Banks perform two strictly separate tasks, only one of which has been considered so far. On the one hand, they serve as depositing institutions, offering safekeeping and clearing services. They accept deposits of (commodity) money and issue claims to money (warehouse receipts; money substitutes) to their depositors, redeemable at par and on demand. For every claim to money issued by them they hold an equivalent amount of genuine money on hand, ready for redemption (100 percent reserve banking). No interest is paid on deposits. Rather, depositors pay a fee to the bank for providing safekeeping and clearing services. Under conditions of free competition—free entry into the banking industry—the deposit fee, which constitutes a bank’s revenue and possible source of profit, tends to be a minimum fee; and the profits—or rather, the interest returns—earned in banking tend to be the same as in any other, nonbanking industry.
On the other hand, originally entirely separate institutionally from deposit institutions, banks also serve as intermediaries between savers and investors—as loan banks. In this function they first offer and enter into time-contracts with savers. Savers loan money to the bank for a specified—shorter or longer—period of time in exchange for the banks’ contractual obligation of future repayment plus some additional interest return. From the point of view of savers, they exchange present money for a promise of future money: the interest return constituting their reward for performing the function of waiting. Having thus acquired temporary ownership of savings from savers, the bank then reloans the same money to investors (including itself) in exchange for the latters’ obligation of future repayment and interest. The interest differential—the difference between the interest paid to savers and that charged to borrowers—represents the price for intermediating between savers and investors and constitutes the loan bank’s income. As for deposit banking and deposit fees, under competitive conditions the costs of intermediation also tend to be minimum costs, and the profits from loan banking likewise tend to be the same as those that can be earned elsewhere.
Neither deposit banking nor loan banking as characterized here involve an increase in the money supply or a unilateral income or wealth redistribution. For every newly issued deposit note an equivalent amount of money is taken out of circulation (only the form of money changes, not its quantity), and in the course of loan banking the same sum of money simply changes hands repeatedly. All exchanges—between depositors and depositing institution as well as between savers, the intermediating bank and investors—are mutually advantageous.
In contrast, fractional reserve banking involves a deliberate confusion between the deposit and the loan function. It implies an increase in the money supply, and it leads to a unilateral income redistribution in the bank’s favor as well as to economic inefficiencies in the form of boom-bust business cycles.
The confusion of both banking functions comes to light in the fact that under fractional reserve banking, either depositors are being paid interest (rather than having to pay a fee), and/or savers are granted the right of instant withdrawal (rather than having to wait with their request for redemption until a specified future date). Technically, the possibility of a bank’s engaging in such practices arises out of the fact that the holders of demand deposits (claims to money redeemable on demand, instantly, at par) typically do not exercise their right simultaneously, such that all of them approach the bank with the request for redemption at the same time. Accordingly, a deposit bank will typically hold an amount of reserves (of money proper) in excess of actual daily withdrawals. It becomes thus feasible for the bank to loan these “excess” reserves to borrowers, thus earning the bank an interest return (which the bank then may partially pass on to its depositors in the form of interest paying deposit accounts).
Proponents of fractional reserve banking usually claim that this practice of holding less than 100 percent reserves represents merely an innocuous money “economizing,” and they are fond of pointing out that not only the bank, but depositors (receiving interest) and savers (receiving instant withdrawal rights) profit from the practice as well. In fact, fractional reserve banking suffers from two interrelated fatal flaws and is anything but innocuous and all-around beneficial. First off, it should be noted that anything less than 100 percent reserve deposit banking involves what one might call a legal impossibility, for in employing its excess reserves for the granting of credit, the bank actually transfers temporary ownership of them to some borrower, while the depositors, entitled as they are to instant redemption, retain their ownership over the same funds. However, it is impossible that for some time depositor and borrower are entitled to exclusive control over the same resources. Two individuals cannot be the exclusive owner of one and the same thing at the same time. Accordingly any bank pretending otherwise—in assuming demand liabilities in excess of actual reserves—must be considered as acting fraudulently. Its contractual obligations cannot be fulfilled. From the outset, the bank must be regarded as inherently bankrupt—as revealed by the fact that it could not, contrary to its own presumption, withstand a possible bank run.
