Economics

Economic Recessions, Banking Reform and the Future of Capitalism

The London School of Economics and Political Science

Hayek Memorial Lecture

October 28, 2010

It is a great honor for me to have been invited by the London School of Economics to deliver this Hayek Memorial Lecture. To begin, I would like to thank the school and especially Professor Timothy Besley for inviting me, Professor Philip Booth and the Institute of Economic Affairs for allowing me to also use this as an opportunity to introduce my most recent book entitled “Socialism, Economic Calculation and Entrepreneurship,” and finally Toby Baxendale for making this whole event possible.

Today I will concentrate on the recent financial crisis and the current worldwide economic recession, which I consider to be the most challenging problem we as economists must now face.

The Fatal Error of Peel’s Bank Act

I would like to start off by stressing the following important idea: all the financial and economic problems we are struggling with today are the result, in one way or another, of something that happened precisely in this country on July 19, 1844… What happened on that fateful day that has conditioned up to the present time the financial and economic evolution of the whole world? On that date, Peel’s Bank Act was enacted after years of debate between Banking and Currency School Theorists on the true causes of the artificial economic booms and the subsequent financial crises that had been affecting England especially since the beginning of the Industrial Revolution.

The Bank Charter Act of 1844 successfully incorporated the sound monetary theoretical insights of the Currency School. This school was able to correctly discern that the origin of the boom and bust cycles lay in the artificial credit expansions orchestrated by private banks and financed not by the prior or genuine savings of citizens, but through the issue of huge doses of fiduciary media (in those days mainly paper banknotes, or certificates of demand deposits issued by banks for a much greater amount than the gold originally deposited in their vaults). So, the requirement by Peel’s Bank Act of a 100 percent reserve on the banknotes issued was not only in full accordance with the most elementary general principles of Roman Law regarding the need to prevent the forgery or the over-issue of deposit certificates, but also was a first and positive step in the right direction to avoid endlessly recurring cycles of booms and depressions.

However Peel’s bank Act, not withstanding the good intentions behind it, and its sound theoretical foundations, was a huge failure. Why? Because it stopped short of extending the 100 percent reserve requirement to demand deposits also (Mises 1980, 446-448). Unfortunately, by Peel’s day, some ideas originally hit upon by the Scholastics of the Spanish Golden Century had been entirely forgotten. The Scholastics had discovered at least three hundred years earlier that demand deposits (which they called in Latin “chirographis pecuniarium,” or money created only by the entries in banks’ accounting books) were part of the money supply (Huerta de Soto 2009, 606). They had also realized that from a legal standpoint, neglecting to maintain a 100 percent reserve on demand deposits is a mortal sin and a crime not of forgery, as is the case with the over-issue of banknotes, but of misappropriation.

This error of Peel’s Bank Act, or rather, of most economists of that period, who were ignorant of something already discovered much earlier by the Spanish Scholastics, proved to be a fatal error: after 1844 bankers did continue to keep fractional reserves, not on banknotes of course, because it was forbidden by the Bank Charter Act, but on demand deposits. In other words, banks redirected their activity from the business of over-issuing banknotes to that of issuing demand deposits not backed by a 100 percent reserve, which from an economic point of view is exactly the same business. So, artificial credit expansions and economic booms did continue, financial crises and economic recessions were not avoided, and despite all the hopes and good intentions originally put into Peel’s Bank Act, this piece of legislation soon lost all of its credibility and popular support. Not only that, but the failure of the Bank Act conditioned the evolution of financial matters up to the present time and fully explains the faulty institutional design that afflicts the financial and monetary system of the so-called free market economies, and the dreadful economic consequences we are currently suffering.

When we consider the failure of Peel’s Bank Act, the evolution of events up to now makes perfect sense: bubbles did continue to form, financial crises and economic recessions were not avoided, bank bailouts were regularly demanded, the lender of last resort or central bank was created precisely to bail out banks and to permit the creation of the necessary liquidity in moments of crisis, gold was abandoned and legal tender laws and a purely fiduciary system were introduced all over the world. So as we can see, the outcome of this historical process sheds light on the faulty institutional design and financial mess that incredibly is still affecting the world at the beginning of the second decade of the 21st century!

The healthy process of capital accumulation based on true savings

Now it is important that we quickly review the specifics of the economic processes through which artificial credit expansions created by a fractional-reserve banking system under the direction of a Central Bank entirely distort the real productive structure, and thus generate bubbles, induce unwise investments and finally trigger a financial crisis and a deep economic recession. But before that, and in honor of Hayek, we must remember the fundamental rudiments of capital theory which up to the present time and at least since the Keynesian revolution, have been almost entirely absent from the syllabus of most university courses on economic theory. In other words, we are first going to explain the specific entrepreneurial, spontaneous and microeconomic processes that in an unhampered free market tend to correctly invest all funds previously saved by economic agents. This is important, because only this knowledge will permit us to understand the huge differences with respect to what happens if investment is financed not by true savings, but by the mere creation out of thin air of new demand deposits which only materialize in the entries of banks’ accounting books. What we are going to explain now is nothing more and nothing less than why the so-called “paradox of saving” is entirely wrong from the standpoint of economic theory (Hayek 1975, 199-263). Unfortunately this is something very few students of economic theory know even when they finish their studies and leave the university. Nevertheless this knowledge applies without any doubt to one of the most important spontaneous market processes that every economist should be highly familiar with.

In order to understand what will follow, we must visualize the real productive structure of the market as a temporal process composed of many  very complex temporal stages in which most labor, capital goods and productive resources are not devoted to producing consumer goods maturing this year, but consumer goods and services that will mature, and eventually be demanded by consumers, two, three, four, or even many more years from now… For instance, a period of several years elapses between the time engineers begin to imagine and design a new car, and the time the iron ore has already been mined and converted into steel, the different parts of the car have been produced, everything has been assembled in the auto factory, and the new cars are distributed, marketed and sold. This period comprises a very complex set of successive temporal productive stages. So, what happens if the subjective time preference of economic agents suddenly decreases and as a result the current consumption of this year decreases, for example, by ten percent? If this happens, three key spontaneous microeconomic processes are triggered and tend to guarantee the correct investment of the newly saved consumer goods.

The first effect is the new disparity in profits between the different productive stages: immediate sales in current consumer goods industries will fall and profits will decrease and stagnate compared with the profits in other sectors further away in time from current consumption. I am referring to industries which produce consumer goods maturing two, three, five or more years from now, their profitability not being affected by the negative evolution of short term current consumption. Entrepreneurial profits are the key signal that moves entrepreneurs in their investment decisions, and the relatively superior profit behavior of capital goods industries which help to produce consumer goods that will mature in the long term tells entrepreneurs all around the productive structure that they must redirect their efforts and investments from the less profitable industries closer to consumption to the more profitable capital goods industries situated further away in time from consumption.

The second effect of the new increase in savings is the decrease in the interest rate and the way it influences the market price of capital goods situated further away in time from consumption: as the interest rate is used to discount the present value of the expected future returns of each capital good, a decrease in the interest rate increases the market price of capital goods, and this increase in price is greater the longer the capital good takes to reach maturity as a consumer good. This significant increase in the market prices of capital goods compared with the relatively lower prices of the less demanded consumer goods (due to the increase in savings) is a second very powerful microeconomic effect that signals all around the market that entrepreneurs must redirect their efforts and invest less in consumer goods industries and more in capital goods industries further from consumption.

Finally, and third, we should mention what Hayek called The Ricardo Effect (Hayek 1948, 220-254; 1978, 165-178), which refers to the impact on real wages of any increase in savings: whenever savings increase, sales and market prices of immediate consumer goods relatively stagnate or even decrease. If factor incomes remain the same, this means higher real wages, and the corresponding reaction of entrepreneurs, who will try in the margin to substitute the now relatively cheaper capital goods for labor. What the Ricardo Effect explains is that it is perfectly possible to earn profits even when sales (of consumer goods) go down, if costs decrease even more via the replacement of labor, which has become more expensive, with machines and computers, for instance. Who produces these machines, computers, and capital goods that are newly demanded? Precisely the workers who have been dismissed by the stagnating consumer goods industries and who have relocated to the more distant capital goods industries, where there is new demand for them to produce the newly demanded capital goods. This third effect, the Ricardo Effect, along with the other two mentioned above, promotes a longer productive process with more stages, which are further away from current consumption. And this new, more capital-intensive productive structure is fully sustainable, since it is fully backed by prior, genuine real savings. Furthermore, it can also significantly increase, in the future, the final production of consumer goods and the real income of all economic agents. These three combined effects all work in the same direction; they are the most elementary teachings of capital theory; and they explain the secular tendency of the unhampered free market to correctly invest new savings and constantly promote capital accumulation and the corresponding sustainable increase in economic welfare and development.

The unsustainable nature of the Bubbles induced by artificial credit expansions created by the fractional-reserve banking industry.

We are now in a position to fully understand, by contrast with the above process of healthy capital accumulation, what happens if investments are financed not by prior genuine savings but by a process of artificial credit expansion, orchestrated by fractional-reserve banks and directed by the lender of last resort or Central Bank.

Unilateral credit expansion means that new loans are provided by banks and recorded on the asset side of their balance sheets, against new demand deposits that are created out of thin air as collateral for the new loans, and are automatically recorded on the liability side of banks’ balance sheets. So new money, or I should say new “virtual money” because it only “materializes” in bank accounting book entries, is constantly created through this process of artificial credit expansion. And in fact roughly only around ten percent of the money supply of most important economies is in the form of cash (paper bills and coins), while the remaining 90 percent of the money supply is this kind of virtual money that only exists as written entries in banks’ accounting books. (This is precisely what the Spanish Scholastics termed, over 400 years ago, “chirographis pecuniarum” or virtual money that only exists in writing in an accounting book.)

It is easy to understand why credit expansions are so tempting and popular and the way in which they entirely corrupt the behavior of  economic agents and deeply demoralize society at all levels. To begin with, entrepreneurs are usually very happy with expansions of credit, because they make it seem as if any investment project, no matter how crazy it would appear in other situations, could easily get financing at very low interest rates. The money created through credit expansions is used by entrepreneurs to demand factors of production, which they employ mainly in capital goods industries more distant from consumption. As the process has not been triggered by an increase in savings, no productive resources are liberated from consumer industries, and the prices of commodities, factors of production, capital goods and the securities that represent them in stock markets tend to grow substantially and create a market bubble. Everyone is happy, especially because it appears it would be possible to increase one’s wealth very easily without any sacrifice in the form of prior saving and honest hard individual work. The so-called “virtuous circle of the new economy” in which recessions seemed to have been avoided forever, cheats all economic agents: investors are very happy looking at stock market quotes that grow day after day; consumer goods industries are able to sell everything they carry to the market at ever increasing prices; restaurants are always full with long waiting lists just to get a table; workers and their unions see how desperately entrepreneurs demand their services in an environment of full employment, wage increases and immigration; political leaders benefit from what appears to be an exceptionally good economic and social climate that they invariably sell to the electorate as the direct result of their leadership and good economic policies; state budget bureaucrats are astonished to find that every year public income increases at double digit figures, particularly the proceeds from Value Added tax, which, though in the end is paid by the final consumer, is advanced by the entrepreneurs of the early stages newly created and artificially financed by credit expansion.

But we may now ask ourselves: how long can this party last? How long can there continue to be a huge discoordination between the behavior of consumers (who do not wish to increase their savings) and that of investors (who continually increase their investments financed by banks’ artificial creation of virtual money and not by citizens’ prior genuine savings)? How long can this illusion that everybody can get whatever he wants without any sacrifice last?

The unhampered market is a very dynamically efficient process (Huerta de Soto 2010a, 1-30). Sooner or later it inevitably discovers (and tries to correct) the huge errors committed. Six spontaneous microeconomic reactions always occur to halt and revert the negative effects of the bubble years financed by artificial bank credit expansion.

The spontaneous reaction of the market against the effects of credit expansions: first the financial crisis and second the deep economic recession.

In my book on Money, Bank Credit and Economic Cycles (Huerta de Soto 2009, 361-384) I study in detail the six spontaneous and inevitable microeconomic causes of the reversal of the artificial boom that the aggression of bank credit expansion invariably triggers in the market. Let us summarize these six factors briefly:

1st The rise in the price of the original means of production (mainly labor, natural resources, and commodities). This factor appears when these resources have not been liberated from consumer goods industries (because savings have not increased) and the entrepreneurs of the different stages in the production process compete with each other in demanding the original means of production with the newly created loans they have received from the banking system.

2nd The subsequent rise in the price of consumer goods at an even quicker pace than that of the rise in the price of the factors of production. This happens when time preference remains stable and the new money created by banks reaches the pockets of the consumers in an environment in which entrepreneurs are frantically trying to produce more for distant consumption and less for immediate consumption of all kinds of goods. This also explains the 3rd factor which is

3rd The substantial relative increase in the accounting profits of companies closest to final consumption, especially compared with the profits of capital goods industries which begin to stagnate when their costs rise more rapidly than their turn over.

4th “The Ricardo Effect” which exerts an impact which is exactly opposite to the one it exerted when there was an increase in voluntary saving. Now the relative rise in the prices of consumer goods (or of consumer industries’ turnover in an environment of increased productivity) with respect to the increase in original-factor income begins to drive down real wages, motivating entrepreneurs to substitute cheaper labor for machinery, which lessens the demand for capital goods and further reduces the profits of companies operating in the stages furthest from consumption.

5th The increase in the loan rate of interest even exceeding pre-credit expansion levels. This happens when the pace of credit expansion stops accelerating, something that sooner or later always occurs. Interest rates significantly increase due to the higher purchasing power and risk premiums demanded by the lenders. Furthermore, entrepreneurs involved in malinvestments start a “fight to the death” to obtain additional financing to try to complete their investment projects (Hayek 1937).

These five factors provoke the following sixth combined effect:

6th Companies which operate in the stages relatively more distant from consumption begin to discover they are incurring heavy accounting losses. These accounting losses, when compared with the relative profits generated in the stages closest to consumption, finally reveal beyond a doubt that serious entrepreneurial errors have been committed and that there is an urgent need to correct them by paralyzing and liquidating the investment projects mistakenly launched during the boom years.

The financial crisis begins the moment the market, which as I have said is very dynamically efficient (Huerta de Soto 2010a, 1-30), discovers that the true market value of the loans granted by banks during the boom is only a fraction of what was originally thought. In other words, the market discovers that the value of bank assets is much lower than previously thought and, as bank liabilities (which are the deposits created during the boom) remain constant, the market discovers the banks are in fact bankrupt, and were it not for the desperate action of the lender of last resort in bailing out the banks, the whole financial and monetary system would collapse. In any case, it is important to understand that the financial and banking crisis is not the cause of the economic recession but one of its most important first symptoms.

Economic recessions begin when the market discovers that many investment projects launched during the boom years are not profitable. And   then consumers demand liquidation of these malinvestments (which, it is now discovered, were planned to mature in a too-distant future considering the true wishes of consumers). The recession marks the beginning of the painful readjustment of the productive structure, which consists of withdrawing productive resources from the stages furthest from consumption and transferring them back to those closest to it.

Both the financial crisis and the economic recession are always unavoidable once credit expansion has begun, because the market sooner or later discovers that investment projects financed by banks during the boom period were too ambitious due to a lack of the real saved resources that would be needed to complete them. In other words, bank credit expansion during the boom period encourages entrepreneurs to act as if savings had increased when in fact this is not the case. A generalized error of economic calculation has been committed and sooner or later it will be discovered and corrected spontaneously by the market. In fact all the Hayekian theory of economic cycles is a particular case of the theorem of the impossibility of economic calculation under socialism discovered by Ludwig von Mises, which is also fully applicable to the current wrongly designed and heavily regulated banking system.

The specific features of the 2008 Financial Crisis and the current economic recession.

The expansionary cycle which has now come to a close was set in motion when the American economy emerged from its last recession in 2001 and the Federal Reserve embarked again on a major artificial expansion of credit and investment, an expansion unbacked by a parallel increase in voluntary household saving.  In fact, for several years the money supply in the form of banknotes and deposits has been growing at an average rate of over ten percent per year (which means that every seven years the total volume of money circulating in the world has doubled).  The media of exchange originating from this severe fiduciary inflation have been placed on the market by the banking system as newly-created loans granted at extremely low (and even negative in real terms) interest rates.  This fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real estate assets, and the securities which represent them and are exchanged on the stock market, where indexes soared.

Curiously enough, like in the “roaring” years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the unit prices of the subset of consumer goods and services (which are only approximately one third of the total number of goods that are exchanged in the market).  The last decade, like the 1920s, has seen a remarkable increase in productivity as a result of the introduction, on a massive scale, of new technologies and significant entrepreneurial innovations which, were it not for the “money and credit injection,” would have given rise to a healthy and sustained reduction in the unit price of the goods and services all citizens consume.  Moreover, the full incorporation of the economies of China and India into the globalized market has gradually raised the real productivity of consumer goods and services even further.  The absence of a healthy “deflation” in the prices of consumer goods in a stage of such considerable growth in productivity as that of recent years provides the main evidence that the monetary shock has seriously disturbed the whole economic process. And let us remember the “Antideflationist Hysteria” of those who, even during the years of the bubble, used the slightest symptoms of this healthy deflation, to justify even greater doses of credit expansion.

As we have already seen, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no shortcut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all high rates of voluntary saving.  (In fact, before the crisis and particularly in the United States, voluntary saving not only failed to increase, but even fell to a negative rate for several years.)

The specific factors that trigger the end of the euphoric monetary “binge” and the beginning of the recessionary “hangover” are many, and they can vary from one cycle to another.  In this crisis, the most obvious triggers were first, the rise in the price of commodities and raw materials, particularly oil, second, the subprime mortgage crisis in the United States, and finally, the failure of important banking institutions when it became clear in the market that the value of their debts exceeded that of their assets (mainly mortgage loans erroneously granted).

If we consider the level of past credit expansion and the quality and volume of malinvestment produced by it, we could say that very probably in this cycle the economies of the European Monetary Union are in comparison in a somewhat less poor state (if we do not consider the relatively greater Continental European rigidities, particularly in the labor market, which tend to make recessions in Europe longer and more painful).  The expansionary policy of the European Central Bank, though not free of grave errors, has been somewhat less irresponsible than that of the Federal Reserve.  Furthermore, fulfillment of the convergence criteria for the monetary union involved at the time a healthy and significant rehabilitation of the chief European economies.  Only some countries on the periphery, like Ireland and Spain, were immersed in considerable credit expansion from the time they initiated their processes of convergence.

The case of Spain is paradigmatic.  The Spanish economy underwent an economic boom which, in part, was due to real causes (like the liberalizing structural reforms which originated with José María Aznar’s administration).  Nevertheless, the boom was also largely fueled by an artificial expansion of money and credit, which grew at a rate nearly three times the corresponding rates in France and Germany.

Spanish economic agents essentially interpreted the decrease in interest rates which resulted from the convergence process in the easy-money terms traditional in Spain:  a greater availability of easy money and mass requests for loans from Spanish banks (mainly to finance real estate speculation), loans which Spanish banks granted by creating the money ex nihilo while European central bankers looked on unperturbed. Once the crisis hit Spain the readjustment was quick and efficient: In less than a year more than 150,000 companies -mainly related with the building sector- have disappeared, almost five million workers who were employed in the wrong sectors have been dismissed, and nowadays we can conclude that although still very weak, the economic body of Spain has been already healed. We will later come back to the subject of what economic policy is most appropriate to the current circumstances. But before that, let us make some comments on the influence of the new accounting rules on the current economic and financial crisis.

