Legalized Suspensions of Payments

1. The Social Function of Bankruptcy

The fundamental problem of fractional-reserve money tokens is redemption. If a sufficiently large number of the customers choose to demand redemption at the same time, the issuer cannot possibly comply. He goes bankrupt.

Most people tend to regard bankruptcy as a negative event that should be prevented if possible. As far as a bankrupt person and his business partners are concerned, this opinion is understandable. But it is erroneous to assume that bankruptcy is detrimental from any larger social point of view. Bankruptcy fulfills the crucially important social function of preserving the available stock of capital. And it plays this role in all conceivable scenarios: when it results from fraud, when it results from insolvency, and when it results from illiquidity. Let us briefly consider these three cases in turn.

(1) The characteristic feature of a fraudulent company is that from the very outset its promoter never conceived it to generate revenue from real products. Its only purpose was to channel funds from beguiled investors into the pockets of the promoter. The damage done to the investors is patent. Yet such fraud is also socially destructive, because it consumes capital without reproducing it, thus diminishing future wages and the productivity of human efforts. Fraudulent fractional-reserve banking is a case in point. Bankruptcy is its natural death, with the follow-up of criminal persecution of the banker.

(2) In contrast to a fraudulent company, an insolvent company rather unintentionally consumes more resources than it produces. It too impoverishes society, even though in the short run it benefits certain stakeholders of the insolvent company, such as employees and suppliers. The only way an insolvent company can operate for any length of time at all is when it can consume the capital of another entity. Usually this someone is the owner, but sometimes also the creditors. As soon as these people refuse to invest additional funds into it, the insolvent company comes to a standstill. The employees are fired and then work for other firms at lower wage rates; and the machines and other capital goods are sold to other firms for less than their previous book value. This is bankruptcy. It puts an end to wasteful—and therefore socially undesirable—firms, and it forces their stakeholders (laborers, capitalists) to invest their human and material resources in other firms, where the rewards are lower, but which produce more than they consume.

(3) An illiquid company differs from an insolvent company in that it does not suffer from a fundamental mismatch between selling proceeds and cost expenditure. There is “just” a problem of temporary financial mismanagement. A case in point is legalized fractional-reserve banking. Suppose a banker, say, Smith is unable to comply with large-scale redemption demands, for example, during a run on his bank. Smith claims that the fundamental economic data of his firm are excellent. There is just a temporary mismatch between payments and receipts. If his customers only gave him five more hours (days, weeks, months), he could sell his assets for cash and thus comply with the redemption demands. Would it not be bad if he went bankrupt, just because right now he was temporarily unable to honor his promise?

Most people are tempted to agree. As a consequence, legislators have often granted the legal privilege of suspended payments to fractional-reserve banks. But as so often in politics, “suspended payments” is a rather shameless euphemism. It sounds warm-hearted and generous, but the reality is very different. The government no longer enforces payments that the privileged banks have promised to make to their creditors, whereas it continues to enforce payments that these banks receive from their debtors. This is the meaning of suspended payments.

Before we discuss this privilege in more detail, notice that its very premises are questionable. It is usually not possible for fractional-reserve banks to sell their assets at the book value in a reasonably short time, especially if the run is not limited to their bank, but spreads to other banks. In an economy-wide run—historically a frequent phenomenon—the money prices of all assets decline more or less drastically below their book values. No bank can then sell its assets at book value. Hence, the entire (artificial) distinction between insolvency and illiquidity evaporates.

Moreover, even if we grant for the sake of argument that the bank’s assets could be sold in a fairly reasonable time at or above book value, the economic case for the rigorous application of bankruptcy law still holds water. Consider that Smith in our above example has not, in fact, complied with the contractual obligation to redeem his notes on demand. At the very least, therefore, he must be considered a bad steward of his customers’ money, and the function of bankruptcy would be to drive him out of a leadership position for which he is obviously unfit.

Furthermore, consider that competitors might have anticipated his difficulties and prepared themselves for buying the assets of the Smith Bank. Why should these people be punished for exercising foresight and restraint? After all, they have held back the money necessary to buy the bankrupt company, thus providing to its creditors the very cash that the present owner Smith could not provide. If they had known that fractional-reserve banking was exempt from bankruptcy law, they would probably have set up a fractional-reserve bank too. Rather than preparing to repair the damage done by Smith, they would have created more of that same damage, which enjoys the sanction of the law.

2. The Economics of Legalized Suspensions

As long as fractional-reserve banking enjoys no other privilege than being legally recognized, the additional privilege of suspended payments cannot have any large-scale repercussions. The reason is, as we have argued above, that under such conditions fractional-reserve banking would not play any great role in the first place.

Moreover, on a free market, a bankrupt bank would collapse very soon anyway, despite the additional privilege of suspended payments. The use of that privilege is a double-edged sword. It helps the bank out of a momentary calamity, but it also shows the bank to be unreliable—not a great starting point for keeping current customers and attracting new ones. Banks have survived suspensions only when their primary customer was the government itself. The Bank of England went bankrupt after two years of operation, in 1696, and survived only because of government help. The English Crown, which had helped set it up, remained its main customer and granted additional privileges, such as suspension of payments, and legal protection against the competition of other banks.

Things are completely different when fractional-reserve banknotes are legal tender. Here it is sufficient that we concentrate on the most relevant case, namely, on the case of a fractional-reserve bank that enjoys a monopoly legal tender privilege. As we have pointed out before, such a regime entails the tendency to make the privileged banknotes the only currency of the country. If the bank goes bankrupt in such a situation, and if the government then grants it the additional privilege of suspended payments, then this legal act transforms the banknotes from (false) money certificates into paper money.

If a bank can count on the government to authorize suspension of payments, moral hazard comes into play. The bank has less reason to be cautious and keep high reserves. And the bank customers will be encouraged into debt with a bank that they know has the government’s blessing. The result is more frequent bankruptcies.

3. The Ethics of Legalized Suspensions

It is probably not necessary to dwell at any length on the ethical inadmissibility of suspended payments. We have said already that the very term “suspended payments” is a shameless euphemism designed to cover up the reality of breach of contract. The bank that suspends payments adopts the absurd position of asserting the legal principle that valid contracts be executed, but only when it insists on receiving payments in fulfillment of its contractual rights; while at the very same time, quite literally in one breath, it rejects the same principle when it denies making payments in fulfillment of its contractual obligations.^[1] We mention this only for the sake of completeness in our exposition. No serious attempt at justifying suspended payments has ever been undertaken, at least not on grounds of common law. And no tenable case for legalizing suspensions can be made on grounds of public expediency, as we have argued at length.