Wednesday, March 27, 2013

Rothbard and Free Banking

The Mystery of Banking, by Murray Rothbard

Chapter VIII: Free Banking and the Limits on Bank Credit Inflation

I am reading this book by Rothbard because I want to understand his argument regarding the fraud of fractional reserve banking.  He presents this case quite directly in Chapter VII.  I will in the near future explore Rothbard’s arguments regarding the fraud (I have certain disagreements on this subject), however I believe it is valuable to first work through his views on free banking.

As with all of Rothbard’s writing, I find his work here so simple and direct, so easy to understand, that I find little reason to interject any of my own thoughts for the purpose of clarification.

Mention free banking at a table full of Austrians, and you will typically get one of two reactions:
1)      Well of course.  If you believe in free markets, why would this not extend to banking as well?
2)      Banking must be based on 100% reserves – gold reserves, in fact.  Anything else is fraudulent.

From my limited exposure to the monetary ideas of the champions of the Austrian school, what I have found is that Rothbard appears to be the first and strongest proponent of the idea that fractional reserve banking is fraudulent.  When Mises discusses free banking, he does not mention fraud – instead he focusses on how free banking offers a self-regulating means to check credit expansion.  Sennholz discusses the reforms he would advocate to move toward a proper market-based banking system.  Of the seven items he lists, not one deals with reserve requirements.

I am sure I am missing many examples, likely on both sides of this discussion – I am no scholar in this field.  But I look for clues, and have been in many discussions, and I have yet to find examples or suggestions counter to my understanding as described above.

I fall into the camp of 1) above.  No, I do not believe fraud is acceptable in a free market, but I have yet to be convinced that what we have in banking today is fraud in the sense of a warehouse issuing multiple receipts to the same good.  In any case, I will go into this further in a subsequent post – this will come when I work back to Chapter VII.

For now, I will look into Rothbard’s views on free banking.  As the premier (to my understanding) advocate of the idea of fractional reserve banking as fraud, it seems instructive to understand Rothbard’s views on free banking.

Let us assume now that banks are not required to act as genuine money warehouses, and are unfortunately allowed to act as debtors to their depositors and noteholders rather than as bailees retaining someone else’s property for safekeeping. 

I find no reason to require banks to act as anything.  Let each institution devise its business plan and then see if they can succeed in the marketplace for customers.  I will propose even taking a step back from Rothbard’s assumption – assume an environment where banking is so free that even deposit banking is reborn.  In this case, I would not consider it unfortunate that some banks are allowed to act as debtors to their depositors – as long as the relationship is documented properly.

Let us also define a system of free banking as one where banks are treated like any other business on the free market.  Hence, they are not subjected to any government control or regulation, and entry into the banking business is completely free.

Additionally, no government insurance for deposits, no government authorized lender of last resort, none of it.  I am quite certain that these features are inherent in Rothbard’s statement.

There is one and only one government “regulation”: that they, like any other business, must pay their debts promptly or else be declared insolvent and be put out of business. 

This need not be a “government” regulation, and given Rothbard’s credentials as the ultimate libertarian if not anarchist, I suspect he means “government” as in governance, and certainly not the state as manifest today.

In short, under free banking, banks are totally free, even to engage in fractional reserve banking, but they must redeem their notes or demand deposits on demand, promptly and without cavil, or otherwise be forced to close their doors and liquidate their assets.

The above four quoted items are taken from the first paragraph of the chapter.  This, to me, is the proper place to start – a market free from government interference, control, or favor.

Let us examine whether there are any strong checks, under free banking, on inflationary credit expansion.

This is critical – what are the means of enforcement?  Are they market based, or does enforcement require a third party stepping in between two otherwise willing participants?  Rothbard goes on to identify several steps of possible enforcement, from the most general to the most specific and strict:

The buildup of trust is a prerequisite for any bank to be able to function, and it takes a long record of prompt payment and therefore of noninflationary banking, for that trust to develop.

There are other severe limits, moreover, upon inflationary monetary expansion under free banking.  One is the extent to which people are willing to use bank notes and deposits.

A more pertinent and magnificently powerful weapon against the banks is the dread bank run—a weapon that has brought many thousands of banks to their knees. A bank run occurs when the clients of a bank—its depositors or noteholders— lose confidence in their bank, and begin to fear that the bank does not really have the ability to redeem their money on demand.

Rothbard hails the bank run as a great weapon against inflationary credit expansion.  What is seen as calamity by most is, in reality, a means to severely limit the damage caused by unchecked credit expansion.

The bank run is a marvelously effective weapon because (a) it is irresistible, since once it gets going it cannot be stopped, and (b) it serves as a dramatic device for calling everyone’s attention to the inherent unsoundness and insolvency of fractional reserve banking.

