UNLV Retrospective Theses & Dissertations

1-1-1991

Fractional reserve banking: The genesis of macro-instability

John Nicholas Koch
University of Nevada, Las Vegas

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 Order N um ber 1350552

F ractional reserve banking: The genesis of m acro-instability

Koch, John Nicholas, M.A.

University of Nevada, Las Vegas, 1992

Copyright © 1992 by K och, John N icholas. A ll rights reserved.

UMI
300 N. ZeebRd.
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FRACTIONAL RESERVE BANKING: THE GENESIS OF MACRO-INSTABILITY

By

John Nicholas Koch

(702) 435-4931

A thesis submitted in partial fulfillment of the

requirements for the degree of

Master of Arts

in

Economics

Department of Economics

University of Nevada, Las Vegas

August 1992
 APPROVAL PAGE

The thesis of John Nicholas Koch for the degree of Master

Arts in Economics is approved.

'

■Vl
Chairperson, Murray N. Rothbard, Ph.D.

/ ,
/ / •—/
_y i b /
Examining Committee Membdr, Hans-Hermann Hoppe, Ph.D.

Examinin^DCommittee Member, ^Cerry R. Ridgeway, Ph.D.

Graduate Faculty Representative, David T. Beito, Ph.D.

Graduate Dean, Ronald W. Smith, Ph.D.

University of Nevada, Las Vegas

August, 1992
 ABSTRACT

Fractional Reserve Banking: The Genesis of Macro-Instability

Koch, John Nicholas, M.A. University of Nevada, Las Vegas,
1992. 93pp. Major Professor: Murray N. Rothbard.

This thesis is a theoretical criticism of fractional reserve

banking. The Austrian school (especially the works of
Mises, Hayek and Rothbard), consider credit expansion to be
the genesis of macro-economic instability.

This study applies Austrian interest, capital and business

cycle theory to challenge the widely held assumption that
our present economic system is fundamentally sound. Using a
theoretical construct known as the "Angel Gabriel Model",
the devastating consequences of continuing credit expansion
are explored. Fractional reserve free banking is also
considered within this model and found to be an
unsatisfactory option when compared to 100 percent reserve
banking. In conclusion, policy proposals and system
transition are considered in the event of a general economic
collapse.
(§> 1992 John Koch

All Rights Reserved

 TABLE OF CONTENTS

1. Introduction ....................................... 1

PART ONE

FRACTIONAL RESERVE BANKING

2. Grounds for Questioning the Long Term Viability of

Fractional Reserve Systems ....................... 4

3. The Market's Historical Response to Fractional

Reserve Banking ..................................... 5

4. Possible Factors Delaying a More Severe Market

Response ............................................ 9

5. The Illogical Foundation of Fractional Reserve . 12

PART TWO

THE RETURN OF THE ANGEL GABRIEL

6. Angel Gabriel: Chairman of the F e d ............... 19

PART THREE

FRACTIONAL RESERVE FREE BANKING

7. I n t r o d u c t i o n ......................................... 32

8. George Selgin: The Theory of Free Banking . . . 34

9. The Historical R e c o r d ................................ 35

10. Fractional Reserve Free Banking in Ruritania . . 51

11. C o n c l u s i o n ........................................... 73

PART FOUR

THE FUTURE WITHOUT FRACTIONAL RESERVE BANKING

12. Failure of the Present S y s t e m .......................76

13. System Transition ................................... 78

iv
 TABLE OF CONTENTS (Continued)

14. Policy Proposals .................................. 82

15. C o n c l u s i o n ............................................85

16. N o t e s .................................................. 88

17. B i b l i o g r a p h y ......................................... 92

v
 1

1. Introduction

We are living in a unique period of history. Since the

final collapse of the Bretton Woods Agreement in 1971, no

currency in the world has maintained even the most tenuous

ties to gold. The present financial system is relatively

new, yet most mainstream economists assume that (given

proper fiscal and monetary management) it is viable and able

to cope with a changing and vibrant economy. The purpose of

this thesis will be to challenge that assumption.

Much of what is considered macro instability is, in essence,

a market response to fractional reserve banking.

Historically, the market has ultimately reacted violently to

fractional reserve banking. Bank runs, stock market

crashes, the collapse of the Bretton Woods System and other

financial phenomena tend to occur in a panic. Government

orchestrated, fractional reserve credit expansion has always

led to crisis and collapse, except under the present system.

It may be too soon to evaluate, however. Judging from the

way the market has responded in the past, is it not possible

that the market may respond in an equally violent manner,

which has not been seen because of the relatively short and

peculiar nature of this particular period? This is the

primary question that this thesis will explore.

 2

I will begin by establishing grounds for questioning the

long term viability of any fractional reserve system, and

continue with a brief historical review to illustrate that

there has never been such a system that has operated for

very long without periodic crises that are more severe the

longer the duration of the credit expansion. Because

fractional reserve banking limits credit expansion to a

greater degree, it is preferable to government sponsored

banking, however, 100 percent reserve banking is far

superior to both. I will discuss reasons why a more severe

market response to credit expansion has not already occurred

and conclude Part One by exploring the logical contra­

dictions upon which any fractional reserve system is based.

In Part Two, using a theoretical construct familiar to

Austrian economists known as the "Angel Gabriel" model, I

will attempt to illustrate the inevitable consequences of

sustained and systematic, long term expansion of credit.

Part Three will discuss an area of much recent interest:

fractional reserve free banking. I will question the basic

assumptions upon which fractional reserve free banking is

based and also the historical record. It is important to

show that 100 percent reserve banking is superior to

fractional reserve free banking, for if it were to be

implemented, its disruptive effects would be seen as an

 3

indictment of the free market and not the inevitable

consequences of a fundamentally flawed system.

In conclusion, I will explore the implications of a collapse

of fractional reserve and some of the ramifications of this

assertion. Throughout this thesis, I will be drawing

heavily upon interest, capital and business cycle theory as

developed by the Austrian school, especially Mises, Hayek,

and R o t h b a r d . [1] Even though most Austrian business cycle

theory presumes some form of gold s t a n d a r d , [2] much of the

analysis can be applied to our present system.

 4

PART ONE

FRACTIONAL RESERVE BANKING

2. Grounds for Questioning the Long Term Viability of

Fractional Reserve

The purpose of this thesis is to explore and question the

long term viability of any financial system based upon

government controlled fractional reserve banking. Many

questions immediately come to mind but among the foremost

might be, "If any credit expansion is not viable in the long

run, why hasn't the present system already collapsed?"

It is true that in the almost sixty years since the United

States began to disengage the dollar from gold the banking

system has almost always operated on some form of fractional

reserve. There have been recurrent recessions and stock

market crashes, yet no general collapse. The majority of

mainstream economists are confident that existing policy

tools can prevent such a collapse, yet the 1987 stock market

crash may give rise to question that belief. Although a

variety of explanations as to the cause of the crash have

been offered, all fall short except for one. As Rothbard

writes,

To put it simply; the reason for the crash was the

credit boom generated by the double-digit monetary
expansion engineered by the Fed in the last several
y e a r s .[3]
Although there have been several such sharp downturns since

the Great Depression, nothing has approached its severity

and duration. Even many economists critical of mainstream

economics feel that the system can stumble on indefinitely;

that there is nothing inherent in the system that must lead

to its inevitable collapse as long as people are willing to

accept occasional economic downturns. Yet, because few

question its soundness does not mean that there might not be

a serious problem. It may be useful to examine how the

market has responded to credit expansion in the past.

3. The Market's Historical Response to Fractional Reserve

Systems.

Historically, the market has always reacted violently to

credit expansion. Although the credit expansion may have

been gradual, the inevitable response was rapid. The price-

specie-flow mechanism identified by David Hume, although not

applied to fractional reserve banking until the early 19th

century, demonstrated how the market responds to inflation.

When one nation increases its currency more rapidly than

others, price inflation is a result. As domestic prices

rise relative to imports, individuals spend more on imports

and less on domestic products. As foreign suppliers redeem

the inflated currency for gold, a gold drain begins from the

inflating nation. The gold reserves upon which the currency

 6

is based begin to erode and the inflating nation must

contract its supply of currency or its banks will collapse,

and this contraction has always occurred in a panic.

The Bretton Woods System was also a victim of the market's

inexorable response to a fractional reserve system. Under

the Bretton Woods agreement, the United States was bound by

law to redeem in gold all dollars held by foreign central

banks. As the United States continued to inflate throughout

the 1950s and 1960s, dollars piled up in Central Banks

overseas until market pressures could not be held off any

longer. Europeans realized that dollars were no longer

worth 1/35 of an ounce of gold and desired to redeem their

dollars in what amounted to a classic Gresham's Law

situation. The Bretton Woods System collapsed on August 15,

1971, in what might be viewed as a "bank run". The

depositors who wished (and were entitled by law) to redeem

their dollars were foreign central banks while the banker

who defaulted was the central bank of the United States.

The world entered a unique period in history, for this was

the first time that not a single currency in the world could

be redeemed in gold in any form. As Dr. Rothbard writes,

For the first time in American history, the dollar

was totally fiat, totally without backing in gold.
Even the tenuous link with gold maintained since
1933 was now s e v e r e d . [4]
 7

Because the gold standard provides an effective check to

unlimited credit expansion, many economists proposed that

eliminating the gold standard might also circumvent the

inevitable market response. It is, however, extremely

difficult, if not impossible, to avoid market response in

the long run. Many might say the market is "invincible" and

any attempts to manipulate it in any area only leads to

crisis, failure, or a drastic reduction in the standard of

living. The collapse of Bretton Woods, the price-specie-

flow mechanism, and recessions are all market responses to

credit expansion. Much of what is considered "mainstream

macro policy" is an attempt to circumvent such responses.

It is true that we no longer have a gold standard to check

credit expansion but might not the market have a new, and as

yet unseen reaction to our present system, given that it is

not quite twenty years old? Both Mises and Rothbard have

written about the "Runaway Boom" [5] as the ultimate check

on inflation but how does this mechanism work? Does it

occur as a result of government greed and mismanagement or

is there a fundamental flaw due to the logical co n t r a ­

dictions inherent in any fractional reserve system?

If there is indeed a fundamental flaw to this system, one

would have expected certain events to occur before any major

crisis. One is the collapse of Bretton Woods. According to

the Austrian theory of the business cycle, it is the

 8

cessation of, or decrease in, the rate of inflation that

ushers in the end of the boom. The Austrian theory stands

alone in identifying the inevitable "bust" as a result of

the previous "boom". Most of the theoretical work done on

the Austrian theory, however, assumes some form of gold

standard. Any gold standard will eventually force the

cessation of credit expansion if the government wishes to

defend the gold standard. But what happens when the

government abandons the gold standard (as Nixon abandoned

Bretton Woods) and yet continues to expand credit? Has the

market been circumvented?

In 1971, the government faced only two options: either

defend the Bretton Woods System or abandon it. It chose to

abandon it. Any market response to continuing credit

expansion (such as bank runs, monetary contractions or

depressions) would have occurred after that point. Since

previous market responses occurred in roughly ten year

intervals, isn't it possible that the market may have a new

but similar response that will not be seen for 25 to 30

years - or possibly even longer? Can we expect a continuing

string of boom periods followed by sometimes sharp but

manageable recessions or can we expect a rapid and general

collapse and cessation of credit expansion as in the past?

Is the Savings and Loan crisis an expansion of a fundamental

problem or a one time aberration that can be corrected?

These are the questions this thesis will be dealing with. I

hope to establish enough evidence to at least question the

belief that the present system is fundamentally sound. It

may be useful to discuss some reasons why the market may not

have already responded to this continuing and unchecked

credit expansion.

4. Possible Factors Delaying a Severe Market Response to

Unlimited Credit Expansion.

