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Maturity mismatching, ethics and economics: Rejoinder to Bagus, Howden and Huerta de Soto

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Abstract

Is maturity mismatching, borrowing short and lending long, merely risky, or would it be banned in the free society as a rights violation? The pres-ent paper is the latest episode in a debate series on this issue. The present authors take the position it is unethical and should be against the law. Our debating partners subscribe to the opposite point of view. Keywords: Banking, lending, ethics, law. JEL Classification: E2, E59, P16. Resumen: ¿Es el descalce de plazos, es decir, endeudarse a corto y prestar a largo plazo, simplemente arriesgado, o estaría prohibido en una sociedad libre como una violación de derechos? El presente artículo es el último episodio de una serie de debates sobre este tema. Los presentes autores toman la posi-ción de que no es ético y debería estar en contra de la ley. Nuestros compañe-ros en el debate mantienen el punto de vista contrario. Palabras clave: Banca, préstamos, ética, Derecho. Clasificación JEL: E2, E59, P16.
Maturity Mismatching: Is this a legitimate banking practice?
Philipp Bagus
William Barnett II
Walter E. Block
David Howden
Jesús Huerta de Soto
1
Table of Contents
Introduction to Maturity Mismatching: Is this a legitimate banking practice?.......
1. Time deposits, dimensions and fraud Barnett and Block....................................
2. The Legitimacy of Loan Maturity Mismatching: A Risky, But Not Fraudulent,
Undertaking Bagus and Howden.............................................................................
3. Rejoinder to Bagus and Howden on Borrowing Short and Lending Long
Banett and Block.....................................................................................................
4. The Continuing Continuum Problem of Deposits and Loans Bagus and
Howden...................................................................................................................
5. Maturity Mismatching and “Market Failure” Barnett and Block........................
6. Entrepreneurial Error does not equal Market Failure Bagus, Howden and
Huerta de Soto.........................................................................................................
7. Maturity mismatching, ethics and economics: Rejoinder to Bagus, Howden
and Huerta de Soto Block and Barnett..................................................................3
About the authors ………………………………………………………
2
Introduction to Maturity Mismatching: Is this a legitimate banking practice?
This book consists of a debate between William Barnett II and Walter E. Block
on the one hand, and Philipp Bagus, David Howden and Jesus Huerta de Soto on
the other. The general concern is the legitimacy of banking practices. More
specifically, the authors focus on the nature of deposit taking and loan issuance,
and to which legal or ethical constraints banks should adhere.
In most debates on important issues, the two sides may seem distant, not just
with respect to the immediate disagreement, but also to a variety of ancillary
topics. Although the reader may suspect that we share little common ground,
this is not the case. In fact, all five of us find ourselves in almost unanimous
agreement as to a plethora of issues, both relevant and not, to the debate at hand.
All of us, for example, are staunch Rothbardians. That is, all five of us oppose
an imperialist foreign policy, support personal liberties, and favor free enterprise
and Austrian economics. More narrowly, our band of five are united in
opposition to fractional-reserve banking, a controversial issue even amongst
followers of the praxeological school.
What can be said regarding the benefits of reading this book?
First, this is a compilation of essays on banking. At the risk of committing the
fallacy underlying the diamonds – water paradox, this is the single most
important industry in the entire economy, now more than ever. Money, interest
rates, and inflation permeate the entire economy in a manner in which other
important industries (steel, computers, transportation, energy, etc.) do not.
Money is the medium of exchange, and any industry with the ability to affect the
supply of money will have systemic effects throughout the broader economy. It
is for this central reason why banks, with their ability to alter the money supply
by issuing deposits, affect all other businesses; but the corollary does not hold. It
is crucially important, then, that our laws are cognizant of the banking
controversy covered herein.
Second, this book promotes Austrian economics, the last best hope for the return
of rational economics to the dismal science profession. It cannot be denied that
Block and Barnett, on the one hand, and Bagus, Howden and Huerta de Soto on
the other, disagree on maturity mismatching as a banking practice. This includes
borrowing short and lending long (bsll), as well as borrowing long and lending
3
short (blls). But all five of us, again, are staunch Austrian economists.
Praxeology, the technique of the Austrian school is used throughout, widely and
deeply.
Third is the benefit of debate itself. All too often in modern academia, debate is
stifled and the status quo thus endorsed. The forces of political correctness
maintain that espousing the wrong view is per se a violation of rights. Such
people would do well to remember John Stuart Mill’s “On Liberty,” particularly
where he writes:
“The greatest orator, save one, of antiquity, has left it on record that he
always studied his adversary's case with as great, if not with still greater,
intensity than even his own. What Cicero practised as the means of forensic
success, requires to be imitated by all who study any subject in order to
arrive at the truth. He who knows only his own side of the case, knows
little of that. His reasons may be good, and no one may have been able to
refute them. But if he is equally unable to refute the reasons on the opposite
side; if he does not so much as know what they are, he has no ground for
preferring either opinion. The rational position for him would be
suspension of judgment, and unless he contents himself with that, he is
either led by authority, or adopts, like the generality of the world, the side
to which he feels most inclination. Nor is it enough that he should hear the
arguments of adversaries from his own teachers, presented as they state
them, and accompanied by what they offer as refutations. That is not the
way to do justice to the arguments, or bring them into real contact with his
own mind. He must be able to hear them from persons who actually believe
them; who defend them in earnest, and do their very utmost for them. He
must know them in their most plausible and persuasive form; he must feel
the whole force of the difficulty which the true view of the subject has to
encounter and dispose of; else he will never really possess himself of the
portion of truth which meets and removes that difficulty. Ninety-nine in a
hundred of what are called educated men are in this condition; even of
those who can argue fluently for their opinions. Their conclusion may be
true, but it might be false for anything they know: they have never thrown
themselves into the mental position of those who think differently from
them, and considered what such persons may have to say; and consequently
they do not, in any proper sense of the word, know the doctrine which they
themselves profess.”
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We the authors can confidently say that a perusal of this book will give the
reader both sides of the bsll and blls controversy. He will know them “from
persons who actually believe them; who defend them in earnest, and do their
very utmost for them. He must know them in their most plausible and persuasive
form…”
Philipp Bagus0
William Barnett II
Walter E. Block
David Howden
Jesus Huerta de Soto
References:
Barnett, William II and Walter E. Block. 2009. “Time deposits, dimensions and
fraud,” Journal of Business Ethics; Vol. 88, No. 4, September, pp. 711-716;
http://www.walterblock.com/wp-content/uploads/2009/06/barnett-block_time-
deposits-fraud-2009-1.pdf;
http://www.springerlink.com/content/a88l166702524r55/; http://blog.mises.org/
archives/011398.asp;
http://www.springerlink.com/content/a88l166702524r55/fulltext.pdf?page=1;
https://www.researchgate.net/publication/225634696_Time_Deposits_Dimensio
ns_and_Fraud?ev=prf_pub; http://link.springer.com/article/10.1007%2Fs10551-
008-9976-9
Bagus, Philipp and David Howden. 2009. “The Legitimacy of Loan Maturity
Mismatching: A Risky, but not Fraudulent, Undertaking.” Journal of Business
Ethics. Vol. 90: 399–406;
http://www.springerlink.com/content/pn81764318674wv0/?
p=9881dca0cc1540b4bdfca8c126998d16&pi=36; http://www.springerlink.com/
content/pn81764318674wv0/
0 The authors thank Nathan Fryzek for his efforts in attaining reprint permission for the first
six essays in this book, and also the publishers of the Journal of Business Ethics (chapters 1-
6), and Procesos de Mercado (chapter 7) for their reprint permissions. We also thank Jeanette
Capocaccia for editorial assistance.
5
Barnett, William II and Walter E. Block. 2011. “Rejoinder to Bagus and
Howden on Borrowing Short and Lending Long” Journal of Business Ethics.
Volume 100, Number 2, pp. 229-238, May; DOI: 10.1007/s10551-010-0677-9;
https://springerlink3.metapress.com/content/44x8878431714443/resource-
secured/?
target=fulltext.pdf&sid=ibnjjd4520xsog550csa0ey2&sh=www.springerlink.com
; http://www.springerlink.com/openurl.asp?genre=article&id=doi:10.1007/
s10551-010-0677-9;
https://www.researchgate.net/publication/225476829_Rejoinder_to_Bagus_and_
Howden_on_Borrowing_Short_and_Lending_Long?ev=prf_pub
Bagus, Philipp and David Howden. 2012. “The continuing continuum problem
of deposits and loans” Journal of Business Ethics. Vol. 106, issue 3, pages 295-
300;http://econpapers.repec.org/article/kapjbuset/v_3a106_3ay_3a2012_3ai_3a3
_3ap_3a295-300.htm; http://hdl.handle.net/10.1007/s10551-011-0996-5
Barnett II, William, and Block, Walter E. 2015. Maturity mismatching and
“market failure”. Journal of Business Ethics. doi:10.1007/s10551-015-2706-1.
Bagus, Philipp, Howden, David and Huerta de Soto, Jesus. 2016. Journal of
Business Ethics. http://link.springer.com/article/10.1007%2Fs10551-016-3123-
9; doi:10.1007/s10551-016-3123-9
Block, Walter E. and William Barnett II. 2017. “Maturity mismatching, ethics
and economics: Rejoinder to Bagus, Howden and Huerta de Soto.” Revista
Procesos de Mercado, Vol. XIV, #2, Autumn.
http://www.jesushuertadesoto.com/revista-procesos-de-mercado/vol-xiv-no2-
2017/
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Chapter 1.
Time deposits, dimensions and fraud
William Barnett II and Walter E. Block
7
Time deposits, dimensions and fraud
Abstract: We stipulate, arguendo, that fractional reserve demand deposit
banking is per se fraudulent. We ask whether or not time deposit banking can
also be illicit, and answer in the positive, if there is a mismatch between the time
dimensions of deposits and loans. To wit, if an intermediary borrows short and
lends long.
Key words:
Time deposits, dimensions, libertarianism, private property rights, fraud
JEL category:
E2, E59, P16
8
Time deposits, dimensions and fraud
I. Introduction
The purpose of this paper is to explore the ethical and economic status of
mismatched time deposit lending and borrowing.0 It arises, of course, with
respect to fractional-reserve-demand deposits. One problem that has interested
us for some time is the continuum problem with respect to such deposits.
Suppose we accept, arguendo, that fractional-reserve-demand deposits should be
illegal, but that fractional-reserve-time deposits should be legal. Then, it would
be against the law for a bank or other financial institution to accept a demand
deposit and turn around and lend it out; but it would not be for it to accept a time
deposit for, say, six months and turn around and lend those funds out. The
continuum problem arises when we ask whether it is OK to take in a time
deposit for say, one month, and lend it out? Of course, But, how about one
week? one day? one hour? one minute? one second? That is, just how
instantaneous does “instantly” have to be for the purpose of determining
whether a transfer of funds to a bank constitutes a demand or a time deposit?
The real issue for economics does not lie with the length of the time period
between the deposit and when it must be repaid; i.e., the time length of the time
between that at which X received the deposit and that at which X is obligated to
return the funds. Consider the case where A deposits funds with X, where X is
obligated to return the funds, not instantly (whatever that may mean) on demand
beginning at the moment of deposit, but, say, instantly on demand at any time
commencing, say, one minute after the moment of deposit. Is such an account a
demand or a time deposit?
That question is irrelevant for economics. In contrast, the relevant question for
economics is: What may X do with the funds that have been deposited with it?
The answer is really quite simple: X may lend A’s deposits out for any period of
time such that the term of the loan ends no later than the earliest moment at
which X is legally obligated to return the funds to A. Thus, with a true demand
deposit X may not lend the funds at all. However, with six-month deposit made
on 1/1/2008; i.e., a deposit that X is not legally obligated to redeem before
6/30/2008, X may lend the funds out for a period ending no later than 6/30/2008.
Specifically, is it proper (for a bank or any other such institution) to borrow
short and lend long? That is, suppose A lends B $100 for a year, B turns around
0 Of course, this also raises the issue of whether fractional-reserve banking should be illegal.
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and lends that $100 to C, but not for a single year; rather, for two years. Before
we can confront that issue, let us consider a bit of background.
We take it as a given for the purposes of this paper that fractional reserve
demand deposits are illegitimate, could not survive in the free economy and are
economically destructive.0 Let us briefly review each of these claims.
First, fractional reserve demand deposits are illicit because they involve the
creation of more property titles than there is property in existence. For example,
right now, in a small town, there are 1,000 cars, we may suppose. There are also
precisely 1,000 titles to these automobiles. All is well. But if someone were to
print up an additional 100 property titles for these items, for which there are no
additional vehicles, and tried to circulate them, that is, by seizing control of
someone else’s property with them, this would clearly be recognized as the
fraud that it is. It would not matter at all whether this was done “contractually”
or not; for there is something more basic than mere voluntary agreement: the
laws of logic and reality. If there were 1,100 titles for only 1,000 cars, 100 of
those autos would have not one but two owners. Nor would these 100 cases
consist of partial ownership, where two people are partners, and own 50% each
of a vehicle. No, they would constitute cases where two individuals each own
100% of the automobile, an utter impossibility. This is like a surface that is all
red and all blue in the same respect at the same time. It is for this reason that a
“contract” whereby the party of the first part agrees to confer on the party of the
second part, for an agreed upon fee, a “square circle” would be considered an
invalid agreement. There is no such thing as a square circle, and the laws of
logic prevent “one” from ever coming into existence.
Similarly, we may suppose that in the same small town there are now 1,000
ounces of gold money, and, also, the identical number of titles to these gold
ounces, namely, 1,000. The same analysis applies. If someone prints up an
additional 100 titles to gold ounces of money, there is fraud afoot, there is
something logically amiss, no matter who or how many people agree to this act.
For, with these additional titles to 100 ounces of gold that do not exist, there is
now an “over ownership” of property. Two people, not one person, own each
and every ounce of this excess money, an utter impossibility. This we take it is a
praxeological claim, not open to empirical refutation.
0 For material in support of this contention, see Block and Garschina, 1996; Hoppe, et. al.
1998; Hoppe, 1994; Hulsmann, 2000, 2002a, 2002b; Rothbard, 1962; de Soto, 1995, 1998,
2001. For the opposing viewpoint: Sechrest, 1987, 1989a, 1989b, 1991a, 1991b, 1993, 2007;
Selgin, 1994, 1998, 2007a, 2007b, 2007c; Selgin and White, 1996; White, 1992, 1995, 1999.
10
Because it is fractional reserve banking that is being considered, we ask how the
additional titles come into existence. The answer, of course, is that individuals
pay money into a demand deposit. Some portion of these deposits is kept “in
reserve” and the remainder is lent, in the process creating additional demand
deposits; i.e., the new (excess) ownership titles are lent into existence. The
cause of the problem is that the bank had no right to make such loans, because it
did not have the relevant elements of ownership of the deposited funds. That is,
it had title to the funds only for period for which it had borrowed them, so it
only had the right to lend these monies for a period ending no later than the time
at which it had to repay the loan by which it acquired the funds it lent.
Second, fractional reserve banking for demand deposits could not long endure in
the free enterprise system where property rights and the niceties of bankruptcy
law are respected, save for the possibility (probability?) that they might be able
to exist with very high reserve ratios, say 98% or more, but this is an empirical
question. For fractional reserve banks (FRBs) would be immediately subject to
negative clearing house accounts by 100% reserve banks demanding immediate
payment for their paper and/or demand deposits. And, since failure to
immediately make good on any and all demand deposits outstanding against a
ban constitutes bankruptcy, and, since bankruptcy in turn is grounds for
immediate dissolution of a company guilty of so egregious behavior, the
prognostication for such companies is not a positive one. Again, it must be noted
that this is an empirical, not a praxeological claim. That is, there is always the
possibility that, for reasons that need not concern us in detail,0 the 100% banks
would not call for the immediate payment of all demand deposits and notes
issued by the FRBs. If so, immediate bankruptcy would not be the necessary
result.0 Moreover, the differential clearing rate need not necessarily favor the
100% bank, as it would depend on the relative sizes of the different banks
extant, and the actual patterns of money transfers among their depositors.0
0 The issue turns on whether or not the transactions costs of “attacking” the 99% fractional
reserve bank through adverse clearing house balances, are more or less than the benefits of
eliminating a competitor.
0
The second mentioned author of the present article maintains that in equilibrium, e.g., in the
evenly rotating economy, FRB could not exist, assuming profit seeking behavior on the part
of the 100% reserve banks. The first mentioned author demurs because he finds the concept
of equilibrium in economics, in any of its guises including the ERE, unscientific.
0
For example, suppose that Bank A, (a 100% reserve bank) had demand deposits of 100
ounces of gold and Bank B, (a 98% reserve bank) had 50. If Bank B’s depositors only did
business with other customers of Bank B, but some of Bank A’s customers bought things
from customers of Bank B, it would be Bank A, the 100% reserve bank, that would lose its
gold to Bank B, the 98% reserve bank.
11
Third, FRB is economically destructive in that it is the causal antecedent of the
Austrian Business Cycle (ABC).0 FRB leads to an increase in the money stock,
compared to what it would have been in the absence of this institution; given
that this new money enters is lent into existence, it drives risk-adjusted, interest
rates down below the level that would otherwise have obtained. This, in turn,
encourages and rewards businesses and households that borrow and spend the
new funds before the price inflation that is the inevitable consequence of the
increase in the stock of money occurs. In general, this involves investing in the
most interest-rate-sensitive sectors of the economy and purchasing interest-rate -
sensitive consumers’ goods, which are incompatible with the unchanged time
preferences of the economic actors. When these misallocations can no longer be
sustained, there is a crisis that initiates a cleansing depression, undoing the mal
effects of FRB induced monetary/credit expansion.
With this as a background, we are now ready to explore the thesis of the present
paper: that not only is fractional reserve banking for demand deposits fraudulent,
but so also can time deposit banking be fraudulent, when there is a mismatch in
the time dimension between the bank’s borrowing and lending, such that it
borrows short and lends long.
In section II we explore the legitimacy of time-dimension-mismatched lending
and borrowing. We conclude in section III.
II. Mismatched time deposits
Suppose B borrows $100 from A for a year, and then lends that $100 to C, but
not for a single year; rather, for two years. Is this a legitimate market
transaction? At first blush, it is not: the time dimensions0 do not match. B the
banker is lending the $100 to C for a period of time, two years, that he, B, has no
proper control over. A lent B these funds to be sure, but only for one year, not
two. It is as if A lends B a book for a year, and B lends that book to C for two
years. B simply has no right to lend to C what he does not have in his proper
possession. A entrusted B with the book for one year, and B goes off and
0 On Austrian Business Cycle Theory (ABCT) see: Barnett and Block, 2005, 2006; Block,
2001; Block and Garschina, 1996; Carilli and Dempster, 2001; Garrison, 1994, 2001, 2004;
Garrison and Bellante, 1988; Hayek, 1931; Mises, 1998; Rothbard, 1975, 1993.
0 For the importance of dimensions in economic analysis see Barnett, 2003, 2004.
12
confers on C something he was not initially given by A.0 And what is true for
books is also the case for money.0
But the defense is not without an answer of its own. Suppose the following. At
the outset of our little tableau, A lends $100 to B for a year. B lends this “same”
$100 to C, for two years, as before. Now the first year is up, and A wants his
$100 back from B.0 B, of course, cannot demand this money back from C, for it
is not due for an entire additional twelve months, until the end of year two, and
at present it is only the end of year one. Whereupon B goes out into the market
and borrows $100 from D, for a year. He gives this $100 to A, absolving himself
of any problem with the latter. Now the end of year two arrives. C’s $100 is now
due to B. B takes these funds and turns them over to D, acquitting himself of any
difficulty with D. Case closed: B owes no one anything. Assuming appropriate
interest rate arrangements, B has earned profits sufficient to maintain himself in
business. Where is the rights violation, the defender of borrowing short and
lending long asks?
In this case, there is still that little matter of over determination of property titles,
precisely the shortcoming of FRB. Consider the situation during the first year of
our little scenario. There are not one but two people with a valid claim for that
$100 at the end of the first year. First of all there is A; he lent the $100 to B for
only one year, and has a legitimate claim on this money at the end of the year.
And then there is C who was told by B that these monies are not due back until
the end of year two. There is thus a logical incompatibility in this scenario,
similar to the one that emanates from FRB.0
0 We abstract from the possible difficulty that A does not want B to lend anything to C, for
any amount of time. We assume that B may lend to C what was entrusted to him by A; the
only issue revolves around the time dimension.
0 Dissimilar to cases of loans of books, lawnmowers, etc., which are not, in general, fungible
goods, and which require, therefore, the return of the exact item lent, money is a fungible
good, and therefore unless it is specified in the loan contract that the identical pieces of money
must be returned -- a term not to be found in real world contracts -- a loan of money may be
repaid with any equal amount of money.
0 Plus interest, of course, but we ignore this complication.
0
What of the possible objection to our thesis that the futures market would also have to be
banned if we are correct? There, too, the man who sells in a futures market promises to do
something that he does not have it in his power to do, at least at the present time. This
objection fails, for there is a relevant difference between the two cases: the person who
borrows short and lends long does something he has no right to do, whereas in the futures
market both buyers and sellers are only promising to do something in the future, but what
they promise is something they have every right to do, and therefore they have every right to
promise to do so.
13
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III. Conclusion
Fractional reserve demand deposits are not the only fraudulent banking practice.
Also to be added to this list are time deposits, where the bank borrows short but
lends long. This practice, borrowing short and lending long, is engaged in by
others than commercial banks; e.g., investment banks. Of course, investment
banks do not issue deposits, time or demand, when they borrow short. In fact,
the reason for the Bear Stearns collapse and bailout was the inability of this firm
to roll over or refinance its short-term debt when the credit markets seized-up.0
Because it could not roll over its short-term debt, Bear Stearns would have had
to pay it off as it came due. In turn this would have required BS to liquidate
assets immediately in order to acquire the necessary funds. Many of these assets
were derivatives of various kinds with thin markets, at best, or no markets at all.
Moreover, the quality of many of those assets had turned out to be significantly
lower than supposed because the underlying securities included subprime-
mortgage notes. Therefore, they would have had to have been liquidated in a
fire sale. That BS had a liquidity problem was obvious to all involved. But
mere liquidity problems can be overcome in various ways. The more serious
difficulty was that the fire sales were expected to reveal that BS was actually
bankrupt. That is, the revenues from the fire sales were expected to be so low
that BS’s liabilities exceeded its assets and it had negative equity, aka
insolvency.0
But it is most unlikely that the bankruptcy of BS would have been a sufficient
cause to for the Fed and the treasury to get involved, even though this process
undoubtedly would have been long, acrimonious, and expensive, as the various
claimants fought over whatever value was thought to remain.0 Rather, as they
themselves stated, the reason for the intervention was fear of systemic risk in the
financial system; i.e., they feared a breakdown of the financial system that
would have spread to the “real” economy. The cause of their concern was that
0 For more on this episode, see Reisman, 2008; Shostak, 2008
0 Thus the hue and cry among some that the haircut BS’s shareholders took under the
governmentally-arranged bailout was not short enough – their heads should have been
completely shaved.
0 Economic losses are generated when resources are misallocated. However, if it were
apparent that a use of resources was a misallocation, such use would never be undertaken. So,
mistakes are made, but they only come to light later when they manifest themselves as
financial losses. Bankruptcy proceedings are one method of distributing, ex post facto, the
losses among the various relevant parties.
15
the sale of BS’s assets at very low prices would have negatively affected other
financial institutions because of mark-to-market rules.0
These distress prices would have set benchmarks that other firms would have
had to use in pricing their assets, requiring them to write down the value of their
own assets. In turn, this would have eroded their capital, thereby threatening or
destroying their capital adequacy. Moreover, because the credit markets were
seizing up, these other firms, too, would have been unable to roll over their
short-term debt. With the short-term debt markets frozen and without the ability
to borrow long term0 the only alternatives would have been to raise capital by
selling equity or to reduce the need for capital by selling assets. It is true that
some major firms did sell equity stakes to sovereign wealth funds, but the cost to
the stockholders of the dilution of their share of the remaining assets was very
high, and in the cases of preferred stock, the interest rates and other terms were
very high. This meant that the FRS and the UST expected massive, fire sales of
assets that would have resulted in a financial meltdown that would have then
have led to such a widespread collapse of credit markets that non-financial
businesses would have been unable to fund operations, much less property,
plant, and equipment. That is, the FRS and UST feared that if BS were not
bailed out it would collapse, inducing a breakdown of the entire financial system
and concomitant crash of the “real” economy. These fears of the FRS and the
UST led to their efforts to force an orderly sale of Bear Stearns to JPMorgan
Chase; i.e., a bail out of BS, with all that implies for the too-big-too-fail
approach to governmental policy and attendant moral hazard in the guise of the
greater-fool approach to investing, the greater fools being the taxpayers.0
0 Mark-to market rules require that the value of a financial asset be recorded on the books at
the current market price for that, or similar, instruments. If no market exists, then (computer)
models are used to concoct a price.
0 Who would have lent capital to them long-term in such circumstances?
0 It would take us too far afield to argue for the laissez-faire public policy in this case. The
interested reader may consult Rothbard (1975), for the argument that bail outs, subsidies to
business, etc., are never justified, either on an economic or ethical basis.
16
References:
Barnett, William II. 2003. “The Modern Theory of Consumer Behavior: Ordinal
or Cardinal?” The Quarterly Journal of Austrian Economics. 6 (1): 41 − 65.
http://www.qjae.org/journals/qjae/pdf/qjae6_1_3.pdf
Barnett II, W. 2004. “Dimensions and Economics: Some Problems.” Quarterly
Journal of Austrian Economics. Spring. Vol. 7, No. 1, pp. 95-104
http://www.mises.org/journals/qjae/pdf/qjae6_3_2.pdf;
http://www.mises.org/journals/qjae/pdf/qjae7_1_10.pdf
Barnett, William II and Walter Block. 2005. “Professor Tullock on Austrian
Business Cycle Theory,” Advances in Austrian Economics, Vol. 8, pp. 431-443
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17
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18
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19
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20
Chapter 2. The Legitimacy of Loan Maturity Mismatching: A Risky, But Not
Fraudulent, Undertaking.
Phillip Bagus and David Howden
Abstract:
Barnett and Block (2008) attack the heart of modern banking by claiming that
the practice of borrowing short and lending long is illicit. While their claim of
illegitimacy concerning fractional reserve banking can be defended, their
justification lacks substance. Their claim is herein strengthened by a legal
analysis of deposits and loans based on Huerta de Soto (2006). A combined
legal and economic analysis shows that while lending deposits can be regarded
as illicit, the maturity mismatching of loans is legitimate contrary to Barnett and
Block's claim. No over-issuance of property rights is involved with this practice
once the distinction between present and future goods is taken into account.
However, while the practice is not illicit per se, it is greatly assisted and
developed through the presence of a fractional reserve banking system, and can
sometimes breed detrimental effects.
Key words:
Time deposits, private property rights, fraud, maturity mismatching, fractional
reserve banking
JEL category:
E2, E59, P16
Section:
Business and Law
The Legitimacy of Loan Maturity Mismatching: A Risky, But Not Fraudulent,
Undertaking.
21
Introduction
In their recent article “Time Deposits, Dimensions and Fraud” Barnett and
Block (2009) argue that if one accepts fractional reserve banking as fraudulent it
would follow that the general practice of borrowing short and lending long
should also be considered illicit. Hence, not only demand deposits would entail
fraudulent activity, but the argument could also be extended to time deposits.
While the use of demand deposits as loan collateral has been criticized by
several economists in the Austrian tradition,0 Barnett and Block reach into new
territory with their second, broader claim. In fact, their article could not be of
greater importance in face of the current economic crisis. By asking the crucial
question if borrowing short and lending long are legitimate market transactions,
we find the answer conveys important implications for the modern banking
system, which is largely based on the practice of maturity mismatching. In fact,
we maintain that the current economic crisis was caused by entrepreneurial error
surrounding such a practice, but that this practice is not fraudulent, and need not
always result in detrimental errors.
In their article Barnett and Block start with two additional assumptions
concerning fractional reserve banking besides that it constitutes an illegitimate
activity. They claim that such a practice would probably not survive in a free
economy and that it is economically destructive.0 Barnett and Block then try to
show that the first claim of illegitimacy holds true for maturity mismatching in
general. However, they do not investigate if the other two claims also hold true.0
Contrary to Barnett and Block, we take on this task and argue that while
maturity mismatching is not illicit, it would likely be diminished within the
constraints of free-banking, and can be economically destructive when coupled
0 See Bagus (2003), Hoppe (1994), Hoppe, Hülsmann and Block (1998), Huerta de Soto
(1995, 1998, 2006), Hülsmann (1996, 2000, 2008) and Rothbard (1991), for this point of
view.
