July 23, 2003

The Libertarian Case Against Fractional-Reserve Banking

Gene Callahan is not convinced by any of the traditional libertarian arguments (fraud, creating money out of nothing and de-stabilization of the economy) against fractional-reserve banking:

The question as to whether the marketing or presentation of a product is fraudulent must, as I see it, be based on the expectations of the "typical consumer." Of course, this is a fuzzy concept. That being the case, the old dictum caveat emptor should probably decide the borderline cases. However, there is little question that if a restaurant sells "Irish stew" on its menu, customers expect a stew made with either beef or lamb. If, upon ordering it, a customer discovers the meat in the stew is actually that of a stray dog killed by the restaurant owner, it is clear to me that he has been defrauded, despite the fact that the dish may indeed be a stew prepared in the Irish fashion.

On the other hand, the courts should ignore the beliefs of an especially obtuse consumer. The fact that someone buys birdseed expecting that he will be able to grow birds from it should not open the seller to charges of fraud.

Therefore, the question of whether fractional-reserve banking is fraudulent in any particular case must turn on typical expectations about what such notes imply. There is no a priori answer to such a question. In a society where 100-percent reserve banking was the norm and I opened the very first fractional-reserve bank, the burden on me to explain my product well might be very high. On the other hand, in a society where almost all banking was fractional-reserve and most people were quite familiar with the practice, it might be taken as a matter of course that banknotes were claims on fractional reserves. Legal precedent and an estimate of the beliefs of the typical consumer must be relied upon to resolve each case.

Nevertheless, it seems to me that as a first rough cut as to what would be sufficient to dismiss fraud charges against an fractional-reserve bank, a contract signed with depositors informing them that there deposits are not held in full in the bank and some indication on the notes themselves that they are claims on fractional reserves ought to pass muster. Some fractional-reserve banking critics might contend that under such conditions, no one would patronize fractional-reserve banks. I doubt that is true, but even if it were the case, it would be a purely practical, not a legal, matter.

Personally, I tend to be persuaded by the fraud argument against fractional-reserve banking but Callahan's argumentation is very consistent and well worth reading.