1. A History of Modern Theories in Support of a 100-Percent Reserve Requirement

We know that distrust of fractional-reserve banking dates back at least as far as the Salamancan theorists of the sixteenth and seventeenth centuries, David Hume in the eighteenth century, theorists of the school of Jefferson and Jackson in the decades following the founding of the United States, and the important group of theorists from nineteenth-century continental Europe (Modeste and Cernuschi in France; Michaelis, Hübner, Geyer, and Tellkampf in Germany). Moreover, certain highly distinguished economists of the twentieth century, such as Ludwig von Mises and at least four recipients of the Nobel Prize for Economics (Friedrich A. Hayek, Milton Friedman, James Tobin, and Maurice Allais) have at some point defended the establishment of a 100-percent reserve requirement on demand deposits placed at banks.

THE PROPOSAL OF LUDWIG VON MISES

Ludwig von Mises was the first twentieth-century economist to propose the establishment of a banking system with a 100-percent reserve requirement on demand deposits. Mises made his recommendation in the first edition of his book, The Theory of Money and Credit, published in 1912. At the end of this first edition, in a section literally reproduced in the second, which was printed in 1924, Mises draws the following conclusion:

Fiduciary media are scarcely different in nature from money; a supply of them affects the market in the same way as a supply of money proper; variations in their quantity influence the objective exchange value of money in just the same way as do variations in the quantity of money proper. Hence, they should logically be subjected to the same principles that have been established with regard to money proper; the same attempts should be made in their case as well to eliminate as far as possible human influence on the exchange ratio between money and other economic goods. The possibility of causing temporary fluctuations in the exchange ratios between goods of higher and of lower orders by the issue of fiduciary media, and the pernicious consequences connected with a divergence between the natural and money rates of interest, are circumstances leading to the same conclusion. Now it is obvious that the only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media. The basic conception of Peel's Act ought to be restated and more completely implemented than it was in the England of his time by including the issue of credit in the form of bank balances within the legislative prohibition.

Mises adds:

It would be a mistake to assume that the modern organization of exchange is bound to continue to exist. It carries within itself the germ of its own destruction; the development of the fiduciary medium must necessarily lead to its breakdown.¹

Mises again considers the model for an ideal banking system in his 1928 book, Geldwertstabilisierung und Konjunkturpolitik (Monetary stabilization and cyclical policy). There we read:

The most important prerequisite of any cyclical policy, no matter how modest its goal may be, is to renounce every attempt to reduce the interest rate, by means of banking policy, below the rate which develops on the market. That means a return to the theory of the Currency School, which sought to suppress all future expansion of circulation credit and thus all further creation of fiduciary media. However, this does not mean a return to the old Currency School program, the application of which was limited to banknotes. Rather it means the introduction of a new program based on the old Currency School theory, but expanded in the light of the present state of knowledge to include fiduciary media issued in the form of bank deposits. The banks would be obliged at all times to maintain metallic backing for all notes— except for the sum of those outstanding which are not now covered by metal—equal to the total sum of the notes issued and bank deposits opened. That would mean a complete reorganization of central bank legislation.... By this act alone, cyclical policy would be directed in earnest toward the elimination of crises.²

Two years later, on October 10, 1930, before the Financial Committee of the League of Nations in Geneva, Mises delivered a memorandum on “The Suitability of Methods of Ascertaining Changes in the Purchasing Power for the Guidance of International Currency and Banking Policy.” There, before the monetary and banking experts of his day, Mises expressed his ideas as follows:

It is characteristic of the gold standard that the banks are not allowed to increase the amount of notes and bank balances without a gold backing, beyond the total which was in circulation at the time the system was introduced. Peel's Bank Act of 1844, and the various banking laws which are more or less based on it, represent attempts to create a pure gold standard of this kind. The attempt was incomplete because its restrictions on circulation included only banknotes, leaving out of account bank balances on which cheques could be drawn. The founders of the Currency School failed to recognize the essential similarity between payments by cheque and payments by banknote. As a result of this oversight, those responsible for this legislation never accomplished their aim.³

