My latest article for the IEA:
The Austrian school agrees that monetary policy errors were the cause of the recession, but believes that these errors were made long before 2008. Indeed years of artificially low interest rates led to an unsustainable boom and widespread misallocations of capital (manifesting themselves largely in the housing industry). Due to this disruption in economic coordination a recession was inevitable, and the best hope for monetary policy was that it prevented the ‘primary recession’ caused by the bubble unwinding turning into a “secondary recession” that sucked in the whole economy.
When this branch of the Austrian School suggests a monetary injection to offset a change in money demand, they should always be wary that this may well have a chance to stabilise the nominal price level, this has in itself nothing to do with realigning the structure of production so that entrepreneurs are making the goods and services in the right amounts at the right time to create a recovery. Perversely , this money injection may well distort the production structure further and create more miss allocation of resources as there would appear to be more spending in the economy, laying the foundations for an elongation of the recession.
I would also be interested to know if when a free bank issues new IOU’s to accommodate a rise in demand to hold money , or a fall in the desire to spend on goods and services , is it not putting purchasing power in the hands of the select few at the expense of the masses as they can spend and get real goods and services exchanged for newly minted bank IOU’s. Is this no different to counterfeiting?
Also , in the very real example of this current crisis, what makes you think a free bank would want to issue new bank liabilities to business that does not have the customers it used to? I suspect no accommodation would ever be met.
Does this branch of the Austrian School think that creating new bank IOU’s will create wealth?
Finally , would this branch of Austrian Economics support the QE1 and or the QEII program of QE?
Toby – I suggest you read/re-read Steve Horwitz’s “Microfoundations and Macroeconomics”, George Selgin’s “Less than Zero” and Larry White’s “Free Banking in Britain” since these issues are discussed extensively.
I don’t think the aim is “stabilising the nominal price level” – if you read the article I refer to nominal *income*.
Steve and George have commented publicly on QE so you should read what they have to say for themselves [e.g. http://www.coordinationproblem.org/2011/01/qe1-and-monetary-disequilibrium.html%5D, but in a nutshell:
Does this branch of the Austrian School think that creating new bank IOU’s will create wealth?
No – see the debate between Robert Sadler and Current on this site [https://www.cobdencentre.org/2011/02/the-crime-known-as-quantitative-easing/]. I am not aware of any Austrian economist claim that QE creates wealth. Rather, they claim that it *may* prevent the unnecessary destruction of wealth, which would occur if a monetary deflation were permitted.
would this branch of Austrian Economics support the QE1 and or the QEII program of QE?
I think that’s too simplistic a question – you need to actually engage with what individual people argue, rather than lumping them together and attributing the exact same policy outlook. If you read my IEA article I try to address this point directly – that QE1 might work in theory but is almost certain to fail in practice. I think most would argue that the case for a monetary expansion was greater in Summer 2008 than it is now. I have written a number of articles criticising QE and QEII that have appeared on this website (for example http://www.adamsmith.org/think-piece/finance/the-threat-of-qe2/).
Note that QE is a tool to achieve a specific objective. People shouldn’t confuse a debate about the tool with one about the objective.
Ok, so we are going to go around in circles again.
So the purpose is to stabalise nominal income not the general price level. Why? What is the purpose of this? What do advocates of this hope to achieve . Shall we seek to stabalise the income level of the apple farmers?
Wealth is goods and services, money in exchange is the final good that represents what is being traded. More money units in the situation of an increase in demand to hold cash will mean that the same goods and services offered by suppliers to those people demanding goods and services will now have more money units chasing the goods and services (increase in price level if spent) So is the idea that a confidence trick is played on people to try to hold up nominal income ( if that is achieved then the price level has not fallen) to keep spending moving to by the goods and services offered and hope that what ever has caused the demand to hold
more money blows away.
What is the selection criteria for the lucky few people who get the new minted purchasing power at the expense of others?
Not wanting a money deflation is a good motive indeed. The destructions of wealth that takes place brings misery for most. The masses loose for sure.
Playing a trick on people after the act by giving more credit or bank IOU’s is never going to deal with the initial cause: too much credit created in the first place. This will not re instate a new more favourable money demand level that tricks people to buying more goods and services than they want. New false demand and supply ratios are made during the boom period and sadly for all, some such Lehman style big event reveals these false signals and a new and more appropriate money demand level is set. Creating more bank IOU’s and attepmting to trick people into spending is like taking the horse to water and saying “drink horse” and it does not want to.
This disequilibrium theory does still not do it for me.
As said and not answered, I think it would also be potentially very dangerous and distorting to the structure of production.
Also, as said above, I doubt if free banks would lend. Is there any evidence in the past that they did in times of great crisis?
On a second best basis , lending to solvent as per Begehot (odd word to use if they need to crisis borrow) banks, new fiduciary media (Bageohot) will only be capital distorting.
These are some interesting questions but if you read/re-read the main sources I think you will see them being dealt with.
I have read both books and asked questions of their authors and I’m still not sure they are ‘dealt with’. Among other things there is the observational/measurement problem of tracking just what income is (and in real time, too).
My suspicion from talking to SH is that he was defaulting to GDP which we Austrians know is a disatrous measure. To my comment that at least he should track business sales (as the most accurate gauge of business spending – far greater in magnitude, more discretionary, and hence more variabel than the consumer & state spending on which GDP so concentrates qv, Bastiat’s Iceberg), he gave the impression that he had not thought of this angle.
GS was very polite and informative, but when I asked just how his free fractional banks could be expeceted to lend new money into existence at just the time that demand for it rose in a destabilizing fashion, when this was most likely to occur at moments of crisis – i.e. when all prudent bankers would be pulling their horns, not extending them – answer came there none.
Keeping the core level money supply stable – a la Mises – and letting prices adjust to a fixed nominal (but expanding real) stock and not venturing off into late Hayek dilettantism about compensating for the belated discrimination between money and non-money instruments seems a far more workable solution to me – as well as being one whose forseeable stringency also provides a safguard against over-expansion in the first place.
I know what you mean about income. I don’t think that stabilising nominal income is really the same thing as monetary equilibrium. People demand a stock of money to make transactions with, not just to exchange goods that are bought from income or are constituents of GDP.
