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Thursday, January 15, 2009

Tales From The History of Money and Banking Part 1

There are many books on the history of money and banking, philosophy and economics but very few if any that integrate these concepts together to show how essential the concept of money is to civilization. The lack of integration directly follows from the disastrous state of the economics profession and of modern philosophy. The result is that most people are left without any understanding of the fundamental economic or philosophical ideas needed to combat the government's assault on money.

As we are yet again experiencing first hand, the current socialized system of fiat money and fractional reserve banking is immoral in principle and a complete and utter disaster in practice in the same way and for the same reasons that any form of socialism is immoral and disastrous. Despite the destruction wrought by socialized money, fiat money and fractional reserve banking is taken as the metaphysically given and hardly questioned even by professional economists. What I would like to begin doing in this blog is to integrate the history, economics and philosophy of money and banking but in a way that makes the basic concepts intelligible to the non-economist and non-philosopher. I am not going to do this in an organized way but will post periodically and at some point maybe try and tie the ideas together in a more organized fashion with a view towards formally publishing. So please comment away and help lead me in the right direction.

In this post, I am going to focus on the history and meaning of fractional-reserve banking and distinguish the concept of storing money somewhere with the concept of lending money to someone. These are two distinct concepts legally and practically, however, today's banks package these practices together in a way that I claim is inherently fraudulent and based on some terrible common law legal precedents from the 19th century.

The reason I am starting with this is that it sets the stage for understanding the various economic crises that occurred, particularly in the 19th century, when the U.S. was actually on some form of a gold standard. As we will see in future articles, these economic crises would not have occurred under a gold standard if the government had served its proper role in enforcing banks' contractual obligations to redeem in specie (gold or silver) and to properly safeguard assets entrusted per the deposit contract. In turn, these panics, recessions, and depressions that were caused by the government led to more government intervention ultimately resulting in the complete nationalization of the money supply and banking system in 1913 in the form of the Federal Reserve system which haunts us to the present day.

To start, let me define "fractional-reserve banking". Fractional-reserve banking is the banking practice of only holding a fraction of your customers deposits and lending out the balance while simultaneously maintaining an obligation to redeem all deposits on demand (if that sounds contradictory it is). Fractional reserve banking has been around in essence for centuries. Even when notes were redeemable in gold, many banks practiced fractional reserve banking by lending out their customers gold and keeping a little bit around in case someone came asking for it (and they hoped that a lot of customers didn't come asking for it...). Today, banks are required by law to keep about 10% of their deposits on "reserve" at a Federal Reserve bank. In other words, they claim that you can withdrawal all of your money at any time but they don't really have it all because they loan it out. So, if all the customers showed up at the same time and asked for their money, the bank would collapse. To understand fractional reserve banking better, it's important to discuss the history of the fundamental legal issues underlying deposit contracts and loan contracts and to trace how fractional reserve banking involves a bastardization of the two entirely distinct legal and business concepts.

If you wanted to store a bike for the winter but didn't have storage space you might consider renting a garage somewhere. You would find a place that rents space and pay them a fee to store and safeguard your bike there. The contract is rather straightforward in the sense that you are placing your property in someone's safekeeping but at no point would you consider transferring direct title to the bike to the garage owner, i.e., you still own the bike even though you are storing it on someone else's property. More importantly, the act of placing your bike in safekeeping does not imply that the garage owner takes title to your bike. At any time, you would expect to be able to show up at the garage and get your bike, right? This type of transaction is known as a "bailment" in the sense that you are hiring someone to safeguard your stuff. The contract is known as a "regular deposit" contract.

The situation gets a little more complicated when you have "fungible" goods. Fungible goods are things like grain, gold, or jelly beans that all look alike when you put them in a big pile. If a bunch of people want to store their grain in one place, often they will just pool the like grain together in a big pile and when you want your "share" of the grain you deposited earlier you show up and they just give you that amount of grain. There is no practical way the storage place could figure out exactly what pebbles of grain were yours and you really wouldn't care as long as you got the same amount you deposited of the same quality. The quantity that you are owed has the fancy legal name "tantundem" and this type of contract is known as an "irregular deposit" contract.

Notice that the principle is exactly the same in the case of a regular deposit contract and an irregular deposit contract. You are storing a good whether it be something specific like a bike or something fungible like gold (money) and you expect the safe keeper to maintain possession of your property at all times

These two types of contracts should be distinguished from the "loan" contract. In a loan contract, you transfer legal ownership of something like money to someone else and allow them to use it in any way they wish (or in a way specified in the contract). In this case, you are transferring title to someone else in exchange for future goods specified in the contract such as the amount of money plus interest

You can see that these transactions are based on two very distinct concepts. In one case, you actually pay someone a fee to perform the service of safekeeping. In the other case, you transfer ownership of property in the present in exchange for future goods, i.e., for payment in the future.