Mises would later explain that a banking system based on the gold standard and a 100-percent reserve requirement would tend to push prices down slightly, which would benefit most citizens, since it would raise their real income, not through a nominal increase in earnings but through a continual reduction in the prices of consumer goods and services and relative constancy in nominal income. Mises deems such a monetary and banking system far superior to the current system, which is beset with chronic inflation and recurrent cycles of expansion and recession. In reference to the economic depression then afflicting the world, Mises concludes:

The root cause of the evil is not in the restrictions, but in the expansion which preceded them. The policy of the banks does not deserve criticism for having at last called a halt to the expansion of credit, but, rather, for ever having allowed it to begin.⁴

Ten years after delivering this memo before the League of Nations, Mises once more defended a 100-percent reserve requirement, this time in the first German edition of his all-embracing economic treatise, published as Nationalökonomie: Theorie des Handelns und Wirtschaftens (Economics: Theory of Action and Exchange). Here Mises again presents his thesis that the ideas essential to the Currency School require the application of a 100-percent reserve requirement to all fiduciary media; that is, not only to banknotes, but also to bank deposits. Moreover, in this book Mises advocates the abolition of the central bank and indicates that while this institution continues to exist, even if the issuance of new fiduciary media (bills and deposits) is strictly prohibited, there will always be a danger that “emergency” budget difficulties will be cited as political justification for issuing new fiduciary media to help finance the needs of the state. Mises implicitly responds thus to theorists of the Chicago School who in the 1930s proposed that a 100-percent reserve requirement be set for banking, but that the monetary base remain fiduciary, and that the responsibility for issuing and controlling the stock of money continue to fall to the central bank. Mises does not consider this the best solution. In this case, even with a 100-percent reserve requirement, money would still ultimately depend on a central bank and would therefore be subject to all sorts of pressures and influences, particularly the danger that in a financial emergency the state would exercise its power to issue currency in order to finance itself. According to Mises, the ideal solution would thus be to establish a system of free banking (i.e., without a central bank) subject to traditional legal principles (and hence, a 100-percent reserve requirement).⁵ In this book Mises accompanies his defense of a 100-percent reserve requirement with his objection not only to the central bank, but also to a fractional-reserve free-banking system: although such a system would greatly limit the issuance of fiduciary media, it would be inadequate to completely eliminate credit expansion nor the recurrent booms and economic recessions which inevitably come with it.⁶

In 1949 Yale University Press published the first English edition of Ludwig von Mises's economic treatise, entitled Human Action: A Treatise on Economics. In this English edition Mises repeats the arguments from the German edition, but he expressly refers to Irving Fisher's plan for establishing a 100-percent reserve requirement for banking. Mises disapproves of Fisher's plan, not because it includes a proposal for a 100-percent reserve requirement, which Mises fully supports, but because Fisher seeks to combine this measure with the conservation of the central bank and the adoption of an indexed monetary unit. In fact, according to Mises, the suggestion to reestablish a 100-percent reserve requirement, yet preserve the central bank, is insufficient:

[I]t would not entirely remove the drawbacks inherent in every kind of government interference with banking. What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract.⁷

Mises again expresses his ideas on a 100-percent reserve requirement in an appendix (on “Monetary reconstruction”) to the 1953 English reissue of The Theory of Money and Credit, where he explicitly states:

The main thing is that the government should no longer be in a position to increase the quantity of money in circulation and the amount of checkbook money not fully—that is, 100 percent—covered by deposits paid in by the public.

