Springer 2010

Journal of Business Ethics (2011) 98:505511

DOI 10.1007/s10551-010-0590-2

The Case Against Fiduciary Media: Ethics

is the Key

ABSTRACT. Salerno (http://mises.org/daily/4389, 2010a)

asserts that in the debate between those who favor and
oppose fractional reserve banking, the important issue is
not whether or not this institution is inherently fraudulent, but, rather, does it or does it not cause the business
cycle. We join this author in thinking both important;
however, we reverse this order.
KEY WORDS: fractional reserve banking, fraud, business cycle, contract, ethics

Introduction
In a recent article, Joseph Salerno (2010a) has rightly
criticized the position of free bankers such as
Lawrence White and George Selgin with respect to
their stance on fractional reserve banking (FRB).
However, in his article, Salerno states the fundamental theoretical challenge in the debate is not the
ethicallegal issue of FRB as fraud, but rather the
deep and serious issue of whether, and in what
circumstances, FRB is responsible for the business
cycle. However, is this really the most fundamental
challenge? While we agree with Salerno that the
issuance of fiduciary media by commercial banks
does indeed result in business cycles, we argue this is
not the most important issue to settle; that in fact the
ethical issue is fundamental and thus more important.
In our article, we begin by briefly reviewing the
current debate between the free bankers and the
advocates of 100% banking over fractional reserves.
We then turn to the issue of why ethics is fundamental. We demonstrate the circumstances under
which a person who has a strongly held ethical belief
is forced to reject an economic-utilitarian argument,
and show how this applies in the case of the free
bankers.

Walter Block
Laura Davidson

The current debate

According to Salerno (2010a):
Several recent blog posts indicate that the modern
supporters of free banking continue to misconstrue
the fundamental theoretical challenge posed by their
critics. The main question is not about the ethical-legal
issue of whether or not fractional-reserve banking is
fraud under all circumstances. Nor, ultimately, is it
even about fractional-reserve banking versus 100percent reserve banking. It is about whether the creation of fiduciary media, fraudulent or not, produces
the sequence of phenomena we recognize as the
business cycle.

At the outset, it seems a bit harsh to criticize

someone for saying that the main question is X
rather than Y, as we shall do in this article. The
entire issue appears to be inescapably subjective. Our
main question may not be Salernos main
question, and his may not be ours. One response to
our criticism is that all Salerno is saying here, all he
logically can be asserting, is that he is interested in the
positive issue, not the normative one; anyone such as
us who disagrees with him merely signifies that he
has different tastes than that author. In our opinion,
to allow this issue to be dismissed on grounds of
de Gustibus non Disputandum, however, would be
a mistake. We contend that there is more that can be
said about it, and that it does not all come down to
different preference rankings between Salerno and
the present authors.
Salerno is saying, correctly in our view, that
Selgin and White are misinterpreting Mises reasons
for advocating free banking. We agree with Salerno
that Mises advocated free banking because he
thought it would eventually lead to the demise of
fiduciary media, and not as Selgin and White would
have it, because he favored fiduciary media. Indeed,

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Walter Block and Laura Davidson

we support Salerno, and enthusiastically so, in his

entire positive analysis. However, we do think it is a
mistake for Salerno to concentrate on this, and to
denigrate the related ethical issues.
From an ethical-legal standpoint, the debate is
between those who believe demand deposits should
legally require a 100% reserve because FRB is
morally wrong, and the free bankers who take the
position that FRB is morally permissible provided
depositors contractually agree to the arrangement.
Salerno, however, frames the debate in economicutilitarian terms as between two competing schools of
positive, not normative, thought. He see this as the
older, more important, more substantive debate.1
According to Salerno (2010a):
Thus, the deep and serious debate over free banking
is not a new debate carried on within a narrow circle
of free marketeers or libertarians or Austrians or
whatever you want to call them; it is a very old one
between two divergent movements in monetary theory whose views have never been reconciled. The one
movement may be called the neo-Currency School
(NCS) and the other, the neo-Banking School (NBS).
Their forerunners, the Currency School and Banking
School respectively, squared off in a titanic debate in
the mid-19th century that was never finally resolved.