0 They seem to imply a truism by stating: “[F]ractional reserve banking for demand deposits
could not long endure in the free enterprise system where property rights and the niceties of
bankruptcy law are respected.” Barnett and Block previously make the claim that fractional
reserve banking is incompatible with the respect of property rights. In fact, fractional reserve
banking could not endure for any period of time in the free enterprise system, as it would be
forbidden owing to this reason. From this perspective it seems superfluous for them to show
how competition would limit the extent of fractional reserve banking.
0 Although they do provide a case example with the recent Bear-Stearns collapse. This
exposition, however, only demonstrates tangential evidence that maturity mismatching breeds
detrimental effects.
22
with fractional reserve deposits. Consequently, we defend the thesis that
borrowing short and lending long is legitimate, even if it is fraught with peril.
While Barnett and Block's claim of illegitimacy for fractional reserve bank can
be defended, their justification lacks substance. Their claim can be strengthened
by a legal analysis of deposits and loans which we provide via a legal analysis
based on Huerta de Soto (2006). This combined legal and economic analysis
shows that using demand deposits in order to grant loans is illicit. Yet, the same
analysis shows that the maturity mismatching by lending intermediaries is
legitimate, contrary to Barnett and Block's claim. No “over-ownership” of
property titles is involved when the distinction between present and future goods
is accounted for. This follows from the fact that, in contrast to a deposit, lenders
give up the availability of loaned money during the full term of a loan contract.
We find that Barnett and Block ask both too much, and too little, of their
findings. Too much by claiming that maturity mismatching is fundamentally
fraudulent and should be treated as such. They claim too little, however, by
failing to seek the answer as to why in this specific instance maturity
mismatching has reaped such seemingly fraudulent results.
A legal and economic analysis of deposits and loan contracts
In order to make the argument that fractional reserve banking (i.e., using
demand deposits to grant loans) is illicit while maturity mismatching based on
borrowing short and lending long is licit, it is important to first investigate the
differences between deposits and loans. Huerta de Soto (2006) shows that both
deposit and loan contracts have a long tradition evolving from Roman law. They
both can involve specific (i.e., art) or fungible goods (i.e., money). Thus, a
deposit of a Rembrandt painting, 100 tons of wheat in a silo, or $100 with a
depositary may all be made. Similarly, a car, a gallon of olive oil, or $100 may
be lent to a borrower.
It is crucial to understand that there are clear legal and economic differences
between the two types of contract. In a deposit contract, the depositors deposit
goods with the depositary because they wish for the depositary to safe guard the
goods, while retaining at all time the availability of their use. It does not matter
if the good is a painting, wheat or money. A loan contract in contrast involves
the borrower relinquishing the availability of the car, olive oil or money for a
specified time period. This willingness to relinquish the availability stems from
generosity or in exchange for an interest payment. The differences between
23
deposit and loan contracts have evolved spontaneously under Roman law and
these differences were well known to Roman legal theorists at the time.
There are three main economic differences between monetary deposit and
monetary loan contracts.
First, in the monetary loan contract there is an exchange of present goods for
future goods. The borrower receives monetary units now in exchange for
monetary units that will be paid back in the future. Yet, in the monetary deposit
contract there is no exchange of present goods for future goods. Depositors do
not give up the monetary units but hold the right to claim them whenever they
wish on demand. A deposit with a depositary institution is undertaken as it is
thought to be a safer option than personally safeguarding the relevant good.0
Second, in the monetary loan contract the availability of the money is
transferred. The lender gives up, and the borrower gains, this availability and
use of the money until the end of the contract. In contrast, in the monetary
deposit contract there is complete and continuous availability of the money for
the depositor. One could even argue that the availability of the money is
improved for depositors as they regard it safer under the custody of the
depositary, and that additional availability services may be offered (i.e., ATMs,
debit cards, etc.).
Third, in the loan contract interest is paid as there is an exchange of present
goods for future goods.0 On the contrary, in the monetary deposit contract there
will be no such interest paid as there is no exchange of present goods for future
goods. Banks are able to pay interest on demand deposits by treating them as
loans, that is to say, by using the money in the present for profitable activity,
instead of holding it for safekeeping for the customer. By treating a demand
deposit in this manner, we find that banks violate their custody obligations by
appropriating the money for an alternative use, which enables them the profits to
pay interest on these otherwise interest-free deposits.
As a result of these three economic differences, there exist three main legal
differences between the two contracts.
0 Advocates of fractional reserve banking claim that monetary deposits do involve an
intertemporal exchange. However, from a legal perspective, the essence of a deposit is the
safeguarding principle and it does not involve an intertemporal exchange. Thus, advocates of
fractional reserve banking seem to argue that what is called a “monetary deposit” is really a
loan.
0 Although the interest payment might be waved out of friendship or other reasons.
24
First, the purpose of the two contracts is radically distinct. The essential element
or purpose of a loan is to transfer the complete availability of the present goods
to the borrower. The essential element or main motivation for the depositor in a
deposit contract is the safekeeping or custody of the money.0 The depositor pays
the depositary a fee for this safekeeping service. Second, the monetary loan
contract requires the establishment of a term for the return of the loan and the
calculation of the interest payment. On the contrary in a deposit contract there is
no term for returning the money. It is “on demand”; the depositor can withdraw
the deposit whenever they wish to do so. Third, the obligation for the borrower
and the depositary are different. It is the borrower´s obligation to return the
tantundem, and pay the required interest at the end of the stipulated term. On the
contrary, it is the depositary's obligation to keep the tantundem available to the
depositor at all times (i.e., he must hold a 100 percent cash reserve).
We may now come to a legal assessment of the legitimacy of fractional reserve
banking and the bank practice of using demand deposits to grant loans. There
are several possibilities to assess modern banking. First, if we assume that many
depositors are not aware of the fact that the bank does not safeguard their
deposits but uses them, we are faced with fraud. The bank appropriates the
deposit without knowledge of the depositors. This is the conclusion that Barnett
and Block reach by using a different argument.
Second, there also exists the possibility that depositors are aware of the bank's
use of their deposited money. In fact, this is likely true for many depositors
today. Let us assume that the depositor wants to make a genuine deposit and
knows that the money is going to be used by the bank (i.e., that the bank regards
the deposit as a loan). An indicator to the depositor that the money will be used
is the payment of interest. Payment of interest to the depositor is, as we have
seen, incompatible with a deposit contract. Instead it is the depositor who should
pay the depository for the safekeeping services! When the depositor is unaware
of the bank's use of the money we are faced with an error in negotio – the
contract is impossible from a technical and legal point of view. It is impossible
from a technical point of view as Barnett and Block vividly point out. Indeed, it
is logically impossible that both the bank and the depositor own the money and
maintain its full availability. The contract is also impossible from a legal point
of view as the purposes are contradictory. The bank receives the money as if it
would receive a loan and gains its availability while the depositor hands it over
0 For fungible goods such as money, it is not necessary to guard the same units as were
deposited. The depositary just has to safeguard the tantundem (i.e., an equivalent amount of
quantity and quality of the deposited good).
25
as if it were a deposit for safekeeping. Depositors is being deceived if they
believe that full availability of the money exists with this type of contract. As
Huerta de Soto (2006, 143) points out: “[L]egally null and void [is] any contract
in which one of the parties authorizes the other to deceive him or accepts in
writing self-deception to his own detriment.” In fact, even if the different
purposes of each side of the contract was clear and agreed upon the contract is
impossible to carry out at all times and therefore unenforceable.0
However, there is still a third possibility. The contract that involves the handing
of the money to the bank is neither a deposit or a loan but an aleatory contract.
Both parties would be aware of the fact that the bank uses the money. The
“depositor” would not have the availability of the money but the right to ask for
the money and the bank would try its best to give it to the “depositor”
(Hülsmann 2000, 108). Here it becomes a question of probabilistic
entrepreneurial forecasting if the bank would have the money or not when the
“depositor” asks for it. Yet, in our modern banking system the contracts are not
so clear. In fact, bankers can be somewhat deceptive when it comes to their
practices; they are reluctant to specify the precise nature of the contract and of
the safekeeping obligation. They may also fail to make clear whether they have
been authorized or not by the “depositor” to use the deposited money.0 As
Huerta de Soto (2006, 145) points out:
To fail to clarify or fully specify these details indicates a remarkable ambiguity
on the part of bankers, and in the event that adverse legal consequences result,
their weight should fall on the bankers’ shoulders and not on those of the
contracting party, who with good faith enter into the contract believing its
essential purpose or cause to be the simple custody or safekeeping of the money
deposited.
Thus, at least without clear and unambiguous contracts it seems hard to defend
our present fractional reserve banking system from a both a legal and ethical
point of view.
0 We must stress again, the contradictory nature of these contracts makes them unenforceable
both in practice, and legally. Both parties cannot legally agree to any contract based on
contradictory terms (i.e., that both may have full availability of the money under contract).
The practical problems that arise in enforcing such contracts becomes evident given this legal
insight.
0 One example of this ambiguity is the conduct of bankers regarding “time deposits.” Time
deposits have a term and the saver renunciates the availability of the deposit for this term in
exchange for interest. Hence, time deposits become loans to the bank; they are not deposits. It
becomes, as a result, confusing to call them “time deposits.” The strong distinction between
demand deposits and time deposits becomes blurred.
26
Legitimacy of maturity mismatching
Although lacking substance, Barnett and Block's critique of fractional reserve
banking comes close to our legal and economic analysis. They thus state:
“[F]ractional reserve demand deposits are illicit because they involve the
creation of more property titles than there is property in existence.” We see that
a depositor has the title to the deposited money and at the same time the banks
makes use of it by granting a credit based on its use as collateral. They refer to
the technical and logical impossibility that both the bank and the depositor can
claim the money at the same time. While their analysis is correct, the
complementary legal analysis is much richer by explaining the contradictory
nature of such contracts even if depositors are aware of the appropriation of the
deposited funds by the bank.
Unfortunately, Barnett and Block's lack of legal analysis also contributes to their
misguided condemnation of maturity mismatching. It is a non sequitur to deduce
from the illegitimacy of fractional reserve banking the illegitimacy of maturity
mismatching in general. This can be best shown by analyzing the following key
passage where they discuss the example of a bank that uses a demand deposit,
granting part of it as a loan, thus holding only a fractional reserve:
The cause of the [fractional reserve banking] problem is that the bank had no
right to make such loans, because it did not have the relevant elements of
ownership of the deposited funds. That is, it had title to the funds only for period
[sic] for which it had borrowed them, so it only had the right to lend these
monies for a period ending no later than the time at which it had to repay the
loan by which it acquired the funds it lent.
Barnett and Block are correct that the bank had no right to use the deposited
money. Yet, this is not because there was no transfer of ownership of the
monetary units, but rather because the purpose of a genuine deposit contract is
safekeeping.0 The obligation of the depositary is holding a 100% cash reserve;
doing otherwise is a breach of contract. Putting this difference aside, the authors
are right that the bank had no right to make such loans. However, the second
0 Legally, the ownership of the individual money units is transferred to the depositary. Thus,
the transfer of ownership in the monetary deposit contract can lead to the belief that the
monetary deposit contract is a loan. However, the depositor maintains the complete
availability of the money units and remains the owner in the material sense. It could well be
argued that there is no true transference of ownership in the monetary deposit contract, but
rather that “the concept of ownership refers abstractly to the tantundem or quantity of goods
deposited and as such always remains in favor of the depositor and is not transferred” (Huerta
de Soto 2006, 5).
27
sentence does not seem to follow from the first nor does it seem to be implied in
it. In fact, the bank never borrowed the money as Barnett and Block seem to
imply. Deposits are not loans; therefore, depositories do not have the right to use
deposited funds as if they were loans. In distinction, borrowers have the right to
use the borrowed funds made available to them. This is the purpose of a loan
contract – the transfer of the availability of the funds in question. This breeds the
following question, namely, if banks are allowed to make loans for a longer time
period than loans were received by them.
It may first be pointed out that we agree with Barnett and Block that loan
contracts are legitimate contracts. In these contracts the availability of funds is
transferred to the borrower until the term of the contract expires. The borrower
can do with these funds whatever they please during this period. The only
obligation is the return of the tantundem plus the stipulated interest upon expiry
of the term. Now, would loan maturity mismatching be illegitimate? In contrast
to Barnett and Block, it does not appear so.
If B borrows $100 from A for a year, and then lends $100 to C for two years no
rights are violated. This is so because borrower B has received full availability
of the $100 for a year and may use it however they wish. The only obligation
inherent in the contract is the remittance of $100 plus interest at the end of the
year. B can certainly do so even though a simultaneous loan of $100 is made to
C for two years. As Barnett and Block correctly point out, B could try to find a
person D that is willing to lend him $100 at the end of the first year to return the
loan to A.0 B's procedure might be considered risky or even foolish but it does
not violate anyone's rights. From legal, economic and logical perspectives there
is no problem with this use of a loan, in contrast to the use of a deposit. How do
Barnett and Block justify the alleged illegitimacy of borrowing short and
lending long? Relying on their above example their argument boils down to:
[T]here is still that little matter of over determination of property titles, precisely
the shortcoming of FRB. Consider the situation during the first year of our little
scenario. There are not one but two people with a valid claim for that $100 at the
end of the first year. First of all there is A; he lent the $100 to B for only one
year, and has a legitimate claim on this money at the end of the year. And then
there is C who was told by B that these monies are not due back until the end of
year two.
0 There are also other ways for B to fulfill the contract. They may sell assets in order to fulfill
the contract, obtain payment by C, or ask the A for an extension on the original loan.
28
There are two main short-comings with this argument. First of all, contractual
obligations can still be fulfilled. Money is a fungible good as Barnett and Block
seem to recognize. If the loan would be a Rembrandt painting and A lent it for
one year to B and B lent it for two years to C, B, of course, could not fulfill their
original contract and would assuredly fail to do so at the end of the first year.
However, as money is a fungible good, B can honor both the contract and his
obligations. At the end of the first year, A has a claim to some $100 and during
the first year C has the claim to another $100. They are not the same $100
dollars as Barnett and Block seem to think.
Second, there is no over-subscription of property titles. The 100 present dollars
are always owned by no more than one person. Barnett and Block neglect that
loan contracts do not deal solely with present goods. Loan contracts constitute
an exchange of present goods for future goods. The $100 that A lends to B
represents present goods and are transferred from B to C. The $100 that B has to
give to A in one year are future goods. These $100 of future goods are distinct
from the $100 of present goods and also from the 2-year future goods that C
owes to B. As the loan contract is always in terms of future versus present
goods, there can never be a contradictory legal nature leading to an over-
subscription of property titles, unlike that which may occur with demand deposit
contracts based on continual and full availability of the funds. Goods may only
become oversubscribed, as Barnett and Block wish to demonstrate, if claims
against them exist in the same temporal moment.
We see that $100 today are not the same as the $100 in a year nor the $100 in
two years. Thus, there is no over-subscription in property titles, as they are titles
to different kinds of goods, namely to present goods (money available on
demand), future goods (money made available in one year's time) and future
goods (money made available in two years' time). At the end of the first year
there is no over issuance of property titles either. When B pays off his debt with
A, there exist $100 of present goods in A's hands and the claim to $100 in one
year by B.
Detrimental effects from maturity mismatching
While maturity mismatching is legitimate in contrast to today's fractional
reserve banking system, it shares with fractional reserve banking the feature that
it would probably not survive in a world of free-banking (or at least see its
prominence greatly reduced) and that it also has the potential to be economically
destructive.
29
Without a central bank as a lender of last resort, borrowing short and lending
long is a very risky business. Banks are continuously forced to roll over their
short term liabilities to cover longer term loans. More sound competitors might
lend to the maturity mismatched banks on a short term basis and together initiate
a run on the bank in the sense that they suddenly refrain from allowing the bank
to roll over with fresh loans. This would place a considerable check on the
amount of maturity mismatching in practice. Additionally, speculators could
assume a position as a short-term lender to such banks and simultaneously short
the bank's stock. By eliminating or reducing the amount of maturity roll over,
the maturity mismatched bank can suffer severe liquidity problems, resulting in
a falling stock price and benefits reaped by the speculators.
When coupled with fractional reserve banking, maturity mismatching may be
economically destructive and serve as the causal antecedent of the Austrian
Business Cycle.0 Often credit expansion is viewed as the sole source of this
cycle. In fact, credit expansion and detrimental issues surrounding maturity
mismatching are two sides of the same coin.
The classical example of credit expansion is the investment of demand deposits
– debts that are due at every instant – by granting a several year loan to a
company that finances a long-term investment project using these demand
deposits as collateral. As Mises (1953, 263, citing Knies (1876, 242)) states
about maturity mismatching in general:
For the activity of the banks as negotiators of credit the golden rule holds, that
an organic connection must be created between the credit transactions and the
debit transactions. The credit that the bank grants must correspond quantitatively
and qualitatively to the credit that it takes up. More exactly expressed, 'The date
on which the bank's obligations fall due must not precede the date on which its
corresponding claims can be realized.' Only thus can the danger of insolvency be
avoided.
The case of maturity mismatching using time deposits rather than demand
deposits shifts the issue slightly. Risk is reassigned from one party (the
borrower) to another (the lender). If there existed no market for mismatched
term durations for loans, borrowers could only borrow from lenders willing to
match their time horizons or they would be faced with borrowing short-term
themselves and rolling over their loans periodically as the durations dictated.
0 On Austrian Business Cycle Theory (ABCT) see: Bagus (2007, 2008), Bagus and Howden
(2009), Garrison (1994, 2001), Hayek (1929, 1931), Huerta de Soto (2006), Hülsmann
(1998), Howden (2008), Mises (1998), and Rothbard (1975, 1993).
30
Absent a lender of last resort (i.e., a central bank with unlimited credit issuing
power), it becomes clear that the extent of this practice would be curtailed. If the
sole source of lending were in the hands of institutions foregoing present
consumption to make these loans, the amount of future loans would be limited –
the need for future consumption would continually place downward pressure on
the amount of available loanable funds. However, a central bank has in its power
the ability to continually create loans (i.e., credit) and hence ensure that future
lending possibilities will be made available. As lending intermediaries realize
this, they can begin extending their mismatching to a level not deemed
appropriate under an environment with an expectation of more limited future
loans. The recent turmoil provides a case in point.
Absent fractional reserve banking, maturity mismatching allows investments to
be undertaken in the present, with no strict guarantee that future consumption
will be adequately curtailed to allow the resource availability needed to
complete the projects. Entrepreneurial forecasting will guide how effective the
future dated loans will be with respect to their ability to be continually re-
financed through additional short-term borrowing. As entrepreneurs may err in
this function, losses may result much like the market has been plagued with
recently; this in no way constitutes fraudulent activity. To the extent that this
practice is combined with fractional reserve banking, we see the increased
possibility for entrepreneurial error to result as the coordination process of
present and future loans is disrupted.
31
Conclusion
Barnett and Block tackle a very important question for understanding our recent
economic turmoil as the crisis is marked by a huge amount of maturity
mismatching. Is this maturity mismatching legitimate? They argue that
analogous to fractional reserve banking it is not. In this article a legal and
economic analysis of two fundamentally different types of contract – deposit
and loan – has been made. Deposit contracts require the depositary to hold a
100% cash reserve, available on demand. Fractional reserve deposit banking is
therefore illicit. However, loan maturity mismatching is a legitimate economic
transaction as the only obligation of the borrower is the return the tantundem at
the end of the contract. Barnett and Block maintain that in mismatching loan
contracts there is over-issuance of property rights. However, for fungible goods
there is no right to specific units of a good specified in a loan contract. Thus, it
is possible that mismatched loan contracts will be honored. Consequently, they
are found to be legitimate. Moreover, loan contracts are exchanges of present for
future goods. As the titles to these different goods are also different in nature,
there is no over-issuance of property titles.
While loan maturity mismatching is a legitimate activity, its amount would
probably be very reduced on a free market due to its inherent riskiness and the
continual check of competition. Moreover, loan maturity mismatching can be
the cause of an Austrian Business Cycle when coupled with fractional reserve
banking and its inherent credit creation. As such, the present crisis which is
characterized by a huge amount of maturity mismatching is at least partially
caused by this exact process, and the entrepreneurial errors it has bred. We may
thank both Barnett and Block for bringing attention to maturity mismatching as
one source of today's market turmoil. However, while we may agree that
fractional reserve banking constitutes fraudulent activity, we fall short of
making the same endorsement concerning maturity mismatching.
32
References
Bagus, Ph.: 2003, ‘The Commons and the Tragedy of Banking’, November 12,
http://mises.org/story/1373
Bagus, Ph.: 2007, ‘Asset Prices – An Austrian Perspective’, Procesos de Mercado:
Revista Europea de Economía Política 4(2), 57-93.
Bagus, Ph.: 2008, ‘Monetary policy as bad medicine: The volatile relationship
between business cycles and asset prices’, The Review of Austrian Economics 21
(4): 282-300.
Bagus, Ph. and D. Howden: 2009, ‘The Subprime Solution: How Today's Global
Financial Crisis Happened, and What to Do About It. By Robert J. Shiller: A
Review’, Quarterly Journal of Austrian Economics. Forthcoming.
Barnett, W: II and W. Block: 2009, ‘Time Deposits, Dimensions and Fraud’,
Journal of Business Ethics.
Garrison, R. W.: 1994, ‘Hayekian Triangles and Beyond’, in J. Birner and R. van
Zijp, (eds.), Hayek, Coordination and Evolution: His Legacy in Philosophy,
Politics, Economics, and the History of Ideas (Routledge, London).
Garrison, R. W.: 2001, Time and Money: The Macroeconomics of Capital
Structure (Routledge, London).
Hayek, F. A.: 1929, Geldtheorie und Konjunkturtheorie (Gustav Fischer, Vienna).
Hayek, F. A.: 1931, Prices and Production (Routledge, London).
Hoppe, H.-H., with J. G. Hülsmann and W. Block: 1998, ‘Against Fiduciary
Media’, Quarterly Journal of Austrian Economics 1(1), 19-50.
Hoppe, H.-H.: 1994, ‘How is Fiat Money Possible? or, The Devolution of Money
and Credit’, Review of Austrian Economics 7(2), 49-74.
Howden, D.: 2008, 'Stability of Gold Standard and its Selected Consequences: A
Comment', Procesos de Mercado: Revista Europea de Economía Política 5(1),
159-175.
Hülsmann, J. G.: 1998, ‘Toward a General Theory of Error Cycles’, The Quarterly
Journal of Austrian Economics 1(4), 1-23.
33
Hülsmann, J. G.: 1996, ‘Free Banking and the Free Bankers’, Review of Austrian
Economics 9(1), 3-53.
Hülsmann, J. G.: 2000, ‘Banks Cannot Create Money’, The Independent Review: A
Journal of Political Economy 5(1), 101—110.
Hülsmann, J. G.: 2008, The Ethics of Money Production (Ludwig von Mises
Institute, Auburn AL).
Huerta de Soto, J.: 1995, ‘A Critical Analysis of Central Banks and Fractional-
Reserve Free Banking from the Austrian Perspective’, Review of Austrian
Economics 8(2), 25-38.
Huerta de Soto, J.: 1998, ‘A Critical Note on Fractional-Reserve Free Banking’,
The Quarterly Journal of Austrian Economics 1(4), 25-49.
Huerta de Soto, J.: 2006, Money, Bank Credit and Economic Cycles (Ludwig von
Mises Institute, Auburn AL.)
Knies, K.: 1876, Geld und Kredit. Vol. II (Berlin: Weidmännische Buchhandlung)
Mises, L.: [1949] 1998, Human Action (Ludwig von Mises Institute, Auburn, AL.).
Mises, L.: [1912] 1953, The Theory of Money and Credit (New Haven, Yale
University Press).
Rothbard, M. N.: [1962] 1991, ‘The Case for a 100 Percent Gold Dollar’, In
Search of a Monetary Constitution, Leland B. Yeager, ed., (Harvard University
Press, Cambridge, MA), pp. 94-136.
Rothbard, M. N.: [1962] 1993, Man, Economy, and State (Ludwig von Mises
Institute, Auburn, AL.).
Rothbard, M. N.: [1963] 1975, America's Great Depression (Sheed and Ward,
Kansas City).
34
Chapter 3. Rejoinder to Bagus and Howden on Borrowing Short and Lending
Long
William Barnett II and Walter E. Block
35
Rejoinder to Bagus and Howden on Borrowing Short and Lending Long
Abstract:
In Barnett and Block (2009) the present authors claim that borrowing short and
lending long is fraudulent, and thus ought to be prohibited on legal grounds.
Bagus and Howden (2009) take issue with our ethical analysis. The present
paper is our response to these authors; it is an attempt to defend Barnett and
Block (2009) against the very interesting and important, although we believe,
erroneous, criticisms of Bagus and Howden (2009).
Key words:
Banking, fraud, fractional reserves, natural law, continuum problem
JEL category:
E2, E59, P16
36
Rejoinder to Bagus and Howden on Borrowing Short and Lending Long
We are extremely grateful to Bagus and Howden (2009) for their critique of our
article Barnett and Block (2009). Their essay is fair minded (they take us to task
for what we have actually said, not for what we have not said; in all too much of
the literature of this sort, the critic avoids this requirement, and instead engages
in straw man argumentation). This is not at all true in the present case; thus, we
have attained real disagreement with our critics, instead of acting as "ships that
pass each other in the night."
Not only is their critique on point, it was most convincing. At several times in
the writing of this our reply, we were on the verge of actually agreeing with
them, and renouncing our own views. In the event this is not to be, as our
response, see below, constitutes a reiteration and defense of our original view,
and thus a rejection of theirs. However, we found their arguments very incisive,
and thus were forced to "dig deeper" than we had thought we would be able to
do. Had we but contemplated their excellent albeit, we think, erroneous
objections, we would have incorporated and answered them in our original
paper. We had not. Thus, we are extremely grateful to them for enabling us,
forcing us, to confront the difficult issues addressed in both our papers.
Although Bagus and Howden (2009), hereinafter BH, take a different path than
Barnett and Block (2009), hereinafter BB, they arrive at the same conclusion:
fractional-reserve demand-deposit banking is illegitimate. Therefore, this paper
does not consider the differences in reasoning that brought about this result.0
Moreover, shortly after our original paper (Barnett and Block, 2009, or BB) we
published another essay (Barnett and Block, 2009A) on the consequences for
business cycles of borrowing short and lending long. Similarly, BH also
understand as do Barnett and Block (2009A) that maturity mismatching
regarding loans of time deposits can have detrimental effects. In contrast, BH
emphasize the microeconomic effects whereas BB emphasizes the business
cycle implications, noting particularly how such mismatching plays a causal role
in the misallocation of resources that constitutes the boom phase of Austrian
Business Cycles. So we set this topic aside also. Instead, this paper addresses
BH’s claim that borrowing short and lending long by an intermediary, provided
that the intermediary party is not lending out funds deposited with it, should not
be illicit. Two issues are raised herein. The first is that of a continuum problem.
The second has to do with the concept of future goods.
0 This is not to suggest that the issues raised by the different reasoning are either unimportant
or uninteresting.
37
Consider the concept of a demand deposit. BH (400) use such expressions as: 1)
“…depositors …retain[] at all time the availability of [the deposited goods]
use;” 2) “Depositors …hold the right to claim [the deposited monetary units]
whenever they wish on demand;” and, 3) “… in the monetary deposit contract
there is complete and continuous availability of the money for the depositor.”
But time is a continuum, at least for our purposes. This presents a problem for
the concept of “demand deposit.” For example, assuming arguendo that BH’s
hypothesis that BB’s approach (to intermediated monetary transactions of the
type considered herein)0 is invalid and that their perspective based on a clear
distinction between a deposit and a loan is valid, one asks what is the relevant
time period that separates a loan from a deposit? For example, A wishes to
establish an account with B in which A turns money over to B with the
expectation that B will later on return it to A. If the term of the contract requires
that A, upon making a demand for the return of his funds, may be required to
wait before they are returned, does this render the contract a time deposit?
Suppose the waiting period to be one second? five seconds? 10 seconds? What
is the maximum period of contractually allowed delay between demand and
return that still qualifies the relation as a deposit and not a loan? One sees the
problem, we hope. Say the relevant period is one minute; then all an
intermediary has to do to convert demand deposits into time deposits, thereby
skirting BH’s objection to lending out funds so acquired, is to insert a clause
allowing, but not requiring, such a delay into its contracts, making sure to
clearly inform the intermediary’s clients to that effect, and, lo, the issue, no
doubt along with all demand deposits, disappears, as all demand deposits
become time deposits, in one fell swoop. (One is entitled to ask, “who gets to
make the decision as to the relevant time period?” In a truly free society, no
definitive answer would be forthcoming.)0 Therefore, we conclude that
distinguishing between demand deposits and time deposits, insofar as
maintaining that it is fraudulent to borrow short and lend long if a particular type
of financial transaction is referred to as a demand deposit but not fraudulent if it
is referred to as a time deposit, is inapposite.
