A critical note on fractional reserve free banking


Over the last fifteen years, there has been a certain revival of some of the old economic doctrines of the Banking School under the auspices of a group of theorists who defend the idea that fractional-reserve free banking would not only lead to fewer distortions and financial crises than those generated by the current central banking system, but would also achieve the elimination of economic recessions. Given that these theorists base their reasoning on different variations, with a greater or lesser degree of sophistication, of some of the arguments of the old Banking School, we will group them together under the name of the Neobanking School or, if one prefers, the “Fractional-Reserve Free Banking School”. This School is formed by a coalition of theorists with heterogeneous origins.(1) Thus, its components include distinguished members of the Austrian School, such as Lawrence White (2) , George A. Selgin (3) and, more recently, David Horwitz (4) ; members of the English Subjectivist School, like Kevin Dowd (5) ; and, lastly, monetarists like David Glasner (6) , Leland B. Yeager (7) and Richard Timberlake (8) . Even Milton Friedman, although he cannot be considered to form part of this new School, has gradually lent towards it, above all after his disappointment on seeing the failure of the central banks when putting his well-known monetary rule proposal into practice (9) .

Furthermore, some modern theorists of the Fractional-Reserve Free Banking School, led by George Selgin, have proposed a theory of what they call “monetary equilibrium” which, using some analytical elements from the Monetarist and Keynesian Schools, aims to show that fractional-reserve free banking would merely adjust the creation of fiduciary media (bank notes and deposits) to public demand for them. Thus, they argue that fractional-reserve free banking would tend to achieve a “monetary equilibrium” better than other alternative systems, as it would adapt the supply of money to its demand more efficiently.

In simplified terms, this argument is based on considering what happens if there is an increase in the demand for fiduciary media by the economic agents. The reasoning is that, if this occurs, the rhythm of the exchange of fiduciary media for the reserves of the banks will decrease, meaning that the latter will increase and the banks, anxious to obtain higher profits and aware of the increase in their reserves, will expand credit and the issue of bank notes, giving rise to an increase in the issue of fiduciary media that will tend to respond and adapt itself to the previous increase in the demand for them. The contrary occurs in the event of a decrease in the demand for fiduciary media: the economic agents will withdraw a higher amount of reserves in order to dispose of them, meaning that the banks will feel their solvency to be endangered and will be forced to reduce credit and decrease the issue of deposits and bank notes. Thus, the decrease in the supply of fiduciary media will follow the previous decrease in the demand for them.(10)

This theory of “monetary equilibrium” is evidently reminiscent of Fullerton’s Law of Reflux and the old arguments of the Banking School concerning the “needs of trade”. According to the Banking School, the creation of fiduciary media by private banks would not be harmful if it responded to an increase in the “needs” of the traders (11) . According to the new theory of “monetary equilibrium”, the creation of fiduciary media (bank notes and deposits) by private banks would not generate economic cycles if it responded to an increase in the demand for such instruments on the part of the public. Although the embryo of this reformed version of the “needs of trade” theory had already been set forth in Lawrence H. White’s book on Free Banking in Britain (12) , it was nevertheless not developed by this author, but by one of his most distinguished students, George A. Selgin. We will now make a critical study of Selgin’s theory of “monetary equilibrium” in more detail and, in general, of fractional-reserve free banking.


1. The consideration of the changes in the demand for fiduciary media as an exogenous variable

Selgin bases his analysis on considering that the demand for money in the form of fiduciary media is a variable which is exogenous to the system and increases or decreases at the will of the economic agents. Therefore, for Selgin, the main virtue of the free banking system is that it adapts the issue of deposits and bank notes to the increases and decreases in the demand for them. However, this demand is not exogenous to the system, but is determined endogenously by the system itself. This is because money is not a consumer good the increase of which raises the well-being of the economic agents, but is a generally accepted means of exchange, able to fulfil its function perfectly regardless of its volume. At least since Hume, we have known that, from the point of view of the economic system, any volume of money is optimal and that the only thing it determines is the generally higher or lower level of the prices of the goods and services which are exchanged for it or, more precisely, the lower or higher purchasing power of the monetary unit. Therefore, any amount of money fulfils perfectly its function as a means of exchange, and only the decreases or increases in the monetary supply are significant because they produce the effects of redistribution and distortion on the structure of production foreseen in the Austrian theory of economic cycles. Moreover, the increases in the amount of money in circulation generated by a free banking system in the form of fiduciary media (bank notes and deposits) tend to decrease the purchasing power of the monetary unit and this variation affects, in turn, the demand for monetary units in the form of fiduciary media on the part of the economic agents. Thus, other things being equal, the lower the purchasing power of the monetary units, the greater the demand for them will be. The demand for money in the form of fiduciary media is endogenous to the system and increases as a consequence of a prior creation of deposits and bank notes by the banks (13).

It is not a pure coincidence that the theorists of the Fractional-Reserve Free Banking School usually begin their analysis by assuming that there have been mysterious variations in the demand for fiduciary media, the origin and etiology of which they never explain. It is as if they were aware that, on the supply side, the Austrian analysis has demonstrated that the credit expansion causes important distortions of the economy which seem to justify a rigid monetary system that prevents the monetary expansions and contractions generated by their fractional-reserve free banking system. On the supply side, therefore, it seems that the theoretical arguments support the establishment of an inelastic monetary system such as the pure gold standard with a 100 per cent reserve requirement for bank demand deposits. Consequently, it is easy to understand that, if the defenders of the Neobanking School want to justify theoretically a fractional-reserve free banking system that may freely give rise to important increases and decreases in the supply of fiduciary media, they must resort solely to the demand side of the problem, in the hope of being able to show that, when these modifications in the fiduciary media supply occur (and they will be inevitable in a fractional-reserve free banking system), it is because they always satisfy prior variations in the demand. Thus, a hypothetical “monetary equilibrium”, which existed previously and had been altered by an exogenous variation in the demand for fiduciary media, will be re-established.

However, the evolution of events is usually the opposite of what these theorists indicate. It does not start with autonomous or original movements in the demand for money, but rather in the manipulation of the monetary supply (credit expansion) which, to a greater or lesser extent, all fractional-reserve free banking systems tend to generate autonomously and exogenously. These increases of the credit expansion will distort the productive structure and only later will they provoke a period of deep economic recession which leads to sudden variations in the demand for money.

