Is Fractional-Reserve Banking
Fraudulent?
by Nelson Hultberg
September 19, 2005
"Where you and Professor Fekete are making your mistake is that
you are condoning fraud with your toleration of fractional-reserve
banking in the discounting of real bills. It is incumbent on government
to prohibit such a practice. The law must make sure that in the case
of time deposits, bankers be required to loan no more than the amount
of the deposit. And the law must stipulate that demand deposits can
never be loaned at all since they are payable to the owner on demand."
So wrote a reader in response to my recent article, The
Money Fallacies of Rothbard. This reader is defending the advocacy
of 100% gold reserve banking. And he is prepared to enforce by
law its requirements. Under such a system, no banker would be able
to issue credit in excess of the gold coins that have been given
to him under a time contract, and no banker would be able to loan
or invest demand deposits of gold coins at all. Any violation of
these requisites is to be termed fraud, and any banker partaking
in such is to be prosecuted. This is basically what the Rothbardian
camp will have to endorse if they are to implement their goal of
a 100% gold monetary system.
How Do We Define Banking Fraud?
The important questions that we must ask here are: Would such a
legal approach be logical and practical? Would it be true to freedom
and justice? And most crucial of all, is it fraud for bankers to
loan in excess of their gold reserves? Let's investigate further
and see if we can come up with some definitive answers.
The determination of what is "fraud" in the policies of banking
revolve around how we are to define the money that a depositor gives
to a bank. For several centuries now, it has been defined by the
courts in Europe and America as a loan to the bank. The banker
is thus entitled to invest those funds in various profit-making ventures.
In this sense, all banking can be considered to be "investment banking." We
as depositors operate fully aware of this. We realize that the banker
is going to invest our money in any number of possible vehicles --
real estate loans, auto loans, venture capital loans, treasury bonds,
muni-bonds, real bills, etc. We know that banks are in business to
make money, and that they are going to put our deposits to work in
pursuit of profits. In other words, we know ahead of time that
this is going to take place. We also know that we don't have to deposit
our money in such a bank under these conditions. But we do so because
it is more preferable than keeping our money under the mattress,
or in a safe deposit box.
Murray Rothbard challenges this practice and says that it should
be declared by the courts as fraudulent. He maintains that the depositor's
money should be declared to be what is termed in legal jargon, a "bailment." This
means that the deposit should be declared to be equivalent to a warehoused
item. The banker cannot loan it out; he must keep it on hand for
whenever the depositor wishes to demand it back. In other words,
the depositor is not loaning his money to the banker; he is putting
it there for safekeeping to be retrieved whenever he wishes. [See The
Case Against the Fed, Mises Institute, 1994, pp. 40-45.]
The banker, under the Rothbardian "bailment" system, would be able
to only loan out or invest clearly stipulated time deposits of gold
and gold notes, i.e., CDs. All demand deposits of such, i.e., checking
accounts, would have to be warehoused. No percentage of them could
be loaned out or invested by the banker, whether in real estate,
bonds, or real bills. Period. Thus the term 100% banking. All deposited
money (whether in gold or gold notes) must be warehoused unless it
is stipulated as a time deposit. And any credit issued by a banker
on time deposits of gold cannot exceed the amount of the time deposits.
This certainly is one way to structure the banking system. It would
be super safe that is for sure. But would it be practical, and would
it be free and just under the principles of a free-market society?
Unfortunately the real issue is being overlooked by almost everyone:
Are we to mandate by law that all banking be of this nature?
Or should we simply leave the market FREE to decide on its own what
kind of banking structure people would prefer to utilize?
For example, in a genuinely free-market there would be nothing to
stop entrepreneurs from forming Rothbardian "warehouse banks" by
opening up for business to try and attract customers. And no doubt,
they would gain a certain portion of the depositing public. They
would have to charge their customers for this service, but I'm sure
there are a certain amount of people who would be willing to pay
for such a warehouse form of banking. However, I doubt their number
would be sizeable. Far and away, most depositors would prefer to
deposit their money in the more conventional "fractional-reserve
banks" because these types of banks would offer higher interest
for their time deposits, and they would not charge for their demand
deposits. In fact in a true free-market, many such banks would probably
pay interest on demand deposits also. Some do right now under our
present form of banking.
Government or Market -- Which Is Best?
Here is the paramount issue involved -- to which Rothbardians remain
steadfastly impervious. What they are advocating will require that government
mandate what type of banking the people should be allowed to
partake in, rather than letting the marketplace decide. Government
will have to legally stipulate that no one be allowed to operate
a "fractional-reserve" bank, that all banks must in fact be "warehouse" banks.
This is why I have stated in past articles that Rothbardians will
have to become government interventionists in order to implement
their 100% gold monetary system. They must interject government into
the free interaction of entrepreneurs and customers to dictate what
form of trade they may partake in.
If men and women are simply left alone to make up their own mind
(i.e., if we allow the marketplace to decide), then both fractional-reserve
and warehouse forms of banking would spring up. My guess is that
the overwhelming majority of people would choose to bank with the
former rather than the latter. But which one they choose is not the
issue. The issue is who is to make the choice between these two forms
of banking -- the government or the people? Are we to have the choice dictated to
us by politicians and their armed police, or are we going to be allowed
to freely decide for ourselves in the marketplace?
Because they declare fractional-reserve banking to be fraud, Rothbardians
must opt for state dictates and armed police to decide. If they truly
believe such banking practices to be fraudulent, they must bring
in the law. This is the law's job, to prohibit "fraud." The question
of allowing fractional-reserve banking thus cannot be left up to
the free choice of the marketplace. It must be mandated by government.
