Reason Podcast

Does Fractional Reserve Banking Endanger the Economy? A Debate

Texas Tech University's Robert Murphy vs. Cato's George Selgin at the Soho Forum


On April 16, 2018, two free market economists debated a topic that has long divided libertarians. Fractional reserve banking refers to banks' standard practice of keeping only a portion of their depositors' money on hand and loaning out the rest. In The Mystery of Banking (1983), the anarcho-capitalist economist Murray Rothbard called fractional reserve banking "a shell game, a Ponzi scheme, a fraud in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts." Other libertarian economists, such as Larry White and Steve Horwitz, have argued that the practice is perfectly defensible.

At The Soho Forum, a debate series in New York City that is sponsored by the Reason Foundation, Robert Murphy debated George Selgin over the following resolution: "Fractional Reserve banking poses a threat to the stability of market economies."

Murphy, a research assistant professor with the Free Market Institute at Texas Tech University, argued for the affirmative. He has a Ph.D. in economics from NYU has addiliations with the Institute for Energy Research, the Mises Institute, the Fraser Institute, and the Independent Institute. He has authored hundreds of articles and several books explaining economics to the layperson, including Choice: Cooperation, Enterprise, and Human Action.

Selgin, who opposed the resolution, is a senior fellow and director of the Center for Monetary and Financial Alternatives at the Cato Institute and professor emeritus of economics at the University of Georgia. His research covers a broad range of topics within the field of monetary economics, including monetary history, macroeconomic theory, and the history of monetary thought. He is the author of The Theory of Free Banking, Bank Deregulation and Monetary Order, Less Than Zero: The Case for a Falling Price Level in a Growing Economy, and most recently Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage.

The Soho Forum runs Oxford-style debates, in which the audience votes on the resolution at the beginning and end of the event. The side that gains more ground is victorious. ?In this case, Selgin won by convincing 14 percent of the audience to switch over to his side.

Up next month at the Soho Forum: George Mason University economist Bryan Caplan vs. Harvard economist Edward Glaeser on whether "all government support of higher education should be abolished." The debate is tied to Caplan's recent book, The Case against Education: Why the Education System Is a Waste of Time and Money. Buy tickets here. Watch Nick Gillespie's interview with Caplan here.

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  1. As a practical matter, if enough depositors wanted their money at the same time, wouldn’t the government just declare a “bank holiday”?

    1. In most cases, yes, if you have a centralized banking system. The level of “enough” isn’t well-defined, though.

    2. Government can only declare bank holidays for government controlled banks. Government can declare no such thing under free banking because governments would not be controlling the banks.

      1. Well, they could shoot people who went into the banks. It wouldn’t be much of a holiday, though.

        1. It wouldn’t be much of a holiday, though.

          But ammo manufacturers would give thanks.

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  2. Two videos with two awesome economists in a row! I quite like Selgin; I read one of his early works late in high school and it was extremely interesting.

  3. Greg Proops vs. George Costanza. Looks promising.

    1. THANK you. I knew I wasn’t the only one who thought that motherfucker looks like Jason Alexander.

  4. “”a fraud in which fake warehouse receipts are issued””

    They are NOT warehouse receipts! There is no contract, agreement, or promise to return the exact same dollars one deposited. There is also no contract, agreement, or promise to immediately and without question to instantly turn over all deposits upon demand. Historically, demand deposits had clauses regarding getting your deposit back. Either get your deposit now in full, or with interest in thirty days after some assets have been sold.

    The full reservist ancaps appear to be unclear on the nature of contracts. They are not sacred writs of inviolability, the are… contracts. One agrees to do X otherwise Y. If one fails to do so, one has not committed a capital crime, one is merely in breach of contract. There is a process in place already to deal with breach of contract. The bank can’t pay you back for whatever reason, so you sue. That is all. If the bank goes bankrupt, it’s no different from anyone else who goes bankrupt. Anarchism does not ban online sales just because seller might possibly go bankrupt between the time you place and order and the time they ship it. So why are anarchists so keen on banning banking just because there’s a risk that banks can go bankrupt? Even if there should be a higher risk of banks going bankrupt, that does not alter the first principles of anarchism that voluntary economic transactions between two individuals are permitted.

