Book Reviews

Paper Money Collapse 2nd edition teaser

One of the interesting things that happened at the End of the World Club on Monday evening, was a teaser of what’s new about Detlev Schlichter‘s Paper Money Collapse (2nd edition). We are promised some discussion about Bitcoin (which really got going about the time PMC first appeared on bookshelves).

Also promised is an update of Detlev’s views and he hopes to include discussions that have taken place in various forums (such as on his blog).

Further updates as we get them.




Sound money for Europe

You can be sure that most of my colleagues in the European Parliament do not embrace the concept of the free market. Day after day, I hear them speaking up for the protection of established interests or attempting to regulate away risk. However, there is one area where there is a genuine coalition of interests and that is the need for banking reform.

Despite all the legislation, nearly six years after the run on Northern Rock and almost five years since Lehman Brothers collapsed, we’ve endured an onslaught of new financial regulations emanating from Brussels, but we haven’t solved the fundamental problem. If a bank went bust tomorrow it would still need taxpayers to bail it out. The Left hate bail outs because they believe taxpayers’ money should be spent elsewhere and not on subsidising what they see as “rich bankers.” While those of us who believe in free and open markets think that companies that fail ought to be allowed to go bust to allow better-run rivals and new entrants to fill the gap in the market. This coincidence of interests has formed the basis of the Left-Right coalition.

For the last few years, I have been pushing three items within the family of Cobden Centre proposals: no taxpayer bail out; director liability and sorting out IFRS accounting standards.

We have spent the past five years introducing legislation that does not tackle the fundamental problem of banks needing bailouts when they fail. I have been making this point for several years and it seems that finally other legislators share this view.

In a report on banking reform adopted by the European Parliament in early July, there was genuine agreement on the need for an overhaul of the banking sector. Most political groups agree that supervisors will need to spell out procedures to wind down failing banks without taxpayer funding and to create a scheme to allow customers of failed retail banks to continue to pay their bills or withdraw money from ATMs until ownership is resolved.

However, we have to be realistic and recognise that at some point, governments will be tempted to use taxpayers money. Therefore, we agreed to encourage banks to separate wholesale banking activities from retail activities in the event of failure so that the savings of retail savers are not used to subisidise the trading activities in the investment arms of banks. This so-called ringfence need not necessarily be structural but a clear distinction needs to be made.

In the same report, I tabled an amendment which received the support of a large part of the European Parliament that we should explore how to make directors more liable for failure including exploring the feasibility of a return to the partnership model of ownership. Although there are concerns about how this would work in practice, the principles of director liability and the need for a better alignment between performance and reward are now firmly on the agenda.

I have also worked with the Cobden Centre, PIRC and Steve Baker MP to point out the concerns that many investors have expressed over IFRS. This included hosting a packed event in the European Parliament organised by the ACCA where Gordon Kerr from the Cobden Centre spoke alongside representatives from the auditors, the banks and the standard-setters themselves. This discussion helped us to secure the support of all major political groups in the European Parliament for a major review of international accounting standards.

In making the case for a review, it has been important to highlight the apolitical nature of this issue. All political groups regardless of party, are supporting calls for simpler standards that drive better governance and question why banks are able to book unrealised profits without making sufficient provision for potential losses.

In addition, supporters of the work of the Cobden Centre believe it is vital that consumers understand how fractional reserve banking works. This means making consumers aware that when they open bank accounts, their money is not actually on deposit at the bank. I have consistently spoken in parliamentary debates on the need for banks to be much more transparent with consumers when they open accounts and to distinguish between deposit accounts, current accounts where so-called savers are really lending their money to a bank and investment accounts. In time, I hope to be able to introduce amendments pushing for such transparency.

It may be far away and many may question whether the UK should remain a member of the EU, but as long as Britain remains in the EU and I remain a Member of the European Parliament I will continue to seek to influence the debate and share the ideas of the Cobden Centre with MEPs across the political spectrum.


Money demand and banking – some challenges for the “Free Bankers”

Within the Austrian School of Economics there has long been disagreement and therefore occasionally fierce debate about the nature and consequences of fractional-reserve banking, from here on called simply FRB. FRB denotes the practice by banks of issuing, as part of their lending activities, claims against themselves, either in the form of banknotes or demand deposits (fiduciary media), that are instantly redeemable in money proper (such as gold or state fiat money, depending on the prevailing monetary system) but that are not fully backed by money proper. To the extent that the public accepts these claims and uses them side by side with money proper, gold or state fiat money, as has been the case throughout most of banking history, the banks add to the supply of what the public uses as money in the wider sense.

Very broadly speaking, and at the risk of oversimplifying things, we can identify two camps. There is the 100-percent reserve group, which considers FRB either outright fraud or at least some kind of scam, and tends to advocate its ban. As an outright ban is difficult for an otherwise libertarian group of intellectuals to advocate – who would ban it if there were no state? – certain ideas have taken hold among members of this group. There is the notion that without state support – which, at present, is everywhere substantial – the public would not participate in it, and therefore it would not exist, or that it constitutes a fundamental violation of property rights, and that it would thus be in conflict with libertarian law in a free society. This position is most strongly associated with Murray Rothbard, and has, to various degrees and with different shadings, been advocated by Hans-Hermann Hoppe, Jesus Huerta de Soto, and Jörg Guido Hülsmann.

The opposing view within the Austrian tradition is mainly associated with George Selgin and Larry White, although there are other notable members of this group, such as Steve Horwitz. This camp has assumed the label “free bankers” and it defends FRB against accusations of fraud and misrepresentation, maintains that FRB is a normal feature of a free society, and that no property rights violations occur in the normal conduct of it. But this group takes the defence of banking practices further, as it also maintains that FRB is not a disruptive influence on the economy, a position that may put the free bankers in conflict with the Austrian Business Cycle Theory, although the free bankers deny this. This point is different from saying that FRB is not fraudulent or suspect. We should always consider the possibility that otherwise perfectly legitimate activities could still be the cause of economic imbalances, even in a free market. If we did find that to be the case, we might still not follow from this that state intervention or bans are justified.

But the free bankers go even further than this. Not only is FRB not problematic, either on grounds of property rights nor on economic stability, FRB is even beneficial as it tends to maintain what the free bankers call short term monetary equilibrium, that is, through FRB the banks tend to adjust the supply of money (by issuing or withdrawing deposit money on the margin) in response to discretionary changes in money demand in such a way that disruptions would not occur that otherwise seem unavoidable under inelastic forms of money when changes in money demand would have to be absorbed by changes in nominal prices. FRB is thus not just legitimate, it is highly beneficial.

Purpose of this essay

As I said before, this is an old debate. Why should we reheat it? – Before I answer this question, I should briefly state my position: I am not fully in agreement with either camp. I do believe that the free bankers’ defence of FRB is largely successful but that their claims as to it being entirely innocuous and certainly their claims as to its efficiency in flexibly meeting changes in money demand are overstated. In my view, their attempts to support these claims fail.

