Monday, May 19, 2014

Hoppe and Salerno on Fractional Reserve Banking

I get such pushback on this subject; it doesn’t help that I can point to Rothbard and Mises as recognizing that the best regulator of credit creation is the free market.  It doesn’t help when I point to Sennholz, who offers his seven objectives to restore sound money – none of which call for an end to fractional reserve banking. 

When I suggest that such stalwarts find the market to be a perfectly fine regulator, thus precluding any benefit to introducing some third party agent to take over this function…nothing.  When I ask how it is possible that a business agrees to a) take a deposit and hold it, b) not charge a fee for storage, and c) on top, pay interest, all I get is…silence.

When Dr. North bluntly states that the cause of inflation as we have lived it does not have at its root fractional reserve banking, but instead the monopoly protection, nothing.  When I show that Ballvé even writes of lending pure time deposits – going even farther than I suggest – it makes not a dent.

When I ask individuals who I consider to be experts on the topic: who should I read to get a good understanding of the case fractional reserve banking as fraud?  I receive two replies:  Murray Rothbard in the Mystery of Banking, and Jesús Huerta de Soto with his book Money, Bank Credit, and Economic Cycles.  My read of Rothbard lead me to my statement above.  As to de Soto, I offer my thoughts here.

Crickets chirping; the same arguments made in return without addressing any of my assertions or objections – like I didn’t hear them the first time.  Wah, wah, wah – do I sound like I am whining?

OK, how about Hoppe and Salerno.  Through their words, I will try one more time.

I will begin with Hoppe:

Let’s say A deposits 10 ounces of gold with a bank and receives a note (a money substitute) redeemable at par on demand. Based on A’s deposit, then, the bank makes a loan to C of 9 ounces of gold and issues a note to this effect, again redeemable at par on demand.

Should this be permitted? I don’t think so. For there are now two people, A and C, who are the exclusive owner of one and the same quantity of money. A logical impossibility. Or put differently, there are only 10 ounces of gold, but A is given title to 10 ounces and C holds title to 9 ounces. That is, there are more property titles than there is property. Obviously this constitutes fraud, and in all areas except money, courts have also considered such a practice fraud and punished the offenders.

I agree fully with this statement.  In fact, such an agreement is an impossibility – two individuals cannot have the same claim on the same asset at the same time.  A contract that purports this is not possible, as the ends are impossible to achieve.  If this is what is meant by fractional reserve banking, we don’t have to worry about it – as it is not a legal possibility. For the bank in the middle: fraud!

But today’s deposit contract is not this.  Can you imagine if today’s deposit contract stated this, while the banks practiced the opposite?  You don’t think class-action lawyers wouldn’t go after a multi-trillion dollar judgment?  And win?

On the other hand, there is no problem if the bank tells A that it will pay interest on his deposit, invest it, for instance, in a money market mutual fund made up of highly liquid short-term financial papers, and make its best efforts to redeem A’s shares in that investment fund on demand in a fixed quantity of money. Such shares may well be very popular and many people may put their money into them instead of into regular deposit accounts.

This comes close to accurately reflecting today’s deposit contract – although using the term “money market mutual fund” clouds the issue.  Today’s deposit contract is not a bailment.  The depositor is subject to the banks best efforts to return the deposit on demand.  So, except for this minor terminology point, I agree fully with this statement as well.

Two individuals do not have the same claim on the same asset at the same time.  This is the reality of today’s deposit contract.  There is no fraud in this; it is not a logical impossibility.

But as shares of investment funds they would never function as money. They would never be the most easily and widely saleable commodity of all.

Well…maybe or maybe not.  What is certain is when I pay with FRNs, a check, a bank transfer, etc., my counterparty accepts the payment at par.  The digits in the bank that represent my deposit function as well or better as money than any other thing on earth today.

To summarize: other than a very minor point or two, I am in significant agreement with Hoppe’s views.

Now, to Salerno.  To the Daily Bell question, “Do you believe in private fractional banking or should it be illegal?” Salerno replies:

I am neither a philosopher nor a legal theorist, but I believe in the absolute right of individuals to enter into any voluntary contract that they choose.

So far, so good.  (As an aside, this statement really helps me in my view of the sanctity of contract and specific performance.)

But a contract must be meaningful to be enforceable.

I agree completely.

If I pay you for a promise to paint my house red and green all over, this is not a contract but an absurdity.

When I first read this a few years ago, I had to read it several times to understand Salerno’s meaning.  Given the context of his statements, he is suggesting that a house cannot be painted both completely green all over and completely red all over at the same time.  Of course, I agree.

