FRAUD, FRAUD CYCLE, AND BUSINESS CYCLE

AN AUSTRO-THOMISTIC INVESTIGATION
INTO THE NATURE AND EFFECTS OF FRAUD

TUUR DEMEESTER*

Abstract
In this article we present the thesis that Misesian value free praxeology is
inadequate to give a comprehensive account of the essential nature of the business cycle,
and that instead the business cycle should be analyzed from a broader judicial
philosophical framework. Carrying out this analysis leads us to explaining the busines
cycle as being essentially a fraud cycle, to rehabilitating Menger's concept of imaginary
goods, to reformulating deposit and loan contracts as essentially trusts, and to reassessing
the case for honest fractional reserve banking.
In order to show the validity of our main thesis, we answer to seven possible
objections against it, and as a means to demonstrate its relevance, we suggest a solution
for three paradoxes that arise within the orthodox Austrian approach to the business
cycle.

* DRAFTDO NOT CITE: Critical remarks and suggestions are welcome at tuur@rothbard.be.

1
 TABLE OF CONTENTS
Fraud, Fraud Cycle, and Business Cycle

1. Method ......................................................................................................... 6
An epistemological challenge ....................................................................... 6
Solution: an Austro-Thomistical framework .......................................... 10
2. The Nature of Fraud ................................................................................ 12
A short history and etymology of fraud ................................................... 12
On means, goodwill, and the convivial order ........................................ 16
On Fraud and Imaginary Goods .............................................................. 17
3: The Effects of Fraud ............................................................................... 20
Is Fraud a Cyclical Phenomenon? ............................................................. 21
Initial state of affairs: Order ....................................................................... 22
Phase I: Fraud ............................................................................................... 23
The Swindler and the Ungenuine Trust.................................................... 23
Phase II: Recovery ....................................................................................... 25
Graphical Illustration of the Fraud Cycle ................................................. 27
4.Reply to Seven Objections ....................................................................... 28
First objection................................................................................................29
Second objection ...........................................................................................33
Third objection ..............................................................................................34
Fourth objection ...........................................................................................36
Fifth objection ...............................................................................................40
Sixth objection ...............................................................................................42
Seventh objection ........................................................................................45
5. Three Austrian Paradoxes ....................................................................... 55
4.Conclusion .................................................................................................. 57
1. METHOD

An epistemological challenge

Since action is never its own end, but rather the means to an end,
we call an action good or evil only in respect of the consequences of
the action. It is judged according to its place in the system of cause
and effect. It is valued as a means. And for the value of the means
the valuation of the end is decisive.1
Ludwig von Mises

moral acts take their species according to what is intended, and

not according to what is beside the intention, since this is accidental

Thomas Aquinas

ACCORDING TO THE AUSTRIAN THEORY OF THE BUSINESS CYCLE, developed in

1912 by Ludwig von Mises in his Theorie des Geldes und der Umlaufsmittel, fractional reserve
banking, and more specifically the expansion of credit by the ex nihilo creation of fiduciary
media, is the primary cause of the boom-bust cycle in the economy.2 This cycle is
initiated by a period of artificial growth and eventually and unavoidably leads to
economic crises, depressions and recessions. Mises always insisted on economics being
value free, but in his magnum opus Human Action, he nonetheless makes it clear what
practice causes the harmful effects of the business cycle:
The notion of normal credit expansion is absurd. Issuance of
additional fiduciary media, no matter what its quantity may be, always sets

1 On the Epicurean vein in Ludwig von Mises's writings, see Martin Masse's presentation The
Epicurean Roots of Some Classical Liberal and Misesian Concepts, delivered at the Austrian Scholars
Conference, Ludwig von Mises Institute, March 18, 2005, in Auburn, Alabama.
2 Often an artificially low interest rate is cited as being the essential cause of the business
cycle. However, it should be clear that, in absence of a central bank (acting as a central planning
bureau), the lower interest rate is an effect, rather than a cause, of the issuance of fiduciary media.
And even with a central bank present, it merely acts as an incentive mechanism that stimulates
economic actors to demand more (cheap) credit, thus enabling the banks to issue more fiduciary
media. It is however only this money printing, and not the interest rate per se, which boosts the
inflationary boom that initiates the the business cycle. In America's Great Depression, Murray
Rothbard reminds us that Mises points out (Human Action, p. 789n.) that if the banks simply
lowered the interest charges on their loans without expanding their credit, they would be granting
gifts to debtors, and would not be generating a business cycle. (America's Great Depression, Auburn,
Ala.: Ludwig von Mises Institute: 2000, p. 33, footnote 37). For the sake of clarity, here is Mises's
Theory of Money and Credit:
"The issuers of the fiduciary media are able to induce an extension of the
demand for them by reducing the interest demanded to rate below the natural
rate of interest, that is below the rate of interest that would be established by
supply and demand of the real capital were lent in natura without the mediation
of money, whereas on the other hand the demand for fiduciary media would be
bound to cease entirely as soon as the rate asked by the bank was raised above the
natural rate." Ludwig von Mises, Theory of Money and Credit (New Haven: Yale
University Press, 1953), p. 306-307.
and further:
The number and extent of purchases and sales on credit are by no means
independent of the credit policy followed by the banks, the issuers of fiduciary
media. If the conditions under which credit is granted are made more difficult,
their number must decrease; if the conditions are made easier, their numbers
must increase. Ibid., p. 309.
 in motion those changes in the price structure the description of which is
the task of the theory of the trade cycle. Of course, if the additional
amount issued is not large, neither are the inevitable effects of the
expansion.3
Walter Block summarises the position of Ludwig von Mises as follows:
[T]he Misesian view is that the banks don't have to search for the natural
rate in order to avoid generating the business cycle; all they have to do is
not expand credit beyond their cash holdings. This is surely a much easier
task. The banks' insistence on expanding credit generates the business
cycle, and makes them responsible and thus "guilty" as charged.4
Mises's student Murray Rothbard also stated it very clearly:
The basic point is that banks only generate a cycle by expanding (fractional
reserve) credit; the key is the act of credit expansion, not whether their interest
charge was correct.5
Other than his teacher, Rothbard saw no contradiction in integrating moral
judgments within a praxeological framework,6 and combined Misesian apriorism
enthusiastically with the traditional judicial principles that have been developed since the
Greek and especially Roman antiquity, and medieval scholasticism. Rothbard also applied
this judicial reasoning to the practice of fractional reserve banking, which lead him to
make the following statement:
[a]ll men are subject to the temptation to commit theft or fraud. . . . Short of this
thievery, the warehouseman is subject to a more subtle form of the same
temptation: to steal or borrow the valuables temporarily and to profit by
speculation or whatever, returning the valuables before they are redeemed so that
no one will be the wiser. This form of theft is known as embezzlement, which the
dictionary defines as appropriating fraudulently to ones own use, as money or
property entrusted to ones care.7
Rothbard's standpoint, that fractional reserve banking is essentially fraudulent, has
since been championed by some of the most prominent theorists of the Austrian School.8

3 Ludwig von Mises, Human Action (Fox & Wilkes: San Francisco, 1996), p. 442.
4 Walter Block and Kenneth M. Garschina, Hayek, Business Cycles and Fractional Reserve
Banking: Continuing the De-Homogenization Process, The Review of Austrian Economics Vol. 9, No. 1
(1996): 77.
5 Murray Rothbard, as quoted in John P. Cochran, Steven T. Call, and Fred R. Glahe
Austrian Business Cycle Theory: Variations on a Theme, Paper prepared for Presentation at Austrian
Scholars Conference 8 (2002), Mises Institute, Auburn, Alabama, March 15-16.
6 On the problems with value free science, see Frank van Dun, Economics and the Limits
of Value Free Science (Reason Papers No. 11 (Spring 1986) 17-32.), in which the author quotes Ludwig
von Mises: The intellectual methods of science do not differ in kind from those applied by the
common man in his daily mundane reasoning. The scientist . . . merely uses them more skillfully and
cautious (Ludwig von Mises, Human Action, (Fox & Wilkes: San Francisco, 1996), p. 58.), and goes on
to say that [n]either science nor "our daily mundane reasoning" fare well if we do not see the
continuity or do not recognize that both equally face the challenge of reasonableness. If the ethical and
political requirements of the dialogue are valid for science, then they are universally valid wherever
judgment and decision based on knowledge may be involved. Van Dun continues: If the ethics and
politics of the dialogue are valid for speech, they are also valid for action. Respect for the rational
autonomy of an agent is just as much a requirement of reasonableness as respect for the rational
autonomy of a speaker. Frank van Dun, Economics and the Limits of Value Free Science (Reason
Papers No. 11 (Spring 1986) 17-32.) pp 26-27.
7 Rothbard, The Mystery of Banking, p. 90, as quoted in Jess Huerta de Soto, Money, Bank Credit,
and Economic Cycles, (Auburn, Ala.: Ludwig von Mises Institute, 2006), pp. 183-84.
8 It is perhaps relevant to note how another major Austrian economist, Friedrich von Hayek,
explicitly refused to accuse bankers as being guilty for the damaging effects of the business cycle:
... we can also see how nonsensical it is to formulate the question of the causation
of cyclical fluctuations in terms of "guilt," and to single out, e.g., the banks as those
"guilty" of causing fluctuations in economic development. Nobody has ever asked
Those who have contributed most in defense of this position are Jess Huerta de Soto,
Hans-Hermann Hoppe, Jrg Guido Hlsmann, and Walter Block. Now, if these scholars
are correct, which we believe they are, fraud is in effect the act that sets in motion the
entire business cycle; it is its essential cause. This poses us before a major epistemological
challenge: if fraud, a judicial phenomenon, is actually the most fundamental cause of the
business cycle, is it then possible to develop a comprehensive theory (i.e., a theory offering a
complete explanation of the essential causes) of the business cycle using nothing more than
the Misesian (allegedly value free) methodological instruments? The answer is, or so we
hold in this article, negative.
We can define fraud concisely as deliberate deception causing injustice.9
Following this definition, fraudulent actions are rendered meaningless in a theoretical
context that does not allow for the normative distinction between just and unjust.
This is why, for example, reference to the value free term error often tends to confuse
matters, because it lumps together just and unjust sources of change in society, the
former being essentially coordinating, the latter essentially discoordinating.10 This, as we
propose at the end of our article, leads to paradoxes that cannot be solved within a
utilitarian praxeological framework. Now, given that fraud is a judicial concept, it seems
only natural to suggest that a comprehensive understanding of the business cycle should
be rooted, not primarily in a value free body of praxeological theory, but rather in a
broader normative judicial-philosophical framework. Doing so is an important aim of this
paper.11

Solution: an Austro-Thomistical framework

In response to the epistemological challenge of the Austrian Business Cycle
Theory, we will here attempt to adapt a broader perspective, one of philosophical realism.
More specifically, we will here exert ourselves starting from a metaphysical framework
broadly in accordance with that developed by Saint Thomas Aquinas (1225?-1274 A.D.).
To the modern reader and student of the Austrian School of economics this may seem a
bit of a surprising choice, given that only few Austrian economists make explicit
reference to St. Thomas in their writings. Given that an investigation of the historical and
philosophical parallells between Thomism and Austrianism is outside the scope of this
article, we limit ourselves to three quotes as a means of illustration, each from a major
figure in the Austrian tradition, each made late in their lives. The first quote by Ludwig
von Mises, in one of his last works, The Historical Setting of the Austrian School of Economics,

them to pursue a policy other than that which, as we have seen, gives rise to cyclical
fluctuation, seeing that the latter originate not from their policy but from the very
nature of the modern organization of credit. (Hayek 1933, p. 189as quoted in
Block and Garschina's previously mentioned article, pp. 81-82.)
One wonders why the banker, unlike like any entrepreneur in the economy, should only
conduct his business in ways other people ask him to do, i.e., why he should not be held responsible
for his own actions. Furthermore, de Soto, in his Money, Bank Credit, and Economic Cycles, has
convincingly shown how, throughout history, there have been bankers who actually have resisted to the
temptation of fraud.
9 For a full definition, see the next section.
10 The original idea behind Law was order, from the Scandinavian lag, meaning order or
bond. Hence the opposite of Law was disorder, in Germanic werra, meaning confusion or
disorder. Similarly, the antonym of lag was orlaeg, clearly related to the Dutch word for war, oorlog.
Thus, lawful principles were traditionally seen as leading to order, and transgressions of the Law were
thought of as leading to chaos. All the above in Frank van Dun, Natural Law, Liberalism, and
Christianity, Journal of Libertarian Studies vol. 15, no. 3 (Summer 2001) , pp. 1-36, esp. p. 3.
11 The original subtitle of this article was an Austro-Thomistic investigation into the causes and
effects of fraud. In our investigation into the causes of fraud, we were lead to the questions of how
means are generated, and what the different causes of injustice are. During all of this, we relied heavily
on the philosophical vocabulary of St. Thomas, much more so than in the article as it is presented here.
Eventually, however, we decided not to include this section, in part because it may lead us too far from
the main point, but also because we felt the theory developed therein was even more immature than the
one presented here.
the second is by Murray Rothbard, in a 1987 review of a book on the philosophical
background of the Austrian School, and the third quote is by Franz Brentano, the
influential German intellectual and colleague of Carl Menger, where he reflects back on
his formational years.

