Readers of this site will immediately realise that this recent article by Telegraph journalist Ambrose Evans-Pritchard is most confused. Much of our work aims to refute such muddy thinking.
I would love to hear from AEP, or from Prof Congdon, exactly how creating money is supposed to create wealth.
If the Central Banks of the world buy private sector bank debt, they create new demand-deposit money that the private sector banking system can then lend. So more money units chase the same goods and services? Where is the new wealth?
Many people associate rising money supply measures with rising GDP and increased prosperity. Mistaking correlation for causation, they view an increasing money supply as the source of prosperity. This puts the cart before the horse.
Wealth is only created when entrepreneurs make better goods and services, satisfying more of the needs of consumers, in better and more convenient and cheaper ways, via more capitalistic and hence more efficient methods of production. Both the capital investment and the subsequent purchase of the new goods and services should be supported by real savings (forgone consumption).
If such genuine wealth creation occurs, it will prompt banks to increase lending, and under our current system of fractional reserve banking this will necessarily entail an expansion of the money supply. This expansion is the result, not the cause, of wealth creation. Artificially increasing the supply of money will not create wealth, any more than injecting mercury into your thermometer will cause a rise in temperature.
As it is wealth we need to get us out of this hole, all policy should be directed at lowering taxes and reducing the burdens on entrepreneurs.
When it comes to central bankers, it is not dangerous defeatism we should fear, but catastrophic hubris.
Though I generally agree with the Austrian Business Cycle Theory, I don’t think there is any need for “deflationary purging”, or that it can do any good.
Toby, you wrote:
“So more money units chase the same goods and services? Where is the new wealth?”
Think about this in the opposite context. Why can creating more money units in a boom possibly result in *less* new wealth?
This is the key problem with the Rothbardian argument. The Rothbardian theory holds that actors are fooled by Cantillon effects and the associated account-falsification during the boom, but not during the bust. Often they hold that prices are sticky during the boom, but perfectly flexible downwards during the bust.
Steve Horwitz wrote something very much like what I’ve written above in reply to one of my comments, in a thread a couple of years ago. After thinking about it I came to the conclusion that he’s right.
Creating more money units in a boom can never create more wealth.
Creating more money in a bust can never create more wealth.
Creating more money units anytime can never create more wealth.
As I said “Wealth is only created when entrepreneurs make better goods and services, satisfying more of the needs of consumers, in better and more convenient and cheaper ways, via more capitalistic and hence more efficient methods of production. Both the capital investment and the subsequent purchase of the new goods and services should be supported by real savings (forgone consumption).”
If more money units are created in a boom, then more goods and services that will be supplied, in the round, should bring about price falls. If the more money units exactly matches the more goods and services and everything else stays equal, the famous economist saying ceteris paribus, then prices will stay the same. So if more real wealth is created in a boom, purchasing power does not go up, with a Dowd, Horwitz, White style money adjustment, but stays the same as the new money units inflate the prices back up to where they were before. That is all fine and well and good if you want to pursue a price stabilization agenda, but do not confuse it with creating wealth, the two are very different.
Also, when more money units are created, you create an exchange of nothing, the new money unit, for something, the real goods and services that you exchange the new money unit for. This would be called counterfeiting if it was done by you or me in the private sector but can be used by the State and its handmaidens the private sector banks for their own betterment. This is not in the interests of the people and takes real wealth from them by stealth: this is dishonest. Politically, I could not support what they propose. Economically their policies could be implemented to counter changes in the demand to hold money. If implemented by a central committee planners, we are not far away from we are today, if implemented by a fractional reserve free banking system like they propose it would be better for sure, but you would not be achieving any wealth creation.
In my humble, but considered position as a wealth creator, this is why I do not support the fractional reserve free banking position Horwitz and co suggest, but the free banking position I mention here that makes banks work toward the normal commercial law and the normal accounting law that we all have to work to and they do not, https://www.cobdencentre.org/2010/03/free-banking-the-balance-sheet-and-contract-law-approach/ .
So creating new money units in a boom will not create less wealth and I do not say less wealth, I say no new wealth is created by this process.
During the most recent bust, I can personally testify that significant price adjustments downwards in all sectors of the economy have happened and especially in wages, the latter thought to be the stickiest.
As you know, I do not favour a deflationary purge but a fix of the money supply as demonstrated by this article https://www.cobdencentre.org/2010/05/the-emperors-new-clothes-how-to-pay-off-the-national-debt-give-a-28-5-tax-cut/, from which you let the purchasing power of money change in accordance with the production or not of goods and services in the economy.
> Creating more money units in a boom can never create more wealth.
>
> Creating more money in a bust can never create more wealth.
>
> Creating more money units anytime can never create more wealth.
But, if creating more money units can never create more wealth then how can it ever create less wealth? ABCT supposes that it can create less wealth.
I certainly think that creating more money units can in some specific circumstances create more wealth. Just as it can create less wealth in some circumstances.
In general I think that the institutional setup of a nation affects it’s real wealth. That includes monetary policy, and lots of other things.
Later in your reply you wrote:
> So creating new money units in a boom will not create less wealth
> and I do not say less wealth, I say no new wealth is created by
> this process.
I don’t think you understand what I meant. Maybe I didn’t phrase it well.
Think about the ABCT theory of how unsustainable booms occur. One of the key points of that theory is that there are real losses involved. Let’s consider an economy with a central bank that starts at equilibrium. In that case the central banker has three choices at the start, he can expand the money supply, keep it the same or reduce it. ABCT says that if he creates money at that stage then misallocation will occur. A boom will occur followed by a bust. Afterwards the economy will be in a worse position than it would have been had the central banker kept the money supply the same. So, the creation of money at that stage results in *less* wealth in the future than keeping the money supply steady would have done. This is saying the money is non-neutral.
> If more money units are created in a boom, then more goods and
> services that will be supplied, in the round, should bring about
> price falls. If the more money units exactly matches the more goods
> and services and everything else stays equal, the famous economist
> saying ceteris paribus, then prices will stay the same. So if more
> real wealth is created in a boom, purchasing power does not go up,
> with a Dowd, Horwitz, White style money adjustment, but stays the
> same as the new money units inflate the prices back up to where
> they were before. That is all fine and well and good if you want to
> pursue a price stabilization agenda, but do not confuse it with
> creating wealth, the two are very different.
I don’t think the two things can be so tidily separated.
Monetary calculations are used to measure profit and loss. Entrepreneurs augment that with a subjective set of expectations of the future. But, they cannot calculate in real values. Estimations can be done certainly, but they can’t be done perfectly especially by small businesses. If they could be then money would be “a veil” and could not create business cycles. Like all Austrian Economists I don’t think that money is a veil.
The point of the monetary disequilibrium theorists is that this can’t possibly apply only to price inflation and not to price deflation. Nor can it apply to money inflation and not money deflation.
> Also, when more money units are created, you create an exchange of
> nothing, the new money unit, for something, the real goods and
> services that you exchange the new money unit for.
Not necessarily. If I were to promise to do something in the future then that promise could have value to others. But, have I created it “out of nothing”, no, not really because I must take into account that I have made the promise in my own planning.
Similarly, if a free bank promises to redeem a banknote then it has created a liability against itself. It must plan for that liability just as it must plan for a timed liability.
> This would be called counterfeiting if it was done by you or me in
> the private sector
The crime involved in counterfeiting is creating a certificate that pretends to be something that it isn’t. Money creation need not involve that. Counterfeiting is when one organization or individual writes a fake liability on some other organization or individual. But, money can be created by an organization writing a real liability on *itself*.
> If implemented by a central committee planners, we are not far
> away from we are today, if implemented by a fractional reserve free
> banking system like they propose it would be better for sure, but
> you would not be achieving any wealth creation.
What you are saying in the last part here is that the stability of prices has no value. That’s what I disagree with. Long term planning cannot be done without some stability, so, having stability does create wealth.
> the free banking position I mention here that makes banks work
> toward the normal commercial law and the normal accounting law that
> we all have to work to and they do not,
We’ve already discussed that quite a lot. As I said last time I think you’re taking a narrow view of what accounting entails. If businesses had to keep current assets to cover all liabilities that had a probability of becoming current then many types of businesses could not operate. Not only fractional-reserve banks but also insurers and many others.
> During the most recent bust, I can personally testify that
> significant price adjustments downwards in all sectors of the
> economy have happened and especially in wages, the latter thought
> to be the stickiest.
Price adjustments across the structure of production are always necessary to recover from an ABCT bust. The prices of misallocated capital and human capital must fall relative to useful capital.
But, that doesn’t mean that there must be a general fall in prices. If that occurs it’s an unnecessary problem.
> As you know, I do not favour a deflationary purge but a fix of the
> money supply as demonstrated by this article
> from which you let the purchasing power of money change in
> accordance with the production or not of goods and services in the
> economy.
Your plan advocates fixing the money supply. That means that the purchasing power of money changes with production and with changes in the demand for money. Ceteris paribus, if the demand for money falls then prices rise, and visa-versa if the demand for money rises then prices fall.
What you say only holds true if the demand for money remains relatively stable. The view of many monetarists is that demand for money is naturally quite stable. I doubt that that’s true in general because recessions bring uncertainty which makes holding more money useful. Similarly, booms bring more certainty which make holding assets, debt and goods more attractive.
You Say “But, if creating more money units can never create more wealth then how can it ever create less wealth? ABCT supposes that it can create less wealth.”