It is true that, if there exist many free banks that are not supported by a central bank, the credit expansion will stop long before would be the case in a environment in which the central bank orchestrated and drove it, and also used its liquidity to support any banks which might be in danger. This is the main argument in favour of free banking originally developed by Parnell and also later considered as a second-best by Mises (14). However, it is one thing to affirm that completely free banking will find its limits to the credit expansion earlier, and quite a different one to say that in no case will the credit expansion generated by a fractional-reserve free banking system distort the productive structure because it will only tend to re-establish a hypothetical “monetary equilibrium”. In fact, Ludwig von Mises himself makes it very clear that all credit expansion distorts the productive system, thus totally rejecting the essence of the modern theory of monetary equilibrium. Mises states that “the notion of ‘normal’ credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the trade cycle”.(15)

The theory of “monetary equilibrium” does not recognize that the supply of fiduciary media generates, to a large extent, its own demand. In other words, the modern free banking theory shares the essential error of the old Banking School which stems, as Ludwig von Mises so rightly showed, from not having realized that the credit demand from the public is a magnitude which depends precisely on the banks’ willingness to lend. Thus, banks which are not too concerned about their future solvency are in a situation where they can expand credit and place new fiduciary media in the market simply by reducing the interest they ask on the new loans they create and making easier the other contractual conditions they normally require for granting their new credits (16) . Moreover, the increase in money to which the credit expansion gives rise tends, at least during an initial period, to increase the demand for fiduciary media. In fact, those economic agents who are not entirely aware that an inflationary process of expansion has commenced will see how the prices of certain goods and services start to grow relatively faster and, maintaining the hope that these prices will have to return to their “normal” level, will probably decide to increase their demand for fiduciary media. To quote Mises again, “This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings”.(17)

Therefore, it is not only that the banks of a fractional-reserve free banking system can initiate a credit expansion unilaterally; also, over a long period of time, the increase in the supply of fiduciary media (which can always be placed in the market by lowering adequately the interest rate) tends to produce, at the start, an increase in demand, which will last until the public begins to distrust the situation of economic boom and realizes that there is going to be a general price rise, followed by a crisis and a deep economic recession.

We may conclude that if the origin of the mutations (including increases in the demand for money) is on the supply side, the essential foundation of the “theory of monetary equilibrium”, according to which the supply of fiduciary media simply adjusts itself to the demand for them, disappears. In reality, it is the demand for fiduciary media which, at least for a significant time period, tends to adjust itself to the greater monetary supply generated by the banks in the form of credits.(18)


2. The theory of “monetary equilibrium” is based on an exclusively macroeconomic analysis

Attention should be drawn to the fact that the modern analysis of the free banking theorists ignores the microeconomic effects which arise from the increases and decreases in the supply and demand of money generated by the banking system. In other words, even accepting, for dialectic purposes, that the origin of all evils is, as they assume, unexpected mutations in the demand for money by the economic agents, it is evident that the fiduciary media supply generated by the banking system to accommodate the changes in the money demand does not arrive instantaneously at the precise economic agents whose valuations in respect of holding new fiduciary media have mysteriously been modified. They rather flow into the market through very specific points and in a very precise way: in the form of credits granted by reducing interest rates and received, in the first place, by certain entrepreneurs and investors who thus tend to initiate new investment projects which distort the structure of production.

It is not surprising, therefore, that the modern theorists of the Free Banking School tend to ignore many essential elements of the Austrian theory of economic cycles. It is evident that this Austrian theory is difficult to fit in with their analysis of the issue of fiduciary media in a fractional-reserve free banking system. This is why they normally take refuge in an exclusively macroeconomic analysis (monetarist or Keynesian, depending on the case) and use the instruments which, like the equation of exchange or the concept of “price level”, tend precisely to conceal the important microeconomic phenomena which take place in an economy when there is credit expansion and the amount of fiduciary media changes (variation in relative prices and intertemporal discoordination).

In normal market processes, the supply of consumer goods and services tends to vary in accordance with the demand for them and the new production of this type of goods tends to reach precisely the consumers whose subjective valuation of them has increased. However, the situation in relation to money is very different. Money does not directly satisfy any human need (that is, it is not a consumer good). Therefore, any volume of money can perfectly fulfil its mission as a generally-accepted means of exchange. The only thing that the money volume determines is the purchasing power of the monetary unit, which is greater if the volume is lower than if it is higher. Generally, the modern Free Banking School theorists tend to ignore this essential principle of monetary theory and, as we have seen, the intimate relationship which exists between the supply and the demand for money. Neither do they usually mention that the growth in the supply of fiduciary media does not generally go immediately and directly into the pockets of the economic agents whose demand for them may have increased, but reaches them after a long and sinuous process, passing previously through the pockets of many other economic agents and distorting the whole productive structure during this long transitional phase.


3. The confusion between the concept of saving and the concept of demand for money

The attempt to recover at least the essence of the doctrine of the “needs of trade” and demonstrate that fractional-reserve free banking will not give rise to economic cycles has led George A. Selgin to defend a very similar thesis to that set forth by John Maynard Keynes when he discussed bank deposits. We should remember how, for Keynes, the man who holds the additional money corresponding to the new bank credit is said to be saving: “Moreover, the savings which result from this decision are just as genuine as any other savings. No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth”.(19)

George Selgin’s position is entirely parallel to that of Keynes and he considers that the public demand to hold cash balances in the form of bank notes and deposit accounts simultaneously reflects the desire to offer short-term loans for an identical amount through the banking system. In fact, Selgin affirms that “to hold inside money is to engage in voluntary saving. Whenever a bank expands its liabilities in the process of making new loans and investments, it is the holders of the liabilities who are the ultimate lenders of credit, and what they lend are the real resources they could acquire if, instead of holding money, they spent it. Under these conditions, banks are simply intermediaries of loanable funds”.(20)

We do not feel it possible to uphold this argument. In fact, an increase in the balances of fiduciary media that the public wish to hold is perfectly compatible with a simultaneous increase in the demand for consumer goods and services if the public decides to decrease its investment expenditure. The truth is that any economic agent may use his money balances in any of the following three ways: he may spend them on consumer goods and services; he may spend them on investments; or he may hold them in the form of cash balances or fiduciary media. There is no other alternative. The decision as to the proportion that will be spent on consumption or investment is different to and independent of the decision taken on the fiduciary media and cash balances one wishes to hold. Thus, it cannot be concluded that all money balances are equivalent to “savings”, as it is perfectly possible that the increase in the monetary balance takes place as a result of a decrease in investment expenditure, which makes it possible to increase the final monetary expenditure on consumer goods and services. Under these circumstances, there will be a decrease in saving by the economic agent, who will simultaneously have increased his money balances.

We do not, therefore, consider the statement that “every holder of demand liabilities issued by a free bank grants that bank a loan for the value of his holdings” to be correct (21) . This is the same as saying that any creation of money, in the form of deposits or bank notes, by a bank in a fractional-reserve free banking system implies, ultimately, the a posteriori grant of a loan for the same amount to the bank. However, the bank generates credits from nowhere and offers purchasing power to the entrepreneurs, who receive it without taking any account at all of the real desires on consumption and investment of the economic agents who, in the final analysis, will become the ultimate holders of the fiduciary media it creates. And thus it is very possible that, if social preferences on consumption and investment have not changed, the new fiduciary media created by the banks will be used to increase consumer goods expenditure, forcing the relative prices of this type of goods to rise. As Hayek rightly says, “So long as any part of the additional income thus created is spent on consumer’s goods (i.e. unless all of it is saved), the prices of consumer’s goods must rise permanently in relation to those of various kinds of input. And this, as will by now be evident, cannot be lastingly without effect on the relative prices of the various kinds of input and on the methods of production that will appear possible”. (22) Hayek clarifies even more our position when he concludes that “All that is required to make our analysis applicable is that, when incomes are increased by investment, the share of the additional income spent on consumer’s goods during every period of time should be larger than the proportion by which the new investment adds to the output of consumer’s goods in the same period of time. And there is of course no reason to expect that more than a fraction of the new income [created by the credit expansion], and certainly not as much as has been newly invested, will be saved, because this would mean that practically all the income earned from the new investment would have to be saved”.(23)

