Fractional Reserve Banking: Fraud or Not?

 Posted by on 12 June 2006 at 9:45 am  Uncategorized
Jun 122006

From an Objectivist perspective, is there anything fraudulent about fractional reserve banking?

That question first occurred to me a few months ago, when I listened to Murray Rothbard’s lecture “Banking and the Business Cycle” from the Mises Institute’s generally uninformative Home Study Course in Austrian Economics. Rothbard insists that fractional reserve banking is fraudulent, but never adequately explains why.

Some searching online led me to this Objectivism Online thread on the topic. The arguments against fractional reserve banking seemed highly rationalistic to me, but I didn’t know enough to draw any solid conclusions.

A bit later, I re-read Alan Greenspan’s essay “Gold and Economic Freedom,” including this passage in favor of fractional reserve banking:

A free banking system based on gold is able to extend credit and thus create bank notes (currency) and deposits, according to the productive requirements of the economy. Individual owners of gold are induced, by payments of interest, to deposit their gold in a bank (against which they can draw checks). But since it is rarely the case that all depositors want to withdraw all their gold at the same time, the banker need keep only a fraction of his total deposits in gold as reserves. This enables the banker to loan out more than the amount of his gold deposits (which means that he holds claims to gold rather than gold as security for his deposits). But the amount of loans he can afford to make is not arbitrary: he has to gauge it in relation to his reserves and to the status of his investments (Alan Greenspan, “Gold and Economic Freedom,” The Objectivist, July 1966, pg 109).

At this point, I’d say that I’m reasonably clear about the way in which fractional reserve banking works. Although I have some lingering worries (or perhaps just confusions) about the “money multiplier” created by the cycle of deposit-loan-deposit-loan (discussed by my friend Jimmy Wales here), I’m even far more clear about that than I was originally.

As for the proper legal status of fractional reserve banking, I cannot see any fraud in it, so long as all parties are adequately informed. If I know in advance that my bank might lend up to some fixed percentage of its total deposits rather than safeguarding them all for mass withdrawal at any moment, then how is that bank defrauding me — or anyone else? After all, if the demand for past deposits exceeds the supply of reserves, then some procedure contracted by all in advance will have to be invoked. That might be painful, but it wouldn’t be fraud.

Before I posted on this topic, I decided to read the section on fractional reserve banking in George Reisman’s Capitalism. To my surprise, he’s not just opposed to fractional reserve banking, but in favor of outlawing it as fraud. His critical philosophic argument comes in a section entitled “The Moral Virtue of the 100-Percent-Reserve Gold Standard”:

What underlies the practical advantages of the 100 percent-reserve gold standard over any form of fractional-reserve system is its moral superiority. It operates consistently with the law of the excluded middle and does not attempt to cheat reality by getting away with a contradiction. It recognizes that lending money precludes retaining that money in one’s possession, and that retaining money in one’s possession precludes lending it. The 100-percent-reserve system follows the principle that either one lends money or one retains the money, but not both together, with one and the same sum money. In contrast, a fractional-reserve system applied to checking deposits or banknotes is a deliberate attempt to cheat reality. It is the attempt to have one’s money and lend it too. It is a system fully as dishonest as all other recurring efforts that take place in one form or another in attempts “to have one’s cake and eat it too.”

Just as such attempts typically entail taking away someone else’s cake, fractional-reserve banking applied to checking deposits or banknotes entails some parties gaining credit at the expense of other parties, and others unexpectedly being placed in need of credit. Again and again it results in financial contractions, depressions, and deflation, accompanied by widespread bank failures, which last represents the cheating coming home to roost. Again and again, individuals who believed they owned money, who would never have dreamed of lending out the money they needed to hold to make purchases and pay bills, and thus of lending, to the point of their own insolvency, wake up to learn that the checking deposits or banknotes they hold represent loans that have become uncollectable.