The negative influence of the new accounting rules.

We must not forget that a central feature of the long past period of artificial expansion was a gradual corruption, on the American continent as well as in Europe, of the traditional principles of accounting as practiced globally for centuries.

To be specific, acceptance of the international accounting standards (IAS) and their incorporation into law in most countries have meant the abandonment of the traditional principle of prudence and its replacement by the principle of “fair value” in the assessment of the value of balance sheet assets, particularly financial assets.

In fact, during the years of the “speculative bubble,” this process was characterized by a feedback loop:  rising stock-market values were immediately entered into the books, and then such accounting entries were sought as justification for further artificial increases in the prices of financial assets listed on the stock market.

It is easy to realize that the new accounting rules act in a pro-cyclic manner by heightening volatility and erroneously biasing business management:  in times of prosperity, they create a false “wealth effect” which prompts people to take disproportionate “risks”;  when, from one day to the next, the errors committed come to light, the loss in the value of assets immediately decapitalizes companies, which are obliged to sell assets and attempt to recapitalize at the worst moment, when assets are worth the least and financial markets dry up.  Clearly, accounting principles which have proven so disturbing must be abandoned as soon as possible, and the recent accounting reforms recently enacted, must be reversed.  This is so not only because these reforms mean a dead end in a period of financial crisis and recession, but especially because it is vital that in periods of prosperity we stick to the principle of prudence in valuation, a principle which has shaped all accounting systems from the time of Luca Pacioli at the beginning of the fifteenth century till the adoption of the false idol of the International Accounting Rules.

It must be emphasized that the purpose of accounting is not to reflect supposed “real” values (which in any case are subjective and which are determined and vary daily in the corresponding markets) under the pretext of attaining a (poorly understood) “accounting transparency.”  Instead, the purpose of accounting is to permit the prudent management of each company and to prevent capital consumption, as Hayek already established as early as 1934 in his article “The Maintenance of Capital” (Hayek 1934). This requires the application of strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, whichever is lower), standards which ensure at all times that distributable profits come from a safe surplus which can be distributed without in any way endangering the future viability and capitalization of each company.

Who is responsible for the current situation?

Of course the spontaneous order of the unhampered market is not responsible for the current situation. And one of the most typical consequences of every past crisis and of course of this current one, is how many people are blaming the market and firmly believing that the recession is a “market failure” that requires more government intervention. The market is a process that spontaneously reacts in the way we have seen against the monetary aggression of the bubble years, which consisted of a huge credit expansion that was not only allowed but even orchestrated and directed by central Banks, which are the institutions truly responsible for all the economic sufferings from the crisis and recession that are affecting the world. And paradoxically central banks have been able to present themselves to the general public not only as indignant victims of the list of ad hoc scapegoats they have been able to put together (stupid private bankers, greedy managers receiving exorbitant bonuses, etc.), but also as the only institutions which, by bailing out the banking system as a last resort, have avoided a much greater tragedy.

In any case, it is crystal clear that the world monetary and banking system has chronically suffered from wrong institutional design at least  since Peel’s Bank Act of 1844. There is no free market in the monetary and banking system but just the opposite: private money has been nationalized, legal tender rules introduced, a huge mess of administrative regulations enacted, the interest rate manipulated and most importantly, everything is directed by a monetary central-planning agency: The Central Bank.

In other words, real socialism, represented by state money, Central banks and financial administrative regulations, is still in force in the monetary and credit sectors of the so-called free market economies.

As a result of this fact we experience regularly in the area of money and credit all the negative consequences established by the Theorem of the Impossibility of Socialism discovered by those distinguished members of the Austrian School of Economics: Ludwig von Mises and Friedrich Hayek.

Specifically, the central planners of state money are unable to know, to follow and to control the changes in both the demand for and supply of money. Furthermore, as we have seen, the whole financial system is based on the legal privilege given by the state to private bankers, who can use a fractional-reserve ratio with respect to the demand deposits they receive from their customers. As a result of this privilege, private bankers are not true financial intermediaries, but are mainly creators of deposits materializing in credit expansions that inevitably end in crisis and recession.

The most rigorous economic analysis and the coolest, most balanced interpretation of past and recent economic and financial events lead inexorably to the conclusion that central banks (which, again, are true financial central-planning agencies) cannot possibly succeed in finding the most convenient monetary policy at every moment.  This is exactly the kind of problem that became evident in the case of the failed attempts to plan the former Soviet economy from above.

To put it another way, the theorem of the economic impossibility of socialism, which the Austrian economists Ludwig von Mises and Friedrich A. Hayek discovered, is fully applicable to central banks in general, and to the Federal Reserve and (at one time) Alan Greenspan and (currently) Ben Bernanke in particular.  According to this theorem, it is impossible to organize any area of the economy and especially the financial sector, via coercive commands issued by a planning agency, since such a body can never obtain the information it needs to infuse its commands with a coordinating nature. This is precisely what I analyze in Chapter 3 of my book on Socialism, Economic Calculation and Entrepreneurship, which has been published by Edward Elgar in association with the Institute of Economic Affairs, and which we present today (Huerta de Soto, 2010b).

Indeed, nothing is more dangerous than to indulge in the “fatal conceit” – to use Hayek’s useful expression (Hayek, 1990) – of believing oneself omniscient or at least wise and powerful enough to be able to keep the most suitable monetary policy fine-tuned at all times.  Hence, rather than softening the most violent ups and downs of the economic cycle, the Federal Reserve and, to a lesser extent, the European Central Bank, have been their main architects and the culprits in their worsening.

Therefore, the dilemma facing Ben Bernanke and his Federal Reserve Board, as well as the other central banks (beginning with the European Central Bank), is not at all comfortable.  For years they have shirked their monetary responsibility, and now they find themselves up a blind alley.  They can either allow the recessionary process to follow its course, and with it the healthy and painful readjustment, or they can escape forward toward a “renewed inflationist” cure.  With the latter, the chances of an even more severe recession (even stagflation) in the not-too-distant future increase dramatically.  (This was precisely the error committed following the stock market crash of 1987, an error which led to the inflation at the end of the 1980s and concluded with the sharp recession of 1990-1992.)

Furthermore, the reintroduction of the artificially cheap-credit policy at this stage could only hinder the necessary liquidation of unprofitable investments and company reconversion.  It could even wind up prolonging the recession indefinitely, as happened in the case of the Japanese economy, which, though all possible interventions have been tried, has ceased to respond to any stimulus involving either monetarist credit expansions or Keynesian methods.

It is in this context of “financial schizophrenia” that we must interpret the “shots in the dark” fired in the last two years by the monetary authorities (who have two totally contradictory responsibilities:  both to control inflation and to inject all the liquidity necessary into the financial system to prevent its collapse).  Thus, one day the Fed rescues Bear Stearns, AIG, Fannie Mae, Freddie Mac or City Group, and the next it allows Lehman Brothers to fail, under the amply justified pretext of “teaching a lesson” and refusing to fuel moral hazard.  Finally, in light of the way events were unfolding, the US and European governments launched multi-billion-dollar plans to purchase illiquid (that is, worthless) assets from the banking system, or to monetize the public debt, or even to buy bank shares, totally or partially nationalizing the private banking system. And considering all that we have seen, which are now the possible future scenarios?

Possible future scenarios and the most appropriate economic policy.

Theoretically, under the wrongly designed current financial system, once the crisis has hit we can think of four possible scenarios:

The first scenario is the catastrophic one in which the whole banking system based on a fractional reserve collapses. This scenario seems to have been avoided by central banks which, acting as lenders of last resort, are bailing out private banks whenever it is necessary.

The second scenario is just the opposite of the first one but equally tragic: it consist of an “inflationist cure” so intense, that a new bubble is created. This forward escape would only temporarily postpone the solution of the problems at the cost of making them far more serious later (this is precisely what happened in the crisis of 2001).

The third scenario is what I have called the “japanization” of the economy: it happens when the reintroduction of the cheap-credit policy together with all conceivable government interventions entirely blocks the spontaneous market process of liquidation of unprofitable investments and company reconversion. As a result, the recession is prolonged indefinitely and the economy does not recover and ceases to respond to any stimulus involving monetarist credit expansions or Keynesian methods.

The fourth and final scenario is currently the most probable one: It happens when the spontaneous order of the market, against all odds and despite all government interventions, is finally able to complete the microeconomic readjustment of the whole economy, and the necessary reallocation of labor and the other factors of production toward profitable lines based on sustainable new investment projects.

In any case, after a financial crisis and an economic recession have hit it is necessary to avoid any additional credit expansion (apart from the minimum monetary injection strictly necessary to avoid the collapse of the whole fractional-reserve banking system). And the most appropriate policy would be to liberalize the economy at all levels (especially in the labor market) to permit the rapid reallocation of productive factors (particularly labor) to profitable sectors.  Likewise, it is essential to reduce public spending and taxes, in order to increase the available income of heavily-indebted economic agents who need to repay their loans as soon as possible.  Economic agents in general and companies in particular can only rehabilitate their finances by cutting costs (especially labor costs) and paying off loans.  Essential to this aim are a very flexible labor market and a much more austere public sector.  These measures are fundamental if the market is to reveal as quickly as possible the real value of the investment goods produced in error and thus lay the foundation for a healthy, sustainable economic recovery.

However, once the economy recovers (and in a sense the recovery begins with the crisis and the recession themselves which mark the discovery by the market of the errors committed and the beginning of the necessary microeconomic readjustment), I am afraid that, as has happened in the past again and again, no matter how careful central banks may be in the future (can we expect them to have learned their lesson? For how long will they remember what happened?), nor how many new regulations are enacted (as in the past all of them and especially Basel II and III have attacked only the symptoms but not the true causes), sooner or later new cycles of credit expansion, artificial economic boom, financial crisis and economic recession will inevitably continue affecting us until the world financial and banking systems are entirely redesigned according to the general principles of private property law that are the essential foundation of the capitalist system and that require a 100 percent reserve for any demand deposit contract.

Conclusion.

I began this lecture with Peel’s Bank Act, and I will also finish with it. On June 13 and 24, 1844 Robert Peel pointed out in the House of Commons that in each one of the previous monetary crises “there was an increase in the issues of country bank paper” and that “currency without a basis (…) only creates fictitious value, and when the bubble bursts, it spreads ruin over the country and deranges all commercial transactions”.

Today, 166 years later, we are still suffering from the problems that were already correctly diagnosed by Robert Peel. And in order to solve them and finally reach the only truly free and stable financial and monetary system that is compatible with a free market economy in this 21st century, it will be necessary to take the following three steps:

First, to develop and culminate the basic concept of Peel’s Bank Act by also extending the prescription of a 100 percent reserve requirement to demand deposits and equivalents. Hayek states that this radical solution would prevent all future crises (Hayek 1984, 29) as no credit expansions would be possible without a prior increase in real genuine saving, making investments sustainable and fully matched with prior voluntary savings. And I would add to Hayek’s statement the most important fact that 100 percent banking is the only system compatible with the general principles of the law of property rights that are indispensable for the capitalist system to work: there is no reason to treat deposits of money differently from any other deposit of a fungible good, such as wheat or oil in which nobody doubts the need to keep the 100 percent reserve requirement.

In relation to this first step of the proposed reform it is most encouraging to see how two Tory MPs, Douglas Carswell and Steve Baker, were able to introduce in the British Parliament on September the 15th and under the 10 minute rule the first reading of a Bill to reform the banking system extending the prescriptions of Peel’s Bank Act to demand deposits. This “customer Choice Disclosure and Protection Bill” will be discussed in its second reading, three weeks from now, on November the 19th, and has two goals: first to fully and effectively defend citizens’ right of ownership over money they have deposited in checking accounts at banks; and second, to once and for all put an end to the recurrent cycles of artificial boom, financial crisis and economic recession. Of course this first draft of the bill still needs to be completed with some important details, for instance the time period (let us say a month) under which all deposits should be considered demand deposits for storage and not for investment, and any contract that guarantees full availability of its nominal value at any moment should be considered at all effects a demand deposit for storage. But the mere discussion of these matters in the British Parliament and by the public at large is, in itself, of huge importance. In any case it is exciting that a handful of MPs have taken this step against the tangle of vested interests related to the current privileged fractional-reserve banking system. If they are successful in their fight against what we could call the current “financial slavery” that grips the world they will go down in history like William Wilberforce –with the abolition of the slave trade- and other outstanding British figures to which the whole world owes so much.

Second, if we wish to culminate the fall of the Berlin wall and get rid of the real socialism that still remains in the monetary and credit sector, a priority would be the elimination of Central Banks, which would be rendered unnecessary as lenders of last resort if the above 100 percent reserve reform is introduced, and harmful if they insist on continuing to act as financial central-planning agencies.

And third, who will issue the monetary base? Maurice Allais, the French Nobel Prize winner who passed away two weeks ago, proposed that a Public Agency print the public paper money at a rate of increase of 2 percent per year. I personally do not trust this solution as any emergency situation in the state budget would be used, as in the past, as a pretext for issuing additional doses of fiduciary media. For this reason, and this is probably my most controversial proposal, in order to put an end to any future manipulation of our money by the authorities, what is required is the full privatization of the current, monopolistic, and fiduciary state-issued paper base money, and its replacement with a classic pure gold standard.

There is an old Spanish saying: “A grandes males, grandes remedios”. In English, “great problems require radical solutions”. And though of course any step toward these three measures would significantly improve our current economic system, it must be understood that the reforms proposed and taken by governments up to now (including Basel II and III) are only nervously attacking the symptoms but not the real roots of the problem, and precisely for that reason they will again miserably fail in the future.

Meanwhile, it is encouraging to see how a growing number of scholars and private institutions like the “Cobden Centre” under the leadership of Toby Baxendale, are studying again not only the radical reforms required by a truly honest private money, but also very interesting proposals for a suitable transition to a new banking system, like the one I develop in chapter 9 of my book on Money, Bank Credit and Economic Cycles. By the way, in this chapter I also explain a most interesting by-product of the proposed reform, namely the possibility it offers of paying off, without any cost nor inflationary effects, most of the existing public debt which in the current circumstances is a very worrying and increasingly heavy burden in most countries.

Briefly outlined, what I propose and the Cobden Centre has developed in more detail for the specific case of the United Kingdom, is to print the paper banknotes necessary to consolidate the volume of demand deposits that the public decides to keep in the banks. In any case, the printing of this new money would not be inflationary, as it would be handed to banks and kept entirely sterilized, so to speak, as 100 percent asset collateral of bank liabilities in the form of demand deposits. In this way, the basket of bank assets (loans, investments, etc.) that are currently backing the demand deposits would be “freed”, and what I propose is to include these “freed” assets in mutual funds, swapping their units at their market value for  outstanding treasury bonds. In any case, an important warning must be given: naturally, and one must never tire of repeating it, the solution proposed is only valid in the context of an irrevocable decision to re-establish a free-banking system subject to a 100 percent reserve requirement on demand deposits. However, no matter how important this possibility is considered under the current circumstances, we must not forget it is only a by-product (of “secondary” importance) compared to the major reform of the banking system we have outlined.

And now to conclude, should in this 21st century a new Robert Peel be able to successfully push for all these proposed reforms, this great country of the United Kingdom would again render an invaluable service not only  to itself but also to the rest of the world.

Thank you very much.

REFERENCES

HAYEK, Friedrich A. (1937), “Investment that Raises the Demand for Capital”, Review of Economics and Statistics, 19, no. 4. Reprinted in Profits, Interest and Investment, pp. 73-82.

HAYEK, Friedrich A. (1948), “The Ricardo Effect” in Individualism and Economic Order, Chicago: University of Chicago Press, pp. 250-54.

HAYEK, Friedrich A. (1975), “The ‘Paradox’ of Saving” in Profits, Interest and Investment and other Essays on the Theory of Industrial Fluctuations, Clifton, N.J.: Augustus M. Kelly.

HAYEK, Friedrich A. (1978), “Three Elucidations of the Ricardo Effect” in New Studies in Philosophy, Politics and the History of Ideas, London: Routledge and Kegan Paul, pp. 165-78.

HAYEK, Friedrich A. (1984), “The Monetary Policy of the United States after the Recovery from the 1920 Crisis”, Chapter 1 in Money, Capital and Fluctuations: Early Essays, R.M. McCloughry, ed., Chicago: University of Chicago Press.

HAYEK, Friedrich A. (1990), The Fatal Conceit: The Errors of Socialism, W.W. Bartley, III (ed.), London: Routledge and Chicago, Il.: The University of Chicago Press.

HUERTA DE SOTO, Jesús (2009), Money, Bank Credit and Economic Cycles, Auburn, Al.: Mises Institute (2nd English edition). First Spanish edition 1998.

HUERTA DE SOTO, Jesús (2010a), The Theory of Dynamic Efficiency, London and New York: Routledge.

HUERTA DE SOTO, Jesús (2010b), Socialism, Economic Calculation and Entrepreneurship, Cheltenham, UK and Northampton, Massachusetts, USA: Edward Elgar.

MISES, Ludwig von (1980), The Theory of Money and Credit, Indianapolis, Ind.: Liberty Classics. First German edition 1912, 2nd German edition 1924.

102 comments to Economic Recessions, Banking Reform and the Future of Capitalism

  • [...] Paul Green: Huerta de Soto at the London School of Economics yesterday – – absolutely terrific and to an overflowing [...]

  • The whole superstructure of his argument rests on a fundamental error he merely asserts without arguing for: that a bank expanding its assets funded by new demand deposits represents investment without savings. Whether you can see it as obvious, or whether you can’t see it at all, the correct analysis of a bank’s demand deposit liabilities are that they are the savings of the customer, and can only get there by the customer providing those resources to the bank, and keeping them there (whether for a longer or for a shorter time). For example, if a man earns $10,000 and spends $5,000 and invests the balance in $5,000 of bonds issued by a telecommunications company, he has saved that $5,000 and lent it to the telecommunications company. If he then sells those $5,000 of bonds to his bank, in exchange for a demand deposit of $5,000 with his bank, the quantity of his savings is the same as before, only the form changes. The bank has borrowed $5,000 from its customer and used this to finance $5,000 in additional investments, the customer has changed the form of his savings from the teleco bonds to the bank demand deposit. The teleco company still has the same amount of resources to use to finance its switches, exchanges and cables etc. The bank customer has the same amount of savings as before, and his wealth is not a lot different either. The bank books its new asset at cost, i.e. the amount credited to its customers account, and only makes a profit or loss from the difference between the earnings on the asset (including any fair value impairments booked) and the cost of finance. The bank is a financial intermediary, borrowing and lending on its own account, but intermediating savings in the process. The saver has no more inclination to spend his wealth as before, although, should he want to spend it, his wealth is in a form that makes the spending easier. The bank could facilitate his spending his wealth even if he still held the beneficial interest in the bond and the bank held the bond as the customer’s nominee or custodian: the bank could grant him an overdraft, and allow him to spend up to the overdraft limit while he’s still holding the bond. Alternatively the customer could always sell the bond to a third party and spend the proceeds as well. So, regardless of how he holds his wealth a) his savings are about the same and b) the bank or the market can help him spend his wealth if he wants to. Clearly de Soto is proceeding on the basis of a fundamental error, and his economics are non-sensical for anyone who recognises his fundamental error.

