Accounting for fractional-reserve banknotes and deposits--or, what's twenty quid to the bloody midland bank?

• Author: White, Lawrence H.
• Position: Controversy

For centuries--even before government guarantees came on the scene--Western payment systems predominantly have used banknotes and demand deposits backed by fractional rather that 100 percent reserves. Explaining the long historical prevalence of fractional-reserve instruments poses a difficult challenge to those who believe that such products necessarily or usually represent a fraud. (1) A business practice is fraudulent, of course, only if someone is duped. The challenge then is to explain how the public was duped continually for centuries. How on earth did the bankers keep the word from getting out? The challenge is especially great when we notice that if an informed public really had wanted to patronize money warehouses, then money-warehousing entrepreneurs would have profited by getting the word out. As George Selgin and I wrote in 1996,

competition will beat down the returns to capital invested in fractional-reserve banking until the marginal bank is earning only the normal rate of return. In this situation, were it really true that most depositors are willing to forego the interest they are receiving (and instead pay storage fees) in order to have the security of a 100-percent-reserve bank--but simply don't realize that their banks aren't holding 100 percent reserves--then any banker (who does know what the banks are up to, after all), possessing even an ounce of entrepreneurial insight, would see an easy way to grasp pure profit. All the banker has to do is to offer credible 100-percent-reserve accounts, while alerting the public to the other bankers' practices, and depositors will come flocking in. (97-98) In his article "Has Fractional-Reserve Banking Really Passed the Market Test?" in this issue of The Independent Review, Jorg Guido Hulsmann tries to meet this challenge. In his view, fractional-reserve banking has not really "passed the market test." He offers an imaginative story about how the bankers managed to keep the public duped for centuries: they "relied on obscurity of language, which the bankers have promoted intentionally and fraudulently," and they acted as a "cartel" in accepting and redeeming one another's notes and checks. Their customers, when trying to pay with fractional-reserve banknotes and checks, became virtual co-conspirators in hiding the differences. Money warehousers could not profit by exposing the differences because bank lawyers persuaded the courts to render decisions that effectively banned the business of money warehousing. Thus, fractional-reserve banking prevailed over warehouse banking not because of the workings of a substantially free market, but because of government intervention in the market and the abridgement of freedom of contract.

This story, fortunately or unfortunately, is a fictional tale that does not fit the details or the broad patterns of banking history. Some ambiguities were unavoidable when deposit banking was a new business, but the distinctions needed for clear deposit contracts were established early on. The banknotes and demand deposits popular historically were in fact clearly distinct from warehouse certificates. Warehouse certificates were not a viable type of circulating currency note; in fact, warehouse certificates are inherently unsuited to circulate and are not known ever to have circulated historically. Banks that agreed to accept one another's liabilities at par were not acting as a "cartel" or conspiring against their customers. They did not adopt the more cartel-like policies (holding one another's notes as reserves) that Hulsmann imagines. Court decisions that affirmed fractional-reserve banking contracts did not ban money-warehousing contracts.

Fractional-reserve banking did not need fraud or coercion to prevail over warehouse banking. It prevailed by offering customers a better deal. Fractional-reserve banking really has passed the market test. Government interventions were later responsible for central banks and for taxpayer-backed deposit guarantees (on these issues there is no quarrel between Hulsmann and the "free bankers"), but they were not responsible for the historical prevalence of fractional-reserve banking.

Fiduciary Media Were Differentiated from Money-Warehouse Certificates

Hulsmann appears at first to be open to the possibility of nonfraudulent fractional-reserve banking, indicating that it might legitimately play some role in the market economy if fractional-reserve banknotes were clearly differentiated from money warehouse certificates. By Hulsmann's criteria, however, clearly differentiating fractional-reserve banknotes amounts to ruling out of bounds the kind of banknote contract that actually has been popular historically and admitting only an odd kind of fractional-reserve contract. His belief that widely used historical banknotes were not in fact clearly differentiated from "100 percent money certificates" seems to rest ultimately on his a priori conviction that the banknotes would not and could not have been popular if people had realized what they were getting.