FRB is, in principle and usually, neither fraud nor a scam, and the question to what extent the depositing public fully grasps how FRB works is not even material in settling this issue. In their 1996-paper ‘In defense of fiduciary media’, Selgin and White argue that the type of money that FRB brings into circulation has to be distinguished from fiat money; they explain that FRB is not fraudulent and that it does not necessarily involve a violation of property rights; third party effects, that is any potentially adverse effects that FRB may have on those who do not participate in it, are not materially different from adverse effects that may emanate from other legitimate market activity, and thus provide no reason for banning FRB; furthermore, Selgin and White claim that FRB is popular and that it would occur in a free market. I agree with all these points. There is no basis for banning FRB, so it should not be banned. This position is, in my view, correct, and it also happens to be obviously libertarian. I may add that I believe it is also almost impossible to ban FRB, or something like FRB, completely. We could ban FRB as practiced by banks today but in a developed financial system it is still likely that other market participants may from time to time succeed in bringing highly liquid near-money instruments into circulation, and that may cause all the problems that the 100-percent-reserve crowd associates with traditional FRB. The question is now the following: do these problems with FRB exist? The free bankers say no. FRB, in a free market, is not only not a source of instability, it is a source of stability as it manages to satisfy changes in money demand smoothly. These positive claims as to the power of FRB are the topic of this essay. I do not believe that these claims hold up to scrutiny.

Why is this relevant?

At first it does not appear to be relevant. Selgin and White declare in their 1996 paper, and I assume their position on this has not changed, that they are opposed to state fiat money and central banking. This sounds similar to the conclusions that I develop in my book, Paper Money Collapse. I advocate the strict separation of money and state. No central bank and no state fiat money. I think it is extremely likely that an entirely uninhibited free market in money and banking would again chose some kind of inflexible commodity – a natural commodity with a long tradition as a medium of exchange, such as gold, or maybe a new, man-made but scarce commodity, such as the cryptographic commodity Bitcoin, or something similar – as the basis for the financial system, and even if the market were to continue with the established denominations of dollars, yen, and so forth, as the public is, for now at least, still comfortable using them, would somehow link the issuance of these monetary units again to something inelastic that was not under anybody’s discretionary control.

In any case, if we assume that some type of ‘market-gold-standard’ would again resurface, it is very clear that under such purely market-driven, voluntary arrangements and with essentially hard money at its core, any FRB activity would be strictly limited. FRB-practicing banks would not have lender-of-last resort central banks watching their backs. There would be no limitless well of new bank reserves to bail out overstretched banks and to restart new credit cycles whenever the old ones have run their course. There would be no state-administered and tax-payer-guaranteed deposit insurance, or any other arrangement by which the cost of failure in banking could be socialized. Lowering reserve ratios and issuing additional fiduciary media (substitute money, i.e. deposit money) would be legal (the state would abstain from any involvement in monetary affairs, including the banning of any such activities) but it would come with considerable business risk, as it should be.

Would there still be FRB? Certainly. And in my view, the remaining FRB activity, adding as it does to the elasticity of the money supply at the margin and thus potentially distorting interest rate signals, is going to lead to capital misallocations to some degree, and thus initiate the occasional business cycle. That, in my view, is the price we have to pay for having a developed monetary economy and entire freedom in money and banking with all the undeniable advantages such a system brings. Importantly, I believe that these costs are unavoidable. But they are minor due to the absence of FRB-boosting state policy. – No, an entirely free market would not fulfil any dreams of uninterrupted bliss or realise the macroeconomist’s fantasy of everlasting ‘equilibrium’, both notions that Ludwig von Mises frequently rejected and ridiculed, but it would for sure be considerably better, and much more stable, than anything our present elastic monetary system can produce.

In Paper Money Collapse, I argue that inelasticity of supply is a virtue in money. That is why gold is such an excellent monetary asset. Complete inelasticity is unattainable in the real world but something like a proper gold standard is close enough. But for the ‘free bankers’ the remaining elasticity under restricted FRB (restricted by a stable commodity base) would be a boon. It would further stabilize the economy and establish…equilibrium. In my view, these claims are unsupported. But, you may say, why should we argue about the specific features of the post-fiat-money world if we are in agreement that such a post-fiat money world is in any case preferable to the present one?

The reason is simply this: how do we evaluate current policies? On this question I thought that most Austrians, as advocates of gold or something similar, and as critics of fiat money, would still be in broad agreement. But to my initial shock and my lasting amazement I found that some Austrian free bankers frequently cannot bring themselves to reject ‘quantitative easing’ and other heavy-handed central bank intervention on principle, and that they are able to embrace monetarist policy proposals, such as nominal GDP targeting by central banks, as a kind of second-best-solution that will do for as long as our first choice of separation of money and state is not realised. I believe these positions to stand in fundamental conflict with key tenets of the Austrian School of Economics and, apart from that and more importantly, to be simply unjustifiable. I think they are misguided. But it seems to me that the occasional support for them among free bankers originates in certain expectations as to what the equilibrating forces of ‘free banking’ would bring about in a free market in terms of a stable nominal GDP, and the free bankers can thus advocate certain forms of central bank activism if these are bound to generate these same outcomes. Therefore, in order to refute the idea of nominal GDP targeting we have to show that the free bankers’ expectations as to ‘monetary equilibrium’ under free banking lack a convincing analytical foundation. In this essay I want to pose some challenges for the free bankers. In a later article I hope to address NGDP-targeting as such.

Money does not need a producer

Among all goods money has a special place. It is the most liquid good and the only one that is demanded only for its exchange value, that is, its price in other goods and services. Anybody who has demand for money has demand for real money balances, that is, for effective purchasing power in the form of money. Nobody has demand for a specific quantity of the monetary asset per se, like a certain number of paper notes or a particular quantity of gold, but always for the specific purchasing power that these monetary assets convey.

In contrast to all other goods and services, changes in money demand can in theory be met by either producing additional quantities or by withdrawing and eliminating existing quantities of the monetary asset (changing the physical quantity of money), or by allowing the price of money, money’s exchange value, to change in response to the buying and selling of money versus non-money goods by the public (changing money’s purchasing power). Furthermore, it can be argued, as I do in Paper Money Collapse, that the superior market process for bringing demand for and supply of money in balance is the latter, i.e. the market-driven adjustment of nominal prices in response to the public’s buying and selling of money for non-money goods according to money demand. Why? – Well, mainly because the process of adjusting the physical quantity of money does not work. 1) We lack a procedure by which we can detect changes in money demand before they have begun to affect prices, and if prices are already beginning to change then these price changes already constitute the very process that satisfies the new money demand. This makes changing the quantity of money superfluous. 2) We lack a procedure by which we can expand and contract the supply of money without affecting the supply of credit and without changing interest rates. This makes changing the quantity of money dangerous. Money demand and loan demand are different things. Our modern fiat money systems are, in any case, not really designed for occasionally reducing the supply of money but for a continuous expansion of the money supply. As the Austrian Business Cycle Theory explains, expanding the supply of money by expanding bank credit must distort interest rates (artificially depress them) and lead to mismatches between voluntary saving and investment and thus to capital misallocations.

To this analysis the free bankers appear to voice a few objections. Before we look at the differences, however, let’s first stress an important agreement: the free bankers agree that nominal prices can do the adjusting and bring demand for and supply of money in balance. But they introduce an important condition: in the long run. In the short run, they argue, the process is not quite as smooth as many hard-money Austrians portray it to be.

Selgin and White (‘Defence’, 1996):

In the long run, nominal prices will adjust to equate supply and demand for money balances, whatever the nominal quantity of money. It does not follow, however, that each and every change in the supply of or demand for money will lead at once to a new long-run equilibrium, because the required price adjustments take time. They take time because not all agents are instantly and perfectly aware of changes in the money stock or money demand, and because some prices are costly to adjust and therefore “sticky.” It follows that, in the short run (empirically, think “for a number of months”), less than fully anticipated changes to the supply of or demand for money can give rise to monetary disequilibrium.

