Some More Quibbles with Free Banking

If you are interested in monetary theory and what the Austrian School has to say about this debate, the paper that Anthony linked to last week is well worth reading. It addresses some common misunderstandings about Monetary Equilibrium Theory (MET).

This theory is controversial and is much critiqued in Austrian circles. It is but one branch of two very clear conceptions of money developed by Austrian School theorists past and present.  Both concern the Theory of Free Banking, with MET supporters favouring Fractional Reserve Free Banking and the rest of the Austrians favouring Full Reserve Banking. It may seem a mystery why people so philosophically aligned come up with very different final policy conclusions.  Both support the absence of the State in the banking architecture, preferring a free market for banks, but due to differences in definitions and monetary theory, they disagree about the ground rules for the market.

S Horwitz is a key developer of the MET School and A Evans (H&E) is clearly sympathetic. P Bagus and D Howden (B&H) are for the Full Reserve policy solution.  As a side note, Selgin and White from my reading are the intellectual “daddies” of H&E with respect to money and banking. I see little of MET mentioned in their works (especially their latter writing) and more of disequilibrium. This subtle use of language is important, as any Austrian will tell you; human action is dynamic and thus ever changing. Perhaps you can be less in disequilibrium but never in equilibrium. I mention this as H&E stress the importance of getting definitions right.

Definitional Issues – Savings

H&E say,

Unlike inflation, we believe that Bagus and Howden are defining savings in the same way as Free Bankers – meaning the act of abstaining from consumption.

So far so good.

They then clarify an important point:

Bagus and Howden (p. 39) write: “Horwitz suggests that the creation of deposits increases the supply of savings, as depositors are lenders of real loanable funds. In other words, the mere creation of credit and the corresponding new deposits constitute an increase in real savings.” We reject this interpretation because they misrepresent the causality. Bagus and Howden claim that Horwitz is saying that creating deposits increases the supply of savings, which suggests that the causality runs from money creation to savings. However, the Horwitz quote in question clearly says the reverse:

Savers supply real loanable funds based on their endowments and intertemporal preferences. Banks serve as intermediaries to redirect savings to investors via money creation. Depositors give banks custody of their funds, and banks create loans based on these deposits.” (1992, p.135)

The order is that savers provide funds to banks by increasing their deposits, and then those new deposits, which banks receive as reserves, serve as the basis for loans to the bank’s borrowers. Those loans are credited to the borrower’s deposit account. So it is not the case that the “creation of deposits increases the supply of savings” but precisely the opposite: increases in the supply of savings (“real loanable funds”) enable banks to create new loans and additional supplies of money. In other words, savings in the form of holding larger bank balances makes possible the funds for investment that are created through the lending process.

Further clarity is given with this helpful quote:

To see what free bankers actually argue, consider Selgin and White (1996 p.102),

“an increased demand to hold claims on intermediaries, including claims in the form of banknotes and demand deposits, at the expense of holding additional consumer goods, is equivalent to an increase in desired saving”

Note that they do not say that an increase in the demand to hold bank liabilities constitute an increase in savings, they say that an increase at the expense of holding additional consumer goods does. If the increase in demand to hold bank liabilities is facilitated by a substitution from other forms of saving (e.g. from capital goods), then there has only been a change in the composition of savings.

However, I have to conclude that still after years of debate and lots of reading and writing, debating and hair pulling, the eminent Professors, possibly all six mentioned thus far, do not quite have an adequate concept of savings.

Granted, I am a mere layman, but the experience of life and a joyful self education in reading great and not so great economists leads me to conclude that yes savings is a matter of abstaining from consumption, but with respect to what you hold as a money balance in the form of a bank IOU, you may well be abstaining from consumption, but that does not mean you are putting forward your savings for loanable funds. In a conversation with a noted eminent Free Banker, we labelled this “inadvertent savings.” This is a very important distinction to be made and I would define savings as “an act of abstaining from consumption and willingly offering for loanable funds.” The mere fact of just having a bank IOU, i.e. a demand deposit, does not mean you wish that your purchasing power be lent to someone else!

With this in mind, we can observe that if there is a large change in demand for money to the extent that noticeably fewer goods and services are being transacted for money in the economy, i.e. we are in a depression as we are today, then an accommodation by a fractionally reserved free banking system will funnel all those new loanable funds (the depositors’ higher money balances) to individuals and business who in turn demand it to support their weaker activities. This may well be not what the depositor base wants. The depositor base in times like we have today probably want their money balances kept safe as a precaution. Indeed, in my example, having sold my business, I keep enough money balance on deposit (I am loath to say savings now!) for the express purpose of sustaining me and my family, i.e. for ongoing consumption and for “rainy day purposes,” the latter due to the massive uncertainty that exists in the economy today. This means, ALL my cash is NOT set aside for money to be mediated to the loanable funds markets as far as I am concerned. This is exactly what I do not want happening to my deposits. In a mature fractional reserve free banking system, this will happen despite my wishes unless I want to deposit under my mattress or shoe box etc.

The Holy Grail of economics is that the savings of today provide the investment money to the companies and entrepreneurs to make the products, the goods and services that the savers will eventually want to buy with their returned savings. How can this happen when a banking system will mediate money away from precautionary balances that have been “inadvertently saved” back out into loans?

