The Ethics of Fractional Reserve Banking

One of the great failures of economics, mostly mainstream but also some who identify themselves as Austrians, is myopia. This myopia takes two forms, the first is the ethics of utilitarianism, the second is over specialization. Let us analyze this in the context of fractional reserve banking.

Fractional reserve banking is the peculiar banking practice in which a bank does not have 100% of demand deposits on hand at all times. If all depositors of a bank were to demand their deposits simultaneously, as they are permitted to do via the contract signed when they opened a demand deposit account, the bank would be unable to satisfy all demands and thus its inherent insolvency would be revealed de facto.

Let us consider a widget warehouse. In this case, the warehouse operator defines a widget. Demand depositors of widgets sign a contract such that their widgets are mixed with those of other customers and they can claim their widgets at any time by presenting a warehouse receipt. Note that unlike a safety deposit box at a bank, the contract does not stipulate that they will receive the exact same widget deposited. Rather, they will receive an equivalent widget. Here we see the importance of how the warehouse operator defines a widget.

Legally, the warehouse operator is required to have 100% of all deposited widgets on hand at all times. If he uses any of the deposited widgets for any purpose such that the 100% reserve requirement is violated, he has committed the crime of embezzlement.

What happens if, like the bank example above, all of the demand depositors demand all of their widgets simultaneously? If the warehouse operator is honest, he simply returns all of the widgets to all of his customers. If he is dishonest, he will be unable to satisfy all redemption requests and will be forced to go out of business. Then they lawsuits will begin to sort out how the widgets actually in the vaults should be allocated to the defrauded customers. Then criminal proceedings against the warehouse operator will follow.

Replace widgets with money (here meaning demand deposits) and the ethical objections to fractional reserve banking are laid bare. Fractional reserve banking is an inherently fraudulent activity. When the mysticism that envelops money and banking has been cleared, we are left with a cut and dried case that is no different than that of our widget warehouse example.

Yet, over the centuries, as repeatedly emphasized by Jesus Huerta de Soto in his magnum opus “Money, Bank Credit, and Economic Cycles“, banks have been able to acquire a special legal status that allows them to systematically and continually violate the property rights of demand depositors. Only later did economists begin to evaluate the practice of fractional reserve banking and generally come to the conclusion that not only is it unobjectionable, but is vital for creating circulating credit needed for a growing economy.

Now we come to the myopia of all to many economists. The circulating credit justification for fractional reserve banking is a utilitarian argument (that also happens to be incorrect, see “The Intellectual Error of the Money Printers“). The failure to acknowledge traditional legal principles regarding property rights of warehouse depositors or being unaware of the issue is a failure to realize that economics does not live in an intellectual vacuum. Indeed, this is one of the most important insights of von Mises, emphasized in his definition of economics as catallactics being a specific branch of praxeology, the science of human action. Such failures in the worldview of all to many economists, lead them to advocate the inherently and obviously unethical practice of fractional reserve banking.

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