So, we are still fully in alignment.

Likewise if I pay you (or even if you pay me) to store my motorcycle in your garage so that it is always available for me to use it and I grant you the freedom to rent it out at will.

Again, an impossibility.

My point is that the deposit contract as modern free bankers conceive it, is a meaningless fiction. It implies that a sum of money can be both maintained on deposit for instantaneous withdrawal by the depositor and lent out to a borrower.

This is not the contract I envision.  It is also not today’s deposit contract.  But I am getting ahead of myself (and ahead of Salerno).

Now I am not saying that a free banking deposit contract can never be formulated in a meaningful way. But then it would not be a "deposit" contract at all, but a short-term credit transaction.

This is, in fact, today’s non-deposit deposit contract.

In fact, some free bankers have admitted that bank deposits are actually "call loans" which are extended to brokers by banks and which mature daily.

Call it what you want – it is a short-term credit transaction.

This being the case, it would be explicitly stated in the contract that the "depositor's" funds were being lent or invested by the "banker" and that immediate withdrawal is contingent upon the liquidity position of the bank.

Why?  Why must it be explicitly stated?  I assure you, it is NOT explicitly stated that the bank is holding your deposit for you.  It is NOT explicitly stated that the depositor has first claim on the deposit in all circumstances (in fact, the opposite IS stated).  So, which non-existent explicit statement wins?

There would also have to be explicitly stipulated in the contract the recourse available to the depositor and the banker's obligations in the case of temporary suspension of withdrawal privileges.

To some degree, there is.  Regulation CC outlines the conditions and situations that could bring rise to the depositor not having access to his deposits on demand.

But again, if it is not explicitly stated, does this invalidate the practice?

It is highly unlikely that, under these circumstances, the short-term financial instruments – no longer masquerading as immediate claims to fixed sums of money – issued by free bankers would gain much circulation as currency.

But these short-term financial instruments have gained circulation as currency.  This reality cannot be dismissed.  The reason why?  Again, I get ahead of myself….

Thus to answer the question you posed: I do not believe that "private fractional-reserve banking," as it is commonly understood in debates among libertarians and Austrians today, should be illegal. It is a self-contradictory concept that could never be formulated into a meaningful contract on a free market. (Emphasis added, and I would also bold it except I don’t want to appear too obnoxious.)

Precisely!  But this self-contradictory concept is not today’s deposit contract.

Salerno gets to the heart of the matter; well, he opens the door but doesn’t explicitly walk in.  I will do it for him: these instruments have gained circulation as currency because of the government guarantee. 

The problem is the monopoly.  The problem is not fractional reserve banking as the term is commonly understood in debates amongst Austrians today. 

Look, if Hoppe and Salerno aren’t clear enough, with my minor tweaks, then I can say nothing more to be any more convincing.  I will leave it at this.

Well, for now.


  1. Interesting. Food for thought. Thanks.

  2. You can reference a million economists and ignore the fact that creating all money as debt that needs to be paid back with interest that can only be paid back if even more money is created as debt at an exponentially increasing rate is an unsustainable ponzi scheme that transfers wealth from the productive sector to the money creating/manipulating financial sector, And that is exactly what you see when you look at the numbers, massive debt everywhere despite fantastic technological productivity increases, and financial sector wealth growing like a cancer as the real productive economy spirals down.

    1. Interest in and of itself is of no concern. It is impossible to imagine productive life on earth without such a concept.

      If you want to discuss this further, demonstrate that you have read the following two posts, and comment on points made in these:

  3. BM,

    You have been right on this issue all along. You convinced me long ago. Please move to the head of the class, and it is a distinguished class indeed.


    1. gpond, thank you.

      I guess my main gripe - right or wrong takes care of itself - is that points are not directed toward my arguments. It is just the same stuff that has been turned stale by its repetition.

  4. BM,

    I think the problem here is that you want to discuss the legitimacy of FRB in terms of today’s actual market whereas Hoppe and Salerno confine themselves to analyzing FRB in the context of a free market. In this context there will be competing forms of money proper, defined as the most saleable good in a particular region. The fact that money is an economic good (whether physical or logical) means that its supply is limited and tightly connected to the prevailing production structure. Hoppe and Salerno’s conclusions regarding FRB are just the direct consequence of the fact that multiple legitimate claims cannot exist for the same good, in this case where the good in question is money.