Furthermore, in this appendix Mises also proposes a process of transition to the ideal system, with the following goal:

No bank must be permitted to expand the total amount of its deposits subject to check or the balance of such deposits of any individual customer, be he a private citizen or the U.S. Treasury, otherwise than by receiving cash deposits in legal-tender banknotes from the public or by receiving a check payable by another domestic bank subject to the same limitations. This means a rigid 100 percent reserve for all future deposits; that is, all deposits not already in existence on the first day of the reform.⁸

Though further on we will again deal with the process of transition to the ideal banking system, we observe here that Mises, in keeping with his 1928 writings, proposes the same system of transition as the one applied to banknotes with Peel's Act (which required that only newly-created bills be backed 100 percent by specie).⁹

F.A. HAYEK AND THE PROPOSAL OF A 100-PERCENT RESERVE REQUIREMENT

F.A. Hayek, undoubtedly Mises's most brilliant disciple, first wrote about a 100-percent reserve requirement when, at the age of twenty-five, he published the article, “The Monetary Policy of the United States after the Recovery from the 1920 Crisis,” following his return from a study tour of the United States. Indeed, in this article, Hayek strongly criticizes the monetary policy the Federal Reserve had put into operation at the time. The Fed's policy was designed to maintain the stability of the dollar's purchasing power in a context of rapidly growing productivity, and it had already begun to generate the substantial credit expansion which would ultimately cause the Great Depression. For the first time in his life, Hayek refers to the 100-percent reserve requirement in a footnote of this seminal article. He states:

As we have already emphasized, the older English theoreticians of the currency school had a firmer grasp of this than the majority of economists who came after them. The currency school hoped also to prevent cyclical fluctuations by the regulation of the note issue they proposed. But since they took only the effects of the note issue into account and neglected those of deposit money, and the restrictions imposed upon bank credit could always be got round by an expansion of transfers through bank deposits, Peel's Bank Act and the central bank statute modelled upon it could not achieve this aim. The problem of the prevention of crises would have received a radical solution if the basic concept of Peel's Act had been consistently developed into the prescription of 100 percent gold cover for bank deposits as well as notes.¹⁰

In his remarkable work, Monetary Nationalism and International Stability, published twelve years later in 1937, F.A. Hayek again speaks of establishing a banking system based on a 100-percent reserve requirement. At that time, theorists of the Chicago School had already made a similar proposal, which they attempted to base on the central bank's paper currency. In contrast Hayek asserts that the ideal solution would be to combine a 100-percent reserve requirement for banking with a return to a pure gold standard. In this way, all bank-notes and deposits would be backed by gold 100 percent, and a worldwide, sound monetary system effective at preventing government manipulation and “monetary nationalism” would emerge. Hayek concludes:

The undeniable attractiveness of this proposal lies exactly in the feature which makes it appear somewhat impracticable, in the fact that in effect it amounts... to an abolition of deposit banking as we know it.¹¹

Nearly forty years later, F.A. Hayek again took up the subject of money and banking in his famous work, Denationalization of Money. Although modern fractional-reserve free-banking theorists have used this book to justify their model, there is no doubt that Hayek proposes a system of free banking and private issuance of monetary units and that ultimately he wishes to see the banking model with a 100-percent reserve requirement prevail. In fact in the section he devotes to the change of policy in commercial banking, Hayek concludes that the vast majority of banks

clearly would have to be content to do their business in other currencies. They would thus have to practise a kind of “100 percent banking,” and keep a full reserve against all their obligations payable on demand.

Hayek adds a harsh criticism of the current banking system:

An institution which has proved as harmful as fractional reserve banking without the responsibility of the individual bank for the money (i.e., cheque deposits) it created cannot complain if support by a government monopoly that has made its existence possible is withdrawn.¹²

