Almost all contemporary Austrian economists are united in their opposition to central banking and in their advocacy of a system of free competitive banking. However, a vigorous debate has arisen over the precise meaning of “free competitive banking.” Does “free banking” require 100-percent-reserve-deposit banking, or does it allow or even require fractional reserve banking? In a recent article that appeared in the Review of Austrian Economics, George A. Selgin and Lawrence White, the two most prominent contemporary Austrian proponents of “free banking” as fractional reserve banking, have undertaken a systematic attempt to answer their numerous Austrian critics and defenders of 100-percentreserve-deposit banking.
Against the charges made by their critics, Selgin and White try to establish two theses. First, they claim to show that the practice of fractional reserve banking, that is, the issue of fiduciary media, does not constitute fraud but is justified by the principle of freedom of contract, and in particular they contend that fractional reserve banking is in accordance with the title-transfer theory of contract as developed by Murray N. Rothbard (such that Rothbard, who holds that fractional reserve banking is fraudulent, must have failed to grasp his own theory). Second, they attempt to show that the creation of fiduciary media does not of necessity lead to economic inefficiencies and discoordination but may actually help prevent an otherwise unavoidable crisis and thus improve economic performance. In the following, we will demonstrate that neither the central normative claim nor the secondary positive claim is established.
THE ISSUE OF FRAUD I: MONEY,MONEY SUBSTITUTES, FIDUCIARY MEDIA, AND THE TITLE-TRANSFER THEORY OF CONTRACT
In order to resolve the question of whether or not fractional reserve banking constitutes fraud, from the outset a few factual assumptions and terminological issues will have to be clarified. Fortunately almost complete agreement on these matters exists on both sides of the debate, and thus we can be extremely brief. Money cannot but originate as a commodity, such as gold. Gold, then, as money is defined as “the generally acceptable medium of exchange,” and as such is uniquely characterized by its “supreme salability in comparison with all other assets” (such that its “possession puts one in the position of being able to make any potential purchase with minimum inconvenience”). Money substitutes, in turn, are defined as claims or titles to specified amounts of money gold. If money substitutes (paper notes) are fully covered by reserves of money (gold), Mises denotes them “money certificates,” and we will refer to them here simply as money substitutes. If money substitutes (paper notes) are uncovered by money (gold), they will be referred to as fiduciary media instead.
Based on these assumptions and definitions, we can now turn to the question of whether or not the issue of fiduciary media constitutes fraud. Fortunately the discussion of this issue is facilitated by the fact that Selgin and White explicitly accept the Rothbardian titletransfer theory of contract. That the issue of fiduciary media is inherently fraudulent, as Rothbard and Hoppe claim, Selgin and White find
impossible to reconcile with Rothbard’s … title-transfer-theory of contract which we accept, and which Rothbard otherwise uses to defend the freedom of mutually consenting individuals to engage in capitalist acts with their (justly owned) property. Rothbard defines fraud as “failure to fulfill a voluntarily-agreed-upon transfer of property.” Fractional-reserve arrangements cannot then be inherently or inescapably fraudulent. Whether a particular bank is committing fraud by holding fractional reserves must depend on the terms of the title-transfer agreements between the bank and its customers.…
Whether it is fraudulent to hold fractional reserves against a bank liability does not depend per se on whether it is a demand or time liability, but only on whether the bank has misrepresented itself as holding 100 percent reserves. The demandability of a particular claim issued by a bank, i.e., the holder’s contractual option to redeem it at any time, is not per se a representation that the bank is holding 100 percent reserves against the total of its demandable claims. Rothbard argues otherwise, based on the view that a bank’s demand deposits and notes are necessarily “warehouse receipts” and not debts. We do not see why bank and customer cannot contractually agree to make them debts and not warehouse receipts, and we believe that historically they have so agreed.
While this may sound plausible at first glance, it does not withstand serious scrutiny. In fact, the quoted passage reveals that the most basic lesson concerning property and contract has been overlooked. As Hoppe formulated it, “two individuals cannot be the exclusive owner of one and the same thing at the same time.” 7 This is an immutable principle; it is a law of action and nature that no contract can change or invalidate. Rather, any contractual agreement that involves presenting two different individuals as simultaneous owners of the same thing (or alternatively, the same thing as simultaneously owned by more than one person) is objectively false and thus fraudulent. 8 Yet this is precisely what a fractional-reserve agreement between bank and customer involves.