    (cutting this short because of posting limit)

    1. (quickly finishing up)

      Bank runs: All activity is risky. Deposits are risky. Life is risky. Everything you do is risky. But the risk is why you get interest on your deposits. One does not ban an activity in a free society just because it might be risky. Get back to first anarchist principles. Sheesh.

      Inflation: First off, if anything that’s an externality. We should not ban deposits because they contribute to inflation any more than we should ban automobiles because they contribute to smog. Banking police is now how anarchism deals with externalities. Sheesh.

      Second, inflation under free banking would be limited by market forces. The definition is NOT the expansion of the money supply, it is rather the expansion of the money supply beyond the demand for money. A free banking system would tend not to expand the supply of money greater than its demand. Go read you Mises, money is an economic good like all other economic goods. The supply and demand of a good will reach an equilibrium, even if that good happens to be money. Sheesh.

      1. I seem to remember that plenty of “anarchist libertarians” had disagreements with Murray over the reserve banking issue, back in the day.

      2. “Bank runs: All activity is risky. Deposits are risky. Life is risky. Everything you do is risky. But the risk is why you get interest on your deposits. One does not ban an activity in a free society just because it might be risky. Get back to first anarchist principles. Sheesh.”

        As an individual, you have no requirement to put your money in a bank, which all are ‘fractional ‘ in the US by now. You can bury it in a coffee can, or stuff it under your mattress.
        So shut up and buzz off if you don’t like it. If they fail, reach under that mattress.

    2. I had the opposite problems with ancaps, actually. I couldn’t convince them that it was okay for fractional reserve banking to exist because their customers agree to the lending out of money. Even if the customer and bank had a contract they just couldn’t accept it.

      1. That too. One could write an encyclopedia on how some AnCaps’ obsession with stamping out FRB is just plain cognitive dissonance.

        “Smash the state! Except for the banking police, we’ll still need them!”

      2. If you agree to deposit your money with a business and that they can loan out the money and not keep a reserve in case customers want cash, then that’s on the customer.

        Credit Unions have the best terms typically for customers and are the most conservative without all the big bank overhead.

        Big banks should be allowed to fail because they play a shell game with their customer’s money and bribe politicians to protect them from moral hazard.

    3. Actually a bank not paying you what you deposited is theft.

      Customers never agree to deposit their money and in return you don’t have to pay them back. The banks gets to use the customers money and in return the customer gets it on demand. If its a large amount then you might have to wait a few days until a truck can deliver that much cash.

      A certificate of deposit is a contract in which you leave money inside a bank for a certain period of time and in return the bank pays you interest and your money at the end of the term.

      Banks know what the deal is otherwise, people would not put their money in banks and instead just hide it like they used to.

      1. “”Actually a bank not paying you what you deposited is theft.””

        No, it’s breach of contract. If you and I have an agreement that you do X for me in return for me giving you Y in the future, and if I fail to do Y then I am in breach of contract and NOT theft. You might get all emotional over it and say I’m a thief, but I am not. I have not forcibly taken anything from you. You might even get all emotional and look for stuff to accuse me of fraud with, but I am not being fraudulent I am merely in arrears.

        In addition, deposit contracts do not say “instantaneously on demand no matter what”. They did not do that historically and they do not do that today. if you don’t like the terms of the contract then don’t deposit your money. Sheesh.

        If the bank completely refuses to honor the contract, you might indeed have a cause that they were just scamming you all along. But merely not paying you the instant you demanded all your deposit back is not theft. It is not in itself a crime. Banks are not on-demand warehouses. If that’s what you want get a safe instead and put your deposits in it.

        1. Brandybuck|4.27.18 @ 5:31PM|#
          “”Actually a bank not paying you what you deposited is theft.””
          No, it’s breach of contract”

          No, it is not. Under ToS, you are informed that a bank run may cause a loss of principal, but that you are insured under one of several agencies up to $X.

        2. Brandy, why would people give their cash to banks if they knew banks can steal their money and simply say, “and it’s gone” like in South Park?

          Answer: people wouldn’t deposit their money.

