Provocative and insightful Cobden Centre post by Toby Baxendale:
If you are interested in monetary theory and what the Austrian School has to say about this debate, the paper that Anthony linked to last week is well worth reading. It addresses some common misunderstandings about Monetary Equilibrium Theory (MET).
This theory is controversial and is much critiqued in Austrian circles. It is but one branch of two very clear conceptions of money developed by Austrian School theorists past and present. Both concern the Theory of Free Banking, with MET supporters favouring Fractional Reserve Free Banking and the rest of the Austrians favouring Full Reserve Banking. It may seem a mystery why people so philosophically aligned come up with very different final policy conclusions. Both support the absence of the State in the banking architecture, preferring a free market for banks, but due to differences in definitions and monetary theory, they disagree about the ground rules for the market.
S Horwitz is a key developer of the MET School and A Evans (H&E) is clearly sympathetic. P Bagus and D Howden (B&H) are for the Full Reserve policy solution. As a side note, Selgin and White from my reading are the intellectual “daddies” of H&E with respect to money and banking. I see little of MET mentioned in their works (especially their latter writing) and more of disequilibrium. This subtle use of language is important, as any Austrian will tell you; human action is dynamic and thus ever changing. Perhaps you can be less in disequilibrium but never in equilibrium. I mention this as H&E stress the importance of getting definitions right.
Definitional Issues – Savings
H&E say,
Unlike inflation, we believe that Bagus and Howden are defining savings in the same way as Free Bankers – meaning the act of abstaining from consumption.
So far so good.
They then clarify an important point:
Bagus and Howden (p. 39) write: “Horwitz suggests that the creation of deposits increases the supply of savings, as depositors are lenders of real loanable funds. In other words, the mere creation of credit and the corresponding new deposits constitute an increase in real savings.” We reject this interpretation because they misrepresent the causality. Bagus and Howden claim that Horwitz is saying that creating deposits increases the supply of savings, which suggests that the causality runs from money creation to savings. However, the Horwitz quote in question clearly says the reverse:
Savers supply real loanable funds based on their endowments and intertemporal preferences. Banks serve as intermediaries to redirect savings to investors via money creation. Depositors give banks custody of their funds, and banks create loans based on these deposits.” (1992, p.135)
The order is that savers provide funds to banks by increasing their deposits, and then those new deposits, which banks receive as reserves, serve as the basis for loans to the bank’s borrowers. Those loans are credited to the borrower’s deposit account. So it is not the case that the “creation of deposits increases the supply of savings” but precisely the opposite: increases in the supply of savings (“real loanable funds”) enable banks to create new loans and additional supplies of money. In other words, savings in the form of holding larger bank balances makes possible the funds for investment that are created through the lending process.
Further clarity is given with this helpful quote:
To see what free bankers actually argue, consider Selgin and White (1996 p.102),
“an increased demand to hold claims on intermediaries, including claims in the form of banknotes and demand deposits, at the expense of holding additional consumer goods, is equivalent to an increase in desired saving”
Note that they do not say that an increase in the demand to hold bank liabilities constitute an increase in savings, they say that an increase at the expense of holding additional consumer goods does. If the increase in demand to hold bank liabilities is facilitated by a substitution from other forms of saving (e.g. from capital goods), then there has only been a change in the composition of savings.
However, I have to conclude that still after years of debate and lots of reading and writing, debating and hair pulling, the eminent Professors, possibly all six mentioned thus far, do not quite have an adequate concept of savings.
Granted, I am a mere layman, but the experience of life and a joyful self education in reading great and not so great economists leads me to conclude that yes savings is a matter of abstaining from consumption, but with respect to what you hold as a money balance in the form of a bank IOU, you may well be abstaining from consumption, but that does not mean you are putting forward your savings for loanable funds. In a conversation with a noted eminent Free Banker, we labelled this “inadvertent savings.” This is a very important distinction to be made and I would define savings as “an act of abstaining from consumption and willingly offering for loanable funds.” The mere fact of just having a bank IOU, i.e. a demand deposit, does not mean you wish that your purchasing power be lent to someone else!