Thus, the first objection of the free bankers is that the account of the hard-money Austrians about the smooth adjustment of prices in response to changes in money demand is a bit superficial and slick. In the real world, not all prices will respond so quickly. Not all goods and services are being priced and re-priced in a continuous auction process, and when the public reduces money-outlays at the margin in an attempt to increase money-holdings, not every producer of goods and services will quickly adjust the price tags of his wares.

I do think some of this criticism is valid, and I am not excluding myself from it. My own account of the process of adjustment of money’s purchasing power sometimes runs the risk of glossing over the real-life frictions involved. However, to my defence, I acknowledged some of these problems in Paper Money Collapse, although I do not treat them extensively. See page 144-145:

In the absence of a flexible money supply, sudden changes in money demand will have to be fully absorbed by changes’ in money’s purchasing power. One could argue that this, too, has the potential to disrupt the otherwise smooth operation of the economy. Indeed, as we have seen, this phenomenon will also affect the prices of different goods differently. [This refers to the fact that when, for example, people try to raise their money holdings, they will reduce money-outlays on non-money goods or sell non-money goods for money, but they won’t cut every single expenditure item by an equal amount, or liquidate a tiny portion of each of their assets but will always cut the expenditure or sell the asset that is lowest on their present value scale. Downward pressure on prices from rising money demand will thus not be the same for all prices.]…A change in the demand for money will change overall prices but also relative prices and therefore the relative position of economic actors and the allocation of resources in the economy. All of this is true but it must lead to a different question: Is any of this avoidable….?

Is ‘monetary disequilibrium’ a unique phenomenon?

The free bankers are correct to point to these problems but it is also true that every change in the preferences of economic agents leads to similar problems. If consumer tastes change and money-flows are being redirected from certain products to certain other products, this, too, means that nominal spending on some items is being reduced. Profitability will decline in some parts of the economy and increase in others. This, too, will ultimate redirect resources and change the economy but all of these processes “take time because not all agents are instantly and perfectly aware …” of what is going on, and also for other reasons, including the stickiness of some prices. I think agents are never “instantly and perfectly aware” of anything, and that the slickness of economic models is never matched by reality. Accordingly, the real world is constantly in disequilibrium, and as economists we can only explain the underlying processes that tend towards equilibrium without ever reaching it. I wonder, however, if the concerns of the free bankers, valid though they are, are not just examples of the frictions that always exist in the real world, in which tastes and preferences change constantly, and change in an instant, but prices, knowledge, and resource use always move more slowly.

Furthermore, the issue of stickiness of prices should not be overstated. These days many prices do appear rather flexible and tend to adjust rather quickly: not only those of financial assets but also industrial commodities, and even many consumer goods, from used cars to hotel stays to flight tickets to everything on eBay. Discounting in response to a drop in nominal spending is the first of line of defense for almost every entrepreneur, I would guess, and if what the entrepreneur faces is indeed a higher money demand among his clientele, rather than a genuine change in consumption preferences, then sales should stabilize quickly at the lower price.

But I think the main point is this: how can the banks do better? What do the free bankers say to my two points above that changing the quantity of money is not really a viable alternative to allowing changes in nominal prices? Let’s address the first point first:

Point 1) We lack a procedure by which we can detect changes in money demand before they have begun to affect prices, and if prices are already beginning to change then these price changes already constitute the very process that satisfies the new money demand. This makes changing the quantity of money superfluous.

How do banks detect a change in money demand – before it has affected prices?

Banks have no facility to create money and money alone (deposit money, fiduciary media). New money is always a byproduct of banks’ lending operations. Banks can only create money by expanding their balance sheets. Thus, they always create an asset (a new loan) at the same time they create a new liability (the demand deposit in which the bank pays out the loan to the borrower, and which is part of the money supply). Therefore, if you suddenly experience a rise in money demand, if you suddenly feel the urge to hold more of your wealth in the form of the most fungible object (money), the bank can’t help you. Of course, you could go to the bank and borrow the money and then keep it in cash. This is a possibility but I think we all agree – and the free bankers seem to agree as well – that this is very unusual, and that it must be rare. Banks meet loan demand, not money demand, and the two are not only different, they are the opposite of one another. Borrowers do not have a high marginal demand for money; quite to the contrary, they have a high marginal demand for goods and services, i.e. non-money items (that is why they are willing to incur interest expense). The loan is in the form of money but the borrowers usually spend the money right away on whatever they really desire.

Banks are not in the money-creation business (or only in it by default – no pun intended); they are really in the lending business. The idea that rising money demand would articulate itself as higher loan demand at banks is wrong, and the free bankers do not usually make that mistake. They know (and some of them even stress) that money demand articulates itself in the markets for non-money goods and services (including, but not restricted to, financial assets). People reduce or increase spending in order to establish the desired money holdings.

To the extent that, when people experience a higher money demand, they sell financial assets to banks, the banks do indeed directly experience the heightened money demand, and if the banks increase their FRB activities in response and expand their balance sheets accordingly (the financial assets they buy enter the asset side of the balance sheet – they are the new loans – and the new demand deposits the banks issue to pay for them sit on the liability side of the balance sheet), the quantity of money is indeed being expanded in response to money demand. But to the extent that the public does not sell to FRB-practicing banks or that the public reduces other outlays or sells non-financial assets, the banks are not directly involved as counterparties. How can they still detect a rising money demand?

[As an aside, the free bankers sometimes speak of ‘the public having a higher demand for demand deposits or ‘inside money’ ’, and that the banks should be allowed to ‘accommodate’ this. I think these statements are confusing. Depositing physical cash in a bank, or conversely liquidating demand deposits to increase holdings of physical cash, are transactions between various forms of money. In a functioning FRB system, both forms of money, physical cash and bank-produced deposit money, are almost perfect surrogates. Both are used side by side, and both satisfy the demand for money. That is the precondition for FRB to work. The factors that occasionally determine preferences for a specific form of money are fundamentally different from those that affect the demand for money overall. If the public, for example, reduces demand deposits and accumulates physical cash, i.e. switches from ‘inside money’ to ‘outside money’, this may be because it is concerned about the health of the banks, and this is unrelated to the public’s demand for money, which in this case may be unchanged. As an example, in the recent crisis, the demand for physical cash increased in many countries, relative to the demand for bank deposits. At the same time, overall money demand also probably increased. But importantly, both phenomena are fundamentally different.]

The answer is this: if the public, in an attempt to raise money holdings, reduces money spending, this will slow the velocity of money, and to the banks this will be clearly visible. Money doesn’t change hands as quickly as before, and that includes transaction-ready deposit money at banks. Importantly, the slower velocity of money means a reduced risk of money outflows for each bank, in particular the likelihood of transfers to other banks that are a drain on existing bank reserves. Thus, the banks now have more scope to conduct FRB, that is, to reduce their reserve ratios, lower loan rates and issue more loans, and obviously to produce more deposit money in the process.

In the essay mentioned above, ‘In defence of fiduciary media’, this explanation appears in footnote 29, the emphasis here is different and so is the wording but the essence is the same, in my view. Banks increase FRB in response to a drop in money velocity. A rising money demand articulates itself in a lower velocity and thus a tendency for more FRB:

But how can the banks manage to expand their demand deposits, if total bank reserves have not changed? The increased demand to hold demand deposits, relative to income [increased money demand, DS], means that fewer checks are written per year per dollar of account balances. The marginal deposit dollar poses less of a threat to a bank’s reserves. Thus a bank can safely increase its ratio of deposits to reserves, increasing the volume of its deposits to the point where the rising liquidity cost plus interest and other costs of the last dollar of deposits again equals the marginal revenue from a dollar of assets.