This explains a theoretical weak point in MET and the Theory of Free Banking (the two are slightly different, as noted above), but it might actually make the fractional reserve free banking position more robust if they addressed this issue of precautionary deposits or inadvertent savings.

H&E do not want to be drawn into legal or ethical issues concerning this debate and wish to keep it to the economics. I say they can never be separated and via the door I have just opened to strengthen up their theory, I would say that if depositors were asked to clarify their intentions then only money set aside for savings would go to savings, while money kept as a precautionary balance or for current on-going consumption would not be lent out. This was the objective behind the Carswell-Baker Bill presented to Parliament last year.

It is interesting to speculate, as speculation only it is, but all the panics in the halcyon days of fractional reserve free banking in Scotland (1770, 1772, 1778, 1793, 1797, 1802–1803, 1809–1810,1810–1811, 1818–1819, 1825–1826, 1836–1837, 1839, and 1845–1847; see Checkland, Scottish Banking: A History, 16951973, Glasgow: Collins, 1975), may well have been averted or substantially mitigated had people been able to distinguish how they wanted to have their on-demand money balances treated.

I would suggest that some empirical research needs to be done and maybe one of the eminent professors might like to get a graduate student to do this as part of their research. Empirically find out what element of cash balances held as on demand deposits are in fact precautionary and not intended to be lent to other people and enterprises. Find out how much of depositors’ current accounts, that are currently lent out by the banking system, are really intended for investment (with acceptance of risk). My hunch (and a hunch only), is that at times of panic / depression, when money demand does change, most savers want their money kept safe. Moreover, in these depressing times, as people refrain from consumption, they do not want the goods and services produced in the quantities and formats that were offered up before the change in demand.  Depositors’ reduced appetite for investment would send an important signal.

I am a sceptic as to the merits of fractional reserve free banking for many reasons, both legal and moral, but greater awareness on the part of depositors, with an explicit choice between safe-keeping and investment, would tighten up the monetary theory aspects of its approach.

By the way, Selgin’s Theory of Free Banking is very worthwhile to read in full. B&H are right to single this book out.  It presents a new theory that will be debated for many years to come.

To conclude, with H&E’s clarification of what they do and do not mean by savings and the holding of bank liabilities, I submit the debate would be enriched if this potentially large element of precautionary and current or near-current consumption element of a bank IOU is dealt with.

Much more could be said on this debate. I hope my “observer” contribution is valuable to the professionals. Although H&E value the academic approach over internet-based economics, I have no intention of writing this up in academic language and or providing footnotes citing references. Aristotle never did, and if it is good enough for that giant polymath, it is good enough for a speck on the body of knowledge like me! I hope some find this constructive and useful.

33 Comments

  • mrg says:

    I would define savings as “an act of abstaining from consumption and willingly offering for loanable funds.”

    That sounds like ‘investment’ to me.

    I’d say that ‘savings’ is simply “an act of abstaining from consumption”. You might do that for precautionary reasons, or for investment. What you labelled “inadvertent savings”, I would call “inadvertent investment”.

    I agree that the distinction is important. It’s unfortunate that “investment” accounts are called “savings” accounts, and that money in “current” accounts is also used for investment.

    I agree that it would help to have clarity about what happens to money in the various accounts. Anyone opening an “investment” account should realise that along with interest, comes risk, and these accounts should not be covered by deposit insurance.

    Of course, thanks to inflation, savers are forced to put their money at risk just to stand still.

    • Current says:

      Investing is actually buying capital. As you say saving is abstaining from consumption. If a person does that by lending then they are doing “capitalist saving” in Mises terms (I don’t know what the mainstream term is). If a person just stockpiles consumer goods then Mises called that “plain saving”.

      I think in modern usage a person who is holding commodity money or fiat money is also said to be saving. I don’t know a good word for the type of saving they’re doing though to differentiate it from the others.

  • Steve Horwitz says:

    Toby,

    Your early point about equilibrium/disequilibrium is mere semantics. If you’re going to talk about the problems associated with monetary disequilibria such as inflation and deflation, you are implicitly comparing those situations to one of equilibrium.

    Of course we’re never IN equilibrium. In my discussion of MET in my book I talk about all of these issues. You should get around to reading it one of these days. :)

    • Steve, I respectfully submit semantics is important. You have followers going around saying money accomodation to change in money demand will sort out all the problems, end of (assuming no state involvement etc). The head banging type always takes a simplified view. There are many people who just think prices adjust downwards in an instant and all problems are resolved, these are head bangers to. Calling your work MET is going to encourage more headbangers at the margin, why do it ? I never compare anything to a state of equilibrium only as a hypothetical construct (not real). People flit between the two states as if both are real. This is the heart of all the problems of economics.

      Your 2000 book I read then. I get sent those editions in that series. I will re read line by line as opposed to a read on a beach with the kids.

  • George Selgin says:

    When I taught grad monetary economics back at GMU in the 80s, I included writings by Yeager and others emphasizing the possibility and important of monetary disequilibrium. These were mainly aimed at challenging the New-Classical assumption that money prices continuously and completely adjusted to clear the market for money balances, even in the face of large money supply or demand innovations. For Yeager and (as Yeager argued at length) for almost all pre-New Classical economists (including most Old Classical economists), some degree of price “stickiness” was to be taken for granted.