To Current:
When more money units are created, I deposit £100 in a bank, it lends £90, then £81 and so on and so forth, all the people who have been lent the credit buy their bits of kit to make things, to sell things etc, on a large scale, this is the boom.
When the bust happens and there is a money deflation, the person who was lent the £81 and the person lent the £90 , who have real businesses, no longer have the support of that credit. They go bust. The money supply or supply of money units contracts, so what was created is now destroyed in a deflationary crunch. So it is to this extent that the illusion of new wealth can be created, and indeed real goods and services are manufactured, but these are just bid away from the consumption end, as the production end of the structure of production bids resources away from the consumption end. The workers in the production end, now with higher wages, spend away and cause the consumption sector to out bid the production sector for resources, this then ends when things become so expensive and unviable. This is the bust.
If the original £100 was earned by selling some good and service then we can say that this money has been backed by production. The £90 and the £81 are not backed by anything except thin air. So they can only facilitate consumption of existing goods without any prior production. This latter point I think is the thing you are having difficulty with. So the boom is in reality an illusion, a shuffling around of the structure of production. Money units in themselves create no wealth up or down, just chaos.
That is why the FRFB School I believe need to pay closer attention to the fact that any media issued without prior production will not create any new wealth or loose any wealth, just cause a reshuffling of the existing structure of production, boom bust chaos.
> When more money units are created, I deposit £100 in a bank,
> it lends £90, then £81 and so on and so forth, all the
> people who have been lent the credit buy their bits of kit
> to make things, to sell things etc, on a large scale, this
> is the boom.
I agree that a boom may be created if account falsification takes place, or if the interest rate is pressed below the natural rate. However, if there is a demand for the new money that’s being created then things are quite different. In that case the additional money will prevent account falsification and prevent the interest rate from rising above the natural rate.
> When the bust happens and there is a money deflation, the
> person who was lent the £81 and the person lent the £90 ,
> who have real businesses, no longer have the support of
> that credit. They go bust. The money supply or supply of
> money units contracts, so what was created is now
> destroyed in a deflationary crunch.
That certainly may happen. It occurred in this bust and during the Great Depression. But, there have been may recessions where it hasn’t happened.
In this explanation you put the cart before the horse. If the central bank restrict the money supply then that may cause money deflation and affect the supply of credit.
What normally happens though is the opposite. In a typical modern fractional reserve system a bank holds a small fraction of assets So it is to this extent that the illusion of new wealth can
> be created, and indeed real goods and services are
> manufactured, but these are just bid away from the
> consumption end, as the production end of the structure of
> production bids resources away from the consumption end.
> The workers in the production end, now with higher wages,
> spend away and cause the consumption sector to out bid the
> production sector for resources, this then ends when things
> become so expensive and unviable. This is the bust.
Yes, I’m not disagreeing with the ABCT theory here.
> If the original £100 was earned by selling some good and
> service then we can say that this money has been backed by
> production. The £90 and the £81 are not backed by anything
> except thin air.
After you lend £100 to a bank it could then lend £90 to someone else. But, it can only do that if that other party is a good risk. The bank-account money we use today is not backed by “thin air”, it is backed by debt. But, that “backing” is quite far from any true sort of backing because of the activities of the Federal Reserve and the FDIC. Bank don’t have to care that much about the quality of their assets because they are Federal Reserve backed. But, that need not be the case, free banking is possible.
When discussing this Rothbard confuses two very different scenarios. He talks about early goldsmith who lied about the amount of gold they held in their vaults. These goldsmiths claimed to be issuing bailment contract, but were not. He then talks about banks, but banks generally did not claim to be issuing bailment contracts, they issue debt contracts. (I agree with you that people are very confused about the situation now though).
> So they can only facilitate consumption of existing goods
> without any prior production.
Notice that all debt contracts can do that. If I plausibly promise to do X in the future then that promise is an asset to the other party. But, no production has occurred, I’ve deferred my production until later.
To explain my view more fully I’ll post something else about it in a while.
Current , you say…
“I agree that a boom may be created if account falsification takes place, or if the interest rate is pressed below the natural rate. However, if there is a demand for the new money that’s being created then things are quite different. In that case the additional money will prevent account falsification and prevent the interest rate from rising above the natural rate.”
A demand to hold money means individual cash balance goes up and transactions for goods and services go down. If this is a ceteris paribus situation then this would be associated with an economic down turn.
A lower demand to hold money means individual cash balance goes down and transactions for goods and services go up. If this is a ceteris paribus situation then this would be associated with an economic up-turn.
Why would printing more money units do anything to assist or desist with this situation?
In fact, new money units will only create account falsification.
If there is more productivity and more goods and services in the economy and people exercise on-going demand for these new more plentiful and cheaper products, the demand for the services of money to transact these and lower cash balances and buy more goods and services takes place. Purchasing power of money goes up and prices go down. Should a Central bank seek to prevent this, they do it by putting more money units in circulation or in a fractional reserve free banking world of Selgin / White / Horwitz and Dowd, the banks would create more media to facilitate the transaction of these services. This would generally offset the increase in purchasing power and lead to a more stable price environment.
You can reverse this process in a down turn. This is all theoretically rigorous , that I do not doubt. It will however set in motion accounting falsification and create more potential error and more potential for credit induced business cycle.
This situation is a zillion times more preferable than what we have today, but it does involve accepting that you can lawfully exchange new money units to the lucky first recipients , who can then exchange something for nothing, hence I prefer honest money, fixed money supply and let purchasing power changes regulate the changes in the demand for money. Which leads nicely onto your next point…..
“If I plausibly promise to do X in the future then that promise is an asset to the other party. But, no production has occurred, I’ve deferred my production until later.”
As a businessman I only really understand notes of paper with the Queens fine head on it. If I transacted on promises only, I would be out of business very quickly.
I deposit cash, I am told it is mine (un true) I am told it is on demand and I can get it back therefore when I want (un true), I am never told it is an IOU from the bank and it is in fact a debt to me and that this debt is supported by some mortgage payer, some entrepreneur somewhere in the system that they have lent to. A very dishonest business is banking today.
Make banks honest, if they want to issue debt let them and make them tell their customer. Better still , have a custodial account and a savings account , one where the bank provides a safe keeping service the other where they provide an intermediation service . That in a very broad stroke would provide the majority of services that are required of a bank.
If a bank issued new media not tied to a debt obligation then it would not just be dishonest as above , for sure you would only have a transaction of nothing for something.
Before I reply, I’d just like to clear something up. I’ve been criticising a couple of the Cobden centre posts recently. That’s not because I have a grudge against the Cobden centre. I want to provide some constructive criticism, that’s all. I think Toby understands this, I’m just mentioning it for any others reading.
> A demand to hold money means individual cash balance goes up and
> transactions for goods and services go down. If this is a ceteris
> paribus situation then this would be associated with an economic
> down turn.
>
> A lower demand to hold money means individual cash balance goes down
> and transactions for goods and services go up. If this is a ceteris
> paribus situation then this would be associated with an economic
> up-turn.
>
> Why would printing more money units do anything to assist or desist
> with this situation?
>
> In fact, new money units will only create account falsification.
It’s simplest to discuss this by considering a non-progressing economy first. That is, an economy without productivity growth where the real price of goods and services remains the same.
It’s also simplest to describe relative changes first. Imagine a steady state where the demand for money across the economy is stable. It could be that one group, perhaps fishermen in the north increase their demand for money. Meanwhile, another group, perhaps farmers in the south decrease their demand to hold money by an equal amount. These demands could be met in several different ways.
Firstly, the change could occur “directly”. The farmers could spend their surpus money on goods and services. The fishermen could live more frugally on their earnings and spend less of them until they have the holding of money that they demand.
Consider a business selling goods and services to the northern fishermen, these could be consumer goods or producer goods. As they fishermen tighten their belts the profits of those businesses will fall. Similarly, the profits of businesses that supply those businesses will temporarily fall. Exactly the opposite will happen in the case of the southern farmer. As they spend their money prices will rise. Profits of those who supply them with goods and services will temporarily rise.
Secondly, rather than the change happening directly the finance industry can become involved. The southern farmers could save their money in savings accounts or shares. The northern fishermen could borrow money from banks. In practice a change like this would take place both directly and through the banking industry.
There is nothing harmful about these movements. The overall price level of consumer goods is unlikely to change. The prices of consumer goods bought by southern farmers may rise, but that of consumer goods bought by northern fishermen would similarly fall. The overall price of producer goods is similarly unlikely to change. Disturbances will occur, prices will take time to change, and then things will return back to normal. In both of these cases there may be some changes due to the different supply elasticities in the various markets, different price stickiness and whether each group decides to change their buying decisions in the consumer goods or producer goods markets, or both. (As a sidenote, it could be argued that those complicating factors have large effects. But, these sorts of relative change in money demand can’t be truly dangerous. They happen all the time as branches of industry wax and wane, and as geographical locations become more of less successful. If they did cause recessions then we would never be out of a recession, a market economy would be impossible.)
The accounts of the farmer, fishermen and those they trade with remain accurate. Since the consumer goods price level doesn’t change there is no falsification. It may be considered by some “unjust” that those who sell goods to the farmers see a temporary rise in profits, and those who sell goods to the fishermen a fall. But, it doesn’t mean that the accounts of either are affected. The profits and losses involved are, in that sense, real profits and losses.
The problems come when there is an overall change in demand for money. If I decrease my demand for money, ceteris paribus, then there is an overall change. The problem for macroeconomics though is when there is a very large change in demand.
