Should Fractional Reserve Banking Be Illegal?

There is widespread thought amongst libertarians/ Austrian school economists that fractional reserve banking (FRB) should be illegal.  It is not very often that libertarians, especially anarchists, say, “There ought to be a law”.  Who am I to take on intellectual giants like Murray Rothbard and Walter Block?  I would like to suggest though that libertarians should not be all that concerned about fractional reserve banking.

People often get worked up over the trade deficit of the United States, when this is really not a problem.  It is really the result of a problem, which is a fiat currency and massive federal debt.  In much the same way, fractional reserve banking is not really what makes the system fraudulent.

Instead of advocating that banks be mandated by law to hold 100% reserves, it should be good enough to simply advocate a free market.  I hate to tell this to other libertarians, but we don’t need another law.  We simply need to repeal the ones we have.  If we get rid of government banking regulations, the FDIC, and the Federal Reserve, the problem of fractional reserve banking will take care of itself.  In short, we simply need a free market in banking.  It is not to say that things will be perfect or that banks will never fail, but you wouldn’t have that guarantee with a law on the books either.

A free market in banking would probably result in gold being the main currency.  Libertarians often advocate a gold standard, but it is really a free market in money that is desired.  The free market chose gold for thousands of years because of its good qualities as money.  Assuming that gold would be the primary money, banks would accept gold as a place for you to store your money.  Perhaps they would be in coin form so that the weight and content is easily identifiable.  The bank could issue certificates that could be redeemed for a certain amount of gold.  If a bank wanted to really show its honesty, it could stamp a serial number on gold coins and issue certificates with that same number.  Any customer could drop by the bank at any time and ask to see the gold coin corresponding to the certificate.  Such a bank would be practicing banking with 100% reserves.

But let’s suppose that a bank did loan out the gold that you gave them.  First of all, if the bank only held 10% reserves, which is the minimum that banks are required to hold today, there would be a run in a short time and the bank would be out of business.  But a bank would be foolish to do this in a free market.  The reason banks only hold 10% reserves now is because the FDIC is there to back them up.  The FDIC is the only reason that people are not running to their banks and withdrawing all of their money right now.  The FDIC is really what makes banking today fraudulent.

Now some libertarians will argue that you can’t have any fractional reserve banking because there would be more than one person that has a claim on the same property.  But what then of insurance companies?  If every single American were to get into a car accident tomorrow, then the car insurance companies would not be able to make good on the claims.  The car insurance companies and their customers are betting on the fact that not everyone will file a claim at the same time.  I have yet to see anyone argue that insurance companies should be illegal (although I’m sure there is someone).

Libertarians are often asked how things would work if left to the free market.  For example, people will ask how roads could be operated by businesses and how people would pay their bills to use the roads.  I cannot answer these questions and nobody else can either.  We can only suggest possible ways that the market might handle this.  The same goes for fractional reserve banking.  I don’t know how things would operate in a world of free banking.  I can only guess.

Perhaps some banking will be like buying a cd at a bank.  You can lock in a rate for a fixed time.  If you want to withdraw the money early, you may have to pay a penalty.  Or perhaps a penalty would depend on how high the reserves were at that time for the bank.  Maybe you could have a cd, but with no guarantee that you will be able to withdraw your money early.  There are any number of financial instruments that could be used in a system of free market banking and money.

So what of fraud?  If you deposit your money into an account and the owner of the bank runs off with your money, you can sue that person for stealing.  We don’t need another law.  We need to let the free market work.  Again, fractional reserve banking is a problem primarily because of the FDIC and fiat money.  Libertarians should not be telling people what kind of contracts they are allowed to enter into.  If a bank openly practices fractional reserve banking and I want to take my business there, that should be up to me.  It is my money and I am taking the risk.

This is really more of a moral issue for me.  Perhaps Murray Rothbard was right and that fractional reserve banking is detrimental to an economy, even in a free market economy.  But regardless of the utilitarian argument, who am I to tell two other parties what they may and may not do?  As long as a bank is being honest about its practices, who am I to interfere with contracts that others are making?  If there were a law preventing fractional reserve banking in a free market, who would we point the gun at? Would we point a gun at the banking customer or the banker himself or both?  Would we threaten them with fines?  Would we lock them up?  Would we shoot them if they disobeyed?  And what kind of law would this be?  Would it be a federal law?  Where is this power granted in the Constitution?

This is a great example of why I consider myself a panarchist ahead of being an anarchist.  If people want to get together and agree on something, who am I to stop them if they are not interfering with someone else's rights?  If a group of people want to get together and have socialized medicine, who am I to stop them?  If they want to get together and have fractional reserve banks, who am I to stop them, as long as I am not being forced to participate?

In conclusion, libertarians should not worry about fractional reserve banking.  It will be used by the Federal Reserve to inflate the currency as long as there is a Federal Reserve.  In a free society, fractional reserve banking will not take place anywhere close to the extent that it currently does, if at all.  We already have laws that allow people to use the courts to sue for fraud.  We don’t need any more laws.  Our main goal should be to eliminate the Fed by repealing legal tender laws and to get back to sound money.