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this chapter contains a critical examination of the differ-
ent theoretical attempts to legally justify fractional-
reserve banking. We will consider the proposed argu-
ments intended to legally support a monetary irregular deposit
contract in which the depositary can make self-interested use of
money on demand deposit. In light of the legal doctrine pre-
sented in chapter 1 and the economic analysis to be performed
in the following chapters, we will critique two main lines of
defense.
1
INTRODUCTION
The legal doctrines aimed at justifying fractional-reserve
banking have been formulated ex post facto. They have not
been based on preexisting legal principles that have given rise
to certain legal acts. On the contrary, as we explained in the
previous chapter, banking practices have long infringed upon
basic, universal legal principles and have done so in response
to specific circumstances which have conspired to make these
violations possible (human avarice; inadequate regulation; gov-
ernments’ financial needs; systematic intervention of the
115
authorities and confusion arising from the depositum confessa-
tum, a product of the canonical ban on interest). As is logical,
the lack of a legal basis for such a widespread practice soon
prompted bankers and theorists alike to search for a fitting
legal justification. Moreover, this urge was reinforced by the
fact that, on almost all occasions, the government or public
authorities ended up being the main beneficiary of fraudulent
banking practices. Therefore it is not surprising, given the tra-
ditional symbiosis between political authorities and the intel-
ligentsia, that the latter was driven by the former to search for
legal grounds to support the practices it permitted and
encouraged.1
Finding adequate legal grounds was essential to the sur-
vival of the whole network of vested interests which frac-
tional-reserve banking generates. It was clear to any educated
person that these practices should be based on something
sounder than a mere de facto situation. It is not enough to real-
ize and affirm, as Shepard B. Clough does, that
In fact, [goldsmiths] even lent money given them for safe-
keeping on the theory and experience that they needed to
have on hand only enough to meet the expected, current
demand of depositors. This practice led them, at least by the
seventeenth century, to the issuing of “promises to pay,”
that is, “goldsmiths’ notes,” which, like modern banknotes,
circulated from person to person. These “promises to pay,”
which could be paid by using the deposits of customers,
came actually to exceed the amount of money on deposit.
When this happened credit had been actually created by
issuing paper—a very major discovery.2
Nevertheless, no matter how “major” one considers the
“discovery” that it is possible to make fraudulent use of
depositors’ money or issue deposit receipts for a greater
116
Money, Bank Credit, and Economic Cycles
1See Bertrand de Jouvenel, “The European Intellectuals and Capital-
ism,” in Friedrich A. Hayek, ed., Capitalism and the Historians (Chicago:
University of Chicago Press, 1954).
2Shepard B. Clough, The Economic Development of Western Civilization
(New York: McGraw-Hill, 1959), p. 109; italics added.
amount than is actually deposited, it is clear that these acts
share the same characteristic present in all other criminal acts
of misappropriation which have always been the object of doc-
trinal analysis by criminal law experts. The similarity between
the two sets of actions is therefore so obvious that theorists
could not remain impassive in the face of a legal irregularity
such as this in the economy.
Hence it is not surprising that great efforts have been
made to justify what appears completely unjustifiable: that it
is legitimate, from the standpoint of general legal principles,
to misappropriate funds deposited for safekeeping and to
issue deposit receipts for more money than is actually
deposited. However, the interested parties (bankers and gov-
ernments, mostly) have found it so important to find an ade-
quate theoretical justification beyond the easy solution of sim-
ply declaring legal a corrupt, criminal practice (which is what
has ultimately happened, despite all the doctrinal façades and
constructions), that many jurists are still at work trying to con-
fer legal respectability on a procedure that is commonplace
even now.
Doctrinal attempts to justify the use of a fractional reserve
in the irregular deposit can be classified into two large groups.
The first group of doctrines was intended to settle the issue by
equating the irregular deposit contract with the loan contract.
We will analyze this group of theories in detail and show that,
from a legal point of view, it is impossible to equate these two
contracts. Writers of the second and more recent set of doc-
trines start by acknowledging that there are fundamental dif-
ferences between the loan and irregular deposit contract.
