What gives money value, and is fractional-reserve banking fraud?

I thought I should address a couple of points that I consider to be misconceptions and that frequently come up in discussions with the audience or other speakers when I present my views on the fundamental problems with fiat money. I am not always in a position to correct these misconceptions right then. They are often woven into questions on other points and I have to leave them uncommented so as not to disrupt the flow of the debate. My book is, I believe, quite clear on these points, so I could simply refer people to Paper Money Collapse. But, for whatever reason, it is still the case that many in my audience make inferences from similar arguments to my own, and I fear that some of the differences between these positions might get overlooked. These differences are not unimportant, and I think it is worthwhile to highlight and clarify them.

The first point is related to the question what gives money its value? The second point is the question of whether fractional-reserve banking is fraudulent, and should be banned on the basis of property rights.

Let’s first restate the central premise of Paper Money Collapse. The main message is that today’s mainstream views on money are flawed. The most important difference between commodity money, such as a proper gold standard, and ‘paper money’, such as our present fiat money system, is the elasticity of the money supply. In the former, money is essentially inelastic, in the latter it is perfectly elastic. The present consensus holds that elasticity is a big advantage. It makes fiat money, if managed properly, superior, as it allows monetary authorities to stabilize the economy. This position provides the intellectual foundation for our present fiat money arrangements. My argument is that this is false, and that the opposite is true, and that this was already understood and explained some time ago by eminent economists: the elasticity of the money supply in a fiat money system, and the constant expansion of the money supply under present arrangements in particular, systematically distorts relative prices, disorients economic actors and destabilizes the economy over time. Imbalances accumulate, which obstruct further growth and which will be countered with accelerated money injections, destabilizing the economy further. Elastic money is unnecessary, suboptimal, unstable, and ultimately unsustainable.

It is clear that my analysis rehabilitates the gold standard. It was not only unnecessary to abandon the gold standard, it was a major mistake. It is also immediately clear that I consider fractional-reserve banking an inherently destabilizing force in the economy. Even when money was essentially gold and the supply of money proper inelastic, fractional-reserve banks managed to circulate fiduciary media, that is, claims on gold that are supposed to be redeemable in gold but are not fully backed by gold. To the extent that the public used these fiduciary media the same way it used money proper (gold), the supply of what was used as money in the economy expanded and an element of elasticity was introduced into the overall money supply, even under a gold standard. Fractional-reserve banking makes money elastic, expands the money supply – within limits, so therefore only to a degree – and causes economic dislocations. Most mainstream economists today do not even consider these distortions as they work under the entirely untenable assumption that constant money injections are harmless as long as inflation stays within tolerable ranges.

Now let me address the misconceptions on these two points that often appear to enter the debate. Some critics of fiat money and advocates of the gold standard express the following sentiments, which I consider to be unfounded and which are very different from my position: “How could we even have come to accept pieces of paper that are not backed by anything of value as money? Money has always been backed by tangible assets and it should again be backed by something tangible. Gold and silver have intrinsic value but paper money has an intrinsic value of zero. The public gets fooled into accepting these pieces of paper as money. If it realized how money was created and that it was not backed by anything, the public would dump it. Only gold (or silver) can ever be money.”

Those views are not always expressed this bluntly, but a trace of them is often apparent in discussions about the failure of paper money, and because they point in the same direction as my arguments – toward the abolishment of state fiat money and a return to hard money, most probably gold – they are still not my views. In fact, I consider them to be wrong. They include fundamental misconceptions about money.

Who or what bestows value on money?

Do the paper tickets in your wallet have value? Of course, they do. They are valuable.

Why are they valuable? For one reason and one reason only: Because others in society accept these paper tickets as a medium of exchange. They accept them in exchange for goods and services in the knowledge that they can trade them again for goods and services from others.

This social convention – and only this social convention – makes these paper tickets money and thus bestows value on them. That is why paper money is money and that is why you act quite rationally when you hold some of your wealth in the form of these paper tickets (how much of your wealth is a different question) and when you use them as a medium of exchange.

Most money today is not even paper money but immaterial money. It only exists as bits on a computer hard-drive. Do these bits have value? Of course, they do. As long as others in society accept them in exchange for goods and services, as long as others accept them as money, they are money. They have exchange value. They are immaterial and of no use whatsoever, other than as a medium of exchange for as long as people accept them as a medium of exchange, which – on a purely conceptual level – might be forever.

Who bestows value on these paper tickets or bits on the computer hard-drive? The trading public does. And who determines how valuable these forms of money are? The trading public does. And who can remove the value from these paper tickets or this virtual money? The trading public.

Now consider a proper gold standard. All money is gold. Who determines the exchange value of each gold coin? You got it: the trading public does. Gold also has value as an industrial commodity or as an item of jewellery (in contrast to paper tickets and binary digits) but this value – its non-monetary value – only really played a role when gold made the transition from industrial commodity to monetary commodity, when it was first used as money. At that point its previous use-value as a commodity became the reference point for its first ever use as money. Once gold had become widely used as a medium of exchange or as a monetary asset, however, it was the public’s demand for such a monetary asset – the public’s demand for money – that determined gold’s exchange value. From that moment on – and this moment occurred a few thousand years ago – it was demand for gold as a form of money that determined its price, not its residual use as an industrial commodity, which at this point only retained secondary importance.