But, I’m still principally on Horwitz’s side, my difference with his view are minor.
That’s very odd because he has a whole theory about that. I’ll probably explain it some time in a debate here, though I haven’t the time now.
I don’t believe that nominal income targeting is the real issue here. I mentioned it because Toby implied that monetary equilibrium theory is about stabilising nominal *prices*, and I wanted to correct him.
I think Corrigan and Current are now challenging the right hand side of the equation of exchange, which is a good debate to have. FWIW I’m still thinking this through so I can’t contribute much. But I would say two things: 1. nominal income targeting is a debate Austrians should be contributing to, not ignoring; 2. all Austrians understand the limitations of GDP (but that doesn’t automatically mean alternatives like Gross Domestic Expenditure or Net Private Product Remaining are any better).
But when Corrigan talks about “tracking” nominal income (and indeed this applies to Toby’s comments) I think we’re in danger of confusing a debate about ideal monetary regimes vs. policy responses in the present environment.
The point about stabilising nominal income (or PT, or whatever)is that Free Bankers suggest that this is what market institutions would naturally do. There is no calculation problem here other than one about entrepreneurial judgment, but banks would have additional sources of information (e.g. redemption requests) not available today. The problem is that in the real world (*given* central bank management of the money supply), the argument is that we would have better outcomes if they attempt to replicate what would happen under a free market, rather than keep the money supply fixed. Of course there *is* a calculation problem here, but that’s why we need to abolish central banking!
In addition, I think there’s a conflation of the general functioning of credit creation within a Free Banking environment and what would happen in “moments of crisis.” The first (and glib, but relevant) response is that we would not expect to see such severe crises. I don’t think the defense of Free Banking should rest on it’s perceived response to a situation that it is principally advocated to prevent happening. The whole point of competitive note issue is so redemption runs are localised to specific institutions, and not system wide (i.e. runs are more likely to be contained).
I agree with Current that I don’t think Selgin is silent on this. I think there’s a discussion of this in “The Theory of Free Banking” (from p.158). He is chiefly arguing against central banking, so it’s not perfectly applicable here, but it’s something to be getting on with.
Anthony:
you cite: ‘Bagehot’s preferred, practical solution was for the bank expressly to commit itself to lending freely during crises, though on good collateral only, and at “penalty” rates.’
This is not quantitative easing. You cannot defend QE with Bagehot.
Hi Philipp – directly after that quote I say “unlike QE it avoids a slew of unfavourable side effects”. I’m surprised you thought I was defending QE – look at the title of the article!
Corrigan’s claim that I was unable to explain to him how free banks can expand the stock of money when the real demand for it increases surprises me, both because the matter is indeed the subject of several chapters of Theory of Free Banking (the subtitle of which is “Money Supply under Competitive Note Issue”) and because I distinctly remember answering the question–or attempting to–while in London, though I cannot recall to whom (I thought it was at the Cobden dinner); I certainly don’t recall drawing a blank on something I’ve explained many times before.
Briefly, the answer is that when a (free) banks’ customers decide to accumulate rather than spend its IOUs, it will be encourage to lend more simply in order to relieve itself of the excess reserves it would otherwise find itself accumulating. A similar tendency will also be in play if demand for bank money generally increases, thought the details are more subtle.
Besides my book chapters I’ve elaborated the theory in articles in the JMCB and the Economic Journal. I don’t see how I could do much more than that.
All of this supposes that the “crisis” in question is one in which there’s an excess demand for bank money. Of course, if by “crisis” one means that no-one trusts the banks any longer, that’s another matter. For then it’s a question of people wanting to cash in bank deposits (and notes, if such exist) for whatever the base money is. It is a truism that no fractional reserve system can survive such a general crisis of confidence, though devices such as the option clause, allowing for temporary suspension of payments, might serve to avoid damage from runs based on ill-informed panic. (See my article “In Defense of Bank Suspension” on how this works.) But let’s be clear: whether _general_ crises of confidence and runs based upon them are likely to be common enough to justify regulatory restrictions aimed at coping with such is an empirical question, and the empirical evidence overwhelmingly shows such crisis to be exceedingly rare, notwithstanding popular beliefs to the contrary (and popular policies and economic models based on those beliefs).
Good Evening George, it is a pleasure to have you blogging on this site.
I am happy that a free bank, when faced with customers holding more money balances, in a fractional reserve world , with banks not backed with any govt support what so ever, can issue more of money by way of making more loans. If they do this, they can only lend out what they have. I will assume all their clients know that they are doing this, as you know, I have gave reservations about the contractual status of what the banks in the UK say they are doing with “your money” and what they are actually doing with your loan to them!
System wide, there has been a money deflation followed by a money inflation. The pack of cards has been re-shuffled. This implies that some new people have benefited from this reshuffling right? Some people now have purchasing power that they would not have had previously – this disturbs my pro liberty bones . So when prices should have been falling, they have now re balanced . Is this not right?
People changing the demand to hold more money is sending a big price signal out to entrepreneurs that there is not that much demand that we hitherto thought was out there, now a free banking system has created more money out there. Is this not dangeously confusing for the entrepreneurs and the distortions in the structure of production that must follow?
I have lived and worked through three recessions so far , early 90’s, early 00’s and now. All that I observe is banks back into their boxes, become feareeful of everything, even if like today they are 100% govt backed and dry up lending. I doubt empirically if a FR free banking system would ever be able to get money out there into the economy anyway. Thus I suspect the money demand increase would never be compensated by a new issue of bank IOU’s.
I could see a FR free banking system work in a economy not contrasted by extremes like we have today. I know AJE has said it is wrong to assume that there will be less trouble with a FR free banking system, I think apriori that is the case. Empirically and from first hand real life , I think FR banking is blown out of the water by the real recession events and lending that becomes tighter than anyone can imagine. As said, this is with too big to fail, so with no too big to fail, I think a FR free bank system would be much better , but still not do what its advocates say it will do on the tin.