These theorists have focused their efforts on the construction
of a new legal concept of “availability” and hold that this
notion should be taken “loosely,” meaning bankers should
only be required to carry out their investments “prudently”
and to comply with regulations and bank legislation at all
times. A detailed study of this second set of theories will
demonstrate that they ultimately entail a return to the failed
attempt of the first group, i.e., to justify the use of a fractional
reserve in the irregular deposit by equating the deposit con-
tract with the loan contract. Thus, the doctrines of the second
Attempts to Legally Justify Fractional-Reserve Banking 117
set fall into the same errors and legal contradictions we will
see in those of the first. In addition, in the next chapter we will
explain why the doctrinal essence of the new interpretation of
availability (based on the “law of large numbers”) is inadmis-
sible from the standpoint of economic theory.
We therefore conclude that past attempts to legally justify
fractional-reserve banking with respect to demand deposits
have failed. This explains the ambiguity constantly present in
doctrines on this type of bank practice, the desperate efforts to
avoid clarity and openness in its treatment, the generalized
lack of accountability and ultimately (since fractional-reserve
banking cannot possibly survive economically on its own), the
fact that it has been provided with the support of a central
bank which institutes the regulations and supplies the liquid-
ity necessary at all times to prevent the whole set-up from col-
lapsing. In chapter 8 we will discuss central banking and
show, through a theoretical analysis, that the nationalization
of money and the central bank’s regulation of the banking sys-
tem and its laws governing it have been incapable of main-
taining a stable financial system that avoids economic cycles
and averts bank crises. Thus, we may conclude that the frac-
tional-reserve banking system has failed as well, even though
it is backed and protected by a central bank.
At the end of this chapter we will examine several new
types of financial contracts, some of which closely resemble
those bankers employ in connection with bank deposits. In
particular, we will consider the different financial operations
involving a “repurchase agreement.” We will show that these
entail an evasion of the law; whenever payment of a previ-
ously-established price is guaranteed regardless of the sec-
ondary-market price at the time the agreement is imple-
mented, such operations conceal a true deposit contract.
Finally, we will take a look at the profound, essential differ-
ences between the financial operations related to banking and
those connected with life insurance. The latter represents a
perfected form of true saving, where present goods are
exchanged for future goods. It is an exchange with especially
appealing features, but they in no way involve appropriation
of demand deposits, credit creation, nor issuance of receipts
118
Money, Bank Credit, and Economic Cycles
without backing. We will also discuss the corrupting influence
exerted on the insurance business by the recent trend (most
apparent in government legislation) toward clouding and
obscuring the traditional legal and technical boundaries between
the two types of institutions (life insurance and banking)
ent theoretical attempts to legally justify fractional-
reserve banking. We will consider the proposed argu-
ments intended to legally support a monetary irregular deposit
contract in which the depositary can make self-interested use of
money on demand deposit. In light of the legal doctrine pre-
sented in chapter 1 and the economic analysis to be performed
in the following chapters, we will critique two main lines of
defense.
1
INTRODUCTION
The legal doctrines aimed at justifying fractional-reserve
banking have been formulated ex post facto. They have not
been based on preexisting legal principles that have given rise
to certain legal acts. On the contrary, as we explained in the
previous chapter, banking practices have long infringed upon
basic, universal legal principles and have done so in response
to specific circumstances which have conspired to make these
violations possible (human avarice; inadequate regulation; gov-
ernments’ financial needs; systematic intervention of the
115
authorities and confusion arising from the depositum confessa-
tum, a product of the canonical ban on interest). As is logical,
the lack of a legal basis for such a widespread practice soon
prompted bankers and theorists alike to search for a fitting
legal justification. Moreover, this urge was reinforced by the
fact that, on almost all occasions, the government or public
authorities ended up being the main beneficiary of fraudulent
banking practices. Therefore it is not surprising, given the tra-
ditional symbiosis between political authorities and the intel-
ligentsia, that the latter was driven by the former to search for
legal grounds to support the practices it permitted and
encouraged.1
Finding adequate legal grounds was essential to the sur-
vival of the whole network of vested interests which frac-
tional-reserve banking generates. It was clear to any educated
person that these practices should be based on something
sounder than a mere de facto situation. It is not enough to real-
ize and affirm, as Shepard B. Clough does, that
In fact, [goldsmiths] even lent money given them for safe-
keeping on the theory and experience that they needed to
have on hand only enough to meet the expected, current
demand of depositors. This practice led them, at least by the
seventeenth century, to the issuing of “promises to pay,”
that is, “goldsmiths’ notes,” which, like modern banknotes,
circulated from person to person. These “promises to pay,”
which could be paid by using the deposits of customers,
came actually to exceed the amount of money on deposit.
