Titles in search of property: Should fractional-reserve banking come to an end?

In my article, "Free Banking and Fractional Reserves" in Issue 29 of THE VOLUNTARYIST (December 1987), I conceded that "fractional reserves do not constitute a breach of contract when and where that practice is specified" between the banker and his customer. After reading Hans-Hermann Hoppe's 1998 article on "Fiduciary Media" (Volume 1, Number 1 of THE QUARTERLY JOURNAL OF AUSTRIAN ECONOMICS, pp. 19-50, with Jorg Guido Hulsmann and Walter Block), I want to reconsider this concession. Is a voluntary fractional reserve contract between consenting parties legitimate, or should a public consensus be reached that fractional reserve banking is contrary to the general legal principles of a libertarian society? The purpose of this brief article is to examine these questions, and to consider their ramifications.

The first of Hoppe's points that I would like to review is his reference to the "tragedy of the commons." In the conclusion to footnote 6, on page 23 of Hoppe's original article, he explains that "every issue of fiduciary media - to titles in search of property - sets in motion a rush always starting with the bank and its clients, to fill these empty tickets with existing property; and in the course of this rush, invariably the firstcomers will physically enrich themselves (through the appropriation of existing quantities of property) at the expense of a corresponding impoverishment of latecomers, whose quantity of existing property is physically diminished while they have been left with a larger number of property tickets." In other words, when customers of a fractional-- reserve bank make a "run on the bank", the firstcomers get the money, while the latecomers are left holding the proverbial bag with nothing in it. Or, as Murray Rothbard wrote in WHAT HAS GOVERNMENT DONE TO OUR MONEY?:

The issue of warehouse receipts for non-existent goods, identical with genuine receipts, is fraud upon those who possess claims to nonexistent property. ... Which particular receipts are fraudulent can only be discovered after a run on the bank has occurred (since all the receipts look alike), and the latecoming claimants are left high and dry. [p. 24, fn 17]

At the peak of the silver market in early 1980, the Hunt brothers and other speculators were "squeezing" the market. They did this by owning an enormous stockpile of silver bullion and owning future contracts under which they were entitled to purchase even more silver. The Hunts were "long" in the market, hoping for further price appreciation; while the "shorts," or people who had sold silver they didn't own, were hoping that the price would decline. Then they could profit from buying silver at a lower price in order to fulfill their selling contracts which were at a higher price. Every "squeeze" or attempt to "corner" the market usually involves a situation similar to the "tragedy of the commons," or one similar to a "run" on the bank. If no one sold property they didn't own, there would be considerably less danger of market speculations between the bears and the bulls. Queries: Should the sale and purchase of naked futures contracts and short stock sales be abandoned in a free market? Should-speculators be able to buy and sell contracts to non-existent quantities of things which they promise to deliver in the future - or to commodities which they don't properly have title to and then be able to satisfy these contracts by offset rather than actual physical delivery? What parallel exists between fractional-reserve banking and short sales on the stock market and commodity speculation via the futures market?

While I am not prepared to answer these questions in this article, the question of promising to buy and sell property which one does not own and does not have on hand was astutely discussed by W. Stanley Jevons in his book MONEY AND THE MECHANISM OF EXCHANGE (New York: D. Appleton and Co., 1919). In Chapter XVII, "The Nature and Varieties of Promissory Notes," Jevons made the following observations:

He who issues a representative or promissory document, engaging to give a certain quantity of a defined commodity in return for the document when presented, may really make any one of three distinct engagements.

1. He may promise to keep a certain identical article in his possession until it is called for.

2. He may engage to have in his possession a certain amount of commodity ready to meet the promissory notes, without distinguishing between portion and portion of a similar substance.

3. The undertaking may merely be to the effeet that the required commodity shall be forthcoming when the note is presented, no covenant being made as to the quantity to be held in stock for the purpose.

Specific Deposit Warrant

The most satisfactory kind of promissory document is the first, which is represented by bills of lading, pawn-tickets, dock-warrants, or certificates which establish ownership to a definite object. ... The important point concerning such promissory notes is, that they cannot possibly be issued in excess of the goods actually deposited, unless by distinct fraud. ...

General Deposit Warrant

We pass to the case in which the issuer of a promissory document engages to keep on hand goods exactly equivalent in quantity and quality to what are specified thereon, without taking note of individual parcels. ... The difference [between a specific deposit warrant and a general one] seems to be slight, but it is really very important, as opening the way to a lax fulfillment of the contract. ...

Difference between a Special and a General Promise

He who has made a special promise to give definite parcels of goods in return for particular individual papers, cannot issue any such promissory papers without holding corresponding goods. If he does so, he will continually be liable to be convicted of fraud or default by the presentation of a particular document.