"What is known as the Austrian School of Economics started in 1871 when Carl
Menger published a slender volume under the title Grundstze der
Volkswirtschaftslehre [Principles of Economics].... Until the end of the Seventies
there was no 'Austrian School.' There was only Carl Menger."12
Ludwig von Mises

Carl Menger, the founder of Austrian economics, was steeped in Aristotelian

epistemology and method . . . This volume has convinced me that it was not
simply Aristotle per se, but the Aristotelian Franz Brentano, a Catholic priest, born
in southern Germany, who formed the dominating milieu of Austrian philosophy
and provided Carl Menger with his basic philosophic framework.13
Murray Rothbard

First of all I had to apprentice myself to a master. But since I was born when
philosophy had fallen into most lamentable decay, I could find none better than
old Aristotle. To understand him, which is no always easy, I enlisted the help of
Thomas Aquinas.14
Franz Brentano

In what follows, we work in agreement with Gabriel J. Zanotti, when he asserts that
Mises's praxeology . . . could function as a theorem within a Thomistic philosophical
structure,15 and try our hand at making a contribution to what has been called the
Rothbardian project, of integrating the Austrian with the Thomistic tradition.16

12 Mises, The Historical Setting of the Austrian School of Economics, (Auburn, Ala.: Ludwig von Mises
Institute, 1984).
13 Murray Rothbard, Review of Austrian Economics: Historical and Philosophical Background,
Wolfgang Grassl and Barry Smith, eds., London: Croom Helm, pp. 250. From Journal of Applied
Philosophy, Vol. 4, No. 2, 1987, 248-50.
14 Brentano (ANR, p. 291)., as quoted in Rolf George and Glen Koehn's article Brentano's
relation to Aristotle, published in The Cambridge companion to Brentano, Dale Jacquette ed. (Cambridge:
Cambridge University Press, 2004)
15 Gabriel Zanotti, Misesian Praxeology and Christian Philosophy, The Journal of Markets &
Morality 1, no. 1(Spring 1998), 60-66. The following articles point at similarities between Mengerian-
Misesian thought and Aristotelian-Thomistic thought. On purposeful human action, free will valuation,
error and a priori methodology, see the short article of Gabriel J. Zanotti, Misesian Praxeology and
Christian Philosophy, The Journal of Markets & Morality 1, no. 1(Spring 1998), 60-66. On
foundationalism (the belief that logically self-evident, noncontradictory statements form a genuine
foundation for knowledge about reality) versus impositionism (the Kantian notion that the categories of
the mind impose the perceived relationships and essences onto that what is being perceived), see
Steven Yates, What Austrians Should Know About Logic (And Why), The Quarterly Journal of Austrian
Economics Vol. 8, No. 3 (Fall 2005): 39-57. Also on this subject, the paper of Franois Facchini's
Apriorism, Introspection, and the Axiom of Action: A Realist Solution, Quarterly Journal of Austrian
Economics (2007) 10:234-249. On the Aristotelian roots of praxeology, see Geoffrey Allan Plauch, On
Praxeology and the Question of Aristotelian Apriorism (published online, March 9, 2006).
16 See Jude Chua Soo Meng, Hopp(e)ing Onto New Ground: A Rothbardian Proposal for
Thomistic Natural Law as the Basis for Hans-Hermann Hoppes Praxeological Defense of Private
Property (published online, 2007).
2. THE NATURE OF FRAUD
Multis annis jam transactis
nulla fides est in pactis
Mel in ore, verba lactis,
Fel in corde, fraus in factis.17
Anonymous

imaginary wealth is exchanged for real wealth; and the real

wealth is consumed by those who have produced nothing in place
of it.
Garet Garrett

In the present paper, we define fraud in brief as being deliberate deception causing
injustice. In a more precise definition, we may call it a deceptive act, or series of acts, with
which someone knowingly brings into being a situation of injustice. In this section we will first
indicate how this definition is historically and etymologically consistent, followed by an
investigation into the judicial context in which fraud arises. We close with a revisitation of
Menger's imaginary goods in relation to fraud.

A short history and etymology of fraud

To grasp fraud in its historical context, it is necessary to go back to the Roman
concept of the dolus. In Roman law dolus (from dolere, suffer, having sorrow),
traditionally took on the meaning of deception.18 Dolus was subdivided in on the one
hand dolus bonus; benine deception that can reasonably be expected and that is quite
commonly accepted,19 and on the other hand dolus malus; deception with an explicit
negative connotation. Aquilius Gallus, as quoted by Cicero, described dolus malus as to
do one thing and to pretend another.20 The description by Gallus did not offer a clear

17 This rhyme was beautifully translated by nineteenth century scholar and wizard Charles
Leland:
For many year, my friend, the fact is
That honesty is out of practice
And honey'd words and fawning smile
Are ever mixed with fraud and guile.
Charles G. Leland, Meister Karl's Sketch-Book (Parry & McMillan: Philadelphia, 1855), p. 335.
18 In his famous and very influential Etymologies, Isidore of Seville (560-646 A.D.) defines
dolus as follows:

Deception (dolus) is a cunning of the mind, so named from the fact that it deludes
(deludere), for the deceiver does one thing and pretends to do another. Petronius thinks
otherwise when he says What, judges, is deception (dolus)? Surely, it is when
something is done that is painful (dolere) to read about. You have 'deception'; now hear
about evil.. The Etymologies of Isidore of Siville, (Cambridge University Press, 2007), p.
122.
Modern etymologists seem to prefer Petronius's interpretation.
19 In K. Zweigert, International Encyclopaedia of Comparative Law (Mohr Siebeck, Tbingen:
Martinus Nijhoff Publishers, 1981), p. 86, the following is asserted on the dolus bonus: ...dolus bonus
expresses the legal order's acknowledgement that in trade and commerce common eulogismes and
exaggerations may be used so as to present a product to potential customers in as favorable a light as
possible. For an elaborate discussion of the doctrine of the dolus bonus, see pp. 86-9 of this work.
20 Cicero, De officiis, 3, 14, 60: C. Aquilius, collega et familiaris meus, protulerat de dolo malo formulas;
in quibus ipsis, cum ex eo quaereretur, quid esset dolus malus, respondebat, cum esset aliud simulatum, aliud actum..
contrast between deception causing injustice, and deception that may be disapproved by
some, but that is not strictly unjust (such as that of a salesman selling the perfect
house). In fact, the pure notion of fraud, or dolus malus, was for a long time no part of
the legal vocabulary on the basis for which one could accuse others in court. The reason
why has been indicated by the 19th century classicist J.B. Moyle:
It is well known that until the time of Cicero fraud was no defense whatever to
an action or an agreement expressed in solemn form, such as a stipulation, but
that straightforward dealing was deemed essential to the perfect validity of those
other contracts which were sued upon by actiones bonae fidei: thus it is said that
a covenant dolum malum a venditore abfuturum was superfluous and unnecessary,
and that the vendor (and no doubt the purchaser equally) was unable to contract
himself out of the consequences which his fraud could entail, because 'dolus semper
abesse oportet in iudicio empti, quod bonae fidei sit'.21 (Italics are our own.)
Good faith was thus presupposed in the lawful order, which was then obviously
breached whenever deception took place.
This changed with the actio de dolo, an edict enforced by Aquilius Gallus himself in
66 B.C., which clearly defined dolus malus as an act causing injustice, and therefore
punishable by law.22 As time went by, the use of the word fraud in stead of dolus came to
be used as a more specific concept to refer to deception causing unjust damage or loss.
Fraud derives from Latin, fraus, which is related to Greek thrauein (to break) and titroskein
(to wound, damage). These etymologies indeed give some indication of the breach of
trust and the consequent injury or injustice as being essential to the phenomenon of
fraud.
Both the deceptive and the unjust character of fraud have been emphasized by
different thinkers throughout history. We limit ourselves a brief account of the
interpretation of two theorists in the Aristotelian tradition: Thomas Aquinas and
Leonardus Lessius.
Thomas Aquinas categorized fraud (fraus) under cunning (astutia).23 He gave three
general cases in which fraud can occur: when one hands someone something that is
different in nature, something that is from a different quantity, or that is from a different
quality, than was originally promised. Clearly St.Thomas had an exchange in mind, in
which the victim gives up a real thing in exchange for a thing that is only real in his
imagination. The victim thus inevitably and involuntary suffers a loss, which results in a
state of injustice.
The description of Leonardus Lessius (1554-1623) also confirms the defining
characteristics of deception and injustice as we proposed them. Lessius, a member of the
School of Salamanca,24 in his early and most famous work De iustitia et iure ceterisque
virtutibus cardinalibus (1605) summarized the scholastic consensus on the phenomenon of
fraud. He devided it under the dolus, whereby fraus was meant for cases of dolus that are
related to an object or an assignment that needs to be executed. Lessius distinguished

21 J.B. Moyle, The Contract of Sale in the Civil Law, (Oxford: Clarendon Press, 1892), p. 58.
22 See J.E. Spruit, Cunabula Iuris: Elementen uit het Romeinse Privaatrecht, (Deventer: Kluwer, 2003),
p. 421.
23 Thomas Aquinas, Summa Theologiae, II.II, 55, art. 5, specifically the second counterargument.
24 See Marjorie Grice Hutchinson, The School of Salamanca, (Oxford: Clarendom Press, 1952) pp.
81-89. Hutchinson writes:
Leonardus Lessius (1554-1623), professor of theology at Louvain, was a Flemish
Jesuit who had studied under Suarez and was a friend of Molina and Vasquez. He was
the author of a treatise de justitia et jure (1605) which ran through nearly forty
editions published in Atwerp, Louvain, Lyons, Paris, and Venice. Lessius was
especially celebrated for his expert knowledge of commercial practice, and he was
often consulted by the merchants of Antwerp on problems of business morality, just
as their forefathers had appealed to Vitoria and the doctors of Paris some eighty years
earlier.
from fraud fallacia and periurium, the former being deceit which only involves words, and
the latter deceitful words that are accompanied by an oath.
The main characteristics of fraud are also beautifully portrayed in an illustration by
the Italian renaissance aesthetician Cesare Ripa, published in his influential Iconologia25. Let
us read the revealing description:
'Fraud'. A woman with two
Faces, one young, the other old;
Feet like Eagles talons; a Tail
like a Scorpion, two Hearts in
her right Hand, and a Mask in
her left. The two Faces denote
Fraud and Deceit, ever
pretending well: the two
Hearts, the two Appearances; the
Mask, that Fraud makes things
appear otherwise than they are;
the Scorpion, and Eagle, the
bale Designs and Discord they
foment, like Birds of Prey, to
rob Men of their Goods or
Honour.
We believe our historical case, that fraud is deliberate deceit causing injustice has
now been sufficiently substantiated. Let us conclude with two modern definitions of
fraud. Webster's Dictionary defines the lemma fraud as follows:
intentional perversion of truth to cause a person to give up property or some
lawful right.26
This is a more precise definition, by J.B. Moyle:
Fraud in the narrower sense may be defined as a false statement made with
knowledge of its falsehood for the purpose of inducing the other party, and
actually inducing him, to make the contract to his detriment.27

On means, goodwill, and the convivial order

Fraud is thus deliberate deceit causing injustice. Injustice is the breach of justice,
with the latter being, traditionally, the domain in which man acts responsibly, only claims
what is his to claim, and where he lives peacefully within his means. Injustice, then,
involves a transgression of this natural order: the lawbreaker refuses to live within his
means and unjustifiably interferes with the means of others. We can define an unjust
action or violation (i.e., an action violating justice) as an action that is brought to bear on
a person or his means by an external agent, contrary to the person's intention.28

25 The first, unillustrated edition of Iconologia was published in 1593. The famous illustrations
only came with the third, 1611 edition. The description is from the 1709 English translation. Ripa's
depiction of 'Fraud' appears on the cover of a book used for the purpose of this article: Toon van
Houdt, red., On the Edge of Truth and Honesty, (Leiden: Koninklijke Brill NV, 2002).
26 Fraud. (2009). In Merriam-Webster Online Dictionary. Retrieved September 17, 2009, from
http://www.merriam-webster.com/dictionary/fraud
27 J.B. Moyle, The Contract of Sale in the Civil Law, (Oxford: Clarendon Press, 1892), p. 58.
28 For an act to be violent it is not enough that its principle be extrinsic, but
we must add 'without the concurrence of him that suffers violence.' Thomas
Aquinas, Summa Theologica, II-I, 9, art. 4.
For what follows, it is important to note that, since willing implies knowing, ignorance causes
involuntariness. As Thomas Aquinas writes,
. . . a man may be ignorant of some circumstance of his act, which he was not
bound to know, the result being that he does that which he would not do, if he knew
of that circumstance . . . Such ignorance causes involuntariness simply. Thomas
 Now, in order to study the appearance the fraud cycle, we have to consider the
state of affairs in which fraud is not present, after which we can study its appearance,
effects, and disappearance. Given that the essential nature of fraud is injustice (because
fraud is aimed at injustice29) we depart from a situation where injustice is absent. Fraus et
jus numquam cohabitant, as the Latin dictum goes; where there is justice, there is no fraud,
and vice versa. Our starting point is thus a orderly state of affairs, which we can call the
convivial order30 or natural order. It is a situation in which people live next to one
another and respect each other as natural, i.e., reasonable, persons; where each lives
within his own means and where a basic level of trust is cultivated, bona fides, good faith, or
goodwill, which means that in their daily dealings, people choose not to trap, trick or
deceive one another, as a hunter would do to an animal, but rather try and resolve
disagreements through reason and argumentation. Structural lack of this basic
truthfulness would render all social cooperation impossible, causing the fabric of the
convivial order to disintegrate.31

On Fraud and Imaginary Goods

We now have a broader understanding of the nature of fraud. Given that fraud is a
distortion of sound judgment, it follows that the person subjected to fraud misconceives
certain resources as being suitable as goods that are in fact not suitable in the intended
sense, or that he misconceives certain resources as possessing a potency that they really

