Huerta De Soto and full reserve banking.

Mervyn King, Governor of the Bank of England, said recently: “Of all the many ways of organising banking, the worst is the one we have today.”

Agreed. Question, is: what’s the best alternative?

Huerta Do Soto (DS) proposes an alternative. It’s set out in his book, “Money, Bank Credit, and Economic Cycles”, which is downloadable here. I’ll try to summarise the book: a summary which will doubtless be unfair, inaccurate and biased towards my own views. Anyway, here goes.

Paragraphs in italics below are 100% my own views, not DS’s.

Ch 1 (pages 1 – 37). This sets out the difference between two very different “animals”. First there is a deposit for safe-keeping which is intended to be repayable on demand by the depositor. The depositor may well have to pay the depositee for costs involved in safe-keeping. Second there is a loan for a longer or specific period of time. In this case the depositee normally pays interest to the depositor or lender.

Banks blur the distinction between the two, that is deposits that are supposed to be instantly repayable are not – because about 90% of them have been loaned on to others. De Soto attaches importance throughout the book to the fact that his breaks fundamental legal principles.


I disagree with the “legal” point. The fact an activity breaks a law or basic legal principles is not important. The important question is “what harm is done by the law breaking?” FR certainly does harm in that it amounts to letting commercial banks print money, which they do big time in a boom (exactly when the extra money is not desirable). I.e. FR leads to instability. Put another way, the harm comes from the instability, not from the fact that a legal principle has been broken.


Ch 2 & 3 deal with historical examples of the above illegality and attempts to legally justify fractional reserve.

There is plenty of historical material here. I am grateful to DS for opening my eyes to the extent to which many of the problems relating to money and banking were being discussed by ancient Romans and Spaniards and other mainland Europeans 500 years or so ago: long before Anglos got in on the act.

Another interesting point is that when FR first started, the bankers concerned were aware that they were doing something underhand. I.e. it has taken time, even centuries, for the process to become respectable.

Ch 4. This deals with the credit expansion process. De Soto says in respect of the generating money ex nihilo that “businessmen rush out to launch investment projects as if society’s real saving had increased, when in fact this has not happened. The result is artificial economic expansion or a “boom,” which by processes we will later study in detail, inevitably provokes an adjustment the form of a crisis and economic recession.” That is one of the central messages of the book.

Ch 5. Pages 256-291. An explanation of capital investment involving Robinson Crusoe and his desire to make a stick to collect fruit, and how making the stick involves sacrificing current consumption.

p. 291-341. DS (like many Austrians, I think) attaches importance to what are sometimes called “intermediate goods”. E.g. one firm makes metals, another turns metals into car parts, and finallya car manufacturer puts the parts together.

I just don’t get this. If FR leads to instability, then that is the problem. No doubt the latter problem plays out differently as between an economy where a lot of intermediate production is involved, and in contrast, a simpler economy with relatively little intermediate production. But this strikes me as unimportant. But maybe I’ve missed something here.

Pages 347-95. De Soto claims that FR produces artificially low interest rates which in turn leads to a misallocation of resources. De Soto claims that the above mentioned “intermediate goods” point is central to explaining this misallocation of resources.

I agree that FR leads to artificially low interest rates and a misallocation of resources. As to the intermediate goods point, as I’ve already said, I don’t get it. Seems to me that artificially low rates will clearly lead to a misallocation of resources - end of argument. Period. I don’t see the need for the “intermediate goods” points, but to repeat, maybe I’ve missed something.

DS repeats the classic Austrian idea that recessions are good in that they hasten the destruction of malinvestments made during the preceeding boom.

I’ve always disagreed with the latter point because malinvestments are CONSTANTLY BEING DISPOSED OF, in that hundreds of firms go bust or lay off staff per week and hundreds of new firms start up, or existing firms expand. Do we need two million people unemployed and GDP lower than it could be in order to get rid of malinvestments? Plus if a recession is unnecessarily prolonged, some malinvestments will go bust which given less of a recession may turn out to be viable in the long run given a bit of re-organisation, new management, or whatever.

Chapter 6. More on the history and theory of business cycles.

Chapter 7. Criticism of Keynsianism and Monetarism.

Chapter 8. Arguments for and against central banks. DS (like von Mises and Rothbard) is anti-central bank mainly because in acting as lender of last resort, they encourage recklessness.