Now, let's say that a garage owner from our example above has a bunch of people store their
bikes with him for safe keeping, and he gives each of the bike owners a piece of paper that entitles them to come and pick up their bike. He notices that these bike receipts can be used by the bike owners to buy other things. For example, he observes that a bike owner who wanted to buy a sofa simply traded his bike receipt to the sofa owner. He knows that the sofa owner could take the bike receipt to his garage and demand the bike, but since he doesn't expect all the bike owners to show up for their bikes at the same time he gets an idea. He prints up more bike tickets than he has bikes and trades them for things or loans the tickets to others. People happily accept the bike tickets in a trade because they expect that they can get the bike anytime they want. And since people trust that the bikes are at the garage, very few people actually show up to get the bike. So the garage owner prints even more tickets and buys even more things and lends to even more people. This is great. The local economy booms as the garage owner purchases more and more things resulting in large bike ticket revenue for other local merchants and the persons which borrowed tickets purchase things. At some point, one or two of the merchants go to get the bikes. At first, the garage owner is fine. But as more nervous people show up, the bikes begin to disappear until they are all gone. At some point, since there are more tickets than bikes, the garage owner will not be able to make good on his obligation to redeem the tickets in bikes and he goes bankrupt along with his customers.

Should the garage owner's actions be considered fraudulent in that he misappropriated assets that were entrusted to him by virtue of a deposit contract and issued tickets for assets that did not actually exist? Furthermore, what if the government not only refused to prosecute the garage owner but allowed him to "suspend" bike redemption? Wouldn't the government's action encourage more and more garage owners to misappropriate their clients assets if they believed that the government would not enforce the redeemability of the receipt tickets?

It's important to point out that historically (and logically), the activity of deposit and loan were conducted as two separate businesses. The business of warehousing goods dates back at least to Ancient Greece and Egypt. De Soto[1] analyzes the writing of a Greek named Isocrates from 393 B.C. in which he discusses a case of misappropriation by a banker of a customer's deposit. De Soto discusses the implications of the case:

It is therefore clear that in Greek banking, as Isocrates indicates in his speech, bankers who received money for safekeeping and custody were obliged to safeguard it by keeping it available to their clients. For this reason, it was considered fraud to employ that money for their own uses.
The history of misappropriation of deposits made under the principle of irregular deposit contracts has a sordid history from Ancient Greece through the 20th century. In other words, since customers rarely needed all of their gold (or whatever fungible good was being stored), the safe keeper was tempted to loan it out to make "extra" money. As long as the customers didn't all show up at the same time he was safe. But as soon as rumor started and customers began demanding their property (a classic run on the bank), it was soon discovered that the goods were not all there and disaster ensued.

A notable exception was the Bank of Amsterdam for about 150 years from 1609 to the 1790's. The Bank of Amsterdam literally maintained almost a 100% reserve ratio (kept 100% of all the customer deposits) for 150 years. Quoting De Soto[1]:

It was founded after a period of great monetary chaos and fraudulent (fractional-reserve) private banking. Intended to put an end to this state of affairs and restore order to the financial relations, the Bank of Amsterdam began operating on January 31, 1609 and was called the Bank of Exchange. The hallmark of the Bank of Amsterdam was its commitment, from the time of its creation, to the universal legal principles governing the monetary irregular-deposit. More specifically, it was founded upon the principle that the obligation of the depository bank in the monetary irregular-deposit contract consists of maintaining the constant availability of the tantundem in favor of the depositor; that is, maintaining at all times a 100-percent reserve ratio with respect do "demand" deposits. This measure was intended to ensure legitimate banking and prevent the abuses and bank failures which had historically occurred in all countries where the state had not only not bothered to prohibit and declare illegal the misappropriation of money on demand deposit in banks, but on the contrary, had usually ended up granting bankers all sorts of privilege's and licenses to allow their fraudulent operation, in exchange for the opportunity to take fiscal advantage of them.
The committment by the Bank of Amsterdam to a 100% reserve ratio allowed it to satisfy every request for withdrawal in any manner of crisis that arose. Quoting De Soto[1]: "Increasing and lasting confidence in its soundess resulted, and the Bank of Amsterdam became an oject of admiration for the civilized economic world of the time" [1].

The Bank of Amsterdam led to the creation of the Bank of Stockholm in 1656 which divided itself into two separate departments: one for safekeeping assets and one for loans. Again, these practices are and were considered to be two separate activities. However, although they were supposed to function independently of one another, the Bank of Stockholm violated the separation and it was nationalized in 1668 by the Swedish government. Quoting De Soto[1]:

Not only did it violate the traditional principles which guided the Bank of Amsterdam, but it also initiated a new fraudulent and systematic practices: the issuance of banknotes or deposit receipts for a sum higher than actual deposits received in cash. This is how banknotes were born, along with the lucrative practice of issuing them for a higher amount than the total of deposits. Over time, this activity would become the banking practice par excellence, especially in the centuries that followed, during which it deceived scholars, who failed to realize that the issuance of banknotes had the same repercussions as artificial credit expansion and deposit creation.
The disatrous Bank of England was created in 1694 to help finance public expenditures In the wake of a half century of expensive wars that left England desperate for funds but unable to suck any more tax revenue out of its subjects. Rothbard discusses the details of the creation of The Bank of England [2]:

The Bank of England promptly issued the enormous sum of L760,000, most of which ws used to buy government debt. This had an immediate and considerably inflationary effect, and in the short span of two years, the Bank of England was insolvent after a bank run, an insolvency gleefully abetted by its competitors, the private goldsmiths, who were happy to return to it the swollen Bank of England notes for redemption in specie.

It was at this point that a fateful decison was made, one which set a grave and mischievious precedent for both British and American banking. In May 1696, the English government simply allowed the Bank of England to suspend specie payment -that is, to refuse to pay its contractual obligation of redeeming its notes in gold- yet to continue in operation, issuing notes and enforcing payments upon its own debtors. The Bank of England suspended specie payment, and its notes prompty fell to a 20 percent discount against specie, since no one knew if the Bank would ever resume payment in gold.