The end of World War II left the United States as the

dominant economic, military, and political power. Most of

Europe and Japan could only be rebuilt, at least initially,

with American products. The Marshall Plan authorized

billions of dollars in aid so that those products could be

purchased. The Bretton Woods System established the dollar

as the primary reserve currency for most of the w o r l d ’s

central banks. Consequently, the demand for the dollar

tremendously increased and the United States was able to

increase the supply of the dollar without enduring a

decrease in the nominal value of the dollar. The increased

demand for the dollar lasted well into the sixties when the

European and Japanese recovery was almost complete and

foreign central banks began to build up large dollar

reserves.

The effects of World War II and other offsetting factors

were unique to the period and could not continue forever.

During the 1950s and 1960s West European countries reversed

their previously inflationary policies and came increasingly

under the influence of free market and hard money

authorities many of whom had been influenced by Ludwig von

Mises. Rothbard writes, "The United States soon became the

most inflationist of the major powers. Hard money

countries, such as West Germany, France and Switzerland,

increasingly balked at accepting the importation of dollar

inflation, and began to accelerate their demands for

redemption in g o l d . " [6] By the late sixties, the market's

inexorable response to continued credit expansion resulted

in the collapse of the Bretton Woods agreement.

It can be argued that if certain events had not occurred,

the system would not have collapsed, but this is missing the

point. Even if the Bretton Woods crises had not occurred

until several years later, and even if the United States had

continued to increase the supply of dollars, Bretton Woods

would still have been doomed. The important point to

remember is that it was a system that was not viable in the

long run and that, amazingly, lasted as long as it did. In

any credit expansion, there are events peculiar to that

historical period that can be pointed out as the event that

forced the end of the credit expansion or in the case of

Bretton Woods, forced the end of the system. But these are

proximate causes and not the primary cause for collapse. If

 11

the effects of these events could have been eliminated, the

credit expansion might have continued for a time, but

eventually the pressure to stop the inflation

would have become overwhelming.

There are also other reasons why we might not have seen how

the market reacts under a pure fiat system. According to

the Austrian theory of the business cycle, the adverse

effects of the previous credit expansion will not be felt

until inflation, or the rate of inflation, has been reduced.

This point cannot be accurately predicted because the crisis

can always be pushed a little further into the future with

an injection of credit. At the heart of the Austrian Theory

is the idea that credit expansion causes an intertemporal

dislocation. This will inexorably result in the market

attempting to readjust. What many mainstream economists see

as recession or depression is just the market attempting to

readjust and return to the old capital/consumption ratios

that existed before the credit expansion. Because capital

prices rise relative to consumer prices during the boom,

they also fall relative to consumer prices during the bust.

We have already seen a substantial fall in the real estate

market over the past few years.

In recent years, foreign investment in the United States has

increased dramatically. Real estate and stock prices have

 12

risen over the past decade as a result of credit expansion

and new foreign investment. This has kept the value of the

dollar relatively strong and U.S. capital markets fairly

firm. The trend has been for U.S. consumers to buy foreign

consumer goods and for foreign suppliers to purchase U.S.

capital and debt. The Federal government makes a tremendous

demand upon credit markets but this has been roughly offset

by foreigners willingly supplying more credit. This trend

cannot continue forever because interest rates cannot remain

artificially high in the U.S. relative to the rest of the

world. Market forces tend to make real rates of interest

the same in all nation. U.S. Government borrowing has

pushed interest rates up but this cannot continue

indefinitely without bankrupting the U.S. When this trend

reverses itself, capital values will have lost one of the

key factors maintaining support. The value of capital goods

will fall relative to consumer goods. This may be the

signal that the market is finally responding to the previous

credit expansions. The government may be faced with two

choices: continue inflating at an accelerating rate or

convert to a more rational and viable system.

5. The Illogical Foundation of Fractional Reserve

Characteristics Unique to Fractional Reserve

A distinguishing characteristic of fractional reserve

 13

systems is that two parties have full and exclusive

ownership of the same asset over the same time period. When

one deposits funds in a fractional reserve institution, and

those funds are in turn loaned to a third party, a unique

situation arises which cannot be found in any form. In

other enterprises, only one party owns assets at any

particular point in time. Transferral of ownership is

precisely defined. In fractional reserve, however, when a

bank extends a loan, it allows the debtor virtual ownership

of those funds for the duration of the loan as long as he

meets the terms. These same funds, however, are supposedly

available on demand to the original depositor. This is, in

fact, the genesis of bank runs, for when two parties retain

full and exclusive ownership of the same asset during the

same time period, whoever first takes possession of that

asset retains possession, leaving no legal recourse to the

other owner.

The law has attempted to circumvent this logical

contradiction by ruling that fractional reserve deposits are

not the legal property of the depositor but, "a loan", which

the debtor (fractional reserve institutions) must repay on

demand. [7] The essential point, however, that must be

remembered is that individuals act "as if" their deposits at

fractional reserve institutions were their property and not

an investment. Indeed, most depositors would be shocked to

 14

discover otherwise. Other forms of fractional reserve such

as ponzi schemes or grain elevators issuing unbacked

warehouse receipts, have been codified into law as fraud.

Our present system also gives rise to the peculiar situation

where the marginal costs of producing a good (debt) are

lower for one producer (the government) than any of its

competitors. In fact, government costs of creating debt

through the banking system are virtually nil, for the

monetary base upon which the debt is pyramided is

constituted out of thin air. In any other enterprise, there

may be one producer whose marginal costs are lower than its

competitors but none whose marginal costs are effectively

zero. Indeed, if there were, he would produce to the point

where his product practically became a free good. It is

only because the government has chosen to limit its credit

expansion to a certain extent that this has not occurred.

If government expanded production of debt to its limit drove

and all other producers of debt off the market, then

everyone except the government would be involved in the

purchase of goods (only the government is investing or

producing) and this is nothing more than an extreme case of

hyperinflation. Also, in any other example, the production

of good implies the non-production of all other goods which

might be created from the original inputs. This is not true

of debt incurred through a fractional reserve system. Debt

 15

established from other sources however, implies that there

are investors who have decided to forego present consumption

in favor of future consumption.

It is these logical contradictions which give rise to all

the problems associated with fractional reserve and which

will ultimately result in a future crisis.

Enterprises Commonly Mistaken as Forms of Fractional Reserve

To justify their support of fractional reserve, some

theorists claim that it exists in many forms throughout the

economy, not just in the financial world. They often cite

bridges as an example of fractional reserve. Imagine a

bridge which is constructed to meet the needs of a

community. Normally, the bridge is large enough to handle

any amount of traffic. If every member of the community

attempts to cross at the same time, however, many members

would be unable to cross. Theorists use this analogy to

demonstrate that if all members of a fractional reserve bank

were to withdraw their funds at the same time, the bank

would be unable to provide sufficient liquidity to meet

their needs. This supposedly is an example of a fractional

reserve institution existing on the market.

 16

I disagree with this conclusion. As was mentioned earlier,

the essential aspect of any fractional reserve system is

that more than one party has full and exclusive ownership of

the same asset over the same period of time. If an

individual built a bridge and sold shares promising the

shareholders the right to cross the bridge at any time, and

he oversold the number of shares to such an extent that not

all shareholders were able to cross at the same time, he

would be guilty of fraud. If the number of shares he sold

was such that most shareholders could cross the bridge most

of the time, and this was clearly understood by the

shareholders, "most of the time" bridge-crossing shares

would sell at a discount compared to "all of the time"

bridge-crossing shares. Similarly, if fractional reserve

banknotes operated on a "most of the time" redemption basis

their notes would circulate at a discount compared to "all

of the time" redemption of the one hundred percent reserve

banks.

Rothbard destroys the "fractional reserve bridge" argument

when he writes,

But the most critical fallacy of this analogy

is that the inhabitants do not then have a legal
claim to cross the bridge at any time. (This would
be even more evident if the bridge were owned by a
private firm.) On the other hand, the holders of
money substitutes most emphatically do have a legal
claim to their own property at any time they choose
to redeem it. The claims must then be fraudulent,
since the bank could not possibly meet them all.
A bank that fails is therefore not simply an entre-
 17

preneur whose forecasts have gone awry. It is a

business whose betrayal of trust has finally been
publicly revealed. [8]

Mark Skousen refers to yet another view of fractional

reserve,

And Charles A. Conant compares banknotes to the

commodity futures market in justifying uncovered
notes. They are "simply an engagement to deliver
metallic money...In this respect it does not differ
from an engagement to deliver wheat, except that the
article promised is of more general acceptability...
It is not necessary in either case that the signer of
the engagement should possess the full amount of the
commodity which he promises; it is only necessary
that his reputation and other forms of property
should inspire confidence in his ability to fulfill
the p r o m i s e . [9]

Conant fails, however, to realize the great differences

between the commodity futures market and a fractional

reserve system. In the first place, a commodity futures

contract is an agreement to deliver a specific quantity of a

commodity at a specific date in the future, not on demand as

is true of fractional reserve. Second, the production of a

commodity requires the employment of scarce resources that

could be employed producing other goods. The producer of a

commodity must choose among numerous possibilities available

and choose the one he feels will be in his best interest.

In other words, he must make a decision to forego all other

possible combinations. This is not true of the producer of

fractional reserve debt for it is created out of thin air,

and the producer foregoes nothing. Third, transferral of

ownership is precisely defined under a futures contract

where only one party maintains exclusive ownership at any

particular point in time, whereas fractional reserve funds

are owned fully and exclusively by more than one party

during the same time period.

While it may be true that a commodity contract may not be

honored, just as a bank may be unable to honor its

depositors claims during a bank run, the former is merely a

broken promise, whereas the latter is afflicted by

fundamental problems that make future payment of all claims

i mpossible.
 19

PART TWO

THE RETURN OF THE ANGEL GABRIEL

6. Angel G a b r i e l : Chairman of the Fed

I would like to borrow a theoretical construct that Dr.

Rothbard effectively utilizes, known as the "Angel Gabriel

Model", to illustrate the futility and disruptive effects of

artificially increasing the money supply. The Angel

Gabriel, looking down from above and feeling for the plight

of humanity, overnight doubles the cash balances of every

individual on earth. He feels this will make everyone on

earth twice as well off. Money, however, is a peculiar

commodity and, unlike almost everything else, an increase in

its supply does not result in an increase in the general

well b e i n g . [10] The first individuals to spend the new cash

will be the ones to benefit, for a doubling of the money

supply did not include a doubling of all goods and services

in the economy. Prices will begin to rise and the last

individuals to spend the new money will actually find

themselves worse off. Not only has the Angel Gabriel failed

to improve the lot of humanity, but relative prices have

been disturbed, requiring an eventual a d j u s t m e n t . [11]

To illustrate my point, I would like to suppose that the

Angel Gabriel has returned, but that now he is armed with a

doctorate in mainstream economics and is confident that he

can now rectify his past mistakes. He descends upon a small

 20

nation by the name of Ruritania (again borrowing from Mises

and Rothbard). In the Angel Gabriel's view, Ruritania is

primitive in the areas of economics and banking. Ruritania

maintains a one hundred percent gold standard, which means

that its currency is redeemable on demand for a fixed weight

of gold coin and its banking system operates on a one

hundred percent reserve system. The Angel Gabriel convinces

the Ruritanians that their system is hopelessly outdated and

persuades them to establish a fractional reserve banking

system, using fiat currency, insured by the federal

government and manipulated by a Central Bank of which the

Angel Gabriel is appointed chairman.

Figure One shows the situation in Ruritania prior to the

Angel Gabriel's well-intentioned but misguided intervention.

The graph shows the supply and demand of investment funds.

