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I have seen Objectivists describe fractional-reserve banking as fraudulent for allowing the loaning of what one doesn't in fact have -- while others have expressed no concern and indicated it would even occur naturally given a free market in money. Can someone here can shed some light?

asked Oct 02 '10 at 11:13

Greg%20Perkins's gravatar image

Greg Perkins ♦♦

I think the question is worded incorrectly. Legal means that something is within the law. FRB is within the law. The laws of a country are the rules made by its legislators. The question on this forum should instead be, "does FRB met the test of morality according to Objectivism"

(Oct 07 '10 at 01:07) garret seinen garret%20seinen's gravatar image

In which case the answer would be yes, but still not settle the whole of the matter. Not every opponent of the practice is hung up on claims of fraud, theft or voodoo.

(Oct 08 '10 at 22:04) JJMcVey ♦ JJMcVey's gravatar image

The moral legitimacy of fractional reserve banking is a subject of dispute both inside and outside the Objectivist movement. As an application of principles to a complex real-world situation there is room for honest disagreement, which is why there is no consensus.

The anti-fractional-reserve position was indicated in the question: such a bank, critics allege, is lending something it doesn't actually have. If Alice deposits an ounce of gold in a bank, the bank is obligated to give it back to her on demand. The bank can't do this if it has lent that ounce of gold to Bob, and that's what fractional reserve banking consists of.

The pro-fractional-reserve position is that this issue can be resolved by contract. Most of the time, depositors do not show up and demand all of their money from the bank. If Alice and Bob each deposit an ounce of gold in a bank, the bank can lend one ounce to Carol and only be in trouble if Alice and Bob both demand their money at the same time. Since there is a risk here, it has to be disclosed, but as long as it is -- and Alice and Bob are compensated for the risk by receiving interest on their deposits -- where's the fraud?

Pro-fractional-reserve advocates sometimes draw an analogy to insurance. No insurance company is funded at a level that would enable the payment of simultaneous claims to all of its customers -- insurance works because of carefully computed statistical risk analysis. If fractional reserve banking is inherently fraudulent because it involves making a promise it is not possible to keep under all circumstances -- when Alice and Bob both want their deposits back at the same time -- then insurance is inherently fraudulent for the same reason.

answered Oct 02 '10 at 12:29

Kyle%20Haight's gravatar image

Kyle Haight ♦


Morally and legally, there is no question that fractional reserve banking is a perfectly fine practice. So long as there is no concealment of the fact, then there are no grounds for condemning it a priori. The question is what would actually make economic sense? And the historical record is clear: free banking gives rise to fractional reserve banking. See Larry White and George Selgin, who spend their time looking at reality rather than, per Rothbard, deducing rationalistically.

(Oct 02 '10 at 12:42) Publius ♦ Publius's gravatar image

Good answer but I think you grant to much to the enemies of FRB.

"If Alice deposits an ounce of gold in a bank, the bank is obligated to give it back to her on demand." Not true. At minimum, it's understood by all parties that a fraction Alice's savings are invested, and that her deposit carries risk.

The insurance analogy is a good one. Another is a gym, which may sign up many members. It promises them they can come work out any time. If they all showed up at once, the gym would be over capacity. But in practice, that never happens, and everyone understands the minute risk involved.

(Oct 03 '10 at 02:34) jasoncrawford ♦ jasoncrawford's gravatar image

FRB is not lending out Mary's money while still promising to pay her back, it instead is lending out 20 times as much money as Mary deposited. In other words, injecting 20 or more times as many token into the market place competing for goods and services and thereby driving up everyone's costs. What is really happening is the value is being taken out of the money previously earned. Yes it is fraud, on a massive scale.

(Oct 03 '10 at 02:53) garret seinen garret%20seinen's gravatar image

To my understanding, the bank does not lend out 20 times the money it has. Instead, it lends out a fraction of its deposits--hence the term. E.g., it lends out 95% of Mary's money.

The multiplier effect you're referring to is real, but it results from the loans being re-deposited and a fraction of them being lent out, and this happening multiple times. However, there is still no fraud. And the beneficial effect is that as much capital as possible is put to productive use at any given time, instead of stagnating in the vault.