In issuing and accepting a fiduciary note (at a necessarily discounted price), both bank and customer have in fact, regardless of whatever they may believe or think about the transaction, agreed to represent themselves—fraudulently—as the owner of one and the same object at the same time. They have in fact contracted to create additional titles and claims to the same existing quantity of property. In issuing fiduciary notes, they do not—and cannot—bring more property into existence. Indeed, no contract whatsoever can possibly increase the existing quantity of property, but can only transfer (redistribute) existing property from one person to another. The quantity of existing property can only be increased through additional appropriation and production (and a thus enlarged quantity of property can in turn lead to a correspondingly increased number of titles to property). But fractional reserve banking and the issue of fiduciary media, while it does not and cannot increase the amount of property in existence, also does not involve (as all other contracts do) a transfer of existing property or titles to existing property from one hand to another. Neither does the issue and acceptance of a fiduciary note signify a transfer of property from bank to client or vice versa. To be sure, as the result of a fiduciary issue, the distribution of assets and liabilities in the accounts of bank and client is altered. But no existing quantity of property is actually transferred from bank to client, or vice versa, and the total quantity of property in existence has remained unchanged. Rather, fiduciary media represent new and additional titles to or claims on an existing and unchanged stock of property. They are not the result and documented outcome of an additional supply of property on the part of the bank or its client. Instead, they represent an additional supply of property titles, while the supply of property has remained constant. It is precisely in this sense that it can be said of fiduciary media that they are created out of thin air. They are property-less titles in search of property. This, in and of itself, constitutes fraud, whether according to Rothbard’s definition of the term as “a failure to fulfill a voluntarily-agreed-upon transfer of property” or according to Selgin and White’s own definition of it as “a willful or deliberate deception for purposes of gain.” Each issuer and buyer of a fiduciary note (a title to money uncovered by money), regardless of what he may believe, is in fact—objectively—engaged in a misrepresentation for the purpose of personal gain. The bank and its client have consented to misrepresent themselves as the owners of a quantity of property that they do not own and that plainly does not exist; and whenever they buy an existing quantity of property in exchange for titles to a nonexisting quantity of property, they have become invariably and inescapably guilty of an act of fraudulent appropriation.
Selgin and White’s failure to recognize this, and their belief in the ethical innocence of fractional reserve banking, is due to two confusions. On the one hand, as has already been indicated, they do not recognize that no object—and no quantity of money (gold)—can be owned by more than one party at a time and that no contract can possibly increase the quantity of property in existence, and thus that any pretension to the contrary is inherently fraudulent. On the other hand, and intimately related, Selgin and White do not recognize the fundamental praxeological difference between property and property titles. Rather, in subsuming money (gold) and money substitutes (banknotes) under the same heading of “money” they continually obfuscate this very distinction. For if money (gold) and titles to money (banknotes) are both defined as “money,” then it indeed seems to follow that it does not make any difference whether the supply of money or that of banknotes increases. Both are “money” and hence, by definition, in both cases the same event—an increase in the supply of money—has taken place. But this does not alter the facts; it only defines them out of existence.
Of course, as Selgin and White correctly note, everyone is free to adopt any definition and make any distinction that he wishes. Yet definitions do not create real distinctions; they can, though, make them disappear. They can only either reflect such distinctions or else ignore and confuse them; and clearly, to refer to both money and money substitutes indiscriminately as money is to obscure the difference between two categorically—praxeologically—distinct phenomena and states of affairs. A title to money and an increase of titles is not the same thing as money and an increase of money. Rather, unlike an increase in the quantity of money (gold) or an increase of titles backed by a corresponding increase of money, any increase in the quantity of titles to money unaccompanied by an increased quantity of money necessarily implies that one and the same quantity of money is owned by more than one person at the same time; and since such a thing is physically impossible—the quantity of money is unchanged and all existing money must be presently owned by some-one—every redemption of a fiduciary title, then, be it into money or any other form of real property, involves an act of illicit appropriation.