Aquinas, Summa Theologica, II-I, 6, art. 8 (Whether ignorance causes

involuntariness?).
29 Human action is essentially purposeful. The essence of an act is the end or purpose towards
which it is intended. Without a purpose, behavior is pointless or random; it looses its meaning and
ceases to be action. Now fraud is an act, which applies deception as a means, or intermediary end,
towards injusice. It follows that the essential nature of fraud is injustice. See also Thomas Aquinas, II
Sent., d. 2 a. 2, a. 1.: the finis operis is the goal to which the deed is ordered by the doer, and this is
called the nature of the deed. On human action and the role of the finis operis, see Gabriel Zanotti, "El
Metodo de la Economia Politica", Revista Libertas 40 (May 2004), p. 37.
30 On the concept of the convivial order, see the work of Frank van Dun. In his Concepts of
Order (2006, p. 23), he writes, for example: A convivial order is not a society. It is a catallaxy, an
order of friendly exchange among independent persons. We can find examples of convivial order . . .
wherever people meet and mingle and do business in their own name, whether or not they belong to
the same or any social organisation. . . . [T]he paradigm of conviviality is a relation between natural
persons.
31 The law of the first society islet us act in good faith (bona fide agito) . . . Thus, in the
Roman system of right, at times, the expression good faith is taken to signify natural right itself.
(Giambattista Vico, Universal Right (Amsterdam: Rodopi, 2000), p. 42.) When people act in bad faith, are
double-minded and deceitful, the convivial order ceases to exist: it would be impossible for men to
live together, unless they believed one another, as declaring the truth one to another (Thomas
Aquinas, Summa Theologiae, II-II, 109, art. 3). Toon van Houdt's comment, describing the views of the
scholastic theorists, is also relevant in this respect. It is worth citing it in full:
On a practical level, fraud and deceit are criticized as being detrimental to social life
and to the instruments of communication on which the social life is based. Indeed,
both a liar and a dissembler make abuse of the signs which we have at our disposal to
express our inner thoughts and emotions and, by doing so, to enter into a meaningful
communication with others. They corrupt the natural function of language and body
language which consist of a number of signs which enable us to signify or indicate
something. According to the moral theologians, these signs have not been given to us
for our own sake but rather for the sake of our fellow men. While truthfulness entails
simplicity or open-heartedness (simplicitas), lying and deceit create discord and
duplicity (duplicitas). Indeed, both a liar and a dissembler bear one thing in their heart
but show something completely different. In short, they create a gap between signifier
(words, gestures, facial expressions, etc.) and signified (thoughts and feelings,
character and moral disposition), and pervert the natural function of speech and body
language. By doing so, they destroy mutual trust and sympathy which are deemed
essential to any society. Toon van Houdt in On the Edge of Truth and Honesty, p. 9
(italics in original).
do not. This illusionary reality is constituted of what we may call imaginary goods. Let us
in what follows investigate what is understood by this.
In the act of fraud, the deception of the swindler imprints in the minds of his
victims an understanding of the world that is not conform to the way things really are: he
makes them believe in the existence of goods that do not actually exist,32 or he secretly
changes the state of affairs, thus instilling in them the mistaken belief that actually
removed goods are still available to them. In either case supposed goods are created that
appear to be fitted to satisfy human wants,33 but do not actually: imaginary goods. We
here use this term in line with Carl Menger's definition: things that are incapable of
being placed in any kind of causal connection with the satisfaction of human needs [that]
are nevertheless treated by men as goods.
Menger saw two possible ways in which imaginary goods can come into being:
(1) when attributes, and therefore capacities, are erroneously ascribed to things
that do not really possess them, or (2) when non-existent human needs are
mistakenly assumed to exist. In both cases we have to deal with things that do
not, in reality, stand in the relationship already described as determining the
goods-character of things, but do so only in the opinions of people.34
Menger errs, as has been pointed out by Mises35, when he claims in an elaboration
of (2) that imaginary goods can derive from imaginary value or imaginary wants. The
reason why Menger is mistaken is that imagination (phantasy, illusion) ultimately springs
from the senses,36 but value and wants ultimately do not. Hence, wants nor value can
possibly be illusory. However this does not in the least refute the possibility of the
existence of imaginary goods, since the first cause of this phenomenon as suggested by
Menger, the false ascription of capacities to things that do not really possess them, is
perfectly valid. Capacities of substances are indeed detected by the senses, and can
therefore be perceived where they are not present, or overlooked where they are. It
follows that the distinction between imaginary and true goods is a valid one.
It is interesting to note that while Menger's criteria of the good clearly exclude
imaginary goods as actual goods (Menger stipulates an objectively possible causal
connection between the desired end and the potency of the resources), Mises's suggested
correction of Menger lumps together imaginary goods with actual goods. Writes Mises:
. . . the third prerequisite for a thing to become a good would have to read: the
opinion of the economizing individuals that the thing is capable of satisfying their
wants37
Mises goes on to recognize that [t]his makes it possible to speak of a category of
imaginary goods, only to dismiss the distinction as pointless;38 reason being that
imaginary goods are also sold for real prices in the marketplace.

32 One could remark here that the word for deception in Germanic languages ('bedrog' in
Dutch, 'Betrug' in German), is related to the on. draugr ('ghost'), the os. gidrog (''appearance', 'chimera'),
wt. bitriaga ('administering damage in a cunning way' )and the oi. drogha ('damage'). Indeed, mala fide
deception, and thus also fraud, deliberately brings about a harmful illusion or 'mental high' to work to
the advantage of the deceiver/swindler, and to the detriment of the victim.
33 Mises, Human Action, p. 93.
34 Carl Menger, Principles of Economics, (Auburn, Ala.: Ludwig von Mises Institute, 2007), p. 53
35 See Mises' 1928 article, translated as Remarks on the fundamental Problem of the Subjective
Theory of Value, in Austrian Economics: An Anthology, (Irvington-on-Hudson: Foundation for
Economic Education, 1996) ed. Bettina Bien Greaves, p.119-36.
36 . . . an imaginary vision originates from sense; for the imagination is moved by sense to act.
Thomas Aquinas, Summa Theologica, I, 12, art. 3.
37 Mises, Remarks on the fundamental Problem of the Subjective Theory of Value (published
in Austrian Economics: An Anthology, Irvington-on-Hudson: Foundation for Economic Education, 1996;
ed. Bettina Bien Greaves, pp. 119-36). Italics in original.
 We hold, however, that the distinction between true and imaginary goods is not
pointless, but rather a vital one; and this not only for philosophy of law, but also for
economic science. In philosophy of law, because the differentiation of true and imaginary
goods aligns exactly with the difference between fraudulent and bona fide transactions;
only actions in the category of fraud are intrinsically aimed at the creation of imaginary
goods39. As for the economic sciences, we admit that in the context of a market setting,
where each actor makes entrepreneurial predictions in the face of uncertainty, where both
imaginary and true goods are traded alike, and where the imaginary or true character of a
good is only distinguishable after the facts, the distinction between both types seems
hardly, if at all, relevant: both will be demanded and offered on the market, which will
determine a market price for each of them in similar ways. However when considered
from the point of view of the Austrian business cycle theory, the situation changes.
Namely, it is our suggestion that the fundamental explanation of why crises and recessions inevitably
must take place following any fraudulent expansion of the money supply, lies exactly in the fact that credit
expansion in the form of ex nihilo creation of fiduciary media essentially amounts to the generation of
imaginary goods. Recognition of this fact leads to the insight that the bust phase of the crisis
is simply the pop of an illusionary bubble and a return to reality.

3: THE EFFECTS OF FRAUD

Oh! What a tangled web we weave, when first we practice to
deceive!
Sir Walter Scott

Introduction
We have thus far analyzed the context in which fraud becomes possible (the
convivial order), as well as the essential characteristic of the good with which fraud
interferes (sound judgment), and the inevitable byproducts of fraud (imaginary goods).
These will suffice as preliminary observations. We can now enter into a description of the
essential elements of the fraud cycle. Before we continue, it is suitable to recognize the
author who first conceived of the fraud cycle, even coining the term. It was Jrg Guido
Hlsmann, in his 1998 paper Towards a General Theory of the Error Cycle, where he
also provided a short description of this phenomenon:
The victim of fraudulent behavior is not aware of his situation and thus behaves
as if everything was still in order. He thinks that he still can realize all the projects
he had planned. He does not know that the quantity of his means has been
diminished. Therefore, he will not adjust the structure of his property to the new
circumstances. He is likely to leave for holidays in cases where he should rather
begin to save and live from hand to mouth. If fraud occurs on a large scale,
society's capital structure will be distorted in an exactly analogous way. People do
not apprehend that the capital stock has been diminished by the embezzler and

38 Later authors in the Austrian tradition also seem to have rejected or at least brushed aside the
category of imaginary goods. Joseph T. Salerno, for example, in Epistemological Problems of Economic Science
(p. 185), calls the distinction superfluous. Further, George Reisman, though he acknowledges
imaginary goods as a valid concept, states:
it is not necessary, however, for economics to devote any special consideration to
such goods beyond acknowledging the fact of their existence. This is both because
they constitute unimportant exceptions and because the economic principles that
apply to such goods, such as the laws of price determination, are the same as that
apply to genuine goods. George Reisman, Capitalism, (1996), p. 41.
39 Imaginary goods are an inevitable by-product of fraud. The intimate intertwinement of both
phenomena is illustrated by the origins of the German word for fraud, which is Betrug; see footnote 32.
 needs to be refilled through savings. Sooner or later they wil discover this error.
This is when the crisis sets in.40
As is to be expected from the title of his article, Hlsmann dismisses his own
theory and defends instead another one, that of the general error cycle or illusion
cycle of government.
Now, for our present analysis of the fraud cycle. We begin this section by asking
whether fraud actually is a cyclical phenomenon and with an analysis of the general
context in which fraud occurs. Next, we examine the fraud-phase of the cycle, which
consists of an ungenuine trust, and an inflationary boom. This is followed by a discussion
of the recovery-phase, consisting of the crisis, the deflationary correction, and the
rectification. We conclude our analysis of the fraud cycle with a graphical illustration.

Is Fraud a Cyclical Phenomenon?

A cycle is a causal chain of events that is repeated or repeatable (the word derives
from kyklos, circle). It seems that there are two ways in which phenomena can be called
cyclical. A first is a logico-sequential cyclicality, a second is cyclicality through time. The
logico-sequential cyclicality is a natural feature of all phenomena: they move from non-
existence, over appearance, towards disappearance. In this sense, every individual
phenomenon is cyclical in nature. A second way in which a phenomenon may be called
cyclical is when the circular sequence of aspects of which the phenomenon is constituted
is not only sequential, but also temporal, i.e., stretched out in time. The phenomenon of
fraud can be marked as also being cyclical in this second sense. The time element is
inherent in the nature of fraud, for the reason that, by definition, there exists a (short or
long) time lag between the moment someone becomes the victim of fraud, and the
moment in which the fraud is uncovered. We here follow the same line of reasoning
Guido Hlsmann applies in his theory of the error cycle:
The theory of error cycles starts from the fact that error is committed at the
moment choice but only revealed in the future. There is always a time lag between
a wrong choice and the discovery that it was a wrong choice, and at the moment
of choice, one is never aware of one's errors-otherwise one would not engage in
this action at all. The necessary time lag between an error and its discovery
implies an error cycle, with all the familiar features of the business cycle theory.41
What we assert is thus that cyclicality is a quality that necessarily follows from the
constitutive features of the phenomenon fraud. In other words: fraud is not
sometimes, but always and inevitably cyclical in nature.
Let us now proceed to a description of the fraud cycle. As we will see in what
follows, it can be divided in two general phases: the first is the phase of fraud, and the
second is the phase of recovery.42 Before the first phase, fraud, we find ourselves in an
environment where good faith allows for trade and friendly relations: the convivial order.

Initial state of affairs: Order

This is the state of affairs we have studied in the above section On means, good
faith, and the convivial order. Frank van Dun calls this the natural, or convivial, order:
[T]he convivial order is ius-based. The word ius refers to the Latin verb iurare,
which means to swear; to speak solemnly; to commit oneself toward others. The
ius-relation implies no positions of authority or command, but direct personal
contacts resulting in agreements, covenants and contracts, in mutual

40 Guido Hlsmann, Toward a General Theory of Error Cycles, p. 12.

41 Guido Hlsmann, Toward a General Theory of Error Cycles, p. 8.
42 We use the same division as Hlsmann's: Fundamentally, two stages can be distinguished.
At the beginning of the first stage the error is committed. The crisis marks the point in time where
the error is discovered. Then begins the second stage, a phase of reestablished sobriety. Guido
Hlsmann, Toward a General Theory of Error Cycles, p. 8-9.
 commitments, obligations or iura. Strictly speaking, the ius-relation can exist only
between natural persons, as they are the only persons that are naturally capable of
independent speech and action. 43
In the convivial order, people maintain friendly relationships and generally trust
each other. In this atmosphere of genuine trust,44 people engage in mutually beneficial
cooperation, which results in peaceful commerce, division of labour, and sustainable
economic growth. The attitude of genuine trust that exists in the convivial society is
expressed in trusting relationships between individuals, or trusts. In a trust, a trustor
assumes the truthfulness of another person and has good reasons to expect that the other
will perform one or more actions.45 These good reasons may be implicit, embedded in the
social and cultural context, or made explicit, for example by a specific promise of the
other person. The person wherein the trust to perform an action is placed, is whom we
can call the trustee.