          Hint: you might 2nt to read your bank agreement more closely. I for one never have to wait more than a business day or two to take large cash deposits out.

  5. If there is a run on banks then yea. There is not enough cash to cover all deposits.

    Devaluing coins by taking all the precious metals out of them and being $20T in debt is a bigger problem right now.

  6. Regardless of whether you think Fractional Reserve Banking is harmful, it is none of the government’s business. It’s a question between the bank and their depositors.

    Or “lenders” would be a better term. When you “deposit” money in a bank, you are lending the money to the bank. When you lend somebody money, you take a chance that they won’t pay you back. Maybe because they can’t — because _their_ assets are now nearly worthless. Maybe because they don’t choose to: they found something they want to do with the money that they like better than paying it back and preserving their reputation.

    Especially if you’re being paid interest for the money, or if you’re getting all the services of a bank account — check processing, monthly statements, access to tellers and/or ATMs — for free or a reduced rate, you should expect that the borrower is going to do something with your money. Maybe improve their house. Maybe use it as capital in their business. But something. ANd it can happen that, because they used it, they might not have it when you decide you want it back.

    (to be continued)

  7. (continued)

    The fraud, if there is any, is the government’s claim that your money is “insured” by FDIC. FDIC can fix things up if a small bank fails. Some other bank will take over the assets and liabilities of the failed bank, possibly for the (implied) promise that the government will give them special treatment in the future (a sort of bribe and/or inverse blackmail), possibly in exchange for some money out of the taxpayers pockets.

    In the worst case — a major, multiple bank failure like 2008 — this might mean that the government prints money to make up the difference. So let’s say that such a failure occurs, and it turns out there’s only enough money “in” the banks to pay half of all the bank deposits in the country. The government prints the other half. You “get your money back”, but the money supply has been increased, so the “money” you get back is only worth about half as much.

    That’s fraud by the government. Potentially. So far, we’ve been lucky. Even the TARP program didn’t cost the government (us taxpayers) money in the long run. The Feds got all the money back in a few years, with interest. But that’s not saying it can’t happen.

    But as between the depositor and the bank, that’s just part of their contract. Like any other loan, there’s a chance you won’t get the money back.

  8. The money always appears out of thin air.
    Imagine if the air were thick, like on Titan.

  9. None of the comments redress the fundamental objection to the practice.

    When a bank engages in fractional reserve, first that refers ONLY to it loaning demand deposits, NOT time deposits. Although, as a matter of practical reality today, no bank would deny a depositor his money in a time account if demanded (since such might start a run on the bank), as a matter of law, money in a time account belongs to the banker, and the relationship between bank and depositor is one of debt. Rothbard’s objection to fractional reserve was that allowing a bank to treat a demand deposit as if it were a time deposit converts a de facto relationship of bail into a de jure relationship of debt, and that’s (libertarian) fraudulent because the bank in effect is being allowed to create money from thin air by counting some of its deposits twice. Furthermore, when the practice is extended throughout the banking system, the amount of extra money potentially created (this limit never actually is reached) is the reciprocal of the fractional reserve….

    1. So, for example, if the reserve requirement is only 10%, then the potential money to be created by the entire banking system is 1/.10 or 10 times the amount on deposit.

      Now, the Austrian argument is this: At the (unexpanded) monetary level, the pure rate of interest (no insurance) is determined purely by time preferences, and this rate, with insurance, determines the LENGTH of productive processes the economy can sustain. But, when the banks engage in fractional reserve, ADDITIONAL FUNDS, existing solely as book entries at the bank, become available, and the supply of money available for loans increases. This artificially depresses the interest rate BELOW what it would have been on the market and DECEIVES entrepreneurs into thinking that longer processes of production now will be profitable.

      The crunch comes when the additional money bleeds out of the capital plant into the general population, since this is inflationary in the absolute sense. The depositor no longer is getting the return he expected from his deposit, and unless his time preferences change to accommodate that, he will withdraw some of his savings and spend them for consumption (adding further to the inflation and inducing thereby more withdrawals….

      1. Needless to say, if this condition persists across the entire banking system, what happens eventually is that the banks are bled of their deposits, and now they have to call in loans in order to meet their reserve requirements.

