Is Fractional Reserve Banking Fraudulent?

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I. Prof. Eric Posner comments on the Block-Caplan debate on fractional reserve banking, which can be found here.

I ran across this odd debate between Bryan Caplan and Walter Block. Here is Block’s argument ("frb" means fractional reserve banking):

Consider this: A deposits 10 ounces of gold in B’s bank; B gives A a demand deposit for these 10 ounces. B turns around and lends C 9 of these ounces, giving C a demand deposit for these 9 ounces. Thus, A and C both own full rights to these 9 ounces.

There is now a problem of over-determination or conflict in rights. A and C both have a FULL right to these selfsame 9 ounces of gold. They are both FULL owners of these 9 ounces.

But, one of the essences of the libertarian philosophy we share is that there CANNOT be a conflict in rights. Any seeming conflict is due to a misspecification of one or the other right. Yet, here, with frb, we have a GENUINE conflict in rights. Thus, frb is incompatible with libertarianism.

Note, I am NOT talking about practicality. It might well be (given no bank run) that A and C will not ACT incompatibly with one another; that is, both will not demand that B pay them these 9 ounces, an utter impossibility. No, I am talking about RIGHTS. Right now, before any bank run, there is STILL a rights contradiction.

Caplan just sputters. Here is the problem with Block’s argument, as I think any lawyer would immediately recognize.

Block confuses property rights and contract rights. If I give the bank some cash and pay it to put this cash in a safety deposit box, then the bank can’t use that cash. It can’t lend it out to someone else; it can’t list it as an asset on its balance sheet; it can’t touch it without my permission. If the bank were to do so, then it would have engaged in theft, and the relevant employees would go to jail. Lawyers call this transaction a bailment.

But if I deposit some cash with the bank, I don’t retain my property interest. Instead, I’m making a loan to the bank and I obtain a contractual right to repayment on demand. If I demand my cash (plus interest, if any) and the bank fails to pay me, then I can sue it for breach of contract and demand expectation damages. If the bank were not a bank but just an ordinary borrower, and it was insolvent, then I have to race other creditors for its assets; otherwise, my contract right is converted into a claim in bankruptcy, and I have to share with other creditors. (Since it is a bank, I may well obtain full compensation from the government, but that is not relevant to the debate.)

If you asked the bank whether it might lend out your money, it would most certainly tell you that it would. So it is not lying to you, and there can’t be fraud. Nor is there any other contradiction, incompatibility, or problem with the arrangement. Depositors take a risk that the bank will breach the contract but anyone who enters a contract takes the same risk.

Block doesn’t seem to have any problem with contract rights per se, but he does have a problem with a person entering a contract that gives another person the right to demand assets that the first person might not have. But all contracts are like this. People enter contracts expecting that they will be able to transfer money, goods, or services when they are due, but everyone understands that intervening events might make the transfer impossible, impractical, or unwise. The other party obtains a right to obtain damages for breach of contract, but if every contract where the probability of nonperformance is greater than zero were considered fraudulent, we would have no economy.

The above material constitutes a statement of Professor Eric Posner’s, and can be found here.

II. Walter Block replies to Eric Posner

There is so much about which I disagree with Prof. Posner. Perhaps it would be best to consider Posner’s views one bit at a time, and subject them to scrutiny. He offers four different paragraphs of criticism of my anti-frb argument, and I will consider them each, in order.

1.”Block confuses property rights and contract rights. If I give the bank some cash and pay it to put this cash in a safety deposit box, then the bank can’t use that cash. It can’t lend it out to someone else; it can’t list it as an asset on its balance sheet; it can’t touch it without my permission. If the bank were to do so, then it would have engaged in theft, and the relevant employees would go to jail. Lawyers call this transaction a bailment.”

I agree with this statement entirely, and enthusiastically. This is precisely the claim of those of us who would legally ban fractional reserve banking. However, as can be seen below, we apply this not only to cash in a safety deposit box, but to ALL deposits with a bank.

2. “But if I deposit some cash with the bank, I don’t retain my property interest. Instead, I’m making a loan to the bank and I obtain a contractual right to repayment on demand. If I demand my cash (plus interest, if any) and the bank fails to pay me, then I can sue it for breach of contract and demand expectation damages. If the bank were not a bank but just an ordinary borrower, and it was insolvent, then I have to race other creditors for its assets; otherwise, my contract right is converted into a claim in bankruptcy, and I have to share with other creditors. (Since it is a bank, I may well obtain full compensation from the government, but that is not relevant to the debate.)”

Here, I sharply disagree. A major matter of contention between the defenders and opponents of the legality of frb revolves, precisely, around the issue of whether or not a depositor, call him A, with some cash with the bank (in the form of a demand deposit), retains his property interest in those funds. I say No, and offer some reasons. One, if this is true, then, when the bank lends out money to a borrower, C, and gives him a demand deposit for (a fraction of) the amount deposited, there are not one but TWO people each of whom has a FULL ownership right in the SAME amount of money. This is a logical impossibility. Two, another way of putting the matter is that there are now more titles to property than there is property. In the numerical example mentioned above, there are now only 10 gold ounces, and there are two people, A (10) and C (9) with rights to 19 gold ounces. A manifest impossibility.