The straits of the Bank of England were shown in an account submitted a the end of 1696, when its notes outstanding were L765,000 backed by only L36,000 in cash. In those days, few noteholders were willing to sit still and hold notes when there was such a low fraction of cash.

Specie payments resumed two years later, but the rest of the early history of the Bank of England was a shameful record of periodic suspensions of specie payment, despite an ever-increasing set of special privileges conferred upon it by the British government.

The reason this is significant is as De Soto[1] explains "This was the dawn of the modern banking system, based on a fractional-reserve ratio and a central bank as lender of last resort."

In the next part, I will discuss various 19th century crises that occured in the United States as a result of fractional reserve banking compounded by the government's suspension of specie redemption, and I will discuss several seminal court cases in the 19th century which ultimately established the "legality" of fractional reserve banking by removing the distinction between the deposit and loan contract.

[1] Money, Bank Credit, and Economic Cycles, Jesus Huerta De Soto

[2] The Mystery of Money and Banking, Murray N. Rothbard


SN said...

Great post. Always interesting to read some meaty history. I think Economics needs more of that.

It would be good to move to a system where there were two distinct types of bank accounts, and one of them was clearly fully-reserved. With our current system, no bank has an incentive to offer such a system.

It is even possible that a lot of people might be convinced to place their money in fractional-reserve accounts, and that a lot of people would accept such notes at a reasonable discount from the 100% notes. Difficult to speculate how the proportions of balances would look. Neverthless, the legal framework should allow and also not discourage such a dual scheme.

On another note, from memory, I think there's an example of a pre-Fed U.S. bank has kept 100% or close to 100% reserves; but, I'll have to go back an check a reference for more detail.

At the time, companies also followed a practice of issuing shares where shareholders would subscribe to the full value, but the company would only call on a certain percentage. So, the bank could reach into the personal wealth of shareholders, if things went wrong, upto the amount of subscription.

HaynesBE said...

Nicely done. I linked to this on my post today on “Money is Debt.” We are thinking along the same lines as to the concepts which are key to today’s misconceptions. You have piqued my interest in de Soto’s book!

I don't think that fractional reserve banking is inherently fraudulent. As long as the terms of deposit are clear to the contracting parties, I do not see that it would be fraud. Clearly having the government allow suspension of deposit claims is a violation of property rights and should not be permitted.

Some other books you may want to read are Money and Freedom by Hans Sennholz, Gold and Liberty by Richard Salsman, and Luster of Gold, a book of FEE reprints with several essays by Hazlitt and Sennholz. Salsman also has a monograph “BREAKING THE BANKS: Central Banking Problems and Free Banking Solutions” which I will be glad to send you as a pdf attachment if you email me (haynesbe@gmail.com). I can also send you an article Salsman wrote which was published in The Crisis in American Banking ed. Lawrence White, titled “Bankers as Scapegoats for Government Created Banking Crises in U.S. History."

If you would be kind enough to share a tentative outline of what you hope to post on in the future, I can just link to you and concentrate my efforts elsewhere!! Thanks for your work.

Anonymous said...

Beth, I think fractional reserve banking *is* fraudulent. The reason is that it triggers the same mechanism as common fiat money inflation: first, it does expand the money supply; second, the people who get the fractional notes in their hands first are in a position to buy before prices have risen, while those who receive them later can buy only after prices have risen. Thus, the second group of people are actually defrauded by the first group. That the contracting parties agree is irrelevant in this context. It's the "non-contracting" parties who suffer.

On this subject, see Reisman, p. 957f.

David Hillary said...

Although you give some argument why a deposit of money should be considered a bailment rather than a loan, if the banker and the customer agree that the deposit is a loan on current account and repayable on demand, as per the recognised common law banker-customer contract terms, this covers all your objections.

(See my blog post http://davidhillary.blogspot.com/2008/11/banking-defined-and-defended-part-1.html for the case for why bank obligations should be considered loans rather than bailments.)

You claim: 'In other words, they claim that you can withdrawal all of your money at any time but they don't really have it all because they loan it out. So, if all the customers showed up at the same time and asked for their money, the bank would collapse.'

This analysis overlooks the two ways, other than holding 100% reserves against demand liabilities that enable a bank to repay all its demand liabilities, should customers and note holders so demand:
1. The bank could have sufficient liquid assets to liquidate simultaneously with the demands. Call this 'asset liquidity.'
2. The bank could replace demand liabilities with term liabilities such as commercial paper simultaneously with the demands. Call this 'funding liquidity.'

Of course under real world free banking banks used a combination of reserves, liquid assets and funding capacity to pay any liabilities that are payable on demand, i.e. some reserves to meet immediate redemption needs, some liquid assets to liquidate to replenish reserves if and as required within the short term (or to invest excessive reserves into for the short term if and as required in the short term), and an appropriate mix of equity and term debt and other funding sources for ensuring the funding of the bank's desired holdings of long term less liquid assets (i.e. a portfolio of loans and advances).

The bike storage analogy is not comparable to banking in the relevant ways: there is no market for investing bikes or making loans and advances of bikes, so the bike institution has no ability to either borrow bikes it might need or to invest bikes it might not need to hold in storage (assuming, for the sake of argument, that a bike storage facility could be confused with bike loans in the way your analogy portrays).

