4. A Critical Look at the Modern Fractional-Reserve Free-Banking School

The last twenty years have seen a certain resurgence of the old economic Banking School doctrines. Defenders of these views claim that a fractional-reserve free-banking system would not only give rise to fewer distortions and economic crises than central banking, but would actually tend to eliminate such problems. Given that these theorists base their reasoning on different variations of the Old Banking School arguments, some more sophisticated than others, we will group the theorists under the heading, “Neo-Banking School,” or “modern pro-Fractional-Reserve Free-Banking School.” This school is composed of a curious alliance of scholars,¹⁰³ among whom we could mention certain members of the Austrian School who, in our opinion, have missed some of Mises's and Hayek's teachings on monetary matters and the theory of capital and economic cycles, members like White,¹⁰⁴ Selgin¹⁰⁵ and, more recently, Horwitz;¹⁰⁶ members of the English Subjectivist School, like Dowd;¹⁰⁷ and finally, theorists with a monetarist background, like Glasner,¹⁰⁸ Yeager¹⁰⁹ and Timberlake.¹¹⁰ Even Milton Friedman,¹¹¹ though he cannot be considered a member of this new school, has been gradually leaning toward it, especially following his failure to convince central bankers that they should put his famous monetary rule into practice.

Modern fractional-reserve free-banking theorists have developed an economic theory of “monetary equilibrium.” They base their theory on certain typical elements of the monetarist and Keynesian analysis¹¹² and intend it to demonstrate that a fractional-reserve free-banking system would simply adjust the volume of fiduciary media created (banknotes and deposits) to public demand for them. In this way they argue that fractional-reserve free banking would not only preserve “monetary equilibrium” better than other, alternative systems but would also most effectively adjust the supply of money to the demand for it.

In a nutshell, this argument centers around the hypothetical results of an increase in economic agents' demand for fiduciary media, assuming reserves of specie in the banking system remain constant. In that event, theorists reason, the pace at which fiduciary media are exchanged for bank reserves would slacken. Reserves would increase and bankers, aware of this rise and eager to obtain larger profits, would expand credit and issue more bills and deposits, and the growth in fiduciary media would tend to match the prior increase in demand. The opposite would occur should the demand for fiduciary media decrease: Economic agents would withdraw greater quantities of reserves in order to rid themselves of fiduciary media. Banks would then see their solvency endangered and be obliged to tighten credit and issue fewer banknotes and deposits. In this way a decrease in the supply of fiduciary media would follow the prior decrease in the demand for them.¹¹³

The theory of “monetary equilibrium” obviously echoes Fullarton's law of reflux and, especially, the Old Banking School arguments concerning the “needs of trade.” According to these arguments, private banks' creation of fiduciary media is not detrimental if it corresponds to an increase in the “needs” of businessmen. These arguments are repeated and crystallized in the “new” theory of “monetary equilibrium,” which states that private banks' creation of fiduciary media in the form of notes and deposits does not generate economic cycles if it follows a rise in public demand for such instruments. Although Lawrence H. White does develop an embryonic version of this reformed “needs of trade” doctrine in his book on free banking in Scotland,¹¹⁴ credit for theoretically formulating the idea goes to one of White's most noted students, George A. Selgin. Let us now critically examine Selgin's theory of “monetary equilibrium,” or in other words, his revised version of some of the Old Banking School doctrines.

THE ERRONEOUS BASIS OF THE ANALYSIS: THE DEMAND FOR FIDUCIARY MEDIA, REGARDED AS AN EXOGENOUS VARIABLE

Selgin's analysis rests on the notion that the demand for money in the form of fiduciary media is a variable exogenous to the system, that this variable changes with the desires of economic agents, and that the main purpose of the free-banking system is to reconcile the issuance of deposits and banknotes with shifts in the demand for them.¹¹⁵Nevertheless such demand is not exogenous to the system, but endogenously determined by it.

It is no coincidence that theorists of the Fractional-Reserve Free-Banking School begin their analysis by focusing on certain more or less mysterious variations in the demand for fiduciary media, and that they neglect to explain the origin or etiology of these variations.¹¹⁶ It is as if these theorists realized that, on the side of the money supply, the Austrians have demonstrated that credit expansion seriously distorts the economy, a fact which in any case seems to warrant a rigid monetary system¹¹⁷ capable of preventing the monetary expansions and contractions typical of any fractional-reserve banking system. Therefore on the side of supply, theoretical arguments appear to support the establishment of a relatively inelastic monetary system, such as a pure gold standard with a 100-percent reserve requirement for banknotes and deposits.¹¹⁸ Hence if defenders of the Neo-Banking School wish to justify a fractional-reserve free-banking system in which there may be substantial increases and decreases in the money supply in the form of fiduciary media, they must independently look to the side of demand in the hope of being able to demonstrate that such modifications in the supply of fiduciary media (which are inevitable in a fractional-reserve system) correspond to prior variations in demand which are satisfied by the reestablishment of a hypothetical, preexistent state of “monetary equilibrium.”

