Jesús Huerta de Soto, “A Critical Note on Fractional-Reserve Free Banking,” The Quarterly Journal of Austrian Economics, vol. 1, no. 4 (Winter 1998), pp. 41-46, minus the footnotes. (Another good one is Bagus, Howden & Block, “Deposits, Loans, and Banking: Clarifying the Debate,” The American Journal of Economics and Sociology, vol. 72 (2013), pp. 627–644. [PDF.])

[I]n the first place, it should be noted that the practice of banking with fractional reserves involves a logical impossibility from the juridical point of view. In fact, whenever a bank grants loans against money which has been deposited with it at demand, an ownership of money that did not previously exist is created from nowhere for an amount identical to that which has been loaned by the bank. The depositor holds his money in the form of a deposit and it forms part of his money balances. Simultaneously, the person receiving the loan from the bank receives an amount of money which, in turn, becomes part of his cash balances. This result shows an extremely serious juridical irregularity as contracts, at most, can only be the materialization of a cross transfer of properties … but cannot create property ex nihilo … This result, at least in the initial stages of the formation of the modern banking system, arose as a consequence of the undue appropriation and fraud committed by many bankers who used money given to them as deposits for loans.

Once the bankers obtained from the government the privilege of acting on the basis of fractional reserves, their criminal status disappeared, at least from the standpoint of positive law. But this privilege in no way endows the monetary bank deposit contract with an adequate juridical foundation. On the contrary, this contract appears, on most occasions, as a contract which is null and void, from the point of view of general legal principles, since the predominant purpose of one of the parties, the depositor, is to make a deposit, while the other party, the depository banker, receives it as a loan. And, according to most standard legal principles, when each of the participants in an exchange believes that he is making a different contract, that contract is null and void. If this juridical theory of the predominant subjective purpose of the contract (the main causa of the contract in Roman Law) is applied to the millions of bank contracts currently in force, it would be very easy to see how the immense majority of the depositors think that they have, in fact, made a contract in which the nature of a deposit predominates, in order for such a deposit to form part of their money balances which can be transformed into currency at any time. On the contrary, the bankers receive the money as a loan, as demonstrated by the fact that they, in turn, hand it to their borrowers, who thus increase their money balances. I think that nobody can deny the serious juridical ambiguity of the bank demand-deposit contracts which have been made to date. They are called “deposits” commercially and contractually and, in fact, this name corresponds to the real main purpose which the banks’ clients intend to attain. However, the bankers receive the deposits and use them as if they were loans … Furthermore, it is clear that, if the majority of depositors cheat themselves (or are cheated) with regard to the true nature of the contract they make and, moreover, are tempted by the promise of interest or the provision of free-banking services, it cannot be accepted that the fact that this type of transaction is carried out massively is a prima facie demonstration that shows or reveals the public’s real preference for this type of contract, or much less that it is socially necessary.

Third, even if the two parties, the depositors and the bankers, coincided exactly in the belief that the predominant purpose of the transaction was a loan (which is not certain to have been the case for the majority of people), the juridical nature of the monetary bank-deposit contract would not be resolved. This is the case because, from a juridical point of view, it is impossible that the banks can comply with the obligation to return the deposits they have received for an amount in excess of the reserves they hold. This impossibility is, furthermore, aggravated to the extent that the practice of fractional-reserve banking can generate banking crises and economic recession which endanger the public’s confidence in the banks. And contracts which are impossible to put into practice under certain circumstances are also null, according to general legal principles. Only by maintaining 100-percent reserve which guaranteed that supposed “loans” granted (by the depositors) may be repurchased (by the banks) at any moment, or through the existence and support of a central bank which provided all the liquidity contracts with a covenant for the repayment of their nominal value at any moment be made possible and, therefore, valid.