BH (400) make much of a purported difference between present goods and
future goods. On numerous occasions in their missive BH refer to "future
goods." Apart from, perhaps, science fiction, there are, at any given time, that is,
0 For the purposes of this paper, BB’s approach is that the relevant distinction is between
lending borrowed funds for a period longer than that for which they were borrowed and
lending borrowed funds for a period no longer than that for which they were borrowed. We
refer to the former phenomenon as borrow short – lend long (bsll).
0 This is because of the continuum problem. See on this Block and Barnett, 2008.
38
at all times, no such thing as "future goods." Yes, there are half completed cars
and sweaters which are scheduled to become finished in the future, and there are
capital goods whose function it is to render partially completed goods to fully
completed ones, but none of these things can be properly characterized as
"future goods." Rather, these are all present goods: present half completed cars
and sweaters, present capital goods, e.g., present machines to create finished
cars and sweaters, present wool, glass, rubber, knitting machines etc.
Nor is this, merely, a matter of infelicitous and misleading nomenclature. BH’s
criticism of BB rests heavily on the distinction between the present and the
future, and we fear that their employment of erroneous terminology may well
have led them astray.
BH (400) state:
First, in the monetary loan contract there is an exchange of present goods
for future goods. The borrower receives monetary units now in exchange
for monetary units that will be paid back in the future. Yet, in the monetary
deposit contract there is no exchange of present goods for future goods.
Depositors do not give up the monetary units but hold the right to claim
them whenever they wish on demand. A deposit with a depositary
institution is undertaken as it is thought to be a safer option than personally
safeguarding the relevant good.4
BH continue in their own footnote 4 as follows:
Advocates of fractional reserve banking claim that monetary deposits do
involve an intertemporal exchange. However, from a legal perspective, the
essence of a deposit is the safeguarding principle and it does not involve an
intertemporal exchange. Thus, advocates of fractional reserve banking
seem to argue that what is called a “monetary deposit is really a loan.
But there can be no ‘exchange of present goods for future goods,” because
future goods do not (yet) exist.0 According to Mises (1998, 93) goods are means
to ends. Moreover, Mises (1998, 521) states: “As the consumers' goods are
present goods, while the factors of production are means for the production of
future goods….” It is obvious from this that that future goods do not exist.
Rather, what exists are but present expectations as to future goods; i.e., these are
0 Barnett and Block (2007, 134, n. 16).
39
means0 that we expect to exist at some point in the future.0 Moreover, according
to Rothbard (2004, 68):
Goods being directly and presently consumed are present goods. A future
good is the present expectation of enjoying a consumers’ good at some
point in the future. A future good may be a claim on future consumers’
goods, or it may be a capital good, which will be transformed into a
consumers’ good in the future. Since a capital good is a way station (and
nature-given factors are original stations) on the route to consumers’ goods,
capital goods and nature-given factors are both future goods.
We include the above quote from Rothbard, but note problems therewith. First,
he implies that only: “Goods being directly and presently consumed are present
goods.” [Bold emphasis added]. Therefore, for him, as he states: “A future good
may be a claim on future consumers’ goods, or it may be a capital good, which
will be transformed into a consumers’ good in the future.” But that definition
flies in the face of ordinary English usage. First, current claims against as yet
non-existent future goods are but promises with the expectations that such
promises will be honored at the relevant time in the future. And, capital or
producers’ goods are currently existing goods, not future goods.
BH (400) state: “The borrower receives monetary units now in exchange for
monetary units that will be paid back in the future.” Consider, then, a monetary
loan contract: it consists of an exchange of present goods in the form of money
for a different present good; to wit, a promise,0 whether reduced to writing or
not, to return at a specified time or times, the principal along with interest. As
future goods do not (yet) exist, the lender cannot receive a future good or goods
in return for the present good (money) with which he parts. Contra BH (400),
the borrower does not “receive […] money now in exchange for monetary units
that will be paid back in the future,” but rather for a (mere?) promise of money
to be paid back in the future. [Bold emphasis added.] That borrowed money
will be paid back in the future is an assumption, not verity; in fact, much
0
Mises (1998, 521) states that: “…the factors of production are means for the production of
future goods.”
0
In Austrian economics, capital goods are referred to as higher order goods (order two and
higher) to distinguish them from goods of the first order - consumers’ goods. In Garrison’s
(2001) perhaps better terminology, they are referred to as earlier order goods.
0
From the point of view of morality, it makes no difference whether the promise is made in
writing or not, whereas from the economic point of view, the promise may involve less risk to
the lender if it is.
40
borrowed money is not repaid, witness the events of the last few years.
Therefore, BH’s distinction between a monetary loan contract and a monetary
deposit contract on the grounds that the former involves an exchange of a
present for a future good whereas the latter does not, is invalid.
As to the nature of a demand deposit, consider first 100% reserve banking. A
deposits $100 with B. What does A receive in return? It is a (current) promise,
backed, perhaps, by insurance,0 by B that he will safeguard, $100, although not
necessarily A’s $100, because money is fungible, and return $100 upon demand
by A. B makes this promise in return either for upfront payment of fees by A
for expected services or for promises of such fees if and when the services are
rendered by B. In any case, because we, as do BH, look upon this a warehouse
function, no title to $100 transfers from A to B, nor has A made a loan of $100
to B, therefore the issue of borrowing short and lending long does not even arise.
Second, in sharp contrast, consider the nature of “fractional-reserve demand
deposits.”0 A deposits $100 with B. What does A receive in return? It is a
0 We refer here to market, not governmental or governmentally subsidized, insurance against
natural disasters and/or thievery of one type or another.
0 BH, Huerta de Soto, and many others to the contrary notwithstanding, at least in the U.S.
demand deposits are, legally, loans from the depositor to the depository institution. This was
made clear in Marine Bank v. Fulton Bank 69 U.S. (2 Wall.) 252, 255-256, where the U.S.
Supreme Court stated (emphasis added):
But here we are reminded of the banking character of the agent, who insists
that it was impossible to keep plaintiff's money separate from its own, and that
plaintiff knew this fact, and secondly that from the course of business it was
understood that when the money was collected and placed to the credit of plaintiff's
account, the defendant would use it.
As to the first proposition, it cannot be admitted that there was any
impossibility in keeping plaintiff's money separate from defendant's. It is every day
business for bankers, who have vaults and safes, to receive on special deposit small
packages of valuables, and even money, until the owners call for them. There is not
only no impossibility in this, but there is no serious difficulty in it. It is simply an
inconvenience, and but a slight one, as placing a small slip of paper around the bills,
labeled with the owner's name, would have marked their identity and their separation
from the property of others’, without occupying any additional space. Even this
inconvenience the defendant could have avoided at any time by refusing any longer to
hold the deposit. But the truth undoubtedly is, as stated in the second branch of the
proposition, that both parties understood that, when the money was collected, plaintiff
was to have credit with the defendant for the amount of the collection, and that
defendant would use the money in his business. Thus the defendant was guilty of no
wrong in using the money, because it had become its own. It was used by the bank in
the same manner that it used the money deposited with it that day by city customers;
and the relation between the two banks was the same as that between the Chicago
bank and its city depositors. It would be a waste of argument to attempt to prove that
this was a debtor and creditor relation.
41
(current) promise by B that he will disburse $100 upon demand by A,
accompanied frequently, with below cost transactions services and/or interest
payments. B makes this promise in return for the loan of the deposited funds
which B expects to invest, save for a reserve (required by law in the U.S.), in
various ways in the expectation of earning sufficient returns to cover all of his
expenses plus a profit. To the extent that B’s investments are not demand loans,
such activity constitutes borrowing short and lending long.
BH (399) characterize our disagreement as one regarding "maturity mismatching
in general." Not so, not so. We favor legal prohibition for only one type of
"maturity mismatching," borrowing short, lending long (BSLL), but not for
another, borrowing long, lending short (BLLS). For all we know this may be no
more than a typographical error of theirs, but it is good to get the record straight,
just in case.
It is not at all "superfluous" (BH, 404-405, endnote #2) to show that even in an
otherwise free economy, one that did not prohibit fractional reserve banking
(FRB) by law, still, this system would tend to fall part due to its inner
contradictions. We herein assume that in a free society it would not be illegal to
impugn the financial reliability of FRBs to meet their contractual obligations.0
All deposits made with bankers may be divided into two classes -- namely,
those in which the bank becomes bailee of the depositor, the title to the thing
deposited remaining with the latter; and that other kind of deposit of money peculiar
to banking business, in which the depositor, for his own convenience, parts with the
title to his money, and loans it to the banker; and the latter, in consideration of the
loan of the money and the right to use it for his own profit, agrees to refund the same
amount, or any part thereof, on demand. The case before us is not of the former class.
It must be of the latter. The parties seem to have taken this view of it, as is shown by
the reply made by the Chicago bank, May 1 and 6, to the New York bank, when
inquiring how the account stood.
The counsel have argued as to the effect of mixing the money of plaintiff with
that of defendant. In the view we take of the matter, there was no such admixture. It
being understood between the parties that, when the money was received, it was to be
held as an ordinary bank deposit, it became by virtue of that understanding the money
of the defendant the moment it was received.
Thus, whether we like it or not, whether we think it moral or immoral, whether we
think it logical or not; i.e., whether we think that to maintain that a demand deposit is a loan is
an oxymoron, de facto an de jure, at least in the U.S., a demand deposit is a loan.
Of course, we do not agree that such should or would be the case in a truly free
society; rather, we reject that position. That is, we are in this footnote merely reporting on the
law as it currently holds. We are not supporting it. Indeed, in our view, it is completely
misbegotten.
0 For the libertarian opposition to libel laws in general, see Rothbard, 1982; Block, 1976.
42
Paraphrasing accurately BB (712), BH (404-405, endnote #2) state: "FRB is
incompatible with the respect of property rights," to argue that BB’s point that
FRB could not survive in a market absent governmental deposit insurance,
central bank lender-of–last-resort activity, and laws prohibiting impugning FR
banks for just that activity, is superfluous.
But "superfluity" depends upon the goals of the writers themselves. And, our
goal was (and still is) to drive a stake through the heart of the intellectual case
for FRB. We believe in "piling on": exposing every flaw in this pernicious and
immoral practice. Why should we limit ourselves to what critics might consider
to be non superfluous?
Curiously, BH (399) then take us to task for not investigating "two other
claims": whether "maturity mismatching ... would likely be diminished within
the constraints of free-banking and can be economically destructive when
coupled with fractional reserve deposits."
This is more than passing curious. First, BH criticizes us for being superfluous.
Now, they tax us for not going off on a tangent. Our view on this matter is that
as a general rule, it is legitimate to criticize an author for what he says, on topics
he has chosen to address, but not for failing to address topics that the critic
would like the author to contemplate. We do not accept this criticism, as on BB
(712, endnotes omitted), we state:
Second, fractional-reserve banking for demand deposits could not endure
for long in the free enterprise system where property rights and the niceties
of bankruptcy law are respected, save for the possibility (probability?) that
they might be able to exist with very high reserve ratios, say 98% or more,
but this is an empirical question. For fractional-reserve banks (FRBs)
would be immediately subject to negative clearing house accounts by 100%
reserve banks demanding immediate payment for their paper and/or
demand deposits. And, since failure to immediately make good on any and
all demand deposits outstanding against a bank constitutes bankruptcy, and,
since bankruptcy in turn is grounds for immediate dissolution of a company
guilty of so egregious behavior, the prognostication for such companies is
not a positive one. Again, it must be noted that this is an empirical, not a
praxeological claim. That is, there is always the possibility that, for reasons
that need not concern us in detail,3 the 100% banks would not call for the
immediate payment of all demand deposits and notes issued by the FRBs.
If so, immediate bankruptcy would not be the necessary result.4 Moreover,
43
the differential clearing rate need not necessarily favor the 100% bank, as it
would depend on the relative sizes of the different banks extant and the
actual patterns of money transfers among their depositors.5
As to the question of whether “maturity mismatching (again, BSLL, but not
BLLS) be economically destructive" (BH, 399), we do take up the latter issue in
Barnett and Block, 2009A.
Another lacuna in our paper according to BH (399) with regard to our "claim of
illegitimacy for FRB" is that it "lacks substance." Of course it does. In BB we
were not at all concerned to re hash the well documented proofs of FRB's
illicitness. We were addressing an entirely different issue: the impropriety of
BSLL. So, we contented ourselves with citing the literature demonstrating the
flaws in FRB. Once again, we must insist that not every paper can consider all
topics. There must be specialization and division of labor in intellectual essays
as in everything else; it is unfair to be criticized for not dealing with all possible
topics. It makes as much sense for BH to upbraid us on this ground as it would
were they to do so for not writing about, in BB, the sunspot theory of global
warming, or the poetry of Shakespeare, or the music of Mozart.
A bit of central planning, genus financial regulation, has somehow snuck into
the BH analysis. We expect this is inadvertent, but these authors (BH, 401) do
say "Payment of interest to the depositor is, as we have seen, incompatible with
a deposit contract. Instead, it is the depositor who should pay the depository for
safe-keeping services."
This may well be true. Indeed, it probably is, in the overwhelming majority of
cases. But it is by no means the praxeological certainty that these authors make
it out to be. Have they never heard of sales publicity? In such a case, customers
are actually paid to take goods off the hands of vendors (there is a negative
"price") as a public relations or advertising ploy. Suppose a business firm were
to notify the public that the first 100 "customers" to deposit money (or wheat,
clothes, furniture) with them would not only get this service at a reduced price,
nor, even, for free, but that the warehouse would actually pay them.0
Based on what they say, however, BH would have to conclude that this
depositor did not deposit anything, after all, but rather, since he was paid to do
0 We write this about a year after the passing of Michael Jackson. Based on the publicity
accorded this rock star, it is likely that if a warehouse could announce that Michael Jackson
had entrusted it with his valuables - (the warehouse paid Jackson to do so), it would have been
well worth it to the warehouse for the publicity it could thereby garner.
44
so, he was, wait for it, a lender! Their error lies in thinking that who pays whom
is the definitive determinant of whether a financial transaction is a deposit or a
loan. It is not. Rather, the distinction rests upon whether or not the banker, or
ware-houser, has the right to lend out the funds or fungible goods transferred
from the party of the first part (A) to the party of the second part (B), in the first
round, and from the party of the second part (B) to the party of the third part (C)
in the second round of this complex transaction. If it is a deposit, B has no such
right to lend out A's property to C. If it is a loan from A to B, then B most
certainly does have this right in our view, provided only that it does not take the
form of BSLL.
State BH (402): "It is a non sequitur to deduce from the illegitimacy of
fractional reserve banking the illegitimacy of maturity mismatching in general."
BH are very much in error in thinking us (BB) guilty of this non sequitur. We
make no such deduction; if we did, we would assume BH would cite such a
claim from BB. This, they fail to do, even though it would constitute a smoking
gun type of evidence against us. In fact, for us, the deduction runs in the exact
opposite direction; i.e., we think FRB is a subset of BSLL and because we think
BSLL should be illegitimate, FRB, necessarily, ought also be illegitimate.
In the view of BH (402), "the purpose of a genuine deposit contract is
safekeeping." Maybe so. Indeed, likely so. Probably, these authors are correct in
the overwhelming majority of cases. But this need not be so, and thus their
statement cannot achieve the praxeological status we assume they mean to give
to it. For purposes are subjective. Different people may have different goals for
their human actions. One goal of depositors is surely safekeeping, vershtehen
tells us. But, it cannot be denied, there are others. Maybe, as a favor to the bank;
to pay off a personal debt to the banker. For the prestige of being associated in
this way with so august a personage as the banker. Or, perhaps, to economize
on transactions costs. For if safekeeping is the purpose, why not rent a safety
deposit box?
BH (402) quote the following two sentences from BB (712): "The cause of the
[fractional reserve banking] problem is that the bank had no right to make such
loans, because it did not have the relevant elements of ownership of the
deposited funds. That is, it had title to the funds only for period [sic] for which
it had borrowed them, so it only had the right to lend these monies for a period
ending no later than the time at which it had to repay the loan by which it
acquired the funds it lent."
45
Whereupon BH (402) criticize us as follows: "... the second sentence does not
seem to follow from the first nor does it seem to be implied in it. In fact, the
bank never borrowed the money as Barnett and Block seem to imply."
But, we do not “imply” any such thing. Rather, we come out and rather
blatantly assert that the bank did borrow the money, and did not have it on its
books as a deposit. And, we stand by this assertion, BH's criticism to the
contrary notwithstanding. The difficulty here stems from the bracketed insertion
BH place in their quote from us. They insert the words: “fractional reserve
banking.” But that is not at all what we meant. As is clear from the context, the
correct insertion at this point would have been (not that any insertion was
needed), not FRB, but BSLL. Had BH paid careful attention to what we
actually wrote, we suspect, this confusion never would have arisen.
It may well be that a large part of the problem we have with BH is a semantic
one; i.e., concerning the meaning of “demand deposit.” BH, as does Huerta de
Soto (1995, 1998, 2006), take it to be a synonym for a modified (because it
involves fungible goods) form of “bailment.” We, in contrast, interpret it as a
synonym for “loan.” Of course, U.S. law agrees with us and vice versa.
Moreover, not even BH would take deposit in the terms “time deposit” and/or
“certificate of deposit” and/or “savings deposit” to be a synonym for “bailment.”
Therefore, it seems that they are really maintaining that when used in the term
“demand deposit,” the term “deposit” means “bailment;” i.e., demand bailment,”
a redundancy, or else that the term “demand deposit” is a synonym for
“bailment,” but that when “deposit” is used in conjunction with “time” or
“saving,” etc. it does not mean “bailment.” However, it would appear that they
frequently drop the “demand” from “demand deposit” and still mean “bailment.”
That is, they seem to want the words “deposit” and “bailment” to be synonyms,
ignoring the issue of the use of “deposit” in other uses.
But the problems of conflicting rights are not limited to that form of BSLL
known as demand deposits; rather, it is present in all forms of BSLL. For
example, suppose A lends (in the form of a time deposit) $100 to B for one year.
B then relends this amount of money to C, for a term of not one year, but two
years. No matter how BH twist and turn, at the end of year 1, there is a conflict
in rights. Both A and C have a right to this same $100. Yes, B can duck out of
this quandary by obtaining the needed funds from D or by asking A to be
patient, or by paying off A with his, B's, own money. But, it cannot be denied
that there is a conflict in rights. The fact that something has to be done about
46
this crisis (go to D for a new loan, ask for the patience of A, use B's own funds)
demonstrates this rights conflict.
Assume now that all of these options fail. That is, there is no D willing and able
to provide the requisite funds, A is unwilling to wait for another year for his
money, B has insufficient funds of his own, C cannot be prevailed upon to
prepay his loan back to B at the end of one year, when his contract allows him to
keep A’s money, via B, for two years. Then what? BH (402) say that B’s
actions in making this loan to C “might be considered risky or even foolish." We
would agree. But we go further, far further. We would charge B with a criminal
act. Would BH go along with us on this? If so, they are forced by logic to agree
with us that BSLL is per se a rights violation, and ought to be outlawed. If not,
then what? Ok, B made a mere "mistake." A is out the $100 to which C now (at
time t1) also has a right.
It seems difficult for a libertarian to take the position that B is not a criminal,
merely an unwise and unfortunate banker.0 The practitioner of FRB is in the
same identical legal position as he who follows BSLL, as does our B. FRB,
also, is a case in which there is a rights conflict (BH agree with us on this.) But,
and this is the kicker, there, too, the rights violation can be ameliorated. As BH
are on record as accepting the illegitimacy of FRB, if we can show that this too
can be ameliorated, their objection to the illicitness of BSLL will be
compromised, at least on this one ground. So, how can the agreed upon evils,
the rights violations, the rights incompatibilities of FRB, be rectified?
We return to our examples of BB. Only now we change the nomenclature. A,
B, and C stood, respectively, for the initial lender, the banker and the subsequent
borrower, all in the BSLL case. Now, X, Y, and Z stand, respectively, for the
initial depositor (not lender), the banker and the borrower, respectively under
FRB. The other differences between the two cases are: A lends $100 to B for
one year which entire $100 B then relends to C for two years; whereas X makes
a $100 demand deposit with Y, only $90 of which (we assume a 10% reserve,
whether required by law or not.) Y lends to Z for one year.
Here goes: X deposits (does not lend, but rather deposits) $100 in cash in the Y
bank. Under FRB, Y credits X with a demand deposit of $100 in Y’s bank, that
X may withdraw at any time. Whereupon Y lends to Z, for a term of one year,
0 Fungibility, that is, in this case, relying on D, is a weak reed upon which to base as much as
BH base on it. Banish fungibility, and at one fell swoop BH must necessarily agree with us:
both FRB and BSLL are criminal activities. Our example is an attempt to show that the two
practices occupy the same moral, or, rather, legal space.
47
$90 cash of X's $100 cash deposit in return for a note from Z for $90, plus the
agreed upon amount of interest. Y’s (relevant) assets, then, consist of the $10
cash, or 10%, he has remaining from X’s $100 deposit that he keeps in his vault
as “reserves,” and Z’s note for $90. But, then, immediately thereafter, X writes
a check for "his" $100. (Scare quotes to indicate a rights conflict.) Y, the
fractional reserve banker has cash assets of only $10, and outstanding
obligations of $100. How can Y get out of this mess? We once again resort to
BH (2009, endnote 10). Y can ask X for forbearance; please tear up your check
for $100, or at least reduce it to $10. Y can ask Z to prepay his outstanding
loan. Y can also go, tin cup in hand, to an outside party, W, and ask him for $90
in this case. Or, Y can use some of his own assets, if he has a sufficient amount,
for this purpose.
Yes, there are disanalogies between the two cases. Y, the FRB, is in far worse
shape than B, the bank that merely engaged in BSLL. After all, B, but not Y,
was guilty of actual money creation. But, there are similarities too. Both
activities are illicit (at least under the libertarian legal code (Rothbard, 1998;
Huebert, 2010), and the fact that both might, under certain conditions in some
specific cases, be patched up does not change that evaluation in the slightest.0
Can Y undo his money creation? Yes. How? Simple. Engage in the opposite of
money creation, namely, money destruction. How would this work in our case?
First, Y approaches Z and calls in that "loan" of $90. (Of course, most loans are
not “demand” or “call” loans., and, therefore, Y may have no right to call the
loan to Z.) Assuming away that difficulty, Y, we may posit, apologizes to Z,
saying that he had not the right to make that demand-deposit-based loan to Z in
the first place, since the money X entrusted to Y was a deposit, not a loan. Then
Y places this $90 in his own coffers, and once again is in a position, with a now
100% reserve, to make good on any call for this amount of money on the part of
X, as X has a right to do. The same can be said for the BSLL case. Here, too,
rectification can be made. But the bottom line is that just because compensation
can be offered to the victim, does not mean that a crime against him was not
perpetuated in the first place. So much for BH's (2009) critique of BB (2009),
that "contractual obligations still be fulfilled. This does not prove that BSLL is
not a criminal enterprise.
0
Bernie Madoff stole a lot of money. If he somehow paid it all back, that would go a long
way in the direction of compensation. But, he would still be a thief!
48
What about their critique (BH, 403), that "there is no oversubscription of
property titles"? This, too, fails. There is indeed an over determination of
property, specifically at the end of year 1. At that point in time, B owes $100 to
A, and does not have it. Yes, he might be able to get it, (see supra) but that
does not demonstrate that there is no conflict in rights. Indeed, this cuts in
completely the opposite direction. The fact that B has to get this $100 shows
that there is a conflict in rights: the total cash in this example is $100. At the
end of the one year period for which A lent it to B, it all belongs to B. But he
has none of it. It is all in C’s possession, or more realistically, C has spent it and
it has flowed into the stream of commerce. Could we trace the specific
monetary units involved, God only knows in whose hands these units would be
when A’s loan to B came due. Obviously, there is a conflict over the titles to
these units between A and the current possessors, assuming the latter to be
holders-in-due-course; i.e., assuming they acquired them for value and in good
faith.
BH are quite right to stress the importance of time in their analysis. But a
proper appreciation of this dimension, we contend, vitiates their thesis, and
militates in favor of ours. For, B must have the money precisely at the end of
the first year. What of the possible objection that B can borrow the $100 from D
one second before the end of the year. This, too, fails. There is no difference
between this situation and that of demand deposits. X makes a demand deposit
of $100 in Y’s bank. Y lends all of it to Z for 10 years. As long as Y can
borrow the $100 one second before X asks for it back, Y can pay X.
Nevertheless, Y did not have the right to lend it for longer than he had borrowed
it. The conflict of rights becomes obvious if Y cannot raise the $100 when X
wants to withdraw it. De facto, X’s right to his $100 has become contingent, not
certain. Why? Because it is in conflict with Z’s (and subsequent individual’s in
the chain) rights as a holder-in-due-course to use the $100, properly acquired.
Just because, possibly, Y can get out from under his conundrum, does not mean
that there was no initial difficulty.
Suppose B, the BSLL bank fails to achieve any of the ameliorations mentioned
by BH in their endnote 10. Then, at the end of year one, B will not be properly
considered to be "unwise" as BH characterize him, but, rather, an actual
criminal. For, B has contracted with A to return his $100 to him at that time,
and B does not have the requisite funds, nor is B able to put his hand on this
amount of money, given our assumptions B will be in precisely the same
position if, instead of borrowing $100 from A for one year, and lending these
funds to C for two years, B had borrowed a lawn mower, or a specific painting
49
for 12 months, and then lent it to C for twice that amount of time. The
fungibility of money, in this case, not only masks the underlying reality, but is
an essential enabling factor to render such illicit financial practices practical.
Fungible, schmungible. BH were misled by fungibility. With non fungible
goods, it is clear, even BH would have to concede (they ignore this point) that
BSLL is a criminal activity. There is no possibility of undertaking any of the
activities noted in their endnote #10, save for C’s immediate return of the loaned
item upon demand by B. But fungibility is merely a cloak for the underlying
reality of what occurs with the BSLL. B is undertaking to do something (deliver
$100 to A in one year) that he is precluded as a matter of right – he can only
honor his obligation by good fortune − from doing given his contract with C
(entrusting this amount of A's for two years to C). B's two contracts, one with
A, the other with C, are, absent contingent extraneous actions, logically
incompatible with each other. It cannot be denied that if B is "lucky," and can
borrow $100 from D for the second year, or can finance his obligations to at the
end of the year out of his own funds, he will not be found out as a contract
violator. But the same can be said for the employee who "borrows" a tool from
his employer over the weekend, and manages to return it before business
opening on Monday. His pecadillo, too, will be kept secret. He will not be
exposed as the criminal he really is, either. But for all of that, both the tool
"borrower," and the bank that engages in BSLL, are criminals, sometimes
successful and sometimes not.
Compare and contrast the practice of BSLL with that of BLLS (borrow long,
lend short). In the latter case, three is no criminal activity − not potential
criminal behavior and not actual criminal acts either. The contract B makes
with A is fully consistent with the one that B undertakes with C. At the end of
year one, there is no crisis the resolution of which necessitates attempts at extra
contractual action.
FRB is but a special, limiting, case of BSLL. BH see clearly the difficulties
with the former. If they could but perceive that BSLL is but the general case of
which FRB is a special case, perhaps their opposition to FRB would then carry
over to BSLL, and they could support BB (2009), withdrawing the criticisms
they made of it in BH (2009).
Why do we say that FRB is but a special case of BSLL? BSLL occurs anytime
that an intermediary borrows from one party and lends the borrowed funds to
another party for a longer period than that for which he borrowed the funds
50
initially. FRB, is a subset of BSLL in that it only occurs in those instances for
which intermediary promises to repay the borrowed funds on demand.
FRB, in addition to being a special, limiting, case of BSLL, is unique in another
way. BSLL always, i.e., whether or not of the FRB type, involves an increase in
credit. But only FRB also and always involves an increase in money, something
that BSLL of the non-FRB type never does.
What of this possible objection, which we offer to BH, free of charge? “BB say
that BSLL is a criminal act, since if B fails to somehow make good for the fact
that C’s debt to B is not due for another entire year, and B cannot pay off A
what B owes A at the end of the first year as a result, B has in effect stolen from
A. But the same thing can occur under BLLS, which BB favor! Suppose, under
BLLS, that B borrows $100 from A for a year, and lends it out to C for 6
months. C repays at the end of this period. Whereupon B lends C this $100 of
A’s for a second six month period. All is well so far. However, this time C
reneges. He pays B nothing at the end of this second six month period. Here,
again, as in the BSLL case, B is unable to refund A’s $100 to him at the end of
the year, as B is contractually obliged to do.”
