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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.



  • Wafa says on: April 18, 2009 at 5:38 am


    No. That's not what fractional-reserve banking is about at all. Fractional reserve banking involves depositors loaning money to other folks i.e. businesses, consumers etc, with banks as an intermediary. If interest is paid, it is simply their share of the profit from the loan.

    The kind of "warehouse receipt" deposit you say Rothbard describes is what we get from a safe deposit locker. Anyone & everyone is welcome to use safe-deposit lockers if they choose. That is not the function of a bank deposit, especially not an interest-bearing one. The function of a bank deposit is to allow savers to loan money to those who want to borrow. It is not fraudulent for a bank to do exactly what it says it's going to do with your money.

    • nothirdsolution says on: April 18, 2009 at 1:18 pm


      There's a big difference between lending money (in which case it's not available to the lender), and creating pure debt obligations out of thin air. Go read Modern Money Mechanics from the Chicago Fed and get back to me.

      • antboy says on: April 20, 2009 at 9:19 am


        Nothing like giving someone a link to a 50-page paper to end a discussion. BTW, giving him a defective link was a nice added touch. ;)

        Wafa's point is clear: the depositor is not being defrauded because he knows bloody well that banks lend out deposits, and that there is no way their checking account is going to pay interest if the bank is just warehousing deposits. Ask any room full of people if they think that all bank deposits are sitting in the vault at the bank. Outside of the occasional smart ass, you'll never see ANYBODY raise their hand. They've seen IT'S A WONDERFUL LIFE.

        Moreover, bank notes, like all notes, are promises. This is a part of the formal definition of a note in the legal code They are not receipts. Only gold is gold, and only a gold receipt is a claim check on gold. A gold note from a bank is a PROMISE to pay gold on demand, and as long as the promise is honored, the bank hasn't betrayed anybody. Is a bank note actually a debt obligation rather than an actual transfer of money? Yes, I agree with you. The problem is that you assert, without evidence, that bank notes not backed by 100% reserves won't trade at par with commodity receipts, and there is plenty of empirical evidence to refute that. Since turnabout is fair play, I suggest you read Lawrence White's FREE BANKING IN BRITAIN at and then get back to Wafa.

        If you want to argue that FRB causes business cycles that wouldn't occur under 100% reserve banking, that's reasonable. Those of us who favor FRB will argue that the advantages outweigh the disadvantages, and that in free banking in the past, FRB won out over 100% reserve banks, because of the fee differences and the willingness of depositors to accept the risk of default in exchange for more favorable financial arrangements..

        Of course, you, me, and Wafa all want to get rid of central banking and legal tender laws, the only difference being that Wafa and I clearly won't violently prevent banks from being established that make it clear they lend out money on deposit. And I suspect that you wouldn't either, and mainly are arguing that 100% reserve banking will drive out FRB banking in a free market. I think you're wrong, but we can still co-exist in that society and one of us be a good loser when our prediction turns out to be wrong about which type of banking will prevail.

        • nothirdsolution says on: April 20, 2009 at 11:50 am


          Wafa's point is clear: the depositor is not being defrauded because he knows bloody well that banks lend out deposits, and that there is no way their checking account is going to pay interest if the bank is just warehousing deposits.

          The banks don't lend out deposits. That's the point. If they were lending deposits, no new money would be created. It's not the banks qua lending intermediary that riles me, it's the ability to create pure debt obligations out of thin air.

          I've received some similar comments via e-mail. I have another post on this topic in the works, so check back in the next few days.

          • antboy says on: April 20, 2009 at 1:28 pm


            Fair enough: a bank note or deposit created to satisfy a "loan" approval (I put it in quotes to keep you happy) is actually just an IOU from a bank promising to redeem in money. It is not money. Only money is money. As long as they redeem such notes and deposits in money when requests are made, they are completely honoring their obligations, and have defrauded nobody. Scotland operated for well over a century that way. Canada also had a stable FRB system without bank failures right through the entire Great Depression.

            As for the argument that the widespread acceptance of bank notes and created deposits reduces the value of money, so what? Nobody is entitled to have the value of their asset maintained, only to have the asset itself maintained. If I come out with an improved product that causes demand for yours to drop, you can't sue me for damages, and certainly not for fraud.

            So if you're going to argue (quite reasonably) that banks aren't lending out deposits, then they have committed no fraud against depositors or anyone else holding money. If people choose to accept "money substitutes" because of their enormous convenience, you have no right to complain that this reduces the value of your money.
            In other words, you are entitled to your 87 ounces of gold, but not what that will buy you in terms of other goods and services.

