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Wednesday, December 15, 2010

The Federal Reserve: Heart of Tyranny #3. An Introduction to Paper Money

#1. Introduction  

#2. What is Money?

#3. An Introduction to Paper Money

Before delving into the origins, history and nature of the Fed, I'd like to offer some more general background to go along with my last post.  This section will set the stage for understanding, in principle, how the current financial crisis is not a random event but an endemic feature of the current monetary system created and overseen by the government's central bank, i.e., the Federal Reserve.   

In the last post, I argued that exchanges of value are necessary to advance human life and that, due to their unique properties, precious metals have been the objective money choice of the market for thousands of years.  Contrary to the claims of modern economists, gold and silver are not “barbarous relics” from a bygone age, but vital and necessary tools of exchange, which allow for an advanced division of labor economy and an increasing quality of life.        

The first stage in human economic development was the advent of barter.  The next stage was the adoption of a standard asset to serve as a medium of exchange, i.e., precious metals.  The next stage was the use of paper money. 

Most people do not want to carry valuable hunks of gold and silver with them at all time in order to execute various transactions.  For simple or small everyday trades, it might make sense to carry coins of gold or silver, but for any larger transactions, it becomes impractical, and perhaps dangerous, to haul around precious metals.  Historically, individuals stored their holdings of precious metals with goldsmiths who could provide safe storage, in effect, acting as the first bankers. The idea was simple: gold is deposited and stored in the goldsmith’s safe in exchange for a receipt entitling the holder to receive the gold upon demand.  Then, when when the receipt holder buys something, he pays the seller with the receipt rather than walking to the goldsmith to get gold and hauling it back to the store. The seller is fine with the receipt since he can use the receipt to pay for other things or just take the receipt and get the gold from the goldsmith.  Hence, people began accepting paper receipts rather than exchanging the actual gold, i.e.,  the paper receipts functioned as money.  However, keep in mind, this is just a convenience.  The paper is “as good as gold” since the receipt entitles the bearer to immediate withdrawal of an actual value, i.e., the gold. 

Before we go further, let’s define several concepts. 

First, say you were to store your purple and green bicycle at a warehouse.  The warehouse gives you a receipt so that any time you want, you can retrieve your purple and green bicycle out of storage.  At all times, the bicycle remains your property.  In other words, at no time did you exchange direct title with the warehouse.  You contractually agreed that the warehouse would store your property and make it available to you any time you asked.  Such a legal relationship is known as a bailment. The contract of this type is known as a “regular deposit contract.”  

Second, say that instead of storing a specific and unique bicycle, you wish to store wheat, or sand, or gold, i.e. a fungible good.  Items that all look alike and can’t be told apart when put in a big pile are known as fungible goods. If a bunch of people want to store their grain in one place, often they will just pool all the grain together in a big pile.  Since there is no practical way the storage place could figure out exactly what pebbles of grain are yours, you receive, upon demand,  precisely the same amount and quality of the grain you originally deposited. A contract in which you store a fungible good and retain title to this precise amount, or "tantundem", 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 availability of your actual property or the tantundem at all times.

These two types of contracts should be distinguished from the "loan" contract or mutuum. 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 an amount of money plus interest

You can see that deposit and loan are based on two very distinct concepts. In one case, you actually pay someone a fee to perform the service of safekeeping but legally retain title. In the other case, you transfer ownership of the property in the present in exchange for future goods, i.e., for payment in the future.  Historically, the function of safekeeping is known as deposit banking, and the function of loan as loan banking. 

For example, let's say that you deposit some gold with a goldsmith and he gives you a receipt mandating the gold to be payable upon demand, i.e., upon presentation of the receipt to the goldsmith.  If the goldsmith keeps the gold in a safe as he is contractually obligated to do, there is no problem.   The receipts can be traded over and over in the market, and at some point, if someone presents the receipt to the goldsmith, he simply removes the gold from the safe, and pays it to the holder of the receipt.

But, what if the goldsmith, rather than placing the gold in a safe, lends the gold out in an attempt to earn profits on your gold?  As long as no one shows up with the receipt, he is not in jeopardy.  But, as soon as someone presents a receipt and demands the gold, the goldsmith is in trouble.  He has lent the gold and therefore, does not have it.  In this case, the holder of the receipt could rightfully sue or bring criminal charges against the goldsmith as he guilty of fraud and/or misappropriation.  Transfer of title was never made to the goldsmith, and the gold was not his to lend.           

For another simple example, say that one lends his gold to the goldsmith for one year.  The goldsmith offers the lender a note in which he promises to return the same amount of gold plus 10% interest in one year.  In this case, transfer of title has taken place.  The lender is entitled only to a future payment, not the actual gold.  The court would acknowledge that a loan has taken place, and rely on the terms of the contract to settle any dispute regarding a breech of the loan contract.      

