Prices and the demand for money

Banking theory remains one of the most heatedly debated areas of economics within Austrian circles, with two camps sitting opposite each other: full reservists and free bankers.  The naming of the two groups may prove a bit misleading, since both sides support a free market in banking.  The difference is that full reservists believe that either fractional reserve banking should be considered a form of fraud or that the perceived inherent instability of fiduciary expansion will force banks to maintain full reserves against their clients’ deposits.  The term free banker usually refers to those who believe that a form of fractional reserve banking would be prevalent on the free market.

The case for free banking has been best laid out in George Selgin’s The Theory of Free Banking.[1] It is a microeconomic theory of banking which suggests that fractional reserves will arise out of two different factors,

  1. Over time, “inside money” — banknotes (money substitute) — will replace “outside money” — the original commodity money — as the predominate form of currency in circulation.  As the demand for outside money falls and the demand for inside money rises, banks will be given the opportunity to shed unnecessary reserves of commodity money.  In other words, the less bank clients demand outside money, the less outside money a bank actually has to hold.
  2. A rise in the demand to hold inside money will lead to a reduction in the volume of banknotes in circulation, in turn leading to a reduction of the volume of banknotes returning to issuing banks.  This gives the issuing banks an opportunity to issue more fiduciary media.  Inversely, when the demand for money falls, banks must reduce the quantity of banknotes issued (by, for example, having a loan repaid and not reissuing that money substitute).

Free bankers have been quick to tout a number of supposed macroeconomic advantages of Selgin’s model of fractional reserve banking.  One is greater economic growth, since free bankers suppose that a rise in the demand for money should be considered the same thing as an increase in real savings.  Thus, within this framework, fractional reserve banking capitalizes on a greater amount of savings than would a full reserve banking system.

Another supposed advantage is that of monetary equilibrium.  An increase in the demand for money, without an equal increase in the supply of money, will cause a general fall in prices.  This deflation will lead to a reduction in productivity, as producers suffer from a mismatch between input and output prices.  As Leland Yeager writes, “the rot can snowball”, as an increase in uncertainty leads to a greater increase in the demand for money.  This can all be avoided if the supply of money rises in accordance with the demand for money (thus, why free-bankers and quasi-monetarists generally agree with a central bank policy which commits to some form of income targeting).[2]

Monetary (dis)equilibrium theory is not new, nor does it originate with the free bankers.  The concept finds its roots in the work of David Hume[3] and was later developed in the United States during the first half of the 20th Century.[4] The theory saw a more recent revival with the work of Leland Yeager, Axel Leijonhufvud, and Robert Clower.[5] The integration of monetary disequilibrium theory with the microeconomic theory of free banking is an attempt at harmonizing the two bodies of theory.[6] If a free banking system can meet the demand for money, then a central bank is unnecessary to maintain monetary stability.

The integration of the macro theory of monetary disequilibrium into the micro theory of free banking, however, should be considered more of a blemish than an accomplishment.  It has unnecessarily drawn attention away from the merits of fractional reserve banking and instead muddled the free bankers’ case.  Neither is it an accurate or useful macroeconomic theory of industrial misbalances or fluctuations.[7]

The Nature of Price Fluctuations

The argument that deflation resulting from an increase in the demand for money can lead to a harmful reduction in industrial productivity is based on the concept of sticky prices.  If all prices do not immediately adjust to changes in the demand for money then a mismatch between the prices of output and inputs goods may cause a dramatic reduction in profitability.  This fall in profitability may, in turn, lead to the bankruptcy of relevant industries, potentially spiraling into a general industrial fluctuation.  Since price stickiness is assumed to be an existing factor, monetary equilibrium is necessary to avoid necessitating a readjustment of individual prices.

Since price inflexibility plays such a central role in monetary disequilibrium, it is worth exploring the nature of this inflexibility — why are prices sticky?  The more popular explanation blames stickiness on an entrepreneurial unwillingness to adjust prices.  Those who are taking the hit rather suffer from a lower income later than now.[8] Wage stickiness is also oftentimes blamed on the existence of long-term contracts, which prohibit downward wage adjustments.[9]

Austrians can supply an alternative, or at least complimentary, explanation for price stickiness.[10] If equilibrium is explained as the flawless convergence of every single action during a specific moment in time, Austrians recognize that an economy shrouded in uncertainty is never in equilibrium.  Prices are set by businessmen looking to maximize profits by best estimating consumer demand.  As such, individual prices are likely to move around, as consumer demand and entrepreneurial expectations change.  This type of “inflexibility” is not only present during downward adjustments, but also during upward adjustments.  It is “stickiness” inherent in a money-based market process beset by uncertainty.

It is true that government interventionism oftentimes makes prices more inflexible than they would be otherwise.  Examples of this are wage floors (minimum wage), labor laws, and other legislation which makes redrawing labor contracts much more difficult.  These types of labor laws handicap the employer’s ability to adjust his employees’ wages in the face of falling profit margins.  Wages are not the only prices which suffer from government-induced inflexibility.  It is not uncommon for government to fix the prices of goods and services on the market; the most well-known case is possibly the price fixing scheme which caused the 1973–74 oil crisis.  There is a bevy of policies which can be enacted by government as a means of congesting the pricing process.

But, let us assume away government and instead focus on the type of price rigidity which exists on the market.  That is, the flexibility of prices and the proximity of the actual price to the theoretical market clearing price is dependent on the entrepreneur.  As long as we are dealing with a world of uncertainty and imperfect information, the pricing process too will be imperfect.

Price rigidity is not an issue only during monetary disequilibrium, however.  In our dynamic market, where consumer preferences are constantly changing and re-arranging themselves, prices will have to fluctuate in accordance with these changes.  Consumers may reduce demand for one product and raise demand for another, and these industries will have to change their prices accordingly: some prices will fall and others will rise.  The ability for entrepreneurs to survive these price fluctuations depends on their ability to estimate consumer preferences for their products.  It is all part of the coordination process which characterizes the market.

The point is that if price rigidity is “almost inherent in the very concept of money”,[11] then why are price fluctuations potentially harmful in one case but not in the other?  That is, why do entrepreneurs who face a reduction in demand originating from a change in preferences not suffer from the same consequences as those who face a reduction in demand resulting from an increase in the demand for money?

Price Discoordination and Entrepreneurship

In an effort to illustrate the problems of an excess demand for money, some have likened the problem to an oversupply of fiduciary media.  The problem of an oversupply of money in the loanable funds market is that it leads to a reduction in the rate of interest without a corresponding increase in real savings.  This leads to changes in the prices between goods of different orders, which send profit signals to entrepreneurs.  The structure of production becomes more capital intensive, but without the necessary increase in the quantity of capital goods.  This is the quintessential Austrian example of discoordination.

In a sense, an excess demand for money is the opposite problem.  There is too little money circulating in the economy, leading to a general glut.[12] Austrian monetary disequilibrium theorists have tried to frame it within the same context of discoordination.  An increase in the demand for money leads to a withdrawal of that amount of money from circulation, forcing a downward adjustment of prices.