We conclude that the only thing that makes any substance or non-substance money and that bestows an exchange value on this substance or non-substance is the use of it as a medium of exchange, a facilitator of trade, by the trading public. Once something has become money – and in order to be money it has to be widely accepted as money – its physical properties, or even the absence of any physical properties, are entirely unimportant. They are, for lack of a better word, ‘immaterial’. Money only has exchange-value and no direct use-value. For its use as money and for determining its exchange value as money (its purchasing power in trade) it does not matter one bit what other use-value, if any, the monetary asset may have. One paper dollar has the specific exchange value it has today not because of any other use-value it has – because it evidently has none other than being a medium of exchange – but simply by its exchange value in trade. The same is true of gold. An ounce of gold has the value it has today because of the specific demand for it as a monetary asset. It would retain its monetary value even if, by some act of magic, it lost overnight all its use-value as an industrial commodity or an item of jewellery. Would this affect gold’s price and lead to a one-off adjustment in the gold price? Probably. But it would not make gold worthless. I am even fairly confident, although nobody can be certain, that the drop in price would be relatively small.

The whole doltishness of Warren Buffett’s tiresome refrain that people are stupid to buy and hold gold as it doesn’t produce anything and, by the way, if you put all gold on one big heap what could you do with it, hehehe, now becomes apparent. The man may be able to read balance sheets and income statements. He evidently does not understand monetary economics. — What good would it do us if we piled all paper money in one big heap? Maybe we could have a nice fire. And all those immaterial money units that the Fed and the banks create on their computers – you cannot even put them into any pile, Mr. Buffett. Yet, all these things have value and it is quite reasonable to hold some of your wealth in the form of these ‘things’.

Mr. Buffett, statist that he is, does not object to you holding any of your wealth in state-issued paper dollars or in immaterial deposit money at Bank of America, in which he – increasingly a supporter of big business, the establishment and the status quo – has a stake. Just you holding gold, that bothers him.

Why gold is coming back

The reason why more and more people begin to prefer holding physical gold rather than paper money or electronic ledger money at shaky banks is not – at least not first and foremost – because of the physical properties of gold versus those of these other monies. The reason is that more and more people expect, correctly in my view, that the trading public, which always is the entity that bestows exchange value on or removes exchange value from any form of money, will bestow ever less value on paper money and electronic money going forward. Why? Because these forms of money are being produced in ever larger quantities for political reasons. Not their physical properties, or lack thereof, are the central problem with paper money and present forms of electronic money but the complete elasticity of their supply in present monetary arrangements. More specifically, the central problem today is that the massive over-issuance of these types of money over recent decades has created substantial imbalances that now cause considerable headaches for the banks and the various governments and that will most certainly result in ever more paper and electronic money being produced to fend off the painful dissolution of these imbalances.

If the central problem with fiat money were its physical characteristics than we would not have to know anything about economics or about the specific process of paper money creation and its impact on the economy in order to pass a negative judgement on this form of money. But I do not think that this is possible. That today’s money consists of otherwise worthless pieces of paper or of immaterial electronic book entries is not the problem. What matters is the process of money creation and the impact on the economy. Once we have understood this process it is clear that the elasticity of the money supply is at the core of the problem and that we have now reached a point at which the further and accelerated production of these forms of money is almost a certainty. And that is why investing in gold makes sense, as gold is the oldest, most widely established form of money – the one with the most universal and longstanding social convention backing it – and as its supply is both inelastic and by its nature fundamentally outside the politicized process of modern fiat money creation.

Sometimes people tell me that they hesitate to buy gold as its value rests merely on others considering it valuable. What if we woke up tomorrow and people no longer considered this metal a monetary asset and thus especially valuable? This is a fair point but it applies logically to any form of money. The value of the paper money in your wallet and the electronic money in your bank account equally rests on the public continuing to accept them as money. Any form of money is only money through the acceptance of the trading public. There is no other potential source that its value could be derived from.

It is important to stress that the government does not and cannot bestow value on its paper money. This seems to be a widespread myth, as evidenced by this quote from, Philip Coggan’s recent book Paper Promises (p. 37):

“If people think that the value of something is equal to the cost of creating it, which in the case of paper and electronic money is virtually zero, then why do we accept it at all? We know there is no longer enough gold or silver to support it. The answer must be that we have faith in the government that stands behind it. The government can raise the taxes necessary to give the currency value.”

This is evidently wrong. The government does not support or back its paper money with anything. It is irredeemable money. You can take your state paper money notes to the state central bank but all you will get in exchange for them is new, freshly printed paper notes with the same numbers printed on them. The paper money in circulation does not constitute a claim on any assets that the government may possess or any reserve that the central bank may hold or any taxes that the government may collect. It is not a claim on the state at all. It is, in fact, a claim on nobody. Therefore, it is not debt. Today’s banknotes are, just like gold, assets that are nobody’s liability (in contrast to the electronic deposit money that is a liability of the specific bank that issued it and that will in fact disappear when the bank disappears). But this means the government does not guarantee money’s purchasing power. If these pieces of paper money retain any purchasing power at all it is because the trading public continues to use them as money.

In the debates on the present Greek crisis one often gets the perception that paper money would collapse if the states went bankrupt. This is completely unfounded. Sovereign default is only a threat to paper money – and a serious threat at that – because states, even when they are defaulting, retain the monopoly of paper money creation and when they are about to go bankrupt they tend to issue ever more money to sustain their spending and to appear solvent. The threat to money’s purchasing power thus comes again from the risk of over-issuance, and is again linked to the elasticity of the money supply, and not the creditworthiness of the state. If the ECB stopped printing euros, many European states would soon run out of money and default, and so would many banks, but that would not diminish the euro’s value as money, as a medium of exchange among the eurozone’s trading public, at least not that of the paper euros in circulation or the electronic euros in surviving banks. If the trading public could be confident that the market would not be swamped with paper euros in order to bail out overstretched eurozone banks and governments, there would be no reason to stop using this currency. Note that in a proper gold standard, the state would merely be a money-user, just like any household or company, and would have to manage its own finances sensibly, and if it didn’t do so, it would default on its obligations, yet nobody would stop using gold as money in response.