With any market we have four cases to consider. A rise in demand without a change in supply and a fall in demand without a change in supply. A rise in supply without a change in demand and a fall in supply without a change in demand.
Suppose that there is a rise in demand for money without a change in the supply. A rise like that could happen if there were a foreign financial crisis, or war. People would worry that it may affect their future economic plans, and deal with that uncertainty by holding more money. It’s worth treating this situation in microeconomic detail…. Agents across the economy decide to hold more money. They can do that in two ways. Firstly, they could reduce their expenditures and retain more income as money. Like the fishermen, they can tighten their belts. If this happens then there will be a fall in profits for those whom they normally trade with. Those businesses must cut their prices, and the suppliers to those businesses must cut their prices too. But, for a great many reasons prices are sticky and cannot be changed that quickly. That means that there will be no rapid fall in prices. Secondly, those demanding more money could turn to the banks looking for it. But, since we are discussing a situation where the stock of money is fixed the banks are unable to help. That means the interest rate will be bid higher. In this case account falsification will occur because as prices are falling money is becoming worth more. A profit margin that is falling in monetary terms may be remaining the same when measured in terms of units of output consumer goods.
The result of all this is that there will be a recession until prices fall. As that happens the real value of money holdings will rise. That will drive a further change in demand for money – a reduction in demand.
The second case is a fall in demand for money with no change in supply. This case is the mirror image or the rise in demand I’ve described above. Some agents have excess money they don’t want, they have two choices. They can spend it on goods and services, that will cause money profits to rise for the businesses who benefit from that extra trade. It will cause prices to rise too, steadily. Prices are sticky in both directions, so the price change will not manifest itself immediately. Account falsification will occur here too, profits will appear to rise. Instead of buying more people could save their money with banks, that would cause the rate of interest to fall. In this case we may see ABCT occur. There may be an unsustainable boom until prices rise, then a bust.
The third case is an unchanging demand for money matched with a rise in supply. This is the case that interests ABCT theorists the most because it’s very likely that central bankers will raise the supply of money for political reasons. In that case those who recieve new money can spend it. That will cause a rise in profits for those businesses who they trade with. This is similar to the second case where there is a fall in demand for money. Accounts falsification will occur in the direction of overestimating profits. Prices will rise but only slowly. The interest rate will fall. In this case ABCT is very likely to occur, there will be a boom followed a bust. (Because of central banking practice it is much more likely that there would be ABCT in this case than in the second case. I could go into that more, but there’s no reason to here).
The fourth and final case is a steady demand for money matched by a fall in supply. I don’t think I need mention much about this, since it all follows from the other three cases above. If the central bank reduce the money supply ceteris paribus then there will be a recession until prices fall.
> If there is more productivity and more goods and services in the
> economy and people exercise on-going demand for these new more
> plentiful and cheaper products, the demand for the services of money
> to transact these and lower cash balances and buy more goods and
> services takes place. Purchasing power of money goes up and prices
> go down. Should a Central bank seek to prevent this, they do it by
> putting more money units in circulation or in a fractional reserve
> free banking world of Selgin / White / Horwitz and Dowd, the banks
> would create more media to facilitate the transaction of these
> services. This would generally offset the increase in purchasing
> power and lead to a more stable price environment. You can reverse
> this process in a down turn. This is all theoretically rigorous ,
> that I do not doubt. It will however set in motion accounting
> falsification and create more potential error and more potential for
> credit induced business cycle.
Price trends that arise from productivity are a different subject to what I’m discussing here. Selgin and Horwitz don’t believe that the price level should remain stable in a case of rising productivity. Selgin has written a long article called “Less than Zero” explaining why it is better to allow the price level to fall as productivity rises. I don’t know about White and Dowd.
The crucial point is that it’s much better to offset large changes in the demand for money by corresponding changes in supply. Doing so prevents unexpected changes in the price level and account falsification. It prevents the rate of interest from rising above the natural rate or falling below it.
> but it does involve accepting that you can lawfully exchange new
> money units to the lucky first recipients , who can then exchange
> something for nothing,
I don’t believe that the exchange of a new fractional-reserve note must be the exchange of “something for nothing”. The bank that issues the note must have debt to cover that note.
The problem that we currently face is that the state can alter the price of that debt through the central banking and deposit insurance schemes.
> As a businessman I only really understand notes of paper with the
> Queens fine head on it. If I transacted on promises only, I would be
> out of business very quickly.
That depends entirely upon the quality of the promises. Certainly for small, unstable businesses their promises may be worth little. But the situation is quite different for large established businesses. I don’t think what I’m saying here is particularly controversial. I’m simply applying principles that apply to all debt to a particular kind of debt – fractional-reserve banknotes.
Relatively recently central banks took full charge of money. But, before that money was exactly and precisely “promises”. That’s what it was in the Scottish era of free banking and at many other times in history.
Do you think that it should be illegal to create debt contracts? If not, then why is fractional reserve money special?
I’m a bit confused about your viewpoint here because later you write:
> If a bank issued new media not tied to a debt obligation then it
> would not just be dishonest as above , for sure you would only have
> a transaction of nothing for something.
What happens if a bank issue new media that *is* tied to a debt obligation. Why is that dishonest if it is revealed?
> I deposit cash, I am told it is mine (un true) I am told it is on
> demand and I can get it back therefore when I want (un true)
When has a bank refused to pay you cash on demand? In my view there is nothing untrue about a banks promise to pay on demand.
> I am never told it is an IOU from the bank and it is in fact a debt
> to me and that this debt is supported by some mortgage payer, some
> entrepreneur somewhere in the system that they have lent to. A very
> dishonest business is banking today.
That may be so, but that doesn’t mean that it *must* be so.
When I have a spare hour or so I’ll explain how a “monetary equilibrium” type banking industry could be created without fractional reserves. It can be done using only 100% reserves. That will separate the fractional-reserve issue, and the associated ethical questions from the questions about money supply and demand.
Over at the Mises institute blog I’ve had a lot of discussions about money with 100% reservists. Arguments arise about both economic issues and moral issues. On the one hand there are the questions about the business cycle and growth. On the other there are those about ethical banking. We can separate the two by discussing a form of 100% reserve banking that would operate on monetary equilibrium principles. I wrote about this briefly in the huge thread on the Baxendale plan.
Let’s suppose that there are two countries. Country A uses a 100%/bailment gold standard as described by Rothbard. Country B uses “land money”. In country B there is a lot of agricultural land. Banks use some of that land to provide money, banknotes are titles to land. If you have a one acre note then you can go to the bank that issued it and recieve an acre of land in return. The banks hold 100%-reserves, for each note they issue they hold the same amount of land. The contract on the banknote is a bailment, the holder owns the land and the bank deals with it for them as their agent, the banks are “land warehouses”. We’ll suppose that in both countries the banks provide normal banking services too.
It could be argued that this couldn’t work in practice because land isn’t all the same. For this example I’m not suggesting something I think is really feasible, it’s a thought experiment. However, the inhomogeneous fertility of agricultural land could be dealt with by weighting the amount of land against fertility.
The first difference between these two standards is nature of the asset they use. The monetary gold used in country A doesn’t provide any return when stored in a vault. However, land can be used, the banks could charge a fee to their customers by taking crops from the land. That fee could be explained on the contract printed on the banknote. The banks could employ normal farmers to do the farming for them, they don’t need to actually deal in agriculture.
Neither country A nor country B have a central bank, only commercial banks exist. Money can only be created if a customer deposits the reserve asset with a bank, or if the bank buys a reserve asset with it’s own resources. But, the situation isn’t exactly the same. Much work and cost is needed to convert gold jewellery into monetary gold and even more is needed to turn monetary gold into jewellery. Something similar could be said for most industrial uses of gold. The same thing can’t be said for land though. In country B a farmer can visit a bank with his normal land titles and have them converted into money. There is no melting down involved, it’s a paper transaction.
As I wrote before, we must investigate the situations where money supply and demand change. Firstly, suppose that supply of gold in country A increases while the demand for money remains the same. In this case it may be profitable to convert some of that gold into monetary gold and bank it, if the prevailing industrial gold prices are low. If that happened then the supply of money would increase. When the money is spent the Cantillon effect/account falsification will take place, if the change were not expected. As Guido Huelsman points out this wouldn’t occur in practice because a huge surprise discovery of gold is so unlikely. If a major technological change occurred in the gold-mining industry then the market would expect a slightly rising price level in the next few years and the effect would be minimal. The situation for land is a bit different. In country B the price of normal land would always be very close to that of land-money. In that case, if the demand for money were to remain the same then all the new land would be sold to normal farmers.
Both country A and country B don’t have to worry that much about a fall in the supply of money. Monetary gold stored in vaults doesn’t erode. Land does erode, but very slowly.
The really interesting part though is the demand for money. In most cases the demand for money would not change that quickly due to domestic effects. There are a few though where it can. A fall in demand for money could be caused by improvements in debt contracts which make it possible to use debt instead of money for some purposes. It could also happen because a large rise in banking fees forces people to economise on money. But, neither of these things are very likely to happen often if at all.