    Perhaps another way to show that demand deposits are savings of the customer, consider a person who earns $800/week, and spends $500/week, and lets the difference accumulate in his demand deposit account with his bank. Clearly the worker is saving $300/week, and the worker’s savings are being paid to the bank. The bank uses the funds to invest in loans to homeowners and businesses, who in turn use the funds to finance land, buildings, and plant, and stock and accounts receivable. The bank books the demand deposits as its liability, and the loans its makes as its assets. Regardless of why the worker has his wages less spending paid to his bank, and regardless of when in the future he may withdraw the funds to spend or convert them into other assets, so long as he is spending less than he is earning he is saving, and so long as the funds are paid (in the form of a loan repayable on demand) to the bank they can finance the bank’s investments, and the banks investments are financed by the worker’s savings.

    There are many ways of looking at it, but each perspective supports what I’m saying. If you look at it legally, the courts hold that the funds are a debt owing from the bank to the customer — an implied term: necessary to make the contract work, and sufficiently obvious it goes without saying. (That is if the bank does not make it an express term, which in at least some cases it is.) If you look at the accounting treatment, the funds are booked as a debt owing from the bank to the customer. If you look at the economic substance, the customer is the saver and the bank is the user (or intermediator) of the funds for productive investments. De Soto is greatly and fundamentally in error. See http://www.lostsoulblog.com/search?q=de+soto for more material re de Soto

    • Robert Sadler

      To David Hillary,

      I am afraid I don’t quite understand your argument (RE De Soto’s fundamental error) and I have a number of questions. Firstly, how does the bank finance its initial purchase of the bonds? Secondly, how does the banks reserve ratio fit into your analysis? If I understand you correctly you are arguing that De Soto is in error for arguing that banks are expanding credit beyond the initial demand deposit yet your argument appears to implicitly assume 100% reserves. Otherwise, it is clear that the bank would lend out the $5,000 savings that the man has deposited (for ease I assume 0% reserves) to another party who would presumably deposit it in a bank account (for example, the Telco). Therefore, there are now two parties with competing claims to the same $5,000 – the money supply has doubled or we have “money out of thin air” if you like.

      • Robert,

        The bank finances the purchase of the bonds by borrowing the full amount from its customer, in my example. So the exchange is between just 2 parties: the man and the bank. The bank acquires the asset in exchange for the bank’s promise to pay $5000 to the man. The man sells the bonds in exchange for the claim on the bank. The bank’s accounting entry is:
        Dr Bonds (teleco) $5000
        Cr Customer (man) $5000

        The debit entry is the asset account recording the bonds at cost to the bank, the credit entry is the liability account recording the bank’s obligation to its customer the man.

        The man’s accounting entry records his disposal of the asset (the teleco bond) in exchange for another asset, the claim on the bank for $5000:

        Dr Bank $5000
        Cr Bonds (teleco) $5000

        Note that this assumes that the man recorded his investment in the teleco bonds at cost of $5000, and that he had not accrued any interest on it, and that its carrying value was the same as what he sold it to the bank for. If he had the asset recorded in his books at any other value, any gain or loss on the sale would have to be recorded on the sale, for example, if the asset was recorded by him with a carrying value of $4990, and he sold it for $5000 his entry would be:

        Dr Bank $5000
        Cr Bonds (teleco) $4990
        Cr Gain on Sale $10

        The gain on sale account is an income account rather than an asset account.

        The bank’s reserve ratio will fall as a result of its aquisition of the asset, unless the asset is regarded as part of the bank’s reserves. The term ‘reserves’ in the bank’s reserve ratio may refer to metallic reserves, or reserves of all liquid assets, or some other definition depending on the definition used, which in turn depends on the monetary standard and banking system. For example, under central banking, balances with the central bank and bank notes issued by the central bank are almost always counted as reserves. In many debates about fractional reserve banking it may be assumed that ‘reserves’ means reserves of metallic currency, as these assets represent chattels in possession rather than claims on other parties. The purpose of the example was to illustrate the situation where the customer wishes to retain his balance with the bank rather than withdraw it, so implicitly, the bank’s need for reserves is being ignored, for example we could simply assume that the bank is willing and able to re-finance this amount by issuing bonds on the market and/or by selling marketable assets rather than by using some of its reserves on an other than temporary basis. So my argument implicitly assumes not 100% reserves but 0% reserves, at the margin, for this transaction.

        The teleco does not gain any new funds as a result of the transaction, since it already had issued the bonds to the man, and only the ownership of the bonds has changed from the man to the bank. The bank’s available funds for lending do not increase to any extent beyond the bonds it aquired in the transaction – the bank fully invested the man’s savings in the bonds aquired. The only party with more funds on account is the man, who gave up the teleco bonds in exchange for them. His total assets is unchanged (assuming the bonds were sold to the bank for their carrying value), only the form has changed. The bank’s total assets has increased, but its equity position has not, as the bank’s liabilities increased the same amount as its assets. The change in the form of the man’s assets does increase the stock of ‘money’ because the claim on the bank is money to the man, but the bonds were not. This ‘money’ has not been created out of thin air, but out of a non-money asset, i.e. the bonds. $5000 of teleco bonds has been turned into $5000 in money. The consequences of the transaction, however, is not what de Soto claims.

        • Robert Sadler

          David,

          Thank you for your reply. Unfortunately, I have more questions for you. You say that the “stock of money” has increased based on the conversion of the man’s bonds to money (i.e. cash). In the stock of money do you also include the cash that the Telco received in return for selling the bonds? I assume that the Telco would deposit this cash at the bank. In this case, don’t we have the situation whereby both the Telco and the man have a $5000 demand deposit balance at the bank which has grown out of the same $5000? (A total money stock of $10,000 pyramided on the initial $5000 bond transaction).

          Further, I don’t understand how the bank borrows $5000 from the man since the man has no money (He had $10,000, spent $5000 and lent the remainder to the Telco). I understand that you say that it is a “promise to pay” but you also say it is a demand deposit. It appears as though the bank “wrote a check on itself” much the way the Fed does when engaging in similar transactions. Working within the confines of the example you gave, if both parties come to the bank to collect their demand deposits in full the bank is in real trouble.

          • Robert, the money the man saved served to mediate the transaction whereby the teleco obtained switches, cables etc. (fixed assets) financed by the loan from the man. The teleco therefore does not hold the amount borrowed as cash or as a balance with its bank, but in the form of fixed assets.

            The man’s employer expensed his wages and the amount paid to him by bank transfer:
            Dr Employment Expense $10,000
            Cr Bank $10,000

            The man booked income he earned and the funds in his bank account:
            Dr Bank $10,000
            Cr Wage income $10,000

            The man expensed his living costs:
            Dr Living expenses $5,000
            Cr Bank $5,000

            This leaves the man with a bank balance of $5,000, which he lends to the teleco:
            Dr Bonds (teleco) $5,000
            Cr Bank $5,000

            The teleco gets the man’s cash and records the issue of the bonds as:
            Dr Bank $5,000
            Cr Bonds issued $5,000

            The teleco buys fixed assets with the bank balance:
            Dr Fixed Assets $5,000
            Cr Bank $5,000

            So, both the man and the teleco have no funds in the bank in connection with the man’s savings and the teleco’s bond issued and fixed asset investments financed thereby.

            The bank obtained an asset and a liability by buying the man’s bonds. You could say the bank drew a cheque on itself, although technically it would be a promissory note, since the bank is both the drawer and the drawee, but I’ll not complicate things be explaining all the ins and outs of negotiable instrument law. If the bank drew a cheque on itself, the man would have deposited it to his current account with the bank, and the bank would have collected it by presenting it to itself, and crediting the amount to the customer’s account. The result is the same in any case: the bank ends up crediting the account of the man to record the amount owing to him as a result of the bank’s purchase of the man’s asset. The bank’s accounting entry:
            Dr Bonds (teleco) $5,000
            Cr Customer deposits (man) $5,000

            The man’s entry is the reverse:
            Dr Bank $5,000
            Cr Bonds (teleco) $5,000

            Note that the customer’s account with the bank is in credit from the bank’s perspective and in debit from the customer’s perspective, as the balance is the asset of the customer and the liability of the bank.

            This is little different from a merchant selling goods on credit at cost. The merchant, if selling goods for $1,000 that it purchased for $700 records the sale as:
            Dr Accounts Receivable $1,000
            Dr Cost of goods sold $1,000
            Cr Sales Income $1,000
            Cr Inventory $1,000

            (the only difference is that there is an income and expense also recorded for the goods sold and the cost of goods sold)

            The corresponding entry for the buyer (assuming that the buyer does not expense the purchase but capitalises it as either fixed assets or inventory):
            Dr Inventory/fixed assets $1,000
            Cr Accounts payable $1,000

            The customer deposits of the bank is the same as its accounts payable, and the bank asset of the customer is the same as its accounts receivable. The principal difference is functional: the bank balance is repayable on demand and can be used to pay for goods and services or to buy assets or pay dividends, and counts as ‘cash’ for accounting purposes, whereas accounts receivable cannot be used this way, because a) the funds are not payable on demand and b) the debtors do not offer payment services as part of the contract.

            That is not to say that the accounts receivable cannot be used. In times past it was common for bills of exchange to be used to evidence accounts receivable and as a means of finance: the merchant would draw a bill of exchange on its ordering customer, and the ordering customer would accept it by signing it, and return it to the merchant. The bill would be like this:
            Issued: 01 Jan 2010
            To: Customer
            Pay: Merchant
            Amount: $1,000
            On: 01 Apr 2010
            Signed: Merchant
            Signed: Customer

            The merchant would then sell the bill to his bank or financier or to an investor at a discount (e.g. in the above case, a price of, say $970, the $30 discount representing interest to be earned over the life of the bill), and use the funds to pay for the materials and labour to complete the customer’s order. On maturity the bank presents the bill to the customer or the customer’s bank (the customers bank having been given a mandate to pay not only the customer’s cheques but also his bills and notes). If the customer fails to pay, the holder could then present the bill to the merchant, who would be liable as well.

          • Current

            I agree with David Hillary here.

            The point is that when a commercial bank writes “a check on itself” that cheque will be cashed. To the commercial bank it is *a liability*. We are so used to thinking of money as an asset that we often find it different to think of it as the opposite.

            For example… Terry wants to borrow an amount of 200 Oz of gold. Jim is a normal citizen, he lends 100 Oz of gold in coinage to Terry. Jim and Terry sign papers and leave. Then Frank who is a banker arrives, he lends a 100 Oz gold note to Terry. Both parties sign papers and leave. It may seem that Frank has created the note out of thin air and spent it. But, this isn’t how it is to Frank at all. He knows that Terry hasn’t borrowed money worth 200 Oz of gold in order to keep it, but to spend it. When Terry spends the 100 Oz gold note the person who receives it will redeem it, if they don’t then the person after them will. By issuing a banknote Frank has put into circulation something which is money to other people, but is to him a promise to redeem. He gets an interest-free loan from all of those other people until the time when someone redeems the banknote, and at that time he must pay.

            Another 100% reserve supporter discussed a similar example with me recently. He said that when a we have current accounts when bank creates a loan it creates a database entry for the loan amount and that’s all. Suppose the loan is again 100 gold ounces, but a current account is used rather than notes. Frank lends it to Terry as before. Frank puts an entry for 100 ounces in his computer database certainly. But Terry is borrowing because he wants to spend the money, so he will soon withdraw it and spend it on whatever goods he setup the loan to but. To do that there must be a transfer of 100 gold ounces from Frank’s bank to the banks of whomever Terry spends his money with. Banks transact between each other using base money. That means that Frank must have 100 ounces of reserves before he starts. In this example, as in the previous, Frank obtains an asset – the debt contract that the businessman agrees to, in order to obtain that the bank must give up that 100 gold ounces of reserves. In order to obtain those reserves it must borrow money from savers.

            What David is trying to show here is that although banks certainly create money they do not create it out of “thin air”, they create it from debt. For every £ that customers have in on-demand accounts the bank must hold at least a £ of assets. Those assets will be split between financial assets such as loans and reserves, but loans will be the larger part. All that banks earn in profit is the difference between the rate of interest paid on current accounts and that paid by borrowers less their overheads. If banks could really get a “free lunch” from creating money then no banking industry could operate without a government enforced reserve ratio, but governments don’t enforce such a ratio. In fact, reserve ratios were only an invention of the 19th century.

        • Robert Sadler

          David,

          Thank you for the well explained reply. Sorry to belabor the point but I think we still have the same problem. As you helpfully show, the Telco immediately spends the $5000 cash from the man. However, you state the Bank provides the man with a promissory note to pay the man $5000 on demand. But if the man turns up the next day and demands his $5000 the Bank will have no money to pay him.

          I realize that I am working within the strict confines of your example and in the real world the Bank would have methods of financing this draw (with more debt) however, at any given time there is a finite amount of liquidity in the world. At some point it is inevitable that more people will demand their cash than the Bank has reserves to pay them, hence, the recent liquidity crisis.

          So I have a few more questions for you. 1) In your view, without intervention from a Central Bank or Governments how would FR banks survive such a liquidity crisis? 2) Do you accept that Fractional Reserve Banking is inflationary? 3) Do you agree that inflation ultimately leads to the business cycle?

          Current, please feel free to answer these questions as well, your contributions are welcome.

  • Antonio

    If as you say “the courts hold that the funds are a debt owing from the bank to the customer” why is it called demand deposit? Are you sure you understand anything about what fractional reserve really means? The bank is creating money out of thin air, expanding the monetary base that causes the business cycle. Maybe you should try reading The Mystery of Banking (Murray N. Rothbard) before embarrassing yourself.

    • Current

      > why is it called demand deposit?

      That term has always been confusing. However, David Hillary is quite right, balances in current accounts are debts. Your balance at your bank is a loan to the bank, and so that balance is savings.

      David Hillary’s criticism of De Soto is entirely correct.

      > The bank is creating money out of thin air, expanding the monetary
      > base that causes the business cycle.

      Whether it is or not is a different question. The point that David Hillary is making here is that the case for ABCT can’t be made by claiming that current account balances are not savings, because they are savings. David quotes Larry White and Steve Horwitz they certainly believe that ABCT exists but that doesn’t mean that all creation of fiduciary media is destructive.

    • Why the words ‘demand deposit’ are used to describe the bank-customer contract are not relevant. It is enough that these words have a recognised legal meaning, so that those who use those words can rely on them being held to have that meaning, and to include all the implied terms that are necessary to make the contract work and are sufficiently obvious to go without saying.

      In fact the law does not look so much to the words used, as to the nature of the relationship between the parties, although the words used are indeed considered carefully. The law looks to both the words and the nature of the relationship to see the terms that are included, either expressly or by implication. For example, you could call it a ‘money service’ or a ‘payment service’ or a ‘savings and payments service’ or an ‘investment and payment service’ and the courts would, if they considered the nature of the relationship to be the same as a bank-customer contract, end up treating these words the same as the more traditional wording ‘current account’ or ‘banking service’.

      If you wish to create a new type of contract, the law does not restrict you from changing the terms by making them express terms. In fact, one rule for an implied term is that it must not contradict an express term. So, if you want to have a ‘storage account’ and require the institution to maintain storage in a particular form, you can simply include those requirements as express terms, and the law and the courts will uphold them accordingly.

      You link ‘creating money out of thin air, expanding the monetary base that causes the business cycle’ however you do not explain why accepting funds on current account constitutes ‘creating money out of thin air’ or why it has the results you purport. I suggest that you should be the one who is embarrassed by making such hollow and unsubstantiated claims.

  • The money multiplier based on deposits has two serious drawbacks: 1) is based on a contract null and void, and 2) creates money as loans that has no basis in real savings.

    Which is the fundamental error of Huerta de Soto’s argument?

    I see nothing in your argument that legitimates that type of contract, or explain where is the pre-requisite savings that need any kind of investment.

    • Current

      > 1) is based on a contract null and void

      No it isn’t. There is nothing odd about on-demand contracts, they are used in many other fields of business.

      > 2) creates money as loans that has no basis in real savings.

      See my reply above to David Hillary.

    • Both of your points 1) and 2) are fundamentally wrong. If the parties wish to have a debt repayable on demand, the law should support rather than veto such provisions. Whether the contract involves risk of default is beside the point: every contract has such risk, and if parties wish to run such risks, the law is not to stand in the way.

      As I have argued at some length (sufficient to support the point), funds on current account with a bank ARE savings of the customer so long as they are outstanding. Why do you just assert things without arguing for them? what do you expect us to do, having already put forward supporting points and arguments, when you simply assert the contrary? No one will take you seriously unless you enter the fray with some arguments, and have some skin in the game. Otherwise you’re just a Ph.D specialising in unsubstantated assertions.

  • Paul

    I went through the several articles critiquing De Soto, and even found a Mises quote being used to show the ‘feasibility’ of fractional reserve banking. But it should be clear that Mises was only illustrating the mentality of the issuer of fiduciary media, and his trade cycle theory could be interpreted as being against the notion of spending and saving a monetary unit at the same time.

    Perhaps I’m just too dull to comprehend how the central bank process that allows for such simultaneous saving and spending is after all not inflationary. This school of thought is nonetheless fascinating.

    • Current

      > But it should be clear that Mises was only illustrating the
      > mentality of the issuer of fiduciary media

      No he wasn’t. Read the surrounding text from the free copy of “The Theory of Money and Credit” on Mises.org.

      He went much further in that book in the section on redemption: “Consequently the chief rule to be observed in the business of a credit-issuing bank is quite clear and simple: it must never issue more fiduciary media than will meet the requirements of its customers for their business with each other. But it must be admitted that there are unusually big difficulties in the practical application of this maxim for there is no way of determining the extent of these requirements on the part of customers. In the absence of any exact knowledge on this point the bank has to rely upon an uncertain empirical procedure which may easily lead to mistakes. Nevertheless, prudent and experienced bank directors—and most bank directors are prudent and experienced—usually manage pretty well with it.”

      Nobody is saying that you can simultaneously save and spend a money unit at the same time. What we are saying is that the bank balance of a person is saving until such time as it is spent. If Bill has £100 in his account then he is saving that amount until he spends it. Just as if you hold 100 shares then you’re an investing in that company until you sell the shares.

      Rothbard and Mises had very different views on monetary economics. This is something that’s often sidelined by economists associated with the Ludvig Von Mises institute who wish to support Rothbard’s view. Mises didn’t think that fractional-reserve banking and on-demand accounts were fraudulent, Rothbard was the first Austrian economist to claim that. Nor did Mises think that creation of fiduciary media will necessarily cause a business cycle. His theory is rather that supply of money-substitutes beyond the demand for them will cause a business cycle. His chief reason for advocating a 100% reserve gold standard was that under central banking the government has a very great amount of control over money creation. That allows governments to use it for political ends and create ABCT. Mises wanted to stop that. But, in the longer run he wanted free banking, he did not exclude the possibility of returning to fractional reserves after that.

  • [...] de Soto, catedrático de Economía de la Universidad Rey Juan Carlos, ofreció una conferencia en The London School of Economics sobre la reforma bancaria que en estos momentos debate el [...]