The y axis indicates the interest rate and the x axis

indicates the quantity of funds invested. I would like to

assume for the duration of this example that time

preferences remain constant. Consequently, the supply and

demand curves for investment funds and the real interest

rate remain constant since all are determined simultaneously

by time p r e f e r e n c e s .[12] Ruritania is in a state of

equilibrium.
 21

NB indicates loanable funds generated from non-bank sources

FR indicates loanable funds generated from fractional reserve sources

FIG. 1

Interest
Rate

NB

Qo
Loanable Funds

FIG. 2

^•o
Interest
Rate i1

NB

Loanable Funds
Interest
Rate
 23

Also, the entire supply of investment is extended by non-

fractional reserve lenders or individuals. Investment

undertaken by non-fractional reserve lenders or individuals

can always be considered "one hundred percent reserve" since

to invest upon which any other party has a legal claim is

considered embezzlement. Non-fractional reserve investors

must forego present consumption for investment which

fractional reserve institutions do not.

The Angel Gabriel now embarks upon what many economists

would consider an inspired and responsible program of

systematic government engineered credit expansion. The

Angel Gabriel accomplishes the initial increase in

investment by lowering the reserve ration for fractional

reserve institutions. He also plans to begin a program of

government deficit spending and, after the reserve ratio has

been sufficiently lowered, to manipulate the money supply

through open market operations.

Prior to the appearance of the Angel, there were two types

of banks operating in Ruritania: investment banks and

deposit b a n k s . [13] Investment banks accepted funds from

individuals or institutions and invested them, sharing the

eventual profits earned from those investments with the

lenders. Those individuals did not have access to those

funds until the loan matured or the loan was sold to another
 24

lender such as the secondary loan market. Deposit banks

allowed their depositors to withdraw their funds at any time

but charged a fee for their services. The deposit banks in

Ruritania are now allowed to operate on a fractional reserve

system, offering withdrawal of funds on demand even though

only a fraction of those funds are available at any time.

In Figure 2, the new supply curve is indicated by SI and the

interest rate falls to II. The quantity of investment in

the economy shifts from QO to Q 1 . The Angel Gabriel proudly

informs the Ruritanians that investment will now be

stimulated and the economy will never again have to suffer

from a shortage of funds. Never again will the so-called

"price level" be subject to wild swings even though the

Ruritanians had never experienced such swings, only a

history of gently falling prices. The quantity of

investment in the economy is divided into that portion which

is extended by fractional reserve institutions (indicated by

FR) and that portion which is extended by non-fractional

reserve lenders or individuals (indicated by N B ) .

The market will respond to this credit expansion. With the

new interest rate at II, investors with time preferences at

the margin will wish to withdraw their funds from investment

and spend it on consumption. In Figure 3, Q0Q2 amount of

 25

investment will be removed from the market. At interest

rate II, these investors would rather consume than invest.

It will take a certain period of time for this to be

accomplished but the process will begin the moment the

interest rate has been artificially lowered by credit

expansion.

As these funds that had previously been invested are

withdrawn and spent on consumption, the interest rate will

begin to rise as the supply curve shifts to the left.

Consequently, not the entire amount of Q0Q2 will be

withdrawn from the market but only Q 0 Q 4 . The funds will be

withdrawn entirely from non-fractional reserve sources and

not from fractional reserve sources. For fractional reserve

sources to withdraw any funds from the market would result

in excess reserves and fractional reserve institutions when

guaranteed by the federal government seldom hold excess

reserves. They have no incentive to do so. The new supply

curve would approach S2, where the supply of fractional

reserve debt and the supply of debt extended by one hundred

percent reserve institutions equilibrate.

In addition, if the new credit (Q0Q1) enters the economy

through the credit markets, capital prices will be bid

upward. Factors of production will be bid away from the

 26

consumer goods industries and employed in the capital goods

industries. The original structure of relative prices has

been distorted. This will inevitably result in a future

correction, and it will be this correction that will prove

to be the undoing of the good Angel's efforts.

It will now be apparent that the amount of debt Q3Q1 was

extended below market rates. This debt was extended

primarily by fractional reserve institutions since non-

fractional reserve funds were leaving the market and

fractional reserve funds were entering the market as the

interest rate fell. There will be a tendency for all

enterprises and all stages of production to return the same

rate of p r o f i t . [14]

Any enterprise that consistently operates below the market

rate of interest will eventually be abandoned. Because

Ruritania was in equilibrium prior to the credit expansion,

we can assume that all enterprises and stages of production

returned the same rate of profit. The value of capital is

also inversely related to the interest rate. Because the

quantity of debt was extended at lower interest rates, when

the value of capital was high, now that the interest rate

has risen, the value of capital against which this

investment was secured, will now have fallen. If non-

fractional reserve institutions had extended this

investment, they would be forced to take a loss and recover

what they could from the mal i n v e s t m e n t s . But these

malinvestments were made primarily by fractional reserve

institutions and because the government has guaranteed these

malinvestments, the government will eventually be forced to

purchase these losing enterprises and at their original

inflated price. For the government to fail to do so would

result in a government insured fractional reserve

institution defaulting.

What has basically been described is the business cycle. If

the Angel Gabriel expanded credit only once, this process

would occur and the economy would eventually move closer and

closer to equilibrium, providing there was nothing else to

disturb it. But the Angel Gabriel committed to continuous

credit expansion contracting credit only when he felt that

inflation was rising too rapidly. He will not allow credit

to contract for any significant period of time. The

adjustment process just described will occur for every

credit expansion. Since there is a continuous expansion,

there will be a continuous adjustment reacting to an almost

infinite number of events that will affect the rate at which

the economy adjusts. It is impossible to predict the exact

moment when the market will adjust and it will not adjust at

a constant rate. It is safe to say, however, that

eventually it will be impossible for the Angel to deceive

 28

the market. It is only in the early stages of a credit

expansion that the interest rate can be held below the

market rate of interest. The long term interest rate cannot

be affected. As Rothbard writes,

The answer is that an increase in the supply

of money does lower the rate of interest when
it enters the market as credit expansion, but
only temporarily. In the long run, (and this
long run is not very "long"), the market r e ­
establishes the free-market time-preference
interest rate and eliminates the change. In the
long run a change in the money stock affects
only the value of the monetary u n i t . [15]

There are several degenerating forces operating here that

will eventually force the collapse of the Angel's systems.

First of all, the expansion of investment by fractional

reserve institutions will force the contraction of

investment by non-fractional reserve lenders. These are

non-banking institutions or individuals that do not require

reserves. This might be considered a variation of Gresham's

Law where "bad debt" drives out "good debt". Or perhaps

more precisely, "Continuous expansion of investment extended

by governmentally insured institutions will eventually force

investment extended by non-fractional reserve lenders off

the market." (Unless another has come up with this idea,

maybe this can be "Koch's Law".) Ultimately this system has

the potential to drive out all non-fractional reserve

lending, where fractional reserve institutions extend all

investment, and non-fractional reserve lenders have left the

 29

market and their investors have switched all their funds

into consumption.

Secondly, in the early stages of credit expansion, the ratio

of investment extended by fractional reserve institutions to

non-fractional reserve lenders is small, but as time passes

the ratio must rise. A recession in the early stages is not

serious because the fall in capital values will primarily be

written off by non-fractional reserve lenders. A recession

in the latter stages of a continuous credit expansion is

very serious, for most of the debt in the economy is

extended by fractional reserve institutions. A sharp drop

in capital values against which this debt is secure will

force the fractional reserve institutions to default. It

would not take very many defaults by institutions guaranteed

by the government to destroy confidence in the entire

system. A massive bank run of the entire system would

result.

But the Angel Gabriel has promised to guarantee the

liabilities of these institutions, in effect guaranteeing

their assets at inflated capital values! When the

fractional reserve institutions extend the lion's share of

investment in the economy, capital values cannot fall very

far, for the government has guaranteed their value. Under

this system, the government must, in effect, "sell debt low

 30

and later buy debt high." Exactly the opposite of any

rational, profitable, enterprise.

Even continuing the previous rate of credit expansion will

not be enough at this point. Individuals have begun to

anticipate the credit expansion, and the market, which

reacted slowly at first, is now reacting more quickly than

the Angel can expand credit. It is at this point that the

Angel Gabriel is faced with two equally unappealing choices:

continue the credit generation at ever higher rates until

the currency and the entire fractional reserve system

collapses, or slow the rate of credit expansion, allow

capital values to fall and consequently allow the collapse

of the fractional reserve banking system. The Angel no

longer has any "brakes" and can only use the "accelerator"

if he wishes to delay the crisis. Either path leads to the

same outcome: collapse the system.

This is an example of the "runaway boom" described by

Rothbard but it is an inevitable consequence of the logical

contradictions upon which any fractional reserve system is

based and not necessarily malicious or inept behavior on the

part of government. Fractional reserve institutions by

their very nature always extend loans at below the market

rate of interest. It must be stressed, however, that the

"nominal" rate of interest may not fall at all during a

 31

credit expansion. In fact, it often rises. As Rothbard

writes,

Credit expansion does not necessarily lower

the interest rate below the rate previously
recorded; it lowers the rate below what it
would have been in the free market and thus
creates distortions and m a l i n v e s t m e n t s .[16]

This disheartens the Angel Gabriel for once again his

attempt to "produce bread from stones" has failed and he has

wrecked the Ruritanian economy. But there is still hope for

he has just begun to read Human Action by Ludwig van Mises.

 32

PART THREE

FRACTIONAL RESERVE FREE BANKING

7. Introduction

The central assertion of this thesis is that a fractional

reserve system is not viable in the long run due to the

logical contradictions upon which it is based. In recent

years, however, there has been much interest in what is

called "free banking". This point of view correctly

identifies the need to remove government intervention in the

banking industry but stops short of prohibiting fractional

reserve. Free banking theorists show the superiority of

unregulated fractional reserve over central banking, but

fail to show that a 100 percent free banking system would

function even better. Fractional reserve free banking is

superior because competition among banks places greater

limits on credit expansion than central banking. Mises

writes,

If the governments had never interfered,

the use of banknotes and deposit currency
would be limited to those strata of the
population who know very well how to d i s ­
tinguish between solvent and insolvent
banks. No large-scale credit expansion
would have been p o s s i b l e .[17]

Rothbard has clearly outlined the moral problems involved

with fractional reserve banking, and this section will

emphasize the basic practical problem of fractional reserve:

 33

the ultimate collapse of the credit expansion. This is an

important question for if a fractional reserve free banking

system were to be implemented, its destabilizing effects

would be generally seen as an indictment of the free market

and not as an attempt to operate a fundamentally flawed

system. It is unfortunate that several authors who are

otherwise sympathetic to free market principles do not

realize that a fractional reserve system should be codified

into law as a fraudulent practice. As Rothbard writes,

Banking theory, however, has taken a very

bad turn with free banking. We have to show
that this is the old currency school argument
r e h a s h e d ...moreover the free banking people
violate the basic Ricardian doctrine that
every supply of money is optimal. Once a
market in a money is established, there is no
longer a need for more money. That is really
the key p o i n t . [18]

A recent book on this subject is George S e l g i n ’s,

The Theory of Free B a n k i n g . In this section, I will briefly

review Selgin's main points and then, applying the Angel

Gabriel model developed earlier, show that 100 percent free

banking is far superior to fractional reserve free banking

not only for macro-stability but also for depositors and the

banking system itself. I will review the historical record

and show that fractional reserve free banking has never

operated without chronic, periodic, financial crises, which

would be absent under 100 percent free banking. Fractional

reserve banking interferes with the economy's attempts to

 34

move toward equilibrium. Contrary to the free banking

theorists, fractional reserve banking can only disrupt

equilibrium, not facilitate movement towards it.

8. George Selgin: The Theory of Free Banking

One of the most important recent works on fractional reserve

free banking is George Selgin's The Theory of Free B a n k i n g .

This section will briefly highlight some of the main ideas

Selgin has illustrated in this book. As Lawrence White

writes,

The central results show that the standard

'rule of excess r e s e r v e s 1— that a competi­
tive bank cannot safely expand its liabilities
by more than the size of its excess reserves—
applies to note-issuing as well as to the more
familiar deposit-creating banks, provided
that money-holders do not accept various
brands of notes indiscriminately. The rule
does not, however, apply to a monopoly issuer.

