The Night Watchman

The only authorized source of the thoughts and opinions of Per-Olof Samuelsson


Is "fractional reserve banking" compatible with Objectivism?

(Written in April 2010; latest revison February 20, 2011)

"Fractional reserve banking" is the practice of lending out more money than one actually has. It is also known as "the issuance of fiduciary media", or, in the German original, "Umlaufsmittel". For example, a bank has a certain amount of gold in its vaults, and then issues banknotes that are supposed to be backed by this amount or gold, but it issues more banknotes than are actually covered by the gold. This practice "works" as long as not every customer demands gold for his notes; but if this happens, there will be a bank run and the bank goes bankrupt (unless it is bailed out by the central bank).

Objectivists are divided on the question whether this practice is OK or not. Some (including me) claim that the practice is inherently dishonest and should ultimately be outlawed; others claim that it is a normal "market phenomenon" and should be allowed. And the vast majority (I believe) has not given the issue any thought.

Ayn Rand herself never addressed this issue in writing. And I don’t think she addressed it verbally either. I once asked George Reisman whether he had brought it up with her, and he answered that the only time he tried to do so, she wasn’t interested in the matter. So there is no "official Objectivist doctrine" here.

But there are two things that have bearing on the issue that she did address. One is the virtue of honesty, and the other one is fraud as an indirect form of force. If the practice is dishonest and fraudulent, it is not compatible with Objectivism – it is as simple as that.

So why is it fraudulent? For the same reason that any inflationary practice is fraudulent.

Hopefully, you are familiar with Ludwig von Mises’ argument against inflation: new money always reaches some people before it reaches others. Those who receive it first are in a position to spend the money before prices have risen; those who receive it last can spend it only after prices have risen. The first group stands to gain from inflation; the second group stands to lose. The second group is defrauded.

In today’s world of fiat money, this fraud is perpetrated by governments and central banks. But the effect would be essentially the same under free banking, if banks issue fiduciary media. Those who get "fractional loans" are in the position to spend before prices have risen; others can only spend after prices have risen. This, true enough, is inflation on a much smaller scale than we have today; but it is still inflation.

My conclusion is that "fractional reserve banking" is a violation of the virtue of honesty.

Another way to say this is that "fractional reserve banking" is a form of counterfeiting. And while a proper government should not intervene in the economy, it certainly should keep an eye on fraud and counterfeiteng and outlaw any such practices.

Here are two quotes from George Reisman that explain the point better than I can do:

The supporters of the 100-percent-reserve principle divide into two groups. There are those who advocate its imposition by law. Those among this group who are committed to the principle of individual rights and laissez-faire capitalism justify this by claiming that the creation of fiduciary media is tantamount to counterfeiting and is fraudulent. They claim that it is the same in principle as accepting goods in a warehouse, issuing receipts for the goods, and then selling the goods; or selling more tickets to a theater performance than there are seats.

The second group holds that if the issuance of fiduciary media is conducted openly, without deception—that is, if it is no secret to the owners of banknotes and checking deposits that the backing for them is debt—one cannot outlaw the practice. These supporters of the 100-percent-reserve principle advocate its achievement by means of a policy of free banking—that is, merely the total absence of all government intervention in banking. This view is well expressed in a passage quoted in von Mises’s Human Action from the nineteenth-century French economist Cernuschi. It was made in reference to fiduciary media in the form of banknotes, but it applies equally to fiduciary media in the form of checking deposits as well. Cernuschi said: "I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer." (Capitalism, p. 514f.)

And:

[I]t is mistaken to believe that the imposition by law of 100-percent-reserve banking in connection with checking deposits and banknotes would constitute government interference. It would constitute nothing more than the just exercise of the government’s power to combat fraud—the fraud of having one’s funds lent out despite the bank’s deliberate creation of the impression that in making a checking deposit or purchasing banknotes one fully retained the possession of one’s funds.