Furthermore, Selgin considers that all notes or deposits issued by a bank are “financial assets” which instrument a “loan”. Juridically, there are serious problems with this idea, which we will explain later. Economically, his error consists of considering that money is a “financial asset” that represents the voluntary saving of an economic agent who “lends” present goods in exchange for future goods. However, money is in itself a present good and holding fiduciary media balances gives no indication of the behaviour of the economic agent who owns the money in relation to the proportion in which he wishes to consume or invest: increases and decreases in his balances of bank notes and deposits are perfectly compatible with simultaneous increases and decreases in the proportion in which he decides to consume or invest. As we have already seen, it is perfectly conceivable that the increase in the fiduciary media balances takes place simultaneously to an increase in the consumption of goods and services, for which it is only necessary for the economic agent to disinvest some of the resources he had saved and invested in the past. In fact, the supply of and demand for money determine its price or purchasing power, while the supply of and demand for “present goods” in exchange for “future goods” determine the interest rate (or social time preference rate) and the overall volume of savings and investment (24). We can, therefore, conclude that money is a perfectly liquid present good (25) . For the overall banking system, fiduciary media are not “financial assets”, as they are never withdrawn from the system, but rather circulate indefinitely, passing from hand to hand, since they are money (or better, a perfect “money substitute”). On the contrary, a financial asset represents the delivery of present goods in exchange for future goods which must always be returned on a certain future date (even if it is after a short time period) and its creation results from a real and previous increase in saving by the economic agents.

New savings always require a decrease in the rate of real consumption that has existed. They are not the difference between real consumption and the hypothetical “potential” consumption which could be enjoyed if all the fiduciary media balances were spent on consumer goods. Selgin appears to uphold this second erroneous conception when he criticizes Machlup (26) for considering, in our opinion correctly, that the expansionary granting of credits provides a purchasing power that has not previously been sacrificed from consumption (i.e., saved) by anybody. Credit should always come from previous saving if it is not to distort the productive structure. If this consumption sacrifice has not taken place, but rather the investment is financed by a newly-created credit, the structure of production will, as we know, inexorably become distorted. For this reason, Selgin, like Keynes, is forced to redefine the concept of saving. For them, saving takes place ipso facto from the moment at which new fiduciary media are created, to the extent that their initial holder could spend them on consumer goods and does not do so. And credit expansion without previous saving need not generate economic cycles because, otherwise, the very foundations of the logical framework of their theory would be entirely destroyed. In short, we find that Selgin’s arguments are very similar to those put forward by Keynes in his General Theory which, as we have seen, were refuted many years ago by Mises, Hayek and Anderson.

Moreover, the creation of fiduciary media implies an increase in the money supply which tends to decrease the purchasing power of money, “expropriating” the value of the monetary units of the citizens dilutedly and imperceptibly. It is, without doubt, sarcastic to affirm that this expropriation is a “voluntary” saving made by the economic agents which suffer it and finally hold the notes and deposits created by the banks. It is not surprising that these doctrines have been defended by authors like Keynes, Tobin, Pointdexter and, in general, those who justify inflationism, credit expansion and the “euthanasia of the rentiers”, in the interests of economic policies the sole objective of which is to maintain a high level of “aggregate demand”. But it is surprising that authors like Selgin and Horwitz, who, as members of the Austrian School, are more familiar with the dangers involved, have had to resort to the theories we are critically analyzing to justify their “fractional-reserve free banking” system. Finally, if the argument that all creation of fiduciary media implies ipso facto an increase in savings were true, it could also be used to justify all credit expansions, not only the credit expansion that takes place in a way that is, in fact, limited by a free banking system, but also the orchestrated credit expansion without any limitation or control by a central bank. Perhaps Selgin and the theorists who share his doctrines do not realize that, on resorting to some old Keynesian arguments to justify their free banking system, they are indirectly justifying expansionary economic policies that may be carried out much more “efficiently” through a central bank, all of which is harmful to the same free banking system they wish to defend.(27)


4. The danger of the historical illustrations of free banking systems

The bibliography of the modern Neobanking School theorists devotes great effort to historical studies intended to support the thesis that the fractional-reserve free banking system immunizes economies against cycles of boom and depression, thanks to the “monetary equilibrium” mechanism. However, firstly, the historical studies made to date, instead of concentrating on an analysis of whether the free banking system avoided credit expansion, artificial booms and economic recessions, have, in practice, been limited to studying whether bank panics were more or less frequent and serious than in a central bank system (which is, obviously, a very different matter). Moreover, secondly, it is very doubtful that the empirical evidence presented to date can serve as an adequate illustration of the virtues of a fractional-reserve free banking system, as most of the historical cases studied cannot be considered totally free: the private banks involved directly or indirectly received support, either from the government in order to suspend convertibility, or from another larger bank or group of banks that acted as last resort lenders to provide liquidity, or from legal or customary practices that made it difficult for the system to work freely. We will discuss these two aspects briefly.

An illustration of the first problem is contained in a recent study by George A. Selgin in which he compares the bank panics that took place in different historical “free” banking systems with other systems in which the banks were controlled by a central bank. The conclusion he reaches is that, in the latter case, the number and seriousness of the bank panics was greater.(28) And the main thesis of Lawrence White’s book on banking freedom in Scotland is based on the argument that the Scottish banking system, relatively “freer” than the English system, was more “stable” and subject to less financial upheavals.(29)

However, as Murray N. Rothbard has pointed out, the fact that, in relative terms, there were less bankruptcies of banks in the supposedly free Scottish banking system than in the English system does not in any way mean that the Scottish system was superior. (30) In fact, bankruptcies of banks have been almost completely eliminated under the present systems based on a central bank and this does not mean that they are superior to a free banking system subject to the law, but rather the contrary. The existence of bank bankruptcies, far from indicating that the system works badly may be a sign of the healthy social process of economic reaction that takes place in the market against the aggression implied by the privileged practice of banking with a fractional reserve. Thus, where there is a fractional-reserve free banking system and bank bankruptcies and suspensions of payments do not occur regularly, it is inevitable to suspect that there are institutional reasons which defend the banks from the normal consequences of practising their activity with a fractional reserve and which are able to play a role similar to the one currently played by a modern central bank. In short, the alleged historical case would not be a truly free banking system and, therefore, its supposed greater stability could not be considered as a historical illustration to support the conclusions of the theory of monetary equilibrium. Thus, it seems that, in the case of Scotland, the banks had “promoted” the use of their notes in economic transactions to such an extent that almost nobody demanded they be paid in gold and anybody who occasionally requested cash at the cash desk of their bank received general disapproval and all kinds of pressures from the bankers, who described this behaviour as “disloyal” and threatened to make it more difficult for the customer to obtain credits in the future. Moreover, “Scottish banks pyramided on top of the Bank of England and were often bailed by the bank”. (31) Finally, other studies show that the Scottish fractional-reserve free banking system was constantly subject to recurrent and successive phases of credit expansion and contraction, which led to the corresponding economic cycles of boom and recession over the years 1770, 1772, 1778, 1793, 1797, 1802-1803, 1809-1810, 1810-1811, 1818-1819, 1825-1826, 1836-1837, 1839 and 1847 (32) . Although there could be fewer bank panics in Scotland than in England in relative terms, the successive cycles of boom and recession were equally serious and Scotland was not free of credit expansion, artificial booms or the subsequent phases of recession. It seems, therefore, that before giving a final opinion, we should seek historical examples of true fractional-reserve free banking systems, in order to analyze whether or not they gave rise to credit expansions and economic recessions.