            It's the fraud argument I find wanting. You can make a reasonable argument about business cycles (although Austrians have by no means convinced the mainstream economic community), and I will simply say that there are enough advantages to FRB to make cycles acceptable, if that is the price to be paid. If you want to claim that 100% reserve banks will outcompete FRB banks in a free market, you have to fight the evidence of history. Lawrence White and George Selgin, both Austrians, have written plenty on historical examples of stable FRB systems with notes trading at par to money, and 100% reserve banks didn't emerge and overwhelm them, because they had to charge fees.

            If you haven't read the 2nd edition of FREE BANKING IN BRITAIN, you really should.

            I look forward to your next post. I understand that these arguments can get pretty detailed, and appreciate the respectful manner in which you make your case.

  • Wafa says on: April 20, 2009 at 1:52 pm


    Just to make a couple of things clear:
    1. Banks do lend out portions of their deposits. New money is created because when a loan is made, it almost necessarily implies a transaction gets conducted. Eg: you borrow money, buy a car, or borrow money & pay a supplier. The seller gets the money & puts it in their bank account, whereupon it becomes a new deposit. The bank lends out part of it & the cycle continues. It would work exactly the same way even if all our money was gold coins rather than fiat money.

    2. I'm not convinced that central banks & legal tender laws are the root of all evil. I am open to other ideas but I think it all needs more study. Even if we got rid of legal tender laws we'd still need strong regulatory bodies to prevent fraud. Recent history shows that the market cannot prevent that successfully in the short to medium term.

    3. Business cycles are caused by human nature, not central banks (with a few obvious exceptions like 1981). Business cycles result from the natural herd mentality that causes overinvestment when times are good, & then the opposite herd mentality when everyone realizes they overinvested & stops investing altogether. Keynes sniffed around the idea & understood the basics, but overall behavioral economists have done a much better job of explaining business cycles & bubbles than the Austrians ever did.

    • antboy says on: April 20, 2009 at 4:30 pm


      I didn't mean to misrepresent your views: I see we have some significant differences in our perspective.

      1. I hope semantic disagreements don't make the discussion unclear: there are so many different definitions of money in a fiat system that people can often talk past each other. I think both your perspective and David's can be intelligible, and how I debate depends on what definition someone wants to use. Obviously, if we define bank deposits as money, lending in a fractional reserve system creates more of it.

      2. I think FDIC insurance is a major source of the problem, both in the 1980s and now. There is no incentive for bank customers to care about prudent behavior. But I do think legal tender laws play a major role in giving the government a free hand to inflate, and the runaway Fed is a major source of the current disaster. Who is supposed to regulate the regulator who acts like a chicken with his head cut off?

      Recent history is of a heavily-regulated system, so it doesn't show how a freed market would operate. The writings by White and Selgin that I mentioned in earlier posts show that markets produce enormously stable banking systems when unregulated. I would also emphasize that enforcement of laws against fraud is not the same as regulation, and that reputation becomes of primary importance in a system without a central bank or government insurance, so that the potential for fraud is significantly reduced. This isn't merely conjecture: free banking has existed in several different countries, often for very long periods of time, and its disappearance was usually because governments like having a way of creating revenue for themselves. There is extensive literature on the topic for those who want to make a sincere investigation.

      3. I'm not prepared to draw any conclusions about the cause of business cycles, but I think the overinvestment theory is untenable. There is no limit on human wants, so investment can never be excessive. Keynes had no appreciation for the fact that "capital" is not a fungible good. I think there are problems with Austrian malinvestment theory as well, although they might be resolvable. I'm also prepared to believe that cycles are a matter of human nature going to extremes of optimism and pessimism, but the times when "everyone" stops investing are typically associated with government behavior that panics businesspeople and makes it difficult to plan for the long-term future. I have to say, however, that behavioral economics, to date, seems to be a series of anecdotes and psychological observations rather than a coherent system. It may be on the right track, but I remain an agnostic on the cause of business cycles. I just don't know.

  • nothirdsolution says on: April 20, 2009 at 6:19 pm


    Antboy & Wafa – thanks both for civil commentary. I'll be in touch.

  • Neverfox says on: April 21, 2009 at 12:25 am


    I was going to write a long-winded response to some of the points in this discussion that I think are mistaken or at least up for debate (e.g. that we have anything resembling the cartoon 90/10 FRB system laid out in MMM, that deposits create loans, that bank notes aren't money etc.) but they are all summed up in Steve Keen's work here. I highly suggest digesting his analysis of the circuitist credit view of money before drawing too many definitive conclusions about what kind of system we actually have.

