Tuesday, November 16, 2010

Martin Wolf is Confused About Fractional Reserve Banking, Part 1

In a post at FT.com where he elaborated on what he believed were technological obstacles to the establishment of a gold standard, economist Martin Wolf made the following claims:

"Economists of the Austrian School wish to abolish fractional reserve banking. But we know that this is a natural consequence of market forces. It is wasteful to hold a 100 per cent reserve in a bank, if depositors do not need their money almost all of the time. Banks have a strong incentive to lend some of the money deposited with them, so expanding the aggregate supply of money and credit."

Clearly, one can conclude from this analysis that Dr. Wolf is uninformed of the Austrian critique of fractional reserve banking. Let us scrutinize Wolf's first claim, that fractional reserve banking "is a natural consequence of market forces" i.e., of the market operating.

We must begin with a description and analysis of markets. A market is a network of economic agents who voluntarily exchange ownership of goods between each other. A free market is a network where the economic agents engage in such exchange in the general absence of aggression, of initiatory violence. If markets exist within society, then private property rights are recognized to some extent in society, for the recognition of private property rights are a necessary condition for the existence of markets (in the proposition "If p, then q" q is a necessary condition for p). If all markets are networks of economic agents who voluntarily exchange ownership of goods between each other, then all markets are social phenomena that presuppose the recognition of private property rights
precisely because all networks of economic agents who voluntarily exchange ownership of goods between each other are social phenomena that presuppose the recognition of private property rights.

All voluntary transfers of ownership of goods are exercises of private property rights. If a particular social order denies the exercising of private property rights, then such a social order cannot contain voluntary transfers of ownership of goods. When there are no exercises of private property rights, there are no voluntary transfers of ownership of goods. That settles that.

Thus, market operations ("market forces") are non-coercive operations, since coercion is the only means by which one may violate the private property rights of another. As a result, no market operations can possibly involve fractional reserve banking because such banking is not a non-coercive operation. How so?

Well, fractional reserve banking is a simple process. A bank first enters into
monetary irregular deposit contracts with customers. A monetary irregular deposit contract is a voluntary agreement between two parties where one party, the depositor, agrees to transfer custody of a certain quantity of money to the other party, the depositary, for the purpose of safeguarding the quantity of money, in exchange for a safeguarding fee charged by the depositary. According to such a contract, the depositor only relinquishes custody of the quantity of money; he does not relinquish ownership, something which he still retains and which allows him to regain custody of his quantity of money on demand. In short, according to such a contract, the depositor's quantity must remain constantly available to him. In exchange for the deposit, the depositary gives the depositor a deposit receipt or deposit receipts (also known as bank notes) which act as money substitutes. They represent the quantity of money he deposits and he uses them to regain custody of his deposit by submitting them to the depositary. After a bank enters into many such deposit contracts, its total reserve of money increases.

Fractional reserve banking is the practice of lending money substitutes to borrowers who have not deposited money with the lender, where the lent substitutes give the non-depositing borrowers in question a claim to a portion of the total reserve, the reserve being the product exclusively of acts of depositing by depositors. A hypothetical scenario will help to expalin this practice. Lets say Smith Bank enters into a monetary irregular deposit contract with depositor Jim and as a result the depositor Jim deposits 1,000 ounces of gold into Smith Bank. In exchange for their deposits, Smith Bank gives deposit receipts (which act as money substitutes) to depositor Jim which are collectively worth 1,000 ounces of gold and allow the depositor Jim to withdraw his gold on demand. So far, Smith Bank's total reserve = 1,000 gold ounces and it has issued deposit receipts = to 1,000 gold ounces.

Fractional reserve banking occurs when Smith Bank decides to lend, say, deposit receipts to borrower Rick that give him a claim to 900 ounces of gold within its total reserve. When this occurs, Smith Bank produces a conflict of property rights where depositor Jim and borrower Rick each possess a claim to the same physical quantity of gold; the deposit receipts held by depositor Jim and borrower Rick each grant them exclusive control over the same deposit. Naturally, this contradicts the conditions of the monetary irregular deposit contract, according to which depositor Jim is to possess exclusive control over his deposit of money. He cannot control his entire deposit of gold if borrower Jim reserves the right to withdraw 900 ounces of it. Fractional reserve banking necessitates the violation of monetary irregular deposit contracts by granting other parties the ability to withdraw (i.e., steal) portions of deposits made by depositors. Such an ability prevents the depositors from exercising their private property rights, which includes the right to withdraw their deposits on demand. As economist Murray Rothbard once argued, such a banking practice amounts to embezzlement, a violation of private property rights.

That takes care of the nature of fractional reserve banking as a non-market institution.

I'll deal with Wolf's other two claims in later posts.

1 comment:

  1. What is this, the U-Store-It theory of banking? I put money in the bank every week. I don't get "banknotes" in return. I don't pay a fee to the bank for "storage services", on the contrary, I RECEIVE a fee from the bank in return for letting them use my money. And this certainly isn't a coercive or fraudulent arrangement. We are both adults and we understand what is going on.