4. Banking, Fractional-Reserve Ratios and the Law of Large Numbers

Our analysis up to this point permits us to comment on whether it is possible, as certain scholars maintain, to insure through the application of the law of large numbers the practice of fractional-reserve banking. Essentially we will respond to the argument that banks, in order to fulfill their customers’ normal requests for liquidity, and in accordance with the law of large numbers, only need to keep on hand, in the form of a cash reserve, a fraction of the money deposited with them in cash. This argument lies at the heart of legal doctrines aimed at justifying the monetary irregular bank-deposit contract with a fractional reserve. We critically examined this contract in chapter 3.

The reference in this area to the law of large numbers is equivalent to an attempt to apply the principles of insurance techniques to guard against the risk of deposit withdrawals, a risk assumed in advance to be quantifiable and thus technically insurable. However, this belief is mistaken, and as we will see, it is based on a misconceived idea of the nature of the phenomena before us. Indeed, far from the type of events which correspond to the natural world and represent an insurable risk, banking related phenomena fall within the realm of human action and are therefore immersed in uncertainty (not risk), which by its very nature is not technically insurable.

For in the field of human action the future is always uncertain, in the sense that it has yet to be built and the only part of it possessed by the actors which will be its protagonists are certain ideas, mental images, and expectations they hope to realize through their personal action and interaction with other actors. Moreover the future is open to man's every creative possibility; hence each actor faces it with a permanent uncertainty which can be reduced through the patterned behaviors of the actor and others (institutions) and the alert exercise of entrepreneurship. Nevertheless the actor will not be able to totally eliminate this uncertainty.⁹² The open, permanent nature of the uncertainty we are referring to makes both traditional notions of objective and subjective probability, and the Bayesian conception of the latter inapplicable to the field of human interaction. In fact Bayes's theorem requires a stable, underlying stochastic structure incompatible with the human capacity for entrepreneurial creativity.⁹³ This is so for two reasons: first, it is not even possible to know all of the potential alternatives or cases; and second, the actor only possesses certain subjective beliefs or convictions—termed by Mises case probabilities (of unique events)⁹⁴—which as they are modified or broadened tend to change by surprise, i.e., in a radical, divergent manner, the actor's entire map of beliefs and knowledge. Thus the actor continually discovers completely new situations of which previously he had not even been able to conceive.

This concept of uncertainty, which corresponds to single events in the field of human action and hence of economics, differs radically from the notion of risk applicable within the sphere of physics and natural science. Table V-7 provides a summary.

Clearly the events related to customers’ more or less massive and unexpected withdrawal of deposits from a bank correspond to the sphere of human action and are immersed in uncertainty, which by its very nature is not technically insurable. The technical-economic reason it is impossible to insure uncertainty stems basically from the fact that human action itself brings about or creates the events which an attempt is made to insure. In other words, withdrawals of deposits are invariably influenced by the very existence of the insurance, and therefore the necessary stochastic independence between the existence of the “insurance” (a fractional-reserve requirement supposedly established according to the law of large numbers and bankers’ experience) and the occurrence of the phenomenon (bank crises and runs which provoke the massive withdrawal of deposits), precisely what is meant to be insured, does not exist.⁹⁵ A detailed demonstration of the close connection between the attempt to apply the law of large numbers in the form of a fractional-reserve requirement and the fact that this “insurance” inevitably triggers massive withdrawals of deposits is simple. The development of the Austrian theory, or circulation credit theory of the business cycle (covered in this chapter), makes it possible. Indeed fractional-reserve banking permits the large-scale granting of loans unbacked by a prior increase in saving (credit expansion) and initially provokes artificial widening and lengthening of the productive structure (illustrated by the shaded areas in Chart V-6). Nevertheless sooner or later the microeconomic factors explained in detail in the previous section set in motion social processes which tend to reverse the entrepreneurial errors committed, and consequently the productive structure comes to resemble that illustrated in Chart V-7. There we see that the new stages by which an attempt was made to lengthen the productive structure (stages six and seven of Chart V-6) disappear altogether. Furthermore the “widenings” of stages two through five are liquidated, bringing about the general impoverishment of society, a result of the unwise investment of its scarce real saved resources. Accordingly a highly significant number of the recipients of loans derived from credit expansion are ultimately unable to repay them and become defaulters, initiating a process in which both suspensions of payments and bankruptcies multiply. Hence default comes to affect a very large percentage of bank loans. In fact once the crisis hits and it becomes evident that the investment projects launched in error should not have been undertaken, the market value of these projects is reduced to a fraction of their initial value, when it does not disappear completely.

