Hoppe on Fractional Reserve Banking: A Critique

In Hans-Hermann Hoppe, The Economics and Ethics of Private Property: Studies in Political Economy and Philosophy (Boston and London, 1993), 205–254 (see also 175–204), we have various arguments against fractional reserve banking.

(1) In Hoppe (1993: 210ff.), we have the same tired and ignorant argument offered by other opponents of fractional reserve banking: that fiduciary media and fractional reserve banking involve exclusive ownership of one and the same thing at the same time. In fact, this is Hoppe’s central argument and it is plainly false.

Hoppe asserts that the issue and acceptance of a fiduciary note cannot signify the transfer of property from bank to client or vice versa (Hoppe 1993: 210). But Hoppe’s assertion that fiduciary media are “property titles” is utterly wrong. The private bank note or other fiduciary note is not a title to property left as a bailment (or depositum). Some of the earliest British goldsmith notes, forerunners of later private bank notes (or fiduciary media), were clearly negotiable credit/debt instruments payable on demand, with the statement “I promise to repay upon demand ...” demonstrating that these were IOUs or debt records, not certificates of bailment (Selgin 2011: 11; see Melton 1978 for examples of these goldsmith notes).

IOUs are acknowledgements of a debt owed, and negotiable instruments are the most important form of IOU in modern capitalism. They include (1) promissory notes and (2) bills of exchange. Promissory notes (or notes payable or simply notes) are a specific promise to pay, which are often negotiable debt instruments.

The bill of exchange (or sight or time draft) usually involves three parties, the drawer, the drawee and the payee. When the drawee (usually a bank) has agreed to provide credit to the drawer than the bill of exchange becomes a debt instrument used as a means of payment.

But even in a bill of exchange the drawer and drawee might be the same person and his promise to pay accepted by the payee on trust. In cases where the drawer/drawee has yet to obtain the money he will later use to honour his bill of exchange, we have a mere promise to pay, accepted as a fiduciary media and used as a means of payment.

If a bill of exchange is negotiable, then it may be transferred as a means of payment by the payee and used to obtain payment of the specified amount by the new holder (this is signified by adding the words “or order” after the name of the payee). Thus the bill of exchange is treated and used as money in the sense of being a means of payment and a medium of exchange. The same is true of negotiable promissory notes:

“the most usual form of a negotiable promissory note in England is: ‘£60 (or other sum). London, 1st Jany. 1860 (or other place or date). Two months after date (or on demand, or any other specified time), I promise to pay to Mr. A. B. or order fifty pounds, value received. (Signed) C. D.’ A more common form in America is: ‘New York, Jany. 1st, 1860. Value received, I promise to pay A. B. or order one thousand dollars in two months. C. D.’ But no especial form is necessary. The essential things are, a distinct promise, and sufficient certainty as to the payee, the payer, the amount, and the time of payment. And we must remember that the one purpose of all these certainties is to make the note, as far as the law can make it so, the absolute equivalent of money. As to the certainty of the payee, he may be either the original payee, or one who is made a payee by the indorsement of an original payee or of an indorsee; for every indorsee may become an indorser.” (Riply and Dana 1861: 167).

In principle, a negotiable bill of exchange or promissory note may pass from the original payee to a second, third and fourth party, and be used as a widely-accepted means of payment and medium of exchange in the community, and acting just like money. The private fractional reserve bank note functions in the same way, and the issue of bank money (or credit money), the negotiable bill of exchange and promissory note have all constituted the major manner in which an endogenous system of credit money is able to expand the money supply of a nation:

“About the end of the Sixteenth Century, the merchants of Amsterdam, Middleburgh, Hamburgh, and some other places, began to use instruments of credit among themselves, and as they came into personal contact, these documents naturally assumed the form of an acknowledgement of the debt by the debtor, with a promise to pay it to bearer on demand, at the time fixed. These documents were called bills obligatory, or of debt, or of credit, and were transferable by indorsement in all respects like Bills of Exchange.

These documents are now called Promissory Notes, and an English writer in the time of Charles I., Gerard Malynes, strongly advocated their introduction into England, but he saw that the Common Law prohibited it. They first began to be used by the goldsmiths, who, as shewn afterwards, originated the modern system of banking in England soon after 1640. They were then called goldsmiths' notes, but they were not recognised by law. The first promissory notes recognised by law were those of the Bank of England in 1694, which were, technically, bills obligatory, or of credit. By the Act founding the Bank, their notes were declared to be assignable by indorsement (Act, Statute 1694, c. 20, s. 29). But this did not extend to other promissory notes. In 1701 and 1703 it was decided that promissory notes were not assignable, or indorsable over, within the custom of merchants. In consequence of these decisions, the Act, Statute 1704, c. 8, was passed, by which it was enacted that promissory notes in writing, made and signed by any person or persons, body politic or corporate, or by the servant or agent of any corporation, banker, goldsmith, merchant, or trader, promising to pay any other person, any sum of money, should be assignable and indorsable over in the same manner as inland bills of exchange.

These promissory notes, of all sorts, including Bank of England notes, as well as the notes of private bankers and merchants, were all placed exactly on the same footing as inland bills of exchange, that is, they were all made transferable by indorsement on each separate transfer.

In the case however of bank notes (by which, in law, is always meant Bank of England notes), as these were always payable on demand, and the payment was quite secure, the practice of indorsement soon fell into disuse, and they passed from hand to hand like money. In the case of private bankers of great name, the indorsement was often omitted. But, though the ceremony of indorsement was often dispensed with as superfluous, it must be observed that in no way altered the character of the instrument, and the receiver of the note took it entirely at his own peril, and ran exactly the same risks as if he took any other instrument of credit without indorsement.” (Macleod 1866: 87–88; on the historical aspects of promissory notes and bill of exchanges, see Macleod 1866: 84–87).

