Against the Welfare State – and Bank Bailouts

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The welfare state is undoubtedly one of the elements of government opposed by libertarians, not only due to its inherent injustice and economic destructiveness, but also because of its ability to provide fuel and sustenance to the growth of the metastasising state

If we are launch a critique of the welfare state we must first attempt to define it and to distinguish it from other categories of government activity. Such a task is not an immediately clear cut one as, fundamentally, all government expenditure sustains the welfare of its beneficiaries. If the government launches an invasion of a foreign country, spending on military grade weaponry, aircraft and whatever else will very much contribute to the “welfare” of armaments manufacturers yet we wouldn’t ordinarily classify this as part of the welfare state. Similarly, if the government decides to build a new road or railway line we wouldn’t usually describe this as providing “welfare” to the construction workers who undertake the leg work (although certain “job creation” schemes that simply pay people to carry out pointless work could be classified as welfare).

Whether or not a particular government outlay is classified as part of the welfare state is therefore defined more by its purpose rather than by its effect. The purpose of a foreign war is usually to gain control of valuable resources (even if it is veneered with an alternative justification such as spreading freedom and democracy). The purpose of building a road or railway is to “improve” the country’s transportation and communication networks. None of these projects is designed to provide some kind of comfortable lifestyle to those who undertake them (and, ignoring the possibility of benefiting favoured lobbyists and donors, to the extent that a government has a particular purpose in mind and wishes to achieve it efficiently it will have a desire to remunerate its suppliers as little as possible rather than as highly).

Welfare spending, on the other hand, is markedly different. Its purpose is always couched in the language of providing some kind of “help”, “care”, or “assistance” to the citizenry, as if the government is a giant nanny who appears with an equally giant milk bottle whenever one’s own teat runs dry. Given this, then, we can attempt to define the welfare state as that portion of government activity which is devoted to the sustenance of either the existing lifestyle of a particular citizen or to a lifestyle that is thought to be the minimum that is equitable in terms of wealth and income. The welfare state therefore provides a cushion or relief from events that may intercede in that lifestyle so, for example, if you get sick, the government will provide you with either free or subsidised healthcare; if you lose your job you will be entitled to unemployment benefit; and if you have baby the government will give you some money so that you are able to take care of it and give it an “adequate” upbringing. Granted, this definition if the welfare state is not precise and it will overlap with many other types of expenditure – few government outlays have a single purpose, even if some of these purposes are not made public – but we can be satisfied that it is reasonably accurate.

In spite of the fact that the welfare state is a moral issue and that its proponents believe that its existence is justified by the fact that the able should take care of the less able (“from each according to his means to each according to his needs”) it is arguable that the strength of its cause derives more from a misunderstanding of economics and that an amelioration of these misunderstandings is likely to weaken the foundations of the welfare state most effectively. Rather, therefore, than elaborating on the fact that the welfare state is, in a genuine free market, a morally unjustifiable confiscation and redistribution of property from its owners to non-owners respectively, let us concentrate mainly on a proper realisation of the economic effects of the welfare state in order to find the source of its undoing.

The type of welfare spending that we will focus on specifically is the bailout of the banks. This selection may appear surprising as surely most supporters of the welfare state are flat out opposed to bailing out the banks? And yet if we look closely, the qualities of bankers’ bailouts fits our definition of welfare spending all but perfectly. The financial services industry was accustomed to its business of expanding credit during the boom years and ploughing them into ultimately unsustainable malinvestments; its practitioners were richly rewarded for doing so and could afford big houses, expensive cars, private schools for their children, exotic foreign holidays, and so on. Metaphorically, they became accustomed to a lifestyle of gambling and partying fuelled by the punch bowl of monetary expansion. Following the inevitable crash that revealed the extent of the malinvestments and the huge losses that would ensue, the bailout of the banks was designed precisely to prevent the liquidation of this crumbling economic structure so that the banks could keep on making loans, keep on making profits from those loans, and so their top employees would not lose the lifestyle to which they had become accustomed. It was meant to refill the punch bowl and to keep the music playing so that the party would never end. The difference, therefore, between bankers’ bailouts and what we typically regard as the welfare state is simply a matter of degree, not of kind. They each provide a taxpayer funded cushion for their respective beneficiaries that insulates their lifestyles from the effects of either their own choices or from events that are beyond their control. Indeed, the collapse of the financial services industry as we know it would also have seriously curtailed the ability of governments to retain their accustomed lifestyle of borrowing and spending. To that extent, therefore, the bank bailouts were an exercise in self-preservation. The only perceived difference between bank bailouts and the welfare state is that the beneficiaries of the former were “rich” and not “poor”, which, it must be understood, is itself a misrepresentation. Many of those affected by a collapse of the financial services sector would not necessarily have been multi-millionaires as any insolvencies and downsizing is likely to have hit those lower down the pecking order first such as local branch managers and tellers before it hit those in the penthouse offices.