But there is an important difference between the two.  In the first case, the oversupply of fiduciary media is largely exogenous to the individual money holders.  In other words, the increase in the supply of money is a result of central policy (either by part of the central bank or of government).  Theoretically, an oversupply of fiduciary media could also be caused by a bank in a completely free industry but it would still be artificial in the sense that it does not reflect any particular preference of the consumer.  Instead, it represents a miscalculation by part of the central banker, bureaucrat, or bank manager.  In fact, this is the reason behind the intertemporal discoordination — the changing profit signals do not reflect an underlying change in the “real” economy.

This is not the issue when regarding an excess demand for money.  Here, consumers are purposefully holding on to money, preferring to increase their cash balances instead of making immediate purchases.  The decision to hold money represents a preference.  Thus, the decision to reduce effective demand also represents a preference.  The fall in prices which may result from an increase in the demand for money all represent changes in preferences.  Entrepreneurs will have to foresee or respond to these changes just like they do to any other.[13] That some businessmen may miscalculate changes in preference is one thing, but there can be no accusation of price-induced discoordination.

The comparison between an insufficient supply of money and an oversupply of fiduciary media would only be valid if the reduction in the money supply was the product of central policy, or a credit contraction by part of the banking system which did not reflect a change in consumer preferences.  But, in monetary disequilibrium theory this is not the case.

None of this, however, says anything about the consequences of deflation on industrial productivity.  Will a rise in demand for money lead falling profit margins, in turn causing bankruptcies and a general period of economic decline?

Whether or not an industry survives a change in demands depends on the accuracy of entrepreneurial foresight.  If an entrepreneur expects a fall in demand for the relevant product, then investment into the production of that product will fall.  A fall in investment for this product will lead to a fall in demand for the capital goods necessary to produce it, and of all the capital goods which make up the production processes of this particular industry.  This will cause a decline in the prices of the relevant capital goods, meaning that a fall in the price of the consumer good usually follows a fall in the price of the precedent capital goods.[14] Thus, entrepreneurs who correctly predict changes in preference will be able to avoid the worst part of a fall in demand.

Even if a rise in the demand for money does not lead to the catastrophic consequences envisioned by some monetary disequilibrium theorists, can an injection of fiduciary media make possible the complete avoidance of these price adjustments?  This is, after all, the idea behind monetary growth in response to an increase in demand for money.  Theoretically, maintaining monetary equilibrium will lead to a stabilization of the price level.

This view, however, is the result of an overly aggregated analysis of prices.  It ignores the microeconomic price movements which will occur with or without further monetary injections.  Money is a medium of exchange, and as a result it targets specific goods.  An increase in the demand for money will withdraw currency from this bidding process of the present, reducing the prices of the goods which it would have otherwise been bid against.  Newly injected fiduciary media, maintaining monetary equilibrium, is being granted to completely different individuals (through the loanable funds market).  This means that the businesses originally affected by an increase in the demand for money will still suffer from falling prices, while other businesses may see a rise in the price of their goods.  It is only in a superfluous sense that there is “price stability”, because individual prices are still undergoing the changes they would have otherwise gone.

So, even if the price movements caused by changes in the demand for money were disruptive — and we have established that they are not — the fact remains that monetary injections in response to these changes in demand are insufficient for the maintenance of price stability.

Implications for Free Banking

To a very limited degree, free banking theory does rely on some aspects of monetary disequilibrium.  The ability to extend fiduciary media depends on the volume of returning liabilities; a rise in the demand for money will give banks the opportunity to increase the supply of banknotes.  However, the complete integration of monetary disequilibrium theory does not represent theoretical advancement — if anything, it has confused the free bankers’ position and unnecessarily contributed to the ongoing theoretical debate between full reservists (many of which reject the supposed macroeconomic benefits of free banking) and free bankers.

We know that an increase in the demand for money will not lead to industrial fluctuations, nor does it produce any type of price discoordination.  Like any other movement in demand, it reflects the preferences of the consumers which drive the economy.  We also know that monetary injections cannot achieve price stability in any relevant sense.  Thus, the relevancy of the macroeconomic theory of monetary disequilibrium is brought into question.  Free banking theory would be better off without it.

This suggests, though, that a rejection of monetary disequilibrium is not the same as a rejection of fractional reserve banking.  It could be the case that a free banking industry capitalizes on an increase in savings much more efficiently than a full reserve banking system.  Or, it could be that the macroeconomic benefits of fractional reserve banking are completely different from those already theorized, or even that there are no macroeconomic benefits at all — it may purely be a microeconomic theory of the banking firm and industry.  These aspects of free banking are still up for debate.

[1] George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue (Totowa, New Jersey: Rowman & Littlefield, 1988).  Also see George A. Selgin, Bank Deregulation and Monetary Order (Oxon, United Kingdom: Routledge, 1996); Larry J. Sechrest, Free Banking: Theory, History, and a Laissez-Faire Model (Auburn, Alabama: Ludwig von Mises Institute, 2008); Lawrence H. White, Competition and Currency (New York City: New York University Press, 1989).

[2] Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium (Indianapolis, Indiana: Liberty Fund, 1997), pp. 218–219.

[3] Ibid., p. 218.

[4] Clark Warburton, “Monetary Disequilibrium Theory in the First Half of the Twentieth Century,” History of Political Economy 13, 2 (1981); Clark Warburton, “The Monetary Disequilibrium Hypothesis,” American Journal of Economics and Sociology 10, 1 (1950).

[5] Peter Howitt (ed.), et. al., Money, Markets and Method: Essays in Honour of Robert W. Clower (United Kingdom: Edward Elgar Publishing, 1999).

[6] Steven Horwitz, Microfoundations and Macroeconomics: An Austrian Perspective (United Kingdom: Routledge, 2000).

[7] Some of the criticisms presented here have already been laid out in a forthcoming journal article: Phillip Bagus and David Howden, “Monetary Equilibrium and Price Stickiness: Causes, Consequences, and Remedies,” Review of Austrian Economics.  I do not support all of Bagus’ and Howden’s criticisms, nor do I share their general disagreement with free banking theory.

[8] Yeager 1997, pp. 222–223.

[9] Laurence Ball and N. Gregory Mankiw, “A Sticky-Price Manifesto,” NBER Working Paper Series 4677, 1994, pp. 16–17.

[10] Horwitz 2000, pp. 12–13.

[11] Yeager 1997, p. 104.

[12] Yeager 1997, p. 223.  Yeager quotes G. Poulett Scrope’s Principles of Political Economy, “A general glut — that is, a general fall in the prices of the mass of commodities below their producing cost — is tantamount to a rise in the general exchangeable value of money; and is proof, not of an excessive supply of goods, but of a deficient supply of money, against which the goods have to be exchange.”

[13] Joseph T. Salerno, Money: Sound & Unsound (Auburn, Alabama: Ludwig von Mises Institute, 2010), pp. 193–196.

[14] This is Menger’s theory of imputation; Carl Menger, Principles of Economics (Auburn, Alabama: Ludwig von Mises Institute, 2007), pp. 149–152.

64 comments to Prices and the demand for money

  • Rob R.


    This is a very interesting article and I have a couple of questions.

    - Supporters of FRB would accept that without FRBs to adjust the money supply following a change in its demand the process of price changes you describe would move things back towards equilibrium. However they would claim that with FRBs the process (since it avoids a change in the purchasing power of money) would be quicker and less disruptive to economic activity. I don’t really see anything in your article that identifies the negative consequences of the FRB theory here. Can you clarify what you see these as being and why a change in the PPM is preferable ?