Growth in the money supply in the form of credit expansion distorts the productive structure and gives rise to an economic boom and subsequent recession, stages during which significant variations in the demand for money and fiduciary media take place. Hence the process is not triggered, as theorists of the modern Free-Banking School suppose, by independent, catalytic changes in the demand for fiduciary media, but by the manipulation of the supply of them. All fractional-reserve banking systems carry out such manipulation to one degree or another by expanding credit.

It is true that in a system composed of a multiplicity of free banks unsupported by a central bank, credit expansion would stop much sooner than in a system in which the central bank orchestrates widespread expansion and uses its liquidity to aid those banks in jeopardy. This is the pro-free-banking argument Parnell originally developed and Mises later identified as second-best.¹¹⁹ However it is one thing to assert that in a completely free banking system credit expansion would be curbed sooner than in the current system, and it is quite another to claim that credit expansion brought about in a fractional-reserve free-banking system would never distort the productive structure, since a state of supposed “monetary equilibrium” would always tend to return. In fact Mises himself very clearly indicates that all credit expansion distorts the productive system. Hence Mises rejects the essence of the modern theory of monetary equilibrium. Indeed Mises affirms:

The notion of “normal” credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle.¹²⁰

The chief failing of Selgin's theory of “monetary equilibrium” is that it ignores the fact that the supply of fiduciary media largely creates its own demand. In other words, modern free-banking theory contains the Old Banking School's fundamental error, which, as Mises adeptly revealed, lies in a failure to reflect that public demand for credit depends precisely on banks' inclination to lend. Thus those bankers who, in the beginning, are not overly concerned about their future solvency are in a position to expand credit and place new fiduciary media in the market simply by reducing the interest rate they ask for the new money they create and easing their normal credit terms.¹²¹ Therefore, in contrast with the assumptions of Selgin and the other theorists of his school, bankers can initiate credit expansion in a free-banking system if for some reason they disregard their own solvency, whether or not a prior variation in the demand for fiduciary media has occurred. Another factor explains why, during a prolonged period, the increase in the quantity of depoisits (from credit expansion) actually tends to stimulate demand for fiduciary media. In fact all economic agents who are unaware that an inflationary process of expansion has begun, and that this process will ultimately cause a relative decrease in the purchasing power of money and a subsequent recession, will notice that certain goods and services begin to rise in price faster than others and will wait in vain for such prices to return to their “normal” level. Meanwhile they will most likely decide to increase their demand for fiduciary media. To again cite Mises:

This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings.¹²²

Not only are banks in a fractional-reserve free-banking system able to unilaterally instigate credit expansion, but during a prolonged period the resulting increase in the supply of fiduciary media (which can always be placed in the market through an opportune reduction in the interest rate) tends to create further demand. This increase in demand will last until the public loses some of its unrealistic optimism, begins to distrust the economic “bonanza,” and foresees a widespread rise in prices, followed by a crisis and profound economic recession.

We have argued that the origin of monetary changes lies on the side of supply, that banks in a free-banking system are able to manipulate the money supply, and that the corresponding issuance of fiduciary media creates its own demand in the short and medium term. If the above assertions are true, then Selgin is utterly mistaken in claiming that the supply of fiduciary media merely adjusts to the demand for them. Indeed the demand for fiduciary media, at least during a considerable period of time, adjusts to the increased supply which banks create in the form of loans.¹²³

THE POSSIBILITY THAT A FRACTIONAL-RESERVE FREE-BANKING SYSTEM MAY UNILATERALLY INITIATE CREDIT EXPANSION

Various circumstances make it possible for a fractional-reserve free-banking system to initiate credit expansion in the absence of a corresponding, prior increase in the demand for fiduciary media.

First, we must point out that the monetary equilibrium analysis of modern free-banking theorists contains many of the same limitations as the traditional neoclassical analysis, which, both in a micro- and macroeconomic context, merely deals with the final state of social processes (monetary equilibrium), a state to which the rational, maximizing behavior of economic agents (private bankers) supposedly leads. In contrast, the economic analysis of the Austrian School centers on dynamic entrepreneurial processes, rather than on equilibrium. Each entrepreneurial act coordinates and establishes a tendency toward equilibrium, which, nevertheless, is never reached, because during the process itself circumstances change and entrepreneurs create new information. Thus, from this dynamic point of view, we cannot accept a static model which, like that of monetary equilibrium, presupposes that immediate, perfect adjustments between the demand for and the supply of fiduciary media take place.