Hulsmann begins by describing two "inherently different" ideal-type banking products: "money tides and fractional-reserve IOUs." Although he allows that "most financial instruments have, of course, an intermediate-type nature," he does not allow that demandable debt--the common contractual form historically taken by demand deposits and banknotes--is a blend of the two types. Thus, the spectrum between his two ideal types excludes major real-world banking products.

In the first ideal type, the bank "issues standardized money titles, such as banknotes, to the depositing customers, who can then use these banknotes in their daily transactions in lieu of money proper." At the same time, the bank "acts here as a warehouse for money, and therefore its money titles are covered 100 percent." In this case, "the depositor retains an exclusive legal claim to the money at any point in rime, even though the money is physically stored in the warehouse."

Although this arrangement sounds straightforward, closer examination reveals that it would not be feasible for a money warehouse to provide attractive "banknotes" or a product "such as banknotes." It is easy to see how a warehouse bank would provide checkable deposits. To cover its operating costs, the warehouse bank easily can deduct (at low transaction cost) monthly storage fees from the deposit balances on its books and debit-per-transaction fees against the deposit accounts to or from which it transfers payments. But how can a warehouse bank assess fees for storing the 100 percent reserves it holds behind a payable-to-bearer note that circulates as an ordinary banknote does--that is, that changes hands without the issuer's knowledge? Because the bank would not know who the current holder of the note is, it could not deduct periodic storage fees from the holder's account balance. (The current holder need not even have an account at the bank.) Without collecting storage fees, the warehouse bank would incur losses on its notes. Thus, Ludwig von Mises's dictum that "Issuing money-certificates is a ruinous business if not connected with issuing of fiduciary media" (1966, 435) applies most forcefully to circulating notes.

One conceivable way to charge storage fees to the holder of a payable-to-bearer warehouse note is to have the note depreciate in the holder's hands at a scheduled rate (the schedule might be printed on the back of the note), entitling the bearer to slightly less money in the vault each week. Such a depreciating note would be an unattractive product, however, in comparison to a currency that remains at par, either "money proper" or a fractionally backed note (whose issuer holds interest-earning assets and thereby can defray costs without collecting fees from note holders). (2) Such a depreciating warehouse note would saddle the holder both with a negative return and with the computational cost of dealing with a nonpar medium of exchange.

We can imagine other ways to collect storage fees that would avoid nonpar valuation, but they would make holding and spending a warehouse note less attractive than using an ordinary bearer banknote (or basic money) in other ways. (1) A warehouse note can be signed over and dated on each transfer, and storage fees can be assessed retroactively on each signer when the note is returned to the warehouse for redemption. Under that plan, transfer would be cumbersome, and it would have to be limited to customers of clearinghouse-member banks who agreed to pay the fees and who provided clear identification (sacrificing the anonymity usually associated with using currency). Collecting the tiny fees due from each signer probably would not compensate the bank for the labor of entering the names and dates from the back of the note. (2) An occasional "negative lottery" can be held, canceling the redeemability of (say) 0.5 percent of the notes in circulation (if the competitive storage fee is 0.5 percent per period). This plan, however, eliminates the warehouse note's potential appeal to risk-averse individuals. Either of these techniques renders the warehouse note less attractive to hold and use than a fractional-reserve note that is considered safe.

Judging by historical evidence from free banking systems of the past and by the fees charged by gold warehousing services today, the default risk involved in holding a fractional-reserve note or deposit issued by a reputable bank (a member of the clearinghouse) is less than a money warehouse's likely storage fee. Storage fees are 1 percent per annum on gold warehouse accounts currently offered by e-gold Ltd. or Crowne Gold. Annual losses to note holders and depositors were a small fraction of 1 percent in nineteenth-century Scotland, Canada, and Sweden (to name three systems that have been studied relatively well). Faced with such percentages, the potential clientele for warehouse banking will be limited to highly...