Now , fix the money supply as Mises says, by either freezing the lawful reserve ratio today and saying everthing going forward is either custody deposits or time savings, would stop the money deflation point . We can debate the worth of option clauses and my exception clauses for sure and these should be a feature of any free market proposed policy suggestion to legislators. It does not address the requirement for banks to compensate the new higher level of money demanded with new loans, some , that I don’t doubt are needed, but would not the situation of panic be much reduced so that indeed a credit created money induced boom that led to bust that led to higher demand for money ever happen?
I am out of my league and crystal ball gazing here, but the little deductive powers I have tell me that absent the ability of banks to create credit , then we have no credit induced boom and bust, therefore, with the knowledge that banks dont lend in the real world when money demand goes up, I fall down on the side of a Mises style solution or a Huerta De Soto style fix of the money supply level, note not a Rothbardian solution of let money deflation happen. At least one part of the problem is dealt with and I suspect by dealing with a fixing of supply, you much reduce money demand issues.
Toby writes: “I would also be interested to know if when a free bank issues new IOU’s to accommodate a rise in demand to hold money , or a fall in the desire to spend on goods and services , is it not putting purchasing power in the hands of the select few at the expense of the masses as they can spend and get real goods and services exchanged for newly minted bank IOU’s. Is this no different to counterfeiting?”
No, it isn’t. Imagine a dealer selling a bond on behalf of a corporate borrower. The bond purchaser refrains from consuming (or, perhaps, purchasing other financial assets) in order to acquire the bond; the seller in turn secures the “purchasing power” sacrificed by the buyer. Banks, like the dealer in question, are credit intermediaries. Only they acquire small bits of savings, which they assemble into larger bundles and then issue as credits in the forms of loans or perhaps in exchange for securities. In some cases the bits of savings are “callable” so the banker must rely on getting new bits to replace former ones as they are called in. That’s an entrepreneurial challenge–not (as Rothbardians imagine) a crime. Whether borrowers are “few” compared to ultimate lenders is neither here nor there; and as for “luck,” that (as they say) has nothing to do with it: the borrowers pay for their borrowings, and there’s no reason to assume that the terms favor them more than the favor the depositors who, if they don’t receive interest themselves, do receive desirable payment services in return for the savings they contribute.
I do understand this example.
However, I do think that with very specific disclosure, it will not be a “crime.” At the moment is it negligent misrepresentation (civil law issue) as far as I can deduce. A simple tidy up of contract law should resolve this point for Rothbardians.
You say money disequlibrium is the name , if you need to attach one, to the system you advocate , other people say monetary equilibrium theory (MET). Now if banks do not lend like today in a FR banking world with full state support, I dont think they will with zero state support, the latter which all readers of this site should want. Thus to get back to the former money equilibrium, someone is going to have to pump out more cash right? If this is the case, I cant see how this will NOT be counterfeiting. Maybe you would reject the MET position, or what I understand it to be may well be wrong?
First as a free market person, I would say we are always in disequilibrium trying to get to the never possible equilibrium state. So why is there any need or desire for more money to be issued by a free bank anyway? Don’t get me wrong, for all suffering business people ( as I have been ), I am sure more money is wanted in a FR state supported system and in a FR free banking one, but is not the better solution to let the new demand for goods and services in the economy to be met by business people changing their plans, painful as this may be?
Thoughts please.
Pardon: Of course I should have written “Yes it is (different from counterfeiting)”!
Well, “monetary disequilibrium” refers to the notion that, when either money demand or supply changes suddenly, prices don’t quickly adjust, so you can have a period, perhaps protracted, of excess money supply or excess demand for money. I actually haven’t used the expression much lately, as it doesn’t really figure in discussions of how free banks function (they tend for reasons I’ve tried to describe here) to keep money supply on track with demand.
As for banks being unwilling to lend: well, you can’t legitimately assume that a free banking system “looks like” our banking system right now with some restrictions taken off! We presently have a traumatized banking system, and it is traumatized owing to a wide variety of interventions, including easy central bank money (before 2007) tight central bank money (after), implicit and explicit guarantees (including TBTF for some), Community Reinvestment Act requirements (in the U.S.), Basel capital requirements, and much else besides. Some of the regulations (e.g. capital requirements) are now contributing to the credit shortage–as are new regulations supposedly aimed at preventing reckless lending–aimed, that is, at firmly shutting the barn gate now that the horse has long since escaped.
Let me first say my post was not intended to convey any disrespect to Prof S who, as I said, paid me the courtesy of a full response to an e-mailed question. In this, he candidly admitted his Free Fractional Bank adjustments would only take place in normal times – a position he here re-iterates.
He further conceded that such a process would not work in abnormal ones and was left, therefore, to rely upon the hope that, under a system of FFRBs, these would not occur with anything like the frequency or magnitude of current crises.
He may well be correct in that assertion, but this still does not address the question of whether the dubious benefits of damping out the effects of changes in money demand in normal circumstances – surely a minor irritant at worst – coupled with a confessed inability to cope at the very time such demands do become disruptive, makes the game seem at all worth the candle to those of us who suspect that such an exigency only arises because we have fractional banks in the first place.
Surely, if panics are held to be reduced in number and intensity by making fractional banks free, then they would be further diminished by making free banks non-fractional!
I’m currently enjoying the St. Patrick’s day celebrations in Ireland, so I haven’t time for a long reply.
Toby write above
I’m writing an article at present that will mention this issue.
Sean Corrigan writes:
I’m not convinced that this crisis is one of those type that involve a failure of confidence in all banks. There have been many banks that have been solvent throughout the crisis. If something similar happened in a free-banking world then bank balances would shift to those good banks. As the bad ones went bankrupt the solvent ones would expand by buying their assets.
I also don’t think that the matter of monetary equilibrium is mute in normal times. Large changes in demand for money have occurred in the past in recessions that haven’t involved bank crises. With a Rothbardian system these recessions would become much more major. Also, as I mentioned in my first article here we must remember that falls in demand for money can also occur. Without FRFB those would result in unexpected price inflation and cause ABCT.
Finally, if we abandon fractional reserves we lose Adam Smith’s “road through the air”. Holding money no longer means supporting the existence of highly productive assets like business loans. It means investing in gold which is a very low productivity asset. This is damaging to long term growth.