  • Stephen

    If I deposit $1M into a bank: 1) I do not exchange present goods for future goods; 2) I have $1M in liquid assets; and 3) The money supply is unchanged.

    If the bank extends a $900K loan out of my demand deposit based on the fractional-reserve principle: 1) I have $1M in liquid assets; 2) The bank exchanges $900K of my present goods for future goods; 3) The borrower has $900K in liquid assets; 4) The money supply has increased by $900K.

    David and Current: 1) How can I possibly have $1M in liquid assets at the same time that the borrower has $900K in liquid assets? 2) What other business operates in such a way that the time structure of its assets does not match the time structure of its liabilities? 3) Do you believe that fractional-reserve banks should be allowed to freely compete on the market? 4) Do you support the historical measures that have been implemented to relieve fractional-reserve banks of their legal obligations to return depositors’ money and continue operations? 5) Do you support fiat money, central banking, and legal-tender privileges?

    • Stephen, the FRFB school do not have such an idea of law and property rights as you do. I am more with you on this. I suspect Current will say that he agrees that two claims to the same property cannot exist, however, what if freely consenting adults wish to engage in such transactions knowing that they diminish their property rights and co mingle them with others , strange as it may sound to most people with a legal background, so that multiple titles to property can be created to facilitate more on lending and thus more return to the parties to this legally odd and unique transaction.

      Should this type of contract be allowed?

      Stephen, like Current you write well. You are more than welcome to submit an article if you would like do as he has done.

      • Stephen

        Toby,

        On the unhampered market the agreement we are discussing would not entail diminished property rights. If I loan my money to a bank in exchange for IOUs from that bank and the bank in turn loans a portion of that money out, I am knowingly putting my money at risk. If the bank declares that it cannot presently redeem its IOUs, it has not defaulted on the contract. Of course, these types of IOUs in general would not be accepted at par with money or money titles and different banks’ IOUs would be valued differently, so these instruments would play virtually no monetary role in the economy.

        This discussion is complicated by the fact that currently bank notes and bank account balances are denominated in meaningless abstract units. On the unhampered market the IOUs we are discussing would not be money, so they wouldn’t entail the same property conflicts.

        Thank you for the compliments, I would definitely be interested in contributing to the honest money movement. Perhaps you can email me and we can discuss this further?

        • Current

          > On the unhampered market the agreement we are discussing would
          > not entail diminished property rights. If I loan my money to a
          > bank in exchange for IOUs from that bank and the bank in turn
          > loans a portion of that money out, I am knowingly putting my
          > money at risk.

          Yes.

          > If the bank declares that it cannot presently redeem its IOUs,
          > it has not defaulted on the contract.

          That’s not right. If the contract promise to redeem at any time then the bank *has* defaulted. It can be sued, if it doesn’t pay it can be declared bankrupt and turned over to an administrative receiver.

          Just because a person takes a risk by entering into a contract doesn’t mean that it is permissible for the other party to fail. This confuses two things, the risk entailed in the contract and the breaking of it.

          Consider a marriage. If a woman marries an abusive man we may say that she took a risk. If she is beaten up by him some may say that she “had it coming”, but even those people would be reluctant to say that the man has committed no offence.

          • Stephen

            The bank would not have defaulted on the contract because the depositors are knowingly putting their money at risk. The bank cannot enter into an agreement stating that the depositors have an air-tight legal claim on their money on demand; it can only enter into an agreement promising to do its best to redeem its IOUs on demand. Under this sort of arrangement, if the bank cannot redeem its IOUs on demand, it has not defaulted and can promise to redeem its IOUs in the future.

          • Current

            I am not a lawyer, and nor do I play one on the internet. But, as far as I understand it things work like this…

            Every contract that exists or has existed demands that certain parties do particular things. One of those parties, or several, may not be able to fulfil their obligations. Now, that doesn’t mean that contracts can’t be agreed upon where there is a risk of non-fulfilment of obligations. Certainly contracts can be made that have clauses that determine what happens in certain cases where non-fulfilment occurs. But, if a contract doesn’t have such clauses for every case then the fall-back is the law.

            For example, suppose I rent out a house to you then a nearby river floods, and floods the house. You will not be able to use it because it’s flooded. We may not have put in a clause about what happens in that case in the tenancy contract. What that means is that common law and legislation comes into play and it determines who is responsible for what.

            So, banks can simply agree to pay and let other laws sort out what happens if there is a default historically they have done this quite often. Of course it may be better for them to specify the terms more clearly. Option clauses may be used. These give the bank the option to pay at a later date if the bank adds on an interest payment to the customer at that time. Normally customers have only agreed to this if the interest rate is high to prevent the bank from inconveniencing them by using the clause. Even this though doesn’t make the situation entirely clear because it doesn’t state what happens if the bank fails to pay once it’s invoked the option clause. In that case the bank has defaulted and general law determines what happens next.

            People have suggested that the law shouldn’t work like this, but that’s how it does work presently, AFAIK.

    • Current

      > If I deposit $1M into a bank: 1) I do not exchange present goods for
      > future goods; 2) I have $1M in liquid assets; and 3) The money
      > supply is unchanged.

      I agree with your point 1 & 2, but 3 is a bit more tricky, I’ll come on to that later.

      > If the bank extends a $900K loan out of my demand deposit based on
      > the fractional-reserve principle: 1) I have $1M in liquid assets; 2)
      > The bank exchanges $900K of my present goods for future goods; 3)
      > The borrower has $900K in liquid assets; 4) The money supply has
      > increased by $900K.

      In a fractional reserve banking system money-substitutes are a form of debt. By opening an account and putting $1M in it you have *lent* the bank that sum. When the bank makes the loan it does not exchange $900K of *your* present goods for future goods. The bank exchanges $900K that *belong to it* for the loan.

      It’s quite true that if the bank had offered you a bailment contract (money warehousing) and they lent out your money then that would be fraud. It’s also quite true that many current account users don’t know that their account is a debt.

      > David and Current: 1) How can I possibly have $1M in liquid assets
      > at the same time that the borrower has $900K in liquid assets?

      This is a bit of a strange question, if what you describe were to happen then both parties would have the liquid assets that you describe. That’s what happens.

      Your bank account is a money-substitute because the bank can fulfill certain criteria set by the market. The bank provide, on behalf of the customer, payments to other parties reliably. They do that often by paying out base money, through redemption.

      It’s true that the bank doesn’t keep all of the customers account in base money, but it doesn’t really need to. But, customer demands for banking services don’t occur all at once, so the bank can estimate the reserve it needs to keep on hand at any particular time. So, the bank can keep a large part of it’s assets in other types of assets than base money. My point in our earlier discussion was that the bank can’t do without those other assets. It doesn’t have a special power to operate when insolvent and therefore create money “out of nothing”. Certainly a bankrupt banker may fool everyone for a limited time, so may other bankrupt businesses. But that can’t continue for long, once word got out that the bank had less assets than liabilities there would be a run.

      > 2) What other business operates in such a way that the time
      > structure of its assets does not match the time structure of its
      > liabilities?

      Lot’s of businesses do that. Insurance companies for a start. A person with an insurance contract can claim on an insurance company at any time, but the company only keeps a very small quantity of money on hand to pay them.

      > 3) Do you believe that fractional-reserve banks should
      > be allowed to freely compete on the market?

      Yes, absolutely.

      > 4) Do you support the
      > historical measures that have been implemented to relieve
      > fractional-reserve banks of their legal obligations to return
      > depositors’ money and continue operations?

      No. However, banks should be subject to normal receivership laws which do allow some leeway. That’s to say, like other business when a bank fails it’s better that it go into the hands of an appointed receiver to try to sell it as a going concern than for it to be liquidated straight away. (If you’re an American what I mean is that bankrupt banks should go into Chapter 11 bankruptcy first, and only if they can’t be sorted out into Chapter 9).

      > 5) Do you support fiat
      > money, central banking, and legal-tender privileges?

      Certainly not.

      • Stephen

        Fractional-reserve banking is not comparable to insurance. Insurance companies do not have liabilities outstanding that they lack sufficient assets to meet. They insure against events that are systematically unpredictable, and collect premiums so that they can make good on their agreements when such events occur. They do not have liabilities until systematically unpredictable events occur, and at that time they have to make good on their agreements.

        If, by loaning my money to a bank, the bank agrees to give me an air-tight legal claim to my money at any time, then it is engaging in fraudulent activity if it doesn’t have enough money available at all times to cover its liabilities. If, by loaning my money to a bank, the bank agrees to give me IOUs promising to do its best to give me my money back when I demand it, the bank is not engaging in fraudulent activity by loaning my money out, and it can deny present demands for redemption and promise that it will make good on its IOUs in the future.

        You are arguing that it is not fraudulent if they don’t have my money available since the contract is not a bailment, but you are also arguing that they are legally required to pay my money back when I demand it. These are conflicting positions.

        • Current

          > Fractional-reserve banking is not comparable to
          > insurance.

          Certainly it isn’t exactly comparable, but there are many similarities.

          > Insurance companies do not have liabilities
          > outstanding that they lack sufficient assets to meet.

          That depends entirely on the amount of claims that they get.

          > They
          > insure against events that are systematically unpredictable,
          > and collect premiums so that they can make good on their
          > agreements when such events occur. They do not have liabilities
          > until systematically unpredictable events occur, and at that
          > time they have to make good on their agreements.

          Yes.

          Estimating them is somewhat similar to estimating how much reserves a bank will need in a time period to fund redemptions.

          > If, by loaning my money to a bank, the bank agrees to give me
          > an air-tight legal claim to my money at any time, then it is
          > engaging in fraudulent activity if it doesn’t have enough money
          > available at all times to cover its liabilities.

          If you have agreed to a debt contract then the bank is only in breach if it fails to pay in practice. It defaults if and when it fails to pay. Certainly, if you and the bank have agreed to a bailment (warehousing) contract then the bank is in breach if it fails to store your money honestly at any time. However, bank accounts and banknotes are not bailment contracts

          > If, by loaning my money to a bank, the bank agrees to give me
          > IOUs promising to do its best to give me my money back when I
          > demand it, the bank is not engaging in fraudulent activity by
          > loaning my money out, and it can deny present demands for
          > redemption and promise that it will make good on its IOUs in
          > the future.

          This is what I used to think just before I completely gave up on the Rothbardian 100% reserves position.

          The problem is that if it should be illegal to create on-demand contracts with fractional reserves, then why does the situation change so that it should be legal if the bank agrees to pay after a time period. That time period could be one month, one day or one hour.

          > You are arguing that it is not fraudulent if they don’t have my
          > money available since the contract is not a bailment, but you
          > are also arguing that they are legally required to pay my money
          > back when I demand it. These are conflicting positions.

          No they aren’t, there’s a difference between “having” and “paying”. The bank doesn’t need to have 100% reserves but on the other hand it must pay. Suppose I go to a bank teller and withdraw £50K. Now, just before I make that request the bank can have any structure of finances that it wants. But, once I have made the request the bank must be able to serve it or the bank will be in breach-of-contract.

          Working this way is possible because redemptions demands are not strongly related to each other. The balances of bank accounts don’t change quickly and when they do change the withdrawals are usually similar in quantity to payments in. The bank must keep enough reserve to deal with the variation, but in practice this isn’t that much. And, banks can bolster there reserves by borrowing reserves from other banks.

          • Stephen

            If a fractional-reserve bank is legally required to pay its depositors on demand, then it must conceivably be able to do so; however, at any given moment, it cannot possibly fulfill its obligations.

            How can a contract be entered into under which a bank owns its depositors’ money until the moment they demand it back but may do whatever it wishes with that money until such demands are made? If the bank loans money out that is invested in long-term projects, those resources are tied up and cannot simply be converted back into money on demand.

          • Current

            > If a fractional-reserve bank is legally required to pay its
            > depositors on demand, then it must conceivably be able to do so;
            > however, at any given moment, it cannot possibly fulfill its
            > obligations.

            It can’t fulfill all it’s obligations if they all come due at the same time certainly. The same is true of an insurance company too.

            > How can a contract be entered into under which a bank owns its
            > depositors’ money until the moment they demand it back but may
            > do whatever it wishes with that money until such demands are
            > made?

            A contract of that sort *can* be legally entered into. In fact almost every contract is similar to some degree, I’ll explain why below.

            > If the bank loans money out that is invested in long-term
            > projects, those resources are tied up and cannot simply be
            > converted back into money on demand.

            No, they can’t, but that doesn’t mean that the bank can’t agree to always pay, it just means that it’s conceivable that they can’t. It’s also conceivable that I’m from Jupiter. In practice it means is that the bank must be careful about figuring out how to do that. That said, it’s not rocket science, all the bank must do is figure out under what circumstances it’s customers are likely to redeem, and what variations are involved in redemptions on aggregate.

            As I said earlier contracts that don’t deal with every contingency are common. It’s impossible or at least impractical to write a contract that can deal with every conceivable contigency.

            A few years ago I was involved in a big bit of purchasing for the company I worked for. Me, one of the companies lawyers and some other folks worked on it for some time. The lawyer found holes in the contract and things that weren’t dealt with. But, occasionally she would say “we’ll let the common law deal with that”, by which she meant that she wasn’t going to do anything about it in the contract. Despite that contract being very long there were many contigencies that were conceivable but not dealt with. For example, it entailed a vendor delivering a large piece of hardware to my employer. There was no statement about what would happen if the roads were closed when the vendor tried to do this, or if the vendor’s lorry didn’t fit my employer’s lorry bay.

            Here’s a challenge, take any contract you have signed and read through it. See if you can find concievable situations that are not dealt with, I bet you’ll find plenty.

  • Alberto Dietz

    Game, set, match: Huerta de Soto.
    http://www.youtube.com/watch?v=nZWhf8ejBrU

  • Stephen,

    Banks provide liquidity to borrowers and lenders and investors. For example, those lending to the bank on current account have liquidity by way of redemption — they can redeem their claim by order on the bank. Those with overdraft facilities also gain liquidity, they can draw on these facilitieis at any time up to their credit limit. Likewise, investors in bonds issued by the bank have liquidity by way of marketability – they can sell the bonds on the secondary market. The bank obtains and supports this liquidity by being able to raise replacement funds by issuing more bonds (i.e. funding liquidity) and by being able to sell some assets (those that are marketable — this is called asset liquidity). The bank can also redeem any funds that are lent to other banks that are repayable on demand.

    Other businesses can also mismatch the time structure of their assets and liabilities, ranging from supermarkets, to other commercial businesses with overdraft facilities. Such overdraft facilities rely on the lender not demanding repayment, even though the lender could demand repayment at any time. Various other entities may also structure their finances in ways not unlike banks do. Even if bank were unique, that would not make them wrong to operate a different busienss model.

    In reply to question 3) yes. In reply to question 4) it depends on what you mean. If you mean steps that make the funds not legally payable, no, if you mean steps that make funds that are legally payable, but the bank is unable to pay (e.g. a default or suspension of payments by the bank) can be restructured under insolvency laws, I don’t have a problem with this (these laws are normally the same laws that apply to other insolvent entities or other entities in default on their obligations). I don’t support the desirability or need for ‘option clauses’ (some free bankers do, but not me). I guess the key fudge banks have that you may be referring to is the move from a metallic standard (i.e. the bank has to pay gold coin) to a fait standard (i.e. the bank has to pay in central bank notes, and the central bank does not have to redeem its notes in gold coin). I don’t support this move, as I don’t support either unanchored fait standards nor central banking, and I guess that answers your last question. I support legal tender laws recognising gold coin as the principal legal tender and standard of value, with other media as subsidiary or secondary legal tender (e.g. to provide for the discharge of small sums or small parts of larger amounts) provided that the media have a commercial value not less than the legal value (e.g. tokens, being promissory notes payable to bearer on demand, and being commercially acceptible at par should be able to discharge amounts that are less than 1 gold coin). I feel this is better than having multiple metals (copper and silver) and the associated problems.

    • Stephen

      David,

      If a loan is extended out of my demand deposit, which remains a present good for me, it claims to exchange present goods for future goods, but does nothing of the kind. The reason that I have present goods at my disposal is because I have provided a valuable good or service and received money in exchange. The “money” that is created out of my demand deposit is a debt, and as such is not money at all. Overdraft services operate on the same principle.

      Bonds do represent legitimate liquidity because they are exchanging present goods for future goods. Someone offers savings and in turn receives a bond that is payable at some future date, plus interest for the sacrifice of the use of those present goods.

      Property rights are rights of exclusive control. Two parties can’t have legal claims of exclusive control at the same time. If the whole situation falls apart when both parties exercise their legal rights of exclusive control, the situation is fraudulent.

      Another point is that even if my money remains in the bank and I do not withdraw it, I participate in the market with the knowledge that my deposit is part of my cash balances. The same is true of the borrower.

      The real interest rate — the market price of present goods in relation to future goods — relies on accurate information regarding the genuine pool of savings. The mechanisms of creating “money” from debt that we are discussing distort this information. Since the interest rate plays a critical role in coordinating the activities of consumers, savers, investors, and producers and fosters the development of a sustainable distribution of scarce resources that satisfies as many consumer wants as possible, the larger pool of savings that appears to exist due to the creation of fiduciary media creates the illusion that consumers are willing to forego current consumption in exchange for goods of greater value in the future, even though they may want to consume even more goods in the present. The bottom line is that this misinformation prevents the structure of production from reacting appropriately to changes in the market, and I think you are familiar with the rest of the ABCT.

      Where do you find fault with this analysis?

      • Current

        > Bonds do represent legitimate liquidity because they are exchanging
        > present goods for future goods. Someone offers savings and in turn
        > receives a bond that is payable at some future date, plus interest
        > for the sacrifice of the use of those present goods.

        I don’t think that’s what David is saying. David’s point is that there is a secondary market for bonds which is very liquid. If I own a bond then it may only pay me the coupon in 1 year’s time and the principle in 25 years time. But, on the secondary market I can get a price for it at any time that market is open. That price varies certainly, but some bonds, generally those of government and very stable businesses are very liquid.

        > Property rights are rights of exclusive control. Two parties can’t
        > have legal claims of exclusive control at the same time. If the
        > whole situation falls apart when both parties exercise their legal
        > rights of exclusive control, the situation is fraudulent.

        I agree, but I don’t think that fractional reserve banking really violates this princple. In your earlier example the person loaned the $900K owns that money, the bank owns his loan, and you own a loan from the bank – a current account. What you own – a debt – is different to what the borrower owns.

        Suppose a bank has 10% reserve, which is £1M then that doesn’t mean that 10 account holders have ownership of each pound. The account holders don’t own any of the reserve, the bank owns it. The account holders own debts to the bank.

      • I think the misinformation is the idea that demand deposits are not savings, and that frb creates distortions.

        I don’t really buy into the whole ‘present goods’ vs. ‘future goods’ distinction. But I guess if you’re got savings on current account with a bank, then you’re planning to consume them in the future (or are able to do so). Whether that future is later this afternoon, tomorrow, next week or next year perhaps you have not decided yet, and I can’t see how that matters. The whole banking system relies on a balance between funding and assets, and so, while some might decide to consume this afternoon, on average, most people leave their money in the bank for longer periods of time, and what one customer consumes (withdraws) another saves (deposits). The better way to think of it is in terms of savings and investment, production and consumption. What matters is that the overall amount of savings matches the overall amount of investment, and the overall amount of production equals consumption plus net savings. Within those totals, some people are saving more than they produce, while others are consuming more than they produce. Some of the savings are held in the form of balances with banks, which are fluctuating from day to day on a per customer basis, but which, in aggregate, exhibit a fairly stable source of funding (so long as the bank’s solvency is not in question). The banking system provides a liquid form of savings, that can fund long term investments. You can’t complain that the investments aren’t funded from savings, only that the savings are contractually due (potentially) before the investments are due to mature — i.e. the bank transforms the maturity, or has a maturity mismatch.

