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The Fractional Reserve Banking “Contract”

May 13th, 2009

One of the arguments I’ve seen leveled in favor of fractional reserve banking in recent weeks, goes something like this:

Any law against fractional reserve banking denies otherwise free men their right to contract with one another.

On a purely technical point, there need not be any specific “law” against the practice in order to nullify the practice. Per common-law tradition, the only essential question is whether courts would tolerate or maintain contracts of this sort.

So, there need not be any grievance between depositor and his banking institution, for fraud or theft to occur as a result of fractional reserve banking:in fact, they may both be completely satisfied with the outcome of their arrangement at any point in time.  However, there remains the possibility that a third party has been injured by their agreement.

Though two men may form a compact to injure or defraud a third, no enforceable contract exists among them, which is to say that neither party may be contractually obliged to specific performance based on the existence of such a “contract”. Furthermore, even the existence of a valid contract (i.e., one with a legal purpose), shall not be construed in such a manner as to preclude a third party, unintentionally and accidentally injured during the fulfillment of the contractual obligations, from pursuing remedy from those who injured him.

If we can establish that fractional reserve banking does amount to fraud or theft, or that it causes harm (negative externalities) to others, we can safely assume that a free court would refuse to honor or enforce such “contracts.”

Comments

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  • Mike Gogulski says on: May 14, 2009 at 1:59 am

     

    Perhaps notable also, but tangent to your focus here: where privilege is given to fractional-reserve, other modes are disadvantaged.

  • antboy says on: May 17, 2009 at 4:13 am

     

    While anarchists would oppose either fraud or theft, I think we need to be careful about the slippery slope of declaring any negative externality to be actionable harm. We must establish a legitimate property claim of a third party that was injured. Statists might use the vague argument of "negative externalities" to justify intervention, but you are as far from being statists as can be imagined, and I expect more from you before you call for violent intervention or suppression. Since value is subjective, a third party not deprived of their life, liberty, or property can't just say "I feel harmed" and collect.

    In earlier posts, you have suggested (and please forgive and correct me if I have misunderstood) that there is no necessary relationship between bank notes and bank deposits. Accepting that, I'd say a bank note is a redeemable promise for whatever underlying asset it represents, that a common law society would allow anyone (not just a bank) to make such a promise and judge them to have caused restitutable harm only if they dishonored their promise upon demand (and there wasn't an option clause), and that in no way does it constitute fraud or theft.

    I give you a product. You give me a note promising to provide an ounce of gold (or a pound of sauerkraut) upon demand. How in heaven's name is that a fraudulent transaction? What third party has any claim in connection with that transaction? And if I trade the note to someone else, it is no different than the originating transaction.

    Notes aren't money: they are IOUs for future goods or services. Sure, we both believe that some unit of account will emerge within a society as a convenient and common measure, and that it will start to be called money by everyone, but as the Scottish experience demonstrated, actual reserves may end up being utterly insignificant (1-2% of outstanding notes), and all measures of value are subjective and differ for each and every individual in society.

    I see no reason a common law court would fail to uphold a contract to trade a product for a promissory note.

    • nothirdsolution says on: May 18, 2009 at 3:28 pm

       

      Again, off-the-cuff reactions so don't murder me if they're not totally coherent or well-thought out, I'm putting them down here as "notes" for the future. :)

      We must establish a legitimate property claim of a third party that was injured.

      Yes, I agree that we must establish that a legitimate property claim has been violated. That was the cliff-hanger on which I ended the post. I know I didn't make that case, I just said if we can make this case, then the "FRB = Theft" argument becomes a lot more tenable. The next step, of course, is for me to make (or attempt to make) that argument.

      Notes aren't money: they are IOUs for future goods or services.

      Maybe this is part of the distinction… Yes, a promissory note is exactly what you describe. The vendor, by accepting a Promissory Note, is acting as a creditor, risking whatever product he sold on credit to the buyer. He does this on good faith or whatever, under the assumption that the buyer will pay him back in the future (probably plus interest). A banknote representing deposits, on the other hand, is an ownership claim to a certain asset that already exists, i.e., has already been produced. So when someone claims that a Promissory Note is a deposit, this is where it starts to get shady. It's not. A Promissory Note is money (or very likely to be money, by which I mean the product of labor/resources) in the future. Pretending that it is at also money in the present is where IMO things start to FUBAR.

