James Leroy Wilson's one-man magazine.

Monday, March 15, 2010

Is it fraud if there is more paper money than real wealth?

Lew Rockwell links to a post by Tony Baxendale of England's Cobden Centre against fractional reserve banking. The argument seems that it goes against all the principles of contract law.

I love Lew and the Mises Institute, and Richard Cobden is one of the great heroes of civilization. Nevertheless,I find this argument confusing. It's true that I abhor the idea of money backed by nothing. That's why we need a free market in money. At the same time, seems to me that the 100% Reserve people kind of miss the boat. A while ago I suggested a conceptual difference between certificates of ownership of an amount of precious metal, on the one hand, and bank notes, on the other. Either one could circulate as money; the certificate redeemable in gold (or silver, or whatever the certificate says); whereas the bank note would be a claim to some of that bank's assets,which may or may not include gold or silver, and may include many different things.

If banks lend out more bank notes of value greater than their assets, and these notes circulate as currency, the market itself will judge their value. If that bank's depositors know this is the case, and there are no legal tender laws requiring these bank notes to be accepted as money, I see no ethical problem. I don't understand how any Austrian economist or libertarian would object.

Imagine this principle without a bank. Let's say I'm the owner of a chain of department stores, theoretically called Wilshop. My stores dominate the industry, and are the primary gathering place and economic center of many small towns.

Let's say I come up with an idea: create my own money. These would be paper gift certificates/coupons that would be good for purchases in any of my stores. Anyone could come in and, for $19, receive $20 worth of Wilshop certificates. The more you pay, the better the deal; e.g., $90 will get you $100 in certificates; $850 will get you $1000 in certificates. When you shop at Wilshop, everything you buy, even things on sale, would be discounted all the more if you pay with the Wilshop certficates (certs for short).

Now imagine that the Wilshop store is the only game in town - the only grocery store, the only furniture store, the only clothing store. Other businesses would likely accept Wilshop certs as currency, since everyone shops at Wilshop. Soon, people start buying up Wilshop certs in bulk. Soon, more people hold Wilshop certs that exceed the value of the Wilshop merchandise inventory. Yet more and more people purchase the certificates, so that there is twice, 10 times, even 30 times more Wilshop certs than there is Wilshop inventory.

If everyone came to Wilshop at once and tried to spend all their Wilshop certs, only the first 3% would actually get their value back.

But would it be unethical for Wilshop to sell more Wilshop certificates than the equal value of its inventory? Only if Wilshop promised that the inventory was available, and that the certificates could be spent and redeemed, and then failed to follow through. If no promise was made, it's not Wilshop's fault that others decided that the Wilshop cert was a viable means of currency. If the Wilshop cert entitles you to use it in Wilshop stores only as supplies last, but does not claim that you are entitled to a share of the merchandise inventory, then frankly no fraud would exist. If people no longer liked or trusted Wilshop, they would stop accepting Wilshop certs as payment in their own transactions.

There is nothing intrinsically wrong with a store selling more gift certificates at discounted prices that exceed the value of the inventory itself. For that reason, I do not see how, in a completely free market monetary system, it is intrinsically wrong for banks to issue more of their own notes even if they exceed the value of the deposits they hold. Provided the depositors know the risks involved (just as Wilshop customers understand the risk of buying Wilsop certifcates), and that no one would be legally compelled to accept the bank note as currency, I have no idea why any Austrian School economist or libertarian would outlaw such practices.

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