I think this explanation is exceedingly clever and accurate. I do not, because I cannot, object to the logic. But does it help us? I have two observations:

1)   Is it really probable that this process is faster and more efficient than the adjustment of nominal prices? The objection of the free bankers was that the adjustment of nominal prices takes time. But so does this process. The bankers will not be “instantly and perfectly aware” of what is happening anymore than the producers of goods and services. When the public reduces spending in order to preserve money balances the effect will be felt as soon by the producers of whatever the public now spends less money on, as by the bankers who see fewer cheques being written. Why would we assume that the bankers respond faster? Sure, prices can be sticky, but does that mean that accelerated FRB will always beat nominal price changes in terms of speed? Will the bankers always expand their loan book faster than the affected producers discount their product? It is not clear to me why this would be the case.

2)   More importantly, the banks will, by definition, give the new deposit money first not to those who have a higher demand for money but to their loan clients who, we just established, have no demand for money but for goods and services, and who will quickly spend the money. From there, the money will circulate and may, finally, reach those who do indeed have a higher demand for money. But there is no escaping the fact that this is a roundabout process. For the very reason that banks can only produce money as a byproduct of their lending business, those who do demand higher money balances can only ever be reached via a detour through other markets, never directly. Bank-produced money has to go through the loan market first, and has to change hands a few times, before it can reach those who originally experienced a high money demand. There is no process as part of which we could ever hear a banker say to any of his customers: you have a higher money demand? Here, have some. – The question is now, what type of frictions or unintended consequences of this procedure of satisfying money demand do we encounter? Are these frictions likely to be smaller or even greater than the frictions inherent in allowing nominal prices to do the adjusting to meet changes in money demand?

Before we address these frictions a few words on a related topic: the free bankers sometimes seem to imply that unwanted fiduciary media (demand deposits, inside money) would return to the banks. This is not correct, or rather, it would only be correct if people wanted to exchange the demand deposit for physical cash but this is a transaction that is, as we have seen, unrelated to money demand. Claims against any specific bank may be unwanted, or demand deposits may be wanted less than physical cash, but this is unrelated to overall money demand. If deposit money is seen as a viable money good, and this is the precondition for FRB to work, any excess holding of money, whether inside money or outside money, whether cash or demand deposit, will not be returned to a bank and exchanged but will be spent! If banks increase their FRB activities and bring new fiduciary media into circulation, this money will circulate until it reaches somebody with genuine money demand. Often – when money demand has not risen simultaneously – this process involves inflation as a lower purchasing power for each monetary unit is required to get the public to voluntarily hold the new monetary units.

Is money demand a form of desired saving?

According to the free bankers, banks respond to a drop in money velocity as a result of rising money demand by engaging in extra FRB. At lower velocity, the risks inherent in FRB are smaller and this encourages banks to reduce their reserve ratios marginally, create extra loans and produce extra money, i.e. new deposit money that is now satisfying at least some of the new money demand. But what about the extra bank credit that also comes into existence? Hasn’t Mises shown that bank credit expansion is a source of economic instability; that bank credit expansion sets off business cycles? If extra loans at lower interest rates are not the result of additional voluntary saving but simply of money printing, and these loans still encourage extra investment and capital spending, then these additional projects will ultimately lack the real resources, resources that only voluntary saving can free up and redirect towards investment, that are needed to see the projects through to conclusion and to sustain them. Extra bank credit is thus bound to upset the market’s process of coordination between saving and investment – coordination that is directed via market interest rates. Would the extra FRB not start a Misesian business cycle? Would the allegedly faster and smoother process of satisfying changed money demand via FRB, via the adjustment in the nominal quantity of money rather than nominal price changes, not create new instabilities as a result of the artificially lower interest rates and the extra bank credit that are the necessary mirror image of new deposit money?

In Austrian theory, desired savings are a function of time preference. A lower time preference means the public attaches a lower importance to consumption in the near future relative to consumption in the more distant future. The discount rate at which future goods are discounted is lowered and the propensity to save rises, i.e. the willingness to reallocate income from meeting present consumption needs to meeting future consumption needs rises. The extra savings are offered on the loan markets at marginally lower rates. This encourages a marginal increase in investment. The marginally lower rates on the loan market thus accurately reflect the marginally lower time preference of the public. But lower rates as a result of credit expansion and FRB can unhinge this process. That is the core message of the Austrian Business Cycle Theory. How can the free bankers get out of this dilemma?

The free bankers counter this point by claiming that an increased demand for money reflects a lower time preference. Holding more money is a form of saving.

Although in the already quoted “Defence of Fiduciary Media”, Selgin and White at some point state that

We agree that time preference and money demand are distinct, and that a change in one does not imply a change in the other.

They also write, and this is more crucial to the case they are making, I believe,

The argument for the equilibrating properties of free banking rests in part on recognizing that 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.

In any case, in the examples they provide later, time preference, desired saving, and money demand always move together.

While I agree that accumulating money balances can be a form of saving (I say that much in Paper Money Collapse), it does not have to be the case, and I think it is more helpful to disentangle saving, consumption and money demand. Holding money is non-consuming, as Selgin and White point out, but it is equally non-investing.

If I sell my laptop on e-Bay so I have more readily spendable money (demand deposits) in my bank account so that I can take advantage of any unforeseen spending opportunities during my holiday in Greece, would we say that my time preference has declined, and that this is an act of saving? This is a switch from a consumption good to money, and Selgin and White would label this an act of saving, at least as I understand them. But the laptop would have delivered its use-value to me over a long period of time. Now I hold instantly spendable demand deposits instead. Has my time preference really dropped?

Here is a different example, one where we encounter a switch from investment goods to money, an example that Selgin and White put forward in their paper and where they argue that in such an operation total desired saving remains unchanged. Time preference remains the same. In the example given, the public sells bonds and accumulates cash or demand deposits instead. Both, money and bonds are non-consumption goods and thus saving-instruments in the Selgin and White definition. According to their theory, the banks would now acquire the bonds and issue deposit money against them. By doing this (increased FRB activity), the banks satisfy the demand for more money and keep interest rates from rising – which is appropriate as overall desired savings have not changed and time preference is still the same. – However, has the public’s time preference really not changed? Rather than holding a less liquid, long-term debt instrument the public now holds the most fungible asset (money). Is it fair to say that when people liquidate their bond portfolios that their time preference remains unchanged? – Maybe the public does this precisely for the reason that time preference has increased. The public may spend the money soon on consumption goods, or the public considers market interest rates too low and as no longer representative of the public’s time preference, and a drop in bond prices (rise in yields) is thus warranted to reflect this, and should not be cancelled out by the banks’ accelerated FRB.

The short run versus the long run

Furthermore, I suspect that there is an inconsistency in claiming that, in the long run, nominal price changes do bring the demand for and supply of money in line and then to argue that in the short run, money demand is best – and automatically – met by quantitative changes in the supply of money via FRB. The long run is evidently only a string of short runs, and if changes in money demand have been satisfied in the short run via FRB, how can these changes then still exercise up- or downward pressure on nominal prices in the long run?


The free bankers are correct to point to real-life frictions in the process of satisfying a changed money demand via an adjustment of nominal prices. The process is neither smooth nor instant, but then almost no market process is in reality. Their explanation that a rise in money demand will lead to a drop in money velocity and that this will, on the margin and under normal conditions, encourage additional FRB and thus an expansion of bank-produced money also strikes me as correct. Yet, the free bankers fail, in my view, to show convincingly why this process would be faster and smoother than the adjustment of nominal prices, and in particular, why the extra bank credit that also comes into existence through FRB would not generate the problems that the Austrian School under Mises has explained extensively.

