As our more regular readers know well, every now and then I like to take another stab at debunking the myth that fractional reserve banking has fraudulent roots. Besides occurring in numerous textbooks, that myth is routinely expounded in the writings and lectures of certain contemporary Austrian School economists. Moreover, as we'll see, it is occasionally given credence in reputedly scholarly publications by persons who don't identify themselves with that school.
As I write this, with Congress still out of session, things are pretty slow here in DC. So it seems as good a time as any to rejoin the old debate, which I do first by drawing attention to a paper, "Banks v Whetston (1596)," by David Fox, a Cambridge law professor and barrister, and the author of a fascinating legal treatise on Property Rights in Money (OUP, 2008).
A Hum-Drum Case
Although he wrote "Banks v Whetson" for a 2015 volume titled Landmark Cases in Property Law, Fox hastens to explain that the case in question may not really qualify as a "landmark" since "very few lawyers have heard of it and it does not have a strong history of citation in later decisions." Its significance, so far as he's concerned, lies on the contrary fact that it was perfectly hum-drum. Because of that, the case supplies a particularly clear illustration of the common law's ca. 1596 understanding of property rights in money — an understanding which prevailed, according to Fox, "throughout the middle ages and into the early modern period."
The plaintiff in Banks v Whetson, having accused the defendant of robbing him of his money, brought an action in detinue (that is, for the return of specific property) against him. The defendant in turn filed a demurrer, which was argued in the Court of King's Bench. The case was adjudged without argument for the defendant, on the grounds that the money in question consisted of loose coins rather than ones enclosed in a bag or chest. For that reason, the court observed, it was impossible to distinguish them from other, similar coins. Because the plaintiff could not establish that any particular coins in the defendant's possession had in fact been taken from him, the court held that his case lacked the technical requirements for a suit in detinue.
As Fox explains, the decision in Banks v Whetston rested on a by-then long-established distinction between detinue on the one hand and "the varieties of debt action which lay to enforce claims for delivery of generic fungibles" on the other. So far as the common law courts were concerned, the distinction was just as applicable to money as to other fungible goods. Money, Fox explains,
could either be a specific item of property (as when it was bailed for safekeeping in a sealed bag or locked chest) or it could be owed as a fungible amount under a debt expressed in pounds, shillings and pence. In principle, there was no objection to a plaintiff suing in detinue to recover money bailed in specie, provided that the object of his claim could be identified clearly enough… The thing detailed by the defendant had to be identified as the same thing which the plaintiff delivered to him.
If the plaintiff's case was instead to enforce a generic obligation for the payment of money, then his action was in debt… In contrast to detinue, debt lay to recover a certen summe of money. The distinction…signaled two commercially different kinds of transaction: one involving the enforcement of the plaintiff's property (where the property in question happened to be coins) and the other for the enforcement of a simple monetary obligation to pay a generic amount denominated in monetary units.
Paper, Plastic, or a Loan?
The legal distinction between detinue and debt had, as its practical counterpart, what Fox calls "the bagging rule." If someone wished to retain title to a sum of money, despite surrendering possession of it, and to therefore be able to sue in detinue for its recovery, that person had to place the money in question in a bag or chest, and preferably in a sealed bag or a locked chest. "The bagging of money removed the evidential uncertainty about identifying coins as the property of one person or another, and in a detinue action it allowed the money to be restored in hoc individuo."
More importantly for our purposes, the bagging rule also supplied a simple means for distinguishing between different kinds of financial transactions — one which, whatever its shortcomings, was
readily understood by the commercial parties and by juries who were charged with determining the capacity in which a person received or held sums of money. The simple question "Was the money in bag or not?" cut through the conceptual artificialities of determining what might have been the intent of the parties, of the sort encountered in modern-day law.
So long as money was surrendered in a closed bag or chest, it was understood that its possessor "held it in right of another so that he was not free to spend it as his own":
To seal coins in a bag…constituted an assertion by the person whose seal was on the bag that the property in the money was in him or in some third person to whom the money had to be remitted. Either way, it showed, negatively, that the person holding the bag might not have the full property in it. He was quite possibly a bailee who might be liable in detinue… (my emphasis).
The common law courts denied, on the other hand, "that one person could maintain an enforceable title to any [loose] money that had passed — voluntarily or involuntarily — into the possession of another person" (my emphasis again). "In this respect," Fox observes, "the common law's treatment of property in money was no different from its treatment of fungible commodities."
