Rothbard on fractional reserve banking: a critique.

• Author: Rozeff, Michael S.
• Position: Report

Murray Rothbard, in The Case for a 100 Percent Gold Dollar (1974), maintains that fractional-reserve banking is fraudulent. Viewing it as coercive and unlawful, he argues that banks ought to be allowed to serve only as warehouses for money. He insists that all deposits become bailments, not debts or credits. (1) Money would always be an asset, never a liability. A proper bank would, in his view and by law, hold all deposits intact and become a 100 percent reserve-storage or safety-deposit bank, although to call such a business a bank under these conditions is something of a misnomer because such a so-called bank makes no loans.

Rothbard's firm belief that fractional-reserve banking constitutes fraud rules out fractional-reserve free banking even in a free market. This position, I argue, goes against basic ideas of liberty and the free market, both of which Rothbard champions. When he regards fractional-reserve banking as fraudulent and proposes its illegality, he introduces his own ethical judgment based on his own assessment of the merits of any and all exchange transactions that may occur between banker and depositor. He introduces his own idea of the appropriate property rights in a bank deposit, his own idea of what appropriate money must be, and his own idea of libertarian law. Although he is entitled to his opinions, the market participants in a condition of liberty in free markets decide all these matters for themselves, and their reasoning and valuations may differ from Rothbard's. They may not regard fractional-reserve banking as fraudulent, and they may want to transact via fractional-reserve banking arrangements. They may wish to circulate media of exchange that are someone else's liabilities.

Rothbard's position has since been espoused in books by both Jesus Huerta de Soto (2001) and Jorg Guido Hulsmann (2008) as well as in articles, such as one by Hans-Hermann Hoppe, Hulsmann, and Walter Block (1998) that argues against fiduciary media. These latter-day adherents to Rothbard's position show no diminution in the strength of their convictions, despite the criticisms presented by George Selgin and Lawrence H. White (1996), who have argued against Rothbard's position and supported free banking. For example, Hulsmann writes in his book, "There is no tenable economic, legal, moral, or spiritual rationale that could be adduced in justification of paper money and fractional-reserve banking" (2008, 238). This extraordinary statement boldly restates Rothbard's beliefs. If a community willingly and freely uses paper money, shall Hulsmann maintain that they have no rationale? Moreover, it is not difficult to locate scholarship that provides viable economic reasons for paper money and fractional-reserve banking. (2) It is quite easy to find numerous real-world instances in which paper money, tokens, scrip, and credits arose spontaneously (see Timberlake 1987). I argue here that the Rothbardians have not proven, either on grounds of morality or on grounds of economics, that paper money or fractional-reserve banking evinces criminal behavior.

Monetary Freedom

Instead of arguing, as Rothbard does, that monetary freedom necessarily requires 100-percent-reserve banking, let us ask what monetary freedom might look like. The institutions and practices that arise under freedom are impossible to know in advance. We can imagine many possibilities. People themselves decide what kinds of property rights they want and find acceptable in bank accounts. They hammer out what is fraudulent and what is not. Banks and their customers decide the details of their own exchanges. People decide what value standards (units of account) to use to establish prices and what media they want to use as money, whether commodity, paper, electronic, or something else. People may demand bank audits as they see fit, and they may become part of the market structure. Banks may issue their own banknotes. Perhaps banks arrange central clearing houses that issue notes. Retail establishments may become involved in issuing various clearing certificates. Local clearing systems may arise that use credit clearing. People trade and use banknotes as money if they wish. They depreciate those currencies that they believe are losing value, and they flock to the media that they think may appreciate or hold their value. If media are convertible, people decide on the appropriate media of redemption.

People who make market exchanges decide more fundamentally what policies and practices they regard as fraudulent. With monetary freedom, none of us is in a legal position to decide a priori what kinds of monetary arrangements are fit for others. We can decide only what we find acceptable for ourselves and act accordingly. In this regard, people may turn to Rothbard's ethics and follow his advice or to the Holy Bible and seek its counsel or to any number of other sources in order to arrive at the ethics that form the basis of what they find acceptable in market arrangements. In the present state of human knowledge, ethics are contentious.

Although the Rothbard school can argue its ethical case based on the notion that a deposit is the property of the depositor, it cannot prove this case because a deposit of assets may well be freely exchanged for a deposit account whose property rights do not necessarily entail a warehouse receipt or the bank's legal obligation to segregate the deposit and hold it in storage for the depositor. Rothbardians are in no position to determine what form the property rights in a deposit account must take while simultaneously advocating liberty and a free market. If they stipulate the former, they abridge liberty and the market. If they choose the latter, the market participants stipulate the property rights.

The Main Proposition

I argue a simple proposition about free-market fractional-reserve banking. Suppose that in a free-market situation, depositors in a bank agree to make their deposits even knowing full well that the bank intends to lend out some of these deposits. Depositors may also know full well that they may lose some of their deposits. An analogous case involves making a risky loan even when knowing that the loan may not be fully repaid. Depositors may willingly accept a degree of risk in order to obtain other items of value to them, such as checking services and interest payments. Moreover, in a free market, insurance and risk-shifting services may arise for such credits. (3)

My proposition is that in this free market characterized by willing and voluntary behavior by both depositor and banker, with all actions being known and above board, the fractional-reserve banker's actions are not inherently criminal because what private parties agree to among themselves (without coercing innocent others) cannot be called criminal. Rothbardians may inform depositors that they are being robbed, but if the depositors prefer the arrangement, they have the final word. They have defined the property rights acceptable to them, and they must live by them. If this proposition is true, then, in this free-market scenario, vilifying the banker or accusing him of embezzlement, legalized counterfeiting, or fraud or worrying that he is printing money out of thin air or creating two rifles to the same property has no ethical weight. The Rothbardians express views on the ethics of arrangements that others are making, but they have no claim to being more ethically right than the others with regard to what the latter have agreed to.

Rights in Deposit Accounts

To understand how a deposit might be made in a bank and then loaned out nonfraudulently, we need only think of analogous cases for other kinds of firms. Every day billions of dollars are loaned to corporations doing all kinds of business, and the managers of these companies take the money and invest it as they see fit, usually under a variety of constraints that the lenders impose on them and that they accept. They do not hold the money in a warehouse ready to be returned to the lenders at a moment's notice. The loans are risky because payment at maturity is not assured, but this risk is compensated by a higher rate of return than the return on a safer loan. These loans are widely regarded, of course, as legitimate and moral. I know of no school of ethical thought that has proven they are not. I know of no reason to forbid them because of their inherent criminality.

Consider another case that is even closer to fracrional-reserve banking. Stock brokers every day lend securities that have been left with them in margin accounts. The buyers of these securities have signed hypothecation agreements with their brokers that define a set of property rights. The property rights in the money deposited into the account are exchanged for the property rights in the account. The physical deposit is not identical to the account. These agreements allow the brokers to lend the securities. The securities are then carried in "street name," which means the buyers do not have title to them. The buyers instead have property rights defined by their account agreement. The account owner retains the right to sell these securities. The broker, called upon to sell a stock that he has loaned out, then obtains the stock elsewhere or from his reserves and sells it for his...