Rothbard vs. Mises on Fractional Reserve Banking
June 29, 2012
I have been aware of this deep division within the Austrian school of economics ever since the summer of 1963. The division still exists, and will likely continue to exist. It stems from rival views of civil government. Mises was a classical liberal who favored a minimal state. Rothbard was an anarchist who denied the legitimacy of civil government. Mises was a Kantian who did not believe in natural law and natural rights. Rothbard believed in both.
In the summer of 1963, I had the best job I ever had. I was hired to read books. I was paid $500 a month, which in today's money is over $3000 a month. There were almost no income taxes on low incomes, and almost no Social Security taxes in 1963. Furthermore, I was not married, and I had free room and board that was paid for by R. J. Rushdoony, who had hired me for the summer.
I read all of Murray Rothbard's books that summer. This included The Panic of 1819, Man, Economy, and State, and America's Great Depression. I also read Ludwig von Mises' books, Human Action, Socialism, and The Theory of Money and Credit. I was busy.
I had taken a week-long evening seminar the previous summer from Mises. It became apparent to me at that time that Mises held a different view of civil government from Rothbard's view. Mises was an advocate of limited civil government. He was a representative of nineteenth-century liberalism. Rothbard was a pure anarchist. He believed that every civil government is evil. For him, it was a moral issue.
In my summer of reading in 1963, I recognized another fundamental distinction between the two men's positions. Mises was an advocate of free banking. He did not believe that the civil government should be involved in setting a particular ratio of required reserves. This meant that he did not believe that commercial banks should operate under a legislated restriction on the amount of fiduciary media, meaning fiat money, in relationship to the quantity of gold and silver in the banks' vaults.
In contrast, Rothbard advocated 100% reserve requirements for all commercial banking: no fractional reserves. He believed in a 100% gold standard. He had made this position clear the previous year in an article in a collection of essays, In Search of a Monetary Constitution, published by Harvard University Press: "The Case for a 100% Gold Dollar. I read that essay, too.
NATURAL LAW VS. KANTIAN UTILITARIANISM
There was a third and far more fundamental difference between Mises and Rothbard. I did not understand this for at least another decade. Rothbard was a defender of classical natural law theory, along the lines of Aristotle. Mises was a self-conscious Kantian, and he rejected entirely the concept of natural law.
This distinction became visible a decade later in Rothbard's book, For a New Liberty: The Libertarian Manifesto (1973). On pages 30 and 31, he rejected utilitarianism as a foundation of social theory. He did not mention Mises in his list of compromising utilitarians, but Mises was a utilitarian. On pages 31 to 36, he rested his case on natural law: man as an autonomous self-owner of himself. He then stated his commitment to the principles of natural law and natural rights.
In his 1981 book, The Ethics of Liberty, he devoted considerable space to a defense of both natural law and natural rights. All of Part 1 is devoted to a discussion of natural law. This was a clear-cut rejection of Mises's epistemology. Mises, as a Kantian, did not believe in natural law. In all of his policy prescriptions, he studiously avoided any reference to ethics. In contrast, Rothbard rested all of his policy recommendations on a specific concept of ethics.
Mises was adamant in his rejection of all of this. Here is what he wrote in Human Action.
Now it is true that the liberal and democratic movement of the eighteenth and nineteenth centuries drew a great part of its strength from the doctrine of natural law and the innate imprescriptible rights of the individual. These ideas, first developed by ancient philosophy and Jewish theology, permeated Christian thinking. Some anti-Catholic sects made them the focal point of their political programs. A long line of eminent philosophers substantiated them. They became popular and were the most powerful moving force in the prodemocratic evolution. They are still supported today. Their advocates do not concern themselves with the incontestable fact that God or nature did not create men equal since many are
born hale and hearty while others are crippled and deformed. With them
all differences between men are due to education, opportunity, and social
But the teachings of utilitarian philosophy and classical economics have
nothing at all to do with the doctrine of natural right. With them the only
point that matters is social utility. They recommend popular government,
private property, tolerance, and freedom not because they are natural and
just, but because they are beneficial. The core of Ricardo's philosophy is
the demonstration that social cooperation and division of labor between
men who are in every regard superior and more efficient and men who are
in every regard inferior and less efficient is beneficial to both groups.
