Why is the Fractional Reserve Account a Mutuum, not a Bailment?

Certain anti-fractional reserve banking Austrians complain that fractional reserve (FR) banking is illegitimate, because FR accounts are not loans “in the economic sense.” This objection is derived from Mises’s comments on FR banking here:

“It is usual to reckon the acceptance of a deposit which can be drawn upon at any time by means of notes or cheques as a type of credit transaction and juristically this view is, of course, justified; but economically, the case is not one of a credit transaction. If credit in the economic sense means the exchange of a present good or a present service against a future good or a future service, then it is hardly possible to include the transactions in question under the conception of credit. A depositor of a sum of money who acquires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him. The depositing of the money in no way means that he has renounced immediate disposal over the utility it commands.” (Mises 2009: 269; see also Huerta de Soto 2006: 14–15; Rothbard 2011: 733–734; cf. Rozeff 2010).

Essentially, this reduces to the question whether the FR account (or even callable loan) constitutes “the exchange of a present good or a present service against a future good or a future service.” The Austrian argument assumes that money is a good (Huerta de Soto 2006: 696), and with respect to any commodity money system that assumption can be accepted, when money proper in the sense of the commodity money base is distinguished from debt instruments used as a medium of exchange. In a fiat money system, money as the final means of payment is the fiat base money, the obligations of the central bank, and in fiat money systems one will have to say that the FR account involves the exchange of present units of account/medium of exchange for future goods (considered as banking services) and units of account/medium of exchange.

The FR reserve account is an exchange of present for future goods (or exchange of present units of account/medium of exchange for future goods and units of account/medium of exchange), for the following reasons:

(1) you give up the ownership and possession of your money (the present good) in exchange for

(2) the future goods that are (a) interest (which will be paid at a certain future date) and/or (b) banking services (e.g., the use of cheques, debit cards, electronic funds transfer, etc.), and (c) repayment of your loan as recorded in the debt instrument you receive, your FR account.

It is clear that the argument for the FR reserve account constituting an exchange of present for future goods relies on the crucial point that the FR clients do in fact give up the ownership of their money.

Now how do we know that the FR bank clients do, in actual fact, give up the ownership of their money? The reason is that we have overwhelming empirical evidence: we can look carefully at the present and historical actual actions and practices of FR clients and bankers, their free exchanges, their contracts, how both parties understand these actions and contracts, and how these practices were understood in human legal systems.

Let us review the two pieces of evidence:

(1) Real World Contracts, Exchange and Banking Practice.

First, the voluntary and free contract entered into to by two parties that we call the fractional reserve bank account was a real world banking practice, specified by written and verbal agreement.

In Roman law, there were a number of types of real contract (contracts re), as follows:

(1) mutuum (loan for consumption);
(2) commodatum (loan for use);
(3) pignus (pledge), and
(4) depositum or depositum regulare (bailment for safe keeping).

In Roman law, the mutuum contract included loans repayable on demand (loans with a call option, as it were), and the explicit evidence for this can be found in the Institutes of Gaius (161 AD):

“The agreement enforceable as mutuum could only be for the restoration of an equal sum of money or of goods equal in quantity and similar in quality to those lent, at a date named or, if no date was named, on demand.” (De Zulueta 1953: 149).

Already under Roman civil law, the mutuum loan of money involves either (1) a time deposit or (2) a demand deposit/callable loan. Because money can be regarded as representing a certain value, what is deposited is a quantity of a thing (quantitas) and not an individual thing itself (corpus). The depositor thus receives back the same quantity (tantundem) of money, not the same money itself (Zimmermann 1990: 215–216). The essence of the mutuum contract is that ownership rights to the money pass from the creditor to debtor: in the case of a FR account the bank now became the owner of the money.

Therefore the mutuum was the legal framework and concept under which fractional reserve banking was conducted in ancient Rome (Zimmermann 1990: 218). Whether the mutuum was a time deposit or a demand deposit depended on the type of contract between the two parties, and there is no reason to think that fractional reserve banking was held as either immoral or illegal (for how Roman law influenced Medieval law on banking, see Dotson 2004: 89–92). The evidence for the existence of FRB in the Roman Republic and Roman Empire is overwhelming (Harris 2006: 11; Harris 2011: 236). There is not one shred of evidence that it was regarded as immoral or prosecuted as a crime.