    One doesn’t have to believe in free or fractional-reserve banking to favor Yeager’s position over the New Classical view; nor does believing that prices are “sticky” make one a “Keynesian,” as some (displaying a very poor knowledge of the history of monetary thought) claim. On the contrary: as I’ve indicated on this forum and elsewhere, anyone who claims to take Wicksell’s ideas about occasional departures of interest rates from their “natural” levels, which includes anyone who claims to find merit in the Austrian business cycle theory (ABCT) (which is built on a Wicksellian foundation), implicitly accepts Yeager’s position and rejects the New Classical alternative. I say “implicitly” because some Rothbardian types (and here is where the apparent connection with 100-percent versus free-banking views comes in) simultaneously claim (1) to subscribe to the ABCT and (2) to believe, along with New Classicals (though without acknowledging the affinity), that prices are perfectly flexible. In fact, those two positions aren’t reconcilable, and persons who subscribe to them both merely succeed in showing that they don’t understand how the ABCT works, that is, they don’t understand that a degree of price stickiness is necessary if interest rates are ever to diverge from their Wicksellian “natural” values.

    Whether free banking or 100-percent reserve banking is more capable of avoiding such divergence is, again, a separate matter.

    • Good Evening George,

      I speak as a practical man. On the 15th of Sept 2008 at 07.58 hrs in the morning, Lehman went bust. 15% of the top line of my then business vanished over night. With a line of 7% if I did nothing, this would mean near certain bust for my former business. By March 2008, all wages that had to were adjusted back by 10%. Other costs had come off and margin had risen. The latter was counter intuitive as you would expect the magin to fall off the edge of the cliff as well, but less competitors meant higher margin for the work that was there. Within 18 months profits were resorted and costs crept back a bit , but not much. I would make and educated guess that most prices could adjust back so most business is profitable in an 18 month period.

      Contrast this with the public sector and the people we pay to do nothing ie the unemployed and the incapacity benefit people, these have all beeen either index linked or their increases, yes increases have been slower than before.

      So it can be done IF you do not have a state sector that is big and all dominating as we do in this country. It is a very powerful voting block. So faced with these realities, we can assume price stickiness in the state sector and in the private , you have an ability to adjust back, but over a period of time of years or many months.

  • Current says:

    In economics “saving” is an objective criteria. It is something an outside observer can recognise without needing to speculate on the psychology of the actor. It isn’t a subjective criteria (like marginal use-value for example) which only the acting individual can really understand. A person saves when they abstain from consuming income. A person may save by lending, that’s what Mises calls “Capitalist Saving”, or by stockpiling consumer goods (what Mises calls “primitive saving” I think).

    > The mere fact of just having a bank IOU, i.e. a demand deposit,
    > does not mean you wish that your purchasing power be lent to someone
    > else!

    If a person accepts a bank IOU then that means that they have lent to someone else. Fiduciary media is debt money and the act of accepting fiduciary media is an act of lending (and therefore saving). If a person doesn’t want to lend to a bank then they must hold something other than fiduciary media, such as commodity money or goods.

    > This may well be not what the depositor base wants.

    An individual (depositor is a confusing word as we’ve discussed before) chooses to save with a bank when he or she accepts their fiduciary media. That individual can’t place condition on how the bank behave after they have made that decision. The bank must abide by any promises it has made, but it’s customers can’t tell it how to invest the money they have lent to it. Only if the bank and customer agree some plan beforehand can the customer complain.

    > This means, ALL my cash is NOT set aside for money to be mediated to
    > the loanable funds markets as far as I am concerned. This is exactly
    > what I do not want happening to my deposits.

    Well, that’s fair enough. If you want that then hold money-in-the-narrower sense. I remember you telling me once that you do bank with a 100% reserve bank.

    > How can this happen when a banking system will mediate money away
    > from precautionary balances that have been “inadvertently saved”
    > back out into loans?

    I don’t see how a “precautionary balance” clearly differs from any other sort of balance. A person who is planning their own finances may label some part “precautionary” in their own plan. It’s not something directly observable from the outside though. It’s very difficult for economists to look into other people’s planning and pick out the categories that they are using. If I’m have sausages for my dinner then an observer would have to know me very well to be able to say “he ate that sausage because he was hungry, that second sausage because it tasted good, and that last sausage to please the host”, especially because each sausage could provide all three services. It’s similarly difficult to divide the purposes for holding money balances up into “precautionary”, “speculative” and “transactional”.

    However, I think what you mean by “precautionary” is that in case of a personal emergency of some sort the balance could be useful. A balance may serve that task even though it was invested. The important question is can the bank redeem the balance if needed. If the answer is “yes” to an acceptable degree of certainty then a person can hold a percautionary balance that is a loan.

    > I would say that if depositors were asked to clarify their
    > intentions then only money set aside for savings would go to
    > savings, while money kept as a precautionary balance or for current
    > on-going consumption would not be lent out.

    There’s nothing wrong with clearly asking depositors, I support that. But, I doubt your assumption that consumers would demand that balances that are “precautionary balance or for current on-going consumption” be kept fully reserved.

