August 27, 2015

Fractional Reserve Banking and the Present System

By In Articles, Economics

In an earlier post, I explained that fractional reserve banking was the scenario in which there are more claims to money than can be fulfilled by the supply of money held in reserve.  The nature of these claims must not be like “lottery tickets,” wherein there is only a chance that the money claimed will actually be redeemed.  If they are, then we are not talking about fractional reserve banking properly understood.   I roughly defined fractional reserve banking [FRB] as the following:

[FRB] is, by definition, a contract wherein it is agreed upon that the money deposited is a bailment that is to be returned upon demand by the customer; wherein at the same time, that money is loaned out to some other customer.

Thus and therefore, FRB constitutes a breach of contract.  And according to this definition, Bionic Mosquito, to whom I have been responding, agrees that FRB is a breach of contract.  The problem for him is that he argues that this is not the common definition of FRB (more on this below).  But in any case, according to that definition, FRB is a breach of contract, and thus, illegitimate.

But this leads us to a tricky problem.  For as my esteemed critic has pointed out, and as I too seemed to imply, our modern banking system, not being one in which the above contract was signed, appears to escape the definition of FRB!  In which case, the entire plethora of Austrian works pointing the finger to our current Fractional Reserve system for our economic woes are entirely confused –for perhaps we don’t have an FRB system at all.

In order to address this problem, which is one I anticipated but decided to leave out of my previous article due to considerations of length, I will lean heavily on an essay by Hans-Hermann Hoppe [with Guido Hulsmann and Walter Block] entitled “Against Fiduciary Media.”  Here, Hoppe touches on this exact problem as he seeks to dismantle the stalwarts of the “Free Banking” camp– George Selgin and Lawrence White. Let me reiterate once again, that although Bionic Mosquito (BM) at this point seems to take Selgin/White’s position over against the Full Reserve camp, BM is a vigorous champion of the Hoppean formulation of the libertarian private property society.

So as to not completely regurgitate my previous article on the matter (it must be read in order to understand where I am coming from), I will simply start where I left off.  We must ask ourselves: what is the nature of today’s deposit contract?  When one puts his money in the bank, what is the legal nature of that transaction?  It would seem that the de facto position of the full reserve camp is to say that the deposit is clearly not a loan– the money deposited still belongs to him!  To which BM and the free bankers would immediately say: “but that’s not what the contract itself states.”  In other words, there is a distinction between the theoretical construction of money and banking and the real life contracts that have been agreed upon in our current situation.  And since the modern contracts do not indicate that money deposited is guaranteed to be returned upon demand, there is no breach of contract and (applying my own definition of FRB) no Fractional Reserve banking.  Or so it appears and the free bankers argue.

To remedy this problem, we need to step back a bit.

In part one of Hoppe’s essay, he defines FRB as I do, concluding that

two individuals cannot be the exclusive owner of one and the same thing at the same time. 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.  Yet this is precisely what a fractional-reserve agreement between bank and customer involves.

Now, BM agrees that Fractional Reserve Banking is a breach of contract assuming my definition. Part of his argument against me is that I take up a definition that he does not see as common.  So he provides an alternative from the Mises Wiki page:

Fractional-reserve banking (or FRB) is the widespread banking practice in which only a fraction of a bank’s demand deposits are kept in reserve and available for immediate withdrawal (as cash and other highly liquid assets), whilst the remaining cash is lent out to borrowers (and so is never actually available for immediate withdrawal to legitimate deposit-holders). The bank in effect lends out most or even all of the funds it receives in demand deposits, whilst at the same time guaranteeing that all deposits are available for immediate withdrawal upon demand.

I actually don’t mind this definition at all, but I think it lends support to my case, rather than BM’s.  For notice the end part: whilst at the same time guaranteeing that all deposits are available for immediate withdrawal upon demand.  For Bionic to use this definition, he would have to change it to: “whilst at the same time guaranteeing (with exceptions) that some deposits may be available for withdrawal, sometimes immediately, sometimes after a waiting period.”  My point here is not that Bionic Mosquito is wrong in his scheme of things (for these are just definitions– and this shouldn’t just be a silly semantic argument), but rather that my own definition is not abnormal (and I had previously justified my definition with de Soto and Rothbard).

Now then, back to Hoppe and the theory of fractional reserves.  To reiterate, what I aim to show here is that, even given my definition of fractional reserve banking, I can justify the accusation that the current system is based on fractional reserves.  To do this, the present system needs to be clarified.