Bentham, the radical, shouted: "Natural rights is simple nonsense: natural and imprescriptible rights, rhetorical nonsense." With him "the sole
object of government ought to be the greatest happiness of the greatest
possible number of the community." Accordingly, in investigating what
ought to be right he does not care about preconceived ideas concerning
God's or nature's plans and intentions, forever hidden to mortal men; he
is intent upon discovering what best serves the promotion of human welfare
and happiness (p. 174).
There is, however, no such thing as natural law and a perennial
standard of what is just and what is unjust. Nature is alien to the idea
of right and wrong. "Thou shalt not kill" is certainly not part of
natural law. The characteristic feature of natural conditions is that
one animal is intent upon killing other animals and that many species
cannot preserve their own life except by killing others. The notion of
right and wrong is a human device, a utilitarian precept designed to
make social cooperation under the division of labor possible. All moral
rules and human laws are means for the realization of definite ends.
There is no method available for the appreciation of their goodness or
badness other than to scrutinize their usefulness for the attainment of
the ends chosen and aimed at.
From the notion of natural law some people deduce the justice of
the institution of private property in the means of production. Other
people resort to natural law for the justification of the abolition of
private property in the means of production. As the idea of natural
law is quite arbitrary, such discussions are not open to settlement.
State and government are not ends, but means (p. 716).
In response, without mentioning Mises by name, Rothbard wrote in 1981, "It is indeed puzzling that so many modern philosophers should sniff at the very term 'nature' as an injection of mysticism and the supernatural" (Ethics of Liberty, p. 9).
Between Rothbard and Mises, there was an unbridgeable ethical divide.
100% RESERVES VS. FREE BANKING
We come now to monetary theory. Here, the distinction between Mises and Rothbard is intense. Mises openly rejected the idea that government should have any role in setting a specific percentage of gold and silver or other assets, including bank deposits, in relation to their issuance of what he called fiduciary media, but which hard money advocates refer to as fiat money. In contrast, Rothbard called for 100% reserves.
Here is where the distinction was fundamental. Mises called for free banking, meaning banking run exclusively by contracts, as an aspect of limited civil government. Mises believed that the state has an obligation to use the threat of violence to force individuals to honor the terms of their contracts. With respect to banking, he was explicit. On page 440 of Human Action, we read the following: "What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract." This could not be clearer.
In an article published in The Review of Austrian Economics (Dec. 1988), "The Myth of Free Banking in Scotland," Rothbard quoted this passage directly in footnote 18. (Note: he cited page 443. He was using the third edition published by Regnery in 1966, It appears on page 440 of the 1949 Yale University Press edition.) What is significant for this discussion is the single sentence in Rothbard's essay which referred to the issue of fiat money. Here is that sentence: "The answer to fraud, then, is not administrative regulation, but prohibition of tort and fraud under general law."
Here is the problem as it relates to these rival theories of banking regulation. Mises believed that the civil government can and should use coercion to compel the honoring of contracts. Rothbard cited this passage as justification for a banking system in which fraud is prohibited. He regarded all fractional reserve banking as fraud. But he invoked Mises's position at exactly the place in this essay in which he spoke to the issue of how, exactly, 100% reserve banking could be enforced.
The key word here is enforced. Mises was crystal clear. The state should enforce contracts. But Rothbard, by citing this passage, gave the impression that he, too, believed that the state has an obligation to enforce contracts. This is the only statement in this essay which addressed the problem of how it is possible to get 100% reserve banking in an economy. Yet he footnoted Mises's statement which called for the use of state coercion to achieve this result.
I find it incredible that Professor Walter Block refers to this essay as having categorically refuted my position on Rothbard's view of 100% reserve banking under an anarchist social order. Not only does it not refute my position regarding Rothbard's recommended system, it in fact appears to have implicitly surrendered to Mises on the point of the legitimacy of civil government in this one instance. I know of no other case in all of Rothbard's writings in which he surrendered to Mises's position on the legitimacy of civil government as an agency of coercion.