    - You say you support FRB, just don’t accept it has a role to play in maintaining monetary equilibrium. FRB theory however identifies this role (in expanding and contracting loans in response to changes in the demand for money) as key to their profit-maximizing strategy. Can you clarify how you would see FRB functioning without that part of their role taking effect ?

    • Rob, it is very unfortuante that FRFB’s think this. They should know that if preferences change ie people realise that they can’t have all the goods and services they think they can have via a credit induced boom as the real wealth is not there , that more loanable funds given to make more things will be a sustainable solution to an increase in the demand to hold cash balances .

    • Jonathan M. F. Catalán


      Regarding changes in the purchasing power of money, any attempt to maintain the purchasing power of money must end in failure. The purchasing power of money is a relationship between the medium of exchange and the good in question, and if the price of the good in question changes so does the purchasing power of that medium of exchange. Changes in the purchasing power of money are natural to changes in preferences.

      So, my point is that fiduciary expansion cannot avoid a change in the purchasing power of money, since the injection of new monies does not correspond to the reduction of old spending, and so prices would still need to change around changes in preference.

      Bagus and Howden, in a forthcoming paper, argue that fiduciary expansion can actually make the adjustment process more difficult, because it makes it more difficult for the entrepreneur to respond to changes in preferences, but I don’t think their argument is very convincing. For me, the most convincing argument is just that it wouldn’t work for what it was intended to do.

      As for your second question, like I write in the article, free banking theory is not a macro theory and it should not be seen as a macro theory. It is a theory of how the banking firm would operate. Whether it leads to one macro effect or another is inconsequential.

      • Rob Thorpe

        What is “unexpected inflation”? Entrepreneurs do not have 100% foresight regarding consumer preferences. In that sense, all inflation, to some degree, is “unexpected”. That it is unexpected or not, in my opinion, is not the key issue.

        I agree with you that entrepreneurs don’t have perfect foresight.

        I think the issue here is what arguments about the price level mean.

        Any particular agent has to think about the cost of the goods they aim to buy in the future. They must think of their likely future income and the likely future value of assets they own and/or debts they must pay. What’s relevant to them is the price of the good they aim to buy, not goods in general, their income, not income in general, and the value of their assets, not assets in general.

        However, what we’re looking at in ABCT is an argument that about aggregate economic fluctuations coming from monetary calculation. All agents will inevitably be wrong about the things I mention to some degree. What we are interested in is the degree to which those errors will be clustered around a particular time.

        In my opinion the rough-and-ready ideas of “expected” and “unexpected” inflation are useful here.

        You write:

        The key issue is whether or not it reflects consumer preferences. What allows entrepreneurs to “expect” price movements is how well they can foresee changes in consumer preferences. It doesn’t matter if this is an upward movement in prices or a downward movement in prices. Individual prices are constantly moving in both directions.

        I think you’re trying to apply logic to the price level which doesn’t apply to it.

        I agree that an important part of the task of entrepreneurs and other agents is to come to expectations about the future prices of goods that they deal in. I think your point is that for relative prices, or “exchange ratios” that isn’t something that concerns business cycle economics. I would disagree in the case of interest rate, which are relative prices.

        But, I think the main issue here is the price level. Though it’s true that every agent is looking at their own prices, and agent will be in error I still think “unexpected” and “expected” changes are a useful idea. In general the public may be aware that consumer prices (for example) will rise in the future. Certainly they will all be looking at their own prices which may not follow the general trend, but that’s mostly a side-issue. We can safely say that if consumers expect there to be a rise in the price level then they will be better prepared beforehand than if they don’t. The same is true for businesses, though the correlation of producer goods prices is much less close than for consumer goods.

        As I see it the injection-effect argument which underpins ABCT relies on an unexpected change in the price level gradually occuring from an injection of new money. Account falsification can only occur if businesses and shareholders believe that the extra money profit they have earned represents an extra profit in real terms. If they expect the price level to rise then it doesn’t apply.

        If I have the time I’ll write a reply to your article.

        • Jonatan M.F. Catalan


          I’m sorry, but I don’t see your point in the first part of your response. I don’t see what deflation caused by an increase in the demand for money has to do with business cycle theory. In fact, this is addressed in my article – the business cycle is caused by an artificial change in relative prices by an increase in fiduciary media through the loanable funds market. It is an increase in the supply of money without a change in the relevant preferences of individuals. This is not the case with an increase in demand for money.

          We are talking about two completely different pricing phenomena.

          I don’t understand the second part of your response, either. What about the price level? What entrepreneurs look at is the prices of inputs and outputs, not the tendency of a “general price level”.

          • Rob Thorpe

            This issue is too complicated for me to treat in a blog comment.

            I may write an article on it if I have the time, but I’m quite busy at present.

  • Toby Baxendale

    I have a lot of sympathy with this view. As you can see from the comments I make and articles I write, like the writer I too make the point that a change in preferences leaves choices for all us entrepreneurs to make to bring our costs into line with the new demands.

    Money accommodation, i.e. lending new loanable funds to business that “need” it are those that do not have the strong balance sheets, the strong consumer propositions and the fighting spirit to live, thus this policy of accommodation will more than likely set off another boom and bust.

    Contrast with a confusing money supply increase, either a sustained, if possible, by a free banking system or a for sure sustained central bank emissions of money, this will cause all the nastiness of a full on capital distortion as per the Austrian Theory of the Business Cycle and thus even more uncertainty to cope with than just consumer preferences changing !

  • Rob R.

    That’s a good insight that I hadn’t though of before – that the firms that are unable to withstand a change in the demand for money are the ones that should not be bailed out by additional loans.

    At least in theory though an increase in supply of money in response to an increase in demand should prevent capital distortion rather than cause them.

    • Rob, thank you for your comments , like with all these things it depends who gets the loanable funds?

      If it is the people “who need it” these will be the people who have seen demand fall away from their business to such and extent that the capital structure of that business needs more debt to “support” it. This to me sounds like marginal business. Thus the Theory is weak in this respect.

      If these types of business do get new loanable funds when consumer preferences have gone to other things then this Theory runs the danger of being recession elongating and eventually slowing the corrective process .

    • Rob Thorpe

      I’ve criticised Toby Baxendale’s view of malinvestment many times on this website. Unfortunately today I can’t find a convienent link to any of them.

      Let’s remember that what we are talking about is the effect of a change in the demand for money. 100% reserve supporters such as Toby believe that it would be better if deflation occurred during a slump. I disagree.

      Just as unexpected inflation confuses entrepreneurial planning, so does unexpected deflation. Because prices take time to change unexpected deflation causes a reduction in both output and prices. People save out of income in order to increase their holding of money, that forces prices down, but before they fall output falls. That output fall has a knock on effect, the “Wicksellian cumulative rot”.

      This certainly puts stresses on marginal businesses. Toby’s argument here is that putting such stress on marginal businesses is a good thing. I don’t agree. As I wrote in the article above, it’s quite reasonable to think that a business proposition with lower profits also produces a lower return to wider society than one with higher profits. However, that doesn’t mean that a businesses with low profits provides no benefit to society. It also doesn’t mean that if that business were to go bankrupt and it’s assets were to be sold that entrepreneurs from other businesses could necessarily make better use of them.

