July 14, 2015

Money, Currency, and Fractional Reserve Banking: An Overview

By In Articles, Economics

Being as we subscribe to what has been labelled “The Austrian School” of economics, we often refer positively to things such as “The Fed” and the “Gold Standard” and “Fiat Money.” Perhaps then an overview is in order.

Where Money Comes From

When we think of money, we often think of the green pieces of paper in our wallets. Of course, this world is quickly fading away and our children may not even know that much. For digital money seems to be the wave of the future. But in any case, we must ask ourselves where money came from because presumably money had existed long before the printing press and the idea of “cash.”

A man who lives off of his farm to feed his family and never engages in economic exchanges with “society” at large has no use for money. What he produces himself is what he eats.  What he finds on his property is what he uses to build his house. If he wants eggs, he ventures out to the chicken coop and when bacon is on the menu, a pig is slaughtered.  And so forth. There is no use for money.  Money does not ever cross his mind.

And when he discovers a nearby family that grows apples, he may choose to exchange his eggs for a bucket of apples.  The man already had something that was desired by the apple grower; and vice versa. And thus a profitable exchange results.  This is known as “direct exchange:” when the two exchangers want the good being received so that they may consume it.  There is nothing else to be done. Each party received the means toward his satisfaction.  Again, no money is needed in this direct exchange.

However, what happens when the farmer discovers that there is still another family nearby that produces horseshoes, which the farmer most certainly desires, but that family does not desire anything that the farmer produces on his farm? The horseshoe producing family is not interested in eggs, bacon, or anything else that the farmer has the ability to produce. No, the horseshoe family only wants apples! No direct exchange can occur and the farmer has no means by which to acquire the horseshoe. Is all hope lost?  Not in the least! For the farmer, a brilliant man, solves his predicament by first trading his eggs to the apple grower for apples, but not so that he can consume the apples, but rather so that he might then proceed to trade the apples for the horseshoes.

In this latter case, the apples were traded not for their own use, but for the use of acquiring the horseshoes, which is what the farmer was ultimately aiming for.  In step one, the farmer receives apples; and in step two, he receives horseshoes.  This process, then, represents what we call an indirect exchange.  The apples here are simply being used as a medium of exchange.  It is this medium of exchange that we call money.

As Murray Rothbard has written on indirect exchange:

At first glance, this seems like a clumsy and round-about operation. But it is actually the marvelous instrument that permits civilization to develop.

Indeed, without a medium of exchange, without money, there is no mass economic growth that we have seen since the middle ages.

Now then, consider a scenario in which there are not just three families exchanging their goods, but a hundred families who all want what someone else is producing. Obviously trying to figure out what “medium of exchange” will work for which future exchange can become quite cumbersome and complicated.  However, the mediums of exchange that arise as the families begin to exchange with each other over the years, begin to narrow until there are generally two or three highly marketable monies that are well known to always be in demand. That is, there are certain monies– certain goods with extensive demand– that rise above the rest and are used frequently in nearly all exchanges.

Murray Rothbard, in his book What Has Government Done to Our Money?, explains the history:

Historically, many different goods have been used as media: tobacco in colonial Virginia, sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scotland, copper in ancient Egypt, and grain, beads, tea, cowrie shells, and fishhooks. Through the centuries, two commodities, gold and silver, have emerged as money in the free competition of the market, and have displaced the other commodities. Both are uniquely marketable, are in great demand as ornaments, and excel in the other necessary qualities. In recent times, silver, being relatively more abundant than gold, has been found more useful for smaller exchanges, while gold is more useful for larger transactions. At any rate, the important thing is that whatever the reason, the free market has found gold and silver to be the most efficient moneys.

It is important that we observe two things about this process and the foundation of money: 1) Governments are not the source of money, the market is; and 2) money is a commodity that has prior economic use on the market. That is, it wasn’t just randomly decided one day that Commodity X would be the money. Rather, money was birthed from among the millions of economic transactions over time.

Where Currency Comes From

Now then, we have our money. Gold and silver, being historically the most well-received monetary commodities, have for thousands of years been the monetary unit and therefore we will refer to money in all that follows as gold/silver for ease.

But we find we have another set of problems.  Gold and silver can be difficult to carry around; it can be bulky, heavy, and quite obvious when one is carrying lots of it (therein attracting criminals and the like).  Moreover, it comes in all shapes and sizes, and therefore weights, causing exchanges to be cumbersome and time consuming; not at all very efficient, at least compared to what we are used to today.