The article is an historical account of Scottish banking under fractional reserves. In an article of 16 pages, there is only one sentence that deals with a theory of banking law, and that single sentence ignores both his theory of anarchism and his theory of 100% reserve banking. It invokes Mises' theory of limited civil government and free banking. Yet Prof. Block cites the essay as definitive.
Prof. Block might argue that Rothbard did not really believe that the state should impose coercion in order to enforce contracts. I would agree, and I do not assert that Rothbard openly surrendered his position in this case. He surely appeared to, however. A reader unfamiliar with his anarchism or his defense of 100% reserve banking would have no evidence of either position in this article. But I do insist that by citing Mises in this instance in his defense of general law and tort law, Rothbard evaded the fundamental problem with his system of 100% reserve banking. The fundamental problem with his system is simple to state: there is no final agency for the enforcement of contracts that does not rely on the threat of violence.
Rothbard's theoretical rejection of the legitimacy of civil government inescapably moves his position on 100% reserve banking toward Mises's system of free banking. Mises denied that the state should impose 100% reserves. Rothbard argued that there should be no state. This means -- but he never said -- that what Mises rejected as a bad policy, Rothbard rejected on principle: a state law mandating 100% reserves.
Mises demanded that the civil government enforce contracts, but he denied the wisdom of allowing bureaucrats to set an unofficial ratio of bank reserves. Here, I cite the full passage in Human Action.
But even if the 100 per cent reserve plan were to be adopted on the basis of the unadulterated gold standard, it would not entirely remove the drawbacks inherent in every kind of government interference with banking. What is needed to prevent any further credit expansion is to place the banking
business under the general rules of commercia1 and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract. If banks are preserved as privileged establishments subject to special legislative provisions, the tool remains that governments can use for fiscal purposes. Then every restriction imposed upon the issuance of fiduciary media depends upon the government's and the parliament's good intentions. They may limit the issuance for periods which are called normal. The restriction will be withdrawn whenever a government deems that an emergency justifies resorting to extraordinary measures (p. 440).
Mises believed that bankers compete against bankers, and that bankers would demand payment in gold or silver from other banks which they did not believe were practicing sound banking practices, meaning high reserve ratios. Mises also trusted depositors to make runs on low-reserve banks in order to get their gold and silver out of any bank which they suspected of unsound banking practices. So, from their peers and also from their depositors, bankers under free banking face the pressure of redemption of their banknotes, checks, and other fiduciary media.
Mises did not believe that his system of competitive redemption would produce 100% reserve banking. He did believe that it would be very difficult for any bank to expand its issuance of fiduciary media at any ratio higher than what banks generally adopted as sound banking practice.
Rothbard believed that 100% reserve banking is a moral issue. Mises never recommended any policy in the name of morality. In contrast, in Rothbard's book, The Mystery of Banking (1983), he made it clear that he believed that the question of fiat money is a moral question. He regarded the issuance of fiat money by banks as a form of theft: a form of fraud. "It should be clear that modern fractional reserve banking is a shell game, a Ponzi scheme, a fraud in which fake warehouse
receipts are issued and circulate as equivalent to the cash supposedly
represented by the receipts" (p. 97).
Both men held to the Austrian theory of the trade cycle. Both men placed fractional reserve banking at the center of their analysis of economy. This is because they both understood that in a high division of labor society, the central institution is money. Mises argued from 1912 until his death that it is the expansion of fiduciary media by banks that causes the boom-bust cycle. He argued that the misleading price signals that are produced by fiduciary media, especially in the area of interest rates for loans, are what lead a majority of entrepreneurs to make the same investment mistakes simultaneously.
Rothbard never provided even a paragraph to explain how 100% reserve banking can exist in a society that does not have a state. In the one sentence in which he affirmed the ability of general law and the tort system to uphold high reserves, though not necessarily 100% reserves, he appealed to the authority of Mises, who in turn appealed to the legitimacy of state coercion to enforce contracts.
The question that I must address at this point is the question of the legitimacy of civil government, and its function in upholding contracts.