MURRAY N. ROTHBARD AND THE PROPOSAL OF A PURE GOLD STANDARD WITH A 100-PERCENT RESERVE REQUIREMENT

In 1962 Professor Murray N. Rothbard's now classic article, “The Case for a 100-Percent Gold Dollar,” appeared in the book, In Search of a Monetary Constitution¹³ (which was edited by Leland B. Yeager and also contains articles by James M. Buchanan, Milton Friedman, Arthur Kemp, and others). In this article, Rothbard first develops his proposal for a pure gold standard based on a free-banking system with a 100-percent reserve requirement. In this paper, Rothbard criticizes all who support a return to the spurious gold standard rooted in a fractional-reserve banking system controlled by a central bank. Instead he suggests what he views as the only coherent, stable long-term solution: a free-banking system with a 100-percent reserve requirement, the abolition of the central bank, and the establishment of a pure gold standard. According to Rothbard, the result would be the prevention not only of the recurrent cycles of boom and recession caused by fractional-reserve banking, but also of the possibility, even with a 100-percent reserve requirement as defended by Chicago School theorists in the 1930s, that the conservation of the central bank should leave the entire system vulnerable to the political and financial needs of each moment.

Nevertheless we deem Rothbard's main contribution to be the strong legal foundation on which he builds his proposal. In fact he accompanies his economic analysis with an essentially legal, though multidisciplinary, study aimed entirely at showing that banking with a 100 percent reserve is simply the logical result of applying traditional legal principles to the banking field. Hence, on this particular point, in the present book we merely try to develop and extend Rothbard's original thesis. Specifically, Rothbard compares the banker who operates with a fractional reserve with the criminal who commits the crime of misappropriation:

[H]e takes money out of the company till to invest in some ventures of his own. Like the banker, he sees an opportunity to earn a profit on someone else's assets. The embezzler knows, let us say, that the auditor will come on June 1 to inspect the accounts; and he fully intends to repay the “loan” before then. Let us assume that he does; is it really true that no one has been the loser and everyone has gained? I dispute this; a theft has occurred, and that theft should be prosecuted and not condoned. Let us note that the banking advocate assumes that something has gone wrong only if everyone should decide to redeem his property, only to find that it isn't there. But I maintain that the wrong—the theft— occurs at the time the embezzler takes the money, not at the later time when his “borrowing” happens to be discovered.¹⁴

Although Rothbard has correctly presented the legal aspects of the issue, he has followed the Anglo-Saxon legal tradition without realizing that even stronger legal support for his thesis lies in the continental European legal tradition, based on Roman law, as we explained in the initial chapters.¹⁵

MAURICE ALLAIS AND THE EUROPEAN DEFENSE OF A 100-PERCENT RESERVE REQUIREMENT

In Europe, the Frenchman Maurice Allais, who received the Nobel Prize for Economics in 1988, has championed the proposal of a banking system subject to a 100-percent reserve requirement. As Allais recently stated:

The credit mechanism as it currently operates, based on the fractional coverage of deposits, the ex nihilo creation of money, and the long-term lending of short-term-loan funds, substantially aggravates the disruptions mentioned. Indeed, all major crises in the nineteenth and twentieth centuries stemmed from an excessive expansion of credit, from promissory notes and their monetization, and from the speculation this expansion fueled and made possible.¹⁶

Though Maurice Allais often quotes Ludwig von Mises and Murray N. Rothbard, and though Allais's economic analysis of the effects of fractional-reserve banking and its role in provoking economic crises is impeccable and heavily influenced by the Austrian theory of the economic cycle, in the end Allais does suggest the conservation of the central bank as the organization ultimately responsible for controlling the monetary base and overseeing its growth (at a fixed rate of 2 percent per year).¹⁷ For Allais believes the state alone, and not bankers, should take advantage of the expropriation which comes with the possibility of creating money. Thus his proposal of a 100-percent reserve requirement is not the logical result of applying traditional legal principles to banking, as in the case of Murray N. Rothbard. Instead, it represents an attempt to assist governments in administering a stable monetary policy by preventing the elastic, distorting credit expansion which all fractional-reserve banking systems generate from nothing. In this sense, Maurice Allais simply follows the old tradition established by some members of the Chicago School, who proposed a 100-percent reserve requirement to make government monetary policy more effective and predictable.