We have outlined this description of bank bailouts because every single argument that welfare statists use to oppose them are, in fact, the very same arguments that apply to their conception of the welfare state. We will therefore take each of these arguments in turn and show just how both bank bailouts and the welfare state, which are both a form of welfare spending, are economically destructive.

The first argument against the bank bailouts used by its opponents is that it creates moral hazard. In other words, if the banks can privatise their gains yet socialise their losses it provides an incentive to carry on and, indeed, augment the very destructive activity that was the source of the problem in the first place. All of this is true and we can have no quarrel with it. Yet it applies equally to the welfare state as well. Proponents of the welfare state imagine that if the government throws money at all of the events that manifest themselves as pitfalls in one’s own lifestyle then these pitfalls will simply go away. However if the government simply pays for a problem when it occurs then it creates as much of a moral hazard as the bank bailouts because all you have done is simply lowered the cost to individuals of bearing these pitfalls – and lowered cost leads to a swelled demand. If you pay people when they get sick, there will be more sickness; if you pay people when they are unemployed there will be more unemployment; if you pay people when they have children people will produce more children that need a roof and need feeding. The welfare state is not the solution to the problems it seeks to resolve; it is, rather, a fertiliser for their growth and proliferation, just as bank bailouts are a fertiliser for the growth of credit expansion, malinvestment and repeated boom and bust cycles.

The second argument against bank bailouts, related to the one we just outlined, is that it shoves the cost of the bad decisions of the bankers onto the shoulders of everybody else. Yet isn’t this precisely what the welfare state does? Welfare statists imagine that nearly every unfortunate circumstance in which people find themselves is not the product of their own making and that they are therefore blameless and should be (patronisingly) pitied – in short, that people do not bear any responsibility for their own circumstances. However, this is not the case with many of the issues that the welfare state attempts to address. As was argued in a previous essay on universal healthcare, the majority of medical ailments from which people suffer are not the unfortunate result of a random, illness lottery but are, rather, directly related to their environment and lifestyle – particularly diet, exercise and consumption of alcohol, tobacco and narcotics. If, therefore, people choose to pursue a lifestyle of eating gluttonously, exercising little and smoking and drinking heavily with this resulting in sickness, then if the government picks up the tab this simply forces the cost of these bad decisions onto everyone else. People, in most cases, choose to have children, or at least to engage in the intercourse that results in children – it isn’t a random, spontaneous event that appears out of nowhere to inflict itself upon people’s lifestyles. To the extent, therefore, that people cannot afford to raise these children properly and the government intervenes then the cost of other people’s bad decisions is again shovelled onto the shoulders of everybody else. But even those aspects of the welfare state that are not necessarily the fault of the individuals concerned – such as unemployment – is usually the result of government anyway. Low employability is caused not only by inadequate state education, but also government interference in the labour market such as minimum wages and excessive regulations that cause the cost of employment to exceed that of the productivity of the lowest skilled workers. Why, therefore, do welfare statists propose a government solution to what is a government created problem? Why not just get rid of the government created problem?

The third argument against bank bailouts is that they perpetuate what we might call a crony “corp-tocracy” where taxpayers’ money is siphoned off into the hands of the government’s favoured millionaire chums. Yet this is precisely the result of the welfare state also. Although the nominal beneficiaries of the welfare state are individual people, someone has to be paid in order to carry out the work of the welfare state. Not only does a welfare state require the creation and sustenance of a vast, leeching bureaucracy to administer it all but particular parts of the welfare state have to be contracted out to individual specialists. For example, public housing schemes need to find construction companies, hospitals need to find doctors and they need to purchase medicines from drug companies. The interests of these suppliers to the welfare state is to ensure that their compensation for carrying out their tasks is as high as possible; indeed, one of the reasons why the welfare state is such a burgeoning expense is because the disconnect between the consumer that pays and the supplier that is paid results in spiralling costs for the services of the latter, with the result that the majority of welfare spending goes not to the individual people but straight into the bank accounts of large corporations and contractors. Moreover, the welfare state is not usually a fixed pool of services that are provided by the government, but includes also private organisations and charities that lobby the government for money in order to solve the particular societal “problems” and grievances that they happen to have identified. Much of this money is simply wasted, as suggested by the recent collapse of Kids Company, a UK children’s charity, around a week after it received a £3 million grant from the government. Indeed, in the UK – when the chief executives of high profile charities are paid six figure salaries and they have been chastised for “aggressive” funding raising strategies that were recently attributed, at least in part, to the death of a pensioner – the substantive difference between a charity on the one hand and a corporation on the other is becoming increasingly questioned.