(Oct 03 '10 at 03:11) jasoncrawford ♦ jasoncrawford's gravatar image

Incidentally, when we had free banking in this country--when there was no federal deposit insurance or bank bailouts, and banks had to keep themselves solvent--I believe the average reserve ratio was around 40%, far more conservative than the 10% the government requires today. (I can't find a reference on this right now, though). A 40% reserve ratio leads to only a 2.5x multiplier, not 20x.

(Oct 03 '10 at 03:12) jasoncrawford ♦ jasoncrawford's gravatar image

Jason, if I product something for my money but you don't yet you stand in the customer line for the concrete or the ipad that I desire, my price will be higher because two of us seek to buy the same item. As an individual I'm worse off. Calling a thing better for society carries no weight to an Objectivist. So we'll agree to disagree, as this end my part.

(Oct 03 '10 at 03:30) garret seinen garret%20seinen's gravatar image

Jason is correct about the difference in historical reserve ratios under free banking. During the free banking period between 1836 and 1862, capital reserves fluctuated around 40%, with a high of 55% in 1842 and a low of 38% in 1854.

In 1863 the National Bank Act introduced significant elements of centralized banking into the economy; reserve ratios dropped constantly afterwards to a low of 16% in 1913.

(Figures from Historical Statistics of the United States Through 1970 as cited in Richard Salsman's Breaking the Banks: Central Banking Problems and Free Banking Solutions.)

(Oct 03 '10 at 16:20) Kyle Haight ♦ Kyle%20Haight's gravatar image

Publius is correct that there's nothing inherently evil in the practice and that the actual question is purely economic. The problem is that his answer to the economic question is inadequate and presumes that anything that arises in a free market among rational men is automatically correct.

FRB is worthless because it is nothing more than pure monetary expansion, using credit as money. It does not change people's core attitudes towards what real-capital they will maintain, and actually hinders real-capital formation by increasing market risks with nothing to show for this.

(Oct 03 '10 at 23:39) JJMcVey ♦ JJMcVey's gravatar image

While I suppose fractional reserve banking could be made to be non-fraudulent (by turning checks into the equivalent of bearer-bonds), I find it highly unlikely that it would work in practice. Fractional reserve banking inherently leads to runs on the bank without the interference of government-run deposit insurance, backed by the government power of taxation (and/or printing of currency).

Consider for a moment what would have happened to the FDIC had the government not bailed out the banks and had the FDIC been limited to its piddly deposit insurance fund. The FDIC would have gone broke.

(Oct 13 '10 at 12:53) anthony anthony's gravatar image

Good summary Kyle. I am against FRB, therefore I am also against insurance companies and gym clubs, because they all make a promise they can not keep. Making a false promise knowingly, is objectively wrong.

The fact that depositors, insured people, and gym members consent to the contract does not make the actions of the bank, the insurer and the gym moral worthy.

(Oct 02 '12 at 02:23) Moo Moo's gravatar image

If the contract honestly states all the relevant facts and known hypotheticals, then there is no false promise being made.

(Oct 02 '12 at 07:15) anthony anthony's gravatar image
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I have researched and written about this issue fairly extensively on my blog (www.ratcapblog.com). I recommend Jesus Huerta de Soto's book: Money, Bank Credit, and Economic Cycles for a start.

My view is that the problem stems from a problem in the philosophy of law, particularly the proper definition of property as it relates to the concept of "deposit" and "loan". Legally, a deposit is when you store something with someone else and expect it, by contract, to be returned upon demand. A loan is when you relinquish title to the property in exchange for a future payment.

I hold that the law must distinguish these two concepts, i.e., the courts should not uphold contracts where two parties conflate these concepts, just as a court can not uphold a contract wherein two parties agree that one will paint the other's house red and blue at the same time. Even if the contract is entered voluntarily, it is impossible to uphold. A bank can not make a deposit available "upon demand" yet loan it at the same time. A deposit is a deposit, and a loan is a loan. They are separate contracts and require different banking functions.

