Friday, August 19, 2016

More on Fractional Reserve Banking…and More!

C. Jay Engel has written a very thorough post on the topic of fractional reserve banking, entitled “Against Fractional Reserve Banking and the Curious Case of the Aleatory Contract: Deconstructing Michael Rozeff.”

The post is very thorough and exhaustive.  I will be clear up front – I will not address it in the manner it deserves to fully be addressed; let me explain why:

So then, as you can see very clearly, Rozeff’s conception of fractional reserve banking is not fractional reserve banking as it was historically practiced and which Rothbard heavily criticized.

If the discussion is entirely about historic practices, Engel and I have no disagreement.  While I have not studied this in any detail, I have no reason to doubt the claim that goldsmiths – charged with storing gold against a receipt for the gold – learned that they could surreptitiously produce multiple receipts for the same gold.

Charging for storage of gold and not actually storing the gold is a contractual breach – if you like, you can call it fraudulent.  You can also call this fractional reserve banking; I am as equally against such a practice as the most ardent critic of FRB.

For this reason (and also that the bulk of the post is directed at Rozeff), I find little benefit in going line by line through the post – while I encourage all interested in the topic to read it.

At the back of my mind is the desire to bring the wonderful and praiseworthy Bionic Mosquito closer to my side of things…

Engel need not concern himself with bringing me to his side of things.  If he is writing specifically about an historic practice, I will not argue and have never argued regarding this.  If his point is that history is specifically what “Mises, Rothbard, Hoppe, Salerno, de Soto, Hulsmann, Block, Bagus, Howden” are arguing, we can all have a beer and part as friends.

Engel need not concern with bring me to his side because I have asked the question multiple times: are we debating today’s practice or historical practice?  I accept the difference.  Engel makes clear that he does as well.  Perhaps I should welcome Jay to my side of things!

Yet there are many who claim that today’s practice is fractional reserve banking and it is fraud.  It is to them that I write and to them that I offer criticism.  Many of these are associated with the Austrian school and many of these claim to be citing Rothbard.  To their claim of leaning on Rothbard I have often disagreed, albeit for reasons different than what Engel suggests.

Engel tells me the paper might get published in a proper Austrian journal, as it well deserves to be.  I might suggest that he beefs up the distinction of historical practice vs. todays practice.  I find this the critical distinction and clarification in the paper.

The rest I offer as points to ponder or other intellectual wanderings…. I hope Engel takes them in the spirit intended – items he might consider as he moves his paper toward publishing.

Thus, I will immediately and at the forefront state my acceptance of Ludwig von Mises’ own taxonomy: money proper is the actual and generally accepted medium of exchange in the economy; money substitutes are titles to, or claims of ownership on, that money (money substitutes arise as individuals decide they’d rather store their money [gold] and trade paper titles to that gold); money certificates are those money substitutes that are backed 100% by the money; fiduciary media is any money substitute that has been created beyond what is backed up.

What if “fiduciary media” is “the actual and generally accepted medium of exchange”?  Is it reasonable for economists to insist that it cannot be this?  What does this do to the entire list of definitions presented above by Engel?

What then is fractional reserve banking? Fractional reserve banking is the practice, not merely of ambiguously “only keeping a fraction of reserves” in the bank, but rather of issuing claims or titles on money beyond what can be physically redeemed.

What if “what can be physically redeemed” is irrelevant to today’s economy?  What does this do to the relevance of the above definitions?

Whether we ought to use the phrase “fractional reserve banking” at all to express the above definition is a different conversation than whether the Rothbardian School happens to define FRB in that way. If there is going to be dissenters, they must dissent on the same terms, else the Rothbardians go uncritiqued.

What if my “what ifs” above are meaningful?  What does this do to the relevance of this entire discussion to the economy as it has developed over the last 50 years or more – in other words, during the entire period that every writer mentioned above by Engel, save Mises, has written on this topic?  Are we reduced to debating camels through the eye of a needle or debating angels dancing on pinheads?