What is more provocative, we learn that the

limits to note issue expand when the demand
to hold inside money increases, and that the
consequent expansion of bank liabilities and
assets is warranted by considerations of
credit-market equilibrium. A bank is able to
vary its liabilities in response to demand
shifts even if its reserves are unchanging,
because an increase in holding demand implies a
fall in the rate of turnover, hence in the
optimal reserve ratio. The theory of optimal
reserves elaborated by Selgin undermines the
mechanistic textbook view of the reserve ratio
as constant, and links changes in desired bank
reserve ratios to changes in the money m u l t i ­
plier. A further surprising and novel exten­
sion is the refutation of the standard view
 35

that no economic forces check a concerted

expansion by b a n k s . [19]

Selgin begins with a brief historical review that only

serves to cloud the debate as to the success or failure of

fractional reserve free banking in actual practice.

9. The Historical Record

Both George Selgin and Larry White have identified many

examples of supposedly successful fractional reserve free

banking systems. If it is really true that a fractional

reserve system is destabilizing, how is it that these

systems appeared to operate for significant periods of time?

There is much debate on this point and it may be that these

systems only appeared to work or were not allowed to operate

long enough or freely enough for them to collapse on their

own. As Rothbard writes,

In recent years, disillusionment in central

banking has understandably set in among many
economists. As a result, some writers have
turned to the alternative of free banking,
praising both the theoretical model and h i s ­
torical cases in which free banking has
allegedly worked effectively. But there may
have been an unwise rush to j u d g e m e n t . [20]

This section will discuss this debate.

CHILE

In the case of Chile, where free banking supposedly

 36

operated, Rothbard points out that for the first half of the

nineteenth century Chile "was devoted to the idea of a pure,

100 percent commodity m o n e y . "[21] After the establishment

of a fractional reserve free banking system in 1860, Chile

embarked upon a "long-run generally accelerating course of

inflation,"[22] that was to last for nearly fifty years.

Instead of leading to prosperity and stability, the

establishment of fractional reserve banking led only to

inflation and monetary crisis.

Selgin countered Rothbard with an article in Austrian

Economics Newsletter entitled, "Short Changed in Chile: The

Truth about the Free-Banking E p i s o d e . " [23] In this article

Selgin claims that the problems with Chile's fractional

reserve free banking system were a result of the Chilean's

government intervention and not any fundamental flaw in

fractional reserve. "Chile's free banking system was

undermined by, (1) its bimetallic legislation of 1851 and

(2) its sanctioning of inconvertible currency to ease the

government's fiscal burdens in connection with its war

with Spain and again in 1878." [24]

Selgin does not feel that fractional reserve free banking

failed in Chile, yet he underscores a problem that free

banking theorists have in making their case. It is very

difficult to find in the historical record an example of a

 37

pure fractional reserve free banking system that actually

operated during a period of macro-stability for a

significant length of time.

SCOTLAND

Initially, Selgin and White pointed to the Scottish free

banking system of the late eighteenth and early nineteenth

centuries as something of an ideal model for a fractional

reserve free banking system. Selgin writes,

From 1792 to 1845, Scotland had no central

bank, allowed unrestricted competition in
the business of note issue, and imposed almost
no regulations on its banking firms. Yet
the Scottish system was thought to be superior
by nearly everyone who was aware of it. Its
decline after 1845 was caused, not by any
shortcoming, but in consequence of the u npro­
voked extension of Peel's Act, which ended
new entry into the note issue business in
Scotland as well as E n g l a n d ."[25]

In the note which followed this passage Selgin wrote,

"Lawrence W h i t e ’s excellent and comprehensive study of the

Scottish system, Free Banking in B r i t a i n , makes it

unnecessary for us to delve into the details of that episode

h e r e . "[26]

Rothbard later countered the claims that the Scottish system

was free and stable in, "The Myth of Free Banking in

S c o tland." [27] Contrary to being an excellent and

comprehensive study of the Scottish system, Rothbard points

 38

out that Free Banking in Britain is, "a brief book of less

than two hundred pages, only 26 are devoted to the Scottish

question and White admits that he relies for facts of

Scottish banking almost solely on a few secondary

s o u r c e s ."[28]

Free banking theorists claim that fractional reserve free

banking is stable and has a stabilizing effect on the entire

economy by efficiently responding to changes in the demand

for currency and bank deposits (inside m o n e y ) . The Scottish

system clearly did not provide stability. Rothbard writes,

But why should lack of bank failure be a

sign of superiority? On the contrary, a
dearth of bank failures should rather be
treated with suspicion, as witness the drop
of bank failures in the United States since
the advent of the FDIC. It might indeed mean
that the banks are doing better, but at
expense of society and the economy faring
worse. Bank failures are a healthy weapon
by which the market keeps bank credit in­
flation in check; an absence of failure might
well mean that that check is doing poorly and
that inflation of money and credit is all the
more rampant. In any case, a lower rate of
bank failure can scarcely be accepted as any
sort of evidence for the superiority of a
banking system.

In fact, in a book that Professor White

acknowledges to be the definitive history of
Scottish banking, Professor Sydney Checkland
points out that Scottish banks expanded and
contracted credit in a lengthy series of boom-
bust cycles, in particular in the years
surrounding the crises of the 1760s, 1772,
1778, 1793, 1797, 1802-03, 1809-10, 1810-11,
 39

1818-19, 1825-26, 1836-37, 1839 and

1845-47. Apparently, the Scottish banks escaped
none of the destabilizing, cycle-generating
behavior of their English c o u s i n s . [29]

Larry J. Sechrest also challenged White in his article,

"White's Free-Banking Thesis: A Case of Mistaken

I d e n t i t y ."[30] Referring to S. G. Checkland's,

Scottish Banking: A History, 1 6 9 5 - 1 9 7 3 , he writes,

Further, Checkland's description of the expan­

sionary phases that preceded each "crisis"
sounds much like the scenario of credit-
induced malinvestment that lies at the heart
of the classic Misesian business cycle.
Checkland sums it up well when he states:
'In principle, it [the Scottish system]
should have been capable of stability, or
at least, of fairly easy contraction. In
reality, it was n o t . ’ Due, perhaps, to its
being established upon the wrong p r i n c i p l e ? [31]

Clearly the Scottish system was neither stable nor free.

Financial crises are very disruptive to the economy and one

wonders why one would choose a banking system that makes

them inevitable (fractional reserve free banking) over one

that precludes their possibility (100 percent r e s e r v e ) . The

Scottish system is certainly not a model for reform.

Sechrest concludes,

--the Scottish system was de facto a central

bank system in which individual private banks
pyramided their note issues upon the reserves
of the three chartered banks, which, in turn,
pyramided their issues upon the reserves of
the ultimate source of liquidity for the
entire British Isles: the Bank of E n g l a n d . [32]
 40

After this example, claims of fractional reserve free

banking theorists of stability and freedom must be carefully

questioned and researched.

CHINA

In yet another example of allegedly successful fractional

reserve free banking, Selgin refers to China. He writes,

Although banking under the Manchus was

subject in many places to local and pr o ­
vincial regulations, in others it was
entirely free. One such case was the
banking system of Foochow, the capital of
Fukien province. From the beginning of the
19th century until the second quarter of the
twentieth Foochow's banking and currency
system was entirely private and free from
any regulatory res t r i c t i o n s .[33]

Loans by Foochow banks were not secured by specific capital

assets as are most loans extended by western banks. "The

security here was the borrower's general property rather

than specific c o l l a t e r a l ."[34] Consequently, the effects of

the business cycle would not erode the bank's asset

portfolio to the same extent as western banks. The Foochow

banks could seize the borrower's general property for the

full value of the outstanding loan and they would not lose

any assets. By contrast, when western banks seize a

defaulter's property, it usually consists of the capital

asset against which the loan was secured. If the market

value of the capital asset has fallen (which is a

characteristic of the end of a credit expansion, or bust)

the bank suffers.

 41

Following White's example, Selgin uses as his indicator of

stability, the number of bank failures.

Prior to 1922 local bank failures were

confined to small banks or cash shops. A
mid-19th century observer reported that only
four small banks had failed from 1844 to 1848,
and that a general crush, seriously affecting
the public interest, is a thing unheard
o f . [35]

Nothing is said, however, of the overall stability of the

economy. The Foochow system of securing debt against a

debtor's general property would limit the losses of the

lending bank, but would not save the economy from the

effects of the business cycle. In addition, if the market

value of the borrower's general property fell below the

value of the loan (due to the fall in capital v a l u e s ) , the

bank would suffer a loss. If this loss could somehow be

anticipated, it would be reflected in the terms of the loan.

If not, either the debtor or creditor would suffer and, most

certainly, the economy at large.

In addition, the capital structure of China in the

nineteenth and early twentieth centuries was very primitive

with most capital being very close to consumption. Because

the business cycle has greater impact on more advanced

stages of capital, it would have had little effect on China

at that time. Little can be learned as to how a fractional

reserve free banking system might operate in an advanced

 42

capitalistic economy, from the historical example of free

banking in China.

Other Historical Examples

According to the Austrian theory of the business cycle,

credit expansion generates the business cycle, yet most

fractional reserve free banking theorists claim that it is

stable. The instability of the Scottish system is obviously

in dispute, but what about the stability of other fractional

reserve free banking systems?

Selgin contends that most fractional reserve free banking

systems operated throughout most of their history with few

crises. With regard to the Canadian system, he writes, "The

Canadian system was an example of a well working free

banking system which suffered few crises and included some

of the world's most prestigious banking firms."[36] The

Canadian banking system suffered no bank failures during

1930-33 in stark contrast to the U.S. during the same

period. Of the Swedish system that existed between 1831-

1902, he writes,

One measure of the success of the Swedish pr i ­

vate note-issuing banks is that, throughout
their existence, none failed even though the
government had an explicit policy of not assisting
private banks in financial trouble. ...Finally,
the absence of banking regulations in Sweden was
crucial to its exceptionally rapid economic growth
during the second half of the 19th c e n t u r y . [37]
 43

Unfortunately, the number of bank failures in a certain

period is not a good indicator of the stability of

fractional reserve free banking systems. There were no bank

failures in the U.S. system until the 1980s because of

Federal Deposit insurance, yet the entire system of

government insurance has been strained to the breaking point

and appears to be getting worse. Also, neither of the

systems was really free in a pure sense. If they had been

completely free, there may have been failures. Also, the

fact that Sweden enjoyed high rates of growth during

its relatively free banking episode is meaningless when one

considers the high growth rates enjoyed by other nations

(such as the U.S.) whose banking systems were less free

during the same period. Growth rates may have been even

higher under 100 percent reserve banking.

Conclusion

Selgin admits that the historical argument in his book is

inconclusive. He concludes with,

Unfortunately, there have been few free

banking episodes in the past, none of which
realized it in pure form. Thus history fur­
nishes an inadequate basis for drawing theore­
tical conclusions about free banking. To rely
exclusively on it would invite generalizing
from features unique to a single episode or
from features attributable to r e g u l a t i o n . [38]

Selgin claims that "the historical record does not provide

any clear evidence of the failure except po l i t i c a l l y of

 44

free b a n k i n g ." [39] The historical record does not provide

any clear record of its success, either. Cases such as

Scotland that were initially held as examples of the success

of fractional reserve free banking have failed upon closer

study to support Selgin's thesis. Where fractional reserve

free banking has failed, Selgin claims it is a result of

government intervention. The Theory of Free Banking clearly

shows the superiority of fractional reserve free banking

over centralized banking, but Selgin has not shown that it

is superior to 100 percent banking or even viable in the

long run.