Assume there exists both property itself and property titles (notes). Besides property in consumer goods, producer goods, and money, titles to consumer goods, titles to producer goods, and titles to money are assumed to exist. The origin of property titles in addition to the existence of property itself promotes legal certainty and reduces and facilitates legal disputes, and hence undoubtedly represents a beneficial (natural) development. Moreover, it allows for two innovations. On the one hand, it becomes possible to separate the act of transferring ownership in property from the act of transferring its possession. That is, it becomes possible to surrender or acquire ownership in objects without simultaneously surrendering or acquiring possession, disposition, and control of the very same objects. Applied to money it becomes possible that, all the while the ownership of existing quantities of money (gold) can change constantly from one person to another, the entire quantity of money may remain—unchangingly—in the hands of one and the same bank (as the manager of money owned by others). On the other hand, with the development of property titles, intertemporal exchanges will be systematically facilitated. Existing (present) property or titles thereto may be transferred in exchange against titles to future property (debt claims); and hence it will be also assumed that next to titles to existing property (consumer goods, producer goods, and money), titles (debt claims) to future consumer goods, future producer goods, and future money exist and are traded as well.
In light of these developments, the following transactions (contracts) between any two parties A (bank client) and B (bank) are possible. A may transfer his money (gold) into B’s disposition and thereby either (1) not give up his ownership in it, or (2) give up his ownership. There is no third possibility. If (1), then A keeps the title to the sum of money transferred to B; B does not have title to it, but acts as a money warehouser (a bailee) for A (as a money bailor). There is no third possibility. If (2), then B acquires the title to the quantity of money put into its disposition by A; A receives from B in exchange either (a) a present-existing-quantity of consumer and/or producer goods previously possessed and owned by B; or (b) a title to a present-existing-quantity of consumer and/or producer goods in B’s possession (but owned now by A) (an equity claim); or (c) a title to a quantity of future consumer and/or producer goods and/or money (a debt claim). Again, there is no third possibility. That is, A cannot both retain ownership of this property and transfer it to B.
Among all possible transactions, not one would result in the issue of a fiduciary note. Fiduciary media, according to Selgin and White’s own definition, are “that portion of redeemable money substitutes backed by assets other than base money.” 10 There are money (gold) and money substitutes (titles to money) in existence, and there are titles to non-money goods (equity titles), and titles to not-yet-existing future goods (debt claims). Apparently, however, no such thing as “money substitutes backed by assets other than base money” would arise out of any of these transactions. Selgin and White assume the existence of fiduciary media (and they simply assume that the absence of fiduciary media must be the result of legal restrictions), but they do not provide a praxeological explanation and reconstruction of the origin of such a peculiar entity and state of affairs. Rather, they only ask, why not? “We do not see why bank and customer cannot contractually agree to make them [that is, demand deposits and banknotes] debts and not warehouse receipts.” Why is it that there can—and should—be no money substitutes backed by assets other than money? For the same reason that there can and should be no car or house titles backed by assets other than cars or houses, that there can and should be no equity titles backed by assets other than equity, and that there can and should be no assets—money, equity, or debt—owned (backed) by more than one person at a time. Titles to money are—and should be—backed by money in the same way and for the same reason as titles to cars are and should be backed by cars. This is what defines them as property titles. It is in accordance with and a reflection of the nature of property and property titles. In distinct contrast, a title to money backed by assets other than money is a contradiction in terms, and its issue and use involves the same sort of objective misrepresentation as the issue of a title to a car backed by assets other than a car (parts of planes and bikes, for instance). 11
The answer to why fractional reserve agreements are ethically impermissible, and why there can be no contracts to make warehouse receipts debt, is that such agreements and contracts contradict (deny) the nature of things. Any such contract is from the outset—a priori—invalid. Selgin and White try to get around this inescapable conclusion by adopting, wittingly or not, an ultra-subjectivist view of contracts and agreements. According to this view, the very fact that a voluntary agreement is reached and/or a contract is concluded demonstrates that it must be a valid—true or permissible—agreement and contract. Yet this view is not only false, it is also incompatible with Rothbard’s title-transfer theory of contract that these authors claim to have accepted. Agreements and contracts per se do not imply anything regarding their validity for the fundamental reason that agreements and contracts do not create reality, but rather presuppose it. More specifically, contracts do not bring property into existence, but rather recognize and transfer existing property. Hence, as in Rothbard’s ethical system, the theory of property must precede the treatment of contracts. Contracts and contract theory presuppose and are constrained by property and property theory. That is, the range of possible (valid) contracts is limited and restricted by the existing quantity (stock) of property and the nature of things, rather than the other way around. Thus, agreements regarding flying elephants, centaurs, squared circles, of perpetui mobile, for instance, are invalid contracts. They cannot—by virtue of biological, physical, or mathematical law—be fulfilled, and are from the outset false and fraudulent.
