Yes, You Can Sell What You Do Not Own

To sell something that you don’t already own is often denounced as deeply immoral. Whether it involves trading financial products to ensure against the default of others, structuring synthetic derivatives, or even naked short-selling, the practice quickly invokes ideas about speculation-as-gambling and the blatant opposition that comes with it. It’s unfair, it’s abstract, and “transactions” without initial ownership hardly seem like transactions at all.

But the guttural opposition against selling things one does not own extends far beyond hostility to financial markets, and exists both in several varieties. Interestingly, the re-occurring resentment towards selling financial products one does not own illustrates a divisive intra-Austrian banking dispute. And by consequence, as I intend to show, in aviation and insurance too.

While the left-wing opposition to financial markets increases with the complexity of the instrument concerned and likely originates in a defamation of sacred values, the right-wing opposition to selling things one does not own is of a peculiarly selective kind. It emerges specifically in the dispute over fractional reserve banking (FRB), and has been an ongoing debate for decades (see for instance here, here, here and here).

The argument comes in a variety of forms, but is usually condensed into one of three points: legally or philosophically speaking, FRB is a fraudulent breach of property rights, since two individuals simultaneously claim ownership over the same property; economically, the outcomes of FRB are said to set the business cycle in motion; and financially, as FRB facilitate maturity mismatch, which, allegedly being the source for banking instability, is not “sound financial management”.

Much has been written in all three areas, but I want to direct attention to the idea that simultaneous ownership claims involves fraud on the part of the issuer. Some critics advance the following definitive principle for determining whether a practice is fraudulent: any contractual agreement that involves presenting two different people as simultaneous owners of the same thing is objectively false and thus fraudulent.

Decades earlier Rothbard had offered the same idea in Man, Economy and State (p. 802): “Someone else’s property is taken by the warehouse and used for its own money-making purposes. It is not borrowed, since no interest is paid for the use of the money.” […] “It should be clear that this practice is outright fraud.”

A practical problem of this fraudulent double-use of deposits is that:  “a bank is always inherently bankrupt, and would actually become so if its depositors all woke up to the fact that the money they believe to be available on demand is actually not there.” (Rothbard, Mystery of Banking, p. 99)

Let’s see how these two principles – the contradiction of multiple owners and the consequence when all deposit-holders redeem deposits at once – fares in the aviation and insurance businesses.

In their cut-throat, low-margin business, airlines flying planes with empty seats represent a huge economic and operational inefficiency. Knowing that not all customers with a purchased seat on a particular flight will show up to travel that day, airlines sell more tickets to a flight than they have physical seats available for that service. This is the well-known phenomenon of overbooking. Let’s have Financial Times explain the concept:

“Overbooking is common practice for the majority of airlines and is perfectly legal. As part of their business, airlines sell too many tickets with the assumption that there will be a certain percentage of “no shows” — either because people miss their flight, their previous flight is delayed or they have a change of travel plans.”

The attentive reader will notice the similarity to FRB. The airline sells more tickets to the rivalrous use of a seat on a particular service than they actually possess, on the statistically sound assumption that not all ticket-holders will make use of that seat. In any binding overbooking scenario, two or more customers hold title to the exact same scarce resource is thereby fraudulent.

If the fact that depositors wake up to the reality that the “money they believe to be available on demand is actually not there,” means that banks are inherently bankrupt, airlines practicing overbooking must similarly be bankrupt and fraudulent. After all, the principle involved (simultaneous ownership of the same scarce resource) and the way through which it is revealed (all customers show up at once) are identical.

What about insurance?

Insurance companies take in premiums upfront against future reimbursement in case damage occurs from well-specified risks such as earthquakes or hurricanes. The Law of Large Numbers is the fundamental modus operandi for all insurance companies; by pooling risks for a large and diverse enough clientele, the outlays for aggregate damages can be assessed fairly confidently.

So, what happens to an insurance company if all their customers show up at once? The funds gathered in fees and the float containing unused claims could not possibly satisfy sufficiently large damages suffered by all clients at once. Again, by the standards of this argument, insurance companies ought thus to be bankrupt. Moreover, they use this float to earn investment income for themselves, without paying interest to the ultimate benefactors of that money.  The service such companies provide their customers – financial assistance in the event of catastrophic damage – can only be provided with money amassed by the company. Facing large enough damages at once reveals that the same money covers many different clients, i.e. providing simultaneous services to several clients on the basis of the same scarce resource.

“The crux of the Austrian position”, as Robert Batemarco neatly put it, “is that the practice of fractional reserve banking gives ownership claims to the same funds to more than one person.” Far from being unique to the business of banking, this occurs in aviation and is the fundamental building block through which insurance companies may operate.

Notice that the line of argument presented here does not refute the claim of fraud, either theoretically or empirically, but does identify an inconsistent application of the fraud standard offered. To remain consistent, proponents of the fraud view have to denounce overbooking practices among airlines as well as the entire business of insurance.

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Joakim Book

Joakim Book holds a masters degree from the University of Oxford and was a visiting scholar at the American Institute for Economic Research in the fall of 2018.