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Real Bills, Phony Wealth: Debtor's Prison

He who sells what isn't his'n buys it back or goes to prison. -- saying

An "elastic currency" has been one of the rallying cries of inflationists. It was a keystone in the campaign for public acceptance of a central bank in the United States. Insufficient growth in the quantity of money, it is claimed, restricts investment and limits the production of goods. Enabling the banking system to create money, then, will remove a serious obstacle in the creation of more wealth. Modern central banking is based on this premise. Freeing the banking system of constraints on credit creation has been the focus of most inflationist programs.

The Real Bills Doctrine, a justly theory left for dead after its defeat in open debate over a century ago, has recently been revived by its modern prophets Antal Fekete and Nelson Hultberg. Their attempted resurrection of this system contains two planks: the issuance of bills of exchange by clearing houses and the monetization of bills by banks.

The monetization of bills occurs when bank issues currency or demand deposits against any asset other than gold. This creates a situation where the entire quantity of bank-issued money substitutes exceeds that which could be entirely redeemed in gold. The partial redeemability of money substitutes is called "fractional reserve banking".

This article will demonstrate the errors of Fekete and Hultberg concerning fractional reserve banking. I will show that Hultberg misrepresents Murray Rothbard's theory of one hundred percent reserve banking; that their arguments on this subject do not prove their conclusions; and that, far from offering any benefit, the institution of fractional reserve banking is harmful and pernicious.

In order to get the facts straight, I will first offer a brief summary of Austrian banking theory. The interested reader should consult Jesús Huerta de Soto's Money, Bank Credit, and Economic Cycles. This magisterial work contains an exhaustive discussion of the legal, historical, and economic aspects of 100% and fractional reserve banking, far in excess of what can be conveyed in a short piece.

When a customer hands gold coins over to a bank, there are two possibilities concerning the contract between the two: either the funds are stored there for safekeeping, or they are loaned to the bank. (De Soto gives a detailed legal analysis of the banking contracts in Chapter 1 of his book). Under the irregular deposit contract, the immediate availability of the funds is not transferred by the depositor to the bank. In order to maintain availability, the bank is required to keep the property on hand for immediate redemption, and the customer pays the bank a fee. Under the loan contract, availability of the funds is transferred to the bank, for a defined period of time, at some rate of interest.

Under a loan contract, the bank is legally able to lend the funds because the funds loaned to them by the customer. The bank must do something to earn a return on the loan in order to cover the interest rate promised to the bank customer. The bank may hold some reserves against loan defaults, but only as a practical matter, not a legal one. The loaned money is not available on demand, although in some types of credit contracts, a bank might agree to make a best effort to liquidate part of their loan portfolio if the depositor wants to cash in part of the loan.

De Soto cites numerous examples in Chapter XX of his book of banking systems that separated their irregular deposit business from their credit business. According to Rothbard, deposit banking as a business was destroyed by a series of bad court decisions in the Anglo-Saxon world. In cases where depositors brought lawsuits against banks for violation of their deposit contract, courts ruled that whenever money changes hands between a bank and its customers, it is necessarily a credit transaction. This legal development destroyed legal protection of bank deposits and opened the way for the widespread development of fractional reserve banking.

Credit banks would offer loan instruments such as CDs, money market funds, and short-term bond portfolios holding bills of exchange. These securities are created when the bank customer loans funds to the bank. All of these exist now and are not problematic under the 100% reserve requirement. Banks could also agree to make a "best effort" to liquidate shares in their underlying bond portfolio for as close to their principal value as possible should a customer wish to withdraw a loan.

Within a 100% reserve banking system, there is no legal problem with banks offering "money market mutual fund with best-effort redemption" (MMF+BER) as a credit contract. These accounts might hold high-quality short-term credit instruments, including bills of exchange. The term 'fractional reserve' does not apply to these funds because the bank management has the legal right to loan some or all of the funds out.

When a customer wishes to liquidate shares in a MMF+BER, the bank could not guarantee immediate payment in gold on demand because most or all of the gold would have been loaned out. However, the bank could make a best effort to sell a portion of the fund's underlying credit portfolio for gold in the credit market. After the sales of securities had settled (a process that currently takes one to three days for most securities in US markets) the funds would be available for the customer.

Under the irregular deposit contract, the bank may not loan out the funds because they would not be available for immediate return to the customer. Fractional reserve banking is a term that applies only to banking under the irregular deposit contract. Fractional reserve banking is then inherently fraudulent because it is a violation of the bank's contract. There is always a temptation for banks to loan their customer's funds because of the interest they could earn on their customers' money. In doing so, the bank is taking the chance that it will face bankruptcy when requests for funds by depositors can be satisfied out of the gold coins belonging to other customers.

While it is true that bank customers who considered MMF+BERs s to be a safe investment could hold some quantity of fund shares in lieu of cash. Doing so would reduce overall money demand, (much in the same way that clearing systems reduce money demand) by enabling people to hold lower cash balances.