If only a subset of the population, rather than the entire public, experiences a higher money demand – and this must be the more likely scenario by far – and this subset than reduces nominal spending on those goods and services that are relevant to this group, and if this then leads to a marginal drop in the prices of these goods and services, the extra demand of this group for real money balances has been met with potentially fairly limited frictions and side-effects, I would argue. By comparison, FRB can never meet money demand of any group directly. Banks always have to inject the new money into the economy via the loan market, that is, at a point where money demand is low and demand for non-money goods is high. Money demand will always be met in a roundabout way. Furthermore, the lowering of interest rates through the additional FRB activity is only unproblematic if the additional demand for real money balances is identical with desired saving and reflects a reduce time preference. These are rather heroic assumptions indeed.

Ludwig von Mises – The real free banker

The 100-percent-reserve Austrians have stuck – correctly in my view – with one of the most important insights of Austrian monetary theory as developed by the school’s most distinguished 20th century representative, Ludwig von Mises, namely the destabilizing force of credit expansion. Unfortunately, the 100-percent-reserve Austrians have taken the critique of banking too far. Claims of misrepresentation, deception, and fraud as being constituting elements of FRB go too far and remain ultimately unsupported.

The self-styled ‘free bankers’ are correct to reject these claims but they are taking their defense of FRB too far as well. By claiming that FRB could smoothly and quickly satisfy any changes in money demand they assign equilibrating properties to FRB that are ultimately unsupportable. In the process, they risk ignoring some of the most relevant Misesian insights. In particular the free bankers, it seems to me, tend to ignore that in an established FRB system, bank-produced fiduciary media (such as demand deposits) will be seen as near-perfect surrogates for money proper (such as state fiat money or gold). In such an environment the banks can (within limits) expand FRB and thus create more fiduciary media regardless of present money demand. Unwanted money (deposit money) then leads to a rise in money velocity and an upward pressure on nominal prices – it does not lead to the public exchanging deposit money for physical cash, as that would be just a switch from one form of money to another. Therefore, the unwanted bank-produced money – that entered the economy via the bank loan market – does not return to the banks. In my view, the free bankers ignore some of the dangers in FRB and overstate its equilibrating powers.

Both camps refer to Mises as an authority, albeit the ‘free bankers’ generally less so. Selgin and White, in their 1996 paper, quote Mises as a champion of free banking. I do, however, believe that the quote, taken from Human Action, has to be read in the context of Mises’ life-long and unwavering commitment to a proper gold standard. Here is the quote:

Free banking is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all the information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular – one is tempted to say normal – feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.

Crises and depressions, in Misesian theory, do not come about because of short-term mismatches between money demand and money supply, or frictions in the adjustment of nominal prices, but because of credit expansion. In order to appreciate Mises’s concerns over credit expansion, one does not have to consider bankers fraudsters (or ‘banksters’), and I can see no evidence in Mises’ writing that he saw bankers that way. But in order to agree with him that banks should be as free as all other enterprises – which, importantly, includes the freedom to fail – you do not have to assign them mystical equilibrating powers, either.

Mises’ conclusions were consistent and his recommendations practical: introduce inelastic, inflexible, apolitical money as the basis of the financial system, a hard monetary core, such as in a proper gold standard, and then allow banks the same freedom, under the same laws of corporation, that all other businesses enjoy – no special bans and no special privileges, such as ‘lenders of last resort’ or tax-payer-backed deposit insurance – and you can allow the market to operate. I believe that this should be the policy proposal under which all Austrians can and should unite.

Any deviation from the core Misesian message also occasionally gets ‘Austrians’ into some strange political company. With their damnation of FRB and allegations of fraud, the 100-percent-reserve Austrians seem at times to play into the hands of populist anti-bank fractions that have recently grown in influence since the financial crisis started, and to inadvertently be associated with the statist proposals of organizations such as the UK’s Positive Money or IMF economists Benes and Kumhof, all of whom consider money-creation by private banks – FRB- as the root of all evil and propose full control over the monetary sphere by the state – a proposal that could not be further from Mises’ ideals.

On the other side, the free bankers are in such awe of the assumed equilibrating powers of FRB in a free market that they confidently predict a stable (or at least reasonably stable) nominal GDP – and if we do not have free banking and a free market yet, why not have today’s central banks target nominal GDP to get a similar result under today’s statist monetary infrastructure? Bizarrely, and completely indefensibly, in my view, these Austrians end up joining forces with aggregate-demand-managing Keynesians or money-supply-managing monetarists. This is not only in fundamental conflict with many tenets of the Misesian framework – it is simply misguided, even under considerations of monetary realpolitik, i.e. of what is politically practicable presently but better than the present system.

Banks should be free but can only ever be so within a proper capitalist monetary system, and that is a system with a market-chosen monetary commodity at its core, and most certainly a hard and inelastic one. No new ‘target’ for central bank policy can ever achieve results that mirror the outcome of a properly functioning monetary system and a free banking market. We do not have a gold standard and free banking at present, and under these conditions I would suggest that a central bank that imitates a gold standard as closely as possible – i.e. one that ultimately keeps the monetary base fairly stable – would be, under the circumstances, the second best’, or least worst, solution. But a full treatment of the NGDP-targeting proposal will have to wait for another blog.

In the meantime, the debasement of paper money continues.

This article was previously published at


Time and Money

Continued from Et in Arcadia ego

Here we come full circle, for what this essentially presumes is that there exist no means by which to achieve the ready monetization of credit since that insidious process – which is one favoured equally by the fractional free bankers as much as by the central banking school and the chartalists – breaks the critical linkage of sacrifice today for satisfaction tomorrow which is what ensures that we do not overstretch our resources or overextend the timelines pertaining to their employment.

Though we have already touched upon the basis for this affirmation, it is so pivotal to the argument, that I will test your indulgence in trying to bring home the point, once and for all. 

When credit is not erroneously transmuted into money, it means that I, the lender, cede temporary control over my property to you, the borrower, postponing my enjoyment of the satisfactions it confers because you have made it plain to me that your desire for it is currently greater than mine. This difference in preference  is – like all such disparities – an exploitable opportunity for us both and, recognising this, my existing claim over a specified quantum of current goods is voluntarily transferred to you, meaning I must abstain from its consumption (whether productive or exhaustive) while you partake of it in my place in what is a wholly co-operative and, moreover, a logically and physically coherent exchange.

You, in return, promise to render me a somewhat larger service some specified time hence, as the reward for my forbearance and the price of your exigency. That surplus – what we regard as the interest payable – will therefore be seen to be the price of time not of money, much less of ‘liquidity’ as the Keynesians would have us believe. Hence, it emerges as a phenomenon much more fundamental to our psychology as mortals and to the Out of Eden impatience with which this afflicts us than to any happenstance of the ‘market for loanable funds’. Once you accept this interpretation, you are at once made aware of just what an abomination is an officially-sanctioned zero – or in some cases, a negative – interest rate and you are presumably one step from wondering whether this monstrosity can be anything other than unrelievedly counter-productive. 

Next, however, imagine that I take your IOU to the bank and that peculiar institution registers my claim upon its (largely intangible) resources in the form of a demand liability of the kind which – by custom, if not by legal privilege – routinely passes in the marketplace as money. Your promissory note – a title to a batch of future  goods not yet in being – has now undergone what we might facetiously call an ‘extreme maturity transformation’  which it has conferred upon me the ability to bid for any other batch of present goods of like value without further delay. It should, however, be obvious that no such goods exist since you have not had time to generate any replacements for the ones whose use I, their lender, supposedly forswore until such time as your substitutes are ready to used to fulfil your obligations, something we agreed would be the case only at some nominated point in the future.