      When we say in ABCT that businesse come into a state where they don’t meet consumer preference we don’t mean that in a direct sense. The conventional meaning is that businesses have extended their capital structure too far. That has meant that their expected returns are lower that the natural interest rate. It doesn’t mean that the output of the specific projects they’re involved in aren’t demanded. It means that at a high interest rate continuing those projects isn’t worthwhile. So, what happens when a recession results in a lower interest rate? Well, that’s *good* because it allows more of such projects to be completed.

      In this case if there are rival bidders for the capital that is tied up in such projects then it’s quite possible for those bidders to buy that capital. There is nothing more standing in the way of that than in normal times.

      I get the impression sometimes that Toby would love the interest rate to rise because if it did then many companies would go bankrupt and that would allow him to buy their assets more cheaply. He thinks he can produce greater returns with those assets (for himself and society) than their present owners. That may be true in a specific case. But, I don’t think that macroeconomic policy should be set on the basis that it’s always true in a recession.

      Toby has written a paper with Anthony Evans suggesting that during an ABCT boom the low interest rates make incompetent entrepreneurs successful. My personal experience of the tech boom tallys with that, I agree. But, I don’t think that recessions can provide an opposite drive. I think that’s rather like thinking that you can cure someone who has been run over by a car by reversing back over them.

      • Jonathan M.F. Catalan


        What is “unexpected inflation”? Entrepreneurs do not have 100% foresight regarding consumer preferences. In that sense, all inflation, to some degree, is “unexpected”. That it is unexpected or not, in my opinion, is not the key issue.

        The key issue is whether or not it reflects consumer preferences. What allows entrepreneurs to “expect” price movements is how well they can foresee changes in consumer preferences. It doesn’t matter if this is an upward movement in prices or a downward movement in prices. Individual prices are constantly moving in both directions.

        So, what’s relevant in my opinion is whether the price change reflects consumer preferences. An increase in the demand for money is a change in consumer preference.

  • Rob , one last thing, an accommodation in money that does not cause price level capital struture distortion will keep the original distortion in place at best. What good is this? This also can’t be sustainable ? What happens when and if money demand goes back to what it was, do we not have more credit induced boom and bust?

  • Rob R.

    I think that FRB supporters would argue that the businesses that would receive the new loans would be generally profitable (otherwise one assumes the profit-maximizing FRBs would not make the loans).

    Further – the FRB mechanism would pick up signals (via the clearing system) on changed money demand relatively quickly and so act as a constantly stabilizing governor on the money supply.

    In the absence of such a mechanism (such as would be the case in a 100% reserve environment) then some otherwise viable (if marginal) businesses may fail. While for the reasons that you give above this may be seen as a good thing, I think the concern is that if it happens systematically it may cause further monetary contractions and lead to the “snowballing rot” that Jonathan quotes Yeager on above and an elongated period of depressed economic activity.

    • Jonathan M. F. Catalán

      The fact of the matter is that if consumer A decreases spending towards industry X, the fact that Bank M injects new monies doesn’t mean that these new monies will be bid towards industry X. Instead, they may go to industry Y. The fact is that prices will still have to adjust. Money injection is not just a macro phenomenon; nobody has cared to look at the microeconomic implications of fiduciary expansion on prices.

      • Rob R.

        I think the logic of your argument is as follows :

        - The phenomena known as an “increased demand to hold money” is in fact made up of a lot of micro level decisions to hold money over purchasing other specific goods.

        - In a FRB system these additional funds may be lent out. They will go to viable borrowers prepared to pay the highest interest rates based on their expectation of future profits. It is very unlikely that they will go to borrowers with the same spending patterns as the new savers.

        - While these 2 sets of actions may keep overall PPM (if its even measurable) at the same level – and so maintain “monetary equilibrium” – this is irrelevant. What has really happened is just that resources have been reallocated to their most efficient uses based on new consumer preference and prices have adjusted to reflect this.

        If that is your logic then I agree with it.

        The advantage of Free Banking would be down purely to more efficient use of capital and the fact that price level stability is maintained would just be an interesting side-effect.

        • I have ethical problems too with this theory , when purchasing power is kept steady , there is a reshuffling of the pack of cards and people whose goods and services are not in demand , get supported with new PP. This must mean somewhere down the line , someone has not got as much PP as before ! This means their property rights must have been infringed .

          • Rob R.

            Whenever a bank lends out money on fractional reserve then it is affecting someone else’s spending power.

            Thats sounds like the long-running debate about the ethics of FRB and lending out money that is also available on demand to the savers.

            I’m not brave enough to try and tackle that one in this thread :)

            • Rob, you either see no problem with this or you see a problem. At some point in time, you will need to decide , is the erosion of sone peoples individual purchasing power (but not at all in aggregate ) to re direct it to places to keep money equilibrium worth the violation of property rights or is it not?

              This of course does not hinge on do you believe the bank deposit contract is one of custody or one of lending, so you do not even have to address the fraud or is it a debt obligation of the bank issue as either way, both types of contact give you purchasing power.

              • Rob Thorpe

                I think Rob R is right.

                Let’s suppose I make skateboards for a living. One day somebody else starts making skateboards too. By competing with my business they erode the purchasing power of the capital I own.

                Is this a violation of my property rights? No, of course not. But, if those competing businesses have achieved their advantage through unjust means it may be a violation of someone else’s property rights.

              • Thats right Rob, unjust means. When you can not treat current creditors as current , but as long term, then this gives you a significant leg up in life right? This is the unfair part of banking. Make them participate in the economy like you and I do and the pinching purchasing power point falls away. It stays in my book until they have lost their legal and accounting privilege.

              • Rob Thorpe

                In that case Toby aren’t you talking about the ethics of FRB? That was Rob R’s original point and I agree with him.

                If anyone is interested I don’t really agree with Toby’s view on accounting laws he presents here. We’ve argued about that before, if anyone is interested:

        • Jonathan M.F. Catalan

          Right, I think any “ethical” discussion on purchasing power runs into problems once you realize that changing purchasing powers is a natural byproduct of changes in preference. It’s why Mises so harshly criticizes “price stability” in Human Action. Then again, and not to start a tangential debate, I’m the same person that is an ethical subjectivist.

  • Toby Baxendale

    Morning Rob,

    By not letting those businesses that need the money go bust, you will be doing what the consumers do not want you to do, that is support business that is producing things less efficiently , more expensively than their current preferences . Hence they theoretical system that is advocated would elongate and recession . The snowballing is true in the sense that you often overshoots on the way up and on the way down, however, all markets clear. The early 20′s springs to mind, the 1907 recession springs to mind. I could mention others, indeed most of the prior century of recessions spring to mind. I am offered businesses now today that trade at 3 x cash flow that have debt that could be swapped out for equity and things are starting to look cheaper and more realistic. When things look really realistic and banks are prepared to take a proper loss on their loans, then the system will clear. This is what is needed today. In a theoretical world of FRFB’S then they would elongate any recovery . The economics of the theory do not stack up in this respect , so it becomes a policy proposal of smoothing out the pain over many years and possibly making it deeper for longer and or taking the pain in 12 to 18 months and letting markets clear.

  • Rob R.

    Hi Toby,

    I see your point. In an economy that is free enough to allow markets to clear efficiently the flexibility in the money supply provided by FRBing would not be needed (and would in fact lead to inefficiencies). All the “overshoots” would be short-lived.

    It seems this was the case in recessions as recent as the 1920′s.