When this happened credit had been actually created by
issuing paper—a very major discovery.2
Nevertheless, no matter how “major” one considers the
“discovery” that it is possible to make fraudulent use of
depositors’ money or issue deposit receipts for a greater
116
Money, Bank Credit, and Economic Cycles
1See Bertrand de Jouvenel, “The European Intellectuals and Capital-
ism,” in Friedrich A. Hayek, ed., Capitalism and the Historians (Chicago:
University of Chicago Press, 1954).
2Shepard B. Clough, The Economic Development of Western Civilization
(New York: McGraw-Hill, 1959), p. 109; italics added.
amount than is actually deposited, it is clear that these acts
share the same characteristic present in all other criminal acts
of misappropriation which have always been the object of doc-
trinal analysis by criminal law experts. The similarity between
the two sets of actions is therefore so obvious that theorists
could not remain impassive in the face of a legal irregularity
such as this in the economy.
Hence it is not surprising that great efforts have been
made to justify what appears completely unjustifiable: that it
is legitimate, from the standpoint of general legal principles,
to misappropriate funds deposited for safekeeping and to
issue deposit receipts for more money than is actually
deposited. However, the interested parties (bankers and gov-
ernments, mostly) have found it so important to find an ade-
quate theoretical justification beyond the easy solution of sim-
ply declaring legal a corrupt, criminal practice (which is what
has ultimately happened, despite all the doctrinal façades and
constructions), that many jurists are still at work trying to con-
fer legal respectability on a procedure that is commonplace
even now.
Doctrinal attempts to justify the use of a fractional reserve
in the irregular deposit can be classified into two large groups.
The first group of doctrines was intended to settle the issue by
equating the irregular deposit contract with the loan contract.
We will analyze this group of theories in detail and show that,
from a legal point of view, it is impossible to equate these two
contracts. Writers of the second and more recent set of doc-
trines start by acknowledging that there are fundamental dif-
ferences between the loan and irregular deposit contract.
These theorists have focused their efforts on the construction
of a new legal concept of “availability” and hold that this
notion should be taken “loosely,” meaning bankers should
only be required to carry out their investments “prudently”
and to comply with regulations and bank legislation at all
times. A detailed study of this second set of theories will
demonstrate that they ultimately entail a return to the failed
attempt of the first group, i.e., to justify the use of a fractional
reserve in the irregular deposit by equating the deposit con-
tract with the loan contract. Thus, the doctrines of the second
Attempts to Legally Justify Fractional-Reserve Banking 117
set fall into the same errors and legal contradictions we will
see in those of the first. In addition, in the next chapter we will
explain why the doctrinal essence of the new interpretation of
availability (based on the “law of large numbers”) is inadmis-
sible from the standpoint of economic theory.
We therefore conclude that past attempts to legally justify
fractional-reserve banking with respect to demand deposits
have failed. This explains the ambiguity constantly present in
doctrines on this type of bank practice, the desperate efforts to
avoid clarity and openness in its treatment, the generalized
lack of accountability and ultimately (since fractional-reserve
banking cannot possibly survive economically on its own), the
fact that it has been provided with the support of a central
bank which institutes the regulations and supplies the liquid-
ity necessary at all times to prevent the whole set-up from col-
lapsing. In chapter 8 we will discuss central banking and
show, through a theoretical analysis, that the nationalization
of money and the central bank’s regulation of the banking sys-
tem and its laws governing it have been incapable of main-
taining a stable financial system that avoids economic cycles
and averts bank crises. Thus, we may conclude that the frac-
tional-reserve banking system has failed as well, even though
it is backed and protected by a central bank.
At the end of this chapter we will examine several new
types of financial contracts, some of which closely resemble
those bankers employ in connection with bank deposits. In
particular, we will consider the different financial operations
involving a “repurchase agreement.” We will show that these
entail an evasion of the law; whenever payment of a previ-
ously-established price is guaranteed regardless of the sec-
ondary-market price at the time the agreement is imple-
mented, such operations conceal a true deposit contract.
Finally, we will take a look at the profound, essential differ-
ences between the financial operations related to banking and
those connected with life insurance. The latter represents a
perfected form of true saving, where present goods are
exchanged for future goods. It is an exchange with especially
appealing features, but they in no way involve appropriation
of demand deposits, credit creation, nor issuance of receipts
118
Money, Bank Credit, and Economic Cycles
without backing. We will also discuss the corrupting influence
exerted on the insurance business by the recent trend (most
apparent in government legislation) toward clouding and
obscuring the traditional legal and technical boundaries between
the two types of institutions (life insurance and banking)
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