Callable Option Loans and Fractional Reserve Accounts

Consider the following comment made by a commentator on a previous post:

“I am saying that, economically, … [sc. loans with a callable option] are no different from demand deposits, or putting one’s money underneath one’s pillow, or one’s wallet, or one’s backyard. Economically equivalent concepts cannot be altered just because they are named differently.

Contracts that are ‘loans with a perpetual call option,’ with no minimum time period, with no exchanging of control for a minimum time period, are, economically speaking, not loans, because at no time does the depositor forsake control or exchange control over the money.”

You can follow the link and read the whole tiresome exchange.

There is something very wrong with this analysis above, and here is why:

(1) If you were to keep your money in a chest in your house or buried in the ground on your property, then the following applies:

(i) Fundamentally, you still own and retain possession of the money as an asset.

(ii) this is merely the holding of an asset you own. It is certainly the hoarding of money as well, and the money involved would be idle, in the sense that it is not being (a) invested in capital goods production for a return, or (b) spent on consumer goods (and it is not even being used to buy a financial asset on a secondary market or second hand good).

(iii) You get nothing in return (no services or goods) in an interpersonal exchange here: and of course there is no interpersonal exchange at all. You also get the same money you dig up or remove from the chest.

(2) In a fractional reserve (FR) transactions account or loan with a callable option (which are both mutuum loans), you have

(i) relinquished ownership rights over any money you lent. The FR account is not a bailment at all, and it certainly requires that you have also lost possession of the money. In exchange for the money lent, you obtain an IOU, a debt instrument we call the FR account, which is merely a debt on the bank’s books. You are now faced with the risk of default, to varying degrees depending on the FR system involved. There is no risk of default in money hoarded in your house, as it is not even a loan.

(ii) Unlike hoarding of money you own at your house, the bank has lent out most of your money since it now has ownership rights. In fact, this is the purpose of banking: “the very essence of banking is to receive money as a [m]utuum” (MacLeod 1902: 318). Money is “sold” to the bank as a mutuum and is to be returned in genere (“in general form”) as a tantundem, which means you do not necessarily get the same money back, but just an equivalent amount with interest. The money has been lent for (a) consumer loans, (b) capital goods investment loans, or (c) purchasing of financial assets which the bank holds as assets on its balance sheet. Some of the original money is retained as reserves held by the bank as money they own, either as vault cash or reserves at the central bank.

(iii) Unlike the hoarding of money at your house (which is holding of your own property), a mutuum loan to the FR bank (either as a FR account or callable option loan) is an exchange of present for future goods, in which you give up the ownership and possession of your money (the present good) in exchange for the future goods that are

(a) interest and/or

(b) banking services (see also Rozeff 2010: 509, as a critique of Mises 2009: 269), e.g., use of cheques, a debit card (which these days allow you to purchase goods via the internet), electronic funds transfer overseas, and often foreign exchange transaction services without charge or little charge compared to other businesses. The most important service that banks offer is, of course, ease in making payments, without holding cash, by cheques or (in earlier periods) private banknotes.

(c) a debt instrument, your FR account. For many people, this frees them from actually holding and storing money in safety at home or on their person, and worrying about whether money they hold might be stolen. The FR account also allows you to call back your loan money in whole or part, if you wish to, as a future good that is the tantundem (not the same money you lent, but different money of the same quantity). This has historically freed people from the inconvenience of holding cash on their person to make payments as well, with the advantage of earning interest on the money given as a loan.

It should be noted that both banking services and interest are certainly future goods. In the case of interest payments, there is also usually a specified date when it will be paid. Thus the denial that future goods are not obtained in exchange for the money lent is absurd.

(3) the act of calling back your FR account loan (in whole or part) or callable option loan is different from merely digging up money buried in the ground: the former constitutes demand for repayment of a debt, and in certain historical FR systems there was the very real risk you might not be repaid. There is a significant difference between calling back a loan (with an element of risk) and merely holding a thing in your own possession (with the comparative security of direct holding).

(4) Finally, the idea that “‘loans with a perpetual call option,’ with no minimum time period, with no exchanging of control for a [sc. fixed] minimum time period, are, economically speaking, not loans, because at no time does the depositor forsake control or exchange control over the money,” if taken seriously, logically requires that all callable option loans must be made illegal by the private law code of any hypothetical anarcho-capitalist society. This appears to be the position of Huerta de Soto (2006), Walter Block and William Barnett (2009), and is attacked by George Selgin and Lawrence H. White here and here. I quote Selgin:

“If De Soto’s position is in fact that callable loans are ipso-facto illegitimate, then that position is even less tenable than I once supposed. For now it isn’t just a question of wishing to suppress fractionally-backed bank deposits, but of wishing to suppress all call loans, starting with brokers loans (which have long played a very important role in financing securities trades) but also including callable bonds and many other non-bank intermediated securities.

With respect to these call loans, there is no question of the ambiguous or deceitful use of the term ‘deposits.’ What’s more, the agents who deal with them include many of the most sophisticated players on the financial scene. Finally, it is well understood that while the ‘callability’ of the loans in question exposes borrowers to an additional risk, the extra risk in question is compensated by lower interest terms than would accompany corresponding time loans. In other words, the call feature is part of a mutually advantageous exchange.”
George Selgin, Comment @May 28, 2009 at 8:21 am, on Joseph Salerno, 2009. “White and Horwitz on Hoppe,” Mises.org, May 18.

But my main conclusion here is as follows: the idea that, “economically speaking,” loans with a callable option and FR demand deposits are equivalent to “putting one’s money underneath one’s pillow, or one’s wallet, or [sc. in] one’s backyard” is untenable.


BIBLIOGRAPHY

Block, W. E. and W. Barnett, 2009. “Time Deposits, Dimensions and Fraud,” Journal of Business Ethics 88.4: 711–716.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1889437

Huerta de Soto, J. 2006. Money, Bank Credit and Economic Cycles (trans. M. A. Stroup), Ludwig von Mises Institute, Auburn, Ala

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

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala.

Rozeff, M. S. 2010. “Rothbard on Fractional Reserve Banking: A Critique,” Independent Review 14.4 (Spring): 497–512.