In an historical sense, private bank notes (fiduciary media) were just like private promissory notes and bills of exchange: European legal systems have understood these as credit instruments, and they were not considered as mere property titles (that is, a receipt for a bailment). Fiduciary media are records of debt and the promise to repay a debt on demand or at a specified date: people can freely and voluntarily accept a debt instrument as a means of payment and medium of exchange, and the exchange involved is in no way fraud. We can see above that it was free contract and the business practices of the private sector that originated them.

If the practice of using negotiable promissory notes and bill of exchanges as money is acceptable, then there is no reason why private fractional reserve bank notes or credit money should be regarded as fraudulent or immoral, for they are in the same moral, legal and ontological category as these other debt instruments.

(2) With the collapse of Hoppe’s absurd claim that fiduciary media are “property titles, ” we are left with his gross ignorance and misunderstanding of the legal nature of the fractional reserve transactions account/checking account. This is sometimes misleadingly called the “demand deposit,” but such an account is not what is known as a depositum or bailment in legal terms. The fractional reserve transactions account is nothing but a debt instrument on the bank’s books (or these days on the bank’s computer system). There is never any initial “bailment” involved, contrary to Hoppe (1993: 218–219).

When the modern fractional reserve bank takes money for a new account, this is actually a personal loan to the bank, which is why the bank can pay interest for it. The money in the deposit becomes the property of the bank. The money is a loan, or legally a mutuum, which means “a contract under which a thing is lent which is to be consumed and therefore is to be returned in kind” (the modern sense of the English word “deposit” is thus misleading when it refers to money in fractional reserve banking). The depositor who lends the money gets a credit (or IOU) from the bank and a promise to pay interest: “the very essence of banking is to receive money as a [m]utuum” (MacLeod 1902: 318). The money has been “sold” to the bank as a mutuum and is to be returned in genere (“in general form”), which means you do not necessarily get the same money back, but just an equivalent amount. In fractional reserve transactions account, you have lost your property rights to the money when you lent it to the bank, and instead have entered into a contract with the bank to allow them to own and use your money, even though they are obliged to return to you on demand the debt they owe to the same amount, in whole or in part, from money from their other reserves, money from the sale of financial assets and their own other loans.

Appendix

There is relevant historical evidnce on the legal development of banknotes in a legal treatise by John A. Russell and David Maclachlan called Chitty on Bills of Exchange, Promissory Notes, Cheques on Bankers, Bankers' Cash Notes and Bank Notes (London, 1859):

“Bankers’ cash notes, which formerly circulated in the metropolis as goldsmiths’ notes, at a time when the only banking transactions in England were entirely in the hands of the goldsmiths, are in effect promissory notes. It appears from Lord Holt’s judgment in the case of Buller v. Crips, that these notes were introduced by the goldsmiths, about thirty years previously to the reign of Queen Anne, and were generally esteemed by the merchants as negotiable. But Lord Holt as strenuously opposed their negotiability as he did that of common promissory notes; and they were not generally settled to be negotiable until the statute of Anne was passed, which relates to these as well as to common promissory notes. They appear originally to have been given by bankers to their customers, as acknowledgments of money received for their use; and they may be, and generally are, payable to bearer. At present, cash notes are seldom issued except by country bankers, their use having been superseded by the introduction of cheques. When formerly issued by London bankers, they were sometimes called shop notes.” (Russell and Maclachlan 1859: 351-352).

In regarding bank notes and goldsmiths’ notes as promissory notes, we have explicit evidence here about how they were considered debt instruments, not certificates of bailment (or “property titles,” titles to property held as a bailment).

On the statute of Queen Anne (reigned 1702-1714), or the Act, Statute 1704, c. 8, see Melton (1986: 110-111).

BIBLIOGRAPHY

Hoppe, Hans-Hermann, 1993. The Economics and Ethics of Private Property: Studies in Political Economy and Philosophy, Kluwer Academic Publishers, Boston and London.

Macleod, H. D. 1866. The Theory and Practice of Banking (2nd edn.), Longmans, Green, Reader, and Dyer, London.

MacLeod, H. D. 1902. Theory and Practice of Banking (6th edn), Longmans, Green, Reader, & Dyer, London.

Melton, Frank T. 1978. “Goldsmiths’ Notes, 1654–1655,” Journal of the Society of Archivists 6.1: 30–31.

Melton, Frank T. 1986. Sir Robert Clayton and the Origins of English Deposit Banking, 1658-1685, Cambridge University Press, Cambridge.

Redlich, F. 1970. “The Promissory Note as a Financial and Business Instrument in the Anglo-Saxon World: A Historical Sketch,” Revue Internationale d’Histoire de la Banque 3: 271-297.

Riply, G. and C. A. Dana (eds). 1861. “Negotiable Paper,” in The New American Cyclopaedia: A Popular Dictionary of General Knowledge, Vol. XII. Mozambique-Parr. D. Appleton and Company, New York. 165–170.

Rogers, J. S. 2004. The Early History of the Law of Bills and Notes: A Study of the Origins of Anglo-American Commercial Law, Cambridge University Press, Cambridge.

Russell J. A. and D. Maclachlan. 1859. Chitty on Bills of Exchange, Promissory Notes, Cheques on Bankers, Bankers’ Cash Notes and Bank Notes: With References to the Law of Scotland, France, and America (10th edn.), Henry W. Sweet, London.

Selgin, G. “Those Dishonest Goldsmiths,” revised January 20, 2011
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1589709