Phase I: Fraud

The Swindler and the Ungenuine Trust

The violation of the convivial order by means of fraud begins when a person (we
will further refer to him as the swindler) decides to act in bad faith, thereby causing in
the mind of another a distorted judgment of the potency of his means, in order to gain to
his detriment. The swindler abuses the other's goodwill by representing something as
true, knowing that it is not. He succeeds in getting the other person to enter in a trust
with him, whereby he as trustee (or fiduciary46) commits himself to an act (or series of
acts) that is regarded as beneficial in the eyes of the trustor, in return for one or more
favours from the part of the trustor. The supposed benefits, falsely promised to the

43 Frank van Dun, Concepts of Order, 2006.

44 See Tuomela, M., 2003, A Collectives Rational Trust in a Collectives Action, Understanding
the Social II: Philosophy of Sociality, Protosociology 18-19: 87-126
45 Maj Tuomela has done interesting work on trust. He writes:
Trust could be conceived of as an attitude that the trustor has towards the trustee in
which the trustor, due to their relationship of mutual respect, normatively expects of
the trustee, on social or (quasi-) moral grounds, that he will intentionally gratify the
trustor within a wide scope of matters. Such a relationship of mutual respect is often
described as one of goodwill and trust. Maj Tuomela, Rational Social Normative
Trust as Rational Genuine Trust, published in Philosophy and Ethics: New Research,
Laura V. Siegal ed., (New York: Nova Science Publishers, 2006), p. 2.)
The grounds of trust as described by Tuomela however, social or (quasi-) moral grounds,
are very vague. In another article he does use the less arbitrary concept of rights, when he asserts:
The trustor believes that the trustee will intentionally perform the desired action
with goodwill towards the trustor, partly in response to the trustor's right to expect
this good-willed action of the trustee. This belief is grounded in the trustor's belief of
having a relationship of mutual respect with the trustee. (Ibid., p. 27).
However, these rights are nowhere defined. It seems to us that the ultimate moral grounds
of trust (i.e., the answer of the question why a trustee should do the act the trustor trusts him to do) rests
in the criterion of reasonability. To illustrate: as a Belgian I cannot travel to Great Britain and trust that
the cars there will drive on the right hand side of the road. This wouldn't qualify as genuine trust; if my
car then was hit by a British driver, it would be absurd to accuse him of breaking my trust. The reason
for this is because it isn't reasonable for me to assume that British cars should drive on the right hand
side of the road. More generally, it is not reasonable to cast judgement over an act or actor without
considering the specific context. Trust has to be based on sound reasons. In our mind, genuine trust
has to be grounded in the same rational foundation as the convivial order itself, namely on the
irrefutable one ought to be reasonable. On the ought of reasonability, see Frank van Dun,
Economics and the Limits of Value-Free Science, Reason Papers No. 11 (Spring 1986) 17-32.
46 This would be a broad interpretation of fiduciary as it was used in Roman law. The Roman
institution of the fiducia found its origins in the use of the pater familias (head of the family) to hand over
the management of his family, domain, and possessions to a friend. See R.H. Maatman, Dutch Pension
Funds (Nijmegen: Kluwer, 2004), p. 63.
trustor, are what we can call imaginary goods.47 The swindler is a trustee in bad faith: he
does not intend (or he knows beforehand that he is not able to) to fulfill his fiduciary
duty and to meet the lawful claim of the trustor.
The swindler and his victim can now, as is common practice between trustor and
trustee, decide to make up a trust agreement. This agreement serves as a fiduciary token,
explicitating the existence of the trustee's fiduciary duty, and with that the relationship of
trust between trustor and trustee. Such a fiduciary token can take many forms: it can be a
written contract, a property title, a receipt of payment, or even a verbal agreement. Its
essential characteristic is that it mediates between trustor and trustee. In the case of fraud,
the fiduciary token confirms the swindler's promise and the claim of the victim; the title
to a good that, given the malafide intentions of the swindler, is doomed to remain
imaginary.
The strategical tricks of his fraudulent business partner lead the victim-to-be to the
belief that there is a possibility to a a genuine trust; a just and mutually beneficial
relationship. However, he is mistaken. The trustee who acts in bad faith is now vested
with the goods and the trust of his victim, while the fiduciary tokens that are handed over
to the latter are empty shells: their title covers less than what should be reasonably
expected under the given circumstances.

Inflationary boom, malinvestment and overconsumption

The fraud has now been committed, and the first phase of the fraud cycle is
initiated. The supply of true goods (means) of the victim has been inflated by an
additional supply of imaginary goods. Inflation derives from the Latin verb inflare,
from in- into + flare to blow. The creation of imaginary goods indeed makes the total
supply of goods seemingly swell, in the same way as that, when seen from a distance, a
water balloon seems to contain ever more water, while in fact it is inflated with more air.
Likewise, the hot air of the imaginary goods leads to a seeming but nonexistent
expansion of the supply of true goods. This is why we consider the word inflation apt
in this context, and call this phase the inflationary boom.48
As long as the deceit lasts, the fraud victim finds himself in a euphorical state of
mind, in that he imagines to possess more means than really is the case. Consequently, he
will invest his means in different ways than otherwise would have been the case. These
investment choices will later prove to be based on a mistaken estimation of available
resources, which is why some, or many, will eventually have to be liquidated because
there simply is not enough capital available for them. In short, fraud leads to
malinvestments. A second implication of the misconceived supply of means is that, since
the victim imagines to have command over means that have more potency that actually is
the case, he will also ultimately consume more (and save less) than would have been the
case in absence of the deceit. Another consequence of fraud is thus overconsumption.

47 This imaginary good can take the shape of an alleged future good, promised but never
actually given to the victim, or it can be actually received resources with properties different in quality
or quantity, than the good the victim believes to have received.
48 In his Human Action, Mises warned against the use of popular terms such as inflation in
academic (praxeological) discourse:
The notions of inflation and deflation are not praxeological concepts. They were not
created by economists, but by the mundane speech of the public and of politicians. . .
. inflation and deflation are terms lacking the categorial precision required for
praxeoIogica1, economic, and catallactic concepts. Their application is appropriate for
history and politics. (Human Action, p. 419-420)
Nonetheless we think the terms of inflation and deflation, if properly defined, can prove
useful in clarifying the the dynamics of both the catallactic business cycle as well as the more generic
fraud cycle.
Phase II: Recovery

Crisis and Crack-up Boom

The second phase of the fraud cycle, the crisis, is initiated at the point in time where
the illusion has reached its maximum size (simply because it cannot get bigger after this):
the moment where the fraud is revealed. Ludwig von Mises, in his description of the
business cycle, used the term Katastrophenhausse to indicate this moment, and it illustrates
the essence of this point in the cycle well: the sudden turn (catastrophe) following the rise
(hausse). At some point in time the genie leaves the bottle, the high wears off and gives
rise to the inevitable downturn. What provokes this downturn is the bursting of the
illusion created by the swindler. The victim now realizes he has been fooled: the fiduciary
tokens he received from the swindler no longer cover the flag or duty they embodied.
Guido Hlsmann puts it this way:
The victim of fraudulent behavior is not aware of his situation and thus behaves
as if everything was still in order. he does not know that the quantity of his
means has been diminished. Therefore, he will not adjust the structure of his
property to the new circumstances. People do not apprehend that the capital
stock has been diminished by the embezzler and needs to be refilled through
savings. Sooner or later they will discover this error. This is when the crisis sets
in.49
The confrontation with the deceit makes the untenability of the situation obvious:
the sum of the victim's means now turns out to be smaller than he thought it was (at any
rate it can serve his intentions less well), and, consequently, this prohibits him from
continuing on the same investment path. The swindler as well notices the change of
climate and will have to change his strategy. This is what we can call the crisis (Gri. krisis:
conflict, but also decision): the deciding moment, the hour of truth, has come, and
the hidden conflict breaks loose. It is now clear that the trust that the victim had placed
in the swindler was painfully misguided.

Correction, Depression, Recovery

The inevitable loss in confidence seriously affects the value of the victim's fiduciary
tokens; these have now appeared to consist largely, or completely, out of hot air. This
causes the illusory bubble to deflate, and the inflationary boom reverses in a deflationary
correction.50 In the words of Hlsmann: [t]he crisis marks the point of time when the
error is discovered. Then begins the second stage, a phase of reestablished sobriety.51
During this process, the fraud victim attempts to exchange the fiduciary tokens he
possesses into true goods (flight into real goods). However, since these are not covered
by true goods, he will inevitably loose all or a large part of his original investments with
the swindler.
The euphoria of the inflationary boom has thus been replaced by a process of
sobering up; the victim of the fraud now assesses the means that are to his disposal in a
more realistic way. This painful process, whereby misconceptions become manifest and
the victim is confronted with the truth of the matter, is what we can call the depression.
The restoration of his own sound judgment in the state of affairs is at the same time the
beginning of the recovery process. This is the process whereby the victim readjusts his
consumption and investment pattern in alignment with the actual means that are under
his command, thus freeing himself from the disorder brought about by the lies of the

49 Guido Hlsmann, Toward a General Theory of Error Cycles, p. 12.

50 In the context of the fraud cycle, and understanding law as order, we agree with
Philipp Bagus when he states that deflation, in contrast to inflation, is not a breach of the law,
but rather, it is the restoration of the law. Philippe Bagus, Deflation: When Austrians Become
Interventionists, The Quarterly Journal of Austrian Economics vol. 6, no. 4 (Winter 2003), p. 25. Just as
a restoration of order can only occur after a preceding phase of disorder, deflation, in the above
sense of the word, can only occur after a foregoing phase of deflation.
51 Guido Hlsmann, Towards a General Theory of Error Cycles, p. 9.
swindler. When this process is finished, order is restored and the fraud cycle is brought to
a close.

Graphical Illustration of the Fraud Cycle

Given all the problems involved with the visual and/or quantitative representation of
theory in the field of axiological science, we suggest the graphical illustration below
merely for educational purposes, in an attempt to give some oversight of how the
simultaneous and successive phenomena involved in the fraud cycle coexist.

Fraudulent deception causes the generation and degeneration of imaginary goods

over time. Hence the two axes of our graphical illustration of the fraud cycle: time (X)
versus goods-character (Y). The X-axis is divided into three phases:

1. First comes the phase of order, during which people are truthful and deal
with each other in good faith. There is no deception, which means that
each actor lives within his means, not claiming command over means that
are not his. This absence of deception further implies that nobody is
deceived into imagining certain goods to be present and available that in
fact are not. During the phase of order, the actors in question still commit
entrepreneurial errors, with the consequent appearance of imaginary
goods, and the malinvestment and overconsumption following this.
However we don't consider these here, since we are dealing with the
effects of fraud and not those of error in general.

2. Next is the first phase of the fraud cycle; the phase during which
the actual fraud (in one or multiple acts) takes place. In the illustration there
are three acts of fraud, marked by T1, T2, and T3. Every act of fraud
causes a decrease in the availability of proper means (the illustration does
not consider accidental increases or decreases unrelated to the fraud), and
an increase in the amount of deprived means. The actual losses suffered
because of the fraud are covered up by a simultaneous creation of
imaginary goods.52

52 The victim of the fraud considers these imaginary goods to be of higher value than the
means he forsakes or allows to be manipulated, which is why we have made the volume of the figure
representing the imaginary goods with a bigger volume than that of the figure representing the
corresponding deprived means. The exact volumes are of course merely arbitrary.
 3. The second and last phase of the cycle is that of the recovery. It starts
when the fraud comes to light (crisis), and, as a consequence, the
imaginary goods shrink rapidly in volume during a deflationary correction.
This is also when the process of deprivation transforms into a
readjustment or recovery process, consisting of a reallocation of the
malinvested goods and an increase in savings (decrease in consumption).
The fraud cycle ends when the damage or deprivation caused by the fraud
has been undone.

4. REPLY TO SEVEN OBJECTIONS

There can be no facts in a world without values.
Frank van Dun

Introduction
Now that we have shown in general terms what the causes and effects of fraud are,
let us turn to some objections to our thesis.
The obvious and general one is the question of whether the business cycle is
essentially a fraud cycle. The analogies between the two phenomena are quite clear, but is
the overlap really of such a kind that there can be no meaningful essential distinction
between both? Can all essential characteristics of the business cycle be explained in terms
of fraud? Can non-fraudulent activities perhaps also lead to fraud cycles? In order to
counter these important criticisms, let us therefore muster our thoughts to show the
reader that the business cycle can be explained as essentially a fraud cycle (objections 1-6),
and that honest fractional reserve banking can impossibly bring about business cycles
(objection 7).

FIRST OBJECTION: THE ESSENTIAL CHARACTERISTICS OF THE BUSINESS CYCLE

CANNOT BE EXPLAINED IN TERMS OF ITS FRAUDULENT NATURE.

On the contrary, we hold that the business cycle is essentially fraudulent, and that
its fundamental characteristics can be explained as consequences of fraud. Let us, in order
to convince the reader, analyse the emergence of a business cycle from a judicial
perspective.
Bankers, at least traditionally, are entrepreneurs who operate in the market and who
offer certain services to the people. More specifically, bankers are entrusted with money
by their customers, and promise to handle this money in specific ways. There is thus a
relationship of trust between bankers and their customers, in the context of which they
enter into formal agreements with one another. When customers hand over money to
their banker in the form of a loan or a deposit,53 the formal agreement involved is
essentially a trust.54 In the case of a depositor-depositary relationship, the formal

53 For an elaborate discussion on the traditional legal nature of the loan contract and deposit
contract, as well as for a detailed historical account of the separate use of these two contract in banking,
see Jess Huerta de Soto, Money, Bank Credit, and Economic Cycles, chapters 1 and 2. See also Jrg Guido
Hlsmann, Banks Cannot Create Money, The Independent Review, v.V, n.1, Summer 2000, pp. 101110
54 trust, n. 1. The right, enforceable solely in equity, to the beneficial
enjoyment of property to which another person holds legal title; a property interest
held by one person (the trustee) at the request of another (the settlor) for the benefit of
a third party (the beneficiary). For a trust to be valid, it must involve specific property,
reflect the settlors intent, and be created for a lawful purpose. (Blacks Law
Dictionary (7th ed. 1999), p. 1513).
agreement in question is more specifically a resulting trust.55 In order to make the trust
between them and their customers formal and binding, bankers have traditionally
formalized and made explicit their fiduciary duties by writing out money titles, which are
essentially fiduciary tokens that confirm that a certain customer X is entitled to receive a
certain amount of money from the banker, either at wish (deposit) or after an agreed
upon period of time (loan).
Now if the banker writes out money titles in excess of the actual money he has in
his own possession (i.e., money lent to or owned by him), he commits the crime of fraud,
since he gives away something that does not belong to him, thus depriving the original
owner, while pretending that is not the case.56 These money titles that are not backed by
actual money are what in the Austrian tradition is called fiduciary media. These
fiduciary media make the people who receive and use them believe they own or control
certain goods which they in fact do not: imaginary goods.57 With the money supply thus
inflated by fiduciary media, actors in the economy will proceed to consume more than
they otherwise would have (overconsumption) and to invest in different places in the
structure of production than they otherwise would have (malinvestment). From the
general perspective of the fraud cycle, we can describe this phase, fueled by fraudulently
created imaginary goods, as the inflationary boom. Of course, the inflationary boom
cannot last forever. Ludwig von Mises explains why:
it is not possible to make the boom last forever because the boom is built
upon paper, on banknotes and checkbook money. It is based on the assumption
that there are more goods available than there really are.
The imaginary good cannot remain undiscovered as such: one day the truth will
come out.The inevitable crisis sets in when a certain threshold of people calls upon their
bank in order to have it meet its fiduciary duties. Often the initial reason for this is not a
sudden loss of confidence in the banks (though it may), but rather the fact that the stock

