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The Libertarian Case Against Fractional-Reserve Banking
7/22/2003

A number of libertarians, first and foremost among them Murray Rothbard, have claimed that fractional-reserve banking is inherently a violation of libertarian principles, and ought to be outlawed in any libertarian society. I will examine some of their claims in this article.

But first, I want to briefly review the basics of fractional-reserve banking and compare it to the system preferred by its critics, 100-percent reserve banking. I will set the stage for the comparison by describing the aspects of a libertarian monetary system that are generally agreed upon by both the defenders and critics of fractional-reserve banking.

First of all, both sides agree that money should not be monopolized by the state (if, indeed, there is any state). All economic actors can attempt to issue money, within the limits proscribed by libertarian law (e.g., one may not murder babies and attempt to use their shrunken heads as money). Banks should not be legally privileged entities: the same responsibility to fulfill their contracts and the same laws against fraud and theft should apply to them as to all other enterprises.

Having agreed to the above, the two libertarian camps split as to whether fractional-reserve banking is permissible within this framework. Let us imagine that gold is the generally accepted medium of exchange that serves as money in such a libertarian society. Banks may operate in one of two general ways. The first, called 100-percent reserve banking, consists in taking in gold for safekeeping and issuing receipts, or bank notes, for exactly the amount of gold on deposit. For every note in circulation at any one time, the bank always has in its possession the full amount of gold to which the note entitles the bearer. One-hundred-percent reserve banks must charge depositors for safekeeping their gold, since they earn nothing from note issuance, while bearing the costs of printing the notes, redeeming them, and storing the gold.

The other way banks might operate is called fractional-reserve banking. Fractional-reserve banks take in gold for deposit, but then issue more notes than they have gold in their vaults. They can profit from lending out the additional notes at interest. Because they can profit in a way not open to 100-percent reserve banks, they can actually pay interest on their deposits, rather than having to charge depositors.

Of course, under such a method of operation, the bank and its depositors run the risk that too many people will try to withdraw their gold at one time. Then the bank will not be able to meet all of their demands. Upon hearing of its failure to do so, other depositors may demand their gold as well. Such an event is called a "run on the bank." A fractional-reserve bank that is genuinely attempting to fulfill its obligations will try to carefully manage its reserves so that runs will not occur. It might also stipulate, in its deposit contracts, that depositors’ gold is only generally available on demand. Should the gold not be available when requested, the bank might promise to pay additional interest on the deposit until such time as it can fulfill the request.

The issue that divides libertarians here is whether the second method of operation is legitimate in a libertarian society. Those advocating that fractional-reserve banking be illegal base their case on several arguments.

The first charge brought against fractional-reserve banking is that it is simply a variety of fraud. The banks have promised to pay out gold on demand, but that is a promise they know they cannot fulfill, at least not all of the time. Some critics of fractional-reserve banking go further and insist that the moment that people realize what a fractional-reserve bank is doing, a run is inevitable. Per their reckoning, it is only by hiding the nature of their shady business that such banks stay in business for a single day.

But surely the question of whether a fractional-reserve bank is engaged in fraud depends on what its customers, and those accepting notes from them, think is going on. For instance, if I know that the contract I have signed to buy the Brooklyn Bridge is a joke designed for novelty purposes, there is no fraud involved. If depositors have somehow been led to believe that all of their gold is held in the bank’s vaults, then clearly it is fraudulent to lend some of that gold out, or to issue more notes than the amount of gold held. And clearly if those accepting the notes in payment believe they are receiving 100-percent reserve notes when they are not, they have been defrauded.

However, if both the depositors and those accepting the notes as payment know they are dealing with a fractional-reserve bank, it is hard to see how a claim of fraud can be sustained. A critic of fractional-reserve banking might contend that they are foolish to engage in such a risky activity, but where could he point to a person who has been deceived? And, since fraud by definition involves deception, if no one has been deceived, there is no fraud.

How, exactly, do we then determine if the people involved understand that they are dealing with a fractional-reserve bank?

I recall reading, many years ago, a discussion by William F. Buckley of a case where a consumer had brought a lawsuit against, I believe, Quaker. The problem, it seemed, was that he had bought some product of the company—grits, if I remember correctly—that had pictured two fried eggs alongside the grits on the package. He believed that, given the packaging, he was entitled to two eggs as well as the grits actually contained in the carton. Buckley asked whether any reasonable consumer could actually expect to find two long-since fried eggs inside a carton of dry goods sitting on an unrefrigerated shelf. He pointed out that there was an image of Ben Franklin on the package, and wondered if Quaker was also liable for not stuffing Franklin’s remains in the carton?

But such considerations are necessarily embedded in a tradition of common commercial practice and case law. For example, in a society, such as medieval Europe, where relics of deceased holy men were highly valued, the picture of a dead saint on a package might actually imply that one would find a bit of his remains inside. ("A lucky bone from St. Jerome inside every specially marked package of Benedictine grits.")

The question as to whether the marketing or presentation of a product is fraudulent must, as I see it, be based on the expectations of the "typical consumer." Of course, this is a fuzzy concept. That being the case, the old dictum caveat emptor should probably decide the borderline cases. However, there is little question that if a restaurant sells "Irish stew" on its menu, customers expect a stew made with either beef or lamb. If, upon ordering it, a customer discovers the meat in the stew is actually that of a stray dog killed by the restaurant owner, it is clear to me that he has been defrauded, despite the fact that the dish may indeed be a stew prepared in the Irish fashion.