    What I take away from this discussion is that we need to focus on the big picture of getting back to freer markets and when we get there hopefully the market itself will tell us whether the benefits of FRBing are real or just an interesting theory driven out of the bad experiences of state control of the money system.

    • Evening Rob,

      Broadly speaking yes.

      There are other concerns with the theory. I mention on this site all the time. When you hold money in a precautionary way, you are refraining from consumption. I know many people today and many fund managers with billions in cash balances , just as there are companies with billions of cash balances holding these in anticipation of a correction and being able to buy things back at the prices that will make them viable for the current level of consumer preferences . Whilst in the meantime, the FRB’s are lending all of this stuff out to these unviable businesses ! This will happen in a FRFB situation ie prolong and deepen the recession and prolong the correction.

      I suspect this may be why in history FrFB’s did not provide the stability that the Theory dictates .

  • John

    *corrected post

    I enjoyed the article, though I am yet to be persuaded.

    Some questions and thoughts:

    1. Your argument relies on the assertion that an excess demand for money will not lead to distortions in the structure of production. Why is that the case?

    If this is because the decision to hold money represents a consumer preference, as opposed to a decision of a central policy – then wouldn’t we be assuming that a change in money preferences by consumers will affect all orders of production uniformly?

    2. I think part of the strength of the free banking argument is that there has been several historical precedents which mimicked it closely. I am not aware of there being historical examples of full-reserve banking (apart from a brief period in Amsterdam).

    3. A common argument of free banking proponents is that fractional-reserve banking was chosen by the market, or at least the market was fine with it. But I think a more realistic explanation was that bankers found it more profitable to operate under a fractional reserve regime – few bankers would have been keen to object to it; perhaps those who refused to operate under a similar regime might have easily been forced out of business (perhaps due to profitability concerns).

    4. Nonetheless, even if it is agreed that the money supply should expand to accommodate an increase in demand for money – I wonder if it’s correct to say that it is impossible to know how to “inflate correctly” (c.f. Hayek’s knowledge problem).

    • John, there are many 100% reserve banks. All custody banks are 100% reserved , these house most pension fund and a good portion of Life companies cash balances . Bank of New York Mellon has a balance sheet 10 bigger than the Federal Reserve and the Tarp money was entrusted to this institution for it’s safe keeping.

      I believe the Bank of Hamburg was a bank of commerce that was like the Bank of Amsterdam. This was told to me by a bullion owner who wishes to establish something similar . I have not looked this up though.

      Banks in the Alpine regions of the world are often 100% reserved .

    • Jonathan M.F. Catalan


      1. This is not a defense of free banking (although I am a free banker); this is a criticism of monetary equilibrium theory. The capital structure is likely to be “distorted” — i.e. it will change shape. What characterizes malinvestment is an increase in investment without an increase in the stock of capital goods. If an increase in the demand for money is the same as an increase in savings (deferred consumption), then the stock of capital goods has increased and investment can increase, as well.

      2. I am a pretty clear-cut Misesian, so I think the strength is theoretical, rather than empirical. But, it is true that there is a lot of empirical evidence of functioning quasi-private banking industries. Kevin Dowd’s book on the history of free banking is a great tome on this exact subject.

      3. Well, “chosen by the market” is an ambiguous term. That is is profitable and stable is a less abstract way of saying that “it’s chosen by the market”.

      4. Right, nobody — I don’t think — is saying “how to inflate correctly”. The increase in fiduciary media in a free banking industry is quite decentralized.

  • Rob Thorpe

    Jonathan Catalán,

    FYI I’m “Current” on other blogs.

    You won’t be surprised that I don’t agree with you about this :). But, I’m busy right now and I don’t have the time to reply soon.

  • Terrific article, Jonathan.

    I’d appreciate your thoughts on two matters, both of which are at a slight tangent to the points you were making.

    - Leaving aside the question of whether it’s a desirable goal (which, like you, I doubt), I’ve long wondered about the presumed ability of FRFB systems to meet any increased demand for money. As you note, they can supply additional banknotes if that’s all the market wants. However, given the minor role banknotes play in today’s monetary system would that meet an increased demand for money in a broader sense? I struggle to see how. For that to happen, wouldn’t banks also have to extend net new loans (and thereby generate fresh deposits)?

    - Which brings me to the second matter. Significant and relatively sudden changes in the demand for money seem unlikely outside a boom/bust framework. If so, then believing an FRFB system will automatically meet the increased demand for money during the bust phase presumes banks would expand their balance sheets at a time of very real peril and pressure. Does it also seem to you that the opposite would more likely be the case?

    More generally, I think FRFB systems tend to (help) create relatively minor boom and bust cycles. Irritating, for sure, but nothing like the catastrophic versions that can result from the central bank sponsored and underpinned variety. Perhaps these smaller cycles are a price we have to pay, an offshoot of our unavoidably imperfect knowledge and occasional tendency to excessive enthusiasms. In theory, full reserve banking is a possible way to prevent these cycles. Trouble is, the more closely I look at it, the harder it is to see how it could be made to work in practice.

    Anyway, that’s a separate and much larger topic.

    • Jonathan M.F. Catalan

      Hopefully, I understand your questions correctly.

      1. Yes, these would be new loans and new monies. It would effectively entail an increase in fiduciary media (after X amount of banknotes are effectively withdrawn from circulation for an indeterminate amount of time).

      2. Right, if the demand for money is stable, so will be the supply of money. And yes, I agree with your ideas on frbr during depressionary periods. I don’t think banks are capable of increasing the supply of fiduciary media (it would be absurd, because at this time they are contracting the money supply to increase capital reserves), and I don’t even think it would be desirable from a macro perspective.

      I don’t think frbr would create business cycles. I just think it would be a more effective method of banking, where most fractional reserves would arise from phenomenon (1) [in the article above].

      • For the most part, yes you have.

        I was also, however, trying to focus on a slightly different aspect. Namely the nature of the relationship between demand for money and the supply of money.

        It seems to me that although demand for loans certainly brings money into existence (through the byproduct of fresh deposits thereby created), demand for money itself doesn’t. It might well bring about the creation of additional banknotes, but as I see it that merely represents the conversion of existing money from one form to another, not a net addition.

        From your answer, if I’ve understood you correctly, you agree. Isn’t this a rather significant issue, given that it seems to strike at one of the foundations of much fractional reserve free banking theory?

        • Jonathan M.F. Catalan

          Right, the demand for money doesn’t itself lead to a rise in the supply of money. If the demand for money rises the supply of money in circulation will fall; the supply of money increases by virtue of bank loans, but not of the rise in demand for money itself.

          How would you say that this strikes at a particular foundation of frbr?

          • On an empirical point, I would think you will find when money demand goes up materially, loans do not gush forward the other way, you have a real credit contraction. Historically we have seen this when banks are free – see my comment 41 at 10.14 hrs. Today this is certainly what we are seeing. So in a FRFB or a state supported FRB system, I see no accommodation to velocity changes but in fact contraction of money full stop.

            • We crossed in midair, Toby. Sorry about that. I hadn’t refreshed the page when I wrote my response (11:49) to Jonathan.

            • Jonathan M.F. Catalan


              Right. Milton Friedman spent much of his research showing that the demand for money is stable. When the demand for money radically rises it tends to be a result of an industrial fluctuation, at which point, in my opinion, the situation is much too complicated to simply prescribe an increase in the supply of fiduciary media. I’ve never really supported expansionary monetary policy after industrial fluctuations.