        What always has been missing from Rothbard’s and other Austrians’ analysis is the critical role that seasonal fluctuations play in this little dance. Twice each year (three times, actually, if you count Christmas), there is a natural and concerted drain on the banking system when farmers altogether withdraw funds to plant or harvest crops. In MOST years, the bankers can prepare for this, and all John Q. Public will see is a dip in stock prices (May and October). However, if something unexpected occurs (like the sinking of the Central America in a hurricane in 1857), there will not be enough “give” in the system to keep all of the banks afloat. In that case, one or more banks will fail, AND ALL OF THE MONEY IT HAS CREATED FROM THIN AIR (since it only is a book entry) DISAPPEARS IN THE BANKRUPTCY. If the bank is big enough (Lehman Brothers), the ensuing violent contraction of the money supply will throw all previous contractual calculations into limbo, and the result will be a depression — prices become DEPRESSED to reflect the smaller money supply generated by the failure of the banks, and contracts written in the OLD money supply potentially become undischargeable….

        1. Any discussion of the problem which fails to address this phenomenon is no discussion at all. And, of course, any discussion of the problem that does consider the ill effects described here necessarily must conclude that, in the long run, fractional-reserve banking imposes more injury on the society than gains — the injury is universal while the gains primarily are individual and determined by who is first in line to get the manufactured cybercash.

  10. OK: I listened to the entire debate. My sense is that both men had a somewhat fractured approach to the problem, but that George was the more coherent, so perhaps he deserved to be declared the “winner.”

    That, of course does not mean that he won, so perhaps it is appropriate here for me to make a couple of observations for those not so up on economic history.

    1) George’s argument to Adam Smith should carry no weight. The reason is because Smith wrote in 1776, and the first general embezzlement law was passed by Parliament in 1799. Now, there had been restricted embezzlement laws as early as 1749, which applied to clerks and tellers — the “unwashed” servants — but prior to 1749, embezzlement wasn’t even a crime (it is not a larceny because an essential element of larceny, trespass in the taking, is missing). So, Smith is arguing from a time in which the wrongfulness of embezzlement was not well understood, and the thinking of the time was that it was OK as long as “gentlemen” did it because “gentlemen” were men of honor who didn’t need criminal laws to hold them to their promised obligations….

  11. Banking, of course, is much older than embezzlement law: The oldest bank still in existence is Monte dei Pasche in Italy, which opened 20 years before the first voyage of Columbus, so banking has been around a long time, and it definitely developed in an age when embezzlement would not have been thought to apply to bankers.

    Of course, the general law of 1799 (passed AFTER the United States separated from England) still excluded banks qua banks (the bank president was included), and of course ultimately the question before us is whether embezzlement law should be extended to banks qua banks because, were that to be done, fractional-reserve banking would have to disappear, and for the same reason that an elevator operator cannot speculate with a farmer’s wheat in the Chicago pits while the farmer is negotiating the wheat’s sale in St. Louis….

    1. 2) I was impressed with one argument George did make and which Bob never really answered to my satisfaction, and that was George’s characterization of demand deposits as similar to a call-money loan. For, even if such a characterization were incorrect, there can be no doubt whatsoever that the American banking system of the nineteenth century was pyramidal in its structure and tended to focus “idle” funds into New York, where they were used by banks and financiers to speculate in stocks via what then was the call-money market, amounting to one-day loans with the funds. And my concern here is how any kind of free market, even one with limited government that used force to make embezzlement “illegal,” actually could police the distinction between a demand deposit vs. a call loan — yes, I understand Bob’s argument that they are different, and see above for WHY economically such makes a difference; but, as a matter of practical reality, I can’t really see how any legal system could police the difference, which of course makes the entire argument nugatory because any prohibition simply would generate no change….

      1. 3) I’m sure George will be quick to jump on my revelation that American banks, under the National Bank Act (which the Federal Reserve Act supposedly were passed to fix but did not fundamentally change), were pyramidal in their operations (and this is why we always failed and Canada so often succeeded) — there definitely IS a regulatory problem here, and to the extent that the Austrians are correct, we become obliged to inquire into the DEGREE that each flaw contributes to market instability, but that will have to be a topic for another day….