        Regarding the property rights-exclusive control issue, I’ve written an extensive reply here:
        http://www.lostsoulblog.com/2008/12/property-rights-analysis-of-banking.html

        • Current

          > I don’t really buy into the whole ‘present goods’ vs.
          > ‘future goods’ distinction.

          I think of saving/lending , borrowing/dissaving and investing as objective economic categories. I think of “present goods” and “future goods” as subjective categories of individual valuation. It’s the individual who knows if he is intending to sell something he owns sooner rather than later.

        • Jose

          Have you read De Soto book “Money, Bank Credit and Economic Cycles”?
          It is impossible to mix deposit and loan without contradictions. Property of the good is transferred or not. If fractional reserve is a x% deposit and (100-x)% loan, then it should be stated and agreeded by customer. Money in a deposit cannot be used without commiting offense of misappropiation. See Common Law critique in the book. Money cannot be used by bank and customer at the same time, only by one of them. If customers think they own the money the marginal utility of money decreases for them and they tend to spend more, thus an inflationary process begins as bank gives more loans with fractional reserve, that leads to bussiness cycles (unemployment, wasted resources and savings, poorer society).
          Please excuse my limited English.

  • [...] Huerta de Soto's Hayek Lecture By Toby Baxendale, on 5 November 10 We have previously posted the text of Huerta de Soto’s speech, and an audio recording via Cobden Centre [...]

  • Stephen

    This is a great discussion.

    To clarify, the terms “present goods” and “future goods”, as I am using them, are not subjective. Present goods are goods that you have exclusive control over in the present, and future goods are goods that you will have exclusive control over at some point in the future. If I agree to loan a bank $1M for a period of one year in exchange for $1.1M one year from now, I am exchanging present goods for future goods: I am transferring exclusive control over $1M worth of unspecified goods to the bank for a period of one year in exchange for exclusive control over $1.1M worth of unspecified goods exactly one year later.

    Money, by its nature, is always a claim on present goods. Exchanging money is equivalent to exchanging actual, though unspecified, goods. Credit in a monetary economy is not fundamentally different than credit in a barter economy. Just as goods that don’t exist cannot be borrowed in a barter economy, claims on goods that don’t exist cannot be borrowed in a monetary economy.

    The essence of your argument is that the bank does not have a liability to pay me until I actually demand my money back and that the bank is solvent until demands are made that the bank cannot come up with sufficient assets to meet. So, as long as the bank can meet demands for redemption, its fiduciary loans do represent real savings.

    The critical point is that fiduciary loans are invested in capital goods, which cannot be instantly liquidated and converted back into money. These resources are tied up in time-consuming processes, and more money — claims to present goods — exists than present goods.

    For the sake of argument, I will accept your assertions that fractional-reserve banking is not fraudulent and that the contracts entered into are legitimate. In this case, on the unhampered market, bank IOUs that promised redemption on demand would not be valued at par with money or genuine money titles. In addition, IOUs from different banks would be valued differently from each other depending upon the associated risks. Therefore, these IOUs would be heterogeneous goods that would not be widely utilized in indirect exchange, so they would play virtually no monetary role.

    • Current

      I think David Hillary has done a great job of presenting the argument. I agree with everything he has written. But I think it’s worth discussing a few things a bit more…

      > To clarify, the terms “present goods” and “future goods”, as I am
      > using them, are not subjective. Present goods are goods that you
      > have exclusive control over in the present, and future goods are
      > goods that you will have exclusive control over at some point in
      > the future. If I agree to loan a bank $1M for a period of one year
      > in exchange for $1.1M one year from now, I am exchanging present
      > goods for future goods: I am transferring exclusive control over
      > $1M worth of unspecified goods to the bank for a period of one year
      > in exchange for exclusive control over $1.1M worth of unspecified
      > goods exactly one year later.

      The definition you give here is quite objective, I’ll grant that. And everything you write here is correct if that definition is used.

      > Money, by its nature, is always a claim on present goods.

      I don’t like the word “claim” I think it’s vague (does it mean something is owed or owned?). But, I agree, money buys present goods according to your definition.

      > Exchanging money is equivalent to exchanging actual, though
      > unspecified, goods. Credit in a monetary economy is not
      > fundamentally different than credit in a barter economy. Just as
      > goods that don’t exist cannot be borrowed in a barter economy,
      > claims on goods that don’t exist cannot be borrowed in a monetary
      > economy.
      >
      > The essence of your argument is that the bank does not have a
      > liability to pay me until I actually demand my money back and that
      > the bank is solvent until demands are made that the bank cannot
      > come up with sufficient assets to meet. So, as long as the bank can
      > meet demands for redemption, its fiduciary loans do represent real
      > savings.

      Here is where things become sticky.

      As I’ve said earlier, a bank doesn’t need to keep 100% reserves in order to furnish demands for redemption. In the days of Scottish free banking in the early 19th century the only means of transport was the horse. Even then banks could satisfy redemption demands by keeping a reserve of only 2.5%.

      Suppose you own a fractional reserve current account to the sum of an ounce of gold. That doesn’t mean that the bank own 2.5% of that sum in gold and nothing else. The bank must hold 100% of the sum, and more for safety, but not in one particular form. Banks choose to hold the remainder in loans. That doesn’t mean that “nothing” or “air” backs the other 97.5% of your money, it means that the projects that the bank has funded and the collateral supplied backs it.

      > The critical point is that fiduciary loans are invested in capital
      > goods, which cannot be instantly liquidated and converted back into
      > money. These resources are tied up in time-consuming processes, and
      > more money — claims to present goods — exists than present goods.

      This is no different that the situation in a bond market. Suppose a business needs to borrow for five years in order to complete a project, it can issue bonds. Each bond holder doesn’t have to lend for five years. The first bond holder who buys the bonds from the issuer may sell them on the secondary market whenever he likes. The next bond holder may do the same. One person lending for five years may be substituted by ten people each lending for six months. If there are trades in the bond market every day then a bond maybe sold at any time.

      This is the problem with drawing a hard line between “present” and “future” goods. By your definition a bond market can change a loan from a “future” good into a “present” good. But, I don’t think this really means anything. The objective element we should be looking at is the existence of a loan and a lender or saver. If you lend £10 for an hour then you are a lender. Similarly, if you hold a current account balance you are a lender to the bank until you spend that money.

      Money and bonds in different ways allow one great sacrifice of the present for the future to be broken down into many thousands of tiny insignificant sacrifices. And by doing so they allow much greater investment.

      > For the sake of argument, I will accept your assertions that
      > fractional-reserve banking is not fraudulent and that the contracts
      > entered into are legitimate. In this case, on the unhampered
      > market, bank IOUs that promised redemption on demand would not be
      > valued at par with money or genuine money titles.

      What you describe has happened, and banknotes were valued on par with money. It’s quite true that banknotes always come with extra risk, but that extra risk is very small and banks can compensate for it by offering extra services which commodity money cannot provide.

      > In addition, IOUs from different banks would be valued differently
      > from each other depending upon the associated risks.

      Not necessarily. Certainly, if a bank is considered too unstable a run will occur. However, a bank may be sufficiently sound that it’s notes trade at par.

      > Therefore, these IOUs would be heterogeneous goods that would not
      > be widely utilized in indirect exchange, so they would play
      > virtually no monetary role.

      This is not what has happened when free banking has actually occurred.

  • Stephen, It looks like you’ve identified the issues, and stated your propositions in a form that can be tested or assessed.

    A gold coin is not a claim on anything or anyone. It is a chose in possession (also known as a chattel in possession) being a form of personal property. Sure you can exchange it for other goods or assets, but it is not a claim on such goods or assets.

    A bank note or balance on current account with a bank is a claim on the bank for money or money’s worth (legally the former but commercially the latter). The amount of goods or assets the money will buy is not a term of the contract with the bank: the contract is denominated in money, not hamburgers or haircuts.

    In accounting the concept of ‘control’ differs from the way you are using it. In accounting, for an asset to be recognised, a number of tests must be passed. An asset is a resource controlled by the entity from which it is probable that economic benefits will flow to the entity. These tests (control and probability) can be passed for a wide range of assets including land, buildings, inventories, accounts receivable, financial instruments, bank balances and cash. In accounting there are also several recognised ways that the recoverable amount of an asset can be recovered. These include by way of use and by way of sale. So long term assets such as buildings do not imply that the entity cannot recover the value of the asset in shorter periods (indeed management intention can affect how assets are recorded, e.g. financial assets at fair value through profit and loss (a.k.a. financial assets held for trading) vs. available for sale financial assets, and the recognition of deferred tax on revaluation of buildings.

    The best answer to the issues you raise is to consider that, from the perspective of a single entity, an asset can be realised sooner than from the perspective of all entities collectively. So long as one entity is paying cash for an asset, the selling entity can realise it sooner than it can be realised through use or consumption. The role of the banking system is to match up buyers and sellers of assets (understood in various ways)

  • A further response in relation to instruments issued by entities of different credit standing. Provided the instruments are payable on demand, the market value of the asset will by at par, because any supply of the asset must be purchased (more accurately redeemed) by the issuer. Thus unless or until the issuer defaults, the instrument will be valued at par.

    Bank balances are not traded, they are redeemed. This means that when you use a balance on current account with a bank to pay for goods or services, you aren’t selling the balance to the seller of the goods, you are demanding redemption, and the bank is paying the seller on your behalf. If the seller chooses to maintain the funds on account with the same bank, the bank can simply do a book entry redeeming the buyer’s balance and issuing the same amount to the seller. If the seller has his account with another bank, the bank has to pay out.

  • Stephen,

    Perhaps this illustration is helpful: suppose persons A and B give a 10 year loan of $1000 to person C. They are to be tenants in common, i.e. they each have shares in the loan to C according to their contributions and A and B agree among themselves, that should either of them want to get their money back they can offer their unwanted share to the other lender. Thus, if A withdraws $100, B must deposit $100 and so on. From the point of C, it is a 10 year loan, but from the point of view of A and B they can get their money back whenever they want provided the other person is willing to take over their unwanted share. Suppose that person C takes such a loan from 1000 people, and arranges so that people wanting out can easily and cheaply be matched with people wanting in, all of a sudden it becomes almost assured that any particular depositor can get his money back whenever he wants (if the interest rate was a floating rate, and the rate increased when there was less supply of funds to C and decreased when there was more, this would help keep the instrument valued at par and create a balance between those wanting in and those wanting out).

    The bank’s business model implicitly works like this. It is legally structured otherwise (i.e. as separate claims on the bank repayable on demand) but in practice it works by replacing customer A’s funding with customer B’s funding, with the onus on the bank to coordinate its funding arrangements.

    I hope this example shows how the bank funds long term investments from an array of on demand funding sources (in addition to term funding and equity capital).

  • One more response: You wrote:
    ‘The essence of your argument is that the bank does not have a liability to pay me until I actually demand my money back and that the bank is solvent until demands are made that the bank cannot come up with sufficient assets to meet. ‘

    The first point is correct but not the second. Should the bank’s assets become worth less than its liabilities, if the bank attempts to continue to trade it can continue to redeem its demand deposits on demand until it runs out of liquid assets. This leaves the loss with the demand funders who have not withdrawn their funds, and with the term funders whose funds are not yet due. So the bank’s insolvency typically occurs before its payment default. See http://www.lostsoulblog.com/2010/01/how-faltering-financial-institutions.html

  • Another very recent example of a finacial institution that continued to trade and pay investors is South Canterbury Finance, a New Zealand deposit taking financial institution. Unlike the previous significant failures in this sector, South Canterbury Finance (SCF) was covered by a government gurantee on its deposits (a form of deposit insurance that was introduced temporarily in Oct 2008). As in the case of Stategic Finance, which was covered in the article linked to in the previous link, SCF uses prior charge secured borrowing to keep paying its obligations. The scandal is that they continued to trade notwithstanding having a grossly negative equity position according to their own management accounts by the time they finally called in the receivers. See http://www.lostsoulblog.com/2010/11/receivers-report-shock-315m-negative.html and http://www.lostsoulblog.com/2010/11/voidable-allotments-directors-liable.html or http://www.lostsoulblog.com/search/label/South%20Cantebury%20Finance for all posts on that company.

  • Stephen

    David,

    My point regarding money is not that it represents a direct claim on any specific goods or people, but that it represents unspecified present goods. You must first sell goods and services in order to obtain money. Loaning money in a monetary economy is fundamentally the same thing as loaning physical goods in a barter economy.

    It is important to distinguish between genuine money titles and IOUs. IOUs will not circulate at par with genuine money titles because they entail risk of loss, whereas genuine money titles do not. IOUs that promise redemption on demand would surely be more liquid than IOUs promising redemption at some point in the future, but they would still entail risk of loss and would not guarantee redemption in the same sense as genuine money titles.

    Your example involving persons A, B, and C is not comparable to fractional-reserve banking. A and B agree that, between them, they will give up $1K for 10 years. No matter how they subsequently decide to rearrange their shares, between them they are giving up $1K for that period of time. This is true no matter how many people are involved. The point is that, among them, they have to agree to rearrange their shares and to give up control of the money loaned out. In this scenario, the bank is acting as a legitimate financial intermediary channeling savings into long-term investments. A and B loan $1K to the bank in exchange for $1K plus interest payable in ten years, the bank loans $1K to C in exchange for $1K plus more interest than A and B are earning payable in ten years, and the bank makes a profit on the interest differential. This is a valuable service that entails no increase in the money supply. If the bank goes bankrupt, its shareholders and creditors will suffer losses.

    In your scenario, A and B actually receive IOUs from the bank, not genuine money titles. Even if the IOUs promised redemption on demand, they are not genuine money titles.

    Do you agree that, if depositors have genuine money titles, fractional-reserve banking results in an increase in the money supply by the amount of credit extended from depositors money?

  • Stephen, you wrote:
    ‘My point regarding money is not that it represents a direct claim on any specific goods or people, but that it represents unspecified present goods.’

    This characterisation is not helpful. Money can be used to acquire investments or assets that produce benefits in the future, as well as goods or services for consumption now. Money does not represent anything other than itself. Money is an asset in its own right, that can be exchanged for other goods, services, assets, property or rights of almost any description.

    You wrote:
    ‘Loaning money in a monetary economy is fundamentally the same thing as loaning physical goods in a barter economy.’

    Again not necessarily (assuming that by ‘physical goods’ you mean present consumer goods). Under barter a person need not lend, and would not even be expected to lend, consumer goods, instead they would invest in capital goods and lend those, e.g. acquiring a building or vehicle and hiring it out to someone who wants to use it. The non-financial capital stock consists mainly of buildings and other land improvements, rather than inventories, and within inventories, a significant part of these are not consumer goods but raw materials and work in progress.

    You wrote:
    ‘It is important to distinguish between genuine money titles and IOUs. IOUs will not circulate at par with genuine money titles because they entail risk of loss, whereas genuine money titles do not. IOUs that promise redemption on demand would surely be more liquid than IOUs promising redemption at some point in the future, but they would still entail risk of loss and would not guarantee redemption in the same sense as genuine money titles.’

    Here you are claiming how the market for different forms of assets will work. This is a theory or claim about economic behaviour. I do not find it compelling, I believe that there is a place in the market for different forms of privately issued financial institutions that can be and will be used to intermediate commerce.

    In accounting terms, A and B still have control of the resources, and so I’m suggesting your use of the term control is too narrow.

    I agree that frb increases the stock of money, I just don’t accept that the consequences of this are what de Soto and co are alleging.

  • Stephen

    David,

    If you accept that FRB increases the money supply, aren’t you admitting that de Soto has not made a fundamental error? If savings were truly the source of the bank’s expansion, as you claim, the money supply would not increase.

    Money is, by definition, the most liquid asset. How can a financial instrument that is not money itself or a genuine money title possibly trade at par with money? See this paper by Jorg Guido Hulsmann: http://www.independent.org/publications/tir/article.asp?a=90

    • Current

      > If savings were truly the source of the bank’s expansion, as
      > you claim, the money supply would not increase.

      That’s not true. When we talk about “savings” it only makes sense to consider all loans as savings. Savings accounts at banks are savings and current accounts at banks are savings too, and so are bonds and other loans.

      There are many ways by which the money supply may increase. In a free banking system none of them involve trading “something for nothing”. In a central banking system only creation of base money by the government involves that. That was the point of the arguments David and I have made. We weren’t denying that banks can create money.

      > Money is, by definition, the most liquid asset. How can a
      > financial instrument that is not money itself or a genuine money
      > title possibly trade at par with money? See this paper by Jorg
      > Guido Hulsmann:
      > http://www.independent.org/publications/tir/article.asp?a=90

      That’s like asking “How can aeroplanes possibly fly”. Aeroplanes do fly and have flown.

      Similarly banks have issued fractional reserve money-substitutes that traded at par, and done so without the assistance of central banks.

      Think about bank accounts. In Europe and Britain, before state provided deposit insurance there was always a risk that a bank could go bankrupt. Any individual could choose to hold fiat notes or to put their money in a current account at low or zero interest. Since the bank could go bankrupt putting it in the current account always ran the risk that if bankruptcy occurred the customer wouldn’t get all his money back. But, despite this risk people still handed their money to banks and held accounts rather than fiat notes. Why did they do this? Because the banks provided useful services, they provided security, payment and transfer services. They provided enough services in short to compensate their customers for the extra risk that those customers ran. The same is still true in areas where the state doesn’t provide deposit insurance.

  • I’m saying the money issued by the bank represents savings.

  • The definition of money is anything used to mediate exchanges, or, more narrowly, anything commonly used to mediate exchanges. If people wish to use financial instruments to do this, de soto has a problem with it, free bankers don’t.

  • Some people continue thinking that the poverty is like a disease that it does not have cure.
    People are surprised when I explain to them that the medication for the poverty was invented 230 years ago by Adam Smith. The medication is the free market. All the countries that applied it have managed to leave of the poverty.
    If the governments abstain to take part in the economy, allowing to the people to look for their own interest freely, their efforts would end up benefitting everybody.
    In a free market, in which the intervention of the government is minimum, the producers compete to each other to offer to the consumers the goods and services of better quality and minor price. This way, looking for his own gain and forced by the competition, producers and businessman end up contributing to the society.
    The free market includes freedom to work, to contract, to buy and to sell, to import and to export without obstacles and taxes, to have freely and surely the private ownership, to have a healthy currency, to pay few and low tributes in relation to the public services offered, as well as other rights that the governments of poor countries restrict useless and perniciously with imposed regulations, protections, subsidies, taxes, bureaucracy and corruption.

