For new readers to this site who are not aware of the debate that exists within the Austrian School, there are those who are supporters of 100% Reserve Free Banking and those who are for Fractional Reserve Free Banking. The importance of this debate is that the School, whilst being the only School in economics to predict the crash, does not have a uniform policy prescription, or at least one policy prescription to fix our economy and put it on a sound and stable footing going forward.
There are a number of policy recommendations from varying branches of the School. We have given a platform to some of them on this site. To caricature: for the Keynesians, it is a matter of spending more via the government, for the monetarists it is print more and more money until the economy fixes itself. Until the differences are resolved within the Austrian School, there can’t be one coherent message to enable us to get out and engage with the political, academic and journalistic fraternities. This article is an attempt to resolve those differences that lie at the heart of our School, rendering it currently impotent in its forward-looking policy prescriptions.
So far, the only two point I see amounting to total agreement between both sides is that the Central Bank should be abolished. If there was a free choice in currency, people would almost certainly choose a commodity-backed currency, as always existed in history prior to the total move to money set by decree of the State. The flavour of what this would be is hotly debated though.
This article is not written to scholarly Journal standards, indeed it is written on a Saturday afternoon and my working life is entrepreneurship and not academia. I aim to stimulate debate within the wider Austrian academic community and beyond, to thoroughly flesh out some of the research areas I recommend and, hopefully, provide grounds for moving forward on a unified, or as near as damn it unified, basis.
A Quick and Dirty Recap on the Differences
The Fractional Reserve Free Banking School
They say all bank deposits are loans. This is the correct position in law since Carr v Carr 1811 in this country.
Therefore in a free banking world, if bank A issues promissory notes (this is a throw back to when the promissory note was redeemable in gold, but the word credit could just as easily be inserted in the place of promissory notes and is more applicable to our day and age) and if bank A lends to its customers in excess of its inherent worth, then Bank B, a more conservative bank and a competitor, may present Bank A’s notes for redemption (or create rumors in the market place to encourage Bank A’s notes to be redeemed) in the knowledge that it has been over inflating its issue. This will cause a run on their competitor’s bank.
This is a good free-market self correcting mechanism that will make sure all parties behave honestly, as large credit-induced booms that will go bust would not happen under this system. Therefore, by removing the ability of banks to go to a Central Bank to be bailed out over night via the discount window, in a Fractional Reserve Free Banking system with a multiplicity of credit / promissory note issuers, never could an over issuing bank go to the Lender of Last Resort, the Central Bank, and get overnight funds to pay its depositors’ redemption requests. The fear of imminent bankruptcy keeps the over issue of credit / promissory notes in a very stable position.
If we think about what has happened since the “Big Bang” in the mid 80s under Lawson when lots of restrictive practices in the City of London were abolished and the legal reserve ratio was abolished (it is now a voluntary system and sits at around 3%), we saw an explosion of credit that has created at least the late 80s / early 90s boom and bust, the late 90s /early 2000 boom and bust and the mother of all booms and busts in the late 2000s. So the free market has certainly been allowed to work as much as possible. As it over extends and under extends it produces catastrophic and distorting results, as we have seen.
This system is not, in fact, free market capitalism, but corporate capitalism. This is because the whole system is underpinned by the Central bank, which lends overnight to the banking systems so they can match their lending with their redemption demands. On the plus side for the State, they can run this system whereby debt is sold via the banking system i.e. their client banks, as all require some kind of liquidity support at some point in time be it explicit or implicit. They can, more importantly, monetize the debt – or, in modern parlance, do QE, which is nothing more than putting more money into circulation than existed before, thus devaluing the pound in our pocket.
This self correcting mechanism of the market is compatible with liberty and does indeed free money from state control. What is more, if you allow people to choose their own money, then the state becomes totally uninvolved with banking and money, and just as we do not have an apple or jam boom and bust, we shall not have a money or credit boom and bust.
