Published on the ALS Thoughts on Freedom blog & LibertyWorks blog on 13 December 2011.
At the recent Mises Seminar in Sydney there was a speech by Chris Leithner that explicitly called for the banning of fractional reserve (FR) banking. Leithner and other Australian libertarians (including Michael Conaghan & Benjamin Marks from Liberty Australia) follow the lead of some American libertarians (Walter Block, HH Hoppe, JG Hulsmann — BHH) and argue that FR-banking is fraud and should be banned, and further that it is economically damaging and causes inflation.
These two issues need to be addressed separately. The first is a deontological issue about whether FR-banking is consistent with a free world. The second is a consequentialist issue about whether FR-banking leads to bad outcomes. It is possible that FR-banking is consistent with freedom and yet leads to bad outcomes, and then those libertarians who accept the “non-aggression principle” would have to tolerate FR-banking even if they don’t like those outcomes. But before delving into that debate, it is worthwhile quickly explaining what we are actually talking about with FR-banking.
Vaults, loans & banks
Anything can be money. In jail (and POW camps) cigarettes have been used as money. In the early years of Australian settlement, rum was used as money. In some small island nations, shells have been used as money. Through much of history, precious metals (especially gold and silver) have been used as money. And today, the most common sort of money is “fiat” paper money that is created by government but is intrinsically worthless (ie it has no value except as money). This is not the place to go into a debate about what should be money or who should decide, but the important point is simply that there is some original supply of money that then becomes the standard “unit of account” and “store of value” and “medium of exchange” in an economy. For the sake of this discussion, this original supply will be called “base money” and in Australia it is created by the Reserve Bank of Australia (RBA).
As soon as money existed, people founds ways to store their money. One option is to put it in your wallet. Or under your bed. Or you could put the money in a vault to make it more difficult to steal. These options have always existed, and they still exist today.
And while many religions have frowned on “usury“, the idea of lending money is also an ancient concept. You sister needs to borrow $10 for the bus, and so you give it to her on the understanding that she will pay you back when you see her next.
But providing “vault services” or even “simple non-tradable loans” is not really banking. For all intents and purposes, when people talk about banking they are talking about FR-banking, which involves another important step. The innovation that gave rise to modern banking was the idea that you could have a secondary market for loans. That means that after you lend $10 to your sister, she gives you an IOU$10 voucher. That IOU$10 voucher is a “financial asset” that you can then sell to somebody else.
If the IOU$10 voucher is widely accepted as being worth the equivalent of $10, then it will circulate in the economy similarly to the original $10. This is why some people say that FR-banking allows for the “creation of money out of thin air”. They are partially right. To be more specific, the “IOU$10 voucher” is actually credit (not base money). However, if the credit is traded like base money then it too becomes a “store of value” and a “medium of exchange” and so the base money (created by the original money supplier) and the credit (created by the people who created the loan) are fungible.
If we allow people to voluntarily create and voluntarily trade in financial assets, then we have allowed FR-banking.
Modern banks accept “deposits” from savers, which basically is the creation of a financial asset. The bank now has your $50 deposit, and you now have a financial asset called “IOU$50 voucher” from your bank. If people are willing to voluntarily accept your financial asset as money (for example, when you use EFTPOS or B-Pay) then there is now effectively $100 in the economy — $50 base money held by the bank (which they can then use), and $50 credit held by you (which you can use).
It is worth pointing out that credit is risky. The person (or bank) who owes you money might not pay it back.
So why would you be willing to exchange $50 of base money for $50 of credit? Probably because it is (1) safer from thieves; (2) more convenient for transactions; and (3) the bank may offer you interest. But for whatever reason, when you deposit with a bank you are engaged in FR-banking and the creation of credit. Congratulations. It is this action that Leithner, BHH & friends want to ban.
One consequence of FR-banking is that if the money supplier creates $100, then there will be more than $100 circulating in the economy. Indeed, it is quite easy for the amount of “credit” to exceed the amount of “base money”, and this is the case in all modern economies. The relationship between (base money) and (base money + credit) is called the “money multiplier” or the “credit multiplier”. For example, if the base money supply is $100 and the credit multiplier is 3 then the (base money + credit) is $300.
There is one more small point to note here before going on. It is possible for the same $1 to be spent several times in the same day. If I go out and spend $20 on lunch then there might have been $20 circulating that day. But if the lunch seller then uses that $20 to buy a hat, then actually $40 has circulated. If the hat seller then uses the same $20 to buy movie tickets then $60 has circulated. The multiple use of the same money is called “velocity”. With all of these concepts in mind, we can now define:
Broad money = base money * credit multiplier * velocity
For most of this article we will ignore velocity, but it is important to know that it exists to have a full understanding of monetary economics. As far as I know, not even Leithner, BHH & friends want to ban the same-day re-use of money and so they don’t object to the existence of velocity.