With this in mind, we can observe that if there is a large change in demand for money to the extent that noticeably fewer goods and services are being transacted for money in the economy, i.e. we are in a depression as we are today, then an accommodation by a fractionally reserved free banking system will funnel all those new loanable funds (the depositors’ higher money balances) to individuals and business who in turn demand it to support their weaker activities. This may well be not what the depositor base wants. The depositor base in times like we have today probably want their money balances kept safe as a precaution. Indeed, in my example, having sold my business, I keep enough money balance on deposit (I am loath to say savings now!) for the express purpose of sustaining me and my family, i.e. for ongoing consumption and for “rainy day purposes,” the latter due to the massive uncertainty that exists in the economy today. This means, ALL my cash is NOT set aside for money to be mediated to the loanable funds markets as far as I am concerned. This is exactly what I do not want happening to my deposits. In a mature fractional reserve free banking system, this will happen despite my wishes unless I want to deposit under my mattress or shoe box etc.
The Holy Grail of economics is that the savings of today provide the investment money to the companies and entrepreneurs to make the products, the goods and services that the savers will eventually want to buy with their returned savings. How can this happen when a banking system will mediate money away from precautionary balances that have been “inadvertently saved” back out into loans?
This explains a theoretical weak point in MET and the Theory of Free Banking (the two are slightly different, as noted above), but it might actually make the fractional reserve free banking position more robust if they addressed this issue of precautionary deposits or inadvertent savings.
H&E do not want to be drawn into legal or ethical issues concerning this debate and wish to keep it to the economics. I say they can never be separated and via the door I have just opened to strengthen up their theory, I would say that if depositors were asked to clarify their intentions then only money set aside for savings would go to savings, while money kept as a precautionary balance or for current on-going consumption would not be lent out. This was the objective behind the Carswell-Baker Bill presented to Parliament last year.
It is interesting to speculate, as speculation only it is, but all the panics in the halcyon days of fractional reserve free banking in Scotland (1770, 1772, 1778, 1793, 1797, 1802–1803, 1809–1810,1810–1811, 1818–1819, 1825–1826, 1836–1837, 1839, and 1845–1847; see Checkland, Scottish Banking: A History, 1695–1973, Glasgow: Collins, 1975), may well have been averted or substantially mitigated had people been able to distinguish how they wanted to have their on-demand money balances treated.
I would suggest that some empirical research needs to be done and maybe one of the eminent professors might like to get a graduate student to do this as part of their research. Empirically find out what element of cash balances held as on demand deposits are in fact precautionary and not intended to be lent to other people and enterprises. Find out how much of depositors’ current accounts, that are currently lent out by the banking system, are really intended for investment (with acceptance of risk). My hunch (and a hunch only), is that at times of panic / depression, when money demand does change, most savers want their money kept safe. Moreover, in these depressing times, as people refrain from consumption, they do not want the goods and services produced in the quantities and formats that were offered up before the change in demand. Depositors’ reduced appetite for investment would send an important signal.
I am a sceptic as to the merits of fractional reserve free banking for many reasons, both legal and moral, but greater awareness on the part of depositors, with an explicit choice between safe-keeping and investment, would tighten up the monetary theory aspects of its approach.
By the way, Selgin’s Theory of Free Banking is very worthwhile to read in full. B&H are right to single this book out. It presents a new theory that will be debated for many years to come.
To conclude, with H&E’s clarification of what they do and do not mean by savings and the holding of bank liabilities, I submit the debate would be enriched if this potentially large element of precautionary and current or near-current consumption element of a bank IOU is dealt with.
Much more could be said on this debate. I hope my “observer” contribution is valuable to the professionals. Although H&E value the academic approach over internet-based economics, I have no intention of writing this up in academic language and or providing footnotes citing references. Aristotle never did, and if it is good enough for that giant polymath, it is good enough for a speck on the body of knowledge like me! I hope some find this constructive and useful.
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10 May 11 | Category: Economics | 2 comments
{ 22 comments }
“Both support the absence of the State in the banking architecture, preferring a free market for banks, but due to differences in definitions and monetary theory, they disagree about the ground rules for the market.”
This is staggeringly dishonest. It’s like saying, “The Pirate Bay and the entertainment industry both support free copying and sharing, they just disagree about the ground rules.” Baxendale and the 100%ers want to impose “ground rules” prohibiting the market entirely. Whatever they think of the State, achieving this aim would only be possible using the State apparatus of coercion.