On the other hand, the courts should ignore the beliefs of an especially obtuse consumer. The fact that someone buys birdseed expecting that he will be able to grow birds from it should not open the seller to charges of fraud.

Therefore, the question of whether fractional-reserve banking is fraudulent in any particular case must turn on typical expectations about what such notes imply. There is no a priori answer to such a question. In a society where 100-percent reserve banking was the norm and I opened the very first fractional-reserve bank, the burden on me to explain my product well might be very high. On the other hand, in a society where almost all banking was fractional-reserve and most people were quite familiar with the practice, it might be taken as a matter of course that banknotes were claims on fractional reserves. Legal precedent and an estimate of the beliefs of the typical consumer must be relied upon to resolve each case.

Nevertheless, it seems to me that as a first rough cut as to what would be sufficient to dismiss fraud charges against an fractional-reserve bank, a contract signed with depositors informing them that there deposits are not held in full in the bank and some indication on the notes themselves that they are claims on fractional reserves ought to pass muster. Some fractional-reserve banking critics might contend that under such conditions, no one would patronize fractional-reserve banks. I doubt that is true, but even if it were the case, it would be a purely practical, not a legal, matter.

Another charge made by some libertarians against fractional-reserve banking is that it creates "claims to goods" that are not based on previous production. One sometimes hears this phrased: "Fractional-reserve banking creates money out of thin air."

Such objections represent a lapse into long-discredited cost of production or labor theories of value. Money is not a "claim" to goods; it is a good itself. Its value arises not from the amount of effort or the cost involved in producing it, but in whatever value people assign to it in making their choices.

Imagine that my physiology was constituted so that, for some reason, my farts smelled so sweet that people would pay to have the chance to inhale them. I could earn money from my flatulence despite the fact that I expended no effort at all in producing it, beyond the ordinary digestive processes I would need to engage in anyway to remain alive. Well, so what? I am producing value out of thin (or perhaps thick) air, but the fact remains that other people do value my gaseous emissions, and are willing to pay to enjoy them. Should I stop producing them out of some feeling of guilt at my undeserved windfall, this would represent a net loss in the satisfaction of my fellow humans.

More realistically, we see every day that people profit from talents and attributes that they expended no effort to procure. A woman born with striking good looks can gain from them by, perhaps, producing a calendar with photographs of her adorning each month. To produce the calendar, of course, takes some resources, but it is clear that the bulk of the proceeds from its sales arise from the woman’s beauty, which was a free gift of nature. Should libertarians work to outlaw such gains?

Moving closer to the case in question, we could envision that a large meteor crashes into my backyard. When I go out to have a look at it, I find it is made of pure gold. Even in a society where gold is money and 100-percent reserve banking is practiced, I have found myself with a large quantity of new "claims to goods" that I did nothing to produce. Do anti-fractional-reserve-banking libertarians want to claim that I have no right to drag my meteor to the bank and cash in on my good luck? Given the people are willing to pay for gold, and that therefore it is a scarce good, how would I benefit others by destroying this free gift of gold that dropped from the sky?

If someone can create something that people value without expending any valuable resources to produce it, this is a great blessing. Those resources are now available for other uses. If the meteor I found reduces the world demand for gold, some resources that would have been devoted to mining can now be used for other purposes.

Unfortunately, a fractional-reserve bank does not produce money "out of thin air." Instead, it produces money by careful management of its reserves and its loan portfolio. If a bank is reckless with its note issuance or makes too many bad loans, its notes begin to trade at a discount to their face value. If the bank is reckless enough, their value can drop to nothing at all. The claim that fractional-reserve banks produce money "out of thin air" would not be an indictment of them if it were true, but it also happens to be false.

The last complaint about fractional-reserve banking I will address is that it will inevitably "de-stabilize" the economy in which it operates. This, it seems to me, is a strange complaint for a libertarian to make. If fractional-reserve banking is a rights violation, then the charge that it will de-stabilize the economy is superfluous: it should be forbidden even if it would stabilize the economy. On the other hand, if all rights-violating charges against fractional-reserve banking are dismissed, is there then a further hurdle actions must cross before they are to be permitted: that they not de-stabilize the economy? This seems to open the door for every sort of interference with voluntary trade. Closing a factory, shorting a currency, pioneering a new product or way of manufacturing—all of these things can de-stabilize an economy to some extent.

As Schumpeter, Mises, Lachmann, Shackle, and other economists have pointed out, a market economy is in a constant state of being "de-stabilized." The human desire to improve our conditions continually replaces old methods of production with new ones, renders machinery produced at great cost obsolete, and makes jobs in which workers have invested years of training disappear. If fractional-reserve banking is truly de-stabilizing, then it represents a profit opportunity for some entrepreneur to find a way to hedge against, and thus dampen, this de-stabilization.

In brief, I do not find any of the libertarian arguments against fractional-reserve banking compelling. The charge of fraud can be handled by clear deposit contracts and proper labeling of notes, while the other two charges I address are either empty or irrelevant. It may be that bank customers would reject fractional-reserve banks if fully informed about their operation—although, again, I doubt that is true—but that is only an argument for full disclosure, not for banning the practice.


Gene Callahan is an adjunct scholar at the Ludwig von Mises Institute and the author of the book, Economics For Real People.

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