In all of the above cases, Rothbard identifies that the bank is subject to the discipline of its own customers.  This is a good check, he suggests, but not the best or ultimate check.  That there are multiple banks with multiple customers offers the best check.  The moment of truth comes when the customer of one bank presents a note from another bank for redemption or deposit:

Fortunately, the market does provide a superb, day-to-day grinding type of severe restraint on credit expansion under free banking.  It operates even while confidence in banks by their customers is as buoyant as ever. It does not depend, therefore, on a psychological loss of faith in the banks.  This vital restraint is simply the limited clientele of each bank.  In short, the Rothbard Bank (or the Jones Bank) is constrained, first, by the fear of a bank run (loss of confidence in the bank by its own customers); but it is also, and even more effectively, constrained by the very fact that, in the free market, the clientele of the Rothbard Bank is extremely limited.  The day-to-day constraint on banks under free banking is the fact that nonclients will, by definition, call upon the bank for redemption.

Rothbard has given, in very simple-to-understand terms, the basis for a market-based approach to check expansion of credit.  Note, his example does not require 100% reserves to be implemented.  It is assumed that banks will operate with something less than 100% reserves.  The check is that the bank will calculate incorrectly the amount of reserves that will be demanded on a given day.  In other words, the better entrepreneurs will succeed and the lessor entrepreneurs will fail.  Just like in any other business.

He follows this with a specific example to drive home the point.  He sets up the example of the Rothbard Bank, with $50,000 capital (in the form of gold), yet having produced $130,000 of claims in the form of demand deposits:

Suppose, then, that Jones is not a client of the Rothbard Bank.  What then?  Smith [a client of the Rothbard Bank] gives a check (or a note) to Jones for the equipment for $80,000.  Jones, not being a client of the Rothbard Bank, will therefore call upon the Rothbard Bank for redemption.  But the Rothbard Bank doesn’t have the money; it has only $50,000; it is $30,000 short, and therefore the Rothbard Bank is now bankrupt, out of business.

The risk of such an event is the check on banks to be prudent regarding credit expansion.

The beauty and power of this restraint on the banks is that it does not depend on loss of confidence in the banks. Smith, Jones, and everyone else can go on being blithely ignorant and trusting of the fractional reserve banking system.

Let’s stop for a moment here.  In the case of this example, Rothbard is describing a true fractional-reserve banking situation: the bank has printed notes that clearly state the claim is redeemable on demand, in this case gold.  The printed notes exceed the bank’s gold reserves. 

Is this fraud?  On the one hand, one might say “Of course.  The bank has created more claims than it can fulfill.” On the other hand, what if the bank is prudent, and is regularly able to meet the condition of the note – redeemable on demand in gold (or in whatever form is stated as backing)?  Is it necessary to ensure 100% redeemability 100% of the time to avoid a fraud charge?  Is the only acceptable business practice on where there is 100% chance of success?  Is this the only sound business practice that could be allowed?

I could envision fraud if a) the customer was paying a fee to store gold, and b) the gold was not all stored, but lent out.  In other words, the depositor was paying a fee for a service not provided.  But if a bank regularly was able to meet its obligations for redemption, I am not sure that less-than-100% reserves equals fraud.  More in Chapter VII, I guess.

Rothbard even holds the door open to a world where fractional reserve banking is not held as fraud (although I suspect he means this in the legal sense and not in the ethical sense):

Free banking, even where fractional reserve banking is legal and not punished as fraud, will scarcely permit fractional reserve inflation to exist, much less to flourish and proliferate.  Free banking, far from leading to inflationary chaos, will insure almost as hard and noninflationary a money as 100 percent reserve banking itself.

If this is so, it seems to me that there is no reason for enforcement by any means other than the market.  It is consistent with Mises’ view.

Rothbard goes on to examine the situation between the two banks:

Why should the Boonville Bank [Jones’ bank] call upon the Rothbard Bank [Smith’s bank] for redemption?  Why should it do anything else?  The banks are competitors, not allies.

It should be clear that the sooner the borrowers from an expanding bank spend money on products of clients of other banks—in short, as soon as the new money ripples out to other banks—the issuing bank is in big trouble.  For the sooner and the more intensely clients of other banks come into the picture, the sooner will severe redemption pressure, even unto bankruptcy, hit the expanding bank.

Does the Boonville Bank want to be left holding the bag for Jones’ deposit?  Of course not; it will immediately call on the Rothbard bank to make good on its note.  In fact, the more banks in the country, the better:

Thus, from the point of view of checking inflation, the more banks there are in a country, and therefore the smaller the clientele of each bank, the better.  If each bank has only a few customers, any expanded warehouse receipts will pass over to nonclients very quickly, with devastating effect and rapid bankruptcy. On the other hand, if there are only a few banks in a country, and the clientele of each is extensive, then the expansionary process could go on a long time, with clients shuffling notes and deposits to one another within the same bank, and the inflationary process continuing at great length.

