Is Fractional Reserve Banking Compatible with Objectivism?

(Written in April 2010; revised February 20, 2011 and January 12 2016.)

According to the best authorities, including Ayn Rand herself, it is. I will return to this later; first my view on why it shouldn’t be:

Fractional reserve banking, or FRB for short, is the practice of lending out more money than one actually has. It is also known as “the issuance of fiduciary media”, or, in the German original, “Umlaufsmittel”.[1] For example, a bank has a certain amount of gold in its vaults, and then issues banknotes that are supposed to be backed by this amount of gold, but it issues more banknotes than are actually covered by the gold. This practice “works” as long as not every customer demands gold for his notes; but if this happens, there will be a bank run and the bank goes bankrupt (unless it is bailed out by the central bank).

Objectivists are divided on the question whether this practice is OK or not.[2] Some (including me) claim that the practice is inherently dishonest and should ultimately be outlawed; others claim that it is a normal “market phenomenon” and should be allowed. And the vast majority (I believe) has not given the issue any thought.

Ayn Rand herself never addressed this issue in writing. And I don’t think she addressed it verbally either. I once asked George Reisman whether he had brought it up with her, and he answered that the only time he tried to do so, she wasn’t interested in the matter. So there is no “official Objectivist doctrine” here.

But there are two things that have bearing on the issue that she did address. One is the virtue of honesty, and the other one is fraud as an indirect form of force. If the practice is dishonest and fraudulent, it is not compatible with Objectivism – it is as simple as that.

So why is it fraudulent? For the same reason that any inflationary practice is fraudulent.

Hopefully, you are familiar with Ludwig von Mises’ argument against inflation: new money always reaches some people before it reaches others. Those who receive it first are in a position to spend the money before prices have risen; those who receive it last can spend it only after prices have risen. The first group stands to gain from inflation; the second group stands to lose. The second group is defrauded.

In today’s world of fiat money, this fraud is perpetrated by governments and central banks. But the effect would be essentially the same under free banking, if banks issue fiduciary media. Those who get “fractional loans” are in the position to spend before prices have risen; others can only spend after prices have risen. This, true enough, is inflation on a much smaller scale than we have today; but it is still inflation.

My conclusion is that fractional reserve banking is a violation of the virtue of honesty.

Another way to say this is that fractional reserve banking is a form of counterfeiting. And while a proper government should not intervene in the economy, it certainly should keep an eye on fraud and counterfeiting and outlaw any such practices.

Here are two quotes from George Reisman that explain the point better than I can do:

The supporters of the 100-percent-reserve principle divide into two groups. There are those who advocate its imposition by law. Those among this group who are committed to the principle of individual rights and laissez-faire capitalism justify this by claiming that the creation of fiduciary media is tantamount to counterfeiting and is fraudulent. They claim that it is the same in principle as accepting goods in a warehouse, issuing receipts for the goods, and then selling the goods; or selling more tickets to a theater performance than there are seats.

The second group holds that if the issuance of fiduciary media is conducted openly, without deception—that is, if it is no secret to the owners of banknotes and checking deposits that the backing for them is debt—one cannot outlaw the practice. These supporters of the 100-percent-reserve principle advocate its achievement by means of a policy of free banking—that is, merely the total absence of all government intervention in banking. This view is well expressed in a passage quoted in von Mises’s Human Action from the nineteenth-century French economist Cernuschi. It was made in reference to fiduciary media in the form of banknotes, but it applies equally to fiduciary media in the form of checking deposits as well. Cernuschi said: “I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.” (Capitalism, p. 514f.)


[I]t is mistaken to believe that the imposition by law of 100-percent-reserve banking in connection with checking deposits and banknotes would constitute government interference. It would constitute nothing more than the just exercise of the government’s power to combat fraud—the fraud of having one’s funds lent out despite the bank’s deliberate creation of the impression that in making a checking deposit or purchasing banknotes one fully retained the possession of one’s funds.

Shysterism in any form is always slippery. Thus if it occurs to anyone to argue that the banks’ customers are not victims of fraud because they clearly know and understand that their funds are being lent out, then the answer is that in that case they would be parties to fraud. Their fraud would be the attempt to make payment to others not with money or reliable warehouse receipts for money, but with claims to debt. They would be engaged in the willful contradiction and deception of claiming to pay someone when in fact imposing on him the position of being a grantor of credit. It should be understood that everything I have said in connection with the subject of the fraud entailed in fractional-reserve banking applies to a context in which the establishment of a 100-percent-reserve gold standard would be a real possibility. It is pointless to accuse either banks or their customers of any kind of fraud in connection with fractional-reserve banking in a context such as that of the present, in which the overwhelmingly greater fraud exists of the government’s creation of a monetary standard that is utterly nonobjective and arbitrary, namely, the fiat-paper standard. (Capitalism, p.957f.)