THE ENFORCEMENT OF CONTRACTS
Anyone who says that there does not have to be a state, but that general law and the tort system of the courts can provide predictable decisions, must deal with what I call the four slogans of American individualism. Following Mises in his methodology of axioms and corollaries, I hereby identify the axiom of American individualism: "Oh, yeah?" This is the bedrock presupposition of American individualists through history.
There are two corollaries. The first corollary is this: "Who says?" This is the great epistemological question for American individualists. The second corollary is like unto it: "Make me." There is a sub-corollary, attached to the second corollary: "You and who else?"
Anyone who wants to deal with the fundamental issues of limited civil government versus no civil government has an intellectual obligation to deal with the principles of American individualism.
AXIOM: "OH, YEAH?"
Let us consider this axiom in relation to a local banker. The banker has benefited from deposits by investors. They have deposited gold coins because they believe what is obviously impossible. They believe that they can get their coins back on demand, but they can also get a rate of interest from the bank.
The only way for the bank to pay a rate of interest is for the bank to lend the gold coins or receipts to gold coins to entrepreneurs or consumers, who in turn promise to pay back more than they borrowed at the end of a specified period of time. The debtor borrows the gold, which serves as money, to buy something. Therefore, the original depositor cannot get his gold coins back during the period of the loan.
The banker has made the promise to depositors only on this basis: he does not believe that all the depositors will come down to the bank on the same day and demand payment in gold. Therefore, the entire banking system rests on a statistical probability. This denies the statistical possibility of payment on demand in 100% of the cases.
Let us say that all of the depositors decide they want to get their coins back on the same day. They line up in front of the bank. Once at the front of the line, each depositor insists that the bank pay him his coins. He stresses his coins. They are not the bank's coins. The contract says so.
The bank cannot pay them their coins. The bank therefore must go out of business at that point. Why? Because the bank has violated its contracts with the depositors. The only way for the bank to survive under these circumstances is for the bank to get the support of the state to legalize its refusal to honor its contract with depositors. The same principle applies to demands for payment by rival banks.
The depositors insist that they are owed their coins. The bank haws and haws and delays and stonewalls. The depositors say: "You owe us our coins."
The banker finally responds with the axiom of American individualism: "Oh, yeah?" and the depositors respond with another response of American individualist: "Yeah."
COROLLARY #1: "WHO SAYS?"
At this point the banker resorts to the first corollary of American individualism. The depositors say that they are owed the gold coins. The banker replies: "Who says?"
The depositors probably say that the banker has made the promise. The banker then insists that the promise does not apply in this particular instance. The depositors have been misinformed.
The depositors say, in response: "Says you."
The banker responds: "Says me."
They are now at an impasse. The banker refuses to honor what the contracts appear to say, but the depositors are not in a position to compel the banker to make payment of that which it is impossible for the banker to do. He loaned out the gold. There is not enough gold in the vaults to pay all the depositors.
The depositors decide that the best way they can get their share of the gold that remains in the vault is to raid the vault. So, they tell the banker to go the vault, get out whatever gold coins are in there, and divvy them up. But on what basis? Equal shares? Or in terms of the percentage owed in the contracts? The banker says that he will not do it. The depositors say he has to do it. The banker says "No, I do not." The depositors say "Yes, you do." "No, I do not." "Yes, you do."
At this point the banker invokes the second corollary of American individualism.
COROLLARY #2: "MAKE ME!"
At this point, the depositors have few choices. They can go home and get their guns, but the banker has guards on his payroll. He probably has thugs on retainer. In a zero-state society, most people with a lot of money would have thugs on retainer.
If the depositors have more guns than the banker, maybe they will be in a position to exact vengeance. Maybe they can string him up from the highest tree. But what they will not be able to do is get their coins back. They cannot make him give back their money, because he does not have their money.
Their only hope is to get their money when the debtors pay off their loans, as promised. But, at this point, the debtors probably have figured out that the banker will no longer be in business anyway. So, why should they pay back the bank, when the bank no longer exists? It would certainly be a lot less expensive to regard the contract as null and void.
