In Defense of Fiduciary Media - or, We are Not Devo(lutionists), We are Misesians! (1)
George Selgin and Lawrence H. White
The Review of Austrian Economics Vol. 9, No. 2 (1996): 83-107 ISSN 0889-3047
Selgin and White: In Defense of Fiduciary Media
Origin Server: https://cdn.mises.org/rae9_2_5_4.pdf The Murray Rothbard both of us knew was committed to a frank and vigorous contest of ideas. He understood that an expression of disagreement was not an expression of disrespect - quite the contrary. Here we wish to honor Rothbard's memory by addressing a set of issues surrounding fractional-reserve banking, issues on which we disagree with some of Rothbard's conclusions despite beginning (we believe) from many of the same premises. Our main concern is to defend the freedoms to issue and use fiduciary media of exchange. The vehicle for our defense is a response to criticisms of our views by Hans-Herman Hoppe in his article "How is Fiat Money Possible? - or, The Devolution of Money and Credit" (1994). Subsequent to Hoppe's article, Jesus Huerta de Soto (1995) and Jörg Guido Hülsmann (1996) have also offered criticisms of our position in lengthy articles in this journal. We address at a few points in the text below what we take to be de Soto's main arguments. Hülsmann's article has appeared too recently for us to address it directly here, but its arguments closely parallel Hoppe's. In particular, Hülsmann, like Hoppe, fails to appreciate Mises's (fairly standard) explanation of why fractional-reserve banking is feasible. We therefore believe that our rebuttal to Hoppe serves to rebut Hülsmann's main arguments as well. The Origins of Fiat Money "Fiat" Redefined by Fiat Labels aside, Hoppe's lumping together of fiduciary media with fiat money is substantively misleading, because it blurs important theoretical differences between the two. The determinants of the quantity of fiduciary media in a fractional-reserve banking system are quite distinct from the determinants of the quantity of fiat money. Economic factors strictly limit the quantity of fiduciary media a banking system can issue, given its reserves of base money. The quantity of fiat money, by contrast, is not subject to any natural economic limit.(6) We have argued (Selgin and White 1994, pp. 1734-5) that a natural limit to the quantity of fiat-type (i.e., irredeemable, non-commodity) money would be lacking even if such money were issued by competing firms. Thus Hayek's (1978) proposal for private fiat-type money unfortunately fails to secure the quantity and value of money. A "free banking" regime with competing issuers of redeemable notes and deposits is quite distinct from a Hayekian regime of "competing fiat monies." 6 To be precise, we mean the quantity measured in units of account, holding the definition of the unit of account constant. —————————————————————————————————————— upon transfer of property."(7) Fractional-reserve banking arrangements cannot then be inherently or inescapably fraudulent. Whether a particular bank is committing a fraud by holding fractional reserves must depend on the terms of the title-transfer agreements between the bank and its customers. Rothbard (1983a, p. 142) in The Ethics of Liberty gives two examples of fraud, both involving blatant misrepresentations (in one, "A sells B a package which A says contains a radio, and it contains only a pile of scrap metal"). He concludes that "if the entity is not as the seller describes, then fraud and hence implicit theft has taken place." The consistent application of this view to banking would find that it is fraudulent for a bank to hold fractional reserves if and only if the bank misrepresents itself as holding 100 percent reserves, or if the contract expressly calls for the holding of 100 percent reserves.(8) If a bank does not represent or expressly oblige itself to hold 100 percent reserves, then fractional reserves do not violate the contractual agreement between the bank and its customer (White 1989, pp. 156-57). (Failure in practice to satisfy a redemption request that the bank is contractually obligated to satisfy does of course constitute a breach of contract.) Outlawing voluntary contractual arrangements that permit fractional reserve-holding is thus an intervention into the market, a restriction on the freedom of contract which is an essential aspect of private property rights. Hoppe declares our defense of the freedom to make fractional-reserve-compatible contracts to be "silly" because, he asserts, "few if any" depositors have ever realized that some of their deposits are being loaned out, even though (as he acknowledges) the payment of interest on deposits would otherwise be impossible. We doubt that most depositors are as naive as Hoppe believes. As Rothbard (1990, p. 47) has correctly observed, "It is well-known that banks have rarely stayed on a '100 percent' basis very long." We thus find it hard to believe that most people who patronize fractional-reserve banks do so under the delusion that 100 percent of the money they deposit remains in the bank's vault until the moment they ask for it back. (We return to this issue below.) —————————————————————————————————————— 7 A more standard definition of fraud confines it to a willful or deliberate deception for purposes of gain. Thus an unintended failure to meet the terms of an agreed transfer due to unexpected circumstances beyond the party's control, would constitute a breach of contract, but not a fraud. Nothing herein turns on this distinction, though. 