Neither the title-transfer theory of contract nor the principle of freedom of contract supports the claim that the issue of fiduciary media and fractional reserve banking is ethically justified. To the contrary, only one other argument remains in support of the claim that fractional reserve banking represents a legitimate form of business.
The argument boils down to a proof from existence: X, Y, or Z exists; it would not exist if it were not beneficial; hence, it should exist (and outlawing it would be detrimental and morally wrong).
Thus, write Selgin and White:
the group [of people] whose freedom of contract we are concerned with here is not a small eccentric bunch, but is the great mass of people who have demonstrated that they do prefer banks that operate on fractional reserves…. Depositors continue to patronize these banks, demonstrating their preference, for them.
… By the principle of demonstrated preference depositors must be presumed to benefit from the package they have agreed to accept, risk and all.
[Consequently,] [if] any person knowingly prefers to put money into an (interest-bearing) fractional-reserve account, rather than into a (storage-fee-charging) 100 percent reserve account, then a blanket prohibition on fractional-reserve banking by force of law is a binding legal restriction on freedom of contact in the market for banking services.
[Moreover,] … [b]enefits accrue to bank depositors and noteholders, who receive interest and services paid for by the extra bank revenue generated from lending out a portion of its liabilities. Benefits accrue to bank borrowers who enjoy a more ample supply of intermediated credit, and to everyone who works with the economy’s consequently larger stock of capital equipment. And benefits must accrue to bank shareholders, who could choose to have the bank not issue demand liabilities if they found the risks not worth bearing.
Selgin and White have here put the cart before the horse. The existence of a practice, however widespread, has no bearing on the question of whether it is justifiable or not. Consider first, for illustrative purposes, the following analogy concerning the ethical permissibility of a state, that is, of a territorial monopolist of law and order (or of justice and protection).
In the words of Selgin and White (applied here in a different context and paraphrased), the group of people whose freedom of contract we are concerned with is not a small eccentric bunch, but is the great mass of people who have demonstrated that they do prefer states (judges and protectors) that operate on a monopolistic basis. Territorial inhabitants continue to patronize these states, demonstrating their preference for them. By the principle of demonstrated preference, territorial inhabitants must be presumed to benefit from the package they have agreed to accept, risk and all. Consequently, if any person knowingly prefers to put money into a tax-bearing state account, rather than into a protection-fee-charging account in nontaxing justice and protection agencies, then a blanket prohibition on state-formation by force of law is a binding legal restriction on freedom of contract in the market for justice and protection services. Moreover, benefits accrue to state depositors and noteholders, who receive interest and services paid for by the extra state revenue generated from employing parts of the deposits for extra tax collections. Benefits accrue to state borrowers who enjoy a more ample supply of intermediated credit, and to everyone who works with the economy’s consequently larger stock of capital equipment. And benefits must accrue to state shareholders, who could choose to have the state not engage in taxation if they found the risks not worth taking.
Given their own libertarian credentials, Selgin and White would presumably reject this analogy as false and inappropriate. But if so, why? What is it that invalidates the second proof, but not the first? What if anything, makes a blanket prohibition (or permission) of fractional reserve banking categorically different from a blanket prohibition (or permission) of state formation and operation?
The answer—that no such difference exists and that both proofs are equally invalid—is to be found in the Rothbardian principle of demonstrated preference. While Selgin and White invoke this principle in support of their conclusion regarding the ethical permissibility of fractional reserve banking, they miss its implication. The principle of demonstrated preference, as explained by Rothbard in his celebrated “Toward a Reconstruction of Utility and Welfare Economics,” presupposes property rights. Not all demonstrated preferences are ethically permissible or socially beneficial. Instead, the only such preferences that are permissible and welfare enhancing are these that are expressed by means of one’s own property and nothing but one’s own property. Every preference demonstration by means of property other than one’s own—with other people’s property—is impermissible and nonbeneficial.
As for the demonstrated preference for states, it runs afoul of Rothbard’s principle. In Rothbard’s analysis, which is presumably accepted by the participants on both sides of the current debate, the violation can be quickly pinpointed. Private property, as the result of acts of (original) appropriation and/or production, implies the owner’s right to exclusive jurisdiction regarding his property, including the right to employ this property in defense against possible invasions and invaders. Indeed, there can be no property without an owner’s right to physical defense, and it is the very purpose of private property to establish separate domains of exclusive jurisdiction. No private-property owner can possibly surrender his right to ultimate jurisdiction over and defense of his property to someone else—unless he sells or otherwise transfers his property (in which case someone else would have exclusive jurisdiction over it). That is, so long as something (a good) has not been abandoned, its owner must be presumed as retaining these rights; and as far as his relations to others are concerned, every property owner may then only partake in the advantages of the division of labor and seek better and improved protection of his unalterable property rights through cooperation with other owners of property. Every property owner can buy from, sell to, or otherwise contract with everyone else concerning supplemental property protection and security services. Yet each owner also may at any time unilaterally discontinue any such cooperation with others. In distinct contrast, a territorial monopoly of protection and jurisdiction—a state—implies that every property owner is prohibited from discontinuing his cooperation with his protector, and that no one (except the monopolist) may exercise ultimate jurisdiction over his own property. Rather, everyone except the monopolist has lost his right to defense and is thus rendered defenseless vis-à-vis his own protector. Obviously, such an institution stands in contradiction to every owner’s demonstrated preference of not giving up his property. Contrary to their demonstrated preference, the monopolist prohibits the people from using their property in physical defense against possible invasions by himself and his agents. A monopoly of protection and jurisdiction rests thus from the outset on an impermissible act of expropriation (taxation) and provides the monopolist and his agents with a license to further expropriation and taxation. Every owner’s range of permissible actions regarding his own property, and hence the value of his property, is diminished, whereas the monopolist’s range of action and control is correspondingly enlarged and his exclusive privilege is reflected in an increase in the value of his property (capitalization of monopoly profit).