So, yes, the public may suddenly, one morning, decide to no longer consider gold money but I would suggest that the risk of the public no longer considering state paper money money is considerably bigger. And again, the reason is not the different physical composition but the fact that paper money is issued by the state for a reason, namely to facilitate the availability of credit beyond the availability of true, voluntary savings, and as this has now led to economic distortions of surreal magnitude, the political owners of the paper money franchise will print ever more of it. Gold is being remonetised by the public – always the ultimate arbiter of what is money and what is money’s purchasing power – because gold not only has a longer history of being money than any of the present paper monies, a history that spans all civilizations and the entire globe, it is also apolitical money, not issued by any central authority and, this is the most important aspect, with its supply essentially inelastic.

You may not wake up tomorrow to a world in which paper money is worthless but you most certainly will wake up to a world in which more state paper money circulates but probably not more gold.

Elasticity and materiality

But is the elasticity of the money supply not intimately linked to the physical characteristics of the monetary substance? To say money is paper or a binary digit, is that not the same as to say money’s supply is fully elastic? Not quite, for we can imagine an immaterial form of money with a fixed supply; at least, we can imagine such a thing since Satoshi Nakamoto invented Bitcoin. Bitcoin is immaterial — it only exists as virtual money on the internet. But equally it is commodity money because it is based on a cryptographic algorithm, which requires time and considerable computing energy to create Bitcoins and which is designed so that the overall supply of Bitcoin is strictly limited. Bitcoin shares with today’s electronic money that represents items on bank balance sheets the feature of immateriality. But in every other aspect it is much closer to gold: Bitcoin’s supply is strictly limited and inelastic, just as is the case with gold. Bitcoin has no issuing authority that benefits from a money-creation monopoly. Neither has gold. Bitcoin is not linked to any sovereign state. Neither is gold. Bitcoin exists outside the state-sponsored fiat-money-addicted banking sector. So does gold.

Whether Bitcoin can ever compete with gold or potentially even replace it is a hotly debated topic. We do not have to discuss it here. The point was simply to show that the key problem with today’s monetary arrangements is their politically motivated elasticity and that this feature is fundamentally different from money’s materiality.

Fractional-reserve banking and fraud

We can now address the second point that frequently comes up when discussing the unsustainability of present fiat money arrangements and that is the question whether fractional-reserve banking (FRB) is fraudulent and whether it should be banned on grounds of private property violation.

Today pretty much all banks are fractional-reserve banks. They can create money – book-entry money or deposit money – on the basis of limited reserve-money (physical cash in their vaults and deposits held at the central bank). Thus, unlike fund managers, banks not only channel savings into investment, they are also in the business of money creation. Most of the registered money stock in modern economies is simply a book-entry on bank balance sheets.

To analyze the fundamentals of FRB it is best to go back to the early days of deposit-banking when money was still essentially gold because back then the distinction between ‘original’ money (gold) and the ‘derivative’ money created by the banks (banknotes for example) was more apparent. The story goes something like this: When somebody deposited gold with a bank he received a banknote in return and was promised that he could immediately reclaim his deposited gold upon presenting the banknote. Banknotes began to be used as payment in economic transactions and to circulate in the economy as money because it was obviously more convenient to use paper tickets to pay rather than heavy gold coins, and the recipient of the banknote could always reclaim the gold. As long as all banknotes were backed by physical gold the supply of money did not expand. This was still a 100 percent gold standard, and the banknotes were simply a new form of payment technology, a means to transfer ownership in money more conveniently.

This changed when the banks began to lend the deposited gold to third parties or, to make it easier, they kept the gold but issued more banknotes than they had gold in their vaults and lent these banknotes to third parties as part of their lending activities. Of course, they still promised to repay all notes in gold when presented to them. Banknotes that are not fully backed by gold are not money proper but fiduciary media, claims on money that are not fully backed by money. Now there was money proper and fiduciary media circulating in the economy side by side. The overall supply of what was used as a medium of exchange in the economy had expanded. The supply of money was extended through FRB.

Critics of FRB argue that this process involves a property rights violation. The original depositor retains ownership in the deposited gold but the bank issues multiple claims on the same amount of gold, and whoever presents the banknote first, probably even somebody who never deposited gold in the first place but who obtained the banknote as payment in a commercial transaction, has the gold delivered to him. This appears to be a logical and convincing argument but there is one problem with it: FRB has been conducted for about 300 years. Have depositors not realized by now that they are being defrauded? If this is indeed fraud, how can the practice survive for so long?

One response is that most people do not understand how FRB works and that the banks misrepresent it. I do not think this is a valid point. To my knowledge, no bank today pretends that deposited cash is simply locked up in the vault waiting to be collected by the depositor at a later stage. Everybody knows (or should know) that banks lend deposited money to third parties. How else would they obtain the income to pay interest on the deposited money? That banks pay interest on deposits (at least in ‘normal’ times) should already give the game away. Think about it: What would you say if you valet-parked your car and the young man taking the car keys from you would offer to pay you a fee for having control of the car for a few hours? Wouldn’t you be suspicious? Would you really think he would just park the car somewhere safe and he is paying you for the privilege of doing so? –If deposit banking were indeed just about safekeeping then the depositor should pay the bank for its safekeeping services, not the bank the depositor for getting control of the money.