Now, let's take a more complicated example.  As before, let's say that an individual deposits gold with the goldsmith in exchange for a demand receipt.  The goldsmith must make the gold available at all times.  However, this time, the customer believes that he will not need all of his gold, so he freely agrees to let the goldsmith lend his gold at the same time.  In fact, he expects that the goldsmith will pay him some interest on his gold as well as make the gold available upon demand.  Both parties freely agree to this arrangement.  The customer subsequently passes these receipts, stamped as "payable on demand" to others when he pays for goods or services believing that the goldsmith will have enough money on reserve to make good.    

This last example is known as "fractional reserve banking."  That is, a customer simultaneously lends his money to the bank while the bank makes the money available at all times.  In this way, a bank holds back a portion of the deposit in reserve (in case the customer wants to withdraw some) and lends the rest.  When this process is carried forth throughout the banking system as a whole, it results in a state where more money is created than actually exists.  In other words, banks effectively create money through the act of lending.  With a fifty percent reserve ratio, the banking system will create twich as much money as has been deposited.  With a ten percent reserve ratio, the banking system will create ten times as much money as has been deposited This legal relationship is the basis of the modern banking system.   

But, is such an arrangement legally possible?  That is, can a court uphold a contract in which two legally distinct entities have the same property available to them at the same time?  In the words of de Soto: "How is it possible that both parties to the same contract simultaneously intend to retain the availabilty of the same sum? "  

The answer is that such an arrangement is legally impossible.  It does not matter that both parties freely entered this contract.  It is not a matter of freedom of contract.  Just as two parties cannot ask a court to uphold a contract in which they agree to simultaneously paint a house red and blue, two parties cannot ask a court to uphold a contract where they intend to retain the availability of the same entity. The law must distinguish these two concepts, i.e., the courts cannot uphold contracts where two parties conflate these concepts. A deposit is a deposit and a loan is a loan.  They are separate contracts and require different banking functions. 

What about money market funds in which customers write checks against their holdings in the fund?  Is this an example of fractional reserve banking since one has their money in a "checking account" yet earns interest?  No, it is not an example of fractional reserve banking.  In this case, one loans his money to the fund and the fund in turns lends the money in the money markets.  When one writes a check, he is asking the bank to liquidate a certain amount of his holdings and to use the proceeds to pay the holder of the check.  A check is not cash, that is, a check is not the same as a deposit receipt marked "payable on demand."  Cash is a "final payment," a check is a promise to pay cash in the future - the immediate future, but the future nonetheless.     

As long as it is legally clear whether a contractual relationship is a deposit or a loan, a court should be able to clearly and objectively uphold the terms of a contract.  If these concepts are conflated, as they are in a fractional reserve banking relationships, it is metaphysically impossible for a court to uphold such a contract.  A simple example will suffice.  Say that there is a run on the bank, i.e., all the depositors show up at the same and rightfully, by virtue of the claim on the receipt, demand their gold, yet, the bank has rightfully, by virtue of the same contract, lent out the money.  Who should prevail in court?  Who has rightful title in this case?   

These issues eventually came to a head.  In past posts, particulary here and here, I have analyzed this issue in some detail.  I followed the work primarily of Jesus Huerta de Soto (see Money, Bank Credit, and Economic Cycles) and Murray Rothbard to offer historical examples to illustrate these concepts.  The first major theme of those posts is that various 19th century common law cases established precedents that deemed "deposits" to become the property of the bank once deposited, thus validating fractional reserve banking and setting the stage for the modern system. 

The second major theme of those posts concerned banking panics throughout the 19th century.  Fractional reserve banking periodically led to runs on the banks as panicked depositors all attempted to withdraw their gold at the same time.  If these insolvent banks had been allowed to fail, the practice would have necessarily been limited, however, the state governments consistently allowed banks to suspend their obligation to redeem their notes in specie (precious metals).  Then, once the panic subsided, banks continued the same cycle of money creation until disaster struck, leading state legislatures to allow suspension, and so on.  As we will see, this disastrous cycle of panics was a major impetus to the drive first, for a national system of banks and then, a "lender of last resort," which would stand ready to bail out these banks in times of stress, i.e., the stage was set for the creation of the Federal Reserve. 

Looking ahead, fractional reserve banking is economically destructive in that it allows banks to create money ex nihilo (out of thin air) and thus sets the boom-bust cycle in motion (since actual savings are not used to fund investment). As Hayek said of these paper money substitutes, they "give to somebody the means of purchasing goods without at the same time diminishing the money spending power of somebody else.”   It is not surprising that bad law leads to bad economics, as it always does.  