Engel then introduces the concept of an aleatory contract:

An aleatory contract is a contract whose fulfillment depends on chance. A good example of this would be a lottery ticket wherein not all lottery ticket holders will be able to claim their prize.

I offer these definitions as well:

The term was a classification developed in later medieval Roman law to cover all contracts whose fulfilment depended on chance, including gambling, insurance, speculative investment and life annuities.

One can classify today’s banking contract as based on “chance,” I guess.  But it is a “chance” that – since the advent of government insurance – has paid out probably something like 99.999999999% of the time.  (I might be off by a billionth of a percentage point, plus or minus).  The performance has been and continues to be far better than the success rate of virtually any other commercially available product.

Please note: if you want to criticize my leaning on government insurance in the above statement, criticize today’s banking for what it is – a monopoly – and not for what it isn’t – fraud.

A contract type in which the parties involved do not have to perform a particular action until a specific event occurs. Events are those which cannot be controlled by either party, such as natural disasters and death. Aleatory contracts are commonly used in insurance policies. The insurer does not have to pay the insured until an event, such as a fire, results in property loss.

But the events can be controlled by at least one of the parties – the bank.  The bank chooses reserve ratios – specifically the amount of physical cash held against deposits.  The bank establishes schemes to back this up – up to and including agreements with other banks, central banks and government treasury departments.

Please note: if you want to criticize my leaning on central banks and government treasury departments in the above statement, criticize today’s banking for what it is – a monopoly – and not for what it isn’t – fraud.

I am not so sure that today’s banking contract fits this definition of aleatory contract.  In any case, Engel and I need not get hung up on this, (returning to Engel) because…

…the aleatory contract as irrelevant when it comes to the theory and history of money.

I have already addressed the “history” part of money, above – absolutely irrelevant when it comes to today’s banking system.  In a way I guess I also addressed the “theory” part.  What if the “theory” part of money as summarized by Engel above and taken from the long list of intellectual heavyweights is irrelevant to the economy as it has developed over the last 50 years or more?

If the entire criticism of fractional reserve banking – in both popular and academic debates – is about what some goldsmiths in Italy did 500 years ago…what a waste of energy – on both sides.  Engel’s post will hopefully guide me toward asking a simple question every single time before I deal with a critic – are you talking about history or are you talking about today?

I can agree with Engel that the discussion only addresses history.  If Engel works through my “what ifs” and other questions above, I will assume that he will agree with me that the criticism is entirely irrelevant today.

However, too many critics of fractional reserve banking – not just bloggers, but individuals with real name recognition – use the term to describe today’s banking practice.

Perhaps for his next commentary, Jay can address this.


  1. Is the argument, then, that FRB is legal because everyone today contractually accepts it? In other words, we all agree that when we give our money to the bank, we are exchanging actual money for fiduciary money? Perhaps this is in the fine print of whatever documents I signed when I opened my bank account...I don't know. But if that's the case, then I guess you're right - FRB is legal because I contractually agreed to its practice. Then that means that all of today's contracts between banks and their customers are aleatory rather than bailor/bailee. Am I interpreting your suggestion correctly?

    1. I have written extensively on this. Banking practice is consistent with the contract signed. One might have many reasons to complain about modern banking (I choose to complain about the monopoly), but fraud isn't one of the reasons.

      As to aleatory contract, I am not settled on this as accurately describing the banking contract - for the reasons stated above.

  2. In all the discussions surrounding FRB and it's evil, it always seems like what is ignored is the role that "legal tender" laws play in all of this.

    Under a system in which people are able to choose what currency they can use without compulsion(tax), penalties, etc.- one might be able to see a scenario in which people might choose a bank using any particular currency(say silver or seashells) that had a 100% reserve ratio as a charter, where they pay more in "fees" so the bank can operate with a profit.