A rise in demand could occur due to the bursting of a foreign bubble. Let’s suppose there is a country C which uses fiat money. ABCT occurs there and there are many investors, businesses and employees affected by the bust in countries A and B. In that case those affected will demand larger balances of money in order to cope with the extra uncertainty the crisis creates. In country A the only way for the total quantity of money to rise would be if other gold were converted into monetary gold. That would only occur if the price of monetary gold rose to the degree that it became worthwhile given the costs of processing. Since these costs are high the quantity of money would not rise much. So, the prices would have to fall, and prices are sticky. Account falsification would occur in the opposite direction, indicating lower profits. All this means that means that there would be a “secondary recession”. Once the foreign shock and the recession is over then the extra uncertainty drops away, and with it the extra demand for money. So, afterwards prices would rise and there would be a short boom.
However, there would not be a secondary recession in country B. If the demand for money rose there then the price of it would rise until it because worthwhile to convert normal land into land-money. Since there is no major cost of reprocessing that would not be a large rise. The banks could buy more land from farmers when the crisis in country C occurred, lend money to customers affected, then once the crisis has passed sell the extra land back again. So, country B could weather the crisis without changes in the value of money and without recession. This is the benefit of the monetary-equilibrium type of standard has over the Rothbardian 100% gold reserve type.
These are the type of problems with Rothbardian 100% gold standards that concern me. If such a standard were established in a country with free trade and free capital movement then influences from abroad would be inevitable. Interest rates are effectively not national anymore, they are strongly affected by foreign interest rates. Investors often live in different countries from their investments, and many jobs depend on international trade. A foreign recession would affect the country that adopted 100% gold reserves. That country would then go into recession until the price level there falls. Such a recession would be inevitably larger than that in other countries where the central bank can increase the money supply to cope. This would be seen (correctly) as a failing of the 100% gold standard, in my view that would probably lead to it’s abandonment.
Hello Current.
Your comments regarding the land-money country versus the gold-money country appear to be valid mainly because there is a large surplus of land in supply not used as money in your starting assumptions. When the demand for money increases, then this results in more land being converted, which does not occur in the analagous gold situation. This appears to be because the starting industrial demand for gold is much less than the monetary demand for gold – most of the gold is sitting in vaults as money, rather than as jewelrey and so there isn’t much spare jewelrey to convert.
With your land example, who is to say that the starting position would not be that all the existing land is already securitised into tradable land titles such that additional demand for money forces the prices of land upwards in a similar way to that of gold?
However, I see the point of your analogy with respect to permitting commercial banks to operate under a fractional reserve system with no central bank. It would allow the banks to speculate on changes in the demand for money being temporary, rather than permanent, and importantly, a market in the trading of this risk would exist. This may allow adjustment to occur more smoothly. If the bank turns out to be wrong, he loses money and so is kept honest. This would appear to be a trade off against the danger that the fractional reserves causing their own instability. Howevever, it seems an odd solution to suggest that – in response to foreigners having currency systems may export ABCT shocks in part due to their fractional reserve systems, that we adopt one ourselves.
I must admit that I am with your friendst that think that full-reserving is the most ethical form of banking and also I suspect that in the trade-off mentioned above, it would bring superior results. My reasons are that through fractional reserves, you introduce an agency-principal problem in that you permit banks to speculate with the capital of others without suffering the same consequences as the owners. This is both unfair to the depositor involved and would also likely result a poor result systemically since it would likely result in inappropriate risk being taken by the bank due to an asymmetric sharing of the prospective profit versus the loss.
> Your comments regarding the land-money country versus the
> gold-money country appear to be valid mainly because there is a
> large surplus of land in supply not used as money in your
> starting assumptions. When the demand for money increases, then
> this results in more land being converted, which does not occur
> in the analagous gold situation. This appears to be because the
> starting industrial demand for gold is much less than the
> monetary demand for gold – most of the gold is sitting in vaults
> as money, rather than as jewelrey and so there isn’t much spare
> jewelrey to convert.
I’ve assumed that the country using land-money has a lot of land. This isn’t realistic, in any existing developed country the value of all the land within it’s borders wouldn’t be great enough for this to be practical.
The problem with gold is quite different. There may be much more gold in jewellery than there is in money. But, converting gold into monetary gold from jewellery is expensive (converting one type of land title into another isn’t so expensive). Jewellery would only be converted in large quantities if the price of monetary gold rose significantly.
That said, Mark Sousken once expressed the view that the problem of converting gold between various forms could be solved. He suggested that if a 100% reserve gold standard were implemented then most gold would be held in non-monetary uses. But, if the price of money rose then mines would raise production and marginal jewellery holders would sell their jewellery to be converted. This may be true, it may be that a 100% gold standard would satisfy monetary equilibrium, but that depends on many complicated empirical questions, we don’t really know.
> With your land example, who is to say that the starting position
> would not be that all the existing land is already securitised
> into tradable land titles such that additional demand for money
> forces the prices of land upwards in a similar way to that of
> gold?
In a case where land is in short supply that may happen, as I said above, in practice in developed countries I expect it would. The difference between the “land standard” I describe here and fractional-reserve free banking is that the land standard only allows one type of asset – land – to back money. Whereas FRFB allows any type of asset to back money.
There is a natural limit to conversion of illiquid assets into liquid ones. A bank has operating costs, the provision of notes and bank accounts has several costs. There is the cost of operation, the extra risk bourne by the bank and the costs of maintaining a redemption fund. The holders of bank accounts and notes pay for those cost by recieving less interest than bondholders do.
A holder of money decides upon the sum he or she holds by considering a trade-off between liquidity and interest. If a large sum of money is held then he or she can deal well with the uncertainties of life. If an opportunity to invest presents itself, or an emergency occurs then that person can respond by spending money. On the other hand, holding a large sum means forfeiting interest.
This is why under the current system which heavily subsidises holding money there are still bonds and shares.
> However, I see the point of your analogy with respect to
> permitting commercial banks to operate under a fractional reserve
> system with no central bank. It would allow the banks to
> speculate on changes in the demand for money being temporary,
> rather than permanent, and importantly, a market in the trading
> of this risk would exist. This may allow adjustment to occur more
> smoothly. If the bank turns out to be wrong, he loses money and
> so is kept honest.
Yes, that’s right.
> This would appear to be a trade off against
> the danger that the fractional reserves causing their own
> instability. Howevever, it seems an odd solution to suggest that
> – in response to foreigners having currency systems may export
> ABCT shocks in part due to their fractional reserve systems, that
> we adopt one ourselves.
Lots of people have said something similar, Jesus Heurta De Soto wrote: “It is curious to observe how the modern theorists of the Free-Banking School, like the Keynesians and the Monetarists, seem obsessed by short-term unilateral changes in the demand for money”. I would argue that these economists are interested in this subject because it is practically important. Heurta De Soto would have to place Mises in the same category because large parts of “The Theory of Money and Credit” are about this topic.
As Tyler has pointed out elsewhere, if Britain were to adopt a 100% reserve standard then bank balances would no longer support loans. Certainly, some customers would move over to using savings bond, but many need to hold bank money. So, the supplies of funds for loans would inevitably fall. This wouldn’t result in a huge rise in the rate of interest though because foreign investors would provide funds. That however, would make Britain much more subject to foreign disturbances. Britain could cut itself off from international capital markets and that may prevent the problem, but at huge cost.
There are other problems with the 100% reserve approach too. What if a technological innovation allows money to circulate faster and reduces the demand for it? In that case prices would rise, account falsification would occur and ABCT would begin. This has happened in the past, the Peel act failed because of the rise of bank accounts. Initially bank accounts were only helpful in reducing the demand for money, later they became proper money-substitutes.
> I must admit that I am with your friendst that think that
> full-reserving is the most ethical form of banking
If fractional reserve banking is done with the knowledge of the account-holder then why is it unethical?
> and also I suspect that in the trade-off mentioned above, it
> would bring superior results. My reasons are that through
> fractional reserves, you introduce an agency-principal problem in
> that you permit banks to speculate with the capital of others
> without suffering the same consequences as the owners. This is
> both unfair to the depositor involved and would also likely
> result a poor result systemically since it would likely result in
> inappropriate risk being taken by the bank due to an asymmetric
> sharing of the prospective profit versus the loss.
Consider a business like Toby’s seafood business. That business has some bailees, some creditors and some shareholders. The business keeps things for those who have bailments – it dispenses warehouse tickets and never takes possession of the assets involved. For creditors the business agrees to pay back a debt according to an agreed schedule. The shareholders own the business and take the profits. Now, this situation is certainly not symmetrical, bailees take the least risk, creditors take more and shareholder the most.
A free bank is not essentially different, the note holders and account holders are a type of creditor. Your write “you permit banks to speculate with the capital of others without suffering the same consequences as the owners.” Note that in any business the first group that take a loss are the shareholders. Creditors only take a loss if the business is bankrupt and put into recievership or liquidation.
Let’s suppose that a business, it could be a bank or another sort of business has £10 million of assets, and it has borrowed £5 million. The management are considering a risky scheme, it has a 75% chance of doubling the value of the company, and a 25% chance of bankrupting it. If the scheme succeeds then the owners own a £20 million company and only have to pay £5 million plus interest to their creditors. This is asymmetric because the creditors are taking a large share of the risk, but not sharing in the reward.
But, despite this possibility normal businesses with both creditors and shareholders work quite well. That is because this situation is what game-theorists call an “iterated game”. Each side plays it many times. The creditors learn how to discipline the shareholders, they learn not to turn up at all if the business venture is too risky.
The same would happen with free-banking. The large companies, such as multi-nationals and listed companies would force free-banks to reveal their financial positions before doing business with them. Banks would discipline each other too. Clearinghouse banks would refuse to do business with banks they considered too risky. Ordinary customers could use that as a sign of whom to trust. Or, ordinary customers could use bailment/100% reserve accounts if they don’t feel able to make a good choice.