This objection fails. There is a disanalogy between the two cases. Under BSLL,
even if C adheres to his contract with B, B still cannot return A’s money to him
(assuming away, now, the various techniques that B can employ, with no
guarantee of success, to get himself out of this difficulty.) In sharp contrast,
under BLLS, as long as C adheres to both of his six month contracts, B faces no
embarrassment; he need not resort to any extra contractual maneuvers in order to
extricate himself from any such problem.
It should be noted that in any legitimate credit transactions; i.e., those where
there is a direct loan from the borrower to the lender so that there is no issue of
BSLL or BLLS, and those where there is an intermediary who engages in BLLS
(and in the limiting case, where the borrowed funds are lent for exactly the
period of time for which they had been borrowed), the borrower may still
default. However, the critical difference is that in BSLL transactions, there is an
inherent conflict of rights whereas in the others there is not.
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Conclusion
We end as we began. Without the insightful objections of BH, we would not
have probed further into these matters. For that, we are extremely grateful to
them. However, we cannot see our way clear to agreeing with their criticisms,
and renouncing our own thesis. We hope and trust that this reply of ours will
spur BH to further deliberations on this matter, as theirs has inspired ours. In
this way, perhaps, the four of us can creep that proverbial one half inch closer to
the truth.
52
References:
Bagus, Philipp and David Howden. 2009. “The Legitimacy of Loan Maturity
Mismatching: A Risky, but not Fraudulent, Undertaking,” Journal of Business
Ethics. Vol. 90, No. 3, December, pp. 399-406.
Barnett, William II and Walter Block. 2007. “Saving and Investment: A
Praxeological Approach.” New Perspectives on Political Economy. 3(2): 129-
138.
Block, Walter and William Barnett II. 2008. “Continuums” Journal Etica e
Politica / Ethics & Politics, Vol. 1, pp. 151-166, June;
http://www2.units.it/~etica/;
http://www2.units.it/~etica/2008_1/BLOCKBARNETT.pdf
Barnett, William and Walter Block. 2009. “Time deposits, dimensions and
fraud,” Journal of Business Ethics; Vol. 88, No. 4, September, pp. 711-716;
www.WalterBlock.com/publications; 88: 711-716;
http://www.springerlink.com/content/100281/?
k=walter+block&sortorder=asc&v=condensed&o=20;
http://www.springerlink.com/content/a88l166702524r55/; http://blog.mises.org/
archives/011398.asp;
http://www.springerlink.com/content/a88l166702524r55/fulltext.pdf?page=1
Barnett, William and Walter Block. 2009A. “Financial Intermediaries, the
Intertemporal-Carry Trade, and Austrian Business Cycles; or; Crash and Carry:
Can Fraudulent Time deposits lead to an Austrian Business Cycle? Yes.”
Journal Etica e Politica / Ethics & Politics; Vol. XI, No. 1, pp. 455-469; http://
www2.units.it/~etica/2009_1/BARNETT_BLOCK.pdf
Block, Walter. 2008 [1976]. Defending the Undefendable. Auburn, AL: The
Mises Institute
Garrison, Roger W. 2001. Time and Money: The Macroeconomics of Capital
Structure. London: Routledge
Huebert, Jacob. 2010. Libertarianism Today. Santa Barbara, CA: Praeger
Huerta de Soto, Jesus: 1995, ‘A Critical Analysis of Central Banks and
Fractional-Reserve Free Banking from the Austrian Perspective’, Review of
Austrian Economics 8(2), 25-38.
53
Huerta de Soto, Jesus: 1998, ‘A Critical Note on Fractional-Reserve Free
Banking’, The Quarterly Journal of Austrian Economics 1(4), 25-49.
Huerta de Soto, Jesus. 2006. Money, Bank Credit and Economic Cycles Auburn,
AL: Ludwig von Mises Institute
Mises, Ludwig von. 1998 [1949]. Human Action, Scholars’ Edition. Ludwig
von Mises Institute. http://www.mises.org/humanaction/chap17sec5.asp
Rothbard, Murray N. 1998 [1982]. The Ethics of Liberty, New York: New York
University Press. http://www.mises.org/rothbard/ethics/ethics.asp
Rothbard, Murray N. 2004. Man, Economy, & State with Power and Market.
Ludwig von Mises Institute
54
Chapter 4. The Continuing Continuum Problem of Deposits and Loans
Phillip Bagus and David Howden
Abstract
Barnett and Block (2011) argue that one cannot distinguish between deposits
and loans due to the continuum problem of maturities and because future goods
do not exist – both essential characteristics that distinguish deposit from loan
contracts. We argue herein that the economic and legal differences between
genuine deposit and loan contracts are clear. This implies different legal
obligations for deposit and loan contracts, a necessary step in assessing the
ethics of both fractional reserve banking and maturity mismatching. While the
former is economically, legally, and perhaps most importantly ethically
problematic, there are no such troubles with the latter.
KEY WORDS: banking, fraud, fractional reserves, maturity mismatching,
natural law, difference loans and deposits, continuum problem, claims to future
goods
55
The Continuing Continuum Problem of Deposits and Loans
Banking practices over the past decade have increasingly caused furor due to
less than satisfactory ethical practices. William Barnett and Walter Block’s
(2011) rejoinder in this journal’s pages recognizes some key points to the issue
at stake. The recent debate has sought a theoretical foundation to explain why
these banking practices are ethically suspect (the interested reader may consult
Barnett and Block (2009; 2011), Philipp Bagus and David Howden (2009), for
the crux of the debate).0
Instead of arguing over some of the finer points, which we largely commend
Barnett and Block for clarifying, we here focus on two large theoretical gaps of
their analysis. As we both seemingly agree on much of what is at stake,
rectifying these points should place us in full agreement. The two points that
make their viewpoint irreconcilable with ours are the continuum of maturities
that distinguishes loans from deposits, and the concept of the future good.
The Continuum Conundrum
The first issue that Barnett and Block have with our fundamental distinction of
loan and deposit contracts concerns the fact that a deposit contract has no term
to maturity as it is on demand. Barnett and Block attack the distinction of the
two types of contracts that are the basis of our analysis. We argue that deposit
contracts do not have a term because the motivation of the contract is
safekeeping – to have the good always and continually available.
That to enter into a demand deposit must imply safekeeping is not an
assumption. Instead, we argue that a legal contract exists whose primary purpose
is the safekeeping and availability of the deposited goods. Such a contract
lacking a maturity must be continually on demand, and hence entail a
safekeeping obligation by the depository. It may be helpful to think of a
continuum of “maturities”, and the specific contracts that embody them. A
contract of infinite maturity (i.e., one that would never require repayment) is
what we commonly refer to as a “gift”. A contract with a positive maturity (i.e.,
one that requires repayment before some future date) is that which we
commonly refer to as a “loan”. Finally, what of a contract of zero maturity (i.e.,
one that must be repaid with no notice, or, in other words, “on demand”)? This
is the type of contract that we commonly refer to as a “deposit”. The purpose of
0 Throughout this paper, unless otherwise noted, references to Barnett and Block will be to
their (2011) rejoinder.
56
deposit contracts is incompatible with the appropriation of the deposited goods
on the part of the depositary and consequently incompatible with the practice of
holding “fractional reserves”. This arises as they are of zero maturity.
Historically, this type of contract has been called a “deposit” (in Latin, a
depositum) if the good is specific, and an “irregular deposit” (in Latin, a
depositum irregular) if the good deposited is unspecific.0
On the contrary, in loan contracts where one party transfers the use of the good
to the other party, there is always a specified and finite term limiting this use.
The motivation here is the transfer of the availability of the lent good for the
term. Barnett and Block raise the important question about the continuum of
maturities, by asking:
[W]hat is the relevant time period that separates a loan from a deposit? For
example, A wishes to establish an account with B in which A turns money
over to B with the expectation that B will later on return it to A. If the term
of the contract requires that A, upon making a demand for the return of his
funds, may be required to wait before they are returned, does this render the
contract a time deposit? Suppose the waiting period to be 1 seconds [sic.]?
5 seconds? 10 seconds? What is the maximum period of contractually
allowed delay between demand and return that still qualifies the relation as
a deposit and not a loan?... Therefore, we conclude that distinguishing
between demand deposits and time deposits, insofar as maintaining that it
is fraudulent to borrow short and lend long if a particular type of financial
transaction is referred to as a demand deposit but not fraudulent if it is
referred to as a time deposit, is inapposite. (p. 230)
What is the minimum amount of time that a good can be lent for before it
becomes a deposit? Here, Barnett and Block force us to deal with a very
pertinent question. We see the continuum problem not as being fundamentally
theoretical in nature but as of a practical problem for the legal system (and its
0 Leland Yeager (2010) suggests that such definitions are an imposition of a preferred
meaning onto a word and that these definitions shift the argument to one about names,
classifications and definitions. We maintain that there exists a certain contract with a certain
legal nature that arises to meet a defined need. The name given to this contract is of secondary
importance. As definitions arise from convention, we prefer the traditional word attached to
such a contract, namely a “deposit” (an alternative term would be “bailment”). Similarly, a
different goal, such as to purchase a good, can also be defined by a contract, with the legal
implications thereof explicated. Although the specific name we attach to such a contract does
not aid nor impair its analysis, it is helpful (though not essential) to use conventional
terminology such as a “purchase contract” or “sales agreement”. Such usage does not assume
anything of the specific contract itself, but enables the analysis of the implications of such an
arrangement.
57
conventions) to deal with.0 As Murray N. Rothbard (2001, pp. 264-265) has
pointed out about the continuum problem in economics:
The human being cannot see the infinitely small step; it therefore has no
meaning to him and no relevance to his action. Thus, if one ounce of a
good is the smallest unit that human beings will bother distinguishing, then
the ounce is the basic unit… If it is a matter of indifference for a man
whether he uses 5.1 or 5.2 ounces of butter, for example, because the unit is
too small for him to take into consideration, then there will be no occasion
for him to act on this alternative.
We maintain that the same is true for law and ethics, i.e., that infinitely small
steps are not taken into account, thus there is no continuum problem.
Take the following example: E exchanges $1 against 1 pound of butter from F.
E goes home and uses a hyper-precise scale to measure his purchase, finding
that he received only
0. ´
99
pounds of butter from F. Strictly speaking, we might
say that this is obvious fraud, since he received less than the contracted 1 pound
of butter. Barnett and Block could rightly point to a continuum problem: Where
does “1 pound of butter” start?
Most legal conventions would probably regard
0. ´
99
pounds of butter as
equivalent to “1 pound of butter”, even though we cannot say so apodictically.
Nevertheless, we do not have to prove such an event a priori. Faced with such a
case, a judge would maintain, in all likelihood, that there was no fraud involved:
that the two quantities are legally equivalent. Conventions or judges will decide
in a free society what the relevant steps are.
The same is true for the distinction of demand deposits and loans. A contract
with a “term” (or “waiting period”) of 0.001 seconds, 1 second or 100 seconds
until a depositor receives his funds will probably be regarded as equivalent to a
demand deposit. In modern banking there is almost always some amount of
waiting, even on demand deposits, before the depositor can access his money.
Cashiers and ATMs require time to verify that the account holder is the proper
owner of the account; time is taken to move funds from a safe location (a vault,
locked drawer, etc.) and into the possession of the depositor. These “waiting
periods” are not negations of the fact that deposits must be instantly available –
0 This is not to imply that economic science can separate practical from theoretical problems.
The whole corpus of economics deals with theoretical issues, but their relevance is only
gained through application in the external world; problems of practical importance are linked
to theoretical issues (Rothbard 2001, p. 616).
58
they are physical constraints imposed on us by nature, or conditions of action, so
to speak. When assessing deposit contracts, the important issue is that during
such a waiting period (however small) between when a depositor requests his
funds and they are delivered to him, the bank continually honors the original
goal of the depositor: the safekeeping and full availability of the funds (Bagus
and Howden 2011).
Who does it fall on to answer the relevant question: Is the intention of the person
to have full availability or does he want to transfer the availability of the good
for a certain time (i.e., make a loan)? It falls on judges to decide in each case in
a free society. For “terms” so short that they are seen as equivalent to deposits,
the purpose of the contract is safekeeping and all legal obligations for deposits
will apply. Consequently, the legal system has to determine if a certain contract
was designed to conceal a deposit or whether it is a genuine loan. Conventions
and legal norms that develop in an evolutionary process described by Bruno
Leoni (1961) or Friedrich A. von Hayek (1973) would deal with the important
continuum question. The legal system as a solution to the continuum challenge
should be readily acceptable by Barnett and Block – after all, they endorse such
recourse in Barnett and Block (2008).0
There is place for such conventions even in a world abiding by natural law (as in
Rothbard 1982). Not every norm or judgment can be designed in advance. Take
the homesteading principle. Libertarians in the Lockean/Rothbardian tradition
agree that people can homestead unowned resources by mixing one´s labor with
them. Rothbard (1982, p. 34) states that transforming nature “into a more useful
shape” is homesteading. But what counts as transforming exactly? Is it sufficient
to walk around the property? Or to mark corners to define the boundary’s
outline? Or must the land be tilled? Or is it necessary to build a fence
surrounding the property, to fully separate it from property which you clearly
did not homestead? Perhaps it is sufficient to merely bounce one´s sound waves
(by saying “this is my land”) off its surface.
We are faced with a continuum problem asking the question: where does
homesteading start? In a free society, conventions would determine the exact
norms of homesteading. Although they can vary from one society to another and
0 This is not to imply that every historically evolved event can be considered just. There are
historical cases of fractional reserve banking coming into existence by the misappropriation of
genuine deposit contracts (Huerta de Soto 2009). Moreover, not every historically evolved
occurrence is consistent with the fundamental principles of law. Huerta de Soto (2009), Bagus
and Howden (2009) and Bagus et al. (forthcoming) show that a fractional reserve deposit
contract involves a legal contradiction, and is hence an invalid contract (even if it is
understood and voluntarily agreed upon by both parties).
59
from one time to another, they cannot be unambiguously removed. We maintain
that the same holds true for the continuum question posed by Barnett and Block.
Where is the point where the “waiting period” becomes so long that the contract
can no longer be considered equivalent to a deposit and thus becomes a loan
contract? This depends on conventions. Consequently, there remains a clear
distinction between the two types of contracts with their essential elements of
safekeeping versus the transfer of availability.
Barnett and Block, by raising the continuum conundrum, invoke a philosophical
vagueness-type argument concerning the nature of all concepts. After all: “No
concept, not even those of mathematics, is absolutely precise; and some of the
most important for everyday use are extremely vague” (Charles S. Peirce 1906,
p. 376).0 The illustration of the continuum of maturities in the deposit/loan
contracts is just one example of the near-universal phenomenon of vagueness.
Yet, we maintain, loans are not deposits, and deposits are not loans. A loan that
shares properties with a deposit (such as a loan with a maturity of one second),
represents a borderline case. The existence of these borderline cases does not
invalidate the distinction of the concepts at hand. They do create the necessity of
a well-functioning legal system to adjudicate these cases as they arise.
On the Existence of the Future Good
The other critical area where Barnett and Block blur the crucial distinction
between loans and deposits is the concept of the future good. We previously
clarified that one distinction between loans and deposits is that in a loan a
present good (money today) is exchanged against a future good (money in the
future) (Bagus and Howden 2009). There is no such exchange of present against
future goods in a deposit contract. Barnett and Block attempt to blur the line
between the two types of contracts by stating that: “Apart from, perhaps, science
fiction, there are, at any given time, that is, at all times, no such things as ‘future
goods’” (p. 230).
We must admit that our worthy adversaries are correct in one strict sense. There
exist no future goods today.
0 We thank John Welch for alerting us to this passage, and the application of Charles Peirce’s
work to the issue at hand. Ludwig von Mises (1951, pp. 128-30) discusses the issue of vague
concepts in economics. Specifically, he critiques the idea of excess profits as being separable
from legitimate profits. There is no way to distinguish between different levels of profits, nor
to make value judgments of them. There is a way that we can distinguish between concepts
such as deposit and loan contracts, which remain vague only in practice and not in theory.
60
The precise (and clarifying) expression would be: In a loan contract, present
goods are exchanged for claims on future goods. As Rothbard (2001, p. 144)
states: “In a credit transaction, a present good is exchanged for a future good, or
rather, a claim on a future good.” On the contrary, exchanging “the deposit of a
commodity for a warehouse receipt [generates a] claim to a present good”
(Rothbard 2001, p. 146).0 By adding “claim on”, the clear distinction between
loans and deposits remains. Depositors gain a claim to a present good (the
deposited money is as “present” as money in one´s own pocket), while creditors
gain a claim to a future good.
The distinction becomes important when discussing the determination of
property rights. In Bagus and Howden (2009) we analyzed the legal and ethical
obligations of both monetary loan and deposit contracts. There exist important
legal and economic differences between the two types of contracts which attach
great importance to concept of the “claim to a future good”, as outlined in Jesús
Huerta de Soto (2006, chap. 1, and esp. 13-20).
Most importantly, the causes or motivations for the contracts differ radically. In
a deposit contract, the depositor wants to maintain the availability of the good at
any (and every) moment. The essential element of the contract is the
safekeeping of the deposited good. The obligation of the depository is to hold
the deposited good and maintain its availability for the depositor, thus implying
a 100 percent reserve ratio. As the full availability remains with the depositor,
an appropriation of the money by the depository is fraudulent and unethical.
The motivation in the case of a loan contract is quite different. Here the transfer
of the good for a specific period to the borrower is the essential contractual
element. It is the obligation of the borrower to return the money (not the same
specific notes but their future equivalent, i.e., a tantumdem) with the agreed
upon interest payment at the end of the contract’s term. There are no grounds for
legal recourse by the lender, provided that the borrower fulfills this obligation at
the contract’s maturity.
0 Indeed, Rothbard (2001, chap. 7 and passim) structures the pricing of all goods as a product
of the discounted value of some “future good”, not yet in existence but expected to be. Barnett
and Block have endorsed, in varying degrees and both together and separately, the concept of
the “future good” for categorizing types of both exchanges and goods. See, for example,
Barnett and Block (2005; 2007) and Hans Hermann Hoppe et al. (1998). Their rejoinder
contains a self-citation to Barnett and Block (2007, p. 134n16) to argue against the existence
of future goods, yet the cited passage contains no more substantiating evidence to that end
besides the statement: “[T]he category ‘claims on future consumers’ goods’ is so broad as to
be almost meaningless.”
61
Barnett and Block focus only on an overrepresentation of property rights in the
case of the loan contract. At the same time, they conflate the two different kinds
of contracts (deposit and loan).0 Barnett and Block focus solely on the case of
fraud, when both parties know that they are dealing with a genuine deposit
contract. In banking activity however, some people may be aware that a bank
uses the deposited money (as is arguably the case of many depositors today). We
argue that this special case is also unethical. The contract is invalid as the
purposes of the contracting parties are incompatible and impossible to fulfill.0
As a last defense, Barnett and Block (p. 235) take recourse in money’s fungible
nature. They maintain that fungibility masks the underlying reality of loans, and
that we have been misled by this fact in our analysis. Yet, our rich legal analysis
finds that fungibility is a key to the specifics of the monetary loan contract. In
loans for specific goods the borrower does not destroy the good. For instance, if
we borrow a car or a painting from a friend, we are (usually) obliged to return it
to him in the same condition at the contract’s maturity. In loans of fungible
goods, the use or destruction of the good is one of its essential elements. For
instance, when we borrow two ounces of cooking oil or two eggs from our
neighbor, we are allowed to use (destroy) the good. This is the purpose of the
loan of fungible goods. It makes no sense to return the burned oil or eaten eggs
after cooking (nor, we suppose, would the lender appreciate these goods to be
returned). We have to return the same quality and quantity of the fungible good
(the tantundem) at the end of the (at least implicitly) stipulated term. The same
is true with money. A borrower uses (destroys) the money and returns at the end
of the term not the same money units but others of equal quality and quantity.
Although our analysis applies to the general case of maturity mismatching,
Barnett and Block confine themselves to a special category thereof: lending
money for a longer maturity than it is borrowed for (borrowing short and
lending long). Thus, they find that the practice allows for an oversubscription of
0 Barnett and Block may have fallen prey to fractional reserve banking supporters’ misuse of
the terms “loan” and “deposit”, as they take deposit as a synonym for loan. Barnett and Block
rightly claim that positive laws in the U.S. and elsewhere support their view. Yet the issue at
stake is not whether positive laws are correct or not. We are concerned with the ethics of the
practice, which may be judged independently of the prevailing law of the jurisdiction. By
decree a government can say that a deposit is a loan, a gift, a marriage or any other kind of
contract, yet this does not change the underlying goals, structure and obligations of the
deposit to those of another contract.
0 Interestingly, at least one of the authors of Barnett and Block (2009; 2011) must agree with
us that cases of “deposit” contracts where both the depositor and depository agree that the
depository can make use of the “deposited” funds for loan activities is illegal (see Bagus et al.
forthcoming).
62
property rights as depositors have a claim to their deposited funds at the same
time as the party that borrowed the funds claims them. If borrowing short and
lending long is bad because of a supposed overrepresentation of property rights,
one might ask if borrowing short to invest long is also bad, since making a loan
is an investment. Take the following example: B borrows $100 for one year
from A to invest in an investment project (paying C) that is expected to bring
him $50 profits each year for the next 10 years. Is that not also illegitimate from
Barnett and Block´s perspective? After all, B will not have the $100 given to C
to pay back A at the end of the first year, and likely will not until the second
year. Granted B might roll-over the loan with A or borrow money from someone
else, but this does not make a difference from Barnett and Block´s point of view.
From their point of view there seems to necessarily be a crisis at the end of the
first year and B´s behavior is criminal.
Another example: B borrows $100,000 from A for 20 years to invest in a project
that will not bring him any cash flow at all. He buys a house from C to live in
lasting 50 years. This might save B paying rent of $4,000 per year. Must this
behavior not be criminal as well? B borrowed from A for 20 years and invested
in something that brings him no money back (but does save him $80,000,
ignoring discounting). B might have an income of $20,000 per year or he could
borrow from someone else when the loan comes due after 20 years. However, it
seems to us that Block and Barnett must regard this type of activity as fraudulent
because B will not get the $100,000 back from C before 20 years. We see no
categorical difference between B investing the money he got from A for 1 year
in a loan to C or in a project of a longer term. Thus, it seems to follow from
Barnett and Block´s analysis that all such activities are criminal and should be
prohibited in a free society, reducing mutually beneficial exchanges and
disrupting intertemporal coordination. In our view, the issue of bonds and equity
would play a much greater role in a 100 percent commodity standard monetary
system.
The paradoxical alliance of Barnett and Block (2009) and free bankers
Unfortunately, we fear that Barnett and Block’s arguments are
counterproductive against their proclaimed goal, namely: “[T]o drive a stake
through the heart of the intellectual case for [fractional reserve banking]. We
believe in ‘piling on’: exposing every flaw in this pernicious and immoral
practice” (pp. 232).
63
By raising the continuum question, the claim that there is no clear distinction
between loans and deposits despite all the evidence otherwise, they make a case
similar to that used in the defense of the very practice they aim to expose:
fractional reserve banking. Indeed, supporters of fractional reserve banking may
use an analogous argument. They could claim that self-renewing loans of one
second would be equivalent to a deposit and therefore the obligations for loans
also apply to these “deposits”. In fact, fractional reserve bankers such as
Lawrence White (2007) claim that demand deposits (or “checking accounts” by
his terminology) are callable loans “at least to all appearances”, and therefore
the appropriation and use of the deposited money is legitimate.0
The following syllogisms portray the similarity of the approaches of Barnett and
Block and fractional reserve bankers in contrast to our approach.
A fractional reserve banking argument in favor of maturity mismatching:
1. Loans and deposits represent equivalent contracts (due to deposits having
an unspecified maturity).
2. The same legal obligations apply (to return the contracted money when
asked for).
3. Fractional reserve banking, and hence maturity mismatching, are
legitimate.
The Barnett and Block argument against maturity mismatching:
1. Loans and deposits represent equivalent contracts (due to the continuum
conundrum).
2. The same legal obligations apply (to not loan out the contracted money for
a longer term than the contract’s maturity).
0 Selgin (2010) provides an interesting piece of history, providing evidence that Goldsmiths in
17th century London offered contracts that were neither demand deposits nor loans. These
contracts were akin to aleatory contracts, whereby a financial institution promises its best to
return an invested sum on demand (Bagus and Howden 2009). Lacking a full guarantee of
return, these promises trade at a discount to money (i.e., they would become a type of money
substitute). While Selgin provides evidence that the Goldsmiths offered such contracts, he
maintains that Goldsmiths did not pioneer fractional reserve banking. Selgin’s empirical
evidence that Goldsmiths offered a third contract distinct from the two we posit that are
legally permissible is not irreconcilable with our own view. Indeed, Selgin’s work would only
be problematic if it could be shown that: 1) people who agreed to these contracts wanted to
maintain the full availability of their money, or 2) if these historical instances were used to
argue for the legitimacy of the fractional reserves demand deposit.
64
3. Fractional reserve banking, and hence maturity mismatching, is
illegitimate.
In distinction, we argue that:
1. Loan and deposit contracts represent legally distinct concepts.
2. Different obligations apply to either type of contract.
3a. Fractional reserve banking is illegitimate (as it violates the safekeeping
obligation of the deposit contract).
3b. Maturity mismatching is legitimate (as it does not per se violate the
obligation of loan contracts – to return a tantundem after a specified period)
Barnett and Block, in striving to show the illegitimacy of the banking practice of
maturity mismatching, are actually undermining the strongest case against
fractional reserve banking. The essential differences between loan and deposit
contracts and their distinct obligations – holding a full reserve of deposited
money to meet redemption demands versus returning a tantundem at the end of a
loan’s maturity – explain the specific and unique ethical cases of each practice.
Fractional reserve banking violates a depositor’s full availability of his money
and thus, creates an ethical dilemma. Maturity mismatching involves no such
oversubscription of property rights, nor does it imply a violation of depositor’s
rights (as it does not involve deposited money, but rather makes use of a loan).
Fundamental legal principles show that the obligation in a loan contract is to
return the good (or its tantundem) at the end of the stipulated term (or before the
contract’s termination). The practice of maturity mismatching does not impede
the fulfillment of this obligation. The obligation in a genuine deposit contract is
to safe keep the tantundem. This obligation rules out the tandundem´s
appropriation during the duration of the contract, thereby invalidating the
holding of only fractional reserves against demand deposits.
65
References
Bagus, P., and D. Howden: 2009, ‘The Legitimacy of Loan Maturity
Mismatching: A Risky, but not Fraudulent, Undertaking’, Journal of Business
Ethics 90(3), 399–406.
Bagus, P., and D. Howden: 2011, ‘The Economic and Legal Significance of
“Full” Deposit Availability’, working paper.
Bagus, P., D. Howden and W. E. Block: forthcoming, ‘Deposits, Loans and
Banking: Clarifying the Debate’, American Journal of Economics and
Sociology.
Barnett, W., and W. Block: 2005: ‘Money: Capital Good, Consumers’ Good, or
(Media of) Exchange Good?, The Review of Austrian Economics 18(2), 179-94.
Barnett, W., and W. Block: 2007: ‘Saving and Investment: A Praxeological
Approach’, New Perspectives on Political Economy 3(2), 129-38.
Barnett, W., and W. Block: 2008: ‘Continuums’, Etica & Politica 10(1), 151-66.
Barnett, W., and W. Block: 2009: Time Deposits, Dimensions and Fraud’,
Journal of Business Ethics 88(4), 711-16.
Barnett, W., and W. Block: 2011, Rejoinder to Bagus and Howden on
Borrowing Short and Lending Long’, Journal of Business Ethics 100 (2), 229-
38.
Hayek, F. A.: 1973: Law, Legislation and Liberty: Volume 1- Rules and Order.
Chicago: University of Chicago Press.
Hoppe, H.-H., J. G. Hülsmann, and W. Block: 1998, ‘Against Fiduciary Media,
Quarterly Journal of Austrian Economics 1(1), 19-50.
Huerta de Soto, J.: 2006, Money, Bank Credit and Economic Cycles. Auburn,
AL: Ludwig von Mises Institute.
Leoni, B.: 1961, Freedom and the Law. Princeton, N.J.: D. Van Nostrand
Company.
Mises, L. v.: 1952 [1951], ‘Profit and Loss’, in Planning for Freedom, 3rd
edition. South Holland, IL: Libertarian Press. pp. 108-50.
66
Peirce, C. S.: 1955 [1906] ‘The Concept of God’, in J. Buchler (ed.)
Philosophical Writings of Peirce, New York: Dover Publications. pp. 375-79.
Rothbard, M. N.: 2001 [1962], Man, Economy, and State. Auburn, AL: Ludwig
von Mises Institute.
