How Banks Go Bust

How Banks Go Bust by Murray N. Rothbard for Mises

[The Case Against the Fed, Chapter 8, “Problems for the Fractional-Reserve Banker: Insolvency.” (Slightly edited for publication as a separate article.)]

 

The fractional-reserve banker, even if he violates his contract, cannot be treated as an embezzler and a criminal; but the banker must still face the lesser, but still unwelcome fact of insolvency. There are two major ways in which he can become insolvent.

The first and most devastating route, because it could happen at any time, is if the bank’s customers, those who hold the warehouse receipts or receive it in payment, lose confidence in the chances of the bank’s repayment of the receipts and decide, en masse, to cash them in. This loss of confidence, if it spreads from a few to a large number of bank depositors, is devastating because it is always fatal. It is fatal because, by the very nature of fractional-reserve banking, the bank cannot honor all of its contracts. Hence the overwhelming nature of the dread process known as a “bank run,” a process by which a large number of bank customers get the wind up, sniff trouble, and demand their money. The “bank run,” which shivers the timbers of every banker, is essentially a “populist” uprising by which the duped public, the depositors, demand the right to their own money. This process can and will break any bank subject to its power. Thus, suppose that an effective and convincing orator should go on television tomorrow, and urge the American public: “People of America, the banking system of this country is insolvent. ‘Your money’ is not in the bank vaults. They have less than 10 percent of your money on hand. People of America, get your money out of the banks now before it is too late!” If the people should now heed this advice en masse, the American banking system would be destroyed tomorrow.1

A bank’s “customers” are comprised of several groups. They are those people who make the initial deposit of cash (whether gold or government paper money) in a bank. They are, in the second place, those who borrow the bank’s counterfeit issue of warehouse receipts. But they are also a great number of other people, specifically those who accept the bank’s receipts in exchange, who thereby become a bank’s customers in that sense.

Let us see how the fractional-reserve process works. Because of the laxity of the law, a deposit of cash in a bank is treated as a credit rather than a bailment, and the loans go on the bank’s balance sheet. Let us assume, first, that I set up a Rothbard Deposit Bank, and that at first this bank adheres strictly to a 100-percent reserve policy. Suppose that $20,000 is deposited in the bank. Then, abstracting from my capital and other assets of the bank, its balance sheet will look as in Figure 4:

So long as Rothbard Bank receipts are treated by the market as if they are equivalent to cash, and they function as such, the receipts will function instead of, as surrogates for, the actual cash. Thus, suppose that Jones had deposited $3,000 at the Rothbard Bank. He buys a painting from an art gallery and pays for it with his deposit receipt of $3,000. (The receipt, as we shall see, can either be a written ticket or an open book account.) If the art gallery wishes, it need not bother redeeming the receipt for cash; it can treat the receipt as if it were cash, and itself hold on to the receipt. The art gallery then becomes a “customer” of the Rothbard Bank.

It should be clear that, in our example, either the cash itself or the receipt to cash circulates as money: never both at once. So long as deposit banks adhere strictly to 100-percent reserve banking, there is no increase in the money supply; only the form in which the money circulates changes. Thus, if there are $2 million of cash existing in a society, and people deposit $1.2 million in deposit banks, then the total of $2 million of money remains the same; the only difference is that $800,000 will continue to be cash, whereas the remaining $1.2 million will circulate as warehouse receipts to the cash.

Suppose now that banks yield to the temptation to create fake warehouse receipts to cash, and lend these fake receipts out. What happens now is that the previously strictly separate functions of loan and deposit banking become muddled; the deposit trust is violated, and the deposit contract cannot be fulfilled if all the “creditors” try to redeem their claims. The phony warehouse receipts are loaned out by the bank. Fractional-reserve banking has reared its ugly head.

Thus, suppose that the Rothbard Deposit Bank in the previous table decides to create $15,000 in fake warehouse receipts, unbacked by cash, but redeemable on demand in cash, and lends them out in various loans or purchases of securities. For how the Rothbard Bank’s balance sheet now looks see Figure 5:

In this case, something very different has happened in a bank’s lending operation. There is again an increase in warehouse receipts circulating as money, and a relative decline in the use of cash, but in this case there has also been a total increase in the supply of money. The money supply has increased because warehouse receipts have been issued that are redeemable in cash but not fully backed by cash. As in the case of any counterfeiting, the result, so long as the warehouse receipts function as surrogates for cash, will be to increase the money supply in the society, to raise prices of goods in terms of dollars, and to redistribute money and wealth to the early receivers of the new bank money (in the first instance, the bank itself, and then its debtors, and those whom the latter spend the money on) at the expense of those who receive the new bank money later or not at all. Thus, if the society starts with $800,000 circulating as cash and $1.2 million circulating as warehouse receipts, as in the previous example, and the banks issue another $1.7 million in phony warehouse receipts, the total money supply will increase from $2 million to $3.7 million, of which $800,000 will still be in cash, with $2.9 million now in warehouse receipts, of which $1.2 million are backed by actual cash in the banks.

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