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Free Banking and Economic Development, Part 1

(A few years ago I was hired to contribute some articles on free banking and related subjects to an online forum called the Free Market News Network. I wrote several before the checks stopped coming, and then insisted that those already published be taken off the site, which has since ceased to exist.

For a long time I thought the articles were lost for good. But I recently uncovered them on a UGA backup drive, and so have decided to make some of them available again here.)


Some self-styled friends of the free market think the world would be better off without fractional-reserve banks. They believe, among other things, that fractional reserves are inherently fraudulent and that they promote business cycles. Lawrence White and I have addressed these and related criticisms of fractional reserves both in this forum and elsewhere. Here I wish not to refute claims concerning supposed disadvantages of fractional-reserve banking, but to point to one of its crucial advantages—an advantage its opponents studiously ignore.

This advantage has to do with economic development, and industrial development especially. To state the matter baldly: the most tangible achievements of the free market—the vast improvements in technology and productivity, the industrial plant and infrastructure from which these derive, and the extensive retailing networks that deliver industry’s fruits to consumers—would be far more meager were it not for past and present lending financed by fractionally-backed bank liabilities. To condemn fractional-reserve banking in any form is, in other words, to strike a blow, albeit unwittingly, at one of the supporting pillars modern capitalism.

This claim is hardly unique to modern-day champions of free banking. It has, on the contrary, been widely subscribed to by economists since the very beginnings of industrialization. Although The Wealth of Nations (1776) appeared when Great Britain’s Industrial Revolution was just getting started, that didn’t keep Adam Smith from noticing the substantial contribution fractional reserves had made to British, and especially Scottish, industrial development. Smith’s homage to fractional reserves occurs as part of his refutation of Mercantilism, with its naive identification of a nation’s wealth with its stock of coin and bullion. That stock, Smith says,

makes no part of the revenue of the society to which it belongs; and though the metal pieces of which it is composed, in the course of their annual circulation, distribute to every man the revenue which properly belongs to him, they make themselves no part of that revenue.

Indeed, Smith goes on to say, the real resources devoted to producing a nation’s money—to that “great wheel of commerce” that makes efficient exchange possible—are necessarily diverted from the production of other goods and services. Fractional reserves promote real economic growth by reducing the cost of money—what today’s economists might term money’s “opportunity cost”:

The substitution of paper in the room of gold and silver money, replaces a very expensive instrument of commerce with one much less costly, and sometimes equally convenient. Circulation comes to be carried on by a new wheel, which it costs less both to erect and to maintain than the old one….[T]he circulating notes of banks and bankers are … best adapted for this purpose.

Public confidence in Scottish banknotes was already such in Smith’s time as to allow exchanges in that country to be conducted with only a fifth as much gold and silver as would have been needed had coins alone been used. The savings on metallic money translated into a corresponding increase in Scotland’s working capital. “The operation,” Smith says, “resembles that of the undertaker of some great work, who, in consequence of some improvement in mechanics, takes down his old machinery, and adds the difference between its price and that of the new to his circulating capital, to the fund from which he furnishes materials and wages to his workmen.” Scotland, a relatively backward and poverty-stricken country at the onset of the 18th century, was by Smith’s day rapidly catching up with England, the world’s wealthiest country. That Scotland’s fractional-reserve banks had “contributed a good deal to the increase” in Scotland’s wealth was, according to Smith, a matter that “cannot be doubted.” No wonder Smith favored free banking, or something very close to it. He approved of only two special banking regulations—and approved of them, I should add, on rather faulty grounds. The regulations, which dated from 1765, were the outlawing of notes for less than one pound and of “optional clause” notes giving banks the contractual right temporarily to suspend specie payments. That Smith had nothing good to say about permanently irredeemable, “fiat” money should go without saying.

Economic research since Adam Smith’s day has mainly tended to bolster his favorable views on fractional-reserve banking, both by amassing evidence of its beneficial effects and by delving more deeply into the basis for fractional-reserve banks’ unique ability to harness scarce savings and put them to good use. In the second part of this essay, I will briefly review some of these “post-Smithian” findings.

  • Paul Marks

    I hope I do not sound like Bill Clinton, but it "depends what you mean by the word…"

    If by "fractional reserve banking" you mean that more money can be lent (borrowed) than is really saved, or that savings still have the money AFTER it has been lent out to borrowers….

    Well neither of those two things make sense – they violate basic logic. And to expect good things to follow from violating the basic rules of reasoning is folly.

    For example, if you were to declare that 1+1=3 you might then say "look I have got two Dollars and turned them into three Dollars – whereas if we stick with your silly common sense we will only have two Dollars". Then you could go on to say "look at all the wonderful things we can do with this extra Dollar I have created from nothing – and think how much more good we could do if we declared that 1+1=10, or a hundred, or a thousand…."

    However, you would still be in error – 1+1 would still = 2. And no amount of extreme cleverness on your part can change that fact.

    And acting in violation of basic facts (such as no more money can be borrowed than has really been saved, and if a saver lends out money they do not have it any more – till when and IF it is paid back) leads to bad (not good) consequences.