The depositors would like to get paid by the debtors. To do this, they have got to establish a legal claim over the assets of the bank. But how are they going to do this, if a local bank is out of business? Who has a legal claim on the bank's assets?
This becomes the next phase of the debate. The depositors will claim that the lenders owe them the money. Probably more than one of the lenders will respond: "Oh, yeah?" A few of them may even add: "Who says?" A majority of them will then add: "Make me."
In the system of civil law defended by Mises, these questions are resolved rapidly, or least as fast as the courts allow them to be settled. The court system can invoke the executive, and the executive has a staff of people with badges and guns. This staff of people can enforce whatever the courts decide the proper distribution of the assets ought to be. The courts will decide what the contract means. The question will no longer be asked: "Who says?" The other objection will also not be raised: "Make me."
COROLLARY #2(a) "YOU AND WHO ELSE?"
The issue here is the issue of sovereignty. Sovereignty is the issue of badges and guns. Who in society has the right to serve as the final court of appeal?
In a society with no civil government, the person who has the largest and most well-armed group of thugs gets to make this decision. He may be challenged by another group of thugs, but until that takes place, he determines how the courts will adjudicate the issues before them. In other words, this is a warlord society.
THE WARLORD SOCIETY
The warlord society is a system of gangs. But, because the warlord wants cooperation from the people, and also from the smaller gangs, and because ultimately self-government is the most important form of government, the warlord agrees to certain kinds of terms that will be acceptable to those under his jurisdiction. These people will accept certain rules as binding the courts, and the warlord agrees, because he wants to get cooperation at a lower price than it would cost him if people resisted the decisions of the courts.
Under such a system, there can be settlements of disputes. The settlements are made on the basis of coercion. This is how they are made under a system of civil government. It was the position of Mises, as distinguished from Rothbard, that the state is a legitimate way to get issues settled with the least amount of violence and the greatest predictability. Under this system, Mises believed there would be greater predictability, lower costs of enforcing the decisions of judges, reduced violence between individuals, reduced violence between plans, and a social order favorable to the division of labor.
Part of this system of laws was the system of the enforcement of contracts. Mises rested his case for free banking on the existence of a civil government which would enforce the decisions of the courts. The courts had a monopoly of jurisdiction, and therefore had an answer to the crucial question: Who says?" They also had an answer to the sub-corollary: "You and who else?"
Rothbard never devoted a book to a consideration of this fundamental analysis of the warlord society. I regard this as the greatest single gap in all of Rothbard's writings. It needed a book. It got part of one chapter.
He had a theory of multiple police forces, which he discussed in chapter 12 of For a New Liberty. The problem here should be obvious: the police force with the most efficient system of warfare will turn itself into the state. Out of the warlord society comes a victor. On page 273 of For a New Liberty he wrote that a warlord society would have this advantage: there would be no interstate wars. "In the first place, since there would be no overall State, no central or even single local government, we would at least be spared the horror of inter-State wars, with their plethora of massive, superdestructive, and now nuclear, weapons."
I do not understand this distinction between warlord wars and state wars. Armed camps fight. Warlords' clashes are clashes between states. Warlord gangs have the characteristics of states. They have people with guns, and implicitly they have some system of badges.
He never offered a theory of his state-less society. He offered a few paragraphs as a hypothesis.
We cannot blueprint a market that exists only as an hypothesis, but it is reasonable to believe that police service in the libertarian society would be supplied by the landowners or by insurance companies. Since insurance companies would be paying benefits to victims of crime, it is highly likely that
they would supply police service as a means of keeping down crime and hence their payment of benefits. It is certainly likely in any case that police service would be paid for in regular monthly premiums, with the police agency--whether insurance company or not--called on whenever needed (p. 270).
Rothbard argued that "police companies would be tapping a mass-market; with the economies of such a large-scale market, police protection would undoubtedly be much cheaper" (p. 273) But successful police companies would be those that were most efficient in assembling systems of coercion. At some point, the police department is no longer hired by the citizens; the citizens are hired by the police department.
Let me describe the progression of rival warlords/police companies:
"Oh, yeah?" "Yeah!"