    > may well have been averted or substantially mitigated had people
    > been able to distinguish how they wanted to have their on-demand
    > money balances treated.

    Where is the evidence that customers then didn’t know they were lending to a bank. Given that all these bank failures you mention happened, how could it have escaped notice? (I’ll let George comment on how important he thinks those bank failures if he wants to).

    > Moreover, in these depressing times, as people refrain from
    > consumption, they do not want the goods and services produced in the
    > quantities and formats that were offered up before the change in
    > demand.

    This idea seems to me to suffer from a circularity problem. If the economy is depressed then incomes are uncertain and larger money holdings are demanded. As that demand for larger money holdings is accepted spending falls, and with it prices and output. That consequently causes incomes elsewhere to fall and uncertainty to spread. This is what Horwitz calls “Wicksellian-Cumulative Rot”. So, each decision isn’t taken in a vacuum, the “depression” isn’t simply a force from outside that people respond to. Rather, in a situation with a fixed money supply, the depression is exacerbated by their response.

    Even in a depression the idea that bank customers want safety doesn’t necessarily conflict with fractional-reserve banking. The issue is case by case, is bank X or bank Y robust enough to survive the recession? Bank customers and potential bank customers must answer this question for themselves, using aides such as reputation, track-record, consumer guides and audited accounts.

  • Dear Selgin,

    I do like your comment. I have a question, maybe a bit off-topic: must we really be worry at price-stickiness? I mean: prices are not independent forms of life, they are the result of individual decisions to exchange goods and services (in a free-market environment, not necessarily our actual world); if prices look sticky i.e. they appear not so fast in including the continuos varying of some fundamental variables, cannot it be due to a “rational” (not necessarily in the classical sense) behaviour not to lose too much efforts and time in following the continuous stream of – maybe conflicting – news, thus limiting to from-time-to-time above-a-certain-threshold adjustments? Is it not a way to “equilibrate” efforts and benefits, hence a wider concept of “equilibrium” (again: not in the classical use of the word) itself?

  • @Current

    I add that we could simply distinguish money- (or other assets-) holding to simply transfer purchasing power into the future (which should be the actual meaning of savings) from willingly lending money to finance an economic activity to gain its interests (which should be the actual meaning of investments, where an entrepreneur is necessary). Both of the two descend from “abstaining from consumption”, thus this term cannot ab origine be classified as savings or investments.

    In my opinion too, no one really thinks that a bank IOU is a mere deposit instead a form of lending; nevertheless bank contracts explicitly say “the sum becomes bank’s property, the client has the right to receive an equal amount bank on request” (at least in Italy, where the Civil Code also says this, but I am sure it’s worldwide).
    Anyway the sight-deposited sum is savings by the client perspective (who simply does not consume now to consume later in search of its intertemporal consumption equilibrium), becomes a debt by the bank perspective, and gets transformed into an investment when the bank lends it to an entrepreneur. We must simply decide what we are looking at.

    • Current says:

      I add that we could simply distinguish money- (or other assets-) holding to simply transfer purchasing power into the future (which should be the actual meaning of savings) from willingly lending money to finance an economic activity to gain its interests (which should be the actual meaning of investments, where an entrepreneur is necessary).

      I am making that distinction. Holding assets is “plain saving” or “primitive saving”. Lending is “capitalist saving”.

      Lending money to an entrepreneur isn’t investment in economics terminology. Investment is the act of buying capital goods, it’s what the entrepreneur does. Lending or “capitalist saving” is what the person who puts money in a bank account is doing.

      In my opinion too, no one really thinks that a bank IOU is a mere deposit instead a form of lending; nevertheless bank contracts explicitly say “the sum becomes bank’s property, the client has the right to receive an equal amount bank on request” (at least in Italy, where the Civil Code also says this, but I am sure it’s worldwide).

      There certainly is confusion amongst the public about what banks do. The research the Cobden Centre did which Anthony Evans links to below shows the problem.

      I’m glad that Italian laws make it explicit that bank accounts are lending. In Britain banks don’t make it very explicit. I think that at the minimum the law in Britain should be changed to make banks add in a clause like this.

    • Good Evening Leonardo, IHC,

      In the UK, I have never seen a bank contract that says my deposit of £X is and act of lending that becomes theirs. At 16 when I did “O” Level economics and was given a text book by Lipsey, I learned about it and with all the many accounts in my business and personal life over the years, I am still waiting for a banker or a bank document to tell me this. 25 years have passed and I am still waiting. Glory the Civil Code of Italy.

  • Ingolf Eide says:

    Toby’s suggestion that banks provide depositors with a choice seems reasonable. Why couldn’t the banking system be required to provide a 100% reserve product for those depositors who truly are concerned with security and unquestionable liquidity, who don’t want to lend their funds. Even though the effect in the end might be small, perhaps even vanishingly small (see below), I’d have thought it could only enhance system stability. And remove a canker from this whole debate.

    As to its likely effect, what appears a straightforward distinction (100% reserves on callable deposits, or not) becomes a good deal less so when examined more closely.

    Where, for example, is the line to be drawn? Presumably no-one would suggest that three-month deposits should be covered (or even one month deposits), but what about one-week deposits? Two-day deposits? And so on.

    You see the problem.