“In a mature fractional reserve free banking system, this will happen despite my wishes unless I want to deposit under my mattress or shoe box etc.”
But if, as Baxendale claims, many or even most depositors would prefer to keep their money balances safe in 100% reserve warehouses, why should this be the case? In a free market for banking, there would be no bailouts or government deposit insurance to distort the market. Would not entrepreneurs exploit the latent demand for 100% reserve deposits by offering such a service, in competition to the fractional reserve banks? If so, Baxendale could easily find a company offering to warehouse his money for a reasonable fee.
The reality is that Baxendale’s hypothetical predicament is the result the near total absence of any real market demand for such a product. Only Baxendale and a handful of other 100%er cranks have a problem with fractional reserve banking. They disapprove of the choices made by consumers in a free market; hence, they propose to use force to get their way.
100%er’s regard fractional reserve banking as a form of fraud. So when they say they want 100% reserves enforced (whether by a traditional government or not), they’re not asking for the State to design the banking industry. They’re asking for law enforcement (which can be stateless or not) to do essentially the same thing it does when it requires the bank to, say, not lie to you about what interest rate it’s charging you on a loan.
P.S. Austrian school economics is not anarchism. The latter is a political program, not an economic theory.
The problem with basing a law on the 100%ers’ claim that fractional reserve banking is inherently fraudulent (apart from its evident absurdity) is that it has been thoroughly and repeatedly disproven. The 100%ers rely on the use of contorted and deceptive definitions such as calling banknotes ownership titles to goods.
P.S. I don’t recall criticising Baxendale for being insufficiently anarchistic; I attacked his claim to “support the absence of the State in the banking architecture, preferring a free market for banks” as contradicted by his support for drastic regulation that would preclude any free market in banking.
Duke,
You have hit on my biggest beef with Rothbard. He is such a strong advocate of a limited state that he will use the full power of the state to enforce his interpretation of what is good for the “unlimited” state.
How can fractional reserve banking be fraud if willfully I engage in fractional reserve banking with full knowledge? There is less risk involved with FRB than with buying a futures contract.
Disagree with you on the risk; I think FRBs are like ponzi schemes–but I don’t think Ponzi schemes should be outlawed. I don’t even think they are bad.
Disagree with your criticism of Rothbard: some statements of the FRBers support his interpretation. As long as they are very clear and willing to provide the notice needed then it is not fraud as far as I can see.
This crank would like you to know , that in Switzerland , Austrian, some places in Germany and many of the tax havens of the world, there are many trillions of deposist held as custody for a very low charge. The market is rigged in the USA and the UK to favour a FRB who can use all current creditors money to do what it likes with.
“Whatever they think of the State, achieving this aim would only be possible using the State apparatus of coercion.”
Or private courts and protection agencies under a libertarian law code as Rothbard described.
Okay… certainly such an anti-liberty law could not be part of a libertarian law code, notwithstanding Rothbard’s (wrong) opinion on the issue.
A private law system could, of course, enforce non-libertarian laws if the public demanded it. In a nation full of extreme Islamic fundamentalists, private courts and protection agencies could force women to wear burkhas. However, the economic incentives in such a system encourage the public to reduce their demand for non-libertarian laws. Thus, a ban on fractional reserve banking would be unlikely to appear, and even more unlikely to last.
Free bankers do not argue that “the mere creation of credit and the corresponding new deposits constitute an increase in real savings”. It’s Bagus and Howden who get their causality wrong, at least when trying to paraphrase free banking theory. If the demand for money rises, it’s not the consequent expansion of fiduciary media that creates the savings. Rather, the savings is represented by the quantity of money held as a part of that increase in the demand for money (deferred expenditure). By creating fiduciary media that savings can then be spent by another individual, where as in lieu of the creation of fiduciary media you decrease the quantity of money in circulation.
Baxendale writes,
This argument doesn’t make sense. That fiduciary media is created as the demand for money rises doesn’t mean that the holder of that money suddenly loses his “purchasing power”. You can spend money held whenever you’d like; banks respond when the volume of returning liabilities increases (they decrease the amount of circulating fiduciary media).