55 ". . . a resulting trust arises whenever legal or equitable title to property is

in one party's name, but that party, because he is a fiduciary or gave no value for the
property, is under an obligation to return it to the original title owner, or to the person
who did give value for it".
Donovan Waters, "Law of Trusts in Canada", 2e ed. (Toronto: Carswell, 1984), p. 300., as
quoted in Robert Chambers, Resulting Trusts (Oxford University Press: New York, 1984), p. 1.
Chambers further quotes the essential characteristic of the resulting trust as being the person in whose
favour the trust arises is the person who provided the property or equitable interest vested in the
person bound by the trust; quoting ibid., p. 302. On the history of the legal institution of the resulting
trust, see chapter 14 Unjust Enrichment of David J. Ibbetson, A Historical Introduction to the Law of
Obligations, (New York: Oxford University Press, 1999), pp. 264-284, esp. p. 267.
56 It is important to note that the institution of fractional reserve banking, whereby customers
are falsely lead to believe they have immediate access to their demand deposits, is inherently injurious.
It has been said that when fractional reserve banking is practiced in moderation, the detrimental
effects will not be that great, nor will they become immediately apparent. However, this is no ground to
justify the practice; stealing a thousand monetary units from a millionaire will also not likely produce
great damage to the person, but that does not justify the institution of stealing. One could also hold that
today's bankers know of no better. That is to some extent true, fractional reserve banking is common
practice and has been institutionalized to a great extent. However, that does not detract from the
deceitful nature and harmful effects of this practice, as the current state of the economy tragically
illustrates. A thief who knows no better is still a thief.
57 Note that hereby it does not matter essentially whether this happens in the form of writing
out circulation credit (credit merely based on the trust in the bank, not directly covered by the bank's
assets) or in the form of mere embezzlement of deposits. One could imagine a bank (for example a
central bank) that writes out circulation credit without any actual assets at all to cover it. This practice
would set in motion a business cycle. On the other hand, one could also imagine a bank or financial
institution (the investment firm of Bernard Madoff comes to mind) whereby lent or deposited money is
systematically embezzled on a large scale. Also this would lead to malinvestment, overconsumption and
the inevitable crisis and recession in the economy.
of real savings in the market place has been depleted to such an extent that it starts
becoming apparent in rising prices of consumer goods.58
When it becomes clear how difficult it is for financial institutions to meet their
obligations, people start becoming suspicious. Garet Garrett puts it cogently, referring to
the crisis following a debasement of a gold standard currency:
Suddenly doubt, then coming awake and panic. The spirit of gold has been
debased by senseless inflation. The faith is lost. All with one impulse people rush
to seize the gold itself as the only reality leftnot only people as individuals ;
banks, also, and the great banking systems and governments do it, in competition
with people. This is the financial crisis.59
During the crisis, consumers collectively call upon their banks to meet their
financial obligations or fiduciary duties (bank run), which results in bank failures. These
consumers will simultaneously also adjust their consumption patterns, which leads to a
painful readjustment of the structure of production during which capital goods are re-
allocated from the stages far removed from consumption, towards the stages closer to
consumption. The effect is widespread failures in the economy and temporary
unemployment. In addition, a deflationary correction will take place in the form of a
contraction of the (fiduciary) money supply. Translated in terms of the more general
fraud cycle: an increasing amount of fraudulent practices are being uncovered, and as a
consequence, a deflationary correction takes place which diminishes the supply of mala
fide fiduciary tokens (fiduciary media) in circulation. This contraction of the money
supply, in turn, is in fact how the deflationary correction of goods, a move from a supply
fraudulently inflated by imaginary goods towards a supply ridden from these imaginary
goods, becomes apparent in the economy. The recovery phase of the business cycle is set
in motion when entrepreneurs, now empowered by a more realistic assessment of their
means, start providing goods and services to meet the readjusted, more realistic demands
of their fellow men.
The following table gives an overview of the most important features of the fraud
cycle and their corresponding, more specific, features of the business cycle.
Table 1: Comparison Fraud Cycle - Business Cycle
Fraud Cycle Business Cycle

Essential cause Deceit Deceitful creation of

money titles (fractional
reserve banking)

Actors Trustor and trustee Depositor and depositary

Relationship Trust Resulting trust

Means Mala fide fiduciary tokens Fiduciary media

Effects Inflationary boom of Inflationary boom of

imaginary goods, possibly fiduciary goods,
accompanied by a boom in accompanied by a boom in
fiduciary tokens fiduciary media

Deflationary correction: Deflationary correction:

imaginary goods are seen fiduciary media are seen as
as such, mala fide fiduciary such, contraction of the
tokens become valueless money supply

58 For a detailed discussion of the different phases of the business cycle, see Huerta De Soto's
Money, Bank Credit, and Economic Cycles, pp. 347-395.
59 Garet Garrett, A Bubble That Broke the World, (Boston: Little, Brown, and Company, 1932), p.
124.
Restoration Readjustment of Readjustment of the
consumption and saving structure of production, by
pattern by the victims a shift in demand from the
part of the consumers

The victim's saving and Restoration of the

investment patterns structure of production, in
returns to being more in line with the real goods
line with the supply of real present in the marketplace
goods.

Order is restored Order is restored

(rectification): in so far as
possible, damages are
repaired and means return
to their rightful owners
people live within their
means again
(rectification): the assets of
the bankrupt banks are
returned to their rightful
owners; banks stop writing
out fiduciary media, and
become full reserve banks

We have now seen that the essential characteristics of the business cycle can indeed
be explained in terms of the fraud cycle. Let us consider some further possible
objections.

SECOND OBJECTION: ERRORS CANNOT BE EXPLAINED BY SINGULAR CHANGES OF

CONDITIONS. THE CLUSTERS OF ERROR THAT LEAD TO CRISES AND RECESSIONS IN
THE ECONOMY MUST THEREFORE BE EXPLAINED BY OTHER FACTORS.

Guido Hlsmann writes:

Does the occurrence of singular events necessarily lead to error? This is the
decisive question. Yet this is definitely not the case. Errors cannot be explained
by singular changes of conditions because even such changes can be
anticipated.60
On the contrary, we hold that errors can be explained by singular changes of
conditions. As writes St. Thomas:
Hence in one way truth varies on the part of the intellect, from the fact that a change
of opinion occurs about a thing which in itself has not changed, and in another
way, when the thing is changed, but not the opinion; and in either way there can be a
change from true to false.61 (italics are our own)
Deception, and the errors that follow from acting upon it, can be caused by single
changes of things. Now we agree with Guido Hlsmann when he states that the
existence of singular events could only serve as a basis for a consequentialist explanation
of error, if they implied error. Otherwise, a mere change of conditions, and even a singular
one, could never be a sufficient explanation of error. Indeed fraud, as we have seen
above, leads to a breakdown of the mutual trust of the market place and a creation of
imaginary goods that cause illusion, or error, to be inherently anchored in the chain of
events. Thus fraud, even a singular act of fraud, implies error.
We further agree with Hlsmann when he says that
a program for the essentialist explanation of recurrent clusters of errors has to
identify more or less permanent patters of action (institutions) in which the error
of many persons is inherent. Instances of crises are then explained as situations in

60 Guido Hlsmann, Toward a General Theory of Error Cycles, p. 3.

61 Thomas Aquinas, Summa Theologiae, I, 16, art. 8.
 which many acting persons become aware of their errors or of the consequences
of their errors.62
Indeed, in the institution of fraud, the occurrence of error is inevitable. A single
instance of fraud thus inevitably leads to errors on the part of its victims. This is why we
have to disagree with the same author when he states that [e]rrors cannot be explained
by singular changes of conditions because even such changes can be anticipated.63 On
the contrary, fraud, or deliberate deception causing injustice can by definition not be
anticipated, because if it was, it would have never been fraud in the first place. We
maintain that fraud, even singular events of it, causes and thus explains error.

THIRD OBJECTION: FRAUD CANNOT BE THE ULTIMATE EXPLANATION FOR THE

BUSINESS CYCLE, SINCE IT DOES NOT EXPLAIN FOR THE RECURRENCE OF THE
BUSINESS CYCLE.

Writes Guido Hlsmann:

Any business cycle theory is essentially a theory of error. Its aim is to explain the
recurrence of the phenomenon that we call crisis; that is, a situation in which the
simultaneous economic failure of many people becomes obvious. Thus business
cycle theory not only has to explain the occurrence of error but the recurrence of a
cluster of errors as well.64
On the contrary, we hold that the business cycle is not inherently recurrent. Or, put
differently, we hold that recurrence is not an essential quality of the business cycle. A
cycle, as we've explained above, is a recurrent or reproducible succession of events. Now,
given that the human will is free, there can be no absolute regularities in the incidents of
human action. Man is free to act and to refrain from acting. It follows that he is also free
to set in motion cyclical phenomena, and likewise free not to do so. Therefore we must
conclude that any cycle brought into being by human action, must possess the characteristic, not of (self-
generating) recurrence, but rather that of (voluntary) reproducibility.
Along these lines, Murray Rothbard states that
[r]ecurrence [of the business cycle] stems from the fact that banks will always try
to inflate credit if they can, and government will almost always back them up and
spur them on. When the storm has run its course and recovery has arrived, the
banks and the government are free to inflate again, and they proceed to do so.
Hence the continual recurrence of business cycles.65
What Rothbard points out is in fact how the recurrence of the business cycle is the
result of a free choice. Neither fractional reserve banking nor inflation, and consequently
neither the business cycle, are necessarily recurrent phenomena. Both Ludwig von Mises
and Murray Rothbard attested to this fact. Writes Mises:
Papiergeldinflationen zeigen keine Regelmssigkeit der Wiederkehr. Sie
entspringen im allgemeinen einer bestimmten Lage der Politiek und nicht
irgendwelchen Vorgngen innerhalb der Wirtschaft.66

62 Guido Hlsmann, Toward a General Theory of Error Cycles, p. 9. Hlsmann formulated

this paragraph while making the case for inclusion of the institution of government into the general
theory that would explain the business cycle. We disagree, and hold that the right institution to refer to
is that of fraud. See also below, under the reply to the objection on government interference, footnote
76.
63 Guido Hlsmann, Toward a General Theory of Error Cycles, p. 3.
64 Ibid, p. 1.
65 Murray N. Rothbard, America's Great Depression, (Auburn, Ala.: Ludwig von Mises Institute:
2000), p. 33-34.
66 Ludwig von Mises, Geldwertstabilisierung und konjunkturpolitik, (Jena: G. Fischer, 1928), p. 56.
 And Rothbard:
To avoid the business cycle, then, it is not necessary for the banks to be
omniscient; they need only refrain from credit expansion. If they do so, their
loans made out of their own capital will not expand the money supply but will
simply take their place with other savings as one of the determinants of the free-
market interest rate.67
Here is a final argument. Defendants of the idea that business cycles are necessarily
recurrent can be asked the following question: suppose that in the course of history, only
one banking system had once existed wherein fractional reserve banking had emerged,
and this banking system had only generated one single inflationary boom, followed by
one crisis and one deflationary correction. Suppose further that after this economic crisis,
the public called loudly to only allow for full reserve banking, and that it was granted its
wish: the old full-reserve system was installed once more, remaining in place until the
present day. Let us even, for the sake of argument, assume that this banking system
operated under a central bank supported by the force of government. What else would
we call that unique episode in history, but a business cycle? And if we didn't call it so,
how would we meaningfully differentiate it from genuine business cycles?68
We conclude here, with the contention that recurrence is not an essential but rather
an accidental property of the business cycle.

FOURTH OBJECTION: THE ESSENTIAL THEORY OF ECONOMIC CYCLES IS

INCOMPLETE WITHOUT AN ACCOUNT OF THE ROLE OF GOVERNMENT

The above objection is our (granted, perhaps somewhat unjustified) interpretation

of the following paragraph of Hlsmann:
The fraud cycle is likely to recur as long and insofar as government meddling
with money takes place. It is the very purpose of monetary interventions to
commit fraud on large numbers of market participants. Now, one could insist
that fraud is not a feature particular to government. Even on the free market
there could be counterfeiters and fraudulent bankers holding only fractional
reserves for the money they issued. This is true. However, such instances could
never be sufficient to establish a business cycle theory. Let us recall that such a
theory has to explain why there is a cluster of errors and why this cluster of errors
is likely to recur again. Pointing to the possibility of fraud on the free market does
not solve these problems. At best, one can in this manner explain clusters of errors,
but one invariably fails to explain their recurrence.69
On the contrary, we hold that government involvement is an accidental (or
posterior) cause of economic cycles, not a substantial (or prior) cause.70 In our opinion, in

67 Murray N. Rothbard, America's Great Depression, p. 33.

68 In his article Toward a Theory of Error Cycles, Guido Hlsmann gives a similar account,
except he leaves out the government and gives the example of a free banking cartel that produces a
singular economic crisis, to show that this is no business cycle because there is no recurrence. With our
counterexample, we hope to have shown that even with government taken into the equasion, the
business cycle is not necessarily recurrent. See Guido Hlsmann, Toward a General Theory of Error
Cycles, p. 15.
69 Ibid., p. 15. Italics in original.
70 On prior and posterior causes, see St. Thomas:
For a cause can be called prior or posterior; for example, when art and the physician
are given as causes of health, art is prior and physician a posterior cause It should
be observed that it is always the more universal cause that is called remote and the
more specific proximate Thomas Aquinas, On The Principles of Nature, translated in
Thomas Aquinas Selected Writings (Penguin Group: London, 1998), p. 27.
On the difference between substance and accident, one of the classical texts is Porphyry's
Isagoge:
order to develop a theory that fully describes the essential causes of economic cycles, one
does not need to integrate into it a factor called government interference. Our
counterargument is made up of two parts. First, we defend that government action can
only exist in the metaphorical sense of the word, and second, we defend that the business
cycle does not need an explanation for its alleged necessary recurrence, because it does
not have such a necessary recurrence.
Let us begin with the first part of our reply to the objection, on the nature of
government. The government is in essence a corporation, an artificial personality that can
only act or speak in a metaphorical way, by the acts and through the mouths of
certain natural persons that act and speak on behalf of it. As writes Frank van Dun:
A corporation that is compatible with natural law is no more than an association
of natural persons, who agree to recognize the association as an artificial person
in its own right. However, as far as other persons are concerned, the existence of
the association and its recognition by the partners as an independent artificial
person in no way diminish the responsibility or the liability of the partners.71
Indeed, everything of what we call interference by the government has been and
will be given shape by individual human action, and should thus be explained and
accounted for in terms of individual human perception and intention:72 [T]here is really
no government as such; rather, there are only individuals acting as members of the
apparatus that we call the State.73 This means that even though the government is for
sure a phenomenological reality, it is not an actual person who can be accused or
blamed of anything, hence also not of the emergence of business cycles. No, the actors
that fool others into fraud schemes (thus setting in motion cycles in the economy) are
invariably natural persons. Considered from the perspective of the victims of these
schemes, we can say that there are many reasons that can lead these people into being
fooled, and the romantic associations, the good reputation, and the alleged
trustworthiness that are often being attached to the phenomenon of the government
are just a few examples of the many possible sources of deception. We admit of course
that government officials, given their attributed status of authority, are indeed in a very
good position to create institutions that are surrounded by an aura of trustworthiness,
institutions that may in reality not be so trustworthy at all,74 but that does not make these
(nor the governments themselves) the sole or necessary fabricators of business cycles. In
summary, we believe the illusion cycle of government is a real existing phenomenon, but we hold that it
does not explain for all the business cycles, and furthermore that it should be recognized as it is, an
accident of the more general fraud cycle.

