Why Is Fractional-Reserve Banking Fraud and Embezzlement?

All Austrian School scholars agree that a central bank’s fractional reserve banking system has harmful effects on the economy. If anyone thinks it can be justified, then regardless of whether that view is right or wrong, he can never be regarded as a member of the Austrian School. However, there is disagreement over fractional reserve banking by private banks outside the central bank system. George Selgin and Lawrence White argue that if the government does not control the quantity of the medium of exchange, does not back private banks through a central bank, and does not otherwise interfere in the monetary and financial system, then there is no problem with private banks adopting fractional reserve banking. By contrast, scholars including Murray N. Rothbard and Jesus Huerta de Soto maintain that fractional reserve banking can never be justified under any circumstances, and that it is always problematic whether practiced by private banks or by a central bank. Their argument is distinctive in that it defines fractional reserve banking as fraud, namely embezzlement.

Embezzlement is a financial fraud in which a person entrusted with another’s property arbitrarily uses that property or refuses to return it (by concealing it). For example, an accounting employee who handles large sums of money may embezzle an employer’s assets; a lawyer or fund manager may embezzle funds from a client’s trust account; and a married person may embezzle a spouse’s property. Embezzlement covers a very wide range, from trivial to severe cases. A major example of embezzlement is a Ponzi scheme. If the criminal act of using another person’s property without authorization is practiced widely in society, especially if it is institutionally embedded and regarded as legal, the resulting legal and economic problems are substantial. And the Austrian School mainstream—in Rothbard’s view—says that fractional reserve banking is precisely such an example.

Fractional reserve banking is a system in which private banks can earn profits by lending out part of deposits without maintaining reserves sufficient to meet all withdrawal claims at once. For example, if the reserve ratio is 5 percent and customer A deposits $10,000 in a bank, the bank can lend $9,500 of A’s deposit to customer B. In reality, only $500 remains of A’s deposit. Of course, other customers have also deposited money in the bank, so A can withdraw $10,000 whenever he wants—but that money is diverted from other customers’ deposits. Thus, if all depositors demand withdrawal at the same time, the bank will go bankrupt. This is because, in a situation where there should in principle be only one owner of a given dollar, two or more joint owners come into existence. A is naturally the rightful owner of the $10,000 he deposited. But B, having met various conditions and borrowed lawfully, is likewise the rightful owner of the $9,500 loan. As a result, there are simultaneously two owners of the same $9,500. It is physically and logically impossible for two or more people to possess exclusive control rights (ownership) over the same physical resource. For this reason, the Austrian School mainstream argues that fractional reserve banking should be regarded as fraud—because it cannot properly fulfill its contractual obligations, since it cannot allow all deposits to be withdrawn at the same time—and as embezzlement, because it arbitrarily uses customers’ funds.

Some may object that there is no problem because the bank lends deposited money to others and, in return, pays deposit interest. But strictly speaking, lending under fractional reserve banking is no different from a Ponzi scheme in which dividends to existing investors are paid with money received from new investors. Without new depositors or backing from the central bank, the practice of diverting customers’ deposits and lending them out cannot be sustained. Therefore, such an objection should be rejected. Moreover, we have an excellent alternative: a 100 percent reserve banking system. Under a 100 percent reserve system, private banks can lend only time deposits, which cannot be withdrawn during the contracted period. This prevents bank runs and fundamentally blocks fraud and embezzlement.

Even if fractional reserve banking operates without central bank backing, it is still no different from a Ponzi scheme and therefore can never be justified in a free society. At the same time, lending through fractional reserve banking increases the quantity of money circulating in the market, causing a decline in purchasing power and inflation, and thereby creating the possibility of business cycles. Fractional reserve banking poses serious problems from the standpoints of law, ethics, and economics alike.

Original title: 왜 부분지급준비제도는 사기이자 횡령인가

Author: Kyeong-hun Kim

Date: 2021-08-30

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=free_opinion&pn=10&idx=24156