You are correct that money loan contracts transfer the title to the loaned money to the debtor, in exchange for a claim on the debtor for repayment of principal (and interest, if any), whereas under bailments, title is retained by the bailor, and the bailee gets possession only. (see also my blog post http://davidhillary.blogspot.com/2008/12/property-rights-analysis-of-banking.html for more on property rights analysis of banking.)

Your terminology of 'tickets' shows that you are not aware of, or avoiding, the actual form and substance of the legal documents that evidence bank obligations, in particular bank notes. The term 'ticket' has no clear legal meaning, the term 'note' in relation to money, does, a promissory note, a document that embodies a debt of the maker to the bearer or payee. Banks do not issue 'tickets' they issue bank notes, which embody an obligation of a debtor, the maker, to a creditor, the 'holder in due course.' Documents of title have names such as 'warehouse receipt' and 'bill of lading', not 'notes'.

It is also interesting to note that you criticise 'some terrible common law legal precedents from the 19th century' but I'm not sure you understand them. I'm presuming you're referring to Foley v Hill? This case was about whether or not a banker, in relation to the balance deposited with a banker subjected the banker to a fiduciary duty in favour of the depositor, and not whether or not a banker is acting as bailee. If the court had found that the banker did have a fiduciary duty in relation to the funds deposited, the result would not be 100% reserve banking, instead the banker would be charged with the responsibility to invest the funds prudently and account to the depositor for actual financial results. Instead, the court correctly found that money, when paid to a banker, ceases to be the money of the customer and becomes the money of the bank, and that the bank is known to treat the money as its own, make what profit it can, which profit it keeps to itself, and to repay the same amount of money on the demand.

Regarding the BoE, any debtor, whether solvent or insolvent, is not precluded from exercising his rights as a creditor. If I borrow $100 from John and lend it to Paul, and then become insolvent, even though I can't pay John, Paul still has to pay me. This, of course, enables my creditors to recover as much as possible from my bankruptcy, any why should not Paul honour his debts even if some others do not?

HaynesBE said...


Thank you for the response and the reference to pg 957. From my reading of that section, what Reisman is objecting to is any attempt to “have your cake and eat it too” –or in this case, “save your money and lend it too.” It’s attempting to cheat reality: to pretend that something exists which doesn’t. In this section he is clearly arguing for legal enforcement of 100% reserve banking (in conjunction with a gold standard) as a means of protecting property, of preventing the “fraud of having one’s funds lent out despite the bank’s deliberate creation of the impression that in making a checking deposit or purchasing banknotes one fully retained the possession of one’s funds.” He goes on further to state that even if the depositor and the banker are in agreement that the money may be lent, the system perpetrates fraud on other receivers of bank notes not fully backed by gold: the notes would be used as receipts for gold when in fact they were claims to debt.

I am still not sure that fraud could not be avoided in a system of completely free banking. On pages 514f, Reisman presents the case for legally allowing fractional reserves in a system of free banking, giving the explanation that although legal, such a system would have its own checks and balances so in actual practice, significant credit expansion would not occur. He gives a quote of Cernuschi from von Mises’ Human Action: “I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.” A combination of the need of the bank to preserve its reputation for sound money, and the ability of others to drain the gold reserves of the bank by redeeming their banknotes would serve to keep inflationary money creation to a minimum. If peopel knwo that a particular bank inflates its notes but chose to accept the notes anyway, I'm not sure it would be fraud. I need to think more on this.

David’s comment is quite complex and it will take more time for me to understand and integrate his points. Also, I recently received reference to an article by George Selgin and Lawrence White (two prominent free banking advocates) which I hope will shed more light on this subject. "In Defence of Fiduciary Media" http://mises.org/journals/rae/pdf/RAE9_2_5.pdf This is an interesting topic I plan to explore further.

One last comment. I particularly liked Reisman’s statement (pg. 958) that “It is pointless to accuse banks and their customers of any kind of fraud in connection with fractional reserve banking in a context such as the present, in which the overwhelmingly greater fraud exists of the government’s creation of a monetary standard that is utterly nonobjective and arbitrary, namely, the fiat-paper standard.”

HaynesBE said...
This comment has been removed by a blog administrator.
The Rat Cap said...

Thanks all for the great comments. I am glad I was able to stimulate some excellent conversation regarding a crucial idea. Some of the points raised I will attempt to address in my forthcoming post on the subject and a few points I will attempt to address here.

It appears that for years there has been a debate amongst free market economists related to the status of fractional-reserve banking in a free market. Some hold that it is inherently fraudulent and others hold in effect that two parties can “contract” to anything and therefore the market should be left alone to decide. Thanks to Beth for trying to pin Reisman down, but I admit that I have been somewhat confused by Reisman. I had also noticed the section where he argued as you stated that “the system perpetrates fraud on receivers of bank notes” not fully backed. I believe his final position was as Beth stated that the law should allow it but that in practice it would be very limited in a free market, i.e., if the government performed its proper function in upholding contractual obligations. Beth also pointed out his position that the issue is minor in comparison to the real problem: fiat money.

As I said in my post, I think the importance of this topic lies not only in understanding the practice itself but how this practice historically led to central banking and fiat money which I hope to show in future posts (in essence, fractional-reserve banking compounded by the government’s default on its obligation to enforce specie redemption caused the boom-bust chaos which ultimately was misinterpreted and used to justify more government intervention).

With regard to some specific comments, David states “if the banker and the customer agree that the deposit is a loan on current account and repayable on demand, as per the recognized common law banker-customer contract terms, this covers all your objections.”