The 100% Reserve Free Banking School
Turning to supporters of 100% reserves, the participants in this debate would agree that there should be no Central Bank and free choice in currency with a strong disposition that people, if left to their own devices, would choose gold or silver or a combination as they have overwhelmingly done in history in most places of the world.
Their problem and, indeed, mine is with the very nature of the demand deposit: the relationship between the bank and its depositing customer. Unlike the Fractional Reserve Free Bankers, the 100% Reserve Free Bankers say that when the vast majority of people deposit money in their bank account, such as their salary and their savings, they think that it is “theirs” and indeed it is safe. Of course we all know that banks own “your money” and indeed they owe you “your” money. A bank statement is the bank saying they owe you want you think is “yours.”
The loan you make to the bank is used by the bank (one loans to the bank in ignorance, I suggest). Indeed, once in the banking system, with its ability to multiply on average in the UK up to 33 times the level of credit, with only 3% of your money ever kept in reserves, it is clear that you only have 3% of “your” money in the banking system at any one point in time. As long as no more than one in 33 people walk into the bank to withdraw that which they think is theirs at the same time, then the claim or “their” money is still safe.
This rapid expansion of credit is the start of the Austrian Theory of the Business Cycle. I struggle to see how anyone can doubt the causes of the Business Cycle and both parts of the Austrian School are united on this. Now, the 100% Reserve advocates say that even under a free banking system with no Central Bank, there will still be boom and bust. This is because as the economy grows and there are more participants in the economy, transacting the sale of more goods and services (it is said by all economists except the 100% Reserve Free Banking advocates) the need for the services of more money grows. A series of fractional reserve free banks can issue extra money in the form of credit or promissory notes and you can thus accommodate the needs of trade.
This will cause a boom and bust, just as the current set up with a Central Bank under pinning the system does. This will be the case as every bit of credit issued not backed by prior real savings will cause a lengthening of the structure of production that will set in motion the capital misallocation of resourses that will look like a boom. But as there are no real savings to support the outcome of this new investment activity backed by bank created credit, that will indeed lead to a bust. If you are not happy with why this will cause boom and bust, I suggest cribbing up on the Austrian Theory of the Business Cycle, in particular Hayek in Prices and Production (PDF).
100% Reserve Free Banking advocates will say that to accommodate the growing population and the needs of trade, we should be happy at the spontaneous increase in our purchasing power of our monetary unit (i.e. falling prices). This is wholly beneficial to us all and is not in any way ever going to cause boom and bust.
Jesus Huerta de Soto in his brilliant book Money, Bank Credit, and Economic Cycles (PDF) in Chapter 9 adds a very seductive and interesting twist to the debate when he outlines a reform program that would lead to the total paying off of the National Debt (a very topical issue now!) and a very sound, solid banking system going forward. I have summarized these thought here: A Day of Reckoning .
A Way Forward, the Balance Sheet and Contract Law Approach to Free Banking
On the Nature of a Bank Deposit
I outlined the start of my case in this article last week: Why All Banks Are Insolvent. It does seem to me that it is critical to decide: should current bank deposit contracts be loans, as they lawfully are, or safe keeping / custodian deposits? If they are loans, the Fractional Reserve Free Bankers have the day, if they are custodian accounts or safe keeping accounts the 100% Reserve Free Bankers have the day.
As mentioned in that article:
I commissioned a survey for the Cobden Centre in Oct 2009 with ICM over 2,000 people. 74% of people think that they are the legal owner of the money in their current account rather than the bank. Paradoxically 61% know that their money is lent out even though 67% want convenient (now) on demand access. The full results of this survey will be published shortly in another paper.
This would overwhelmingly suggest that people want safety, they think their money is theirs, even though it is the banks’. They would also like it lent out as long as they can have it back when they want it. I conclude people want safety and easy access, but really they are confused!
It is worth while understanding how a legally binding contract is determined and pondering the glaring confusion that exists with a bank deposit contract.