More claims to present goods than goods themselves now exist (strictly speaking, the proportion of the first relative to the second has been artificially increased) and thus the actions we may now simultaneously undertake have become dangerously incongruous. Our initially co-ordinated and therefore unexceptionable plans have become instead a cause of what is an inflationary conflict no less than would be the case if I had sold you my place at the head of the queue for the cinema only to try to barge straight past you in a scramble for the seat in question.


What is worse, is that this disharmony will not be limited to us two consenting adults – indeed, we may both actually derive an undiminished benefit from it – but by dint of the very fact that the disturbance we have caused will ripple through the monetary aether to inflict its pain upon some wholly innocent third party who is blithely unaware of the shift in the monetary relation which we have occasioned with the aid of the bank. In our cinema analogy, the bank has given me a duplicate ticket which will allow me to bump some uncomprehending late-arrival out of the place for which he has paid and denying him his right to see the show.

Monetization in this manner has done nothing less than scramble the economic signals regarding the availability of goods in time and space. Thus  it confounds rational economic calculation in the round and so begins to render honest entrepreneurial ambition moot. Such a legalised misdemeanour is bad enough in isolation, but we know that this will be anything but an isolated infraction. When banks can monetize debts, they will: when they can grant credit in the absence of prior acts of saving, they will – indeed, we demand that they do no less out of the misplaced fear that otherwise economic expansion will be derailed.

The truth is, of course, that the greater the number of economic decisions which come to be conducted on such a falsified basis, the higher and more unstable is the house of cards we are constructing on the credulity of the masses, the conjuring tricks of their bankers, and the connivance of the authorities who are charged with their supervision.  Worse yet, the feedbacks at work are such that each new card we add to the pile appears to justify the installation of every other card beneath it and the more imposing the edifice grows, the more eagerly we rush to make our own contribution to this financial Tower of Babel and the more frenetically the banking system works to assist us until it finally collapses under the weight of its own contradictions. 

To modern ears, more attuned to the rarefied talk of the exotica of credit default swaps, payment-in-kind junk bonds, and barrier options, this may all seem rather laboured and old-fashioned with its parallels to the classical treatment of the ‘wage fund’ and its echoes of the hard money Currency School which fought the great controversy of the 19th Century with its loose credit, Banking School challengers.

For this I make no apology, for much of what we Austrians stand for can trace its roots back to the reasoning first laid out by Overstone, McCulloch, and Torrens in that grand debate, just as our opponents tonight can trace their lineage back to the likes of Tooke, Fullarton, and Gilbart (I might here blushingly recommend to you a modest little tome entitled Santayana’s Curse in which I deal with the relevance of the background to that debate to modern-day finance).

It is also important to bear in mind that the game of finance cannot be conducted in a vacuum, to always be clear that its workings exert a profound effect on everyday decision making and that finance is a force for good when the rules of that game are in harmony with those laws of scarcity and opportunity which govern what is loosely termed the ‘real’ economy of men and materials. 

Moreover, the elision of these two types of claims – money and credit – by what must be a fractional reserve bank has dramatically raised the stakes. The near limitless, fast-breeder proliferation of credit which this enables and the facile transformation of this credit into money breaks all sorts of self-regulating, negative feedback mechanisms between supply, demand, price, and discount rate. Greater, credit-fuelled demand leads to higher prices. 

Higher prices should discourage further demand, but instead encourage more people to borrow in order to play for a further rise in prices, just as it flatters the banking decision to grant such loans since the earlier ones now appear to be over-collateralized and their risk consequently diminished. Divorced from a grounding in the world of Things and no longer intermediators of scarce savings but simply keystroke creators of newly negotiable claims, our modern machinery is all too prone to unleash a spiral of destabilizing – and ultimately disastrous – speculation in place of what should be a mean-reverting arbitrage which effortlessly and naturally reduces rather than exacerbates untoward economic variation. 

Sadly, my monetarist and Keynesian rivals see nothing but positives in this arrangement and given their unanimity on the issue, I would hazard a guess that the complex adaptive system types are happy enough to bow to this consensus and to accept that this is simply the way things are when they construct their models and run their simulations. The laymen – even the expert laymen, if I may be allowed such an oxymoron – have been even more united in bemoaning anything which might inhibit banks’ ability to shower credit upon everyone and anyone who asks them for it. If we had no shadow banks, who would give the aspiring taxi-driver the price of his medallion or the wannabe nest-maker her mortgage, one participant asked, as if we all took it for granted that to enjoy goods for which one has not earned the means to pay was their god-given right.

Nor do the free-fractional types, as eloquently represented here by Professor George Selgin, have any objection to the mechanism itself, being, on the contrary, keen to suggest it will do far more good than harm by dampening down fluctuations which they fear may emanate from a suddenly increased to desire to hold money for its own sake. All they ask is that the ‘free’ banks they advocate are forced to come out from under the aegis of a central bank of issue and away from the current fiction of government deposit insurance and so have no-one to shield them from the consequences of any excess or imprudence into which they might stray.

It will probably not now surprise you to learn that while we agree that banks should indeed stand on their own two feet like those involved in any other branch of business, very few of us Austrians share his sanguinity on this issue, either on theoretical grounds or as a result of our own somewhat different interpretation of the (mainly Scottish) historical record.

For our part, we would rather that the kernel of money-proper around which all other obligations are arrayed is both unable to be near-costlessly expanded at political or commercial will or shrunk as a consequence of any wider calamity. Given this fixity, we trust that any change in economic circumstances will see prices adjust to reflect that without occasioning any major harm (our model economy has undergone a radical Auflockerung by now to ensure this). Nor do we believe that credit will be denied all flexibility, certainly not within the dictates of what the saver can be persuaded to accord to the investor, or the vendor to the buyer.

It is true that this would be a world characterized by the slow decline of most prices as human ingenuity and honest entrepreneurship were continuously brought to bear on the eternal problem of scarcity, but neither would this hold for us any terrors. After the initial transition, people would soon become acclimatized to such a benign environment and would adjust their expectations and their capital structures to best fit it. 

As for Professor Selgin’s bogeyman of a sudden tumultuous rush to hold money for its own sake – which apocalypse he fears above all should we prohibit his Free Banks from printing up such liabilities, willy-nilly – we see little reason to believe such impulses could reach very far up the pecuniary Richter scale in a society which had wisely denied itself the volatile mix of massive fictitious capital, extreme leverage, inflationary gambling, morally-hazardous speculation, soft-budget public choice profligacy, and reckless maturity mismatches with which we are so afflicted in our  present era of easy-money, chronic price-appreciation, and the granting of overarching central-bank ‘put-options’. 

Sound money is more likely to prove conducive to sound business practice and hence to a sound night’s sleep for all.


To sum up then, the only valid economics is micro, not macro; individual, not aggregate. Value is subjective not objective. The consumer is sovereign in the choice of where he spends his dollar – and all values can be imputed from where he does so – but he should first earn that dollar through his prior contribution to production.

Entrepreneurial discovery is the evolutionary mainspring which drives our secular material advance and the entrepreneurial profit motive – in an honest-money, rent-free world – is the ‘selfish gene’ of that ascent. That same motivation mobilizes the set-aside of thrift in the form of capital and capital – to risk pushing the biological metaphor beyond the point of useful illustration – is the enzyme pathway leading to the synthesis of what it is we most urgently want at the lowest possible cost. 

In all of this, the workings of a sound money should be so seamless and subliminal that we pay it no more attention than we do the fibre-optic networks or 4G radio waves used for the transmission of our digital data. Finance should be based on funding – i.e., the sequencing and surrender of the right to employ real resources through time.