Regarding anything else the customer base wants, what they “want” will have to be delineated in the contract they signed with the bank. If they no longer like the contract they had signed before then they need to withdraw their money and deposit it in a new bank, or they need to re-draw their contract with the existing bank. If no bank is willing to provide them a contract that they want then they need to either “suck it up” or withdraw their deposit and stash it under their mattress (whether in inside money or outside money).
Selgin’s and Horowitz’s responses to B&H are worth reading. B&H don’t cover new ground, and their interpretation of free banking theory is amazingly loose for scholars of their stature.
I realize that Braxendale corrects Howden and Bagus himself now, so disregard that first paragraph. >_>
The critics of “free banking” can sometimes be careless in some of their representation of what they are arguing against. I can personally point you to many more instances. However, (in general) beware making the logical error of ignoring or not taking seriously the argument at hand because of some errors or misrepresentations being made by the author.. Also, beware of making the error of mistaking claims and assertions for an argument. Often, It is the logical implications that follow from the proposed set of assertions that are used as the basis for a refutation. It is no rebuttal then to come back and simply say: “This is a misrepresentation” based on the initial assertions of the theory being criticized. That is what you just did.
Money demand up, you have the purchasing power but it is also lent out to accomodate the increase in demand of loanbale funds – this is the point of The Theory of Free Banking righ? My point is that you may be holding onto more money due to uncertainty and you want to keep your purchasing power for you only. In the FR bank system and in the FRFB system, you have no choice. This means you “inadvertantly save.” This means the real world matching of savings and investments to give a structure of production that is more condusive to produce the goods and services people want, is hampered. This may be why there were so many problems of boom and bust in the Scottish free banking period.
Toby, aren’t times of increased demand for money also usually times of reduced demand for goods and services? Hard times? Whilst some liquidity strapped firms would be hunting for loans, I’d have thought overall loan demand would usually be down.
“This argument doesn’t make sense. That fiduciary media is created as the demand for money rises doesn’t mean that the holder of that money suddenly loses his “purchasing power””
Interesting. Changes in demand for money are time neutral. Yet somehow, the innovation of fiduciary media makes it so that time preference is always pushed downward no matter how those cash balances are accumulated.
“You can spend money held whenever you’d like; banks respond when the volume of returning liabilities increases (they decrease the amount of circulating fiduciary media).
In other words, aggregate MV tends to remain constant. This is the suppose to be the new microfoundation of Macroeconomics according to Horwitz. Aiming for constant P is macro, but aiming for MV is micro.
Methodological individualism at its best.
It’s a simple matter of liberty, and I find it stange that any Austrian should reach for the policy/legislative prescription so readily to enforce 100% reserving on everybody by force of Law. Which I supose makes me a free banking adherent. I rather think that Rothbard had a blind spot about this, and the one thing that stuck out for me in ‘The mystery of banking’, was that even after dispassionately and gcogently showing that, absent a central bank , the market would sort and constrain FRB , he nevertheless fulminated vehemently against the very concept of FRB. Thats his choice , and he would hypothetically have been free to place his money with a 100% reserver, or under his bed.
Central banks with a State-granted monopoly mandate on the issue of currency are antithetical to liberty, irrespective of whether whether on a full reserve or fractional basis ( granted, given a state monopoly on currency issue, a full reserve is probably the lesser evil, but thats like being asked ‘would you prefer your arm chopped off, or just the hand?’). If a private bank wants to operate on a disclosed fractional reserve basis, in a free market its up to them to choose to do so, and there is no legitimate policy ground to outlaw it. Its up to the public to choose whether to place deposits with such a bank or not, after weighing up offered returns and risk. That sorts out the sheep from the goats, and the market will soon discount privately-issued currencies relative to one another according to the risk and liquidity management approach and reputation of the issuer. If a bank holds itself out to be a full reserve operator but actually behaves fractionally, thats just ordinary fraud , and it will swiftly go out of business. The wrong lies in the deceit, not in the fractional reserving in and of itself.
