Are Free Market Fiduciary Media Possible? On the Nature of Money, Banking, and Money Production in the Free Market Order
Abstract: Recent debates in monetary theory have centered on so-called free banking and the role of banks in providing money in the form of fiduciary media in a pure market economy. This paper examines how and to what extent fiduciary media can emerge in a pure market economy. Based on the theory of value, it is argued that those economists are mistaken who claim that money substitutes must in all cases be interpreted as being money titles. Those economists too are mistaken, however, who claim a large role for the circulation of fiduciary media in a pure market economy. It is argued that holding fiduciary media in one’s cash balance is an entrepreneurial error, as fiduciary media by their nature do not have the qualities people demand in holding money. Money is the comparatively most certain good and the present good par excellence, qualities that fiduciary media do not have. Holding fiduciary media instead of money is therefore an entrepreneurial error, and like all errors in the free market, it will tend to be eliminated in the process of entrepreneurial profit and loss, leading to the virtual disappearance of all fiduciary media from the market economy.
JEL Classification: B53, E22, E51, G21
Kristoffer J. Mousten Hansen ([email protected]) is research assistant at the Institute for Economic Policy at the University of Leipzig.
The author would like to thank Mr. Karras Lambert, Dr. Tate Fegley and Dr. Karl-Friedrich Israel for comments on an earlier draft of this paper, as well as Dr. Salerno, Dr. Thornton, Dr. Newman and the other participants in the 2020 Mises Institute Summer Fellows’ Seminar, where an earlier version of the paper was presented, and the participants in the session on institutional analysis of the 2020 Southern Economic Association meeting. Two anonymous reviewers also provided helpful comments that significantly improved the paper. The final version was completed during a stay as visiting fellow at the American Institute for Economic Research, whose support is gratefully acknowledged.
There has in recent decades been a fierce debate among economists and monetary theorists following in the footsteps of Ludwig von Mises between the so-called free banking school, which admits a large role for fractional reserve banking in the monetary system, versus what we here will call the full-reserve school, which denies any social benefit from fractional reserve banking and the issuance of fiduciary media. A lot of the controversy has centered on whether fiduciary media—money substitutes not covered by reserves—are fraudulent or not, and therefore whether they are at all legitimate in a pure free market based on complete respect for property rights and freedom of contract.
In this article the issue of fraud will be sidestepped and the focus will be on the question of the emergence of fiduciary media in a pure market economy, where all men and institutions, and specifically all banks, are subject to “the rule of common law and the commercial codes that oblige everybody to perform contracts in full faithfulness to the pledged word” (Mises 1953, 440). In particular, there would be no legal tender laws, no deposit insurance, and no central bank acting as lender of last resort. In such a free market order, a bank that failed to honor its contractual obligations would be treated no differently from any other company or person that failed to do this.
If fiduciary media would naturally emerge in such an order, this would prima facie be evidence that they are compatible with it. Mises, despite his hostility to inflation and credit expansion of all kinds, nevertheless suggested that the use of fiduciary media would be a part of a free banking system absent government interventions (Mises 1998, 440; my italics):
Free banking [i.e., banking subject to the commercial codes etc.] is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status.
The free bankers have gone further than this and argue that the use of fiduciary media is beneficial to the economy; while the full-reserve school, pursuing the economic analysis of Mises critical of inflation and credit expansion, have often assumed the position, following the example of Murray N. Rothbard, that fractional reserve banking is a harmful institution and must be outlawed wherever it appears in the free market, since money substitutes are interpreted as titles to money and fiduciary media are by this definition necessarily fraudulent (Rothbard 2009, 2008; Huerta de Soto 2009; Hoppe 2006a, 2006b; and Bagus, Howden, and Gabriel 2015).
It is this article’s contention that the full-reserve theorists are mistaken when they insist that money substitutes must be interpreted as always being money titles, as this is at odds with the theory of value. A callable loan, for instance, could become a fiduciary medium if it is judged to be just as certain and serviceable as money proper by acting individuals. The free bankers too, however, are mistaken when they claim a large role for the circulation of fiduciary media in a pure market economy. It will be shown how it is fundamentally erroneous to consider a mere unbacked claim on a person or an institution as equivalent to money. The error consists in mistaking a future good, or a claim to a future good, for a present good, and in mistaking an unsafe asset for the comparatively safest good, viz., money. As all other errors in the free market, the error of mistaking fiduciary media for fully backed money certificates will tend to be corrected in the process of entrepreneurial profit and loss, leading to the virtual elimination of all fiduciary media from the market economy.