Another thing worth mentioning: Fractional reserve banking under free banking could hardly cause the kind of “boom-bust” cycles that we see under fiat money. And depressions or recessions in the 19th century were milder and of shorter duration than we have seen in the 20th century. The reason for this is that competition among banks puts definite limits on the issue of fiduciary media. Mises writes about this in The Theory of Money and Credit.

Here is a quote from Ayn Rand to illustrate my point:

Inflation is not caused by the actions of private citizens, but by the government: by an artificial expansion of the money supply required to support deficit spending. No private embezzlers or bank robbers in history have ever plundered people’s savings on a scale comparable to the plunder perpetrated by the fiscal policies of statist governments. (The Ayn Rand Lexicon.)

Very true. The proviso I would like to add is that some inflation is made possible by “fractional banking” under free banking. But the harm is severely limited in this case; it is limited by competition between the banks.

Should pick-pocketing be legalized?

In December 2010 I wrote two notes on Facebook on the subject of fractional reserve banking that I reproduce below. If you want to see the discussion, click here and here. There were a couple of objections that I did not answer or answered very sweepingly; time permitting, I will return to them later.

Yes, why not? Pick-pocketing is a market phenomenon, and phenomena appearing in the market, springing from the market itself, should not be criminalized. Pick-pocketing appears on the market – it is not the result of government interference – and it springs from the market itself, not from something outside the market. The proof of this is simple: if there were no market, there would be no pockets to pick. Also, if a person goes to a market-place, he must be aware that there may be pick-pockets operating in that market-place; if he is not cautious enough to avoid being pick-pocketed, he has only himself to blame: it was a calculated risk he took, merely by going to that market-place.

Well, perhaps you sense that there is something seriously wrong with this argument.

But I constantly hear this same argument with regard to fractional reserve banking. In a society with free banking, it is said, fractional reserve banking would have to be legal, because it is a matter of agreement between the banking granting a loan with fractional money and the person taking the loan. Both parties are aware of the risks involved, and both parties are willing to take that risk; so what’s fraudulent about this?

This argument by-passes a point I have made several times: the defrauded party in fractional reserve banking is neither the bank nor the customer taking the loan: it is everybody else. Fractional loans will have the same effect that every expansion of the money supply has: prices will go up. But the person taking the loan will be in a position to buy with his loan before prices have risen; other people are in the opposite position of buying after the prices have gone up. The loaner gets an unfair advantage over the non-loaner. The non-loaner, is in fact, defrauded. His pocket has been picked.

But this simple point (simple to students of “Austrian” economics) does not get through to non-Austrians.

For example, I just yesterday read a comment here on Facebook to the effect that the “Austrian” opposition to fractional reserve banking (spelled out in simple terms by George Reisman and in more complex terms by Ludwig von Mises) is a symptom of the “rampant rationalism of the Austrian school”.

Well, to answer with the same coin, this is an example of the “rampant empiricism, and the capacity of complete misintegration, of some people claiming to be Objectivists”.

A Thought Experiment

Let me make a thought experiment. Imagine an economy with no central bank and no government intervention. In this economy there are only two banks; let’s call them the Mulligan bank and the Lawson bank.[3] Both banks are gold-based, and they both issue bank notes backed by the gold in their vaults. The denomination of the notes is rand, and one rand corresponds to one ounce of gold. (I choose rand, because a Krügerrand contains exactly one ounce of gold; but if you want to associate to a famous writer who advocated the gold standard, that’s OK with me.)

The Mulligan bank is careful not to issue more notes than are actually covered by the gold in its vault; it operates on a 100% gold standard. The Lawson bank, on the other hand, is not that careful: it issues more notes than are covered by its gold; it’s on a “fractional” gold standard. (We can assume, for example, that its gold reserves are 90%.) Thus, if you are a customer at the Mulligan bank, you can be certain that your notes are convertible in gold, if you should need or want actual gold. You cannot be that certain as a customer at the Lawson bank; usually you are on the safe side; but should it happen that many customers want to convert their notes in gold at the same time, there will be trouble.

The bank notes would, of course, have the name of the respective banks printed on them. But the denomination would be the same: there would be 1 rand notes, 10 rand notes, perhaps also 50 and 100 rand notes in circulation issued by those two banks. But the fact of the matter is that the Lawson bank 10 rand note is only worth 9 rand, although it says it’s worth 10 rand.

Now, suppose the public accepts the Lawson bank notes at face value. Under normal circumstances, that would not be unreasonable, because with a 90% reserve, the likelihood of a bank run is not that big.