Fourth, even if it is argued that the impossibility of compliance with bank-deposit contracts of money only occurs every certain number of years for some specific banks, their legal nature would still not be solved, because the practice of fractional-reserve banking is a breach of public order and is damaging to third parties. In fact, fractional-reserve banking, as it generates expansionary credits without the support of real savings, distorts the structure of production and leads the entrepreneurs who receive the loans, deceived by the greater ease of the credit conditions, to undertake investments which, in the final analysis, will not be profitable. When the inevitable economic recession arrives, their investment projects will have to be interrupted and liquidated, with a high cost from the economic, social, and personal points of view, not only for the entrepreneurs and investors themselves, but also for the rest of the economic agents involved in the market process (workers, suppliers, consumers, depositors, bankers, etc.). We cannot, therefore, accept the argument that, in a free society, the banks and their clients should be free to establish the contractual covenants they consider most fitting. [Footnote here reads: “Thus, similarly, a contract between a member of the Mafia and a professional killer can be: (a) completely voluntary, and (b) based on a perfect agreement in relation to the legal nature of the covenant. However, even in an entirely free libertarian society, it is a contract totally null and void because it is damaging to a third party (the potential victim).”] Actually, when mutually satisfactory agreements between two parties are made with damages to third parties and therefore, constitute a breach of public order, the corresponding “contracts” are entirely null and void.

Hoppe (1994, pp. 70-71) explains that this type of contract damages third parties in three different ways: first, to the extent that the credit expansion increases the monetary supply and decreases the purchasing power of the monetary units of the other holders of money balances, part of the value their monetary units would have if the credit expansion had not occurred, is expropriated; second, the depositors in general are damaged because, as a consequence of the credit expansion process, the probability that, in the absence of a central bank, they will be able to recover their monetary units intact decreases; and, if a central bank exists, to the extent that, although the return of their nominal deposits might be guaranteed, the purchasing power of their monetary units will be significantly reduced; and, third, the greatest damage produced is to the rest of the borrowers and economic agents in the form of generalized malinvestment, financial crisis, unemployment, and significant unrest, stress, and human suffering.

Any manipulation of money, which is the generalized means of exhange accepted in society, always implies, in accordance with the very definition of the concept of money, that unidentified third-party participants are affected. We are, of course, not talking about the so-called pecuniary externalities which are transferred in the market through the price system as a result of changes in subjective valuations and in human action subject to general legal principles. On the contrary, we refer to serious social interferences which originate from the irregular juridical foundation of bank demand-deposit contracts which make possible the anomaly of multiplying the amount of money, regardless of the wishes of the parties, without any saving taking place or anything new having occurred. In fact, economically speaking, the effects of credit expansion are, from a qualitative point of view, identical to those of the criminal forgery of coins and bank notes … Both of them imply the creation of money, the redistribution of income in favor of a few people to the detriment of the other citizens, and the overall distortion of the productive system. However, from a quantitative point of view, only a credit expansion is able to expand the monetary supply by a sufficient volume and at a rate capable of feeding an artificial boom and causing a recession. In comparison with the credit expansion of fractional-reserve free banking and the monetary manipulation of governments and central banks, the criminal forgery of money is child’s play and almost imperceptible.

The above considerations have had their influence on some modern fractional-reserve free-banking theorists, who have proposed, in order to guarantee the stability of the system, that the banks should establish a safeguard clause on their notes and deposits, informing their clients that the bank may decide, at any time, to suspend or defer the return of the deposits or the payment of the corresponding notes in cash. It is clear that the introduction of this option clause goes against the nature of the concept of money, the essence of which is precisely the availability of perfect, i.e., immediate, complete and totally unconditional, liquidity at any moment. The option clause means that the depositors and note holders, in crisis conditions, can be converted into compulsory lenders, rather than continuing as depositors holding perfectly liquid monetary units or perfect money substitutes. Thus, the traditional deposit contract would be converted into a peculiar form of random contract or lottery, in which recovery of the corresponding deposits would depend on the luck, influence, and other specific circumstances of each moment. No objection can be raised to the fact that certain parties decide to make such an irregular random contract. But, to the extent that in spite of the existence of this clause and perfect knowledge of its implications by all of the participants (bankers and their clients), they and the rest of the economic agents would behave as if they considered, from the subjective point of view, that for practical purposes their demand deposits are perfectly liquid, then the banking system could identically create credit expansions. The option clauses, therefore, would not avoid the reproduction of the process of expansion, crisis, and economic recession which the practice of fractional-reserve free banking can create. The option clauses at most can protect the banks, but not society or the economic system, from the damages produced by the successive phases of credit expansion, boom, and recession. Thus, the option clauses arguments is only a last line of defense that in no way solves the problem that fractional-reserve free banking can produce very serious systematic damages to third parties which constitute a breach of public order.

