Fractional reserves and demand deposits: historical evidence from an unregulated banking system.

• Author: Nair, Malavika
• Position: Essay

Economists who otherwise favor a free market in monetary and banking services have engaged in long-standing debate regarding banks' ability to affect the money supply and the exact nature of that effect (Rothbard 1983, 1990, 1994; Selgin 1988, 2000, 2012; Hoppe 1994; White 1995, 2003; Hulsmann 1996, 2000, 2003; Selgin and White 1996; Hoppe, Hulsmann, and Block 1998; de Soto 2006; Bagus and Howden 2010; Yeager 2010). Should banks be made to operate under a 100 percent reserve rule that completely constrains their ability to affect money supply or a fractional-reserve rule that would leave the exact level of reserves to be determined by market forces? Under fractional reserves, banks issue notes or checking deposits that circulate in place of money proper, in excess of the level of reserves that would be required to redeem them all at one time. Hence, the focus of this debate is on the level and creation of inside money or banks' ability to affect money supply. However, there seems to be agreement on either side regarding the market's creation of outside money or money proper. Both sides tend to favor some sort of commodity money or several competing commodity monies over central banks' creation of fiat base money.

The debate has proceeded along three broad dimensions: theoretical, legal, and historical. Theoretical considerations include questions such as the optimal supply of money and the economic benefits that may be obtained by allowing banks to expand and contract the money supply according to their clients' needs (Hulsmann 2000; Selgin 2000). The legal aspect of the debate revolves around the question of whether keeping fractional reserves constitutes fraud or not. Several economists have stressed the time dimension involved in the issuing of instantly redeemable claims to money (Rothbard 1983, 1990, 1994; Hoppe, Hulsmann, and Block 1998; de Soto 2006). In this interpretation, redeemable claims to money (bank notes or checkable deposits) are warehouse receipts, issued on the basis of money deposited for the purpose of safekeeping. Hence, the deposited money represents a bailment or a present good, and the overissue of money substitutes constitutes fraud. A bailment is legally defined as an act of delivering goods to a bailee for a particular purpose, without transferring ownership of the goods. In our case it would be deposits of money at the bank for the purpose of safe-keeping. This deposited money is contrasted to explicit credit transactions that involve forgoing the use of money for a certain time period during which the lender earns an interest return. Some analysts contend that fractionally backed banknotes or checkable deposits actually constitute a sort of hybrid instrument, somewhere in between pure present goods and pure credit transactions, and hence do not constitute fraud (Selgin 1988; Selgin and White 1996; White 2003).

This essay contributes to the historical aspect of the debate. The main issue is whether historical episodes of banks' keeping fractional reserves and affecting money supply in a truly laissez-faire setting exist or not. Such episodes would afford us the opportunity to understand and surmise better the development of banking products in the case of deregulation of banking in present times. In an essay titled "Has Fractional-Reserve Banking Passed the Market Test?" (2003), Jorg Guido Hulsmann first argues for two strict categories of banking products: warehouse receipts and IOUs issued on the basis of credit transactions. Warehouse receipts are money substitutes or inside money issued on the basis of money deposited for safekeeping, whereas IOUs represent investments made by people earning an interest return. He then points to the possibility of a third instrument that may develop on the free market, an IOU with a redemption pledge (R,P) or promise to redeem at any time (IOU + RP). Although Hulsmann does not see such as instrument as fraudulent, he is skeptical about the extent to which it would exist and proliferate in a free market. He surmises that clear product differentiation would emerge, and market participants would be naturally discouraged from holding such a risky asset. He writes, "We can be fairly certain that virtually all monetary exchanges would be made in cash or genuine money titles only.... The IOUs + RP of the various issuing banks would be valued differently because these banks have different risk exposures owing to their particular geographical situation and especially to the particular structure of their assets and liabilities. From this condition, it follows that, for all practical purposes, each individual IOU + RP would be a heterogeneous good. It therefore would be unsuitable as a medium of exchange in a wide network of indirect exchanges" (2003, 403).

Lawrence White (2003) agrees with Hulsmann about the possibility of the third type of instrument but believes fractional reserve banks would not only promise to pay money on demand for IOUs but would make legally binding contracts to pay money at any time. Thus, he believes banks would offer IOU plus redemption on demand contracts (IOU + RODC). He cites the historical experiences of free banking in Scotland, Canada, and Sweden, among others, in support of this claim. In the most prominent case of Scotland in the 19th century, where competing banks had a freedom to issue notes, there was widespread circulation and acceptance at par of fractionally backed notes. Although the case of Scottish free banking provides valuable insight into the economic mechanisms at work between banks with freedom of note issue, disagreement still exists over whether conditions there can be categorized as truly laissez-faire (Carr and Mathewson 1988; Rothbard 1988; Sechrest 1988; Munn 1991; White 1995).

George Selgin (2012) documents the origins of fractional-reserve banking in seventeenth-century England. Goldsmiths are believed to have originated the practice of lending out gold kept with them for safekeeping, while issuing demandable liabilities to the depositors. Although many economists sec these origins as fraudulent, Selgin (2012) provides some evidence to the contrary. He not only shows that deposits with goldsmiths paid an interest return, hence pointing to the existence of a debt transaction, but also provides circumstantial evidence indicating that all parties were probably knowledgeable that the notes issued by the goldsmiths were only fractionally backed. (1)

This essay provides another historical episode of fractional-reserve deposits evolving on the free market. The Chettiar banking system in late-nineteenth-century India functioned without any government regulation, and there is clear unambiguous evidence (beyond Selgin 2012, which provides only circumstantial evidence) from various secondary as well as primary sources that bankers kept fractional reserves on checking deposits. They did this by offering interest-paying checking deposits that were redeemable at any time, very similar to the IOU + RP envisioned by Hulsmann (2003). Though they did not issue their own banknotes, their IOUs were in the form of bank deposit balances that could be drawn on by check. Hence, they were able to affect money supply, although the ultimate...