Wednesday, 8 April 2020

George Selgin and Lawrence White consider whether the bank system is fraudulent.

Summary.     Much of Selgin & White’s work “In Defense of Fiduciary Media…”, published in 2005, is a thoughtful consideration of the much disputed question as to whether our existing or “fractional reserve” bank system is fraudulent. One argument they put against the fraud charge is that fraud only takes place where someone loses money for unacceptable reasons. Actually there is such a thing as a fraudulent offer: that is, it is possible a system or organisation to be fraudulent because of the fraudulent offers it makes, even if no one actually loses money.

Selgion and White (henceforth "the authors") also argue against full reserve banking, as they usually do. However, it is argued below that full reserve is actually compatible with Selgin & White’s views. 


The basic “fraud accusation” made against fractional reserve is as follows. Fractional reserve banks accept depositors’ money and lend on that money, but then claim depositors’ money is totally safe. That is, banks promise depositors that assuming a depositor does not ask a bank to transfer some of the depositor’s money to a third party, the depositor will get $X back from the bank for every $X deposited (possibly plus interest and possibly less bank charges). But that promise is clearly fraudulent because much of that money is loaned on by the bank, and loaned out money is never totally safe. Indeed, any promise of that nature is classed as fraud when done by financial institutions other than banks (e.g. pension funds, mutual funds, unit trusts etc). Ergo the reality is that it is fraud when done by a bank: it is only legal because governments have given banks an entirely artificial form of privilege, namely excusing them from the “fraud charge”.

Incidentally and re the idea that banks are not intermediaries, but rather entities which create the money they lend from thin air, I deal with that point here. Plus a Bank of England article makes much the same points in that connection that I do: the point being that while commercial banks do create money, they also act as intermediaries. (Title of the two latter works are respectively, "Our bank system is fraudulent and risky" and "Money Creation in the Modern Economy")


Fraudulent offers.

One debatable claim by the authors, is as follows.

In the first para under the heading “Rebutting the charge of fraud” (p.86), the authors invoke a definition of fraud which does not stand inspection. The definition is “failure to fulfil a voluntarily agreed upon transfer of property”.

Well I suggest that whether or not a failure to transfer property takes place or not has no bearing on whether the offer made by banks to depositors is fraudulent or not.

To illustrate, if I offer to take money off you and put the money on a horse and I tell you you’re guaranteed to win money or at least get your money back, that is a fraudulent offer, and for the obvious reason that any horse can perform badly on a particular day! Whether you actually give me money, and whether you actually do or don’t get your money back has no bearing on whether the original offer was fraudulent.

Indeed, I consulted a lawyer friend of mine on this, and he confirmed that the common sense view here correct: that is, a dishonest or fraudulent offer is itself fraud regardless of whether anyone loses money as a result of the offer.

Fractional and 100 percent reserve accounts.

Then in the next paragraph, the authors argue that banks only act in a fraudulent way if they claim to operate 100 percent reserve accounts when in fact they are operating fractional reserve accounts. As they put it, “…it is fraudulent for a bank to hold fractional reserves if and only if the bank misrepresents itself as holding 100 percent reserves, or if the contract expressly calls for the holding of 100 percent reserves.' If a bank does not represent or expressly oblige itself to hold 100 percent reserves, then fractional reserves do not violate the contractual agreement between the bank and its customer…”. (The authors make much the same point near the bottom of their p.88).

Well the simple answer to that is that about 90% of depositors don’t have any idea what the phrases “100 percent reserve” or “fractional reserve” mean! Thus the authors’ “100 percent / fractional reserve” point is plain irrelevant.

The reality is that most depositors are persuaded by banks that depositors’ money is totally safe, and the second undeniable reality is that that money just isn't totally safe: witness the fact that taxpayers had to come to the rescue of sundry banks during the bank crisis that started in 2007/8!

I.e. fractional reserve is only safe because governments back the fraud / risky practice that is fractional reserve with near limitless amounts of taxpayers’ money.

Interference with free markets.

Next, in the para starting “But whether the informed…” (p.88), the authors argue that a ban on fractional reserve would amount to an unjustified interference with the right of banks and depositors to come to mutually acceptable agreements.

That’s a good point: i.e. it is hard to see why depositors should not have fractional reserve accounts, as long as relevant banks make it abundantly clear that depositors’ money can go up in smoke any time. After all, people are free to place their money with mutual funds, private pension schemes etc and the latter sort of entities have to make it very clear that depositor / investors can lose as well as make money in the process.