    There is nothing inconsistent about holding the above free market analysis and recognizing that FRB loses its significance (as regards fraud) in a monetary situation where there are no physical or logical constraints to its supply. (The simple problem of multiple claims goes away if there is no production constraint for what is being claimed, but this does not mean that all FRB-related problems go away.) In the current situation the fraudulent status that FRB would have in a free market has been displaced by the more fundamental property rights violation that denies individuals the opportunity to establish their own forms of money. In light of this it becomes meaningless to say that anyone “freely chooses” to participate within the modern banking system.

    1. Del

      “I think the problem here is that you want to discuss the legitimacy of FRB in terms of today’s actual market…”

      It is in today’s market where individuals regularly claim that FRB is fraud. It is not.

      “…whereas Hoppe and Salerno confine themselves to analyzing FRB in the context of a free market.”

      I believe I have referenced their comments appropriately.

      “Hoppe and Salerno’s conclusions regarding FRB are just the direct consequence of the fact that multiple legitimate claims cannot exist for the same good, in this case where the good in question is money.”

      I have addressed this in my post. How much clearer must I be?

      My points are simple, and I find them confirmed via all of the references I make in this post:

      Today’s deposit contract does not give two individuals the same claim to the same asset at the same time. Therefore there is no fraud.

      The resultant FRNs and their equivalents are money.

      This is true today. To the extent the practice emerges in a free market (as, it seems, has happened in the past), it would (by definition) also be true in a free-market.

      Mises suggests that most people would not take notes in a free market. Maybe, maybe not. The answer to this is irrelevant to me; it is also irrelevant to proper application of theory.

  5. I'm curious - where is all this pushback on your blog? Or is it somewhere else? I've only seen a few comments on this post and your last one on the subject.

    1. Autolykos

      It is frustration built up over the years. What prompted me yesterday was the referenced discussion at Mises. It frustrates me when I receive rote responses to these points. I don’t mind disagreement, but at least address the arguments.

      See below.

  6. I have told you before on this blog that deposit contracts state that your money is available for you at any time for your withdrawal barring any reasonable delay for processing, etc. Your argument was "well if the bank they're trying to get your money from isn't available right away means that fractional lending is legitimate because the other bank is engaging in it. I also told you I actually went and read the deposit contracts for myself and they ALL say the same thing. I've also gone to that nebulous Federal statute "Regulation CC" you keep deferring to as explaining what that reasonable delay is, and it is ambiguous to say the least. It simply does not do what you're trying to explain it does.

    The only thing that justifies this scenario is legal precedent supporting it, not the deposit contracts or Federal statute.

    BM, you're good on a lot of stuff, but you're still wrong on this.

    1. " is ambiguous to say the least."

      I agree it doesn't say unambiguously that the bank is lending your money. It is written easy enough for a third grader to infer. I have written point by point regarding this regulation. You make a simple assertion and claim it to be definitive ("I have told you...")

      Show me in the regulation or the bank contract where it says, unambiguously, that the bank is holding your money, as a bailment.

      If you find that, I will join you in the biggest class-action suit of all time.

    2. “I have told you before on this blog that deposit contracts state that your money is available for you at any time for your withdrawal barring any reasonable delay for processing, etc.”

      Setting aside the fact that the “etc.” in your paraphrase above is a rather meaningful list, I will ask you: when, since the 1930s, has a bank in the US failed to deliver on the request for withdrawal? If so, how long was the delay?

      Where else in the world, in a reasonably healthy banking system and absent war, has a depositor not received his funds? I can think of two examples: Cyprus and Iceland (and arguably, neither banking sector was very healthy relative to the overall local economy). Rather tiny examples when you consider where the big money resides.

      I will guess the track record of the banking industry approaches 99.99% success in this matter of availability. I can even go overseas and withdraw funds via a debit card from my hometown bank in the local currency, instantaneously. It works every time.

      Does this not satisfy your expectation of availability?

      You are looking for fraud or perfection or something. There is no fraud - and 99.99% is pretty close to perfect. It isn’t clear what you are after.

      You want the contract to state explicitly that the bank is lending out your money; as I mention in this post, such an explicit statement is not necessary in order to avoid fraud (a rather squishy term in-an-of-itself). Alternatively, I maintain there is no explicit statement in the contract toward the idea that the bank is holding your deposit as a bailment.

  7. I'm from Israel, and I'm studying the issue of fractional reserve banking in general and from austrian perspective, and I find your articles on the subject the best.
    I don't know what's the common practice in the US, but here we do pay fees for banking, virtually, every transaction made gets charged (there's a line fee, which is paying for every new line in your account history), so it's not as straight forward as you state it, also from legal POV, a contract between a company and individuals, which 99% that acts against 99% of the individuals believe to be be true, is it valid or not? Where has this massive percentage of the misinformation came from?
    I agree that the FRB itself isn't the issue, it's mainly the backing of central bank and credit insurance, but there is pivotal point argument that makes a discussion necessary, in the last 20 years, the rise of computing and communications has made FRB much easier and at much bigger scales, can we still trust this model to be stable? Did you see any study of the the affect of digitalized banking on the process of lending and borrowing?