If the promises made by him, however, are only general ones, any promissory document can be met by any portion of the commodity of the proper quality, and it will be necessary to present most or all of the documents in order to disclose the default. The way is thus opened for the speculative issue of promissory notes. ...

Moreover, it now becomes possible to create a fictitious supply of a commodity, that is, to make people believe that a supply exists which does not exist. ... [emphasis added]

It might be urged, indeed, that there is a natural right belonging to all persons to make promises, if they can thereby benefit themselves. ... [But] it used to be held as a general rule of law, that any present grant or assignment of goods not in existence is without operation. Though the rule seems to be generally disregarded, there are many cases in which it might be advantageously enforced. [pp. 201-206]

Another topic related to the "natural right to make promises" regards the enforceability of voluntary slavery contracts in a free society. Should an individual be able to make a contract promising that he or she will become a slave? What happens if the promissor willingly becomes a slave, and then changes his or her mind? Murray Rothbard in THE ETHICS OF LIBERTY examines these questions. He concludes that voluntary slavery contracts should be unenforceable because "there is no transfer of title" when Smith promises to abide by the wishes of Jones for the rest of his life. "Smith's control over his own body and will are inalienable. Since that control cannot be alienated, the agreement was not a valid. contract, and therefore should not be enforceable. Smith's agreement was a mere promise, which it might be held he is morally obligated to keep, but which should not be legally obligatory." [p. 135]

Rothbard also notes that the very concept of "voluntary slavery" is a contradictory one: "for so long as a laborer remains totally subservient to his master's will voluntarily, he is not yet a slave since his submission is voluntary; whereas, if he later changed his mind and the master enforced his slavery by violence, the slavery would not then be voluntary." In short, Rothbard concludes that we are limited by "the facts of the human condition [and] by the nature of man and his world." [pp. 40-41] In his consideration of slave contracts, Rothbard takes a position very analogous to Hoppe's position on the illegality of fractional-reserve bank notes. Hoppe observes that it is the nature of reality that "two individuals cannot be the exclusive owner of one and the same thing at the same time" and that no contract or promise can invalidate this fact of nature. If a contract tries to make simultaneous ownership by two different people of the same property occur then such a contract "is objectively false and thus fraudulent." [p.22]

This is one of Hoppe's main reasons for arguing that the practice of fractional-reserve banking should be outlawed: it contradicts reality and denies the nature of things. A fractional-reserve contract "is from the outset - a priori - invalid." Hoppe bases his argument on the fact that "the theory of property must precede the treatment of contracts ... inasmuch as contracts are constrained by property and property theory. Thus agreements regarding perpetual motion machines are invalid, ... and from the outset false and fraudulent. ... A fractional-reserve banking agreement implies no lesser an impossibility and fraud than that involved in the trade of flying elephants or squared circles. ... [T]he bank and its customers may agree to make money substitutes debts instead of warehouse receipts, but just as they may say that triangles are squares, their saying so does not make objective reality conform to their desires and agreements." [pp. 25-26] Just because some people might prefer fractional-reserve banking agreements is no reason that such contracts "are ethically permissible or socially beneficial." [p. 31] Some people prefer to confiscate the goods and services of others, but the agreements they make with their cohorts over how to share the spoils are not enforceable. No one urges that this is a restriction on their freedom to contract as they please. Similarly, Hoppe argues that "no one may operate a fractional reserve bank for the same reason that no one, in any other line of business, may engage in counterfeiting, that is, the production and sale of titles or copies to non-existing property or originals." [p. 33] To prohibit fractional-reserve banks "is not a restriction on freedom of contract in the market for banking services, but the requirement of ... [honest] money and banking." [p. 34]

Now what does it mean when someone urges that murder, or fraud, or fractional-reserve banking be outlawed or prohibited in a free society. Who should establish the prohibition? Who should define `murder' or 'fraud' or `fractional-reserve' banking? In statist societies, it is usually the government and government judges that answer such questions. But on the contrary, in a free society, each and every person must answer these questions. As Ayn Rand put it, "Who is the final authority ... ? Any man who cares to acquire the appropriate knowledge and to judge, at and for his own risk." Who defines what is proper usage in the English language? - not a monopolistic organization of force but rather the sanction of custom and good sense. So when Rothbard writes in "THE CASE FOR A 100 PER CENT GOLD DOLLAR" that since "fraction al-reserve banking is fraudulent, then it could be outlawed not as a form of administrative government intervention in the monetary system, but rather as part of the general legal prohibition of force and fraud," [p. 119] the implication is that in a free society there must be a generally accepted legal code. In FOR A NEW LIBERTY, Rothbard explicitly concludes that such a code must be "consistent with libertarian principles." It is necessary

to lay down precise guidelines for the private courts. If, for example, Court A decides that all redheads are inherently evil and must be punished, it is clear that such decisions are the reverse of libertarian [principles, and] that such a [decision] would constitute an invasion of the rights of redheads. Hence, any such decision would be illegal in terms of libertarian principle, and could not be upheld by the rest of society. It then becomes necessary to have a legal code which would be generally accepted, and which the courts would pledge themselves to follow. The legal code, simply, would insist on the libertarian principle of no aggression [or fraud] against person or property, define property rights in accordance with libertarian principle, set up rules of evidence (such as currently apply) in deciding who are the wrongdoers in any dispute, and set up a code of maximum punishment for any particular crime. [pp. 234 - 235] ...