While Selgin and White may acknowledge this, they fail to recognize that a fractional reserve banking agreement implies no lesser an impossibility and fraud than that involved in the trade of flying elephants or squared circles. In fact, the impossibility involved in fractional reserve banking is even greater. For, whereas the impossibility of contracts regarding flying elephants, for instance, is merely a contingent and empirical one (it is not inconceivable that in another possible world, somewhere and sometime, flying elephants may actually exist, thus making such contracts possible), the impossibility of fractional reserve banking contracts is a necessary and categorical one. That is, it is inconceivable—praxeologically impossible—that a bank and a customer can agree to make money substitutes (banknotes, demand deposit accounts) debts instead of warehouse receipts. They may say or certify otherwise, of course, just as one may say that triangles are squares. But what they say would be objectively false. As triangles would remain triangles and be different from squares, so money substitutes would still be money substitutes (titles to present money) and be distinct from debt claims (titles to not yet existing future goods) and equity claims (titles to existing property other than money). To say otherwise does not change reality but objectively misrepresents it.
In doing what Selgin and White believe clients and banks to have done—to agree to make warehouse receipts debt—the money depositor A receives from the bank B a claim to present money, rather than a debtor equity title. That is, A does not in fact give up ownership of the deposited money (as would have been the case if he had received a debtor equity claim from B). While A retains title to the money deposit, however, B does not treat A’s deposit as a bailment, but rather as a loan, and enters it as an asset onto its own (B’s) balance sheet (offset by an equal sum of outstanding demand liabilities). While this may appear initially to be merely a harmless accounting practice, it involves from the outset a misrepresentation of the real state of affairs. 12 Since both, B as well as A, count the same quantity of money simultaneously among their own assets, they have in effect conspired to represent themselves in their financial accounts as owning a larger quantity of property than they actually own: that is, they have become financial impostors. 13 Though fraudulent, this would not matter so much if everything were left at this. However, as soon as B acts as if things were the way he represents them on his balance sheet to be—as if the bank owned the deposited money and only had the obligation to redeem outstanding warehouse receipts on demand—mere misrepresentation is turned into misappropriation. If B, in accordance with this misrepresentation, lends out money, or more likely, issues additional warehouse receipts for money and lends these out to some third party C, in the expectation of eventually being repaid principal and interest, the bank becomes engaged in undue appropriation, because what it lends out to C—whether money or titles to money—is in fact not its (B’s) own property but that of someone else (A). It is this fact—that the title transferred from B to C concerns property B does not own—that makes fractional reserve banking from the outset fraudulent.
It is not the case, as is claimed, that fraud (breach of contract) is committed only if B, the fractional reserve bank, is actually unable to fulfill all requests for redemption as they arise. Rather, fraud is also committed each time B does fulfill its redemption obligations. Because whenever B redeems a fractionally covered banknote into money (gold) (whenever a note holder takes possession of his property), it does so with someone else’s money: if B redeems C’s note, it does so with money owned by A, and if A wants his money too, B pays him with money owned by D, and so on. Qua defenders of fiduciary media and fractional reserve banking, Selgin and White would have to maintain that there is no breach of contract as long as B is able to fulfill its contractual obligations with someone else’s property (money).
Yet this is patently wrong, and it stands in clear contradiction to Rothbard’s title transfer theory of contract that Selgin and White claim to have accepted. In accordance with Rothbard’s contract theory, individuals are only entitled to make contracts regarding the transfer of their own property. In contrast, fractional reserve banking, by its very nature (even if it is practiced successfully), involves contracts concerning the transfer of other people’s property. Hence this practice—the issue of fiduciary media—is in principle (inherently) incompatible with the title-transfer theory of contract—and it turns out, not surprisingly, that it is Rothbard, and not his two interpreters, who ultimately demonstrates a better grasp of his own contract theory.