    OR, one could see some people opting for a bank that uses gold or oil as a currency, with 90% reserves as a charter in which it's member accept an aleatory contract by it's nature in exchange for lower fees, for example.

    My whole point being, is that in an environment where government has mandated the currency to be used and also regulates the institutions that utilize it- there is no "choice", there is no "libertarian" option in such a system- just degrees of harm.

    Ron Paul touched on a similar notion very briefly in one of his "Liberty Report"'s a couple of months ago in a discussion on "free trade".

    Trump has touched on it lightly as well but IMO doesn't fully understand the issues at hand. He accuses China of currency manipulation but doesn't consider the US governments(or complain about it) own role in such.

    You can't have "free trade" without having "free choice currency"(ostensibly for both sides) and naturally any discussions about the evil of monetary base manipulation should also include whether people have a free choice to avoid said manipulation by using other currencies without penalty.(like in FRB discussions)

    A push/focus for/on free market currency seems to resolve FRB issues/discussions to some extent IMO. (assuming there is no fraud of course- but "is fraud acceptable" isn't up for debate by most people)

    Starting off by accepting the notion government should have a right regulate currency and/or fractional reserve banking is a statist position through and through...and if we accept it as a starting point we've lost the debate as libertarians before it's even really started.

    1. Nick, see here:

      This topic has always gnawed at me; I guess now is as good a time as any to throw out some red meat.

    2. Quoting Hulsmann:

      "The reason why governments abandoned de- basement and started cooperating with fractional-reserve banks was the technical superiority of this type of fiat inflation. It allowed the governments to obtain additional revenue that they did not dare ex- tort from their citizens through taxation, yet without hurting their creditors, without disrupting the insertion of their countries into the international division of labour, and without abolishing competition in banking altogether."

      Hulsmann says legal tender laws are predicated on a violation of private property laws. I don't know if I agree, but to Nick's point, FRB -- though I agree it is not fraudulent because nobody today believes paper money is a money substitute but accepts that it is money proper -- is still part of a broader system that intentionally draws actual wealth into the central banks and pushes volatile fiduciary media onto the masses -- the volatility of which the government controls.

  3. I won’t get into: “But it is a “chance” that – since the advent of government insurance – has paid out probably something like 99.999999999% of the time.” Combining my analysis with the present system requires another and future holistic treatment.

    “What if “fiduciary media” is “the actual and generally accepted medium of exchange”?  Is it reasonable for economists to insist that it cannot be this?”

    —Definitionally, this is like asking “what if the title to the house is the house itself?” That is, if the title to money is itself the money, then it is no longer a title. Something can’t carry two mutually exclusive definitions at once. This is something I added to my essay in preparation for it’s official publication. In fact, this question refers back to the critique that Bohm-Bawerk had for Macleon (Rozeff’s major influence on this issue). The issue is not physically redeemed qua physical redemption, but rather that there is a praxeological difference between goods that satisfy the desires of an individual and the claims on those goods. Bohm-Bawerk called this the difference between material of wealth and forms of wealth. Confusing these two is why MacLeod opined that doubling the supply of credit (IOUs) in the economy was literally a doubling of the wealth. And it was up to Bohm-Bawerk to address this confusion. If you ever want to consider why this can’t be the case, I suggest Malavika Nair’s essay in The Theory of Money and Fiduciary Media (edited by Hulsmann).

    Thanks for the comment. I don’t feel a need to press anything else at this time. You’ve helped to motivate me to investigate this subject much further than I otherwise would have.

    1. “Definitionally, this is like asking “what if the title to the house is the house itself?””

      In this world of money backed by nothing, redeemable into nothing, I ask: what is the difference between “money proper” (the actual and generally accepted medium of exchange in the economy) and “fiduciary media” (any money substitute that has been created beyond what is backed up) – in a world where NOTHING BACKS UP everyone’s “generally accepted medium of exchange?