The fourth argument against bank bailouts is that they distort the economy, shovelling excess funding into the financial services sector and expanding their profits at the expense of other industries. Again, nothing about this is untrue and, indeed, as “Austrian” economists we would make an even more detailed case about how the resulting credit expansion distorts the consumption/investment ratio in order to result in unsustainable malinvestments across the entire economy. Yet the welfare state distorts the economy also, only in a more incremental and pacing manner. In the first place, the increased incentive caused by the welfare state to exacerbate the very problems it is supposed to solve, such as sickness and unemployment, reduces the capacity of the labour market and thus shrinks the extent of the division of labour that would otherwise have been possible. Second, the burgeoning cost of the welfare state caused by an artificially inflated demand for welfare requires more and more resources to be confiscated by the government in order to fund it. Thus, the areas of the economy that are devoted to providing welfare are swollen at the expense of other areas of the economy which must correspondingly shrink. Third, this is compounded by the fact that a large, government pot of gold encourages rent seeking behaviour, which in the case of welfare means (as we stated above) large numbers of special interest groups lobby the government each with a claim that they have identified some societal affliction that is ripe for resolution by government spending. Governments are eager to attract this kind of attention for more government spending means not only more power and prestige but also provides another outlet with which to bribe citizens with their own money when making election “promises”. The result of this, again, is that the total portion of the economy that is devoted to welfare spending is artificially inflated compared to what consumers would otherwise prefer.

The final argument against bank bailouts that we will consider is that they create a feeling of bitterness and resentment in the general population, a fissure of hate, contempt and distrust between the bankers and the people whom they supposedly serve. Again, all of this is true. However, it applies just as readily to the welfare state. Its proponents usually justify the imposition of the welfare state by stating that it is morally good for us to care and look after one another as if we are all one big family. This may be true enough, but the welfare state does not create that situation. In order to become a morally better person I have to choose to care and to look after my fellow man – I have to decide to do it voluntarily. I am looked upon with admiration because in spite of all of the personal luxuries I could have spent my money on, I willingly deprived myself of them and was happy to give the money to a person in need. The welfare state, however, does not give me any choice in this regard – it just forces me to do it regardless of what I want. The action, therefore, is not as the result of any personal sympathy or empathy for the plight of the less fortunate, nor of any aspiration to moral heights. Instead, the void left by an absence of sympathy and empathy is likely to be filled by bitterness and resentment as my hard earned money has just been confiscated from me to go to people who I believe may not deserve it, particularly if it goes to some cause that I may disagree qualifies for welfare spending (such as breast enhancement surgery on the NHS or unemployment benefits to those who are just workshy). The welfare state therefore creates the opposite of any charitable feeling whatsoever and destroys any notion of brotherhood or family. When this is coupled with the welfare state’s encouragement of the afflictions it seeks to solve then the result is a society with a lower, rather than higher, moral standing. This is exacerbated by the interdependent relationship between bank bailouts on the one hand and the welfare state on the other. Bank bailouts mean that the banks take the money of the taxpaying public and plough it into assets so that the income of anyone who owns these assets – i.e. the bankers themselves – is swollen while the incomes of those who do not stagnates. The resulting price inflation lifts the affordability of assets such as houses and basic necessities, such as food, out of the grasp of those on low incomes. The consequence is another artificially swollen demand for welfare to give ordinary people somewhere to live and something to eat. Thus, the poorest in society demand increased taxes on the rich – i.e. the very bankers who were bailed out – in order to fund increased welfare spending. The result, therefore, is a toing and froing of mutual theft, a circle of robbery where bankers demand taxpayers’ money to continue their casino operations, after which everyone else demands some of it back to ameliorate the resulting effects. Far from being a moral and harmonious society all we end up with is hating each other and trying to grab whatever we can out of each other’s pockets.