Thus, it will be argued that the full-reserve theorists are correct in asserting that fractional reserve banking has no role to play in the free market, since only by an error of judgment would anyone accept fiduciary media as money. Rather than encouraging the use of fiduciary media, the free market and free banking would correct such errors, leading to the virtual suppression of fiduciary media.
A Note on Definitions
In this paper we will take the approach to monetary theory developed by Ludwig von Mises for granted. As already noted, Mises’s influence on both free-banking and full reserve theorists is apparent, but his monetary theory is also the one that best elucidates the economic facts. Specifically, the classification of money in the narrow and the broader sense that Mises (1953, 50–59; cf. Hülsmann 2012, 33–34) pioneered in 1912 helps distinguish between fiduciary media, other money substitutes, and money in the narrow sense.
Money, taken simply, is a common medium of exchange, valued for its purchasing power. If two commodities are commonly used as money, they are valued separately according to the laws that govern the value of money; they are not somehow aggregated to form one total money supply.
Money in the narrower sense, or money properly speaking, is simply the commodity used as money. Under the gold standard, physical gold was money in the narrow sense. In the modern economy, physical cash is money in the narrow sense.1
Money in the broader sense is perfectly secure and instantly redeemable claims to money in the narrow sense. They can be used in commerce in exactly the same way as money is. “A claim to money may be transferred over and over again in an indefinite number of indirect exchanges without the person by whom it is payable ever being called upon to settle it.” (Mises 1953, 50). The reason for this is that money is not consumed or “used up” in the way that other goods are. Simply by possessing money, the individual gains all the services that money can render, and hence fully secure and present claims to money will be deemed equivalent to money in the narrow sense. Money in the broader sense is more usually referred to as money substitutes and can be further subdivided into money certificates and fiduciary media.
Money certificates are claims to money that are fully backed by money in the narrow sense. E.g., a bank that held physical cash for the full amount of its outstanding demand deposits would only issue money certificates. This would clearly only be a change of the form, not the substance, of money, and issuing money certificates would have no influence on the money supply.
Fiduciary media are claims to money that are not fully backed by money. Commercial demand deposits are nowadays the prime example of this, but historically private banknotes too were fiduciary media. These claims are used as if they could be instantly redeemed, but in reality the issuing bank only ever keeps reserves on hand to be able to redeem a fraction of its issue of money substitutes. Fiduciary media can take the legal form of warehouse receipts, titles to money, and callable loans, that is, instantly redeemable claims on a person or bank such as demand deposits.
Since an issue of titles to money or warehouse receipts in excess of what is kept on reserve is clearly fraudulent, this case will not be considered. This article will deal exclusively with fiduciary media in the form of callable loans. Every time the terms fiduciary media and claims to money are used, they will refer only to callable loans.
It is important to note that the individual holding a money substitute cannot tell whether it is a money certificate or fiduciary medium. This distinction can only be made on a systemic level, as an outsider looking at the economy. To the individual person holding money, the money substitute must have the status of a money certificate, he must be certain of the issuer’s ability to redeem it on demand, since, as Jeffrey Herbener has noted (2002, 83), “people only demand money-substitutes, not fiduciary media, and their demand exists only when they have confidence in full redemption.”
The reader will excuse this brief outline of the basic definitions in the Misesian system. Most of it should be familiar to monetary theorists, but since the argument made here hinges on a clear understanding of the relation between money and fiduciary media, it was thought expedient to include this brief synopsis.
THE FREE BANKING SCHOOL AND THE FULL RESERVE SCHOOL
There are two fundamental positions in the debate on the status of fiduciary media: the free banking school and the full reserve school.2 The free bankers believe that fiduciary media are a useful part of the money supply, and that no fraud is necessarily involved in issuing them. What is here termed the full reserve school is of the opposite view: fractional reserve banking is necessarily fraudulent, and not only is it not beneficial, but the use of fiduciary media is positively harmful, as it causes inflation, Cantillon effects, and the business cycle. While these controversies have a long history reaching back into the nineteenth century and the great British monetary debates (cf. Smith 1936), the current debate among modern Austrian and Austrian-inspired economists began in the wake of the contributions of Ludwig von Mises.