$0.02
I take Guido Huelsmann’s view, which is that FRB is going to be an economic disaster, but should not be outlawed so long as sufficient disclosure is made so that there is no fraud:
Here
he writes:
See also my posts Fractional-Reserve Banking, Contracts of Deposit, and the Title-Transfer Theory of Contract http://blog.mises.org/10451/fractional-reserve-banking-contracts-of-deposit-and-the-title-transfer-theory-of-contract/ and
UK Proposal for Banking Reform: Fractional-Reserve Banking versus Deposits and Loans
http://blog.mises.org/13868/british-proposal-for-banking-reform-fractional-reserve-banking-versus-deposits-and-loans-2/
Thanks Mr Kinsella, I shall have to digest these resources you have provided, which may take a little time, and I couldnt ask for mor ethan an acknowledgement that there shouldnt be a LAW against it. while taking Mr Hulsmann’s point, I would mention the power of reputation, which in an unprotected market context ( read: no access to bailouts) would be any serious bank’s most jealously preserved ‘asset’. The rest is a matter of the customer balancing what ‘deposit’ (OK technically, its a ‘loan’) rates would be offered, as against the risk of the bank hashing up its liquidity management, assessed on the usual risk/return principles, and th ebank targeting particular segments of the market on both th edeposit and lending legs.
Thus far (pending a deeper reading of your above references), I would not be so pessimistic as Mr Hulsmann as to predict that FRB banks would not find any demand in a free market, but I would expect banks transparently doing fractional reserving in such a milieu would settle on far more prudent reserving ratios than those currently prescribed by regulators, on the simple premise that, absent recourse to State rescue, a bank’s desire to stay in business is sufficient incentive to manage its liquidity and its credit risks prudently.
Furthermore, most people I know strive to maintain current account balances as small as possible, and feed them on a ‘just in time’ basis to meet withdrawals, as current account deposits dont yield any meaningful return ( and most corporations I know have dedicated treasury functions to manage this optimally, including recognising the counterparty and systemic risk the banks represent to them). Larger amounts not earmarked for imminent withdrawal tend to be placed on notice or money market accounts paying higher rates, which are well recognised as being loans to the bank rather than cash deposits. I can see no reason to believe that this would not also pertain in significant numbers in a free banking world.
Finally, I would also mention that even in the current regime, the customer still has the option to make a low-risk deposit whose ownership remains firmly with him, even in the event of bank failure – as the bank merely holds it as a trustee in ‘safe custody’, in a locked box with the depositors name on it. It tends to be little used ( at least in my part of th eworld) because it attracts a custody fee rather than a credit balance interest, and it entails personally calling at the bank to make a withdrawal, which is rather inconvenient.
cant we look at money as a commodity like power for example.the utility cos promise that you’ll have electricity 24×7.but reality is that if everyone plugs in at the same time,the grid crashes because its design optimized to expect some queueing of devices across the day.why couldnt money (a scarce commodity) be subject to smart queuing also.?
or should we all take power cos to court for “deceit”
At all points this arrangement should be apparent, especially on whatever the bank uses as a claim note (money). If a borrower goes to the bank, borrows, say, $1,000 in notes, then each note should be labeled as “20% Reserves” so anyone accepting the note can plan the risk of of acceptance accordingly. The fraud isn’t just related to the individual making the deposit, but also related to anyone accepting the currency for payment. The arrangement between the depositer and the bank, as to what needs to be done should the bank lack the reserves to satisfy all withdrawls, is the easy part of the discussion. The question is how the varying reserve arrangements banks use is transmitted to third parties that accept the currency. Without the noted reserve level stamped on the currency itself, stamping a certificate with “20 oz Gold” is fraudulent because there isn’t a guarantee that all 20 oz will be available should the individual accepting payment arrive at the bank to collect, or deposit in his own account with a different bank and have that bank seek out a transfer of the gold.
The chance of fraud is particularly potent with electronic commerce, considering cash transactions are becoming rare. How would this reserve ratio and appropriate agreed risk premium for accepting the currency be transmitted to Amazon.com, for instance?