... accidents are naturally adapted to be of posterior origin, and possess a nature
adjunctive to substance. Again, of species the participation is equal, but of accident,
even if it be inseparable, it is not equal; for an Ethiopian may have a colour intense, or
remitted, according to blackness, with reference to an(other) Ethiopian.
See also Aristotle, Topics.
71 Frank van Dun, Modern Business Corporation Versus the Free Market?, (article published
on personal website, 2003), pp. 4-5.
72 See also our response to the fifth objection.
73 Guido Hlsmann, quoted from Political Unification: a Generalized Progression Theorem,
Journal of Libertarian Studies 13:1 (Summer 1997), p. 88.
74 The example par excellence is perhaps the Central Bank, an institution created in the womb of
the government itself:
One of the reasons the public could be lured from gold to bank notes was the great
confidence everyone had in the Central Bank. Surely, the Central Bank, possessed of
almost all the gold in the realm, backed by the might and prestige of government,
could not fail and go bankrupt! The Central Bank thus became armed with the
almost unlimited confidence of the public. By this time, the public could not see that
the Central Bank was being allowed to counterfeit at will, and yet remain immune
from any liability if its bona fides should be questioned. Murray Rothbard, What Has
Government Done to Our Money?, (Auburn, Ala.: Ludwig von Mises Institute, 1990), p.
74.
 To illustrate our point further, let us imagine for a moment Suzie, a woman who
was born and raised in a perfect convivial society. She has never heard of concepts such
as government, nation, democratic rule, or their likes. If she were to pay our
country a visit during the current economic crisis, could she then, without knowing
anything about the government, still be able to come to an understanding of the
essential workings of the business cycle?
We believe so. What Suzie would see is many persons committing fraud (often
because they knew no better) by writing out loans out of thin air, by printing money, by
insuring others without sufficient capital coverage, etc.. When she would ask why these
people did this, often she would hear that these harmful acts of deception were
committed on behalf of the entrepreneurs (so they have money to invest), the people
(so they have money to buy, say, houses), the bank (so it has a source of income),
and/or on behalf of the government (so it has sufficient resources to operate), among
probably many other reasons. She would also see people getting duped because they
wrongfully believed that the deposit insurance, the central bank, the courts or the
government was going to help out if the other contracting party turned out not to be so
trustworthy as he seemed. And often she would also see people who believed they had a
valid contract with the government, a contract that would get them all kinds of benefits
(and of which Suzie, after talking to enough government representatives would know a
lot of them could not be met). Our protagonist could do all of this without understanding
the exact workings or historical position of government. Her experience of it would be
that it is simply a kind of a corporation, and one being used, among many others, as an
excuse for people to commit, hide, or legitimize their fraudulent activities. Such an
understanding would suffice to understand the crisis in the economy, and thus the
essential characteristics of the business cycle.
Here follows the second part of our reply to the objection, where we specifically
respond to Hlsmann's statement that At best, [by pointing to the possibility of fraud
on the free market,] one can explain clusters of errors, but one invariably fails to explain
their recurrence. Let us in answer first repeat our opinion, as stated in the argument
against the third objection, that the business cycle can and need not be necessarily
recurrent. In fact, Hlsmann also recognizes this:
[W]e deny that there is a kind of inescapable escalation mechanism of government
interventions, with one intervention leading necessarily to the next one..75
Now, we agree with Hlsmann that in the institution of government the error of
many persons is inherent;76 however, the presence of government is an accidental, not an
essential, cause of the business cycle. The reason why the quality of government
interference is accidental is because the quality of recurrence, as argued above, is also
accidental. And whoever rejects a quality of a phenomenon as being essential (which we
do here with the characteristic of necessary recurrenceinsisting that it be called an
accidental quality instead), likewise has to reject as being essential those causes who
contribute to the genesis of this accidental quality, but not to any of the fundamental
qualities. In our opinion, government interference is such a cause. Given that we here
wish to follow Hlsmann in an attempt to formulating a general theory, we have to object
against the introduction of accidental predicates in the theory.

FIFTH OBJECTION: THE BUSINESS CYCLE IS A MACRO-ECONOMICAL

PHENOMENON. ITS ESSENCE CANNOT BE EXPLAINED VIA A MICRO-ECONOMICAL
PHENOMENON SUCH AS AN ACT OF FRAUD.

75 Italics in original. Guido Hlsmann, Toward a General Theory of Error Cycles, The
Quarterly Journal of Austrian Economics vol. 1, no. 4 (Winter 1998), p. 13.
76 Guido Hlsmann, Toward a General Theory of Error Cycles, p. 9. We hold, however, that
the general institution sought after in this context is fraud instead of the more accidental
government. See in this respect, under the reply to the second objection, footnote 64.
 On the contrary, we are of the opinion that the business cycle theory must rest
upon the theory of the micro-economical, intersubjective, phenomenon of fraud. The
reason why is that it is always the meaning and intention of interacting individuals that
gives sense and reality to social phenomena;77 without meaning or intention, which are
necessarily individualistic, social phenomena simply do not exist. The need to replace the
almost inevitably positivistic macro-economic approach by a methodological subjectivism
is captured in this paragraph by Paul Ricoeur (as quoted by Gabriel Zanotti), whereby the
link to our reply to the fourth objection concerning government intervention is
immediately made:

Every event foreign to meaning (Sinnfremd)such as flood or a diseasewill

detach us from the domain of comprehensive sociology. This is the first
threshold. The individual is the carrier of the sense. This proposition defines the
methodological individualism of comprehensive sociology. Regardless of what
may or should be said about the state, or about power of authority, singularities
are always their rationale. Should an institution not be perceived by the
members of a community as resulting from a number of reasons, which provide
the meaning to a certain course of action, it would not longer be considered as
the subject matter of comprehensive sociology; thus it would be easily related to a
natural disaster 78
Ludwig von Mises essentially says the same in his Human Action:

If we scrutinize the meaning of the various actions performed by individuals, we

must necessarily learn everything about the actions of collective wholes.79 (italics
are our own)
Thus, macro-economical phenomena necessarily find their essential cause and
explanation in the meaning and purposes of acting and interacting individuals. Applying
this to our current thesis, we hold that explaining the business cycle in terms of fraud and
the fraud cycle is not a reduction of the former to the latter, but that it is rather the
clarification of the essential nature of a social phenomenon. The business cycle, as we've
argued above, is one specific type of fraud cycle. And just as the phenomenon of theft
can occur in many different forms, from petty thievery to large scale robberies, the
phenomenon of the fraud cycle can manifest itself both on the micro-level (take for
example the worker who secretly buys his personal groceries from the company's credit
card) and the macro-level (such as Bernard Madoff's ponzi scheme, or the massive
issuance of unbacked credit by banks and central banks). The more deception involved,
the graver the consequent inflationary boom, crisis, and deflationary correction, and the
more difficult the eventual recovery process will tend to be. In the specific context of the
business cycle, this relation becomes observable by the link between the amount of
fiduciary media issued and the resulting cyclical effects:
Issuance of additional fiduciary media, no matter what its quantity may be,
always sets in motion those changes in the price structure the description of
which is the task of the theory of the trade cycle. Of course, if the additional amount
issued is not large, neither are the inevitable effects of the expansion.80 (italics are our own)
All this being said, the reader may be still left to wonder why fractional reserve
banking, or more specifically the issuance of fiduciary media, creates effects on a scale
that surpasses by all measures the effects of any other sort of fraud thinkable. The answer
lies in the high saleability of money titles:

77 Gabriel J. Zanotti, Intersubjectivity, Subjectivism, Social Sciences, and the Austrian School
of Economics, Journal of Markets & Morality, Vol. 10, No 1 (Spring 2007), p. 118. (italics in original)
78 Paul Ricoeur, Hegel and Husserl on intersubjectivity, in Del Texto a la Accion (FCE, 2000),
as quoted in Gabriel J. Zanotti, Intersubjectivity, Subjectivism, Social Sciences, and the Austrian
School of Economics, p. 137.
79 Ludwig von Mises, Human Action (Fox & Wilkes: San Francisco, 1996), p. 42.
80 As quoted earlier, Ludwig von Mises, Human Action (Fox & Wilkes: San Francisco, 1996), p.
442.
 "As in every other case of counterfeiting (forgery)of stock and commodity
certificates, banknotes, land titles, original art, etc.,will physically diminish or
despoil the original moneystock, commodity, land, or artowner's proporty.
But a counterfeiter of money is particularly dangerous and invasive because
money's definining characteristic as the most easily saleable and widely aceptable
of all goods; that is, because money-counterfeits open to their seller the widest
possible range of objects for undue appropriation... ."81
This concludes our answer for now.

SIXTH OBJECTION: IN ORDER TO KEEP THE CRISIS AT BAY IN THE CONTEXT OF

THE BUSINESS CYCLE, THE CREATION OF FIDUCIARY MEDIA NECESSARILY MUST
TAKE PLACE AT AN EVER ACCELERATING PACE, WHEREAS IN THE CASE OF FRAUD,
NO SUCH ACCELERATION IS NEEDED.

On the contrary, fraud is a lie, and only lies can conceal lies. And given that all that
is true must agree with itself in every way,82 ever more lies are needed to upkeep the
illusion of truth. As anthropologist Donald Symons put it:
The truth fits seamlessly into the world, and doesn't require managing. Lies
don't, and constantly need superintending so that other supporting lies can be
told 83
And also Balthasar Gracian:
One deceit needs many others, and so the whole house is built in the air and
must soon come to the ground.84
Given that deceit needs many others, the only action a swindler who wants to avoid the
truth from surfacing (i.e., the crisis to hit) can resort to is further deception. A typical and
first new fraud to hide the initial fraud is the creation of a fiduciary token that fools the
victim into trusting the swindler more than he otherwise would have. Within the context
of fractional reserve banking, we could name the option clause, the pooling of money
reserves and deposit insurance schemes as examples of how, in a vain attempt to escape
the harmful consequences of fractional reserve banking,85 fraudulent behavior is extended
into other areas. Writes Hlsmann:

81 Hans Hermann Hoppe, with Jrg Guido Hlsmann and Walter Block, Against Fiduciary
Media, Quarterly Journal of Austrian Economics, vol. 1, no. 1 (1998), p. 33.
82 Aristotle, Prior Analytics, chap. 32 (Oxford: Oxford University Press, 2009), p. 52.
83 Quote from Paul R. Ehrlich, Human Natures: Genes, Cultures, and the Human Prospect
(Washington: Island Press, 2000), footnote 168, p. 390 (Symons, personal communication, 25 January
1999)
84 Baltasar Gracian, Art of Worldly Wisdom, as translated by Joseph Jacobs (London: Macmillan
and Co., Limited, 1892), p. 105. The original quote reads as follows:

Un embeleco ha menester otros muchos, y ass toda la fbrica es quimera, y como

se funda en el aire es preciso venir a tierra ...
85 See also de Soto: ...the more banks merge and the larger their subsequent market share, the
greater the possibility that the citizens who receive the bank's fiduciary media will be there own
customers. Jess Huerta de Soto, Money, Bank Credit, and Economic Cycles, pp. 203-204. This process is
not sustainable, as is indicated by Hlsmann:
However, one must not overlook that these effects are caused by the pooling of
money, not by money pools as such. They are merely temporary. Pooling, therefore,
cannot avoid bank runs forever. Because there are now greater facilities to provide
liquidity the banks will expand their fiduciary credits, thus reducing the reserve ratio
again. Only for the time needed for this expansion can the pooled stock of money
suffice to help even the biggest banks out of liquidity problems. Guido Hlsmann,
Free Banking and the Free Bankers, The Review of Austrian Economics Vol 9, No. 1
(1996), p. 46.
 Although an embezzler cannot avoid that the nature of his activities will sooner
or later be detected, he can try to keep the show going for a while by extending
the illusion on which his activity is based. This endeavour is central to the
development of monetary institutions for the last three centuries.86
In this respect it is well worth analyzing the contributions of Guido Hlsmann a
little further. In his remarkable 1997 article Political Unification: A Generalized
Progression Theorem, the German philosopher-economist gives an exposition of how
and why the progression of ever increasing monetary planning and growing government
takes place. He begins with the statement that [t]he growth of government ... can be
explained by the change of opinion among the ruled, and continues by recounting how
throughout history citizens have been convinced of the alleged virtue of monetary
unification (being a form of political unification in order to secure continuous
government revenues). Hlsmann lays emphasis on the fact that every time a general
crisis of confidence looms, a new and larger deus ex machina is invented to ease the
concerns. In the domain of money, he shows how taxation is followed by inflation
generated by fractional reserve commercial banks, which in turn is followed by central
bank generated inflation:
The fractional-reserve commercial banks are inherently bankrupt, and sooner or
later this becomes obvious. Then they abdicate, and the central banks take over.
As the latter are structurally bankrupt as well, it is but a question of time until
they also voluntarily abdicate.87
Hlsmann makes a similar analysis on why on the political level one can observe a
seemingly continuous progression into ever larger and more encompassing political
entities. The starting point in the article is the point where the inflationary policies have
driven governments towards bankruptcy and the only viable solution left is the provision
of liquidity from other governments that are not yet bankrupt.
Hlsmann continues:
The price to be paid for the assistance is, of course, in terms of political favours.
Let us point out again that here, as in the case of fractional-reserve banking, each
government has an interest in this deal. It is obvious that the bankrupt
governments have incentives to pay the political price. The not-yet-bankrupt (but
already highly indebted) governments have an incentive to bail them out, too. As
a consequence of the high degree of international division of labour, the
bankruptcy of one government has immediate repercussions on the budgets of all
other governments. Therefore, highly indebted governments have an interest in
avoiding the slightest disruption on the international financial markets, as this
could precipitate their own fall. Even the bankruptcy of a small government
would threaten them. This has to be avoided.88
He concludes:
All kinds of breakdown or uncontrolled sudden change are a nightmare for the
establishment. The paramount interest of todays politicians and bureaucrats is to
make the show somehow go on. Therefore, bankrupt governments want to be bailed
out and not-yet-bankrupt governments are ready to help them. The result is
political unification. This is the mechanism at work that incites political
unification in modern democracies.89
We can relate this conclusion back to the statement quoted earlier, from the same
author's article on error cycles:

86 Guido Hlsmann, Toward a General Theory of Error Cycles,, p. 18.

87 Guido Hlsmann, Political Unification: a Generalized Progression Theorem, Journal of
Libertarian Studies 13:1 (Summer 1997), p. 90. (italics in original)
88 Ibid , pp. 91-92.
89 Ibid, pp. 91-92. Italics are our own.
 Although an embezzler cannot avoid that the nature of his activities will sooner
or later be detected, he can try to keep the show going for a while by extending the
illusion on which his activity is based.90
Hlsmann, in our mind, in fact shows in his brillant analysis of political unification
how government officials, i.e., trustors, who want to make the show somehow go on,
i.e., who want the inflationary boom to last, necessarily have to extend, at an ever
accelerating pace, the already existing institutions, i.e., they have to extend the fraud by
creating more imaginary goods. In doing so he describes an accident of the fraud cycle,
the one also investigated by himself in his important article Towards a General Theory
of Error Cycles, and a cycle we could call the fraud cycle of government. Hlsmann
suggests to summarize the general progression theorem (that explains the progression of
small interventions by the government to interventions of ever larger dimensions) by
saying that each step towards more dependency has its origin in a bankrupt regime.91
We suggest a slight alteration, into each step toward more dependency has its origin in a
fraudulent regime.
In conclusion we can say that the acceleration theorem of the Austrian Business
Cyclethat the inevitable crisis can only be delayed for a limited period of time by
creating fiduciary media at an ever accelerating pacealso holds for the Fraud Cycle, in
that the inevitable crisis can only be delayed for a limited period of time by creating
imaginary goods (generated by means of fiduciary tokens) at an ever accelerating pace.

SEVENTH OBJECTION: HONEST BANKING DOES ALSO CAUSE BUSINESS CYCLES.

HENCE, THE FRAUD CYCLE THEORY IS INVALID OR, AT LEAST, OFFERS AN
INCOMPLETE EXPLANATION OF THE BUSINESS CYCLE.

Introduction

The critic who believes also honest banking can cause business cycles would have
good reason to use this as an argument against our present thesis; in order to confidently
state that fraud is the primary cause of all business cycles, it must be clear that only
fraudulent practices, and never bona fide practices, can cause business cycles. We
therefore invite the reader to join us in investigating the case in which all parties that are
involved with the financial activities of a certain fractional reserve bank are perfectly
aware of what happens with the money that is entrusted to that bank, i.e., the case of
honest fractional reserve banking.
There are a number of theorists who have already analyzed this possibility. In a
1996 article, Walter Block and Kenneth M. Garschina, discuss the argument that
fractional reserve banking can be practiced in an honest fashion. They acknowledge that
this is logically possible, but hold that it is nonetheless implausible.92 Next, Guido

90 Guido Hlsmann, Toward a General Theory of Error Cycles, The Quarterly Journal of
Austrian Economics vol. 1, no. 4 (Winter 1998), p. 18. Italics are our own.
91 Ibid, p. 90.
92 Walter Block and Kenneth M. Garschina, Hayek, Business Cycles and Fractional Banking:
Continuing the De-Homogenization Process, published in The Review of Austrian Economics 9 (1)(1996):
77-94. Block and Garshina use the example of the fractional reserve parking lot, whereby the owner
of the parking lot (analogous to the banker working with fractional reserves) does not sell the right to a
parking lot, but rather the chance to find a free parking lot where one can park his car; a lottery ticket
for money. In the words of the authors: If the fractional reserve parking lot were to be an accurate
analogy to monetary practice, instead of being called a demand deposit, it should be called
purchasing a lottery ticket for money or some such. Further, in every other waypublicity, explicit
contracts, etc.banking procedures would have to be brought into line with parking lot practice. Then,
and only then, could the charge of fraud be dropped. Inder such conditions there would still be the
empirical question of whether or not anyone would purchase a lottery ticket money deposit. In a later
article by Walter Block and William Barnett II, where the authors discuss the possibility of the honest
fractional reserve bank at length, the notes issued by honest fractional reserve banks are called play
Hlsmann discusses the possibility of honest fractional reserve banking in his 2000
article, Banks Cannot Create Money.93 He similarly concludes that the practice is
possible, and admissible (since no law should suppress any foolish activity just because it
is foolish), but nonetheless would lead a fringe existence in a truly free economy. Jess
Huerta de Soto (1998), as we understand him, holds that honest fractional reserve
banking can not be justified at all, because even the use of an option clause will never
prevent third parties from being affected by the harmful effects of fractional reserve
banking.94 De Soto's argument is fairly short, and it is hard to figure out whether his
analysis is to be considered in a context of centralized planning of money production
(legal tender, central bank) or rather in the context of free and decentralized coinage. Still
and all, to us it seems only fair not to assume failure, but to grant our adversaries in this
issue an honest chance by assuming that the honest businessman who believes in
fractional reserve banking can actually find a contract that is indeed harmless both to his
contracting clients as well as to third parties. It is with this assumption in mind that we
begin our investigation into the nature of such a contract. Once we have more clarity on
what that contract entails, we can investigate what the economical effects of its
implementation could be (i.e., whether it can cause business cycles).

Reply to the objection

For the purpose of clarity, let us restate the objection: honest banking does also
cause business cycles. Hence, the fraud cycle theory is invalid or, at least, offers an
incomplete explanation of the business cycle.
On the contrary, we hold that truly honest banking can never lead to business
cycles. Fractional reserve banking differs from 100 percent reserve banking by the fact
that the fractional reserve banker does not safekeep a part of the money that has been
entrusted to him, but goes on to use it as if it is his own: speculating, writing out loans,
etc. As a consequence, the bank in question cannot at all times repay the agreed upon
sum to its customers. The customer of the honest fractional reserve bank is aware of this.
This means that the client's entitlement to immediate availability can not be part of the
contract between the banker and the client. In other words, the fractional reserve banking

money, and monopoly money. See In Defense of Fiduciary MediaA Comment; or, What's
Wrong with Clown or Play Money?, The Quarterly Journal of Austrian Economics Vol 8, No. 2 (Summer
2005): 55-69.
93 Jrg Guido Hlsmann, Banks Cannot Create Money, The Independent Review, v.V, n.1,
Summer 2000, ISSN 1086-1653, pp. 101110.
94 However, even if a safeguard clause were introduced and
participants (bankers and their customers) were fully aware of it, to the extent that
these individuals and all other economic agents subjectively considered demand
deposits and notes to be perfect money substitutes, the clause referred to would
only be capable of preventing the immediate suspension of payments or failure of
banks in the event of a bank run. It would not prevent all of the recurrent
processes of expansion, crisis and recession which are typical of fractional-reserve
banking, seriously harm third parties and disrupt the public order. (It does not
matter which option clauses are included in contracts, if the general public
considers the above instruments to be perfect money substitutes.) Hence, at
most, option clauses can protect banks, but not society nor the economic system,
from successive stages of credit expansion, boom and recession. Jess Huerta de
Soto, Money, Bank Credit, and Economic Cycles (Auburn, Ala.: Ludwig von Mises
Institute, 2006) , p. 163.
He reiterates his position in chapter 8 of the same work:
For even an agreement found satisfactory by both parties is invalid if it
represents a misuse of law or harms third parties and therefore disrupts the public
order. This applies to monetary bank deposits which are held with a fractional
reserve and in which, contrary to the norm, both parties are fully aware of the
true legal nature and implications of the agreement. (Ibid., p. 711-12)
contract cannot be a deposit contract.95 In his article Should we Let Banks Create Money?,
George Selgin recognizes this fact, and uses it to answer his adversaries in the free
banking debate:
In a recent twist on the conventional fraud argument, Hans-Hermann Hoppe
and his co-authors (1998) argue that holders of fiduciary media are, in fact, not
victims of bank fraud at all but co-conspirators who assist bankers fraudulent
undertakings by misrepresenting themselves as the owners of a quantity of
property that they do not own and that plainly does not exist. Apart from
begging the question of who are the victims, this novel fraud argument is based
on a simple failure to recognize that redeemable banknotes and deposit credits are
not titles, as Hoppe and his co-authors claim.96
An additional reason why it is not possible for an honest fractional reserve banker
to make use of a deposit contract is the fact that deposit contracts presume no transfer of
property; the deposited goods are at all times to be kept safe by the depositary for the
depositor. However, precisely by assuming command over his reserves and using them
for his own benefit, the honest fractional reserve banker confirms to us that he does not
safekeep them at all. In fact, the only possible way whereby a person can justifiably use
goods as if they were his own, as the fractional banker does, is by becoming their actual
owner. Thus, given that in any valid and sound contract the essential facts should be
accurately and adequately described, the contract with the honest fractional reserve
banker should clearly not be a deposit contract, but instead a contract in which the
transfer of property is clearly described.
Now, in the course of history, people have come up with a classical solution for
transfer-of-property agreements whereby one party accepts money or goods from an
other, not to safekeep it for the latter, but to put it to use for himself. Given the fact that
within such an agreement it is technically impossible that the trustee always keeps the
goods required to be returned available to the trustor, another kind of contract was
designed to deal with these circumstances: the loan or mutuum contract.97 This loan or
mutuum contract requires that both contracting parties agree beforehand on a set term,
whereby the debtor commits himself to have the loaned goods, or their equivalents
(goods of the same quantity and quality), plus a possible extra fee (the interest) available
for the the lender by the end of the term. Writes Jess Huerta de Soto:
... a fixed term is an essential element in the loan or mutuum contract, since it
establishes the time period during which the availability and ownership of the
good corresponds to the borrower, as well as the moment at which he is obliged
to return the tantundem. Without the explicit or implicit establishment of a fixed term, the
mutuum contract or loan cannot exist.98

95 . . . if a person knowlingly puts money into an interest-bearing account, this contract