What we can see from this brief comparison of the welfare state to bank bailouts, therefore, is that there is very little qualitative difference between the two and that the arguments that are used to oppose bank bailouts apply just as easily to the welfare state. The amelioration of welfare demand is achieved not through the redistribution of a fixed pool wealth but through the raising of real incomes by increasing the productive output per person. In order to achieve this we need to eliminate both the bank bailouts and the welfare state so that we can return to a genuine economy where everyone serves each other rather than engages in mutual plunder. The rich would have to earn their wealth by directing and increasing the productive capacity of the economy to best meet the needs of the consumer; the poor earn their money by providing the labour to bring about this direction, with their wages being able to buy more and more goods as a result of the increased output. Not only would this create a more prosperous society where poverty has truly been consigned to the history books, but the vanquishing of hatred, resentment and antagonism would create a morally superior one too.

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Fractional Reserve Banking – The Ethics and Economics

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Fractional reserve banking is a prime topic for study on the part of libertarians on the one hand and of “Austrian” economists on the other. For not only is the practice, in the way it is carried out today, deeply unethical it also creates macroeconomic instability and is one of the causes of economic crises such as that which we are enduring currently. This essay will explore in particular the ethical and economic consequences of the legal framework imposed by government fiat that breathes life into this practice, concluding that it is government that is at the heart of its unethical nature and causes the endurance of its bad effects.

What is Fractional Reserve Banking?

A bank engages in fractional reserve banking if it retains as reserves only a fraction of its liabilities that can be redeemed on demand – most often, this means money that is held in current or “checking” accounts where you are entitled to withdraw your money at a moment’s notice. If customers have deposited in the bank £10 million of cash and the bank’s reserve requirement (or its internal practice, depending upon the regulatory regime) is 10% then the amount of cash held by the bank for withdrawal by those customers is a mere £1 million. This may be easier to visualise when deposited money consisted not of paper but of gold and other precious metals. When you deposited your gold in a bank, you were issued with a paper warehouse ticket stating the amount of your deposit (say, 10oz) and the fact that you were entitled to withdraw it on demand. If your bank engaged in the practice of fractional reserve banking then only a portion of this gold would actually be in the bank ready for you to withdraw. Incidentally, these warehouse tickets were the origin of paper money – a £10 banknote issued by the Bank of England still states “I promise to pay the bearer on demand the sum of £10”, £10 originally meaning 10 pounds in weight of sterling silver. Indeed, all of the monetary denominations such as pounds, dollars, francs and marks were originally fixed weights of precious metal. These days, of course, the note is backed by no commodity whatsoever and statements of account at banks merely indicate a promise to pay the sum stated in paper money which has, to all intents and purposes, replaced metals such as gold and silver.

The obvious question, then, is where on Earth has this money gone? If it is not in the bank then where is it? And more importantly, why is it not in the bank? Have the bankers taken your money and used it to purchase luxury consumption goods, hoping that you will never come back for it? Not quite; the answer is that the bank has loaned the money to borrowers, usually for the long term to people who wish to take out a mortgage, for example, in spite of the fact that all of the bank’s liabilities are payable on demand. In this practice of “borrowing short to lend long” the bank takes a gamble that two conditions will be met. First, that it will only ever need the fraction of deposits kept as reserves in order to meet the number of withdrawals by its depositors that are likely to be required at any one time; and second, that a sufficient number of the borrowers will pay back the money that has been lent out. The primary motivation for this is, of course, to earn interest on the sums lent. This is why most banks do not charge their depositors a fee for their services – they are using your money deposited to earn an income from other people.

Fractional Reserve Banking – Fraudulent or Legitimate?

The question of whether fractional reserve banking is fraudulent is a matter for debate in libertarian circles. Could not, for example, two persons agree to engage in the practice? If I know, for example, that my bank will only keep a fraction of the money as reserves and I know it is at risk of the bank’s insolvency then is there any breach of the non-aggression principle?