    Whatever the theoretical merits of the 100% reserve line of argument the effect on credit expansion should it ever be implemented would probably be less than most seem to anticipate. Can anyone doubt the banks would soon develop a suite of products that contrive to fall outside the bright line but nevertheless meet the liquidity test from its customers’ viewpoint? I don’t think so. Indeed sweep accounts intended to achieve these ends have been around since the mid 90s. Then too, being required to to bear the full costs of banks having to hold 100% cash reserves to cover their accounts might soon discourage all but the most determined depositors.

    As an aside, it’s in no small part because of difficulties of this sort that free banking can seem so attractive. Rather than lawmakers and regulators playing a constant (and probably on balance losing) game with banks, the problems, opportunities and responsibilities are organically sheeted home where they should belong.

    I’d long been in the 100% reserve camp but the arguments and evidence presented by George Selgin et al have gradually moved me a long way towards their view of things. It’s not an entirely finished debate in my mind yet, but it’s getting close.

    • Good Evening Ingolf Eide,

      There are many hundreds if not thousands of 100% reserve banks in Switzerland, Austria, various tax havens around the world and for as little a 10 bases points you can park your deposits for save keeping. These banks are very solid. None have gone bust. They cant via bank run, only by bad management.

      If you deposit for 30 days, they maturity match for 30 days. This is limited to over night or very short lending. The longer you go out, the better rates you will get, but at each time they maturity match and have capital there for the odd bandy loan they take a hit on. This is nice conservative and very booring , safe banking. They can’t create credit out of thin air like FR banks can in a growing FR system. In a mature FR system, granted, they can only lend what they have.

      There can be no confusion with this 100% model, it offers safe keeping for money you cant afford to loose and the matching of savers and borrowers. Never does it make multiple claims on money, never does it do anything other than its says.

      Often these banks are still partnership banks and they take their fidiciary role seriously.

      It is very difficult to compete with a FR lender who can have only a small part of deposits available and promise to have all available. Imagine if you in your business could use all your current creditor money to work for you. You would have a massive advantage re your competitors. For me in my old business it would have been a £10m advanatage! This is a rigged game. One system to me is honest, the other is dishonest from a moral and legal privilege point of view. From economic theory and a black letter law point if view, the FR system is doing nothing wrong.

  • George Selgin says:

    “Why couldn’t the banking system be required to provide a 100% reserve product for those depositors who truly are concerned with security and unquestionable liquidity, who don’t want to lend their funds?”

    They do, Mr. Eide: it’s called a safety deposit box. But perhaps you have another product in mind, so I will answer your question: if there is such a product, and it might have been profitably supplied 9that is, there was a good market for it), why do you suppose banks haven’t provided it? There is certainly no law against it, and never has been such. Nor can the answer hinge on deposit insurance, as no such product was popular in former banking systems lacking such. Has massive entrepreneurial failure been to blame, or is it rather that fractionally-backed deposits have proven so much more attractive that they killed the market for the alternative product? Having studied banking history in some detail, I submit that the latter explanation is the right one.

    Leonardo, the “worry” is simply one concerning whether equilibrating adjustments are made in the least costly and least disruptive manner–it is a worry, in short, about economy in the strictest terms. So, for example, following a massive decline in V or M (never mind the cause), one can imagine getting back towards a state of monetary equilibrium either by waiting for a general, proportional decline in every P and w, including those fixed by long-term contracts; alternatively one can imagine an adjustment in M sufficiently rapid to reverse or compensate for the initial innovation without similarly taxing the price system and without thereby creating opportunities for wasteful relative price distortions.

    • George ,

      The market is rigged to favour FR banks! Because a FB can class its current creditors as just creditors , they can use money entrusted to them irrespective if the depositor thinks the bank is safe keeping or on lending.

      The current FR banks can only exist with the most stupendous levels of state taxpayer support. You know that.

      They state is committed to inflationism irrevocably, no suprises, offering to store money for 10 bases points per year is a non starter when to stay still you need a 10% return to give 5% net of tax to stay still in perchasing power terms!

      Now in your mature FRFB enviroment, you would for sure, as you did in the Scottish banks, have a healthy safe deposit base banking utility business, in addition to the FR and note issue element . Checkland is replete with this.

      This is the salient point in all of this….

      Leonardo, the “worry” is simply one concerning whether equilibrating adjustments are made in the least costly and least disruptive manner–it is a worry, in short, about economy in the strictest terms. So, for example, following a massive decline in V or M (never mind the cause), one can imagine getting back towards a state of monetary equilibrium either by waiting for a general, proportional decline in every P and w, including those fixed by long-term contracts; alternatively one can imagine an adjustment in M sufficiently rapid to reverse or compensate for the initial innovation without similarly taxing the price system and without thereby creating opportunities for wasteful relative price distortions.

      “Why couldn’t the banking system be required to provide a 100% reserve product for those depositors who truly are concerned with security and unquestionable liquidity, who don’t want to lend their funds?”

      They do, Mr. Eide: it’s called a safety deposit box. But perhaps you have another product in mind, so I will answer your question: if there is such a product, and it might have been profitably supplied 9that is, there was a good market for it), why do you suppose banks haven’t provided it? There is certainly no law against it, and never has been such. Nor can the answer hinge on deposit insurance, as no such product was popular in former banking systems lacking such. Has massive entrepreneurial failure been to blame, or is it rather that fractionally-backed deposits have proven so much more attractive that they killed the market for the alternative product? Having studied banking history in some detail, I submit that the latter explanation is the right one.