A more interesting historical case which illustrates the inability of a fractional-reserve free banking system to avoid artificial expansions and economic crises is, perhaps, the Chilean financial system of the 19th century. In fact, during the first half of the century, Chile did not have a central bank and enjoyed a free banking system with a 100 per cent reserve requirement. For several decades, its citizens strongly resisted a number of attempts to introduce a fractional-reserve banking system and, over those years, they enjoyed great economic and financial stability. Things began to go wrong when, in 1853, the Chilean government contracted Jean-Gustav Courcelle-Seneuil (1813-1892), one of the most conspicuous French fractional-reserve free banking theorists, as lecturer in Political Economy at the University of Santiago de Chile. Courcelle-Seneuil’s influence in Chile over the ten years for which he was teaching there was so great that, in 1860, on his advice, a law was issued which permitted fractional-reserve free banking, without a central bank, to be established. From that date onwards, the traditional financial stability of the Chilean system disappeared and there were successive phases of artificial expansion based on the granting of new credits and banking collapses and economic crises, with the suspension on the convertibility of paper money on several occasions (1865, 1867 and 1879). A period of inflation and serious economic, financial and social imbalance commenced, which still forms part of the collective memory of the Chileans today and explains that financial disorders continue to be erroneously identified with the doctrinal libertarianism of Courcelle-Seneuil.(33)

We also have other interesting historical studies that analyze true free banking systems, with no kind of central bank or institutional restrictions on the withdrawal of deposits in cash whatsoever. All of them confirm the thesis that fractional-reserve free banking systems can generate important credit expansions able to provoke deep economic recessions. Thus, Carlo M. Cipolla has made a study interpreting the banking and economic crisis of the second half of the 16th century which, although it refers strictly to the Italian banks, is also directly applicable to the Mediterranean financial system, as the trading and financial circuits and flows between the different Mediterranean nations (Italy, Spain, etc.) were intimately related at that time (34). Cipolla explains that the monetary supply in the second half of the 16th century included a large amount of “bank money” or deposits created out of nowhere by the bankers who did not keep a 100-percent-reserve ratio of the cash which had been deposited with them at demand by their clients. This led to a tremendous artificial thriving of the economy, which inexorably reverted from the second half of the 16th century onwards, when the depositors began to undergo and fear growing economic difficulties and the succession of bankruptcies of the most important bankers in Florence commenced. This expansionary phase was started in Italy, according to Cipolla, by the managers of the Ricci Bank, who used a significant part of the bank’s newly created deposits to purchase public funds and grant credits. This policy of credit expansion dragged the other banks along with it, if they wanted to be competitive and maintain their profits and market share. A state of credit euphoria was thus created, which gave rise to a great artificial expansion that soon began to revert. Thus, we can read an edict of 1574 in which accusations are made against the bankers who refuse to return the deposits in cash and which proclaims the fact that they are only “paid with ink”. They had increasing difficulties in returning the deposits in ready money and a significant money shortage began to be perceived in the Venetian cities. The artisans could not withdraw their money or pay their debts and there was a heavy credit contraction (in other words, a deflation) and a deep economic crisis, which Cipolla analyzes in detail in his brilliant book (35). Also a very similar conclusion may be reached by analyzing the case of the banking system of Catalonia during the 14th and 15th centuries. In general, it operated with a reserve of 30 per cent and also gave rise to great credit expansions and economic recessions.(36)

In short, historical experience does not appear to support the theses of the modern fractional-reserve free banking theorists. Even in the historical less regulated free banking systems, there were cycles of boom and recession which originated from the credit expansion of the banks as well as bank panics and bankruptcies. Recognition of this fact has led modern Free Banking School theorists, like Stephen Horwitz, to insist that the historical evidence against their theory of monetary equilibrium, even though it has a certain degree of relevance, cannot serve to refute the fractional-reserve free banking theory, which should be done by strictly theoretical procedures.(37)


5. The non-consideration of juridical arguments

The fractional-reserve free banking school theorists tend to leave legal considerations out of their arguments. They normally forget that the analysis of banking issues must be essentially multidisciplinary because there is an intimate theoretical and practical connection between the juridical and economic aspects of all social processes in general and those related to banking in particular.(38)

Thus, in the first place, it should be noted that the practice of banking with a fractional reserve involves a logical impossibility from the legal point of view. In fact, whenever a bank grants loans against money which has been deposited with it at demand, a dual availability of the same sum of money is created: first, it is available to the original depositor and, second, it is available to the borrower who receives the loan. It is clear that two individuals cannot simultaneously enjoy the availability of one and the same thing and that to make the same thing available to a second person is a fraudulent act.(39) The undue appropriation and fraud are evident and were committed at least in the initial stages of the formation of the modern banking system.

Once the bankers obtained from the government the privilege of acting on the base of a fractional reserve, their criminal status disappeared, at least from the standpoint of positive law. But this privilege in no way endows the monetary bank deposit contract with an adequate legal nature. On the contrary, this contract appears, on most occasions, as a contract which is null and void as, from the point of view of its purpose, one of the parties, the depositor, makes the transaction considering it as a deposit, while the other, the depositary banker, receives it as a loan. And, according to the most standard legal principles, when each of the participants in an exchange believes that they are making a different contract, that contract is null and void.

Thirdly, even if the two parties, the depositors and the bankers, coincided in the belief that the transaction were a loan, the legal nature of the monetary bank deposit contract would not be resolved. This is the case because, from an economic point of view, it is impossible that the banks can, under all circumstances, comply with the obligation to return the deposits they have received for an amount in excess of the reserves they hold. This impossibility is, furthermore, aggravated to the extent that the practice of fractional-reserve banking tends to generate banking crises and economic recessions which recurrently place the solvency of the banks in danger. And contracts which are impossible to put into practice under certain circumstances are also null, according to general legal principles. Only by maintaining a 100 per cent reserve which guaranteed that the supposed “loans” granted (by the depositors) may be repurchased (by the banks) at any moment, or through the existence and support of a central bank which provided all the liquidity necessary in moments of difficulty, could these “loan” contracts with a covenant for the repayment of their nominal value at any moment be made possible and, therefore, valid.