      You will forgive me if I am missing something obvious, but the FRN in my wallet is what, exactly more than or other than the FRN? What does it represent besides itself? Into what can I redeem it? Shall I redeem my FRNs into a piece of the White House? Is this the house to which you refer?

      Again, I do not intend to be dense, but if this distinction in the context of TODAY’s economy cannot be explained in a manner simple enough for me to understand, it is useless as an economic concept in TODAY’s world. We can write extensively about past practice; we can write extensively about the superiority of commodity-based money. But the distinction is meaningless in today’s economy.

    2. Money proper is Federal Reserve Notes (the green pieces of paper, the bill itself). The Fiduciary media is the deposit accounts. There are about 1.25 trillion in Notes out there to the 13 trillion in "claims" in deposit accounts" In your wallet is money proper.

      When we were on the gold standard, these notes were money substitutes (some fiduciary media). Now the paper itself is money.

      See here's the thing. This is exactly what I was talking about when I said people didn't understand Mises' taxonomy. Fiat money is money proper under a non-gold standard. That seems weird to most self-educated Austrians, who rightly don't like fiat money. But fiat money may actually be money proper in a world where gold as money is illegal and the dollar is legal tender.

      Here's a good chart (I included in this in the journal rendition of my recent essay):

      I don't really want to get into the weeds on this. It's a finer point. But I think that people have a lot to learn about the Misesian taxonomy of Money. I wrote on it here:

    3. “Money proper is Federal Reserve Notes (the green pieces of paper, the bill itself)…. Fiat money is money proper under a non-gold standard.”

      We are getting closer, Mr. Engel, and thank you for indulging me (and your paper also was very helpful). You have stated simply what has always seemed true to me.

      At the risk of taxing your patience, this begs a further question. In today’s era, where Federal Reserve Notes are money proper, where fiat money is money proper under a non-gold (non-commodity) standard, where the fiat money is not backed by anything and can therefore be created in any quantity, I offer the following two scenarios:

      First: the Fed prints $1 trillion of Federal Reserve Notes. These circulate or are otherwise deposited in true demand-deposit accounts: in other words, all $1 trillion is “money proper.”

      Second: the Fed prints $100 billion of Federal Reserve Notes. Virtually all of it is deposited in what are today known as demand deposit accounts, yet are fractionally-reserved; in your terms, accounts governed by aleatory contract terms. Some small, relatively meaningless fraction circulates. The deposited $100 billion – through the act of fractional-reserve banking – results in the creation of $900 million of fiduciary media. The result is $1 trillion, made up of both money proper and fiduciary media.

      In both cases, $1 trillion is created from nothing. This, more than any other categorization of the types of currency units in circulation, would seem the key issue.

      In both cases, the security of the deposits is virtually identical: the first scenario is clear on this, and the second scenario has offered 99.9999999% certainty since the advent of FDIC insurance.

      The question: economically, what is the difference?

      I accept one difference is the possibility of interest due on the $900 billion in scenario two, although this need not be the case I suspect. In any case, interest just changes the calculation regarding cash flow, and therefore potential bankruptcy – nothing more. But on this point, I digress greatly.

      So I return to my question: economically what is the difference?

  4. In other words, money substitutes are supposed to be backed up (by money), but money itself is not backed up by anything. That's fine. It is the medium itself. That's part of the taxonomy. Gold was not backed by anything. And today, federal reserve notes (the money proper) is not backed up.

  5. Gold is backed by its multiplicity of uses.

    Thanks to both of you for teaching us through this exchange.

    1. Thank you.

      I owe thanks to Mr. Engel. He has done much heavy lifting on this topic.

  6. It's been a long time since Business Law, but I do believe that valid contracts must be entered into in Good Faith. Banks present themselves as places where people can deposit their money and then withdraw said money later. And yet, this is not the case. Try to withdraw cash and the bank eventually refuses because they don't have the cash. They know at the start that they wouldn't be able to do it. So, I still think that fractional reserve banking contracts are invalid because they're not in Good Faith.

    Igor Karbinovskiy