By the time that Banks v Whetston was decided, in 1596, the "bagging principle" was old-hat. Yet another half-century or so was to pass before England's goldsmiths would pioneer there the practice of fractional-reserve banking. In other words, the first goldsmith-banker to lend or otherwise make use of coins "deposited" at his bank had every right to do so, according to principles of common law that had by then been firmly established for over a century, so long as the coins were tendered loose rather than in sealed bags or other containers. The presumption that the banker had good title to any loose coins he received existed regardless of the other terms of the specific deposit agreement, excepting only such terms expressly indicating that the coins were to be held in trust. A depositor's right to recover any part of a deposited sum, whether after a specific term or on demand, or a banker's promise to pay a particular sum, whether to a specific person or to the bearer of a circulating banknote, was proof of the banker's indebtedness, and nothing more.
Keepers of the Faith
In light of the simplicity of the bagging rule, and the fact that that rule appears to have been perfectly well-established when the practice of fractional reserve banking was but a twinkle in some goldsmith's eye, one might expect spinners of the yarn that fractional reserve banking was (and perhaps still is) a form of theft to respond to doubting Thomases by changing the subject, rather than by boldly declaring their accounts to be fully consistent with the fine points of early modern English common law. The same goes for purveyors of the related whopper that banknotes and deposit credits were originally (and, by some accounts, still are) "titles" to cash.
Were it only so! Alas, among certain devotees of Murray Rothbard-style Austrian economics, the fractional-reserve-is-fraud fairy tale amounts to a dogma to be upheld, by hook or by crook, in the face of every sort of contradictory evidence.
Two especially relentless defenders of the Rothbardian faith are Philipp Bagus and David Howden, who, with some other coauthors, have maintained a steady output of papers claiming, among other things, that according to legal principles prevailing at the time, in both Roman and common law, early fractional reserve bankers did indeed routinely lend money that didn't belong to them.
Having once before confronted Bagus and Howden, with both barrels blazing (see here and my reply here), only to have them deny receiving so much as a scratch , I doubt that anything said here will faze them, let alone strike a mortal blow. Still I consider it worthwhile, for the sake of those standing on the sidelines, to show how these economists deal with fundamental points of early modern English common law that David Fox and numerous other historians of law and banking, from Henry Dunning Macleod to James Steven Rogers, have painstakingly elucidated.
Consider "Oil and Water Do Not Mix, or: Aliud Est Credere, Aliud Deponere," a 2015 Journal of Business Ethics paper Bagus and Howden wrote with Amadeus Gabriel, a genuinely Austrian Austrian economist. Like several of Bagus and Howden's other papers, this cryptically-titled number (the Latin comes from a passage in the Digest of Justinian) rests its case against fractional reserve banking not on a direct appeal to the common law but on the distinction found in more ancient Roman law between "regular" and "irregular" deposits contracts:
In a regular deposit contract, specific things are deposited such as a Rembrandt painting. Such contracts are called bailments in common law. In an irregular deposit contract, fungible goods such as bushels of wheat, gallons of oil or money are deposited. … Most money deposits are irregular.
So far so good. But the authors go on to declare that:
Over time governments failed to enforce the traditional legal principles of monetary irregular deposits. … A special privilege is given to bankers (but not to private persons) to violate these obligations in the case of monetary irregular deposits… . The practice of fractional-reserve banking was legalized ex-post.
The violations to which Bagus, Howden, and Gabriel refer consist of banks' having lent some of the cash deposited with them, instead of keeping it on hand, as the terms of a depositum irregulare supposedly obliged them to do.
This would be dandy reasoning, so far as Continental developments are concerned, were it indeed the case that, according to Roman law, an "irregular" money deposit was in fact a bailment in the strict sense of that term, with the depositor retaining a valid title to the deposited sum, as opposed to a loan, by which the money became the banker's property. But that simply wasn't so. Instead, according to just about every authority on the topic, with the singular exception of Jesus Huerta de Soto, upon whom Bagus, Howden, and Gabriel rely, a banker who received an "irregular deposit" became the owner of the deposited money!
Concerning Huerta de Soto's understanding of what an irregular deposit contract entails, as conveyed in the first chapter of his magnum opus, Money, Bank Credit, and Economic Cycles, "Lord Keynes" (the pseudonymous blogger at Social Democracy for the 21st Century) concludes, on the basis of a painstaking review of relevant sources, that it
is utterly unorthodox. He cites certain Spanish legal sources and Spanish legal scholars for his definition, but it is clearly eccentric and aberrant, certainly with respect to Roman law and Anglo-American law.