My position is that a deposit is a deposit and a loan is a loan which your statement above would contradict. It is not both. This is somewhat obvious in the case of non-fungible goods and slightly less obvious in the case of fungible goods. If you deposit gold in a money warehouse as was common historically and you receive a ticket or warehouse receipt, the law should recognize this deposit as a bailment not a loan, i.e., the depositor maintains legal title to his good or tantundem in the case of a fungible good. In fact, as Rothbard points out, it’s unfortunate that this business was even called “banking”. For the warehouse to use the customers gold as its own (as if the gold were lent to the warehouse) is a case of misappropriation or embezzlement and should be regarded as such. The tickets or receipts are not “notes” in this case in the sense that they represent a promise by the bank to “pay the money back” but in fact are simply receipts that allow you to claim your gold on demand like picking up your car at a valet. Whether individuals wish to trade these receipts is entirely up to them but the law should regard a deposit as a deposit.

If an individual indeed “loans” their gold to a bank then they enter into a contract where the ownership of the gold is legally transferred to the bank in exchange for a future promise to pay the gold back usually plus interest. This contract should be regarded differently than an irregular deposit contract for legal purposes. If the bank gives the lending customer a “bank note” which states that the bank promises to pay the money back and states the terms, etc. and people trade these notes I do not have a problem with it as long as the terms are stated on the note and the law makes a distinction between a receipt and a note. In other words, if someone wants to trade with me and they offered me a “receipt” for gold on demand and someone else offered me a “note” for gold to be paid in the future by a third party, I would regard the value of these two offers differently. If one tried to pass a “note” off as if it were equal to a receipt, i.e., pass the note off as if it meant that I could receive the gold “on demand” I would regard that as fraudulent.

When I referred to the “terrible 19th century common law cases” I did indeed have Foley v Hill in mind as one of the cases as I will discuss in future posts. I do not agree that the court was correct. You are right that the court found that when money is deposited in a bank it ceases to be the property of the depositor and the bank may do with it what it wishes which is exactly why I disagree with the case and why Rothbard and De Soto reference it as seminal. For the reasons above, I believe a deposit should be regarded as a bailment not a loan and the court grossly erred in not making this distinction.

As Rothbard points out on p. 93-94 of The Mystery of Banking:

["Even though American banking law has been built squarely on the Foley concept, there are intriguing anomalies and inconsistencies. While the courts have insisted that the bank deposit is only a debt contract, they still try to meld in something more. And the courts remain in a state of confusion about whether or not a deposit-the “placing of money in a bank for safekeeping”-constitutes an investment (the “placing of money in some form of property for income or profit”). For if it is purely safekeeping and not investment, then the courts might one day be forced to concede, after all, that a bank deposit is a bailment; but if an investment, then how do safekeeping and redemption on demand fit into the picture?

Furthermore, if only special bank deposits where the identical object must be returned (e.g., in one’s safe-deposit box) are to be considered bailments, and general bank deposits are debt, then why doesn’t the same reasoning apply to other fungible, general deposits such as wheat? Why aren’t wheat warehouse receipts only a debt? Why is this inconsistent law, as the law concedes, “peculiar to the banking business”?"]

With regard to the BoE, the Rothbard quote was pointing out that the BoE was able to suspend its obligation to pay its creditors in specie but continued to issue notes and demand that its debtors pay it back. In your example, that would be like the law saying you have no legal obligation to pay John but Paul has a legal obligation to pay you. In a bankruptcy case, you are certainly literally right that Paul would still continue to have an obligation to pay notwithstanding your own insolvency but in context, Rothbard was highlighting the irony that the BoE had essentially committed fraud but due to its intimate connection with the Crown was “allowed” to suspend its obligation while its debtors obligation remained in full force. I think you are nitpicking that one a bit...

I hoped this helped to clarify my position and I look forward to more comments or questions. Thanks again for your comments.

HaynesBE said...

Do take a look at Selgin and White "In Defence of Fiduciary Media" http://mises.org/journals/rae/pdf/RAE9_2_5.pdf
I think you will find it interesting.

The Rat Cap said...

I wanted to add a comment to my previous comment for clarification since I did not make it explicit enough earlier.

The whole notion of fractional reserve banking rests on the idea that a bank can lend out depositors’ funds. In other words, the bank carries the depositors’ funds on to its balance sheet as liabilities and holds loans against these reserves as assets. My argument that an irregular deposit contract be treated legally as a bailment implies that a bank should not be allowed to carry depositors funds on its balance sheet in the same way that a warehouse can not carry goods stored there on to its balance sheet. Again, to allow banks to get away with this is to grant banks special status under the law that any warehouse of any other fungible good would not be allowed. (If you store a bike at a warehouse, the warehouse doesn't include the bike as part of its "reserves" on its balance sheet - much less issue notes against these so-called reserves.)

In the case of a loan contract, if a customer lends money to a bank, then the bank legally obtains title to the funds in exchange for a note which promises to pay the customer back.

Say customers lend a bank 10 oz of gold in exchange for notes that promise principal plus a 5% interest rate for 1 year. The bank turns around and lends the funds to a real estate developer who promises to pay 10% in one year. In what form would the bank lend the funds to the real estate developer? Since the bank now owns the gold, the bank can give the real estate developer a receipt for 10 oz. of gold payable on demand (real cash).