        1. 4) The one thing I do think that speakers on this topic must address ultimately is the international dimension to the problem (whatever the causes) — so often in these major crises, what one sees is the “unexpected factor” (see previous thread, above) arising not in the United States but in some other country that we cannot control. So, let’s say that Libertarians get into power and rectify the banking problem, both in terms of fractional reserve and regulatory weakness. Would this not be meaningless in the long run if, say, the central bank of Austria fell apart (as it did in 1931), or Germany went into crisis (as it did in 1872-3), or England suffered a depression because the House of Baring got ripped off in the course of buying too many Argentinian bonds (1890-93)? Because, if it is not possible to cure the problem without eradicating it everywhere at once, then it seems to me that we are reduced simply to applying more band aids to an uncorrectable situation, and that of course means that the debate is only that, and something no one really can “win.”

  12. Robert Crim, please write a book. I might get to it.

  13. I attended the debate. I’m a huge fan of Soho Forum. Both debaters were well spoken, which is not always the case. And yet I didn’t care…this was libertarians arguing with libertarians about something only libertarians care about, and frankly something precious few libertarians even care about it. It was as if two guys went to spring break and were surrounded by thousands of attractive coeds, yet sat in a darkened room playing video games… playing them really really well….yet sheesh!

    1. To be sure, arguments over banking and finance can be difficult to wade through. But, how about this, perhaps, to ratchet up your interest: Neither of these men would consider the Glass-Steagle Act to be any kind of cure to the problem, yet it is a fact that this Act, repealed by Republicans and Clinton so that Jamie Dimon could make more money for Citibank, created a firewall between banks that create cybercash and banks that could leverage it. Thus, repeal of the law directly contributed to the blowup of the system a decade later upon the failure of Lehman Brothers, which was, indeed, improperly regulated as a result of the repeal (point for George!).

      And that cost the country ten trillion dollars, all added to the national debt, which of course will be an albatross around every American’s neck in the decades to come.

      It does pay to get this right and refrain from the temptation to inseminate the co-eds (who are going to be good and fucked in any event).

  14. The only point you can reasonably give the full-reservists, is that without debt there can be no default, but this is hardly a revelation. But they miss so much:

    1. The price rigidity of a full reserve system would be far more destabilising–to the extent that rapid growth would simply not occur.

    2. Time deposits and demand deposits are just different ends of a redemption interval spectrum, *discriminated by the interest paid on them*.

    3. Anytime you are not consuming, you are saving. If that savings is removed from the economy, there are opportunity costs. Banking allows anyone with a bank account to invest most of their savings. If the loans tend to be sound, this is good, no great, for everyone.

    4. The use of bank IOUs as money develops with the banking industry, which develops with the economy, and is restrained by the availability of basic money, money demand, and bank competition. So even during the development of a banking system, there is no price inflation. Once established, the new total money supply (basic money plus circulating IOUs) continues to be regulated in the same way, so with stabilized economic growth this has the appearance of a relatively fixed money supply varying up and down slightly to maintain short term price stability in the face of changing money demand (like during demand shocks). Still, no price inflation.


    1. (continued)

      5. On its face it may seem to the naive that banks create money out of thin air to lend, but since a bank’s total deposits always exceed its total loans, and at the time of each loan the bank has more than enough reserves to cover that loan, we see that this is not in fact the case. Banks could do exactly what they do by only loaning out literal bags of basic money. However, since they require borrowers to deposit those funds back with the lending bank, they keep the basic money untouched in the vault and take an appropriate shortcut on their ledgers. The naive see this loan without the movement of any basic money, and cry, “out of thin air!”

      6. How deluded do you have to be to deny that the purpose of banks is to loan deposits, and that interest is something paid on a loan?

  15. Fractional reserve is fraudulent for the simple reason that banks lend on depositors’ money, while suggesting to depositors that their money is safe, which it quite clearly isn’t because loanded on money is NEVER SAFE. I expanded on that point, and dealt with George Selgin’s counter-arguments recently here:

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