Law of Contract
Traditionally the formation of contracts has been analysed in terms of offer, acceptance, consideration (and later, intention to create legal relations).
Meeting of the Minds
Horrocks v Foray :
In order to establish a contract, whether it be an express contract or a contract implied by law, there has to be shown a meeting of the minds of the parties, with a definition of the contractual terms reasonably clearly made out, with an intention to affect the legal relationship: that is that the agreement that is made is one which is properly to be regarded as being enforced by the court if one or the other fails to comply with it; and it still remains a part of the law of this country, though many people think that it is time that it was changed to some other criterion, that there must be consideration moving in order to establish a contract.
Clearly, the depositor does not think he is making a loan to the bank, and the bank knows it is not safe-keeping but on-lending. There is no “meeting of minds.”
The standard which is adopted in deciding whether or not a contract has been concluded is objective rather than subjective. Smith v Hughes (1871):
If, whatever a man’s real intention may be, he so conducts himself that a reasonable man would believe that he was assenting to the terms proposed by the other party, and that other party upon that belief enters into the contract with him, the man thus conducting himself would be equally bound as if he had intended to agree to the other party’s terms.
It would seem that there is confusion at best about the real intentions of the depositor.
Acceptance must be communicated to the offeror – Entores v Miles Far East Corp .
The general rule is that acceptance of an offer will not be implied from mere silence on the part of the offeree and that an offeror cannot impose a contractual obligation upon the offeree by stating that, unless the latter expressly rejects the offer, he will be held to have accepted it – Felthouse v Bindley (1862) 11 CB (NS) 869.
In Order to Create a Binding Contract, the Contract Must be Certain
Scammell and Nephew Ltd v Ouston  – Viscount Maugham – “in order to constitute a valid contract the parties must so express themselves that their meaning can be determined with a reasonable degree of certainty. It is plain that unless this can be done…consensus ad idem would be a matter of mere conjecture.”
Confusion does not constitute a lawful contract.
Previous Course of Dealing Does not Mean Binding Contract Exists
University of Plymouth v European Language Center Ltd  – one party could not rely on an exchange of e-mails and telephone calls as establishing a binding contract with another party, even though the parties had worked together for some years.
It would be very interesting to test that if over the course of a lifetime of banking you always thought that you were depositing for safekeeping if the law courts would give the above interpretation when there has in the vast majority of cases, never been a meeting of the minds.
Tweedle v Atkinson (1861) – consideration must move from the promise.
The classic definition of consideration was expressed in Currie v Misa (1875) LR 10 Ex 153:
a valuable consideration, in the sense of the law, may consist either in some right, interest, profit or benefit accruing to the one party, or some forbearance, detriment, loss or responsibility given, suffered or undertaken by the other.
Your banking in some way shape or form , even your “free” bank account, does invariably have some charge somewhere down the line, they get you somewhere, so I would be happy that there is consideration in the current bank arrangements.
Intention to Create Legal Relations
Meritt v Meritt  – In determining the intention of the parties an objective test is used by asking if reasonable people would regard the agreement as legally binding.
With two parties so at odds, I cannot see how we have any intention to create legal relations in the vast majority of deposit contracts.
I would even go as far to say that the vast majority of deposit contracts are unlawful under the Law of Contract.
A sensible policy prescription should be to align the banks to the account holders’ wishes and make the deposit contract one where the bank holds the depositors’ money as custodian / safe keeper and not as borrower. Make this contract explicit. Charge a fee for custodianship / safe keeping.
When a depositor wants to earn some interest on his money, allow an explicit lending contract to be put in place so that the depositor understands that his money has been loaned out, and that it is his no more. He now has a right to his lent money back some agreed time in the future, with a coupon paid.
This allows banks to go back and do what their time honoured role has been, to mediate between the saver and the borrower and to act as custodian and safe keep money for their clients. This is unashamedly boring, and steady as you go banking.