Several Theoretical Scenarios of Free Banking Failure

In "Implications of Free Banking and Note Issue: Answers to

some q u e s t i o n s " ,[40] Selgin considers several scenarios in

which a banking system might fail. He begins by questioning

why most individuals would wish to withdraw all their funds

from a fractional reserve banking system at the same time,

"If the public were truly indifferent concerning these

advantages of bank money, fractional reserve banking would

have never arisen in the first place; like the sizes of

bridges and tunnels, the size of bank's holdings of reserves

relative to liabilities reflects observed patterns of public

behavior over long stretches of time." [41]

 45

Selgin has, like many others, inappropriately identified

bridges as a form of fractional reserve. The fallacy of

this argument has been discussed earlier. Beyond this

inappropriate comparison, Selgin has assumed that a

fractional reserve free banking system could operate in

something close to equilibrium and that it is not disruptive

to equilibrium in and of itself. As he states, "A run on

the banks, leading to unexpected withdrawals of the ultimate

money of redemption must therefore be something exceptional,

due to extraordinary c i r c um stances."[42] He gives several

examples of these "extraordinary circumstances".

In the first example, he assumes a bank failure due to poor

management. If the bank has truly been mismanaged, then it

should be allowed to fail. If its asset portfolio is sound,

then it will be purchased by another institution as a quick

method to increase market share and its clients will not

lose. In the second example he deals with bank run

"contagion effects". These could be dealt with in our

present system by creation of a secondary market for bank

liabilities and would not be a problem at all under free

banking. He concludes this example by stating, "under free

banking, no information externality problem would exist to

give rise to a bank-run contagion."[43] The third example

is a natural or national disaster. In this case he asks,

"How then, would banks in a free banking system respond?

 46

They would probably respond the way insurance companies

presently respond to great national as well as natural

disasters: by having a special clause in their agreements

with its customers, allowing them to refrain from meeting

their obligations in the usual manner whenever a great

emergency occurs."[44]

Although some insurance companies operate as fractional

reserve institutions, they need not necessarily so do.

Selgin has once again inappropriately compared fractional

reserve banking to other enterprises such as insurance

companies. Selgin feels that as long as depositors are

aware that certain banks maintain an option clause where

they may suspend specie payment under special circumstances

there is no problem. To him, this is just an extension of

the principle of "freedom of choice". Individuals would be

free to trade with banks that promise to redeem in specie at

all times and under any circumstances or with banks that

suspend payment.

Selgin clearly believes that there is nothing inherently

unstable about fractional reserve banking, only in systems

that are not "free banking". When referring to the dramatic

rise in the demand for money that often occurs at the end of

an expansion of credit he writes,

Such disturbances caused by changes in currency

demand are what monetarists like Henry Simons,
 47

Lloyd Mints, and Milton Friedman have in

mind when they refer to the "inherent insta­
bility" of fractional reserve banking. Yet
this instability is really not inherent in
fractional reserve banking at all. It is
only inherent in fractional reserve banking
systems that lack freedom of note issue,
including, in particular, all central
banking s y s t e m s . [45]

He does not consider the problems discussed above a serious

impediment to the operation of a fractional reserve banking

system. Even granting an ideal banking world to Selgin,

however, where there are no natural or national disasters

and no loss of confidence in the system, he still fails to

address one critical point: that which follows from the

central idea of this thesis. Over time, all enterprises and

all stages of production will return something close to the

market rate of i n t e r e s t .[46] The profits generated by an

enterprise will eventually just cover the costs of that

enterprise plus the market rate of return on the capital

invested in that enterprise. When a certain enterprise

returns profits above the market rate of interest,

entrepreneurs from less profitable enterprises invest

capital until competition brings the rate of return down to

the market rate of interest.

The opposite occurs when an enterprise operates below the

market rate of interest. Entrepreneurs will leave an

industry that is returning something less than the market

 48

rate of return and enter an industry that is returning the

market rate. Any enterprise cannot consistently operate

above or below the market rate of interest forever. When a

fractional reserve institution extends credit it must do so

at a rate of interest below the market rate. Fractional

reserve free banking, by its very nature, must operate below

rates of return that it would receive if it were not

fractional reserve. Consequently, fractional reserve free

banking must fail not because of any exogenous event but

because of the endogenous contradictions upon which it is

based. Loss of confidence in the system or a national or

natural disaster would exacerbate already existing problems

and the credit expansion would eventually collapse

regardless of these events.

The Impossibility of Achieving Equilibrium Under Fractional

Reserve Free Banking

Because historical examples do little to support his

argument, Selgin embarks upon a theoretical model. He also

employs the fictional nation of Ruritania as has Mises and

Rothbard before him. He continues with a solid discussion

on the development of money, money warehouses, and then

banks in fictional Ruritania. He then treats the

development of fractional reserve banking as an important

and logical next step. "The lending of depositor's balances

is a significant innovation: it taps a vast new source of

 49

loanable funds and fundamentally alters the relationship

between Ruritanian bankers and their d e p o s i t o r s [47]

After this brief introduction, Selgin then makes a startling

assumption. He contends that it is possible for an

equilibrium condition to be achieved between the supply and

demand of loanable funds under fractional reserve free

banking. It is here that he makes his fatal error. The

analysis that follows and comprises the bulk of his book

rests upon this fallacious assumption.

He states two conditions that must be met in order to

achieve equilibrium and, as usual, assumes the public will

hold only inside money. He writes,

As the public holds only inside money,

with commodity money used only in bank
reserves to settle clearing balances these
conditions are as follows: First, the demand
for reserves and the available stock of co m ­
modity money must be equal. Second, the
real supply of inside money must be equal
to the real demand for it. Once the first
(reserve equilibrium) condition is met, the
tendency is for any disequilibxium in the
money supply to be corrected by adjustments
in the nominal supply of inside money. An
excess supply increases, and an excess demand
reduces, the liquidity requirements (reserve
demand) of the system. This is shown in
chapters 5 and 6 below.

On the other hand, if the reserve-equilibrium

condition is not satisfied, the system is
still immature. An excess supply of reserves
then causes an expansion of the supply of in­
side money. If this leads to an excess supply
of inside money, it will promote an increase
 50

in both reserve demand and prices causing both

the nominal demand for money and the demand
for reserves to rise.

There must be one price level at which both

equilibrium conditions are met. When this
price level is achieved, the system is in a
long-run equilibrium. For the sake of simpli­
city, the analysis that follows starts with a
free banking system (similar to Ruritania's) in
long-run equilibrium and assumes an unchanging
supply of bank r e s e r v e s .[48]

This equilibrium condition, however, cannot be met under

fractional reserve banking for the nature of such a system

constantly moves the economy away from equilibrium, not

towards it. The analysis that follows this fallacious

assumption is basically sound but meaningless if this

equilibrium condition cannot be achieved. It is only under

100 percent free banking that equilibrium between the supply

and demand for credit can be achieved, and in fact much of

Selgin's equilibrium analysis applies to a 100 percent

system rather than a fractional reserve system. Fractional

reserve credit expansion affects the market rate of interest

and consequently the value of all capital and not just

capital which may be purchased by these new loans or against

which they are secured. This was H a y e k 's point when he

wrote in the introduction of Prices and P r o d u c t i o n , "What

was, however, of prime importance for my purpose was to

emphasize that any change in the monetary demand for capital

goods could not be treated as something which made itself

 51

felt only on some isolated market for new capital goods,

but that it could be only understood as a change affecting

the general demand for capital goods which is an essential

aspect of the process of maintaining a given structure of

p r o d u c t i o n [49] This is one of the main ideas of H a y e k 's

book and he shows that monetary expansion affects the prices

of all capital, not just specific markets or more advanced

stages of capital (although these do tend to be stimulated

to a greater degree than lower stages of c a p i t a l ) . The

following analysis will prove why this equilibrium

(necessary for a fractional reserve free banking system to

function s m o othly), cannot be achieved.

10. Fractional Reserve Free Banking in Ruritania

At the heart of fractional reserve free banking theory is

the assumption that equilibrium can be achieved between the

supply and demand for credit under fractional reserve. Many

economists (especially of the Austrian school) have shown

the importance of building theories that rest firmly upon a

realistic set of a s s u m ptions.[50] Selgin himself recognizes

this fact when he writes, "To be really useful in

interpreting the effects of regulation in the past, or in

predicting the consequences of deregulation in the future, a

theory of unregulated banking should be based on realistic

assumptions drawn, if possible, from actual expe r i e n c e ."[51]

Unfortunately it is impossible to achieve equilibrium

 52

between the supply and demand for credit under any

fractional reserve system.

I would like to introduce the Angel Gabriel again, to prove

that fractional reserve banking frustrates even the best of

intentions. After his disastrous experience earlier as

Chairman of the Fed, he is eager to redeem himself. The

Ruritanians have not lost faith in him. He is still in

charge of the economy but with the collapse of the system

there is little to manage. Centralized government

controlled fractional reserve banking has collapsed and the

banking system is now a 100 percent system in long run

equilibrium. Time has passed and the economy has fully

adjusted to the previous crisis. The system is very similar

to the theoretical system that Selgin employs to illustrate

his ideas except that it is not yet fractional reserve.

There is free entry into the banking system and no banking

regulations. There is no credit extended by fractional

reserve institutions at this point since to properly analyze

fractional reserve banking one must start at the beginning

and all fractional reserve institutions begin as 100 percent

reserve.

Even institutions that plan to immediately become fractional

reserve institutions the moment their doors open must begin

as 100 percent institutions. At inception, fractional

 53

FIG. U

Interest
Rate

NB

C1
Total Credit

FIG. 5

Interest
Rate

NB

Total Credit

FIG. 6

Interest
Rate

NB FR

c4
Total Credit
 54

reserve institutions have no deposits; hence they are 100

percent reserve institutions. The axis in Fig. 4 represents

the interest rate and the x axis represents the total amount

of credit extended in the economy. Over time, the Angel

Gabriel has noted that never more than 20 percent of total

deposits (after clearings) are ever withdrawn from the 100

percent reserve banking system. Thinking that his previous

mistakes were a result of centralization and government

control, the Angel feels that it might be a good time to

introduce fractional reserve free banking and allow market

forces to keep the extension of credit and the issuance of

banknotes within "reasonable limits". He has read George

Selgin's book, The Theory of Free B a n k i n g , and is eager to

put these ideas into practice. The Angel feels that the

economy will be better able to respond to changes in the

demand for money and credit and that this will result in a

rise in the standard of living due to increased investment.

When the Angel is questioned by one of the local Ruritanians

(who is also an avid student of Mises and R o t h b a r d ) , about

the effects of credit expansion as illustrated by the

Austrian theory of the business cycle, the Angel feels these

effects would be negligible under fractional reserve free

banking. He says,

The problem with the Austrians, is that

they completely ignore the demand side of
the money market. Monetary disequilibrium
 only occurs when money is issued in excess
of demand for money balances at given prices.
Harking back to the equation of exchange,
(MV=PQ) [52], the optimal reserve ratio is
a function of MV, money times velocity.
One needs to distinguish between changes in
the stock of bank money that accomodate changes
in the public's willingness to hold bank money
(so that the increased stock of bank money
d o e s n ’t add to total spending) and changes
that do add to total spending and hence tend
to raise prices and the prices of factors of
production. One must look at the "stream of
spending" M times V) and stabilize that, not
the price level. If the banks are behaving in
such a way that M increases only when V falls,
and vice versa, there is no problem. Starting
from this framework, excessive bank expansion i
defined in a different way and one must ask if
free banks engage in that kind excessive
expansion, which they don't tend to do. They
tend, in fact to stabilize MV since the optimum
reserve ratio is a function of MV. If MV rises
the banks will need more reserves. If the
quantity of reserves is fixed, the banks will
not be able to expand credit beyond this point.
The quantity of MV is stabilized automatically.
There is no link between fractional reserve
banking and monetary trade cycles, although
trade cycles can be very severe with fractional
reserve banking, (which I found out early in my
c a r e e r ) , but only with a banking system that
allows MV to fluctuate, which central banking
systems do.

With this explanation the Angel dismisses the Ruritanian

begins his planned credit expansion.