Rothbard, M. N.: 1998 [1982]. The Ethics of Liberty. New York: New York
University Press.
Selgin, G.: 2010. Those Dishonest Goldsmiths’ (April 14, 2010). Working
Paper. Available at SSRN: http://ssrn.com/abstract=1589709
White, L. H.: 2007, ‘Huerta de Soto's Case Against Fractional Reserves, Free-
Market News Network (08 Jan).
Yeager, L. B. (2010). Bank reserves: A dispute over words and classification.
The Review of Austrian Economics, 23(2), 183-191.
67
Chapter 5. Maturity Mismatching and “Market Failure”
William Barnett II and Walter E. Block
68
Maturity Mismatching and “Market Failure”
Abstract:
The present article is a continuation of the debate two sets of authors (Bagus and
Howden versus Barnett and Block) have been engaging in regarding one type of
maturity mismatching: borrowing short and lending long (BSLL). All four
authors had agreed that this practice can set up the Austrian Business Cycle
(ABC); the present author denies that BSLL would be a legitimate commercial
interaction in the free society; Bagus and Howden continue to maintain that it
would be licit. Our main criticism of Bagus and Howden is a reductio ad
absurdum: that this opens them up to the charge of embracing the doctrine of
market failure; this is something highly problematic for the two of them, since
all four contributors to this debate are well-known supporters of laissez faire
capitalism.
Key words:
Borrow; lend; deposit; maturity mismatching, fractional reserve banking, ABC;
banking ethics
JEL category:
E2, E59, P16
69
Maturity Mismatching0 and “Market Failure”0
I. Introduction
The main focus of the present paper is to reply to Bagus and Howden (2012).0
But before we do, let us reprise the history of the debate between the two sets of
authors. One part of it consists of Barnett and Block (2009A, 2009B); theirs, in
addition to the aforementioned, includes BH (2009).
For how long should a debate in the literature such as this be continued?0 In our
view, it should last as long as marginal benefits outweigh marginal costs. And,
in turn, this depends, crucially, on whether anything new and important is added
to the dialogue. Needless to say, since we are now putting forth a new entry in
this series, it is our contention that BH (2012), have indeed added new and
important insights to our series. Otherwise, we would not be replying to them.
And, also, in our view, we, too, contribute something new to this discussion.
Hopefully, they will regard this present effort of ours in the same manner.
In this present article, we try to close this theoretical gap by analyzing the
effects of maturity mismatching. We argue that the time dimension of savings is
a very important factor for the structure of production and its sustainability. The
role and nature of maturity mismatching in a free market is discussed. This
analysis is then contrasted with the role of excessive maturity mismatching in a
hampered economy, showing fractional reserve banking as a special case of
maturity mismatching and fractional reserve banking, central banking, and
government guarantees as promoters of this practice.
0 Merely because the duration, however defined, of a financial institution’s assets and that of
its liabilities is the same is no guarantee of the absence of maturity mismatching, any more
than saying that because the average height of two groups of youths is the same, there is no
height mismatching between the two groups. This should be kept in mind in interpreting
Mises’s and Rothbard’s statements on pages 7 and 8, infra.
0 As with so many terms in economics; e.g., value, wealth, income, money, and capital, there
is no unique definition of “market failure” accepted by all professional economists. Cf., e.g.,
Eatwell, et al. (1991, 3: 326-328), and Hummel (2008). Of course, all economists would
agree that markets “fail” in the sense that all humans are imperfect creatures, and markets
consist of the actions of our species. This of course is not at all what is meant by “market
failure” in the economic literature. To prevent misunderstanding, herein, “market failure” is
taken to refer to a situation or condition arising in a free-market economy in which
governmental intervention, taking into account the costs of such action(s), would improve the
allocation of resources in the sense of a Pareto improvement.
0 BH, henceforth
0 For an analysis of debates, apart from their substantive content, see Block, Westley and
Padilla, 2008.
70
In section II we explain why the concept of “market failure” is alien to Austrian
economics, to which all four of us subscribe. The purpose of section III is to
demonstrate that BH in this case do indeed embrace market failure, contrary to
their long standing and eloquent support of Austrian economics, which rejects
this doctrine. The focus in section IV is to reiterate this view, rejecting BSLL0
on ethical grounds, and maintaining that it creates, exacerbates and enhances the
ABC. Section V of this paper merely mentions BH (2012) on continua (since we
offer no criticism of them on this issue), section VI criticizes BH on future
goods, and section VII on their attempted reductio ad absurdum criticism of our
position that it is compatible with free banking and supports the fractional
reserve system (which we oppose). We conclude in section VIII.
II. Austrian economics
The exact nature of Austrian economics is an unsettled matter. For many, its
essence consists of praxeology: the Austrian school sees itself as a branch of
pure logic; not as an empirical science.0 As such, it produces laws, not
hypotheses, as does the mainstream branch of economics, mired as it is in
logical positivism. For other Austrians, the key seems to be subjectivism. For
example, Hayek (1979, 52-53), perhaps the most well-known Austrian
economist, stated: “And it is probably no exaggeration to say that every
important advance in economic theory during the last hundred years was a
further step in the consistent application of subjectivism.”0 For other members of
0 BSLL is one way of describing the primary type of maturity mismatching. Another, and, we
think, more discerning, and therefore more useful way is LSBL; i.e., lend short – borrow long.
The former considers the two transfers from the point of view of the intermediary, whereas
the latter contemplates the transactions from the perspectives of the ultimate lender and
borrower
0 Block, 1973, 1980, 1999; Batemarco, 1985; Fox, 1992; Hoppe, 1989, 1991, 1992, 1995;
Hulsmann, 1999; Mises, 1969, 1998; Polleit, 2008, 2011; Rizzo, 1979; Rothbard, 1951, 1957,
1960, 1971, 1973, 1976, 1997a, 1997b, 1997c, 1997d, 1993; Selgin, 1988.
0 On subjectivism see also Barnett, 1989; Block, 1988; Butos and Koppl, 1997; Cordato,
1989; DiLorenzo, 1990; Garrison, 1985; Gunning, 1990; Kirzner, 1986; Mises, 1998; Rizzo,
1979, 1980; Rothbard, 1979, 1997
71
this school of thought, the core is market process0 coordination,0 or spontaneous
order.0,0
We now want to introduce a new way of looking at the Austrian school of
economics, a perspective of which we claim BH run afoul. This perspective
focuses on the denial of the concept of market failure. For Keynes and the
Keynesians, “market failure” might as well be their middle names, as their entire
corpus is predicated upon the idea that from time to time0 markets, if left to
themselves, will experience substantial involuntary unemployment,0 or excess
price inflation, and that only governmental intervention can steer them toward
the middle of the road where neither occurs.0 For the Marxists, the entire free
market economy is one big failure. The neoclassical economists also revel in
0 There was an entire Austrian journal, Market Process, devoted to this perspective, in print
from 1983 to 1991.
0
Austrian economists have set up a blog on this basis: http://austrianeconomists.typepad.com/;
see also Block, 2003; Boettke, 2001; Garrison, 1985, 1994; Loasby, 1998; O’Driscoll, 1977A,
1977B; Salerno, 1991.
0
See Barry, 1982; Boettke and Coyne, 2005; Hayek, 1960, 1967, 1973; Klein, 2006;
O’Driscoll, 1977; also:
http://www.google.ca/
#hl=en&gs_nf=1&cp=17&gs_id=4&xhr=t&q=spontaneous+order&pf=p&output=search&scl
ient=psy-
ab&oq=spontaneous+order&aq=0&aqi=g4&aql=&gs_l=&pbx=1&bav=on.2,or.r_gc.r_pw.r_q
f.,cf.osb&fp=ebde00da22e92377&biw=1280&bih=907
0 For the view that the Austrian school may possibly be defined in terms of its finding that
there are no constants in economics as there are in physics and chemistry, see Wenzel, 2012.
See also Clark and Primo, 2012. This is not to say that those Austrians who focus, say, on
only one of these, reject all the others. Rather, it is a matter of emphasis. Our contention here
is that all members of this school adhere to most if not all of these doctrines, but place
different emphases on the importance of each.
0
Perhaps we should rather say, “very often.”
0
“Involuntary unemployment” is another of those terms about which economists disagree.
Praxeologically, there can be no such thing, although, of course, thymologically it is a well
know phenomena. Keynes (1936, 15), himself, had a most unusual concept, and expression
thereof, of involuntary unemployment.
0
Keynes, 1936; Hazlitt, 1959, 1960
72
market failure: monopoly, externalities, public goods, asymmetric information,0
the list goes on and on.0 Even members of the so-called-free-market Chicago
School of economics0 embrace market failure, insofar as they support the
Federal Reserve System,0 anti-trust (McChesney, 1991), and government
welfare programs (Friedman, 1962). It is the Austrian School of economics, and
only the Austrian School, which entirely rejects0 the market failure concept.0
III. BH embrace market failure
In what way are BH inconsistent with this anti market-failure philosophy of the
Austrian school? They admit that maturity mismatching, specifically BSLL will
lead to, or create, or exacerbate, the ABC,0 and, yet, they maintain that this
practice should be legal. This being the case, they acknowledge that there is
indeed an instance of market failure, namely, BSLL. BH do not explicitly
acknowledge that BSLL is a market failure. That is, they do not offer the
following syllogisms:
0
Consult any introductory, intermediate, or advanced microeconomics textbook.
0
Sometimes, the market failures can become pretty esoteric. See Block 2001.
0
For a critique of that institution on this score, see Hoppe, 2002; Block, 2002A; Rothbard,
2002; DiLorenzo, 2002; North, 2002
0
Friedman and Schwartz, 1963
0 See on this: Anderson, 1998; Barnett, et. al, 2005; Block, 2002B; Callahan, 2000; Cowen,
1988; Guillory, 2005; Higgs, 1995; Hoppe, 2003; MacKenzie, 2002; Rothbard, 1985;
Simpson, 2005; Tucker, 1989; Westley, 2002; Woods, 2009
0 It cannot be denied, however, that there are exceptions to this general rule. See for example
Block, 1977.
0 Evidence for this claim is provided below.
73
A. Major premise: BSLL causes the ABC
B. Minor premise: The ABC is a market failure
C. Conclusion: BSLL causes market failure
Major premise: BSLL causes market failure
Minor premise: We, BH, defend the legality of BSLL in a free society
Conclusion: Therefore, we, BH, are guilty as charged of defending market
failure as a component of a free society.
However, BH do unambiguously accept A. They acknowledge that BSLL will
cause an ABC, but do not see that as a market failure. Their error, we claim, is
that they overlook the fact that they are logically required to acknowledge that
their position entails embracing the doctrine of market failure, and that this is
incompatible with their support for Austrian economics. Their maintaining that
BSLL should be legal results from their failure to see the market failure aspect,
or else they get themselves in the position of holding that BSLL is a market
failure, but that, even as such, such contracts should be legal.
The present authors readily agree with BH that BSLL will indeed foment the
ABC. Hence for us, but not for them, BSLL constitutes a market failure.
Therefore, we maintain that it should be illegal, especially in a free society.
Let us be clear on what we are saying here. If act X is or should be illegal under
laissez faire capitalism, then it cannot be a market failure. For example, murder,
rape and theft do indeed occur, and they are “failures” in a very basic non-
controversial sense, but they do not constitute “market failure” since they are all
illegal in the free society, and should be considered in that regard. On the other
hand, soi-disant public goods, externalities,0 high industrial concentration,
asymmetric information, income and wealth disparities, etc., would all exist in a
regime of full economic freedom. Because non-Austrians regard these
0 A negative externality is said to exist when an action of A negatively impacts one or more
other people. If A is within his rights, then in a free society such act would not be considered
a market failure; e.g., if a person paints his house white and you don’t like white houses that
does not make this act a negative externality in any meaningful sense. However, if A is not
within his rights then we have a “failure” but it is not a market failure, as A is operating
outside of the law. Positive externalities are merely situations where one or more people
think that X should act in certain ways to benefit Y, even though, in a free society, X would
have no such obligation.
74
conditions as failures that would and do take place without government
intervention into the economy, they consider them to be “market failures.”
Stipulate that BSLL results in an ABC.0 (Both sets of authors, BH, and the
present writer, all support this contention). If that (an ABC) is not an economic
failure, then nothing is. But, unless it is outlawed, BSLL would indeed occur
under laissez faire capitalism; this is something all four authors agree upon.0
Therefore, if BSLL is not outlawed in a free society it would constitute a market
failure. BH, but not the present authors, fall into the market failure trap. Would
that they were, instead, to use their very considerable talents and energies to
demonstrate why BSLL should be made illegal. If they had done so, they would
have helped to eradicate BSLL as a yet another supposed market failure. Instead,
they have tried and tried and tried to demonstrate the very opposite: that BSLL,
although perhaps risky and unwise, would be licit in the free enterprise system;
hence, they embrace the fallacious doctrine of market failure, whether they
realize this or not.
The problem we have with BH throughout this entire debate is that they are
supporting a practice (BSLL) that even they admit undermines the free market,
which, presumably they support. But what is this free-market? Quite simply, it
is the system of voluntary exchange. To adhere to the concept of market failure
is to support, at least in some case(s), coercion as superior to economic freedom.
That is, if BSLL is a legitimate element of a free enterprise system and if it also
can cause an ABC, then, BSLL is a type of market failure. In that case,
governmental intervention can, at least in principle, alleviate the situation, either
by preventing it, or at least mitigating its effects, assuming a not excessive cost
of the “appropriate intervention.” Therefore, because BH maintain that BSLL is
a legitimate element of the free market, to be consistent they must consider it a
type of market failure. That is, they must hold that governmental intervention is
warranted in a free enterprise economy to deal with the market failure, BSLL.
0 This assumes, of course, that the magnitude of the BSLL is non-trivial.
0 A complication; the present authors define economic freedom so as to include a ban on
BSLL; Bagus and Howden contend that BSLL is compatible with free enterprise. In contrast,
all four of us maintain that in the truly free society, fractional reserve banking would be
outlawed. For a critique of the latter, see Bagus, 2003; Bagus, Howden and Block,
forthcoming; Barnett and Block, 2005, 2008, 2009; Block, 2008; Block and Caplan, 2008;
Block and Garschina, 1996; Block and Humphries, 2008; Block and Posner, 2008. See also
Bagus (2007, 2008), Hoppe (2006), Barnett and Block (2007).
75
However, if as we maintain, BSLL is not a legitimate part of a free economy,
then there is no justification for governmental intervention to eliminate or lessen
the negative effects of BSLL. The only possible lawful action of government re
BSLL would be to enforce individuals’ property rights by prosecuting anyone
who engages in BSLL.
Of course, having, de facto, admitted the validity of the concept of market
failure, BH have allowed the camel to get its nose under the tent. Once that
happens it is “Katy, bar the door.” There are many alleged types of market
failure, but, uncontroversially, the main or most popular ones would include
insufficient competition either on the buy-side or the sell-side, and including
“natural monopolies, principal-agent problems; e.g., goal incongruency,
shirking, and moral hazard, externalities, public goods, transactions costs,
asymmetric information, and unequal wealth or income. Our point is that BH in
their analysis of maturity mismatches buy into the notion that legal actions
compatible with the free society can nevertheless have gravely deleterious
effects. If that is not a market failure, then nothing is.
Let us now demonstrate that our friends and debating partners, BH, do indeed
buy into the notion that BSLL leads to the ABC.
States Bagus (2010):
“In this article it is argued that a 100 percent reserve system can still bring
about artificial booms by maturity mismatching if there is a central bank or
government support and guarantees for the banking system. Even if we
accept the case for a 100 percent reserve requirement, we see that the
maturity mismatching of liabilities and assets (borrowing short and lending
long) is itself perilous—and in the same sense that fractional reserves are
perilous.”
Bagus (2010, footnotes deleted) avers:
“At the core of the traditional Austrian business cycle there is maturity
mismatching in the term structure of the assets and liabilities of the banking
system. In the process that underlies the business cycle, banks use short-
term liabilities with zero “maturity” (i.e., demand deposits) to finance long-
term projects via longer-term loans. However, the current economic turmoil
is marked not only by massive maturity mismatching in the form of
fractional reserve banking, but also by maturity mismatching on the part of
investment banks via structured investment vehicles (SIVs), that use short-
76
term repurchase agreements or short-term financial papers to finance
longer-term investments. Naturally, the following question comes to mind:
If one kind of maturity mismatching, i.e., the use of demand deposits to
finance loans, can cause the business cycle, would not other kinds of
maturity mismatching have similar effects, i.e., the use of funds obtained
from the issue of short-term commercial paper to finance longer-term
loans.”
Here, Bagus (2010) answers his own question:
“In this article it is argued that a 100 percent reserve system can still bring
about artificial booms by maturity mismatching if there is a central bank or
government support and guarantees for the banking system. Even if we
accept the case for a 100 percent reserve requirement, we see that the
maturity mismatching of liabilities and assets (borrowing short and lending
long) is itself perilous—and in the same sense that fractional reserves are
perilous.”
In fact, Mises himself came close to considering this question as early as 1912.
As Mises (1953, 263, citing Knies (1876, 242)) states about maturity
mismatching in general:
“For the activity of the banks as negotiators of credit the golden rule holds,
that an organic connection must be created between the credit transactions
and the debit transactions. The credit that the bank grants must correspond
quantitatively and qualitatively to the credit that it takes up. More exactly
expressed, ‘The date on which the bank’s obligations fall due must not
precede the date on which its corresponding claims can be realized.’ Only
thus can the danger of insolvency be avoided.”
Mises shows that maturity mismatching violates the golden rule of banking that
goes back to Hübner (1853). When a bank or other financial entity takes on
short-term liabilities to invest them for a longer term, it violates the “golden
rule.” Yet Mises does not follow up with an investigation concerning the effects
of the violation of this institution with respect to the structure of production.
In a similar way, Murray N. Rothbard comes close to an analysis of maturity
mismatching (2008, p. 98):
“Another way of looking at the essential and inherent unsoundness of
fractional reserve banking is to note a crucial rule of sound financial
77
management—one that is observed everywhere except in the banking
business. Namely, that the time structure of the firm’s assets should be no
longer than the time structure of its liabilities.” (Italics in the original)
Rothbard also regards the practice of maturity mismatching as unsound and even
puts it on par with fractional reserve banking. Yet, he neither investigates if
maturity mismatching absent from fractional reserve banking, i.e., with 100
percent reserves, could distort the structure of production nor if the changes
induced by it are sustainable.
And again (Bagus, 2010): “Maybe the most important conclusion of our
analysis is that not only fractional reserve banking can lead to an Austrian
business cycle. Even with 100 percent reserve requirements for demand
deposits and a constant money supply, excessive maturity mismatching …
can lead to unsustainable booms.”
In BH (2009C) both of these authors take this position: “However, while the
practice (BSLL) is not illicit per se, it is greatly assisted and developed through
the presence of a fractional reserve banking system, and can sometimes breed
detrimental effects.” The point is, if BSLL “can sometimes breed detrimental
effects”0 and it should be allowed by law as these authors contend, then it
constitutes a market failure, an implication with which, we contend, BH will be,
or at least should be, uncomfortable.
IV. Reiteration of our view
If B borrows $100 for one year from A, B may not lend that $100 to C for two
years. Why not? Because B does not have title to that $100 for two years; rather,
B has title to the $100 for only one year.
Yes, B may burn it (that is, the $100 over which he has legitimate control for
one year) if he wants to do so, as long as he has another $100 by the time this
year is up, so as to be able to repay A. But, B may not lend to C more than what
he has borrowed from A, for to do so would be to set up a contract with C that is
incompatible with the agreement already made with A. That is, B may not lend
to C that $100 for the second year, since he has no proper possession of it from
A for that amount of time.
0 BSLL, even excluding its fractional reserve subset, can cause the ABC, depending upon the
extent of the mismatching and assuming sufficient magnitude.
78
This raises important issues that are dealt with in Common Law under the nemo
dat quod non habet rule and exceptions thereto. A rough translation is that “no
one may give, or lend, or trade that which he does not have.”0 Malcolm (1958,
pp. 31-32) tells the story of a “gift” made to him by his teacher and mentor
Ludwig Wittgenstein: "On one walk he 'gave' to me each tree that we passed,
with the reservation that I was not to cut it down or do anything to it, or prevent
the previous owners from doing anything to it: with those reservations it was
henceforth mine." This “gift,” were it not a philosophical joke, would be a clear
violation of nemo dat quod non habet, since Wittgenstein, clearly, did not have
ownership rights over these trees, and thus could not legitimately give them to
Malcolm or anyone else. But the same identical conclusion would follow had
the former, instead, lent them to the latter, or traded with him for something he
owned. It would appear that this rule is a paradigm case of being contrary to
BSLL, for this is exactly what is done under that system: B borrows $100 from
A for one year, and then B turns around and lends this amount of money to C to
10 years. B lent something to C to which he did not have (full) title.
Consider yet another counter example. A’s time preference is the following; he
wants to have a binge, an orgy of spending for one week, a year hence (we may
suppose he expects that he will die at that time, and wants to go out with a
blast). The structure of production will take on a certain “shape” (Barnett and
Block, 2006) if A’s time preferences are incorporated into the societal structure
of production.0 And, if A lends this $100 directly to C for one year, after which
C pays A, then this, too, is compatible with A’s desired structure of production.
However, suppose B intervenes. B, the intermediary, borrows that $100 from A
for one year, but then lends out this precise amount of money to C, for, say, 10
years. C’s time preferences are much lower than A’s. C will invest this money of
A’s C borrowed from B for a much longer duration. The fruits of it will not be
available for 10 years, long past the death of A.
0 Here is another formulation of this rule: “21(1) Subject to this Act, where goods are sold by
a person who is not their owner, and who does not sell them under the authority or with the
consent of the owner, the buyer acquires no better title to the goods than the seller had, unless
the owner of goods is by his conduct precluded from denying the seller's authority to sell.”
Source: http://www2.derby.ac.uk/ostrich/The_law_of_the_art_and_antiquities_market/
recovery%20of%20stolen%20art_wimba/page_05.htm. For more on this see:
https://www.google.com/?gws_rd=ssl#q=nemo+dat+quod+non+habet+
0 Actually, it is more appropriate to speak of the “structure of action,” to include both the
structure of production and the structure of consumption, its analog re consumption, however
to pursue that path would take us far afield, and, in any case is not necessary to our point.
79
Two things follow ineluctably from these considerations. One, the structure of
production will take on very different contours in these two scenarios; two, the
structure of production will be less in keeping with consumption preferences
with the intermediation of B, compared to what would have ensued without his
involvement in this commercial interaction.
Why is it ethical to pervert A’s wishes in this manner? Given that the money is
spent by C in lengthier processes than would otherwise have ensued, A will not
be able to have his final party as departs this mortal coil. As far as A is
concerned, there is very little difference between this scenario and the case
where B stole A’s $100 from him outright.
Further, the present authors perhaps derive some measure of support for our
position based on the insights of Salerno (2012; italics added by present
authors):
“In the jargon of economics, fractional-reserve banking always involves
“term structure risk” arising from the mismatching of the maturity profile
of its liabilities with that of its assets.
In layman’s terms, banks “borrow short and lend long.” The inherent problem is
revealed when the withdrawal of deposits exceeds a bank’s existing cash
reserves. The bank is then compelled to hastily sell off some of its longer-term
assets, many of which are not readily saleable....
“In the presence of such policies, the deposits of all banks are perceived and
trusted by the public as one homogeneous brand of money substitute fully
guaranteed by the federal government and backed up by the Fed’s power to print
up bank reserves at will and bail out insolvent banks. Under this monetary
regime, there is absolutely no check on the natural propensity of fractional-
reserve banks to mismatch the maturity profiles of their assets and liabilities, to
expand credit and deposits, and to artificially depress interest rates. We can
expect bubbles to continually grow in various sectors of the economy and the
subsequent financial crises to continue unabated....
“In fact on the banking market as I have described it, I foresee the ever-
present threat of insolvency compelling banks to refrain from further lending of
their deposits payable on demand. They would retain in their vaults and ATMs
the full amount of the cash deposited. This means that if a bank wished to make
loans of shorter or longer maturity, they would do so by issuing credit
instruments whose maturities matched the loans. Thus for short-term business
80
lending they would issue certificates of deposits with maturities of three or six
months. To finance car loans they might issue three-year or four-year short
bonds. Mortgage lending would be financed by five- or ten-year bonds.”0
0 We are tentative in claiming full support for our position by Salerno (2012) since he also
writes thusly: “Thus for short-term business lending they would issue certificates of deposits
with maturities of three or six months. To finance car loans, they might issue three-year or
four-year short bonds. Mortgage lending would be financed by five- or ten-year bonds.” That
is, Salerno seems to favor a rough, but not an exact, matching. However, that is not perfectly
clear. Moreover, he “only” addresses bsll and not borrow long, lend short (blls).
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V. Continua
The continuum issue is very tangential to the key issue of our paper; to wit:
BSLL and market failure. We open up this section of our paper to say so, and to
keep ours matching the format of BH (2012).
VI. Future goods
We are very grateful to our debating partners for conceding our point about
“future goods.” They state (2012, 298), “We must admit that our worthy
adversaries are correct in one strict sense. There exist no future goods today.”0
However, they interpret this (former) difference between us as merely a verbal
disagreement. We demur from that conclusion.
The issue of fungibility of money also arises in this section. State BH (2012,
298): “… fungibility is a key to the specifics of the monetary loan contract. In
loans for specific goods the borrower does not destroy the good. For instance, if
I borrow a car or a painting from a friend, I am obligated to return it to him in
the same condition at the contract’s maturity. In loans of fungible goods the use
or destruction of the good is one of its essential elements. For instance, when we
borrow two ounces of cooking oil or two eggs from our neighbor, we are
allowed to use (destroy) the good. This is the purpose of the loan of fungible
goods. It makes no sense to return the burned oil or eaten eggs after cooking…”
This is another very good attempt at a reductio on their part. However, in our
view BH place too great reliance on fungibility. Let us consider, for the moment,
a non-fungible example. Take the case where A lends B his unique Picasso
painting, for the period of one year. B, as is his wont, turns around and allows C
to borrow it from him for a period of 10 years. Now, here is a case where even
BH would cavil. They (2009) state: “If the loan would be a Rembrandt painting
and A lent it for one year to B and B lent it for two years to C, B, of course,
could not fulfill their original contract and would assuredly fail to do so at the
end of the first year. However, as money is a fungible good, B can honor both
the contract and his obligations. At the end of the first year, A has a claim to
some $100 and during the first year C has the claim to another $100. They are
not the same $100 dollars as Barnett and Block seem to think.”
0 To our way of thinking, this indicates ever the more that these authors, as in our case also,
are intent upon getting to the truth of these matters, let the chips fall where they may We
greatly appreciate this.
82
Our response is, “Not so fast.” There are similarities between the two cases that
BH ignore.0 For example, if B lends out A’s Picasso to C for 10 years, having
the rights to it for only one year, it is still possible for B to come out of this
morass alright. B can go to C at the end of the year and ask C for the picture
back even though the latter has the rights to it for nine more years. Perhaps C
will give in to B’s supplications, or more likely C might sell his post-one-year
rights to B. If so, then, according to what BH should say about this, there would
be no problem. To utilize the title of their 2009 publication, this might well be
“A Risky (Undertaking), but not (a) Fraudulent (one).” But as a matter of fact,
these authors do not at all say this. Rather, they concede at least for the case of a
specific good such as the unique Picasso painting, that maturity mismatching of
this sort would not only be “risky” it would also be “fraudulent.”
Let us consider some other cases. A mother, let us call her B to preserve our
nomenclature, makes a promise to her two children, yes, you guessed it, they are
called, respectively, A and C. She promises each of them the same specific toy,
even though she has only one such in her possession. Possibly, maybe, perhaps,
she can get another one by the time she has promised to deliver this toy to the
both of them. But this is by no means guaranteed. It is a rare toy. Should she
(ethically? morally? legally?) make such incompatible promises? Extrapolating
from the insights of BH, this might be “risky” but it is not at all “fraudulent.”
We disagree and maintain that there is indeed something wrong with such a
procedure.0
Here is another instance of this difficulty. Girl B promises, no, contracts, to
marry both boy A and boy C at the end of the year. We stipulate that she cannot
marry them both, at least not at the same time. This is another case of a person
entering into two contracts that are incompatible with one another. It is our view
that girl B legally erred not only when the end of the year comes due and she
cannot marry both, but, also, at the very outset, when she enters into both of
these incompatible contracts.
0 This seems to be a constant refrain between them and us. We tend to see similarities,
continuums, they, black and white sharp differences.
0 Is the mother guilty of fraud at the outset, when she makes these incompatible promises? Or,
only at the end of the year when she is to make good on both these promises? We incline
toward the former.
