Wednesday, 16 April 2014

Prof. Lawrence H. White’s flawed defence of fractional reserve.

In this article, entitled “Accounting for Fractional Reserve….”, Prof White tries to defend fractional reserve. He essentially makes two points in his opening paragraphs, as follows.
1. If fractional reserve is so defective, why is there no big demand for full reserve accounts or accounts where money is simply warehoused rather than loaned on?
2. The popular argument against fractional reserve namely that it is fraudulent looks silly in view of the fact that fractional reserve has been going for centuries, yet there is no widespread perception that it is fraudulent. That is, how on Earth did bankers manage to keep secret the fraudulent nature of fractional reserve, or as he puts it “How on earth did the bankers keep the word from getting out?”
The simple answer to the first point is that the basic reason for wanting a “warehouse” account is that it avoids the risk involved I having one’s money loaned on or invested by a commercial bank, and there is a HUGE DEMAND for accounts where money is not loaned on by a commercial bank. In the UK there is National Savings and Investments, where no less that A THIRD of the entire UK population have an account. And in the US there are money market mutual funds which invest just in government debt.
It’s truly amazing that Prof. White (and Prof. George Selgin who White quotes in support of his views) don’t seem to have noticed Britain’s NSI or American money market mutual funds.
Of course you could argue that the latter two types of account are not true “warehouse” accounts in that money is not simply warehoused: it is loaned to government. But that is immaterial. To repeat, the basic attraction of a warehouse account is the SAFETY it offers. Now if government is daft enough to offer 100% safety combined with interest (all paid for by the taxpayer) then why not take advantage of the offer?

Risk spreading.
In short, the popularity of Britain’s NSI and American money market mutual funds is clear evidence of something which is no more than a very boring statement of the obvious, namely that most people want to spread their risks. That is, while most of us are happy to take high risks with a small portion of our wealth (e.g. bet on a horse or a roulette wheel or invest a small amount in say a dodgy Australian gold mine), we also want to keep some of our liquid wealth in a very safe form.
So if government didn’t offer 100% safe accounts which offer interest, you can be sure there’d be significant demand for 100% safe accounts which offer NO INTEREST. Indeed for the last four years or so, the average checking or current account in the West has offered a zero or even negative real (inflation adjusted) rate of interest.

Deposit guarantees.
Incidentally, the whole picture here is muddied by the existence of taxpayer funded deposit guarantees (up to £85,000 in the UK). That is, the above mentioned and supposedly “risky” commercial bank accounts are not risky in the sense that taxpayers foot the bill when they go wrong. The best way round that problem is to assume that we’re talking about sums over £85,000 or to imagine that we’re dealing with a genuine free market: that’s where there is no taxpayer funded guarantee.

Let’s now consider White’s second main point, namely that if fractional reserve was fraudulent, the word would have got out by now.
The first problem there is that White doesn’t tell us what the alleged fraud actually is. Instead, he refers us on his first page to about ten books and articles which apparently set out the fraud. Now is anyone is going to plough thru that lot to find out what the fraud is?
Second, given the number of works he cites that apparently set  out the fraud, it’s unlikely those works all agree with each other. Indeed, there are several popular “fraud” charges made against fractional reserve and I personally don’t agree with some of them.
It’s thus near impossible to deal with his claim that for fraud to exist, someone must be duped. Reason is that there are all degrees of “duping” from slight misrepresentation to serious and carefully thought out fraud. And the extent of misrepresentation doubtless varies depending on which of the fraud charges levelled against fractional reserve one is considering.
Anyway, as a second best, I’ll consider White’s arguments as they relate the basic fraud that I personally think lies behind fractional reserve, which is thus.  
A fractional reserve bank promises to return to depositors the exact sum deposited (maybe plus interest and maybe less bank charges). But of course the flaw or fraud there is that the money is loaned on or invested by the bank and that involves the risk that the loans or investments go bad. And sure as night follows day, once every twenty or thirty years the loans do go wrong, and the bank can’t repay all the money they owe depositors.
So how much fraud or misrepresentation takes place there? Well you certainly don’t find commercial banks advertising the fact that there is a one in twenty or thirty chance of depositors losing their money! Quite the reverse: their publicity normally includes claims like “Your money is safe with us”.
Of course the contract governing an account at a typical bank, the small print in particular, may say something different. But that’s near irrelevant. The typical bank customer does not read the small print  - and probably wouldn’t understand it if they did. It is thus indisputable that banks are guilty of a certain amount of misrepresentation or to put it more strongly – “fraud”.