The market has a solution for this as well.  As time went along, people began to break down the gold and silver into small pieces, easy to recognize and to carry.  These are known as coins, and are used for small “day to day” transactions as opposed to the melting down of the gold into large bars for big transactions.  This process of coinage is itself a market service and the history of coinage is an interesting one.  Private minters can stamp the coins with their seal, guaranteeing their weight and purity and produce these coins en masse for wide use.

One historical example of these coins is the rise of the American Dollar. Where did this “dollar” come from? Rothbard explains in his book History of Money and Banking in the United States:

The name “dollar” came from “thaler,” the name given to the coin of similar weight, the “Joachimsthaler” or “schlicken thaler,” issued since the early 16th century by the Count of Schlick in Joachimsthal in Bohemia. The Joachimsthalers weighed 451 Troy grains of silver. So successful were these coins that similar thalers were minted in Burgundy, Holland, and France; most successful of these was the Maria Theresa thaler, which began being minted in 1751 and formed a considerable portion of American currency after that date. The Spanish “pieces of eight” adopted the name “dollar” after 1690.

In other words, the dollar itself was simply a name for a certain coin that represented a fixed weight of silver.  Writing on the Constitutional use of the word “dollar,” Michael Rozeff points out that the dollar was a reference to the commonly used “Spanish milled dollar” which was based on a “specific weight of silver.”  The Coinage Act of 1792 makes this idea a law when it states that “the money of account of the United States shall be expressed in dollars or units… of the value [mass or weight] of a Spanish milled dollar as the same is now current, and to contain three hundred and seventy-one grains and four sixteenth parts of a grain of pure… silver.”

But the development of money’s ease of use continues on even beyond coinage. For a) not all gold held in savings are necessarily in coin form, it may be in large gold bar form, and thus difficult to protect away safely; and b) coins too can be difficult to carry around all day if one decides to keep with him a decent amount of money.  Private business therefore offered to hold on to the gold for the customer and give him paper that, at any time, could be brought back in exchange for the gold that was rightfully theirs.  These paper slips were not themselves money, but were rather warehouse receipts that proved ownership of the actual money that was being securely stored.  Rothbard:

Certain firms, then, will be successful on the market in providing warehousing services. Some will be gold warehouses, and will store gold for its myriad owners. As in the case of all warehouses, the owner’s right to the stored goods is established by a warehouse receipt which he receives in exchange for storing the goods. The receipt entitles the owner to claim his goods at any time he desires. This warehouse will earn profit no differently from any other—i.e., by charging a price for its storage services.

Each private business that provided this service would create receipts with its brand on it and eventually, because the receipts could always be turned back in to the warehouse for the gold (the real money itself) the receipts eventually began to be traded on the market as money substitutes. These money substitutes can also be referred to as currency.  Therefore, within an economy with a variety of warehouse businesses, there exists competing currencies.  The important thing to know here is that for every money substitute trading out in the economy, there needed to be an equal amount of money backing that substitute.

These warehouses, then, are also known as banks.

Where Banks Come From

One of the greatest tragedies of modern banking is the sheer and mass ignorance of the fact that there are actually two types of banking that take place when we use the word bank.  This point cannot be overstated and the reader must always come back to this point when considering money and banking in the future.  There is a difference between what we will call loan banking on one hand, and deposit banking on the other.  In today’s world, these two different banking services have been fused together in a way that makes banking itself a type of fraud.  We will expand more on this below.

On the free market, there are two types of banking: loan and deposit. What we described above in the warehouse scenario was an example of deposit banking; wherein a customer would pay a fee to the warehouse to store his money whilst he kept with him and used for exchanges, money substitutes or currency.  With a deposit bank, the money held in storage does not belong to the bank, but to the customer.  It is not loaned to the bank for the banker’s use, because at any time the customer wishes to bring his warehouse receipts back in for his gold, he may do so.