8 Whether it is fraudulent to hold fractional reserves against a bank liability does not depend per se on whether it is a demand or time liability, but only on whether the bank has misrepresented itself as holding 100 percent reserves. The demandability of a particular claim issued by a bank, i.e., the holder's contractual option to redeem it at any time, is not per se a representation that the bank is holding 100 percent reserves against the total of its demandable claims. Rothbard (1990, pp. 49-50) argues otherwise, based on the view that a bank's demand deposits and notes are necessarily "warehouse receipts" and not debts. We do not see why bank and customer cannot contractually agree to make them debts and not warehouse receipts, and we believe that historically they have so agreed. —————————————————————————————————————— But whether the informed would-be customers of fractional-reserve banks be a majority or a minority, their freedom of contract is at stake. 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 contract in the market for banking services. Walter Block (1988, pp. 28-30), though he (following Rothbard) judges fractional-reserve banking "as presently constituted" to be "a fraud and a sham," acknowledges that fractional-reserve banking could be non-deceptive and voluntary. To make it so, Block argues, the bank needs to affix an adequate disclaimer to banknotes and deposit contracts regarding the bank's fractional-reserve-holding and redemption policies. Hoppe (1994, p. 71), citing Block, similarly allows that fractional-reserve practices would be non-fraudulent if the bank explicitly informed depositors that it reserved the right to "suspend or defer redemption" at any time. If the proponents of the "fraud" objection to fractional-reserve banking thus concede that the objection vanishes when banks apply the equivalent of a "warning sticker," then they concede that fractional-reserve banking is not inherently fraudulent. Fraud occurs only if a bank's customers are misled about its practices. The remaining normative debate boils down to the question of whether a warning sticker really is needed to avoid misleading customers (which in our view depends on whether the reasonable default assumption, absent a sticker, is really that 100 percent reserves are being held), and, if so, to the question of how explicit the sticker must be. There is also the positive question of whether fractional-reserve banknotes and deposits really could circulate among an informed public. Our view is that a mandatory "warning sticker" is certainly less objectionable than an outright ban on fractional-reserve banking, and would not impede the practice of fractional-reserve banking, but that it is not really needed to avoid misrepresentation, because a "deposit" is not commonly understood to be a 100-percent-reserve bailment unless otherwise specified. As Rothbard (1970b, p. 34) once described the libertarian approach to preventing product adulteration, "if a man simply sells what he calls 'bread,' it must meet the common definition of bread held by consumers, and not some arbitrary specification. However, if he specifies the composition on the loaf [Rothbard does not suggest that this should be mandatory], he is liable for prosecution if he is lying." We maintain that the common definition or default meaning of a "bank deposit" is, as courts have recognized (Rothbard 1983b, pp. 93-94), that of a debt claim against the bank and not of a warehouse receipt. Block and Hoppe propose slightly different warnings as adequate to avoid fraud. It is not clear whether they are merely offering examples, or instead believe these to be the only sorts of adequate warnings. Block's warning would detail the bank's reserve ratio and its policy for meeting redemptions when they exceed its reserves (e.g., first-come first-served). His example seems to assume that the bank would hold a fixed reserve ratio (because it specifies the precise ratio on its notes). The bank and its customers might well both prefer, however, to allow the bank discretion to vary the ratio as prudence dictates. Under varying conditions, a varying ratio is necessary to maintain a constant default risk. Hoppe's warning would inform claim-holders that the bank reserves the right to suspend or defer redemption at any time.