Should a bank be allowed to offer explicitly a fractional reserve account, when you as the depositor know right from the off that they are going to lend your money out a number of times over so there are many claims to this original money that you have deposited? I would say yes under contract law so long as it was explicit and conformed to all the case law listed above, but fundamentally no as this would require the bank to exist under legal and accounting privilege. I work from the assumption that all state sanctioned privilege is a bad as one party is exploiting another lawfully at the expense of the other party. This is antithetical to liberty. I would also add that there could be a similar type of fractional contract but this would be within the realm of hedge funds which operate under the normal commercial law that we all work under – except banks. This will be explored later.
The Balance Sheet Approach
In an article I wrote last week, I outline what I term the Balance Sheet approach to banking. I compare the balance sheet of the UK’s largest company BP, with that of one of our largest banks, Barclays. In a separate article, I look at the accounting treatment of its record profits for 2009 and some remarkable accounting trickery , all perfectly lawful – except that I would not be able to do and such trickery in my business. The link is here More on Banking and the Barclays 2009 Results. The important thing to note is that BP has current creditors and long term or non current creditors. Barclays has only creditors. Why does BP split out its current creditors from its long term ones?
As far as I am aware, in the UK Under International Financial Reporting Standards and UK Generally Accepted Accounting Principles, you have to report your creditors as current, under one year and over one year. This shows the outside world what your ability is to pay your debts, as and when they fall due. Most companies will always aim to match their current creditors with their current debtors, their less than one year creditors, but over current creditors, with the equivalent matching on the debtors’ side and with the long term debt being matched with long term creditors.
Most companies in this sense in the commercial world, other than banks, would indeed be 100% reserve companies and not companies that only keep a small fraction of money aside to pay their creditors. A very good research project for a graduate would be to map out all the FTSE 100 companies and see what percentage were 100% reserved and what were not. With those that were not, what were above 95% , 90%, 85% etc. In reality, if they are not very highly reserved their auditors will not sign off their accounts and they run the risk of insolvency. There is a grey area between a 99%, 95% reserved company as to if it is solvent and at the extreme end, the banks, where they are 3% reserved to current creditors!
Banks need another set of laws that only apply to themselves to operate. Thus they have a privilege accorded only to them. This allows them, like Barclays, to have creditors and debtors only. So all the current money on demand is lumped in with a catch-all lump of all creditors. This implies to the outside world that they perfectly balance their short term creditor needs, i.e. withdrawals with their long term debtors’ repayment profiles such that they never prejudice the current creditor losing his/her shirt. I do not know what specific accounting laws that the banks are allowed to audit to, but they sure are not GAAP that applies to all other commercial organizations. I do intend to find out when I have time, and again, this could be a rich source of research work for a graduate. Notwithstanding, it is clear there is one law for all commercial companies and one law for banks.
It should be clear that a lending and custodian bank where a deposit contract of either type conforms to the Law of Contract, at all points in time will conform to the normal commercial law.
It is clear that a Fractional Reserve Free Bank violates the law of contract and the normal commercial law for every company, thus they have accounting and legal privilege. A custodian / lending bank, conforming to the law of contract and normal commercial accounting law, could not compete with a fractional reserve free bank as the latter would be able to fully use all of its clients’ deposited money to do whatever it pleases, including the creation, on average, of 33 times more deposits. If we take the example of Barclays with some £300 billion of current creditors, the ability to fully use this would place it at a distinct unfair advantage with all other commercial enterprises. Indeed, under the current law, if would be very difficult indeed for a custody / safe keeping bank to get off the ground, the odds are so stacked in favour of the current arrangement.
The Case for Free Banking Under the Normal Commercial Law
Hence I conclude that the current system of making sure companies disclose and match timed liabilities to keep solvent is good and fair to all parties. The anomaly that is fractional reserve banking, be it in its Central Bank sponsored format or in its hypothetical format with no Central Bank, can only work with this legal and accounting privilege in place. This sets one party (the banks/bankers) at a distinct and unfair advantage to another parties (ie all other people / enterprises).