In real life, each banker, according to his insight and entrepreneurial creativity, subjectively interprets the information he receives from the outside world, both in terms of his level of optimism in evaluating the course of economic events, and in terms of the volume of reserves he considers “prudent” with a view to maintaining his solvency. Hence each banker, in an environment of uncertainty, decides each day what volume of fiduciary media he will issue. In the above entrepreneurial process, bankers will clearly commit many errors which will manifest themselves in the unilateral issuance of fiduciary media and will distort the productive structure. Granted, the process itself will tend to reveal and eliminate the errors committed, but only following a period of varying length, and damage to the real productive structure will not be avoided. If we add that, as we saw in the last section, the supply of fiduciary media tends to create its own demand, we see it is highly unlikely that a fractional-reserve free-banking system (or any other market) could reach the “monetary equilibrium,” that its theorists so desire. For in the best of cases, private bankers will attempt through a process of trial and error to adjust their supply of fiduciary media to the demand for them, which is unknown to bankers and tends to vary as a consequence of the very issuance of fiduciary media. Hence scholars may debate whether or not the entrepreneurial coordination process will bring the coveted state of “monetary equilibrium” within bankers' reach, but scholars cannot deny that throughout this process entrepreneurs will commit innumerable errors in the form of the unjustified issuance of fiduciary media, and that these errors will inevitably tend to affect the productive structure by provoking economic crises and recessions, just as the Austrian theory of economic cycles explains.¹²⁴

Second, a large or small group of bankers could also collectively orchestrate the expansion of fiduciary media or decide to merge in order to share and better “manage” their reserves, thus increasing their capacity to expand credit and improve profits.¹²⁵ Unless fractional-reserve free-banking theorists wish to prohibit this type of entrepreneurial strategy (which we doubt), it will obviously result in credit expansion and consequent economic recessions. It can be argued that inconcert expansion will tend to correct itself, since, as Selgin maintains, the total increase in interbank clearings will raise the variance in the clearing of debits and credits.¹²⁶ However, aside from Selgin's assumption that the total volume of metallic reserves in the banking system remains constant, and despite the doubts of many authors regarding the effectiveness of Selgin's mechanism,¹²⁷ even if we allow for the sake of argument that Selgin is correct, it can still be argued that the adjustment will never be perfect nor immediate, and therefore in-concert expansion and mergers may provoke significant increases in the supply of fiduciary media, thus triggering the processes which set economic cycles in motion.

Third and last, with every increase in the overall stock of specie (gold) banks keep as a “prudent” reserve, a fractional-reserve free-banking system would stimulate growth in the issuance of fiduciary media which does not correspond to prior rises in demand. If we remember that the world stock of gold has been mounting at an annual rate of 1 to 5 percent¹²⁸ due to the increased world production of gold, it is clear that this factor alone will permit private bankers to issue fiduciary media at a rate of 1 to 5 percent per year, regardless of the demand for them. (Such creation of money will produce an expansion followed by a recession.)¹²⁹

In conclusion, significant (fiduciary) inflationary processes¹³⁰ and severe economic recessions¹³¹ may occur in any fractional-reserve free-banking system.

THE THEORY OF “MONETARY EQUILIBRIUM” IN FREE BANKING RESTS ON AN EXCLUSIVELY MACROECONOMIC ANALYSIS

We must point out that the analysis of modern free-banking theorists ignores the microeconomic effects which arise from increases and decreases in the supply of and demand for fiduciary media instigated by the banking industry. In other words, even if we admit for the sake of argument that the origin of all evil lies, as these theorists suppose, in unexpected changes in economic agents' demand for fiduciary media, it is clear that the supply of fiduciary media which the banking system supposedly generates to adjust to changes in the demand for them does not instantaneously reach precisely those economic agents whose valuation of the possession of new fiduciary media has altered. Instead this supply flows into the market at certain specific points and in a particular manner: in the form of loans granted via a reduction in the interest rate and initially received by individual businessmen and investors who tend to use them to initiate new, more capital-intensive investment projects which distort the productive structure.