The answer to this question lies in the consequences of the terms upon which such an arrangement could be made and the also in the legal and regulatory context. There are two basic possibilities; either one’s deposit of money in a bank is a bailment, in which case the bank acts as a custodian of your money (like a warehouse or storage facility); or, the deposit takes the form of a loan to the bank and the bank is simply your debtor. In the former case, you retain proprietary title to the money and it is ring fenced from the bank’s own assets. If the bank goes bust then its creditors cannot get their hands on your money. Your bank statement is not a statement of account but, rather, an inventory of property deposited in the bank for safekeeping. In this scenario, but for one important qualification that we will mention below, the statement of account (or the warehouse ticket for gold deposits) is defined as the cash on deposit – in other words, it is the same thing. That is why people accepted paper tickets in trade when they were titles to gold. These transactions are not payments of money at all; they are transfers of the bank’s obligation to redeem cash on demand from one person to another. Because the obligation to pay is a full, proprietary title the transfer of this obligation is as good as the cash itself. Under this banking arrangement, fractional reserve banking would be fraudulent. If the bank loans out the money to a third party then it is required to grant full proprietary title over the money to the third party debtor in exchange for a promise to pay back the sum lent once the maturity date of the loan is reached. But the bank cannot legally divest itself of a title that is not in its possession. In essence the bank would be selling property which it does not own. It is exactly the same as me purporting to sell your house or your car to someone else and pocketing the cash – or a storage warehouse loaning out the furniture that you have deposited there for safekeeping. In practice, what happens is that the bank creates two simultaneous titles to the cash on deposit – one for you as the original depositor and one for the borrower. Both of you are under the delusion that you have exclusive title to the cash on deposit whereas in reality it could be claimed by the other person. In the second case, however, where the deposit takes the form of a loan to the bank, if this is agreed and understood by both parties in a genuinely free legal and regulatory environment then all well and good – there is certainly no breach of the non-aggression principle for libertarians to complain about. If the bank goes bust with it goes any claim to your money. However, one important aspect is that what is now in the depositor’s possession – a mere promise that you will receive payment in cash on demand rather than a full, proprietary title to cash – is a markedly different good from cash or a proprietary title to cash. Hence, we are now talking about two different goods – money on the one hand and a loan agreement on the other, something that is below the quality of money as the most marketable commodity. While it therefore may be a perfectly legal arrangement and people may be able to trade these loan agreements in exchange for goods and services (as we do today when we make electronic transfers) we would expect a loan agreement to trade at a discount compared to real money. Should this be doubted, even under full reserve banking the paper ticket to warehouse deposited gold was regarded as a distinct commodity by the trading public; when gold coins were stamped with a dollar value equal to the dollar value of a paper ticket, even though redemption of that paper ticket would guarantee payment of the same dollar value in coin, Gresham’s law came into effect and the paper tickets were traded while the coin was hoarded1. Under a system with genuine market pricing, therefore, we would expect warehouse receipts to gold to trade at a discount compared to real gold. If this is so then clearly loan agreements – far less secure than 100% warehouse receipts – would trade at a discount even lower than this.