As the Fractional Reserve Free Banking system ex the central bank can only work with the positive intervention of legal privilege and a setting aside of all the principles of contract law, it would seem the case for it is negligible indeed. Added to the fact that there is still the possibility of business cycle inducing properties as they could automatically grow to the needs of trade, we need to map out an alternative that allows people to keep safe, save, invest and speculate.
In the above, I outlined the two forms of deposit that would accord with the normal commercial law that would exist without legal and accounting privilege, i.e. a straight forward safe keeping or custodian contract and a straight forward loan contract.
I would also propose the possibility of a third, called a “High Risk” deposit. This is a deposit contract that again is explicit, that allows one party to deposit in the full knowledge that the institution may or may not engage an over issue of credit, or even promissory notes that may take the form of money if they can become a generally accepted medium of exchange, provided that like in any other company, they are subject to audit and a market valuation up or down of underlying assets at least once per year. As in a normal company’s balance sheet, each year, your properties or other chattels are re valued up, or impaired down, so you can and should do this with the “High Risk” deposit account. This way, there is no extension or contraction of credit over the audit year that does not have real wealth behind it. The boom and bust implications of functioning this way are that of any normal commercial activity.
Any deposit can be made between freely consenting adults provided it is enforceable under the Law of Contract and does not rely on the grant of a state sanction / privilege under commercial law and accounting standards to operate. This would be supporting something that was antithetical to liberty.
Personally, I would prefer to keep these kind of “High Risk” deposits in Hedge Funds and the like – clearly away from banks so as not to confuse. It would be quite possible for somebody with a higher risk profile to place all his money at the disposal of a hedge fund and the hedge fund to offer normal banking services, such as transacting cheques, direct debits, standing orders, issuing debit cards that the hedge fund would subcontract back to the regular standard custodian / safe keeping lending bank. This would give the appearance in almost every respect of the current fractional reserve banking.
To all intents and purposes the overwhelmingly vast majority of non bank companies are 100% reserve companies i.e. they square up with their creditors as and when they fall due or could fall due, unlike fractional reserve banks who make very little provision and rely on state sanction to exist like this.
The balance sheet and contract law approach to free banking allows a solid safe and traditional approach to banking to be the banking system’s default position, but then allows freely consenting adults all other options to enter into whatever deposit contracts they like so long as they are truly lawful.
If this is accepted, I would think it is clear that the proposal of De Soto mentioned above, concerning banking reform, becomes a real possibility in order to be the key policy solution and recommendation of the Austrian School.
It would be right and proper that the School that was the only School to predict the Great Credit Crunch / Meltdown, could provide a series of solutions for a lasting and sustainable recovery.
I have laid out my case that there is such a discrepancy between what the overwhelming majority think happens with their deposited money that under contract law, I doubt very much that an enforceable contract exists as currently offered by the banking system. I propose a reform that would very clearly demarcate what is a custodian / safe keeping contract and what is a lending contract. I agree that freely consenting adults who do no harm to others should be allowed to do as they please which means contract as they please, but entering into a fractional reserve free banking contract would violate very solid good balance sheet accounting and financial reporting standards that have been developed over many years to make sure trade happens without violation of people’s property rights. After that I propose a third contract that could have similar characteristics to a fractional reserve free bank account, called a High Risk account that would allow more speculative activities. The market would evolve in time, and new ways of doing things would no doubt emerge. As long as these new ways of doing things conform to commercial law and do not exist on privilege, then there would be no reason to get het up about this type of innovation.
Some of the debates existing in the wider free banking school need to be addressed.
What is the Difference Between a Fractional Reserve Contract and a House Insurance Contract?