Therefore it is unsurprising that modern free-banking theorists overlook the Austrian theory of business cycles, since this theory does not fit in with their analysis of the issuance of fiduciary media in a fractional-reserve free-banking system. These theorists thus take refuge in an exclusively macroeconomic analysis (monetarist or Keynesian, depending on the case) and, at most, use instruments which, like the equation of exchange or the “general price level,” actually tend to conceal the truly relevant microeconomic phenomena (variations in relative prices and intertemporal discoordination in the behavior of economic agents) which occur in an economy upon the expansion of credit and growth in the quantity of fiduciary media.

In normal market processes, the supply of consumer goods and services tends to vary along with the demand for them, and new goods generally reach precisely those consumers whose subjective valuation of them has improved. However where newly-created fiduciary media are concerned, the situation is radically different: an increased supply of fiduciary media never immediately and directly reaches the pockets of those economic agents whose demand for them may have risen. Instead, the money goes through a lengthy, cumbersome temporal process, or transition phase, during which it first passes through the hands of many other economic agents and distorts the entire productive structure.

When bankers create new fiduciary media, they do not deliver them directly to those economic agents who may desire more. On the contrary, bankers grant loans to entrepreneurs who receive the new money and invest the entire amount without a thought to the proportion in which the final holders of fiduciary media will wish to consume and save or invest. Hence it is certainly possible that a portion of the new fiduciary media (supposedly issued in response to increased demand) may ultimately be spent on consumer goods, and thereby push up their relative price. We know (chap. 7, p. 552) that according to Hayek:

[S]o long as any part of the additional income thus created is spent on consumer's goods (i.e., unless all of it is saved), the prices of consumer's goods must rise permanently in relation to those of various kinds of input. And this, as will by now be evident, cannot be lastingly without effect on the relative prices of the various kinds of input and on the methods of production that will appear profitable.¹³²

Hayek clarifies his position even further:

All that is required to make our analysis applicable is that, when incomes are increased by investment, the share of the additional income spent on consumer's goods during any period of time should be larger than the proportion by which the new investment adds to the output of consumer's goods during the same period of time. And there is of course no reason to expect that more than a fraction of the new income [created by credit expansion], and certainly not as much as has been newly invested, will be saved, because this would mean that practically all the income earned from the new investment would have to be saved.¹³³

As a graphic illustration of our argument, let us suppose that the demand for fiduciary media increases, while the proportion in which economic agents wish to consume and invest remains unchanged.¹³⁴ Under these conditions, economic agents must reduce their monetary demand for consumer goods, sell bonds and other financial assets and, especially, reinvest less money in the different stages of the productive process until they can accumulate the greater volume of bank deposits they wish to hold. Therefore if we suppose that the social rate of time preference has not altered, and we use a simplified version of the triangular diagrams from chapter 5 to represent society's real productive structure, we see that in Chart VIII-1 the increase in the demand for fiduciary media shifts the hypotenuse of the triangle toward the left. This movement reflects a drop in the monetary demand for consumer and investment goods, since the proportion of one to the other (or time preference) has not varied. In this chart, surface “A” represents economic agents' new demand for (or “hoarding” of) fiduciary media (see Chart VIII-1).

The fundamental conclusion of the theory of monetary equilibrium in a fractional-reserve free-banking system is that banks would respond to this rise in the demand for fiduciary media by expanding their issuance by a volume equal to that of the new demand (represented by surface “A”), and the productive structure, as shown in Chart VIII-2, would remain intact (see Chart VIII-2).

Nonetheless we must remember that banks do not directly transfer the new fiduciary media they create to their final users (the economic agents whose demand for fiduciary media has increased by the volume represented by surface “A” in Chart VIII-1). Instead, the deposits are lent to entrepreneurs, who spend it on investment goods and thereby initially create a more capital-intensive structure, which we represent in Chart VIII-3.

Nevertheless this more capital-intensive productive structure cannot be maintained in the long term. For once the new fiduciary media reach their final recipients (who in the very beginning accumulated the bank money they needed, as surface “A” in Chart VIII-1 indicates), they will spend them, according to our postulate of unchanging time preference, on consumer and investment goods in a proportion equal to that shown in Charts VIII-1 and VIII-2. If we superimpose Chart VIII-3 on Chart VIII-2 (see Chart VIII-4), the distortion of the productive structure becomes clear. Shaded area “B” represents the investment projects entrepreneurs have launched in error, since all of the fiduciary media banks have issued to adjust to the increase in the demand for them have been channeled into investment loans.¹³⁵ Shaded area “C” (with a surface identical to “B”) reflects the portion of the new fiduciary media which the final holders spend on the goods closest to consumption. The productive structure regains the proportions shown in Chart VIII-1, but only following the inevitable, painful readjustments which the Austrian theory of economic cycles explains and which a free-banking system, as we have just seen, would be incapable of preventing. Therefore we must conclude, in contrast to what Selgin and White suggest,¹³⁶ that even if the expansion of fiduciary media fully matches a prior increase in the demand for them, it will provoke the typical cyclical effects predicted by the theory of circulation credit.