Because only 20 percent of the deposits in the Ruritanian

banking system are ever withdrawn, the Angel encourages a

gradual expansion of credit that will eventually equal 80

percent of total deposits. The Ruritanians follow his

advice and credit expands from Cl to C2 in Fig. 5. This

 56

also results in a five fold increase in the Ruritanian money

supply due to the money multiplier. The amount of credit

extended by non-bank sources is indicated by 0C1, and the

amount of credit extended by fractional reserve is indicated

by C1C2. The interest rate falls from il to i2.

At the interest rate of i2, however, there are fewer

individuals who wish to save and invest their funds. At

this interest rate they would prefer to consume rather than

to invest, so their funds are withdrawn from the credit

market as these loans mature or are sold at a discount on a

secondary credit market. In Fig. 5, C1C3 amount of credit

begins to be withdrawn from the market and, as the interest

rate rises, the withdrawal slows until, in Fig. 6, it stops

at C4 and the interest rate settles at i3.

This is not an equilibrium position, however, for the value

of the capital against which these loans were secured has

fallen and the creditors who extended these loans must now

suffer losses. Ceteris paribus, the interest rate varies

inversely with the value of capital. During the credit

expansion, the value of capital (against which both non-bank

credit and fractional reserve credit was secured) increased

as the interest rate fell. Loans extended after the onset

of the credit expansion were secured against inflated

capital. When creditors began to leave the market, the

 57

interest rate began to rise and the value of capital began

to fall. This will hurt all creditors, but especially

creditors who extended loans during, or at the end of the

credit expansion. For the most part, these will be

fractional reserve institutions since they were extending

credit while non-bank investors were withdrawing credit. As

Frank Fetter wrote,

Contract [interest] is based on and tends to

conform to economic interest [i.e., the 'natural
interest' price differential between stages]...
It is economic interest that we seek to explain
logically through the economic nature of the
goods. Contract interest is a secondary problem-a
business and legal problem-as to who shall have
the benefit of the income arising with the
possession of the goods. It is closely connected
with the question of o w n e r s h i p . [53]

Loans are extended against the current market value of a

capital asset. If the value of that capital asset falls in

the future, the creditor suffers losses, for in essence, the

creditor is the true owner of the capital. As Mises writes,

"The creditor is always a virtual partner of the debtor or a

virtual owner of the pledged and mortgaged property. He can

be affected by changes in the market data concerning them.

He has linked his fate with that of the debtor or with the

changes occurring in the price of the collateral. Capital,

as such, does not bear interest; it must be well employed

and invested not only in order to yield interest, but also

lest it disappear e n t i r e l y ."[54]

 58

As the economy attempts to move back to its equilibrium

position, the interest rate rises and the value of capital

falls. Because by the very nature of fractional reserve,

the majority of the loans extended during the credit

expansion were extended by fractional reserve institutions,

they will find themselves in a very embarrassing position.

Now that the economy has begun to adjust, inflation has set

in as a result of the five-fold increase in the money supply

during the credit expansion.

Fractional reserve institutions will find that although

never more than 20 percent of deposits were ever withdrawn

(after clearing) under 100 percent banking, more than 20

percent will be withdrawn under fractional reserve. This

will occur whether or not there is a loss of confidence in

the system. The dramatic rise in prices will necessitate a

much greater amount of money in circulation to sustain the

same number of purchases. Small purchases for which the

writing of checks is impractical, will require more specie

which much be withdrawn from the banks.

This will occur at the worst possible time for the banks,

for their asset portfolio has fallen and they must begin

contracting credit and increasing reserves. Their debtors

(those who borrowed from fractional reserve institutions)

will find that the enterprises they have embarked upon have
 59

proved to be not nearly as profitable as they had thought

and will wish to borrow even more in order to keep their

malinvested enterprises afloat. They will also wish to

borrow at the old, low interest rates that they originally

received. But fractional reserve institutions are

contracting credit at this point, not extending credit.

What appears to be an increase in the demand for credit is

really just an attempt to postpone the demise of

malinvestments undertaken during the credit expansion.

Contrary to fractional reserve free banking t h e o r i s t s ,

fractional reserve institutions will not be able to respond

to this illusory increase in credit demand because it occurs

simultaneously with the strong forces that are forcing these

institutions to contract credit.

Fractional reserve institutions begin to fail, not because

of government interference, but because of the inherent

logical contradictions of this system itself. The

inevitable loss of reserves, devaluation of its asset

portfolio and inability to extend credit will force the

fractional reserve banking system to contract credit and

cause depositors to fear for the safety of their deposits.

This may lead to a run on the banks which will cause an

immediate and possibly fatal crisis. Bank runs have in the

past been the most evident and sensational phenomenon of

 60

fractional reserve banking. But the system would still be

forced to contract credit and lose profits even if a bank

run did not occur. Far from increasing investment and adding

to the stock of capital, fractional reserve banking (even if

it is completely free) wastes investment and ultimately

leads to a lower stock of capital than there would have been

under 100 percent reserve.

Although it may initially appear as a great boon to the

banking industry, fractional reserve ultimately results in

great losses to the banking industry and a lower return on

their investment than under 100 percent reserve. Fractional

reserve banks, by their very nature, must extend credit at

below the market rate of interest whereas under 100 percent

reserve, both deposit banks and investment banks should

expect to receive the market rate of interest over time.

Again, the fractional reserve free banking theorists are

wrong, for fractional reserve wastes investment, not

increases it, lowers banking profits, not raises them and is

unable to efficiently respond to changes in the demand for

credit.

During the bust, non-bank credit should increase as the

interest rate rises but the total amount of credit extended

will contract as the decrease in fractional reserve credit

will more than offset any increase in non-bank credit. At

 61

this point, when the fractional reserve institutions have

fully absorbed their losses, they may be tempted to expand

credit once again and the same sad story will repeat itself.

It is not even possible to imagine a situation where the

economy could be in equilibrium under fractional reserve.

Let us consider Fig. 7 where the interest rate and the

amount of credit extended in the economy appear to be in

equilibrium at the intersection of the supply and demand

curves of credit. This appearance is deceptive, however,

for when considering the total amount of credit extended in

the economy one must consider both credit extended by

fractional reserve institutions and that extended by n o n ­

bank sources.

An entrepreneur who invests his time and money in a project

of his own can be considered to be "investing in himself",

for he could invest his money and labor elsewhere. He is a

100 percent reserve investor and "invests in himself"

because he expects higher returns than investing elsewhere.

A loan extended by either a fractional reserve institution

or an individual or investment firm must still be secured by

some existing capital and at the current market value for

that capital. The only difference, although a crucial one,

is that fractional reserve extends its loans with funds that

may be claimed on demand by another party (and are intended

 62
FIG. 7

Interest
Rate

NB FR

C
Total Credit

FIG. 8

Rate

NB FR

C.
Total Credit
 63

for consumption) while loans extended by an individual or a

non-bank source (intended for investment) may not be claimed

until the loan matures. The immediate effect on the credit

market is the same, however. New credit has the same effect

on the interest rate, the value of capital, and the supply

of credit whether it originates from fractional reserve or

non-bank s o u r c e s .

The long term effect is quite different. Fractional reserve

credit generates the business cycle, m a l i n v e s t m e n t , losses

for creditors (especially fractional reserve institutions

themselves) and ultimately a lower standard of living than

what would have been. Non-bank credit generates solid

steady growth, higher returns for creditors (especially

b a n k s ) , and ultimately a higher standard of living.

Returning to Fig. 7, Ruritania is not in equilibrium since

at interest rate i, more non-bank investors wish to extend

credit than are presently on the market. There will be a

net increase of non-bank credit. Assuming the amount of

fractional reserve credit stays the same, non-bank credit

will increase until interest rate i2, in Fig. 8, is reached.

The interest rate of i2, however, is lower than il where

most of the fractional reserve credit was extended.

Due to inflation, their return on investment will not be as

high as the fractional reserve institutions had anticipated

and they will suffer losses. There will be a drain of

reserves and once again the fractional reserve free banking

system must suffer losses. Equilibrium cannot possibly be

achieved until all fractional reserve credit is removed from

the market. Fractional reserve free banking may be superior

to centralized banking because of the lack of government

intervention and a fixed supply of gold reserves, but only

to the extent that it limits credit expansion. Fractional

reserve free banking is not stable and it is not even clear

that it is viable in the long run. If it is viable, it does

so at lower investment and lower standard of living than a

100 percent reserve banking system.

One hundred percent reserve banking is superior to

fractional reserve free banking because it eliminates credit

expansion altogether. Instead of ignoring the demand side

of the money market (as the Angel Gabriel once t h o u g h t ) , he

now realizes that the Austrians were correct in emphasizing

the disruptive effects of fractional reserve banking, for

all the Angel's carefully drawn analysis collapses under

conditions of continuing disequilibrium. This truth finally

dawns upon the Angel Gabriel and the Ruritanians.

Fractional reserve banking is codified into law as a

fraudulent practice, all banks become 100 percent reserve

deposit banks and Ruritania finally begins a period of

stable growth with a profitable, crisis-free banking system.

 65

Fractional Reserve Free Banking Under Constant Money Demand

Although it is impossible to achieve equilibrium under any

form of fractional reserve, George Selgin makes this

assumption and uses it as the foundation of most of his

book, The Theory of Free B a n k i n g . He begins chapter 3,

"Credit Expansion with Constant Money Demand," by stating,

"Throughout the chapter it is assumed that the public's

total demand between the two forms of inside money (currency

and demand deposits) are c o n s t a n t ."[55] Unfortunately, the

demand for inside money cannot possibly remain constant

under credit expansion for the inevitable inflation

generated by the credit expansion will later change the

public's demand for inside money.

Using the "Rule of Excess Reserves," "The Principle of

Adverse Clearings," and assuming "Note-Brand

Discrimination," Selgin shows that there are limits to

banknote creation as well as deposit creation. The analysis

is clearly and logically written and follows correctly from

the initial assumption upon which it is based. It is

meaningless, however, for fractional reserve banking

generates forces that will upset equilibrium between the

supply and demand for money and will continually upset the

economy's efforts to return to equilibrium.

 66

Fractional Reserve Free Banking Under Changing Money Demand

As Leland Yeager writes, "Probably Selgin's most

'provocative' analytical point (to adopt White's word) is

that the economic limits to note and deposit issue expand

when the public's demand for bank money g r o w s . " [56]

In chapter 4, Selgin clarifies what is meant by the demand

for money which is often confused with the demand for bank

credit or loanable funds. He writes, "Thus to be useful the

expression demand for money must refer to peoples' desire to

hold money balances and not just to the fact that they agree

to receive money in exchange for other goods and services,

including later-dated claims to m o n e y . " [57] This is

consistent with Rothbard who writes, "The total demand for

money on the market consists of two parts: the exchange

demand for money (by sellers of all other goods that wish to

purchase money) and the reservation demand for money (the

demand for money to hold by those who already hold i t ) . "[58]

It is Selgin's contention that fractional reserve free

banking facilitates movement toward equilibrium by better

responding to changes in the demand for money than either

100 percent, or centralized banking. Concerning equilibrium

he writes,
 67

As used here 'monetary e q u i l i b r i u m ’ will

mean the state of affairs that prevails
when there is neither an excess demand for
money nor an excess supply of it at the
existing level of prices. When a change
in the (nominal) supply of money is demand
accommodating— that is, when it corrects
what would otherwise be a short-run excess
demand or excess supply the change will be
called 'warranted' because it maintains m o n e ­
tary e q u i l i b r i u m . [59]

He continues, "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 i t . "[60]

Selgin is confusing two different markets here: the market

for money and the market for loanable funds. This was also

a problem with the banking school. The Austrian policy

prescription in this case would be to allow equilibration

through market processes such as changes in the purchasing

power of money and the interest rate. Selgin, in an effort

to avoid the temporary dislocations that may be involved in

this process, feels that equilibration can be achieved by

fractional reserve free banking without any dislocations.