There was even a clear action and convention by which two parties indicated that their entering into such an mutuum exchange: in actual banking practice for over 2,000 years, since the Roman Republic, two parties have engaged in a type of callable loan called in Latin the mutuum, by which money brought to a bank was determined to be a loan if it was handed over in an unsealed box/bag/container.

In the Middle ages, these conventions continued. The practice of giving over money in an unsealed bag or box, as described above, was recognised in Talmudic law (Goldin 1913: 68), as it was from the Jewish community from which many medieval bankers came.

The convention entered European civil law, and it was still cited by American judges in the 19th century in Dawson et al vs. the Real Estate Bank before the Supreme Court of Arkansas in 1845:

“From a careful consideration of the authorities on this subject, we understand the general rule to be, that where money, not in a sealed packet, or closed box, bag or chest, is deposited with a bank or banking corporation, the law presumes it to be a general deposit [= mutuum loan – LK], until the contrary appears; because such deposit is esteemed the most advantageous to the depositary, and most consistent with the general objects, usages, and course of business of such companies or corporations. But if the deposit be made of any thing sealed or locked up or otherwise covered or secured in a package, cask, box, bag or chest, or any thing of the like kind of or belonging to the depositor, the law regards it as a pure or special deposit [= bailment – LK], and the depositary as having the custody thereof only for safe keeping, and the accommodation of the depositor.” (Pike 1845: 296–297).

The “general deposit” is a mutuum (or loan) and the “pure or special deposit” refers to a depositum (or bailment). The tradition of sealing money in a bag, chest or box to indicate that it was to be held in safekeeping as a depositum (not as a mutuum) goes right back to English banking practices that have been examined by Selgin (2011). In English law, showing the influence of Roman law through the Norman conquest, certainly from Elizabethan times, and probably from the Norman conquest, law and banking practice distinguished the bailment (depositum) deposit of money from the mutuum loan of money. The question whether the mutuum was a FR account (or callable loan) or time deposit would depend on the type of verbal or written contract or whether it was handed over in a sealed bag or not. This is how freely consenting clients and bankers understood their fractional reserve accounts/loans, in real world actions.

So the free actions and contractual understanding of agents engaged in FR mutuum loans throughout history

(2) The Evidence of Law.

In the legal systems, codes and legal treatises of European civilisation for over 2,000 years that described banking practice, the exchanges I have discussed above are clearly recognised. In the 4th edition of A New Institute of the Imperial or Civil Law (1730; 1st edn. 1704), Thomas Wood (1661–1722), the English Doctor of Civil Law (New College, Oxford), defines the mutuum contract:

“Mutuum (a Loan simply so call’d quod de meo tuum fiat [sc. “because let what is mine become yours”])

It hath no one particular name in the English Language.

is a Contract introduced by the Law of Nations, in which a Thing that consists in weight (as Bullion,) in number (as Money,) in measure (as Wine,) “is given to another upon condition that he shall return another thing of the same Quantity, Nature and Value upon demand. More than Consent is required, for the Thing, viz. Money, Wine, or Oil ought to be actually delivered, and more than what was delivered cannot be repaid; but less may be repaid by Agreement. This Contract forces men to be industrious and promotes Trade, and for this reason it may be greater charity to lend than to give. Creditum is a more general Word. In the case of Money, Silver may be repaid tor Gold, unless the Creditor is to be damnified by it; for it shall be understood to be the same kind of Money when it is of the same” (Wood 1730: 212).

First, the transfer of ownership of the money in a mutuum loan is explicitly stated by Wood above in the Latin phrase de meo tuum fiat (“let what is mine become yours”). This phrase (in the form quod de meo tuum fit) goes right back to Roman law (MacLeod 1902: 149) as a way of describing the mutuum loan, and is found as a definition of mutuum in the Digest (at 12.1.2.2) of Justinian (AD 530-533), part of that emperor’s Corpus Iuris Civilis (Body of Civil Law). Secondly, Wood’s statement here is important:

“he shall return another thing of the same Quantity, Nature and Value upon demand”.