    This is the credit money expansion that leads to what is known as a "boom/bust".

    I repeat that the above has not got nothing to do with the criminal law – I trust one does not have to pass a statute declaring that 1+1=2 (not three – and not a hundred) and making it a criminal offence to pretend that 1+1=3 (or a hundred – or whatever).

    Economic development (including the sort of technological wonders you mention) can only be sustained by thrift, hard work and self denial.

    Every Dollar lent out is (if rationality is maintained) a Dollar someone has worked for – and has chosen to save (rather than to spend).

    There are no "short cuts" to lasting prosperity – get-rich-quick financial schemes do not work. Not in the long run they do not.

    Of course if by the words "fractional reserve banking" you do NOT mean leanding out more money than has really been saved and made available for lending, and you do NOT mean that someone can lend money out and keep it at-the-same-time….. well then what I write above does not apply. I fully admit that.

    • George Selgin

      Paul, fractional reserve banking does not necessarily imply lending more than is saved. You will find arguments to this effect contained in my Theory of Free Banking as well as elsewhere.

  • Martin

    "Some self-styled friends of the free market think the world would be better off without fractional-reserve banks."

    What do you (and/or Larry) think about the arguments made by Huerta de Soto on this topic in his book "Money, Bank Credit, and Economic Cycles"?

    • George Selgin

      Not much, Martin. Larry replied in part to Huerta de Soto, but then tired of the effort. I thought of it but gave up: his misrepresentations of my work were so numerous that I would have had to write my own treatise just to rebut him. In any event, the way to decide whether he is right is to read the works he criticizes instead of accepting his own representation of what I and Larry say.

      You must understand that we are trying to combat legions of central bankers, and so have little time to spare for the sake of refuting Rothbardians.

      • Martin

        Thank you for the link. Out of curiosity: is the book otherwise any good, or is just another example of conflating morality with economics as seems to be often the case on this topic?

        "You must understand that we are trying to combat legions of central bankers, and so have little time to spare for the sake of refuting Rothbardians."

        I take it you do not mean him, in particular, to be one of those earlier mentioned hornets?

        Anyhow, it makes sense, when – I am under the impression and agree – like Hayek you think that the Neoclassical school merely has to change its emphasize rather than be completely overhauled, you choose to focus your attention on where it matters.

        Looking forward to part II.

  • Paul Marks

    An obvious alternative definition of "fractional reserve banking" might be as follows….

    I tell people to give me their savings – telling them they can have them back at any time. But I do not put them in a vault and I pay interest on the money I have been given.

    I do this by lending out the vast majority of the money I have been given, keeping only (say) 10% of it on hand (in the vault) in case people start asking for their money back.

    I make my profit by charging a higher rate of interest to the people I lend the money to than I pay to the people I took the money from (which is fine – as long as they actually pay back the principle of the loan, not just pay interest for awhile and then go bust). All goes well unless there is a "run" on my operation (my "bank").

    Now this is fractional reserve banking – but it is not increasing the money supply. Why not?

    Because I only lend out real money (the money I have been given).

    For example, if gold is the money my community (via the civil interactions we call "the market") uses as money – people come to me with their savings (in gold) and I lend out 90% of their savings (in gold).

    Ditto if it was silver – or whatever commodity people choose to use as money.

    There is no credit bubble here (because the money leaves one person and goes to another person – net increase in the money supply zero) and no two people have the same money at the same time.

    The boom/bust stuff only starts if I start to play games.

    For example, if I accept as a "deposit" a bit of paper (rather than gold – or what other commodity my community uses as money) and if I start lending out not gold (or what other commodity my community uses as money), but bits of paper I have printed (or just manipulations on computers – for most modern "money" is not even bits of paper any more).

    So it is NOT actually "fractional reserve banking" that is the source of the irational elements (such as more money being lent than has really been saved – or the money supposedly being in different places at the same time) it is the game playing that is so often associated with fractional reserve banking (rather than, strictly speaking, the fractional reserve banking itself).

    • Martin Brock

      Suppose you want to buy a house. The seller claims the house is worth 100 ounces of gold, and you agree. You arrive at my bank with this proposition, and I provide you with 100 banknotes each promising an ounce of gold. You purchase the house, but you don't hold its title. I hold the title while you repay the loan.

      The 100 banknotes that I provide you are not valuable themselves. They are only records of value. They signify something else of value. The value of what?

      The answer is not "gold". The answer is "a house".

      I have gold in my bank vault only because the titles to houses that I hold are less liquid than gold in my vault. If someone presents a banknote for redemption in gold, gold in my vault is not my only recourse. I can also call the loan on your house, requiring you to provide me more of the value of the house in gold.

      Your mortgage agreement stipulates this recourse, even if you never read it. You may provide me the gold however you like. You could rent a room in the house for example. If worse comes to worse, you need only to resell the house, which you agree to be worth 100 ounces of gold. When I see the gold in my vault fall below a certain level, I call loans this way.

      As a fraction of my outstanding banknotes, how much gold do I need in my vault? The answer surely is not 100%.