His analysis is fundamentally flawed however.

One of the main criticisms of 100 percent banking by

fractional reserve banking theorists is that it is slow to

respond to changes in the demand for loanable funds because

of the inelastic supply of gold. (Throughout this example I

 69

would like to assume as do most theorists that a 100 percent

banking system would be based on gold.) They claim

fractional reserve is necessary to respond to the "needs of

trade". Let us consider a theoretical example to compare

responses of fractional reserve banking to an increase in

the demand for loanable funds with that of non-bank lenders.

Because the supply and demand of loanable funds is

determined solely by time preferences, any change in the

demand for credit implies a change in time preferences.

Figures 9.1 and 10.1 consider two different banking systems;

fractional reserve free banking and one hundred percent

reserve. The total amount of loanable funds extended in

both economies is represented on the x axis while the

interest rate is represented on the y axis. Figure 9.1 is

in long run equilibrium. In Fig. 10.1 the total amount of

loanable funds is divided between that which is extended by

fractional reserve free banking institutions and 100%

reserve banks.

Although in this example, the amount of credit extended in

Fig. 10.1, intersects the supply and demand curves for

credit, this is not an equilibrium position. Since

equilibrium is impossible under fractional reserve, this

economy is in a state of flux, constantly responding to the

disruptive effects of credit expansion. Attempts made by the

 NB indicates credit generated from non-bank sources

FR indicates credit generated from fractional reserve sources

100%' Reserve Free Banking

Banking System

FIG. 9.1 FIG. 10.1

Real
Interest
Rate

Q1 Q1
Total Credit Total Credit

FIG. 9.2 FIG. 10.2

Real
Interest
Rate

Q-l Q2 Ql Q2
Total Credit Total Credit
 70

economy to move towards equilibrium (the bust) will be

offset by new injections of credit (the b o o m ) . Because

equilibrium is impossible under fractional reserve, any

analysis must either begin in disequilibrium or in

equilibrium under 100 percent reserve and then move to

fractional reserve and disequilibrium. In this example, in

order to discuss the effects of a change in the demand for

money in a fractional reserve free banking system we will

begin in disequilibrium.

We now assume that both economies experience an increase in

the exchange demand for loanable funds. The demand curve in

both economies shifts to the right from D1 to D2 in Figures

9.2 and 10.2 respectively. In the 100% reserve system, the

increased demand for loanable funds will increase from Q1 to

Q2. This merely represents a shift of funds from

consumption to investment. There may be some disruption of

the economy as it begins to create more capital relative to

consumption goods but this is unavoidable. This is the best

and least disruptive method for the economy to respond to an

increase in demand for loanable funds. All loans extended

during this period will be, ceteris paribus, profitable if

it is assumed that this is a permanent shift in time

preferences, and consequently a permanent shift in the

demand for loanable funds. The real interest rate at which

these new loans are extended will be higher or equal to the

 71

real interest rate at which the economy finally

equilibrates, and therefore profitable. It is only when

lending institutions extend credit at below the market rate

of interest that the loans are eventually seen to be

u npr o f i t a b l e .

In Fig. 10.2 the fractional reserve free banking economy

experiences the same shift in demand for loanable funds.

This increase in the exchange demand for loanable funds does

not imply a decrease in velocity (hoarding) that we will

next consider. It merely implies that borrowers are now

willing to accept loanable funds at a higher rate of

interest. According to Selgin's system, if there is no

change in the demand for bank reserves, no new credit can be

extended by fractional reserve institutions. The increased

demand for loanable funds will be matched by an increase in

supply from non-bank sources. A fractional reserve banking

system can do little to respond to changes in the exchange

demand for loanable funds.

But what of an increase in the reservation demand for money

itself? Selgin claims this is the area with which

fractional reserve is best suited to deal. While it is true

that an increase in the reservation demand for money itself

(what is commonly referred to as hoarding, and by Selgin

more accurately as a decrease in velocity) will be

deflationary and disruptive, fractional reserve would

actually be worse. First of all, under 100 percent reserve

it is doubtful that a large deflation would take place for

that would imply that large sums of money are not employed

for either consumption or investment but merely hoarded or

destroyed. Historically, the large deflations of the past

(as in the 1930's) were a result of previous credit

expansions. One could more plausibly argue that to

eliminate the disruptive effects of deflation, fractional

reserve banking should be abolished rather than advocating

increased fractional reserve credit expansion during

deflation. But even granting a large deflation under a 100

percent system, one must consider how such a thing could

come about. Why would a large proportion of individuals

desire to hoard money instead of consuming or investing it?

If itwas because of uncertainty about the future, then

hoarding may be a wise policy.

Under fractional reserve free banking an increase in the

reservation demand would result in a decrease in velocity

and an increase in the bank demand to hold reserves. Selgin

writes,

As our earlier discussion made clear, a

free banking system tends to accommodate
changes in the demand for inside money with
equal changes in its supply. An increase
in the demand for inside money balances
results in banks' discovering that their
formerly optimal reserve holdings have become
s uperoptimal the banks are encouraged to
 73

expand their issues of inside money. Co n ­

versely, a fall in the demand for inside
money exposes banks to a greater risk of
default at the clearinghouse, prompting
balance-sheet contraction. In both cases
the system avoids unjustified fluctuations
in aggregate nominal income and prices. [61]

Consequently the banks could increase credit because their

reserves would increase. Even granting Selgin the fact that

individuals would keep their increased hoards at fractional

reserve institutions rather than redeeming them, one must

question the wisdom of extending credit at such a time. As

was said before, if a large number of individuals have

increased hoards because of uncertainty, there may be good

reasons for their actions. The disruption of deflation

under 100 percent reserve would probably be minor compared

to a major increase of unwise and ultimately unprofitable

malinvestments.

11. Conclusion

Selgin contends that, "Free banks maintain constant the

supply of inside money multiplied by its income velocity of

circulation. They are credit intermediaries only, and cause

no true inflation, deflation or forced s a v i n g s ."[62] This

view differs markedly from the writings of Mises and

Rothbard who contend that any credit expansion leads to the

business cycle. According to Mises, "Issuance of fiduciary

 74

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. Of

course, if the additional amount issued is not large,

neither are the inevitable effects of the e x p a n s i o n ."[63]

The Theory of Free Banking rests firmly upon the assumption

that long run equilibrium can be achieved and maintained

under fractional reserve free banking. Once this fallacious

assumption is accepted, Selgin's analysis logically and

correctly follows. As has been shown, however, equilibrium

cannot be achieved under fractional reserve but only under

100 percent reserve. As evidence of this, the introduction

of fractional reserve banking into a 100 percent reserve

system in long run equilibrium would still generate a credit

expansion. Excess reserves in 100 percent deposit banks

making the transition to fractional reserve banking, would

be loaned out even if in long run equilibrium and force the

economy away from this point, requiring a later correction.

It is this fact that destroys the analysis of the fractional

reserve theorists.

This is unfortunate, for most of The Theory of Free Banking

is well written and clearly shows the superiority of free

banking over centralized banking. What is necessary now is

for theorists to base their work upon realistic assumptions

 75

and show the superiority of 100 percent banking over all

other forms.
 76

PART FOUR

THE FUTURE WITHOUT FRACTIONAL RESERVE BANKING

12. Failure of the Present System

The central assertion of this thesis has been to question

the widely held assumption that the present economic system

is fundamentally sound and viable in the long run. This

status quo in which the government is committed to

continuing credit expansion (with periodic minor

contractions) is little more than twenty years old and

without historical precedent, yet few have asked the most

basic question: does it work in the long run? Does it not

seem incredible that so many can assume continuous credit

expansion without some drastic response by market forces?

To say that the banking system is actually supplying this

credit is misleading, for without new reserves (which are

determined by the g o v e r n m e n t ) , the banking system could not

expand credit. Because the federal government insures this

credit (much of which is extended below the real interest

rate) the government is, in fact, the ultimate creditor of

this debt. Other creditors will gradually shift their funds

out of investment and into consumption, leaving the

government with an increasing percentage of total credit

extended. In essence, this is a unique situation in which

the costs to one producer (the government) of supplying a

good (credit) are lower than that of any of its competitors,

for this good can be created virtually out of thin air while

others must forego consumption. As Dr. Hans-Hermann Hoppe

writes, "Placed at a lowered interest rate, the newly

granted credit causes increased investments and initially

creates a boom that cannot be distinguished from an economic

expansion; however this boom must turn bust because the

credit that stimulated it does not represent real savings

but instead was created out of thin a i r . "[64]

In addition, this credit will be extended regardless of

whether or not it is ultimately profitable. The problem is

not as severe when government insures a small percentage of

total debt. Periodic recessions (which involve a fall in

capital goods inflated during the previous booms, relative

to consumer g o o d s ) , hurt creditors who have extended credit

secured to inflated capital values. Non-government

creditors will be hurt most since they hold most of the

debt. In the latter stages of our present system, however,

a fall in capital values will degrade the debt portfolio of

the entire governmentally insured credit system, and the

government will have to guarantee those capital assets at

their original inflated prices when credit secured by those

capital assets was extended. This is why (as was shown in

Part II) much of the debt extended by governmentally insured

 78

fractional reserve institutions must ultimately be purchased

by that same government. This is the real cause of the

present Savings and Loan bailout and must spread to other

fractional reserve institutions insured by the federal

government as well. As long as government continues to

expand credit, the problem will worsen until it is faced

with only two equally unappealing choices: allow the

bankrupt fractional reserve credit system to collapse or

hyperinflate the currency which will ultimately lead to the

collapse of the banking system anyway.

Under the gold standard, falling capital values forced

fractional reserve institutions to contract credit in order

to remain solvent. This often led (though not always) to a

rapid contraction of the money supply and deflation which is

often cited as the main reason to abandon the gold standard.

While this did remove the possibility of a massive

deflation, it did nothing to lessen the dire effects of the

boom-bust cycle. In reality, abandoning the gold standard

has postponed the inevitable market response to credit

expansion and greatly magnified its consequences.

13. System Transition

This thesis has questioned the long term viability of any

fractional reserve system. The conclusion is that any

 79

system, and especially the present one is doomed to

inevitable collapse. But i s n ’t there anything that can be

done? Can't the government do anything to forestall the

inevitable?

The answer is that the government will most probably do

whatever it can to postpone the crisis. By lowering the

rate of interest through accelerated credit expansion, it

can postpone the crisis; it cannot prevent it. This action,

however, will only delay and in fact ultimately exacerbate

the problems generated by previous credit expansions.

But what will this crisis look like? Can anything be said

about its nature or approximate time of arrival? This

future crisis can only be averted by halting credit

expansion now which in itself would cause a crisis. The

only advantage would be that a present crisis would not be

as devastating as one in the future. This is so politically

unrealistic, however, that it is hardly worth discussing.

In the present political and intellectual climate, credit

expansion will be halted only when it is clear that there is

no other alternative.

If one agrees that the government will continue to follow

the present course of continuous credit expansion punctuated

by brief reductions in the supply of high powered money, or

 80

merely reduce the rate of money growth, then certain events

must occur. First, as was discussed earlier, increasing

government credit expansion will continue to drive credit,

financed from non-bank sources, off the market and into

consumption. Later, inflation will degrade the debt

portfolios of both fractional reserve and non-bank debt;

however, since non-bank reserve debt comprises a greater

percentage of total credit, it will be affected to a greater

degree. As time passes and fractional reserve debt

comprises the greater percentage of total debt extended,

this process will be reversed. Since most fractional

reserve debt is extended at below market rates of interest,

this debt will ultimately prove to be unprofitable requiring

the federal government (the ultimate guarantor) to assume

this debt.