Nor, he adds, did classical Roman jurists themselves ever insist, as Huerta de Soto does, that a banker receiving an irregular deposit was obliged to keep the full amount of the deposit at hand. It was therefore perfectly possible, as a matter of Roman law, for a banker to lend coins received as irregular deposits without breaking the law.
With regard to English experience, the Bagus-Howden-Gabriel view is, believe it or not, even less sound, for as Benjamin Geva explains in The Payment Order of Antiquity and the Middle Ages: A Legal History (p. 433), the English common law went one better than the Roman law "in bypassing altogether the category of the irregular deposit, and thus facilitating an easy route to the characterization of the bank deposit as a loan." As we've seen, that characterization was automatically applied to all "deposits" of loose coin.
Concerning Bagus and Howden's remarkable ability to ignore or misread the plain testimony of countless authorities, I hope I may be forgiven for instancing as a case in point their reading of my own 2010 article, "Those Dishonest Goldsmiths," as given in a footnote to another paper of theirs, published in the Journal of Business Ethics. According to that note, my paper
provides evidence that Goldsmiths…offered contracts that were neither demand deposits nor loans. These contracts were akin to aleatory contracts, whereby a financial institution promises its best to return an invested sum on demand. …While Selgin provides evidence that the Goldsmiths offered such contracts, he maintains that Goldsmiths did not pioneer fractional reserve banking. Selgin’s empirical evidence that Goldsmiths offered a third contract distinct from the two we posit that are legally permissible is not irreconcilable with our own view. Indeed, Selgin’s work would only be problematic if 1) it could be shown that people who agreed to these contracts wanted to maintain the full availability of their money, or 2) if these historical instances were used to argue for the legitimacy of the fractional reserves demand deposit.
I do not exaggerate in saying that every part of this purported précis of my article comes as a great surprise to me. In fact, I've never questioned the standard view that, in England at least, goldsmiths pioneered fractional reserve banking. And the whole point of "Those Dishonest Goldsmiths" was to defend the goldsmiths against the charge of misappropriating their customers' deposits and, to that extent at least, "to argue for the legitimacy of fractional reserve banking"!
As for my supplying evidence that goldsmith bankers took part in "aleatory contracts," that claim presumably refers to a single footnote in my paper, concerning a specific transaction with a goldsmith recorded in Pepys diary, in which the banker appeared to have acted as a sort of broker, rather than as a strict intermediary. It never occurred to me that, by referring to that one transaction, and suggesting that such transactions weren't uncommon (in part because they helped bankers and their clients to skirt usury laws), I risked being portrayed as denying that goldsmith-bankers ever engaged in plain-vanilla fractional-reserve banking!
An Asian Outbreak
Were the fractional reserves = fraud fairy tale encountered only in undergraduate textbooks, manifestly idiotic web pages, and papers written by a coterie of ultra-Rothbardian economists for publication in their own house organs (or in journals edited by persons who are neither economists nor historians nor legal scholars), its persistence might be no more a cause for concern than the 450-odd samples of variola vera residing, under heavy guard, at the Centers for Disease Control in Atlanta.
I have, unfortunately, come across at least one serious case of fractiophobia far removed from the bacterial incubators of Madrid and Auburn, Alabama — as far as Seoul, Korea, to be precise. In "How Modern Banking Originated: the London Goldsmith-Bankers' Institutionalization of Trust,"Jongchul Kim, a political scientist at Sogang University, claims that modern banking rests upon a "double ownership scheme" pioneered by London's goldsmiths. In that scheme
two groups — the holders of the bankers' notes and depositors — were the exclusive owners of one and the same cash that was kept safely in the bankers' vaults; and one amount of cash created two balances of the same amount, one for the holders and the other for depositors. This double ownership remains a central feature of the present banking system.
In fact, Kim's claim of double ownership is doubly wrong: neither noteholders nor depositors of loose coin owned — that is, possessed a good title to — the cash to which their claims entitled them. Instead, as both the common-law bagging rule and its Continental counterpart, the concept of a depositum irregulare, made perfectly clear, whatever actual cash the banker retained that had originally come to him in the form of loose coin belonged to the banker alone.
Although Kim devotes many pages, in several different (if similar) articles, to embellishing and repeating his "trust scheme" argument, by doing so he merely succeeds in making it all the more evident that he has completely misunderstood the English common law of property in money. Moreover he has managed to do so despite drawing on the works of scholars like James Rogers Stevens and Benjamin Geva (though not David Fox), the plain language of which cannot possibly have misled him.