Various 19th century common law cases established precedents that deemed that "deposits" became the property of the bank once deposited, thus validating fractional reserve banking and setting the stage for the modern system.

Fractional reserve banking is economically destructive in that it allows banks to create money ex nihilo (out of thin air) and thus sets the boom-bust cycle in motion (since actual savings are not used to fund investment). It is not surprising that bad law leads to bad economics, as it always does. FRB further compounds the creation of money ex nihilo by the Federal Reserve system which creates money when it purchases securities on the open market.

These two factors, the Federal Reserve combined with FRB, is responsible for the boom-bust cycle. The solution is a 100% private banking system based on hard assets (gold and silver) under laws that maintain a legal distinction between the concept of deposit and loan, i.e., effectively mandating a 100% reserve gold standard.

answered Oct 20 '10 at 13:54

The%20Rational%20Capitalist's gravatar image

The Rational Capitalist ♦

edited Oct 20 '10 at 13:56

Excellent The Rational Capitalist. If money is a claim to labor and if you could legally circumvent the labor aspect, you are on your way to owning the world.

(Feb 24 '12 at 11:35) se7ensnakes se7ensnakes's gravatar image

I like the clear distinction between deposits and loans, but I'm not sure it gets rid of fractional reserve banking. It just turns the bank into a loan aggregator. Alice and Bob each lend the bank an ounce of their gold under terms that allow them to 'call' the loan at their discretion. The bank turns around and loans the gold to others, profiting from economies of scale and judgment. The result looks very much like fractional reserve banking.

(Feb 27 '12 at 19:24) Kyle Haight ♦ Kyle%20Haight's gravatar image

Kyle is right, here. That's just addressing terminology. The full panoply of FRB can still be maintained while satisfying those concerns.

The attempt to ban FRB is an unwinnable cause. The practice cannot be made illegal, because that would require a whole raft of further intrusive regulations, eg banning all forms of settling debt by transfer of other debt and banning duration mismatch. I say this as an opponent of FRB! The only solution is customer education on how illadvised it is (including why it is wrong to rely on historical acceptance of it even under mostly-free banking.)


(Mar 03 '12 at 03:44) JJMcVey ♦ JJMcVey's gravatar image
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I know only the most basic facts about economics, but it seems to me that fractional-reserve banking is not only legitimate but indispensable to a healthy economy. If savings are not invested, then they are hoarded. Capital that could be productive is stagnating instead.

A fractional-reserve bank provides an investment service. It's not that the bank takes deposits and just happens to invest some of them, on the side; the investment is an integral part of the service. Not only is there no concealment of the investment, the depositors are actively seeking to have their money invested, by finding the best interest rate they can get for their deposits. (If they're not, and would prefer to hoard their savings instead, they can find a full-reserve bank that will charge them a fee to have their cash sitting in a vault protected by armed guards.)

There are plenty of investment funds, such as money market funds, which allow their investors to withdraw some or all of their assets on demand. Why must a bank be any different?

answered Oct 03 '10 at 03:04

jasoncrawford's gravatar image

jasoncrawford ♦

Jason,FRB is NOT indispensable to a healthy economy. The economy was much better off when there were 2 types of banks. Savings banks & INVESTMENT banks. If your investment bank went out of business & you lost your $$, too bad for you. The savings bank (100% reserve)was uneffected. So, most people saved what they could and invested their RISK capital. Now everything is at risk. EVERYTHING. Also, beware of terms like "hoarding". Doesn't "hoarding" just sound Marxist? What's wrong with keeping your own cash? There are hundreds of economics lectures on youtube. Might want to check some out.

(Oct 03 '10 at 12:52) adamsdad ♦ adamsdad's gravatar image

That's way wrong, Jason, on many points. You're confusing saving with the demand for money, committing the idle-cash fallacy, presuming that only lending from contents of transaction accounts can provide the bulk of financing, and overlooking the fact that "money market" funds aren't fractional unless the instruments themselves are monetised.

