Responding to Jesus H de Soto on Banking

Jesus H de Soto's,  900 page work MONEY, BANK CREDIT, AND ECONOMIC CYCLES is the bible of the anti-fractional reserve banking school that dominates modern libertarian/free market thinking on the topic of money and banking, and represents the views of Walter Block, Lew Rockwell, Hans Hoppe, Tom Woods, not to mention the late Rothbard.


However, there is another libertarian/free market school represented by Lawrence H White, George Selgin, and Steven Horwitz, that supports free banking and fractional reserve banking. I count myself with this school, and I have written the following posts in support of it:

Answering Block's Bank Impossibility Claim

Property Rights Analysis of Banking

Banking Defined and Defended, Part 1

De Soto's work is very long, detailed, somewhat repetitive, but it does deserve a response, and indeed a good response can be made to it. In this post I will outline the main arguments put forward by de Soto, and summarise how free bankers should respond.

De Soto's Main Arguments

1. Under classical Roman law, a 'deposit' of money with a 'bank' gave the banker title to the money deposited, but required the bank to hold the funds deposited solely for the benefit of the depositors and in the form of coin rather than in the form of loans or investments.
2. Under the same legal system loans of money must involve a specified maturity, and the borrower gets full rights to use the borrowed money, unlike in the case of a 'deposit.' Loans cannot be at call or on demand, such a feature would make it a deposit instead.
3. Bankers have always been tempted to use deposited funds they are supposed to hold 100% in reserve, for loans and investments, and in no historical or modern banking system has this temptation been effectively resisted, so that the law as mentioned before was generally honoured.
4. Banks and governments have conspired to legalise and profit from the practice of fractional reserve banking, and in modern civil law countries such as Spain, such practices are only allowed for banks and only due to special legislation.
5. Fractional reserve banking has its logical end in unanchored fiat money systems we see today, with governments and banks operating for mutual benefit, at the expense of social welfare and good law and morals.
6. Fractional reserve banking enables 'credit expansion' that causes or is inflation, and the cause of economic cycles, according to Austrian Business Cycle Theory (ABCT).

 De Soto therefore concludes that fractional reserve banking should be outlawed, central banking abolished, metallic currency restored. He also concludes that substitute financial instruments such as bank notes, repos (with on demand repurchase at a specified price), life insurance (with surrender value and available for surrender on demand) should also be banned or subject to 100% metallic reserves. I suspect he would also like to outlaw overdrafts, which Block has condemned, and which, according to his book, are illegal even today in Spain (and presumably other civil law countries, unless expressly legalised). He may also want to restrict borrowing short and lending long, as Block does.


Free Banking Responses
I will outline responses corresponding the the arguments of de Soto enumerated above:

1. It may well be that classical Roman law treated demand deposits accepted by banks as de Soto has argued and provided a substantial amount of evidence for. The closest English common law term to deal with such a contract is called a 'bailment' where the ownership remains with the bailor, but possession goes to a bailee. Thus the English terms 'deposit' 'bank' and so forth do not need to exactly correspond to the classical Roman law terms, and this limits the force of this argument.
2. The necessity of a specified maturity on loan contracts is not agreed under English common law, and English common law allows for loans to be for any period, including on demand/at call. Although de Soto finds this objectionable, this is really the critical point in the argument. De Soto calls English common law 'lax' however supporters of it would call it flexible.
   
3. If bankers and banking systems have historically been unable to resist the temptation to invest funds raised on demand deposit -- and this is a theme of de Soto's book -- one has to ask the question whether the rule being flouted is good law or an unreasonable restriction on commerce. The same goes for analogous financial instruments -- if people are being creative to get around a restriction, this indicates the merits of the restriction should be reviewed.
4. The undesirable relationships between banks and government can be interpreted in more than just the way de Soto does. Free bankers who are not hostile to fractional reserve banking, for example, also condemn deposit insurance, central banking, prudential regulation, and unanchored fiat currency, and attribute these to the same cause, rather than having anything to do with fractional reserve banking.
5. The logical end of fractional reserve banking in a free market is not the same as in a regulated market. The differences are: the gold coin standard of money would be maintained, and there would be no deposit insurance, prudential regulation, entry regulation or central banks. Free bankers should detail their ideal monetary system to respond to de Soto's claim.
6. Free bankers need to develop an alternative macroeconomic theory that considers 'credit expansion' as not impacting on macroeconomic variable such as employment, price inflation and so forth. This is really something on the 'to do' list.

Free bankers can also argue that the results of the rule impact beyond banking into maturity transformation, repos, life insurance, building society shares, credit union shares, unit trusts/managed funds, overdrafts and other aspects of financial markets and instruments, i.e. it requires absurd restrictions. Although this might have no truck with the consistently absurd like Block, it can help persuade those with more common sense.