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Thursday, July 5, 2012

Fractional Reserves, Legal Tender, and Central Banking

Keeping our eyes on the ball.

If you ever want to see a furious discussion break out among libertarians influenced by Austrian economics, just start talking about money and banking. Despite their agreement on so many things, they often have a variety of views on the ideal banking system and how to best understand terms like “inflation” and “deflation.” The debate over the morality and efficacy of fractional reserve banking is one of the most divisive issues. I have addressed that topic in an earlier column, but here I want to tie it into some broader issues that enter into this debate.

This discussion is prompted by Larry White’s testimony on the history and practice of fractional reserve banking before Rep. Ron Paul’s subcommittee on monetary policy in late June. White’s testimony is a concise yet thorough discussion of why fractional reserve banking came to be and why it is not at the root of monetary problems. As he points out, “[A] fractional-reserve banking system is not unstable when the banking system is free of hobbling legal restrictions and free of privileges.” U.S. history illustrates this point.

No Branch Banking

Until only the last few decades, U.S. banks faced severe legal restrictions on their ability to open branch offices, both across state lines and in some cases even within a given state. These restrictions led to highly under-diversified banks that were more prone to failure and whose troubles would be exacerbated by fractional reserve banking. In the post-Civil War era, regulations that required banks to purchase certain government bonds before issuing currency made them vulnerable to bank runs when the demand for currency rose and they were unable to meet it. Again, fractional reserves combined with this legislation led to recurring panics.

The “solution” to those panics was the Federal Reserve System. It, however, replaced those old regulations with both new regulations and new privileges that combined with fractional reserve banking to create problems. In particular the Fed was given the power to change the quantity of currency and the level of reserves banks hold on deposit at the Fed by either printing more currency or buying government bonds from banks and paying them by crediting their accounts. That power enables it to change the “monetary base,” the foundation from which the banking system can multiply its lending. This privilege belongs to the Fed because it is the only institution allowed to produce currency, which allows that currency to serve as reserves and enables the Fed to create new reserves out of thin air.

Monopoly–not fractional reserve–is the problem. As I’ve said before, there’s nothing wrong with fractional reserve banking that getting rid of central banking wouldn’t cure.

Legal Tender

Some libertarians point to legal-tender laws as another source of trouble. The claim is that because such laws force us to use government money, they make it impossible for us to get out of the system and cut short the multiplier process. The problem with this argument is that it misunderstands legal tender laws. What “legal tender” normally means is that if one is offered the money defined as such in payment of a debt, one must accept it. It does not say that only such money is acceptable in transactions. In other words, payment in legal tender is sufficient but not necessary to discharge a debt or obligation, and legal-tender status does not matter for nondebt exchanges.

For example, a brief look at the U.S. Treasury’s website finds this passage:

[T]he Coinage Act of 1965, specifically Section 31 U.S.C. 5103, entitled “Legal tender,” . . .  states: “United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues.”

This statute means that all United States money as identified above are a valid and legal offer of payment for debts when tendered to a creditor. There is, however, no Federal statute mandating that a private business, a person or an organization must accept currency or coins as for payment for goods and/or services. Private businesses are free to develop their own policies on whether or not to accept cash unless there is a State law which says otherwise.

Nothing in federal law prohibits Americans from not accepting Federal Reserve Notes in payment for goods and services. Legal tender refers only to debts and similar obligations.

Monopoly Status

Yes, the federal government has prosecuted people for trying to establish circulating gold coins, but that is not a matter of legal tender; rather the issue is the Fed’s monopoly. It would be perfectly possible, as was the case before the Fed, to have some kinds of money in a competitive system declared “legal tender” and some not. That would be a privilege, but it would not completely undermine the competitive system.

Libertarians need to aim their fire at the real source of trouble–the monopoly privileges of the central bank. Fractional reserve banking and legal-tender laws are distractions from the real issue.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.