TABLE V-7

The extent to which this generalized decrease in the value of many capital goods is carried over to banks’ assets is graphically illustrated precisely by the loan amounts which correspond to the shaded areas in Chart V-6. This chart reflects, in monetary terms, the erroneous lengthening and widening of the productive structure: changes attempted in the expansive phases of the economic cycle, due to the cheap, easy financing of bank loans (unbacked by a prior increase in voluntary real saving). Inasmuch as the errors committed are revealed and the “lengthenings” and “widenings” of the productive structure are abandoned, liquidated, or realigned, the value of the assets of the entire banking system diminishes dramatically. Moreover this decline in value is gradually accompanied by the credit tightening process we analyzed in accounting terms at the end of chapter 4 and which tends to aggravate even further the negative effects the recession exerts on the assets of the banking system. In fact those entrepreneurs who fortunately manage to save their companies from a suspension of payments and bankruptcy restructure the investment processes they initiated. They paralyze them, liquidate them and accumulate the liquidity necessary to return the loans they obtained from the bank. Furthermore the pessimism and demoralization of economic agents⁹⁶ means that new loan requests and their approval cannot compensate for the speed at which loans are repaid. A serious credit squeeze results.

Therefore one must draw the conclusion that the economic recession caused by credit expansion results in a generalized decline in the value of the accounting assets of the banking system, just when depositors’ optimism and confidence are lowest. In other words, recession and default drive down the value of banks’ loans and other assets, while banks’ corresponding liabilities, the deposits now in the hands of third parties, remain unchanged. With respect to accounting, the financial situation of many banks becomes particularly problematic and difficult, and they begin to announce suspensions of payments and failures. As is logical, from a theoretical standpoint it is impossible to determine in advance which specific banks will be relatively more affected. However we can safely predict that those banks which are marginally less solvent will face a serious liquidity squeeze, a suspension of payments and even bankruptcy. Such a situation can very easily precipitate a generalized crisis of confidence in the entire banking system, prompting individuals to withdraw their deposits en masse, not only from the banks which, relatively speaking, experience the greatest difficulties, but by contagion, from all the rest as well. Indeed all banks which operate with a fractional reserve are inherently insolvent, and their differences are relatively minor and merely a matter of degree, making a significant financial and credit squeeze inevitable. Events of this sort (such as the economic crisis Florentine banks provoked in the fourteenth century) have repeatedly occurred since the dawn of fractional-reserve banking. At any rate it has been demonstrated that the fractional-reserve system endogenously triggers processes which make it impossible to insure banking via the application of the law of large numbers. These processes cause systematic crises in the banking system, which sooner or later plague it with insuperable difficulties. This invalidates one of the stalest arguments to technically justify the existence of a contract which, like that of the monetary bank deposit with a fractional reserve, is of an inadmissible legal nature (as we saw in chapter 3), given that it originates solely from a privilege granted by public authorities to private banks.

One might mistakenly believe that the high incidence of default and the generalized loss of value on the asset side of bank balance sheets, both products of the economic crisis, could from an accounting standpoint be offset with no problem by eliminating the corresponding deposits which balance these loans on the liability side. Not in vain did chapter 4 show that the credit expansion process entails banks’ creation of such deposits. Nonetheless economically speaking this argument is invalid. While banks’ creation of money in the form of deposits initially coincides with their creation of loans, and both are granted to the same actors, loan recipients immediately part with the m.u. received as deposits, using them to pay their suppliers and owners of the original means of production. Hence the direct recipients continue to owe the loan amounts to the bank, yet the deposits change hands at once. This precisely is the root of banks’ inherent insolvency which endangers their survival in the stages of severe economic recession. In fact the businessmen who receive loans commit en masse entrepreneurial errors which the crisis reveals. They mistakenly instigate processes of investment in capital goods, in which the loans materialize, loans whose value falls dramatically or is completely lost. Substantial default results, and the value of a large portion of banks’ assets plummets. However at the same time, the deposit holders, now third parties, maintain their claims intact against the banks that brought about credit expansion, and therefore banks are unable to eliminate their liabilities at the same rate the value of their assets drops. An accounting maladjustment ensues, leading to suspensions of payments and to the bankruptcy of marginally less solvent banks. If pessimism and the lack of confidence spread, all banks may become insolvent, ending in the disastrous failure of the banking system and of the monetary system based on fractional-reserve banking. This instability intrinsic to the fractional-reserve banking system is what makes the existence of a central bank as lender of last resort inevitable, just as the correct functioning of a system of complete banking freedom requires a return to traditional legal principles and thus a 100-percent reserve requirement.