Murray N. Rothbard can be considered the founder of the full reserve school. He first clearly advanced the position that all fiduciary media are necessarily fraudulent, as he saw all money substitutes as titles to a sum of money (Rothbard 2008; 2005). He also categorically denied any economic advantage to society as a whole from the use of fiduciary media, and considered their use the basic cause of the business cycle as well as the problems of inflation (Rothbard 1963, 34–36). Other full reserve theorists follow this basic framework. Jesús Huerta de Soto has argued with a foundation in Roman law that money substitutes are a type of irregular deposit and therefore cannot be increased beyond the amount of money on reserve (Huerta de Soto 2009, 1–36, 119–24) and he too considers the elasticity introduced in the money supply by their use as central to understanding the problems of the business cycle. Hans-Hermann Hoppe (2006a, 2006b) clearly enunciates the Rothbardian position, for instance when he writes (2006b, 200):
Freedom of contract does not imply that every mutually advantageous contract should be permitted. Clearly, if A and B contractually agree to rob C, this would not be in accordance with the principle. Freedom of contract means instead that A and B should be allowed to make any contract whatsoever regarding their own properties, yet fractional-reserve banking involves the making of contracts regarding the property of third parties.
While Robert P. Murphy too belongs to the full reserve school, he has avoided engaging the question of legality in his recent contribution (Murphy 2019) and has focused exclusively on the issue of distortions introduced by fiduciary media and fractional reserve banking. Philipp Bagus, David Howden, Walter E. Block, and Amadeus Gabriel (Bagus and Howden 2010; Bagus, Howden, and Block 2013; and Bagus, Howden, and Gabriel 2015) have entered the ranks of the full reserve school as well, arguing for the impermissibility of fractional reserve banking for involving a confusion between deposits and loans.
Joseph T. Salerno (2010) and Jörg Guido Hülsmann (1996, 2003a) are also here placed in the full reserve camp, although their positions differ slightly. On the one hand, Salerno is fully in agreement with Rothbard when he says that “the 100 percent reserve requirement is not arbitrarily imposed from outside the market, but is dictated by the very nature of the bank’s function as a money warehouse” (Salerno 2010, 362); on the other, he allows that in a fully denationalized system, the shares of banks or money funds that invest part of their “reserves” could become the predominant means of payment in the economy (Salerno 2010, 364). Hülsmann for his part allows for the possibility of “callable loans plus a redemption promise” (IOU RP) circulating on par with money proper (Hülsmann 2003a). Both clearly, however, see no social benefit from stimulating the issue of fiduciary media and both think that it is a historical truth that the vast majority of actually circulating fiduciary media were and are fraudulent, which is why they are decidedly in the ranks of the full reserve school.
The free banking school takes its modern beginning from the works of Lawrence White and George Selgin (White 1995, 1999; Selgin 1988; and Selgin and White 1987, 1996) and also includes economists such as Kevin Dowd (1993), Larry Sechrest (1993), and Steven Horwitz (2000). The point at issue here, the possibility of fiduciary media in a free market, is a key component of free banking theory, and has been defended at length by the free bankers. Their basic claim is that the issue of fiduciary media can take the legal form of a loan or a note with an option clause. Historically, White (2003) has claimed that banknotes indeed took the form of a loan, not a title of ownership to underlying money. This is a strong argument against the full-reserve school’s insistence on interpreting all money substitutes as ownership titles.
The free bankers argue that a free banking system is based on freedom of contract, and therefore interfering with and redefining contracts between banks and their customers, changing loans into warehouse receipts, would be incompatible with the system (Salin 1998) and an unwarranted imposition of the economist’s own ethical judgments on other people (Rozeff 2010). Banks and their clients would be free to make whatever contracts they want, and fractional reserve banking would arise from their free agreement. Selgin (2012) and Evans and Horwitz (2012) have also answered the critiques raised by Bagus and Howden of the free banking position. Selgin in particular argues that the attempt to identify free banking theory with the real-bills doctrine is misguided and that full reserve theorists are wrong to claim that free bankers “confuse an increase in the demand for money with an increase in the overall extent of saving” (Selgin 2012, 139). Selgin here also makes the point, previously made by Hülsmann (1996, 34), that although aggregate demand for money is not the same as the public’s willingness to save and invest, demand for money to hold is a kind of saving. Selgin disagrees with Hülsmann, however, as Selgin (2012, 139) argues that demand for inside money—bank liabilities—is also a supply of savings for investment, whereas Hülsmann sees it as a form of pl
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