So, what happened? The answer is that, when it comes to the specific question of the ownership of coins handed over to a banker, Kim leans, not on such highly reputable legal historians, but on — hold on to your hat! — Murray Rothbard & Company, whose distortions he appears to have swallowed hook, line, and sinker!
Kim's debt to the Rothbardians is particularly clear in his assertions to the effect that goldsmith banking was "self-contradictory":
Goldsmith-bankers' deposit-taking was self-contradictory because it was simultaneously a loan contract and not a loan contract. Because deposits were repaid on demand, the ownership of deposits practically remained in the hands of depositors. But bankers lent deposits at their own discretion and in their own names, and they attained and retained the ownership of the loans.
But there's no contradiction. Notwithstanding what Rothbard and some of his devotees have written, as soon as depositors handed their loose coins over to a banker, that banker became the owner of the coins, while the depositors ceased to own them, either legally or "practically." What the depositors now "owned" was, no longer a certain set of coins, but a contractual right to demand an equivalent sum, whether after a particular term or on demand. Likewise the banker, upon lending coins received on deposit, though he certainly owns the loan itself — meaning the right to a future payment of principal and interest — ceases to own the lent coins. In short, the coins themselves never have but a single "exclusive" owner.
When Kim appears to muster more qualified authorities in support of his "double ownership" thesis, he does so by quoting from them selectively and misleadingly. Consider the following passage:
As legal theorist Benjamin Geva rightly argues, "Fungibility of money…explains the depository's right to mix the deposited money instead of keeping it separate. It does not necessarily explain the depository's right to use the money." A depository is still required to keep an equivalent amount of money deposited.
A reader of this passage might be excused for supposing that Geva himself held the opinion contained in its last sentence. In fact, that opinion belongs to Kim alone. Geva (whose concern is in any case with Roman rather than common law) merely wished to make the logical point that, as he puts it in a subsequent paragraph, "authority to mix does not entail automatically the authority to use" (my emphasis).
This is Serious
If supposedly scholarly elaborations of the myth that fractional reserve banking is inherently fraudulent make claims that are ludicrously at odds with the facts, while more popular presentations of the myth are downright laughable, that doesn't make the myth itself either funny or harmless. On the contrary: by encouraging people who might otherwise be inclined to oppose heavy-handed government regulation of private industries to favor, on ethical grounds, the outright prohibition of many ordinary banking transactions, the myth that fractional reserve banking is inherently fraudulent strengthens the hand of officials and others who want to hamstring bankers for quite different, but equally unsound, reasons, not excluding a general dislike of free enterprise.
Yet (as I and others have argued often on this site an elsewhere), conventional fractional-reserve banking is capable of yielding enormous benefits to society. What's more, it has proven most capable of doing so when and where it has been allowed to flourish with the least government interference, including interference aimed at making certain bankers the beneficiaries of government favors. An unbiased and open-minded review of the historical record will make clear, to anyone who undertakes it, that it is not those nations that have heaped regulation upon regulation on most of their banks, while favoring one or several with privilege after privilege, that have enjoyed the greatest financial stability. It is those that have mainly relied upon open competition between banks free of special privileges that have witnessed the greatest financial stability.
As for those places that have actually gone so far as to ban ordinary banking altogether, if they can be said to have enjoyed financial stability, that stability has been purchased at a very high price, to wit: that of relative economic stagnation.
 In this respect Bagus and Howden remind me of my twin brother Peter. When we used to play army together, I often managed, thanks to my well-honed tactical and stalking skills (and, let's face it, all around physical and mental superiority), to sneak up on him with my toy Tommy gun and let him have it at point-blank range, only to hear him repeatedly shout, "You missed me!" However, when Peter acted that way, I could always settle matters, without risking legal repercussions, by beating him up.
I should not be surprised if some members of the anti-anti-Rothbard vigilante squad treat my reference to "Lord Keynes'" remarks as further proof (Exhibit "A" being my occasional references to "aggregate demand") that I'm a dyed-in-the-wool Keynesian, and as such someone all right-thinking free market types ought to ignore. For the record: I am not now, nor have I ever been, especially fond of Keynes' General Theory.
I have since discovered that Mr. Kim did his postdoctoral research at the Department of Economic History and Institutions at Universidad Carlos III in Madrid. It figures.