The greater the competition and decentralization, the greater the market regulation. It is amazing how this holds true in so many fields.

Thus, we may consider a spectrum of possibilities, depending on how many competing banks there are in a country.  At one admittedly absurd pole, we may think of each bank as having only one client; in that case, of course, there would be no room whatever for any fractional reserve credit.  For the borrowing client would immediately spend the money on somebody who would by definition be a client of another bank.

Finally, we come to the case of one bank, in which we assume that for some reason, everyone in the country is the client of a single bank, say the “Bank of the United States.” In that case, our limit disappears altogether, for then all payments by check or bank note take place between clients of the same bank.  There is therefore no day-to-day clientele limit from the existence of other banks, and the only limit to this bank’s expansion of inflationary credit is a general loss of confidence that it can pay in cash.  For it, too, is subject to the overall constraint of fear of a bank run.

In every developed country in the world, the situation has been of a consolidation of banks, fewer and fewer banks aiding the cause toward fewer checks on credit expansion.  However, this has been driven by, and enforced by, a central bank – a government-empowered cartel.  One can accurately state that the banking system in the United States, for example, is a cartel – in essence, one bank – in practice, though not in corporate structure. 

Rothbard examines the possibility of a cartel arising in a free banking situation:

But couldn’t the banks within a country form a cartel, where each could support the others in holding checks or notes on other banks without redeeming them?  In that way, if banks could agree not to redeem each other’s liabilities, all banks could inflate together, and act as if only one bank existed in a country.  Wouldn’t a system of free banking give rise to unlimited bank inflation through the formation of voluntary bank cartels?

Such bank cartels could be formed legally under free banking, but there would be every economic incentive working against their success.  No cartels in other industries have ever been able to succeed for any length of time on the free market; they have only succeeded—in raising prices and restricting production—when government has stepped in to enforce their decrees and restrict entry into the field. Similarly in banking.

The economic incentives would cut against any cartel, for without it, the sounder, less inflated banks could break their inflated competitors.  A cartel would yoke these sounder banks to the fate of their shakier, more inflated colleagues.  Furthermore, as bank credit inflation proceeds, incentives would increase for the sound banks to break out of the cartel and call for the redemption of the plethora of warehouse receipts pouring into their vaults.  Why should the sounder banks wait and go down with an eventually sinking ship, as fractional reserves become lower and lower?  Second, an inflationary bank cartel would induce new, sound, near-100 percent reserve banks to enter the industry, advertising to one and all their noninflationary operations, and happily earning money and breaking their competitors by calling on them to redeem their inflated notes and deposits.  So that, while a bank cartel is logically possible under free banking, it is in fact highly unlikely to succeed.

 A cartel would not survive in a free market.  The sound banks would fear being dragged down by the unsound.  There will be too many pressures from non-cartel banks (or newcomers that see a profit opportunity by not joining the cartel) to allow this.

We conclude that, contrary to propaganda and myth, free banking would lead to hard money and allow very little bank credit expansion and fractional reserve banking.  The hard rigor of redemption by one bank upon another will keep any one bank’s expansion severely limited.

This is also my conclusion.  Therefore I find no reason to look to anything other than free banking for the regulation of money and credit.  I find no reason to demand 100% reserves or for gold backing.  I find no reason for concern about fractional-reserve banking as fraud.  Even if it is fraud, I find the market to provide the best discipline to root it out.  I find no reason for a conditional free market in banking.  The market will resolve these issues, delivering the right type of banking to the customers that demand the various possibilities.


  1. Great dissection of Rothbard. Thanks.

    I agree with your opinion that the free market would do a fine job on its own minimizing fraud.

    Here's a radical suggestion: could we libertarians just get rid of the term fraud? I think it's a muddy term and not useful in defining NAP. My goodness, don't cosmetic companies commit fraud regularly in their advertising? So what. And so what if your gold storage facility commits fraud about lending out your gold instead of keeping it on hand as promised? If you signed a contract with them to hand over your gold whenever you show up and they don't do it, you just sue them in libertarian court. And, as word spreads, watch their business go down the tubes. Ah, the wondrous invisible hand.

    1. "...could we libertarians just get rid of the term fraud?"

      I think there is merit in this suggestion, as I find it sometimes a struggle to define where the line is crossed as sometimes the lines are too fine.

  2. This is why legal tender laws are so fundamental to such a system as we have in the U.S. I know it's a trivial assertion, but it's one that took me some time to fully grasp. Unless everyone is in on the scam, as it were, then some entrepreneur can and will bring it crashing down.