Recent article published in Libertarian Papers, Vol. 3, Art. No. 18 (2011):
18. “Unanswered Quibbles with Fractional Reserve Free Banking”
by Philipp Bagus & David Howden
Abstract: In this article we reply to George Selgin’s counterarguments to our article “Fractional Reserve Free Banking: Some Quibbles”. Selgin regards holding cash as saving while we focus on the real savings necessary to maintain investment projects. Real savings are unconsumed real income. Variations in real savings are not necessarily equal to variations in cash holdings. We show that a coordinated credit expansion in a fractional reserve free banking (FRFB) system is possible and that precautionary reserves consequently do not pose a necessary limit. We discuss various instances in which a FRFB system may expand credit without a prior increase in real savings. These facets all demonstrate why a fractional reserve banking system – even a free banking one – is inherently unstable, and incentivized to impose a stabilizing central bank. We find that at the root of our disagreements with Selgin lies a different approach to monetary theory. Selgin subscribes to the aggregative equation of exchange, which impedes him from seeing the microeconomic problems that the stabilization of “MV” by a FRFB system causes.
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What does the last sentence exactly mean?
Free banking theory is often simplified (by its proponents) as stabilizing MV. To illustrate the theory mechanically, a free banker will tell you that fiduciary expansion occurs when velocity falls (more accurately, when the volume of adverse clearings falls). Bagus and others argue that by focusing on this MV stabilization, free bankers are ignoring the micro-effects of monetary injections (presumably, on the capital structure).
The authors of the article argue strongly that the distortions caused by increased central bank pumping are radically different from those caused by changes in demand for money under a 100% reserve system.
I’m not sure I fully understanding the case they make.
When central banks pump money:
- Supply of money exceeds demand at initial price level and bank interest rates fall.
- The lowered interest rates cause mal-investment as projects containing a high proportion of interest in their costs appear more profitable
- Eventually (when money pumping stops) prices and interest rates move back to equilibrium
- By this stage the mal-investments are revealed as unprofitable and may need to be liquidated
When demand for money decreases under 100% reserve system then assuming some of the money released from cash balances goes into the loan market then the same process will take place as described above. (Assume that the change in cash balances does not affect underlying time preference)
I guess the effects may not be intense because only a portion of the new money goes out via the loan market but nevertheless I am not really seeing the differences as being as fundamental as stated in the article.
Can anyone clarify what I am missing?
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