Jesús Huerta de Soto, in his fantastic yet huge Money, Bank Credit, and Economic Cycles makes this point well:

Indeed, the contract of deposit (depositum in Latin) is a contract made in good faith by which one person—the depositor—entrusts to another—the depositary—a movable good for that person to guard, protect, and return at any moment the depositor should ask for it. Consequently, the deposit is always carried out in the interest of the depositor. Its fundamental purpose is the custody or safe- keeping of the good and it implies, for the duration of the contract, that the complete availability of the good remain in favor of the depositor, who may request its return at any moment. The obligation of the depositor, apart from delivering the good, is to compensate the depositary for the costs of the deposit (if such compensation has been agreed upon; if not, the deposit is free of charge). The obligation of the depositary is to guard and protect the good with the extreme diligence typical of a good parent, and to return it immediately to the depositor as soon as he asks for it.

Considering this, any misuse of the money wherein the warehouse bank (the depositary) spends the money, loans it out to other people, keeps it for himself, or in any way alters it, constitutes a breach of contract and immediate grounds for lawsuit and subsequent criminal prosecution.  This includes what we will expand on below: fractional reserve banking, wherein the bank has made a promise by way of contract to fulfill the requests of the customers who turn in their receipts for their own money and yet at the same time loans out some of those moneys to other people in the form of bank loans. In other words, it is complete fraud to both maintain a contract to give back the money being stored and also to loan out that same money.  A 100% reserve system then, is legally demanded.

Although warehouse or deposit banking services are not to be mixed with loan banking services, the free market certainly has a healthy place for loan banking too.  In loan banking, people’s savings are channelled into productive loans and investments.  Here, customers essentially lend their money to the bank, which subsequently pools this money together and lends it out to entrepreneurs or other borrowers at a certain rate of interest.  The bank takes a profit and passes some of this along of the customer who first let the bank lend his money on his behalf. Contrary to deposit banking, in loan banking, the owner of the money allows the bank to invest his savings, and agrees that the bank does not have to give back this money until the maturity of the contract.  In other words, the customer lends his money to the bank for a certain period of time, and when the time comes, it is only then that the customer can legally demand his money be returned.

What must be realized here is that this loan bank only loans out money that has been previously saved.  It does not have the ability to simply “print or create money” as banks do today.  On the contrary, what is lent out is money that could have been immediately consumed by its owners, who instead desired a profit and therefore decided to act as capitalists who provide the capital for entrepreneurial activity.  Murray Rothbard, in his much neglected book on banking, writes of loan banking:

No matter how large it grows, it is still only tapping savings from the existing money stock and lending that money to others.

If the bank makes unsound loans and goes bankrupt, then, as in any kind of insolvency, its shareholders and creditors will suffer losses. This sort of bankruptcy is little different from any other: unwise management or poor entrepreneurship will have caused harm to owners and creditors.

Where Central Banks Come From

Unfortunately, the sharp distinction between the two types of banking (warehousing and loan banking) has been too easily ignored, especially by warehouse bankers who, having all this money in their reserves, consider all the various ways a profit could be made!  Rather, it so happens that bankers who should be acting in capacity of a warehouser have been tempted to take the deposits and loan them out, therein suddenly becoming a loan banker.  They do this by printing up fake warehouse receipts and loaning them out on the market.  Whereas before the loan there was a 1:1 ratio of gold reserves in the warehouse to warehouse receipts outstanding, with the expansion of fake warehouse receipts in the form of new loans, the ratio is suddenly shifted.  Suddenly there are too many receipts outstanding for the bank to fulfill with its gold. The bank has shifted from a 100% reserve bank to a fractional reserve bank.

Fractional reserve banking, besides being legally fraudulent and thus to be criminalized by a robust system of law and order, also has economic aspects to its inability to expand too far on the free market.  There are bank runs, consumer distrust, and other such things that come in to play here with an inherently unstable bank.  But more than that, there is the very fact of bank competition in which the customers of other banks, through the course of their acquiring warehouse receipts throughout their day to day activity, will soon (perhaps on a daily or weekly basis) come by redeem these receipts for the money (gold) so that they make take the gold and store it in their own banks.  In other words, no bank can get very far in its inflationary efforts before being completely exposed by simple daily economic factors. So not only is there a legal reason why fractional reserve banking should be rejected, but there are also economic reasons why it can never actually get very far.  Thus, as Murray Rothbard argues in The Mystery of Banking, a free banking system, even if fractional reserve banking is legally allowed (even though it shouldn’t be) would result in a system of “hard money” and low inflation (expansion of the money substitute supply)

