In Defense of Full-Reserve Banking: Bionic Mosquito and Beyond

Honest to goodness, I didn’t want my reply to be this long. Getting into the thicket though required that I venture into some details and definitions –I also wanted it to be educational for those new to money and banking theory.  Thus, what follows is not just a reply, but also a primer on the nature of two types of monetary contracts for those who haven’t read much banking theory.  If Bionic feels compelled to respond, I don’t expect a full fledged refutation. I believe I have understood his argument well and taken it to heart… and don’t think we are all too far apart, once things are defined with precision.  

Reply to Bionic Mosquito

The fantastic and revered Bionic Mosquito (I hope you follow his blogissued a response to my previous comments defending 100% bank reserves on libertarian (property-rights) grounds –not “Austrian” (economic) grounds.  The gist of Bionic’s argument is that A) because of the freedom to contract, my demand for full-reserves in a free society is contrary to libertarian doctrine; and B) a contract which allows a deposit bank to engage in fractional reserve banking is not necessarily to be considered fraudulent, contrary to my claims. For those who need to refresh on the vocabulary here, see my article linked above.

Now, these arguments are entirely legitimate.  If indeed the contract is not fraudulent, if indeed there is no breach of property rights taking place, then Bionic is right that what I preach contradicts libertarian doctrine; and surely I should publicly recant.  Unable to face such public shame, what follows is a defense of my position.

Bionic claims that in a libertarian society (defined as a society in which “there is no legal possibility for coercive aggression against the person or property of any individual” –Rothbard), it is the “contractual nature of the transaction” that renders the fractional reserve banking as being capable of being fraud-free, and thus ethically legitimate.

From Jesus Huerta de Soto's treatise "Money, Bank Credit, and Economic Cycles"
From Jesus Huerta de Soto’s treatise “Money, Bank Credit, and Economic Cycles”
Here is what he is arguing: when an individual has money and decides to put that money in a bank, he is agreeing, by contract (and Bionic provides an example of a real-life Citibank contract), that the relationship between he and the bank could be one of creditor and debtor, not one of custodianship.  In other words, in these contracts (and obviously the implication– and it is a true implication– is that a libertarian society would have similar contracts), it is specified that you are “loaning” the bank your money and that you may not get it back, or at least the bank has the right to withhold your funds until it has the cash to give you.  This contract is more akin (though not precisely) to what Professor Huerta de Soto labelled as a “Monetary Loan” contract, is distinct from what he (with great historical justification) calls a “Monetary Irregular Deposit.”

Bionic states in another article the chief reason he does not understand the demand for a full-reserve banking model.  When reading de Soto and Rothbard, he is perplexed by the fact that their entire case for full reserves over against the fractional-reserve model relies on a desire to treat deposits-as-bailments.  But, Bionic observes again and again, just because de Soto and Rothbard want this, does not mean the contract necessarily treats the deposit this way.  And is not the contract itself supreme over the historical nature of the deposit?  So then, when de Soto launches into a 600 page tome defending the deposit-as-bailment, Bionic can see this as merely irrelevant to his position.  For Bionic, the possibility of deposit-as-loan is all he needs to dissent from the full-reserve position.

Bionic asks: how is this fraudulent? Have not the two parties mutually agreed upon the nature of the contract, the nature of their relationship?  The bank has every right to loan out the money that you loaned to it, and if you need “your” money, then it can simply be borrowed from another client of the bank who agreed to the same. Is there any legal problem with this? Such is the case made by the great Mosquito.

However, I am convinced that Bionic’s overview of his position misses the entire nub of the problem.  For under the above arrangement, no fractional-reserves are necessary for it to take place. Thus, what was explained above is closer to loan banking (without the establishment of a given term– which is the result of our central banking system, a related, but different topic beyond our present scope*) as opposed to old fashioned deposit/warehouse banking because there is a debtor/creditor relationship created.  Something that is entirely permissible by all advocates of full-reserve banking (Murray Rothbard, Joe Salerno, Guido Hulsmann, Hans Hoppe, Huerta de Soto, Philipp Bagus, etc.)  But this is actually Bionic’s main argument: the full-reserve advocates are assuming the contract is a warehouse contract, without considering the possibility that the contract –in fact of real life– may very well be a loan contract.