Current, enjoy Ireland, you are enjoying their fine brew there I see from the above comments.
I would be interested to see a non credit induced crisis or any real sustained financial crisis that does not have its root in money, leaving aside wars etc.
A fall in demand to hold money means people are buying more things, this would only be inflationary if there are more money units chasing the goods on offer, other wise the prices would go down. We must not forget productivity gains in all of this, and the onward march of the dynamic human led economy, whose prime purpose is to provide more goods and services for cheaper prices over time, thus should cause a gentle steady price decrease.
In a mature FRFB system, no bank can lend out more than it has in deposits. In a FB, it can only lend out what it has in savings. What is the real difference between the two? If you mean that some demand deposits that are styled “instant access” would move to custody style accounts, then this means consumers actually need the money as ready money and not as savings i.e. for consumption. Some would move from instant to real timed savings. Do you assume all will move to custody style accounts? I think not. Also, what is the problem with the time preferences of savers matching that of borrowers? Is this not the holy grail of all Austrian School economists? Will this not mean real savings put aside and invested in trade to buy real goods and services demanded in the future? I can only see more bank IOU’s distorting this.
How would the “road through the air” be lost with a FB v a FRFB system? Why invest in gold?
As I say a zillion times on this site, WEALTH CAN ONLY BE CREATED WHEN ENTREPRENEURS FIND NEW WAYS TO SATISFY THE MOST URGENT NEEDS OF THE CONSUMERS BY TAKING THE EXISTING FACTORS OF PRODUCTION AND MAKING NEW COMBINATIONS OVER TIME WHICH PRODUCE MORE THINGS OF USE VALUE. Making more bank IOU’s via a FRFB system does not create more wealth or growth. I am not aware any of the FRFB advocates suggest this either. At best, I believe the suggestion is that more bank IOU’s may give a life line to business that otherwise may well have not got funding as the demand for money changed and this might just allow them to sustain themselves through this stage of the recession before demand for money tunred back to something similar to the old level and their goods and services are bought once more in the volumes needed to sustain those enterprises at the margin. I am dubious of the worth of this as we just distort the structure of production and sow the seeds for the next series of malinvestments.
Keep drinking and stop blogging out their in the Emerald Isle!
I’ve always like English beers best. But, in Ireland it’s not so much the quality as the sheer dedication they put into drinking it you have to admire.
It’s things like wars that I’m thinking about. All sorts of emergencies can increase the demand for money if they make a large enough number of economic actors more uncertain about the future.
I agree that productivity gains produce a steadily decreasing price trend if there is no interference from the money side. So does George Selgin, as he mentioned here recently.
Certainly, if there are more money units chasing the same goods then that would be inflationary, ceteris paribus. However, that’s not the only possible source of inflation or deflation. The Milton Friedman and the Monetarists tried to show that money has a constant velocity of circulation. They constructed a monetary aggregate M2 which they believed had roughly constant velocity. In time they failed, the velocity of M2 was clearly seen to vary and even Friedman himself changed his mind and accepted that velocity changes. The situation with demand for money is very similar because demand for money is closely related. Velocity is effectively an estimate of the inverse of the accepted demand for money. That is, when demand for money falls velocity rises and when demand for money rises velocity falls. I’m aware that there are problems with the velocity idea though many of them go away if it’s used carefully. But, I think what this has shown is that demand for money can’t be constant.
If it demand for money falls then that is inflationary, even if there is no extra money created. Let’s take a very hypothetical example. Suppose that every person has their idea money balance, that is, exactly the right proportion of their assets are money. Except me, suppose I come to the conclusion that I have £1000 more than I need, in that case I’ll spend that £1000 on something. When I do that clearly someone else has £1000 which they don’t want to keep as money either. That means they will spend it too. So, that £1000 will circulate and as it does so prices will be bid up. The effect of £1000 would be minuscule, but if many people reduced their demand for money at the same time there would be a macroeconomic effect.
No, I don’t think that all will go to custody accounts. As you say I think a fair portion will go to timed savings. But, I don’t think that necessarily solves the problem.
This goes back to your discussion with George. I think that current account balances are “real savings” as much as any other savings. Each person may not know exactly when they are going to withdraw from their account and exactly how much. However, a bank can analyse behaviour and calculate a core amount of deposits that can be relied on to a high probability. A bank can then loan on that basis. Current account holders may be saving in a passive manner, but they are still abstaining from consuming, which is the essence of saving.
This is a difficult topic, in my view there are three separate parts to it.
Firstly, let’s consider a 100% gold standard. Suppose a world like ours were to move to a 100% gold standard with the current stock of gold. This would cause an enormous rise in the value of gold. This in turn would make gold mining very lucrative. As a result a great deal of resources would be put into gold mining. This would be wasteful compared to use of those resources for other purposes. The long-run increase in the money supply that the gold mining would provide would not be useful because money is barren in the long-run.
Secondly, in the short-run money isn’t neutral. Yes I am using the same argument twice here. If a monetary system can’t respond to fluctuations in money demand then that will cause loss of output through recessions. This is likely to have an effect on long-term growth as well as a passing effect.
Thirdly, the decisions that surround money holding are changed forever in a way that discourages it and consequently discourages saving. This applies to 100% gold systems and 100% fiat systems. In a 100% gold standard an investment in money is an investment in gold, it can pay no interest. Nor can fiat money pay interest or support provision of banking services. That means ordinary people are left with the choices you outlined above, a custody account and/or timed savings. But, that doesn’t mean they have to split their current balance up into two portions, they also have option of spending some of it. That may have short-term effects, as I’ve argued before. But, it could also have long-term effects because the cost/benefit analysis of spending versus holding money or saving has permanently changed.
There’s another issue that applies only to open economies. If somewhere like Britain were to adopt 100% reserve fiat currency then banks would still need to borrow from somewhere. They would get investments from timed savings, but they are unlikely to get the same as they would from current accounts. So, they would go looking elsewhere for savings and they would find them abroad. The problem with that is that it would increase Britain’s exposure to ABCT coming from foreign banking systems.