However, this is not the end of the story.  For since the time of John Law, who headed what is perhaps the first national central bank in history, the bankers have developed a very cozy and dangerous relationship with the state.  Rather than continuing on in a system of free banking, wherein the government does not regulate the bank, the banking industry has for centuries used the government to attain special privileges that allow it to escape the limitations provided by the market.  Because a free banking system would produce a relatively low inflation and “hard money” situation, the bankers utilize the state so that it can ignore the laws of economics.  They utilize the state by urging it to create a “Central Bank” which acts as a “bank’s bank,” and it alone can manage the money substitute supply and provide a single and unifying currency for the whole economy. The individual banks, then, must use this central bank for its own reserves, much like we individuals use the private banks for our reserves.  This central bank sets policy that all member banks must follow.

One of the myths of the “Progressive Era” was that during this time the government was pitted against “Big Business.”  But this is hardly the case, for it was “Big Business” that lobbied the federal government to render privilege to these lobbying businesses over against their much small competitors. In this context, the United States’ own central bank, the Federal Reserve, was formed in 1913.

Central banking can become very complicated, and we will indeed need to write a future post on the matter, but for now, it is important to know that the central bank serves to protect the desires of the bankers to engage in fractional reserve banking, to print up money with no consequences to itself, and to profit immensely by the ability to simply create currency without the need of it being backed by gold.  Whereas before the central bank, any one bank that decided to take part in the money creation process of fractional reserve banking would soon be faced with the pressures of redemption of the receipts, with the central bank there is only one money substitute (currency), controlled by the central bank and therefore all the banks can inflate together without fear of their competitors redeeming the receipts of each other.  In this way, a central banking system is best thought of as a banking cartel, wherein they can all be made free from the constraints of free market banking and competition.

Central banks then are a product of the relationship between the government’s legal privilege afforded to the single bank and have nothing to do with the free market. Central banks are literally the result of the banks seeking state protection against the free market economy.  For once a central bank system is instilled, it suddenly becomes illegal for a private bank to print its own currency (warehouse receipts) in exchange for holding any amount of gold.  The central bank now has a monopoly on currency production and can inflate (expand) the amount of money in circulation without the legal need to redeem the receipts for gold. This is why in the United States, because of legal tender laws, competing currencies and private warehouse receipts that act as money have been outlawed.  The Federal Reserve system depends on a grant of monopoly and if anyone desires to start a bank, he is forced to participate in the Federal Reserve system and use the “dollar.”

Here lies the reason why “Federal Reserve Notes” do not say on them that they are “redeemable” per the picture to the right. Silver-Certificate-v.-Federal-Reserve-NoteThe silver certificates (currency) in the picture were once redeemable in silver (money). Now, the paper itself has become the money since the world no longer has its currencies backed up by anything.  Whereas the word dollar once referred to a fixed weight of money (silver itself), it now has no actual definition.  The dollar’s backing in silver was eventually changed to gold (the era of the “gold standard”) and then, later, gold was done away with in the 1930’s (being very falsely blamed for the Great Depression) upon the order of Franklin Roosevelt.  The Federal Reserve notes of today are then referred to as fiat money that is, paper money by order of the State, rather than a commodity money provided by the market. The development of the dollar in the 20th century is an intriguing tale in its own right, and we will write on this in the future.

Where Economic Crises’ Come From

It is the fractional reserve nature of modern central banking that has caused economic crises after economic crises. In fractional reserve banking, the banks are allowed to artificially increase the supply of money by printing more receipts than can be redeemed with the money.  Therefore the amount of reserves in the bank that stand behind the currency are only a fraction of the receipts.  This activity of “printing money” is actually and technically an activity of “printing money substitutes.”  Any money substitutes that cannot be redeemed are called fiduciary media.  Money itself, being a commodity, cannot actually be printed; it must be produced in the market.  One cannot simply “print more gold.”  Therefore, banks engage in printing fiduciary media and loaning it out as if they suddenly had more actual money to lend.

The boom and bust cycle, in which things look good for a while, until recessions and depressions rear their ugly heads, are a direct result of the expansion of the supply of money substitutes.  This expansion of loanable funds, because it was artificial and not real, causes severe problems in the economy’s interest rate, which leads to discoordination in the structure of production and a subsequent artificial economic boom, followed by a very painful crash which includes loss in asset values, a drying up of resources, and mass unemployment. And of course, completely unaware of what is actually happening, governments tend to try to “fix” things, especially unemployment. The problem, though is that this merely puts a bandaid on the issue and in the long run actually makes things worse and prolongs the economic pain.