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VII. Reductio ad absurdum rejection of BSLL supports fractional reserve
banking
We congratulate BH on their attempted reductio of our position. Were it
successful, it would very seriously call into question our opposition to BSLL, if
not entirely annihilate it.
In our view, in contrast, opposition to BSLL is part and parcel of rejection of
fractional reserve banking, to which all four of us subscribe. We interpret our
position as going “one better” than merely opposing the fractional reserve
system. What they both have in common is that they engender the Austrian
business cycle.0 Indeed, we see fractional reserve banking as an important subset
of maturity mismatching.0 Fractional reserve (commercial) bankers lend out
money entrusted to them for longer durations than these funds have been
entrusted to them. But, other financial institutions; e.g., investment banks, that
borrow short and lend long, are guilty of precisely the same charge. Indeed, the
one is a special case of the other. BH so clearly see the difficulty in the one, but
not (yet) in the other.
State BH (2012, 300), “Fractional reserve banking violates a depositor’s full
availability of his money and thus creates an ethical dilemma. Maturity
mismatching involves no such oversubscription of property rights…” We of
course agree with our intellectual opponents on fractional reserve banking.
Perhaps there is no explicit “oversubscription of property rights.” However, that
depends upon how one interprets the term “oversubscribe.” According to the
OED, oversubscribe means:0 “To make the subject of excessive demand for
subscriptions; to apply for (tickets, copies of a book, places on a course, etc.) in
0 And, if not prohibited by law, they constitute a “market failure.”
0
Although an important subset of BSLL, in the modern financial system, fractional reserve
banking does not appear to be the most important one. In 2008, it was primarily investment
banks; e.g., Bear Stearns and Lehman Bros., and not commercial banks, that collapsed. And,
they did so because of BSLL that did not involve fractional reserve banking; rather, it
pertained to all sorts of other very short term debt that was used to acquire securities and other
financial assets of much longer terms to maturity. That is, our most recent and major
economic collapse was caused by BSLL, but not its fractional-reserve-banking subset.
Rather, the non-commercial-bank financial intermediaries that borrowed short did not do so
by means of demand deposits but via BSLL; e.g., repos. This should put paid to any claim
that not only is BSLL theoretically unimportant, but also that it is of no practical consequence.
0
Oxford English Dictionary (Online). oversubscribe, v. trans.
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greater quantities than are available.” When A lends $100 to B for one year and
B then lends that $100 to C for two years, both A and C have incompatible
demands for $100 in year two.
In any case, there is at least an implicit difficulty: entering into two contracts
that are mutually incompatible with one another. When the mother obligates
herself to give the same toy to her two children, when girl B obliges herself to
marry the two different boys, A and C, and, yes, when A lends B $100 for one
year and B allows C to borrow this amount for 10 years, an incompatibility takes
place. Does this amount to an “oversubscription of property rights?” It might
well be the case that it does. If not, there is at least a strong resemblance
between the two cases, if not, ahem, a continuum between them.
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VIII. Conclusion
Barnett and Block (2011) said the following of BH: “Not only is their critique
on point, it was most convincing. At several times in the writing of this our
reply, we were on the verge of actually agreeing with them, and renouncing our
own views. In the event this is not to be, as our response, see below, constitutes
a reiteration and defense of our original view, and thus a rejection of theirs.
However, we found their arguments very incisive, and thus were forced to ‘dig
deeper’ than we had thought we would be able to do.”
We claim that the BH position entails acceptance of the fallacious notion of
market failure. This surely lies at the core of the radical Austrian economics to
which they, as well as we, subscribe. We invite them to more seriously consider
our side of this debate. We call upon them to help us refute their own very
incisive points about continuums, future goods, the difference between a
bailment and a loan, and to save us from their charge that our position logically
entails acceptance of fractional reserve banking. If none of the participants in
this debate can do that, we fear we shall have to entertain market failure, a great
failure on all our parts indeed.
BH say there is a sharp distinction between a deposit and a loan. We agree with
them entirely, and enthusiastically. The deposit, or bailment, is not a loan. A
places money in the possession of B, the bank, for safekeeping. It would be
improper for B to lend it out either entirely, or in part (fractional reserve
banking), because B has agreed to make these funds available to A at any time,
and such a loan would be incompatible with this undertaking.
A lends money to B for one year. The question is, What may B do with these
funds? Our answer is, Anything at all he wishes, provided, only, that what B
does is not incompatible with the contract that B has made with A, stipulating
that these monies be returned to A within the one year time period contractually
agreed upon. May B burn this money? Yes, indeed, since such an action would
not constitute an explicit abridgement of the loan agreement. May he lend this
amount to C for a period of ten years? No, he may not, since such actions would
be incompatible with the original undertaking.0
May the economic actor invest money borrowed for a year in a building project
of a decade’s long duration? We appreciate the brilliance of BH in launching
this reductio ad absurdum in our path, but we must reject their effort. The house
0 See our discussion, supra, of the nemo dat quod non habet rule
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that takes ten years to build will presumably be able to be sold at the end of one
year, even though it is not yet completed. So there is a relevant difference
between B lending the money to C for ten years, where the latter has no
obligation whatsoever to pay it back before that time (within the one year
necessary to compensate A), on the one hand, and on the other hand sinking
these funds into a construction project that can be sold within one year, even
though nine more years remain before its final completion.
87
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Chapter 6. Entrepreneurial Error does not equal Market Failure
Phillip Bagus, David Howden and Jesus Huerta De Soto
Abstract
Barnett and Block (forthcoming) claim that Bagus and Howden (2012b) support
indirectly the concept of market failure. In this paper we show that maturity
mismatching in an unhampered market may imply entrepreneurial error but
cannot be considered a market failure. We demonstrate why fractional-reserve
banking leads to business cycles even if there is no central bank and why
maturity mismatching does not per se lead to clusters of errors in a free market.
Finally, we assure that, in contrast to the examples provided by Barnett and
Block, maturity mismatching does not imply the creation of two incompatible
contracts due to the fungible nature of money.
Keywords: Borrow; lend; deposit; loan; compatible contracts; fungible goods;
specific goods; maturity mismatching, fractional-reserve banking, ABCT;
banking ethics
JEL category: E2, E59, P16
99
Entrepreneurial Error does not equal Market Failure
1. Introduction
The paper forms part of a fruitful debate on the ethics of banking, specifically
the act of maturity mismatching (also known as borrowing short and lending
long). The debate started with Barnett and Block0 (2009a, 2009b) who claimed
that maturity mismatching per se constituted an unethical practice. Bagus and
Howden0 (2009) replied that the practice in and of itself would be risky but
legitimate as the legal obligations of each contract can be fulfilled. In their
rejoinder BB (2011) claimed that BH´s distinction between loan and deposit
contracts is not clear due to problem of maturity continuum and the distinction
between present and future goods. BH (2012b) clarified these issues which led
BB (forthcoming) to believe that they had found inconsistencies in BH´s final
formulation by arguing that BH´s case relies on a “market failure”, which is
inconsistent with their general approach. BB make the following propositions:
1. BH stand in the tradition of the Austrian school of economics and do not
subscribe to the neoclassical concept of “market failure.”
2. BH maintain also that maturity mismatching is ethical and permissible on a
free market.
3. BH argue that maturity mismatching on a free market leads to a business
cycle, i.e., constitutes a market failure.
Consequently, BH should be troubled as they find a practice ethical that causes
market failure or, at least, creates severe distortions in the economy. If BB’s
propositions were true, they would have shown an important inconsistency in
BH´s position. In this article we will show that BB are misled with their third
claim. The arguments brought forth by BB induce us to explore some new
theoretical issues on the differences between maturity mismatching in a free
market and fractional-reserve banking. A positive externality of our ethical
debate on maturity mismatching consists in new theoretical insights on maturity
mismatching and credit expansion in general. Despite disagreeing with BB, we
are especially grateful that they have pushed us into this unchartered territory.
0 BB henceforth.
0 BH henceforth.
100
In section 2 we will correct BB´s interpretation of BH´s position on maturity
mismatching. In section 3 we will show that maturity mismatching does not
necessarily lead to a business cycle in an unhampered economy but, instead, is
an important welfare enhancing method to channel short-term savings into
longer-duration wealth creating investment projects. In section 4, we analyze
why credit expansion by a fractional-reserve banking system has distortionary
effects on the time structure of production and maturity mismatching does not
entail these effects in a free market. In section 5, we address the concrete
analogies of BB offered to show that maturity mismatching is an illegitimate
practice and offer a counter example. Section 6 concludes.
2. Individual error and market failure
BB (forthcoming) maintain that BH claim that maturity mismatching will cause
a business cycle. BB do not clarify whether they mean that maturity
mismatching necessarily or only possibly causes a business cycle, but claim that:
[BH] acknowledge that BSLL [borrowing short lending long] will cause an
ABC, but do not see that as a market failure. Their error, we claim, is that
they overlook the fact that they are logically required to acknowledge that
their position entails embracing the doctrine of market failure, and that this
is incompatible with their support for Austrian economics. Their
maintaining that BSLL should be legal results from their failure to see the
market failure aspect, or else they get themselves in the position of holding
that BSLL is a market failure, but that, even as such, such contracts should
be legal.
BB’s subsequent argument hinges on the argument that BH defend that maturity
mismatching will cause an Austrian business cycle in a free market. This claim
is false. Bagus (2010, p.2, emphasis added, as cited in Barnett and Block
forthcoming) writes: “In this article it is argued that a 100 percent reserve
system can still bring about artificial booms by maturity mismatching if there is
a central bank or government support and guarantees for the banking system.”
Furthermore, in footnote 2 of the same article Bagus writes: “[...] the 100%
reserve requirement is not sufficient to prevent business cycles if other
government interventions into the financial system remain intact.” The
conditional clause indicates that business cycles can be caused by maturity
mismatching if undertaken in excess, an outcome promoted by government
interference in the economy, e.g., through a lender of last resort (e.g., central
101
bank or Treasury), bank guarantees or other support to the banking system.
These situations all diverge from the free market base scenario.0
In other words, BH have argued consistently that maturity mismatching may
lead to a boom-bust cycle when fostered by government intervention, but will
not on a free market. Regarding maturity mismatching on a free market BH
(2010, p. 73) summarize their position thusly:
A financial intermediary might borrow short and lend long by continually
rolling over their borrowings, relying on the correct anticipation of the
future availability of savings for success. In a free market there is no
general reason why one would systematically under- or overestimate the
future availability of savings, and thus, the possibility to roll over loans
(Bagus, 2010).
BH (2010, p. 74) further insist: that “[if] not faced with perverse incentives,
there is no reason for entrepreneurs to overestimate systematically the future
amount of savings.” In conclusion:
On the free market, there will always be maturity mismatching to some
extent as entrepreneurs try to anticipate future savings availability.
Arbitrageurs earn a profit by shouldering the risk of mismatching and
arbitraging between terms.
Excessive maturity mismatching discoordinates the term structure of
savings and the term structure of investments (the time structure of
individual savings and investment plans). Three phenomena foster
excessive (i.e., nonsustainable) maturity mismatching: credit expansion, the
existence of a lender of last resort and government bailout guarantees.
Excessive mismatching caused by government interventions leads to an
unsustainable misalignment of the term structures of savings and
0 We quote here from Bagus (2010) because it makes use of the same reasoning as all of BH’s
work on the ethicality and legality of maturity transformation and fractional-reserve banking.
Other articles we have written on the topic (e.g., Bagus and Howden 2013; forthcoming,
Bagus et al. 2015) only implicitly reject this outcome by not referring to it. Instead, our focus
has always (and exclusively) been on maturity transformation in the unhampered market.
Howden and Gabriel (2015) discuss the role of the interest rate in halting excessive maturity
mismatching in the unhampered economy. We do treat maturity transformation as a damaging
economic force when fostered by governmental guarantees in Bagus and Howden (2010a),
though that article only tangentially deals with the core issue of the present debate, namely,
how ethical, legal or economically beneficial fractional-reserve banking is.
102
investments. As a result, financial institutions unsustainably borrow short
and lend long. (Bagus and Howden 2010, p. 81)
Thus, BH distinguish between free-market maturity mismatching and excessive
maturity mismatching fostered by government intervention.0 The former does
not cause Austrian business cycles; the latter does. As the latter is made
“excessive” by government intervention we do not face a “market failure” but
rather a government failure.
Maturity mismatching is a risky activity because the intermediary may not be
able to service their short-term debt obligations. The intermediary may expect to
renew the debt or find another lender or source of income, but this expectation
may be proven erroneous. As BH (2010, p. 74) put it:
There is, however, the possibility of individual entrepreneurial error.
Entrepreneurs might overestimate the availability of future savings. They
may not be able to roll over their debt, revealing the malinvestment that
stems from the overestimation of the resource availability. They will have
engaged in an investment project without securing in full the funds
necessary for its completion,
Individual errors by intermediaries that engage in maturity mismatching in an
unhampered economy occur owing to the uncertain nature of their future
oriented expectations. Entrepreneurs may err, e.g., overestimate the availability
of future savings or the willingness of economic agents to abstain from
consumption in the future. Where there is freedom of choice and free will, there
exists the possibility of error.0 Individual error is part and parcel of human
action. Individual error does not imply a market failure.
The logical possibility exists that entrepreneurs err collectively concerning the
amount of future savings, in the same way that they could err collectively
regarding what products consumers will buy tomorrow and start producing, e.g.,
outdated car phones, or t-shirts in last season’s colors en masse. Yet, there is no
reason to believe that entrepreneurs will err collectively and systematically in
the same direction in a free market. In other words, the opportunity for profit
0 BH assessed the case of excessive maturity mismatching as a cause of Iceland´s recent crisis,
identifying it as a result of government liquidity and solvency guarantees (Bagus and Howden
2011, chap. 2).
0 A free market with the possibility of profits with no losses is akin to the bliss of heaven with
no threat of hell.
103
should make entrepreneurial errors uncorrelated. Clusters of errors are a
characteristic of an intervention hampered economy (Hülsmann 1998; Rothbard
2000), not of a free market. Thus, while a financial intermediary engaging in
maturity mismatching in a free market may individually err, there is no reason
why all such intermediaries should err systematically. While individual error
may cause detrimental effects specific to the company, e.g., for employees of the
entrepreneur, this is distinct from an economy or industry wide market failure.0
3. Maturity mismatching does not lead to a business cycle in the unhampered
economy
To state the trivial, production takes time. Workers employed in any production
process must be sustained over the period during which their efforts mature into
consumable output. Real savings are necessary in order to sustain the owners of
the factors of production. While some savings must be procured before any
investment project begins, some saving may also occur during the production
time supplying goods and services to the owners of the factors of production.0
Entrepreneurs estimate the availability of real savings, not only in the present
but also those that will become available over the course of their investment’s
duration.
By anticipating the flow of future savings correctly, longer and more ambitious
investment projects can be undertaken in the present than by solely relying on
the savings secured before the projects starts. If entrepreneurs were to take into
account only the available real savings in the present, i.e., the available stock of
resources, they would forgo wealth enhancing investment projects by way of
0 BH (2009, 399) write: “However, while the practice (BSLL) is not illicit per se, it is greatly
assisted and developed through the presence of a fractional-reserve banking system, and can
sometimes breed detrimental effects.” BB (forthcoming) cite this sentence and comment:
“The point is, if BSLL can sometimes breed detrimental effects´ [fn omitted] and it should be
allowed by law as these authors contend, then it constitutes a market failure, an implication
with which, we contend, BH will be, or at least should be, uncomfortable.” Actually, BH are
not uncomfortable in the least. First, we state clearly and many times that maturity
mismatching, i.e., BSLL, is greatly assisted by fractional-reserve banking which we (like BB)
do not consider a free-market practice. Second, we defend a free market that allows for
individual errors, which by definition always have detrimental effects, at least for the actor
and potentially also third parties. However, these detrimental effects of individual error do not
constitute market failure which is the widespread and correlated nature of individual errors.
0 Traditional analysis of the savings requirement for long-dated investments focuses on the
concept of the subsistence fund, both in its stock form available before the investment is
undertaken and in its flow form as the ongoing product of simultaneous investments. On the
subsistence fund see Strigl (2001) and Braun (2014).
104
possible longer-dated (and thus more productive) investments. This is the core
of the theory of economic development laid out by Böhm-Bawerk (1930: 82),
and later extended in Mises (1949: 259-64).
By way of example, imagine Robinson Crusoe and Friday stranded on a desert
island. Robinson and Friday can fish with their bare hands and each catch ten
fish per day. Friday wants to engage in the production of a capital good that
increases his fishing productivity (e.g., a sharpened stick). He estimates that it
will take him ten days to locate and sharpen a suitable stick, during which time
his fish production will decline to only one fish per day. He further forecasts that
the sharpened stick will double his fish production. Friday has no savings, but
Robinson has 100 fish saved0 and offers a loan to Friday for five days, after
which the loan must be repaid with an extra five fish as interest. Friday does not
expect to be able to repay the loan at maturity, but is convinced that Robinson
will renew the loan after 5 days, so he takes it. Five days later he pays the five
fish interest payment and convinces Robinson to renew the loan for another five
days. In this example, one can see that without mismatching maturities of the
loan and the investment project, Friday could not have undertaken his project.
He would not have started as he had not secured the necessary savings, which
were necessarily of a different maturity than his investment, to complete the
project.0 Thanks to maturity mismatching, the correct estimate of future savings
coupled with a low future time preference rate (of Robinson) to produce a
capital good (the sharpened stick) was built. Society is wealthier thanks to
maturity mismatching.
Not only does maturity mismatching not necessarily lead to a distortion in the
structure of production, it may also be welfare enhancing. When the social rate
of time preference or aggregate real savings, are constant, maturity mismatching
allows for increased intertemporal coordination.0
0 The perishability of fish is a constraint in this example that we abstract from this point for
simplicity. In any case, money is a perfectly non-perishable savings tool and is the primary
means of saving employed today.
0 We say “necessarily different” here as the duration of the loan is known ex ante, but the
duration of investment is only revealed ex post facto. Since the expected investment maturity
cannot be known in the present with any degree of certainty, whether the maturity of the loan
and the investment it funds are matched can never be known at the initiation of an investment
project, and would only potentially be revealed at the project’s completion.
0 Davidson (2014) maintains similarly that maturity mismatching does not cause distortions in
a free market. We claim, a fortiori, that maturity mismatching is not only neutral but may also
105
Consider the following example, updated for the modern monetary economy. A
bank borrows for one year from A to invest in a project that takes two years to
mature. After the first year A is paid back his loan and increases consumption.
Now person B takes on the role of the saver, abstains from consumption, and
gives a one-year loan to the bank. The bank can now successfully complete the
financing of the project. The structure of production has become more capital
intensive. During production time, there has been no change in social time
preference rates. The only change has been to the composition of savers, with A
originally providing savings and B later completing the task. A increased
consumption after the first year, while B did the opposite and thus neutralized
the aggregate effect on real saving. Entrepreneurs may anticipate correctly the
evolution of the social rate of time preference and aggregate savings, and as
such the availability of short-term savings necessary to roll over their loans. (Or
at least, we cannot rule out a priori that at least some entrepreneurs will
correctly estimate these variables.) There is no necessary intertemporal
discoordination.
Indeed, as Davidson (2014) in a critique of Block and Barnett reminds us, the
starting point of ABCT is a constant social time preference rate. Credit
expansion causes a structure of production to be dissonant with the constant
social time preference rate. A constant social time preference rate implies in our
above example that when A increases consumption, someone (in our case B)
will decrease consumption and take on the role of the saver.
Consider, next, an economy where only the social time preference is
assumed to be constant. The time preferences of individual actors can
change, but gross saving is constant over time, as in the ERE. While the
composition of the investment vehicles in which these savings are held
need not remain the same, the renewal or replacement of those of finite
duration with others of equal value—but not necessarily the same duration
—must take place, this being the necessary implication of the quantity of
gross saving being maintained. With regard to production, some processes
are ongoing, others are newly initiated, and yet others are terminated, but
gross saving and investment continue to equal each other in quantity—that
is, in money value—as capitalist-entrepreneurs freely compete with one
another to supply present money, and original factor owners freely compete
to demand it. (Davidson 2014, p. 77)
be welfare enhancing.
106
Davidson (2014) argues that the effect on interest rates occurring under
fractional-reserve-type credit expansion cannot occur under maturity
mismatching because with constant social time preference the time dimension of
gross saving and investment in the market as a whole continue indefinitely. And
unlike credit expansion, the quantities of gross saving and investment remain
equal to each other over time, ceteris paribus. Therefore, market interest rates
continue to reflect the actual social time preference and no Austrian business
cycle is created.
Davidson (2014, p. 72) contends that the error of Block and Barnett originates
from their example in which they analyze the effects of maturity mismatching
on saving and investment in a very restrictive situation (one one-time saver and
two borrowers), as though the market economy does not exist. In such a
situation of a one-time saver where savings fall to zero when his savings end,
the time dimension of his savings becomes crucial and maturity mismatching
extending the time dimension leads to a distortion.
4. Why maturity mismatching may be beneficial but unbacked credit expansion
is not
If maturity mismatching in an unhampered economy does not systematically
cause recurring business cycles, would credit expansion by a fractional-reserve
banking system also be harmless in an unhampered economy? If there is an
amount of maturity mismatching that is beneficial in the unhampered economy,
can there not also be an amount of credit expansion that could be beneficial,
too? Furthermore, if this was the case, would credit expansion only become
harmful if excessive and fostered by government interventions such as bailout
guarantees or the institution of a central bank, but be perfectly fine if undertaken
by a voluntarily structured fractional-reserve banking system?
First, one of the ethical questions at stake is whether fractional-reserve banking
can be legitimate in a free society.0 Our answer is that fractional-reserve banking
is based on invalid contracts that would not be upheld in a free society. The
existence of fractional-reserve banking presupposes a government granted legal
privilege that permits banks to operate with invalid contracts. This legal
privilege is notably the case today as other depositories of fungible goods (e.g.,
grain silos or oil mills) are not allowed to operate with fractional reserves
(Williams 1984; Huerta de Soto 2009: 125, 129), or the law turns a blind eye to
0 Block and Davidson (2011) maintain that the ethics of fractional-reserve banking is more a
fundamental and important issue than its economic consequences.
107
banks not abiding by the law as is the case in Germany (Köhler 2013: 916, 918).
(Bagus et al. 2015 give a further elaboration of the ways that banks are legally
privileged.)
Second, credit expansion unbacked by real savings in a fractional-reserve
banking system is fundamentally different from maturity mismatching. When a
financial intermediary borrows short and lends long, he may be successful in his
endeavor and the structure of production is sustainable.
In contrast, when a bank creates new monetary substitutes in the form of
deposits and lends them out (i.e., creates fiduciary media), there will be a
problem ceteris paribus (most importantly with constant time preference rates).
When a bank expands credit against deposits, there has been no increase in real
savings. No one abstained from consumption thus releasing resources for a new
investment project. Interest rates are reduced artificially below the level they
would otherwise have had attained.0 Entrepreneurs invest as if real savings had
increased and consumers funded these investments by way of reducing their
present consumption. We are faced here with a clear case of intertemporal
discoordination that forms the nub and kernel of Austrian Business Cycle
Theory (which Barnett and Block are intimately familiar with, and advocates
of). The structure of production becomes unsustainable when the social rate of
time preference does not change favorably towards additional savings. The
shifting of, or additions to investments may only become sustainable if the
social rate of time preference rates decreases in the future, i.e., there is an
increase in real savings driven by consumers curtailing consumption (as in
Bagus and Howden 2010: 67).
We will now contrast this with the example from section 3 which shows that
maturity mismatching can lead to a more capital intensive and sustainable
production structure with the effects of credit expansion. It is possible to
imagine an (albeit unlikely) scenario where credit expansion does not distort the
structure of production. This is the case if after a credit expansion social time
preference changes favorably to such an extent that the structure of production is
sustainable and there is no a bust.
0 Davidson (2014, 86) refers to another important difference between credit expansion and
maturity mismatching. While credit expansion artificially lowers interest rates, thus inducing
entrepreneurial error, in the unhampered market maturity mismatching´s effect on interest
rates is to raise short-term and reduce long-term rates. Maturity mismatching flattens the yield
curve to a level more in line with overall uncertainty and the availability of savings.
108
Imagine that a bank creates $1,000 of new money substitutes and makes a loan
to entrepreneur E for one year. E invests in a project with a maturity of 10 years.
E uses the $1,000 loan to pay his workers at the end of year one. Assume that
workers save their income completely and loan the $1,000 to E with a maturity
of nine years, and E uses the money to pay down his bank loan. The additional
money supply declines as bank credit contracts. As the workers restrain their
consumption (by saving all of their income), the investment is backed by real
savings.
However, if workers only spend part of the money newly created by credit
expansion, a relative rise in consumer goods´ prices will occur, which will in
turn foster intertemporal discoordination. As states Hayek (1976, p. 378):
[S]o long as any part of the additional income thus [by credit expansion]
created is spent on consumers´ goods (i.e. unless all of it is saved), the
prices of consumers´ goods must rise permanently in relation to those of
various kinds of input. And this, as will by now be evident, cannot be
lastingly without effect on the relative prices of the various kinds of input
and on the methods of production that will appear profitable.
The projects initially financed by credit expansion are sustainable only if all of
the newly created $1,000 is saved. The investments are backed by real savings:
workers abstain from consumption for nine years representative of a decrease in
the social rate of time preference. In distinction, explanations of Austrian
business cycles normally start from assuming a constant social rate of time
preference and analyze the effects of credit expansion unbacked by real savings
only later on.
Relax the key assumption in our example and consider what happens if the
workers do not save all of their additional income of $1,000 dollars at the end of
year one. If they spend even a small portion of their new income, consumer
goods’ prices will rise relative to capital goods’ prices, the exact occurrence that
instigates the Austrian business cycle.0
0 In our example when the entrepreneur pays down his bank loan, credit contracts and the
bank increases its reserve ratio. In practice, when a bank loan is paid down, banks often use
the additional reserves to grant another loan. In other words, even though workers save all of
the $1,000 and the entrepreneur pays down his bank loan, there may be an artificial boom
when the bank grants a further loan to another entrepreneur.
109
Credit expanding banks may try to anticipate the willingness of workers to save
the additional income in a manner similar to how the financial intermediary
engaging in maturity mismatching tries to anticipate the future availability of
short-term savings. Yet there are important differences between a financial
intermediary anticipating the availability of future short-term savings and a
credit expanding bank that speculates on an increase in real savings.
While the intermediary can successfully engage in maturity mismatching with
constant social time preference rates (as in the example in section 3), the
fractional-reserve bank has to assume that there is a sudden decrease in time
preference rates when it expands credit. In addition, the bank must be able to
know if the savings by workers are real or just created ex nihilo by credit
expansion of another bank.0 Furthermore, once the one-year loan in our example
is repaid, the bank must abstain from expanding credit again which in practice is
quite unlikely as it entails a sacrifice of profits relative to those banks that do
expand credit (as in Carilli and Dempster 2001 and Huerta de Soto 2009: 667).
In fact, profits of fractional-reserve banks may increase considerably by not
following this rule but by cooperating during the boom by expanding credit at
the same rhythm as other banks.0 In contrast, in the case of a financial
intermediary and maturity mismatching, no cooperation is of help in improving
profits when future short-term savings have been anticipated incorrectly.
5. Why maturity mismatching is ethical and the underlying contracts compatible
BB (forthcoming) restate their view on maturity mismatching by claiming that
the financial intermediary does not have a title to lend money long term if it has
only a short-term debt obligation. In doing so they make an important
concession: namely, that the short-term borrower must not return the same
specific money to the lender, but just the fungible equivalent. Thus, the
borrower is even entitled to destroy the borrowed money if he fulfills his
contract by returning the equivalent sum at the end of the term:
0 Howden (2010) shows that the further one is to the source of the initial credit expansion; the
lesser will be the knowledge of whether a loan is back by real savings or credit expansion.
Investments made without this knowledge will be more fragile as they have a reduced
understanding of the true resource constraint limiting their investments in both magnitude and
duration.
0 This was, after all, one of the primary forces that drove the fractional-reserve free banking
industry in America to demand the imposition of the Federal Reserve (Bagus and Howden
2012a: sect. 3; Howden 2014).
110
If B borrows $100 for one year from A, B may not lend that $100 to C for
two years. Why not? Because B does not have title to that $100 for two
years; rather, B has title to the $100 for only one year. Yes, B may burn it
(that is, the $100 over which he has legitimate control for one year) if he
wants to do so, as long as he has another $100 by the time this year is up,
so as to be able to repay A. (Barnett and Block forthcoming)
It is hard to understand why B has the right to burn the $100, but not the right to
lend it for two years. The obligation in his contract with A is to return any $100
after one year. The fulfillment of this obligation is compatible with burning the
specific $100 bill – as BB acknowledge – as well as lending the specific $100
bill for two years to C.