Let’s see what happens to the purchasing power of the money under those circumstances. Let’s assume that each of the banks has 1 million ounces of gold in their vaults; thus, the total amount of gold money circulating in the economy is 2 million ounces of gold, or 2 million rand.

But now the Lawson bank issues notes to the amount, not of 1 million, but of 1.1 million rand; thus, the total amount of circulating money becomes 2.1 million rand, not just 2 million. And the result of that will be rising prices. We will have inflation. Not much inflation, but inflation nonetheless.

Now, one could change the figures here and assume the Lawson bank has only 80% reserves. That would mean more inflation. One could assume that it has only 10 or 5% reserves, and there will be a real big inflation. However, in this example, I think it would be impossible for the Lawson bank to have such low reserves, because that would simply destroy the public’s confidence in the bank, there will certainly be a bank run and the Lawson bank would go bankrupt. (Remember there is no central bank to bail it out.)

But why would the Lawson bank want to be on a fractional reserve system in the first place? Well, a bank’s business, if it is not just to be a storage place for its customers’ gold, is to lend out money and charge interest on these loans. And in the scenario I have sketched here, the Lawson bank has more money to lend out than the Mulligan bank; by having 90% reserves instead of 100%, they gain a competitive advantage over the Mulligan bank. Being able to advance more loans, they earn more interest than the Mulligan bank.

This may lead to the Lawson bank being tempted to lower their reserve ratio even more: to 85%, then to 80%, etc. But sooner or later a point will be reached, where the public’s confidence in the bank will be severely shattered, so this is a risky undertaking. Also, the Mulligan bank may be tempted to follow in the Lawson bank’s footsteps and lower its reserve requirements.

What about the borrowers? For a bank to lend out money, it would have to lend the money to productive enterprises, so that it will in time get its money back plus interest. The borrower will invest the loan in such things as raw materials, machines, new factories, employing more workers.

And just as the Lawson bank gains a competitive advantage over the Mulligan bank, the customers of the Lawson bank gain a competitive advantage over the customers of the Mulligan bank. They have more money to invest.

Now, it should be known from Mises’ writings that the recipients of new money, or new fiduciary media, are in a position to buy before prices have risen, while others are in the position of having to buy after prices have risen. Now, the Lawson bank’s policy of issuing fiduciary media has this effect of making prices rise. But a person who borrows from the Lawson bank is in a position to buy his raw materials, his machines, the materials needed to build a new factory, to employ his new workers before the prices of these factors have risen. The rest of us will pay him in the form of rising prices later in this cycle. This is why I regard inflation – even the mild inflation of this example – as fraud.

If both banks were on a 100% reserve standard, prices would not rise. (Except insofar as no new gold is being mined and coined, but this is a different matter.)

Of course, this is a thought experiment, and I have simplified matters . In real life we are not likely to encounter a situation with only two competing banks. But the principle will not change, if there are a variety of banks, some of them operating on a 100% reserve standard, others on varying fractional standards.

Of course, in today’s society, we are not likely to encounter free banking and no government intervention in the economy, which makes this reasoning slightly utopian.

However, I think I have made my main points: 1. that the issuing of fiduciary media (or fractional reserve banking) is inflationary even when performed by private banks; and 2. that the practice is fraudulent, insofar that some people stand to gain from it and others stand to lose; and this not because of any objective superiority of the first class of people over the second.

I don’t think I will convince any adversary by this reasoning; but at least I have tried.

What do other economists have to say about this issue? We know both Rothbard and Reisman favor outlawing fiduciary media. But what about Ludwig von Mises, who after all pioneered this subject? Well, there is one quote from The Theory of Money and Credit that might shed light:

[T]he only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media. (P. 447.)

A Contractual Matter?

(Added 2016.)

The argument one keeps hearing from defenders of fractional reserve banking is that it is a contractual matter. “It’s a contractual matter. It´s a contractual matter. Aren’t you listening to what I’m saying? Contractual! Contractual!! Contractual!!!”

But so is a contract killing. The contract killer signs an agreement with his employer that he will kill a certain person. Or, rather, they make a verbal agreement to this effect.

But in this case nobody will miss the fact that there is a third person involved apart from the parties making the deal. This simple fact is systematically missed with regard to fractional reserve banking.

Objectivists for Fractional Reserve Banking

So much for the Objectivist case against FRB, which obviously was not Objectivist at all. Now the Objectivist case for FRB:

Post scriptum February 2011: I wrote earlier that I did not think Ayn Rand addressed this issue verbally. However, since then, I have purchased 100 Voices: An Oral History of Ayn Rand and found the following in the interview with John Ridpath:

I vividly remember another example of her ability to go to fundamentals to clear up a debate. After a Ford Hall appearance, back at her hotel suite, one of us asked her if she could help with a debate many of us were involved in. The issue was: is fractional-reserve banking, because of its creation of expanded credit on a given base, implicit theft or legitimate banking practice. We – several of us doctoral students, if not already PhDs in economics – were split on this issue. With characteristic focus, she asked several questions, revealing a surprising understanding, and then – bingo -the answer was evident to her. It is appropriate – it is a matter of informed, calculated risk and, in essence, not theft at all. (P. 353f.)