Notice that there are two “forms” of money here. First, we have a “receipt” which is payable on demand. Second, we have a “note” issued by a bank that promises to pay something in the future. I imagine that the notes would trade (if they traded at all) at the appropriate discount to reflect the terms of the note and the reputation of the bank which promises to pay. A note that was “callable” (customer has right to demand payment of loan) and had a relatively short term would be more valuable than otherwise.

Say that banks promissory notes begin to be used as money. Could the bank issue more notes than for which it possesses capital? Say the bank wants to lend this time to a shoe factory but the bank does not raise gold from its lenders. Instead, the shoe factory pledges another factory in another town as collateral and the bank sends the shoe factory promissory notes which state that the bank is obligated to pay 5% interest in one year to whoever owns the notes. The shoe factory then trades the notes to buy materials it needs. The bank knows that it has a lien against the shoe factory and so if the shoe factory does not pay back the loan it could foreclose on the collateral and be in a position to pay the notes back to whomever ends up possessing the notes.

I am fine with this since the bank is issuing “notes” that are not redeemable on demand but merely promises to pay interest. I do not think it is inherently fraudulent in this case because the notes do not say “redeemable on demand” nor is the bank relying on depositor’s funds which it legally does not own. In fact, in this case, the bank has secured collateral against the notes. Is this fractional reserve banking? Not really. Anyone could print up notes and promise that they will pay people back in the future. It is up to others to decide to accept such notes as money and it is up to the courts to define what exactly the note is obligated to print in order to not constitute a fraud. A note that says “payable on demand in specie” is fraudulent if the issuer can not reasonably guarantee that it maintains 100% reserve and it almost has to be since a “note” by definition means a loan (so the money is not there) whereas a “receipt” implies a bailment and 100% reserve. Even if the bank contracts with third parties for term financing (as David suggested) this is not sufficient to claim "payable on demand" as there is no guarantee that a third party would be willing to lend to the bank nor is there a guarantee that the third party bank's customers won't be demanding their funds. If the note says that it promises to pay but there is some risk it may not, etc. then it is up to the market to decide. I imagine these notes would trade at a steep discount to warehouse receipts and the lousier the issuer the steeper the discount.

I think once a clear distinction is made between deposited funds and lent funds the rest of the issues pertaining to what constitutes fraud in private bank notes becomes the major legal issue and these notes would trade at various discounts to cash based on the markets appraisal of the nature of the note and the reputation of the bank in regard to its ability to pay. But such a recognition (of the distinction between deposit and loan) obviates the need to consider "fractional reserve" banking as it would be impossible for a bank to hold depositors funds on its balance sheet and therefore to engage in the practice of loaning against "its" reserves.

The Rat Cap said...

oh, when I said ...fungible goods and then used the bike analogy I should have used grain since it is fungible and bikes are not.

David Hillary said...

The word deposit has no singular legal meaning, it could be referring to a loan, a bare trust or a bailment. For example a 'term deposit' with a financial institution is a loan of money repayable at the end of a defined term by the financial institution, but the same financial institution may accept deposits of paper securities that would be held as bailments for safekeeping, and the same financial institution could hold registered securities deposited with it in its own name as bare trustee (nominee) for the beneficial owner (depositor). The meaning depends on the situation and the implied and express terms of the contract. The terms 'bailment,' 'debt,' and 'bare trust' by contrast have fairly specific legal meanings.

I've noticed that Foley v Hill (see http://www.uniset.ca/other/css/9ER1002.html) avoids, although not entirely, the use of the term deposit, instead referring to 'Money, when paid into a bank':

'Money, when paid into a bank, ceases altogether to be the money of the principal (see Parker v. Marchant, 1 Phillips 360); it is then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it. The money paid into the banker's, is money known by the principal to be placed there for the purpose of being under the control of the banker; it is then the banker's money; he is known to deal with it as his own; he makes what profit of it he can, which profit he retains to himself, paying back only the principal, according to the custom of bankers in some places, or the principal and a small rate of interest, according to the custom of bankers in other places. The money placed in the custody of a banker is, to all [*37] intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach, of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal, but he is of course answerable f on the amount, because he has contracted, having received that money, to repay to the [37] principal, when demanded, a sum equivalent to that paid into his hands.'

Have a very good look at the case, as it appears that the status of the banker as a debtor was NOT in dispute, instead, the dispute was about whether the banker has additional obligations in equity, and the cause of the dispute was that the bank had stopped paying interest on the account. Since interest at 3% p.a. was agreed by the bank, there was never any question of the funds being a bailment!

David Hillary said...


Why can't a debt be repayable on demand? Do you object to overdraft lending transactions? current accounts generally?

The Rat Cap said...


Debts can be payable on demand but not in the same way as a "demand deposit". In other words, if you go to the warehouse and ask for your stuff they just go get it and give it to you. A debt is "callable" in the sense that you can demand payment per the terms of a contract. It call obligates the debtor to get the money from somewhere and pay you but it is not exactly the same thing.

I think in a free market under proper rules of contract (as defined by me I guess....) when you go to a bank they would ask you if you want to enter into a deposit contract or a loan contract. Each would be different per our above discussion. (I'm sure you are right in terms of how "deposits" are defined under current law. I am not arguing that but only arguing what should be).

A deposit is simple in that they would merely store your gold for you and give you a receipt that would be tradable. Again, that would not be a "note" but a receipt.