We will see that fractional reserve banking further compounds the creation of money ex nihilo by the Federal Reserve system, which creates money when it purchases securities on the open market. These two factors, the Federal Reserve's creation of money combined with fractional reserve banking led credit expansion, is responsible for the boom-bust cycle and the current financial crisis. The solution is a private banking system based on a 100% reserve hard asset standard under laws that maintain a legal distinction between the concept of deposit and loan, i.e., effectively mandating a 100% reserve gold standard.      


Per Nilsson said...

Thank you for this well-written post!

I have two questions regarding the Full Reserve system:

- Is it OK to buy and sell corporate bonds on the open market? (I.e., is the lender allowed to sell his contract to someone else, whom the borrower has not made an agreement with?).

- Let's assume that I open a savings account in a bank, that promises to repay me the money plus interest on a given date. Can I sell my claim to someone else?

The Rat Cap said...

Per Nilsson,

Thanks for your comment.

Correct me if I'm not answering your question, but I think you are asking if it is ok to resell debt or loan contracts. In other words, is it ok to sell a note wherein one party has agreed to lend money in exchange for future payment at some other date.

In principle, sure it's ok to sell debt or notes. Of course, the terms of the note will specify if the note is marketable, that is, whether it can be transferred or sold.

When a corporation raises money by issuing debt in the corporate bond market, they most certainly expect that the securities are marketable. Traders and investors buy and sell these corporate bonds from one another all day, every day based on their risk appetite and return expectations.

Certain types of loan contracts would probably disallow transfer. Typically, in a simple bank cd, where you lend your money to the bank, the loan contract is entered between you and the bank and the contract cannot be sold. But I see no reason in principle why it couldn't be if the contract allowed.

In principle, this is why it is important to understand the difference between a deposit and a loan. In a loan, ownership is transferred, and the contract will specify the obligations of all parties. In a deposit, ownership is not transferred, and therefore, the nature and obligations of parties in that type of contract are very different.

Per Nilsson said...

Thank you, I'm very satisfied with your answer.

Perplexio said...

Isn't the current financial mess we're in also at least partially due to the move away from the Gold Standard for our currency? Once our currency was no longer backed by Gold but was suddenly backed by "the confidence of the American people" it opened the floodgates for unscrupulous bankers to have a field day with money that wasn't theirs.

The Rat Cap said...


Absolutely, you're right - the overthrow of the gold standard in favor of a system of fiat currency is essentially to blame for the current crisis as well as the boom-bust cycle in general. But, I haven't got that far in this series.

At this point, in the series, I have discussed the concept of money and fractional reserve banking, even under a gold standard, to illustrate how that system leads to a boom-bust cycle (even under gold), to both illustrate the underlying legal and economic principles, as well as to help explain how that system created an impetus toward a central bank, i.e., a lender of last resort that could bail out frational reserve banks and "smooth" out the business cycle.

In other words, the argument that FRB and governemnt misintervention led to these crises didn't win - the argument that more government control was needed won, as usual, and hence the modern Federal Reserve.

Per-Olof Samuelsson said...

I wonder why it is so hard to get this point about "fractional reserve banking" under a gold standard across; especially why it is so hard to get it across to Objectivists.

I have tried to get it across twice in the last couple of weeks in Facebook notes; and, while some people do seem to get the point, well, others don't.

One counter-argument in particular puzzles me. The argument is that "FRB" does not consist in lending out more than the bank has in its vaults, but to lend out less. In other words, if the bank doesn't lend out every ounce of gold in its vaults but, let's say, only 90% of it, then it is engaged in "fractional banking", just because a fraction of the gold is retained as a reserve. Why anyone would think so I find confusing.

The Rat Cap said...


I think it is hard because people think the issue involves only an economic argument, and to oppose it, is to oppose the freedom of contract between individuals. I think that concerns people who are used to opposing direct government intervention since it seems like government intervention.

But it is not government intervention or a case of violating the freedom of contract.

It is a case of recognizing a legal-philosophical principle as it relates to the nature of property - the difference between a deposit and a loan - and carrying this forward into practice.

Freedom of contract does not mean that the court must uphold any contract people sign. If a contract is contradictory it is legally impossible to uphold.

Since frb attempts to conflate the legal concepts of deposit and loan, it results in two unrelated parties having simultaneous claim to the same property. That is ultimately why the courts in the 19th century simply ruled that when you deposit money in a bank, it becomes the bank's property for legal purposes.

There really is no longer such a concept of deposit banking. The only time you actually make a true deposit is if you have a safe deposit box. When you "deposit" your money in a modern bank, you are lending it to them - it really ceases to be your money.

This has huge ramifications in terms of the boom-bust cycle as it results in a creation and destruction of money as a function of the banks lending/debt.