Current,
Thank you for these comments. I must say that you make a very good case. My view is clearly coloured by what I can currently see around me wrt fractional reserves.
Given what you’ve said, the key issue in making free banking work therefore would be to make depositors aware of the risk. My underlying assumption was that the depositors would generally not be aware that their deposits were not 100% safe, but on reflection this is senseless as the implication of no central banks would be periodic bank runs and so depositors would learn pretty quickly!
Current, I suspect that you’re right about this. Thank you for the detailed explanations.
Given that you’ve thought a lot about this, and have put the case for free banking so well, would you perhaps mind telling me where you feel most uncomfortable wrt to adoption of free banking where you might concede full-reserving to be better?
> Thank you for these comments. I must say that you make a very
> good case. My view is clearly coloured by what I can currently
> see around me wrt fractional reserves.
Something that’s worth thinking about is the historic systems that didn’t use fractional reserves.
In the time of Henry VIII and Elizabeth I Britain used gold and silver coins. “Inconvertible” coinage was used, the state determined when coins were made and how many were made. When there were wars and crises the King would expand the money supply by debasing the currency. The state would gather coinage from taxes, take it to a mint then alloy it with more tin, they’d then issue more coins. The debasement carried out in Henry the Eighth’s time was so severe that Elizabeth’s government decide to reverse it by retiring the debased coinage. So, Britain was struck by a decade of inflation followed by sharp deflation.
A similar sort of thing is seen in developing countries today. Most developing countries have a “central bank” but in many cases there is little use of banking services. The economies in those places use fiat notes and coins mostly, not on bank accounts. Bank account balances form little of the money supply. The governments of those places have regularly caused huge inflation by printing huge amount of money in order to win elections or fund wars.
Certainly better 100% reserve systems could be created. A 100% reserve fiat system in a country like Britain or in the Eurozone would not be as dysfunctional as one in Zimbabwe. My point is though that fractional-reserve systems aren’t the only bad monetary regimes. Fractional-reserves and central banking are the instruments used to cause monetary chaos in developed countries, but the hand that wields them is government.
> Given what you’ve said, the key issue in making free banking
> work therefore would be to make depositors aware of the
> risk. My underlying assumption was that the depositors would
> generally not be aware that their deposits were not 100% safe,
> but on reflection this is senseless as the implication of no
> central banks would be periodic bank runs and so depositors
> would learn pretty quickly!
Yes.
It would probably take very few bank failures for people to learn. And, as I said above small depositors could learn a lot from the actions of larger depositors. If Tesco or B&Q refused to deal with particular banks then normal depositors could use that as a sign that maybe they shouldn’t either.
> Given that you’ve thought a lot about this, and have put the
> case for free banking so well, would you perhaps mind telling
> me where you feel most uncomfortable wrt to adoption of free
> banking where you might concede full-reserving to be better?
As far as I can see there are three main problems…
Firstly, the government may interfere with banking through regulations in ways that make it much less effective. This happened a great deal in the US throughout it’s history. You may have read that in the great depression thousands of banks in America went bankrupt. When I first read that I thought “why were there thousands of banks to start with?”. The reason was strict regulations on bank size. In many states banks could only operate in one town, they had to be “one room” banks. Often these were monopolies because it wasn’t worth anyone else’s while to set up a rival one-room bank in a small town. Banks with multiple branches were often outlawed. In some other places a bank had to operate only within one county. This made banks small and unstable. Small banks can’t plan for the future like large banks can.
The most important regulatory problem today is insider-trading laws. The management of companies have large legal scope to hide information about problems from their shareholders, who are the company owners, and other interested parties such as creditors. In my view these laws are harmful in all industries, but they are particularly problematic in banking because whistleblowing over bad-debt is very useful to shareholders and creditors. Because of the long-term nature of loans bank management can easily abuse their position. Kevin Dowd has suggested that the only answer to this is to prevent limited liabilities banks and force all banks to be unlimited liability partnerships. I don’t think it’s necessary to go that far. Insider trading laws could also inhibit 100% reserve free banks too.
The second problem is bankruptcy. During the Great Depression the money supply contracted sharply after the collapse in 1933 of the thousands of bank I mention above. Superficially this looks like an obvious flaw. If a bank collapses then it’s bank accounts cease to be money substitutes, so the money supply falls. But, the real problem here is the liquidation procedure, which is a form of temporary nationalization. The bankrupt bank has assets including reserves and loans. Once through the liquidation procedure the good assets will be sold to other banks, so those other banks can use them to expand the money supply to it’s previous level. When GM went bankrupt the supply of cars was not interrupted because the bankruptcy procedure was quick and in three weeks the “new GM” was formed. Let’s suppose we have free-banking and a bank the size of RBS fails. Maybe free-banking would never produce a bank that size, but let’s suppose it did. In that case the money supply would drop during the liquidation period. There are several ways this could be dealt with. One possible solution would be for the government to require that banks must file detailed documents explaining how to “disassemble” themselves every month or so. (It would be best if the bank were required to file these documents with people who would examine them closely, such as shareholders, big creditors and other big counterparties rather than with a regulator). Then if a bankruptcy did occur the appointed administrator would have a guide to act on quickly. Dowd has suggested that on bankruptcy the ownership of banks should switch immediately to their creditors. That would mean that account holders would immediately become shareholders. I’m not sure that would really help.
The final problem, and probably the worst is the potential for government bailouts. Banks may continue to be “too big to fail”. The failure of a large bank with very many depositors may be too big a political issue for governments to ignore. That means that large banks may take risks as they do today, in the knowledge that they have implicit backing from government. As with the issue of money supply the solution may be quicker liquidation procedures. Free banking couldn’t really survive in an socialist leaning society where arbitrary bailouts are seen as acceptable.
Tim, don’t get too carried away in support of fractional reserve free banking here. Whilst it is far, far better than central bank FR banking, the FRFB School have not addressed these issues which I summarize as time constrains me;
Legal and Accounting Privilege: The Balance Sheet and Contract Law Problem
It relies on legal and accounting privilege to get off the ground in the idealised world of the Free Banking School.
Accounting
It requires a different accounting standard to all other businesses in the world to not provide liquidity for their current creditors. This allows the maturity mis matching , borrowing short and lending long. The butcher, the baker and the candle stick maker can’t do this, a bank can. This sets a bank up in a unique way with a gigantic competitive advantage to a normal commercial operation as it has substantially more resource at its disposal to then compete resources away from others. Only today, I was with a very senior partner at PWC who was telling me that now the banks are back in business, they are significantly competing away at the graduate recruitment level, where the London office needs 1,000 graduates per year and the banks can simply pay more. This means that the playing field is not that of a free market. It is odd that the Free Banking School call themselves free market people when their system needs PRIVILEGE to get it up and running in the first place.
The solution is to have free banks audited to the same standard as any other commercial organisation. If this is the case, they need to maturity match like any other commercial organisation. This means short borrowing with short lending, long with long, medium with medium etc. In fact, call a spade a spade, a free bank, working within the commercial law, can only ever be a full reserve bank. Just like a solvent company is always a full reserve company – other than a bank!
No one in the free banking School has answered this critique. Either it is not credible, then fine, tell me why, or the onus is for this to be disproved.
The Option Clause
If a FRFB did offer all parties who wanted a demand deposit in which they knew their property title was pooled to get a greater return and should all want cash back at once then an option clause would be exercised in effect forcing a depositor to become fully reserved against an illiquid asset, that may become liquid shortly, I would not have a problem with this. In effect, you would have full reserve banking as the option clause itself is recognition that you are fully reserved (and illiquid) at the will of the bank. I am also confident that if this type of banking was done in legal isolation from the lending of savings and safe deposit keeping, then I can see no problem with it. Certainly if the same accounting standard of audit are applied to its balance sheet. If I in business could not pay all my short term liabilities as and when they fell due, to get my annual audit signed off (going concern test look fwd test for the next 12 months), I would have to write to each of my creditors getting a waiver that they would not demand payment, essentially realigning my maturity matching profile, i.e., rescheduling my maturity profile to be a matched profile or fully reserved. What is good for me and all other commercial organisations except banks should be applied to free banks. This means they are to all intents and purposes, full reserve entities.
Contract Law
At best there is confusion in what a depositor thinks or does not think is going on with his / her deposit. The banks do not tell you they own the deposit and owe you a legal obligation to pay. I have show the case law for this on this site. You are regular readers. I hope you have seen. Clarity in making sure the first test of a valid contract needs to take place. This “meeting of the minds” test should be applied to banking, as I would see it a free bank could offer the following;
1. Safe deposit account or custodial account. Full Reserved.
2. Saving timed deposit account. Full Reserved.
3. “Fractional” Account. If no legal privilege and law of contract principles applied that we all in the commercial world have to work to, in effect it is a full reserve account only with maturity matching taking place.
Monetary Equilibrium Theory
This is very eloquent it is better that the Fisher style QT. None of the practitioners of it create wealth. Wealth is about more goods and services with a better use of the factors of production used more efficiently over time to serve the needs of customers etc. Money facilitates the final exchange of these goods and services. When a money demand is adjusted for, if new money is put into the system via a free bank it will cause an exchange of nothing, the paper or electronic digit etc, for real goods and services. This is called counterfeiting. So for me it fails at this hurdle. There is no way around it is a counterfeiting theory.