In the case of a loan contract, the bank could issue very short term notes (effectively cash like bank notes) against the capital you lend to them. This would be very similar to how money market funds work today where you can write checks against your holdings in the fund. Keep in mind, that the notes issues against your fund holding would have different terms than a receipt. Even a money market fund has three day settlement typically (in other words, you can't demand your cash now - they have 3 days to get it). Also, the fund can usually suspend redemptions under certain conditions. That is fine as long as it is disclosed and the note is not claiming to be "payable on demand" or fraudulently claiming to be as good as a receipt.

I'm not necessarily opposed to this example fund creating bank notes for more capital than it possesess as long as it is disclosed on the note. The market would certainly discount the value of these bank notes to actual cash or receipts. Also, if the government performed its proper function in terms of enforcing the terms of the banks contractual obligation upon redemption then it wouldn't be a major problem.

So, in this sense I'm ok with fractional reserve banking in this context, i.e., under a gold standard where deposits are distinguished from loans and as long as notes issued against them contain proper disclosures, i.e., payable on demand is distinguished from "callable on demand".

Again, I think the bigger problem is fiat money not fractional reserves and historically the problem was not necessarily "fractional reserves" so much as the government not upholding the contractual obligation of banks to redeem in specie. The Suffolk System in the 1850's in Massachusetts is a good example of a free market clearing system that dealt with fractional reserves quite well.

But you have really helped force me define my thinking better and although I'm not sure I totally have it here, I'm starting to know what I don't know.

Anonymous said...

Beth: On p. 514f Reisman merely presents the two opposing views on "fractional money" without actually taking sides, and on p. 957f he gives his actual view.

But I agree this is slightly confusing. I once made the mistake of taking p. 514f as his actual view. Then the issue came up in a discussion (in Swedish), and I mailed Reisman and asked him about it - and he directed me to p. 957f.

I think it is still true that "fractional banking" under a gold standard would be less disastrous than what we have today. But an injunction against "fractional banking" is more consistent.

David Hillary said...


You are right that an obligation to pay a debt on demand and an obligation to re-deliver bailed goods (or a share of bailed fungible goods) on demand are not the same. However, debts 'payable on demand' and 'at call' are the same thing, both legally and practically. 'at sight' is also another term used for the same thing.

A cheque is a bill of exchange drawn on banker and payable on demand, and therefore if it is payable after 3 days it is not a cheque, it is a bill of exchange. Under negotiable instrument law there are no days grace to pay: 'Bill drawn at sight to be deemed a bill payable on demand
Every bill of exchange or promissory note drawn and purporting to be payable at sight or on presentation shall be stamped as and shall for all purposes be deemed to be a bill of exchange or promissory note payable on demand without any days of grace, any law or custom to the contrary notwithstanding.' (Bills of Exchange Act 1908 (NZ) section 96). Thus if the cheque is presented to the drawee bank for payment and 'Where it is duly presented for payment and payment is refused, or cannot be obtained' it is dishonoured by non-payment (see Bills of Exchange Act 1908 (NZ), section 47).

A bank does not have to offer you a choice between bailments and current account loans: the bank is free to choose what product it sells and if you don't like its product you don't need to do business with it.

There are no disclosures required on a promissory note, it only needs to be a document in writing, signed by the maker, engaging to pay a sum of money to the bearer. Some low value promissory notes in the form of metal discs just said '1 penny, payable at the India Tea Warehouse.' You can see examples of traditional bank note wordings on contemporary British, Hong Kong and Indian bank notes.

The market or commercial value of bank notes payable on demand will be the same as cheques: they are accepted, if at all, usually at full nominal value, since they turn to cash in the ordinary course of business within a day or two.

The Rat Cap said...


I'm not sure if you are referring to current law or if you are talking about what should be the law in your various comments. I'm not interested here in the former although its useful as context. In other words, I think the entire banking system is based on flawed premises, both legal and moral, and I am suggesting what should be. If we had a private banking system, i.e., a banking system without any government intervention other than to uphold contracts and settle disputes, what should be the legal definition of these transactions and what would likely occur on a free market? I attempt to use history as a guide to understanding this problem. So, I can not disagree with you in cases where you seem to be citing current law as it regards these issues but again, my focus is really to figure out what should be. My remarks should be evaluated in that context.

The Rat Cap said...

In regard to your statement about the market value of a bank note v check I think you misinterpreted my point. I was saying that in a private banking system, the market value of private bank notes would vary in relation to one another and in relation to "receipts" for bailments. For example, in the 19th century, bank notes would trade at premiums or discounts to one another based on the perceived viability of the bank issuing them.

Also, I understand that a bank does not have to offer you a choice between bailments or current account loans nor was I proposing that they be forced to do so. I was merely claiming that in a private banking system, it would be likely that banks would be split into two divisions (like the Bank of Stockholm in the 17th century) where one division deals with bailments and one with loans. In fact, it might be likely that totally separate businesses would arise to deal with both, but I imagine that this function would be consolidated by one institution.

David Hillary said...


Although coinage has been monopolised by sovereigns for many hundreds of years, there have been significant periods of time when the business of issuing bank notes and current account banking has been largely private enterprise.

The law and usage of negotiable instruments including cheques (and other bills of exchange) and bank notes (and other promissory notes) has developed largely from common law that upholds the rights and obligations of the parties (although negotiable instrument law is now codified in the Bills of Exchange Acts or other legislation of practically all countries).

