Is Fractional Reserve Banking Ethical Part V: Conclusion and Compromise

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Introduction:

The debate over whether Fractional Reserve Banking is ethical to proceed over approximately a decade (the late 1980s/ early 1990s to the early 2000s). Resulting from subsequent papers repudiating the previous claims over the researchers on the other side of the issue. It should be noted that in these series of retaliatory papers that technical arguments were presented in tandem with ethical justifications for or against this practice. For the sake of brevity, I chose to focus on the ethical considerations of the topic. However, this does not exclude a potential technical comparison of Fractional Reserve Banking in the future. 

To any reader who has never thoroughly examined nor given a second thought to Fractional Reserve Banking, I hope reading this series of essays was illuminating. Fractional Reserve Banking is arguably the most prevalent banking system globally. Yet, something that impacts our lives daily we never think to question its inner mechanics let alone whether it is ethical. The ethics of banking extend beyond whether the patrons are benefiting at the expense of someone else, either through easy access to loans or interest payment on savings. There are potential ramifications to the economy. 

Distortions in the credit market are precisely the impetus for business cycle calamities such as the cataclysmic burst of the Housing Bubble in 2007. Providing loans backed up by fiduciary media is nothing more than a house of cards waiting to fall done. Artificially manipulating factors such as prices, interests, and money supply can only facilitate the misallocation of resources. Such indicators operate as unspoken signals to consumers and entrepreneurs. Due to this fact, these distortions create an illusory image of the loan market and naturally economic agents respond accordingly (p.108). A fact that both George Selgin and Lawrence White are too quick to refute and dismiss (p.102). This carries the implications of defrauding the economy as a whole versus being isolated to the bank’s customers. Even if you are the type to limit all your transactions to precious metals or cryptocurrency, it is worthwhile to read up on this topic.

Summary of Compelling Arguments From the Austrian School:

It is difficult to say whether the Free-Bankers or the Austrians are on the right side of the debate. Both camps provided some truly convincing arguments. The Austrian opposition notes how ownership can only legitimately be taken on by one person and Fractional Reserve Bank obfuscates this immutable law of property ownership. From a contractual standpoint, that the agreements between banks and clients in such an argument are illegitimate. Since the terms are not only unclear to the typical layman but are a categorical misrepresentation. Presenting fiduciary media as actual money. The disingenuous nature of this faulty contract is only compounded by the fact that these claims for money are based upon the banknotes that are not back by currency or specie. Attempting to redeem them for actual currency is analogous to using a deed for a boat and attempt to claim ownership of a house. Also that it is a false analogy to argue that any devaluation of present money caused by the issue of fiduciary media is no different than an increase in the supply of a good due to protection or harvesting. 

This is because the increase in the supply of lumber from harvesting more oak trees is derived from legitimate market processes and in-turn does not seek to directly devalue anyone else’s property. Also, that in no way can Fractional Reserve Banking represent the Demonstrated preference of bank clients. Demonstrated preference can only be expressed with one’s property. Fractional Reserve Banking by its very nature disrupts this relationship.

Summary of Compelling Free-Banking Arguments:

The Free-Bankers also bring up some compelling moral defenses in favor of Fractional Reserve Banking. They are even bold enough to directly claim the practice is not fraudulent. Through a banking client electing to accept the terms of service regardless of their understanding, the contract is still valid. It would be one thing if these banks purported to practice 100 percent reserve banking, but function as a Fractional Reserve institution. These contracts are formulated between consenting adults, it would be antithetical to the principle of individual freedom to prohibit such arrangements. The real trouble comes from government interference. One only needs to look at the large array of protections awarded to backs through the FDCI to see the true culprit in shielding unsavory banking practices from insolvency or litigation. Also, the ignorance or the naiveté of the consumer is not a reasonable justification for banning a product or service. Even though the risk of a bank run is present, it is a relatively rare occurrence from a historical standpoint. If faced with a potential bank run the bank can issue an option clause suspending redemption, solving the issue through valid contractual recourse. Speaking of redeeming bank deposits. A customer assumes the risk of not being able to redeem money when they agree to open an FRB account. They assume the risk. In turn, for the opportunity cost of having their liquid money held and the potential risk of a bank run/ insolvency, they receive an interest payment. Overall, patrons must prefer Fractional Reserve systems to 100 percent reserve banking. There have never been any governmental decrees in modern history that all banking must be done via a Fractional Reserve System. Despite its flaws, ultimately, the people prefer being paid interest payments versus having to pay warehousing fees.