Current, you are a big fan of MET. I like it alot, bit it falls at the end as far as I can see.
FRFB is a great contribution to the debate by very eminent scholars. I do not aim to compete with their knowledge but as a particle wealth creator in the economy who is alive to these issues and seeks the truth, I see failings.
I think a middle ground can be draws between the FRFB and the Free Bankers by lifting banks fully out of legal and accounting privilege and making them obey laws that we do. With correct labelling and information, free banks will be maturity matchers (full reserve) just like all other companies.
As a lover of freedom and a hater of one class having privilege over another as the FRFB School inadvertently advocate, I could never endorse the work of FRFB’s fully.
Nutty Talk
FRFB School supporters use very odd examples to try to explain their case as to why other parts of the world of commerce are not full reserve. Two common confusions I have talked about before.
Do Grain Store Examples Shed any Useful Light into this Debate?
I am often told by advocates of Fractional Reserve Free Banking that banking is like a grain store. That if ten tons were to be deposited by one man who took a certificate from the store holder explicitly stating that the store will be lending 9 ton of the grain out to bread makers in exchange for the original depositor not having to pay for the storage, or even being paid to store there – what would be wrong with this? Also, it would tell me under what time period my grain would be being used by others, and when I could get my grain back. Well, the answer is nothing at all as the contract is explicit – except that I will never get my grain back at all as it is being consumed by someone else. I will never get it back!
Grain examples should be avoided, for they certainly do not stack up.
What is the Difference Between a Fractional Reserve Contract and a House Insurance Contract?
With my house insurance, I pay, not loan, money to an insurance company in exchange for the right to a policy, my consumable item if you like, with the explicit knowledge that they are hoping to charge me and all the other policy holders more than they would pay out in the eventuality of a disaster that I am trying to insure against. There is a small risk that the insurance company will get its sums wrong and not be able to pay me out in full or at all. The policy tells me this.
With a deposit contract, I think I am depositing for custody and safe keeping and only the enlightened few know they are loaning their forgone purchasing power i.e. money to the bank.
So insurance is paying for a product that you consume by virtue of holding the policy for its life time. You know that there is a small risk that you may not get 100% of what you have bought.
With banking, you loan your purchasing power with the overwhelming people doing this in ignorance of what they have committed to. The vast majority expect to have the quiet and peaceful enjoyment of their purchasing power at their convenience and do not deposit in the knowledge that there may be wholesale default.
Thank you Current and thank you Toby for taking the time to explain your points of view at such length. It’s really very much appreciated.
I’m unable to contribute anything in addition. I’ll read and digest.
Toby – may I suggest this as an excellent thread for anyone interested in the debate between free banking and fully-reserved banking. I don’t know whether it is possible to highight it in any way on the site – it would be a shame after all the work that the two of you have put in for it to end up buried.
Toby, some of the following I’ve explained in simple terms. I know you could follow it if I used more jargon. I’ve written it this way so Tim and others can understand it…
> Legal and Accounting Privilege: The Balance Sheet and Contract Law
> Problem
>
> It relies on legal and accounting privilege to get off the ground in
> the idealised world of the Free Banking School.
>
> Accounting
>
> It requires a different accounting standard to all other businesses
> in the world to not provide liquidity for their current
> creditors. This allows the maturity mis matching , borrowing short
> and lending long. The butcher, the baker and the candle stick maker
> can’t do this, a bank can. This sets a bank up in a unique way with
> a gigantic competitive advantage to a normal commercial operation as
> it has substantially more resource at its disposal to then compete
> resources away from others. Only today, I was with a very senior
> partner at PWC who was telling me that now the banks are back in
> business, they are significantly competing away at the graduate
> recruitment level, where the London office needs 1,000 graduates per
> year and the banks can simply pay more. This means that the playing
> field is not that of a free market. It is odd that the Free Banking
> School call themselves free market people when their system needs
> PRIVILEGE to get it up and running in the first place.
>
> The solution is to have free banks audited to the same standard as
> any other commercial organisation. If this is the case, they need to
> maturity match like any other commercial organisation. This means
> short borrowing with short lending, long with long, medium with
> medium etc. In fact, call a spade a spade, a free bank, working
> within the commercial law, can only ever be a full reserve
> bank. Just like a solvent company is always a full reserve company –
> other than a bank!
>
> No one in the free banking School has answered this critique. Either
> it is not credible, then fine, tell me why, or the onus is for this
> to be disproved.
Firstly, we must be clear about what maturity mismatching is. Maturity mismatching is not directly connected to debts that are payable on demand. Debts payable on demand are mearly one sort of maturity mismatching. Let’s suppose that I borrow 100 ounces of gold from Tom and agree to pay it back with interest in two yeasr. I then lend 90 ounces of gold to Jill, she agrees to pay me back in three years. So, the schedule of my lending in longer than that of my borrowing. That means that I must find someone else to lend me 100 ounces of gold to pay back Tom, to cover the time until Jill pays me. This is not illegal, but I must do two things. I must not misrepresent myself to any party, and I must be able to show that I had good reason to think that I would be able to role-over my debt.
The accounting issue Toby is talking about here is a bit different. Accounting rules require that for a company to be legally solvent it must be able to pay short term debts. It must be able to cover “current liabilities”. The principle behind this idea is that a business must be able to pay it’s debts and other commitments as they become due. In my opinion this doesn’t mean what Toby thinks it means.
Let’s suppose that I own a small shop. In that shop, if I were careless while washing the floor, someone could slip and fall. If they did I would have to pay damages. Those damages could put me out of business. Let’s suppose that hasn’t happened, does the possibility of it happening make a difference to my accounts? Let’s suppose I don’t have enough short-term assets to deal with being sued, does that mean that I can’t cover my current liabilities? I would argue that the answer is no. The probability of such an accident occurring is low and that must be taken into account.
The same principle applies to banks. There could only be one reason for forcing a bank to keep enough liquid assets to cover all of it’s liabilities from current accounts: a reasonable probability that that would be necessary. It would only be necessary if it were likely that a large proportion of account holders were to withdraw large sums or close their accounts, but that isn’t likely for a bank. In banks planners monitor the use of accounts and monitor redemptions. They estimate the amount of the reserve asset that will be needed at a given time to pay customers and use in transfers. In the old days the reserve asset was gold, now it’s fiat money, but in both cases the principle is similar.
The situation is different for a normal business. For a non-banking business it would be quite normal for counterparties to exercise their right to payment when it comes due. That’s because the liabilities of normal businesses don’t fulfill a service to their customers. If I have an account with Mises.org with £200 in it then I can use that to buy books on Austrian economics, but that’s about all. If I have an account with RBS then I can use that for a wider range of purposes.
The insurance industry is in a similar position to the banking industry. A company could insure 20000 houses against fire, one day
all of those houses could burn down. That doesn’t mean though that the company must keep assets to the value of all 20000 houses in reserve, if it did then insurance would be impossible. It means that the insurer must keep a prudent amount of funds available, how much that is depends on the circumstances, just like a bank’s redemption fund. Neither insurance companies, nor banks, use a special legal privelege.
Since Toby brought up insurance later I’m going to discuss it here…
> What is the Difference Between a Fractional Reserve Contract and a
> House Insurance Contract?
>
> With my house insurance, I pay, not loan, money to an insurance
> company in exchange for the right to a policy, my consumable item if
> you like, with the explicit knowledge that they are hoping to charge
> me and all the other policy holders more than they would pay out in
> the eventuality of a disaster that I am trying to insure
> against. There is a small risk that the insurance company will get
> its sums wrong and not be able to pay me out in full or at all. The
> policy tells me this.
>
> With a deposit contract, I think I am depositing for custody and
> safe keeping and only the enlightened few know they are loaning
> their forgone purchasing power i.e. money to the bank.
>
> So insurance is paying for a product that you consume by virtue of
> holding the policy for its life time. You know that there is a small
> risk that you may not get 100% of what you have bought.
>
> With banking, you loan your purchasing power with the overwhelming
> people doing this in ignorance of what they have committed to. The
> vast majority expect to have the quiet and peaceful enjoyment of
> their purchasing power at their convenience and do not deposit in
> the knowledge that there may be wholesale default.
Here Toby point to public ignorance about the nature of bank accounts. I think that the public should be told the legal status of their current accounts. The law should require banks to tell customers explicitly that their account is a loan to the bank. (It may be a good idea to ban the word “deposit” too).
The fact that modern banks are cagey about this is not related to the comparison between banking and insurance. The comparison I make above would stand if banks were completely clear about the nature of accounts.
All of this is closely related to the “grain elevator” discussion…
> Nutty Talk
>
> FRFB School supporters use very odd examples to try to explain their
> case as to why other parts of the world of commerce are not full
> reserve. Two common confusions I have talked about before.
>
> Do Grain Store Examples Shed any Useful Light into this Debate?
>
> I am often told by advocates of Fractional Reserve Free Banking that
> banking is like a grain store. That if ten tons were to be deposited
> by one man who took a certificate from the store holder explicitly
> stating that the store will be lending 9 ton of the grain out to
> bread makers in exchange for the original depositor not having to
> pay for the storage, or even being paid to store there – what would
> be wrong with this? Also, it would tell me under what time period my
> grain would be being used by others, and when I could get my grain
> back. Well, the answer is nothing at all as the contract is explicit
> – except that I will never get my grain back at all as it is being
> consumed by someone else. I will never get it back!
