The Scholarly Debate

Modern Austrian economists have extensively debated this topic. On one hand, Murray Rothbard, Jesus Huerta de Soto, Hans-Hermann Hoppe (1, 2, and 3), Guido Hulsmann (book, and these articles (1, 2, and 3)), and others argue against fractional reserve banking. On the other hand, Larry White (book) and George Selgin (book), (articles: 1, 2, and 3, and 4) among others, argue that fractional reserve banking is a good form of banking innovation that emerges on a free market.

It is not easy to summarize all the points of view of this debate, and the reader is encouraged to read the authors themselves to make their own mind up. After many years of reading on this question, I find the views of the first camp of economists more convincing. The pro-FRB arguments are theoretical and suffer from a serious problem of being able to demonstrate valid free market examples of stable fractional reserve banking systems. Their favorite example concerns the Scottish banking system, which they claim was independent of the Bank of England for a period at the turn of the 19th century during which Scottish banks suffered fewer crises than English banks. According to this view, fractional reserve banking in Scotland, by being independent of the English central bank, was a more sustainable alternative. But as closer research by Murray Rothbard shows, the actual record of events unfolding there contradicts with their views significantly, as to render their conclusions invalid. Contrary to White and Selgin's assertions, Scottish banks were pyramiding their debt obligations on top of Bank of England paper, just like English banks, and they suffered regular and recurring crises no different from those suffered by the English banks. To quote Rothbard:

From the beginning, there is one embarrassing and evident fact that Professor White has to cope with: that "free" Scottish banks suspended specie payment when England did, in 1797, and, like England, maintained that suspension until 1821. Free banks are not supposed to be able to, or want to, suspend specie payment, thereby violating the property rights of their depositors and noteholders, while they themselves are permitted to continue in business and force payment upon their debtors.

So the pro-fractional reserve economists' claims that fractional reserve banking can be built in a free market without a central bank is based on a banking system that had a central bank allow it to suspend redemption of its paper in gold for a quarter century. Whatever one thinks of fractional reserve banking, one cannot present this as a valid example of it emerging on a free market. In a free market, depositors would be able to withdraw their gold from these banks as they had agreed, and there would be competitor banks that would offer full reserve redemption that would drive the non redeeming banks out of business. As with every example of fractional reserve banking, it was the banks' monopoly power, enforced by the state, which allowed it.

The pro-fractional reserve banking side have also argued that fractional reserve banking allows for the free market to adjust the supply of credit and money in the economy in response to changing demand conditions. But this is no different than Keynesian conceptions of the money supply and the role of the government in managing it, by accepting the flawed premise that the supply of money itself needs to be adjusted to the demand for it, when in reality, money is the one unique good whose quantity is irrelevant to its performing its functions. As any quantity of money is enough for any economy, the quantity of the money does not need to be adjusted to fluctuations in demand; rather, the changes in demand will cause the value of the money to vary accordingly, offering valuable economic signals. As Hulsmann explains:

It is also wrong to suppose that fractional reserve banks are particularly well suited to "adjust" the supply of money in response to prior changes in the demand for money balances. The reason is that no such special adjustment is necessary in the first place. That somebody has an increased demand for money means that he is willing to pay a higher price to obtain money or that he requires a higher price for the money he sells. In both cases, the increased demand ipso facto increases the purchasing power of money, thus equilibrating demand and supply of money. And the same thing holds true, of course, for the case of a reduced demand for money. Therefore, the supply of money does not have to be adjusted to the demand for money. Unlike all other commodities, money itself constantly adjusts to the conditions of the market. The services rendered by any unit of money are constantly adjusted under the impact of changes in the demand for and supply of money. Of course, this self-adjustment does not work out to everybody's benefit. No adjustment does, and no institutional arrangement such as fractional reserve banking can change this fact.

Another error that the pro-fractional reserve banking side make is in their appropriation of the term "free banking" to mean fractional reserve banking. Some of the anti-fractional reserve banking Austrians, most notably Jesus Huerta de Soto, argue from legal principles and historical case studies that fractional reserve banking is fraud, and that a legal system that protects against fraud should ban it. Selgin and White argue, convincingly, that if people are willing to agree to dealing with a bank practicing fractional reserve banking, then there is no fraud involved. Selgin and White can thus appropriate the term "free banking" to refer to government allowing a free market in banking, which, in their view, would lead to fractional reserve banking growing and thriving, such as in their favorite example, Scotland.

But de Soto's argument, regardless of its validity in legal terms, is not the economic argument against fractional reserve banking. For a legal authority looking to regulate banking, it may make sense to ban fractional reserve banking, to prevent banking collapses and boom and bust cycles, but that is hardly a free market argument against fractional reserve banking.

The economic argument against fractional reserve banking is that it could not survive in a free market without government coercion, and that the absence of a central bank and legal tender laws would render fractional reserve banking unsustainable. The larger the scope of the fractional reserve banking, the larger the impact it will have on the economy at large. A free market would punish people who take part in these businesses with bankruptcy, thus prevent them from having the capital necessary to repeat this experiment, and deter others from emulating them. In more modern times of low-cost information and relatively open financial markets, fractional reserve banking is unsustainable because any bank that is practicing can be rendered insolvent by what I like to call a "liquidity vulture attack".

The free banking school thus takes Mises' support for a free market in banking as support for fractional reserve banking, but a more accurate reading of his words would clearly show he understood that fractional reserve banking was the driving force of the business cycle:

The notion of "normal" credit expansion is absurd. Issuance of additional fiduciary 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 expansion.

He also understood full well that banks must hold full reserves in order to operate safely:

It is very easy for a bank to increase the number of people who are ready to accept loans granted by credit expansion and paid out in an amount of money-substitutes. But it is very difficult for any bank to enlarge its clientele, that is, the number of people who are ready to consider these claims as money substitutes and to keep them as such in their cash holdings. To enlarge this clientele is a troublesome and slow process, as is the acquisition of any kind of good will. On the other hand, a bank can lose its clientele very quickly. If it wants to preserve it, it must never permit any doubt about its ability and readiness to discharge all its liabilities in due compliance with the terms of the contract. A reserve must be kept large enough to redeem all banknotes which a holder may submit for redemption. Therefore no bank can content itself with issuing fiduciary media only; it must keep a reserve against the total amount of money-substitutes issued and thus combine issuing fiduciary media and money certificates.

It was a serious blunder to believe that the reserve's task is to provide the means for the redemption of those banknotes the holders of which have lost confidence in the bank. The confidence which a bank and the money substitutes it has issued enjoy is indivisible. It is either present with all its clients or it vanishes entirely. If some of the clients lose confidence, the rest of them lose it too. No bank issuing fiduciary media and granting circulation credit can fulfill the obligations which it has taken over in issuing money substitutes if all clients are losing confidence and want to have their banknotes redeemed and their deposits paid back. This is an essential feature or weakness of the business of issuing fiduciary media and granting circulation credit. No system of reserve policy and no reserve requirements as enforced by the laws can remedy it. All that a reserve can do is to make it possible for the bank to withdraw from the market an excessive amount of fiduciary media issued. If the bank has issued more banknotes than its clients can use in doing business with other clients, it must redeem such an excess.