I believe the correct answer is that the depositor knows what is going on but that he does not care about the deposited gold as such. This follows directly from our analysis above. Remember the depositor deposits gold that he considers money. He does not care that this is a tangible asset, that it is shiny and has certain other physical properties. He does not consider this gold to be an industrial commodity or a piece of jewellery. It is money – a medium of exchange. When he deposits it with the bank he receives a banknote that is  — equally a medium of exchange. The depositor has not given up anything. As long as the fiduciary medium he now possesses has the same purchasing power as the deposited gold – and this is the precondition for FRB to work – he has not foregone any economic benefit. The gold was a medium of exchange that provided him with limitless spending flexibility. The banknote he now holds in return for the deposited gold is equally a medium of exchange that provides him with limitless spending flexibility. In fact, the assumption of the banker that most depositors may never ask for their gold back is not absurd at all. As long as not too many banknotes get circulated, thus having their purchasing power meaningfully diluted, or as long as the issuing bank does not run into trouble, the banknotes may circulate forever. These are, of course, risks that the depositor shoulders but in compensation he receives interest on his deposited gold – which in fact the early goldsmiths paid as early as the late seventeenth century! – and he has the additional benefit of the convenience of paper tickets. The bottom-line is that the willing and knowing participation of the depositor in the FRB scheme is no riddle at all but may be a fully rational subjective choice.

I believe that the analysis of the anti-FRB economists rests too much on the analogy with other safekeeping contracts. When valet-parking my car, I hand over a valuable consumption good in return for a useless and pretty much valueless piece of paper. The benefit I receive from owning a car and the benefit I receive from holding a little paper ticket (well, there is no real benefit at all in the latter) are hardly comparable. That I may never reclaim my car and be content with holding that piece of paper forever is hardly a realistic assumption. But in the case of FRB it is. Exchanging money proper for fiduciary media means exchanging one medium of exchange for another medium of exchange.

I am not arguing that FRB is fine. All I am saying is that it is entirely conceivable that depositors voluntarily and knowingly participate in it. The problem with FRB is not that the depositors get defrauded but that it introduces an element of elasticity into the money supply. Thereby FRB undermines itself. When the banking sector in aggregate manages to lower reserve ratios and expands the overall money supply via FRB, they inevitably start a credit boom, and we know that this boom will end in a bust. FRB leads to business cycles, as Austrian Business Cycle Theory has explained so well. And it is in the business cycle downturn that the FRB banks run into trouble and that the public begins to distinguish again between fiduciary media, which are bank liabilities, and money proper, which is nobody’s liability. Again, we are back at the point of elasticity, which is the real Achilles heel of our system.

This is already a pretty long blog — so I stop here. I will conclude by saying briefly what I think is the one thing that needs to be done: it is to get the state out of money and banking completely. No central bank, no lender of last resort, no inflation targets, no bank regulation, no deposit insurance, no government backstops. All these modern interventions are supposed to make banking safe but what they really do is make money more elastic as they greatly incentivize banks to lower their reserve ratios and extend the money supply. This makes the economy less stable and banks ultimately less safe. Much less safe. These state interventions are nothing but gigantic state subsidies for FRB. This is what needs to stop. The state should not (and in my view cannot) ban FRB. It should simply cease to subsidize it and to socialize its costs.

In the meantime, the debasement of paper money continues.

This article was previously published at Paper Money Collapse.

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26 replies on “What gives money value, and is fractional-reserve banking fraud?”
  1. says: Toby Baxendale

    Good Morning Detlev,

    I often get asked the same things. Like you I explain that money is subjectively valued by us like anything else.

    Re fractional reserve banking , I think the most of us who advocate free banking of either a 100% variety or a fractional variety will say subject to freely consenting parties agreeing to do what they want to do, so long as they do not harm / violate other peoples private property rights, bank as you wish. This could support a fractional reserve contract. There will be purist on either “side” who will not accept that position. These are very small in number indeed.

    I would encourage all look at our Public Attitudes to Banking survey of 2000 people which you can download here http://www.cobdencentre.org/2010/06/public-attitudes-to-banking/ , I wrote this

    “My take is that people are confused. 74% think they own their money, when of course they do not, the bank does. 15% want safe keeping and 67% want easy access. Easy access implies safe keeping to me as there is no access if you have a bank run. I do feel that clarity, more so than ever, is required to start the clearing up of this mismatch of understanding between what a bank actually does and what people think it does. This can only be resolved by a change in law as mentioned in this article. At the same time, our fractional reserve free banking colleagues may take comfort from our finding that 61% of those surveyed do not mind having their money lent out so long as the lending isn’t reckless. This strengthens the position of allowing FRFB between consenting adults. The debate will roll on. We hope this will add an empirical edge that will sharpen the focus of some of the best thinking Austrian economists.”

    I will add, contra what you think, only 8% do understand that they lend money to the bank when their salary cheque goes in, let alone their irreplaceable life savings.

    Lord Denning, surveying accommodation of commercial practice in English law: ‘You will find it said from the time of Lord Coke that the law so favours the public good that it will in some cases permit a common error to pass for right… communis error facit jus.’ Quoted as part of a fascinating discussion on ‘What makes a bank?’ in Commercial Law: Texts, Cases and Materials (1999) p558.

    I think the word fraud is a red herring . Our greatest common law lawyer of the 20th Century acknowledges that it seems we have allowed common error to pass as right with regards to banking.

    I think of it more as the common law offence of negligent misrepresentation as opposed to fraud . As when I bank at a bank, the numb nut that I speak to refers to my money, not my loan to him, his safe keeping for me, not his risk taking etc, etc. I don’t think he is fraudulent , just a numpty .