Michael said...

this was an informative post dough. appreciate it. could you perhaps make a post about interest and specifically the morality of charging interest. All the arguments I've heard in support of it usually talk about risk but I find them lacking.

The Rat Cap said...


Check out the following: "The Morality of Money Lending"


Per Nilsson said...

I thought about this for a while and a question came to my mind.

Suppose I write a check against a money market fund that have I invested in. I give this check as a payment to my carpenter. He immediately goes to the local car dealer and "spends" it. (And so on...) If everyone started to accept such payment practices, wouldn't that increase the velocity of money? And perhaps even reduce the purchasing power of money slightly?

The Rat Cap said...


No, I don't think it would. When you write a check against a money market fund, the fund must sell securities or make a redemption to pay your check. So, it is a one to one. The carpenter gets his payment, but the fund sells an equivalent amount of securities.

A check is almost a short term loan from the seller. He is agreeing to give you the stuff, and you agree to pay him in a few days whenever the check clears.

The problem comes when a bank creates money against reserves. So, if you deposit $100 in a bank, it sets aside $10 and lends $90. Then someone takes the $90 to another bank. That bank sets aside $9, and lends $89, and so on. The banking system ends up with $1000 of money against $100 of reserves.

That's what causes the problem as far as FRB is concerned. Of course, the Fed creates money too, but here I am just discussing the FRB process.

John McVey said...

Sorry Doug, you're incorrect as to what is the essential nature of FRB and are committing the fallacy of the frozen abstraction. The essence of FRB is the monetisation of credit, which can be done without any problem either legally or epistemologically or metaphysically. You can make the economic arguments and I will agree with you - I am no fan of FRB - but they do not support your legal and philosophical claims.

FRB in at least some form must remain legal, irrespective of its lack of economic merits. Indeed, a ban cannot even be effective without also banning a wide variety of other practices that you would otherwise recognise as legitimate, and which ban would end up destroying a very large part of the economy. So, by all means, decry particular injustices and again you will find me agreeing with you, but the fight against FRB in principle must proceed on an economic basis and can only be defeated by changing people's attitudes and behaviours as market participants rather than political constituents.



The Rat Cap said...


Part I of my response

Although you accuse me of committing various fallacies (quite pretentiously I might add), after reading your post, I hold that you have failed to challenge my central argument and instead replaced it with a strawman argument that bears no resemblance to my central argument.

Your central thesis seems to be related to the usage of debt as a medium of exchange, an activity which you claim is the essence of FRB.

First, where did I ever say that "debt" could not be used as a medium of exchange? Second, what does this have to do with FRB or my central argument related to FRB?

With respect to the former, "debt" certainly can and has been used as a medium of exchange (in the way you describe in your post). I have no problem with "notes" being used as a medium of exchange. Because, they are, in fact, recognized as notes. They are loan contracts in which future payment is promised. If one chooses to accept a loan contract in exchange for something, then so be it.

On this point see:

1. Rober Blumen on the concept of "clearing."


2. Von Mises on the use of debt or bills (Human Action, See III.16.11 - III.16.16)


3. Rothbard, The Case Against the Fed, p. 29 "Loan Banking"

What does this have to do with FRB?

FRB involves the case where:

1) warehouse receipts are issued by a deposit bank to someone who has deposited specie (gold or silver)

2) the bank simultaneously makes the deposit "available upon demand" and loans out the money

In other words, "bills" or notes being used as a medium of exchange are fundamentally different than a warehouse receipt marked "avaiable upon demand."

A bill or note (loan) is a different legal contract (which I explain in my post) and is not a final payment. It is a promise of final payment.

A warehouse receipt or anything marked "available upon demand" is a title to an existing asset.

The market necessarily values the latter higher than the former. Accepting a loan or bill in exchange depends on the reputation of the person offering the bill. Historically, only large merchanges with a long track record could use these in commerce. I doubt any seller would accept a "note" from just anybody. However, a warehouse receipt functions like cash, in that it entitles the bearer to an actual asset, not a promise of future payment.

In my post, I note that the nature of these contracts necesitates different legal contracts and different treatment under law.

FRB violates this by trying to pass a warehouse receipt as "available at all times" yet proceeding to allow banks to lend out the money so that it is not truly available.

The Rat Cap said...

Part II

The "monetization of credit" is not the essence of FRB as you say, if you mean that debt instruments simply can be used a medium of exchange.

The essence of FRB is the attempt to legally conflate a deposit with a loan or to try and retain the benefit of a deposit of a good while getting the benefit of lending out the good, or the attempt to have your cake and eat it too.

After you rebut this strawman argument, you logically infer that only the "deleterious economic consequences" of FRB can be used to oppose it, an argument, if it was made, which you rightly oppose.