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  • George Selgin

    "Now this is fractional reserve banking – but it is not increasing the money supply. Why not? Because I only lend out real money (the money I have been given). For example, if gold is the money my community (via the civil interactions we call "the market") uses as money – people come to me with their savings (in gold) and I lend out 90% of their savings (in gold). Ditto if it was silver – or whatever commodity people choose to use as money."

    Paul, this is all quite correct, and it is (as I argue elsewhere) all that happens in a competitive banking system. Central banks, though, are a different matter entirely for they truly can create money–reserve money–"out of thin air." Commercial banks in contrast must acquire fresh reserves the hard way before they can engage in (more) lending.

  • I don't doubt that 100% reserves would harm development, but wouldn't this behave as another "regulation" that financial firms would figure out how to work around? I imagine that this would have hastened the appearance of shadow banking onto the scene, for example.

    • I'm not really sure full reserves would "harm" development as much as some might claim. If the demand for money is relatively stable, then the opportunity for fiduciary expansion is limited. The major difference is that banks would be holding on to more gold than they would otherwise.

  • Justin R.

    A broad question, but how do you think this concept applies to economic development today? Does mobile banking provide a somewhat similar benefit (access to funds, credit, etc.)?

  • Matt Young

    Assume we had a transparent banking network, the network allocating loans across the yield curve. Further assume the depositor has some basic knowledge of a yield curve and trusted the bankers to keep 15% reserve and invest wisely.

    Then fractional reserve banking is investing depositor cash across the bankers yield curve, about as risky as investing across the transportation index. But there is nothing more fraudulent here then goes on anywhere else.

  • RickDiMare

    Psychologist C.G. Jung is well known for his theory of typology, within which he believed each human being to have a predominantly introverted or extraverted attitude/orientation toward the world. (And it goes without saying that one’s childhood experience with parents/authorities plays a big role in establishing one’s orientation.)

    I mention this because discussions about fractional- vs. full-reserve banking always make me envision the full-reservists asking something like: Just exactly whose money am I depositing anyway? Is it MY money or not? And if it’s not viewed as MY money by the establishment, how can I make it so?

    The problem is that most people who believe in government, and work for it, either directly or indirectly, tend to be extraverts, so they are pre-disposed to see money as a socio-political media to which they should have liberal access. They see the world from the “outside looking in” and money as a highly amorphous, malleable idea or concept that is for the general benefit of society.

    However, introverts tend to see money, and its accumulation, as something that originates from within one’s body and mind (labor), and may even believe that “the world” is not something “out there,” but a concept that comes from within each individual mind. They see the world primarily from the “inside looking out” and money as a kind of commodity that can be privately owned and controlled.

    The fact is that both orientations are, to some extent, valid when it comes to money, and the U.S. Constitution is capable of accommodating both orientations. But the problem, as I see it, is that the extravert-dominated legal system doesn’t adequately represent or support the introvert’s view, which view the extravert tends to regard as selfish, unrealistically individualistic, pessimistic, or even pathological.

    The bottom line is that conflict over fractional- vs. full-reserve banking shows why we urgently need an international network of lawyers who, under McCulloch v. Maryland (1819), will help some depositors (to whom it is of great import) claim a property right in their money by maintaining U.S. coin-only accounts, thereby minimizing the extent to which socio-political forces can access their deposits and dictate (through income taxation on fiat media) how their money is used.

  • Othyem

    Sort of OT, a few threads back someone asked in regard to future research with free banking "where do we go from here." This should answer that question. Taking a free banking perspective on economic development offers a VERY promising and robust research program, in my opinion. It's something I plan on taking on myself since economic development is another one of my interests. In fact, I had the exact same title planned for my undergrad thesis. I just ordered several books on the topic, too.

    • Martin Brock

      Where do we go from here? The only meaningful research into the efficacy of a particular theory of free banking is a free bank realizing the theory in the marketplace. All the talk about central bank policy misses the point. Free banking is not a central bank policy. It's not a state policy of any sort. Any of us could create a free bank tomorrow. If we want free banking, we should just get on with it. States will try to subsidize state banking services by taxing free banking services. We need to think about this problem, but if we wait until states stop trying, we'll never start, because states will never stop trying.

  • George Selgin

    I agree that the role of free banking in development–the potential future role, that is–is a subject deserving more research. Indeed, my colleague Bill Lastrapes and I have a working paper, "Banknotes and Economic Growth" that is intended as a step in this direction.

  • sparks

    Back to buying Martin's house, and where do we go from here. What if the "fractional-reserve banking" system's fiat dollars were allowed to go along its merry way, but was fazed out of the housing industry in its respective country by a single "free-banking" entity that operated with its own housing notes equal to the country's fiat money. Leaving transitioning and other details for another time, I am wondering what you think about these two different systems working at the same time within the same country? In theroy it would be best if they were kept independent of each other for the idea I have in mind, but in practice the fiat dollars and housing notes could be traded. What I am striving for with is to reduce risk (boom and bust) for a large portion the money supply by dedicating it via housing notes that can only be reedeemed for fiat dollars when they are taken out of the "housing loop". Advantageous terms and interest rates would be the draw for these housing notes to stay in the "loop". Over time could these two systems coexist, or would one swollow the other?