But this is a very sticky issue, this thing the Rothbardians are
calling fraud. Are they defining it correctly? I don't think so.
Fraud's first requisite is what we call "intent." The defrauder has
to be "intending" to deceive and rob the other party of his property.
He has to be engaged surreptitiously in acts of thievery. He has
to be purposely trying to steal values from someone by not
fully disclosing relevant details.
Is this what would take place in a free-market banking system? In
other words, would it be fraud for bankers to partake in fractional-reserve
lending under the requirement to redeem all notes in gold upon demand
and openly disclose their policies and their portfolios? I think
not. It is fraud for banks to be able to suspend specie payment and
still operate, and it is fraud for banks to hide their portfolios
from the public. But if these privileges and policies are disallowed,
then what bankers and their depositors do between themselves in free
trade is their business. If the bankers wish to hold only 50% gold
coin reserves behind their purchase of merchants' real bills because
they know from hundreds of years of experience that such a reserve
is more than sufficient to handle redemption requests, it is not
fraud. They are openly divulging this aspect of their portfolio to
the public, and they are not intending to steal anything from anybody.
To some this might be risky and irresponsible, but to suppress this
by use of government law is to violate the rights to free trade of
the bankers and depositors.
The Rothbardian detractors of fractional-reserve banking have constructed
a theory of malfeasance to serve their ideological agenda! In
so doing, they are leaving out the concept of "intent." And they
are ignoring the fact that under a free-market system of banking
the policies and portfolios of all bankers would be fully disclosed.
Therefore the practice of fractional-reserve banking in a free-market
system would not be fraudulent. The reason why is because all banks
would be required to redeem all gold notes in specie (and if they
didn't, they could be held liable under law for their failure). In
addition, they would have to fully disclose the content of their
portfolios, which would be brought about through the "competition
for reputation" that would naturally develop in a monetary system
devoid of government control. See my article, Real
Bills vs. Rothbard's 100% Gold System for a detailed discussion
of why and how this would work. So the key is to divorce banking
totally from the government control and intervention that is corrupting
it, and it would police itself as far as quality and liquidity are
concerned through natural market forces. Perhaps it could even be
mandated legally that banks fully disclose every quarter, but that
is a question that legal scholars such as Edwin Vieira would have
to answer.
Further Disclosure -- Boon or Bane?
Rothbardians, no doubt, would insist on further, more explicit forms
of "disclosure" on the part of banks, such as mandating a written
warning to be issued to all potential depositors stating that they
are engaging in business with a fractional-reserve bank, and that
they as depositors are not to assume their funds are held 100% in
the vault. If such a warning were to be legally required, I doubt
that such a disclosure would deter many would-be depositors.
In a free-market system, the primary determinant as to where one
deposits his or her funds will always be that bank's reputation built
up over the years. Fractional-reserve banking is perfectly capable
of being operated safely if done in a system with gold convertibility
backing it that is devoid of central government control. The reason
why such a system became abused in the past is because banks were
granted special privileges by government regarding their portfolios
and the necessity for specie redemption. Eliminate the privileges
and protections from government, and fractional-reserve banking ceases
to be dangerous.
Under such a benign form of fractional-reserve banking, the
responsible practitioners would gain the lion's share of customers
via the reputation they have built up over the years. Requiring them
to announce in writing to all potential depositors that their funds
will be loaned out and invested for profit rather than stored in
the vault would be rather gratuitous; it would be to announce what
everyone already knows.
To be consistent, the Rothbardians would then have to also require
that all airlines announce, ahead of time in writing, to all their
passengers that they are embarking upon a journey in an aircraft
that could crash and kill them? Rather gratuitous, I would say. It's
something that everyone knows and basically lives with. No one has
to get on the plane; they could choose to drive, or take a train
to their destination. They could choose safer forms of travel if
they desired.
Here is where we meet the slippery slope of state interventionism!
Our politicians and bureaucrats, operating under a Rothbardian mandate
to warn bank depositors and airline travelers of the dangers of their
endeavor, would certainly not stop there. They would, of course,
extend their "protective bureaucratism" to every nook and cranny
of our lives. Is this not what they are doing presently in modern
society? Thus if Rothbardians wish to legally mandate that depositors
be warned about engaging in fractional-reserve banking, they are
going to have to abandon their free-market philosophy and don the
hat of Nanny State bureaucratism. There is no logical cut-off point
where they can successfully contain their "banking mandates" from
spilling over into all other human endeavors.
What are we to conclude from all this? Fractional-reserve banking,
properly conceived and implemented, is not fraudulent. To
try and prohibit it will require an unjust violation of the rights
of free men. To try and discourage it with government propaganda
warnings will merely unleash the monster state to permeate the rest
of our economy. Depositors basically live with the fact that bankers
are investing their deposits, rather than storing them in their vaults.
If Rothbardians will just allow the marketplace (that they so rightly
champion) to freely and fully operate, then all depositors would
be able to choose a warehouse form of banking if they desired
its higher level of safety over the fractional-reserve form.
And they would also be able to choose the opposite if they so desired.
Would this not be far more in keeping with the ideals of freedom?
Would this not be the more just way to organize our banking system?
The answer should be obvious. Those who have bought into the Rothbardian
agenda of a 100% gold system are grievously wrong about what proper
banking is and is not. Their prescriptions will never build a sane
and prosperous economy, much less a free one. Our answer to this
monumental monetary question is to restore a true free-market society
in America that gives all men and women the right to make their own
choices as to which form of banking they prefer.
© 2005 Email Nelson
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