    As for FRB and fraud, I'm mostly with antboy and White on this one. In fact, if you want to read more from White about the charge (from Rothbard, Block, & Hoppe) that FRB is inherently fraudulent, see here. I also think the circuit theory of credit money underscores this. If everyone agrees to trust the third-party (bank) and "subscribe" to the token system ("I'll accept tokens from you as a wage if you agree to sell me stuff with those tokens later"), where is the fraud and where is the need for a commodity money? It begs the question to assume that money must be commodity money to be a legitimate medium (consequentialist considerations aside).

    I would love to hear your responses to the Keen and White articles, nts. Do they introduce any new concepts for you or are they ideas that you have already considered and rejected?

    • nothirdsolution says on: April 21, 2009 at 12:10 pm


      I feel like I'm in grad school all over again! Thanks for the links.

      Banking is a pretty monstrous topic, and it's one I revisit occasionally, so athough I'll get around to reading these papers (and the others linked, above!) my initial reply probably won't address them, since it's already in draft stage. Just an FYI so I'm not dodging the issues raised by these authors.


    • nothirdsolution says on: April 21, 2009 at 5:29 pm


      In footnote 10, Keen inquires:

      Though Austrians advocate a private money system in which banks would issue their own currency, they assume that under the current money system, all money is generated by fractional reserve lending on top of fiat money creation. This is strange, since if they advocate a private money system, they need a model of how banks could create money without fractional reserve lending. But they don’t have one.

      I think Keen has entirely missed the mark with this comment: Austrians assume (and maybe I'm oversimplifying here) all currency is generated by fractional reserve lending on top of fiat money creation. One point on which they are very clear is that nobody can create "money" which is in fact a market phenomenon that evolves over time (the Regression Theorem). If it is possible to create something out of thin air, then that something isn't money.

  • Neverfox says on: April 22, 2009 at 2:05 am


    Then I think Keen would say that their definition is too narrow. But nevertheless that only begs the question when speaking to a circuitist, chartalist or other endogenous money theorist, who, by definition, view money differently and don't accept the dichotomy between currency and money. For example, the circuitist Graziani stated his view as follows:

    In order for [credit] money to exist, three basic conditions must be met:

    a) money has to be a token currency (otherwise it would give rise to barter and not to monetary exchanges);

    b) money has to be accepted as a means of final settlement of the transaction (otherwise it would be credit and not money);

    c) money must not grant privileges of seignorage to any agent making a payment.

    Furthermore, endogenous money theorists like Basil Moore challenge the conventional view that gold coins are the natural evolution of money any more than token or credit money:

    The crucial innovation was the finding that a banking house of sufficient repute could dispense with the issue of [gold and silver] coin and instead issue its own instruments of indebtedness. The payability of bank IOUs to the bearer rather than to a named individual made them widely usable as a means of payment.

    Austrians may disagree but it will take more the restating their definition of money to make their argument. I think that Keen demonstrates (and I have programmed a computer model of a pure credit economy myself to "check the math") that it can work, at least technically. The real test for libertarians and anarchists will be to determine what if anything is unlibertarian about that process, perhaps by analyzing it from the perspective of contract or title theory. This is something I am very much interested in exploring.

  • Neverfox says on: April 22, 2009 at 2:19 am


    Indeed it is a big topic; I'm still learning a great deal, from Austrians, Post-Keynesians…anything I can get my hands on really. I'll hope to write more on the subject on my blog since it's my current obsession.

  • Neverfox says on: April 22, 2009 at 2:23 am


    I might also add that Lawrence White and George Selgin just may be the answer to Keen's challenge but I'm still learning about their full theory.

    • antboy says on: April 22, 2009 at 8:32 am


      I think you may be right: some free banking advocates of the Selgin/White position believe we will end up with a system in which gold is the unit of account but never actually used, and that the money supply will expand through the creation of notes until it drives the price of gold down to its use as an actual commodity (eliminating any exchange value premium that a 100% reserve system would produce), thereafter being as stable as the commodity itself.

      Keen's article is too much of a parameter shift for me to absorb without a great deal of thought. I asked a dear friend of mine who is an economist with a special interest in the history of money and banking (and a supporter of the Selgin and White free banking point of view) if he could look at the Keen article when time permits, and I hope to offer some substantive thoughts eventually, though I can't promise when that will be.

      I do think that some angry debates on money can turn out to be semantic disagreements: the definition of money is obviously ambiguous, as evidenced by the different measures of money used in public discourse.

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