FR-banking as fraud
Since Leither, BHH & friends claim to be strict libertarians, they can only justify their call for a ban by arguing that FR-banking is fraudulent. But here their argument immediately runs into trouble, because people who enter into FR-banking contracts do so voluntarily and then they clearly follow the rules of their agreement. Where is the fraud?
Hoppe responds by saying “two individuals cannot be the exclusive owner of one and the same thing as the same time” (quoted in BHH, 21) and then BHH go on to say “yet this, precisely, is what a fractional reserve agreement between a bank and a customer involves” (22). This is an extraordinary admission of ignorance. Under FR-banking there is no instance where two people own the same thing. When you deposit $50 in a bank the bank now owns the $50 base money and you own the IOU$50 financial asset. They are two different things.
Leithner makes a similar argument, saying: “It’s also logically impossible for two people simultaneously to own the same item of property. They may, of course, say or even certify otherwise — just as I may say, certify and sincerely believe that 1 + 1 = 3 or that I own a kangaroo that can speak Finnish”. Leithner is of course correct that two people cannot simultaneously own the same item, but FR-banking does not involve simultaneous ownership (or talking kangaroos). Like BHH, Leithner is showing that he simply doesn’t understand how banks work.
It is actually astounding that we should even be having this discussion, and it deeply embarrassing for Leithner, Block, Hoppe and Hulsmann.
BHH go on to say that the creation of new credit (which they call “fiduciary media”) does not create any new property. That is true, but also blindingly obvious and totally irrelevant.
At one point BHH imply that the simple act of creating credit is fraudulent, saying that because credit comes “out of thin air” and because it isn’t linked to new property then the existence of credit “in and of itself, constitutes fraud” (22). Wow. They are literally saying that it should be illegal to give somebody a loan, since the act of giving a loan creates credit. Their basic problem here is that BHH don’t understand that “base money” and “credit” are different things, and so they think that credit is fraudulent because it pretends to be base money. But the simple truth is that base money and credit are different things, as explained in the introduction to this essay. This sort of undergraduate mistake makes BHH painful to read and utterly meaningless.
Suffice to say, if two people voluntarily agree to a loan, there is no fraud. This is true under any definition of contract. It also doesn’t matter if you call the newly-created credit a “financial asset” or “fiduciary media” or “widget” or whether we discuss the issue in French or Chinese or Esperanto. Saying that “credit is fraud” is no better than the pointless communist slogan that “property is theft”.
But if BHH allow loans to exist, and they allow people to voluntarily trade in the consequent financial assets, then they have allowed FR-banking. So they really are caught.
That is the end of BHH, but Leithner comes back with one more argument. He claims that putting money in an FR-bank cannot be called “deposit” because that word has some sort of sacred meaning that can never be violated. Consequently to misuse the sacred word is to commit fraud, even if the definition of the word is clearly stipulated in the contract. It is not clear why Leithner thinks he has divine inspiration about the “one and only correct” use of one specific word in the English language, but part of his justification seems to be the rules of Rome 2000 years ago.
This is an amazingly shallow argument, that rests entirely on a pointless semantics game. If every bank did a “find and replace” in their contracts and changed the word “deposit” to “pedosit” (or whatever other word you like) then the exact same system of banking would exist and Leithner could have no more objection. Further, Leithner’s complaint must disappear for the banking system of any country that doesn’t use English (unless Leithner’s divine language powers extend to other languages too). And finally, if we use a standard dictionary instead of the Leithner dictionary, then we discover that the word “deposit” is already accepted to mean money placed in a FR-bank account.
In a final desperate attempt to salvage the “fraud” theme, Conaghan argues that he accepts people’s right to create credit (which he also calls fiduciary media), but his “problem is when that gets traded with someone who isn’t aware, thinks that the promissory note is backed by something and later finds out it’s not”. In other words, Conaghan is worried that when you offer to pay using EFTPOS or B-Pay, the seller may not know that you are using EFTPOS or B-Pay. Once again — wow.
One of the Austrian economists who are caught semi-defending BHH & friends is Stephan Kinsella, who concludes that “the solution is for the bank to be very clear about what they are doing … as long as things are clear, we have no fraud, no problem”. There is nothing particularly wrong with this sentiment, except that banks are already extremely clear about what they are doing. It is in the contract you sign with the bank. It is in every banking and finance textbook. It is blindingly obvious if you think about banks for more than 5 seconds. And if you’re still not sure, you can simply ask your bank, and they will tell you to your face how banking works.
FR-banking as dangerous
While the “fraud” arguments are embarrassingly silly, the arguments about the consequences of FR-banking are more complicated. Allowing people to make and trade in financial assets has a number of consequences, some good and some ambiguous.
The main benefit of allowing trading in financial assets is that it provides more efficient matching between savers and investors. This means lower real interest rates for borrowers and higher real interest rates for savers — which leads to more saving and investing. Basically, FR-banking reduces transaction costs in the inter-temporal market, and so the invention of FR-banking was an amazing economic innovation that allowed for a significant increase in real investment and capital accumulation. It is no surprise that the growth of FR-banking is correlated with economic development.