Shysterism in any form is always slippery. Thus if it occurs to anyone to argue that the banks’ customers are not victims of fraud because they clearly know and understand that their funds are being lent out, then the answer is that in that case they would be parties to fraud. Their fraud would be the attempt to make payment to others not with money or reliable warehouse receipts for money, but with claims to debt. They would be engaged in the willful contradiction and deception of claiming to pay someone when in fact imposing on him the position of being a grantor of credit.It should be understood that everything I have said in connection with the subject of the fraud entailed in fractional-reserve banking applies to a context in which the establishment of a 100-percent-reserve gold standard would be a real possibility. It is pointless to accuse either banks or their customers of any kind of fraud in connection with fractional-reserve banking in a context such as that of the present, in which the overwhelmingly greater fraud exists of the government’s creation of a monetary standard that is utterly nonobjective and arbitrary, namely, the fiat-paper standard. (Capitalism, p.957f.)


Another thing worth mentioning: "Fractional reserve banking" under free banking could hardly cause the kind of "boom-bust" cycles that we see under fiat money. And depressions or recessions in the 19th century were milder and of shorter duration than we have seen in the 20th century. The reason for this is that competition among banks puts definite limits on the issue of fiduciary media. Mises writes about this in The Theory of Money and Credit.

Here is a quote from Ayn Rand to illustrate my point:

Inflation is not caused by the actions of private citizens, but by the government: by an artificial expansion of the money supply required to support deficit spending. No private embezzlers or bank robbers in history have ever plundered people's savings on a scale comparable to the plunder perpetrated by the fiscal policies of statist governments. (The Ayn Rand Lexicon.)
Very true. The proviso I would like to add is that some inflation is made possible by "fractional banking" under free banking. But the harm is severely limited in this case; it is limited by competition between the banks.

Post scriptum February 2011: I wrote earlier that I did not think Ayn Rand addressed this issue verbally. However, since then, I have purchased 100 Voices: An Oral History of Ayn Rand and found the following in the interview with John Ridpath:

I vividly remember another example of her ability to go to fundamentals to clear up a debate. After a Ford Hall appearance, back at her hotel suite, one of us asked her if she could help with a debate many of us were involved in. The issue was: is fractional-reserve banking, because of its creation of expanded credit on a given base, implicit theft or legitimate banking practice. We - several of us doctoral students, if not already PhDs in economics - were split on this issue. With characteristic focus, she asked several questions, revealing a surprising understanding, and then - bingo -the answer was evident to her. It is appropriate - it is a matter of informed, calculated risk and, in essence, not theft at all. (P. 353f.)

The first thing I want to say about this is that I am extremely disappointed. The second thing I want to say is that reasoning is totally wrong for the reasons I have already stated above. If Ridpath quotes her correctly (and why souldn't he do that?), she says that FRB is "a matter of informed, calculated risk". Sure, it is a matter of informed, calculated risk on the part of the bank and the person taking the fractional loan. But the victims of FRB - those who stand to lose because their money loses some of its value - are not informed. They are, as I have said, defrauded. (But I am repeating myself...)

In fact, the same kind of argument could be used for any form of counterfeiting. A counterfeiter certainly knows he is taking a risk when he puts his counterfeit notes on the market, and this risk is certainly calculated.

Ayn Rand should be given some benefit of the doubt. Not even she was omniscient and/or infallible; and she wasn't a professional economist. I doubt that she had read and digested Mises' The Theory of Money and Credit, which is the most thourough exposé of fiduciary media (and of course she hadn't read the passages from Reisman I quoted earlier). But one really wonders what Ridpath and those other doctoral students and PhDs said to her that lead her to this conclusion.

But here we are. I have accused those Objectivists who are in favor of FRB of being "Objectivists for counterfeiting". And now I see Ayn Rand herself was an Objectivist for counterfeiting. What hope can I have on making Objectivists change their minds on this issue, when the foremiost authority on Objectivism is on their side? Life can be hard, sometimes...


(This short and condensed note will be expanded later with more observations. In the meanwhile, Scandinavian readers may consult my article Why "fractional reserve banking" should be outlawed.)


Post scriptum July 2012: I have since written several blog posts on this subject:

Fractional Reserve Banking Yesterday and Today
More on Fractional Reserve Banking
A Belated Open Letter to Ayn Rand on Fractional Reserve Banking
Debating Fractional Reserve Banking

Now, I don’t mind disagreements on this subject (it is not entirely self-evident); but I do mind getting e-mails giving me pro-FRB arguments that I have already answered.

 

Published by : Per-Olof Samuelsson, Drakensköldsgatan 3, SE- 632 25 Eskilstuna, Sweden
E-mail: per-olof.samuelsson@swipnet.se
Home page: www.nattvakt.com