Can There Be a Compromise?

There are certain aspects of both arguments that appear to be flawed. The Free-Bankers are too lackadaisical when it comes to distortions in the credit structure enabled by Fractional Reserve Banking. The Austrians to some extent seem too rigid in their interpretation of property ownership. Under many of their arguments likening the practice to a Ponzi scheme. Yet, to be conceptually consistent would not these same economists also take issue with multi-level-marketing? Then again it could also be counter-argued that MLM schemes and Fractional Reserve Banking while present similar confusions, property rights have much greater degree clarity in MLM arraignments.

Back in 2000, the economist Jorg Guido Hulsmann wrote an article in the Independent Review refuting the Fractional Reserve practice of creating “money”. Hulsmann (see page 108) much like his anarcho-capitalist counterparts Hoppe and Block are opposed to government intervention. If FRB is morally and technically flawed how can we address the issue of it short-comings without introducing state involvement? In this twenty-year-old article, Hulsmann presents a summary of points previously made by Hoppe and Block that would alleviate some of the issues relating to the categorical confusion. It should be noted that Hulsmann in that these suggestions for informal rules and norms of banking presume no state involvement in banking. Also, the author details the intimate relationship between the FRB and the government. Going so far as to refer to it as a “handmaiden” of government (p.108). Making it easy to infer that Hulsmann believes that the intertangled marriage between Fractional Reserve Banking and government is an unbreakable bond. However, let’s take these suggested conditions as theoretical and contingent upon a banking system free of regulation. See his suggestions below:

“…Fractional reserve banks would have to use a different language than they commonly use because words such as “deposit” are deceptive. They would have to make it clear that money “deposited” with them is, in fact, a credit of unspecified duration. And the “banknotes” they issue would have to be presented not as money titles but as some sort of very liquid IOUs..”

            “..On the “FR notes,” one would have to find a promissory note of the following type:

 The FR Bank promises the holder of this note to try to redeem it out of its gold reserves. Because FR notes are not 100 percent covered by gold presently in our bank, in case we cannot redeem, the following rules apply. . . .  (p.108)”

Is Fractional Reserve Banking Ethical -Part IV: The Defense of Fractional Reserve Banking

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Part I: Click here.

Part II: Click here.

Part III: Click here.

It is quite clear at this point that followers of Austrian economics view Fractional Reserve Banking as nothing more than a Ponzi Scheme. However, proponents of the Free Banking School (arguably an outgrowth of the Austrian School) believe that this practice is legitimate providing there isn’t any government interference in banking. Even the uninitiated observer will admit that this contingency is a highly unrealistic one. In the modern era, banking continues to be a heavily regulated industry. Free Bankers may have a relatively cogent ethical argument from a theoretical standpoint. After all, it is the responsibility of a mentally competent adult to be aware of the terms of service for any product or service they choose to receive. Ignoring the fine is not an exculpatory factor. Either from a legal standpoint or from an ethical perspective. Also, to be conceptually consistent one should scrutinize multi-level marketing schemes. Such a business model mirrors similarities to Fractional Reserve Banking. Hence why opponents liken it to a Ponzi scheme or pyramid scam.

Argument #1: It Isn’t Fraud.