      Leonardo, the “worry” is simply one concerning whether equilibrating adjustments are made in the least costly and least disruptive manner–it is a worry, in short, about economy in the strictest terms. So, for example, following a massive decline in V or M (never mind the cause), one can imagine getting back towards a state of monetary equilibrium either by waiting for a general, proportional decline in every P and w, including those fixed by long-term contracts; alternatively one can imagine an adjustment in M sufficiently rapid to reverse or compensate for the initial innovation without similarly taxing the price system and without thereby creating opportunities for wasteful relative price distortions. ”

      There is no straight answer . See my comments to you earlier. Empirical support needs to be involved in this as yes , with no state sector, I am a “let the adjustments take place man” with the state payroll , things are complicated and maybe a money adjustment is best or to me, better still a total inside and outside money fix to give a bedrock of stability to adjust would be the best option.

  • George Selgin says:

    In my reply to Mr. Eide I meant to write “so I will answer your question with a question.” Pardon the omission.

  • Anthony J. Evans aje says:

    I’d just like to add brief responses to three of Toby’s points:

    1. In your discussion of MET you repeat B&H’s mischaracterisation that Steve and I explicitly address in our article – see the bottom of page 5. The “daddies” are Mises and Hayek!

    2. Your definition of savings is interesting (I would define savings as “an act of abstaining from consumption and willingly offering for loanable funds”), but I don’t think re-defining terms is going to help debate here. Note that B&H define savings as “the part of income that is not consumed” (p.43). You’ve written this article as a critique of free banking, but I see it more as a critique of the conventional understanding of savings.

    3. This explains a theoretical weak point in MET and the Theory of Free Banking (the two are slightly different, as noted above), but it might actually make the fractional reserve free banking position more robust if they addressed this issue of precautionary deposits or inadvertent savings

    They do – you present this as though it’s an either/or distinction, but safety deposit accounts or other 100% reserve funds are perfectly compatible with Free Banking. It comes down to consumer choice here, and the exent to which people wish to make tradeoffs at the margin. I don’t think your proposed empirical study would help much, because of the problems we found when we did something very similar

    http://www.cobdencentre.org/2010/06/public-attitudes-to-banking/

    For me the main problem with the Carswell Bill is that it rests on assumptions that (i) you know why people value a particular good; (ii) this reason is so strong it creates a corner solution; and (iii) this applies to *all* consumers.

    To be clear, I would argue that (i) attempting to make this inference violates the notion of subjective value; (ii) people make trade offs at the margin; (iii) *some* people understand how fractional reserve accounts operate.

    If it is the case that lots of people have money in current accounts that they believe are being 100% reserved and would prefer to be 100% reserved, then by all means launch a class action. I can just see it now: “we demand that you stop paying us interest on our money balances and start charging us a fee”!

    • Good Evening AJE,

      Point 1, yes accepted, I thought the way you talk about LW and GS these are your inspiration on these matters.
      Point 2, the latter is correct.
      Point 3, you have not understood what I have said or I have not explained well enough.

      If savings and investment match, in this goldilocks world, there is enough money going into make the goods and services that people want to buy when their savings are returned, yes it is hypothetical and it is a theoretical state of equilibruin. Moving swiflty to the real world. We established via survey that many people think they are saving and that their money is theirs, not the banks and that it is sitting in the vaults and it is not. Now some of this money is not for on lending as these people do not know they have got involved in lending, we established that in our survey. So these savings are “inadvertant.” If you made a very clear distinction between money for safe keeping and money for investment, you fine tune the ability of the system more towards that goldilocks state. This would help stability in the economy what ever its system, honest banking, FRB, FRFB, or any banking.

      • Anthony J. Evans aje says:

        We established via survey that many people think they are saving and that their money is theirs, not the banks and that it is sitting in the vaults and it is not

        I don’t think the results support such claims. We asked the following question: “Thinking about the money that banks hold on their customer’s behalf via their current accounts, what percentage of that money do you think is: Held as reserves in their vaults to meet immediate withdrawals”

        Of those who put a number on it just 1% of people thought the reserves were between 91-100%. The most common response was 1-10%. And note how loaded the question was!

        I think the survey was a useful first attempt to forge an empirical aspect to this debate, but that’s all. I know you’ve already seen this, but others following this thread might be interested in previous comments I’ve made about the survey:

        http://thefilter.blogs.com/thefilter/2010/06/public-attitudes-to-banking.html

        http://thefilter.blogs.com/thefilter/2010/10/do-banks-mislead-their-customers.html

  • Ingolf Eide says:

    No problem, and no argument (just one minor sidebar).

    As I said: “being required to to bear the full costs of banks having to hold 100% cash reserves to cover their accounts might soon discourage all but the most determined depositors” and “the effect in the end might be small, perhaps even vanishingly small.”

    Presumably, though, such a product could be offered by banks at much lower cost than individuals using safety deposit boxes. Whether a worthwhile number would ever wish to take it up is another matter.