THE CONFUSION BETWEEN THE CONCEPT OF SAVING AND THAT OF THE DEMAND FOR MONEY

The attempt to recover at least the essence of the old “needs of trade” doctrine and to show that a fractional-reserve free-banking system would not trigger economic cycles has led George A. Selgin to defend a thesis similar to the one John Maynard Keynes presents in connection with bank deposits. Indeed let us remember that, according to Keynes, anyone who holds additional money from a loan is “saving”:

Moreover, the savings which result from this decision are just as genuine as any other savings. No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth.¹³⁷

George Selgin's position resembles Keynes's. Selgin believes public demand for cash balances in the form of banknotes and deposit accounts reflects the desire to offer short-term loans for the same amount through the banking system. Indeed, Selgin states:

To hold inside money is to engage in voluntary saving.... Whenever a bank expands its liabilities in the process of making new loans and investments, it is the holders of the liabilities who are the ultimate lenders of credit, and what they lend are the real resources they could acquire if, instead of holding money, they spent it. When the expansion or contraction of bank liabilities proceeds in such a way as to be at all times in agreement with changing demands for inside money, the quantity of real capital funds supplied to borrowers by the banks is equal to the quantity voluntarily offered to the banks by the public. Under these conditions, banks are simply intermediaries of loanable funds.¹³⁸

Nonetheless it is entirely possible that the public may simultaneously increase their balances of fiduciary media and their demand for consumer goods and services, if they decide to cut back on their investments. For economic agents can employ their money balances in any of the following three ways: they can spend them on consumer goods and services; they can spend them on investments; or they can hold them as cash balances or fiduciary media. There are no other options. The decision on the proportion to spend on consumption or investment is distinct and independent from the decision on the amount of fiduciary media and cash to hold. Thus we cannot conclude, as Selgin does, that any money balance is equal to “savings,” since a rise in the balance of fiduciary media may very well depend on a drop in investment spending (via the sale of securities on the stock market, for instance) which makes it possible to increase final monetary expenditure on consumer goods and services. Under these circumstances an individual's savings would drop, while his balance of fiduciary media would rise. Therefore it is incorrect to qualify as savings all increases in fiduciary media.

To maintain, as Selgin does, that “every holder of demand liabilities issued by a free bank grants that bank a loan for the value of his holdings”¹³⁹ is the same as asserting that any creation of money, in the form of deposits or notes, by a bank in a fractional-reserve free-banking system ultimately amounts to an a posteriori concession of a loan to the bank for the amount created. However the bank generates loans from nothing and offers additional purchasing power to entrepreneurs, who receive the loans without a thought to the true desires of all other economic agents regarding consumption and investment, when these other individuals will ultimately become the final holders of the fiduciary media the bank creates. Hence it is entirely possible, if the social time preference on consumption and investment remains unchanged, that the new fiduciary media the bank creates may be used to step up spending on consumer goods, thus pushing up the relative prices of this type of good.

Fractional-reserve free-banking theorists generally consider any note or deposit a bank issues to be a “financial asset” which corresponds to a loan. From a legal standpoint, this notion involves serious problems, which we examined in the first three chapters. Economically speaking, the error of these theorists lies in their belief that money is a “financial asset” which represents the voluntary saving of an economic agent who “loans” present goods in exchange for future goods.¹⁴⁰ Nevertheless money is itself a present good,¹⁴¹ and the possession of cash balances (or deposits) says nothing about the proportions in which the economic agent wishes to consume and invest. Thus increases and decreases in his money balances are perfectly compatible with different combinations of simultaneous increases and decreases in the proportions in which he consumes or invests. In fact his balances of fiduciary media may rise simultaneously with his spending on consumer goods and services, if he only disinvests some of the resources saved and invested in the past. As Hans-Hermann Hoppe points out, the supply of and demand for money determine its price or purchasing power, while the supply of and demand for “present goods” in exchange for “future goods” determine the interest rate or social rate of time preference and the overall volume of saving and investment.¹⁴²