> Grain examples should be avoided, for they certainly do not stack
> up.
We didn’t invent the grain elevator example, it comes from Rothbard’s book “The Case Against the Fed”. We talk about them because Rothbardian’s talk about them. I agree that it doesn’t shed much light on the situation because a grain store is not like a bank.
The key problem is that a grain store is a different kind of service than a bank. A grain store provides storage services. A bank doesn’t primarily provide money storage services – it provides banking services. However, discussing other types of company does sometimes shed light on the discussion.
> The Option Clause
>
> If a FRFB did offer all parties who wanted a demand deposit in which
> they knew their property title was pooled
That’s not quite what happens. In FRFB the current account holder gives his property to the bank in exchange for a current account balance or banknote. That current account balance or banknote is a type of debt certificate. All of the bank’s assets are owned by the bank, the account holder surrenders ownership of them when he lodges them in his account.
> to get a greater return
> and should all want cash back at once then an option clause would be
> exercised in effect forcing a depositor to become fully reserved
> against an illiquid asset, that may become liquid shortly, I would
> not have a problem with this. In effect, you would have full reserve
> banking as the option clause itself is recognition that you are
> fully reserved (and illiquid) at the will of the bank. I am also
> confident that if this type of banking was done in legal isolation
> from the lending of savings and safe deposit keeping, then I can see
> no problem with it. Certainly if the same accounting standard of
> audit are applied to its balance sheet. If I in business could not
> pay all my short term liabilities as and when they fell due, to get
> my annual audit signed off (going concern test look fwd test for the
> next 12 months), I would have to write to each of my creditors
> getting a waiver that they would not demand payment, essentially
> realigning my maturity matching profile, i.e., rescheduling my
> maturity profile to be a matched profile or fully reserved. What is
> good for me and all other commercial organisations except banks
> should be applied to free banks. This means they are to all intents
> and purposes, full reserve entities.
I’m not sure I understand this.
An option clause gives a bank’s planners a safety strategy. Let’s suppose we have a gold standard. If the bank doesn’t have enough gold in it’s redemption fund to serve a customer’s request then the bank can offer a debt contract instead. If my bank can’t pay me 100 ounces of gold when I ask for it then the bank has the option to offer me a certificate promising to pay 115 ounces in a years time. The interest rate must be high because otherwise I wouldn’t agree to the option clause in the first place.
Like any other liability the bank must have assets to cover it. On it’s balance sheet the bank must have a larger sum of assets than liabilities, if it doesn’t then it’s insolvent. The option clause doesn’t really make much difference to this. A note without an option clause is still a debt.
Certainly option clauses add some extra safety to fractional reserve banking. That said, banks have very rarely used the option.
> Monetary Equilibrium Theory
>
> This is very eloquent it is better that the Fisher style QT. None of
> the practitioners of it create wealth. Wealth is about more goods
> and services with a better use of the factors of production used
> more efficiently over time to serve the needs of customers
> etc. Money facilitates the final exchange of these goods and
> services. When a money demand is adjusted for, if new money is put
> into the system via a free bank it will cause an exchange of
> nothing, the paper or electronic digit etc, for real goods and
> services. This is called counterfeiting. So for me it fails at this
> hurdle. There is no way around it is a counterfeiting theory.
A loan doesn’t create any wealth. However, that doesn’t mean that a loan is an exchange of “something” for “nothing”.
Let’s suppose that we have a gold standard. For example, lets consider the balance sheet of a free bank. It has the following assets:
* 1. 1000 ounces of gold – the redemption fund or reserve.
* 2. Long-term mortgages worth a combined value of 10000 gold ounces.
* Total 11000 gold ounces.
It has the following liabilities:
* 3. Long-term bonds payable to bond holders with a combined value of 2000 gold ounces.
* 4. Current account balances redeemable on demand with a combined value of 8000 gold ounces.
* Total 10000 gold ounces.
Suppose that this bank wants to increase it’s current account balances by 3000 ounces. Can it simply do that without doing anything else? No, it can’t. The bank must have a corresponding asset, it must find borrowers that want loans and will pay them back, and it must also find more gold for it’s redemption fund. Except for very short term loans like overdrafts, the borrowers must put up assets as collateral.
> FRFB is a great contribution to the debate by very eminent
> scholars. I do not aim to compete with their knowledge but as a
> particle wealth creator in the economy who is alive to these issues
> and seeks the truth, I see failings.
>
> I think a middle ground can be draws between the FRFB and the Free
> Bankers by lifting banks fully out of legal and accounting privilege
> and making them obey laws that we do. With correct labelling and
> information, free banks will be maturity matchers (full reserve)
> just like all other companies.
>
> As a lover of freedom and a hater of one class having privilege over
> another as the FRFB School inadvertently advocate, I could never
> endorse the work of FRFB’s fully.
Banks certainly do enjoy certain legal privileges today, like you I disagree with that. But, as I said above I don’t think that keeping fractional reserves is really a special legal privilege.
Hi Toby – I’m confused as to what is actually meant by duration matching also.
Would you insist that a company’s loan should always be fully-amortising throughout its life? If not, if a largely debt-financed company’s loan comes due within a year, how would this be dealt with under the system that you envisage. Would you say that this company was technically insolvent despite the fact that could
a) renegotiate a new debt contract
b) potentially sell some long-term assets in order to cover the loan
If you don’t insist on fully-ammortising loans, how would this situation be technically any different from that of a fractional reserve bank other than in terms of magnitude? After-all, the FR bank has long term assets it could sell, and some degree of equity.
Are you sure that the injustices that you point out do not in reality stem from the existance of the central bank rather than the fractional reserve?
Okay – here ends my brief flirtation with free banking. Thank you Current, and thank you Toby, but I think Toby is right.
At the heart of this, we don’t want an entity able to create multiple bits of paper all maquerading as the same bit of money. Under a free banking system with perfect information where everyone knew every banks’ positions all the time, the rational response to a free bank operating fractional reserves would be for customers to put an appropriate discount on every note such that the potential for fractional reserving would not even occur.
However, the system does not have perfect information, banks act in their own interests, they would create money sustitutes and people wouldn’t really know about how much they’d create nor probably pay much attention until it hit them in the face. Much easier -therefore – just to tighten up on property law and – as Toby says “call a spade a spade”.
However, I am still a little confused about the requirement for duration matching, Toby. If a bank – for example – borrows short and lends long under a fully-reserved system, then when the short loan to the bank expires, the bank merely has to find another creditor – perhaps at a differnt price. There has been no expansion of the money supply, and the bank is fully-reserved. The bank could still go bust if it cannot find another creditor, but their has been no fraud during this process. Hence, banks can still perform the useful task of duration transformation. Seem reasonable?
Finally, I would note that the normal likely interest rate structure would probably be very flat across time – there’d be a bit due to liquidity preference- but without the central bank supporting the short end, the normal process of lending long and borrowing short would probably not be very profitable.
By the way, these subjects are being discussed over at the Coordination problem blog:
http://www.coordinationproblem.org/2010/09/steve-horwitz-larry-white-and-george-selgin-what-is-wrong-with-this-proposal-for-bank-reform.html
> Okay – here ends my brief flirtation with free banking. Thank
> you Current, and thank you Toby, but I think Toby is right.
It was a brief romance.
> At the heart of this, we don’t want an entity able to create
> multiple bits of paper all maquerading as the same bit of
> money.
That’s a very Rothbardian view of things. In my view when a bank gives out a set of banknotes those notes are money if they are accepted by the market as such. They are only “masquerading” as something they aren’t if market participants have been led to believe that 100% reserve banking is going on when it isn’t.
> Under a free banking system with perfect information
> where everyone knew every banks’ positions all the time, the
> rational response to a free bank operating fractional reserves
> would be for customers to put an appropriate discount on every
> note such that the potential for fractional reserving would not
> even occur.
No it wouldn’t be, think about it a bit more.
I understand the logic behind this. Let’s suppose I have a gold coin containing 10 ounces of gold, and a bank balance for 10 ounces of gold. The bank has a finite chance of going bankrupt, let’s suppose I estimate that as 0.1%. The logic then follows that I shouldn’t value my 10 ounce bank balance at 10 ounces, but rather at 9.99 ounces.
But, my bank offers me banking services, it isn’t simply a warehouse. I can setup payments to other parties such as standing order and direct debits. The account may pay interest too. Those benefits must compensate me for the extra risk. If they didn’t then I wouldn’t deposit.
Historically there have been many times and places where banks have been well known to be fractional-reserve institutions. Customers have used them anyway, and valued the services they provide as sufficient compensation for the slightly extra risk.
> However, the system does not have perfect information, banks
> act in their own interests, they would create money sustitutes
> and people wouldn’t really know about how much they’d create
> nor probably pay much attention until it hit them in the
> face.
When I talk to people who have read about Austrian economics they always presume that any business is interested in maintaining it’s own solvency, except banks?
Why do you think banks different from other businesses? What is it about them that means that their owners do not have a self-interested motivation to maintain a good balance sheet?
If banks really are afflicted with this problem then why do Rothbardians propose to continue to allow timed savings? Why shouldn’t a bank offering timed-savings products such as bonds offer more of them than is prudent?
> Much easier -therefore – just to tighten up on property
> law and – as Toby says “call a spade a spade”.
In what way is 100% reserve banking “calling a spade a spade”?