According to Salerno, the NCS, whose proponents include Ludwig von Mises and Murray
Rothbard, argue that the issuance of fiduciary media
by commercial banks through the fractional reserve
process always generates business cycles and is
therefore a bad, i.e., it decreases social utility.2 The
NBS, whose proponents include Lawrence White,
George Selgin and Steve Horwitz, believe that
although money creation by a central bank produces
business cycles, the issuance of fiduciary media by
commercial banks under a system of free banking
does not, and is therefore benign. In fact, the additional quantity of money so issued mysteriously
matches any increase in the reservation demand for
money and thus, instead of causing business cycles,
actually helps alleviate demand shocks that would
otherwise arise out of changes in the money relation.
Under these circumstances, they believe it increases
social utility.
While the supporters of FRB3 are gravely in error
on all counts,4 Salerno implies that the main line of
attack against them should be to challenge their

economic position, one which claims the beneficial

effects of fiduciary media, rather than to call into
question their ethical position, which claims free
banking is compatible with the free enterprise ethic
and thus morally right. To that end, the battle
between the two sides appears to be an argument
regarding Mises position on the matter. Thus, for
example, while White maintains that Mises would
have opposed a complete ban on fiduciary media on
the grounds their issuance by commercial banks can
help alleviate demand shocks and reduce the cost of
supplying a media of exchange, Salerno counters
that White erroneously ignores one of Mises most
important contributions to monetary theory, namely,
that fiduciary media cause business cycles. And while
supporters of White and Selgin claim Mises was a
free banker, Salerno replies Mises was nothing of
the sort, that he only advocated unregulated banking
because he believed it more likely attainable as a
practical matter than (e.g., superior to) the legal
imposition of a 100% reserve as a means of eliminating fiduciary media.
If this is the main line of attack against FRB
supporters, it is not very productive because
although the issue of what Mises meant in his various
treatises is certainly important from the perspective
of the history of economic thought, the correct
interpretation of his work does not by itself establish
the truth of any economic proposition. The truth of
such propositions can rest only on sound deductive
reasoning, something with which Mises himself
would have profoundly agreed; indeed, the entire
corpus of his writing is a case in point. Treating
anyones work, no matter how masterly it might be,
as the gospel truth is always dangerous. For as
great as this Titan of the Austrian School was, it
is certainly possible that in a career spanning
many decades, Mises might occasionally have been
inconsistent or ambiguous in his writings, or even
incorrect in his reasoning. The exegesis of any student of Mises can never solely be relied upon to
reveal the truth of any economic proposition sought,
even if the master himself were brought back from
the grave to confirm or deny it.
More important, however, is that taken as a whole,
the economic-utilitarian argument, as opposed to the
ethical-legal one, is the weaker of the two when it
comes to convincing the FRB crowd they are
wrong. Let us now turn to address this issue.

The Case Against Fiduciary Media: Ethics is the Key

Why ethics is fundamental
While an economic argument, based on sound
praxeological reasoning, proving that FRB always
causes business cycles, is certainly important and
enlightening, using such an argument to defeat
supporters of FRB requires the following additional
chain of logic (hypothetical syllogism).
1. Business cycles are always bad
2. FRB always causes business cycles
3. Therefore, FRB is always bad.
However, this line of reasoning cannot be made
because it puts the cart before the horse. The first
premise makes the assumption, without any justification, that business cycles are in fact bad, i.e., bad
from a utilitarian perspective. In other words, it
presumes to know that social utility is increased in
the absence of business cycles, a point which is often
taken for granted, but which in fact can only be
established by Paretos Unanimity Rule.
The Unanimity Rule states we can only know
if social utility has increased from an exchange
(or exchanges) if, as a result of that exchange (or
exchanges), no individual is made worse off and at least
one individual is better off. If one individual is worse
off, we cannot make any statement about social utility.
Since interpersonal comparisons of utility are always
invalid, which means utilities can never be added or
subtracted, statements regarding an increase in social
utility can only be made in the case of unanimity.
To state that business cycles are bad is to state that
social utility will increase in their absence. But
according to the Unanimity Rule, we can only make
this statement if the state of affairs that causes business cycles to be eliminated involves exchanges
where it is certain that no individual is worse off. If it
is not certain that no individual is worse off, then
we cannot make the statement. Since voluntary
exchanges always ensure that no market participant
suffers a loss of utility, and coercive exchanges always
ensure that at least one person suffers a loss of utility, we
cannot make the statement business cycles are bad
unless we know that voluntary exchanges eliminate
business cycles and coercive exchanges cause them; in
other words unless we know FRB is coercive.
Thus, while it is certainly important to prove
FRB causes business cycles, it is incumbent upon the