If we were to ban the creation of credit, then there would be no matching between savers and borrowers, and so significantly less investment. Even if we take the watered down “you may make loans, but not trade in them” then there would be much higher transaction costs as you could only borrow from somebody who had the exact same debt-maturity preferences as yourself. This also would significantly reduce investment, therefore reduce capital accumulation and economic growth.
The obvious benefits of FR-banking is further shown by “revealed preference”, where people who have the choice between FR-banks and vaults overwhelmingly chose to put their money in FR-banks. If FR-banks provided no benefit, then why have they been so popular? Selgin and White make this point, but unfortunately it was too complicated for BHH to understand. In response, BHH try to draw an analogy between “voluntarily dealing with banks” and “involuntarily having to deal with government”, but amazingly fail to understand that the former is voluntary and the latter is involuntary.
There is another consequence of FR-banking that is harder to assess — and that is the impact on broad money, monetary distortions & the business cycle.
Here it is necessary to quickly review some monetary economics. When the amount of broad money increases faster than the amount of production, then there will be inflation. When the amount of broad money increases slower than the amount of production, there will be deflation. If all prices adjusted instantly then there would be no problem (money neutrality). But prices do not adjust immediately or uniformly around the economy, which leads to mal-investment and artificial boom/bust cycles (also called “monetary distortions”). This is the short version of the Austrian Business Cycle Theory. So far, so good.
Critics of FR-banking point out that allowing credit will mean that broad money is higher than base money (due to the credit multiplier), and that this must be inflationary. The most simple form of this argument rests on a confusion between “stocks” and “flows”. It is true that if you suddenly introduced FR-banking then broad money would increase by the amount of the credit multiplier… but the simple fact is that we already have FR-banking and we already have a credit multiplier. So long as the credit multiplier doesn’t change, then it will not impact on the amount of broad money (and so it will not impact on inflation).
A more nuanced argument is to point out that the credit multiplier does change, and that a sudden and significant change in the credit multiplier will create a sudden inflationary or deflationary distortion. This is true, but it begs the question “why does the credit multiplier change”? Put another way — “why would people/banks be more willing to give loans”?
On this issue, BHH actually agree with Seglin and White and other libertarians that in a free market people/banks will be more willing to give loans because there are more productive investment opportunities. The logical consequence of this is that the increase in the credit multiplier (and consequently broad money) will be related to an increase in production, and so there would be no significant monetary distortion. Indeed, as Seglin and White explain, the growth of the credit multiplier would be necessary to prevent a potential deflationary monetary distortion. But while BHH effectively admit that FR-banking doesn’t cause inflation, they go on to argue that prices adjust instantly and so there is no such thing as “monetary distortion” anyway. They don’t seem to realise that such a situation of money neutrality makes the whole debate irrelevant and FR-banking perfectly benign.
Opponents of FR-banking could perhaps claim that people/banks will start providing more loans due to “animal spirits” or “irrational exuberance” or some other random force, and this is possible. It is certainly true that when you allow people to provide loans (or undertake any activity), they may make mistakes. If enough mistakes are made, then it could create a monetary distortion. However, this potential cost must be weighed against the above benefits. Further, it is worth remembering that monetary distortions can easily be created even without FR-banking (a sudden change in production, or the base money, or velocity) so banning FR-banking will not prevent monetary distortions.
We don’t just have to rely on theory about FR-banking and inflation; we can look at the evidence. During his speech at the Mises Seminar, Chris Leithner claimed that FR-banking caused inflation. He then proceeded to show a graph of price changes over the 19th and 20th century which showed mild deflation over the 19th century and then continued inflation in the 20th century after the introduction of government central banking. What Leithner failed to notice was that FR-banking existed all throughout the 19th century, and yet it didn’t lead to inflation. In other words, he proved himself wrong.
There is one other reason why people may complain that FR-banking is dangerous, and that is the possibility that FR-banks could go bankrupt. That is certainly true, but it is also true for any other business in the world. When you give money to a bank, or any other business, you need to take responsibility for the risks you take. If you give money to a high-risk bank (presumably for higher interest) then you must accept the possibility that you could lose some of your money.
To each their own
The beautiful thing about a free economy is that if people have different preferences, they can buy different things. Under “free banking” there would be competition between different money suppliers, and competition between different banks, each offering their own products. There is no need for BHH to determine the “one true way to bank”, just as we don’t need to determine the “one true way to bake bread”. In a free economy, we can simply allow people to make their own choices, and the more effective system is likely to win out.
There are of course many problems with the current monetary system, and those problems were a significant cause of the American financial crisis. Key among these problems were government mismanagement of money supply (printing too much money) and moral hazard where the government effectively subsidises bad banking decisions, and so they get more bad banking decisions. Austrian economics has a lot to say about these matters, and the economic discussion would improve significantly if Austrian ideas were better understood. Unfortunately, while we have some Austrian economists arguing that “credit is fraud” and wanting to effectively ban banking, it will be hard for the broader economic community to take us seriously.