The rest of White’s article.
Given that White goes badly wrong in the first 500 words of his article, I can't summon up the will to read the remaining 15,000 or so words. Life is short. The rest of the article is concerned with some obscure arguments against fractional reserve put by Jörg Guido Hülsmann. But if there is anything inspiring in those 15,000 words, I’d be grateful if anyone can tell me what it is.

P.S. (17th April 2014). Another flaw in White’s argument is thus. He argues that full reserve banks have been non-existent or nearly so thru history, ergo there is no economic case of them.

Now that would be a valid argument if real world free markets were perfect markets or nearly so. The reality however is that the authorities thru history have never had good control of dishonest bankers. And as for the levels of criminality over the last ten years amongst bankers, that has reached record levels.

Now if you face the choice between a bank offering you interest and an ostensibly honest bank offering you zero interest combined with 100% safety, there is little reason to trust the latter. That is, the reality is that you face a small chance of losing your money whatever you do, so you might as well plumb for “small chance of total loss plus interest” rather than “small chance of total loss with no interest”.

That certainly helps explain the scarcity of full reserve banks thru history.



  1. Britain’s NSI and American money market mutual funds may well be very safe. But they do not provide normal banking services (eg. ATM, checking and debit/credit cards). So the popularity of these investments does not explain why the financial markets today don't offer any full reserve bank accounts.

    Why aren't there any full reserve banks? This is the question addressed by Prof. White. He argues quite well that historically (and contrary to an article by Hülsmann) this was not the result of fraud, oligopoly or legal impediments. Full reserve banking was unable to compete with fractional reserve banking because of higher charges/lower interest to depositors.

    You mention a second and perhaps even more important reason today. The potential competitive advantage of full reserve banking, namely relative safety for depositors, has been substantially eroded by taxpayer funded deposit guarantees.

    One solution is to outlaw fractional reserve banking.

    An alternative solution is to renounce taxpayer funded deposit guarantees.
    Then, in Prof. White's words "any banker possessing even an ounce of entrepreneurial insight, would see an easy way to grasp pure profit. All the banker has to do is to offer credible 100-percent-reserve accounts, while alerting the public to the other bankers’ practices, and depositors will come flocking in."

    1. Hi KongKing,

      I’ll take your points in turn. Re checking, some mutual funds do offer that service. See the following two:

      Re NSI, they don’t offer checking or plastic cards, but with some of their accounts you can get money out instantaneously online. Thus to say they don’t offer checking is a bit like saying I cannot draw a cheque on a typical British high street bank savings account: strictly true, but I can transfer money from the savings account to a checking account in five minutes and then draw a cheque on the check(qu)ing account.

      Re your 2nd para, obviously a full reserve account involves higher charges / no interest, but as compensation, they offer complete safety, and I suggest there is market for the latter. As to why that gap in the market has not been catered for thru history, I’ve put one answer to that in the P.S. above.

      Re your final paragraph or two and “renouncing taxpayer funded deposit guarantees”, it strikes me that White is actually admitting there is a gap in the market for 100% safe full reserve accounts. That is, he is saying “get government interference out of banking, and the place for full reserve accounts opens up.”

      In fact that point of his amounts to much the same as my point above, namely that the reason there are no full reserve accounts offered by commercial banks is that government (thanks to taxpayer largesse) provides something even better: 100% safety combined with interest.

  2. The following may shed some light on the currently limited role of the NSI in the UK.
    As far as I can understand the latest NSI accounts (2012-13):
    * Roughly 45% of the £100 billion liabilities are owed to Premium Bond holders (a UK lottery).
    * Most of the other liabilities were owed to holders of various types of bonds.
    * Only about 3% was owed to Individual Savings Accounts.
    * There is mention of 25 million NSI "customers". However, these include Premium Bond holders and maybe many customers are double counted if they hold several accounts.
    * The number of individuals with online/phone accounts was only about 1.5 million, barely 2% of the UK population.
    * None of the NSI accounts provide facilities for banking services such as ATM, cheques, debit cards, standing orders, overdrafts etc.

    Significant changes were announced in the recent 2014 UK budget, notably the big increase in overall NSI investment savings a/c limit each tax year to £15,000 from June 1st.
    The current interest rate is 1.5% tax free! See you there!?


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