Presently, states exist everywhere, and almost everyone resides under state protection. Regardless of this preference demonstration, however, there is nothing wrong, ethically or economically, with blanket protection against state formation. No one may form a state, for the same reason that no one may expropriate or rob anyone else. In a court of law, it would be sufficient that a single property owner objected to the monopoly’s existence, and the monopolist would have to cease in his current operation as a tax-yielding protection agency and be repaired to the legal status of a nontaxing but fee-charging law-and-security agency (a normal specialized firm). A tax-yielding protection agency is a contradiction in terms—an invasive protector—and must be forbidden, irrespective of any benefits accruing to state depositors, state borrowers, and state owners. To do so is not a legal restriction on freedom of contract in the market for justice and protection services, but the very presupposition of freedom of contract and justice. Everyone putting money or any other resources into a tax-yielding protection account is engaged in unlawful action and subject to punishment.
Just as states exist everywhere, so do fractional reserve banks, and nowadays practically everyone is banking with fractional reserve banks. What, if anything, is the difference between the status of a state and that of a fractional reserve bank? Why should fractional reserve banks not be outlaw banks just as states outlaw protection agencies? To be sure, just as there can be no doubt concerning a demand for protection services, there can also be no doubt as to a demand for banking services. Yet the demand for protection services that private property owners may properly demonstrate does not include a demand for tax-yielding protection services, as we have seen. It exclusively permits a demand for fee-charging protection agencies. Why should an analogous distinction not be true also for banking services? Why should a demand for interest-yielding demand deposit accounts not be just as impermissible as the demand for tax-yielding protection accounts, on the ground that both interest-yielding deposit accounts and tax-yielding property protection are contradictions in terms? Why should the functions of a money warehouser and clearing institution (100-percent-reserve-deposit banking) and as an intermediary of credit (savings-and-loan banking) not be the only just forms of banking (just as fee-charging protection agencies are the only legitimate form of protection)?
The answer depends on whether or not the demonstrated preference for fractional reserve banking services, that is, the issue and acceptance of fiduciary media, involves solely and exclusively the property of the two contracting parties. At any given point in time, the quantity of property (appropriated goods)—whether consumer goods, producer goods, or money—is given. Fractional reserve banking does not increase the quantity of existing property (money or otherwise), nor does it transfer existing property from one party to another. Rather, it involves the production and sale of an increased quantity of titles to an unchanged stock of money property (gold); that is, the supply of and the demand for counterfeit money and illegitimate appropriation. As in every other case of counterfeiting (forgery)—of stock and commodity certificates, banknotes, land titles, original art, etc.—the issue and sale of money copies (banknotes) uncovered by originals (gold) will physically diminish or despoil the original money—stock, commodity, land, or art—owners’ property. But a counterfeiter of money is particularly dangerous and invasive because of money’s defining characteristic as the most easily salable and widely acceptable of all goods; that is, because money-counterfeits open to their seller the widest possible range of objects for undue appropriation (from money to almost every other form of real property).
Thus, it is no wonder that of all forms of forgery, the counterfeiting of money has always held the greatest attraction. So long as money exists there will also exist a persistent demand for counterfeit money. Regardless of this attraction and demand, however, there is nothing wrong with a blanket prohibition against fractional reserve banking. No one may operate a fractional reserve bank for the same reason that no one, in any other line of business, may engage in counterfeiting, that is, the production and sale of titles or copies to non-existing property or originals. In a court of law, it would be sufficient that a single money or other property owner brought suit against a fractional reserve bank as a manufacturer of counterfeit money, and the bank immediately would have to cease its current operation and be reduced to its two original functions: deposits and loans. An interest-yielding (rather than fee-charging) deposit bank is a contradiction in terms: it is a counterfeiting money warehouser, and must be outlawed, irrespective of any benefits accruing to bank depositors, borrowers, and owners. To do so is not a restriction on freedom of contract in the market for banking services, but the requirement of lawful money and banking. Everyone putting money or other resources into interest-yielding deposit accounts is engaged in undue and unlawful appropriation.