(Oct 03 '10 at 23:41) JJMcVey ♦ JJMcVey's gravatar image

OK, JJ--I'd like to hear more elaboration on this, you're clearly more well-read on the issue. Perhaps you could write your own answer? I'll go look up the "idle cash fallacy".

In the meantime, I've also realized that there may be at least two meanings of "fractional-reserve banking", and we may not all be talking about the same thing. I'll try to write something soon to clarify.

(Oct 04 '10 at 00:32) jasoncrawford ♦ jasoncrawford's gravatar image

Adamsdad: Good point about savings vs. investment banks--that's part of what I meant when I said we may not all be talking about the same thing. Will write a clarification later.

Re "hoading": Didn't mean to sound Marxist. There's certainly nothing morally wrong with choosing not to invest one's cash. It's just that in general, investment is a good idea.

(Oct 04 '10 at 00:34) jasoncrawford ♦ jasoncrawford's gravatar image

I did a three part blog post on the issue about two weeks ago - jjmcvey.blogspot.com - it is not as good as I had hoped (it needs more work and more data in Pt 2), but it should definitely get people thinking more deeply.

The idle-cash fallacy is the idea that it is better to put deposited money to use instead of leaving it idle in a bank vault. It is a fallacy because the money WILL sit idle in that vault whether or not the economic fund it represents is lent from. The lending only uses its presence as a basis for monetary expansion.

(Oct 04 '10 at 01:06) JJMcVey ♦ JJMcVey's gravatar image

A bank is different from an investment because it allows you to write checks.

There's nothing wrong with investing some of your money. But there is something wrong with spending the same money that you are investing. If an individual does that it's called check kiting, a form of fraud. If a bank does it, it's called fractional reserve banking, and perfectly legal.

(Oct 13 '10 at 13:11) anthony anthony's gravatar image
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The problem with our current fractional reserve system is not that it's fractional, but that the government manipulates the reserves of banks through the federal reserve. In a free market, people will allocate some of their money to consumption, some to low risk long term reserves, and some to high risk speculation. Choosing between banks, I would choose a bank with high reserves for my low risk savings, and low reserves for my high risk speculation. Each bank would, depending on their own strategy, insurance coverage, etc. set their own reserves, they would disclose them, and people would be free to use that bank or not. The forces of supply and demand would determine the correct reserve rate for different markets and different types of banks. The rate of reserve is essentially a price, the tradeoff between risk and return. When the government tries to dictate reserve rates, the results are similar as when the government tries to dictate the price of any good or service ignoring the forces of supply and demand. If I want to start a bank and keep 50% reserves, and you want to put your money in my care provided I give you 10% interest, why should the government prevent us from entering into that contract? It is not legitimate for the government to prevent us from doing that, or to try to dictate the rate of reserve and the rate of interest because that would be an infringement in our freedom.

answered Oct 06 '10 at 17:51

Francisco's gravatar image

Francisco ♦


AS long as individuals are dealing with each other freely, I have no problem with whatever they agree upon. None of my business. I would prefer 100% reserve banking but would not pretend to disallow any other PRIVATE agreements.

(Oct 06 '10 at 19:30) adamsdad ♦ adamsdad's gravatar image

Fractional Reserve Banking (FRB) is not immoral and is not fraudulent if the customers of the bank are aware that the bank is utilizing this method of banking. The problem is often confused with government control of the banking system. The fact that the Federal Reserve uses fractional reserve banking is not the problem. The problem is that the government mandates this for all banks.

Fractional reserve banking carries inherent risks (i.e. inflation). Instead of localizing those risks to banks that use fractional reserve banking, the government forces all banks to assume the same risk and all customers of all banks are forced into a system that they are not allowed to opt out of. Force is the issue, not the method of banking.

As to the method of banking, this method has been successfully used in the United States under a relatively free market banking system called The Suffolk System. The Suffolk System was a self-regulated, near perfect, banking system utilizing fractional reserve banking.

The original intent of fractional reserves was to inflate the money supply of a bank to prevent a total collapse of the bank and any associated banks due to a bank run. Banks, like other businesses, need to make money. They do this by loaning out deposits or by investing money on deposit with the bank.