THE OLD CHICAGO-SCHOOL TRADITION OF SUPPORT FOR A 100-PERCENT RESERVE REQUIREMENT

The Chicago School prescription of a 100-percent reserve requirement dates back to March 16, 1933, when Henry C. Simons, Lloyd W. Mints, Aaron Director, Frank H. Knight, Henry Schultz, Paul H. Douglas, Albert G. Hart and others circulated an anonymous six-page document called “Banking and Currency Reform.”¹⁸ Albert G. Hart later expanded on this program in his article, “The ‘Chicago Plan’ of Banking Reform,” published in 1935. Here Hart expressly recognizes Professor Ludwig von Mises as the ultimate father of the proposal.¹⁹ Later, in November of 1935, James W. Angell published a comprehensive article in which he defends this position and analyzes its different aspects. His article is entitled “The 100-Percent Reserve Plan,”²⁰ and was followed by a paper by Henry C. Simons, “Rules versus Authorities in Monetary Policy,” which appeared in 1936.²¹

Of the Chicago theorists, Henry C. Simons comes closest to the thesis that a 100-percent reserve requirement is not a mere economic-policy proposal, but an imperative of the institutional framework of rules which is vital for the correct functioning of a market economy. Indeed Simons asserts:

A democratic, free-enterprise system implies, and requires for its effective functioning and survival, a stable framework of definite rules, laid down in legislation and subject to change only gradually and with careful regard for the vested interests of participants in the economic game.²²

Nevertheless Henry C. Simons defends a 100-percent reserve requirement with the basic purpose of restoring complete government control over the quantity of money in circulation and its value. He had announced his proposal one year earlier, in a pamphlet entitled “A Positive Program for Laissez-Faire: Some Proposals for a Liberal Economic Policy,” published in 1934. As indicated in this pamphlet, at that time Simons already believed that deposit banks which maintained

100 per cent reserves, simply could not fail, so far as depositors were concerned, and could not create or destroy effective money. These institutions would accept deposits just as warehouses accept goods. Their income would be derived exclusively from service charges—perhaps merely from moderate charges for the transfer of funds by check or draft.... These banking proposals define means for eliminating the perverse elasticity of credit which obtains under a system of private, commercial banking and for restoring to the central government complete control over the quantity of effective money and its value.²³

Simons's contributions²⁴ were followed by those Fritz Lehmann made in his article, “100 Percent Money”²⁵ and by the article Frank D. Graham published in September of 1936 with the title, “Partial Reserve Money and the 100 Percent Proposal.”²⁶

Irving Fisher compiled these proposals in book form in 100 Percent Money.²⁷ Following World War II, they were taken up again by Henry C. Simons in his 1948 book, Economic Policy for a Free Society, and by Lloyd W. Mints in Monetary Policy for a Competitive Society.²⁸ This trend culminated in the publication of Milton Friedman's A Program for Monetary Stability in 1959.²⁹ Milton Friedman, like his predecessors, recommends the current system be replaced with one which includes a 100-percent reserve requirement.³⁰ The only difference is that Friedman suggests the payment of interest on such reserves, and in an interesting footnote he mentions the complete free-banking system, defended by Gary Becker, as one way to approach this objective.³¹

Henry C. Simons comes closest to recognizing the juridical-institutional demands for a 100-percent reserve requirement.³² However, in general, Chicago theorists have defended a 100 percent-reserve banking system for exclusively practical reasons, believing this requirement would make government monetary policy easier and more predictable. Therefore the theorists of the Chicago School have been guilty of naiveté in ascribing to governments the desire and ability to administer a stable monetary policy under all circumstances.³³ This naiveté parallels that shown by modern neo-banking defenders of fractional-reserve free banking when they rely on spontaneous interbank liquidation and clearing mechanisms to halt under all circumstances planned, simultaneous expansion by most banks. These theorists fail to see that although a fractional-reserve free-banking system would have more limitations than the current system, it would not prevent the creation of fiduciary media, nor, logically, would it immunize the market against economic crises. Hence we must conclude that the only effective way to rid society of special privileges and economic cycles is to establish a free-banking system governed by legal principles; that is, a 100-percent reserve requirement.³⁴