If BB argue that it is legitimate for B to burn the $100 bill, why is it not
legitimate to lend it for 1,000 years to C, or to lend it to an astronaut to take on a
one-way mission to Mars? In all cases, the specific $100 bill is basically “lost”
as concerns human action on Earth. This does not take away that B can fulfill his
loan payment to A at the end of the year by means of an alternative $100.
Furthermore, it matters not whether this $100 is procured from B’s existing
savings or is borrowed anew on the loans market so long as A has his contract
fulfilled.
BH (2012b) argued that while maturity mismatching would be a legitimate
practice for fungible goods, it is illegitimate for specific goods. If B borrows
$100 for one year from A, he may lend $100 to C for ten years. It is a risky, but
not fraudulent practice. In contrast, if B borrows a specific good such as a
Picasso painting for one year from A, he is not allowed to lend it for ten years to
C. From this distinction, BB (forthcoming) attempt an interesting reductio ad
absurdum by stating:
[I]f B lends out A’s Picasso to C for 10 years, having the rights to it for
only one year, it is still possible for B to come out of this morass alright. B
can go to C at the end of the year and ask C for the picture back even
though the latter has the rights to it for nine more years.
Therefore, BB believe that BH should also maintain that maturity mismatching
in case of the Picasso painting would be just risky but not fraudulent. BB are
certainly correct that B could deliver the painting back if he could convince C to
return it earlier. The decisive difference between this case of maturity
mismatching with that of fungible goods is that the latter has no conflict at the
moment when B lends to C. When B borrows money short from A to lend money
111
long to C, these two contracts are compatible and can be fulfilled ab initio. In
contrast, when B borrows the Picasso painting for a short term from A to lend
long term to C, these two loan contracts are not compatible at that moment.
They cannot be fulfilled at the same time. The motive of A is to lend the Picasso
for one year to B, and B´s motive to lend the Picasso for ten years to C. The
motives are incompatible. 0 Under contract law, this contract would be void ab
initio as it is impossible, an outcome that at least one of BB has endorsed in the
past as an argument against fractional-reserve banking (Bagus et al. 2013).
An alternative way to look at the ethicality of monetary maturity mismatching is
through the lenses of title-transfer theory of contract (Davidson 2015). While
mainstream contract theory focuses on the expectations of the contracting parties
and argues that there is an exchange of promises, the title-transfer theory regards
a contract as an exchange of titles on property.0 Maturity mismatching does not
involve any duplication of property titles (Davidson 2015). When A lends B $
100 for 1 year, B receives the title of the money and A receives the title to a
claim on $100 within one year (i.e. a bill of exchange). A full exchange of the
title to the money takes place.0 When B transfers the money and its full title to
C, B receives the title to a different claim, for instance, to a claim on $100
within two years.
Let us apply the title transfer theory of contract on the proposed example of the
Picasso. In the case of the painting, the lender´s claim is naturally not
represented by a bill of exchange, which is evidence only of an obligation on the
part of the debtor to payee. But the "loan" of something like a Picasso creates a
fundamentally different kind of arrangement; in effect, a zero-fee lease contract,
where the use of the property is transferred, but not its ownership, and therefore
0 Even though the contract is void (i.e. no court would enforce it) the parties can still dissolve
the contract mutually and agree to another, valid contract (i.e., debt renegotiation). For
instance, B could convince C to give him the Picasso back after one year.
0 Already Lysander Spooner criticized the contract theory based on promises. See also Barnett
(1986, 1992) for problems associated with a contract theory relying on promises. On the title
transfer theory of contract see Evers (1977) and Rothbard (1982). For a recent overview see
Kinsella (2003).
0 As Davidson (2015, p. 8) puts it: “There is no half-way measure in the case of money.
Because of money’s very nature, money’s title cannot be divided into different kinds of
ownership privileges in the way of an easement or a rental contract. Consequently, there can
only be one right associated with it: Full unrestricted ownership.”
112
the "lender's" (or leaser´s) "claim" is to the title itself.0 B cannot lend the Picasso
for 10 years to C, because he does not receive the ownership but only the right
to use it for one year. B does not own the full title to the Picasso. He cannot burn
the Picasso as he could do with a money loan. And he does not hold the right to
lend it for 10 years.
Finally, BH (2012b) made the analogy of an individual borrowing short (for 20
years) in order to invest in building a house that lasts 50 years (with the
mortgage being paid down after 20 years out of savings of the houseowner or
being renewed by a new lender). BH did not regard this common practice as
criminal and argued that following BB´s logic, one had to regard such mortgage
financing as criminal. BB (forthcoming) respond by changing the example
slightly. If money is borrowed for one year, in order to finance a house that
takes ten years to build, BB find this ethically unproblematic. (We agree: the
practice is risky but not fraudulent.) How can BB maintain that borrowing
money short to lend it long is fraudulent, but borrowing money short to invest it
long (in a house) is not fraudulent? For them (forthcoming) the difference
consists in the fact that: “The house that takes ten years to build will presumably
be able to be sold at the end of one year, even though it is not yet completed.”
But the same is true for any money loan invested.0 If B borrows for one year
from A to lend for 10 years to C, at the end of the first year, B may be able to
sell the loan contract with C to D in order to pay A. Thus, our analogy holds and
if BB consider borrowing short to invest long in a building project to be
legitimate, they must also consider maturity mismatching as legitimate.0
0 Davidson (2015) shows that Block and Barnett´s confusion arises because those authors fail
to recognize that the English language employs two very different meanings for each of the
terms "loan" and "claim."
0 Indeed, it is nonsensible to speak of savings without making reference to the investment that
embodies them (Braun 2014: chap. 19).
0 More generally, the ethicality of maturity mismatching does not depend on the loan being
self-liquidating loan (or a real bill) or not.
113
6. Conclusion
The concept of “market failure” is serious business, and is not to be dealt with
lightly. We have shown that a specific maturity mismatching in an unhampered
market may constitute an entrepreneurial error but it does not systematically
trigger business cycles. Block and Barnett would have to consider
entrepreneurial error as market failure if they wanted to maintain their position.
We doubt they do. There is nothing wrong with entrepreneurial error, in fact, if
anything economists and ethicists should consider them as the necessary evil
they are.
Entrepreneurs make plans in the present based on expectations of the future.
Commonly the relevant expectations are thought of in terms of satisfying a
future consumer demand, e.g., what color t-shirt will be popular next summer,
will fuel efficiency or power be more demanded in automobiles, etc. In this
paper we have stressed two points.
The first is that expectations must also focus on the future availability of real
savings. The nub and kernel of economic growth theory is that longer-dated
investments are more productive than shorter-dated ones. To take an extreme
view on it, the technology that we enjoy today has only been made possible by
previous investments. It is trivial to point out that these advances would never
have been undertaken if their savings had to be made available both in terms of
magnitude and duration at the point when these investments began. (The average
period of production, a requisite datum if one wants to match the duration of
savings with that of investment, is undefinable (Knight 1935).) Maturity
transformation is an economic action that allows longer-dated investments to be
undertaken today and fully funded only later by new savings. On grounds of
economic efficiency, to advocate for the banishment of maturity transformation
is to demand the world to take a giant economic step backwards. We doubt this
is what Barnett or Block advocate.
However, economic considerations alone are not sufficient to ethically
legitimize an action. The question at stake boils down to one of property rights
and obligations. Specifically, does a borrower have an obligation to not do
anything with a borrowed good beyond the contracted duration of use and
availability the loan gives him. Standard contract law and traditional (and a
priori) legal principles give two cases for dealing with this question.
114
The borrower is barred from using specific goods for a maturity longer than that
contracted for. The reasons are two-fold. On the one hand, the contact is
impossible to fulfill ab initio. If A borrows a painting from B for one year and
lends it to C for two years, there is no assured way for B to make good on his
contract to A. The reason why this contract cannot necessarily be honored comes
from the second reason it is invalid: there is no meeting of the minds. The loan’s
purpose is to make use of the lent good over its maturity. Some might say that B
could always borrow the painting back from C at the end of year one, but this
would not be in accord with the reason why C borrowed the painting for two
years. Specific goods borrowed must be used within their contractual maturity.
The same reasoning does not apply to fungible goods. Since the only criterion
that matters for these goods is that an equal quantity and quality of good is
returned at the contract’s maturity (i.e., a tantundem), there is always the
possibility for a borrower to obtain additional units to repay the original loan.
Maturity matching is an irrelevant requirement for fungible loans.
In their response, Barnett and Block (forthcoming) do not deal with the
distinction between specific and fungible goods, and thus give a bevy of
examples that confuse the two. This is unfortunate because it makes their
analysis mostly inapplicable to the current debate at hand. There is a beneficial
side effect, however. Barnett and Block are far from the only authors who
neglect the important distinction between specific and fungible goods (see also
Evans 2014: 354 or Yeager 2010: 188 for similar cases). This response has
allowed us to expand and strengthen our original case and thus we conclude
with a summary of the position we have held since Bagus and Howden (2009).
Maturity mismatching, or borrowing short and lending long, is an ethical and
economically beneficial activity provided that it is not assisted artificially (e.g.,
with deposit insurance, bail out guarantees, etc.). Important caveats are that the
borrowed good is fungible and that the loan is actually a loan (i.e., has a
maturity) which is notably not the case with the bulk of loans intermediated by
the fractional-reserve banking system. Separating banks into deposit taking and
loan intermediating divisions would not only reduce economic distortions but
would allow for ethically legitimate practices to be promoted (such as maturity
transformation) while ending those that are illegitimate (such as fractional-
reserve banking).
115
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Chapter 7. Maturity mismatching, ethics and economics: Rejoinder to Bagus,
Howden and Huerta de Soto
Walter E. Block and William Barnett II
Abstract:
Is maturity mismatching, borrowing short and lending long, merely risky, or
would it be banned in the free society as a rights violation? The present paper is
the latest episode in a debate series on this issue. The present authors take the
position it is unethical and should be against the law. Our debating partners
subscribe to the opposite point of view.
Key words:
Banking; lending; ethics; law
JEL category:
E2, E59, P16
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Chapter 7. Maturity mismatching, ethics and economics: Rejoinder to Bagus,
Howden and Huerta de Soto
I. Introduction
The present essay is the seventh0 in a debate series that has been occurring
between Barnett and Block (BB)0 on the one side and Bagus and Howden (BH)
on the other.0 In BB (2009A, 2009B), the first two in this collation, these authors
claimed the maturity mismatching (MM) was incompatible with the free market.
0 Barnett and Block, 2009A, 2009B; Bagus and Howden, 2009; Barnett and Block, 2011A;
Bagus and Howden, 2012; Block and Barnett, 2015; Bagus, Howden and Huerta de Soto
Ballester, 2016
0
We use numerous abbreviations in this paper. They are as follows:
ABC = Austrian business cycle
ABCT = Austrian business cycle theory
BB = Barnett and Block
BH = Bagus and Howden
BHHdS = Bagus, Howden and Huerta de Soto
BLLS = borrow long, lend short
BSLL = borrow short, lend long
FRB = fractional reserve banking
MM = maturity mismatching
SOP = structures of production
The way BSLL has been used in the past, in this series, can be confusing. That is, does BSLL
always include FRB? It should be noted, first, that this debate deals only with BSLL.
Second, that BSLL includes, but is not limited to, FRB. Third, that all five parties agree that
FRB can cause ABC, and that FRB is not a feature of a free market. Thus, when FRB causes
the ABC, this does not constitute market failure. Fourth, that this debate solely concerns
non-FRB BSLL. Fifth, that BB and BH (and now, presumably, Huerta de Soto joins BH in
this) maintain that this form of BSLL may cause ABC. Sixth, that BH (and now, presumably,
Huerta de Soto joins BH in this) maintain that this form of BSLL is ethically acceptable since
it is a part of the free market, and does not constitute market failure. Seventh, that BB
maintain that this form of BSLL is ethically objectionable and not a part of the free market,
and ipso facto does not constitute a market failure. Eighth, BB (and now, presumably, Huerta
de Soto joins BH in this) maintain that, if however, that form of BSLL is morally legitimate
and is part of the free market, then because it can cause ABC, it is a form of market failure.
That is, if, arguendo, BHHdS accept this type of BSLL as a part of the free market, then it
constitutes a market failure as it can cause an ABC. A key insight is to distinguish BSLL with
FRB from BSLL without FRB.
0
In the sixth iteration, the one previous to the present contribution, Jesús Huerta de Soto
Ballester has joined Bagus and Howden. We welcome his arrival on the scene, as he is one of
the foremost Austrian economists and libertarian theoreticians on the entire planet. We now
refer to them as BHHdS, for short. The present authors thank BHHdS for helpful suggestions
regarding an earlier draft of the present paper. As per usual, all errors and infelicities are the
sole responsibility of the present authors, BB.
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In BH (2009), the third entry, they defended the view that was MM was risky,
but, nevertheless, compatible with the free enterprise system and that borrowing
short and lending long (BSLL) creates the Austrian Business Cycle (ABC). BB
(2011A), the fourth, was an attempt to defend Barnett and Block (2009) against
the very interesting and important, although we believe, erroneous, criticisms on
ethical grounds of Bagus and Howden (2009). BH (2012), the fifth, made the
point that “… the economic and legal differences between genuine deposit and
loan contracts are clear. This implies different legal obligations for these
contracts, a necessary step in assessing the ethics of both fractional reserve
banking and maturity mismatching. While the former is economically, legally,
and perhaps most importantly ethically problematic, there are no such troubles
with the latter.” The sixth in this series, BB (2015) charged that MM constituted
a market failure, something no right-thinking Austrian economist, such as BH,
could accept. The present paper is the seventh in this series.
BB (2015) struck a new chord with its charge that BSLL constituted market
failure. Market failure is a concept that all four authors, BB as well as BH,
reject. The most recent contribution to this debate, Bagus, Howden and Huerta
de Soto (BHHdS, 2016, the sixth in this series) took the position (1) that BSLL
is legally and morally legitimate, (2) that BSLL does not cause the ABC at least
not in the fully free economy, and (3) that their defense of BSLL does not
support, is not predicated upon, is not compatible with, the concept of market
failure, which concept, again, all four, now five of us, regard as a fallacy. The
present article rejects all three assertions of theirs.
Before we begin our substantive critique of BHHdS (2016), we offer a few
words about concepts and language. Traditional Austrian Business Cycle Theory
(ABCT) sees as the source of the business cycle an artificial lowering of the
pattern of interest rates, below the levels that would otherwise have obtained.0
These, in turn, would have been based on the (risk adjusted) marginal time
preferences of all economic actors in society. As a result, unsustainable
investments are made in the higher, or earlier (Garrison, 2001) stages of
0 This artificial lowering of rates should be understood to refer to risk-adjusted rates; i.e., the
real culprit is an artificial increase in credit which sometimes takes the form of a lessening of
credit standards.
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production process0,0; this is the boom phase. But these expenditures prove
untenable in the long run; this is the economic bust.
In our view, MM = BSLL + BLLS.0 BHHdS, we think, get it wrong when they
say (p. 1) “… maturity mismatching (also known as borrowing short and lending
long).” That is, in our view, MM and BSLL are by no means equivalent. There
are two, not one, forms of MM: BSLL, yes; but also BLLS. Let us now consider
some examples of each. Here is BSLL: A deposits $10 in bank B for 1 year.
This is a time deposit. B turns around and lends this $10 to C, for a period of 10
years. B borrowed short, but lent long. Here is BLLS: A deposits $10 in bank B
for 10 years. This is a time deposit. B turns around and lends this $10 to C, for a
period of 1 year. Here, B borrowed long, but lent short. As we see matters,
fractional reserve banking (FRB) is merely a special case of BSLL. Here, then,
is an example of FRB0: A deposits $10 in bank B on demand. This is not a time
deposit, but rather a demand deposit. The length of “time” for this demand
deposit is 0 years, 0 months, 0 weeks, 0 days, 0 minutes and 0 seconds.0 B turns
around and lends this $10 to C, for a period of 10 years. With this
0
Long term investments such as are made in mining or heavy manufacture, that are far away,
in terms of time and production from the ultimate consumer.
0
The unsustainable investments may also involve production of goods that are used in the later
stages of production, say, the retail level, but that are quite durable and are used over a long
period; e.g., a shopping mall; a cash register, etc.
0
Note that the acronyms are always in terms of the perspective of the financial intermediary.
If more than one intermediary is involved, then the appropriate terminology in such mediated
credit transactions can be very complex, and the simple acronyms BSLL and BLLS may well
become confusing.
0 For a critique of this institution on economic (ABC) and legal (libertarian) grounds, see
Bagus, 2003; Bagus, Howden and Block, 2013; Barnett and Block, 2005A 2005B, 2008,
2009; Block, 2008; Block and Caplan, 2008; Block and Garschina, 1996; Block and
Humphries, 2008; Block and Posner, 2008; Davidson, 2008; Davidson and Block, 2011;
Hoppe, 1994; Hoppe, Hulsmann and Block, 1998; Howden, 2013; Huerta de Soto, 1995,
1998, 2001, 2006, 2010; 2008; Hulsmann, 2008; Murphy, 2010; North, 2009; Rothbard,
1975; 1990, 1991, 1993; Salerno, 2010A, 2010B, 2011.
0
We abstract from the fact that the bank is only open to disburse funds from Monday to
Friday, 9 a.m. to 3 p.m. The emphasis on zero time in the text involves a bit of a poetic
license. However, routing numbers work 24/7. Even ATMs occasionally run out of funds.
And, sometimes computers experience glitches or electrical networks experiences outages.
And, then, there are periods of natural or man-made (e.g., bank robberies) disasters.
123
lexicographical underbrush cleared away, we are now ready to launch in to our
response to BHHdS (2016.)
We have no doubt that we now speak for all parties to this debate, ourselves, BB
as well as our intellectual opponents, BHHdS, when we say the following. This
has been a very fertile debate; thanks to it, we have made some not insignificant
strides in our understanding of FRB, BSLL, BLLS, MM, ABCT, so called
“market failure” and the role and functioning of central banking in our economy.
This has also been an ideal debate in terms of mutual support0 of the contending
parties not only for their own positions (which pretty much goes without saying)
but also for the views of the other party. That is, we have all strived mightily to
interpret the contributions of the other side in the most positive manner possible.
Nor has there been even the slightest bit of rancor in this debate from either side.
Rather, both contributing parties, in the finest traditions of debate which aims at
light, not heat, have attempted to, and succeeded in, focusing on the substance of
the issues under dispute, with no ego involved; or, at least, the minimum capable
of human beings. Both sides, too, thank the journals which have carried this
exchange; it focuses on Austrian economics and libertarianism, not the main
focus of any of them. They are thus more deserving of praise than would
otherwise be the case.
BSLL (FRB) on the unhampered market is a null-set. It is a veritable logical
contradiction. It is analogous to rent control in the free economy, minimum
wage in the free enterprise system, protectionist tariffs under laissez faire
capitalism. The insistence of BHHdS that they merely claim that BSLL does not
create the ABC in the unhampered market lacks much of the intellectual power
they think is invested in this claim. Of course BSLL (or FRB) cannot create the
ABC in the free marketplace. This is not because of any lack of inefficiency in
them. It is because BSLL (and FRB) cannot exist under pure unhampered
capitalism as they are incompatible with this system. If BSLL (and FRB) do
occur, then to that precise extent, the market is not free.
In section II we assess their defense against our claim that they are guilty of
subscribing to the noxious and fallacious doctrine of market failure. Section III
is given over to other disputes. We conclude in section IV.
II. Market failure
0
Block, Westley and Padilla (2008) report on many debates in which the very opposite is the
case.
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In their introduction BHHdS correctly summarize the position of BB (2015, p.
1) in the form of a syllogism:
“1. BH stand in the tradition of the Austrian school of economics and do
not subscribe to the neoclassical concept of ‘market failure.’
“2. BH maintain also that maturity mismatching is ethical and permissible
on a free market.
“3. BH argue that maturity mismatching on a free market leads to a
business cycle, i.e., constitutes a market failure.
“Consequently, BH should be troubled as they find a practice ethical that
causes market failure or, at least, creates severe distortions in the
economy.”
In the foregoing MM refers only to BSLL.0
However, BHHdS reject this third claim of BB (2015). As against it, they
maintain: “that maturity mismatching does not necessarily lead to a business
cycle in an unhampered economy.” We take this statement as a concession to
our position. And in two ways. First, if MM does not necessarily lead to the
ABC, that means it sometimes does, or sometimes can. That is entirely sufficient
for our viewpoint, since we never maintained that MM always does so.0
Second, we will show that this is an (unacknowledged) alteration of their initial
position, which allowed that it could. It would appear that BHHdS are
“growing”0 if not in office, then in this debate.0
We must perforce agree with BHHdS when they “…argued that a 100 percent
reserve system can still bring about artificial booms by maturity mismatching if
0 Although BLLS, a form of market failure, results in misallocations of resources that, as with
BSLL, the extent of damage done to peoples’ well-being depends upon the magnitude,
thereof.
0 For example, MM (at least BSLL, if not BLLS) must be of sufficient quantity for an ABC to
ensue. If all we are talking about is $5 in the economy the size of that in the U.S., there will of
course be no ABC as a result of the BSLL.
0
The members of the left-progressive movement are fond of saying of conservative politicians
and officials whose stances move in the direction of the former that the latter are “growing” in
office.
0
Perhaps this is due to the insertion of the second H into the lineup of BH?
125
there is a central bank or government support and guarantees for the banking
system.” However, that could not be a market failure, for government is
involved. It is instead a government failure. Similarly, there can be no market
failure “…if other government interventions into the financial system remain
intact.” Again, this would be a government not a market failure. But what are we
to say of this “smoking gun” when BH admit that BSLL, in and of itself, without
any government support whatsoever, leads to the ABC?0 One possible escape
for them would be to claim that MM is a per se statist institution, since it would
be banned under the libertarian legal code (Rothbard, 1998). And, the same
applies to FRB something that both sides of this discussion do agree upon. But
this will avail them little, at least not in this controversy, for this is precisely our
position.
Let us consider this statement of Bagus (2010):
“In this article it is argued that a 100 percent reserve system can still bring
about artificial booms by maturity mismatching if there is a central bank or
government support and guarantees for the banking system. Even if we
accept the case for a 100 percent reserve requirement, we see that the
maturity mismatching of liabilities and assets (borrowing short and lending
long) is itself perilous—and in the same sense that fractional reserves are
perilous.”
There are difficulties here. In a 100% reserve system there is no MM of any
type, BSLL or BLLS. In a 100% reserve financial system there is no
borrowing of any kind or variety; rather we are in a bailment situation.
0
For example, states Bagus (2010, footnotes omitted): “Economists in the tradition of the
Austrian school have shown that one type of maturity mismatching can cause maladjustments
and business cycles. When banks expand credit, by granting loans and creating demand
deposits, they generate immediately withdrawable liabilities to finance longer-term loans. The
newly created demand deposits do not represent a reduction of consumption, i.e., that
characterized by real savings. As a consequence, interest rates are artificially reduced under
the level they would have been in a free market reflecting real savings and time preference
rates [sic]. Thus, entrepreneurs are prone to engage in more and longer projects than could be
financed with the available supply of real savings. Before all projects that are financed by the
credit expansion are finished, a bust occurs.” However, to be fair to them, they do qualify this
statement thus: “In this article it is argued that a 100 percent reserve system can still bring
about artificial booms by maturity mismatching if there is a central bank or government
support and guarantees for the banking system (emphasis added by present authors).” But
then they undermine this qualification as follows: “Even if we accept the case for a 100
percent reserve requirement, we see that the maturity mismatching of liabilities and assets
(borrowing short and lending long) is itself perilous—and in the same sense that fractional
reserves are perilous.”
126
Consider A, who deposits money in a 100% reserve account at B’s bank. B
may not do anything but store these funds; he is legally precluded from
lending them whether for the short or long run. Therefore, Bagus’
statement is an oxymoron in that MM is inconsistent with 100% reserves.
With 100% reserves there can be no MM. His sentence beginning “Even
if…” is illogical because if you except 100% reserves you not only de facto
but also de jure prohibit MM.
BH are on record asserting that FRB generates the ABC. But FRB is merely a
special case of BSLL, which is itself one type of MM. To say that FRB leads to
ABC is a market failure is problematic in that FRB is incompatible with free
enterprise; therefore, it logically cannot be any such thing. FRB would not exist
under laissez faire capitalism. But the same applies to BSLL. It, also, would not
be legal in the free society; therefore, it cannot be considered as part of a free
market. Thus, it also cannot possibly be part and parcel of any market failure.
Let us not conflate matters by bringing in extraneousness issues such as central
banking or “government support and guarantees for the banking system,” or the
Fed. Let us stick to BSLL, which in the view of BHHdS is compatible with the
marketplace. Yet, according to them, it, also may (but not necessarily so) bring
about the ABC. That is sufficient to prove that these authors are supporting a
theory incompatible with the Austrian aversion to the fallacious doctrine of
market failure. This would appear to be the “smoking gun” of the argument;
BHHdS themselves admit that their opposition to BSLL involves them in the
market failure fallacy. As we have seen, FRB is merely a special case of BSLL.
Can there be any FRB in the unhampered market? All of us, on both sides of this
debate, would deny this. Therefore, if FRB, a type of BSLL, may not exist in the
free market than neither can BSLL exist in the free market either. I’m willing to
fight you to the death of this word, “either.”
Now let us consider this statement of BHHdS’s: “On the free market, there will
always be maturity mismatching to some extent as entrepreneurs try to
anticipate future savings availability. Arbitrageurs earn a profit by shouldering
the risk of mismatching and arbitraging between terms.” In a free market,
entrepreneurs would not have to anticipate future savings. Rather, they would
operate on the basis of present savings. One problem here is the failure to
distinguish between real and so-called financial saving. The very act of real
saving is an act of real investment, and vice versa – they are two different names
for the same action(s). Financial investment is the act of exchanging one capital
127
good, money (including newly created fiat money in the form of banknotes0 or
deposits, for various types of claims; e.g., debts or equities of various types.
Financial saving is the act of exchanging0 money for a financial asset. So, what
is the difference between financial saving and financial investment?
Objectively, there really is none; however, subjectively there is a difference – it
depends on the mentality of the saver or investor; i.e., the individual saver’s or
investor’s understanding of his action, particularly with respect to the
riskiness/uncertainty involved. There is no clear dividing line between the two;
however, financial investors understand their act to be one of taking on the risk/
uncertainty of a loss of wealth in the hope/expectation of achieving a substantial
return on their “investment,” whereas financial savers understand theirs to be
one involving zero or near zero chance of loss in return for relatively low, but
safe, return on their “saving.”
0 In the U.S. these consist in Federal Reserve Notes.
0
When “saving and investment” are said to be unequal the referents are so-called financial
saving and investment. However, financial saving and investment are in reality neither saving
or investment. Money is not a sui generis exchange good in comparison to other goods that
are either capital goods are consumers’ goods; rather, money is a capital good A typical act of
financial saving involves exchanging an extant capital good, money, for a financial asset.
Financial assets are liabilities; i.e., promises, or they are equity; i.e., shares of ownership of
extant goods. Such exchanges take the form of an exchange of money for a pre-existing
promise or share or for newly-created such assets. In no case does it involve saving/
investing; i.e. preparation for future consumption; e.g., by foregoing current consumption of
an existing consumers’ good in order to have it available for future consumption, or by
producing durable consumers’ goods or capital goods. Rather, financial saving and
investment involves exchanging one asset for another; they do not consist of production for
the future.
Financial saving and investment may diverge ex ante, but must be equal ex post and
the factors that brings them into equality are the prices, and movements in the prices, of the
financial assets. Note that it is prices, not interest rates/yields, that are the relevant ones. Of
course, there is a one to one relationship between the price of a specific financial asset and its
interest rate, but interest rates are metrics that facilitate the comparison of financial liabilities
that have different terms, including maturities, not prices; and, it is prices that bring about
convergence of the supplies and demands for goods.
For Keynes and his followers of all stripes, it is movements in income that bring about
the ex post equilibration of saving and investment. For non-Keynesians, in general, it is
changes in interest rates. This latter position is often illustrated with a figure depicting the
“Market for Loanable Funds.” In the figure depicting this non-existent market, the interest
rate is measured along the vertical axis and the amounts of funds; (i.e., money) along the
horizontal axis. The figure then displays an upward sloping saving curve and a downward
sloping investment curve. One problem arises because typically the upward sloping curve
represents the supply of loanable funds and the downward sloping curve, the demand for
loanable funds. The implication is that the supply of loanable funds and saving are equal, if
not identical, and similarly for the demand for loanable funds and investment. And this is not
necessarily the case. For more on this, see Barnett and Block (2011B).