In the fourth place, even if it is argued that the impossibility of compliance with bank deposit contracts of money only occurs every certain number of years, their legal nature would still not be solved, because the practice of fractional-reserve banking is a breach of public order and is damaging to third parties.(40) In fact, fractional-reserve banking, as it generates expansionary credits without the support of real savings, distorts the structure of production and leads the entrepreneurs who receive the loans, deceived by the greater ease of the credit conditions, to undertake investments which, in the final analysis, will not be profitable. When the inevitable economic recession arrives, their investment projects will have to be interrupted and liquidated, with a high cost from the economic, social and personal points of view, not only for the entrepreneurs and investors themselves, but also for the rest of the economic agents involved in the market process (workers, suppliers, consumers, etc.). We cannot, therefore, accept the argument, put forward by White and Selgin (41), among others, that, in a free society, the banks and their clients should be free to establish the contractual covenants they consider most fitting. Actually, when mutually satisfactory agreements between two parties are made with legal fraud or damages to third parties and therefore, constitute a breach of public order, the corresponding “contracts” are entirely null and void.

Hans-Hermann Hoppe (42) explains how this type of “contract” damages third parties in three different ways: first, to the extent that the credit expansion increases the monetary supply and decreases the purchasing power of the monetary units of the other holders of money balances, who are expropriated part of the value their monetary units would have if the credit expansion had not occurred; second, the depositors in general are damaged because, as a consequence of the credit expansion process, the probability that, in the absence of a central bank, they will be able to recover their monetary units intact decreases; and, if a central bank exists, to the extent that, although the return of their nominal deposits could be guaranteed, the purchasing power of their monetary units will be significantly reduced; and, third, the greatest damage is produced on the rest of the borrowers and economic agents in the form of generalized malinvestment, financial crisis, unemployment and great unrest, stress and human suffering.

Any manipulation of money, which is the generalized means of exchange accepted in society, always implies, in accordance with the very definition of the concept of money, that unidentified third-party participants are affected (43) In fact, economically speaking, the effects of the credit expansion are, from a qualitative point of view, identical to those of the criminal forgery of coins and bank notes which are dealt with, for example, in articles 283-290 of the Spanish Criminal Code (44). Both of them imply the creation of money, the redistribution of income in favour of a few people to the detriment of the other citizens, and the overall distortion of the productive system. However, from a quantitative point of view, only a credit expansion is able to expand the monetary supply by a sufficient volume and at a rate capable of feeding an artificial boom and causing a recession. In comparison with the credit expansion of fractional-reserve free banking and the monetary manipulation of governments and central banks, the criminal forgery of money is child’s play and almost imperceptible.

The above considerations have had their influence on White, Selgin and other modern free banking theorists, who have proposed, in order to guarantee stability of the system, that the “free” banks should establish a “safeguard”clause on their notes and deposits, informing their clients that the bank may decide, at any time, to suspend or defer the return of the deposits or the payment of the corresponding notes in cash (45). It is clear that the introduction of this “option” clause would be equivalent to eliminating any monetary nature, the essence of which is precisely the availability of perfect, i.e. immediate, complete and totally unconditional, liquidity, from the corresponding instruments. The “option clause” system is therefore based on partial and temporary expropriation of the property rights of the depositors and note-holders whom, in crisis conditions, are converted into compulsory lenders, rather than continuing as depositors holding perfectly liquid monetary units or perfect money substitutes. Thus, the traditional deposit contracts would be converted into a peculiar form of “random contract” or lottery, in which recovery of the corresponding deposits would depend of the luck, influence and other specific circumstances of each moment. No objection can be raised to the fact the certain parties decide to make a such an irregular random contract. But, to the extent that, in spite of the existence of this clause and the perfect knowledge of its implications by all the participants (bankers and their clients), they and the rest of the economic agents would behave as if they considered, from the subjective point of view, that for practical purposes their demand deposits are perfectly liquid, then the banking system could identically create credit expansions. The “option clauses”, therefore, would not avoid the reproduction of all the processes of expansion, crisis and economic recession which are typical of the practice of fractional-reserve free banking. The option clauses at most can protect the banks, but not the society or the economic system, from all the damages produced by the successive phases of credit expansion, boom and recession. Thus, the “option clauses” argument is only a “last line of defence” that in no way solves the fact that fractional-reserve banking produces very serious systematic damages to third parties which constitute a breach of public order.

It is surprising that, in spite of all the foregoing arguments, most of the Neobanking School theorists, instead of proposing the abolition of fractional reserve banking, only propose the elimination of central banks and the complete privatization of the banking system, without making any reference to the 100 per cent reserve requirement. It is true that this privatization would tend to put a stop to the almost unlimited abuses that the monetary authorities commit today in the financial field, but it does not prevent the possibility that abuses be also committed (on a smaller scale) in the private field. This is similar to the situation that would arise if governments were allowed to systematically kill, steal or commit any other crime. The social damage that this would generate would be tremendous, in view of the enormous power and monopolistic nature of the State. And without any doubt, the privatization of these criminal activities (eliminating the systematic practice of them by the government) would tend to “improve” the situation appreciably: at least the great criminal power of the State would disappear and private economic agents would be allowed to develop prevention and defence procedures against these crimes. However, the privatization of criminal activities is not the final solution to the problem they pose and they would only be completely eliminated if they were put down by all possible means, even if they were committed by private agents in an entirely private environment. We may, therefore, conclude with Murray N. Rothbard that, in an ideal economic free market system, “fractional-reserve bankers must be treated not as mere entrepreneurs who made unfortunate business decisions but as counterfeiters and embezzlers who should be cracked down on by the full majesty of the law. Forced repayment to all the victims plus substantial jail terms should serve as a deterrent as well as to meet punishment for this criminal activity”.(46)


6. Conclusion

The traditional form in which the controversy between the supporters of central banks and those of fractional-reserve free banking is posed is essentially erroneous. In fact, the advocates of fractional-reserve free banking do not realize that their proposal unleashes an almost unavoidable trend towards the emergence, development and consolidation of a central bank. The credit expansion generated by any fractional-reserve banking system gives rise to reversion processes, in the form of banking crises and economic recessions, which inevitably cause the citizens to demand the intervention of the government, as well as the state regulation of the activity. Furthermore, the bankers themselves soon discover that they reduce the risk of insolvency if they reach agreements among themselves, merge and even demand the creation of a last resort lender (central bank), which provides them with the necessary liquidity at times of adversity and institutionalizes and officially orchestrates the growth of the credit expansion.(47)

We can, therefore, conclude that the practice of fractional-reserve banking is the main factor responsible for the emergence and development of the central bank. For this reason, the theoretical and practical discussion should be raised, not in the traditional terms, but between the only two feasible systems, radically opposed to each other, which are: either a free banking system subject to traditional legal principles (i.e., with a 100 per cent reserve ratio), in which, therefore, all transactions in which a fractional reserve is established, be they voluntary or otherwise, are considered illegal and a breach of public order; or a system which allows the practice of fractional-reserve banking, from which a central bank will inevitably emerge as a last resort lender and controller of the whole financial system. These are the only two theoretically and practically viable alternatives.


