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On Fractional Reserve Banking.

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The Freeman Magazine has an article on Page 31 called “Questioning Rothbard”.

It argues that although Rothbard was right that fractional reserve banking is fraud if the depositor is given to understand that his money is right there in the bank for safe keeping and will not leave the premises, there is a way to ensure it won’t be fraud.

The article argues:

There are contracts (and have been through history) that
do not violate any of the above stipulations. For example,
it is perfectly possible for clients to place money under
deposit with a bank that fully discloses the fact that the
money is going to be lent out further. In fact, the bank
may even pay the depositor a rate of interest, while also
promising redemption of money at any time. So far, there is
no question of fraud involved. The bank has not hidden the
fact that the clients’ money will be lent out. The client even
earns a rate of return on this activity (albeit a lower rate
than he would earn on a time deposit). The only difference
compared to a time deposit so far is that this account comes
with the added benefit of being redeemable at any time.

The bank also issues redeemable IOUs to the depositors
in the form of either banknotes or checking accounts. Since
this is not an explicit safekeeping deposit or bailment, the
issue of the IOU being a property title or a warehouse
receipt does not exist in this case. The IOU is just that:
a debt claim on the money with a special promise to pay  
the money back any time the depositor may want it.  
Hence, the question of “over-issuing of property titles”
does not arise.

One could argue that there is still a problem of fraud. Granted, the depositor knows exactly what will happen to his money, but the bank has made a promise to him it might not be able to keep. In fact, it knows full well at the very moment of making the promise, that it does not have the funds to keep all the promises it made.

Let’s look at some related concepts, the Ponzi scheme and the chain letter. In these scams, Mr A is promised an exorbitant return on the money he hands over to Mr Ponzi. And Mr Ponzi does indeed pay Mr A for a while, from the money he gets Mr B to invest. And he pays Mr B with money he gets from Mr C. Why is this honorable plan  a fraud? Because Mr Ponzi has no way of paying everyone at once, and indeed once he finds no more new people to continue the chain, he will just eat up the principal he got from everyone [which he was doing all along anyway], but this time with no new principal coming in.

In other words, he made promises he could not keep except in the very short term, and indeed there was no way he could keep his promises to everyone.

How does fractional reserve banking compare? On the one hand, all banks admit that should a large group of people want to take their money out, they bank will have to declare bankruptcy, ensuring huge losses for all their depositors. And this is not just some unlikely event. Historically it has happened over and over. Here are a few random quotes from Wikipedia:

1. The Continental Illinois National Bank and Trust Company was at one time the seventh-largest bank in the United States as measured by deposits with approximately $40 billion in assets. In 1984, Continental Illinois became the largest ever bank failure in U.S. history, when a run on the bank led to its seizure by the Federal Deposit Insurance Corporation (FDIC). Continental Illinois retained this dubious distinction until the failure of Washington Mutual in 2008 during the financial crisis of 2008, which ended up being over seven times larger than the failure of Continental Illinois.

2. The Bear Stearns Companies, Inc. was a New York based global investment bank and securities trading and brokerage firm that failed in 2008 as part of the global financial crisis and recession and was subsequently sold to JPMorgan Chase.

In the years leading up to the failure, Bear Stearns was heavily involved in securitization and issued large amounts of asset-backed securities, which in the case of mortgages were pioneered by Lewis Ranieri, “the father of mortgage securities”.[1] As investor losses mounted in those markets in 2006 and 2007, the company actually increased its exposure, especially the mortgage-backed assets that were central to the subprime mortgage crisis.

3. A bank rescue package totalling some £500 billion (approximately $850 billion) was announced by the British government on 8 October 2008, as a response to the ongoing global financial crisis. After two unsteady weeks at the end of September, the first week of October had seen major falls in the stock market and severe worries about the stability of British banks. The plan aimed to restore market confidence and help stabilise the British banking system, and provided for a range of short-term loans and guarantees of interbank lending, as well as up to £50 billion of state investment in the banks themselves.

Not only has it happened literally many thousands of times, it is expected to happen again and again by people who know about these things. Banks in the US are required by law to buy insurance against exactly such an occurrence.

So what we have here is the banks telling the depositor, “I promise to give you your money on demand, even though I will lend it out to someone, and even though we will not give you back a dime should everyone to whom we made this promise hold us to it ,and even though historically many thousands of banks made exactly this promise and never kept it because people actually held them to it.”

Oh, did they leave that bolded part out?



  1. Smiling Dave says:

    Interesting stuff on your site.


  2. Thanks a lot friend. I do not receive positive comments often.


  3. But we both like Rothbard, which means we share a common way of thinking


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