From the Free Banking perspective, Fractional Reserve Banking is not a fraud. If the banking establishment makes it clear that the services provided constitute Fractional Reserve Banking, then the arrangement is legitimate. This is because the terms of the contract were not violated (p. 87). It would be problematic to present your services as 100 percent reserve banking if it encompasses the practices of the Fractional Reserve System. Fraud would entail a misrepresentation of the bank’s services. 

Taking any measures to prohibit this system of banking is antithetical to the principle of individual freedom. Any such interference would  be obstructing an existing contract between consenting parties. Doing nothing more than disturbing the economic liberty of freedom of contract, which is a pillar of private property rights (p. 87). Individuals who oppose the practice find the freedom of contract argument to be farfetched as few patrons have a firm comprehension of what Fractional Reserve banking entails (p. 88). The naivete of the consumer does not sully the legitimacy of the arrangement. Even Murray Rothbard himself has stated that historically banks have rarely retained a 100 percent reserve system (p.88). Why? Most likely because the banks clients preferred a Fractional Reserve system. If customers prefer an interest payment on their savings versus a maintenance fee for warehousing, so be it (p.88). The market for banking services has responded accordingly.

Circling back to the issue of misrepresentation of services, even the hardline naysayers believe that such a banking system could be admissible under certain conditions. Most notably if there was the further elucidation of the specific details of fractional reserve services. A long-standing concern of economists such as Hans Hermann Hoppe and Walter Block being that such ambiguity makes the practice fraudulent. Creates categorical confusions between money and fiduciary media (p.20-28). Professor Block asserts that the redemption requirements need to be clarified to set aside the concerns of fraud (p. 89). Whereas Block’s counterpart Hoppe stresses that banking institutions should present a warning regarding the suspension of redemption. He analogizes this precautionary courtesy to an option clause. Unfortunately, this concern does not comport with the facts of history. As is evident by the Scottish period of Free-Banking in which specie payment was suspended for decades (p. 89-90).

Another argument that grapples with the question of whether FRB is fraudulent pertains to the ability of the banks to fulfill redemption obligations. Keeping low percentages of reserves on hand turns money redemption into a gamble. However, this concern is inconsequential. Historically even in the absence of government intervention few banks have failed to fulfill any redemption obligations to patrons (p.90). For one, solvent banks are not prone to bank runs. Even in the event, a solvent bank runs out of currency, they can issue an option clause to temporarily suspending redemption. Resolving the issue through contractual channels (p. 91).

Argument #2- The Concerns Over Third-Party Effects Are Not Substantial

The most salient third-party effect or “spill-over effect” confronting the practice of Fractional Reserve Banking is a decreased likelihood of successful redemption. Obviously, in a Fractional Reserve Banking system, the more money that is lent out the fewer reserves the bank will have on-hand. Resulting in adverse consequences for the individual demanding to withdraw money from their account. It should be noted that the depositor agrees to this argument upon opening a bank account. Therefore, by signing on the dotted line of the terms and services of the bank, they choose to assume the risk (p. 93). Despite the risks, bank patrons continue to bank with these institutions. Alone based upon the Rothbardian theory of Demonstrated Preference the individual bankers must benefit from this arrangement. After weighing the benefits concerning the costs (p.93). 

The spill-over effects of Fractional Reserve Banking are not solely confined to banking transactions. The practice has also been claimed to create other distortions throughout the economy. Through how loans are funded it compromises some say the credit structure is compromised. It should be noted that the risks are somewhat minimal. If anything it aides the economy by providing a larger stock of capital (p.94). The issue with this criticism is that much of the instability in the economy comes from the intervention of central banks and governments and not Fractional Reserve Banking. This form of banking is not prone to instability or “cylindrical over-expansion”(p.94). These claims underestimate the fact that the amount of “nominal money” issued offsets the “.. changes in the velocity of money..”. Fractional Reserve banking works to alleviate the disequilibrium and “ business cycle consequences”. Hoppe and the company also assert that any injection of fiduciary media will ultimately result in a business cycle. However, if the increase in fiduciary media is matched by demand a disequilibrium will not arise (p.101-103).