The words “upon demand” confirm that under English law mutuum contracts allow demand deposits or what I call FR accounts (and not just time deposits).

If we turn to modern English law, we can cite the The Laws of England: Being a Complete Statement of the Whole Law of England (vol. 2; 3rd edn.; 1964):

“The contract of mutuum differs from that of commodatum, in that in the latter a bare possession of the chattel lent, as distinguished from the property in it, vests in the borrower, the general property in it still remaining in the lender; where in mutuum that property in the chattel passes from the lender to the borrower.
Mutuum is confined to such chattels as are intended to be consumed in the using and are capable of being estimated by number, weight, or measure, such as money, corn, or wine. The essence of the contract in the case of such loans is, not that the borrower should return to the lender the identical chattels lent (for such specific return would ordinarily render the loan valueless), but that upon demand or at a fixed date the lender should receive from the borrower an equivalent quantity of the chattels lent.” (Halsbury 1964: 112).

This clearly entails that in the case of a mutuum demand deposit in a fractional reserve bank:

(1) Ownership of the money passes from the client to the fractional reserve bank;

(2) The bank returns only money up to the same value (a tantundem), not the original money;

(3) By the terms of the mutuum contract, the money can be returned either at a fixed future date or on demand.

When a modern fractional reserve bank takes money for a new deposit, this is actually a personal loan to the bank. The money in the deposit becomes the property of the bank. This is clearly stated in FR contracts and in modern law. That fact underlies the conclusion that FR banking is an exchange of present for future goods.

The free actions, actual real world contracts, practices and law relating to FR accounts demonstrate that callable mutuum loans involve the transfer of ownership of the money lent.

The typical Austrian advocate of a priori praxeology is incapable of refuting the overwhelming evidence that people have in fact historically freely contracted to give up ownership of their money and enter into a debt contract in the case of FR accounts and callable loans. This how the FR current account/transactions account is properly defined today. The only solution that such Austrian cultists are driven to is the absurd denial of the relevance of the empirical evidence of the FR contract terms, actual banking practice, real world FR exchanges, and the principles defined in law. Such a denial is essentially an admission of defeat in argument.

BIBLIOGRAPHY

Dotson, John E. 2004. “Banks and Banking,” in C. Kleinhenz (ed.), Medieval Italy: An Encyclopedia. Vol. 1, A to K, Routledge, London. 89–92.

Goldin, H. E. 1913. Mishnah. A Digest of the Basic Principles of the Early Jewish Jurisprudence, Baba Meziah (Middle Gate), Order IV, Treatise II, G. P. Putnam’s Sons, New York & London.

Halsbury, H. S. G. 1964. The Laws of England: Being a Complete Statement of the Whole Law of England (vol. 2; 3rd edn.; ed. G. T. Simonds), Butterworth, London.

Harris, W. V. 2006. “A Revisionist View of Roman Money,” Journal of Roman Studies 96: 1–24.

Harris, W. V. 2011. Rome’s Imperial Economy. Twelve Essays, Oxford University Press, Oxford.

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

Macleod, Henry Dunning, 1893. The Theory and Practice of Banking in Two Volumes (2nd edn.; vol. 1), Longmans, Green and Co., London.

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

Rothbard, M. N. 2009. Man, Economy, and State: A Treatise on Economic Principles (2nd edn.), Ludwig von Mises Institute, Auburn, Ala.

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

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

Wood, Thomas. 1730. A New Institute of the Imperial or Civil Law (4th edn.), J. and J. Knapton, London.

Zimmermann, R. 1990. The Law of Obligations: Roman Foundations of the Civilian Tradition, Juta & Co, Cape Town.

Zulueta, Francis de. 1953. The Institutes of Gaius Part 2, Clarendon Press, Oxford.

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.