Imposition of the 100-percent-reserve principle in connection with checking deposits and banknotes is the imposition of financial honesty. It would require nothing more than that banks ask their customers whether in making a deposit or buying banknotes their intention was to lend money to the bank or to keep their money at the bank. In the first case, the bank’s customers would receive a credit to a savings account or certificates of deposit, neither of which they could spend until such time as they withdrew the funds they had lent, which would entail equivalently reducing their savings account or redeeming their certificates of deposit. During the interval the bank, for its part, could lend the customers’ money out, as it thought best. In the second case, the customers would receive either a credit to their checking account or banknotes, both of which they could spend as they wished. But so long as the customers held their funds in the form of checking accounts or banknotes, the bank could not lend or spend the proceeds its customers had entrusted to it. That money would be the customers’ money, which they were not lending to the bank but merely keeping at the bank.

It follows from this discussion that it is mistaken to believe that the imposition by law of 100-percent-reserve banking in connection with checking deposits and banknotes would constitute government interference. It would constitute nothing more than the just exercise of the government’s power to combat fraud–the fraud of having one’s funds lent out despite the bank’s deliberate creation of the impression that in making a checking deposit or purchasing banknotes one fully retained the possession of one’s funds.

Shysterism in any form is always slippery. Thus if it occurs to anyone to argue that the banks’ customers are not victims of fraud because they clearly know and understand that their funds are being lent out, then the answer is that in that case they would be parties to fraud. Their fraud would be the attempt to make payment to others not with money or reliable warehouse receipts for money, but with claims to debt. They would be engaged in the willful contradiction and deception of claiming to pay someone when in fact imposing on him the position of being a grantor of credit. (George Reisman, Capitalism, pg 957-8)

Woah, Nellie!

If a fractional reserve bank lends up to 90% of its total deposits in a laissez-faire capitalist system, its depositors are not dishonestly attempting to cheat reality by holding and lending their money. They are counting upon the quality of the loans of that particular bank, hopefully with good reason. They are also generally counting upon the fact that demand for deposits will be fairly evenly distributed over the large pool of depositors over time, just as Alan Greenspan noted. They are also aware that in times of crisis, their own deposits may not be available to them, hopefully temporarily but also possibly permanently. Where is the dishonesty or fraud in that kind of system? It’s no more fraudulent than pooling risk with insurance.

The claim that payment to others in fractional reserve banknotes would be fraud is also unpersuasive. If Mary owes John $1000 for painting her house, John need not accept banknotes from Mary’s fractional reserve bank if he regard those notes as insufficiently reliable. John could insist upon funds from a 100-percent-reserve bank — or even gold. So how is John deceived and cheated if he accepts fractional reserve notes?

As far as I can see, the charge of dishonesty and fraud only makes sense if you assume that ordinary people are not competent to judge the quality of the financial institutions with which they deal. However, Objectivism certainly does not endorse any such forms of paternalism. Moreover, any legally competent person could understand that full-reserve notes (or in gold itself) would be less risky than fractional-reserve notes.

So while I’m no expert in economics, I cannot possibly regard Dr. Reisman’s argument as a plausible justification for outlawing fractional reserve banking. On a philosophic level, the argument strikes me as highly rationalistic, in that its main line is basically a deduction from the idea that fractional reserve banking means depositing money in the bank to lend to others even while retaining the ability to withdraw it at any time. That does seem like a contradictory state of affairs — if you drop the broader context of the activities of all the bank’s other depositors.

Over the past few years, I’ve heard various Objectivist scholars complain of the heavy rationalism of George Reisman’s work. If his philosophic discussion of fractional reserve banking is any indication, those complaints are warranted. (And please, don’t even get me started on his maliciously rationalistic and context-dropping review of Ayn Rand Answers. I’ve said enough about that already, I think.)

  • Ralph Musgrave

    Strikes me the reason fractional reserve is fraudulent is simple. Banks, 1, accept deposits, 2, make loans, and 3, then tell depositors their money is safe, which it cannot possibly be, because if a bank makes enough silly loans it then cannot repay depositors!! And that’s happened over and over again thru history. I expanded on that point here:

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