    Lodicecincinato.tk

  • Stephen

    David and Current,

    Can you provide your thoughts on the arguments presented by Jorg Guido Hulsmann? Mises makes the same argument:

    “It is a mistake to associate with the notion of free banking
    the image of a state of affairs under which everybody is free
    to issue bank notes and to cheat the public ad libitum. People
    often refer to the dictum of an anonymous American
    quoted by (Thomas) Tooke: “free trade in banking is free
    trade in swindling.” However, freedom in the issuance of
    banknotes would have narrowed down the use of banknotes
    considerably if it had not entirely suppressed it. It was this
    idea which (Henri) Cernuschi advanced in the hearings of
    the French Banking Inquiry on October 24, 1865: “I believe
    that what is called freedom of banking would result in a
    total suppression of banknotes in France. I want to give
    everybody the right to issue banknotes so that nobody
    should take any banknotes any longer.”

    Can you also provide me with more information about the historical instances of fractional-reserve money substitutes trading at par?

    Lastly, since you include these instruments as part of the money supply, do you agree that when these instruments are created that the people who loan them out and make first use of them benefit at the expense of people who don’t? Do you agree that when they enter the economy they raise prices and that when they leave the economy they put deflationary pressure on prices?

    Once again, this is a great discussion. I respect both of you very much and am glad we are engaging in this exchange.

    • Current

      > Can you provide your thoughts on the arguments presented by
      > Jorg Guido Hulsmann? Mises makes the same argument:
      >
      > It is a mistake to associate with the notion of free banking
      > the image of a state of affairs under which everybody is free
      > to issue bank notes and to cheat the public ad libitum. People
      > often refer to the dictum of an anonymous American quoted
      > by (Thomas) Tooke: “free trade in banking is free trade in
      > swindling.” However, freedom in the issuance of banknotes
      > would have narrowed down the use of banknotes considerably if
      > it had not entirely suppressed it.

      The issue here is comparison to central banking. I think that if free banking had prevailed since the 19th century then price inflation would have been much reduced. I think price deflation would be the norm.

      The great inflations of the present and past were orchestrated by central banks. Free banks would not have had an interest in doing anything similar. Selgin and White give the reasons why in their books. In short, if a bank issues more money-substitutes to it’s customers than those customers demand then the that quickly leads to an increase in redemptions.

      But, that doesn’t necessarily mean that issue of banknotes would have been “considerably suppressed” or entirely non-existent.

      Certainly the need to stay solvent and provide for redemptions does put limits on what banks can do. But, they are not so great as to prevent the issue of fractionally-reserved banknotes or accounts.

      > It was this idea which (Henri) Cernuschi advanced in the
      > hearings of the French Banking Inquiry on October 24, 1865: “I
      > believe that what is called freedom of banking would result in
      > a total suppression of banknotes in France. I want to give
      > everybody the right to issue banknotes so that nobody should
      > take any banknotes any longer.”

      Yes. Mises quotes that, but he doesn’t entirely agree with it. He agrees that free banking limits the issue of banknotes, he doesn’t agree that it completely surpresses it.

      Mises says in some places that free banking would only allow issue of banknotes above reserves “within narrow limits”, I don’t agree with him about that. In some historical instances of free banking the reserve ratio has being quite low.

      > Can you also provide me with more information about the
      > historical instances of fractional-reserve money substitutes
      > trading at par?

      See Lawrence H. White’s book “Free Banking in Britain”. There’s a PDF available of it for free from the literature section of Mises.org. He discusses Scottish free banking, but there have been other examples. As David Hillary points out there have been many times when people have traded normal money at par for balances in uninsured current accounts. That continues to this day in places that don’t have deposit insurance and for organizations that don’t have it.

      > Lastly, since you include these instruments as part of the
      > money supply, do you agree that when these instruments are
      > created that the people who loan them out and make first use of
      > them benefit at the expense of people who don’t? Do you agree
      > that when they enter the economy they raise prices and that
      > when they leave the economy they put deflationary pressure on
      > prices?

      It depends on the situation.

      I think the argument for the Cantillon effect is essentially correct. But variations in the demand for money must be taken into account. It should be noted that it’s not *precisely* those people who receive new money that benefit, once money is issued it’s fungible. Those who benefit are those who happen to be reducing their stock of money and buying assets with it. Those who lose out are those who are raising their stock of money by selling assets. If a central bank insider knows that a large injection of money is occurring and will lead to price inflation later then he may buy assets to profit from this using *any money*.

      The 100% reservists put the argument in a way that suggests that the the creation of money in question will definitely lead to an increase in the price level later. That leads to the conclusion that those who receive the money first can buy goods at knock down prices at the expense of everyone else.

      For each person there is a proportion of their wealth that they choose to keep as money-in-the broader-sense (that is money or money substitutes). If each person keeps that proportion the same, or if people reducing their money balances are counteracted by others increasing there balances, then we can say that the demand for money is steady.

      If the demand for money is rising and the stock of money is steady then prices will fall. Similarly, if the demand for money if falls and the stock is steady then prices will rise. (You can derive that from the equation-of-exchange if you like, but it doesn’t require any monetarist assumptions). If there is an unexpected rise in prices due to a fall in demand for money then essentially the same thing happens as with an injection of money. Those who happen to be reducing their stocks of money at the beginning of the trend benefit from buying things at lower prices.

      What this tells us is that the cantillon effect causes redistribution of wealth if the creation of new money exceeds the demand for it.

      > Once again, this is a great discussion. I respect both of you
      > very much and am glad we are engaging in this exchange.

      Thanks

  • Stephen,

    The opinion to which you refer is a theory of economic behaviour, which is not plausible, based on historical and current experience. I.e. where there was free or not so restricted issuer of bank notes, these notes were widely used and viable. For example in Australia (and many other countries), governments raised revenue from taxing note issues (i.e. the business was so viable it could support a tax burden). See Kevin Dowd’s Laissez faire Banking for details on the historical experience of free banking — bank notes were not discounted so long as large, branched banks were allowed.

    Re the idea that spending newly issued money gives some advantage, obviously I’ll disagree on that one. The depositor exchanges assets of the same accounting value for the balance acquired, and so his net worth is not, at the time of the transaction, increased. No spending-inflation effect is to be expected, for the same reason.

    • Stephen

      The theory I am referring to is very plausible. Historical experience alone does not defeat the argument. What other factors were involved? What theory explains what happened? Can you provide me with more information on the episodes you are referring to?

      Current experience clearly does not disprove the theory I am referring to, since we use fiat paper bank notes as money.

      Regarding newly issued money, how can you possibly deny that it confers a benefit onto the creator and early receivers? Don’t you agree that when new money enters the economy, it causes prices to rise?

      • Stephen, if you find your theory that bank notes will not be competitive with coin, and that bank notes will trade at a discount, how do you explain the Australian experience when:
        1. Bank notes were popular and uncontroversial
        2. Bank notes were accepted and received, including by other banks, at par.
        3. The Australian governments taxed note issues and raised revenue therefrom, indicating the viability of the bank note business.

        Even today under fiat standards, private issuers of bank balances dominate the money business. Bank balances are used to pay for goods or services via redemption through the inter-bank payments system. For example Citibank balances pay for goods without any discount to Bank of America balances or Federal Reserve Notes. If you think this is due deposit insurance, here in New Zealand were we don’t have any deposit insurance, ANZ bank balances pay for goods without any discount to RBNZ notes or Westpac, BNZ and ASB balances (RBNZ notes are legal tender).

        As I’ve said many times, the issue of bank balances just changes the form of wealth, and not, at the time of issue, it amount. It does not promote the spending of money anymore than other assets such as houses or cars or concrete-pump trucks. People’s decisions to save or spend do not depend on their bank balances but on their incomes and their savings plans. If you plan to save $200 a week and you earn $800 a week, you have to limit your spending to $600 a week. It doesn’t matter whether your bank balance is $1,000 or $10,000 this rule still applies.

      • Current

        > Current experience clearly does not disprove the theory I am
        > referring to, since we use fiat paper bank notes as money.

        We do, and those are more secure than bank balances. Because, if the government isn’t secure and can no longer assure that fiat paper has some value then bank balances denominated in it clearly have even less value.

        However, despite this banks continue to trade. Why? Because they offer services to the customer that make up for the extra risk entailed.

        • Stephen

          This is not an argument. All bank notes and balances are denominated in the same meaningless abstract units. The value of everything denominated in these meaningless abstract units is backed by government promises to tax its current and future population.

          In our discussion, bank notes and balances are not the same thing as money or money titles.

          • Fiat money units are not meaningless or abstract, they are merely unanchored. This means their value can fluctuate.

            Financial instruments such as central bank notes, bank balances and bonds etc. are claims on their respective issuers. A bank is not promising to tax anyone to repay its debts, it is promising to pay, and has assets, primarily in the form of loans and advances, with which to make good the promise. A central bank also has assets, typically in the form of government bonds, or advances to commercial banks secured by government bonds. For example the European Central Bank does not have any powers to tax anyone, and its assets primarily consist of advances to commercial banks on the security of government bonds.

          • Current

            Stephen,

            I agree with what David has said.

            Under a gold standard we can say “gold is money”. However, even under such a standard people don’t obtain money in order to obtain gold. Mostly they obtain it in order to buy other goods. Only a few goldsmiths demand gold for it’s industrial purpose as an input into the jewellery industry and various other industries.

            As such, the “objective exchange value of money” or “purchasing power of money” as Mises puts it is what that money will buy. Concepts like price indexes are attempts to estimate changes in it.

            Under a fiat money system money is unanchored. But, in any situation except hyperinflation money still has purchasing power, that’s why people hold it.

            Certainly, the *units* that are used are arbitrary in a fiat money system.

            Now, my point is that even in a fiat money system base money is lower risk than a balance in an account. It doesn’t matter particularly what the units involve buy. What matters is that people are prepared to sacrifice a small increase in risk for the extra services banks provide.

            You point to what I call the “Chartalist force” of taxation. In Britain for example normal PAYE taxpayers must have bank accounts and businesses must have them too. But, this can’t explain the extent of the banking business. People who are paid cash also have bank accounts, and although people only need one bank account to pay tax they often have several.

            For example, in Britain bank accounts associated with share trading weren’t insured in the past (I think they still aren’t). A relative of mine was caught up in the bankruptcy of a bank that served share traders about a decade ago. Eventually the receivers paid him his balance back, without interest. Despite this, he still has a bank account for share trading. Why? Because it’s the only way to obtain fast and low cost share trades. The account provides a service to him even at the cost of some extra risk.

  • Robert Sadler

    David,

    I think my earlier reply to you got lost in the shuffle. If you would reply, your thoughts would be appreciated, thank you

    Robert Sadler
    November 5th, 2010 at 13:33 · Reply

    David,

    Thank you for the well explained reply. Sorry to belabor the point but I think we still have the same problem. As you helpfully show, the Telco immediately spends the $5000 cash from the man. However, you state the Bank provides the man with a promissory note to pay the man $5000 on demand. But if the man turns up the next day and demands his $5000 the Bank will have no money to pay him.

    I realize that I am working within the strict confines of your example and in the real world the Bank would have methods of financing this draw (with more debt) however, at any given time there is a finite amount of liquidity in the world. At some point it is inevitable that more people will demand their cash than the Bank has reserves to pay them, hence, the recent liquidity crisis.

    So I have a few more questions for you. 1) In your view, without intervention from a Central Bank or Governments how would FR banks survive such a liquidity crisis? 2) Do you accept that Fractional Reserve Banking is inflationary? 3) Do you agree that inflation ultimately leads to the business cycle?

    Current, please feel free to answer these questions as well, your contributions are welcome.

  • Robert Sadler,

    The bank does not provide a promissory note to its customer. A promissory note is an unconditional promise, in writing, signed by the maker, engaging to pay a sum of money on demand or at a determinable time in the future, to the bearer or to a named payee, or to the payee’s order. An example of a promissory note is a bank note (Bank notes in the UK and Hong Kong retain the traditional ‘promise to pay the bearer on demand the sum of X’ wording, in the US and NZ and Australia, this wording has been dropped, but the documents are still promissory notes).

    A bank is a person who:
    1. maintains current accounts for his customers
    2. pays to its customers orders (i.e. cheques) from such current accounts, and
    3. Collects cheques deposited by its customers on their behalf and credits the proceeds to the customers’ current accounts.

    So, the bank, when it purchases the bonds from its customer, merely performs a book entry to credit the customer’s current account, it does not make a promissory note for the amount, in my example.

    In the example, the customer maintains the $5000 in his account with the bank for some time. It chould be a shorter or longer time, but for the time he retains those funds there, he is lending those savings to his bank and he is funding the bank’s balance sheet by $5,000.

    If or when the customer withdraws this funding, the situation changes: the bank no longer has this source of funding and must either use up some of its reserves, sell some assets or raise replacement funding. One of the points I’ve been stressing is that one customer’s withdrawals must be funded by another customer’s deposits, or by asset sales or depletion of reserves. This is where the financial markets come into place: overall, savings and investments must balance, and the banking system cannot fund any investments without corresponding savings — but those savings do not need to come from the exact same customers and amounts, the amount can be stable even though the make up of the savers/funders is shifting.

    The supply of liquidity is not finite: liquidity can be produced by the issue of marketable securities. For example, the Teleco issued marketable debt securities called bonds. These instruments can be bought and sold easily and quickly, providing their holders with a source of liquid assets. In a similar way, redeemable securities provide liquidity to their holders, as the issuer undertakes to redeem them on demand, and the issuer has the capacity to fund such redemptions through the issue of replacement funding and/or through the sale of marketable assets. The recent crisis was not a liquidity crisis but a solvency crisis. It appears that solvent financial institutions do not have liquidity problems — in fact there are no historical examples of bank failures caused by liquidity mismanagement according to a study by the Bank of International Settlements (see http://www.lostsoulblog.com/2010/03/submission-summary.html ).

    Banks, or more correctly free banking systems, can survive crises by maintaining solvency. This may be through the failure of insolvent banks, restructuring of insolvent banks (e.g. creditor recapitalisation) or through capital raising efforts by stressed banks. Any losses in the banking system generally have to be made up for with new capital raisings, and the payments system and other banking services can generally continue without interruption. The Australian banking system underwent a restructuring in the 1890s as a result of a property market crash and some controversial insolvency laws passed in Victoria and New South Wales, where more than 50% of the banking system went through a debt restructuring procedure. No taxpayer money was used to help this restructuring. Banking and insolvency laws could be improved from the ad hoc and controversial approach taken in that case: I’d like to see major banks have rapid creditor recapitalisation plans and systems to enable major bank failures to happen quickly (within about 1 business day) and without unnecessary interruption (i.e. the good portion of customer deposits would be made available for immediate use, rather than being locked away as happened in Australia in the 1890s). For more on creditor recapitalisation see http://www.lostsoulblog.com/2010/06/living-wills-for-big-banks.html .

    I do not believe FRB is inflationary. I do believe inflation is associated with the business cycle, but I’m not going to comment on causation or detail my business cycle theory (it’s novel and unpublished).

  • Robert Sadler

    David,

    Thank you once again for your reasoned reply.

    I think perhaps I was unclear when I said that “at any given time there is a finite amount of liquidity in the world.” What I mean is that at the precise moment that the man walks into the Bank the amount of cash that the Bank has on hand is finite and in this case, zero. The Bank is also insolvent. Therefore, in this example the Bank will fail.

    One might also suggest that the Bank has committed fraud since it purchased the bonds from the man with the full knowledge that it did not have funds to pay him. A bit like writing a check knowing that there is no money in your account.

    If we expand the example such that the Bank is able to finance the bond purchase with funds from another depositor we still cannot get away from the fundamental problem, no matter the accounting entries; at any time the Bank can fail and inevitably it will because of the business cycle that it helps to create.

    Furthermore, if a Bank is funding Peter’s withdrawal with Paul’s deposit we get into the difficult ethics of pooling of funds, notwithstanding the fact that whole operation begins to resemble a giant Ponzi scheme.

    Surely FRB must be inflationary? If, continuing the example with person A representing the man and person B representing a woman, B deposits $5000 that the Bank could use to repay A as you suggest. Or, if A decides not to make a withdrawal instead the Bank could lend this money to person C, a business owner. C keeps his loan in his account at the Bank. In our economy we have total demand deposits of $15,000 yet the Bank only has $5000 in cash. If we assume a reserve ratio of 1% we eventually get to $500,000 in total demand deposits based on person C’s deposit alone. This is de facto inflation.

    Surely rather than have banks engage in a risky balancing act or complicated recapitalization plans it is better to have 100% reserves. The bank charges a fee for storing people’s cash and if you want to lend the bank money that it can use for its investments you simply buy a bond. There will be no significant risk for the bank’s depositors (since the depositors’ money will be ring-fenced) and the bank can discharge investment risk to the bondholders etc. Fundamentally, we have a far more stable financial system with risk limited to those who knowingly and willingly accept it.

    Lastly, isn’t the Australian Banking Crisis of 1893 an example of why we shouldn’t have FRB? And with your suggestion that FRB needs a recapitalization plan to survive; isn’t this accepting that Free Banks are inherently unstable?

  • Robert Sadler wrote:
    ‘I think perhaps I was unclear when I said that “at any given time there is a finite amount of liquidity in the world.” What I mean is that at the precise moment that the man walks into the Bank the amount of cash that the Bank has on hand is finite and in this case, zero. The Bank is also insolvent. Therefore, in this example the Bank will fail.’

    In a closed economy that uses a metallic standard, the stock of coin at any time is fixed, and whatever the size of this stock it must be willingly held by someone. To change this stock requires mining, manufacturing and/or melting — these are flows, and by definition, flows only change stocks over time. Unlike others, I believe that the role of the cash interest rate is to allocate the stock of metallic currency to those willing to pay the opportunity cost (interest foregone) of doing so, and that the interest rate has a negative relationship to the gold coin stock in a closed economy on a gold standard (i.e. the higher the stock of gold coin, the lower the interest rate, other things being equal).

    However, the banking system and the process of securitisation can create more liquid assets. Consider a business that owns switches, cables and the like and uses them to provide telecommunications services. Almost all the assets it holds have high asset specificity, and are not readily marketable (only non-specific assets are available for rent in spot markets, semi-specific assets are available for rent on long term contracts (e.g. buildings), whereas specific assets must be financed and owned by the users). Yet the telecommunications company can finance 100% of its assets by the issue of debt securities and equity securities, and these securities are marketable and non-specific assets that are bought and sold on spot markets (e.g. recognised securities exchanges) and are liquid assets to their holders.

    In the same way, a bank turns illiquid assets (principally loans and advances) into liquid securities — demand deposits that are liquid by way of a right of redemption, and bonds and shares by way of listings on secondary markets (securities exchanges).

    In both cases the size of the securities and banking markets depends on demand. Assets can be held other than in the form of securities, for example direct investments in land and buildings, or shares in unlisted private companies, or loans and advances to other investors or businesses. The process of issuing and maintaining securities has costs — the costs of making the offers, the costs of preparing annual reports, the costs of paying securities exchanges listing fees, the costs of comkplying with all the listing rules etc. If these costs are not producing a greater benefit, the asset financing can move to non-securitised forms.

    In the case of our example, the marginal reserve ratio for the transaction is zero, but that does not mean the abolute reserve ratio of the institution is zero. The institution will have some reserves, but will rely not only on reserves, but also on the sale or redemption of assets and the re-financing plans or options to honour its engagement to the deposit customer. Most obviously, the institution can sell the teleco bond should the need arise to pay the $5000 to the customer.