Yes, but there is much more to the process required to enable that to happen. The price level must be reasonably predictable to make measurement of profit and loss by accounting methods accurate. Worker/consumers must save so there are funds for entrepreneurs to invest.
As Anthony Evans points out elsewhere, what we’re mostly interested in is in avoiding recession. Although creating money can’t create wealth in some cases it can avoid destruction of wealth.
I think it’s also important to prevent unnecessary unemployment and the suffering that causes.
Recently I had a discussion with Robert Sadler about this “propping up businesses” question ( https://www.cobdencentre.org/2011/02/the-crime-known-as-quantitative-easing/comment-page-1/#comment-25537 ). Why do you think that deflationary recession caused by a fall in the demand for money will only target businesses that have malinvested? I don’t it is targeted. Why do you think it’s a good thing if businesses have their account falsified in the direction which exaggerates losses and minimizes profits? I don’t see how this is positive or how it can reverse the effects of earlier account falsification in the other direction.
Why should a later fall in money demand hurt businesses? Remember, what we advocate in this case is that a fall in money demand should be met by a fall in money supply.
The real problem here is with the 100% reserve argument. Let’s suppose that the demand for money rises and it isn’t accomodated. That means there is both recession and price deflation. Then, some businesses go bankrupt and some people are made unemployed, then slowly prices fall and normality is re-established. Then, once that happens people find they have larger money holdings than they want, so they spend them. This then causes inflation and account falsification in the direction we normally talk about. That is, unexpected price inflation exaggerates profits and minimizes losses.
In this situation the 100% reserve policy would first cause an unnecessarily serious recession, then it would cause an artificial boom. Granted it may not be a large enough boom to be serious but it will still cause misallocation.
Corrigan writes that I am “left, therefore, to rely upon the hope that, under a system of FFRBs, these would not occur with anything like the frequency or magnitude of current crises.”
But it isn’t a matter of hoping: I base my claims on accumulated experience, taken from both free and regulated banking systems. That experience suggests that the sort of panics that concern you would be quite rare. (Regulatory interference is a very important source of actual crises–see me Cato article, “Legal Restrictions, Financial Weakening, and the Lender of Last Resort” and my Critical review piece, “Are Banking Crises Free-Market Phenomena?” As for what is a minor and what is a major financial “irritant”: consider all the harm done by the drying-up of bank credit during the recent crisis–think especially of all the businesses left without means for financing their operations. Now imagine that bank credit vanishes altogether and for good. That’s the “lesser of evils” that’s being suggested, as a cure for crises that history shows to be readily avoidable by the less draconian means of leaving banking to the invisible hand, as it was left for long stretches in Scotland and in Canada.
Anthony,
sorry. Must be that I am not a native speaker. You wrote: “Austrian economists are happy to acknowledge that under certain theoretical conditions QE can work as Congdon suggests – when the demand for money rises a corresponding increase in the supply can restore monetary equilibrium without forcing an adjustment to take place through prices and output. Expansionary monetary policy can prevent the ‘secondary recession’ and avoid the economic pain caused by a contraction of the money supply.”
I interpreted that as a defense/support of QE which I interpreted as standing for quantitative easing. You might have written also: “Some (Austrian) economists ….”
I think you’re focusing on the wrong part of that sentence. The key phrase is “under certain theoretical conditions” – I then go on to explain why they almost certainly do not hold and therefore QE is misguided. As I said to Toby, there’s a difference between the tool and the objective. I’m trying to point out that some Austrians accept Congdon’s objective, and then try to critique the tool on those terms.
You’re right that I might have written “Some (Austrian) economists ….” as opposed to “Austrian economists”. However if you provided me with a charitable reading you would accept that (i) as stated the sentence is correct; (ii) earlier in the article I have already acknowledged that there are different views on this matter within the Austrian school. (Note that *before* I’ve made this distinction what I attribute to the “Austrian school” is something you’re not challenging.)
Obviously it’s the responsibility of the author to be understood, so I appreciate your point, but I’m not sure you’re being charitable. You’re accusing me of defending QE and masking the differences of opinion within the Austrian school – I think any reasonable reading of my article would see that this isn’t the case. But I accept it’s not for me to judge…
Professor Selgin,
In you correspondence with me you wrote:-
‘In short, the theory of self-stabilizing MV does assume a given degree of “moneyness” of bank-supplied notes and deposits, and so won’t hold in the special case of a bank panic. My impression is, however, that “moneyness” tends to change relatively slowly in normal times–that is, it isn’t subject to cyclical variations apart from those related to panics–so that we don’t normally have to worry about it undermining free banks’ stabilizing properties.’
I would dare to suggest that this rather supports my ‘minor irritant’ description.
It also seems you want things both ways in your last reply: FFRBs work well (when they’re not needed, I might cheekily suggest) but, in contrast to Non-Fractional Free Banks, they avoid the evils of credit restriction as experienced in the late crisis – a happenstance which, however, you utterly rule out under your scheme and which we insist could not take place under ours!
I see it differently, Corrigan: with FRFB, you may have rare instances where the supply of bank loans dries up. With Non-FRB’s, the supply of loans is equal at all times to the “dried up” supply under FRFB! You must ask yourself what the people who pine for credit during an FRB crisis will do to finance their enterprises if FRB is altogether banned.
So, the advantages of FRFB consist of both its ability to accommodate routine changes in money demand and its ability to serve as a source of credit that would not be available otherwise. I don’t consider either advantage to be minor, but if I stress the first in my writings it is because proponents of central banking like to argue as if there could be no question of demand-accommodating money supply adjustments in the absence of their interventions. (And also because the avoidance of major central bank screw ups is itself a very substantial advantage, even if the changes in money demand that normally require accommodation are themselves small).
Anthony,
let me say again that I am sorry. I did not want to accuse you of anything. And I should not make suggestions for rephrasing as a non native speaker. I interprete QE as being the following: Interest rates are already at or near zero. The central bank wants to increase the money supply anyway and starts to buy assets to increase reserves. I just don´t think Bagehot applies here because of the penalty rates mentioned in your quote. Rates close to zero (for me part of QE) cannot be penalty rates. Thus, I said that one cannot defend QE with penalty rates. It would not be QE anymore in my opinion.