The first thing I want to say about this is that I am extremely disappointed. The second thing I want to say is that reasoning is totally wrong for the reasons I have already stated above. If Ridpath quotes her correctly (and why shouldn’t he do that?), she says that FRB is “a matter of informed, calculated risk”. Sure, it is a matter of informed, calculated risk on the part of the bank and the person taking the fractional loan. But the victims of FRB – those who stand to lose because their money loses some of its value – are not informed. They are, as I have said, defrauded. (But I am repeating myself…)

In fact, the same kind of argument could be used for any form of counterfeiting. A counterfeiter certainly knows he is taking a risk when he puts his counterfeit notes on the market, and this risk is certainly calculated.

Ayn Rand should be given some benefit of the doubt. Not even she was omniscient and/or infallible; and she wasn’t a professional economist. I doubt that she had read and digested Mises’ The Theory of Money and Credit, which is the most thorough exposé of fiduciary media (and of course she hadn’t read the passages from Reisman I quoted earlier). But one really wonders what Ridpath and those other doctoral students and PhDs said to her that lead her to this conclusion.

But here we are. I have accused those Objectivists who are in favor of FRB of being “Objectivists for counterfeiting”. And now I see Ayn Rand herself was an Objectivist for counterfeiting. What hope can I have on making Objectivists change their minds on this issue, when the foremost authority on Objectivism is on their side? Life can be hard, sometimes…

Post scriptum January 12, 2016: I should have understood, long ago, that fractional reserve banking is part of the “official Objectivist doctrine”. In his essay Gold and Economic Freedom, published in The Objectivist, July 1966 and reprinted in Capitalism: The Unknown Ideal in 1967, Alan Greenspan writes:

A free banking system based on gold is able to extend credit and thus to create bank notes (currency) and deposits, according to the production requirements of the economy. Individual owners of gold are induced, by payments of interest, to deposit their gold in a bank (against which they can draw checks). But since it is rarely the case that all depositors want to withdraw all their gold at the same time, the banker need keep only a fraction of his total deposits in gold as reserves. This enables the banker to loan out more than the amount of his gold deposits (which means that he holds claims to gold rather than gold as security of his deposits). But the amount of loans which he can afford to make is not arbitrary: he has to gauge it in relation to his reserves and to the status of his investments. [Italics mine.]

Greenspan, of course, is famous for not having lifted a finger to restore the gold standard or to establish a free banking system, and for being in charge of the further issuance if fiduciary media.

I have since written several blog posts on this subject:

Fractional Reserve Banking Yesterday and Today
More on Fractional Reserve Banking
A Belated Open Letter to Ayn Rand on Fractional Reserve Banking
Debating Fractional Reserve Banking
A Short Note on Fractional Reserve Banking
Precious Metals Inflation?

[1] ”Fiduciary media” from the Latin word “fides”, which means “trust” or “confidence”. The system works only as long as the public trusts the banks (which they actually shouldn’t, if the banks issue those media). – A literal translation of the German “Umlaufsmittel” would be “circulation media”; they are supposed to help the circulation of money.

[2] For example, listen to this podcast by Yaron Brook, where he calls FRB “a contractual matter” between the borrower and the lender. Brook has expressed the same view on several other occasions.

Another example is Keith Weiner, who claims that FRB does not mean lending out more money that is in the vaults, but less money. (One may get a long way from the truth by simply redefining key concepts.)

George Selgin, who (together with Lawrence H. White) is a leading proponent of free banking with FRB, has appeared a couple of times at Objectivist conferences. (I don’t think he is an Objectivist, though; but it is significant that he is invited to speak at those conferences.)

Richard Salsman attacks “Austrian” economics on most issues, including this one. I answer him here. He has also both plagiarized and back-stabbed George Reisman.

Where Northrup Buechner stands on this issue, I do not know.

Regarding Harry Binswanger, you can read my blog post Debating Fractional Reserve Banking.

Among Objectivists who oppose FRB (apart from George Reisman and myself) I could mention Doug Reich, who some years ago wrote several excellent blog posts on the subject (unfortunately, I cannot link to all of them). – Another one is Brian P. Simpson, who has also in the past appeared at Objectivist conferences. (Both of them are, not surprisingly, fans of George Reisman.)

[3] If you don’t understand the names of the banks, you haven’t read Atlas Shrugged.

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