Central banks do have that weakness. But at the same time, in an ideal world, a responsible central bank supplies extra monetary base when it is needed. I don’t see an efficient way of doing this in a “no central bank” scenario. DS’s proposed way seems to be prolonged periods of deflation (in both senses of the word). The latter certainly would result in falling prices and hence a rise in the value of the monetary base per unit of currency, but I dread to think what levels of unemployment would need to be endured and for what period to achieve this.

Also, if memory serves, the Bank of England intervened in the 1800s to provide liquidity in various crises between its foundation and WWI. Britain did not suffer rampant inflation at any time in that period.


Ch. 9. DS wants “elimination of legal tender regulations which oblige all citizens, even against their will, to accept the state-issued monetary unit
as a liberatory means of payment in all cases. The revocation
of legal tender laws is therefore an essential part of any
process of deregulation of the financial market. This “denationalization
of money,” in Hayek’s words, would allow economic
agents, who possess far more accurate, first-hand information
on their specific circumstances of time and place, to
decide in each case what type of monetary unit it would most
benefit them to use in their contracts.”

p. 739. De Soto says “Therefore our proposal of free choice in currency is clear. In the transition process which we will examine further on,
money in its current form is to be privatized via its replacement
by that form of money which, in an evolutionary manner,
generation after generation, has prevailed throughout history:
gold. In fact it is pointless to attempt to abruptly
introduce a new, widespread monetary unit in the market
while ignoring thousands of years of evolution in which gold
has spontaneously predominated as money”


I don’t agree that gold has in some way been the “natural” currency for centuries, while (presumably) debt based money has not.

This article by A.Mitchell Innes in the Banking Law Journal shows that if anything, it’s been the other way round.

A.Mitchell Innes article is here.


Indeed, the earliest tally stick dug up by archeologists dated from 30,000 years ago. So we can say that debt based money has been practiced for at least that period of time.

Thus the use of debt as a form of money is natural phenomenon. Thus isn’t DS being naïve in thinking that allowing the market to come up with its own form of money will get rid of debt as a form of money?

Third,the gold standard has big problems, e.g. the following:

i) The price of gold fluctuates. Of course governments can get round this by fixing the price of gold, but in this case, the price of gold is what it is because government says so. That’s not much different to a £20 note being worth something because government says so (or says the note is an acceptable way of paying tax).

ii) There isn’t nearly enough gold in the world to supply the world with an adequate amount of money. On can get round this by having central banks hold only small amounts of gold relative to total money supply, but the further this policy is taken, the nearer the currency becomes to being fiat.

According to de Soto, his system has numerous advantages, one of which is “The Proposed Model Promotes Stable, Sustainable Economic
Growth, and Thus Drastically Reduces Market Transaction Costs
and Specifically the Strains of Labor Negotiations.”

I don’t see Bob Crow, leader of the London Tube workers, and one of the most belligerent union leaders in Britain being all sweetness and light just because we have a De Sote monetary set up!!!


p. 760. De Soto then deals with various possible objections to his system. One of these is that: “The proposed system would largely decrease the amount of available credit, thereby pushing up the interest rate and hindering economic development.”

I quite agree. Essentially DS proposes cutting all commercial bank created money or credit, which leaves just monetary base. Plus the latter is presumably limited to the amount of gold available to back the monetary base. That is a HUGE HUGE reduction in the money supply, isn’t it?

De Soto then says “Hence we conclude that there is absolutely no theoretical basis for the assumption that the interest rate would be
higher in the proposed system than it is now. Quite the reverse
would be true.”

Well, that contradicts earlier parts of the book where he says that one of the main faults of FR is that it brings artificially low interest rates !!!!

Incidental points:

Re insurance companies acting as banks, De Soto is aware of the problem here, but does not think it is serious.

He is happy with a scenario where prices gradually decline (deflation in one sense of the word).

I think there is a problem here. Trade unions are very much wedded to their annual wage increase, even if it is only in nominal terms. I feel he is too optimistic about a scenario where deflation (in both senses) reins supreme. Personally I’d prefer to ban FR and maturity transformation and keep central banks plus aim for 2% inflation. That scenario involves risks, as De Soto rightly points out. But I feel it is the least bad of the various options.