[In the ... libertarian society, the basic legal code ... would have to be established on the basis of acknowledged libertarian principle, of nonaggression against the person or property of others; in short, on the basis of reason rather than on mere tradition, however sound its general outlines. [But inasmuch as we already have a historical] body of common law principles to draw on ... the task of ... correcting and amending the common law would be far easier than trying to construct a body of systematic legal principles de novo out of the thin air. [p. 239]

In an article in REASON defending this position, Rothbard wrote that, "In my view, the entire libertarian system includes: not only the abolition of the State, but also the general adoption of a libertarian law code. ... [I]n my view 'libertarianism' includes agreeing to a libertarian law code. If most people believe in outlawing nudism, then there is very little we can do about it; but this simply means that most people have not yet become libertarians." [May 1973, p. 24] This reasoning applies just as readily to slavery, as it does to fractional-reserve banking. In a culture where the ownership of one person by another is considered evil, slaveowners are considered inhumane and repulsive. Yet in the antebellum South, where slavery was widespread and accepted, slaveowners were an elite class. Thus, everything depends on public opinion. In a society where fractional-reserve banking is recognized for what it is: a fictitious increase in the supply of money substitutes, such a practice will be considered fraudulent and hence reprehensible. The only difference between slavery and fraction al-reserve banking is that the former is now considered immoral, while the latter has been protected by the government (much as the government courts protected slavery before the Civil War).

Yet doesn't fractional-reserve banking amount to counterfeiting, and isn't counterfeiting considered impermissible, as Hoppe would put it? If fractional-- reserve banking does differ from counterfeiting, how does it differ in any essential? Both "create money out of thin air": one by printing fraudulent notes; the other by resorting to fractional-reserve loans. Both "extract resources from the public, from the people who have genuinely earned their money." The only difference is that counterfeiting is recognized as an outlawed practice, while fractional-reserve banking is embraced by the government and the banking establishment. [Rothbard, THE MYSTERY OF BANKING, p. 98]

So where does this conclusion leave us? People must be educated to understand that counterfeiting and fractional-reserve banking both undermine "the moral and property rights foundation that lies at the base of any free-market economy." Both distort "the economic system, and amount to stealthy and insidious robbery and expropriation of all legitimate property-owners in society." [Rothbard, THE CASE AGAINST THE FED, pp. 26-27] Once people are convinced of the violation of property rights that fractional-reserve banking engages in, they will disavow the practice as dishonest and fraudulent. Until that time comes, public sentiment will prevail in letting the practice flourish. Or as Abraham Lincoln is reputed to have said about slavery:

With public sentiment nothing can fail; without it nothing can succeed. Consequently, he who molds sentiment goes deeper than he who enacts statutes or pronounces decisions.

Or as I would add: We do not require statutes or court decisions to prohibit fractional-reserve banking. We simply need to educate the public as to why fractional-reserve banking is a rights-violating practice, and then urge them to abandon patronage of fractional-reserve banks.

[Author's Addendum: After writing this article, it occurred to me that there was one other important point to be made regarding the effects of fractional-- reserve banking. George Selgin, Lawrence White, and others who support the contractual right of banks to engage in fractionalizing reserves seem to be oblivious to a very basic insight of Austrian economics namely

that, apart from the industrial or consumption uses of gold, an increase in the supply of money confers no social benefit whatsoever. ... [Ain increase in the supply of money... will not increase production. ... [T]he great attraction of "inflation" (an increase in the quantity of money) is precisely that not everyone gets the new money at once and in the same degree; instead the government and its favored recipients of purchases or subsidies are the first to receive the new money. Their income increases before prices have gone up; while those unfortunate members of society who receive the new money at the end of the chain ... lose because the prices of the things they buy go up before they can enjoy an increased income. [Rothbard, THE ESSENTIAL VON MISES, pp. 23-24]

In short, an increase in the supply of money causes political changes in the distribution of wealth in favor of those who receive the new "fictitious" money first.

Since only the favored few receive the new money earliest, shouldn't the majority of the consuming public be in favor of abandoning the process of artificially increasing the money supply?]

Copyright Voluntaryists 1st Quarter 2002
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