              • Rob Thorpe

                Come on Jonathan, you know as well as I do that an increase in total outstanding loans isn’t needed, only a rearrangement of the type of liabilities supporting loans from non-fiduciary types to fiduciary media.

                This is the fallacy of the MMT horizontal money argument, that all bank liabilities are necessarily money.

              • Jonathan M. F. Catalán


                I don’t know what you mean by a “rearrangement of the type of liabilities supporting loans”. If the supply of money is increasing to meet a demand for money, then the number of liabilities a bank has to deal with is increasing. If banks are having problems with making good on their liabilities then I just don’t see how they can issue more liabilities — liabilities that may suffer from the secondary consequences of a general industrial fluctuation (the profitability of the business venture).

          • I’d understood (perhaps mistakenly) that a tendency to create additional money in response to increased demand for it was seen by some as a particular benefit of fractional reserve free banks. As per our brief discussion, I don’t doubt their theoretical capacity to do so but do wonder whether they’d respond in that way when the need is most urgent. A bit like liquidity, perhaps, which is there except when it’s really needed.

            Presuming I’m right in this, I’m not at all sure it’s a negative. In line with your comment that an increased demand for money reflects a shift in preference away from consumption, any systemic response that tries to counteract it is more likely to hinder than help the adjustment process.

            • Jonathan M.F. Catalan

              An increase in fiduciary media through the loanable funds market will target investment opportunities more often than consumption opportunities, but I too have skepticism about whether or not banks would be able to expand fiduciary media during periods of industrial fluctuations. How could banks expand their balance sheets when they’re suffering an increase in defaults?

              • Anyone who thinks that banks in a depression will increase their loans even if their customers do have more cash held as deposits is not in touch with the world of commerce. They need to protect their own balance sheet and they do this by contracting credit to the most marginal and most risky of their concerns i.e. the people most demanding of loanable funds. It has not happened historically as far as I can see and will not happen in the near future.

            • Correct as far as I am concerned.

  • Rob R.

    There is no reason I can see why FRFB could not create new loans via checking accounts and would not be restricted to note creation.

    It should always be possible for banks to find customers for new funds that become available as a result of increased demand for money but I think you’re point is “would the banks actually want to expand loans in such a scenario or would they be more likely to increase reserve requirements as a precaution”. That’s a great question that I too would welcome an answer from a fee banking expert. If the mechanism of picking up changes in velocity via the clearing system is working well then one could argue that banks would pick up small changes in velocity quickly and adjust their lending appropriately thus stopping the “bust” from developing.

    In the real world however it seems unlikely that this would work with any degree of exactitude and I would agree with you that we may still see “relatively minor boom and bust cycles” in a FRFB world. Perhaps they are a useful way of keeping the free market system healthy by diverting resources away from the marginal firms to ones that have demonstrated better adaptability ?

    • Rob, if you have time to read Checkland, this is the author sited who has documented the FB Scottish period . It is a Lehman event every 5 to 10 years or so. Fantastic bid of economic history . Well worth a read . Stability is not something I would associated with FRFB’s however, I do hold them to be better than FRB’s state supported . I think booms and busts would less under FRFB’s and even less under 100% RFB’s.

      • Rob Thorpe

        If it were a “Lehman event” every 5 to 10 years. Then I’d agree that fractional reserve banking should be banned, and that it is much worse than central banking. However, I don’t think the historical record really indicates that.

        • I can 100% promise you Rob, I am reading now on holiday the 700 or so pages of Checkland,I am totally staggered how anyone can’t see this system as highly unstable (the author even describes it as such) with bank runs starting within a year of the system establishing itself, multiple bankruptcies happening in single digit number of years, and on going every couple of years, with Parliamentary bail out and regular Bank of England bail outs happening all the time, it beggars belief.

          There is something very wrong with the institutional set up of FB in Scotland. I suspect t is because one could not make a fiduciary deposit and know your money is safe in custody , the lack of which fundamentally unbalances time preferences as this money is not being set aside for on lending. There are many issues that then flow from this, some we have touched on.

          Dealing with the failings of this system and putting free banking on robust foundations should be the goal of all of us. I have some clear thoughts on this as you know, but it sure as hell is not the Scottish model.

          By the way, the biggest claim that in times of excess money demand , FB’s will accommodate is empirically shot to pieces by this work as 9 out of 10 times, I exaggerate not, note contraction, no re issue of bills for discount, delay tactics for redemption were all put in place to ensure the banks survival in the face of redemptions into money and to make sure survival chances were extended, a policy of massive credit contraction was embarked upon. So much for MET and accommodation to velocity changes!

          Maybe I read things differently . Take another example, Hayek at best of times floated between being a hard money man to finish up with some more innovative ideas such as competing currencies with a commodity based anchor . In between he did say on occasions that ideally a money accommodation should be done to make money neutral , but against his epistemological position that we all know and that whole section I draw to your attention in “Denationalisation of Money” called “Neutral Money Fictions” in (Denationalisation of money around page 90), I see him to flirt with MET ideas but ultimately reject them.

          Buy a copy and read , it is like reading a great drama it is so up and down, great characters etc. I would really like to know if then you are so keen on FRFB , MET as currently suggested by our Austrian orientated colleagues .

          By the way, I would not ban FRB, just set it on some sounder footings that have been suggested in threads and articles on this site.

          FRFB people now I see claim that there is such a thing as a Hayek Rule (Anthony Evans now does) advocating accommodation. Revisionist economics – what nonsense . It does show how different sets of people can view things very differently .

  • Rob R,

    Agreed. There’s no hard impediment preventing banks from extending net new loans during bad times. I mentioned banknotes separately because their creation need only involve the conversion of existing deposit accounts into a different form.

    Unless I’ve misunderstood you, however, I don’t see that “new funds become available as a result of increased demand for money”. Setting aside changes to base money, doesn’t the stock of money necessarily remain the same unless net new loans are created or (during a serious downturn) the liquidation of outstanding loans via repayment, default or restructuring outweighs any new loans extended?

    I’d have thought the increased demand would instead reveal itself through a fall in the price of other goods (particularly assets) and in time at least (after any initial flurry of panicky liquidation) through, as you note, decreased velocity.

    • Rob Thorpe


      On a banks balance sheet the liabilities may be mostly current account balances, the assets will mostly be loans.

      But, that isn’t indicative of the entire capital market. Today money substitutes are only a small proportion of the total of financial assets.

      To begin with banks can expand the money supply by using fiduciary media (current accounts and notes) for funding rather than bonds. Suppose, for example, that at the beginning of a recession a bank has £X in liabilities in the form of bonds, and £X in money. It can exchange one for the other by buying it’s own bonds. If the bonds are short dated, they may simply not offer them again for renewal as their term ends.

      Banks may also buy other businesses that can provide balancing assets, or be bought by them. Suppose there is a supermarket that is quite a stable business, for example. That supermarket may have outstanding bonds and shares. In a recession it may make sense for that supermarket to merge with a bank or become a bank. Then it can exchange some of those liabilities for current account liabilities which are cheaper.

      Some of this happened in ~2009. Many large and famous US investment banks had no commercial banking arm. After the crisis they quickly opened commercial banking arms, or bought them, so they could borrow that way rather than through the commercial bond market. (Note that because under our current system where deposit insurance protect retail current account users this wasn’t necessarily a good thing).