Posner, in contrast, says Yes. That is, he claims that A no longer has a right to the money he has deposited. But he offers no REASON in support of this contention. Reading in between the lines, it is easy to see what is going on here: Posner is relying on PRESENT LAW, according to which he is entirely correct. This, indeed, is the exact manner that the courts have interpreted demand deposits. However, Posner, sadly, is missing out on the context of the debate between me and Caplan. We were debating, not, what the law IS, but, rather, in sharp contrast, what the law SHOULD BE. Posner mistakenly interprets the Block-Caplan debate as over a POSITIVE statement of law, when it really involves NORMATIVE claims about the law. Yes, yes, Professor Posner’s views of bankruptcy law are entirely correct as regards which creditors are first in line, but they are equally IRRELEVANT to the debate between me and Caplan.

3. “If you asked the bank whether it might lend out your money, it would most certainly tell you that it would. So it is not lying to you, and there can’t be fraud. Nor is there any other contradiction, incompatibility, or problem with the arrangement. Depositors take a risk that the bank will breach the contract but anyone who enters a contract takes the same risk.”

True, again, true; all too true. The bank would indeed NOT lie to a depositor about any such thing. But, lying is only sufficient for fraud, not necessary. There are other ways to commit fraud besides an outright lie. For example, it is fraudulent for a bank or anyone else to try to sell you a square circle, even if they do not lie about it. Why? Because there is no such thing as a square circle, and, in order for a contract to be a valid one, not only must both parties agree to it (neither lies to the other), but, also, the contract must be in accordance with LOGIC (e.g., the law of non contradiction), and “sales” of square circles clearly are not compatible with that consideration. But, neither are frb contracts! They, too, are incompatible with the reality of property rights, according to which there cannot be more titles to property than there is property; there cannot be an A and a C, with rights that are incompatible with those of each other.

For our friends on the left, there are numerous and myriad contradictions of rights. For example, X’s right to “public” accommodation in Y’s home conflicts with the latter’s right to privacy. E.g., X is a homosexual would-be renter, and Y is a Christian landlord, looking for a roommate. For the interventionists, the courts must “balance” these rights. But such rights conflicts are anathema to the libertarian. For us, if there is a seeming rights conflict, one or the other (or both) of the putative rights are not rights at all. Yet, in the case of frb, there are two people, A and C, each with rights to money of 19 units, and the bank, B, cannot possibly satisfy both. So, A and C have incompatible or conflicting rights.

4.”Block doesn’t seem to have any problem with contract rights per se, but he does have a problem with a person entering a contract that gives another person the right to demand assets that the first person might not have. But all contracts are like this. People enter contracts expecting that they will be able to transfer money, goods, or services when they are due, but everyone understands that intervening events might make the transfer impossible, impractical, or unwise. The other party obtains a right to obtain damages for breach of contract, but if every contract where the probability of nonperformance is greater than zero were considered fraudulent, we would have no economy.”

No, not at all. I have no “problem” with contract rights. I am a warm supporter of them. Provided, that is, that they do not constitute a logical contradiction, and are compatible with reality, e.g., underlying property rights. However, ALL contracts are certainly NOT “like this.” Under frb, it is a logical impossibility for B to make good his obligations to both A and C, on demand. Now, it is entirely possible that A and C will not call upon B to do so. But, IF they do, that is, constitute a “bank run” B will then be exposed as being unable to meet his financial obligations. In very sharp contrast, there are NO OTHER contracts quite like this in the economy. Yes, I buy 10 widgets from you for delivery today, in consideration for my promise to pay you $10, tomorrow. A day passes, and I am unable to carry out my part of the bargain. But, it is not a LOGICAL CONTRADICTION to suppose I am unable to do so, as in the case of frb. There is all the difference in the world between being unable to fulfill a contract due to contingent circumstances, as in the widget example, and it being IMPOSSIBLE to do so, as in the case of frb. It is not merely “intervening events” that make it a violation of the laws of logic for B, the Bank, to uphold contracts with lender A and borrower C. It is IMPOSSIBLE for B to do so, given frb.

Posner is to be congratulated for this little gem: “if every contract where the probability of nonperformance is greater than zero were considered fraudulent, we would have no economy.” Beautiful. I wish I had said this. The man, truly, has a way with a word. But it is not merely, that in the case of frb, “the probability of nonperformance is greater than zero,” as in the case of pretty much ALL commercial agreements. Rather it is that even before performance or non-performance becomes an issue (this issue only arises if a bank run occurs), the bank engaged in frb is legally dead in the water. Its instantaneous debts are greater than its instantaneous assets. That is, it is bankrupt from the get-go. Under libertarian law (not, I hasten to add, present statist law), it would immediately be declared bankrupt, and forced to disgorge its property. It would not be allowed to operate for one second. The distinction between frb failure and ordinary business failure rests on the difference between a logical impossibility and a contingent failure, which need not have happened.

All if this is spelled out, clearly, in my part of the debate with Caplan. It is elaborated upon, in great detail, in the bibliography appended to that debate. Yet, more than passing curious, Posner chooses to pretty much ignore all of it in his criticisms of my anti-frb position. A strange way to come to grips with the arguments of an intellectual opponent. Hopefully, if there is to be any future round in this correspondence between me and Posner, he will attempt to come to grips with what I actually say.

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