Second, in lending its excess reserves to borrowers, the bank increases the money supply, regardless whether the borrowers receive these reserves in the form of money proper or in that of demand deposits (checking accounts). If the loan takes the form of genuine money, then the amount of money proper in circulation is increased without withdrawing an equivalent amount of money substitutes from circulation; and if it takes the form of a checking account, then the amount of money substitutes is increased without taking a corresponding amount of genuine money out of circulation. In either case, there will be more money in existence now than before, leading to a reduction in the purchasing power of money (inflation) and, in its course, to a systematic redistribution of real income in favor of the bank and its borrower clients and at the expense of the nonbank public and all other bank clients. The bank receives additional interest income while it makes no additional contribution whatsoever to the real wealth of the nonbank public (as would be the case if the interest return were the result of reduced bank spending, i.e., savings); and the borrowers acquire real, nonmonetary assets with their funds, thereby reducing the real wealth of the rest of the public by the same amount.
Moreover, insofar as the bank does not simply spend the excess reserves on its own consumption but instead loans them out against interest charges, invariably a business cycle is set in motion.The quantity of credit offered is larger than before. As a consequence, the price of credit—the interest charged for loans—will fall below what it otherwise would have been. At a lower price, more credit is taken. Since money cannot breed more money, in order to be able to earn an interest return and a pure profit on top of it, the borrowers will have to convert their borrowed funds into investments. That is, they will have to purchase or rent factors of production—land, labor, and possibly capital goods (produced factors of production)—capable of producing a future output of goods whose value (price) exceeds that of the input. Accordingly with an expanded volume of credit, more presently available resources will be bound up in the production of future goods (instead of being used for present consumption) than otherwise would have been; and in order to complete all investment projects now under way, more time will be needed than that required to complete only those that would have been begun without the credit expansion. All the future goods which would have been created without the expansion plus those that are newly added on account of the credit expansion must be produced.
However, in distinct contrast to the situation in which the interest rate falls due to a fall in the rate of time preference (the degree to which present goods are preferred over future goods), and hence where the public has in fact saved more so as to make a larger fund of present goods available to investors in exchange for their promise of a return of future goods, no such change in time preference and savings has taken place in the case under consideration. The public has not saved more, and accordingly, the additional amount of credit granted by the bank does not represent commodity credit (credit covered by nonmoney goods which the public has abstained from consuming), but it is fiduciary or circulation credit (credit that has been literally created out of thin air—without any corresponding sacrifice, in the form of nonconsumed nonmoney goods, on the part of the creditor). Had the additional credit been commodity credit, an expanded volume of investment activities would have been warranted. There would have been a sufficiently large supply of present goods that could be devoted to the production of future goods such that all—the old as well as the newly begun—investment projects could be successfully completed and a higher level of future consumption attained. If the credit expansion is due to the granting of circulation credit, however, the ensuing volume of investment must actually prove overambitious. Misled by a lower interest rate, investors act as if savings had increased. They withdraw more of the presently available resources for investment projects, to be converted into future capital goods, than is warranted in light of actual savings. Consequently, capital goods prices will increase initially relative to consumer goods prices, but once the public’s underlying time preference rate begins to reassert itself, a systematic shortage of consumer goods will arise. Accordingly, the interest rate will adjust upward, and it is now consumer goods prices which rise relative to capital goods prices, requiring the liquidation of part of the investment as unsustainable malinvestment. The earlier boom will turn bust, reducing the future standard of living below the level that otherwise could have been reached.
Among recent proponents of fractional reserve banking the cases of Lawrence White and George Selgin deserve a few critical comments, if for no other reason than that both are critics of Friedmanite monetarism who hark back, instead, to the tradition of Austrian and in particular Misesian monetary theory. Their monetary ideal is a universal commodity money such as an international gold standard and, based on this, a system of competitive banking which, they claim, would—and should be permitted to do so for reasons of economic efficiency as well as justice—engage in fractional reserve banking and the granting of fiduciary credit.
