There is a doctrine which creates wealth and spreads it around. It is just and moral. It works. It is called capitalism and, today, in practice, there is very obviously something wrong with it.
If one were to summarise the doctrine of capitalism in one word, it would be "property". It is property which enables human social cooperation through production, exchange and consumption. The voluntary exchange of property has rules and these are known as contract.
These two concepts, property and contract, are fundamental to capitalism and yet, in relation to money held on demand in bank accounts, they are applied at best inadequately.
On Wednesday, immediately after Prime Minister's Questions, Douglas Carswell MP will be introducing a moderate and conservative ten-minute rule bill which would introduce sound property rights and contract to monetary deposits. It is potentially of profound importance and I am delighted to support him.
Allow me to explain.
If you deposit securities at the bank, they are held in safe custody, ready for immediate use. They are your property, not the bank's. If you wish to increase the yield of your securities by lending them, then you enter into a securities lending agreement with the bank, which borrows your shares for a period, lending them on at a premium. You have forgone your shares for a term in exchange for a fee. The bank is contractually obliged to return your property at the end of the term.
In other words, you either deposit your securities on demand or you save them by lending them to the bank for a term.
I was once intimately involved in the design of a securities lending system for a major international prime broker. There was no requirement to take securities held in safe custody and lend them while maintaining a liability to return them on demand. Lending securities not contractually designated for the purpose would have been an infringement of property rights in breach of trust, that is, a fraud.
While banks maintain clear property rights in securities on deposit, the same cannot be said of monetary deposits. Thanks to a base of judicial decisions, when you deposit your money on demand at the bank, ready for immediate withdrawal without penalty, it is not your property, but the bank's. Banks can lend money held on demand and of course they do so.
This is fractional reserve banking and it may not be the good thing most bankers think it is.
Fractional reserves on demand deposits allow banks to extend credit in excess of real savings. That leads to the creation and destruction of fiduciary media: claims on money for which there is insufficient money to meet all claims. It is what makes bank runs possible. It means that, as the great economist Irving Fisher wrote in 1935,
our national circulating medium is now at the mercy of loan transactions of banks; and our thousands of checking banks are, in effect, so many irresponsible private mints.
As I explained in my maiden speech:
Unlike the situation in respect of any other commodity, in the case of money, price controls do not drive the product off the market. Artificially lowered interest rates increase the demand for credit, and decrease the supply of savings, but the legal privilege granted to banks means that they can meet demand by extending credit that is unbacked by real savings. There is a good argument to say that that causes the boom-and-bust cycle, the misdirection of resources in the capital structure of production, and over-consumption by consumers.
And since the money supply contracts when banks lend less, we find central banks injecting new money through QE, further distorting an economy already distended by excess credit expansion, in an attempt to cope with the anarchy of money creation and destruction caused by fractional reserve banking.
To repeat: demand deposits of money are not subject to the same principles of property and contract as any other commodity. Banks enjoy the legal privilege of open access to money which they are liable to return on demand. In concert with the central planning of interest rates and a range of government interventions, this is what is wrong with capitalism.
It is around this point that scholars of banking theory begin disagreeing, often with very great passion. However, it is a fact that various economists of the three great traditions - Keynesian, Monetarist and Austrian - have, at various times and for various reasons, proposed ending the system of fractional reserve banking.
Douglas's Bill would assert property rights over demand deposits. Real savings - term deposits - would be loaned to entrepreneurs, delivering an economy built on save and invest.
There is a great deal to communicate on this subject, some of which you can find through the links below. In the meantime, I will conclude with some remarks by Nobel Laureate James M Buchanan at the Mont Pelerin Society in 2009:
The market will not work effectively with monetary anarchy. Politicization is not an effective alternative. We must commence meaningful dialogue with acceptance of these elementary verities.Moreover:
Let us not waste this set of crises by exclusive recourse to jerry-built efforts to patch up the failed monetary anarchy we have witnessed.
Douglas is attempting to begin the process of correcting capitalism by asserting sound property rights and contract in banking. I hope Parliamentary colleagues and activists will hear him out, particularly those who wish us to have an economy built on the investment of real savings.
EventsLondon School of Economics, 28 October, 18:30-20:00: Professor Jesús Huerta de Soto, this year's Baxendale Distinguished Hayek Visiting Professor, will deliver the 2010 Hayek Lecture, Financial Crisis and Economic Recession. In his 1998 book Money, Bank Credit and Economic Cycles (PDF), Huerta de Soto predicted the economic crisis and comprehensively set out its primary cause: credit expansion unbacked by real savings. Huerta de Soto is a passionate and convincing advocate of capitalism and bank reform - I highly recommend this lecture.
The Cobden Centre, of which I am a director, has a developing events programme, including an annual lecture, a Christmas reception and a series of monthly private dinners. Contact us for more information.
Articles and speeches
I gathered together ten plans for financial reform here.The Earl of Caithness condemned fractional reserve banking and said "the fault that really needs correcting is our whole banking system" in his speech on the Banking Bill debate, 2009. The noble lord introduced the Safety Deposit Current Accounts Bill in 2008 with similar intent to Douglas.
In my maiden speech, I condemned fractional reserve banking, central planning of interest rates and the socialisation of risk as the cause of the banking and economic crisis.
James Tyler, Chief Executive of Tyler Capital, explains how the banking system hurts the little guy in The violation of Mr Smith, tells us that Money is not working and sets out How to avoid future encounters with financial meltdown.
Financial engineer Gordon Kerr advocates sound property rights in banking at the European Parliament, explains How To Destroy the British Banking System and asks you to Imagine that the Crisis was a Shortage of Bread.
Entrepreneur and Cobden Centre founder Toby Baxendale describes A day of reckoning: how to end the banking crisis now, developing the next stage of Huerta de Soto's proposals.
Sean Corrigan, Chief Investment Strategist at Diapason Commodities Management, condemns fractional reserve banking and provides a reform in Improper Fractions.
- Jesús Huerta de Soto, Money, Bank Credit and Economic Cycles (PDF, buy)
- Laurence Kotlikoff, Jimmy Stewart is Dead: Ending the World's Ongoing Financial Plague with Limited Purpose Banking