would ex hypothesi not be of the deposit contract type. Ludwig van den Hauwe, Foundations of
Business Cycle Research, p. 1239. For an elaborate discussion, see Jesus huerta de Soto, Money, Bank
Credit, and Economic Cycles, chapter 1.
96 George Selgin, Should We Let Banks Create Money?, The Independent Review, v.V, n.1,
Summer 2000, ISSN 1086-1653, p. 96. Selgin refers to the article Against Fiduciary Media, which is
mentioned further in the text.
97 Isidore of Seville, the seventh century church father, wrote in his authoritative work
Etymologies: "Something borrowed is named mutuum because, that which is given to you from me,
becomes yours from mine, ex meo tuum." Priscilla Throop, Isidore of Seville's Etymologies: Complete English
Translation, (Charlotte, Vermont: Medieval MS, 2005), v.25.13. In so doing, he followed the 2nd century
Roman jurist Gaius. The modern interpretation, however, is that mutuum derives from "mutare", which
means "to change", "to swop", and which is related to "munus", a "friendly turn". For a commentary
on the etymology and history of the mutuum contract, see Reinhard Zimmerman, The Law of Obligations:
Roman Foundations of the Civilian Tradition, (New York: Oxford University Press, 1996), pp. 153-187. See
also Jess Huerta de Soto's authoritative Money, Bank Credit, and Economic Cycles, pp. 2-4 (section
"Mutuum") and pp. 119-146 (section "Why it is Impossible to Equate the Irregular Deposit with the
Loan or Mutuum Contract".
98 Jess Huerta de Soto, Money, Bank Credit, and Economic Cycles, pp. 3-4. Italics in original.
 Let us digress for a moment, and consider the proposal of a proponent of
fractional reserve free banking, just to see whether the fractional reserve contract as he
describes it can be classified as a loan contract. In the article we just quoted, George
Selgin maintains that fractional reserve bankers in fact engage in an IOU with their
customers:
[Redeemable banknotes and deposit credits] are ... IOUs, so there is nothing
inherently fraudulent about there being more of them in existence at any moment
than the total stock of what they promise to deliver. ... A person who deposits
gold in a bank in exchange for a redeemable banknote does not retain ownership
of the gold, but instead gives it up, albeit for an indefinite period of time.99
George Selgin thus holds that the contract of the fractional reserve banker with his
customers is an IOU whereby the trustee can postpone his repayment for an indefinite
amount of time. Selgin's proposal implies, first, that the means given up by the trustor to
the trustee are given up for an indefinite amount of time, and second, that there is no
fiduciary duty at all: the banker can freely choose to postpone his repayment indefinitely.
This certainly is not a loan contract, because as Selgin acknowledges, in fractional reserve
banking there clearly is no fixed term. This illustrates the fact that for our investigation
into the possible nature of the honest fractional reserve banking contract, we have to rule
out the loan contract as well.
We can now come to a first important conclusion, namely that the bona fide
banker who works with fractional reserves is neither a depositary, nor a debtor. The pieces of
paper he writes out to his customers in exchange for their money are not directly
exchangeable property titles (deposit receits), nor titles for reimbursement at a previously
set term (loan receits). But what can they be then? Below we show, in line with de Soto,
that the only remaining possibility for a practice whereby both the fractionality of the
reserves, as well as the bona fide character of the contract remain intact, is that the paper
received by the customers be gamble tickets.
Let us begin by repeating that a fractional reserve bank is by definition (exactly
because it does not hold a 100 percent reserve) not able to repay at all times the sums of
money that appear on the banknotes. This means that customers of this honest bank,
when they close an agreement with the bank, must be fully aware that they not only give
up the full ownership of the money handed over, but moreover that they explicitly,
embedded in the agreement, acknowledge that there is a real and significant chance that they
will not see the sum of their investment again. If the banker fares well and if the
customer exchanges his bank note in time, the latter can make a good profit. However if
the banker ends up in dire straits or if the customer in question is preceded by too many
others in exchanging his notes, then he will loose his entire investment. Given the fact
that we here assume full transparency, both possibilities must also be clearly described in
the contract between the honest fractional reserve banker and his customers. In other
words, it should be perfectly clear for the customer that he does not buy the service of
safekeeping (that would be a deposit), and neither does he buy future goods (this is the
case with a loan), but rather what is bought is the chance to win back a larger sum than his
original investment. This should be made clear to him in what is commonly called an
option clause.100

99 George Selgin, Should We Let Banks Create Money?, The Independent Review, v.V, n.1,
Summer 2000, ISSN 1086-1653, p. 96. In the IOU (I owe you) as proposed by Selgin, the debtor
can postpone his repayment indefinitely and thus does not factually owe anything to the beneficiary.
Also when seen from a more general judicial perspective, we can say that the contract Selgin describes
does not count as a trust, which we defined as an act (or series of acts) that is regarded as beneficial in
the eyes of the trustor, in return for one or more favours from the part of the trustor. If the trustee
can postpone the favor he owes the trustee indefinitely, there is no (fiduciary) dutyand thus no trust.
The contract Selgin proposes is a meaningless agreement because it is unrealizable, and thus null and
void by means of an error in negotio. For a detailed discussion on the error in negotio related to deposit and
mutuum contracts, see again Money, Bank Credit, and Economic Cycles, p. 142-146.
100 For Jess Huerta de Soto's discussion of the option clause, see his Money, Bank Credit, and
Economic Cycles, p. 710-712, and the passage quoted above in footnote 93.
 It should be clear that a bank such as we've just described would be (as far as we
know) an unseen anomaly. However, it is only in this way that a banker operating with
fractional reserves can remain an honest businessman: neither the deposit contract, nor
the loan contract, suffice to describe the practice of fractional reserve banking. An
idealistic or foolhardy entrepreneur that would attempt to establish a bank on the basis of
the contract as described above, would probably, sooner rather than later, find himself
tempted to draw a veil over the contents of the contract, to minimalize the risks in its
description, or to unjustifiably present the seemingly permanent availability of the goods
entrusted to him as real. However, by doing so, he would immediately end up joining his
mala fide colleagues who choose to not reveal their customers the truth of the matter,
with the familiar consequences of malinvestment, overconsumption, and the inevitable
boom, crisis, and depression.
When we take a closer look at the contract of our honest fractional reserve banker,
we in fact note, concurring with de Soto, that it is an aleatory contract, whereby the services
delivered by the bank are in any case an uncertain event which depends upon
circumstances particular to each case.101 From this it follows that the banker, as long as
he gives an honest chance (according to the rules of the game) to his customers, for
example by not dishonestly giving privileges to certain among them, cannot go bankrupt if
all or a lot of his customers at the same time decide to exchange their bank notes. After
the bank run the counter is reset to zero, and customers have to wait until enough
people have bought new gambling tickets and enough time has passed to take their
chance to reap a profit. Thus in the case of honest fractional reserve banking we are
dealing with a situation where, analogous with the world of casino's, the bank always
wins. Of course, our bank can go bankrupt because of bad management, but the point
of importance is that it is not inherently bankrupt: there is no stock of goods the customers
of the bank can justifiably claim as theirs, because they've clearly given up their initial
ownership in exchange for a chance to win it back at some future point in time. In an
honest fractional reserve bank as described above, the banker is never obliged to hold
reserves beyond the amount he himself chooses (and/or the customer allows him) to
hold. We can even state, in line with Ludwig van den Hauwe, that in this case there are
no reserves at all, because [a] bank cannot hold fractional reserves if the money it is
not holding in reserve is money the bank isn't supposed to hold in reserve in the first
place.102
The nature of the only possible contract between a fractional reserve banker and
his customers, as described above, is specific enough for us to come to a conclusion vis-a-
vis the effects it can produce in the economy. The situation is as follows: the transparent
operation of the honest fractional reserve bank allows its customers to know very well
which risks they take by buying bills from the bank; they buy reliable fiduciary tokens,
tokens with a title that describes the conditions of the formal relationship between the
banker and his customer in an adequate way. These conditions are that the customer has
the right to an honest chance in winning back the sum of his investment, plus a
premium. Customers of the honest fractional reserve bank thus know perfectly well that
this bank is not the best place to rely on for their old day, in the same way as that people

101 Money, Bank Credit, and Economic Cycles, p. 142.

102 Ludwig van den Hauwe, Foundations of Business Cycle Research, p. 1239. This is the full quote:
One can even argue that it is nonsensical to speak of the keeping of fractional
reserves on which contracting parties would have agreed. How can a bank keep
fractional reserves if it keeps exactly the amount of reserves it is supposed to keep
by the customer (because this is what they both agreed to)? A bank cannot hold
fractional reserves if the money it is not holding in reserve is money the bank isnt
supposed to hold in reserve in the first place.
Van den Hauwe further states, on the same page:
Only if the bank and its client haveex hypothesiconcluded a deposit contract
does it make sense to impose and enforce a prohibition on fractional-reserve banking
by force of law. This prohibition amounts to no more than that the bank should
honour its contractual obligations.
usually do not put all their life savings on the betting table in the next casino. Because the
customers of our bank are not deceived or misguided, there are also no deceitfully
inflated expectations and no malinvestments (on top of the usual entrepreneurial errors)
that take place. At the point of a general bank run, the losers may be disappointed, but
they are not experiencing anything beyond their reasonable expectations. In short, honest
fractional reserve banking does not produce the familiar effects that lead to boom, crisis, and depression; it
does not bring about business cycles.
Now, how likely is it that, in a free market environment, this kind of banking
would become widespread? We hold that it is very small.103 In a free market, honest
fractional reserve bankers would find it very hard to compete with the bills written out by
their competing full-reserve bankers. The fractional reserve bills will have a low relative
saleability on the market (most people do not have a high preference for gambling),
which is why the chance that these bills will at a given point be seen and used as real
money, which is exactly defined by its high saleability, becomes very small.
Finally, after having analyzed the nature of the only honest contract thinkable
between a fractional reserve banker and his customers, after having established that such
a practice would not lead to business cycles, and after having demonstrated the low
likelihood of such a model becoming widespread in a free market, we must question the
name honest fractional reserve bank itself: is it suitable to use the word bank for an
institution that is no financial intermediator nor a safekeeper of deposits, and whose core
activity consists of writing out gambling tickets? This, we'll leave for the reader to decide.

5. THREE AUSTRIAN PARADOXES, OR HOW A MARKET

PHENOMENON COULD DESTROY THE MARKET , HOW
VOLUNTARY COOPERATION COULD BRING ABOUT CONFLICT,
AND HOW A JUST PRACTICE COULD LEAD TO SOCIAL CHAOS

In what follows, we discuss some problems in the Austrian doctrine, and attempt to
show how they can be resolved via the conclusions reached in this text.
A strong claim of some Fractional Reserve Free Banking theorists is that fractional
reserve banking has passed the market test, and therefore is a sound practice which is
to be tolerated in the libertarian society.104 What is peculiar about this position is that it
boils down to defending a market phenomenon(fractional reserve banking105) that
brings about a destruction of the operation of the market itself. Indeed, if justice is
defined by, say, the absence of direct physical violence and the presence of signed
contracts, fractional reserve banking does seem to have passed the market test, because

103 See also the paper of Ludwig van den Hauwe, The Uneasy Case for Fractional-Reserve
Banking, where he states:
In fact, for several reasons it cannot be credibly maintained that fractional-reserve
free banking would pass the market test; in other words, fractional-reserve banking
cannot be conceptualized as belonging to the set of institutions which would emerge
as the outcome of an invisible-hand process, that is, a process in the course of which
the individual rights of property and contract of all market participants would be
correctly defined and strictly enforced. Ludwig van den Hauwe, The Uneasy Case
for Fractional-Reserve Banking (Munich Personal RePEc Archive, MPRA Paper No.
120), p. 38.
104 See, for example: Selgin and L. H. White, "The Evolution of a Free Banking System," in
Selgin, The Theory of Free Banking, chap. 2, and in White, Competition and Currency, chap. 12; also
Dowd, Laissez-faire Banking, pp. 26-33, 59-68. (these references were made by Guido Hlsmann in his
article Free Banking and the Free Bankers, published in The Review of Austrian Economics Vol. 9,No. 1
(1996): 3-53)
105 We mean here, just as anywhere in the text where the qualifier of honesty is not used, to
speak about the issuance of fiduciary media in a way that is at variance with our sketch of the unlikely
practice of honest fractional reserve banking.
the customers of the banks all have signed fractional reserve-contracts. However if, on
the contrary, fractional reserve banking is recognized as what it is, an essentially
fraudulent activity, it becomes clear that this argument simply begs the question: the
operation of a market presupposes good faith, or absence of fraud, and therefore a
fraudulent activity can never pass the market test. The institutions that operate within
the market place should respect the institutions that allow for the market place to exist in
the first place. As Ludwig van den Hauwe has put it crisply, [t]here is no market for
institutions in the same sense in which there is a market for, say, potatoes.106
Further we can consider the scholars who claim fractional reserve banking is a
legitimate business and at the same time recognize that this practice can lead to business
cycles. They find themselves in the strange position of as a matter of fact contending that
certain (allegedly) just, free market practices can lead to social unrest, chaos and
widespread impoverishment. Thought through consequently, this leads to judicial
relativism; because if a just act can lead to a disruption of the judicial or convivial order,
then what is really the point in insisting that people do the right thing? The simple
recognition of the fraudulent nature of fractional reserve banking solves this paradox:
issuing fiduciary media is not right or permissible, it is wrong and unjust, and thus it
naturally produces chaos in society, not despite of its supposed innocence, but because of
its fraudulent nature.
Another consequence the approval of fractional reserve banking by defenders of
the invisible hand is that for them, bank mergers and bank cartellisation should
logically also be an innocent and totally permissible practice. However, among Austrian
economists it is generally recognized that bank mergers and increased centralization
(ultimately by the establishment of a central bank) in the monetary sphere allow for the
production of fiduciary media on a larger scale, and thus generate more spectacular
booms and more tragic busts in the economy. An approval of bank mergers and
cartelisation as being examples of voluntary cooperation thus puts the fractional reserve
free banking proponent in the paradoxical position of defending a case of voluntary
cooperation that... brings about conflict! This paradox is solved by the recognition that
what cooperating bankers are in fact doing (in so far as they lead customers to the false
belief that their deposits will be at all times available to them) is not engaging in peaceful
voluntary action, but rather in harmful conspiracy.
We have now seen that all three of these paradoxes can be solved by simply
recognizing that the now well established practice of issuing fiduciary media is a
fraudulent activity. Fraud is involuntary and hence it does, strictly speaking, not take place
in the market place;107 fractional reserve banking leads to social chaos because it is
essentially fraudulent; and special agreements among fractional reserve bankers are not to
be classified as peaceful cooperation but rather as harmful trickery.

4. CONCLUSION

With this article, we hope to have convinced the critical reader of three things.
First, of the existence of the phenomenon fraud cycle and the relevance of a general
Fraud Cycle Theory. Second, of the relevance of judicial phenomena for Austrian theory.
And third, expanding on this previous statement, of the necessity to re-integrate the
theorems developed within the Austrian School of Economics with the overarching,
largely Aristotelian, tradition of philosophical realism; the great promise of this project
being, in our opinion, that it will eventually allow for the human sciences to leave behind
its current pre-paradigmatic and highly fragmented condition, and mature into a source
of truth where, starting from the assessment of the human person as a free, intentional
and potentially reasonable being, man will be able to investigate and clarify

106 Ludwig van den Hauwe, The Uneasy Case for Fractional-Reserve Banking (Munich Personal
RePEc Archive, MPRA Paper No. 120), p. 40.
107 See note 28 ignorance causes involuntariness.
psychological,108 social, judicial and moral phenomena via an integrated body of theory.
We believe that such an evolution will pave the way towards a society graced with justice,
peace and prosperity.

108 In the sense of Franz Brentano, as the study of those phenomena which contain an object
intentionally within themselves. See F. von Brentano, Psychology from an Empirical Standpoint, trans. A.C.
Rancurello, D.B.T. And L.L. McAllister, (London and New York: Routledge, 1995), pp. 77-100.