The relationship between states and fractional reserve banks is even more intimate, and in any case quite different from that suggested by Selgin and White. They claim that it would be an illegitimate interference with the operation of free markets if the state were to prohibit fractional reserve banking. In fact, fractional reserve banking is the result of an illegitimate state interference with the market, and prohibiting it would only repair this earlier intervention. Selgin and White recognize that in the evolution of a free banking system, 100-percent-reserve-deposit banking and, functionally separated, loan banking, must (praxeologically) precede fractional reserve banking. In their view, fractional reserve banking is the natural outgrowth of an earlier 100-percent-reserve system. However, they do not offer an explanation for this transition as a natural solution to a problem that cannot be solved under the prior system of 100-percent banking (in the way that Austrians conceive of money as the natural solution to the problem of lacking coincidences of wants under a preceding barter system). They merely affirm that the transition actually occurred.
While one can easily see why and how a banker might want to take advantage of the possibilities of counterfeiting, it is just as clear that any such attempt would not go by without quickly and continually being challenged. Surely the current writers and thousands of earlier legal and economic theorists would have accused fractional reserve banks of counterfeiting and would have brought suit against them. The further course of banking evolution would then depend on a court decision. If the court decided that the issue of fiduciary media qua titles to money uncovered by money constitutes counterfeiting, fractional reserve banks would not come into existence; and only if it decided otherwise would they ever actually appear. Nothing in this evolution is natural; everything appears rather deliberate. Nor would the outcome of such trials naturally be to Selgin and White’s liking. On the contrary, if one were to assume that fractional reserve bankers would be tried on counterfeiting charges before a jury of their own peers (of other businessmen), we dare say that, empirically, the overwhelming number of such cases would end in conviction (the testimony of Selgin and White notwithstanding). Why, then, the almost complete dominance of fractional reserve banking?
The answer is that the courts deciding these matters everywhere are state courts. Only if a single court possesses a territorial monopoly of jurisdiction is it possible that the dispute at hand could be settled once and for all. And that it has been uniformly settled in the way it was, that is, by permitting rather than prohibiting fractional reserve banking, follows from the interest of every court and judge qua state court and state judge. The owners and agents of the state recognize fully as much as bankers the potentials of money counterfeiting as a source of income. In permitting bankers to issue fiduciary media (rather than prohibiting the practice as counterfeiting), banks are made existentially dependent on the state. They can only operate because the state, due to its territorial monopoly of jurisdiction, shields them from counterfeiting suits; and the state does so only under the provision that banks will share with it in the extra revenue and credit derived from legalized counterfeiting. Hence, by permitting fractional reserve free banking the state actually creates the first and preliminary form of a joint-bank-state-counterfeiting cartel under its own ultimate control.
Once fractional reserve banking receives blanket protection from the state, it follows naturally that fractional reserve banks will outcompete 100 percent reserve banks. Not, as Selgin and White 25 assert, because they are better or more efficient banks, but for the reason that, once money counterfeiting is permitted, banks that engage in it tend to outcompete banks that do not. That is, for the same reason that, once industrial air pollution is permitted a polluting steel producer will tend to outcompete a steel producer who does not pollute, and for the same reason that a protection agency with taxing powers, a state, will tend to outcompete protectors without taxing power. Put differently, it is not always the case that good drives out bad. This is the case only so long as private property rights are inviolate. If they are not, and there exist privileged agents or agencies, who are exempt from the universal rules regarding the appropriation, production and transfer of property, then these will tend to outcompete other normal agents. In this case, bad drives out good. Thus, it is completely mistaken to interpret the empirical success of fractional reserve banking as proof of its greater economic efficiency. The success of fractional over 100 percent deposit banking is no more a market phenomenon than is the success of tax-yielding protectors, states, over competitive and nontaxing security producers. It is false to suggest, as Selgin and White do, that fractional reserve banking has stood the market test and represents the outcome of voluntary consumer choices. After all, 100-percent-reserve-deposit banking is not outlawed and consumers are free to bank with them instead of fractional banks if they so prefer. Or would they likewise argue that the polluting steel producer had stood the test of the market because, after all, consumers are free to buy their steel from nonpolluting steel producers, or that states have proven themselves in the market because, after all, consumers are free to buy their security also from agencies without any tax and jurisdictional powers?
Moreover, whereas 100-percent-reserve banking is crisis-proof, fractional reserve banking, as even Selgin and White admit, is not in fact, as we can only briefly indicate here. A system of free fractional reserve banking will, in accordance with Mises’s theory of interventionism, lead to further state interventions and the successive devolution of money. Free fractional reserve banking qua state-protected competition in counterfeiting will lead to a steady contest among banks of testing the viability of increasingly lower reserve ratios. This is bound to lead to banking crises, and these will be used by governments for the introduction of central banking. Central banking leads to still more counterfeiting, and to the abolition of commodity money and adoption of national fiat currencies. Lastly, international—inter-central bank—competition in fiat money counterfeiting will lead to state bankruptcies, and their financial default will be used by the most powerful among the surviving states for the establishment of a one-world government, central bank, and fiat currency.
Hence, the solution proposed by Selgin and White to the current monetary disorder, that is, a gold-based free—fractional reserve—banking system, is in fact the initial interventionist cause of virtually all contemporary monetary problems.