As to the question of justice, White and Selgin offer but one argument destined to show the allegedly nonfraudulent character of fractional reserves: that outlawing such a practice would involve a violation of the principle of freedom of contract by preventing “banks and their customers from making whatever sorts of contractual arrangements are mutually agreeable.” Yet this is surely a silly argument. First off, as a matter of historical fact fractional reserve banks never informed their depositors that some or all of their deposits would actually be loaned out and hence could not possibly be ready for redemption at any time. (Even if the bank were to pay interest on deposit accounts, and hence it should have been clear that the bank must loan out deposits, this does not imply that any of the depositors actually understand this fact. Indeed, it is safe to say that few if any do, even among those who are not economic illiterates.) Nor did fractional reserve banks inform their borrowers that some or all of the credit granted to them had been created out of thin air and was subject to being recalled at any time. How, then, can their practice be called anything but fraud and embezzlement!
Second, and more decisive, to believe that fractional reserve banking should be regarded as falling under and protected by the principle of freedom of contract involves a complete misunderstanding of the very meaning of this principle. Freedom of contract does not imply that every mutually advantageous contract should be permitted. Clearly, if A and B contractually agree to rob C, this would not be in accordance with the principle. Freedom of contract means instead that A and B should be allowed to make any contract whatsoever regarding their own properties, yet fractional reserve banking involves the making of contracts regarding the property of third parties. Whenever the bank loans its “excess” reserves to a borrower, such a bilateral contract affects the property of third parties in a threefold way. First, by thereby increasing the money supply, the purchasing power of all other money owners is reduced; second, all depositors are harmed because the likelihood of their successfully recovering their own possessions is lowered; and third, all other borrowers—borrowers of commodity credit—are harmed because the injection of fiduciary credit impairs the safety of the entire credit structure and increases the risk of a business failure for every investor of commodity credit.
In order to overcome these objections to the claim that fractional reserve banking accords with the principle of freedom of contract, White and Selgin then, as their last line of defense, withdraw to the position that banks may attach an “option clause” to their notes, informing depositors that the bank may at any time suspend or defer redemption, and letting borrowers know that their loans may be instantly recalled. While such a practice would indeed dispose of the charge of fraud, it is subject to another fundamental criticism, for such notes would no longer be money but a peculiar form of lottery tickets. It is the function of money to serve as the most easily resalable and most widely acceptable good, so as to prepare its owner for instant purchases of directly or indirectly serviceable consumer or producer goods at not yet known future dates; hence, whatever may serve as money so as to be instantly resalable at any future point in time, it must be something that bestows an absolute and unconditional property right on its owner. In sharp contrast, the owner of a note to which an option clause is attached does not possess an unconditional property title. Rather, similar to the holder of a “fractional reserve parking ticket” (where more tickets are sold than there are parking places on hand, and lots are allocated according to a “first-come-firstserved” rule), he is merely entitled to participate in the drawing of certain prizes, consisting of ownership or time-rental services to specified goods according to specified rules. But as drawing rights—and not unconditional ownership titles—they only possess temporally conditional value until the time of the drawing, and they become worthless as soon as the prizes have been allocated to the ticket holders; thus, they would be uniquely unsuited to serve as a medium of exchange.
As regards the second contention: that fractional reserve banking is economically efficient, it is noteworthy to point out that White, although he is undoubtedly familiar with the Austrian-Misesian claim that any injection of fiduciary credit must result in a boom-bust cycle, nowhere even mentions the problem of business cycles. Only Selgin addresses the problem. In his attempt to show that fractional reserve banking does not cause business cycles, however, Selgin then falls headlong into the fundamental Keynesian error of confusing the demand for money (determined by the utility of money) and savings (determined by time preference).
