Has fractional-reserve banking really passed the market test?

• Author: Hulsmann, J.G.
• Position: Controversy

The theory of free banking has experienced a great renaissance in recent years. The authors of many articles, books, and doctoral dissertations have made the case for the possibility and suitability of a purely private or competitive banking system. Virtually all these works were inspired by some variant of Austrian economics, which is no surprise, because Austrians tend to analyze institutional arrangements without any a priori bias in favor of government solutions. In any case, the new literature on free banking is one of the most important fruits of contemporary Austrian economics. (1)

Disagreements among these modern authors concern for the most part the economic and legal significance of fractional-reserve banking. More recently, two considerations have played an especially important role in the debate. Defenders of fractional-reserve banking stress that it is a legitimate market activity because, after all, nobody is coerced into accepting fractional-reserve money substitutes. (2) They also emphasize the fact that, today, virtually all Western banking systems operate on a fractional-reserve basis. It is therefore not farfetched to argue that this manifest practical success derives at least in part from the socially beneficial character of fractional reserves, which have, so to speak, passed the "market test," whereas the alternative institutional arrangement of 100 percent reserves for money titles has not. (3)

These arguments are important and powerful ones. My purpose in this article is to evaluate them through a reexamination of fractional-reserve banking in light of the role that product differentiation plays in the market process. I believe this approach is necessary if we are to come to grips with the point of view championed by a group of French economists who, though endorsing a rejection of Lawrence White's and George Selgin's economic case for fractional-reserve banking, uphold it on moral grounds as a possibly legitimate free-market business (see, in particular, Gentier 2001; Nataf 1997; Salin 1998, 2001). By contrast, White and Selgin's position more or less implies that fractional reserves are inherently beneficial and legitimate. Several authors, including myself, have pointed out the shortcomings of this latter position, showing that it relies on fallacious economic principle and refuting it by a discussion of these principles. It now seems to be necessary to restate the case against fractional-reserve banking in a more nuanced way than it has been stated in previous writings. My goal is to examine the precise conditions under which fractional-reserve banking might be a legitimate free-market activity and what the exact nature and scope of this activity would be. My analysis demonstrates the fruitfulness of this focus on product differentiation.

I first describe several types of banking products that can be distinguished meaningfully on practical grounds. I discuss the extent to which fractional-reserve banking involves offering such a distinguishable product and what role this product is likely to play in the market process. Then I analyze an important case in which the market participants do not distinguish between two inherently different banking products--namely, money titles and fractional-reserve IOUs. I show that in this case Gresham's Law becomes operative--the fractional-reserve IOUs crowd out the money titles. The monetary system turns into a fractional-reserve monetary system and becomes subject to recurrent liquidity crises (business cycles) that jeopardize the division of labor in the entire economy. I argue that these consequences result independent of whether their cause--namely, lack of product differentiation--is brought about accidentally or intentionally.

I then show that a good deal of evidence exists for the intentional suppression of product differentiation in the past. In many cases, fractional-reserve banking has relied on obscurity of language, which the bankers have promoted intentionally and fraudulently. I also argue that the differentiation between fractional-reserve IOUs and genuine money rides has been suppressed not only through fraud, but also through outright coercion. Today, money warehousing, along with the concomitant issue of money rides, is not a legally protected business in the Anglo-Saxon world. Fractional-reserve banking alone enjoys legal sanction. Its present-day dominance in deposit banking is therefore not a matter of having passed the market test, but of legal privilege and monopoly.

Finally, I briefly consider the impact of modern monetary institutions--in particular, central banks and paper money--on product differentiation in the banking industry. I argue that these institutions have prevented a clarification of the nature of fractional-reserve banking and that therefore they are best understood as instruments in an extended political cover-up.

Some Types of Banking Products

My purpose in this section is not to give an exhaustive typology of banking products, but to argue that at least two product types differ categorically. Most financial instruments have, of course, an intermediate-type nature: financial engineers try to blend risks and benefits of the various purer instruments into new mixes that appeal to the customers.

A first type of banking is money warehousing. The bank stores money for other people and 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. Fundamentally, the bank acts here as a warehouse for money, and therefore its money titles are covered 100 percent.

A second type of free-market banking is credit banking. Here people invest their money in the bank for a certain length of time--for example, by granting a credit to the bank or by buying its bonds. The bank issues an "I owe you" (IOU) to the creditor, to whom it pays interest, and lends the money at a higher interest rate to a third person, thus earning an income from the interest-rate differential.

The crucial difference between these two types of products--money titles, on the one hand, and credit claims or IOUs, on the other--is that in the first case the depositor retains an exclusive legal claim to the money at any point in time, even though the money is physically stored in the warehouse. By contrast, in the second case the bank obtains a temporary exclusive legal claim to the money during the time of the credit, and only after this time does the creditor regain his exclusive legal claim to the money. Thus, the two types of banking differ categorically. A business either engages in money warehousing and sells money titles or engages in credit banking and sells IOUs. No third possibility exists. It makes no sense to say, for example, that both the banker and his customer have valid legal claims to the same sum of money at the same time, and it would be impossible for both to use the same sum of money at the same time (Hoppe, Hulsmann, and Block 1998).

Credit banking can be modified in countless ways to suit the particular needs of bank customers with tailor-made financial instruments. One modification that is important for our present purposes consists in making the IOUs more liquid. For example, a credit bank can standardize its IOUs to facilitate market penetration, as stock papers or bonds are standardized. In this case, liquidity comes at no expense of return. It is simply an additional feature of the IOU.

Conceivably the most efficacious way to increase the liquidity of IOUs is to promise their owners that the IOUs can be redeemed in cash on demand. This promise is made, for example, in the contemporary case of so-called time deposits. The return on the IOU is then lower than it otherwise might be because the banker keeps a bigger amount of cash to satisfy customers who have chosen this investment scheme. Also, the customers know that they have no guarantee that they can always get money by presenting their IOUs because this possibility is contingent on the amount of IOUs presented by other customers at the same time. After all, the banker merely gives his promise to "try his best" to redeem the IOU on demand. The very fact that some of the money represented by the IOU is lent to other customers prevents him from guaranteeing redemption--at least from guaranteeing it in the same sense in which it can be guaranteed for money titles.

Free Banking under Product Differentiation

The case that can be made for "free-market fractional-reserve banking"--that is, for some sort of fractional-reserve banking that inherently does not violate private-property rights--relies entirely on the scenario I have just described. At least some defenders of fractional-reserve banking concur with this view. Pascal Salin asserts that his case for fractional-reserve banking relies on the following interpretation of a "deposit" contract: "When A `deposits' one unit of gold in the bank, he is no more the owner of one unit of gold, but the owner of a piece of paper (a note) which, according to the bank promise, is redeemable at any time against one unit of gold. In other words, the bank becomes the legitimate owner of gold: There has been an exchange of one unit of gold against one unit of notes" (2001, 4). Salin's scenario is indeed a possible one. It can so happen that a person who "deposits" a sum of money with his banker really means to buy an IOU plus redemption promise.

Indeed, it is not difficult to see that a free market might exist in IOUs plus redemption promise (IOUs + RP). Although these IOUs yield lower returns than other investments, they are more liquid; and although they are not always as liquid as money titles, they are costless or even promise some return. Their high liquidity makes them much more suitable than stock papers or bonds as a means of payment in daily transactions, even though they are not quite as liquid as money titles...