I think you've missed the point of my comments about the value of cheques and bank notes: these instruments are for executing payments and either they are accepted at face value or they are rejected as unacceptible. Sometimes intermediaries might accept them at a small discount for collection far away. Dishonoured instruments obviously may be bought and sold at steep discounts. The market value of instruments payable on demand or within the very short term will always be near par or face value unless the obligor is in substantial difficulty. The history of privately issued bank notes that were not legal tender is that they were accepted, if at all, at par with coin, the reserve ratio of the bank notwithstanding.

garret seinen said...

Have you considered the ownership aspect of money? What has struck me when reading, and I'll say at the outset that I have not done exhaustive reading on economics, even von Mises and Reisman, the ownership or property rights aspect is not clearly articulated. When the fiat currency systems are discussed usually the effect they have on the production systems are the reasons called up for their control or elimination but I've not seen a clear articulation as to why an money not backed by product or a service is, in fact counterfeit.
I believe that by continuously referring back to direct exchange, traders and the evolution of indirect exchange, one could make the case for sound currency more justifiable. If it were ever to become a widely held philosophical belief that all money had to carry an ownership component, it would surly put an end to the status quo, the unrestricted printing by governemnts.

HaynesBE said...

Thoughts on fractional reserve banking have been percolating and I finally had time to write something up.

When I first started reading about fractional reserve banking, I struggled with whether or not the system could be legitimately defended. One of the better defenses in favor of allowing fractions reserve banking is given by Selgin and White. After further consideration though, I have decided that fractional reserve banking can not be defended. I understand that it is currently legal, but then so is fiat paper money. Neither system is consistent with property rights nor the preservation of a properly functioning economy.

Checking deposits at banks are currently (by law) considered to be loans to the bank, although repayable on demand. The actual dollars you deposit do not need to be on hand (held in reserve) in order for you to collect your money. They could exist as liquid assets which are immediately convertible into cash. (I do not understand David’s category of “funding liquidity” to say whether these would also qualify or not.) The form in which the wealth is held is not important. What is essential is assuring that whatever is used to represent that wealth is not allowed to artificially multiply. The problem arises when paper (or electronic) money is created from nothing and then treated as if it represented actual wealth. It is the credit expansion which occurs that is fraudulent.

Doug, when you state, “The whole notion of fractional reserve banking rests on the idea that a bank can lend out depositors’ funds” I must respectfully disagree. I don’t see that lending out funds necessarily leads to artificial money creation—and that is what I view as the “whole notion of fractional reserves.” The problem with fractional reserve banking is that the original deposit is used to justify the creation of multiple other deposit accounts which have no actual wealth behind them. This artificial money creation is the source of inflation and the cause of all the accompanying harmful effects.

The primary functions of money (store of wealth, standard of value, and medium of exchange) are all destroyed when money is disconnected from actual wealth. Inflation, the increase in the supply of money incommensurate with the existence of real wealth, decreases the value of each unit of money. This dilution of value occurs variably over time as prices gradually adjust to the increase in supply, thus destroying the use of money as a standard of value and a medium of exchange. Prices and profit will vary based on the quantity of money instead of the scarcity/abundance of resources relative to demand, thus destroying the prime mechanism for efficient allocation of resources. In addition, since the newly created money must be accepted at face value due to legal tender laws, the value of savings accumulated when the money supply was smaller (unit value thus was greater) will be eroded. The lost value is wealth destroyed.

All systems which allow the creation of “money from nothing” are fraudulent and destructive. This is true whether the increase in money comes from a counterfeiter, a government printing press of fiat paper money, the creation of new reserves by the Fed, or through the credit expansion made possible by fractional reserve banking. In a system of private currency on a gold standard, banks would be required to honor their banknotes upon demand, with gold. No suspension of payment would be allowed. The dangers of a bank run would minimize the temptation to expand note-printing beyond the value of actual reserves. A bank that experienced a run would go bankrupt. The value of money would be far more stable. Prices would be truer reflections of supply and demand. The government would have to tax in order to cover its expenditures, and the true cost of our bloated government would be more directly and immediately felt. (No more stealth taxation through inflation.)

Money, to serve its honest and proper function, is wealth. Commodity money keeps us concretely tied to that fact. The use of paper representations for that wealth provides us with a convenience, and a danger. The danger is if we forget that the paper only represents wealth and then treat it as if it is actual wealth. To think that if we create more paper representations, we create more purchasing power is to forget the most seminal law of economics, production (supply) is demand. If you do not produce, you have nothing to offer for trade. If what you offer for trade is not real wealth, then your transaction is more properly termed theft.

That is why it can not be acceptable to create receipts for more capital than is possessed. Where it becomes confusing is trying to decide what role if any can an uncollateralized I.O.U. play as a medium of exchange. I think that as long as it was clear what was being offered in exchange, then it should be acceptable. Unfortunately, we are forced by the legal tender laws to accept as final payment the government’s uncollateralized I.O.Us, more commonly called Federal Reserve Notes.

A minor point to David. In the U.S. during the period known as the Free Banking Period (a misnomer, by the way) private bank notes circulated widely and were often discounted in value from par based on the reputation and solvency of the issuing bank. Catalogs were periodically printed up listing the various discount amounts for the various notes. I will try to track down the source for this if possible.

This has been an informative exchange. Kudos to Doug for kicking it off and to everyone else for their thoughtful and thought-provoking contributions.

You still gonna do a Part II?

Anonymous said...

Regarding the history of the Bank of Stockholm (or "Sveriges Riksbank") you may be interested in this Wikipedia article:


This was an early horror example of the dangers of fractional banking.