From my point of view, FR is acceptable under the conditions everyone engaging in the transaction is made aware of the FR nature, but because of that, it’s unlikely a FR system would survive. Here’s the scenario as to why I doubt it would survive:
Customer deposits his gold coins with Bank A that has a 80% reserve on its notes. The customer deposits 100 oz of gold and recieves notes that reflect 100 oz of gold with a notation that only 80% is expressly guaranteed to satisfy the reserve the bank set. The bank then guarantees, let’s say, 3% returns on 20% to reflect the lending activities. Armed with his bank notes, he goes and purchases some clothing and a computer (this is an odd store) worth 2 oz gold. He hands over two 1 oz notes to the proprieter. The question now comes on the proprieter to accept the notes with the risk of losing 20% of the sale, or apply a discount and ask for an additional 1/4 of an ounce note to cover the discount. It’s unlikely that the full risk avoidance would be taken, but there will be some risk avoidance for accepting the note that is only guaranteed at 80% of the par. It’s unlikely that accepting an 80% guarantee note at full value will be the normal mode of operation. Should the bank not fail, the proprieter makes extra profit. In either case, the customer of the FR bank is getting the raw end of the deal by reducing his personal account by 2 oz of gold + the risk of being a customer of that bank. The question then remains if the bank customer finds the risk premium that even an 80% reserve requirement will command in the market is greater or less than simply paying a bank a fee to keep what amounts to an untouchabe storage vault available (full reserve). I don’t forsee many people willing to pay what amounts to a sales tax just because they chose a bank that wants to lend a portion of its demand deposits out.
Larger companies would lack the capability of making the decision on a transaction-by-transaction basis and would likely apply an average risk premium on all transactions regardless of what bank note was accepted (high FR customers subsidized by low FR customers and full-reserve customers) or outright refuse to accept any notes from fractional reserve institutions.
While I would say that fractional reserve banking is perfectly fine under a free market, its severe disadvantages for everyone but the bank itself would effectively crush the practice. The only way I can see a fractional reserve banking system existing as a norm is under a legal tender situation.
I think your example is a bit confused–it’s even worse than you say.
You say: “Customer deposits his gold coins with Bank A that has a 80% reserve on its notes. The customer deposits 100 oz of gold and recieves notes that reflect 100 oz of gold with a notation that only 80% is expressly guaranteed to satisfy the reserve the bank set. The bank then guarantees, let’s say, 3% returns on 20% to reflect the lending activities. Armed with his bank notes, he goes and purchases some clothing and a computer (this is an odd store) worth 2 oz gold. He hands over two 1 oz notes to the proprieter. The question now comes on the proprieter to accept the notes with the risk of losing 20% of the sale, or apply a discount and ask for an additional 1/4 of an ounce note to cover the discount. It’s unlikely that the full risk avoidance would be taken, but there will be some risk avoidance for accepting the note that is only guaranteed at 80% of the par. ”
Well, first, the 80% of your 100oz is NOT guaranteed since this part is now commingled with other customers’ money–it’s not particular to YOU. They bank just keeps 80% of all deposits on hand. THat is why there can be a run: if the first 80% of the customers come in and demand they money get deplete all the reserves and you are left having NOTHING. That’s why runs happen. The 80% reserve does not mean each customer is guaranteed to get at least 80%.
SEcond, the 3% interest also cannot be guaranteed.
At most, both can be promises-to-try by the bank–that is both are inherently risky and uncertain. And that is why they would never become money, IMO
It’s a bit confused, but that goes with the territory of attempting to design a fractional reserve banking system that avoids the fraud issue entirely. That’s what I meant by that risk premium, I put it in as a 20% chance that I won’t get the money at all. That’s why I would demand that amount up front (or part of it, depending on market conditions, I’d apply an estimated risk of failure along with the 20% chance of having nothing, so more like maybe a 5% premium for using that money) so if some time down the line that bank does go belly up and I’m not in the first 80%, I’ve built up a buffer ahead of time to hedge against the failure.
And, true, they couldn’t guarantee the 0.6% of the deposit (3% of the 20%) annually, but who would trade away a 20% risk of not having any money in the event of a bank run for an undisclosed, who knows, payment on the amount the bank is lending otherwise free and clear?
The ridiculous tightrope a fractional reserve bank needs to walk, the risks the customers take, and the risk anyone that accepts the bank notes takes ensures, at least in my mind, that full reserve banking would be the de facto method of banking absent a central bank or bailout mechanism.
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