Indeed, the authors say “The remaining normative debate boils down to the question of whether a warning sticker really is needed to avoid misleading customers . . . . . and, if so, to the question of how explicit the sticker must be.”

Well the authors do not answer the latter question, but never mind: I have an answer. The answer is that if banks offering fractional reserve accounts had to publish the the sort of “health warning” or “sticker” that mutual funds etc are required to publish and with equal frequency, then banks would be competing on a level playing field with respect to those other financial institutions. In other words that “level playing field” requirement would dispose of the current reality, namely that banks are artificially privileged in that they DO NOT need to make it clear that depositors that risks are involved in fractional reserve banking.

But we have now arrived at full reserve banking!

Astute readers will by now have realised that we have arrived, ironically, at the sort of set up advocated by proponents of full reserve banking, e.g. Positive Money and Lawrence Kotlikoff. That’s a set up where depositors have a choice of two types of account: first, totally safe accounts, where money is simply held in a totally safe manner and not loaned on and thus little or no interest is earned. Second, there are risky accounts (“investment accounts” as Positive Money calls them) where interest is earned.  (Title of Kotlikoff's work: "The Economic Consequences of the Vickers Commission")

The only element that might seem to be missing from the set up we have arrived at is the latter “totally safe” accounts. Well actually totally safe accounts are in fact available!

As the authors make clear, full reserve accounts are already available in that people can store central bank notes (e.g. $100 bills) in safe deposit boxes (top of p.97).

Safe deposit boxes are relatively expensive, thus they are not an option for many people. However several governments operate state run savings banks where depositors’ money is invested just in government debt (“National Savings and Investments” in the UK).

That is clearly a much cheaper way of organising totally safe accounts, and indeed in the case of UK’s NSI, far from depositors necessarily being charged for holding such accounts, they actually get interest (depending on the type of  account).

And as for countries which do not have state run savings banks, those who want their money to be stored in a totally safe way can always buy government debt, with short term debt being more appropriate here than long term debt, though of course that’s not an option for small savers.

Of course the latter interest paid by NSI rather clashes with the above mentioned “little or no interest” that people with safe accounts are supposed to get. Well the answer to that is that if government choses to pay interest to those depositing money with government, then more fool government: personally I agree with the idea backed by many advocates of Modern Monetary Theory (and Milton Friedman) namely that governments should normally pay no interest on money deposited with government. 

To summarise, it seems that while the authors have criticised full reserve banking in numerous publications, their views are actually very much compatible with full reserve – bar one remaining problem, as follows.

Banning private money creation.

Most advocates of full reserve want to ban money creation by private / commercial banks. So does the above “set up” result in such a ban?

Well not in the sense that under the above set up people would be free to buy as much “fractional reserve money” as they wanted. But that money is not as genuine a form of money as base money in that fractional reserve money can suddenly lose value, if it turns out the issuer of the money has made silly loans. Thus that so-called money is not really money.

Another way in which organisations offering fractional reserve money might seem to be free to issue as much of the stuff as they wanted, in the way they can under the existing system, is for them to simply issue home made money to any borrower who looks viable.

However, there is a problem there for those “issuers” as followers. A proportion of the recipients of that new money will inevitably want their money to be in the above mentioned totally safe form: i.e. to take the form of base money. But it’s the central bank which determines the total stock of base money. Thus any of the above issuers which issue an excessive amount of home made money would find themselves short of base money (aka “reserves”). And possibly Selgin and White might not be too happy about that.

However, I suggest S&W need to bear in mind that central banks actually restrict the amount of home made money that commercial banks issue even under the existing system. To illustrate, if there’s an outbreak of Alan Greenspan’s “irrational exuberance”, and commercial banks create and lend out freshly minted home made money like there’s no tomorrow, the result will be an excessive rise in demand, as a result of which the central bank is likely to raise interest rates so as to rein in the amount of money that commercial banks create and lend out.


Assuming those who want fractional reserve accounts are warned of the dangers in the same way as those who buy into mutual funds or private pension schemes are warned, then given that most countries already have totally safe accounts like those offered by the UK’s National Savings and Investments, the resulting set up would amount to the sort of full reserve system advocated by Positive Money, Lawrence Kotlikoff and others. And that system is not as incompatible with the views of Selgin and White as perhaps Selgin and White think.


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