Incredible banking news from across the pond!
In news that should warm the heart of any Austrian economist, or anyone with a built-in skepticism of fiat money, or anyone who isn’t a fan of the boom-and-bust business cycle (that should cover everyone, right?), two MPs in England are proposing a bill that would mitigate the effects of runaway money creation.
MPs Douglas Carswell and Steven Baker have addressed the problem of bank “ownership” of deposited funds with a new bill requiring that banks not lend depositors’ money without explicit permission of the depositor. Read about it in the Wall Street Journal (from Steven Baker himself), the Telegraph (Toby Baxendale), and more in the Telegraph (from Daniel Hannan).
Although the Steven Baker article is worth reading in its entirety, it hits hard right from the very beginning:
If you borrow a friend’s painting and promise that you will give it back on demand, and you then lend that same painting to somebody else, you have committed a fraud. The same rules do not apply, however, to bankers. British parliamentarians have an opportunity to change that today, and I hope they do.
Today, banks enjoy the legal privilege of fractional reserve banking, meaning they may lend out what they already owe depositors. By lending and investing on-demand deposits, banks create money by extending credit. When the bank’s investments turn sour—and investments often turn sour at some point—the bank cannot pay back the deposits and goes bust. Unless it manages to convince politicians that it is too large to fail, in which case it will be bailed out by taxpayers.
This skewed relationship between bank deposits and normal contract and property rights, combined with state interventions like the central planning of interest rates and various guarantees, is what causes boom and bust. Today I will be supporting my colleague Douglas Carswell, member of Parliament for Clacton, as he introduces a bill to phase out fractional reserve banking. Our friends in the U.S. and Europe are watching closely, for the same crony capitalism afflicts the world.
By way of further exposition of the issue, I would like to point out a sadly all too common misconception about the banking industry. Whereas the common bank depositor believes that he is leaving his money in the bank for safekeeping, and is thus able to withdraw “his” money at any given time, the reality is quite different. The legal structure of bank deposits is that of debtor-creditor. In other words, loaning your friend $20 with repayment to be made on demand is roughly the same as depositing that $20 in the bank – both are loans repayable on call.
Banks have taken advantage of the fungibility of fiduciary media to create a system where effective “ownership” of deposited funds transfers to the bank, which can then do whatever it likes with the money without prior permission of the depositor. This leads to the cycle of credit creation (which hopefully doesn’t have to be explained here). The creation of credit leads to inflation, and it leads to the business cycle by encouraging use of the funds, especially via capital spending, in ways that are well beyond sustainable given the actual capital reserves.
We’ve seen this play out before – The decade between roughly 2000 and 2010 has seen historically low interest rates targeted by the Fed. The natural response was a rise in asset prices (real estate) and capital investment beyond that which was sustainable (housing construction). The aftermath was a market and credit contraction, the likes of which hadn’t been seen in more than 20 years.
Egregiously missing from the modern discourse on banking (read: fractional-reserve banking dependent on centrally-controlled fiduciary media) is any sense of history regarding the banking process itself. Banks qua banks began as deposits of gold under the safekeeping of goldsmiths. Goldsmiths issued notes indicating the amount and type of metallic goods under safekeeping, and traders soon realized that these notes could be used as a convenient proxy for the metal itself. This was a form of decentralized fiduciary media. (“Fiduciary media” itself being a rough translation of umlaufsmittel, or “means of circulation,” from Mises’s Theory of Money and Credit.)
Various landmark court cases over the years have utilized not much more than semantics in defining the legal status of the metal under the care of these goldsmiths, and later, bankers. The original theory was safekeeping, as noted above, for which we use the modern legal term “bailment.” Perhaps the first known case to challenge this bailment relationship was Querini v. Bank of Mariono Vendelino from 1342, in which the court considered whether Querini left her money with the bank for safekeeping or as an investment, when no explicit understanding was reached. At the English common law, to which Americans owe the greater part of their legal culture, the relationship was changed in the courts in the seventeenth century to favor “investment” over bailment. (Jesus Huerta de Soto has written extensively on the legal history of banking, and much of my distilled history comes from that source, generally.)
Fast forward to modern times, and no one with significant political power seems to have thought particularly hard about whether the “investment,” or loan-type, deposit structure is actually beneficial. In other words, we have seen no real push toward treatment of deposited funds as the depositors’ money, regardless of the effects of fractional-reserve banking on the business cycle.
Instead, the legal structure of banking treats all money as if it is risk capital.
Certainly, where a depositor is desirous of treating their demand deposits as risk capital, they should be allowed to do so, and Carswell and Baker’s bill does not change that. However, if depositors are given the choice between bailment and loan (a choice that they haven’t had for centuries), I don’t doubt that a significant portion would choose bailment.
Carswell and Baker’s bill is step in the right direction. By reining in banks’ free use of funds for the artificial creation of credit, it is possible to mitigate the business cycle and help preclude future bank bailouts.