    • See previous comments , many millions of people do around the world where their banking systems have not become so distorted and corrupted.

  • Dear Selgin, thank you for your kind reply.

    I would like separate theoretical and actual economy.
    The point I cannot still understand is this: if V or M lower (automously, I mean, not because of a State intervention), if P suffers of some stickiness then the economy must pay in terms of Q (MV=PQ does not reveal causal effects, but is nevertheless an accounting identity). Why cannot we say that the “cost” in terms of Q is worth-paying by those agents who have simply decided not to adjust their prices?
    In my opinion a free (I stress: free) market sets a series of “rigidities” (like fixing certain terms in wages) after having pondered their implications (or, at least, discovered them by direct experiences), which means having analysed poits such: “how much strain am I willing to suffer before re-setting prices and wages? How much strain are implied by certain rigidities? How much rigidity are worth-paying in terms of efforts to collect due information and re-setting prices?”.

    As to State-implied rigidities, which means our actual world, it is sure they do not come from such an auto-calibrating process, so we must ask – like you do – how we could save the economy from the implied strains and costs onto Q, even though such question subsumes that agents have no ways to reply these external rigidities (e.g. by my own point of view, this subsumes that V cannot be sort of a cushion to equilibrate shocks onto the other variables to “preserve” Q). The first answer I can find is for granted: reducing the power of the State, not a monetary intervention.

    If all this sounds stupid to you, you do not need to reply again.

    • Current says:

      If I may add to George’s reply…

      Why cannot we say that the “cost” in terms of Q is worth-paying by those agents who have simply decided not to adjust their prices?
      In my opinion a free (I stress: free) market sets a series of “rigidities” (like fixing certain terms in wages) after having pondered their implications (or, at least, discovered them by direct experiences), which means having analysed poits such: “how much strain am I willing to suffer before re-setting prices and wages? How much strain are implied by certain rigidities? How much rigidity are worth-paying in terms of efforts to collect due information and re-setting prices?”.

      One way of thinking about the 100% reserve vs fractional reserve debate is that they provide money with different characteristics. In the short-term 100% reserve provides a stable stock of money. Whereas in the short-term fractional-reserve banking provides a stable price of money. Of course neither of these are ideal, in the longer term both would depend on economic growth and the supply of specie.

      Now, as you say price stickinesses or rigidities are something that are introduced by decisions on price setting. Those who set prices can’t adjust them immediately to every factor. Each business and person must come up with their own system.

      Neither George, nor I are denying that the ability to change prices rapidly in the face of changes isn’t important to successful business.

      In our current world in terms of the short-run we are closer to the “stable price of money” idea than the “stable stock of money”. So, this is what people have factored into their plans, even if unconsciously. In my opinion entrepreneurs don’t generally plan for the effects of overall changes in money demand or money supply. If they did then things would be different, in that case FRFBer like George and I would be asking them to change their habits.

      As I’ve said elsewhere on this thread I can’t look into the minds of others. But, one useful way of looking at institutional changes such as this one is in terms of expectations. Coordination is more likely when expectations are fulfilled. In our current world markets deal with relative supply/demand changes for non-money tradables and central banks deal with supply/demand for money. In an FRFB world free banks take up the latter role, and in a 100% reserve world markets in non-money tradables take up both roles. Since we aren’t in that latter world current price setting behaviour is not adjusted to dealing with it.

      Now, I’d argue that regardless of transition costs it is better in the long run to have FRFB than 100% reserve. But my point here is that we can’t call the fall in Q we would get today in a recession if
      M were fixed in any clear sense the decision of agents across the economy. Where I live we drive on the left. It would be like the government saying “it’s better to drive on the right”, then changing the law overnight and arresting people from driving on the left the next day.

  • George Selgin says:

    “Why cannot we say that the “cost” in terms of Q is worth-paying by those agents who have simply decided not to adjust their prices?”

    Leonardo, your questioning is, first of all, far from stupid: it concerns matters at the heart of monetary analysis. The answer, in brief, is that the situation is one laden with 3rd party or spillover effects, or what economists call externalities. It may well be individually optimal for an individual seller to settle for reduced sales volume rather than cut prices. Indeed, part of the problem is that nothing that seller can do will allow him to recoup historical costs, given the collapse of spending. But it is precisely for this reason that monetary expansion can accomplish what cannot otherwise be accomplished, that is, what cannot be accomplished by any realistic pattern of downward price adjustment, for it alone can restore aggregate demand so as to allow historic costs to be recouped by the “typical” seller. The alternative of waiting for all P’s and w’s to decline, on the other hand, has the “typical” seller incurring losses, and does so even if adjustments occur instantaneously. In fact, they may occur only very slowly, with losses mounting and price distortions becoming increasingly severe, because the private gain to any seller from price cutting exceed the social gain. (When seller A cuts prices, part of resulting increase in spenders’ purchasing power may translat5e into increased purchases of seller B’s goods.)

    • Evening George,

      Lets use a real world number rounded example. My old business.

      Start of Day 1 Sept 15th 2008

      On Target Y/E Turnover £100m
      On Target Y/E Costs £93m
      Profits £7m = owner happy

      End of Day 1 Sept 15th 2008

      On Target Y/E Turnover £85m
      On Target Y/E Costs £93m
      On Target Loss of £8m.

