Prof. Lawrence H. White’s flawed defence of fractional reserve.

In this article, entitled “Accounting for Fractional Reserve….”, Prof White tries to defend fractional reserve. He essentially makes two points in his opening paragraphs, as follows.

1. If fractional reserve is so defective, why is there no big demand for full reserve accounts or accounts where money is simply warehoused rather than loaned on?

2. The popular argument against fractional reserve namely that it is fraudulent looks silly in view of the fact that fractional reserve has been going for centuries, yet there is no widespread perception that it is fraudulent. That is, how on Earth did bankers manage to keep secret the fraudulent nature of fractional reserve, or as he puts it “How on earth did the bankers keep the word from getting out?”

The simple answer to the first point is that the basic reason for wanting a “warehouse” account is that it avoids the risk involved I having one’s money loaned on or invested by a commercial bank, and there is a HUGE DEMAND for accounts where money is not loaned on by a commercial bank. In the UK there is National Savings and Investments, where no less that A THIRD of the entire UK population have an account. And in the US there are money market mutual funds which invest just in government debt.

It’s truly amazing that Prof. White (and Prof. George Selgin who White quotes in support of his views) don’t seem to have noticed Britain’s NSI or American money market mutual funds.

Of course you could argue that the latter two types of account are not true “warehouse” accounts in that money is not simply warehoused: it is loaned to government. But that is immaterial. To repeat, the basic attraction of a warehouse account is the SAFETY it offers. Now if government is daft enough to offer 100% safety combined with interest (all paid for by the taxpayer) then why not take advantage of the offer?

Risk spreading.

In short, the popularity of Britain’s NSI and American money market mutual funds is clear evidence of something which is no more than a very boring statement of the obvious, namely that most people want to spread their risks. That is, while most of us are happy to take high risks with a small portion of our wealth (e.g. bet on a horse or a roulette wheel or invest a small amount in say a dodgy Australian gold mine), we also want to keep some of our liquid wealth in a very safe form.

So if government didn’t offer 100% safe accounts which offer interest, you can be sure there’d be significant demand for 100% safe accounts which offer NO INTEREST. Indeed for the last four years or so, the average checking or current account in the West has offered a zero or even negative real (inflation adjusted) rate of interest.

Deposit guarantees.

Incidentally, the whole picture here is muddied by the existence of taxpayer funded deposit guarantees (up to £85,000 in the UK). That is, the above mentioned and supposedly “risky” commercial bank accounts are not risky in the sense that taxpayers foot the bill when they go wrong. The best way round that problem is to assume that we’re talking about sums over £85,000 or to imagine that we’re dealing with a genuine free market: that’s where there is no taxpayer funded guarantee.

Fraud.

Let’s now consider White’s second main point, namely that if fractional reserve was fraudulent, the word would have got out by now.

The first problem there is that White doesn’t tell us what the alleged fraud actually is. Instead, he refers us on his first page to about ten books and articles which apparently set out the fraud. Now is anyone is going to plough thru that lot to find out what the fraud is?

Second, given the number of works he cites that apparently set  out the fraud, it’s unlikely those works all agree with each other. Indeed, there are several popular “fraud” charges made against fractional reserve and I personally don’t agree with some of them.

It’s thus near impossible to deal with his claim that for fraud to exist, someone must be duped. Reason is that there are all degrees of “duping” from slight misrepresentation to serious and carefully thought out fraud. And the extent of misrepresentation doubtless varies depending on which of the fraud charges levelled against fractional reserve one is considering.

Anyway, as a second best, I’ll consider White’s arguments as they relate the basic fraud that I personally think lies behind fractional reserve, which is thus.  

A fractional reserve bank promises to return to depositors the exact sum deposited (maybe plus interest and maybe less bank charges). But of course the flaw or fraud there is that the money is loaned on or invested by the bank and that involves the risk that the loans or investments go bad. And sure as night follows day, once every twenty or thirty years the loans do go wrong, and the bank can’t repay all the money they owe depositors.

So how much fraud or misrepresentation takes place there? Well you certainly don’t find commercial banks advertising the fact that there is a one in twenty or thirty chance of depositors losing their money! Quite the reverse: their publicity normally includes claims like “Your money is safe with us”.

Of course the contract governing an account at a typical bank, the small print in particular, may say something different. But that’s near irrelevant. The typical bank customer does not read the small print  - and probably wouldn’t understand it if they did. It is thus indisputable that banks are guilty of a certain amount of misrepresentation or to put it more strongly – “fraud”.

The rest of White’s article.

Given that White goes badly wrong in the first 500 words of his article, I can't summon up the will to read the remaining 15,000 or so words. Life is short. The rest of the article is concerned with some obscure arguments against fractional reserve put by Jörg Guido Hülsmann. But if there is anything inspiring in those 15,000 words, I’d be grateful if anyone can tell me what it is.

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P.S. (17th April 2014). Another flaw in White’s argument is thus. He argues that full reserve banks have been non-existent or nearly so thru history, ergo there is no economic case of them.

Now that would be a valid argument if real world free markets were perfect markets or nearly so. The reality however is that the authorities thru history have never had good control of dishonest bankers. And as for the levels of criminality over the last ten years amongst bankers, that has reached record levels.

Now if you face the choice between a bank offering you interest and an ostensibly honest bank offering you zero interest combined with 100% safety, there is little reason to trust the latter. That is, the reality is that you face a small chance of losing your money whatever you do, so you might as well plumb for “small chance of total loss plus interest” rather than “small chance of total loss with no interest”.

That certainly helps explain the scarcity of full reserve banks thru history.