    Clear legal definition and an ability for those who want safe keeping services , for their money to be kept safe but still to be plugged into the international payments system is a big thing lacking in the system (a shoe box like some of the more wide eyed members of the fee embanking community suggest is not a satisfactory alternative). If people were told by their bankers, “when your money comes to us, as soon as it hits your account, you have loaned us money, would you like us to keep it in the safe (for this there is a fee of £x) or shall we loan it to Y borrower on a time horizon of 3,6,9,18,24,36,60 months with a return of interests of z, y,z getting bigger the longer the money is put out,” then we would have honest banking for sure and banking that could be free and not require any state support. The bank just needs to run itself like any other business matching its current assets with its current liabilities. I would support also being asked, “would you like to pool your property rights with others , so we can lend to such and such type of business with you in the knowledge we are doing this and we will be able to give you access if and only if we have the money to hand, otherwise the duration of payout is such and such a period of time .” This way, people know their property rights are compromised . They know they can have easy access , but it is subject to the money being there. I would silo this part of the bank, so if it explodes , it explodes into itself.

    You should also be aware, the ability to issues notes as bank liabilities was banned in 1844 in this country . Bills of exchange , at one point, until 1815 when they were taxed in 100’s of % more than notes , were a bigger part of the circulating money, by the late 1880’s these had become only relevant to the property they were issued as security against i.e. no ability to be fractionally reserved. Modern bills, invoice discounting , letters of credit and cheques are specific in regards to what property they relate to. The only thing thus far this has not happened to is demand deposits. I suspect that a fall out from the paper money crisis you write so eloquently about , may be a re thinking on the private property rights in a FR contract.

    With a expanding fractional reserve free bank, not a mature static one, you always have to deal with the fact that yes, as you say, it issues you with one type of purchasing power in exchange for another , but when it is expanding its balance sheet, it is counterfeiting in favour of its new receivers of this new purchasing power . THis I struggle to think how any liberty pro private property rights person like you can want to get involved with. But anyway, enough of this, as George Selgin says , we are all on the side of the angels and we should remember who the enemy is, the state and its central bank, in this battle of ideas.

    1. says: Robert Sadler

      Re fractional reserve banking , I think the most of us who advocate free banking of either a 100% variety or a fractional variety will say subject to freely consenting parties agreeing to do what they want to do, so long as they do not harm / violate other peoples private property rights, bank as you wish. This could support a fractional reserve contract. There will be purist on either “side” who will not accept that position. These are very small in number indeed.

      Hi Toby,

      Consider me a purist.

      I think the problem with allowing “freely consenting parties” to engage in FRB is that there are people who are harmed by FRB who have not given their consent. As you know, once the FRB process gets started it results in the boom and bust of the business cycle. By its very nature, FRB harms the property rights of other people, even if they do not bank with FRB institutions.

  2. says: David Howden

    Hi Detlev:

    I agree that FRB is not necessarily fraudulent. I do think it is erroneous to make the distinction you do between valeting your car and depositing cash. Of course a ticket to your car is not the same thing as having your car. Cash is no different in this sense as cash is doing its job by being deposited — it is by having your cash on deposit and on demand that your cash is serving you. By issuing fiduciary media the bank is compromising this role.

    While it may not matter in most cases, it most definitely does matter in some cases. Witness a bank run. You could just as easily turn your example with the valet around. Of course a ticket to your car is not the same thing as your car being held safe. That is because you are not sure when you are exciting and you want your car available when you return. Yet even if the valet used your car and returned it safely before you needed it their is still a problem. Such is the case with FRB.

    Otherwise, good post.

    1. says: Jose

      AGAINST FIDUCIARY MEDIA. HANS-HERMANN HOPPE. “As Hoppe (1994, p. 67) formulated it, ”two individuals cannot be the exclusive owner of one and the same thing at the same time.” This is an immutable principle; it is a law of action and nature that no contract can change or invalidate. Rather, any contractual agreement that involves presenting two different individuals as simultaneous owners of the same thing (or alternatively, the same thing as simultaneously owned by more than one person) is objectively false and thus fraudulent. Yet this, precisely, is what a fractional-reserve
      agreement between bank and customer involves.”

  3. says: Paul Marks

    On one specific point that Detlev makes he is clearly mistaken.

    This is the idea that under a system of gold-as-money (useing the term “gold standard” can mean just about anything – so avoid the term gold STANDARD) people do not care if they have actual gold or bits of paper.

    That is simply not true – people only accept the bits of paper, under a system of gold-as-money, because they think they represent actual bits of yellow metal.

    They may be totally wrong – after all the bits of paper may serve just as well as a “medium of exchange” (or whatever), but if the ordinary people actually knew that they were exchanging bits of gold for bits of paper (paper that did NOT actually represent actual gold) they would be filled with rage.

    Ditto with a system of silver-as-money or copper-as-money, or any other commodity. The notes are only accepted not because they are a good “medium of exchange”, but because ordinary people believe the represent physical commodity. If they do not – then a deception has taken place.

    On the comment and so on:

    Yes – most people do not know that they lend money to the bank, when they put it into the bank.

    For a contract to be valid the people making the contract should know what they have agreed to – that is why (for example) getting someone to “sign your autograph” and then declaring that they have signed a contract (because there was various stuff in addition to the bit of paper that they could actually see) does not work.

    The word “deposit” is used – yet money is NOT deposited (as it is with a safe deposit enterprise).

    So people are not being stupid – the very language that is used by the banks (and the courts), such as the word “deposit”, is designed to decieve them.

    That looks like intention to decieve (to defraud) to me.