507

abolitionists (those of us who maintain that FRB

should be eliminated) to prove first that FRB is
coercive, i.e., fraudulent. Furthermore, it is necessary to show coercion is bad because it is just plain
morally wrong; in other words that coercion is
objectively morally wrong. To prove these points
must always be the primary goal in any debate about
the validity of FRB. If one can convince an NBS
supporter that FRB is always coercive, he is then
logically forced to concede that it always leads to a
Pareto-inferior result, in which case his economicutilitarian argument falls apart.
To see why the ethical argument is more fundamental than the economic-utilitarian argument,
consider the following examples.
Suppose a person whose moral positions are
grounded in a rational objective ethic, erroneously
believes that FRB does not involve coercion. He
firmly believes the issuance of fiduciary media under
certain circumstances constitutes a free market process, something that is objectively moral. In fact, he
takes the position that outlawing FRB is immoral
because it interferes with the free market. Of
course he is wrong because he does not understand
that his interpretation of free actually involves
coercion. But suppose the reason he fails to understand this is not because of some vapid subjective
feeling on his part, but rather because his reasoning
in arriving at what he sees as a correct objective
moral stance is in fact erroneous.5
Now suppose, having formed these views, he
subsequently becomes convinced of the truth of the
NCSs economic proposition that fiduciary media
always causes business cycles. It might possibly cause
him to re-examine the ethical propositions he holds
to be true, but if his ethical belief is extremely strong,
he can simply say, so what? He can take the position
I know my ethical belief is logically sound, FRB
involves no coercive exchanges; obviously business
cycles cannot result in a loss of social utility.
Suppose a different person takes the firm objective
ethical position that FRB is always morally wrong. If
he becomes (wrongly) convinced by the NBSs
monetary equilibrium theory that fiduciary media
issued by commercial banks alleviates demand
shocks, this will not necessarily change his opinion
on the matter of FRB. He can simply say, I know
my ethical belief is logically sound, FRB involves

Walter Block and Laura Davidson

508

coercive exchanges; obviously alleviating demand

shocks does result in a loss of social utility.
More likely, however, is that a person will not be
persuaded by the economic part of the argument at
all. Thus, for example, free bankers who genuinely
believe FRB to be voluntary, i.e., non-coercive, and
at the same time recognize that business cycles do
indeed result in a loss of social utility, do not accept
any economic argument which links the two. For
free bankers, business cycles are simply incompatible with FRB, and thus they search for an alternative economic result.
Either way, the economic-utilitarian argument is
unpersuasive over an objectively held moral position. A person holding the conviction that FRB is
not coercive can either (1) accept the NCSs economic theory (FRB causes business cycles) and reject
the utilitarian outcome (by claiming business cycles
are not bad) or (2) accept the utilitarian outcome
(business cycles are bad) and reject the economic
theory. As we have seen, it is the latter position that
the free bankers generally adopt.
Let us generalize. Suppose we posit the ethical
argument: Action X is coercive. Let us assume a
respondent to this statement holds a firm objective
position regarding its validity; he either agrees or
disagrees. Suppose, in addition, we make the economic-utilitarian argument: X causes Y, and Y
involves a loss of social utility. To agree with this, the
respondent must say yes to both clauses. If he disagrees with either the economic clause, X causes
Y, or the utilitarian clause, Y involves a loss of
social utility, he will say no.
Ethical Argument:
X is Coercive
Agree?

Yes
No

Economic-Utilitarian
Argument: X causes Y,
AND Y involves a loss of
social utility Agree?
Yes

No

Position A is logically consistent. (It makes perfect

sense to say X is coercive, X causes Y, and Y
involves a loss of social utility).
Position B is logically consistent. (X is coercive,
but X does not cause Y).

Position C is not logically consistent. (It makes no

sense to say X is not coercive, X causes Y, and Y
involves a loss of social utility this contradicts
Paretos Unanimity Rule).
Position D is logically consistent. (It makes sense
to say X is not coercive and either [Statement 1]
X does not cause Y, or [Statement 2] X causes Y,
but Y does not involve a loss of social utility).
A person who agrees with the ethical argument
i.e., someone who answers Yes, X is coercive
does not need to be convinced by the economicutilitarian argument in order to believe X should be
abolished; he can answer it yes or no. He can hold
either position A or B, and still agree X is coercive
(and that it should be legally eradicated), and be
logically consistent in either case.
A person not swayed by the ethical argument
i.e., someone who says No, X is not coercive
can never agree to both clauses of the economicutilitarian argument if he is to remain logically
consistent; if he says yes to X causes Y and Y results
in a loss of social utility, taking position C, he is
being illogical according to Pareto. Thus, assuming
he is rational, he is forced to say No and adopt D.
Applied to the FRB debate, it is why free
bankers, who do not agree that FRB is coercive,
must reject position C at all costs. If they accept
position C they have to admit FRB is not coercive,
and it causes business cycles and it involves a loss of
social utility, a contention that is intuitively illogical, and demonstrably so, when Paretos Unanimity
Rule is applied. Put simply free bankers instinctively realize position C is untenable. Thus, they
take D. From the table above, we see that position D
can be justified by using one of two possible statements. The free bankers adopt Statement 1, i.e.
FRB does not cause business cycles, rather than
the even more unlikely, but still logically justifiable
(given their ethical stance) Statement 2, which
would be FRB causes business cycles, but business
cycles do not involve a loss of social utility, presumably because the former statement sounds
slightly more plausible than the latter. To alleviate
any misgivings they might have about deviating
from orthodox Austrian theory, and to support their
own ideas in the matter, they then cherry-pick
passages from, of all people, Mises, and devise an
enigmatic monetary equilibrium theory to boot.
All of this is necessary to make their economic