I think that increasing the fiat money supply at zero interest rates is never acceptable under no theoretical conditions.
But let me apologize again. I understand now that you oppose QE in most or maybe even all cases.
no need to apologise Philipp! As I say, it’s the authors responsibility to be understood, and I am glad you’ve challenged me on this.
The bottom line is that I’m suggesting Bagehot’s rule and QE can be seen as two different tools that intend to achieve a similar objective. The point of the article is to make those who advocate QE aware that there are some Austrians (i.e. those who don’t follow the Rothbard approach) who want to debate tools, not objectives.
p.s. congratulations on being asked to give the Rothbard lecture at the ASC. I’ve not had chance to watch it yet but I’ve heard you did a great job
Good Evening George,
A FRFB system working well, all up to their reserve ratio limits , would have the same money supply as a 100% reserved system right? Granted, one one have the ability to create new credit, the other, recycle savings, and would not be able to create credit.
If you look at what Jesus Huerta De Soto has said in Money, Banking and Economic Cycles (off memory I think that is what it is called – the BIG book anyway!) in Chapter 9, he proposes a print up of cash to back up all of the demand deposits (I prefer a direct swap of cash for demand deposits and cash then stored if the client wants it as a custody service not on their balance sheet – think of the massive uplift in banks assets!). So the current FRB system is transformed into a 100% FB system over night. The same could be done with a mature FRFB system to a 100% FB system and the money stock and thus I would think the loans will be the same, or put it this way, I can’t see why it will not be.
I had £1.1m of an invoice finance line removed in my last business overnight, with no notice, no asking, no nothing, despite the fact no covenant had been breached, it was not in the terms and conditions of business agreement I had with them but it just happened to be bank policy at the time which chnaged post Lehman. This produces large cash flow strains, job losses , general misery etc. If I was funded by savings or equity, this would not have been the case.
I was offered the plant and fixtures and fittings yesterday of a competitor to my old meat business. This man in 35 years has never made a loss, never missed a loan repayment. The bank said his PROFIT ratio to his mortgages (100% backed commercial freehold property) , was now not acceptable. Another business bites the dust, one of thousands put out of action so far this year. Bank credit that came from nowhere now goes back to nowhere!
Savings cant , in term, go back to nowhere, they exist and can go back to the saver post the term of the savings and be spent and re saved again. This is a far better way to build stable and sustainable industry. In a FRFB system this credit issue is still there – granted, much moderated, much more sensible, much more agreeable etc. In a 100% RFB system, it is not. Infact, it cant create a credit induced boom or bust. Savings are then lent to the borrowers to make products that hopefully they want to spend their returned savings on. Happy days.
I hate bank credit. Yes, might as well get that one off my chest. With bank credit in a FRB system, we all know we have had boom and bust. We all do not like it, we all say absent the government from the picture and things will be alot better.
You say go for FRFB and I say yes if it is to replace what we have today. However we can go one better with a free banking system with no “100%” or “FR” tag Free Banking system.
No credit will exist in a FB only system. Savings will supply the loans to business and retail loans. They form over half of all investments in the UK today and I suspect when people are denined “instant access savings” which is a contradiction in terms to my simple head, they will have to choose, is it hand to mouth cash (custody account) or savings. I suspect most would go to some timed savings as they will want some kind of interest.
So a bank can safe keep, lend and that is it.
With a timed deposit, the bank can grant instant liquidity by exception. This is different , but similar to an option clause. This puts all instant access savings not as current creditors (the option clause keeps them as current creditors and thus does not address any balance sheet solvency issues) but as long term creditors of the bank to match their long term lending. No run or unststainable call can me made on the bank as it can remind redeeming clients that it is by exception that this is offered and they are in fact a timed depositors for what ever term they have signed down to.
The bank would not be able to pull credit from underneath the feet of business if they were in term etc. A FRFB would still be able to do this with contracting credit. On going productivity gains should produce a healthy downward presure on prices ie price deflation. This is what should be the case as it is the aim of all us entrepreneurs to do things better and cheaper than our competitors.
A true FRF account could be offered with full disclousure , but I would suggest that this area of the bank is segmented from the rest so it can’t pull down the custody and lending parts of the bank. Hedge Funds currently play a similar role in society, I see this type of account more sitting in that part of the financial architecture.
Greetings, Toby.
The real money stock will have approximately the same long-run value for any sort of monetary system (approximately because money demand will be higher in a system in which any part of the money stock bears a higher return, pecuniary or otherwise). But the extent of credit intermediation will depend on the nature of the assets that back the exchange media.
When Huerto de Soto imagines printing up enough cash (it sounds like he here has fiat money in mind) to equip banks with 100-percent reserves, what does he imagine happens to the non-cash assets banks had previously been holding? One possibility is that the central bank is exchanging its notes for those assets, so that it in effect takes up the intermediation previously performed by the commercial banks. In that case, we have a central bank in the commercial lending business, which I imagine doesn’t sound like a good idea to you any more than it does to me. Over time, though, it would be possible for the central bank to reduce its holdings of commercial loans and revert to holding only government securities. But then you would to that extent reduce total business credit. The savings wouldn’t go away. But they would be invested in government rather than be in the private sector. The point is that, stingy as commercial banks can be, the 100% solution is still stingier when it comes to the total amount of saving available to private businesses, as opposed to the government (fiat money case) or the gold mining industry (gold reserve case).
Toby writes: “The bank would not be able to pull credit from underneath the feet of business if they were in term etc. A FRFB would still be able to do this with contracting credit. On going productivity gains should produce a healthy downward presure on prices ie price deflation. This is what should be the case as it is the aim of all us entrepreneurs to do things better and cheaper than our competitors.”
Let’s not confuse the callable nature of FRB deposits with callable bank loans. Banks can make callable loans financed with time deposits, and they can make non-callable loans based on FR deposits. (Indeed, some critics of FRB find fault with it precisely because of such ‘maturity mismatching.)
