Steven Horwitz who emailed me the series of responses to Jesus Huerta de Soto's major work against fractional reserve banking, I am pleased to re-publish part 2 of 3. The original site these are supposed to be found on does not seem to be up anymore.
Tuesday, January 30, 2007
In my review http://www.freemarketnews.com/Analysis/240/6709/case.asp?nid=6709&wid=240 of the first chapter of Jesús Huerta de Soto's Money, Bank Credit, and Economic Cycles http://www.mises.org/books/desoto.pdf , I summarized the spirit of Huerta de Soto's argument against fractional-reserve banking as advancing the following (false) syllogism:
1. 1. Warehousing and fixed-term lending are legitimate.
2. 2. Fractional-reserve banking is neither warehousing nor fixed-term lending.
3. 3. Therefore fractional-reserve banking is not legitimate.
To be clear: this syllogism is my paraphrase, not a quotation from the book. My reading is that Huerta de Soto's Chapter One juxtaposes statements of the premises (akin to 1 and 2) and of the conclusion (3), as if to suggest that the conclusion follows. That the conclusion does not follow from the two premises does not, of course, show that what comes after "therefore" must necessarily be false. There might be some other way to reach the conclusion.
The book's second chapter focuses on the second premise of the syllogism, offering examples to show that "bankers have throughout history" not conducted their business along warehousing lines. To Huerta de Soto (pp. 37, 69), who holds that only warehousing is legitimate on demand accounts, this history cannot show that banks have been competing for customers who have wanted something (payment services) other than warehousing, but is instead evidence of "abuses" and "improper activity" by which bankers have "violated traditional legal principles in the irregular deposit". Rather than view fractional-reserve banking as a legitimate contractual alternative to warehousing, he views it as "legally corrupt" and "disgraceful".
In Huerta de Soto's view (p. 48), "most bank failures occurred because bankers violated their obligation to safeguard demand deposits, and they used the money for themselves and put it into private business deals up to the point when, for some reason, the public lost trust in them and tried to withdraw their deposits, finding with great indignation that the money was not available." An institution that represents itself as a warehouse (either explicitly, or implicitly by charging storage fees and not paying interest on demand accounts), yet fraudulently fails to act as one, can of course receive its come-uppance as described. A fractional-reserve bank that does not purport to be a warehouse may also get in trouble from a run. But the historical evidence I'm aware of indicates that most bank failures have occurred because of losses from bad loans. A bank run due to loss of public trust has typically been a symptom of insolvency, not the initial cause. Bad loans can be made by a bank even without fractional-reserve demand accounts: the bank can fund the loans entirely from "time deposits". When the typical bank failure is due to bad loans, and not illiquidity, there is no reason to say that fractional reserves are the source of the failure.
An interesting section of the chapter recounts the history of the famed Medici Bank of medieval Florence, drawing on the archival research of Raymond de Roover's book The rise and decline of the Medici Bank, 1397-1494 (Cambridge: Harvard University Press, 1963). The Medici Bank lasted ninety-seven years. A run on the bank is not included in the list of reasons De Roover (p. 3) offers to explain its eventual failure.
At first, Huerta de Soto (p. 72) emphasizes, the Medici Bank accepted only fixed-term accounts, labeled depositi a discrezione. (To evade church prohibition of usury, interest on the account balance was treated as a gift at the bank's discretion, hence the label.) Later, in Huerta de Soto's words (p. 73), "the bank began to accept demand deposits and to use a portion of them inappropriately as loans". How do we know that the bank's use of the funds (rather than locking them all in the vault) was inappropriate? No evidence is provided that the bank misrepresented itself as a warehouse for the funds placed into demand accounts. Everyone knew it was lending out the funds placed into fixed-term interest-bearing accounts. Was it also paying interest on demand accounts, clearly signaling that it was not warehousing the funds? Apparently yes. According to de Roover (pp. 103-4), the same account could begin with a fixed term and later become redeemable on demand, while continuing to pay interest. One extant account document "certifies that Cosimo and Lorenzo de' Medici & Co. of Venice have received from Lady Jacopa, the wife of Malatesta de' Baglioni of Perugia, the sum of 2,000 fiorini larghi to be placed on deposit for one year. After this first year, the contract is automatically renewable from year to year, but with the understanding that principal and accrued interest, or rather discrezione, are repayable at any time at the request of the depositor" [emphasis added]. It is clear from the payment of interest that Lady Jacopa neither wanted nor expected the Medicis to act as a warehouse.
To Huerta de Soto (p. 74 n. 62), the holding of fractional reserves means that the Medicis were guilty of "violations of the traditional legal principle requiring them to maintain possession of 100 percent of demand deposits," but Florentine banking of that era seems not to have recognized any such principle. De Roover (p. 17-18) says of medieval Florentine bankers:
Apparently, they always stood ready to change moneys and to make payments by transfer and these were the only two functions which the Arte del Cambio [the bankers' guild] attempted to regulate. ...In the banking field, gild regulations did not go beyond the setting of professional standards and the protection of depositors against fraudulent practices. Insolvent or bankrupt money-changers were, of course, excluded from membership until creditors had been fully satisfied.
This passage indicates that payment services were central to commercial banking by this time, while warehousing services were not. Those who placed funds in a bank were normally considered creditors, not holders of warehouse claims. There is no indication that fractional reserves were proscribed.
Huerta de Soto (pp. 81-82) provides further evidence that medieval banking was distinct from the warehousing business when, drawing on Carlo Cipolla's (1989) account, he writes the following about the Ricci Bank of Florence in the 1570s:
...the directors of the Ricci Bank ... used a very large share of their deposits to buy government securities and grant loans. The other private banks were obliged to adopt the same policy of credit expansion if their managers wanted to be competitive and conserve their profits and market share.
It is impossible to reconcile this statement with the view that the private banks were competing for customers who wanted warehousing services. Banks need to lend out funds to compete only in the market for intermediation, which is to say: only if they are paying interest on their liabilities, which is a clear indication to everyone that they are not warehousing. As the Spanish scholastic Saravia de la Calle pointed out in 1544, quoted by Huerta de Soto (p. 87), "How could bankers who pay 7 and 10 percent interest to those who provide them with money to do business possibly refrain from using deposits?"
Huerta de Soto (pp. 83-101) provides us with an interesting account of debates among the Spanish scholastics over the question of whether demandable bank accounts are necessarily warehouse contracts, requiring the banker to hold 100-percent reserves, or may be loan contracts allowing the banker to re-lend the funds collected. Huerta de Soto sides with the former view, considering it alone to be consistent with "the true legal nature of the contract as it had already been developed by Roman juridical science" and with "the objective or essential purpose of the contract (custody and safekeeping)". But to assume in this way that medieval bankers and their demand account customers had necessarily made Roman-style warehousing contracts is to beg the question. Why could they not have made callable loan contracts? Why is only one contractual form permissible for a demand account, for all of human history, no matter what advances are made in financial technology? Advancing beyond the techniques of the Roman argentarii, medieval banks specialized in providing payment services by account transfer. If a customer's purpose was to use bank payment services, that purpose did not require 100-percent reserves. Payment services could in fact be more economically provided by a demand account against which the bank held fractional reserves.