(9) But some banks and their customers might prefer a demandable debt contract that does not give the bank any such right to suspend. What then? Hoppe likens his warning to the "option clauses" historically placed on banknotes, but it should be noted that such clauses only allowed for the deferral, or temporary suspension, and never for the indefinite suspension of redemption (who, after all, would freely choose to take a permanently suspendable note?). The Scottish banks that issued option-clause notes explicitly reserved the right to defer redemption for a specified period, in which case the note would be repaid with a specified (and high) interest bonus.(10) In practice the banks went decades without invoking the option, and the clause-laden notes circulated easily at par, because the banks were not expected to invoke the option. Hoppe's prediction that option-clause notes "would be uniquely unsuited to serve as a medium of exchange" is false, to judge by the Scottish evidence. Equally without historical support is Block's (1988, pp. 30-31) suggestion that, because the holder of a note issued by a bank with a 20 percent reserve has only a 20 percent chance of —————————————————————————————————————— 9 Hoppe would also have the bank inform its borrowers that their loans can be recalled at any time. On this odd suggestion see footnote 13 below. 10 Checkland (1975, p. 67) provides a specimen of an optional note issued by the Royal Bank of Scotland. The face of the note reads, in fairly large print (occupying practically the entire face), "The Royal Bank of Scotland . . . is hereby obliged to pay to [name] Or the Bearer, One Pound Sterling on demand Or, in the Option of the Directors, One pound Six pence Sterling at the End of Six Months after the day of the demand & for ascertaining the demand & Option of the Directors, the Accomptant & One of the Tellers of the Bank are hereby ordered to Mark & Sign this Note on the back of the same." The Bank of Scotland, also known as "the Old Bank," introduced the option clause in 1730. Checkland (1975, p. 68) comments that 'The adoption of the clause does not seem to have impaired the Old Bank's note issue." The public presumably realized that the bank would try to avoid having to invoke the option to defer redemption, both for reputational reasons and because the bank would then, under the terms of the clause, have to pay interest on its notes. The bank did not in fact invoke the option until 1762. Option clauses were outlawed in 1765.—————————————————————————————————————— redeeming it in the event of a bank run, a note issued by a bank known to hold fractional reserves is indistinguishable from a lottery ticket, and would be valued below par if the public were to "fully digest" the implications of its issuer's fractional reserves. It is true that a particular bank's notes would be valued below par if market participants worried that they might not be able to redeem the notes ahead of an imminent run on that bank. But such notes, on which default was considered a non-negligible risk, would not continue circulating, even at a discount. They would immediately be presented for redemption, and thus removed from circulation. The surviving brands of notes would be only those for which all redemption demands made in practice were expected to be met (see Mises 1966, p. 445). Fractional-reserve notes issued by respected banks - and such banks were not historically rare - were in fact able to circulate widely at face value because other banks and the public rightly recognized that the practical likelihood of experiencing any difficulty in redeeming the notes was negligibly small. The notion that a fractionally-backed banknote is akin to a lottery ticket seems to rest on a failure to appreciate the simple fact that fractional-reserve banking is feasible, that is, that a fractional-reserve bank can in practice continually fulfill its contractual obligation to redeem on demand. A fractionally-backed claim to basic money, a banknote or checking deposit balance, can itself serve as a medium of exchange. Because it is thus useful even without being redeemed for basic money, there is no reason to expect all the claims issued by a bank (unlike claims to bread, or winning claims against a lottery) to be redeemed in a given period. As Mises (1980, pp. 299-300) put it, a banker "is therefore in a position to undertake greater obligations than he would ever be able to fulfill; it is enough if he takes sufficient precaution to ensure his ability to satisfy promptly that proportion of claims that is actually enforced against him." A demand deposit is the limiting case of a short-term deposit. Hoppe's view that it is infeasible for a bank to hold a fractional reserve against its