The Ethics of Money Production: Chapter 11

Chapter 11: Legalized Suspension of Payments

1. Bankruptcies, which fractional reserve banks are so apt at falling to, are often seen as a a purely negative event. But they have a larger social importance in maintaining the capital goods available. Three basic cases are observed.

In case of a fraud, the business does not intend to produce real income. Damage is caused to the investors, but also to society at large due to capital consumption and waste. Fraudulent fractional reserve banks are a typical example.

An insolvent business consumes more resources than it creates. It can make some people better off, but can only survive by consuming someone's capital, usually that of owners or lenders. When they stop supporting the company, it goes bankrupt and its employees and capital are freed for more productive uses.

An illiquid business does not suffer from too large costs and too small profits. It has merely a case of temporary mismanagement - it can't meet the demands of its creditors at the moment. (A typical case is a legalized fractional reserve bank in a bank run.) If they'd just wait for a while, the necessary money can be raised. This privilege is often given to the banks by law: they don't have to pay their creditors, but the banks can still collect their debts. They don't fulfill their most basic promise - to instantly redeem their notes on demand. A bankruptcy would force them out of business.

2. Banks with this privilege alone don't have much of an advantage. They can't reduce their reserves overly and suspending payments makes them untrustworthy partners so they'll loose their market position. Historically, they have survived only if the state was their main customer. The Bank of England, for example, went bankrupt after only two years of operation and survived thanks to the English Crown, with more legal privileges against competition.

But if such a bank is also privileged by legal tender laws, its money certificates will turn into paper money (see next chapter).

A legal permission to suspend payments means an even greater moral hazard. The bank does not have have to careful and its customers will take on more debts, as it has the blessing of the state. This of course leads to more bankruptcies.

3. Ethically, there is no justification for this behavior, which amounts to a breach of contract. The bank demands, that others honor their obligations, a principle which it breaks at the very same moment. Enough said.