Full Reserve Fallacy

There is a theory that fractional reserve banking is a fraud, allowing banks to create money "out of thin air". The theory implies that honest banking must be full reserve.

This theory hinges on the definition of the word "bank". Rothbard makes the above argument in "Man, Economy, and State", but explicitly limits his definition of a bank to that of a "warehouse" for money:

When a man deposits goods at a warehouse, he is given a receipt and pays the owner of the warehouse a certain sum for the service of storage. He still retains ownership of the property; the owner of the warehouse is simply guarding it for him. When the warehouse receipt is presented, the owner is obligated to restore the good deposited. A warehouse specializing in money is known as a "bank."

Banks do offer this warehousing service, in the name of safe deposit. But banks are not so narrowly defined. They also generally offer interest-bearing accounts such as saving deposit and term deposit respectively. Rothbard uses the expectation of interest to differentiate warehousing money from lending it:

Someone else's property is taken by the warehouse and used for its own money-making purposes. It is not borrowed, since no interest is paid for the use of the money.

In other words, his call for full reserve does not apply to interest-bearing accounts. However he neglects to point out that interest earned on the money represented by deposits can legitimately offset otherwise necessary account fees. Banks often offer demand deposit (e.g. checking) accounts without interest. The fact of positive yield on the account is not the demarcation between warehousing and lending. The distinction is the contractual agreement between the depositor and the bank.

Since it is convenient to transfer paper in exchange rather than carry gold, money warehouses (or banks) that build up public confidence will find that few people redeem their certificates.

Money certificates representing warehoused money are representative money, a form of money substitute. In the United States, state banks and others formerly issued such certificates. These were eventually replaced by central bank issued gold certificates and silver certificates.

The banks will be particularly subject to the temptation to commit fraud and issue pseudo money certificates to circulate side by side with genuine money certificates as acceptable money-substitutes. The fact that money is a homogeneous good means that people do not care whether the money they redeem is the original money they deposited. This makes bank frauds easier to accomplish.

To the extent that central bank certificates ever represented all of the warehoused money (e.g. gold and silver), they eventually followed the course described by Rothbard. As the sum of certificates became too large to support redeemability, they were abrogated and people were compelled to convert them to fiat. These large scale events occurred in the lifetimes of both Rothbard and his precursor von Mises.

The theory does not limit its condemnation of banking to warehousing (safe deposit) fraud, it extends to honest lending of deposits by banks generally, including demand deposit, saving deposit and often term deposit. As such the theory is invalid. Furthermore it implies a condemnation of lending and investing generally. And as Rothbard himself points out, lending is indistinct from investing:

Whether saved capital is channeled into investments via stocks or via loans is unimportant. The only difference is in the legal technicalities. Indeed, even the legal difference between the creditor and the owner is a negligible one.

All lending originates from a person's accumulated capital, whether deposited in bank or otherwise. There is no source for lending other than savings deposited. There is a related theory that people are too stupid to understand contractual terms of deposit. Yet those who make this argument believe themselves able to understand it. As such the theory is invalid. Given the moral distinction of nonaggression, it is the right of every individual to contract with another voluntarily. Taking this right away would be the crime.