However, it must be emphasized that Money market funds, CDs, or other credit contracts are not money. They are not money for the same reason that all debt is not money. debt is a promise to repay money at some time in the future. The measure of whether something is or is not money is that money enables the final settlement of a transaction of loan. A loan that is repaid with another loan is not really repaid; it is still an outstanding loan.

Bills of exchange are collateralized debt contracts. But collateralized debt is still debt. If the debtor defaulted on the bill, the collateral could be sold for money. Something that can be sold for money is not money as such.

Charles Holt Carroll was one of the most astute banking theorists on this issue. For those seeking an understanding of the difference between money and debt, his writings are unmatched. An opponent of fractional reserve banking, which he called "the organization of debt into currency, he wrote:

The term "deposit," as applied to the amount at the credit of a borrower, is in truth a misnomer, for the borrower deposits nothing -- there is no money in the transaction; it is simply an exchange of debt. Yet it is effectually currency to be used as equivalent to coin at any moment. In event of a bank contraction, it is apt to become a most embarrassing claim upon both bank and borrower, for real dollars that are nowhere -- that never existed.{Carroll 1964 g:87}


The false principle is the formation of a "deposit" in pretended banking by discounting a debt out of itself; creating so much additional debt and making it currency. The credit given by a bank to its customer, which is not the transfer of a prior credit, but which increases the loan and the "deposits" in one and the same transaction, is no deposit, and no banking; there is no value received; it is currency-making out of debt, and, to the extent of its convertibility into coin, it depreciates the value of money, and expels an equal sum of capital from the community that originates in pure loss.{Carroll 1964:276-277}

Fekete advocates his doctrine as a remedy for alleged deficiencies in Rothbard's the system of one hundred percent reserve banking. Fekete makes three arguments against the Rothbard's theory: that bank notes are inherently a grant of credit; that investment could not be financed on a sufficient scale, and that one hundred percent reserve is not compatible with clearing. Fekete is wrong on all counts.

Fekete has written that when someone accepts a banknote, they are necessarily entering into a credit transaction with a bank.

My position is that the holders of gold certificates and, for the stronger reason, holders of bank notes are in fact (voluntary or involuntary) grantors of credit. What they hold is a promise to deliver a present good, not the present good itself. In other words, paper currency such as a gold certificate or a bank note is a future good.

Fekete's discussion ignores the possibility that the bank customer wishes to enter into a deposit contract. Under a bailment contract, the receipt is a title to the gold coins. Titles are not goods per se; they are documentation of the ownership of a good. The owner of a title to a home, for example, owns the home in the present. The title is not a good per se: it documents ownership of the good. In the same way, a bank note is not a good; it is the documentation of the ownership of a present good, the gold coin.

The gold coin would, as Fekete says, be a future good, if the bank customer entered into a credit contract. In that case, the bank would issue a promise for future repayment of its debt to the customer.

And again in Lecture 12:

Some sound-money theorists such as Murray Rothbard see the solution to the problem of credit abuse in the so-called 100 percent gold reserve banking. They suggest that banks should maintain 100 percent gold reserves against all their outstanding credit

Again there is no awareness of the distinction between bailment and credit. Banks would only be required to hold reserves against all of their bailment obligations, not their credit obligations.

In his Lecture 8, Fekete shows a fundamental misunderstanding of the nature of money:

The notion that the bank's promise, if it is to be honest, forces it to have a store of gold on hand equal to the sum total of its note and deposit liabilities stems from a fundamental confusion between stocks and flows. The promise of a bank, as that of every other business, refers to flows, not stocks. The promise is honest as long as they see to it that everything will be done to keep the flows moving.

First there is the error of lumping together note and deposit liabilities. If the notes resulted from credit contracts, there is on reserve requirement. The reserve requirement only comes about through deposit contracts.

But there is a deeper problem here. Money, in distinction from all other goods is always a stock. Every unit of money is held by someone as part of their stock of money. Unlike other goods, money is not consumed as such, it is always held by someone. When the owner of one unit of money spends it, the buyer of that money becomes its new holder. The purpose of deposit banking is to integrity in the holding of gold so that it is available when the owner wishes to spend it. Once a deposit is loaned out, it is no longer available for spending.

Fekete charges "The first thing to be observed about the "100 percent gold standard" is that nothing approximating it has ever been tested in practice." On the contrary, de Soto, in Chapter 2 of Money, Bank Credit, and Economic Cycles, gives numerous examples of 100% reserve banks throughout European history. For example,

The last serious attempt to establish a bank based on the general legal principles governing the monetary irregular deposit and to set up an efficient system of government control to adequately define and defend depositors' property rights took place with the creation of the Municipal Bank of Amsterdam in 1609. It was founded after a period of great monetary chaos and fraudulent (fractional-reserve) private banking. Intended to put an end to this state of affairs and restore order to financial relations, the Bank of Amsterdam began operating on January 31, 1609 and was called the Bank of Exchange.103 The hallmark of the Bank of Amsterdam was its commitment, from the time of its creation, to the universal legal principles governing the monetary irregular deposit. More specifically, it was founded upon the principle that the obligation of the depository bank in the monetary irregular deposit contract consists of maintaining the constant availability of the [deposited funds] in favor of the depositor; that is, maintaining at all times a 100-percent reserve ratio with respect to "demand" deposits. (p. 98)

We will now look at a series of arguments by Fekete and Hultberg that Fekete and Hultberg blur the distinction between the clearing and the Real Bills Doctrine. Their doctrine has two parts: clearing systems to issue bills and fractional reserve banks to monetize them. In order to establish their doctrine, they must show that both parts are necessary. It is not sufficient to show only that clearing systems are beneficial.