However, did I ever make that argument? Did I ever say that the deleterous economic consequences are why it should not be upheld by the courts?

It's quite the opposite. Bad law leads to bad economics. Given that the moral is the practical, when you observe a systemic economic problem, it is usually a symptom of some deeper flaw. The fact that FRB leads to these economic problems should be seen as a warning sign that something is not right, not justification per se.

Historically, the problems associated with FRB would have been contained if the states had simply forced banks to honor their contractual obligation to redeem in specie. This would have largely limited the practice (although still legally problematic, it would have been practically contained). The fact that the states allowed banks to suspend redemption, created obvious moral hazard, and encouraged banks to over issue notes against reserves until disaster struck.

However, it should be noted, that even if FRB was practically limited by virtue of the state upholding this obligation, it is still a violation of traditional legal principles since it allows independent parties to have claim over the same asset at the same time.

The Rat Cap said...

Part III

Traditionally, where the concept of "Bills of Exchange" meets with the concept of FRB is the so-called "Real Bills Doctrine".

This doctrine is the idea that banks can and should create money (out of thin air) as long as it is against a "real bill", a bill that liquidates in less than 60 days.

So, if a farmer wants a loan against his crop, the bank should create money (paper redeemable in specie) AS OPPOSED TO lending the farmer money out of the bank's capital or customer savings accounts.

This is yet another inflationary theory that tries to justify money creation ex nihilo.

See Robert Blumen's "Real Bills, Phony Wealth."


If you intended to justify the Real Bills Doctrine rather than simply claim that debt can be used as a medium of exchange, then we have a deeper divide.

In other words, using debt as a medium of exchange is fundamentally different than pyramiding paper money (money that is redeemable in specie) against collateral. This is just another example of what I oppose in the post.

John McVey said...

Re Part 1

"you have failed to challenge my central argument"

For the most part I don't have a problem with it, and I hadn’t finished responding. My concern is that your focus is too narrow. The entirety of the practical and economic substance of FRB can be created by means that must be legal. If the concerns that you raise were addressed as both reason and justice do demand then that still allows the broader phenomenon to continue for so long as straight economic argument is eschewed. There is no strawman here.

"First, where did I ever say that "debt" could not be used as a medium of exchange?"

I actually took the opposite for granted. My point is that its legitimacy leads to the conclusion I stated. The only way to stop others from implementing it is to make a law that I knew you would not accept as rightful.

"Second, what does this have to do with FRB or my central argument related to FRB?"

You are hanging everything on the word 'deposit.' I am not even disagreeing significantly with you on that score. (What disagreement I do have I will discuss on my blog.) Absolutely, FRB on deposits today is predicated on epistemological corruption. Equally absolutely, the practice of FRB on deposit contracts, back before the corruption was normalised in the language, was a crime that should have seen the goldsmiths et al have the book thrown at them.

The only thing that the finance industry needs to do to satisfy these complaints is to drop all reference whatever to the word 'deposit' and variations thereupon. They need just switch the noun and verb nomenclature over to credit-related words. Those words already exist and are used in that fashion (eg 'please credit my account'), so this is no mere fancy on my part.

As part of that, all express or implied statement in notes or accounts contracts of money being 'available' should also be dropped. Your argument is dependent on the contracts telling people that money that can be had on demand is actually there, and that breach of that is both attempting the metaphsically impossible and is legally a fraud. To the extent that availablility is expressly or legally implied, I agree with you even there. Nevertheless, my point remains. The solution to the problem for the pro-FRB crowd is simple: dump that word, and replace it with 'payable,' which again is already widely in use for that purpose. That then leaves the imprudence of courting disastrous potentialities wherein the potential-actual distinction shuts the door to legal proceedings until actual failure to pay arises.

The most you are suggesting is that the term "FRB" should refer strictly to "deposits" - but that would make it difficult for you to deal with the wider phenomenon because you'd have no clear concept to integrate observations under and no clear words to communicate with. At best, you are telling me that I should call what I discuss "synthetic FRB" - but what is gained by that procedure? Nothing. The fact remains that the whole of the practical, legal and economic substance is still there. Thus I stand by my position that "synthetic" FRB is in fact FRB, that it must remain legal in some form even if the particulars you rightly raise are dealt with as they should be, and that what weapons are left to fight FRB with are economic and educational in nature.

"If one chooses to accept a loan contract in exchange for something, then so be it."

Sure. Then, in time, variants of FRB result when financial engineers think them up and implement them.

John McVey said...

Re Part 2

“you logically infer that only the "deleterious economic consequences" of FRB can be used to oppose it, an argument, if it was made, which you rightly oppose.”