Jesús Huerta de Soto
Professor of Political Economy
King Juan Carlos University of Madrid, Spain

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(1) As David Laidler points out, the recent interest in free banking and the development of the Neobanking School stems from the book published by Friedrich A. Hayek in 1976 entitled, in its second edition, Denationalization of Money: The Argument Refined, An Analysis of the Theory and Practice of Concurrent Currencies, Institute of Economic Affairs, London 1978. Before Hayek, Benjamin Klein had made a similar proposal in his article “The Competitive Supply of Money”, Journal of Money, Credit and Banking, No. 6, November 1974, pp. 423-453. See David Laidler, “Free Banking Theory”, The New Palgrave: A Dictionary of Money and Finance, Macmillan Press, London and New York 1992, Vol. II, pp. 196-197.

(2) Lawrence H. White, Free Banking in Britain: Theory, Experience and Debate, 1800-1845, Cambridge University Press, New York and London, 1984, 2nd edition, IEA, London 1995; Competition and Currency: Essays on Free Banking and Money, New York University Press, New York 1989; and also the article written jointly with George A. Selgin, “How would the invisible hand handle money?”, Journal of Economic Literature, Vol. XXXII, No. 4, December 1994, pp. 1718-1749. In addition, Lawrence H. White has compiled the most important works of the Neobanking School in three volumes on Free Banking: Volume I, 19th Century Thought; Volume II, History; and Volume III, Modern Theory and Policy, Edward Elgar, Aldershot, England, 1993.

(3) George A. Selgin, “The Stability and Efficiency of Money Supply under Free Banking”, Journal of Institutional and Theoretical Economics, No. 143, 1987, pp. 435-456, republished in Free Banking: Volume III, Modern Theory and Policy, Lawrence H. White (ed.), op. cit., pp. 45-66; The Theory of Free Banking: Money Supply under Competitive Note Issue, Rowman & Littlefield, Totowa, New Jersey, 1988; and also the article written jointly with Lawrence H. White, “How would the invisible hand handle money?”, op. cit.; and “Free Banking and Monetary Control”, The Economic Journal, Vol. 104, No. 427, November 1994, pp. 1449-1459.

(4) Stephen Horwitz, “Keynes’ Special Theory”, Critical Review: A Journal of Books and Ideas, Summer-Autumn 1989, Vol. III, Nos. 3-4, pp. 411-434; and also “Misreading the Myth: Rothbard on the Theory and History of Free Banking”, published as Chapter XVI of The Market Process: Essays in Contemporary Austrian Economics, Peter J. Boettke and David L. Prychitko (eds.), Edward Elgar, Aldershot, England, 1994, pp. 166-176.

(5) Kevin Dowd, The State and Monetary System, Saint Martin’s Press, New York 1989; The Experience of Free Banking, Routledge, London 1992; and Laissez-Faire Banking, Routledge, London and New York 1993.

(6) David Glasner, Free Banking and Monetary Reform, Cambridge University Press, Cambridge 1989; “The Real-Bills Doctrine in the Light of the Law of Reflux”, History of Political Economy, Vol. 24, No. 4, Winter 1992, pp. 867-894.

(7) Leland B. Yeager and Robert Greenfield, “A Laissez-Faire Approach to Monetary Stability”, Journal of Money, Credit and Banking, No. XV (3), August 1983, pp. 302-315, republished as Chapter XI of Free Banking, Lawrence H. White (ed.), op. cit., Vol. III, pp. 180-195; and Leland B. Yeager and Robert Greenfield, “Competitive Payment Systems: Comment”, American Economic Review, No. 76 (4), September 1986, pp. 848-849.

(8) Richard Timberlake, “The Central Banking Role of Clearinghouse Associations”, Journal of Money, Credit and Banking, No. 16, February 1984, pp. 1-15; “Private Production of Scrip-Money in the Isolated Community”, Journal of Money, Credit and Banking, No. 4, October 1987 (19), pp. 437-447; “The Government’s License to Create Money”, The Cato Journal: An Interdisciplinary Journal of Public Policy Analysis, Vol. IX, No. 2, Autumn 1989, pp. 302-321.

(9) Milton Friedman and Anna J. Schwartz, “Has Government any Role in Money?”, Journal of Monetary Economics, No. 17, 1986, pp. 37-72, republished as Chapter XXVII of the book The Essence of Friedman, Kurt R. Leube (ed.), Hoover Institution Press, Stanford University, California, 1986, pp. 499-525.

(10) A more detailed analysis can be found, for example, in George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue, op. cit., Chapters IV, V and VI, pp. 52-89.

(11) In fact, the banking arguments had already been set forth at an embryonic stage by the anti-bullionist theorists of 18th-century Great Britain. See “The Early Bullionist Controversy”, “The Bullion Report and the Return to Gold” and “The Struggle over the Currency School”, Chapters 5, 6 and 7 of Murray N. Rothbard, Classical Economics: An Austrian Perspective on the History of Economic Thought, Vol. II, Edward Elgar, Aldershot, England, 1995, pp. 159-274; and also F.A. Hayek, “English Monetary Policy and the Bullion Debate”, Part III, Chapters 9-14 of The Trend of Economic Thinking: Essays on Political Economists and Economic History, W.W. Bartley III and Stephen Kresge (eds.), The Collected Works of F.A. Hayek, Vol. III, Routledge, London 1991, pp. 127-344.

(12) According to Stephen Horwitz, Lawrence White “expressly rejects the real-bills doctrine and endorses a different version of the ‘needs of trade’ idea. For him the ‘needs of trade’ means the demand to hold bank notes. On this interpretation, the doctrine states that the supply of bank notes should vary in accordance with the demand to hold notes. As I shall argue, this is just as acceptable as the view that the supply of shoes should vary to meet the demand for them”. Stephen Horwitz, “Misreading the Myth: Rothbard on the Theory and History of Free Banking”, op. cit., p. 169.

(13) Joseph T. Salerno points out that, for Mises, increases in the demand for money do not pose any problem of coordination, provided that the banks do not try to adapt themselves to them by creating new credits. Thus, even in the event of an increase in savings (in other words, a decrease in consumption) which materializes entirely in an increase in cash balances (hoarding) and not in direct loans in the form of capital goods expenditure, there will be effective saving of the community’s goods and services and a process whereby the productive structure will lengthen and become more capital intensive. If this occurs, the increase in cash balances will simply give rise to an increase in the purchasing power of money and, therefore, to a decrease in the nominal prices of consumer goods and the services of the different production factors which, however, will generate among themselves, in relative terms, the price disparities which are typical of a period in which savings grow and the structure of production becomes more capital intensive. See Joseph T. Salerno, “Mises and Hayek De-Homogenized”, The Review of Austrian Economics, Vol. VI, No. 2, 1993, pp. 113-146, especially pp. 144 onwards; and also Ludwig von Mises, Human Action, op. cit., pp. 520-521.

(14) Salerno criticizes White for defending the thesis that Mises was the prototype of the modern neobanking school theorists without realizing that Mises always criticized the essential positions of the Banking School and that, if he defended free banking, it was as an indirect procedure for attaining the final goal of a banking system with a 100 per cent reserve requirement. Salerno concludes that “To the extent that Mises advocated the freedom of banks to issue fiduciary media, he did so only because his analysis led him to the conclusion that this policy would result in a money supply strictly regulated according to the Currency Principle. Mises’ desideratum was to completely eliminate the destructive influences of fiduciary media on monetary calculation and the dynamic market process”. Joseph T. Salerno, “Mises and Hayek De-Homogenized”, The Review of Austrian Economics, op. cit., p. 137 onwards and p. 146.