    “But if the bank does not lend out the money it can not pay interest – in fact it would have to charge people for looking after their money”.

    Totally ture – I accept that.

    And if people want interest they must accept that banks will lend out their money – and accept the risk that the banks will lose the money.

    As for “fractional reserve banking”.

    Well if the “fraction” is more than the amount of REAL SAVINGS (for example “one hundred tenths”)then there will indeed be a boom-bust.

    No doubt about that.

    The question is would bankers indulge in such extreme antics without government backing?

    Not just without Central Banking – but without any government backing at all.

    For example, in 1907 there was no Central Bank in the United States – yet State governments rushed to allow banks to “suspend cash payments” i.e. BREAK THEIR CONTRACTS during the financial crises of that time.

    And the bankers knew in advance they would not be held to their contracts.

    If they (on the contrary) knew that they would be held to their contracts (regardless of the circumstances) bankers might act rather differently.

    Under a system of no government intervention what-so-ever fractional reserve banking (in the sense of more money being lent out than was ever really saved) might still exist – but it would be on a vastly smaller scale.

    It would be a matter of “cheating on the margins” – not an entire financial system that is actually a vast credit bubble.

    The other points in Detlev’s post (such as the true threat to the Euro not being the Greek or other default, but in the monetary expansion reaction to the situation) are well made.

  4. The whole argument as to whether FRB is fraudulent strikes me as a waste of ink and paper. The IMPORTANT question in relation to FRB is whether on balance it brings benefits. If it does bring benefits notwithstanding the fact that some lawyer can prove it is fraudulent, then it’s the law on fraud needs amending, not FRB that needs to be banned.

    I agree with Deltev that the state should cease subsidising FRB. Indeed if we converted to FULL RESERVE banking, that shouldn’t be subsidised either. However there is a slight problem there which is that the subsidy arises out of the understandable desire to ensure that financially not very astute depositors do no lose large chunks of their savings.

    I think the best solution here is to make depositors chose between 100% safe accounts, where their money is NOT loaned on by their bank, and second, “commercial” accounts, where their money IS LOANED ON, and where there is no state backing if the bank goes bust.

    That way, there is very little by way of subsidy. The 100% safe money is safe, and as to the “commercial” accounts, the state provides no guarantees.

    There is more on this “two account” system in this submission to the Vickers Commission:


    It is certainly an anomaly that if you invest in companies X,Y and Z via the stock exchange, there is no state guarantee if those firms go bust. But if you lend to or invest in those firms via your bank and it all goes belly up, the state rescues you.

    1. says: David Howden

      Hi Ralph:

      although not essential to the argument, the ¨fraudulent¨ argument isn´t without its own merits. By your own reasoning, if some lawyer proved that theft had some benefits, would the law need to be amended to allow for it? That is a pretty untenable case to make.

      FRB doesn´t have to be fraudulent, I am pretty sure almost everyone agrees with that. But that doesn´t mean that the argument in and of itself is not important, only that it only applies to a limit set of cases.

  5. Sir, you say a lot of things I share.
    I would be glad if you spent a little while in reading my writings; you will find some ideas in line with yours (link 1) as well as others even beyond your conclusions, which I would like you to pay a little heed to: why FRB is not a problem per se (tho’ it multiplies also central bank inflationism) in link 2; in what terms paper money is competitive against gold in link 3.
    • 1) a reasoning about the resilience of the euro against the Greek default
    • 2) an Austrian revision of Velocity
    • 3) an idea about Hayek’s concurrent currencies

    There is a point in your article I suggest you to “revise”: what you call “elastic supply” of money is actually “arbitrary supply” of money; the latter is the consequence of central bank interventionism, but the former is an endogenous feature of the monetary system which allows for the economy to autonomously create or shrink the amount of means of payment in circulation (if you give me the pleasure of reading link 2 you can understand my point that credit – here: a form of velocity – is how the economy can make money elastic for the sake of spontaneous coordination with no inflation involved).
    Moreover, critics of FRB form their judgment by considering the final result of credit and money circulation only, thus lose sight that this is not a crowd of simultaneous rights on the same limited amount of money or gold, but a sequence of credit rights in a chain which, as any other credit right, involve risks – and risk is no fraud.
    If we start share the V.L. Smith’s idea that money is essentially a way to book-keep favors, and cash is just a form (or a support) for it, your considerations will get strengthened.

    1. says: Robert Sadler

      Moreover, critics of FRB form their judgment by considering the final result of credit and money circulation only, thus lose sight that this is not a crowd of simultaneous rights on the same limited amount of money or gold, but a sequence of credit rights in a chain which, as any other credit right, involve risks – and risk is no fraud.

      The fraud is (in part) the implication that the money you deposit in a bank is being held for safekeeping purposes rather than as a loan to the bank. The average person has no idea that his deposit is subject to credit risk and arguably is not properly compensated for this risk. Furthermore, he is in no position to properly assess the credit risk and thus demand either a) proper compensation, or b) if he is depositing for safekeeping purposes, demand that his deposit not be lent out but held securely.

      “Any other credit right” as you put it, would not be structured in such a bizarre way. In a standard credit agreement, when the funds change hands, both sides are aware it is a loan, the ownership of the funds transfers to the borrower, the lender assesses the credit risk of the borrower and is compensated appropriately, and there is a maturity date for the loan.

      Last critics of FRB do not form their judgment in the manner you suggest but rather that is merely one issue, amongst the fraud, business cycle, inflation etc.