I’m not sure what you mean here. I oppose FRB in principle on economic grounds (leaving aside unusual extenuating circumstances), while noting that some instances can be rejected even before getting to economics because they are injustices. It is only economic arguments that can be used when there is no injustice involved.

“Did I ever say that the deleterous economic consequences are why it should not be upheld by the courts?”

I did not say that you did. What I did say - or at least intended to say and not get across properly - was that reference to the consequences was intended to give readers incentive to care about the injustices, and that by implication, if these injustices were dealt with then one of the results of that is that the economic consequences could never appear again. I should have been clearer about general case rather than legal. For that I offer my apologies.

“Historically, the problems associated with FRB would have been contained if the states had simply forced banks to honor their contractual obligation to redeem in specie.”

I’ve always agreed with that. FWIW, I had even previously noted in a private email to another that if law had enforced contracts properly then the broader phenomenon I am talking about would be little more than a curiosity, never seen in respectable circles and taken as an indicator of incompetence or low-class cynicism on the part of financiers who resort to it. The fact remains that the right-thinking man would still recognise it as something that ought be legal and that there are no general grounds for actual prosecutions of those inferior financiers.

The problem is that merely getting the courts today to uphold deposit contracts in the manner of undoing the epistemological corruption - of holding that a deposit means an amount actually sitting in a vault - is no longer sufficient to cause FRB to cease. All that financiers would do is the legal-term changes as above, retaining the same mechanics and keeping the same economic system with the same economic effects. The practice has been normalised, and it is going to take economic argument and customer education to denormalise it. This is especially needful in the face of the inevitable economic arguments that these financiers will make as enticements for customers to switch to formal credit contracts that create monetary entities rather than keep the now full-reserve transaction accounts and the now non-monetised savings accounts.

“it allows independent parties to have claim over the same asset at the same time.”

Having properly recognised credit contracts from the get-go eliminates that metaphysical and legal problem. Contracts of unsecured credit do not give creditors direct property in the cash holdings of the debtor. Rather, the creditors have property in uncrystalised general claims to being paid, which right also gives rise to a right to bring the debtors into court in event of non-payment. These properties are separate assets and are tradable as such, independent of both the specie and the other assets that undergird their market value. This, too, is also a long-standing legal principle.

John McVey said...

Re Part 3

Firstly, you’re not saying anything I disagree with regarding the nature of bills, and, secondly, in any event you’re giving too much emphasis to them. My point in raising them was to show that they follow quickly from debt reassignment and that even at that early stage of the development there are implications for monetary and banking practices, including FRB. That was all. It is on par with noting that by 65 million years ago our ancestors had evolved into small furry mammals who until that point spent their lives constantly hiding from big-ass lizards, and so, as we are still mammals, certain things about how we act are true today, but which, because of a bit of bad weather back then, no longer includes a need to hide from big-ass lizards (unless you live in a swamp and have misplaced your knife).

“If you intended to justify the Real Bills Doctrine”

Absolutely not. It is dead and should stay dead. Note issuance backed by bills DOES raise general prices, irrespective of what the bills finance. Of course - as I’m sure you’ve guessed I will say - it should still nevertheless be legal to offer and trade notes thus backed, and, right-thinking people will view these notes very unfavourably despite their legality.

“In other words, using debt as a medium of exchange is fundamentally different than pyramiding paper money (money that is redeemable in specie) against collateral.”

No, it is not fundamentally different. It is concretely different, sharing the same fundamental economic and legal nature. In both cases the economic and legal substance is that a certain amount of money-substitutes is in circulation, these being substitutes for the rights to payment and to pursue legal action in event of non-payment, and whose total value is backed only in part by specie and mostly by the other assets. In both cases money is created because transferable credit claims are created - that is the essential feature of all variants of FRB and why I am justified in rejecting having to use the qualifier “synthetic.” The different types of FRB differ only in the concrete methods by which this result is generated, with different judgements as to what should and should not be legal attachable to those various methods (eg how it was a gross violation of justice for governments unilaterally to convert bailment contracts over fungible goods to credit contracts for delivery of fungible goods).

The Rat Cap said...


I think you are making a couple of errors - first, with respect to the actual meaning of FRB and second, with respect to the meaning of money versus medium of exchange.

Example 1.

Joe deposits 100 oz. of gold in a bank. The bank gives Joe 100 dollars - each dollar is marked " 1oz. of gold available on demand".

The bank sets aside 10 oz. of gold in a vault. It then lends out 90 oz. of gold.

Joe = "I have a 100 oz. of gold"
Borrower = "I have 90 oz. of gold"
Total Money Supply = 190 oz.
Actual money = 100 oz.

This IS fractional reserve banking.

Joe entered into a deposit contract and retained title. The borrower gained title by virtue of the loan. Who owns the gold? Since it was a deposit contract and Joe retained title, the bank cannot lend his property.

