using property that is not theirs?

Carl is very concerned that even explicit contracts agreeing to fractional reserves are a problem. Why? Because of the effect on third parties. He quotes Rothbard to explain:

“Commercial banks - that is, fractional reserve banks - create money out of thin air. Essentially they do it in the same ways as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, when they circulate as equivalent to money among the public.”

Therefore, if fractional reserve banking is the same as counterfeiting, then even people who do not consent are affected by inflationary practices of fractional reserve banking.

I am confused in one regard here because it seems to me that in a free banking system, people who did not want to participate in fractional reserve banking could just refuse to use that bank or to trade with others who use that bank. So wouldn’t the problem take care of itself? Or am I missing something here?

Perhaps it's still a problem because banks and people will potentially get so intertwined with each other that it would be impossible to remain uninvolved in fractional banking practices.

I would be very interested in any comments from those of you more knowledgeable than I am on this topic.


Kent McManigal said...

I'm not knowledgeable, just opinionated.

I think that in a free market, banks which engage in fractional reserve banking would go extinct. It is dishonest. I would never trust a dishonest bank- if they cheat on that, how do I know they aren't cheating me in other ways? And I would let my friends know, too.

On the other hand, if I am wrong and people continue to do business with that bank, how does it hurt me? I am assuming competing currencies here. If a currency is used by the dishonest banks and gets inflated away, I will just not accept that currency in trade.

Unknown said...

Debbie, you're not missing anything. There is nothing fraudulent about fractional reserve banking: the depositor knows their money isn't kept in a vault waiting for them while the bank pays them interest out of the goodness of their heart, and third parties are under no obligation in a free society to accept any note they don't trust. A note is merely a promise to pay money: it is not money itself, and doesn't claim to be. Bank notes are honest promises in a free market, and are accepted based on the reputation of the issuer for honoring their promises as well as contingent payment terms in the event redemption is delayed for a few days.

In societies without central banking, fractional reserve banks won out over 100% depositories every time, because people prefer to be paid for deposits rather than charged for them, and were willing to accept the minimal risk that excessive redemption requests might delay the repayment of their note for a few days. Historically, voluntary clearinghouses formed to deal with such excessive redemption requests against individual banks, and members policed each other by not accepting banks into the clearinghouse that were not considered solvent.

Less Antman said...

I have no idea why I'm listed as Unknown in the above message. I've known myself for years.

Less Antman

Debbie H. said...

Less A., what societies are you referring to where fractional reserve banks won out every time?

On page 4 of this issue, Carl points out that: "100% reserve banks existed in all the great banking centers of Europe (Amsterdam, Venice, and Hamburg) during the 17th and 18th Centuries."

And, you seem to be focused on the risk of excessive redemption requests but what do you think about the idea that they can 'create money out of thin air?'

Less Antman said...

Scotland and Canada are the largest examples, and Larry White's FREE BANKING IN BRITAIN my favorite history book (available online somewhere at no charge), but there are dozens of historical examples. Unfortunately, the most complete history, The Experience of Free Banking, edited by Kevin Dowd, is an academic work that isn't available at a reasonable price.

I don't want to reinvent the wheel, especially since there is now a libertarian website devoted to free banking. Start here for some brief comments on what history tells us from George Selgin, which includes a discussion of the Bank of Amsterdam example:

Notes don't create money out of thin air because notes are not money: they are PROMISES TO PAY MONEY. If you have ever financed a house or car, you gave the bank your personal note. Did you create money because you committed to paying money?

Moreover, in a free society, there are no legal tender laws, so what does it mean to "create money" in such a society? "Money" is simply the name given to whatever medium of exchange has become most popular in that society: in some societies it was salt, in others gold, and in prisons it was often cigarettes. A promise to deliver cigarettes on demand is simply a promise to deliver cigarettes on demand: such a note doesn't claim to actually BE a cigarette itself.

I hope that all makes sense, but please read Selgin's excellent blog post, which is very informative on this matter. Both White and Selgin have done extensive work for decades, and I wonder if today's Carl may have changed his point of view. Of course, you'll have to ask him.

Debbie H. said...

Less, I don't know what happened but your last comment went into my spam filter on blogger so I just found it and posted it. Sorry about that. I guess Blogger just doesn't like you for some reason. :)

Anyway thanks for the additional resources and comments.