But herein lies the problem: what fractional-reserve banking is, by definition, is a mixture of the two types of contracts expressed above.  It 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.  Bionic though, in his reply to my comments, expressly denies that such a contract would be legitimate on libertarian grounds, when he writes:

To be clear: a contract that grants two people the same right to the same deposit at the same time would be illegitimate; it would be deemed an invalid contract. Depending on the details of the situation, it could be fraudulent.

Indeed, but this is the meaning of fractional-reserve banking. De Soto (page 706):

fractional-reserve banking involves a logical impossibility from a legal standpoint. Indeed at the beginning of this book [Money, Bank Credit, and Economic Cycles] we explained that any bank loan granted against demand-deposit funds results in the dual availability of the same quantity of money: the same money is accessible to the original depositor and to the borrower who receives the loan. Obviously the same thing cannot be available to two people simultaneously, and to grant the availability of something to a second person while it remains available to the first is to act fraudulently.

This is de Soto’s definition of a fractional-reserve scenario.

And Rothbard agrees (page 96 of The Mystery of Banking):

Instead, the banker will either lend out the gold, or far more likely, will issue fake warehouse receipts for gold and lend them out, eventually getting repaid the principal plus interest. In short, the deposit banker has suddenly become a loan banker; the difference is that he is not taking his own savings or borrowing in order to lend to consumers or investors. Instead he is taking someone else’s money and lending it out at the same time that the depositor thinks his money is still available for him to redeem. Or rather, and even worse, the banker issues fake warehouse receipts and lends them out as if they were real warehouse receipts represented by cash. At the same time, the original depositor thinks that his warehouse receipts are represented by money available at any time he wishes to cash them in. Here we have the system of fractional reserve banking, in which more than one warehouse receipt is backed by the same amount of gold or other cash in the bank’s vaults.

In other words, wherever bank loans are granted against demand deposits, there we have a problem. But Bionic’s contract example is clearly was not a demand deposit contract, it was a type of loan contract.  We are not arguing that bank loans against deposits-for-loan (which is what Bionic is presenting) are problematic.  Notice especially the phrasing in Rothbard: “at the same time that the depositor thinks his money is still available for him to redeem”  For Rothbard and de Soto, the “original depositor” thinks that his warehouse receipts can demand the money at anytime.  Thus, for their examples, fractional reserve banking exists with warehouse deposit contracts, not the type of contract provided as evidence by Bionic.** Therefore, the example he gives does nothing against the case for full reserve banking.  This leads to our need for a definition of full-reserve banking.

What Bionic should know about the full-reserve position, then, is that a full reserve scenario is defined as one in which all deposit contracts in which the money is agreed to be a bailment,*** not a debt, must restrict the money from being simultaneously either loaned directly or used to support the pyramiding of fiduciary media.  

Bionic may say: yeah, well obviously that formulation of a deposit contract, because the contract specifies the bailment nature, is demanded by libertarian legal theory. To which I say: that is all we mean by full reserve banking.  Bionic may say: but this is not what modern contracts look like. To which I say: but this is all we mean by full reserve banking. Bionic may say: but what if the bailment contract is actually a loan contract? Answer: Then it falls outside the full-reserve definition. All we are talking about, when we say full reserve banking, is that if the contract is a warehouse contract, then it must be kept as such.

In my estimation, what Bionic rightly denies above, is what fractional reserve banking is.  Thus, to state my conclusion before I get to the end: Bionic is no fractional-reserve proponent.  Much to my glee and delight.

The Nature of Fractional Reserve Banking

Now, when speaking of monetary goods, there is a distinction to be drawn between money and money substitutes.  Money is the medium of exchange (we will use gold for our money in what follows).  Money substitutes are those things which trade in the economy in the place of the money (usually for convenience sake).  Money substitutes can be traded back to the bank for the money itself.  Money substitutes are broken down into two categories: money certificates (fully backed up by the money) and fiduciary media (not at all backed up by the money).  Fiduciary media is any money substitute beyond what is fully backed up.  So if there were 100 dollars worth of gold in the bank and 100 one dollar bills out in the economy, it would be a full reserve system and every money substitute (one dollar bill) would be a money certificate.  But if there were 101 one dollar bills, then the one extra dollar bill would be “fiduciary media” and there would be more claims on the gold than can be fulfilled. This is fractional reserve banking, because only a “fraction” of the reserves required to satisfy all claims exist.  The below taxonomy of money was produced in the collection of essays in celebration of the centennial of Mises’ Money and Credit book.


Now, obviously the problem with fractional-reserve banking, as just described, is that there are more claims outstanding than there is money to fulfill these claims.  But free banking theorists Lawrence White and George Selgin try to defend fractional reserve banking by attaching an “option clause” (as also implied by Bionic).  Hoppe explains:

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.