128
Let us analyze this viewpoint expressed by BHHdS. “In other words, BH have
argued consistently that maturity mismatching may lead to a boom-bust cycle
when fostered by government intervention, but will not on a free market.” It
may be possible that to some extent we are talking past each other. If so, we will
be ensnared in a mere verbal dispute, and will not have achieved real substantive
disagreement. For it seems possible that the term “MM” is now being used by
the two sets of authors in entirely different ways. Unless we all become clear on
this, the discussion cannot proceed properly. In our view, MM in all of its
manifestations, BSLL including the FRB subset thereof, and BLLS, is a
purposeful act that ought to be illegal in the just society. It is akin to fraud or
theft or arson. But the way in which BHHdS use this term is to refer to mere
entrepreneurial error. This, we certainly agree with them, would be omnipresent
in any economy peopled by human beings as we know them. Yes, “arbitrageurs
earn a profit” by dealing with the aftermath of error. But they do not at all
function in the face of outright fraud. That is the realm not of arbitrageurs, but of
policemen and courts.
BHHdS reserve the phrase “excessive mismatching” to refer to “…
nonsustainable [sic]) maturity mismatching: credit expansion, the existence of a
lender of last resort and government bailout guarantees.” These authors
summarize as follows: “Thus, BH distinguish between free-market maturity
mismatching [a category whose existence we deny] and excessive maturity
mismatching fostered by government intervention.” Let us be clear. In our
view, MM0 can and does cause ABCs. However, BHHdS have an out. By
“excessive MM” we and BHHdS do not mean the same thing at all. Rather,
they are referring to “credit expansion, the existence of a lender of last resort
and government bailout guarantees.” We most certainly are not. For us, MM
refers to BSLL, including its FRB subset, and to BLLS. These authors then, are
guilty of changing the subject, midstream, so to speak. We were discussing
BSLL. We were disagreeing with them about BSLL, and BSLL only. There is
not a single iota of difference between the contending parties as to “credit
expansion, the existence of a lender of last resort and government bailout
guarantees.” We are all Austro-libertarians, and hence reject these
governmental initiatives on both ethical and economic grounds. We all agree
that “credit expansion, the existence of a lender of last resort and government
bailout guarantees” do indeed bring about the ABC, and are illicit to boot. Why
0 It must be of sufficient magnitude, however. An MM, whether FRB or BSLL or BLLS, of $5
for the entire U.S. economy will not cause much of anything, certainly not an ABC. See on
this fn. 12, supra.
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are we even discussing “credit expansion, the existence of a lender of last resort
and government bailout guarantees?” To be perfectly clear, we consider BSLL
a form of credit expansion, whether it is of the FRB type or not; to wit: if a
financial intermediary borrows money for a period of time, t, and lends it for a
period, T, then if T > t we maintain that this constitutes credit expansion no
matter the length of t.0
Let us discuss now another matter. Their footnote 6 is important enough to quote
in full:
“Bagus and Howden (2009, p. 399) write: ‘‘However, while the practice
(BSLL) is not illicit per se, it is greatly assisted and developed through the
presence of a fractional-reserve banking system, and can sometimes breed
detrimental effects.’’ BB (2015) cite this sentence and comment: ‘‘The
point is, if BSLL can sometimes breed detrimental effects’ [fn omitted] and
it should be allowed by law as these authors contend, then it constitutes a
market failure, an implication with which, we contend, BH will be, or at
least should be, uncomfortable.’’ Actually, BH are not uncomfortable in the
least. First, we state clearly and many times that maturity mismatching, i.e.,
BSLL, is greatly assisted by fractional-reserve banking which we (like BB)
do not consider to be a free-market practice. Second, we defend a free
market that allows for individual errors which by definition always have
detrimental effects, at least for the actor and potentially also for third
parties. However, these detrimental effects of individual error do not
constitute market failure which is the widespread and correlated nature of
individual errors.”
Their second point is problematic from the perspective of economics, at least the
Austrian variety thereof. They defend a free market that allows for individual
errors which by definition always have detrimental effects, at least for the actor,
and potentially for third parties. However, these detrimental effects of
individual error do not constitute market failure which is the widespread and
correlated nature of individual errors.” This is a most unusual definition of
market failure. The mainstream view of market failure is any situation which is
not Pareto efficient; i.e., any situation in which a specific action would make one
or more individuals better off, without making any individual(s) situation(s)
worse.
0 Again, we must be cautious here. Just as a credit expansion of $5 for the entire U.S.
economy will not cause the business cycle, the same applies to a MM of a relatively short
period of time. And, as with the magnitude, neither is an objective fact.
130
III. Other disputes
The heading on p. 3 states: “Maturity Mismatching Does Not Lead to a Business
Cycle in the Unhampered Economy.” How are we to take this claim? In one
sense, we are tempted to agree with our Austro-libertarian collaborators and say:
“Of course not. You are correct. You are totally spot-on. Indeed, you are
necessarily exact. For, if there is MM, then, apodictically, the market is
necessarily hampered. This is due to the fact that MM is incompatible with a
truly free market. BHHdS will not be happy with this response. They will want
to say, presumably, that MM is compatible with the full free enterprise system
and will not lead to the ABC as long as the “… three phenomena (that) foster
excessive (i.e., nonsustainable [sic]) maturity mismatching: credit expansion, the
existence of a lender of last resort and government bailout guarantees” are not in
play.0 Well and good. Here, there is a substantive disagreement between the two
sets of authors. But the way they put matters, with their reading of it, is actually
circular. They assume to be correct the very issue under debate; namely, the
BSLL is indeed a legitimate aspect of the unhampered market.
BHHdS tell an interesting story about Crusoe and Friday. In it, BSLL enables
this duo to create more wealth than would otherwise be possible for them. They
conclude this anecdote with this comment: “Thanks to maturity mismatching,
the correct estimate of future savings coupled with a low future time preference
rate (of Robinson) to produce a capital good (the sharpened stick) was built.
Society is wealthier thanks to maturity mismatching.” Insightful as it is, this
scenario is open to a reductio ad absurdum: for the same tale applies to FRB,
and BHHdS are on numerous occasions on record as opposing FRB on both
economic and ethical grounds. With FRB, A lends $100 to B, the bank. B gives
to A a demand deposit for this amount of money.
Whereupon B turns around and lends $90 to C (keeping a reserve of 10%
against the demand deposit B has given to A.) As part of his transaction with C,
B grants him a demand deposit for this latter amount of funds. Now, together, A
and C can do what A alone could not accomplish. As BHHdS will not say, but
are required by logic to admit: “Society is wealthier thanks to” FRB, also. But
here is the rub. In the FRB case, clearly, the money stock has increased. This has
dire imprecations for the “wealth of society. That is, it overturns the supposed
gain. But the same exact thing can be said for MM, BSLL in this case. Here, A
lends B the bank $100 for one year. B grants A a time deposit of that amount of
0 The present authors have inserted the first parentheses “(that)” into the quote in the text at
this point.
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money for that period of time. Whereupon, as before, B turns around and lends
that $100 (presently, there is no reserve requirement for non-transactions
deposits under Federal Reserve Regulation D) to C for 10 years. It cannot be
denied, as in the previous case, there is now more money in circulation than
otherwise would have been true. And, the same negative effects, as before, come
about with BSLL, as with FRB.
There are problems with BHHdS’s fable about Crusoe and Friday, beyond the
fish that don’t rot, which we accept arguendo. First, Friday would have to
estimate that Crusoe would roll the loan over for a period of at least five more
days after the first five-day loan period, but would also have to assume that after
the second five-day period expired, the loan would be rolled-over yet again, as
after ten days, the capital good would be completed, but not yet put to use. That
could not be done until the eleventh day. Moreover, Friday might have made
entrepreneurial error(s) that would result in consequences quite different from
the propitious results posited by BHHdS. First, of course, Crusoe may roll the
loan over but not for the period of time necessary to complete the production of
the capital good and bring it into production for a sufficiently lengthy period of
time to enable repayment of the loan. This brings us to another problem. Friday
may have overestimated the productivity of the capital good. That alone would
increase the period of time for which the loan would have be in existence,
regardless of the number of times it had to be renewed. Finally, and most
important for this matter, what BHHdS maintain about Crusoe's five-day loan to
Friday could have been maintained if the loan had been a demand loan; i.e., if
Crusoe loaned his saved fish to Friday with the understanding that Friday had to
pay back the loan plus accrued interest on Crusoe’s demand. That is, with their
example, BHHdS have made the case that all BSLL, including FRB, is
compatible with a free market.0 We note, that without any of the risks of
entrepreneurial error affecting anyone apart from the entrepreneur, Friday, the
same results posited by BHHdS could have been achieved merely by having
Friday reduce his daily production (and consumption – we note he had no
savings, and thus, unlike Crusoe, had been consuming his entire production) of
10 fish, by, say, half. This would have freed up time that he could use to
produce the sharpened stick. This would have taken a little longer, but so what?
The additional time is not important in the big picture, especially when the
alternative is the possibility of an ABC, with attendant misallocations of
resources and distortions of the structure of production. Friday does not have to
estimate/forecast/project future saving. All of the necessary savings already
0 This, it need hardly be said, is incompatible with their own position on FRB.
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exist in the form of the 10 fish Crusoe is willing to lend to him. The very acts of
Crusoe in foregoing consumption of the fish he had produced constituted both
real saving and real investment in the stock of durable consumers’ goods. The
question is whether in the process of using the fish to enable production of the
spear, Friday’s entrepreneurial judgment was correct: that it would free up
enough working time to enable the spear to be completed and put to use. A
second question arises as to the accuracy of his entrepreneurial judgment
regarding the anticipated productivity of the spear. In any case, as noted above,
the same results could be achieved by Friday if Crusoe did not exist, or without
any interaction with Crusoe; i.e., in the absence of any granting of credit by
Crusoe. The only difference would be that the spear would not be completed as
early. Note that if Friday undertakes the course of action we posit, there is no
chance that there will be any misallocation of resources resulting from
attempting to produce a capital good that is not in accord with the relevant time
preference; to wit; his own. However, as soon as he borrows short (five days)
from Crusoe, and begins the 10-day (minimum)0 project, the essence of an ABC
– a mismatch between production and preferred consumption, becomes possible
if Crusoe will not roll over the loans as necessary.
Perhaps this is the place to note that Nobel Laureate Friedman,0 as Keynes
(1936), (who, had he lived another 14 years, would undoubtedly have won the
very first Nobel Prize in economics) does not use a bright dividing line
separating FRB and other debts. Keynes (1936, 167, n. 1) states:
“Without disturbance to this definition, we can draw the line between
‘money’ and ‘debts’ at whatever point is most convenient for handling a
particular problem. For example, we can treat as money any command over
general purchasing power which the owner has not parted with for a period
in excess of three months, and as debt what cannot be recovered for a
longer period than this; or we can substitute for ‘three months’ one month
or three days or three hours or any other period; or we can exclude from
money whatever is not legal tender on the spot. It is often convenient in
practice to include in money time-deposits with banks and, occasionally,
even such instruments as (e. g.) treasury bills.”
0 Although the spear is expected to be completed in 10 days, it might not prove productive for
a while until Friday has time to learn to use it.
0
http://www.nber.org/chapters/c5279.pdf
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And, Friedman’s preferred measure of money is M2, which includes, inter alia,
savings deposits, small (less than $100,000) time deposits, and a few other types
of liabilities of depository and other financial institutions’ liabilities that are
overwhelmingly used to fund purchases of financial assets with longer terms to
maturity than those of the liabilities; i.e., that is, they are part of BSLL
operations.
Next BHHdS launch into an example in which “The structure of production has
become more capital intensive: … A bank borrows for 1 year from A to invest
in a project that takes 2 years to mature. After the first year, A is paid back his
loan and increases consumption. Now, person B takes on the role of the saver,
abstains from consumption, and gives a 1-year loan to the bank. The bank can
now successfully complete the financing of the project.”
Here are several comments about this scenario. First, this can be done, too,
under FRB, something rejected by these authors, and, indeed, all parties to this
dispute. Second, it is not necessarily the case that greater capital intensity is
better, more wealth producing, than lesser capital intensity. There can be too
much of a good thing. There are alternative costs to everything. Greater capital
intensity translates into less of something else. We want to optimize capital
intensity, not maximize it in which case we would all die of starvation.
BHHdS offer the following for our consideration: “During production time,
there has been no change in social time preference rates.” But this is
problematic. For what determines the optimal structures of production? The
SoP are determined by the decisions of entrepreneurs of all types: capitalists,
individuals as owners of their labor, and owners of natural resources. For the
SoP to be optimal, they must coincide with the current preferences of
individuals both in their roles as consumers and as suppliers of resources and
with what will prove to be their future such preferences.
What are the difficulties here? First, there are no such things as preference rates
or rates of preference – A is either preferred as is manifested in the act of doing
A, or it is not. In fact, all we can say regarding any action that manifests a
preference for A is that A is preferred and everything else is not. Second, only
individuals have preferences, time or otherwise; there is no such thing as a
“social” preference, the determination of which would necessarily involve
interpersonal utility comparisons.
We again part company from our learned colleagues when they write “It is
possible to imagine an (albeit unlikely) scenario where credit expansion does not
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distort the structure of production. This is the case if, after a credit expansion,
social time preference changes favorably to such an extent that the structure of
production is sustainable and there is no a bust.”
Perhaps the problem here is use of the terms “social time preference” and “the
structure of production.” As discussed above, there is no “social time
preference.” Moreover, although it may have some pedagogical use, the term
“the structure of production” is fatally flawed when used for analytical purposes.
There is no the structure of production; rather there are many production
processes, each with its own structure. Of course, many of these processes are
interrelated, but not such that they collectively constitute a structure of
production; i.e., a unified structure of production. This is the type of
aggregation for which non-Austrians are famous, and which is in large part
responsible for so much error in economic thinking.0
Here is yet another issue on which we disagree. They opine “Relax the key
assumption in our example and consider what happens if the workers do not
save all of their additional income of $1000 dollars at the end of year one. If
they spend even a small portion of their new income, consumer goods’ prices
will rise relative to capital goods’ prices, the exact occurrence that instigates the
Austrian business cycle.”0
But surely the source of the relative price rise of consumers’ relative to capital
goods is all important. Whether the ABC is instigated or not depends, crucially,
on why these relative prices have changed. If this is due to “credit expansion, the
existence of a lender of last resort and government bailout guarantees” then of
course the ABC will be generated. On the other hand, if this is the result of an
exogenous alteration in time preferences, then this will be an essential part of the
market process, and no ABC will ensue. Then, there is the not so minor issue of
scale. If, for example, the “small portion” of the $1000 is only a thin dime, there
will be no ABC fostered. Magnitudes are very important in reality.0
0 We are reminded of Salerno’s (2010C) characterization of Mengerian; i.e., of Austrian,
economics as causal-realist. Such aggregative concepts as a SoP are far from realistic and can
play no useful role in the cause and effect analysis required by economics and supplied
consistently only by Austrian economics.
0 Footnote omitted.
0 See on this Barnett and. 2005-2006.
135
Not only are the source of the changes in relative prices and the relevant
magnitudes important, but it is not, as they assert, that the ABC is instigated by a
rise in consumer goods’ prices relative to capital goods’ prices. Rather, the
ABC is engendered by an unwarranted expansion of credit that that is used to
increase demands for credit-sensitive goods, with consequent effects in terms of
prices of goods and resources and reallocations of resources that prove to be
misallocations; i.e., that distort the SoP.0 Although some types of consumers’
goods, usually durable consumers’ goods, tend to be credit sensitive; e.g.,
houses, automobiles, SUVs, boats, furniture, etc., other major categories; e.g.,
food, energy, clothing, entertainment, etc., tend not to be. The same is true for
capital goods and, importantly, human capital; durable capital goods and those
that are very expensive tend to be credit sensitive, whereas others tend not to be.
To know what happens to the structure of relative prices insofar as the
categories “consumers’ goods” and “capital goods” are concerned, we would
need data that is very accurate and complete. Moreover, as individuals’
behaviors change over time, it is not clear at all when the prices of consumers’
goods would rise relative to those of capital goods. It all depends upon the
actions of individuals in their various roles in the economy. It is not, then,
correct to say that a rise in the prices of consumers’ goods relative to those of
capital goods is what instigates the ABC.
BHHdS state: “If they spend even a small portion of their new income,
consumer goods’ prices will rise relative to capital goods’ prices, the exact
occurrence that instigates the Austrian business cycle.”
This, unfortunately, is very Keynesian. Keynesians assume, implicitly, that any
financial saving detracts from spending on currently produced goods; i.e.,
aggregate demand, and is therefore detrimental to the economy.0 They do not
seem to understand that financial saving is the purchase of financial assets and
real saving is real investment; i.e., that to refrain from spending on consumers’
goods does not mean that one does not spend – it merely means that one spends
0 We have said, above, that there is no such thing as the SoP. Throughout, SoP should be read
in the plural; i.e., structures, not structure.
0 Keynes himself certainly looked on saving as creating problems, and his modern followers
are doing everything in their power to bring about his desired result of the “euthanasia of the
rentier.” Note that to them perhaps the most important cause of our current “troubles” is the
alleged glut of saving. Read any of the relevant New York Times columns of Krugman on this
matter. For intensive rebuttals, see Woods and Murphy (2016)
136
on something other than consumers’ goods.0 When BHHdS assert that if
individuals “spend even a small portion of their new income” it will cause prices
of consumers’ goods to rise relative to those of capital goods, that is to endorse
the Keynesian assumption. We must always ask, on what did they spend the rest
of their new income?
They then “Relax the key assumption in their example…” But that example has
not one but several interrelated assumptions that render the example
problematical. One but needs to consider the relevant balance sheets; i.e., those
of the bank, the entrepreneur and the workers, collectively, at the beginning and
end of each year. If we consider only changes from their positions at the
beginning of the example, and only the changes that result from the example, the
following results are observed.
First, the bank’s balance sheet doesn’t change except during each year. Any
change during the year is reversed by an offsetting change later in the year. At
the end of 10 years it looks the same as it did at the beginning.
The entrepreneur’s balance sheet shows assets of one investment project (at
cost: $10,000) and liabilities of ten $1,000 notes with zero term-to-maturity; i.e.,
due NOW, payable to the workers.
The worker’s balance sheet shows assets of ten $1,000 notes with zero term-to-
maturity; i.e., due NOW, payable by the entrepreneur, and a net worth of
$10,000 (one might reasonably refer to this as sweat equity ). It is obvious
that this example bears little relationship to reality, and thus there is not much to
be learned from it.
Our authors assert: “It is hard to understand why B has the right to burn the
$100, but not the right to lend it for 2 years. The obligation in his contract with
A is to return any $100 after 1 year. The fulfillment of this obligation is
compatible with burning the specific $100 bill—as BB acknowledge—as well as
lending the specific $100 bill for 2 years to C.”
There are several reasons why this is alright. One, in the case of “Burn, baby,
burn” there is no conflict in titles, no legal incompatibility between two different
0
Hoarding, takes the form of lengthening the period of time between the acquisition of an
asset and its use, including use in exchange. In the case that is relevant here, hoarding of
money is merely an increase in the period of time between which the money was acquired and
when it is spent.
137
contracts. In BSLL there most certainly is, just that. B’s contract with A is
incompatible with B’s contract with C. B is granting to C, 10- years-worth of
money, when B has from A only the right to money for a single year. Two,
BSLL creates additional money compared to the burning scenario. Three, B
may burn the $100 for the same reason he can spend it; he has the right to
dispose of it, but only in ways that do not create conflicts of rights. If he spends
the $100 dollars, he no longer has any rights to it, but he still must repay $110 to
A in one year. If he burns the $100 beyond salvage, it no longer exists,
therefore he no longer has a right to it.
We next turn to the issue of fungibility. BHHdS agree with us that BSLL only
works for fungible assets, such as money, or homogenous ones such as gold
bars, corn, wheat, oil, coal, etc. Here is their take on this matter:
“Bagus and Howden (2012b) argued that while maturity mismatching would be
a legitimate practice for fungible goods, it is illegitimate for specific goods. If B
borrows $100 for 1 year from A, he may lend $100 to C for 10 years. It is a
risky, but not fraudulent practice. In contrast, if B borrows a specific good such
as a Picasso painting for 1 year from A, he is not allowed to lend it for 10 years
to C. From this distinction, BB (2015) attempt an interesting reductio ad
absurdum by stating:
‘[I]f B lends out A’s Picasso to C for 10 years, having the rights to it for
only one year, it is still possible for B to come out of this morass alright. B
can go to C at the end of the year and ask C for the picture back even
though the latter has the rights to it for nine more years.’
Therefore, BB believe that BH should also maintain that maturity
mismatching in the case of the Picasso painting would be just risky but not
fraudulent. BB are certainly correct that B could deliver the painting back if
he could convince C to return it earlier. The decisive difference between
this case of maturity mismatching with that of fungible goods is that the
latter has no conflict at the moment when B lends to C. When B borrows
money short from A to lend money long to C, these two contracts are
compatible and can be fulfilled ab initio. In contrast, when B borrows the
Picasso painting for a short term from A to lend long term to C, these two
loan contracts are not compatible at that moment. They cannot be fulfilled
at the same time.”
In our view, fungibility is far too weak a reed upon which to base BHHdS’s
entire argument. Upon further reflection, we realize that with respect to one
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aspect of BHHdS (2016) we fell into an academic trap, one particularly
troubling for Austrian economists, to wit: ignoring reality. Where we discussed
the issue of BSLL in the context of what B might do with that, X, which he
borrowed from A, we maintained that he could not lend to X to C for a longer
period than that for which he had borrowed X from A. We still adhere to this
position. However, when the issue of burning X arose, we maintained that B
could burn X if he so chose because unlike lending X for a longer period of time
that he had rights to X, a case that creates incompatible contracts, burning X
does not create such contracts. And, this is the case whether X is $100 or a
Picasso. Of course, what we failed to take into account in our analysis was the
totality of loan contracts in the normal course of events. That is, the terms and
conditions of loans usually are not restricted to that which is lent, X, (usually an
amount of money), what is to be returned to the lender (usually the principal and
interest), and the date(s) on which such repayments are to be made. In fact, they
include collateral and the maintenance thereof, and what may be done with X.
For example, one may not go to a financial intermediary and borrow money for
the purpose of buying an automobile and use the funds to buy a motorcycle or
take a vacation. Similarly, one may not burn a Picasso one has borrowed
because, even if there is no explicit provision in the loan contract prohibiting
such an act, there is most definitely an implicit such condition. Thus, the reason
one may not burn a borrowed Picasso is not because it is unique and therefore
not a fungible good, rather it is because such an act would be prohibited by the
loan contract. Moreover, if the loan contract explicitly allowed the borrower to
burn it (a most unlikely event), the borrower could do so.
What are we to make of this statement by BHHdS: “BB (2015) maintain the
(sic) BH claim that maturity mismatching will cause a business cycle. BB do
not clarify whether they mean that maturity mismatching necessarily or only
possibly causes a business cycle.”
In our view, it matters not which is the case; either one or the other, and,
certainly, both, undermine their position. Let us consider them one at a time.
Suppose, first, that MM “only possibly causes a business cycle.” That is,
sometimes it does, and upon other occasions it does not. As we specifically
stated, supra: “Magnitudes are very important in reality.”
IV. Conclusion
We heartily agree with BHHdS that entrepreneurial error does not constitute
market failure. We are no longer in the Garden of Eden; we are all nowadays
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necessarily imperfect. Causing an ABC, however, is a horse of an entirely
different color. In the words of one of our intellectual opponents on this matter
(Bagus 2010, pp. 15-16), he admits that BSLL can lead to such an eventuality
and is thus condemned by his own words:
“Maybe the most important conclusion of our analysis is that not only
fractional reserve banking can lead to an Austrian business cycle. Even
with 100 percent reserve requirements for demand deposits and a constant
money supply, excessive maturity mismatching … can lead to
unsustainable booms.”
Nor can we see our way clear to agreeing with them that “The nub and kernel of
economic growth theory is that longer-dated investments are more productive
than shorter-dated ones.” Of course, the meanings of the phrases “longer-dated
investments” and “shorter-dated investments” are critical.
First, if we mean by those terms the period of time involved in the investment
process; i.e., in making the capital goods, there is no reason to think that the
longer it takes to produce a specific capital good, the more productive is that
good. Second, if we are referring to the length of time that elapses from the use
of a specific capital good until the specific consumers’ good to whose
production it contributed is sold to a consumer, then, again, there is no reason to
think that “a longer-dated” such investment is necessarily more productive;
rather, the exact opposite would be the case. Third, if by longer- and shorter-
dated investments we are referring to the durability of the capital goods created
in the investment process, then, yet again, there is no reason to think that a
“longer-dated;” i.e., more durable capital good necessarily is more productive
than a less durable one. Finally, if by “longer-dated” investment one means the
length of time for which funds have been borrowed to finance an investment,
then obviously merely because one finances an investment for a lengthier period
does not make that investment more productive.
In sum, because of the complexity of production processes and structures of
production, we do not think such a blanket statement is true.0
Our Austro libertarian debating partners aver “Maturity transformation is an
economic action that allows longer-dated investments to be undertaken today
and fully funded only later by new savings.” Depending on the meaning of
0 For more on this, see Barnett and Block (2006, Appendix 1, esp. Table 1.)
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“longer-dated investments” this may be true. Then again, it may not, if for no
other reason than that the “new saving” expected (hoped?) to be available might
not materialize, or if it does arise in the future, at that point in time they may
have a superior alternative use. In any case, we do not want to maximize the
period of production; if we did, we would never benefit from our savings.
Rather we desire optimal duration,0 something quite different.
Last but perhaps not least, there is one point that BB (2015) made against BH
(2012) which BHHdS overlook. It is our hope that if they choose to reply to this
present essay of ours in future, they will respond to this when they do.
Included in this regard is the following quote mentioned above (from Bagus,
2010, pp. 15-16); only this time, we will fill in, and, italicize, the material
replaced by the ellipses:
“Maybe the most important conclusion of our analysis is that not only
fractional reserve banking can lead to an Austrian business cycle. Even
with 100 percent reserve requirements for demand deposits and a constant
money supply, excessive maturity mismatching induced by government
guarantees and central bank lending of last resort can lead to unsustainable
booms.”
Our question to them is this. Suppose, arguendo, that there were no “government
guarantees and central bank lending of last resort.” That is, if there was a totally
free market, of the sort even Rothbard himself would endorse,0 then would a
BSLL of sufficient magnitude and duration still lead to “unsustainable booms?”
If they answer “Yes,” we maintain that they are implicitly agreeing with us that
such would constitute a case of market failure. If they answer “no,” then we
have a fundamental disagreement with them. That is, they would then be
maintaining that BSLL of sufficient magnitude and duration to cause an
“unsustainable boom” cannot arise in an otherwise free market economy absent
governmental intervention in the form of government guarantees and central
bank lending of last resort, or some other relevant type of intervention. If that is
their position, then we are back to our fundamental disagreement with them
about economic theory. That is, we assert first, on ethical grounds that BSLL is
inconsistent with a free market; and, second, on the basis of economic analysis,
that BSLL, of sufficient magnitude and duration, and absent any relevant
0 We refer here to the duration of the SoP, rather than the “financial duration.”
0 Except for the fact that there would of course be BSSL, which we will not argue about at this
point.
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government intervention, save for legal approbation of BSLL, will cause an
“unsustainable boom.”
In fact, Mises himself came close to considering this question and taking
our side of this debate as early as 1912. As Mises (1953, 263, citing Knies
(1876, 242)) states about maturity mismatching in general:
“For the activity of the banks as negotiators of credit the golden rule holds,
that an organic connection must be created between the credit transactions
and the debit transactions. The credit that the bank grants must correspond
quantitatively and qualitatively to the credit that it takes up. More exactly
expressed, ‘The date on which the bank’s obligations fall due must not
precede the date on which its corresponding claims can be realized.’ Only
thus can the danger of insolvency be avoided.”
In a similar way, Murray N. Rothbard comes close to our analysis of
maturity mismatching (1983, p. 99):
“Another way of looking at the essential and inherent unsoundness of
fractional reserve banking is to note a crucial rule of sound financial
management—one that is observed everywhere except in the banking
business. Namely, that the time structure of the firm’s assets should be no
longer than the time structure of its liabilities.” (Italics in the original)
In citing these two economists, we are not guilty of an argumentum ad
verecundiam. Yes, of course, Mises and Rothbard are authorities for all
Austrian economists and libertarian theorists.0 But we do not argue that we
are correct because they incline in our direction. Hopefully, we have by
now given sufficient reasons in justification of our position.
We cannot resist ending on this note: "He who sells what isn't his'n, must
buy it back or go to prison."
0 They should be for all scholars, and they are not, but that is a different matter
142
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