All of this would be fine from a libertarian point of view and nobody can stop anyone else from accepting loan agreements freely in exchange for goods and services if that is what they want. The problem with today’s banking system, however, is that there is no genuine choice between these two arrangements. The fact that in today’s world “everybody” uses fractional reserve banks and “everybody” generally accepts mere loan agreements in settlement of debt without a premium does not mean that this arrangement has the full, unbridled consent of the public. First, legal tender laws force the public to accept as payment the government’s own monopoly brand of money and are unable to consider alternative media of exchange. Second, under the guise of “anti-money laundering” (in other words to try and stop drug traders, “terrorists” and other underground operations that are of the government’s own creation) the legal and regulatory regime has all but abolished cash transactions of any significant quantity, thus forcing people to direct their financial needs through banking institutions. Third, government schemes such as the Financial Services Compensation Scheme in the UK or Federal Deposit Insurance in the US (which basically means that the taxpayer is forced to foot the bill if the bank loses your money) provide a positive incentive to use these banking institutions and prevent either the hoarding of cash by the public or any “maverick” banker from splintering away and establishing a full reserve bank2. Fourth, these institutions have been completely cartelised under the aegis of the central bank, meaning that the only institution available for people to use for their banking amounts to little more than a single, fractional reserve bank splintered off into different brand names such as HSBC or Barclays in order to give the illusion of competition in the banking industry. Indeed, the force of government, either in the form of direct enforcement of fractional reserve banking or by forcing the taxpayer to bail out the consequences, has always been required to sustain the practice for any extended period of time as genuine competition between freely standing banks has always restricted their ability to issue large quantities of unbacked notes. The precise effectiveness of this point is debated between “Austrians”. The Mises-Rothbard orthodoxy emphasises that competing banks will swiftly call upon each other for redemption in the event that one bank takes possession of another’s notes. For example, if I deposited gold at Bank A and received for it a paper ticket stating that I had gold deposited in Bank A, I could use this paper ticket to buy goods and services from, say, a grocer. But if the grocer banks at Bank B, he will deposit my note from Bank A with Bank B, but Bank B will call upon Bank A to redeem its note in gold. Hence Bank A would be restricted from over issuing unbacked notes as whenever they fell into the hands of the customers of other banks those other banks would call upon Bank A for redemption in gold. Mises, moreover, also emphasised that the bank’s reputation with its own customers for being able to meet redemption on demand was a decisive limit upon the expansion of unbacked notes3. However, when all banks are issuing the same notes everywhere, with all gold deposited centrally in a monolithic bank (or no gold at all, as under our current regime) then this clearly isn’t possible and all banks would be able to expand together in concert. Later writers, however, have pointed out the importance of interbank lending in neutralising the effectiveness of banking competition, with banks that have over-issued notes borrowing from banks that are under-issued in order to meet redemption demands. In other words banks will not necessarily call upon each other for redemption and will seek instead to earn an interest profit through mutual lending4. However, all we need to conclude here is that people today do not have a genuine choice as to whether they should meet their financial needs through fractional reserve banks. We can, though, still see the difference between payments in cash and other methods of payment in certain limited circumstances. Debit and credit card payments are inherently less secure than hard cash and the risk to the merchant is that the card issuing bank will not honour the transaction after the customer has left with the goods – in just the same way as a deposit bank may be unable to honour a paper ticket to warehouse deposited gold. Acquiring banks and card issuers therefore levy a charge upon merchants in order to guarantee – or at least improve – the security of the transactions and some merchants pass this charge on explicitly to their customers as an additional fee. This results in two prices – a lower price for payment by cash and a higher price for payment by card. It is reasonable to assume also, therefore, that given a genuine choice people would also regard hard cash and deposits in fractional reserve banks as distinct goods of different value. Finally, if the lack of genuine consent of the public in using fractional reserve banks should be doubted, then try asking any banker whether he would be prepared to look his customers in the eye and tell them their money is not really in the bank. The experience of the present author suggests that this is enough to close a debate on the matter with bank employees who actually know how the system operates.

All of this suggests that people do not wish their banking arrangements to be managed with fractional reserves, given a genuine choice. Indeed the entire backbone of Mises’ thesis in The Theory of Money and Credit is that money and what he called “fiduciary media” (notes issued unbacked by gold) are distinct concepts and where people trade fiduciary media at a par with money or backed notes they only do so because they believe that they are not fiduciary media and are, instead, fully backed notes with redemption on demand all but certain. Something to pull the wool over the public’s eyes is needed in order to achieve this. In our world today it is the force of government sustaining fractional reserve banking and compelling people to use it which is the illegal and immoral element. This should be the focus of libertarians in their moral opposition to its practice.

Fractional Reserve Banking and Economic Instability

In addition to the moral element concerning fractional reserve banking, the practice in the way it is carried out today is also economically destabilising. As we know from “Austrian” Business Cycle Theory, the creation of credit that is not supported by any real saving forces the economy onto a path of malinvestment that must collapse once the credit creation stops. Fractional reserve banking is the primary method through which this credit creation occurs. Nevertheless, once again this issue is intricately connected to the legal and regulatory framework in which fractional reserve banking operates and it is this factor that will be emphasised in the treatment below.