If a monetary bank-deposit contract which allows bankers to neglect their obligation to maintain a 100-percent reserve ratio may eventually even lead to the downfall of the banking system (and of many of its customers), how is it possible that historically bankers have insisted upon acting in this manner? In the first three chapters we studied the historical factors and circumstances which gave rise to the bank-deposit contract with a fractional reserve. There we saw that this contract originated from a privilege governments granted bankers, allowing them to use in their own interest the money of their depositors, most often in the form of loans given to the very granter of the privilege, i.e., the government or state, continually overwhelmed by financial pressures. If governments had fulfilled their essential purpose and had adequately defined and defended the property rights of depositors, such an anomalous institution would never have emerged.

Let us now ponder some additional considerations with respect to the emergence of the monetary bank-deposit contract with a fractional reserve. One relevant issue is the great theoretical difficulty which, given the complex, abstract nature of social processes related to credit and money, renders a great many people, even those most involved in these processes, unable to analyze and comprehend the effects which credit expansion ultimately provokes. In fact throughout history most people have generally considered the effects of credit expansion on the economy positive and have merely focused on its most visible, short-term results (waves of optimism, economic booms). However what can be said of the bankers themselves, who throughout history have experienced numerous bank runs and crises that have repetitively and seriously endangered their business or even ended it? Given that bankers have suffered first-hand the consequences of operating with a fractional-reserve ratio, one might think it is in their own best interest to modify their practices and adapt them to traditional legal principles (that is, a 100-percent cash reserve). Even Ludwig von Mises held this idea at first,⁹⁷ yet historical experience, which shows that again and again banks have relapsed into holding a fractional reserve (in spite of the huge risks it entails), does not justify it, nor does the theoretical analysis. Indeed even when bankers are aware that fractional-reserve banking is condemned to failure in the long run, the ex nihilo creation of money, an ability all credit expansion involves, generates such large profits that bankers eventually succumb to the temptation to revert to a fractional reserve. In addition no particular banker can be absolutely certain his bank will be one of those that eventually suspend payments or fail, since he can always hope to be able to withdraw from the process before the crisis hits, demand the repayment of loans, and avoid defaulters. Thus a typical tragedy of the commons, a process known to be triggered whenever the property rights of third parties are inadequately defined or defended (as in the case which concerns us), is set in motion. We will study the process in greater depth in chapter 8. In light of the above it is unsurprising banks face an irresistible temptation to expand their credit before other banks and hence to take full advantage of the profits of the expansion while leaving the rest of the banks, and the entire economic system in general, to jointly bear the extremely harmful consequences which ultimately follow.⁹⁸

To conclude, the technical impossibility of insuring against the risk of deposit withdrawal via a fractional-reserve ratio also explains, as we will see in chapter 8, that bankers themselves have been the chief defenders of the existence of a central bank which, as lender of last resort, could guarantee their survival during panic stages.⁹⁹ From this point of view, the historical emergence of the central bank as an institution was an inevitable result of the very privilege which allows banks to loan most of the money they receive on deposit, through the maintenance of a fractional-reserve ratio. Furthermore it is evident that until traditional legal principles, and thus a 100-percent reserve requirement, are reestablished, it will be impossible to manage without the central bank and to introduce a true free-banking system which is subject to the law and does not adversely affect the course of the economy by regularly provoking destabilizing phases of artificial expansion and economic recession.¹⁰⁰