(15) Ludwig von Mises, Human Action, p. 442 (emphasis added). A little later Mises adds that “Free banking … would not hinder a slow credit expansion” (ibid., p. 443). In the light of the historical examples which we will mention later, I think that Mises was too optimistic when evaluating the role of free banking in limiting credit expansion. However, Ludwig von Mises from the 2nd German edition of his book The Theory of Money and Credit (1924) already had concluded that “It is clear than banking freedom per se cannot be said to make a return to gross inflationary policy impossible”. Ludwig von Mises, Theory of Money and Credit, Liberty Fund, Indianapolis 1981, p. 436. (Ludwig von Mises, Theorie des Geldes und der Umlaufsmittel, Verlag von Duncker & Humblot, München and Leipzig, 1924, p. 408).

(16) “The Banking School failed entirely in dealing with these problems. It was confused by a spurious idea according to which the requirements of business rigidly limit the maximum amount of convertible banknotes that the bank can issue. They did not see that the demand of the public for credit is a magnitude dependent on the banks’ readiness to lend, and that the banks which do not bother about their own solvency are in a position to expand circulation credit by lowering the rate of interest below the market rate.” Ludwig von Mises, Human Action, op. cit., pp. 439-440.

(17) Ludwig von Mises, Human Action, op. cit., pp. 427-428.

(18) It is curious to observe how the modern theorists of the Free Banking School, like the Keynesians, are obsessed by hypothetical sudden unilateral mutations in the demand for money. They do not realize how such mutations are normally only produced endogenously over an economic cycle which always begins as the result of previous mutations in the supply of new money created by the banking system. Apart from this, only exceptional disasters like wars and other catastrophes (natural or otherwise) can explain a sudden increase in the demand for money.

(19) John Maynard Keynes, The General Theory of Employment, Interest and Money. Macmillan, London 1936, p. 83.

(20) George A. Selgin, The Theory of Free Banking, op. cit., pp. 54-55. Selgin’s thesis is the result of the tautological identification of savings and investment which underlies all Keynes’ works and, according to Benjamin Anderson, is the equivalent of considering inflation identical to savings: “One must here protest against the dangerous identification of bank expansion with savings, which is part of Keynesian doctrine. This doctrine is particularly dangerous today, when we find our vast increase in money and bank deposits growing out of war finance described as ‘savings’, just because somebody happens to hold them at a given moment of time. From this doctrine, the greater the inflation, the greater the savings!”. Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914-1946, Liberty Press, Indianapolis 1979, pp. 391-392 (first edition, Van Nostrand, 1949).

(21) George A. Selgin, “The Stability and Efficiency of Money Supply under Free Banking”, op. cit., p. 440.

(22) F.A. Hayek, The Pure Theory of Capital, Routledge & Kegan Paul, London, 1941 and 1976, p. 376.

(23) F.A. Hayek, The Pure Theory of Capital, ob. cit., p. 294.

(24) “First off, it is plainly false to say that the holding of money, i.e., the act of not spending it, is equivalent to saving. In fact, saving is not-consuming, and the demand for money has nothing to do with saving or not saving. The demand for money is the unwillingness to buy or rent non-money goods, and these include consumer goods (present goods) and capital goods (future goods). Not-spending money is to purchase neither consumer goods nor investment goods. Contrary to Selgin, then, matters are as follows: individuals may employ their monetary assets in one of three ways. They can spend them on consumer goods; they can spend them on investment; or they can keep them in the form of cash. There are no other alternatives … Unless time preference is assumed to have changed at the same time, real consumption and real investment will remain the same as before: the additional money demand is satisfied by reducing nominal consumption and investment spending in accordance with the same preexisting consumption/investment proportion, driving the money prices of both consumer as well as producer goods down and leaving real consumption and investment at precisely their own levels.” Hans-Hermann Hoppe, “How is Fiat Money Possible? -or The Devolution of Money and Credit”, in The Review of Austrian Economics, Vol. 7, No. 2, pp. 72-73. Jörg Guido Hülsmann partially disagrees with this approach in his notable article on “Free Banking and Free Bankers”, The Review of Austrian Economics, Vol. 5, No. 1, p. 34.

(25) Gerald P. O’Driscoll, “Money: Menger’s Evolutionary Theory”, History of Political Economy, No. 18, 4, 1986, pp. 601-616.

(26) George A. Selgin, The Theory of Free Banking, op. cit., p. 184, n. 20.

(27) As an additional advantage of the free banking system he proposes, Selgin asserts that economic agents who hold their cash balances in the form of fiduciary media created by free banking can obtain a financial return on them and a series of banking services (payment, accounting, cash, etc.) “free of costs”. Selgin does not, however, mention the cost which fractional-reserve free banking can generate in the form of inflation, artificial booms, incorrect allocation of resources and economic crises. With regard to the supposed “advantage” of obtaining interest on the deposits and not having to pay the costs derived from the cash and accounting services provided by the banks, it is not possible to know if, in net terms, the interest that the economic agents would receive on loans which were really saved in a banking system with a 100 per cent reserve requirement, after deduction of the cost of the corresponding cash and accounting services, etc., would be equal to, higher than or lower than the real interest they currently receive from their current accounts and demand deposits. Finally, neither does Selgin mention what for us is, without doubt, the most important cost (apart from the already mentioned costs of inflation and economic recessions): the free banking system generates an unbearable tendency to establish a central bank as the last resort lender that supports the private bankers and generates the liquidity which ensures that the citizens can “recover” their nominal deposits at any time. See Jesús Huerta de Soto, “A Critical Analysis of Central Banks and Fractional-Reserve Free Banking from the Austrian School Perspective”, The Review of Austrian Economics, Vol. 8, No. 2, 1995, pp. 25-38.

(28) George A. Selgin, “Are Banking Crisis a Free Market Phenomenon?”, manuscript presented at the Mont Pèlerin Society Regional Meeting, Rio de Janeiro, September 5-8, 1993.

(29) Lawrence H. White, Free Banking in Britain: Theory, Experience and Debate, 1800-1845, op. cit.

(30) Murray N. Rothbard, “The Myth of Free Banking in Scotland”, The Review of Austrian Economics, Vol. II, Lexington Books, 1988, pp. 229-245, especially p. 232.

(31) Murray N. Rothbard, Classical Economics: An Austrian Perspective on the History of Economic Thought, op. cit., Vol. II, p. 491.

(32) Sidney G. Checkland, Scottish Banking: A History, 1695-1973, Collins, Glasgow 1975.