Let us posit a first scenario where banking consists of deposits of gold and precious metal in exchange for paper warehouse certificates, certificates that are a legal title to money and do not represent merely a loan to the bank that would permit the latter to do with the gold whatever it likes. If, therefore, A deposited 100oz of gold in a bank the bank would issue a 100oz paper ticket to A and the gold would remain locked up in the bank’s vault ready for A to come and collect at a point in the future when he deems fit. In this instance 100z of gold in the economy has been replaced by a warehouse ticket to 100oz deposited in the bank When this ticket is used and accepted in trade it is “as good as gold” and people will trade the paper as though it was gold, although, as we noted earlier, with the possibility that it may trade at a minor discount compared to the real thing. At this point, the money supply has not altered; rather 100z of money proper has been replaced by a 100z “money substitute”. In this environment, if the bank engaged in fractional reserve banking it would print new paper tickets which represent full, legal titles to gold without any corresponding increase in gold on deposit in its vault – in other words, pure fiduciary media, in Mises’ terminology. Let’s say that the bank lends an unbacked 100oz ticket to a borrower, B. There is now, therefore, 100oz of gold deposited in the bank but 200oz of paper tickets that can be exchanged in trade. The supply of equally homogenous money substitutes that are deemed to be as good as money and are traded as money has therefore doubled. This method of fractional reserve banking (which, we might recall, is also the fraudulent one) will therefore cause economic instability and lead to the business cycle as it has channelled a new supply of money unsupported by real saving through the loan market. The new supply will lower the interest rate on money and will incentivise borrowers to invest in longer term investment projects than are sustainable under the pool of available savings5.

Let us now examine a second scenario where banking does not consist of deposits of gold and precious metal in exchange for paper warehouse certificates but, rather, gold is deposited on loan to the bank that is redeemable on demand. The money is legally the bank’s to do with whatever it likes but the lender may call for redemption at any time, taking the risk that the bank may not have sufficient reserves to meet the redemption. Furthermore let us assume that this arrangement is entirely voluntary and agreed to, with no government impetus or the force of law compelling its use. If A therefore makes such a loan of 100oz to the bank he will receive a paper ticket or a statement of account stating that he has loaned money to the bank that is redeemable on demand. A may be able to trade these “loan agreements” either in paper ticket form or electronically – either way it doesn’t really matter as both would be a transfer between individuals of the bank’s obligation to pay. 100oz of gold has been deposited in the bank and a 100oz loan agreement has been released into the economy. If the bank now engages in fractional reserve banking and makes a loan of 100oz to B by creating out of thin air another paper ticket (that in and of itself constitutes only a loan agreement and not a proprietary title to hard money), we now have 100oz of gold still in the bank but 200oz of paper loan agreements to gold issued in the economy. On the face of it, it would again appear as though the money supply has expanded through credit creation. Wouldn’t this lead to economic instability and ultimately to the business cycle? However, this is unlikely to be the case. For the crucial aspect in starting the business cycle is that the interest rate on money is lowered through people’s inability to perceive money that represents genuine savings and money that has been created out of thin air. In this case, however, it is possible to distinguish between money proper and mere loan agreements to money that are redeemable on demand. An expansion of the latter does not lead to an expansion of the former. While the “interest rate” on the loan agreements may fall as a result of the their expansion, so too would their discount compared to money proper as the increasing abundance of these loan agreements makes the security of redemption less likely. The effect of the increased discount would be raise production costs to borrowers which would offset the reduction of interest rate and prevent the business cycle from occurring.

Let us now fast forward to the situation that we have today. Now, the paper ticket itself has replaced gold as the item that is deposited and as we stated above everyone is either forced or cajoled into using fractional reserve banks under the aegis of a single, central bank. The expansion occurs through the increasing of deposit balances on account – i.e. the numbers on your bank statement. If you deposit £100 worth of Bank of England notes in your account you can transfer the bank’s obligation to pay electronically. If the bank then creates a loan out of thin air by creating another deposit account, both you and the borrower then have the ability to spend these digits in the economy. But, unlike the difference between money proper and mere “loan agreements” that was plainly obvious in the second scenario we explored, here, nobody knows which of the digits being spent represents genuine savings and which have been conjured out of thin air. Hence, the interest rate on money will fall, longer term investment projects will be stimulated and the business cycle begins with its “boom” phase.