Argument #3: The Popularity of Fractional Reserve Banking.

The popularity of Fractional Reserve Banking is another factor to contend with. Banking customers have demonstrated their preference for FRB. Historically, few banks have remained a 100 percent reserve system. However, customers continued to do business with these institutions (p.95). Contributing to this popularity has been the incentive of banks paying interest on deposits versus requiring a warehousing fee (p.95). Banking patrons also held faith that their bank had sufficient funds to fulfill withdrawal demands. Bank runs were generally triggered by other factors signally insolvency to bank clients. Countries such as the United States with greater propensities towards bank insolvency tend to have many protective laws shielding the banks from market pressures (p.95-96). It should also be noted that back in the 1800s when banking legislation was being discussed in the press the banking system was openly described as a fractional reserve system (p.96). Not only fully informing the average constituent of the details of the Fractional Reserve system, even with this knowledge doing little to dampen its prevalence (p.96).

The use of Fractional Reserve Banking has never been compulsory. There has never been any laws or penalties compelling banking in the United States to levitate towards this specific banking system (p.97). Patrons voluntarily assume the risk of engaging in this variety of banking for the trade-off of being rewarded with an interest payment (p.97). The argument that clients are unwittingly tricked into patronizing an illusory form of banking is dismantled by the fact that banks compete for business. Nothing is stopping an enterprising individual from persuasively selling 100 percent reserve services (p.97).

Why the Price of a U.S. Silver Dollar is Higher than 1oz. of Pure Silver.

bitcoins and u s dollar bills
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The current price of 1 ounce of pure silver is approximately $15.21 USD [1]. The average going rate for 2020 Silver Eagle drifts between $20.00- $25.00 [2]. This is not accounting for any variance for any limited edition collector’s coins that command a higher price tag. We are looking at nearly $10.00 premium over an ounce of pure silver. The coins themselves aren’t 100 percent pure silver. They are typically 99.9 % pure. Due to the bonding agents uses to make it a usable coin. Why the premium over pure silver?

We could accept the Cost-of-production theory of value. It was favored by the Classical economists. Who doesn’t love reading a little bit of Adam Smith, David Richardo, or John Stuart Mill? The classical interpretation of value was insufficient for solving the Diamond-Water Paradox. Unfortunately, did not provide us with the precepts to invalidate the Labor Theory of Value. Some people view both theories of value interchangeably, I disagree with such wording. Labor theory in my perception focuses mainly on labor. Generally for the purposes of sowing anti-market bias.

 

Thankfully the fathers of the Marginal Revolution (Menger, Jevons, and Walras) provide us with a novel approach to determining prices and value. That is through the Subjective Theory of Value.  Meaning that the value of goods is determined by the subjective evaluations of the consumer. If you think about as much the costs of production may influence profits, if the price is too high in the opinion of consumers the product will not sell. I can spend $20.00 making handmade coffee cups with a 10 percent mark-up. Odds are no one will buy them because they will see the price as being too high. Ultimately, I would need to find a new supplier for higher-order goods or more efficient production methods. As the producer, I am at the mercy of the consumer. If I do not meet consumer expectations (in terms of pricing or quality) I will not be in business for long.

 

What does this have to with the U.S. Silver Dollar? We could say that the premium of a U.S. Silver Dollar over 1 ounce of pure silver is due to the costs involved in the mint processing it into a coin. However, if the general public is unwilling to pay the $10.00 premium the coin will not sell. What the consumer is really paying for is the convenience of silver processed into a coin. Portability is a characteristic of all forms of money. What you sacrifice in purity is made up for in portability. Transporting raw silver is kind of cumbersome. The consumer is also paying for the officiality of the coin. It has the government seal of approval. Versus the seal of some hair-brained, tinfoil hat-wearing conspiracy theorist. Its having status under legal tender laws instills some sense of trust in its value. Depending on your political beliefs of course. Most folks still find the U.S. mint to be a reliable source.