(33) Albert O. Hirschman, in his article “Courcelle-Seneuil, Jean-Gustav” (The New Palgrave: A Dictionary of Economics, Macmillan, London 1987, Vol. I, pp. 706-707) tells us that the Chileans have even converted Courcelle-Seneuil into a devil, as they consider him guilty of all the economic and financial evils that Chile suffered in the 19th Century. Murray N. Rothbard, however, considers that this is unfair and is due to the fact that the incorrect working of the free banking system that Courcelle-Seneuil introduced in Chile also discredited the rest of the positively liberalizing initiatives which he led in other fields (mining, etc.). See Murray N. Rothbard, “The Other Side of the Coin: Free Banking in Chile”, Austrian Economics Newsletter, Winter 1989, pp. 1-4. George Selgin replied to Rothbard’s article on free banking in Chile in his article “Short-Changed in Chile: The Truth about the Free Banking Episode”, Austrian Economics Newsletter, Spring-Summer 1990, p. 5.

(34) See Carlo M. Cipolla’s important article “La moneda en Florencia en el Siglo XVI”, published in El Gobierno y la Moneda: Ensayos de Historia Monetaria, Editorial Crítica, Barcelona 1994, pp. 11-142, especially pp. 96 onwards. This book is the Spanish edition of the work originally published in Italian with the title of Il Governo della Moneta: La Moneta a Firenze nel Cinquecento, Societá edictrice Il Mulino, Bologna, 1990. In fact, the banking phenomena of the 16th century gave rise to the first developments in banking theory by the theorists of the School of Salamanca. See Jesús Huerta de Soto, “New Light on the Prehistory of the Theory of Banking and the School of Salamanca”, The Review of Austrian Economics, Vol. 5, No. 2, 1996, pp. 59-81.

(35) Cipolla tells us how the Ricci Bank, from the seventies onwards, was not able to meet the demand for payments in cash and, de facto, suspended payments, as it paid simply “with ink” or “with bank policies”. The authorities of Florence, looking only at the symptoms and trying, with typical good intentions, to resolve this worrying situation merely by decrees, imposed on the bankers the obligation to pay their creditors in cash without any delay, but did not attack the fundamental causes of the phenomenon (the undue appropriation of the deposits as loans and failure to hold a 100-percent-cash ratio). This meant that the successive decrees issued met with inevitable failure and the crisis became gradually more serious until it broke with its full virulence in the mid-1570’s. Ibid., pp. 102-3.

(36) We know these details thanks to A.P. Usher’s monumental study The Early History of Deposit Banking in Mediterranean Europe, Harvard University Press, Cambridge, Massachusetts, 1943, especially pp. 278 and 339.

(37) For methodological reasons, we are in full agreement with Stephen Horwitz’s position (see his “Misreading the Myth: Rothbard on the Theory and History of Free Banking”, op. cit., p. 167). What is curious is that a whole school which emerged with the analysis of the supposedly beneficial results of the free banking system in Scotland has finally had to cease to seek the support of historical studies of the free banking system. Stephen Horwitz, discussing Rothbard’s review of the historical case of free banking, concludes that “If Rothbard is correct about them, we should look more sceptically at Scotland as an example. But noting the existence of government interference cannot by itself defeat the theoretical argument. The Scottish banks were neither perfectly free nor a conclusive test case. The theory of free banking still stands, and its opponents need to tackle it on both the historical and the theoretical levels to refute it” (p. 168). This is precisely what we have tried to do in this “Critical Note”.

(38) The multidisciplinary nature of the critical analysis of the fractional-reserve free banking system and, therefore, the importance of the legal considerations, together with the economic ones, has also be brought into relief by Walter Block in his article “Fractional Reserve Banking: An Interdisciplinary Perspective”, published as Chapter III of the book Man, Economy and Liberty: Essays in Honour of Murray N. Rothbard, Walter Block and Llewellyn H. Rockwell (eds.), The Ludwig von Mises Institute, Auburn University, Alabama 1988, pp. 24-32. Walter Block also points out that it is very curious to note that none of the theorists of the modern Free Banking School have made any systematic critical analysis against the proposal to establish a banking system with a 100 per cent reserve. In fact, apart from some isolated comments by Horwitz, the Neobanking School theorists still have not tried to show why a banking system with a 100 percent reserve would not guarantee “monetary equilibrium” free from economic cycles. See Stephen Horwitz, “Keynes’ Special Theory”, Critical Review, Vol. III, Nos. 3-4, Summer-Autumn 1989, footnote 18 on pp. 431-432. The possible criticisms of a 100 per cent reserve free banking system have been handled systematically and refuted by Jörg Guido Hülsmann, “Free Banking and Free Bankers”, The Review of Austrian Economics, op. cit., pp. 10-17.

(39) Hans-Hermann Hoppe, “How is Fiat Money Possible? – or, The Devolution of Money and Credit”, The Review of Austrian Economics, Vol. VII, No. 2, 1994, p. 67.

(40) Thus, similarly, a contract between a member of the Mafia and a professional killer can be: a) completely voluntary; and b) based on a perfect agreement in relation to the legal nature of the covenant. However, even in an entirely free libertarian society, it is a contract totally null and void because it is damaging to a third party (the potential victim).

(41) See, for example, Lawrence H. White, Competition and Currency, New York University Press, New York, 1989, pp. 55-56; and George Selgin, “Short-Changed in Chile: The Truth about the Free-Banking Episode”, Austrian Economics Newsletter, Winter-Spring 1990, p. 5.

(42) Hans-Hermann Hoppe, “How is Fiat Money Possible? -or, The Devolution of Money and Credit”, the Review of Austrian Economics, op. cit., pp. 70-71.

(43) In this respect, our argument is even more rigorous that the argument which is brilliantly put forward by Alberto Benegas Lynch, Jr. in his book Poder y razón razonable, Librería “Le Ateneo” Editorial, Buenos Aires y Barcelona, 1992, pp. 313-314.

(44) “The following will be sentenced to imprisonment for a period between twelve years and a day and twenty years, with loss of civil rights for the duration of the sentence: 1) Those who manufacture false money”, art. 283 of the Spanish Criminal Code. It should be noted that, in a credit expansion, as in the case of the forgery of money, the social damage is very much diluted and, therefore, it will be very difficult for this offence to be prosecuted as a result of evidence brought at the request of the damaged party. For this reason, the offence is described in terms of the conduct (forgery of bank notes) and not in terms of the identification of the specific personal damages to which it leads. The same procedure will have to be followed if, at any time, it is decided to apply the same treatment as a criminal offence to the creation of money by the banks.

(45) These “option clauses” were already in force in the Scottish banks from 1730 to 1765 and reserved the right to temporarily suspend cash payment of the notes they had issued. Thus, referring to bank panics, Selgin says that “Banks in a free banking system might however avoid such a fate by issuing liabilities contractually subject to a ‘restriction’ of base money payments. By restricting payments banks can insulate the money stock and other nominal magnitudes from panic-related effects”. George A. Selgin, “Free Banking and Monetary Control”, The Economic Journal, November 1994, p. 1455.

(46) Murray N. Rothbard, “The Present State of Austrian Economics”, Journal des Économistes et des Études Humaines, Vol. VI, No. 1, March 1995, pp. 80-81.
See Jesús Huerta de Soto, “A Critical Analysis of Central Banks and Fractional-Reserve Free Banking from the Austrian School Perspective”, The Review of Austrian Economics, op. cit. A similar conclusion is reached by Jörg Guido Hülsmann, “Free Banking and Free Bankers”, The Review of Austrian Economics, op. cit., pp. 45-47.