    You wrote:
    ‘One might also suggest that the Bank has committed fraud since it purchased the bonds from the man with the full knowledge that it did not have funds to pay him. A bit like writing a check knowing that there is no money in your account.’

    The bank does not commit fraud or any breach of the securities or companies laws by borrowing without having the funds to repay in the form of cash. Banks, like other companies, are entitled to rely on the liquidation of assets and the raising of replacement funding as other companies are. For example, most companies that have overdraft facilities from their banks do not have any cash or reserves of liquid assets to repay the funds should the lending bank demand repayment, the company relies on the bank not demanding payment unless it is not longer happy with the company’s credit situation. The bank relies on its acceptance of the overdraft borrower’s credit standing, and in security it normally takes over the company’s illiquid assets. I’ve recently looked into the fraud and companies and securities laws related to fraud and related offences, and I can assure you that banks do not commit fraud simply by operating fractional reserves.

    It is not fraud to draw a cheque on an account without funds to pay the cheque: the drawer may be relying on credit facilities provided by the bank, and or from funds he expects to be credited to his account. A cheque does not operate as an assignment of funds held with the banker, it is only an order to the banker to pay on due presentation. In the same way, a banker that makes a promissory note does not operate to assign any funds or assets to the note, it only operates as a promise to pay on due presentation.

    You wrote:
    ‘If we expand the example such that the Bank is able to finance the bond purchase with funds from another depositor we still cannot get away from the fundamental problem, no matter the accounting entries; at any time the Bank can fail and inevitably it will because of the business cycle that it helps to create. ‘

    Unfortunately you’re assuming what you’re trying to prove here. The bank will not fail so long as a) it does not make too many losses (typically on bad loans) and b) its access to replacement finance and/or its stock of marketable assets is not impaired or exhausted respectively. In the recent financial crisis, no major NZ bank suffered any liquidity or solvency problem — all four banks that represent 90% of the banking system, continued to be well capitalised, liquid and profitable (along with their Australian parents).

    You wrote:
    ‘Furthermore, if a Bank is funding Peter’s withdrawal with Paul’s deposit we get into the difficult ethics of pooling of funds, notwithstanding the fact that whole operation begins to resemble a giant Ponzi scheme. ‘

    The funding provided to the bank does not represent claims on specific assets held by the bank, but unsecured claims on the bank. As such, depositors are unsecured creditors and rank equally in any liquidation or restructuring of the bank.

    You wrote:
    ‘Surely FRB must be inflationary? If, continuing the example with person A representing the man and person B representing a woman, B deposits $5000 that the Bank could use to repay A as you suggest. Or, if A decides not to make a withdrawal instead the Bank could lend this money to person C, a business owner. C keeps his loan in his account at the Bank. In our economy we have total demand deposits of $15,000 yet the Bank only has $5000 in cash. If we assume a reserve ratio of 1% we eventually get to $500,000 in total demand deposits based on person C’s deposit alone. This is de facto inflation.’

    Again you’re assuming what you’re trying to prove.

    You wrote:
    ‘Surely rather than have banks engage in a risky balancing act or complicated recapitalization plans it is better to have 100% reserves. The bank charges a fee for storing people’s cash and if you want to lend the bank money that it can use for its investments you simply buy a bond. There will be no significant risk for the bank’s depositors (since the depositors’ money will be ring-fenced) and the bank can discharge investment risk to the bondholders etc. Fundamentally, we have a far more stable financial system with risk limited to those who knowingly and willingly accept it.’

    Banking need not be risky so long as the bank is a prudent lender, and is adequately capitalised and well managed. Here in New Zealand we have four giant Australian owned banks who have 90% of the banking market and operated using the same business model for a very long time, and manage to get through bad times without falling over or needing government help, unlike the US banks (and of late the British ones). In fact the Australian banking system has been sound and strong at all times other than the 1890s, as far as I am aware, and it got through the 1890s by restructuring rather than government bail outs (in the 1890s the customers of the major Australian banks did not suffer losses, only loss of access to funds for a while).

    Recapitalisation is not a strange and complex beast. All it means is issuing more share capital, to replenish the bank’s buffer against losses. Without this buffer, bank customers would go elsewhere.

    • Current

      I’ve agreed with everything you’ve said in this thread apart from this:

      > Unlike others, I believe that the role of the cash interest rate
      > is to allocate the stock of metallic currency to those willing to
      > pay the opportunity cost (interest foregone) of doing so, and that
      > the interest rate has a negative relationship to the gold coin
      > stock in a closed economy on a gold standard (i.e. the higher the
      > stock of gold coin, the lower the interest rate, other things being
      > equal).

      I don’t think that’s quite it. In a commodity money system current accounts are closely substitutable with several other products. On one side we have banknotes which don’t pay interest, but are useful in some circumstances, and gold which can be used between banks and countries. On the other side we have savings accounts that have slower access than current accounts. There is cross-substitution between each of these things, but I don’t think we can be certain that the gold demand determines the interest rate. It may be very important in determining the difference between the interest rate paid on timed savings and that paid on current accounts. But, even then there’s also the question of the bank’s costs. Supporting redemptions cost banks a lot, but they’re not the only cost that current accounts have above savings accounts.

  • Curren,

    As I said, I’m out on a limb with this. Contact me privately if you’d like to review the model (use the link on my blog).

  • Stephen

    The critical point in this discussion is whether the bank can legitimately contract to repay its depositors on demand while simultaneously lending their money out for investment in long-term projects.

    I agree with de Soto’s position that the bank cannot legitimately enter into such a contract because it cannot possibly fulfill all of its legal obligations. Because demand deposits are liabilities that are always due, they must be backed by 100% reserves in order to be consistent with traditional legal principles.

    This does not mean that some form of fractional-reserve banking could not exist in a free market. If a customer agreed to loan a specific amount of money to a bank for an indefinite period of time, and the bank agreed to repay the loan, but did not guarantee to do so at any specific time, I do not see a problem with this contract. The bank may anticipate that it will be able to satisfy requests for repayment, but it cannot guarantee that it will be able to satisfy all requests, because it cannot possibly.

    This critical point is the difference between a demand deposit being equivalent to money or being a different financial instrument.

  • Current

    > I agree with de Soto’s position that the bank cannot legitimately
    > enter into such a contract because it cannot possibly fulfill all
    > of its legal obligations.

    There is always some risk that any party in a contract can’t fulfill their obligations. If every contract were considered null-and-void because that risk exists then no contracts at all could be made.

    > Because demand deposits are liabilities that are always due,

    No, current accounts are due on-demand, not always. Only when a party demands redemption does the bank have to pay, not “always”.

    > This does not mean that some form of fractional-reserve banking
    > could not exist in a free market. If a customer agreed to loan a
    > specific amount of money to a bank for an indefinite period of
    > time, and the bank agreed to repay the loan, but did not guarantee
    > to do so at any specific time, I do not see a problem with this
    > contract.

    Good. But, the problem is that potential customers may have a problem with this. I certainly wouldn’t like it very much if my bank didn’t have the legal obligation to pay back my capital at any time in the future. Even if there were an associated interest rate and regular interest payments such a contract would be very problematic. Option clauses and waiting periods are reasonable and have been accepted by the market. But, I don’t think the market would accept waiting potentially forever.

    Think about this… Under your proposed scheme how can the bank be certain that it can pay all of the customers in the future? It’s assets are not obviously valuable, and how valuable they are is a matter that even other bankers wouldn’t necessarily agree on. So, if you take the view that contracts can’t be made if it’s conceivable that they will fail, then how can the bank guarantee to pay back anything?

  • Stephen

    Hoping that people will not exercise their legal claims is not entrepreneurial risk.

    My point is that, if depositors really do have a legal claim to their money on demand, then the bank is engaging in fraudulent activity if it promises to repay on demand while loaning out that very same money, because it cannot possibly do what it has contracted to do.

    Since the bank cannot possibly guarantee to repay everyone on demand, it can only legitimately contract to pay in the future. My proposed scheme was merely an illustration of what a contract that didn’t violate basic legal principles might look like. These sorts of IOUs would not be accepted well by the market for good reason.

    Do you maintain that it is legitimate to contract to do something that you cannot possibly do?

    • Current

      I’ll just talk about this once more, and then I’ll finish…

      > Hoping that people will not exercise their legal claims is not
      > entrepreneurial risk.

      Yes it is. In fact it’s a very common entrepreneurial risk. When a business takes out an overdraft that a bank can withdraw at it’s discretion that business is taking exactly the same sort of risk. Similarly, insurance companies “hope” that their clients will not exercise too many claims on them.

      > My point is that, if depositors really do have a legal claim to
      > their money on demand, then the bank is engaging in fraudulent
      > activity if it promises to repay on demand while loaning out that
      > very same money, because it cannot possibly do what it has
      > contracted to do.

      The bank *can* do what it’s contracted to do, banks do exactly this and they have been doing it for centuries. Simply because a bank may fail if every account holder came to redeem at once doesn’t mean that such a thing will happen.

      A bank isn’t engaging in fraud if it’s not promising to hold accounts as bailments. Whenever a contract is a debt there is no obligation on the borrower (unless negotiated otherwise) to use the loan for a particular purpose, or hold it in a particular asset.

      With debt fraud does not occur if there is the *theoretical possibility* of the the borrower not paying. If the law did work that way then no debt contracts could be exchanged, since all involve that possibility. The borrower must take reasonable steps to ensure that he (or she or it) can repay. But, that doesn’t mean holding all assets as cash.

      > Since the bank cannot possibly guarantee to repay everyone on
      > demand, it can only legitimately contract to pay in the future.

      In that case, why not 10 seconds in the future? Where I live in Ireland ATMs show adverts for ten seconds while counting money. Surely this is an agreement to pay in the future?

      I’m sure you would say that a bank has to keep 100% reserves for debts 10 seconds in the future. But, if this is so then why doesn’t it have to keep 100% reserves for debts 10 years in the future?

      > My proposed scheme was merely an illustration of what a contract
      > that didn’t violate basic legal principles might look like.

      On-demand debts don’t violate basic legal principles at all. I know DeSoto says they do, Selgin has replied to all that.

      > These sorts of IOUs would not be accepted well by the market for
      > good reason.

      In your preferred scheme would you allow timed debt? If so then why couldn’t a bank issue notes which are debts to be paid in 3 months time? As Toby has pointed out in recent articles why can’t a bank promise to pay in 3 months but pay on-demand in practice. Think about this: would you ban paying of debts early?

      Why is it that in the scheme you outline the debt has no maturity date? Do you believe that maturity dates shouldn’t be legal?

      > Do you maintain that it is legitimate to contract to do something
      > that you cannot possibly do?

      Banks don’t contract to do something that they can’t possibly do. They contract to do something that they can do. When you say “cannot possibly do” what you mean is that there is a remote possibility that they may not be able to do it. I think it is perfectly legitimate to write contracts where there is a remote possibility of non-fulfilment. If it wasn’t then commerce couldn’t occur.

      As David Hillary has written elsewhere searches through the historical record have failed to come up with even one clear example of a bank that failed because it didn’t keep enough reserves to serve all it’s redemption requests. In practice the universal cause of bank failure is bad debts. A bank is found to have bad debts to the extent that it’s probably insolvent. Then when the market find that out there is a run just as the lenders to an insolvent company scrabble to get paid.

      • Stephen

        Current (and David),

        My point is being misunderstood.

        A loan contract guaranteeing repayment on demand and a bailment contract both require that the money be available at the moment it is demanded. If a bank contracts to repay all depositors on demand, yet simultaneously loans out their money, it cannot possibly fulfill its obligations. This fundamental fact remains whether depositors seek repayment.

        Obviously there is nothing wrong with debts that are payable in the future. However, a fractional-reserve bank guaranteeing repayment within a certain time period after a demand is made is fundamentally the same as guaranteeing repayment on demand, unless all of its loans will be repaid during this period.

        The bottom line is that a fractional-reserve bank, once it creates loans from demand deposits, cannot possibly honor the guarantees it has made to its depositors. It does not matter that the bank anticipates not having to fulfill its contractual obligations; it has still entered into contracts with its depositors that, as soon as they exercise their legal claims, cannot be fulfilled.

        I believe in free banking. The point I am trying to get across is that a fractional-reserve demand deposit cannot be a loan which becomes a bailment when repayment is demanded. Either the bank has to repay the loan on demand, or it doesn’t. The question is: is the claim that the depositor receives convertible into money at any time, or is it not? The answer is that it is not. The problem is that it purports to be.

        I believe in voluntary exchange. There is nothing wrong with loaning money to a fractional-reserve bank and receiving different goods in return. However, the bank cannot make the fraudulent claim that what the depositor receives in exchange is convertible into money at any time, because it is not.

        • Stephen

          Also, I did some research on free banking in Scotland, and it appears that the banks actually pyramided their credit on top of the Bank of England.

        • Current

          > A loan contract guaranteeing repayment on demand and a bailment
          > contract both require that the money be available at the moment it
          > is demanded.

          Yes, we agree about that.

          > If a bank contracts to repay all depositors on demand, yet
          > simultaneously loans out their money, it cannot possibly fulfill its
          > obligations.

          Yes it can. Banks have done so for many centuries.

          > This fundamental fact remains whether depositors seek repayment.

          What you are seeking to do here is to switch the legal test from being a practical one to being a theoretical one. According to current law (roughly speaking) a borrower is said to have defaulted when a lender requests money back and the borrower cannot provide it. The test is practical, not theoretical.

          You’re proposing to replace that with a theoretical tests so that if there exists the concievable possiblity that a borrower would not be able to pay back the debt, then the borrower has committed a crime.

          > Obviously there is nothing wrong with debts that are payable in the future.

          I don’t think there is, but I don’t think your point of view is really consistent with that view.

          > However, a fractional-reserve bank guaranteeing repayment within a
          > certain time period after a demand is made is fundamentally the same
          > as guaranteeing repayment on demand, unless all of its loans will be
          > repaid during this period.

          Yes, you’re right. If bank X says that it will pay “on-demand” after time-period Y then after that time period we have the normal fractional reserve system.

          That’s not what I’m saying. What I’m saying is, what if bank X pay after time Y? So, I have a certificate from a bank. It says then when I hand it in to the bank the bank will hand me gold coins in 30 days time. They won’t offer me the *option* of gold coins in 30 days time, they’ll just send them to me. In that case how can you object to this contract.

          But, with that in mind how can you object to the contract if the time period concerned is 30 seconds rather than 30 days?

          > The bottom line is that a fractional-reserve bank, once it creates
          > loans from demand deposits, cannot possibly honor the guarantees it
          > has made to its depositors.

          You have persistently asserted this. However, repeating it time and time again doesn’t make it any more true. Bank do exactly what you claim they cannot do all the time.

          You may claim that bank runs are an exception. But, bank runs are not driven by account holders demanding money, they are driven by bad debts. Once the account holders believe that the bank is insolvent then a run occurs. Runs don’t occur because the bank can’t estimate how much reserves to hold for redemption, banks can estimate that.

          > It does not matter that the bank anticipates not having to fulfill
          > its contractual obligations; it has still entered into contracts
          > with its depositors that, as soon as they exercise their legal
          > claims, cannot be fulfilled.

          Yes, the contracts cannot be fulfilled *if all depositors exercise their claims at the same time*. But it is only when that happens, or when a large enough number of them exercise their claims that the bank must default. And, it is only at that time when legal proceeding need to begin.

          > I believe in free banking.

          Well, what you’re proposing is “free” banking in a legal situation very different from what we have today. Are you proposing that only banks be treated in a different way or that all other businesses should be treated differently too?

          If all other businesses are treated in the same way then that would make debt impossible. It is always conceivable that a company will not be able to pay back future debts. If that conceivable risk means that the courts consider those contracts null-and-void then no debt contracts can be made.

          Or, are you proposing that we should look at practical risks in other cases and look at conceivable risk only when considering on-demand lending? If so then why?

          > The point I am trying to get across is that a fractional-reserve
          > demand deposit cannot be a loan which becomes a bailment when
          > repayment is demanded.

          I’m not sure I know what you mean by this bit?

          > Either the bank has to repay the loan on demand, or it doesn’t.

          It does, there’s no question about that.

          > The question is: is the claim that the depositor receives
          > convertible into money at any time, or is it not? The answer is that
          > it is not.

          No, it is.

          Here’s a question for you. I’ve worked on computer systems that can’t possibly work if all people who have the right to access them do so at the same time. Is it true that such systems don’t work? No, whether they fail or not is a practical matter.

          > I believe in voluntary exchange. There is nothing wrong with loaning
          > money to a fractional-reserve bank and receiving different goods in
          > return. However, the bank cannot make the fraudulent claim that what
          > the depositor receives in exchange is convertible into money at any
          > time, because it is not.

          Well, let’s suppose that future legislators accept your point of view. What’s then to stop banks from fulfilling on-demand contracts in practice. That is, what’s to stop them not promising to redeem on demand but doing so anyway?

          See the discussion here:
          http://www.coordinationproblem.org/2010/11/another-banking-proposal-from-toby-baxendale.html

          • Stephen

            We are having a communication breakdown.

            Maybe this paper by Michael Rozeff, in which he critiques Rothbard and Mises on this issue, will clear things up: http://www.independent.org/publications/tir/article.asp?a=775

            I agree with Rozeff’s analysis. Both Mises and Rothbard built their positions on the assumption that what depositors receive in exchange for their money is a guarantee that is convertible into money at any time. However, this is not the case.

          • Current

            I’ll post on Rozeff’s paper soon. I think he is right about the bulk of it, his arguments are unoriginal most are in Selgin. He misunderstands Mises position, there is more about the subjects he discusses in “The Theory of Money and Credit” than just that quote. Mises position is much more reasonable than Rozeff gives him credit for.

            I agree that we perhaps are having a communications breakdown. But, I’ll say one thing about it right now.

            There is a difference between a promise and absolute certainty. My argument above was not that banks provide absolute certainty, but rather that they promise to pay and that in practice they can do so. Because they can do so in practice they can make a legal promise to pay, however this isn’t the same thing as absolute certainty. There is no such thing as absolute certainty. I can agree with you to do X, though it is not absolutely certain that I can actually do X. If I fail, and we have made no contractual condition to deal with that failure, then the defaults of the legal system determine what happens next. That default need not be “nothing happens”, it depends on the circumstance. I can most definitely promise to do something that isn’t absolutely certain.

            It should be pointed out that there is no absolute certainty with a 100% reserve bank either. It may be robbed for example, or it’s management may abscond with the gold.

  • Stephen, depositors do not hold deposits in order to redeem them immediately, but in order to redeem them at some time in the future at their option. The act of holding a deposit or bank note rather than redeeming it is part of the intention of the customers. What the customer wants is a store of wealth, as well as an eventual means of payment. The customer may be intending the former more than the latter, or the former for now, and the latter at some unknown time in the future. I know that in my household we primarily hold bank demand deposits not to spend the money in the short term, but ‘for a rainy day’. It gives us financial security and provides a savings product that does not have commissions or charges to pay, and that pays modest interest. We also recently held bonds for a higher rate of return, but we paid over $60 in commission to buy a $3500 investment — it is not cost effective for us to try to make our own portfolio of bonds given the modest size of our savings and the transaction costs involved in buying, selling, and managing such a portfolio. Since we use the bank account deposits primarily for savings, our overall balance with our main bank is very stable. However, for households that live from payday to payday, even though the funds are turning over rapidly does not mean that, together with other households with the same bank account characteristics, the bank can’t get stable funding. So long as different households have different paydays, they largely even out.

