Lesson 8 of 9
The other side, at full strength
Economists starting from the same definitions answer the charge of fraud on its own ground: competing banks discipline each other, not a rule.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- The legal charge is answered on its own ground: on the title-transfer theory Rothbard built, a bank defrauds only where it misrepresents what it holds.
- Rivals do the disciplining. A bank that issues more than its customers want to hold sees the claims presented within days, long before the loan matures.
- Hence the sharp conclusion: claims issued to meet a greater desire to hold them are not the credit expansion the cycle theory is about.
The previous lesson gave the case that fractional reserve banking is the root problem. This is the reply, from economists who start from the same definitions and reach the opposite conclusion.
What happens to a bank that issues more than its customers want to hold
- Spending round 1 · four fifths lands at rival banks$40,000
- Spending round 2$8,000
- Spending round 3$1,600
- Spending round 4$320
- Spending round 5$64
The fraud charge, answered on its own ground
Selgin and White accept the title-transfer theory of contract that Rothbard built, and deny that the conclusion follows from it. On that theory a fraud is a failure to perform a transfer voluntarily agreed. So whether a bank commits one depends on what its contract says, and a bank that never claimed to hold full reserves has failed to perform nothing.
They add the more awkward observation. Both Block and Hoppe allow that a sufficiently explicit warning on the account would remove the objection. Allowing that concedes the practice is not fraudulent in itself, and moves the argument to what a deposit is commonly understood to mean.
What actually stops a bank expanding
The economic half, and it is old. Selgin calls it the principle of adverse clearings, traces it to nineteenth-century writers, and notes that Mises states it: a bank that expands while its rivals do not finds the balances at every clearing running against it.
The arithmetic above is why. Claims nobody wants to hold get spent, most of the spending lands at other banks, and those banks present them. Almost the whole issue drains back within a few rounds, far sooner than the loan comes due, and the bank has to contract or find reserves. The discipline is not a rule anybody wrote. It is the other banks, acting daily in their own interest.
Issue that somebody wants to hold
Now the sharp claim. Suppose people decide to hold larger balances and spend more slowly. The bank's claims reach the clearing house less often, and the drain that would have punished the issue never arrives. Selgin calls credit granted in those conditions transfer credit: the holders put off spending, and the bank lent what they put off.
On that reading an increase in fiduciary media matched by an increased demand to hold it does not push the market rate below the natural rate, which is the step the cycle theory needs. Selgin and White attribute monetary instability to central banking and other intervention instead.
The history, and the fight about it
Selgin's first chapter argues the record does not show unregulated banking failing. Canada before 1935 is his clearest case: no bank failure there at the start of the Great Depression, while thousands failed in the United States.
Scotland is contested. Rothbard's review of White's book disputes both that the Scottish banks were independent of the Bank of England and that they performed better, citing Checkland's history for repeated booms and busts. The dispute is unresolved, and a reader should know it is there.
Check yourself
How do Selgin and White answer the charge of fraud?
- By arguing that depositors accept the risk knowingly
- By applying Rothbard's own title-transfer theory, on which fraud requires a misrepresentation about reserves
- By denying that a deposit is a contract at all
Show the answer
Answer: B.
They accept the theory and deny the conclusion. A bank that never claimed full reserves has failed to perform nothing.What is the principle of adverse clearings?
- A legal limit on how much a bank may lend
- That a bank issuing more claims than its customers hold loses reserves to rivals presenting them
- A rule requiring banks to hold reserves at a central bank
Show the answer
Answer: B.
The claims are spent, most land elsewhere, and the other banks present them. The drain arrives well before the loan matures.Which issue does this side say is not the cycle theory's subject?
- Any issue by a bank holding less than full reserves
- An issue matched by an increased desire to hold those claims rather than spend them
- An issue funded by a central bank
Show the answer
Answer: B.
Selgin calls it transfer credit. The claims stay in their holders' hands, so the clearing drain does not arrive.Sources
- Selgin and White, 'In Defense of Fiduciary Media, or, We are Not Devo(lutionists), We are Misesians!', Review of Austrian Economics, volume 9 number 2, 1996, on the reply to the fraud charge from the title-transfer theory of contract, on the concession made by the warning-label proposals, on the three claimed effects on third parties, and on why an increase in fiduciary media matched by an increased demand to hold it is held not to be disequilibrating.
- Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue, 1988, chapter 3, on the rule of excess reserves and the principle of adverse clearings, including the schedule of clearing losses in the figure above and the statement of the principle he takes from Mises; and chapter 5, on transfer credit granted in response to an increased demand to hold a bank's liabilities.
- Selgin, The Theory of Free Banking, 1988, chapter 1, on the historical cases, including Canadian banking before the Bank of Canada was established in 1935.
- Rothbard, 'The Myth of Free Banking in Scotland', Review of Austrian Economics, volume 2, 1988, a review of White's Free Banking in Britain, 1984, disputing both that the Scottish banks were independent of the Bank of England and that they performed better than the English, and citing Checkland's history of Scottish banking for a series of boom and bust episodes.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- This lesson states one side of a live dispute as its authors state it. It is not the position of this track, and the previous lesson is the case it answers.
- The clearing schedule and the $10m example are round invented numbers, the first of them Selgin's own, chosen so the drain can be checked by hand. They describe no bank.
- White's Free Banking in Britain was not read for this lesson. It is named only as the book Rothbard's review reviews, and nothing above is attributed to it.
- Free banking is a policy position held by these authors. Naming it is not endorsing it, and this track takes no policy position.