  6. says: Robert Sadler

    It is important to stress that the government does not and cannot bestow value on its paper money. This seems to be a widespread myth

    This brings to mind an experience I had in a British bank many years ago when Yugoslavia broke up. A teenager was standing at the cashier’s window trying to change some Yugoslav currency back into pounds. He was somewhat dismayed to hear that the bank would not accept the Yugoslav currency because Yugoslavia no longer existed as a political entity. There was no longer a Yugoslav government to provide legitimacy or value to the currency.

    Why are they valuable? For one reason and one reason only: Because others in society accept these paper tickets as a medium of exchange.

    This appears to be a circular argument. It begs the question, why do people accept paper tickets as a medium of exchange? The answer is simple: legal tender laws. Without such, nobody would accept paper tickets as money. Nowhere in history has paper money developed spontaneously on the free market. The conclusion therefore, is that government is necessary for valueless paper money to be accepted as a method of payment and thus, paper money derives its value from government.

    1. says: chuck martel

      An interesting and sad story but does it really prove the point? The management of the British bank refused to accept Yugoslav notes, not merely because of the demise of the Yugoslav government, but because they felt that those notes would eventually have no value among individuals. Fiat monetary systems are vulnerable to that sort of thing.

      1. says: Graham Hodgson

        Not just fiat money but all representative money. Consider if Yugoslavia had been on a gold standard and the bank notes represented and were fully backed by gold. The note was signed by Yugoslavia and enforceable against Yugoslavia – and no-one else. Once Yugoslavia ceased to exist the note ceased to have any value. Even though the gold still existed, there would be no-one to claim it from.

    2. says: Slim934

      I was thinking the same thing. The only reason people value it as a medium of exchange is because over time the government slowly co-opted the system. It moved from state monopoly that they still guaranteed, to monopoly that they sometimes did not honor, to monopoly that they no longer honor (insofar as the money is all fiat now).

      That process did not occur overnight, and it never could in reality. I also do not agree with the whole notion that the physical properties of the material do not make it a money. This strikes me as hogwash, because it is precisely the physical characteristics of the commodity which will determine what sort of use it will take in the economy. Are guns made of steel or bamboo? Steel. Why? Because from the perspective of engineering it has properties which make it useful for that function. Why are gold/silver chosen as a money historically? Because they have physical properties which make them most useful for those functions, and thus the market chose them to perform those functions.

      The easiest way to prove this point is to revoke all legal tender laws and allow a fully private market in money. My guess is that most people will settle on some currency standard backed close to 100% by a precious metal. Some fractional reserve banking would probably occur, but it would not be the majority unless banks were looking to become insolvent. Granted this would be contingent on 1) the state not protecting banks when this happens and 2) establishing clear language on what banks actually do with deposits and having that information communicated to their consumers.

  7. “Nowhere in history has paper money developed spontaneously on the free market.”
    Has ever existed a free market for money? Since 4000 bc I suppose no (I even think that no States are actually born on mere free consent of the inhabitants, I can see only leasing élites and use of force).
    There are traces that primitive societies were using shells as money… shells must have had soooo much value then. On the basis of history, will then free market create a bi-commodity (gold and shell) monetary system?

    If you carefully read Hayek you can find that there is room for free market to adopt more than one single currency, maybe two at the extremes of the “absolute inflation – stability of inflation” trade-off; one can be gold, the other is likely to be mere paper (or electronic… unbacked anyway) money (if the issuer rigidly follows a friedmanian k% rule, of course).

    1. says: Robert Sadler

      Shells are not paper.

      Even today, people use shells as jewelry. Similarly, it is likely that gold was used the same way before it became money.

      The free market will create money using any media that makes sense. I am writing a paper on this in which I will expand upon these arguments.

      1. Oh well… Japanese use (used?) to build houses of paper, and they still use paper to create nice objects like swans (I can do it too), cats and so on (Origami) which can be used as presents (so did I, and it was appreciated). Simply stating “Shells are not paper. Even today, people use shells as jewelry” does not sound so… relevant. And what about bits and bites, are they closer to paper or shells?

        1. says: Robert Sadler

          I am talking about paper money. You brought up shells.

          The point is that before a good can become money, it must have a nonmonetary value. This nonmonetary value, in the case of gold, was likely due to its use as jewelry. Obviously, other aspects are important as well, such as portability, relative scarcity, physical resilience. Paper lacks in the most important of these aspects which is why it would not arise in a free market.

          Houses built of paper? Are you sure?

          1. Yes, have you ever seen that japanese sliding paper walls?

            Anyway, this is the point I was going to: you are reasoning like money has to have an intrisic value before becoming money, but it is not necessary. You must have properties which allow you for using that thing as money such as physical resilience and portability and scarcity (i.e. no one can freely create new money by himself), properties gold has (beside it is really heavy).
            But no intrinsic value is necessary, the value of money is “being accepted as money”, is being object of a social convention. In Austrism money is an institutions and the value of institutions lies in the head of those who make use of it.

            En example: I do a work for a friend A and friend B makes a work for me, so I owe something to B and A ows something to me; to settle this I propose A to pay B or do another work for him, I write on a white paper “hello A, I am Leonardo, instead of paying me with gold for the work I’ve done, please do something for my friend B” and they accept. I have transfered my “credit” to B which has exerted it on A, I have used my credit as money: what intrinsic value has this credit, what intrinsic value in that piece of paper with my words on?
            I could choose to settle that relations another way: I give dollars to B which spends them to pay A who in turn pays me. The circuit is the same, the result is the same, and the intrinsic value of the paper dollar is not relevant – or we have to admit it has got the same relevant intrinsic value than the written piece of paper above.
            I have another way to go: I give a shell to B and say “give it to A, he knows he’ll owe you something”, A trusts in me, goes to B and receives gold or help for a work. Where is the intrisic value of the shell?

