Accounting for Fractional-Reserve Banknotes and Deposits-Or, What's Twenty Quid to the Bloody Midland Bank? (Controversy)
White, Lawrence H., Independent Review
For centuries--even before government guarantees came on the scene--Western payment systems predominantly have used banknotes and demand deposits backed by fractional rather that 100 percent reserves. Explaining the long historical prevalence of fractional-reserve instruments poses a difficult challenge to those who believe that such products necessarily or usually represent a fraud. (1) A business practice is fraudulent, of course, only if someone is duped. The challenge then is to explain how the public was duped continually for centuries. How on earth did the bankers keep the word from getting out? The challenge is especially great when we notice that if an informed public really had wanted to patronize money warehouses, then money-warehousing entrepreneurs would have profited by getting the word out. As George Selgin and I wrote in 1996,
competition will beat down the returns to capital invested in fractional-reserve banking until the marginal bank is earning only the normal rate of return. In this situation, were it really true that most depositors are willing to forego the interest they are receiving (and instead pay storage fees) in order to have the security of a 100-percent-reserve bank--but simply don't realize that their banks aren't holding 100 percent reserves--then any banker (who does know what the banks are up to, after all), possessing even an ounce of entrepreneurial insight, would see an easy way to grasp pure profit. All the banker has to do is to offer credible 100-percent-reserve accounts, while alerting the public to the other bankers' practices, and depositors will come flocking in. (97-98)
In his article "Has Fractional-Reserve Banking Really Passed the Market Test?" in this issue of The Independent Review, Jorg Guido Hulsmann tries to meet this challenge. In his view, fractional-reserve banking has not really "passed the market test." He offers an imaginative story about how the bankers managed to keep the public duped for centuries: they "relied on obscurity of language, which the bankers have promoted intentionally and fraudulently," and they acted as a "cartel" in accepting and redeeming one another's notes and checks. Their customers, when trying to pay with fractional-reserve banknotes and checks, became virtual co-conspirators in hiding the differences. Money warehousers could not profit by exposing the differences because bank lawyers persuaded the courts to render decisions that effectively banned the business of money warehousing. Thus, fractional-reserve banking prevailed over warehouse banking not because of the workings of a substantially free market, but because of government intervention in the market and the abridgement of freedom of contract.
This story, fortunately or unfortunately, is a fictional tale that does not fit the details or the broad patterns of banking history. Some ambiguities were unavoidable when deposit banking was a new business, but the distinctions needed for clear deposit contracts were established early on. The banknotes and demand deposits popular historically were in fact clearly distinct from warehouse certificates. Warehouse certificates were not a viable type of circulating currency note; in fact, warehouse certificates are inherently unsuited to circulate and are not known ever to have circulated historically. Banks that agreed to accept one another's liabilities at par were not acting as a "cartel" or conspiring against their customers. They did not adopt the more cartel-like policies (holding one another's notes as reserves) that Hulsmann imagines. Court decisions that affirmed fractional-reserve banking contracts did not ban money-warehousing contracts.
Fractional-reserve banking did not need fraud or coercion to prevail over warehouse banking. It prevailed by offering customers a better deal. Fractional-reserve banking really has passed the market test. Government interventions were later responsible for central banks and for taxpayer-backed deposit guarantees (on these issues there is no quarrel between Hulsmann and the "free bankers"), but they were not responsible for the historical prevalence of fractional-reserve banking. …