It is surprising that, in spite of all the foregoing arguments, most of the Fractional-Reserve Free-Banking School theorists, instead of proposing the abolition of fractional-reserve banking, only propose the elimination of central banks and the complete privatization of the banking system, without making any reference to what would be the best solution to all the economic and juridical problems discussed in this article: a free-banking system with a 100-percent reserve requirement. It is true that this privatization would tend to put an earlier stop to the almost unlimited abuses that the monetary authorities commit today in the financial field, but it does not prevent the possibility that abuses could also be committed (on a smaller scale) in the private field. This is similar to the situation that would arise if government were allowed to systematically kill, steal, or commit any other crime. The social damage that this would generate would be tremendous, in view of the enormous power and monopolistic nature of the State. And without any doubt, the privatization of these criminal activities (eliminating the systematic practice of them by the government) would tend to “improve” the situation appreciably: at least the great criminal power of the State would disappear and private economic agents would be allowed to develop prevention and defense procedures against these crimes. However, the privatization of criminal activities is not the final solution to the problem they pose and they would only be completely eliminated if they were put down by all possible legal means, even if they were committed by private agents in an entirely private environment. In fact, all central banks, all the present tangle of banking legislation, and all the economic problems which may be generated by fractional-reserve free banking could be solved through a simply article in the Criminal Code of the future Libertarian Society which would say the following: “Any banker who appropriates the money deposited with him at demand for his own benefit and does not maintain a 100-percent reserve in relation thereto at all times shall be punished by imprisonment and obliged to indemnify the victims.”

The traditional form in which the controversy between the supporters of central banks and those of fractional-reserve free banking is posed is essentially erroneous. In fact, the advocates of fractional-reserve free banking to do not realize that their proposal unleashes an almost unavoidable trend towards the emergence, development, and consolidation of a central bank. The credit expansion that can be generated by any fractional-reserve banking system gives rise to reversion processes, in the form of possible banking crises and economic recessions, which almost inevitably cause the affected citizens and bankers to demand the intervention of the government, as well as the state regulation of the activity. Furthermore, the bankers themselves soon discover that they reduce the risk of insolvency if they reach agreements among themselves, merge, and then demand the creation of a lender of last resort (central bank), which provides them with the necessary liquidity at times of adversity and institutionalizes and officially orchestrates and coordinates the growth of credit expansion. Finally, governments cannot avoid the temptation to use this enormous power to create money permitted by fractional-reserve banking for their own benefit.

We can, therefore, conclude that the practice of fractional-reserve banking is the main factor responsible for the emergence and development of the central bank. For this reason, the theoretical and practical discussion should be raised, not in traditional terms, but between the only two feasible alternatives, radically opposed to each other, which are: either a free-banking system subject to traditional legal principles (i.e., with a 100-percent reserve ratio), in which all transactions in which a fractional reserve is established, be they “voluntary” or otherwise, are considered illegal and a breach of public order; or a system which allows the practice of fractional-reserve banking, from which a central bank will inevitably emerge as a lender of last resort and controller of the whole financial system. These are the only two theoretically and practically viable alternatives.