According to Selgin, “to hold inside money is to engage in voluntary saving”; and accordingly “an increase in the demand for money warrants an increase in bank loans and investments” because
[w]henever a bank expands its liabilities in the process of making new loans and investments, it is the holders of the liabilities who are the ultimate lenders of credit, and what they lend are the real resources they could acquire if, instead of holding money, they spent it.
Based on this view of the holding of money as representing saving and an increased demand for money as being the same thing as increased saving, then, Selgin goes on to criticize Mises’s claim that any issuance of fiduciary media, in lowering the interest rate below its “natural” level, must cause a business cycle as “confused.” “No ill consequences result from the issue of fiduciary media in response to a greater demand for balances of inside money.”
Yet the confusion is all Selgin’s. First off, it is false to say that the holding of money (the act of not spending it), is equivalent to saving. One might as well say—and this would be equally wrong—that the not-spending of money is equivalent to not saving. In fact, saving is not-consuming, and the demand for money has nothing to do with saving or not-saving. The demand for money is the unwillingness to buy or rent nonmoney goods, and these include consumer goods (present goods) and capital goods (future goods). Not-spending money is to purchase, neither consumer goods nor investment goods. Contrary to Selgin, then, matters are as follows: Individuals may employ their monetary assets in one of three ways. They can spend them on consumer goods; they can spend them on investment; or they can keep them in the form of cash. There are no other alternatives. While a person must at all times make decisions regarding three margins at once, invariably the outcome is determined by two distinct and praxeologically unrelated factors. The consumption/investment proportion (the decision of how much of one’s money to spend on consumption and how much on investment) is determined by a person’s time preference (the degree to which he prefers present consumption over future consumption). On the other hand, the source of his demand for cash is the utility attached to money (the personal satisfaction derived from money in allowing him immediate purchases of directly or indirectly serviceable consumer or producer goods at uncertain future dates).
Accordingly, if the demand for money increases while the social stock of money is given, this additional demand can only be satisfied by bidding down the money prices of nonmoney goods. The purchasing power of money will increase, the real value of individual cash balances will be raised, and at a higher purchasing power per unit money, the demand for and the supply of money will once again be equilibrated. The relative price of money versus nonmoney will have changed. But unless time preference is assumed to have changed at the same time, real consumption and real investment will remain the same as before: the additional money demand is satisfied by reducing nominal consumption and investment spending in accordance with the same pre-existing consumption/investment proportion, driving the money prices of both consumer as well as producer goods down and leaving real consumption and investment at precisely their old levels. If time preference is assumed to change concomitantly with an increased demand for money, however, then everything is possible. Indeed, if spending were reduced exclusively on investment goods, an increased demand for money could even go hand in hand with an increase in the rate of interest and reduced saving and investment. However, this, or the equally possible opposite outcome, would not be due to a change in the demand for money but exclusively to a change (a rise, or a fall) in the time preference schedule. In any case, if the banking system were to follow Selgin’s advice and accommodate an increased demand for cash by issuing fiduciary credit, the social rate of time preference would be falsified, excessive investment would result, and a boom-bust cycle would be set in motion, rendering the practice of fractional reserve banking fraudulent as well as economically inefficient.
White’s and Selgin’s proposal of a commodity money based system of competitive fractional reserve banking—of partial fiat money—is neither just (and hence the term “free banking” is inappropriate), nor does it produce economic stability. It is no fundamental improvement as compared to the monetarist reality of monopolistically issued pure fiat currencies. Indeed, in one respect Friedman’s pure fiat money proposal contains a more realistic and correct analysis than White’s and Selgin’s because Friedman recognizes “what used to be called ‘the inherent instability’ of fractional reserve banking,” and he understands that this inherent instability of competitive fractional reserve banking will sooner or later collapse in a “liquidity crisis” and then lead to his favored regime—a governmentally provided pure fiat currency—anyway.
Only a system of universal commodity money (gold), competitive banks, and 100-percent-reserve deposit banking with a strict functional separation of loan and deposit banking constitutes a just monetary system that can assure economic stability and present a genuine answer to the current monetarist fiasco.