Money cannot be simultaneously invested and available for withdrawal. The solution is to create a demand-deposit account (i.e. checking and savings accounts) using fractional reserves to guarantee that bank customers can withdraw money "on demand" or to charge a fee for demand deposit accounts so that banks can be compensated for liquidating their investments prior to maturity.

Under a free market system, banks cannot arbitrarily inflate their money supply, since it naturally causes their bank notes to be traded at a discount (their bank notes lose value)--making them less competitive and encouraging customers to do business with a bank that does not debase its currency. At the same time, the flexibility of fractional reserve banking allows customers to withdraw money when they need it. If a bank customer is aware of these terms and conditions and accepts them, there is no conflict and no fraud taking place.

answered Oct 19 '10 at 16:51

David%20Lewis's gravatar image

David Lewis ♦

edited Oct 19 '10 at 16:54


FRB is a pyramid scheme. Anyone, other than a govt bank, trying it would be put in jail. For a good explaination see Paul McKeever (google him) or on youtube: Fractional Reserve Banking vs Ayn Rand's Ethics. Also check out mises.org for the "Austrian School" of economics. Happy hunting!

answered Oct 02 '10 at 11:32

adamsdad's gravatar image

adamsdad ♦


This isn't much of an answer. Could you summarize the explanation you are referring to?

(Oct 03 '10 at 03:24) Justin O ♦ Justin%20O's gravatar image

FRB summarized: Joe deposits $10,000 in his bank. The bank can and does lend $9,000 of Joe's money to Mike. There is now $19,000 of assets in the bank. Joe goes in to withdraw his $10,000. The bank is insolvent (broke). BUT, the Federal Reserve Bank saves the day! They lend the bank enough $$ to pay Joe. Where did the Fed get the $$? They print it. A counterfeiter gets 20 yrs in prison for printing money, for the fed its business as usual. So why does the counterfeiter go to prison? He's debasing the money supply! By the way, the scenario above (Joe & Mike) is not unusual. Happens every day

(Oct 03 '10 at 11:56) adamsdad ♦ adamsdad's gravatar image

No, AD, it is not fraud. FRB is nothing more than the use of another asset as part of the money supply along side gold and silver - no fraud there. The practice is only daft because the asset chosen for monetisation is ill-suited for that use and that the advocates of FRB think monetary expansion creates capital.

(Oct 03 '10 at 23:46) JJMcVey ♦ JJMcVey's gravatar image

Fraud is a legal term. The average bank customer hasn't a clue how any bank works. Sure the info is available but few read it because they don't percieve a need to know. The bank sure isn't going to tell anybody. The fraud is in the govt's presentation of FRB as the agent of price stability. If a stockbroker sells his client an investment without an honest disclosure of what it is, he's in big trouble.

(Oct 19 '10 at 18:57) adamsdad ♦ adamsdad's gravatar image

The question is worded correctly: In a constitutional republic can a private entity affect the nations money supply? According to Article 1 section 8 clause 5, Congress shall have the power to coin Money, regulate the Value thereof. It is a fact that Fractional Reserve Banking is inflationary. Credit in the United States have been used as a weapon by banks to intentionally cause booms and burst If you look at the monetary base and the M1, and compare it to the M3 Money supply you could see that the bulk of our money is in digital format and it is created by bank credit. This is abdication.

(Feb 22 '12 at 09:24) se7ensnakes se7ensnakes's gravatar image

Adam I understand your thought process there, but you really need to look at the "gym" analogy mentioned in the earlier comments.

Where a gym has a capacity of 10 members. But the gym "greedily" signs up 20 members, because it will be unlikely all 20 members will come at the same time.Unlike the banks, the gym can not rely on the Fed to provide extra space in case 20 members turn up at once.

But the principle issue here is, whether it is moral to knowingly give a false promise.

(Oct 02 '12 at 02:33) Moo Moo's gravatar image
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Asked: Oct 02 '10 at 11:13

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Last updated: Oct 02 '12 at 07:15