"Who says?" "I say."
"Make me!" "I will."
"You and who else?" "You'll find out."
So, we are back to the original question: "How can the ethical goal of 100% reserve banking be enforced on the community bankers?"
Mises argued that bankers and depositors would put pressure on suspect banks to maintain sound banking practices, by which Mises meant high reserve ratios. But he also said explicitly that the state would be the agency, and should be the agency, by which depositors and bankers would put pressure on suspect banks, if those banks refuse to honor their contracts and redeem their IOUs for gold on demand.
He did not argue that there would be 100% reserve banking. He only argued that there would be a banking system which would approach 100% reserves. He trusted bankers and depositors and courts far more than he trusted legislatures, which could be easily bought off. He did not trust legislatures to set a reserve ratio for the banking system, because he recognized that the legislators would always want to reduce the ratio of assets in the vaults to IOUs to the public.
Rothbard had a theoretical solution, given his assumption of a zero-state world. He relied on a definition of police forces as private, contractual, and market institutions. He refused to identify them is what virtually everyone else would call them: governments. This led to a major problem: defending the idea of 100% reserve banking in the face of what should be obvious: different banks would be in different jurisdictions.
He appealed to common law judges, but he did not show how common law judges could enforce their rules without the backing of people with badges and guns.
In this system, there is no final court of appeal. He made this clear on page 284 of for New Liberty. He cited the anarchist legal theorist, Bruno Leoni. Rothbard wrote:
And on the absence of "supreme courts":
it cannot be denied that the lawyers' law or the judiciary law
may tend to acquire the characteristics of legislation, including its undesirable ones, whenever jurists or judges are entitled to decide ultimately on a case. . . . In our time the mechanism of the judiciary in certain countries where "supreme courts" are established results in the imposition of the personal views of the members of these courts, or of a majority of them, on all the other people concerned whenever there is a great deal of disagreement between the opinion of the former and the convictions of the latter. But . . . this possibility, far from being necessarily implied in the nature of
lawyers' law or of judiciary law, is rather a deviation from it.
But if there is no final court of appeal, there can be no way to impose 100% reserves on all the banks. Different banks would be in different jurisdictions, and in a particular jurisdiction, the judges of that jurisdiction would interpret the application of the law to specific contracts. So, some banks would be able to operate with less than 100% reserve banking.
In Mises's free banking system, there was a final court of appeal in a nation. In Rothbard's banking system, there is not any such court. But if there is no final court of appeal, there can be no universally established 100% reserve ratio. It is only on the presupposition of a final court of appeal that will in force contracts in such a way that the bankers are not allowed to issue fiduciary media that it is possible to have 100% reserve banking.
My point is this: in operation, 100% reserve banking would at best resemble Mises's system of free banking. It might be far more inflationary, because in Rothbard's system, there is no final court of appeal, and therefore some jurisdictions will have lower reserve ratios. In any case, we are back to the initial problem: somebody has to interpret the contracts, and somebody else has to enforce this interpretation.
Anyone who argues that Rothbard's system of 100% reserve banking could be achieved without the state has an intellectual obligation to show who is going to enforce the common law judges' decisions regarding specific contracts. He has to show that this enforcement system will lead to 100% reserve banking. Mises believed that free banking cannot be assumed to lead to such a system, although he did believe that free banking would approach 100% reserves. Here is what he wrote in Human Action.
Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular-one is tempted to say normal-feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions (p. 440).
Rothbard never wrote a chapter on how 100% reserve banking could exist in theory in a stateless world.
Without a system of badges and guns, there is no way to enforce contracts, other than by force and the threat of force apart from badges and guns.
In his essay on free banking in Scotland in the eighteenth and early nineteenth century, he showed how banks refused to honor their contracts. They refused to supply specie metals on demand. He blamed the government for not enforcing contracts. He was correct.
He never showed how a world without civil government could enforce contracts. The public could refuse to deal with lying banks. But this would still be a system of free banking. No one could put lying bankers out of business, other than by not dealing with them. So, there would be a range of reserve ratios. That was what Mises taught. That was what Rothbard refused to discuss.