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Old 05-18-2005, 10:22 PM
rushdoony rushdoony is offline
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Default Re: Food, Clothing,Shelter should be controlled by government.

Fractional versus 100 % Reserve Banking
Morris J. Markovitz

There has been a long-standing conflict among Austrian economists about the nature of the best or most "freedom-consistent" banking system for a true laissez faire society. The issue is important because the two viewpoints are not merely differences of degree. Both sides invoke the same fundamental moral and economic principles, yet each comes out in opposition to the other.

How can this be? This article contends that it can't be - that there's a logical flaw at the base of both arguments, a very minor but logically critical one - and that actually both sides are right when the issue is restated in the proper terms.

To show this, let us first summarize both sides of the debate. The 100-percenters say that in a free society, force is outlawed, a statement both sides can endorse. Next, since fraud is a form of (implicit) force, it too must be banned. Since a fractional reserve system promises to pay specie in amounts greater than what actually exist, that promise is a fraud. Therefore, the 100-percenters contend, a fractional reserve banking system has no place in a free society.

The fractional reserve advocates, who disagree with the 100-percenters, also base their arguments on free market principles. In a free market, they say, anyone can do what he wants as long as he doesn't use force against others. This includes banks. If a bank issues notes that aren't 100 per cent backed by specie, by what right do we stop them? They aren't forcing people to accept the notes.

Notes of the less-well-backed banks will circulate at a bigger discount than notes that are more well backed. A promise to pay the bearer doesn't have to be backed 100 per cent at all times. Otherwise, a promissory note from an individual who had no gold, but who expected to be earning a gold paycheck in future weeks, would be just as guilty of fraud. That's obviously not the case, and yet, the fractional reserve advocates conclude, there is no difference in principle between an individual's un-backed promissory note and a bank's fractionally backed note.

In summary, the 100-percenters have shown that the fractional reservers are advocating fraud. The fractional reservers have shown that the 100-percenters advocate force (by legally prohibiting the freedom to issue partially backed notes). This is why the debate, while never really hitting the headlines, is such a serious one: from each side's view, the other side is guilty of a severe moral transgression.

Periodically the debate flares up, and each side reasserts its logically self-consistent argument. Neither side, however, refutes the other's argument. Finally, everyone throws up his hands in exasperation and the debate peters out once again. Each side tries to be cordial to the other, but, because such moral issues are involved, the debate has to be an obstacle to genuine goodwill between the two factions.

Having stated the problem, we now come to the resolution. The apparent contradiction arises out of a subtle fallacy, named "intellectual package dealing" by Ayn Rand. Besides accepting the same explicit moral principles, each side, unfortunately, has also accepted the same implicit "package deal."

A "package deal" is the inappropriate "packaging" of two or more different concepts under a single label. It can be used consciously to mislead, or unwittingly, causing confusion. In this case, two completely separate things are meant by the term "banking system," each of which, combined with the same set of free market principles, will support only one side of the debate while refuting the other. Once we separate the two different concepts, there will be no difference of opinion left.

The package deal arises subtly because, in today's mixed economy, institutions called "banks" actually perform more than one function. They are supposed to be safe havens for capital. They are also loan brokers. Throughout most of modern history, "banks" have performed both functions, and in fact both functions have been melded into differing aspects of a single, complicated banking system.

That's probably why the error occurs so naturally and automatically. The two functions have become inextricable from each other in a government-mandated system that tries to have its cake and eat it: to provide 100-per cent guaranteed safety of bank deposits, while employing a fractional reserve method.

The Warehouse Function
One of a "bank's" functions is to be a safe warehouse. This is obviously a valuable function, and in a free market people who desired this service would pay for it. Its analogy in today's world would be a safe-deposit box: a protected stronghold for the storage of valuables, for which the user pays. In a free market, those availing themselves of this "banking" service would deposit their specie in a "bank" where it would be held under lock and key. They would receive, essentially, a warehouse receipt or claim check for it, and in some fashion the service would have to be paid for. The claim checks would then circulate as fully backed money substitutes. This is the image in the minds of the 100-percenters, who nevertheless fear that temptation would lead the "banks" to cheat.

Laws against fraud, however, would prevent this, as applied to this particular banking function. Even in today's market, banks are not allowed to break into private safe-deposit boxes and "borrow" their contents without the owners' consent. The 100-percenters are correct that the same ought to be true in the ideal laissez-faire economy, and for this aspect of banking, the fractional reservers should be able to agree completely. Clearly, stealing from safe deposit boxes is force.

Banking today, however, also entails another completely separate function. Banks act as loan brokers, accepting deposits for which they pay interest instead of getting paid for safe storage. They then lend out these deposits at higher rates and profit from the difference, as well as (and more so) from the creating of deposits via the fractional reserve system.

Today the citizen has no real choice between the two functions. He has nowhere to put his money for safekeeping except into a loan-brokering operation at a bank. (He could put green cash into a safe deposit box, but the inflation engendered by the very system he's trying to avoid precludes this as a sensible option.)

As the fractional reservers; point out, there's nothing wrong with loan-brokering. What's wrong is forcing people to deposit into a loan-brokering scheme by forbidding the alternative, while simultaneously falsely advertising the loan-broker outfit as a safe warehouse. That's what today's banking system does and both sides would agree that it's wrong.

In a free market, both functions ought to be permissible, but clearly defined and separated. This doesn't mean government regulations, but rather legal definitions that distinguish the two concepts, clarify their differences, and serve as the basis for legal redress if and when a loan-brokering operation fraudulently advertises itself as something else, and someone sues.

The 100-percenters want a clean, stable, no-questions-about-it currency that serves the role of money. This they will have without prohibiting the fractional reservers' loan--brokering "bankers." The notes of these loan brokers, in practice, probably will not even circulate as money, but as interest-bearing notes, similar to commercial paper today. If they were clearly identified as a loan-broker's fractionally backed (promissory) notes, then no one would accept them unless the notes paid interest appropriate to the financial risk they entailed. (Remember, it is only the existence of legal tender laws that allow Gresham's Law to work. If people aren't forced to accept bad money, then good money will drive bad money out.)

The 100-percenters can confidently acquiesce in allowing the existence of fractional "loan-brokering" by "banks," knowing that without legal tender laws, these notes will have to show their true colors in the marketplace, as the equivalent of commercial "promissory notes," and never would achieve the status of money. Since a genuine need for safe storage does exist, there will also be someone, somewhere, who issues 100 per cent backed notes for the convenience of his customers, and those pieces of paper will circulate as money, by the natural workings of the market.

In practice, it may well turn out to be most efficient to house these two functions under one roof, but never to blend them into one "system." Just as we have money-market versus bond "switch funds" today, a single institution could offer both services. A cautious citizen might avail himself of only the warehouse facility, where his gold deposits would be physically segregated, and he would pay for this service. If he wanted to lend to industry, he could have some or all of his gold transferred to the other side of the "bank" and accept the risk in return for the interest.

In sum, if we:

a) separate the concept of "banking" into its two distinct functions (warehousing and loan-brokering);

b) recognize this distinction in law, as part of the general body of law on fraud; and

c) eliminate legal tender laws, the result will be a money and credit system that satisfies all the requirements of both camps.

At the time of the original publication, Morris Markovitz was President of a Wall Street management firm.

Reprinted with permission from The Freeman, a publication of the Foundation for Economic Education, Inc., June 1988, Vol. 38, No. 6.
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