As for deflation, we must keep in mind, as I pointed out both in my IEA talk and more briefly at the Cobden dinner, that the long-run rate of inflation isn’t strictly a function of the banking system reserve ratio. In fact I fully agree with Toby regarding the desirability of productivity-driven deflation, but have argued that such deflation is likely to occur under FRFB, so one doesn’t need 100-percent reserves to achieve that outcome.
Good Afternoon George,
You say
“One possibility is that the central bank is exchanging its notes for those assets, so that it in effect takes up the intermediation previously performed by the commercial banks. In that case, we have a central bank in the commercial lending business, which I imagine doesn’t sound like a good idea to you any more than it does to me. ”
The HdeSoto policy modified by me in my own langauge is as follows ;
1. Put physical cash, notes and coins into the hands of all demand depositors.
This is new notes and coins created by the state.
2. As the pre reform demand depositor liability clients of the bank now have physical cash, the bank has no liability to them. This means the bank net worth inflates by the exact same amount that the demand deposits used to be. The customer , as far as he is concerned still has the same purchasing power.
3. The pre reform demand deposit holders then place their cash in a custody account, with the bank or in a savings account with the bank, or in a shoe box or what ever.
When I looked at this a year ago, there were approx £900bn of demand deposit liabilities of with close to £400bn were held by corporate entities. I suspect these would hold their cash in custody ie ready access on the whole and the retail accounts move on the whole into timed savings. Needless to say, I do not know, this is an educated guess.
4. Why should the shareholders of the banks benefit from a £900bn uplift in their net worth? I say they do not deserve this one off enrichment. So, take out the exact same amount of assets from the banking system, to take the shareholders back to the pre reform net worth. Package these assets into mutuals , possibly owned by us all, or the existing banks shareholders, it does not matter, and let them for a fee, be collected out as they mature by the banks from whence they came. Use the funds to pay off the national debt which is approx at this level and release the tax payer of this obligation.
So no, the state does not get involved with running assets and being the banker, but its powers are needed to make this reform happen.
Post Reform
Lending then is based on the forwarding of funds put aside for future consumption by savers.
Longer maturity loans provided as they are today by pension and life companies who already dominate the long term corporate space but could become retail mortgage providers, or better still let the Great Mutual Building Societies come back into the forefront of lending long.
It is impossible to have a bank run or a money contraction in this enviroment and price adjustments take place through purchasing power adjustments.
I trust this clarifies.
Yes it does, Toby. Thanks.
I think Professor Selgin is very much mistaken when he says that ‘no credit will exist in a FB system’ – i.e., absent fractional money creation. Even Hayek made this mistake at one point in his canon by rather astoundingly musing that the business cycle might be a small price to pay for the supposed acceleration of economic development which was afforded by the provision of easy (fractional) bank credit
In truth, the vast majority of exchange in a developed economy takes place between businesses themselves and NOT between businesses and end-consumers (Kuznets, Keynes, and Krugman notwithstanding).
Much of this is routinely conducted on credit terms for the settlement of which no bank is strictly required (and, indeed, for a good proportion of which no bank is in fact involved). Indeed, in less ‘financialized’ times, consumer businesses also conducted much of their activity on credit – whether the local corner shop allowing its clients to purchase ‘on tick’, or Henry Ford making sure (admittedly via the local banks) that his cash receipts were used to help his dealers finance their sales of his cars to the final customer.
Now, yes, when a bank intermediates by buying in the evidence of any such debt and paying for it with the savings it has received on deposit from a third party – thereby allowing one of the firms involved to realise its sales revenues more rapidly (strictly speaking, a matter of replacing that firm’s savings with those of the new depositor) – there may be advantages for both parties – and an honest profit may accrue to the bank to recompense its good offices in matching up two actors who may be totally ignorant of each others’ existence or needs.
Yes, a bank may also put its own equity at hazard by explicitly or implicitly guaranteeing the credit of one of the counterparties for some pre-arranged fee or net interest margin in order to overcome the doubts of the other participant in the deal and, thus, it will again earn a living in the honest furtherance of trade which this represents.
But what a bank should not be able to do is to MONETIZE at whim one of these spontaneous credit transactions and so begin to pervert the ordering of perceived economic scarcity signalled by both the relative prices of current goods and the relationship between current and future goods as expressed in the rate of interest. Yet this is precisely what Professor Selgin’s prescription amounts to, albeit on a much lesser scale than that currently made possible by the fiat-fractional, CB-supported system we all so abhor.
Having much of our money formed of such unwonted intrusions into free exchange – having it largely based upon a debt which can be extinguished at the stroke of a keyboard (whether by default, denial of roll-over, or voluntary ‘deleveraging’) – is what magnifies the instabilities present in the dubious actuarial gamble constituted by fractional reserve banking of any kind.
Were a kernel of hard, unshrinkable money to reside at the heart of the credit system, this would not allow any diminution in the volume of such credit to short-circuit the otherwise compensatory effects of falling prices on REAL money balances which are both the retardant to the progression of – and the ultimate remedy for – any deflationary episode which results from a sudden economic upset.
Therefore, to legislate to allow a sizeable percentage of this money to become just as ephemeral as the credit out of which it has been conjured (as the chartering of even free fractional banks must do: nay, is DESIGNED to do) can only add to financial and monetary instability, not reduce it and so should be rejected out of hand.
Dear Aje,
Regarding the debating tools vs. objectives rhetoric:
This analogy is silly at best, intentionally disingenuous, evasive and misleading at worst. If I use a wrecking bar to repair a piece of stained glass in my broken cabinet door, I will destroy the door. This whiny nonsense of ‘let’s distinguish between debating tools and debating objectives is insulting. The objective is to fix the door. The theory that the wrecking bar (tool) might help fix the door (objective) is irrelevant. It will destroy the door because it’s the wrong tool. Stop apologizing for misguided, so-called “economists” and do something productive with your life.
Thank you!