With my house insurance, I pay, not loan, money to an insurance company in exchange for the right to a policy, my consumable item if you like, with the explicit knowledge that they are hoping to charge me and all the other policy holders more than they would pay out in the eventuality of a disaster that I am trying to insure against. There is a small risk that the insurance company will get its sums wrong and not be able to pay me out in full or at all. The policy tells me this.
With a deposit contract, I think I am depositing for custody and safe keeping and only the enlightened few know they are loaning their forgone purchasing power i.e. money to the bank.
So insurance is paying for a product that you consume by virtue of holding the policy for its life time. You know that there is a small risk that you may not get 100% of what you have bought.
With banking, you loan your purchasing power with the overwhelming people doing this in ignorance of what they have committed to. The vast majority expect to have the quiet and peaceful enjoyment of their purchasing power at their convenience and do not deposit in the knowledge that there may be wholesale default.
If we Accept the Legal Position that a Demand Deposit is a Bank Loan, can you Ever Have a Loan with no Fixed Term i.e. an Indefinite Loan?
This is an impossibility.
The loan under these circumstances should properly be called a gift. Fractional Reserve Free Banking relies on the fact that the legal position says all deposits are loans. In 22 years in business I have never borrowed money without a term implied. Even in the most friendly of loans where I have borrowed from a family member and they have said “pay me back when you can,” there is an implied term, when I can, and that it is not a gift.
You can vary terms then reset the period, re cut it, re dice it , re jig it, re price it, etc, but there are still implied terms. At some point in time, a lender always wants to get paid back, otherwise he/she would not be a lender, but someone giving a gift. Depositors are not giving a gift!
In the three banks that I use, representing a very large chunk of the UK banking business, I see nothing whatsoever in any documentation that leads me to believe that when I deposit I am making a loan. What is more, it does not fit my understanding of what a loan is unless we accept it is a callable loan on demand. If it is on demand, it needs to be provisioned for. Prudent management would dictate 100% reserves against my loan. General accounting principles that apply to all commercial activities bar the banks do not have to.
Everything I have ever seen in banking when I have deposited leads me to believe I am depositing money for custody / safe keeping and not as a loan. The language is always that of custody / safe keeping. Free banking going forward needs to be very explicit in nailing in contract what is custody / safe keeping and what is loaning and what is speculating.
Do Fractional Reserve Banks in a Free Market Environment, i.e. one with no Central Bank, Create Inflation?
I touched upon this point in the main body of the article. The price of money is determined, like all things, by demand and supply. Mises called this the money relation. If there is an increase in both, then there will be no inflation. To be clear, Fractional Reserve Free Banking people who advocate this are correct, there will be no price inflation. However, the number of money units has now gone up, so there has been a money inflation. Do we care? Yes, as Austrians we do. Why? Whoever is in receipt of the new money, in a Fractional Reserve Free Banking world with no Central Bank, the first recipients are the new demanders of money. They will get the wealth effect of having new purchasing power first. Where there should have been an increase in purchasing power (falling prices) for all the existing money holders, there is no increase, thus impoverishing those who are holding the existing monetary unit. Again, this gives special privilege to a certain class of person over another class of person. That is antithetical to liberty. The only way this can be avoided is to have Free Banking that sits within commercial law, accounting rules that apply to everyone, and framed within the time-honoured principles of the law of contract.
Do Grain Store Examples Shed any Useful Light into this Debate?
I am often told by advocates of Fractional Reserve Free Banking that banking is like a grain store. That if ten tons were to be deposited by one man who took a certificate from the store holder explicitly stating that the store will be lending 9 ton of the grain out to bread makers in exchange for the original depositor not having to pay for the storage, or even being paid to store there – what would be wrong with this? Also, it would tell me under what time period my grain would be being used by others, and when I could get my grain back. Well, the answer is nothing at all as the contract is explicit – except that I will never get my grain back at all as it is being consumed by someone else. I will never get it back!
Grain examples should be avoided, for they certainly do not stack up.