Even if they agree to do this, the court cannot uphold a contract in which deposit and loan are conflated.

Example 2.

A farmer has a crop coming due. He needs a new tractor now which costs $100 oz.

Instead of buying the tractor with gold, he offers the tractor seller a "note" or "bill" which says "I agree to pay you in 2 months and I will pay you $102 oz for the tractor now"

The tractor seller says fine and accepts the note. He has effectively LOANED the farmer money. He lent the farmer $100 oz in exchange for $102 oz. in 2 months.

Now, the tractor seller needs some tires to make another tractor which cost $100 oz. Instead of paying in gold, he gives the tire maker the note, transferring the note to the tire maker.

In effect, the farmer will now pay the tire maker. Again, the tire maker has LOANED the tractor seller money.

In effect, the notes are being used as a medium of exchange.

FINE. This is not fractional reserve banking! The notes are not conflating deposits with loans. It is clear who has title at all time under these loan contracts.

Economically, it is not a problem, because one person is forgoing the use of actual money in the present in exchange for money in the future.

At all times, "money" is the actual gold which is the object underlying the contract. The "note" is a medium of exchange, not the "money" itself, i.e., gold.

The market values these things differently.

1. Actual Gold coin

2. Warehouse receipt to gold coin based on a deposit contract in which the holder legally retains title

to the extent that a bank issuing warehouse receipts is trusted, then #1 and #2 are virtually identical in value.

3. A "Bill of Exchange" entitling the bearer to some future amount of money. This Bill is a medium of exchange but it is a loan contract. It is not a "title to an actual asset" . Rather, it is a promise that someone will pay you in the future.

Legally these are 2 very different entities, and they have different economic implications.

Per-Olof Samuelsson said...

Thorsten Polleit makes essentially the same point today at mises.org:


The Rat Cap said...


Hallelujah! Thanks for that link. I highly recommend it to anyone interested in this topic.

He literally makes almost the same argument I have made, just more eloquently and concisely.


John McVey said...

"This IS fractional reserve banking"

I didn't say it wasn't. What I said was that the historically-originating deposits-variant is best understood as a concrete instance of a wider phenomenon, and that it is this wider phenomenon that is best identified as being the FRB concept in general. Were the deposits-variant of FRB made extinct that would still leave the credit-variant, which variant retains the same mechanics and the same economic effects, and also be comprehensible under the same economic concepts (except the concept of ‘deposit’) and by the same economic methods.

"Even if they agree to do this, the court cannot uphold a contract in which deposit and loan are conflated."

Again, I have no major problem with this. However - and this is the minor issue I have with the deposits issue - I do think that it has gone on for so long that the precedent-set legal meaning of deposit now just means the handing over of cash or equivalents to an authorised deposit-taking institution, irrespective of what that institution does with the cash after the fact.

Re example 2, I do know that that much is not fully fractional reserve banking - but it does set the scene for it. Moreover, were it to proceed to a considerable extent it would start to get close to being FRB and would have many of the same economic effects. This is observable in your own example. You noted that the acceptance of coin was forgone. The point I make is: "precisely!"

The credit giving value to the bill was 'created out of thin air', backed by the tractor seller having confidence in the farmer's ability to pay principal and interest at a later date. Likewise, the tyre seller reinforced the credit by accepting it instead of cash from the tractor seller. This is an instance of the circulation of credit that Polleit (and other Austrians) talk about - yet which is perfectly legitimate. This is why bills (and other "money market instruments" that can be created and traded in the same way) are included in M3.

I've continued this part on my blog because that’s where it belongs.

“Economically, it is not a problem,”

It is an economic ‘problem,’ of sorts, to the extent that bills circulate as media of exchange. The greater their increase in quantity the greater their effect on general prices. Of course, this is legally no different to an increase in gold. The only problem economically is that because credit is ephemeral it is considerably more risky than gold. But that is a problem of proper valuation and hence of market acceptability, where the law has no business sticking its nose in other than to uphold contracts.

“It is not a "title to an actual asset" “

I think we’re talking at cross purposes. A right to be paid is not a physical asset, but it is an asset nevertheless, recognisable as such by law, by economics, by business, and by accounting. It is an intangible asset, just as a copyright or publisher’s masthead or patent are intangible assets, or, indeed, complex financial instruments such as derivatives. Compared to some derivatives, ownership of immediate right to payment on demand is child’s play - and financial engineers can strip and staple things as easy as children playing with lego! Yet all of these things are assets, and all can be and are owned.