What the 100% reserve side propose is much more than “tightening” property rights. Historically banknotes and current accounts have almost always been debts. That was a choice of the market. At the beginnings of banking customers could have choosen 100% reserves, but they didn’t. (The Bank of Amsterdam did use 100% reserves for a while, it was a government run institution though).
What the 100% reserve side really propose is to ban the use of debt-titles as money. This isn’t a tightening of property law, it’s a law that prefers one type of title – a property title – over another type – a debt title. It should be noted that it’s a very un-libertarian idea and runs against the rest of Rothbard’s views.
> However, I am still a little confused about the requirement for
> duration matching, Toby. If a bank – for example – borrows
> short and lends long under a fully-reserved system, then when
> the short loan to the bank expires, the bank merely has to find
> another creditor – perhaps at a differnt price. There has been
> no expansion of the money supply, and the bank is
> fully-reserved. The bank could still go bust if it cannot find
> another creditor, but their has been no fraud during this
> process. Hence, banks can still perform the useful task of
> duration transformation. Seem reasonable?
I certainly agree with you about that.
> Finally, I would note that the normal likely interest rate
> structure would probably be very flat across time – there’d be
> a bit due to liquidity preference- but without the central bank
> supporting the short end, the normal process of lending long
> and borrowing short would probably not be very profitable.
It may not be as profitable as it is now. But, think about the situation of ordinary people, they provide a lot of the world’s savings. For many people tying up wealth in a bond for more than one or two years is difficult. They don’t know what will have happened in that time, they may need the money. I was faced with this problem myself a couple of years ago. I decided to put my money in one year and 18 month bonds rather than three or four year bonds because I couldn’t clearly estimate my financial situation in the future. Under any monetary system maturity mismatching is necessary.
> Okay – here ends my brief flirtation with free banking. Thank
> you Current, and thank you Toby, but I think Toby is right.
It was a brief romance.
Ah Current – you make me laugh!
Perhaps I need time and few non-economics books and to mull over this problem a little longer. I’ll follow the debate on the other blog that you suggest. Thanks very much for all the help.
@Tim Lucas & Current
Just to let you know I have been following this thread and found it very informative. I think you have together managed to focus attention on the issue of maturity transformation (nb: maturiy mismatching is a value-loaded term that I don’t like using, but we mean the same thing) which deserves more attention. Especially since it has been seperated from the issue of fractional reserves by Howden and Bagus:
http://blog.mises.org/11398/the-legitimacy-of-loan-maturity-mismatching-bagus-howden-vs-barnett-block/
Thank you to you both for such a civil and enlightening discussion
aje
I’m glad you enjoyed reading. Thank you for the link on the mises site.
It strikes me an excessive number of words have been employed above failing to answer the original question that Toby asked: “how creating money is supposed to create wealth.” Here is my answer.
I think we’ve all tumbled to the fact that a country cannot grow rich just by printing bits of paper with £20 or $20 imprinted in them. However, every economy (larger than desert islands with three families on them) benefits from some form of money. There is also an optimum amount of money. When amount is inadequate, unemployment ensues. When the quantity is excessive, inflation ensues. At the moment we have excess unemployment – certainly in the U.S. In contrast, in the U.K. inflation is more of a problem.
Therefor it is good idea to print extra money – certainly in the U.S. Extra money (assuming it is in the hands of the consumer) induces the consumer to buy extra stuff, which creates extra jobs.
The only problem is that the idiots in power do not seem to have tumbled to the fact that it is Main Street rather than the criminals and fraudsters in Wall Street that need the extra spending power. Evans-Pritchard does not seem to get this point either. Having said that, QE (i.e. stuffing the pockets of the wealthy) WILL have a finite effect. But to repeat, it’s Main Street that needs the extra money. Half of Main Steet is underwater. That’s why Main Steet is not spending. Doh (as Bart Simpson would say).
Ralph,
The view that you give is old-fashioned Keynesianism or post-Keynesianism.
First and foremost, I agree that there can be an “optimum quantity of money”. But, I don’t agree with your view of what it is.
Let’s suppose that price inflation has been 3% per year for several years. In that case prices will be aligned with that trend. Loans and job contracts will take into account that trend. Now, let’s suppose there is a crisis and recession, as there has been. The basic logic of inflation targeting is that the central bank should maintain the price inflation rate. If this occurs then costly adjustments don’t have to be made. As you point out, if the inflation rate falls away from the long run price level trend then unemployment ensues. There are various reasons why that happens. Austrian economists would point to what is called “account falsification”, which is a more general form of “money illusion”.
I don’t know if you are arguing the monetary policy should be used to get inflation back to the long term trend, or if central banks should go beyond that trend. Certainly the central banks should not go above the trend, if they were to do so then that would come with it’s own adjustment costs. The Austrian theory of the business cycle is essentially about this.
The policy of inflation targeting is something that central banks have been claiming to do since Wicksell suggested it at the end of the 19th century. The problem though is that nobody believes them. Central banks could probably target NGDP or MV and that could result in a long-term stable price trend but there are three problems. Firstly, as George Selgin has pointed out the most trouble free trend would be a negative one. Secondly, GDP constituents are not the only traded goods and services, there are also many others. Thirdly, and most importantly the central banks will always be affected by political considerations. That means that their behaviour or policies can never be relied upon. They may create too much money and cause ABCT, as I would argue they did before the recent crisis.
Can that be remedied by creating money? Well, it would certainly help in the medium-term if the price level went back to its trend (though it would be better in the long term to change the trend as Selgin argues). But, that cannot remove all unemployment because much of the unemployment is structural. Human capital was misallocated in the boom, we have the problem of “recalculation” that Arnold Kling often discusses.
The central bank may also not be able to bring price inflation back to trend because it has limited tools at it’s disposal. The fed isn’t helping main street because it can’t do so. It must work through the commercial banks. That however is a very necessary limitation. The incentive that governments have to inflate becomes much stronger if they can spend the created money. Central banking is acceptable to markets precisely because the commercial banks loan the money into existence. So, the political benefit from money creation is limited to being indirect.
The markets know this, that is why if what you suggest were done it would not work and has not worked historically. If the state directly created money then capitalists and investors would not trust it to stop when the price level reached a particular goal. Similarly, when governments borrow money to perform “Keynesian Stimulus” the markets are quite aware that it is unlikely that they will run budget surpluses later to pay the debt off. So, investors expect future tax rates to be higher, or that debasement or default will occur in the future. That causes a “flight to quality” which normally means investors buy things like gold.
This is the paradox of all bureaucracies. If the bureaucrat is made to obey fixed rules then his effectiveness is limited. But, if he’s given discretion nobody trusts him not to use it for his own ends.
Current, I’ll answer some of your points.
You ask “I don’t know if you are arguing the monetary policy should be used to get inflation back to the long term trend, or if central banks should go beyond that trend.” The answer is that I don’t think inflation should go above trend, or the 2 to 3% target.
Next, your point that “….much of the unemployment is structural. Human capital was misallocated in the boom, we have the problem of “recalculation” that Arnold Kling often discusses.”
I am aware that some unemployment is structural (plus some is frictional) and that unemployment can never to reduced to zero. The only exception to the latter zero unemployment point would be if one put all the unemployed onto very unproductive “make work” schemes, and called that “employment”.
Re the structural element in unemployment resulting from the recent house price boom, I had a look at this, e.g. I looked at what proportion of the unemployed in the U.S. are ex-construction workers, etc. My conclusion is that there is a bit of a problem here, but not a huge problem. For more details, see one of my blog post on this subject at:
http://ralphanomics.blogspot.com/2010/09/von-mises-and-whether-us-unemployment.html
Re your point that central banks cannot be relied on because they are subject to political forces, my reaction is “then what’s the solution to this problem?”. The whole idea of central banks is to keep politicians away from the printing press. And that’s about the best we can do, seems to me.
Also, while I’m in favour of independent central banks, there is not actually much evidence that they make much difference, if one of Bill Mitchell’s recent blog posts is anything to go by. This shows a chart which shows no relationship between central bank independence and inflation:
http://bilbo.economicoutlook.net/blog/?p=9922
Your final three paragraphs rather portray central banks and governments as irresponsible, while commercial banks are apparently almost beyond reproach. I suggest that it was commercial banks which nearly brought the entire world economy crashing down recently with their totally irresponsible NINJA mortages, SIVs, CDOs, and other clever clever stuff.
We have to choose between various evils. My favourite “evil” is relatively independent central bank, which CAN when it sees fit create extra money and let government spend that money. And that system, as you rightly point out, WILL go wrong at some point in some country or other.
Re maturity transformation, I set out my ideas on why this is undesirable here, if anyone is interested:
http://ralphanomics.blogspot.com/2010/09/flaw-in-maturity-transformation.html
Briefly, the argument is that borrowing and investment are optimised when the benefits of borrowing and investment equal the pain or disutility of the consumption forgone in order to fund the borrowing and investment. That optimisation will occur when those forgoing consumption know what they are doing. E.g. if all investments expected to last 10 years are funded by people who willingly and knowingly lock up their money for 10 years, then optimisation occurs.
However, maturity transformation enables borrowers and investors to get their hands on short term deposits and spend the money concerned. That results in a rise in aggregate demand. Assuming the economy is at capacity, that in turn means government has to rein in demand (e.g. spend less on health or raise taxes). And that in turn means that health service employees and customers plus taxpayers make sacrifices to enable the above “more than optimum” borrowing and investment.
That there has been “more than optimum” borrowing and investment is hardly in dispute in view of NINJA mortgages.