      • antboy says on: May 19, 2009 at 9:44 am

         

        You've been too respectful in this debate to deserve anything but similar treatment. Feel free to make preliminary statements you may later want to clarify or revise. I certainly am doing so.

        That said, I'm concerned that we're headed for the same impasse that always ends these discussions, in which FRBers are accused of passing off promissory notes as warehouse receipts. The history of free banking makes clear that people knew bank notes were merely promises to pay gold or silver on demand, and they SAID SO on their faces. It was also clear that FRB banks won out over 100% reserve banks every time because of the substantial extra costs of the latter.

        Still, I look forward to your fraud case, when you have the time.

        • nothirdsolution says on: May 19, 2009 at 11:41 am

           

          The history of FRB is also full of examples where refused redemption altogether, even the golden-boy Scottish example there is a 24-year period during which redemption was basically out-of-the-question :)

          The history of FRB also tends to indicate that as a practice it developed typically through fraud, theft, and deception, and only later gained legitimacy under color of law, of course this is tangential to our discussion… (just because it did doesn't mean it must originate in such manner).

          • antboy says on: May 20, 2009 at 11:38 pm

             

            The history of ALL banking is full of examples of redemption refusal: this is not an argument against FRB per se.

            Even accepting your characterization of the Restrictionist period of 1797 to 1821 (it would take too long for too little benefit to argue it), the full period typically cited as the Scottish Free Banking Era extends from 1716 to 1844, or 128 years, so even excluding that period as not being an example of true free banking, we have over a century of FRB in a reasonably unregulated environment. If I'm limited to perfect periods in history, we might as well end all historical discussion of all libertarian topics!

            There are 27 examples of competitive note issue cited by Kevin Dowd in THE EXPERIENCE OF FREE BANKING, and FRB won out over 100% Reserves in every single case, because of the cost differential. FRB advocates are NOT arguing that FRB is risk-free, but that people willingly accept the risks for the benefits. It is true that IOU banking is riskier than Warehouse banking. It is also true that it has won out in competition every time.

            The 2nd edition of White's book on FREE BANKING IN BRITAIN is available for free online, and chapter 3 discusses in detail all the criticism of his representation of Scottish banking in the 1st edition. Too long to repeat. Not too long is a comment by George Selgin yesterday during a debate at mises.org. The nature of the post is he is responding to is obvious, so I'll just quote Selgin:

            ————————-

            DixieFlatline writes: "I hope we see the day when FRB can be exposed to all methods of banking and warehousing in a free market, and then the theoretical debate can be settled with market action." Well D-F, there has _never_ been a law outlawing warehousing banking; the only government regulations concerning reserve ratios have been ones imposing _minimum_, not maximum, ratios. What's more, there have been instances when banking was free of any substantial government regulations, and particularly of regulations that might have served to favor fractional reserve banks over 100-percent reserve banks, including mandatory deposit insurance. In short, the "day" you look forward to seeing has already come and gone–in Scotland from 1765 to 1845; in Canada from, say, the mid-1800s to 1914 or so; and in several other places, as surveyed in Kevin Dowd's _The Experience of Free Banking_. In these instances the debate was in fact "settled by market action"–and that action declared fractional reserve banking the winner, while dealing the warehouse-bank alternative a thorough drubbing.

            And before you shout out, "fraud and deceit!" bear in mind that in those days only relatively well to do and therefore financially savvy people dealt with banks at all–people, in other words, who were just as smart as you. A few might even have been smarter! In any event, they were certainly smart enough to figure out that their bankers weren't paying interest on their "deposits" instead of charging warehousing fees to maintain them out of the goodness of their hearts. The Scotch have many virtues, but munificence isn't one of them!

            Finally, for all those who raise the "fraud" argument, the free bankers have responded at some length to it, in its various forms, in a number of different publications, for which see Walter Blocks bibliography, available on this site. "

            ——————

            The bibliography is on the Mises site, of course, not this one. Anyway, I'm glad our conversation here is free of the nastiness of the Mises debate from which I cut and pasted Selgin's comment (not by Selgin but several others).

  • nothirdsolution says on: May 21, 2009 at 12:07 pm

     

    I'm glad our conversation here is free of the nastiness of the Mises debate from which I cut and pasted Selgin's comment (not by Selgin but several others).

    Me too – I'm an irregular at Mises.org because the good discussion topics inevitably devolve into name-calling flame wars.

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