There will be two ways in which the federal government will

assume this debt. First of all, through open market

operations the government will purchase debt outright,

(usually government bonds) providing liquidity to the

banking industry. Second, it will actually assume control

of problem loans, guaranteeing depositors the full value of

their deposits. This is in effect, purchasing "bad loans"

at their original, inflated value when the loan was first

extended. One might argue that this will not necessarily

produce a crisis since the government is simply purchasing

 81

debt that it previously created. In the process, government

is dramatically increasing the supply of money and will be

limited by the extent to which it is able to contract. The

"brakes" are wearing thin while the vehicle "accelerates".

If history is any indication of how the market will respond

to this credit expansion, it is likely that the crisis will

be rapid and violent. When inflation rises to the point

where it is no longer profitable to leave deposits in

fractional reserve institutions for even short periods of

time, massive with-drawals will occur, leading to a banking

crisis. But what will be the catalyst of this massive

withdrawal? Why will the present, general confidence in the

banking system erode? It depends on the expectations of

individuals in the economy. Mises writes,

This first stage of the inflationary p r o ­

cess 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 holding. As long as such ideas
are still held by public opinion, it is not
yet too late for the government to abandon its
inflationary policy.

But then finally the masses wake up. They

become suddenly aware of the fact that in­
flation is a deliberate policy and will go on
 82

endlessly. A breakdown occurs. The crack-up

boom appears. Everybody is anxious to swap
his money against "real" goods, no matter
whether he needs them or not, no matter how
much money he has to pay for them. Within a
very short time, within a few weeks or even
days, the things which were used as money
are no longer used as media of exchange.
They become scrap paper. Nobody wants to give
away anything against them.

It was this that happened with the Continental

currency in America in 1781, with the French
mandats territoriaux in 1796, and with the
German Mark in 1923. It will happen again
whenever the same conditions appear. If a
thing has to be used as a medium of exchange,
public opinion must not believe that the
quantity of this thing will increase beyond all
bounds. Inflation is a policy that cannot
l a s t . [65]

In the past, most mainstream economists assumed that there

were no fundamental problems with the present economic

system and periodic recessions could be dealt with by "fine-

tuning". The previous discussion shows, however, that in

order to "save" the system the government must ultimately

destroy it.

14. Policy Proposals

The consequences of the collapse of the present system are

grim indeed. But what will follow the present system if the

events outlined in this thesis actually occur? Policy

prescriptions that appeared successful during the Great

Depression will fail if the present system collapses. The

 83

federal government cannot borrow to finance public works

programs in the absence of credit markets. Little can be

collected in taxes with a worthless currency and the world

in the depths of history's worst depression. Contraction of

the money supply cannot be held as the scapegoat when the

money supply had been inflated into absurdity.

I personally feel that most individuals and even economists

will be forced to turn to the gold standard to reestablish

confidence in the currency. As Mark Skousen writes, "I do

not think that a gold standard will be reestablished on its

own. No doubt such an event would create a crisis. But if

a fiat dollar monetary crisis is already happening, a return

to gold may actually reestablish economic s t a b i l i t y ."[66]

Dr. Rothbard has already outlined a plan for returning to a

100 percent gold d o l l a r . [67] Along with the introduction of

a 100 percent gold dollar, a 100 percent reserve banking

system nught also become a popular proposal, forever

eliminating the business cycle, inflation and banking

crises. As Dr. Hoppe writes,

The present economic order is characterized

by national monies instead of one universal
money; by fiat money instead of a commodity
such as gold; by monopolistic central banking
instead of free banking; and by permanent bank
fraud, and steadily repeated income and wealth
redistribution, permanent inflation and r ecur­
ring business cycles as its economic counterparts,
rather than 100 percent reserve banking with
none of these c o n s e q u e n c e s .[68]
 84

This inevitable future tragedy may be the catalyst to

finally establish an economic base which will encourage

economic growth and individual freedom. This may provide a

unique opportunity to the Austrian school. Austrian policy

proposals once thought unrealistic might be seen as the only

rational course during a crisis. Although it is impossible

to predict the timing and exact description of future

events, it is still possible to describe the general

sequence of the inevitable consequences of credit expansion.

Were the Austrian school to concentrate on describing this

sequence and warning of the dire consequences, its

credibility would be greatly enhanced.

The collapse of communism has surprised many Austrians even

though Mises illustrated its fundamental flaws many years

ago in Socialism. It is not that his ideas were not

generally accepted within the school, but more a lack of

confidence in the overwhelming power that the Austrian

school has to offer. Consequently, had Austrians emphasized

the present crisis in communism in the past when it was not

as obvious, credibility in other areas might have been

strengthened. If there is a crisis coming in the present

system, Austrians should concentrate their efforts on

describing events as accurately as possible, thereby

generating popular support for policy proposals that will

shorten the length of the crisis and limit the extent of the
 85

problems. A return to the gold standard in the midst of

hyperinflation may not only become politically possible, but

in evitable.

15. Conclusion

This thesis has basically asked just one question: Is the

present economic system fundamentally sound and viable in

the long run? The foundation of the present system rests

upon fractional reserve banking and governmentally

controlled credit expansion. Historically the market has

always reacted violently to credit expansion resulting in

bank runs, stock market crashes, recessions, depressions

and, (as in the case of Bretton Woods) collapse of the

system itself. Most economists feel that these violent

episodes can be dealt with and circumvented, even though the

present system is little more than twenty years old. In the

long run, market forces cannot be circumvented, especially

if one defines this nebulous term in decades rather than

years. Isn't it then reasonable to question the long term

viability of our present system?

The idea of fractional reserve, when analyzed objectively,

is truly illogical. In essence, fractional reserve allows

two parties full and exclusive ownership of the same asset

 86

over the same time period. To base a financial structure

upon this concept is asking for trouble. The fact that the

system has existed for so long can be attributed to o f f ­

setting factors and the fact the inevitable consequences

have yet to be seen.

Using the Angel Gabriel model, I attempted to illustrate the

future course of the present system and show that fractional

reserve free banking is at best a poor second choice to 100

percent reserve banking. Using the historical record to

support fractional reserve free banking is at best incon­

clusive, for it is difficult to find examples of the pure

model and free banking theorists say little about m acro­

stability of the economy at large. In addition, credit

expansion in an advanced capitalist economy would be much

more disruptive than in an agrarian society where most

capital is close to consumption. Advocating fractional

reserve free banking as an alternative to our present system

could be dangerous, for its failure would be seen as an

indictment of the free market, rather than the failure of a

fundamentally flawed system.

When the collapse finally arrives, we will be faced with two

broad choices. If the collapse is seen as a failure of

capitalism and free enterprise, policy proposals may call

for more pervasive government intervention. In this case

the world may be entering a new dark age. If the collapse

is seen as a failed program of government intervention that

was ultimately doomed from its inception, then there is hope

for a transition to a more rational and viable system. The

return to a 100 percent gold currency and banking system is

crucial to this new system. Any transition will be painful,

but the less government interferes, the less painful that

transition will be. It is up to the supporters of the free

market to somehow make the simple truth known, for the

future holds no other alternatives.

 88

NOTES

1- On the Austrian business cycle theory, see Mises, The

Theory of Money and C r e d i t ; Human A c t i o n , ch. XX; Hayek,
Monetary Theory and the Trade C y c l e ; Prices and
Production; Rothbard, Man, Economy and S t a t e , Vol. 2,
ch 12. Strigl, Capital and P r o d u c t i o n .

2. On the gold standard, see Rockwell, The Gold Standard

and Austrian Perspe c t i v e ; P a u l / L e h r m a n , The Case for
Gold.

3. Rothbard, "Nine Myths About the Crash" p. 3.

4. Rothbard, What Has Government Done to Our M o n e y ? p. 60.

5. Rothbard, Man, Economy and S t a t e , pp. 875-877.

6. Rothbard, The Mystery of B a n k i n g , p. 253.

7. For an excellent discussion of this problem see

Rothbard, The Mystery of B a n k i n g , pp. 93-95.

8. Rothbard, The Case for A 100 Percent Gold D o l l a r , p. 25.

9. Charles A. C o n a n t , Money and B a n k i n g , Vol. II, p. 20.

Referred to in Skousen, Economics of a Pure Gold
S t a n d a r d , p. 85.

10. Rothbard, The Mystery of B a n k i n g , p. 45.

11. Ibid., p. 317.

12. Rothbard, The Mystery of B a n k i n g . Ch. VI and VII.

13. Rothbard, Man, Economy and S t a t e , p. 342.

14. I b i d . , p. 317.

15. Ibid., p. 859.

16. I b i d ., p . 862.

17. Mises, Human A c t i o n , p. 448.

18. Rothbard, "A Conversation with Murray N. Rothbard,"

p . 5.

19. Selgin, The Theory of Free B a n k i n g . p. xii-xiii.

 89

20. Rothbard, "The Other Side of the Coin: Free Banking in

Chile", p. 1.

21. Ibid.

22. Ibid.

23. Selgin, "Short-Changed in Chile: The Truth About the

Free Banking Episode," p. 5.

24. Ibid.

25. Selgin, The Theory of Free B a n k i n g , p. 7.

26. Ibid. Footnote, p. 7.

27. Rothbard, "The Myth of Free Banking in Scotland".

28. I b i d . , p. 229.

29. I b i d . , p. 230.

30. Sechrest, "White's Free Banking Thesis: A Case of

Mistaken Identity," p. 247-257.

31. Checkland, Scottish Banking: A History, 1 6 9 5 - 1 9 7 3 , p.

214, quoted from Sechrest, "White's Free Banking
Thesis: A Case of Mistaken Identity," p. 252.

32. Sechrest, "White's Free Banking Thesis: A Case of

Mistaken Identity," p. 247.

33. Selgin, "Episodes From Asian Monetary History: Free

Banking in Foochow," p. 26.

34. I b i d . , p. 29.

35. I b i d . , p. 30.

36. Selgin, The Theory of Free B a n k i n g , p. 12.

37. I b i d ., p . 7.

38. I b i d . , p. 15.

39. Ibid.

40. In Austrian Economics Newsletter (Winter 1989), p. 4-7.

41. Selgin, "Implications of Free banking and Note Issue:

Answers to Some Questions," p. 8.
 90

I b i d . , p. 9.

Ibid.

44 Ibid.

45 Selgin, "The Implications of Freedom in Banking and

Note Issue," p. 6.

46 Rothbard, Man Economy and S t a t e .

47 Selgin, The Theory of Free B a n k i n g , p. 19.

48 I b i d . , p. 34.

49 Hayek, Prices and P r o d u c t i o n , p. 31.

50 See Mises, Rothbard and Hoppe.

51 Selgin, The Theory of Free B a n k i n g , p. 16.

52 Fetter, "Recent Discussions of the Capital Concept,"

pp. 24-25.

53 For a critique of this concept see Rothbard,

Man, Economy, and S t a t e , p. 727-737.

54 Mises, Human A c t i o n , p. 539.

55 Selgin, The Theory of Free B a n k i n g , p. 37.

56, Yeager, "The Theory of Free B a n k i n g : Reviewed by Leland

Yeager." pp. 13-14.

57, Selgin, The Theory of Free B a n k i n g , pp. 52-53.

58. Rothbard, Man, Economy, and S t a t e , p. 662.

59. Selgin, The Theory of Free B a n k i n g , p. 54.

60. I b i d ., p . 55.

61. I b i d ., p . 101.

62. I b i d . , p. 123.

63. See Mises, The Theory of Money and C r e d i t , pp. 359-67.

Human A c t i o n , pp. 545-73. Rothbard, Man, Economy, and
S t a t e , pp. 850-63.
 91

64. Hoppe, "Banking, Nation States and International

Politics. A Sociological Reconstruction of the Present
Economic Order." p. 8.

65. Mises, Human A c t i o n , pp. 429-30.

66. Skousen, Economics of a Pure Gold S t a n d a r d , p. xii.

67. Rothbard, The Mystery of B a n k i n g , pp. 266-67.

68. Hoppe, "Banking, Nation States and International

Politics. A Sociological Reconstruction of the Present
Economic Order." p. 10.
 92

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