Brian will expand on these economic crises’, their causes, and the Austrian view of the boom and bust cycle in a coming article.  All of the above is the foundation for that post.

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 reformedlibertarian@gmail.com
  • Brian K. Jacobson

    ” A 100% reserve system then, is legally demanded”

    I believe this was something that Rothbard and von Mises went back and forth on, if I’m not mistaken. Rothbard considered it an inherent breach of contract and therefore criminal but Mises thought that the main issues is FDIC deposit insurance, central bank reserve money multiplier, and central bank that provide liquidity (through fiat currency) to banks that go under, as well legal courts that do not prosecute insolvent banks that did not pay back depositors. I usually side with Mises that making it illegal or criminal would be unnecessary, simply removing deposit insurance which institutionalized moral hazard, abolishing central banks and the money multiplier, and prosecuting banks that shorted depositors would move banks in their own interests to have at or near 100% reserves, there would also be the possibility of private bank insurance companies to cover them in the case of a bank run. Thoughts?

    • C.Jay Engel

      It is important to note that I agree that it is “unnecessary” economically because, as both Mises and Rothbard agreed, a free banking system in which fractional reserves are legally allowed, would contain the constraints able to handle pretty much all situations. So I don’t think that a free banking system would create the boom bust cycle.

      However, from a strictly legal theory standpoint, if the contract is written as de Soto expresses it above, one cannot avoid the fraudulent nature of fractional reserves. Rothbard:

      “In my view, issuing promises to pay on demand in excess of the amount of goods on hand is simply fraud, and should be so considered by the legal system. For this means that a bank issues “fake” warehouse receipts-warehouse receipts, for example, for ounces of gold that do not actually exist in the vaults. This is legalized counterfeiting; this is the creation of money without the necessity for production, to compete for resources against those who have produced. In short, I believe that fractional-reserve banking is disastrous both for the morality and for the fundamental bases and institutions of the market economy.”

      You’ve probably read that before (it’s from the Case for a 100 Percent Gold Dollar). The point is not that the legal system “need” to do this in order to prevent a banking crises, but rather that on a strictly legal perspective, it necessarily follows that if a contract is made between customer and warehouser that the customer’s money will be secured in a warehouse, it is a breach of contract to lend that money out. Perhaps this strict warehousing service wouldn’t even be as widespread as a loan banking service in which the above contract is made. But the point is, if a warehousing agreement is made, then it should not be legally breached, even if the economic results aren’t disastrous. This is essentially the case made in chapter one (The Legal Nature of the Monetary Irregular-Deposit Contract) of de Soto’s book.

      Please understand that economically, both Rothbard and Mises (and therefore myself) agree completely. It’s really a small difference. And if you disagree with me, that is perfectly fine:)

      • Brian K. Jacobson

        Hmm, never read DeSoto, the size of the book scared me, but I heard its amazing. I suppose if you realize that the issuing of bank notes, or in our day a digital balance is a receipt that says we have this much money for you, if they don’t then they are lying then that is fraud, and necessarily inflationary. I concede your point, but I also suppose in a free-society with sound free-market money and only voluntary 3rd party banking associations that would inspect and certify the soundness of banks it would still be unnecessary to have the state of insolvency by the bank to be criminally punishable since they really haven’t broken their contract with 1 specific person until they can’t pay back the receipt and that would be when they would be criminally punished for both fraud and theft. The thing with having it illegal just to be in the state of anything less than 100% reserves is who pursues charges against them and who do they pay? If they are 10% short after an audit do they divvy out that 10% equally to each account holder, so from a legal perspective it seems you wait until they actually short someone. Again though from economic perspective in a private-law society the banks would most likely have several voluntary third party banking associations that audit and certify the soundness of banks and should a bank be found insolvent I imagine that would deeply hurt their sales and cause large withdrawal from their existing deposits, so most would have 100% reserves anyways.

        • C.Jay Engel

          I agree with this, and the only thing I would point out is that technically the fraud takes place before it is revealed and it is only upon revelation of the fraud that prosecution can take place anyway. In effect, either way banks would have a very difficult time expanding bank notes beyond what is held in deposit.