Lesson 7 of 9
One side, at full strength
A minority inside this school holds that fractional reserve banking is the root problem. Their argument is legal before it is economic.
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.
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In one minute
- The core claim is legal rather than economic: a deposit and a loan are different contracts, and treating a deposit as if it were a loan breaks the deposit.
- The economic claim follows from it. Claims created without anyone giving up present goods are what sets the cycle in motion, so the practice is the cause rather than an aggravating factor.
- The proposal is that demand claims be fully covered, which would leave lending to be funded by term contracts where the lender actually gives up availability.
This course has described what a bank does. This lesson gives the case that it should not be allowed to, as its own authors make it, without comment.
Two contracts the argument insists are different
A deposit
- The depositor keeps availability at all times.
- No term is agreed, because there is nothing to wait for.
- The essential obligation is that it is there when asked for.
- The depositor gives up nothing in the meantime.
A loan
- The lender gives up availability for a term.
- The term is the substance of the contract.
- The essential obligation is repayment at the end of it.
- The lender has genuinely done without.
Availability is the whole of the difference, and it is not a detail.
The legal argument
Huerta de Soto opens Money, Bank Credit, and Economic Cycles, published in Spanish in 1998 and in English in 2006, with a chapter devoted entirely to this point. He distinguishes the loan, the mutuum, from the deposit of fungible goods, the irregular deposit, and argues that the essential element of the second is continuous availability to the depositor.
On that reading a bank that holds only a fraction against demand claims has not made an aggressive loan; it has failed to perform the deposit. He traces the principle back through Roman law and argues the two contracts are incompatible at the level of their legal logic, so that one cannot quietly become the other.
Rothbard reaches the same conclusion in The Mystery of Banking, where he distinguishes loan banking from deposit banking and treats the warehouse receipt as the correct model of a deposit: the warehouse holds the goods, and issuing receipts for goods it does not hold is not a service it is entitled to offer.
The economic argument
The second half follows from the first, and it is where this lesson connects to the rest of the track.
When a bank creates a claim by lending, somebody can spend who could not before and nobody has given anything up. On this account that is the decisive fact. Genuine saving means somebody has done without, so resources are actually released for longer projects. Credit created by posting is not that, and the projects it starts are not supported by anything real.
The conclusion the authors draw is strong: the cycle is not a malfunction that better management could avoid, it is what this practice does, and no arrangement of central banking makes it safe.
What they propose
That claims payable on demand be fully covered, and that lending be funded by contracts in which the lender gives up availability for a stated term. Huerta de Soto's final chapter is a proposal along those lines.
This track states the proposal because it is part of the argument. It takes no position on it, and the next lesson is the reply from economists who find both halves of this case mistaken.
Check yourself
What is the core of this argument?
- That banks charge too much interest
- That a deposit and a loan are different contracts, and fractional reserves fail the deposit
- That money should be backed by gold
Show the answer
Answer: B.
Huerta de Soto's first chapter makes the essential element of the irregular deposit continuous availability, and treats the two contracts as incompatible in their legal logic.Why does the argument treat created credit differently from saving?
- Because it carries a higher interest rate
- Because in saving somebody has done without, and in created credit nobody has
- Because saving is recorded differently
Show the answer
Answer: B.
The claim is that only genuine abstention releases resources. Purchasing power created by a posting starts projects that nothing real is supporting.What do these authors propose?
- Higher capital requirements for banks
- Full cover for claims payable on demand, with lending funded by term contracts
- A single government bank
Show the answer
Answer: B.
The proposal separates the two contracts so that a lender genuinely gives up availability. Huerta de Soto's last chapter sets out a scheme on those lines.Sources
- Huerta de Soto, Money, Bank Credit, and Economic Cycles, Spanish original 1998, English translation 2006, chapter 1 on the legal nature of the monetary irregular-deposit contract, the distinction from the mutuum, the essential obligation of continuous availability, and the effects of failing to comply with it; and chapter 9, which sets out his proposal for a full reserve requirement.
- Rothbard, The Mystery of Banking, 1983, chapter VI on loan banking, chapter VII on deposit banking, warehouse receipts and fractional reserve banking, and chapter IX on central banking removing the limits a competitive system imposes.
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 next lesson is the reply.
- The $10,000 example is invented to show where the two readings of one contract diverge. It describes no bank and no product.
- The proposal here is a policy position held by these authors. Naming it is not endorsing it, and this track takes no policy position.