It could be alleged that the inherent instability of this arrangement could be countered with the “prudence” of the banker – the idea that an expert fractional reserve banker will be able to loan wisely to only those borrowers who are most trustworthy and will keep on hand enough reserves to meet redemption requirements. This is beside the point. Apart from the fact that it is the least prudent bankers and borrowers who post the highest profits during the boom phase, leaving any conservatives way behind, the fundamental problem for economic stability is that no inter-temporal transaction has occurred – in other words there has been no a trade of present goods for future goods. In normal saving and lending, in order to make loan to the borrower for, say, one year the lender must save for a year. The lender in this instance has given up consumption for one year and freed real resources in the economy to the borrower so that the latter may use these resources in an investment that will come to fruition at the maturity date of the loan in one year’s time, allowing the borrower to pay back the loan to the lender so that the lender can then purchase consumption goods that have come into existence as a result of the borrower’s year-long investment. This is what makes real, sustainable economic growth possible – the harmony of temporal interests over goods between those with short time horizons and those with long. With fractional reserve banking, however, no such harmony exists. The lender – that is, the depositor – does not want to relinquish consumption for a year. He maintains his cash balance in a demand deposit account because he wishes to call upon those funds for current consumption and not consumption in one year. He may, of course, leave the funds in his deposit account for a year but the crucial point is that at the outset this is not certain – he wants to be able to call on consumption goods at a moment’s notice when the time arises. The borrower, however, wants goods that he can invest for a yearlong production process, tying up those goods for that duration until the project comes to fruition. He cannot accept goods that someone else will want back in a shorter time. It is clear that both individuals cannot have their way and that one or the other must ultimately triumph because the same resources cannot be simultaneously consumed and invested. During the boom phase when credit expansion rises, it is the borrower who wins as his increased purchasing power allows him to purchase the resources and invest them in capital goods – hence there is, during the boom phase, a marked price inflation of capital goods as these borrowers take advantage of their newly found purchasing power and a relatively weaker price inflation of consumer goods as the latter become more scarce relative to the demands of consumers. Once the credit expansion stops and starves the borrower of fresh purchasing power, however, it is the lender’s preferences that rule the roost. Either the lender must be prepared to start saving and thus provide the resources to complete the borrower’s investment projects; or, if he is not so prepared and maintains a preference for consumption, then the borrower’s investments must be liquidated. Hence, in the bust phase we experience a heavy price deflation of capital goods as they are hastily sold off and a weaker, relative price deflation in consumer goods buoyed up by the fact that these goods are still in demand.


What we can see from all of this is that the destabilising effects of fractional reserve banking on the one hand and its illegal and immoral aspect on the other are two sides of the same coin. The fact that people do not know which units of currency in existence represent real, genuine savings and which have been conjured out of thin air as fiduciary media is the essence of both the fraudulent  and destabilising nature of fractional reserve banking. The government in bed with a monolithic banking system pulls the wool over everyone’s eyes for their own enrichment at the expense of wasteful malinvestments during booms, followed by unemployment, misery and taxpayer funded bailouts during busts. It is high time that the public realised the true nature of their fractional reserve banking system and anyone who cares for liberty is right to emphasise its odious nature.

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1As Ron Paul has suggested, it was this that resulted in a withdrawal of gold coin from circulation and its concentration as deposits in banks that made it easier for governments to confiscate them. It is for this reason that both Paul and, earlier, Mises urge the need for gold coins to be used physically in transactions. See Ron Paul, “The Political Agenda for the Real Gold Standard”, Ch. 7 in Llewellyn H Rockewell, Jr. (ed.), The Gold Standard – Perspectives in the Austrian School; and Ludwig von Mises, The Theory of Money and Credit, Part Four, Chapter III, “The Return to Sound Money”.

2We can also suggest that, as per Ron Paul’s analysis cited in note 1 above, that as electronic transfers and paper notes bear the same legal value, Gresham’s law comes into effect and the paper notes are stashed away in banks while electronic digits are traded.

3Ludwig von Mises, Human Action, The Scholar’s Edition, p. 436.

4See, for example, Nikolay Gertchev, “The Inter-bank Market in the Perspective of Fractional Reserve Banking”, Ch. 10 in Jörg Guido Hülsmann (ed.), Theory of Money and Fiduciary Media – Essays in Celebration of the Centennial.

5This expansion of credit is not likely to last for very long in a competitive banking environment that lacks deposit accounts. Not only, of course, could overexpansion call for redemption of the overissued notes in specie, but soon the economy would clearly be awash with paper tickets which reveal that something is amiss. Central banking, abolishing competition, would be needed to sustain the expansion of note issue and electronic transfers between deposit accounts would be needed to hide the expansion from plain sight. Ironically, therefore, monetary expansion or “printing money” these days involves a contraction and not an increase of circulating paper notes. As a note of historical interest, Peel’s famous Bank Charter Act of 1844 failed to control economic instability because, following the otherwise insightful Currency School of thought that was prevalent at the time, it concentrated only on banknotes and overlooked the role of deposit accounts in expanding the money supply.