    I suggest you research how the law treats the question you raise about incurring obligations. The tests that apply under companies laws and similar laws a bank can easily meet.

  • Stephen

    Well, this has been a very interesting discussion. We are on the same page with each other about many things — far and away the most important things, to my mind — and it has been enjoyable and thought provoking to discuss these issues with intelligent people who believe in economic freedom.

  • Stephen

    Current,

    I couldn’t reply above so I am replying here. There is no need for you to respond to the whole Rozeff paper unless you want to. I just thought it might clarify my point.

    I understand that the world is an uncertain place and that all contracts involve risk. I don’t understand how issuing money titles that are not actually money titles qualifies as a promise that entails some risk of default.

    Do you have a blog or a way I can contact you? I have some material I want to go through but I would be interested in having further discussions with you.

    • Current

      > I don’t understand how issuing money titles that are not actually
      > money titles qualifies as a promise that entails some risk of
      > default.

      I don’t think that current accounts and banknotes are money titles. Really they’re debt contracts.

      To give an associated example. Let’s suppose I have some land on which there are carrots growing. I could do two things. I could contract to supply you with a quantity of carrots in exchange for a quantity of money. Or, I could sell you ownership of my carrots.

      The first case isn’t quite the same as the second. In the first case I must supply you with the carrots I’ve promised at the time and date specified in the contract (or immediately or on-demand). In the second case you own the carrots.

      In the first case I “default” if I don’t supply carrots at the allotted time. But, I may supply any carrots of the quality specified in the contract, I don’t have to even supply those I’ve grown unless the contract specified that. In this case I have a debt of carrots. The burden of ownership passes from you to me at the allotted time, which may be whenever you request in the case of an on-demand contract.

      In the second case I can’t possibly default at all, because I have already supplied the carrots. From the time I agree the sale they are your carrots even if they’re in my field. If I actually had the carrots when I make the agreement then afterwards they are yours. If I don’t have the carrots then I’m guilty of fraud and laws about that come into play. If I don’t let you take the carrots laws about obstruction come into play.

      Fraud does not occur at the same time as default in a debt contract. Suppose I sold the carrots to you on monday and promised to dig them up for you on wednesday because I’m away on tuesday. If you find out that I didn’t have any carrots by looking in my fields on tuesday then you can take legal proceedings against me straight away you don’t have to wait until I return and then request that I supply the carrots. On the other hand if we’d signed a contract on monday that said that the carrots pass into your possession on wednesday then you have no case against me on tuesday. In that case we have a debt relationship until wednesday and you can only take legal proceedings against me if I default on wednesday.

  • Current

    > Do you have a blog or a way I can contact you? I have some material
    > I want to go through but I would be interested in having further
    > discussions with you.

    That would be interesting. My email address is

    rthorpe at robert thorpe consulting dot com

    Remove all the spaces and substitute in the symbols. No underscores.

    • Stephen

      Thanks for the contact info. I will definitely be in touch.

      I have taken a cursory look at several papers by Selgin and White, and they seem to focus on the need for banks to increase the quantity of money to meet the demand for cash balances and they seem to think that business cycles will not occur as long as the creation of new money matches the increased demand for money. Would you say that is accurate?

      • Current

        > I have taken a cursory look at several papers by Selgin and White,
        > and they seem to focus on the need for banks to increase the
        > quantity of money to meet the demand for cash balances and they seem
        > to think that business cycles will not occur as long as the creation
        > of new money matches the increased demand for money. Would you say
        > that is accurate?

        Yes. I certainly agree with them about that, that’s one of the core principles of monetary disequilibrium theory. It also applies in reverse of course, if the demand for balances falls then the banks must reduce the stock of money. My article on this site, “A Problem with the Baxendale Plan?” was essentially about that:
        http://www.cobdencentre.org/2010/06/a-problem-with-the-baxendale-plan/

        I don’t agree with them about absolutely everything else, but I think they’re very good.

        • Stephen

          I think that is where their analysis goes wrong. Increased demand for money means increased demand for purchasing power, not increased demand for units of money.

          If people demand higher cash balances, prices in general will fall; the purchasing power of money will increase. The structure of production will be lengthened to accommodate the decreased demand for consumer goods, and resources will shift toward capital goods industries.

          If banks increase the quantity of money to meet a higher demand for cash balances, there is no reason for prices in general to change; people can increase their cash balances without prices changing at all. There is also no reason to believe that the people who demanded higher cash balances will receive the new money. In addition, people may demand to hold actual cash as opposed to bank credit.

          How can banks possibly create new money in response to an increased demand for cash balances in such a way that the structure of production responds the same as it otherwise would have, but with prices in general remaining the same?

  • Robert Sadler

    David,

    You state twice that I am assuming what I am trying to prove. I was confused by this but perhaps I can be clearer about what I am assuming and what I am proving.

    You asserted that De Soto had made a fundamental error and then proceeded to provide an example designed to prove this error. I have assumed that you believe this fundamental error is the theory that FRB leads to inflation.

    What I set out to prove is that your example does not support your assertion and in fact, when it is fully analysed, it actually shows that FRB does and absolutely must lead to inflation. If we maintain our discipline and stick to the confines of your example we find two things:

    -the Bank by necessity is insolvent
    -FRB by its very nature must lead to inflation.

    Based on my expansion of your example, there is simply no denying these two facts.

    I must stress, I am not currently trying to prove the cause of the Business Cycle. This is because if you and I cannot agree that FRB leads to inflation there is no point in us debating the causes of the Business Cycle.

    Just a point in fact, in some countries (USA and I believe the UK and Dubai) it is fraud to write a check without funds available to cover it (funds may include your overdraft facility). You cannot rely on funds you expect to arrive in the near future. I cannot speak for New Zealand however.

  • Stephen

    Regarding “free banking” in Scotland, Larry Sechrest’s “White’s Free-Banking Thesis: A Case of Mistaken Identity” is absolutely devastating.

  • Stephen

    Do the proponents of FRFB think that a deposit of 1,000,000 and a subsequent loan of 900,000 extended from that deposit would result in this first balance sheet?:

    Assets = 100,000 cash + 900,000 loan
    Liabilities = 1,000,000 demand deposits

    or this second balance sheet?:

    Assets = 1,000,000 cash + 900,000 loan
    Liabilities = 1,900,000 demand deposits

    • Current

      First the account holder, person A, loans the bank 1,000,000 in base money. Then the bank make a 900,000 loan with another party.

      So, at the start we have:
      Assets = 1,000,000 base money
      Liabilities = 1,000,000 bank account, person A

      The bank will pay the loan into one of their accounts. So, at the moment when when the loans is made we have:
      Assets = 1,000,000 base money + 900,000 loan
      Liabilities = 1,000,000 bank account person A + 900,000 account person B

      But, person B acquired the loan in order to spend it. He wanted to borrow assets not money. So, he will take out the amount. Like for example, when you borrow to buy a house you immediately pay the amount you’ve received from the bank for your mortgage to the person selling the house.

      So, when that happens we’ll have:
      Assets = 100,000 base money + 900,000 loan
      Liabilities = 1,000,000 bank account person A + 0 person B

  • Stephen

    The second entry in this balance sheet clearly demonstrates that the bank created a 900,000 deposit ex nihilo in order to grant its loan.

    In addition, as de Soto demonstrates, if any of the bank’s loans remain unused or find their way back to the bank, the bank can create more fiduciary media ex nihilo, even beyond the amount originally deposited with it. Using our example of a 1,000,000 deposit and assuming a 10% reserve, once just over 11.1% of the loans remain unused or find their way back to the bank, the bank can create more than 1,000,000 in fiduciary media. Assuming the 2% reserve that you frequently mention as being viable, that number is just over 2%.

    My understanding is that free bankers claim that the above process does not lead to the business cycle because the banks are creating new money to meet an increased demand for money. I don’t think that argument holds up (see my post from November 21st, 2010 at 6:33). The question that free bankers need to answer is, how can banks possibly create new money in such a way that the structure of production responds the same as it otherwise would have, but with prices in general remaining the same?

  • Current

    > The second entry in this balance sheet clearly demonstrates that
    > the bank created a 900,000 deposit ex nihilo in order to grant its
    > loan.

    If you mean that the bank created an entry in it’s database for 900,000 then yes, you’re right. But, that isn’t the essential criticism that 100% reservists make. Their criticism is normally that the bank has created money without any cost to itself. This is not true because as the final balance sheet of the bank demonstrates. The bank’s liabilities and assets closely match.

    You may point to the balance sheet before the borrower has taken his money. But, this situation is no different from any other lending. Suppose that I’ve entered into a contract with somone and as a result they are entitled to receive £100 from me. It’s only when they actually claim that £100 that I have to pay.

    > In addition, as de Soto demonstrates, if any of the bank’s loans
    > remain unused

    Yes. But practically speaking this isn’t a very important case. Why would a bank want £X on it’s loan book and the same amount in a customers account. What banks do in this case is to negotiate an overdraft facility with the customer.

    Besides, if the money in question is sitting in a bank account then it can’t affect prices. Suppose that everyone borrowed £100 from their bank and left that £100 in their account. In that case prices wouldn’t change. However, if they spent that money then the banks would have to incur the cost of redemptions. This last part is the crucial point, as demand for money balances falls redemption costs to banks rise. So, banks have an incentive not to keep the amount of money stable, but to keep the “effective amount” stable, the amount weighted by demand or MV as some call it.

    > or find their way back to the bank,

    Yes, that happens. In the 19th century gold standard systems where on central bank had monopoly of note issue it happened a lot.

    All it means though is that banking has positive returns to scale. Many businesses do.

    > Using our example of a 1,000,000 deposit and assuming a 10%
    > reserve, once just over 11.1% of the loans remain unused or find
    > their way back to the bank, the bank can create more than 1,000,000
    > in fiduciary media. Assuming the 2% reserve that you frequently
    > mention as being viable, that number is just over 2%.

    I’m not sure I follow your calculation. If a bank uses a 10% reserve then it has factored in the effect of loans finding their way back to the bank into that calculation.

    > My understanding is that free bankers claim that the above process
    > does not lead to the business cycle because the banks are creating
    > new money to meet an increased demand for money. I don’t think that
    > argument holds up (see my post from November 21st, 2010 at 6:33).

    I’ll reply to that soon.

    > The question that free bankers need to answer is, how can banks
    > possibly create new money in such a way that the structure of
    > production responds the same as it otherwise would have, but with
    > prices in general remaining the same?

    What is your counterfactual here? You say “otherwise would have” what case is attached to the otherwise?

    We’re not saying that fractional reserve free banking would respond the same as 100% reserve free banking. We’re saying it would be better and lead to a quicker recovery and greater output.

    • Stephen

      Sorry that it took me so long to reply.

      My calculation was simply determining what percentage of a bank’s loans would have to find its way back to the bank before the bank could extend credit beyond the amount of its initial deposits. I think it’s important to stress that fractional-reserve banks do not act only as financial intermediaries; they create additional credit beyond what depositors have loaned them.

      I will answer your message below soon.

      • Current

        > My calculation was simply determining what percentage of a bank’s
        > loans would have to find its way back to the bank before the bank
        > could extend credit beyond the amount of its initial deposits.

        I see. My point was that the bank takes into account at all times that some small percentage of it’s loans won’t be redeemed. That’s factored into it’s decision on the size of it’s redemption fund.

        > I think it’s important to stress that fractional-reserve banks
        > do not act only as financial intermediaries;

        No, banks are financial intermediaries.

        > they create
        > additional credit beyond what depositors have loaned them.

        Err, no they don’t. Why do you think they do?

        • Stephen

          See de Soto’s discussion starting on page 200 under “An Isolated Bank’s Capacity for Credit Expansion and Deposit Creation”.

  • Current

    > I think that is where their analysis goes wrong. Increased demand
    > for money means increased demand for purchasing power, not increased
    > demand for units of money.

    Yes, increased demand for money means increased demand for purchasing power. (I don’t think I ever said otherwise).

    > If people demand higher cash balances, prices in general will fall;
    > the purchasing power of money will increase.

    Prices do not move instantaneously, or even close to instantaneously. I agree that if there is a rise in demand for money then gradually over time the purchasing power of money will rise. Then, once the reason for the initial increase in demand for money has passed that demand will fall, and gradually prices will rise again. For this discussion I’ll include wages along with other prices, since that’s what they really are.

    The problem here is that output and employment will fall while this adjustment is taking place. As prices of consumer goods fall so do profits in those industries which then lay off staff. Prices often must adjust in a sequence, when one prices in one industry falls then prices in the inputs to that industry must also fall, and so on. If entrepreneurs correctly anticipate the implications of the initial price drops then this process may be short-circuited to some degree, but expectations can never be perfect.

    This is why large shifts in the demand for money are the interesting case. Population growth, changes in distribution of wealth and so on affect the demand for money. But, they change so slowly that prices can adjust. Introduction of new payment systems may sharply reduce the demand for money but is unlikely to increase it.

    When I make this argument other tend to say that I’m making a Keynesian argument about “sticky prices”. In a way I am. However, the problem with the Keynesian argument is that it often involves empirically over-estimates of the time prices take to adjust. But, that doesn’t mean that prices do adjust instantaneously or even very quickly.

    There is also the problem of account falsification occurring in the opposite direction to that in the ABCT case. Just as unexpected inflation exaggerates profits so unexpected deflation does the reverse.

    It’s worth noting that Mises didn’t argue that prices adjusted instantaneously. In “The Cause of Economic Crises”, for example, he discusses the labour market. He begins by pointing out that adjustments take time, he then continues by discussing how unions and pro-union policies disturb this process causing it to take more time.

    In “Human Action” p.566 Mises discusses the effect of government induced deflation. In that context he writes:
    “A tendency develops toward a fall in the prices of factors of
    production and later toward a fall in the prices of consumers’ goods
    also. Business becomes slack. The deadlock ceases only when prices
    and wage rates are by and large adjusted to the new money relation.”

    The ABCT argument also relies on price adjustments taking time. If adjustments happened instantaneously (or very quickly) then as the central bank increased the supply of money then the price changes would quickly flow though the structure of production. If prices changed very quickly then nobody could be unaware of a change in the purchasing power of money.

    > The structure of production will be lengthened to accommodate the
    > decreased demand for consumer goods, and resources will shift toward
    > capital goods industries.

    Capital goods industries may be able to expand somewhat because they compete for resources (such as labour) with consumer goods industries. However, it’s more complicated than that.

    If the rise in demand for money is permanent then some lengthening of the production structure can take place. But, remember we’re interested in large changes in the demand for money and those are almost always temporary. In the temporary case the rise in demand will be followed by a fall in demand soon after. If capital good industries don’t observe that they may expand and then need to contract. The market may anticipate this to some degree, in that case capital goods industries will refrain from expanding very much for fear of what happens later.

    There is also a countervailing force here. The consumer good industries buy from the capital goods industries, they will reduce their demand when their businesses are not doing so well.

    > If banks increase the quantity of money to meet a higher demand for
    > cash balances, there is no reason for prices in general to change;

    Yes.

    > people can increase their cash balances without prices changing at
    > all. There is also no reason to believe that the people who demanded
    > higher cash balances will receive the new money.
    >
    > How can banks possibly create new money in response to an increased
    > demand for cash balances in such a way that the structure of
    > production responds the same as it otherwise would have, but with
    > prices in general remaining the same?

    As I said in my other message, exactly what do you mean by “otherwise”?

    I don’t think that the events that occur when a rise in demand for money isn’t served by a corresponding rise in supply are beneficial. The losses in employment and output though they’re temporary are not necessary. I also don’t think that we have to risk the problem of reductions in demand for money causing price inflation or ABCT.

    I don’t think that the economy would be the same with a FRFB policy as with a 100% reserve policy, I think that a FRFB policy would give more robustness against shocks and greater economic growth.

    The question about the “people who demanded higher cash balances” is something a lot of people have asked. (In case you haven’t already noticed lots of my replies to you in this thread are things I’ve discussed many times before.)

    Before asking that question though it’s necessary to examine the normal situation. Let’s suppose we have a market-economy where there are currently no overall shifts in money demand, and no shift in prices underway. In that case there will still be many shifts in individuals demands for money, in regional demands and in demands from different branches of industry. We have to ask: how are these demands served? Suppose firstly that there is no banking industry. In that case changes will occur through prices and normal trade. Consider a country with a self-contained (autarkic) economy. In the west region of the country the demand for money is growing. But, in the east of the country the demand is falling. In this case prices will rise gradually in the east and fall in the west. As a gap in prices arises that produces an arbitrage opportunity. Goods can be bought cheaply in the west and sold in the east. So, the overall price level need not change. A price change proportional to the change in demand isn’t necessary anywhere, all that needed is a price change large enough to make arbitrage profitable. If this didn’t happen then free market economies couldn’t perform efficient monetary calculation. David Hume pointed this out, he also pointed out that if the same commodity is money in two countries then a shift in demand for money may be accomplished in the same way.

    We can introduce banking to the above example without introducing on-demand banking. Suppose banks only make loans and borrow long-dated savings. In that case banking may still help by matching lenders and borrowers. But, it doesn’t help as directly as some suppose, most who have a demand for money they haven’t been able to realise would not find it useful to borrow in order to obtain money. Rather in this case banking helps indirectly by providing funding for activities associated with the adjustment. The price changes I mention above, along with banking, are sufficient to take care of internal changes in the composition of money demand, but not in overall changes in it.

    Finally, let’s consider the situation with fractional-reserve on-demand banking. In that case banks can create money if they have the assets and reserves to do so. Let’s say the overall demand for money rises then banks will create more money. As you point out, if this occurs then banks will not hand money to those who actually demand it. But, this is the normal case, and markets handle it all the time. Taking my example above with the east and west of a country, it’s as though the bank is the east.

    A lot of confusion on this subject has been caused by the idea that when a bank creates money-substitutes those who “receive the new money first” profit. This is true in the ABCT scenario, but not necessarily true in any other. When banks issue new money to people in a time of high demand those people can profit by buying things with that money. But, their profit is like that of those who are arbitraging prices between the west and east of the country I mention above. The profit isn’t generated by account falsification which can’t occur without a change in the price level.

    > In addition, people
    > may demand to hold actual cash as opposed to bank credit.

    Banknotes were originally issued by banks, if we had free banking they would be again. As George Selgin has explained, with a free-market in money coinage would become fractionally reserved too. That’s what happened in Britain in the 19th century when free coinage was permitted.

    It’s true that if investors think that a banks financial position isn’t sustainable then they will ask for redemption in the underlying commodity. But, this is a necessary discipline the market imposes.

  • I miss in the discussion the question of the deposits guarantee by the State and the implicit guarantee that the State gives to bank that they will be bailed out.
    I think that without taking into account this two facts, the discussion becomes too conceptual, even legalistic.
    If banks would go bankrupt would they face a run, then, depositors would be very careful about to whom they lend their money. They would monitor what the banks do with their money and they will be conscious of being what they really are: creditors of the bank and not owners of the money in the deposits

  • [...] [Hayek Memorial Lecture, The London School of Economics and Political Science, 28 de octubre de 2010. Publicado originalmente por el Cobden Centre] [...]