That economics is an Austrian economics, not a monetarist one, a Keynesian one, nor a complex-adaptive system one and I heartily recommend it to your consideration.


Fed tightens control over banks activities

On Tuesday July 2, US central bank policy makers voted in favour of the US version of the global bank rules known as the Basel 3 accord. The cornerstone of the new rules is a requirement that banks maintain high quality capital, such as stock or retained earnings, equal to 7% of their loans and assets.

The bigger banks may be required to hold more than 9%. The Fed was also drafting new rules to limit how much banks can borrow to fund their business known as the leverage ratio.

We suggest that the introduction of new regulations by the Fed cannot make the current monetary system stable and prevent financial upheavals.

The main factor of instability in the modern banking system is the present paper standard which is supported by the existence of the central bank and fractional reserve lending.

Now in a true free market economy without the existence of the central bank, banks will have difficulties practicing fractional reserve banking.

Any attempt to do so will lead to bankruptcies, which will restrain any bank from attempting to lend out of “thin air”.

Fractional reserve banking can, however, be supported by the central bank. Note that through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks can engage jointly in the expansion of credit out of “thin air” via the practice of fractional reserve banking.

The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out, because the redemption of each will cancel the other redemption out.

By means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.

The consequences of the monetary management of the Fed as a rule are manifested in terms of boom-bust cycles.

As times goes by this type of management runs the risk of severely weakening the wealth generation process and runs the risk of severely curtailing so called real economic growth.

We maintain that as long as the present monetary system stays intact it is not possible to prevent a financial crisis similar to the one we had in 2007-9. The introduction of new tighter capital requirements by banks cannot make them more solvent in the present monetary system.

Meanwhile, banks have decided to restrain their activity irrespective of the Fed’s new rules. Note that they are sitting on close to $2cg trillion in excess cash reserves.  The yearly rate of growth of banks inflationary lending has fallen to 4.1% in June from 4.2% in May and 22.4% in June last year.

Once the economy enters a new economic bust banks are likely to run the risk of experiencing a new financial crisis, the reason being that so called current good quality loans could turn out to be bad assets once the bust unfolds.

A visible decline in the yearly rate of growth of banks inflationary lending is exerting a further downward pressure on the growth momentum of our monetary measure AMS.

Year-on-year the rate of growth in AMS stood at 7.7% in June against 8.3% in May and 11.8% in June last year.

We suggest that a visible decline in the growth momentum of AMS is expected to bust various bubble activities, which sprang up on the back of the previous increase in the growth momentum of money supply.

Remember that economic bust is about busting bubble activities. Beforehand it is not always clear which activity is a bubble and which is not.

Note that once a bust emerges seemingly good companies go belly up. Given that since 2008 the Fed has been pursuing extremely loose monetary policy this raises the likelihood that we have had a large increase in bubble activities as a percentage of overall activity.

Once the bust emerges this will affect a large percentage of bubble activities and hence banks that provided loans to these activities will discover that they hold a large amount of non-performing assets.

A likely further decline in lending is going to curtail lending out of “thin air” further and this will put a further pressure on the growth momentum of money supply.

In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates. Because the loan was originated out of nothing, it obviously couldn’t have had an owner.

In a free market, in contrast, when money i.e. gold is repaid, it is passed back to the original lender; the money stock stays intact.

Since the present monetary system is fundamentally unstable it is not possible to fix it. The central bank can keep the present paper standard going as long as the pool of real wealth is still expanding.

Once the pool begins to stagnate – or worse, shrinks – then no monetary pumping will be able to prevent the plunge of the system.

A better solution is of course to have a true free market and allow the gold to assert its monetary role. As opposed to the present monetary system in the framework of a gold standard money cannot disappear and set in motion the menace of the boom-bust cycles.

Summary and conclusion

Last week US central bank policy makers voted in favour of tighter rules on banks’ activities. The essence of the new rules is that banks maintain high quality capital equal to 7% of their assets. The new rules are aimed at making banks more solvent and to prevent repetitions of the 2008-2009 financial upheavals. We suggest that in the present monetary system which involves the existence of the central bank and fractional reserve banking it is not possible to make the monetary system more stable and immune to financial upheavals. As long as the Fed continues to tamper with interest rates and money supply we are going to have boom-bust cycles and financial upheavals.


Bank reform demands monetary reform – an essay for Banking 2020

This article was published yesterday at

A vision for the future

Today sees the return of the Financial Services (Banking Reform) Bill to Parliament. It does not do enough.

In the book Banking 2020: A vision for the future, my essay summarises the institutional problems with our monetary and banking orthodoxy:

The features of today’s banking system

As Governor of the Bank of England Sir Mervyn King told us in 2010: ‘Of all the many ways of organising banking, the worst is the one we have today.’

Notes and coins are irredeemable: the promise to pay the bearer on demand cannot be fulfilled, except with another note or coin with the same face value. Notes and coins are tokens worth less than their face value and are issued lawfully and exclusively by the state. This is fiat money.

When this money is deposited at the bank it becomes the bank’s property and a liability. The bank does not retain a full reserve on demand deposits. In the days of gold as money, fractional reserves on demand deposits explained how banks created credit. Today, credit expansion is not bounded by the redemption of notes, coins, and bank deposits in gold.

Because banks are funded by demand deposits but create credit on longer terms, they are risky investment vehicles subject to runs in a loss of confidence. States have come to provide taxpayer-funded deposit insurance. This subsidises commercial risk, producing more of it and creating moral hazard amongst depositors who need not concern themselves with the conduct of banks.

The state also provides a privileged lender of last resort: the central bank. It lends to illiquid but solvent banks getting them through moments of crisis. In a fiat money system, central banks have the power to create reserves and otherwise intervene openly in the money markets. Today this is most evident in the purchase of government bonds with new money, so-called quantitative easing.

The central banks also manipulate interest rates in the hope of maintaining a particular rate of price inflation through just the right rate of credit expansion to match economic growth. That otherwise free-market economists and commentators support such obvious economic central planning is one of the absurdities of contemporary life.

Compounding these flaws is the limited liability corporate form. Whereas limited liability was introduced to protect stockholders from rapacious directors, its consequence today is ensuring no one taking commercial risks within banks stands to share in the downside. This creates further moral hazard.

Regulatory decisions have been taken to encourage banks to make bad loans and dispose of them irresponsibly. Among these are the US Community Reinvestment Act and the present government’s various initiatives to promote the housing market and further credit expansion.

Having insisted banks make bad loans, the regulatory state imposed the counterproductive International Financial Reporting Standards (IFRS) which can over-value assets and over-state the capital position of banks. This drives the creation of financial products and deals which appear profitable but which are actually loss-making. Since these notoriously involve vast quantities of instruments tied to default, the system is booby-trapped.

Amongst the many practical consequences of these policies was the tripling of the money supply (M4) in the UK from £700 billion in 1997 to £2.2 trillion in 2010. Credit expansion at this rate has had predictable and profound consequences including asset bubbles, sectoral and geographic imbalances, unjust wealth inequality, erosion of physical capital, excess consumption over saving, and the redirection of scarce resources into unsustainable uses.

Moreover, credit cannot be expanded without limit. Eventually, the real world catches up with credit not backed by tangible assets: booms are followed by busts.

The essay provides some objectives for monetary reform and sets out proposals from Dowd et al and Huerta de Soto.

