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Free Market Banking: A Reply

April 29th, 2009

Shortly after I published A Belated Reply on Fractional Reserve Banking, Jeff Molby inquired of me via email. I sent him a short response with the intent of responding more completely, here. There were a number of good comments/questions raised by other readers, and I do intend to respond to them, in turn. These things take time, however, so for now, you’ll have to content yourself with my response to Jeff.

Jeff writes:

I don’t support the status quo, but I wouldn’t support a society where 100% reserves are required by law, either. The reserve ratio should be negotiable between any individual and his prospective bank.

For instance, I should be free to contract with a hypothetical bank for an account with the following characteristics:
– I can withdraw my funds at any time
– The bank may loan up to 10% of my funds in any way it sees fit (or maybe it’s restricted in some mutually agreed upon way)
– I am responsible for any losses incurred on that 10%
– I am not charged any sort of warehouse fee

So basically, I would be accepting a certain amount of risk in lieu of warehouse fee and the bank is trying to turn a profit by using the 10% in an efficient way.

This may or may not be a standard position… I just never hear anyone talk about it.

I think this position is more common than you think, in fact it’s similar to the model of banking that most people (who are not bankers, financiers, or economists) believe that we have. And there’s absolutely nothing wrong with this model. However, there’s a huge difference between loan-brokering (which is what you’re describing) and fractional reserve banking. The problem is that the status quo is essentially licensed theft, and to the untrained eye it looks and sounds very much like the sort of thing you’re describing. It’s not.

Insisting on the ability to withdraw your funds at any time means that the bank would be in breach if they could not satisfy your withdrawal demand. The fact of the matter is that once you agree to permit the bank discretionary control over how that 10% of your money is allocated, it’s impossible for the bank to guarantee, or for you to insist, that you may withdraw your funds “at any time”. Any contract or agreement of this sort would be contradictory in nature: the second clause permits the violation of the first clause.

If you mark 10% of your deposits as “loans” and accept that they may be in default, then you are bearing the burden of risk and your investments may rise (or fall!) in value. Although in practice you may be able to withdraw the entirety of your balance at any time, this is not guaranteed, nor can it be. The only enforceable claim you would have is if the bank failed to honor your demand for the 90% of your money that they agreed not to loan.

If you really just want to loan money, why can’t you? For starters, as a central bank the Federal Reserve manipulates the money supply and the interest rates. Members of this cabal (for all intents and purposes, these members consist of all banks) are able to borrow money into existence, and lend it at interest. This privilege puts the individual lender at a severe disadvantage, it also hamstrings people who don’t make any loans or carry any debt (by decimating their savings)#:

Wage earners (most of us) are principally the last people to receive this newly created money, and they receive it only after enough time has passed and the primary and noticeable effects of inflation have rippled through the economy. If you wonder why prices rise, it’s because somewhere, someone else got access to a boat-load of newly minted greenbacks which nobody else knew existed (because in fact they did not exist) and used them to place competing bids on the purchases of real resources. — Fiat Credit Is Not a Loan (24 July, 2008)

Even still, until recently, individual lenders were able to find borrowers. But then the SEC banned interpersonal loans on sites like which matched individual borrowers and lenders.  (The SEC has since relaxed its ham-fisted ban on Prosper lending.)

Because of the auction-like nature of these loans, even with a modest sum like $500 or $1000, a lender could distribute his investments across multiple borrowers, mitigating default risk. In a truly free market, you wouldn’t need a bank to loan your money, you could do it yourself, and pay the warehousing fees for the rest of your money with your loan proceeds.


Note: In another recent comment, the question of whether one has a “right” to purchasing power was raised. I do not intend to answer that question presently, although if it were answered in the affirmative, there could be no conceivable justification for fractional reserve banking.

On the Record: Thoughts on Free Banking

April 21st, 2009

Just some thoughts, for the time being.  Nothing substantive, yet.

People use banks not primarily to store money, or to earn interest on their deposits (most people earn an alarmingly paltry return on checkable deposits and savings accounts alike) but to facilitate the tendering and receipt of payments. Many methods of saving/investing are superior to deposit accounts: short-term CDs, mutual funds, diversified and staggered interpersonal loans granted on a P2P site like, etc.

The ease with which one can now effect the purchase of a good, immediately and across the continent (or the globe!), is a valuable service in its own right.

Depositors of free fractional-reserve banks have a right (subject to some qualifications/restrictions) to redeem their deposits in base money.  What, if any, would be the criteria for holding bankers personally liable for violating their fiduciary obligations in the event of insolvency?

In what medium are fractional-reserve bank loans denominated and how are they to be repaid? Are borrowers required to repay in base money?  If not, where does the interest portion of their payments come from?

My hunch is that nobody, anywhere, ever, has had an interest-bearing deposit account that, for any chosen time interval, has outperformed durable commodities. (I’ll admit that I’m shooting from the hip with this argument.)

In an advanced economy, monetary evolution results in more-or-less widespread use of fiduciary media.

Why does a fractional reserve bank have to loan out 90% of your money in order to pay you 0.25% interest?

Do you really think that you’re not getting totally fucked by inflation?  Really?

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.

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