Any argument in favor of clearing, no matter how sound and valid, does nothing to settle the question of bank reserves. Any arguments establishing the benefits of clearing are not by themselves sufficient to justify his doctrine. Both clearing and FRB together must be established.

Fekete gives as the reason for the failure of 100% reserve banking its incompatibility with clearing systems:

The first thing to be observed about the "100 percent gold standard" is that nothing approximating it has ever been tested in practice. All historical metallic monetary standards had a supporting clearing system, more or less developed, which limited the actual payment in the monetary metal to net trade, that is, the difference between the value of total purchases and that of total sales.

In charging that 100% reserve banking cannot exist because clearing systems are necessary, he proposes a necessary connection between two things that are in fact unrelated. There is no basis for the statement that 100% reserve banking does not allow for the existence of clearing. There is no problem with clearing systems from the point of view of 100% reserve banking. There are four combination of reserve requirements and clearing systems (fractional reserve with/without clearing, 100% reserve with/without clearing) Any of these four combinations is possible. The reserve requirement for banks and the use of clearing systems are independent issues and each one must be decided separately.

Mises and Rothbard wrote extensively about clearing systems. (I have written about this elsewhere.) Fekete seems to think that under 100% reserve banking, all transactions within the economy must be settled at the time they are entered through a physical payment of coin. This is not the case.

Hultberg has written recently:

The most important mistake being made by Corrigan and the Rothbardians is that they continue to ignore the fact that in a free-market system, real bills will automatically spring up and be used wherever they are functional. There is nothing to stop them! They are not fraudulent; and they are not governmentally orchestrated. So they will certainly be utilized among producers, distributors and retailers if we are going to promote freedom.

Mr. Hultberg, please take not that there is absolutely no problem with clearing houses issuing real bills under a system of 100% reserve banking.

Clearing is a useful financial innovation. It is entirely possible to have clearing without the monetization of bills. These benefits of clearing do not depend on the monetization of clearing instruments. The problem from a legal standpoint begins when banks monetize clearing instruments. This is a violation of the 100% reserve requirement. But it is not necessary for banks to monetize clearing instruments in order for clearing systems to work. Nor does widespread use of clearing systems by itself establish a case against Rothbard's banking theory.

Here, Hultberg suggests that the adoption of clearing provides validation by the market that more money is needed:

So is it rational to maintain, as Rothbard does, that there is "never any need for a larger supply of money?" The marketplace itself is telling us just the opposite -- that there is often a definite need for a larger supply of money! If there was no need for a larger supply, why did demand for it spring up so abundantly to create the miracle of bills of exchange from the Renaissance era to the end of the 19th century?

The response to Fekete and Hultberg is a methodological point. No observation by itself can prove a theory. Only a sound theoretical argument can prove a theory. The observation of clearing does not go very far by itself. All that we can conclude from the adoption of clearing is that the people who adopt it derive some economic benefit from adopting it. In particular, the observation does not prove Fekete's theory that bills enable investment to take place without a corresponding growth in savings, and it does not prove Hultberg's case that there is a monetary benefit to a greater quantity of money. The observation itself does not constitute a theory.

Business firms do derive benefits from clearing: it reduces their need to hold as much cash and enables cost savings in gold bar transport. Note that any financial innovation that reduces the need to hold cash results in a corresponding increase in the price level that cancels out any systemic benefit. Those who do not adopt this innovation would be at a disadvantage to those who did.

The second error in Hultberg's argument that market adoption has proved the validity of their system is that the growth of clearing systems per se does nothing to prove the validity of fractional reserve banking. Even the existence of fractional reserve banking does nothing to prove that it is generally beneficial, only that someone benefits. The motivation for lending reserves comes entirely from the banks' desire to earn a profit off their customers' deposits. The benefit goes entirely to the banks. There is no general benefit. (For a discussion of whether fractional reserve banking has "passed the market test", see Hülsmann's article on this topic.)


Fractional reserve banking is the magic elixir of inflationists. To be sure, banks can create money, but in doing so, they do not create wealth, they merely depreciate the value of existing money.

Carroll in one of most lucid critiques, observed, "It is marvelous what a perfect hallucination upon this subject possesses the minds of men otherwise thoroughly intelligent."{Carroll 1964 e:66}


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