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«8 CENTRAL AND FREE BANKING THEORY T his chapter contains a theoretical analysis of the arguments raised for and against both central and free banking ...»

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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.156 155With respect to methodology, we fully concur with Horwitz’s position (see his “Misreading the ‘Myth’, p. 167). However it is curious that an entire school which emerged with the analysis of the supposedly beneficial results of the Scottish free-banking system has been forced to stop relying on historical studies of the free-banking system. Stephen Horwitz, commenting on Rothbard’s review of free-banking history,


If Rothbard is correct about them, we should look more sceptically at Scotland as an example. But noting the existence of government interference cannot by itself defeat the theoretical argument. The Scottish banks were neither perfectly free nor a conclusive test case. The theory of free banking still stands, and its opponents need to tackle it on both the historical and the theoretical level to refute it. (p. 168) This is precisely what we have attempted in this book.

156Hoppe, “How is Fiat Money Possible?—or, The Devolution of Money and Credit,” p. 67.

Central and Free Banking Theory Such 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 Money, Bank Credit, and Economic Cycles 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 157See, for example, White, Competition and Currency (New York: New York University Press, 1989), pp. 55–56, and Selgin, “Short-Changed in Chile,” p. 5.

158Hoppe, “How is Fiat Money Possible?—or, The Devolution of Money and Credit,” pp. 70–71.

Central and Free Banking Theory 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 159The multidisciplinary nature inherent in the critical analysis of the fractional-reserve banking system and the resulting importance of both legal and economic considerations in this analysis not only comprise the focal point of this book; Walter Block also highlights them in his article, “Fractional Reserve Banking: An Interdisciplinary Perspective,” published as chapter 3 of Man, Economy, and Liberty: Essays in Honor of Murray N. Rothbard, Walter Block and Llewellyn H. Rockwell, Jr., eds.

(Auburn, Ala.: Ludwig von Mises Institute, 1988), pp. 24–32. Block points out the curious fact that no theorist from the modern, FractionalReserve Free-Banking School has built a critical, systematic case against the proposal of a banking system with a 100-percent reserve requirement. In fact, except for a few comments from Horwitz, neo-banking theorists have yet to even attempt to show that a banking system with a 100-percent reserve requirement would fail to guarantee “monetary equilibrium” and an absence of economic cycles. See Horwitz, “Keynes’ Special Theory,” pp. 431–32 footnote 18.

Money, Bank Credit, and Economic Cycles 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 160Our position on this point is even more radical than the one Alberto Benegas Lynch takes in his book, Poder y razón razonable (Buenos Aires and Barcelona: Librería “El Ateneo” Editorial, 1992), pp. 313–14.

161 The following shall be punishable by a prison term of eight to twelve years and a fine of up to ten times the face value of the currency: 1. The creation of counterfeit currency. (Article 386 of the new Spanish Penal Code) It is important to note that credit expansion, like the counterfeiting of money, inflicts particularly diffuse damage on society, and therefore it would be exceedingly difficult, if not impossible, to fight this crime based on each injured party’s demonstration of harm suffered. The crime of producing counterfeit currency is defined in terms of a perpetrator’s act and not in terms of the specific personal damage caused by the act.

162Such “option clauses” were in force in Scottish banks from 1730 to 1765 and reserved the right to temporarily suspend payment in specie Central and Free Banking Theory 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) of the notes banks had issued. Thus, in reference to bank runs, Selgin


Banks in a free banking system might however avoid such a fate by issuing liabilities contractually subject to a ‘restriction’ of base money payments. By restricting payments banks can insulate the money stock and other nominal magnitudes from panic-related effects. (Selgin, “Free Banking and Monetary Control,” p. 1455) The fact that Selgin considers resorting to such clauses to avoid bank runs is as significant in terms of the “solvency” of his own theory as it is surprising from a legal perspective that the attempt is made to base a system on the expropriation, albeit partial and temporary, of the property rights of depositors and note holders, who, in a crisis, would be transformed into forced lenders and would no longer be considered true depositors and holders of monetary units, or more specifically, perfect

money substitutes. Let us remember a comment from Adam Smith himself:

The directors of some of those [Scottish] banks sometimes took advantage of this optional clause, and sometimes threatened those who demanded gold and silver in exchange for a considerable number of their notes, that they would take advantage of it, unless such demanders would content themselves with a part of what they demanded. (Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book II, chap. 2, pp. 394–95) On option clauses, see Parth J. Shah, “The Option Clause in Free Banking Theory and History: A Reappraisal,” a manuscript presented at the 2nd Austrian Scholars Conference (Auburn, Ala.: Ludwig von Mises Institute, April 4–5, 1997), later printed in the Review of Austrian Economics 10, no. 2 (1997): 1–25.