      Owner very unhappy.

      Sale Day 22nd of Dec 2010

      On Target Y/E Turnover £84m
      On Target Y/E Costs £77.5m
      On Target Profits of £6.5m.

      Owner = just about happy after 2 bloody hard years of forcing costs down and restoring profitability.

      Why should I be concerned about restoring a over hyped demand and or the aggregate demand across the whole economy when all that really matters other than your cash flow to stay alive , is the bottom line which is just about where it was when the whole house of cards of the paper money FR system started imploding?

      This is what worries me about the economics profession in general a focus on the top line and not on the costs and the bottom line. The top line always sorts out itself if you have a good product sold as and when people want it, for a price they want to pay.

  • George Selgin says:

    Sorry–another mistake: for “private gains…exceed the social gain” read “private gains…fall short of the social gain.”

  • Current says:

    This has been reposted on Mises.org and there is a discussion going on over there…

    http://blog.mises.org/16889/baxendale-some-more-quibbles-with-free-banking/

  • George Selgin says:

    Evening, Toby. Be assured that I don’t want businessmen like yourself to be concerned about the state of aggregate demand; I agree that they’ve got enough to worry about. That’s why I favor an arrangement that keeps that demand from flagging. Then they merely have to struggle to get part of it, which is tough enough; that is, when they see their sales flag, they don’t have to wonder whether it’s they or some bleeding central bank that’s messed up up.

    This isn’t the same as favoring one that keeps (or tries to keep) a boom going. That’s one reason why I’m no a QE2 fan. 7% NGDP growth: Boom. -3%: Bust. Steady 4%: All quiet. (Though that’s given experience of the last few decades. My ideal is more like steady 2%, but left to a competitive banking system to deliver, not some damn central planners–no disagreement between us w.r.t that.)

    The concrete example you supply is terrific, by the way. I’m lucky to have nothing like it to draw on from my own personal experience.

  • Ingolf Eide says:

    Morning Toby.

    (Re your comments at 20:22 and 20:52)

    I see the availability of narrow banks as a good thing and also, as I hope was evident from my comment, like the idea of FRB banks under a free banking regime offering 100% reserve accounts. I still suspect not many would be willing to pay the associated costs but that’s by the by. The market would soon sort that question out, and in any case making the distinction clear seems a useful thing to do in itself.

    There are deeper questions that interest me more, however:

    1. Given the freedom to choose, what kind of banking system would naturally evolve?

    – It seems to me the historical evidence suggests specie-based free banking would be an important (and quite likely dominant) element of the whole. Narrow banks would surely exist as well but I’d guess only at the margin.

    2. Are such specie-based, free banking systems relatively stable?

    – Again, I think there’s sufficient historical evidence to answer with a qualified yes. Both theoretically (and it would appear in practice based on the limited examples available) such systems incorporate quite robust automatic stabilisers.

    3. If all of that’s so, would enforcing 100% reserve banking across the board really be the right thing to do?

    – It seems to me answering yes to this question is a questionable stance for anyone who believes in the markets’ capacity to sort things out.

    In thinking about these matters, it’s important to remind ourselves that in a specie-based free banking system the sort of exponential, malignant credit growth we’ve seen in recent decades simply could not occur. For that to happen, the monetary base has to be continually and quite rapidly expanding.

    Ingolf

    P.S. Would you be good enough to provide links to a couple of the banks you mentioned that operate on a 100% reserve basis? I’d be most interested to look more closely at their inner workings.

  • Chris Cresci says:

    I believe the main problem with MET vs. 100% reserves is the fact that both require tradeoffs with regard to stability. With MET having redeemable money, banks issuing money and fractional reserves you have a problem of an interactively complex system that is tightly coupled due to the fact that the notes from various issuers are fungible and redeemable. The inherent instability of individual fractional reserve banks would thus be projected onto the entire system. With 100% reserves you have banking stability with the rest of the economy in a kind of random flux due to the importance of the price of the underlying commodity. Thus, the inherent instability of commodity prices would be projected onto the entire system. It would be far better to have a system of competitive fiat money issued by non-depository institutions so that the problems with one issuer would not spread to the others and if the value of the currency got too low the issuer could buy it back to keep it up much as a company maintains the price of its shares.

  • Thank you so much Selgin and Current for your kindest replies. I think it will help me enter the “MET phylosophy” some deeper, even though I see a fundamental difference in our positions which will keep me in disagreement.
    In my own opinion, a free-market will maintain a certain degree of nominal rigidities to cope with the costs of countinuous price-tuning and information-seeking; while setting own position in this trade-off problem, operators are aware of incurring into some risks i.e. lower economic activities. As we cannot eliminate risk from human action, and risk is indeed a natural element of entrepreneurial activities, we must accept some “mistakes” or “losses”.

    If nominal rigidities are set by the State, well, it is all another chapter where monetary policy can be a (suboptimal) solution.

    @Baxtendale
    Is there really nowhere some sentence like “the property of sum is transferred to the bank”? Really nowhere? it’s upsetting to me.
    I know that China was studying the Italian Civil Code (the one which contains both civil and commercial norms) before it’s present economic reinassence; maybe all occurred not perchance.

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