The Case Against Fiduciary Media: Ethics is the Key

construction comport with their ethical point of
view. Constrained by their answer to the ethical
question, free bankers thus shoe-horn themselves
into adopting a misguided economic theory. And
because their economic stance is intractable, given its
ethical underpinnings, Salernos utilitarian expostulations against it, while entirely valid, sadly fall on
deaf ears.
The solution, of course, is to lead free bankers
to understand they have used faulty logic in
answering the ethical question; to make them see
why FRB is in fact objectively morally wrong. For
once they are convinced of this, they can hold to any
unorthodox theory they like regarding the economic
consequences of FRB (i.e., position B) and still be in
a position to logically justify its abolition.
Arguments that focus on whether fiduciary media
are good or bad from a utilitarian perspective are in
the end, secondary. The ethical argument always
trumps the economic. This is precisely the reason
why the Rothbardian ethical perspective is always
superior to the Misesian utilitarian one in establishing the logical justification for free markets. Unless a
person is convinced, first and foremost, that a particular action is morally wrong, and objectively so,
any utilitarian argument that criticizes the action by
targeting its economic consequences, will always be
unpersuasive. The moral argument must always
come first.

Conclusion
Salerno and Rockwell articulate the utilitarian
libertarian position: that policy is best which brings
about the greatest amount of utility, or, decreases it
by the least amount. In the present case, this can be
done by making the avoidance of the business cycle
the prime consideration. The present authors, in
contrast, favor deontological libertarianism. In particular, the primary goal is to ensure that FRB is seen
precisely for the fraud that it is, and then that it be
prohibited by law. It is of course important, but it is
only of secondary importance, that prohibiting FRB
will lead to the obviation of the boom-bust cycle.
We maintain that FRB should be outlawed, even if
this will create the business cycle. FRB is wrong, it
should be stopped, and damn the consequences.
Happily, we do not have to renounce our utilitarian

509

concerns, for Salerno has done a superb job in

demonstrating that FRB does indeed cause the
business cycle.
The motto of deontologists is, Justice though the
heavens fall. For pure utilitarians,6 this is either
abject nonsense or meaningless. But we contend it
has great theoretical if not practical application in the
FRB debate.

Notes
1

Salerno is mistakenly supported in this contention by

Rockwell (2010), who states: Private bank inflation
also has moral, legal, and political problems, but Joe
(Salerno) is right: this Misesian point is the key economic one.
2
Also see Salerno (2010b). Unless otherwise indicated, however, all references to Salerno (2010a, b) will
signify Salerno (2010a).
3
Horwitz (2010), Horwitz and Bodenhorn (1994),
Rozeff (2010), Sechrest (1989, 1993), Selgin (1998,
2007), Selgin and White (1996), White (2003, 2007).
4
For support of 100% banking, and thus criticism of
FRB, see Bagus (2003), Bagus et al., unpublished. Barnett and Block (2008, 2009), Baxendale (2010), Block
(2008), Block and Garschina (1996), Block and Posner
(2008), Davidson (2008), Hanke (2008), Hoppe (1994),
Hoppe et al. (1998), Huerta de Soto (1995, 1998, 2001,
2006), Hulsmann (1996, 2000, 2002, 2003, 2008),
North (2009), Reisman (1996, 2009), Rothbard (1991),
Salerno (2010a, b).
5
This is roughly the way we interpret the writings of
free bankers such as White, Selgin, Horwitz, Sechrest, and Rozeff.
6
We doubt that either Salerno or Rockwell would
subscribe to this viewpoint.

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511
Walter Block
Loyola University,
New Orleans, LA, U.S.A.
E-mail: wblock@loyno.edu

Laura Davidson
Seattle, WA, U.S.A.
E-mail: davidsonlaura@gmail.com