If at least some of the claims to money can be legally rescinded (enough to bring the scenario from fractional to full reserve banking), then clearly we have no legal problem– no breach of contract. But if some of the claims can (by contract) be rescinded, they weren’t really claims at all (and indeed, we cannot even properly call them money substitutes) and we no longer are talking about a fractional-reserve scenario, but rather a peculiar lottery scenario. We have moved from a scenario where there is rampant fraud to a scenario where there are simply “loans” being made.  As Hans-Hermann Hoppe observed:

While such a practice [claims to the money being legally rescinded–CJE] 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 ticket. 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 [the option to refuse payment–CJE] 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-first-served” 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– instead of unconditional ownership titles– they only possess temporally conditional value, i.e., until the drawings, and 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.

De Soto argues the same:

Clearly the introduction of this clause would mean eliminating from the corresponding instruments an important characteristic of money: perfect, i.e., immediate, complete, and never conditional, liquidity. Thus not only would depositors become forced lenders at the will of the banker, but a deposit would become a type of aleatory contract or lottery, in which the possibility of withdrawing the cash deposited would depend on the particular circumstances of each moment.

The point of all the above is this: if there is no mixture in the two types of monetary contracts expressed above (loan contract vs. deposit contract), then the system is legitimate on libertarian grounds (De Soto agrees: “There can be no objection to the voluntary decision of certain parties to enter into such an atypical aleatory contract as that mentioned above.”). But fractional-reserve banking cannot take place in such an environment. If fractional-reserve banking is present, then there is a contractual problem mutually exclusive legal claims on the money.

Moreover, fractional-reserve banking (as defined above), contrary to Bionic’s Selgin/White position, does indeed violate the property of some individuals in society.  Hoppe:

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.

To say again what I said above:

Thus, what Bionic should know about the full-reserve position, is that a full reserve scenario is defined as one in which all deposit contracts in which the money is agreed to be a bailment,** not a debt, must restrict the money from being simultaneously either loaned directly or used to support the pyramiding of fiduciary media.  

That’s all Rothbard ever meant in his books advocating full reserves, primarily “Mystery of Banking,” and “The Case for a 100 Percent Gold Dollar.”  This is what Hoppe, Hulsmann, Bagus, de Soto, and others mean as well.  Economically, to reiterate, Bionic and I see eye to eye. This is a contract/aggression issue.  And I would think, after the above reformulation and clarification of the doctrine, Bionic may be on our side after all. For under the assumptions of Bionic’s loan contract, no full-reserve bank proponent, properly defined, would disagree. Evidence has been provided.

And by the way, the reader, and my esteemed critic, should know that I want a free market in money. If the market wants gold, silver, wheat, or tobacco, so be it. A full-reserve position should not be confused with a government mandated “gold standard” in which there is but one government-defined money: gold.  This “gold standard” is merely a practical-policy suggestion (even though we libertarians hate such things) for the dollar in light of the current monopoly on money; a solution to the problem of monetary expansion of frightening proportion. The ideal is competing currencies, competing banks, and a free market in money and banking. More on this in a future article.


*As Rothbard makes clear in Mystery of Banking (page 91-94), de Soto makes clear in his Economic Cycles volume (Chapter One), and Joe Salerno makes clear in his volume on sound money, there is also a legal deconstruction that took place in recent centuries that has led to confusion as to the true nature of the deposit (is it a debt or a bailment?)  Obviously Bionic rightly states that it depends on the stipulations of the contract itself, but my point is simply that there has been legal confusion set in place by poorly decided court decisions, which have seemed to confuse the entire legal order, thereby causing central banks in time past to allow suspension of specie payment in times of financial calamity.

**I think there is some confusion regarding the fact that Bionic is talking hypothetical (what could happen in a free society), whereas Rothbard/De Soto are talking about the historical nature of a bank deposit.  Thus, when the latter seek to defend full-reserves, they are doing so in the context of historical definitions of a deposit as a warehouse contract.

***Rothbard defines bailment according to Robert O. Sklar and Benjamin W. Palmer in Business Law (New York: McGraw-Hill, 1942), page 361:

A bailment may be defined as the transfer of personal property to another person with the understanding that the property is to be returned when a certain purpose has been completed … In a sale, we relinquish both title and possession. In a bailment, we merely give up temporarily the possession of the goods.”

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