Saving always requires that an economic agent reduce his consumption (i.e., sacrifice), thus freeing real goods. Saving does not arise from a simple increase in monetary units. That is, the mere fact that the new money is not immediately spent on consumer goods does not mean it is saved. Selgin defends this position when he criticizes Machlup's view¹⁴³ that the expansionary granting of loans creates purchasing power which no one has first withdrawn from consumption (i.e., saved). For credit to leave the productive structure undistorted, it logically must originate from prior saving, which provides present goods an investor has truly saved. If such a sacrifice in consumption has not taken place, and investment is financed by created credit, then the productive structure is invariably distorted, even if the newly-created fiduciary media correspond to a previous rise in the demand for them. Hence Selgin is obliged to redefine the concepts of saving and credit creation. He claims saving occurs ipso facto the moment new fiduciary media are created, provided their initial holder could spend them on consumer goods and does not. Selgin also maintains that credit expansion does not generate cycles if it tends to match a prior increase in the demand for fiduciary media. In short these arguments resemble those Keynes expresses in his General Theory, arguments refuted long ago, as we saw in chapter 7.

The creation of fiduciary media also entails an increase in the money supply and a consequent decrease in the purchasing power of money. In this way banks collectively and almost imperceptibly “expropriate” the value of citizens' monetary units. It certainly smacks of a bad joke to declare that the economic agents who suffer such expropriation are actually (voluntarily?) “saving.” It is not surprising that these doctrines have been defended by authors like Keynes, Tobin, Pointdexter and, in general, all who have justified inflationism, credit expansion and the “euthanasia of the rentier” for the sake of aggressive economic policies geared to insure an “adequate” level of “aggregate demand.” What is surprising, however, is that authors like Selgin and Horwitz, who belong (or at least belonged) to the Austrian School and thus should be more aware of the dangers involved, have had no alternative but to resort to this sort of argument in order to justify their “fractional-reserve free-banking” system.¹⁴⁴

THE PROBLEM WITH HISTORICAL ILLUSTRATIONS OF FREE-BANKING SYSTEMS

Neo-banking authors devote strong efforts to historical studies which they intend to support the thesis that a free-banking system would protect economies from cycles of boom and depression, owing to the “monetary equilibrium” mechanism. Nevertheless the empirical studies produced thus far have not focused on whether free-banking systems have prevented credit expansion, artificial booms and economic recessions. Instead they have centered on whether bank crises and runs have been more or less frequent and severe in this type of system than in a central-banking system (which is obviously quite a different issue).¹⁴⁵

In fact, in a recent study, George A. Selgin looks at the occurrence of bank runs in different historical free-banking systems versus certain systems controlled by a central bank and reaches the conclusion that bank crises were more numerous and acute in the second case.¹⁴⁶ Moreover the main thesis of the main neo-banking book on free banking in Scotland consists entirely of the argument that the Scottish banking system, which was “freer” than the English one, was more “stable” and subject to fewer financial disturbances.¹⁴⁷

However, as Murray N. Rothbard has indicated, the fact that, in relative terms, fewer banks failed in the Scottish free-banking system than in the English system does not necessarily mean the former was superior.¹⁴⁸ Indeed bank failures have been practically eliminated from current central-banking systems, and this does not make such systems better than a free-banking system subject to legal principles. It actually makes them worse. For bank failures in no way indicate that a system functions poorly, but rather that a healthy, spontaneous reversion process has begun to operate in response to fractional-reserve banking, which is a legal privilege and an attack on the market. Therefore whenever a fractional-reserve free-banking system is not regularly accompanied by bank failures and suspensions of payments, we must suspect the existence of institutional factors which shield banks from the normal consequences of fractional-reserve banking and fulfill a role similar to the one the central bank currently fulfills as lender of last resort. In the case of Scotland, banks had so encouraged the use of their notes in economic transactions that practically no one demanded payment of them in gold, and those who occasionally requested specie at the window of their banks met with general disapproval and enormous pressure from their bankers, who accused them of “disloyalty” and threatened to make it difficult for them to obtain loans in the future. Furthermore, as Professor Sidney G. Checkland has shown,¹⁴⁹ the Scottish fractional-reserve free-banking system still went through frequent, successive stages of credit expansion and contraction, which gave rise to economic cycles of boom and recession in 1770, 1772, 1778, 1793, 1797, 1802–1803, 1809–1810, 1810–1811, 1818–1819, 1825–1826, 1836–1837, 1839, and 1845–1847. In other words, even though in relative terms fewer bank runs occurred in Scotland than in England, the successive stages of boom and depression were equally severe, and despite its highly praised free-banking system, Scotland was not free from credit expansion, artificial booms and the subsequent stages of serious economic recession.¹⁵⁰