Money, Bank Credit, and Economic Cycles 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 163It is interesting to note that many free-banking theorists fail to see that fractional-reserve banking is illegitimate from the standpoint of general legal principles, and instead of proposing the eradication of fractional-reserve banking, they suggest the banking system be completely privatized and the central bank be eliminated. This measure would certainly tend to check the practically unlimited abuses authorities have committed in the financial field, but it would not prevent the possibility of abuses (on a smaller scale) in the private sphere. This situation resembles that which would arise if governments were allowed to systematically engage in murder, robbery, or any other crime. The harm to society would be tremendous, given the enormous power and the monopolistic nature of the state. The privatization of these criminal acts (an end to governments’ systematic perpetration of them) would undoubtedly tend to “improve” the situation considerably, since the great criminal power of the state would disappear and private economic agents would be permitted to spontaneously develop methods to prevent and defend themselves against such crimes. Nevertheless the privatization of criminal activity is no definitive solution to the problems crime poses. We can only completely solve these problems by fighting

crime by all possible means, even when private agents are the perpetrators. Thus we conclude with Murray N. Rothbard that in an ideal freemarket economic system:

[F]ractional-reserve bankers must be treated not as mere entrepreneurs who made unfortunate business decisions but Central and Free Banking Theory




The traditional approach to the debate between advocates of central banking and those of fractional-reserve free banking is essentially flawed. First, this approach ignores the fact that the fractional-reserve free-banking system almost inevitably releases forces which lead to the emergence, development, and consolidation of a central bank. Fractional-reserve banking gives rise to credit expansion, which triggers reversion processes in the form of financial crises and economic recessions, which in turn inevitably prompt citizens to demand government intervention and state regulation of banking.

Second, the very bankers involved in the system soon discover that they can reduce the risk of insolvency if they make agreements between themselves, merge or even demand the establishment of a lender of last resort to provide them with the liquidity necessary in times of difficulty or to institutionalize and officially direct the growth of credit expansion.

We can conclude that fractional-reserve banking has been the main historical cause of the appearance and development of the central bank. Hence we must not approach the theoretical and practical debate in traditional terms, but in terms of two radically different systems: a free-banking system subject to traditional legal principles (a 100-percent reserve requirement) and in which all fractional-reserve operations, whether voluntarily agreed upon or not, are cracked down on as illegal and a breach of public order; and a system which permits as counterfeiters and embezzlers who should be cracked down on by the full majesty of the law. Forced repayment to all the victims plus substantial jail terms should serve as a deterrent as well as to meet punishment for this criminal activity. (Murray N. Rothbard, “The Present State of Austrian Economics,” Journal des Economistes et des Etudes Humaines 6, no. 1 [March 1995]: 80–81; reprinted in Rothbard, The Logic of Action I [Cheltenham, U.K.: Edward Elgar, 1997], p. 165) Money, Bank Credit, and Economic Cycles fractional-reserve banking and from which a central bank (lender of last resort) will inevitably emerge and control the entire financial system.

These are the only two theoretically and practically viable alternatives. Up to this point we have examined the economic effects of fractional-reserve banking, both orchestrated by a central bank and in a free-banking system. In the next and last chapter we will carefully analyze a free-banking system subject to traditional legal principles, i.e., a 100-percent reserve requirement.164 164Leland Yeager seems to have (at least tacitly) accepted my thesis on the unworkability of a fractional-reserve free-banking system, when he proposes a monetary system based only on bank money in which all bank reserve requirements are abolished and no outside or base money is used at all. Yeager’s system would be prone, of course, to all the cyclical problems we have analyzed in detail in this book. See Yeager, “The Perils of Base Money.”

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