Any asset whatever can be used as a final payment in settlement of debts. That means any asset can be turned into money simply by the popularity of use of that asset for that purpose to the point of the same one instance being traded several times before being used for what it is. All that an intangible asset needs for this, besides acceptability for that purpose, is something tangible to evidence them for the sake of the law so as to recognise that finality in event of dispute. That is what paper notes or book entries are for.

The Rat Cap said...


I am at the point where I literally don't understand what you are talking about. I'm sorry, but I have given simple examples and simple arguments and I just don't understand where you are going.

If you still think that "credit" instruments could serve generally as the only money, you are missing the fundamental point. Final payment must be paid with something real, which is always a tangible asset. Even a credit instrument must be ultimately paid in a tangible asset. That is why the market chooses a commodity like gold/silver as money. Credit can serve an important role, but commodity or tangible money will always serve as the final payment.

Stay tuned, I am going to revisit that issue with some links in next posts. Also, see #4 in the series.

John McVey said...


I am not disagreeing with the internal content of you arguments to any great extent. Rather, I am saying:

- that the concept of FRB is broader than you indicate,

- that you underestimate how sophisticated that people can be,

- that, were your arguments properly resolved by the courts, markets would just shift sideways in a manner that leaves the mechanics and the rest of the economic substance untouched unless the purely economic arguments were also made,

- and that you'd be left with limited ability to comprehend these events and to make the requisite economic arguments because you have no concept to integrate things with (or have the mouthfull of "synthetic FRB").

"Final payment must be paid with something real,"


"which is always a tangible asset."

Not true.

Final payment means that a debt is settled without further moral or legal action possible. ("Debt" here simply means that which is owed, and can cover anything from a corporation's huge loan to a child's 1c purchase at the corner candy store). Reassignment of another debt can achieve this by use of "without recourse" clauses, which I also noted was an essential element.

A owes debt X to B. B owes debt Y to C. B can pay debt Y by reassigning to C the claim upon A under debt X. That reassignment by B is a final payment to C **IF** it the claim upon A is transferred without recourse. That is, B's debt Y to C is settled even if C does not get anything at all from A. C can only institute legal proceedings against A, not B. In this fashion can credit be used as a value legally independent of what its settlement is in. Because of that fact, getting from that to a credit-variant FRB practiced by A is but a matter of tweaks on this theme.

But I've already detailed how A can achieve that (and there is more than one way, too), and it is clear that neither of us going to get anywhere at present, so I'll just leave you in peace to ponder this at your leisure.


The Rat Cap said...


Let me say a few things and then I want to recommend a paper.

A "claim transaction" is one in which a tangible good is exchanged, e.g., gold for a tractor.

A "credit transaction" is one in which future goods are exchanged for present goods, e.g., I will pay X gold in the future for this tractor now.

Money is "that for which all other goods and services are traded." Necessarily, in a free market, the commodity, due to its physical nature, that is most marketable will serve as the "general media" -in all exchanges- and will serve as money. Usually this is gold and silver.

(Credit can certainly be used as a medium of exchange but cannot serve as "money" in this sense since it is not fundamental, i.e., it depends on the exchange of "money" in the future. If there was no money, gold and silver or claim tickets on gold and silver, what would loans be based on?)

If courts properly resolved the concept of deposit and loan, claim transactions and credit transactions would serve as two separate, distinct types of transactions.

FRB then could not take place!

Either, actual tangible goods would be exchanged ("claim transaction"), or present goods would be exchanged for future goods ("credit transaction"). IN NO CASE, could someone create a claim ticket "redeemable on demand" in which the good would not actually be there. A deposit would simply be a deposit and a claim on this deposit would be trivial. A loan, by its nature, which involves a future good, is a loan where someone has foregone the usage of their "money" in the present.

A "credit transaction" per se IS NOT A CASE OF FRB. FRB occurs when a bank creates claim tickets "redeemable on demand" out of thin air that are not backed by actual deposits.

Let me suggest you read Shostak's paper:


I think it is very good at isolating the distinguishing characteristic of money and serves as the basis of the current Austrian concept of "True Money Supply."

The Rat Cap said...

Also, let me add to the definition of money in the last comment where I discussed money as necessarily the most marketable commodity, etc.

I said "credit" can serve as a medium of exchange but not as money since credit depends on money! In other words, in a credit transaction, someone exchanges a present good for MONEY in the future.

Not only is that the case, but credit depends on the counterparty's reptutation among other things as well as the terms, etc. Credit could never serve generally as "money" in this sense. Only a marketable commodity that is recognized as being at all times valuable can serve as money throughout the economy.

In any case, FRB depends on the conflation of deposit and loan. It depends on the banks having the legal ability to mark a note as "redeemable upon demand" when they have transferred ownership of the asset. This results in a case where two or more parties have legal title to the same asset. The distinction above adds some more clarity but is not fundamental to my more general point.