    1. Thank you for your comments and questions.

      “I don't know what's the common practice in the US, but here we do pay fees for banking, virtually, every transaction made gets charged…”

      I am familiar with transaction charges and various charges in other countries. Even in the US this is possible – for accounts with small balances, for example (exactly the opposite of what one would expect if a “storage fee” was involved). I would be curious to find if a charge is ever – explicitly – a storage charge. To me, this is the key issue for this aspect of my argument. If it is explicitly a storage charge, and the bank isn’t storing the deposit, it would seem a legally actionable event.

      “…also from legal POV, a contract between a company and individuals, which 99% that acts against 99% of the individuals believe to be be true, is it valid or not?”

      I guess I don’t know what 99% believe. The issue in contract law is not what each party “believes”; the closest concept to this is the concept of “meeting of the minds.”

      The concept of “meeting of the minds” in contract law apparently only came into being in the mid- to late-nineteenth century – it is a relatively new concept. Just because the concept is new doesn’t make it wrong. However, somehow man survived without this concept since the first contract was put in writing.

      To explore this further, I cite from the article “In Contract Law, When Exactly Is There A "Meeting of the Minds"?”

      ------------Begin Cite-----------------------------

      Almost everyone knows that in order for there to be a binding contract there must be a "meeting of the minds."

      It is well established that courts will determine the intent of the parties by looking primarily to the plain meaning of the written words, and a judge will only hear testimony about what parties now say they intended if the words are ambiguous.

      In determining whether there is an ambiguity, the ordinary usage of a term will be employed in the sense that an ordinary and reasonable person would understand it.

      …if the contract states that all terms are contained in the writing itself and that there are no other understandings, then an attack upon a seemingly straightforward term will face an uphill battle.

      And it is almost always insufficient for a party to contend that he or she did not read the clause in question or did not have it explained to them.

      ---------------------------End Cite--------------------

      What do I take from this? First: I am not a banking contract lawyer.

      I am not going to read again the regulations, etc. If you or anyone else does so and points to something different than my recollection I will look into it; with that:

      The “plain meaning of the written words” is that the bank will make funds available, with certain specific (but in some cases, not minor) exceptions. Please see my comments to JFF above for my view of the success of fulfilling this requirement.

      The terms are not ambiguous – for example, available means available (it doesn’t mean storage). The funds will be made available. The funds have virtually always been made available. An ordinary person would understand this, it seems.

      To your last question: “Did you see any study of the the affect of digitalized banking on the process of lending and borrowing?”

      I have seen no such study. It seems clears that technology has made the process more efficient, to the benefit, generally, of all participants.

      I thank you for bringing up the point of what the parties “believe.” Looking into this only solidifies my view. If necessary, I will write a more complete post on this topic. I will think about this.

    2. Thank you for taking the time to reply.
      My comment about digitalized banking making the process easier, is that it lowered the need for cash a lot, and made your bank statement available, so you could follow your transactions without the need of getting cash out and working with it. Before this the exchange between deposits was done with checks only and it was a more difficult task to contend with, also, the big data bases in the banks and the software to manage it, made the scale of data processing much larger, so I'd argue that
      1. Theoretically it played a crucial role in the increase of deposits, because you could loan much more without anyone claiming it.
      2. It benefitted the banks much more than the clients

    3. I understand your question better. Again, I have seen no study on this. However, it is safe to say that every step taken toward the possibility to eliminate using cash has helped to decrease the amount of cash banks had to hold. This would even include checks, but eventually credit cards, etc. This allows banks to loan even more funds.

      The problem caused by these non-cash means compounds as more banks form some sort of cartel (one members’ withdrawal is another members’ simultaneous deposit). As long as such formations are voluntary, I find no reason to stop it – the market will deal with it. However, today’s cartels are government enforced. I can safely speculate that they are much larger than would be possible in a free market.

      Has this benefitted the banks more than the customers? In the government-monopoly system, the answer is certainly yes – if not, why would the banks desire this?

      However, I do not minimize the benefits of ease of payment and transfer to the customers. In any case, much of this would likely also have been achieved in a free-market environment. Given the creativity allowed, I would surmise that customers would have even better mechanisms in a free-market environment.

      Then the market (and a banks’ prudence) would be left to sort out appropriate reserve requirements. As it should be.