P.S. Equally ridiculous is the idea that a monetary deflation would result in the unnecessary destruction of “wealth”. You are missing the point. True wealth is not so easily destroyed. The quick and easy destruction of this “wealth” reveals the true nature of the game here: TRANSFER of wealth. The “wealth” to which you refer was not and is not wealth at all. It is/was the ILLUSION of wealth—easily created by programs like QE, QE 2 and etc., and just as easily destroyed. Real Austrian (Mises, Rothbard) economists understand how to achieve true wealth and prosperity and in a fair, just and free manner. Fractional reserve banking can never be a part of true wealth and prosperity. The evidence of this fact abounds!
Sincerely,
Kevin
Thanks Kevin for your insightful contribution. If you feel like sharing that evidence, or supporting any of your assertions with some argument, I’ll be all ears.
I thought you might respond that way.
For starters: 17%-19% real unemployment, negative real interest rates, all time nominal highs for gold, approaching all time (manipulated) high for silver, gasoline up 56% over past year and rising, food at 10% per annum, secretive (not for long) central bank bailouts to the many of the largest corporations in the world, record home foreclosures, record high commercial real estate vacancies, 2+ TRILLION dollar deficits, national debt that equals GDP, $70+ TRILLION in unfunded government liabilities (vote buying programs), falling tax revenues, government employees paid twice that of private sector workers, record high Wall Street bonuses, nationalization of major industry, banks, insurance companies, rising interest rates despite central bank’s attempts to suppress them by “buying” so-called U.S. Treasury “assets”, foreign countries diversifying out of the U.S. dollar at record clip, politicians promising to “create jobs” (HA!), abandonment of the rule of law whenever convenient (for the elite), and endless imperial wars launched by desperate, failing governments and their bankster handlers in a failed financial & monetary system. Perhaps you haven’t noticed any of the above?
Virtually NONE of the above is possible in a 100% reserve banking system using currency backed by a gold standard (or some other form of fiscal restraint).
Better yet, allow me to simply suggest that you read/re-read Huerta de Soto’s tome ‘Money, Bank Credit & Economic Cycles’ (patronizing, isn’t it?)…
Can you provide me with any evidence that it is *fractional reserve banking*, as opposed to *the state* that has caused these problems?
Or, alternatively, can you provide me with any evidence that any free banker has argued that the above is the price we should be willing to pay for additional flexibility of the monetary system?
There’s a difference between making a coherent argument and reeling off a list of outcomes that no one is defending.
Are outcomes of (monetary) experiments no longer considered evidence? I realize that no one is defending these outcomes, but they ramain the result of an unprecedented (100% fiat) 100 year old experiment in fractional reserve banking, granted, a monopolistic one.
The State has enabled and protected fractional reserve bankers. In return, bankers have ensured that politicians never have to break campaign promises. One can likely trace most of societies ills back to the State. However, market distortions are market distortions, regardless of who has the power to distort. How does one lend out something that one does not have? Who decides where the line is drawn? I don’t have any problems with voluntary accords b/t private individuals/entities, but the result theoretically would be the same—misallocation of capital. As one free bank begins to use increased fractional lending to mitigate poor internal business decisions, please shareholders/stakeholders, or simply save their own hides, other banks would quickly follow suit in order to stay competitive. And, of course, the State would be waiting in the wings with offers of support, at a price.
I suppose the idea of being able to voluntarily bring about our own economic demise is slightly more palatable than what our current system allows.
Apologies for all the hostility, I just don’t take kindly to what I perceived to be the beginnings of the co-option of true Austrian economics. However, remaining open to new ideas and civil debate is and always will be necessary. Cheers for taking my displaced aggression in stride!
George Selgin
March 18th, 2011 at 14:35 · Reply
I see it differently, Corrigan: with FRFB, you may have rare instances where the supply of bank loans dries up. With Non-FRB’s, the supply of loans is equal at all times to the “dried up” supply under FRFB! You must ask yourself what the people who pine for credit during an FRB crisis will do to finance their enterprises if FRB is altogether banned.
***They will either wait for prices to drop, or If they were foolish enough to trust a government and to go out on a limb by taking on too much debt, I will wait and start up a company not saddled with debt and thus lower prices, or…***
Toby says:
I was offered the plant and fixtures and fittings yesterday of a competitor to my old meat business. This man in 35 years has never made a loss, never missed a loan repayment. The bank said his PROFIT ratio to his mortgages (100% backed commercial freehold property) , was now not acceptable. Another business bites the dust, one of thousands put out of action so far this year. Bank credit that came from nowhere now goes back to nowhere!
***Buy up the assets of a perfectly good but underwater franchise… or ***
Corrigan
March 21st, 2011 at 10:45 · Reply
I think Professor Selgin is very much mistaken when he says that ‘no credit will exist in a FB system’ – i.e., absent fractional money creation. Even Hayek made this mistake at one point in his canon by rather astoundingly musing that the business cycle might be a small price to pay for the supposed acceleration of economic development which was afforded by the provision of easy (fractional) bank credit
***Sit back and wait out the inevitable wars from the fact that Hayek’s “acceleration of economic development” is limited to the welfare/warfare state, and not to the division of labor in goods and services, eg, true wealth.
Fractional reserve is tradable, but I would to God it was forbidden.***
@ Kevin
Apologies but for some reason it’s not letting me reply to you inline.
Are outcomes of (monetary) experiments no longer considered evidence? I realize that no one is defending these outcomes, but they ramain the result of an unprecedented (100% fiat) 100 year old experiment in fractional reserve banking, granted, a monopolistic one.
They are, but like any “experiment” you need to hold some things constant. In the examples you use it’s not clear how much of those bad outcomes are down to fractional reserve banking per se vs the fact that it’s a monopolistic one. As I’m sure you’re aware, a lot of work has been done on instances of fractional reserve banking systems that *don’t* have the monopolistic element, and the outcomes seem to be a lot more favourable. There’s a valid debate to be had about the strength of that evidence, but my criticism of you is that you are making assertions without acknowledging that counter position.
I also reject the notion of “true” Austrian economics. In my experience “true” really means “extreme”. I’m not interested in being subjected to a “purity” test, judged against the most anarcho-capitalist branch of Austrian economics. Indeed I take issue with the implication that I am a “false” Austrian purely because I take a broad view as to what constitutes good economics. I think internet commentators should spend more time focusing on the “economics” part than the “Austrian”.