      So, there are other ways of creating money than creating new loans.

      • Rob, I take your point. The financial system, especially in the US, is a much bigger beast than the banking system itself. Still, I don’t see that your examples in any way contradict what I was saying, particularly in a FRFB system.

        If a bank buys back its own bonds, not only is it substituting short-term, potentially unreliable liabilities for longer term more secure ones (surely a risky strategy during difficult, quite possibly illiquid times), but it must also have the reserves available to settle on those purchases. As far as I can see, the same issues would apply to your supermarket example.

        As for investment banks opening commercial banking arms (or changing their status) during the GFC, wasn’t their sole goal to gain guaranteed access to the Fed’s various support schemes?

        • Rob Thorpe

          Think about the trade-off during a boom compared to during a recession.

          During a boom demand for money is lower, or alternatively, velocity is higher. That means that more reserves are needed to deal with that higher rate of transactions. If a recession sets in then velocity fall, and with in the rate of redemptions in-and-out of any particular bank. As a result the bank comes to have more reserves than it’s economic for it to hold.

          During a period of high money turnover it’s relatively more attractive to offer bonds. Current accounts are more risky because the amount of reserves needed to cover fluctuations rises. For a bank with good assets, during a period of low money turnover it’s relatively more attractive to offer current accounts because the amount of reserves needed is lower.

          I don’t think that the investment banks opened commercial banking arms only to obtain access to fed support schemes, but I may be wrong, I don’t know very much about that.

          BTW this logic doesn’t apply at all to the current banking market because of central banking. Central banks generally fix the amount of reserves a commercial bank must hold as a percentage.

          • I see what you’re saying, Rob, and accept that reduced velocity would lessen the need for reserves. What they then choose to do with them is the interesting question.

            It mostly depends, I guess, on the severity of the downturn: if it’s relatively minor they would probably get more aggressive about expanding their lending; if, on the other hand, it’s one where the wheels threaten to come off, they’d likely be doing the opposite.

            As an aside, I wonder about how much choice banks really have in the nature of their liabilities. Individual ones can of course try to tailor their mix to their particular preference, but isn’t the system as a whole heavily dependent on customer preferences?

            • Rob Thorpe

              I see what you’re saying, Rob, and accept that reduced velocity would lessen the need for reserves. What they then choose to do with them is the interesting question.

              The situation we have today is quite different from what we had in the gold standard, or in the very recent past.

              Now that a small amount of interest is paid on excess reserves it’s worth holding them as an asset.

              To put things another way… There are three motivations to owning reserves:
              * 1. Earning interest from them.
              * 2. Using them to facilitate banking, that is as reserves for an amount of fiduciary media.
              * 3. Keeping them for the future, to facilitate future banking.
              * 4. Earning a capital gain from them.

              If reserves no longer earned interest then reason #1 would disappear. Then only #2 and #3 would be relevant. Reason #2 isn’t really a problem. Reason #3 possibly is though, if banks thought that they would need extra reserves in the near future they may stockpile in advance and consequently reduce the supply of money. In my opinion this is something that needs further research.

              #4 is often brought up by critics of the gold standard, Bill Woolsey said something similar recently. If it’s though that gold will rise in value then banks may stockpile it hoping to get a capital gain. This is true to some extent, for various reasons which I could discuss in more detail I don’t think it’s likely to be important.

              It mostly depends, I guess, on the severity of the downturn: if it’s relatively minor they would probably get more aggressive about expanding their lending; if, on the other hand, it’s one where the wheels threaten to come off, they’d likely be doing the opposite.

              As I said earlier, making new loans isn’t the only choice. Banks have a great many timed-savings products. I had a look at the BoE statistics for this, UK monetary financial institutions currently have ~£1.2 trillion in “sight deposits”. Those deposits are current accounts/fiduciary media or liquid enough to be close to it. But, they have ~3.7T in overall liabilities. Banks can vary the amount of liabilities held in each form.

              If you look at the statistics sometimes the total outstanding in current accounts moves against the total liabilities. At present, for example, the total “sight deposits” as measured by the BoE is about the same as it was in Jan 2010. But, the total amount of liabilities has fallen by £322B since then.

              As an aside, I wonder about how much choice banks really have in the nature of their liabilities. Individual ones can of course try to tailor their mix to their particular preference, but isn’t the system as a whole heavily dependent on customer preferences?

              That’s part of what we FRFBers are saying…

              In a free banking system if the demand for money is high then current account customers will put up with low interest on current accounts and fewer free services. That will make that branch of banking more profitable. Then if that high demand for money reduces redemption volatility then that will reduce the cost of providing current account balances too.

              The opposite applies to timed savings. If the demand for money is low that means people are more indifferent to holding assets like current-account balances. Banks must then offer good services and possibly interest to attract them. In this situation customers may find timed-savings more attractive because of the extra interest.

              So, there’s a continual flux as demand and supply changes. Offering interest is the cost of timed-savings to banks, the cost to customers is that it ties up their capital. Offering free services, such as transfers, and keeping reserves is the cost of current-accounts to banks, the cost to customers is the interest they forego.

              This isn’t really the situation we have now… Although timed-savings isn’t that regulated current accounts are. The cost of reserves for current accounts is set by the central bank. On the customers side the possibility of loss is mitigated by deposit-insurance for current accounts, but often not for timed-savings.

      • On a historical note, the Royal Bank of Scotland was established off the back of government creditors (The “Equivalent” people) being rolled into the foundation of the bank and thus becoming its source of new money. So it would appear thus it ever was.

  • Rob R.

    RE: “new funds that become available as a result of increased demand for money ”

    I meant that when a banks customers increase their willingness to hold money (either by holding the banks notes , or holding increases balances in its checking accounts) then FRBs will see this as additional funds that they can lend out.

    I took this to be the mechanism for establish “monetary equilibrium” claimed by FRB supporters that the author is critiquing in his paper.

    My understanding is that under 100% reserve then as you say “increased demand would instead reveal itself through a fall in the price of other goods”.

    I think the view of the author (if I correctly understand it) is that both under FRB and 100% reserve equilibrium following a change in money demand will be re-established via price changes to reflect altered consumer preferences between money and other goods. The fact that under FRB new loans may be created to match the increased savings is irrelevant because the new loans will not be spent in the same way as before the change.

    Thus (in his view) the claims of the FRFBers in regard to monetary equilibrium are not valid.

    • Rob R, your summary of Jonathan’s position in the last two paragraphs seems about right.

      For the rest, have a look at my response to Jonathan a little while ago (23:46). I think it covers the points you’ve raised here.

  • Toby Baxendale

    Rob , your message of the 25th of August 1st one on this thread, out of all the booms followed by busts in history anywhere in the world, can you give me an example where a bank or banks in general have made advances to businesses in the bust phase to accomodate the velocity change ?

    • Rob Thorpe

      As I’ve said elsewhere, commercial banks don’t need to increase their total amount of liabilities. Some of their liabilities are timed and some are fiduciary media. All they need to is increase the latter by reducing the former.

      Have they done this? Yes they have, in many recessions, though not in this one. But, you shouldn’t be satisfied with that answer :)

      I’ll admit the problem for fractional-reserve free-banking here… During the central banking era the money supply is largely controlled by the central bank. It’s the central banks who control the cost of reserves. But during the historical free banking eras we have no accurate statistics for money supply or money demand.