The nineteenth-century Chilean financial system provides another historical illustration of the inadequacy of fractional-reserve free-banking systems to prevent artificial expansion and economic recessions. In fact during the first half of the nineteenth century, Chile had no central bank and implemented a 100-percent reserve requirement in banking. For several decades its citizens firmly resisted attempts to introduce a fractional-reserve banking system, and during those years they enjoyed great economic and financial stability. The situation began to change in 1853, when the Chilean government hired Jean-Gustav Courcelle-Seneuil (1813–1892), one of the most prominent French fractional-reserve free-banking theorists, as professor of economics at the University of Santiago de Chile. Courcelle-Seneuil's influence in Chile during the ten years he taught there was so great that in 1860 a law permitting the establishment of fractional-reserve free banking (with no central bank) was enacted. At this point the traditional financial stability of the Chilean system gave way to stages of artificial expansion (based on the concession of new loans), followed by bank failures and economic crises. The convertibility of the paper currency was suspended on several occasions (1865, 1867, and 1879), and a period of inflation and serious economic, financial and social maladjustment began. This period resides in the collective memory of Chileans and explains why they continue to mistakenly associate financial disturbances with the doctrinal economic liberalism of Courcelle-Seneuil.¹⁵¹

Moreover the fact that various historical studies appear to indicate that fewer bank runs and crises arose in free-banking systems than in central-banking systems does not mean the former were completely free of such episodes. Selgin himself mentions at least three instances in which acute bank crises devastated free-banking systems: Scotland in 1797, Canada in 1837, and Australia in 1893.¹⁵² If Rothbard is correct, and in the rest of the cases institutional restrictions played the role of central bank to at least some extent, then the number of bank crises might have been much larger in the absence of these restrictions.¹⁵³ At any rate we must not consider the elimination of bank crises to be the definitive criterion for determining which banking system is the best. If this were the case, even the most radical fractional-reserve free-banking theorists would be obliged to admit that the best banking system is that which requires the maintenance of a 100 percent reserve, since by definition this is the only system which in all circumstances prevents bank crises and runs.¹⁵⁴

In short, historical experience does not appear to support the thesis of modern fractional-reserve free-banking theorists. Bank credit expansion gave rise to cycles of boom and depression in even the least controlled free-banking systems, which were not free from bank runs and failures. The recognition of this fact has led certain neo-banking authors, such as Stephen Horwitz, to insist that though historical evidence against their views is of some significance, it does not serve to refute the theory that fractional-reserve free banking produces only benign effects, since strictly theoretical procedures must be used to refute this theory.¹⁵⁵

IGNORANCE OF LEGAL ARGUMENTS

Theorists of fractional-reserve banking tend to exclude legal considerations from their analysis. They fail to see that the study of banking issues must be chiefly multidisciplinary, and they overlook the close theoretical and practical connection between the legal and economic aspects of all social processes.

Thus free-banking theorists lose sight of the fact that fractional-reserve banking involves a logical impossibility from a legal standpoint. Indeed at the beginning of this book 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.¹⁵⁶Such an act clearly constitutes misappropriation and fraud, offenses committed during at least the early stages in the development of the modern banking system, as we saw in chapter 2.

Once bankers obtained from governments the privilege of operating with a fractional reserve, from the standpoint of positive law this banking method ceased to be a crime, and when citizens act in a system backed in this way by law, we must rule out the possibility of criminal fraud. Nevertheless, as we saw in chapters 1 through 3, this privilege in no way provides the monetary bank-deposit contract with an appropriate legal nature. Quite the opposite is true. In most cases this contract is null and void, due to a discrepancy concerning its cause: depositors view the transaction as a deposit, while bankers view it as a loan. According to general legal principles, whenever the parties involved in an exchange hold conflicting beliefs as to the nature of the contract entered into, the contract is null and void.

Moreover even if depositors and bankers agreed that their transaction amounts to a loan, the legal nature of the monetary bank-deposit contract would be no more appropriate. From an economic perspective, we have seen that it is theoretically impossible for banks to return, under all circumstances, the deposits entrusted to them beyond the amount of reserves they hold. Furthermore this impossibility is aggravated to the extent that fractional-reserve banking itself tends to provoke economic crises and recessions which repetitively endanger banks' solvency. According to general legal principles, contracts which are impossible to put into practice are also null and void. Only a 100-percent reserve requirement, which would guarantee the return of all deposits at any moment, or the support of a central bank, which would supply all necessary liquidity in times of difficulty, could make such “loan” contracts (with an agreement for the return of the face value at any time) possible and therefore valid.

