no third solution

Blogging about liberty, anarchy, economics and politics

A Belated Reply on Fractional Reserve Banking

April 17th, 2009

A long, long time ago, most likely in response to this statement: “[T]he current system of fractional reserve banking is nothing short of fraudulent. There may be some bad apples among the borrowers, but they are dwarfed in number by the bad apples among the lenders,” Tony inquired:

As you understand it, how much of the problem with fractional reserve banking is the concept and how much is the people who practice it? How, if at all, is your objection tied in with fiat currency?

Let me answer a part of the first question pertaining to “the people who practice it” immediately, I’m working on an essay to address the remainder of Tony’s inquiry which should be finished shortly.


My primary objection is with the concept of fractional-reserve banking. The people who practice it are a much smaller concern, because unfortunately as my Public Finance professor used to say, “People respond to incentives.”  People respond to incentives, no matter how perverted the incentives are made by government. And it is the concept of fractional-reserve banking in government which perverts the incentives. A good many of these people don’t know that it’s wrong. But most of these people can’t think critically.

Case-in-point: over the last decade or so, many brilliant young minds were drawn into what appeared to be lucrative careers in finance, banking, real estate, etc. Many of them are also now out of a job. I know smart people who took jobs in banking or wealth management, or whatever.  They took those jobs because they were the best available sources of income at the time.   A friend of mine was a real estate agent, he made over $100k/year back in 2003.  Bought himself a nice house, had a couple kids, etc.  Can’t sell houses any more.  Can’t bring home commission checks anymore.  I know people in wealth management, now unemployed because there’s no more “wealth” for them to “manage”.  They were responding to the bubble that eventually burst.

Given the choice, individuals don’t want to subsidize Wall Street, and see their savings decimated by inflation. That is why governments make sure that individuals don’t have that choice! Despite some arguments based on a misapplication of Gresham’s Law1, in any free system where unbacked notes compete with specie, the latter will supplant the former.  In some instances, “bad” money may trade side-by-side with good money, but not for long.

The root of that problem is the concept and the implementation of fractional-reserve banking, and its corollary, fiat money, which causes real inflation, and creates inflationary bubbles, which are the illusion of profit that many people chased, exploited, and cashed-in on over the early part of the past decade.

Fractional reserve banking must cause inflation and malinvestment, not necessarily price inflation which is what most mainstream economists mean when they say “inflation,” but real inflation, which is an increase in the supply of un-backed currency or currency substitutes. The very fact that a bank arguably loans (this much is debatable – in fact banks don’t usually operate this way) my deposits to someone else, in order that they may affect a purchase immediately, while simultaneously maintaining the assertion that my money is all still there, is kind of proof by definition.  Fractional reserve banking  permits banks to profit at the expense of depositors, just as any common counterfeiter profits at the expense of everyone who accepts his fraudulent notes, and everyone else who pays higher prices than they otherwise would’ve, as a result.

On this subject, I’m very Rothbardian. Rothbard argues essentially that interest rates on deposits can not exist, because money deposits are warehouse receipts and not loanable funds. Money doesn’t grow in warehouses any more than it grows on trees in your backyard.

A loan implies transference of ownership in exchange for consideration: either future consideration through interest payments, or current consideration in the form of collateral, or a combination of the two. In exchange for these considerations, the lender forsakes his title, for the duration of the loan, to that amount of money, and accepts the risk that the borrower may default, in return he receives collateral (or not) and a claim against the borrowers future productivity. A deposit, on the other hand, does not imply any transference of ownership. When you place your valuable jewelry in a safe-deposit box, the bank does not pretend to own those belongings. A deposit-banker is merely a custodian2, and compensated accordingly for the safeguard of deposits.

For the time being, let me attempt to do a Cliff’s Notes tie-in with fiat currency, the defining characteristic of which is its legal tender status, mandated and enforced by the Government. An individual, having no right to print or otherwise create legal tender3 money from thin air, no group or collective of individuals may be said to have that right, whether they call themselves “The State” or “The Mafia”.  This doesn’t mean that you can’t offer anything in exchange, like liberty dollars or doughnuts, but it does mean that you can’t force the other party to accept it in lieu of your obligation.  Fiat money, on the other hand, has to be accepted on the white market.  It’s backed by nothing (except debt and promises), and redeemable by nothing.  This is the medium in which banks trade.


1. Succinctly, “Bad money drives out good money.” This assertion can only hold where bad money must trade at a face value in excess of its true value in exchange, that is, with the help of legal tender laws.

2. If you drydock your boat for the winter, the warehouse does not pretend to own that boat for any amount of time, he does not claim your boat as an asset in his ledger. He can not sell it and use the proceeds on a business venture, in the hopes that he will earn enough of a return to replace your boat when you come knocking in the springtime.

3. For all debts, public and private. Mandate enforced by a government gun.




no third solution

Blogging about liberty, anarchy, economics and politics