      Of course, this problem affects the case for 100% reserve banking too, that too depends on theory.

  • Rob R.


    I am not (yet!) well-read in banking history but I can well believe that banks would in general be unwilling to extend additional loans during the bust phase even if they did see signs of reduced velocity. Rob Thorpe above notes some alternatives to loans that banks could use during a recession that would have the same affect in terms of the money supply.

    What I do think history does tell us (eg White on Scottish banking) is that free banking is better at checking growth in the money supply than central banking and is therefore better at minimizing (but not eliminating) busts.

    It is not clear how 100% reserve would fare. I’m not sure that history tells us much. Lack of flexibility in the money supply during periods of decreased velcoity might itself generate “busts” even under this regime.

    • Evening Rob,

      Read Checkland , DO NOT BELIEVE ME, PLEASE READ IT YOURSELF!, the authority that White sites and note the author himself describes the system as unstable . Within months they had the 1st bank run, within years and on going there were multiple bankruptcies , bail outs , Acts of Parliament to set up trust to wind up wonky banks, endless special pleading, use of the Bank of England to bail out, rampant speculation , rampant inflation , forced savings from the poor to the bankers etc. Exceptional pressure on redeemers not to redeem , slowly doing it, only doing it in certain branches , lying low if you were a banks agent waiting to be found and anything to prevent someone getting what is theirs back (their money) and in a time promised to them! Optional Clauses inserted to notes to allowing the banks to turn a current creditor into a long term one (for right or for wrong this was banned very quickly) I think you get the picture.

      In my two decades and a bit in business, let me tell you, any business faced with clients going bust reigns in credit. This is the right and proper thing to do to protect ones balance sheet and the interests of your shareholders who pay you. How you can expect banks to do anything else if beyond belief .

      You may be new to our web site, but if you allowed safe keeping for deposits , lending on a timed basis , then segregated from the two former types of account, some free FR accounts , I do think you may get the best of both world and miles better than the State alternatives. Now unless you are a 100% Reserve only or FR only head banger , even if people consent and their actions can’t implode in on others (no bail outs and don’t wipe out peoples irreplaceable savings) i.e. they can only blow up themselves, then I can’t see why this is not the way fwd.

      • Rob Thorpe

        Rest assured Checkland is very high up my reading list, but I haven’t read him yet.

        I know that in the Scottish free-banking period there were many bankruptcies of banks. But, in any business there are always failures. Bankruptcies of businesses don’t by themselves demonstrate any failure of capitalism, and bankruptcies of banks don’t by themselves demonstrate the failure of banking.

        I agree with you that the frequency of bankruptcies was very high and would not be tolerated today, as our existing systems performs much better in that regard. What we should remember is that banking was in it’s infancy at the time. In england (which had central banking) even accounting for the different sizes of the economies there were far more bankruptcies. As time progressed banks became more competent, both under free banking and central banking. By the time of the Canadian free-banking experience banks failures of all sorts were rarer, but they were still rarer under free-banking than under central banking.

        It’s also true that every industry asks for special treatment from government, and many industries (and specific businesses) succeed in getting it. If there were 100% reserve banking I’m sure the same would apply and 100% reserve banks would lobby for special treatment. Some say that the bailouts of various banks by the BoE in Scotland mean that there wasn’t really Free Banking in Scotland. This ignores the fact that the bailouts were very small.

        Which brings me to Steve Horwitz’s reply to don’t think Scottish free-banking was really free: What about Canada?

        If by “inflation” you mean money creation, then certainly banks created money. The question though is: is this a bad thing in all cases? I don’t think it is I think price inflation is what we should really be worried about.

        Price inflation is an interesting issue. In the free-banking era Scotland was in the same monetary area as the rest of the UK. The rest of the UK had central banking, and therefore the actions of central bank determined the price level. That means price inflation can’t be definitively blamed on Scottish free-banking. I’ll admit that it also means that this also means that Scottish free-banking provides little evidence about the effect of free-banking on the price-level. The same applies to forced saving. Whether there is forced saving or not depends on the movement of the real interest rate which is an economy wide price, which means in this case not one tied to Scotland or England.

        You’re quite right that banks put pressure on big customers not to redeem. They tried to make it a matter of Scottish patriotism. But, customers could and did redeem, the law was on their side.

        As I have said many times in this thread, expansion of fiduciary media by commercial banks doesn’t rely on expansion of the asset side of their balance sheets. I agree that in a recession banks will reign in credit. But, as we discussed a few weeks ago, banks hold far more loans than they have fiduciary media outstanding. The remainder is timed savings and shareholders capital. What we FRFBers are saying is that when the demand for money rises banks will move a portion of their liabilities from timed savings to fiduciary media. As the demand for money rises compared to the demand for timed savings the profitability of the former will rise. A net expansion of loans would only be needed for a huge increase in money demand. Even in that situation other businesses that hold safe assets could become banks, or buy banks. I gave some recent statistics on this here:

        You may be new to our web site


        I agree with your policy proposals much more than with your views of banking.

        The reason I still argue with you in articles and in these comment threads is that I don’t think one person’s or one organization’s policy proposals are all that important. Though ideas often come from a small group of people, policy proposals are different they have to be compromises from many people and organizations.

        That’s why I’m as interested in talking about the underlying economic issues as the specific proposals. As I’m sure you realise, when I’m debating with you here, I’m not just looking at it as debating with you. Our discussion is open for any interested person to view.

        • Rob, couple of thoughts (this relates as much to your earlier long comment as to this one).

          That banks respond to shifts in customer preferences (e.g. from timed deposits to call deposits) seems a truism. How far this mechanism would go towards meeting a large shift in demand for money is another matter. Besides, isn’t it a feature of pretty much any banking system, not just FRFB?

          You also suggested banks could buy back outstanding bonds, replacing that funding with fiduciary media. Fair enough, but more in theory than fact I think. The dynamic for individual banks is very different to that of the system as a whole. Any given bank that buys back its outstanding bonds can’t rely on getting the sellers’ proceeds back as deposits; it must be prepared, at worst, to part with reserves equal to the bonds it’s purchasing. Averaged over time and across many transactions it can probably rely on getting something close to its market share, but in tight times is it likely to take that chance on any given transaction? Besides, if things are fraught enough, it may be leary of giving up assured longer term funding for demand deposits.

          Which in turn leads me to wonder how much our differences on these matters stem from the fact that my focus has been on periods of real stress, whereas yours has perhaps been a good deal more general.

  • Rob R.


    I will track down a copy of Checkland – I need to understand the historical record here.

    I am not a “FR only head banger” but it is my view that once central banking is abolished and free banking allowed then (unless it is banned) the fractional reserve model will predominate because it is lower cost for customers and generates better returns for banks.

    Having said that I hope that free banks offer the range of services you identify. I think it highly likely that this will be the case because customers will have to think much more intelligently about their banking choices than now , where the central banks takes away risk (via insurance) and enforce fractional reserve (via regulation and monetary policy).

    Under free banking everyone will have to weigh up the risks v rewards of putting their money in a FRB or keeping it in a ssfe deposit or time deposit. Over time you may indeed get the best of both worlds, though for this you may need competing currencies as well as competing banks.

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