The most basic theory of (fractional-reserve) free banking concerns the supply of money and demand for money. At some times the public on net want to hold more of their assets as money, and at other times less. In the former case we say there has been a rise in demand for money holding, and in the latter case a fall in demand. If a fall in demand isn’t satisfied by a fall in supply, then prices will rise. That’s because people will spend their excess money holdings which will bid prices up. Similarly, if a rise in demand for money isn’t satisfied by a rise in supply then prices will fall. That happens because people will seek to increase their money holdings by keeping money they earn from income or sale of goods instead of spending it. The reduction in spending will cause prices to be bid down. The changes in price that come with a rise or fall in demand for money are costly.
Recently, I was involved in a discussion about free-banking. I’ll paraphrase my opponents arguments here ….
- There is an excess demand for money.
- So, profit could be made by issuing money. Any creation of money would be a loan to the issuer at a favourable interest rate.
- Why then are businesses not creating money? Surely even though free banking isn’t legal this is a flaw in free banking theory? After all, we have laws against drug dealing and despite them drugs are readily available in many places.
It’s useful to explain the term “excess demand for money”. In economics there are often “excess” supplies and demands. If there is an “excess supply”, that means that at the current price sellers of a good are being left with surpluses. As a result those sellers are going to reduce the price soon, and/or make less of the product. Similarly, “excess demand” means that at the current price buyers want to buy more than sellers have, that means the opposite, sellers are going to raise their prices soon, if possible, and/or sell more. So, in the excess supply case the price is being bid down, and in the excess demand case it’s being bid up. By analogy an “excess demand for money” means that the price level is being bid up by a rise in demand for money that hasn’t been matched by supply.
The person I was arguing here asks a good question: if there is an excess demand for money why hasn’t more fiduciary media been created by banks during the recession?
I agree that at least during the earlier part of the recession, though perhaps not now, there was an excess demand for money. This was shown by the period of deflation. I’m sure some of the 100% reserve advocates on this site will disagree with me about that, or argue that the demand should not be met using fiduciary media. My purpose here isn’t to argue about that, but to describe why the money supply didn’t expand in this case.
To begin with, we have to consider what money is. When economists and ordinary people talk about money they mean the medium-of-exchange, today that means notes and coins for small transactions and transfers of bank balances for large transactions. Things like “Bitcoins” are not really money, they are at the most an attempt to create a new form of money and not so far a successful one. This by itself explains why it’s not possible to make an analogy to drug-dealing. For drug-dealing to be practical it’s only necessary that a buyer can meet with a drug vendor. But, for a form of “money” to be actual money it must be widely accepted by a great many traders who accept it as payment. That can’t possibly be done outside the view of the police.
Notes and coins are relatively unimportant in today’s economy. In many countries the state has monopoly privileges on issuing them. This isn’t always true. In some places, types of local money have been created by private groups such as charities and federations of local businesses. Banks are generally not able to issue notes as they once did; as far as I know this applies to the US, UK and Europe. As Toby Baxendale often points out, normal companies must “keep their short-term creditors whole”. They can only produce a banknote if they hold matching short-term liabilities, so they have little or no incentive to create money. In Scotland, which is one of the last places where banks can still issue notes, the quantity of those notes is controlled by the Bank of England.
The local currency movement seems to be growing, though it’s difficult to get good figures. The question may be asked: why didn’t local currency issuers create more money? I think the answer lies in the dominant network effects of state currency. Now state issued notes and coins are accepted everywhere and most customers use them there is little incentive for either normal people or businesses to support alternative currencies. George Selgin has described the many problems with local currencies here. There isn’t just one “stable equilibrium” here though, as Scotland shows, if other types of banknote are important enough and safe enough then vendors will support them. Past historical examples show that when banks and other businesses are allowed to compete in the currency market then privately issued note and coins are likely to arise.
All this said, notes and coins are not as important today as they were. Our principal form of money today is the bank balance. Bank balances are created by fractional reserve banks which are private institutions. Normal businesses can create accounts for their customers and often do. The accounting law mentioned above means that normal companies have no more incentive to create balances for general use than they do to create notes or coins. This leads to the question: why didn’t the banks create more current account balances? In my opinion this is the interesting question.
In many countries, banks must be part of the central banking system. I don’t know if it’s still possible in the US to run a commercial bank that isn’t a member of the Federal Reserve system, but even if it is there are great disadvantages to doing that. The central banks limit the amount of money that the commercial banks can create through regulatory requirements, such as the reserve requirement and capital requirements. But this doesn’t give an explanation; at present and throughout the crisis the banks have held much greater reserves than necessary. The banks are not limited by the reserve requirement at present. In fact, as many commentators have pointed out, if they were to loan more then the money supply would quickly explode.
The reason the banks did not expand the money supply in 2008-2010, and are not doing so greatly now, is that their finances are very fragile. Before the crisis, many of them in the US, UK and Europe, invested in CDOs and CLOs that went bad. There were losses on conventional property loans such as those in Ireland and on loans to other banks involved in these investments. Since banks need assets to back current account balances this is a major problem.
During the boom the protection of current account holders by state-supported deposit insurance schemes was important. The existence of these schemes weakened the interest bank customers would otherwise have had in picking a solvent bank. Northern Rock, for example, was a very risky share even quite a long time before it went bankrupt. But to the ordinary bank customer’s point of view, this risk was minimal because of deposit insurance. In retrospect, this helped “soften up” the banks ready for the onslaught of bad debt ahead.
I’m an advocate of the Austrian Business Cycle Theory and I think it provides the best explanation of the last boom and bust. The toxic assets on the balance sheets of banks are the result of misallocation of capital. Some is due to the secondary effects of the ensuing recession too. In my opinion, to ask for the commercial banking system to deal with this is too much. Commercial banks can’t know for certain when monetary expansion is going to cause a bust. The market interest rate doesn’t easily provide information about the stance of monetary policy. If there is creation of money beyond demand for it, then that doesn’t immediately manifest itself in noticeable price inflation. As a result, banks can’t protect themselves from ABCT busts.
I don’t want to rely too much on ABCT, though. Existing commercial banks suffer from a lack of good assets which prevents them from creating money. Why then don’t other businesses that own (or could access) safe assets start up commercial banks? The problem here is that the regulatory obstacles are large. In the US there are many regulatory bodies that must approve the creation of a bank. A Federal Reserve bank must obey Fed regulations, there are state banking regulations, FDIC regulations and regulations issued by the comptroller of the currency. There are also market issues, such as obtaining membership of transfer networks and creating a structure of branches. The problem any company faces is that they must fulfil their regulatory obligations before the recession is over and the opportunity disappears. Despite this, some have tried. Wal-Mart have tried several times to acquire a US banking license, but they’ve failed. The most plausible explanation for this is that incumbent banks have leaned on the regulators to prevent Wal-Mart from entering the market. This is interesting because of what it shows about US monetary policy. Many have argued that the Federal Reserve can’t expand because the commercial banks won’t expand lending. To the extent that this is true, it concentrates too much on existing commercial banks. If new entrants were allowed into the market, they would not be in the dire financial situation that the existing banks are. New entrants would be in a much better position to lend. If it were not for the bailouts, starting a new commercial bank would be simpler. A business wishing to start a new bank could buy a bankrupt bank and use it’s branch network and access to transfer networks.
The bailouts have caused a strange situation to develop. The existing commercial banks are perhaps not Zombie banks in the technical sense – banks with less than zero net worth – but they are in such a precarious situation that they can’t make many new loans. What preoccupies them is the performance of existing loans. Had they not been bailed out so extensively at the beginning of the crisis, this wouldn’t have happened.