Hoppe argues that the problem with the free banking argument that today’s depository contract provides an example of a non-fraudulent FRB contract, lies with the contract itself in that the contract does not represent the actions of the two parties in fact.  In other words, whereas the modern deposit contract appears to escape being a bailment contract, the action of the contract’s parties contradict this.*  To explain this, let’s start with the following: a praxeological foundation. When a bank client and a bank make an agreement about the nature of the money being deposited,

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.

He continues:

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.

Selgin and White argue the same as BM by asking: “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.”  And the answer is simple: if the nature of the demand deposit is that it is a debt, then the claim must be a title to a quantity of future money, not a present money, for the present money is presently under the ownership of the bank.  And if this is the case, then the very idea that the money can be available on demand by the depositor contradicts the nature of the debt transaction itself.  In other words, the current depository contract is subject to the same criticism that Hoppe applies to Selgin/White:

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.

So then, under the present system, the Selgin/White assumption is that clients and banks have agreed to make warehouse receipts debts so that, rather than the bank holding the money in reserve on behalf of the client, the client is agreeing that the bank is now the owner of the present use of the money. However, in fact, as Hoppe points out,

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. 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.

But this is not the end of the current system. The fractional reserve system comes to life through this confusion of the nature of the depository contract.

[A]s 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 th 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.

To summarize Hoppe’s argument here, we must realize that even though the modern depository contract seems to indicate that the deposit is not a bailment, the client of the bank acts as if it is a bailment because, on a daily basis he uses that money at the same time as the bank has issued more notes to other people representing the legal use of the very same money.  The problematic scenario is one in which the actions of the various parties contradict the nature of the contract.  Hoppe continues:

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).

So then, because in fact the depositor maintains ownership of the present use of the money and in so acting shows that the money deposited is not actually a debt at all, we therefore can conclude that the extension of demand titles to the money to both A and B, constitutes fractional reserve banking.

If the depositor simply hands over the ownership of the present use of the money (that is, he loans his money to the bank), then there is no fractional reserve banking necessary.  jgkjhIt is only because, in our current system, the depositor has the ability to demand the present use of his money at the same time as a borrower has the ability to demand the present use of that money, that we can call it a fractional reserve system.  The bank has merely expanded the number of money substitutes (claims for the money) in the economy via the bank loaning process, but it has not expanded the money itself (now of course, in our fiat system, the money itself can also be printed… but that is not an example of fractional reserve banking per se– that is just run-of-the-mill inflation of the monetary base).**

In conclusion, even if the reader has read Hoppe on fractional reserve banking before, I highly encourage going through the lesser known essay Against Fiduciary Media because it is the most pointed response to the Selgin/White camp. It addresses the very issues discussed in the past several articles in this series.


*In fact, Hoppe makes an even stronger argument, based on praxeological a priori argumentation (in classic Hoppean fashion) by stating:

[Selgin and White] 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.

**For more on this, I recommend familiarizing oneself with Mises’ taxonomy of money.  Among Austrians, there is actually some debate about the proper Misesian taxonomy.  In Robert Murphy’s excellent new book he provides this taxonomy.  However, Guido Hulsmann argues that this one is misleading and instead offers this one.  I follow Hulsmann here.  Hulsmann explains (chapter 1 here):

The diagram [the one republished by Murphy] reflects precisely that sort of thinking about money that Mises wished to overcome. It clings to the physical surface of things. To- ken coins seem to be always fiduciary media, and money certificates seem to have nothing to do with deposits or tokens or banknotes, etc. The very point of Mises’s theory was that these physical manifestations could be very different economic goods, depending on the legal and contractual context.

I actually think that Selgin/White and the free banking folks (not necessarily BM) may be confused precisely because they misunderstand the taxonomy. Hoppe basically says as much about Selgin/White in the above linked essay.  But this is a topic for a future article.

Written by C.Jay Engel

Editor and creator of The Reformed Libertarian. Living in Northern California with his wife, he writes on everything from politics to theology and from culture to economic theory. You can send an email to
  • Understanding the fraud that is fractional reserve banking and ‘fiduciary medial’ why is it that Dr. Salerno, and other Austrian Economists continuously and erroneously refer to the ‘fiduciary medial’ generated by the Fed and the banking system as an expansion of the ‘money’ supply? There is only $1.38-Trillion in Legal Tender Money in circulation around the globe, all the rest is ‘fiduciary medial’, which is totally dependent upon asset values and the solvency of the institutions that manage its functionality and existence as a pseudo-medium.

    If all deposit accounts are credited accounts, then they contain no medium to draw upon, they are just a bank account entry. Being a bank account entry, whenever you use your debit card, you’re not actually drawing upon anything other than your bank’s line of credit, which the bank then deducts the amount used from its debt to the user and adds that amount to the debt it owes to the store’s account.

    Oh what tangled webs we weave when first we practice to deceive….