demand liabilities would seem to imply that it is generally infeasible for a bank to borrow short and lend long, or to practice anything less than perfect maturity matching of liabilities with assets. Rothbard (1983, p. 99) argues explicitly that any bank that practices maturity-mismatching, i.e., has time deposits coming due before loan payoffs arrive, is violating "a crucial rule of sound financial management." The practice is feasible (does not inevitably doom a bank), however, if the bank can count on rolling over or replacing at least some of its time deposits as they come due. Maturity-mismatching clearly does involve risks: not only liquidity risk, but also interest-rate risk. But surely the rules of sound financial management do not say that risk should never, ever be taken. Rather, they call for risk to be balanced against the return for risk-taking. A risk can be worth taking if the risk is small enough relative to the reward for taking it. When long-term market interest rates are higher than short-term rates, banks do earn a reward for assuming the risks involved in intermediating short-term deposits (including demand deposits) into longer-term loans. The view that fractional-reserve banking and maturity mismatching in general are "inherently unsound" practices seems to suggest that no bank should ever knowingly engage in any risk-return tradeoff with regard to the maturity structure of its balance sheet. Jesus Huerta de Soto (1995, p. 30) rejects "the trite argument that the 'law of large numbers' allows the banks to act safely with a fractional reserve," on the grounds that "the degree of probability of an untypical withdrawal of deposits is not, in view of its own nature, an insurable risk." It is true that the atypical withdrawals known as bank runs are not random events. But it does not follow that a bank cannot survive with fractional reserves, because solvent banks are not inherently run-prone. Even in countries (e.g., Scotland, Sweden, Canada) where the legal system vigorously enforced the banks' contractual obligation to pay on demand (and even where legislatures outlawed the contractual escape hatch from runs provided by an option clause), well-known banks with fractional reserves did not experience runs and continually met all their redemption demands for decades (Dowd 1992; Selgin 1994a). If runs were a problem even with solvent banks - that is, if depositors ran simply out of fear that others would run, thereby forcing any less-than-perfectly-liquid bank to default - an option clause would be an available contractual remedy.(11) An option clause in note and demand deposit contracts gives the bank the option to suspend payments in the event of a run, for a period long enough to allow the bank to liquidate its non-reserve assets in orderly fashion. To make the clause acceptable to customers, judging by the historical example of the Scottish optional notes, the bank would have to specify the period of suspension (or at least its maximum length), and obligate itself to make a compensatory interest payment (in addition to returning the note's face value in base money) at the end of any suspension period. —————————————————————————————————————— 11 It is in this connection, and not in connection with the "fraud" issue, contrary to Hoppe's account of our argument (1994, p. 71), that we consider the option clause important. But we can see that from Hoppe's viewpoint the clause also eliminates the charge of fraud, since the bank is no longer promising unconditionally to redeem its claims on demand, and therefore the total of its unconditionally demandable claims no longer exceeds its reserves. —————————————————————————————————————— This payment would not only compensate the customer for the inconvenience and delay, but would also give the bank a visible incentive not to invoke the option except when necessary (in technical jargon, it would make the contract "incentive-compatible"; it avoids a potential moral hazard problem by penalizing a bank that skimps on reserves and thereby runs too great a risk of suspension). Historically, as discussed in the text, some banks did write such option-clause contracts, where their legislatures did not forbid them to do so. But how do we know that not everyone who accepted a fractional-reserve note at face value was in the dark about its fractional backing? At the very least we know that competing banks participated in clearing arrangements in which they agreed to accept one another's notes at par. Certainly the bankers were not in the dark. They did not expect - or find - defaults at the clearinghouse to be more than extremely rare. Normative and Positive Questions Rebutting the Charge of Fraud Third-Party Effects The Popularity of Fractional-Reserve Banking The Resource Cost Savings From Fiduciary Media Inherent Instability Conclusion References