The argument that monetary bank-deposit contracts are impossible to honor only periodically and under extreme circumstances cannot redeem the legal nature of the contract either, since fractional-reserve banking constitutes a breach of public order and harms third parties. In fact, because fractional-reserve banking expands loans without the support of real saving, it distorts the productive structure and therefore leads loan recipients, entrepreneurs deceived by the increased flexibility of credit terms, to make ultimately unprofitable investments. With the eruption of the inevitable economic crisis, businessmen are forced to halt and liquidate these investment projects. As a result, a high economic, social, and personal cost must be borne by not only the entrepreneurs “guilty” of the errors, but also all other economic agents involved in the production process (workers, suppliers, etc.).

Hence we may not argue, as White, Selgin, and others do, that in a free society bankers and their customers should be free to make whatever contractual agreements they deem most appropriate.¹⁵⁷ For even an agreement found satisfactory by both parties is invalid if it represents a misuse of law or harms third parties and therefore disrupts the public order. This applies to monetary bank deposits which are held with a fractional reserve and in which, contrary to the norm, both parties are fully aware of the true legal nature and implications of the agreement.

Hans-Hermann Hoppe¹⁵⁸ explains that this type of contract is detrimental to third parties in at least three different ways. First, credit expansion increases the money supply and thereby diminishes the purchasing power of the monetary units held by all others with cash balances, individuals whose monetary units thus drop in buying power in relation to the value they would have had in the absence of credit expansion. Second, depositors in general are harmed, since the credit expansion process reduces the probability that, in the absence of a central bank, they will be able to recover all of the monetary units originally deposited; if a central bank exists, depositors are wronged in that, even if they are guaranteed the repayment of their deposits at any time, no one can guarantee they will be repaid in monetary units of undiminished purchasing power. Third, all other borrowers and economic agents are harmed, since the creation of fiduciary credit and its injection into the economic system jeopardizes the entire credit system and distorts the productive structure, thus increasing the risk that entrepreneurs will launch projects which will fail in the process of their completion and cause untold human suffering when credit expansion ushers in the stage of economic recession.¹⁵⁹

In a free-banking system, when the purchasing power of money declines in relation to the value money would have were credit not expanded in a fractional-reserve environment, participants (depositors and, especially, bankers) act to the detriment of third parties. The very definition of money reveals that any manipulation of it, society's universal medium of exchange, will exert harmful effects on almost all third-party participants throughout the economic system. Therefore it does not matter whether or not depositors, bankers, and borrowers voluntarily reach specific agreements if, through fractional-reserve banking, such agreements influence money and harm the public in general (third parties). Such damage renders the contract null and void, due to its disruption of the public order.¹⁶⁰ Economically speaking, the qualitative effects of credit expansion are identical to those of the criminal act of counterfeiting banknotes and coins, an offense covered, for instance, by articles 386–389 of the new Spanish Penal Code.¹⁶¹ Both acts entail the creation of money, the redistribution of income in favor of a few citizens and to the detriment of all others, and the distortion of the productive structure. Nonetheless, from a quantitative standpoint, only credit expansion can increase the money supply at a fast enough pace and on a large enough scale to feed an artificial boom and provoke a recession. In comparison with the credit expansion of fractional-reserve banking and the manipulation of money by governments and central banks, the criminal act of counterfeiting currency is child's play with practically imperceptible social consequences.

The above legal considerations have not failed to influence White, Selgin, and other modern free-banking theorists, who have proposed, as a last line of defense to guarantee the stability of their system, that “free” banks establish a “safeguard” clause on their notes and deposits, a clause to inform customers that the bank may decide at any moment to suspend or postpone the return of deposits or the payment of notes in specie.¹⁶² 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. There can be no objection to the voluntary decision of certain parties to enter into such an atypical aleatory contract as that mentioned above. However, even if a “safeguard” clause were introduced and participants (bankers and their customers) were fully aware of it, to the extent that these individuals and all other economic agents subjectively considered demand deposits and notes to be perfect money substitutes, the clause referred to would only be capable of preventing the immediate suspension of payments or failure of banks in the event of a bank run. It would not prevent all of the recurrent processes of expansion, crisis and recession which are typical of fractional-reserve banking, seriously harm third parties and disrupt the public order. (It does not matter which “option clauses” are included in contracts, if the general public considers the above instruments to be perfect money substitutes.) Hence, at most, option clauses can protect banks, but not society nor the economic system, from successive stages of credit expansion, boom and recession. Therefore White and Selgin's last line of defense in no way abolishes the fact that fractional-reserve banking inflicts severe, systematic damage on third parties and disrupts the public order.¹⁶³