            Chinese invented silk money, as silk is easily portable and can stored for a long time. Today we have paper money with a central bank who – among a lot of lousy duties – re-prints deteriorated banknotes so to keep the quality of the banknotes in circulations. The physicality of paper money is no problem indeed.

            1. says: Robert Sadler

              OK but Japanese sliding walls are not houses built of paper. But I think we are going off the point…

              …you are reasoning like money has to have an intrinsic value before becoming money, but it is not necessary.

              I understand why you think this but it is not the case. It is not easy for me to explain in a comment. I will shortly be completing a brief paper that will outline my position. Keep an eye out for it.

              I am aware that medieval China used paper money, enforced on pain of death. Their experiment did not end well. But perhaps it will be different this time…

  8. says: Paul Marks

    Yes legal tender laws and the demand that the currency be used in payment of TAXES are the reasons that that fiat money is used – that and folk memory of the time it was not fiat (after all the terms “Dollar, Pound and Mark” used to refer to real things – weights of metal).

    Still the folk memory would not be enough on its own – it would collapse rather quickly without government support.

    Of course if people want to use bits of paper as money (perhaps because they are skilled in origami) I have no objection.

    Ralph’s point about how government support for FRB is there to protect stupid investors is, partly, self defeating.

    If FRB really is economically benificial (so benificial that we should overlook little things like deception) then government would not need to support it.

    It would function happily on its own (without government for the “suspension of cash payments” and so on) and the silly ordinary people would not lose their (our) money.

    Still I take the point about the public being uniformed.

    For example, how many people (who just take the msm reports on trust) understand that today’s British budget means an INCREASE in taxation on the wealthy?

    The increase in taxes on property are far greater than the cut in the top rate of income tax – and they are REAL (they happen NOW), whereas the cut in the top rate of income tax is just a promise for next year (a promise that will almost certainly be broken).

    I doubt that one in ten people (if one did a test tomorrow) would reply to a question “did the budget increase or decrease the taxation of the wealthy” by saying (correctly) “the budget increased taxation on the wealthy”.

    A society where only a small minority of people have any idea what is going on – even on the blatent things like a budget that was broadcast on national television, is unlikely to survive.

    Although most people are likely to notice the increase in taxation on smoking and (from August) on fuel.

    But will most people spot the real subsidies for the wealthy – such as the increase in the corrupt “export guarantee scheme” (and other corporate welfare)?

    I doubt it.

    Still back to FRB.

    Do not put bankers in prison for it – just UPHOLD CONTRACTS.

    So (under a system of commodity-as-money) the next time FRB banks get into trouble they CLOSE THEIR DOORS.

    No more “suspension of cash payments”, or “lender of last resort” or whatever.

    Of course if the FRB system really is beneficial the FRB banks will not (generally) get into trouble and will not close their doors.

    So no need for any argument.

    1. Goverment help and protection and lenders of last resort are not there to sustain a fiat paper money which otherwise would collapse, they are there to protect a banking system which has to work as a channel of monetary policy; goverments don’t care of the single bank bankrupt, but care of not losing a channel for their policies.
      Consider this: voluntary bank reserves are higher than the minimum required, this means that FRB is not binding, banks estimate they need a bit more reserves. As they are protected, they can have very little reserves on deposits, this means that protectionlessly (like any other enterprise) they would be forced to have higher reserves: 100% reserves is a possible result but not the only one, the same as only gold money is a possibile result but not the necessary only one.
      Free banking can work allowing for FRB, it’s market forces and the actual use of money and credit – the actual need for physical cash – to calibrate bank reserves.

  9. says: Paul Marks

    Of course the general “anti avoidence rule” and the threats of retrospective taxation, violate the rule of law.

    And that is something that even the most “value free” economist should be concerned about.

    After all – even Mr value-free economist himself (Ludwig Von Mises) was a rule utilitarian (not an act utilitarian).

    He understood that where there are no general rules (on contracts, taxation and so on) economic life is undermined.

  10. says: Chris Hulme

    Brilliant article, Detlev.
    In its most simplistic form, I cannot believe that fiduciary media, created out of thin air, is the same thing as real, commodity money.
    Despite FRB being around for 300 years, some people, maybe all of us, must be getting ripped off, even if we are unaware of the problem.
    Keep up the good work.

  11. says: Graham Hodgson

    “Today’s banknotes are, just like gold, assets that are nobody’s liability (in contrast to the electronic deposit money that is a liability of the specific bank that issued it and that will in fact disappear when the bank disappears).”

    In fact, UK banknotes are liabilities on the balance sheet of the Issuing Department of the Bank of England. The counterbalancing assets are the government securities that commercial banks must exchange for the central bank balances they need in order to purchase the banknotes for issue to their customers.

    “Everybody knows (or should know) that banks lend deposited money to third parties. How else would they obtain the income to pay interest on the deposited money?”

    This is not what happens at all. Deposits aren’t lendable but they make demands on the bank’s liquidity and, if created with the backing of a loan undertaking, expose the bank’s capital to default risk. What is really happening when a loan application is being considered is that the bank is deciding on the basis of its existing liquidity and capital constraints how much new endogenous money it can afford to create in the form of new deposits backed by new customer loan undertakings. It also takes account of the ease with which it will be able to borrow reserves from other banks to boost its liquidity. In the long term, it will also compete with other banks to induce customers to transfer in their accounts since, when an account is transferred to a new bank, the old bank must transfer an equivalent balance of reserves to the new bank, which is risk-free liquidity.

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