I was pleased that the Parliamentary Commission on Banking Standards highlighted problems with incentives and accounting – the conversation is going in the right direction. At some point, when it becomes apparent that Mervyn King was right and we do have the worst possible banking system, I hope decision makers will realise that banks and the product in which they deal, money, are inseparable and that meaningful banking reform demands monetary reform.

You can download the book here.


Regulating banks the Austrian way

Most people — from young to old and from all ends of the political spectrum — are united by a common bond. The idea that banks are deserving of taxpayer support is viewed as morally repugnant to them. Business owners see bank bailouts as an unfair advantage that is not extended to all businesses. Those typically on the political left see it as support for the establishment, and a slap in the faces of the little people. Those more at home on the political right see it as just another form of welfare: a wealth redistribution from the hard working segment of the population to the reckless gambling class of banksters.

Despite this common disdain for bankers, there is considerable disagreement on how to deal with them. One group sees less regulation as the solution — letting market forces work will allow the virtues of prudence and industry to prevail. This formulation sees these same market forces as limiting firm size naturally to evade the “too big to fail” issue, through many of the same incentives that foment competitive economic advancement.

Another group sees the solution as more regulation. The natural tendency in business, according to this group, is for large monopolies to form. As companies grow in size, they gain political influence as well as an aura of indispensability. The consequence is that not only will a company come to be seen as too big to fail, but it will also be politically influential enough to seek such recourse if troubles surface.

Like most answers, the truth lies somewhere in the middle.

The first group correctly notes that there are two specific drawbacks of increasing regulation. On the one hand, “one size fits all” regulatory policies (such as is commonly the case on the Federal level) are rarely capable of handling the intricacies and dynamics of business. They also have the effect of relaxing the attention individuals and businesses afford to their own behavior. Under the pretense that the state has enacted wise regulations, individuals see little need to actively monitor companies to make sure they behave in a responsible manner. Businesses too succumb to this mentality. By abiding by the existing regulatory regime, they take solace in knowing that any attack on their integrity can be brushed aside as an attack placed more appropriately on the failures of the regulating body.

On the other hand, increased regulation breeds the problem of what economists call “moral hazard.” An activity is morally hazardous when a party can reap the benefits of an action without incurring the costs. The financial industry is very obviously afflicted with moral hazard today.

Banks and other financial companies have largely abided by the law. I would venture a guess that there is no industry more heavily regulated than the financial services industry, and no industry that spends more time and resources making sure that it complies with this complex regulatory maze. Capital levels must be maintained, reporting must be prompt and transparent, and certain types of assets must be bought or not bought. Banks following these regulations get a sense that they will survive, if not flourish, provided they work within the confines of the law.

However, it is increasingly evident that the financial regulations put in place over the past decades are woefully inept at maintaining a healthy financial industry. In spite of (or perhaps because of) all these regulations, a great many companies are, shall we say, less than solvent. So, who is to blame? It would be easy to blame the companies themselves, except that they did everything that the regulators told them to do.

Why not at least consider relaxing regulations? Doing so would have a two-fold advantage.

On the one hand, businesses would be more obviously responsible for the instability they have now created. On the other hand, without regulations, more reckless or clumsily managed companies would have gone out of business already, lacking the benefit of a regulatory “parent” scolding them for their mistakes. The result would be fewer unstable businesses, and more attention to the dangers of one’s own actions.

I previously mentioned that both sides are correct to some degree, implying that those calling for more regulation had some merit to their arguments. And this is indeed true. However, to paraphrase Inigo Montoya, when they use the word “regulation,” I do not think it means what they think it means.

It is true that not all companies play on a level field. In the financial services industry, and particularly in the banking sector, this is especially apparent. Banks are granted a legal privilege of “fractional reserves.” The result is that banks behave in a way which is fundamentally different from any other type of business, and which is easy to misdiagnose as “inadequate regulation.”

A depositor places money in his bank. The result is a deposit, and the depositor has a claim to this sum of money at any moment. One would think that the bank would be obliged to keep the money on hand, much in the same way that other deposited goods — like grain in an elevator — must be kept on hand. The law begs to differ. Banks are obliged to keep only a portion, or fraction, of that deposit in their vaults and are free to use the remaining sum as they please. Canada and the United Kingdom are examples of countries where there is no legal requirement for a bank to hold any percentage of that original deposit in its vault. In the United States, if a bank has net transactions accounts (deposits and accounts receivable) of less than $12.4 million, the reserve ratio is also set at zero. This differs greatly from grain elevators, where the law strictly states that the elevator owner must keep 100 percent of the deposited grain in the silo.

There are two results of the practice of fractional reserve banking, neither of them positive for the average person.

First, banks grow larger because they have access to a funding source that would otherwise not be available if they conducted themselves by the same laws as other businesses. When commentators say “banks are different,” there is truth in the statement. They have a legal privilege that enables them to grow in scope beyond that which they could naturally. This also explains why many banks, and financial services companies, come to be viewed as too big to fail.

Second, banks become riskier. Every time a deposit is not backed 100 percent, the depositor is exposed to the possibility of not getting his deposit back in full. If a bank uses his deposit to fund a mortgage, and the borrower defaults and cannot repay the bank, there is a risk that the original depositor will lose some of his money. A more common case is a bank run, in which many depositors try to withdraw money at the same time. The result will be insufficient funds to simultaneously honor all redemption demands. This occurred with various banks in Iceland, Ireland, Britain, and Cyprus over the last four years.

Few people worry about this latter problem, however, because of the former one. Since banks have become too big to fail, we are assured that if one goes bankrupt, we as depositors do not stand to lose personally. The government has pledged implicitly, or even explicitly through deposit insurance, that it will step in and bail out the irresponsible actors.

The result is the confusing state of affairs that we have today with two sides both arguing for the same thing — banking stability — via two diametrically opposed means. The “more regulation” camp is pitted against the “less regulation” camp. 

A solution

These two camps are not mutually exclusive. We can solve the problems of moral hazard and “too big to fail” in one fell swoop by ending fractional reserve banking.

By ending this legal privilege, we eliminate the ability for banks to grow to such inordinate sizes. By abiding by the same legal principles (or “regulations,” if you will) as any other deposit-taking firm, banks are not unduly advantaged. If banks shrink in size, the “too big to fail” doctrine is eliminated, or at least greatly reduced. This means that depositors and bankers will realize that if a loss occurs to their bank, they personally stand to lose.

The risk of loss is a great force in removing moral hazard. Remember that it only arises when one person’s ability to gain is not constrained by the threat of a loss. Cognizant of ensuing losses, depositors will demand that their banks adhere to more prudent operating principles, and bankers will be forced to meet these demands.

The critics worried about “too big to fail” are right. We do need more “regulations,” in a sense. We need banks to be regulated by the same legal principles regarding fraud as every other business. The critics worried about moral hazard are also right. We need fewer of every other kind of regulation.

Repairing a broken financial system does not have to be hampered by irreconcilable political differences. Recognizing the true issues at stake — legal privilege and unconstrained risk taking — allows one to bring together advocates of widely differing solutions into one coherent group. Getting bankers to agree to all this is another story.

This article was previously published at


Cyprus and the unraveling of fractional-reserve banking

The “Cyprus deal” as it has been widely referred to in the media may mark the next to last act in the the slow motion collapse of fractional-reserve banking that began with the implosion of the savings-and-loan industry in the U.S. in the late 1980s.

This trend continued with the currency crises in Russia, Mexico, East Asia, and Argentina in the 1990s in which fractional-reserve banking played a decisive role. The unraveling of fractional-reserve banking became visible even to the average depositor during the financial meltdown of 2008 that ignited bank runs on some of the largest and most venerable financial institutions in the world. The final collapse was only averted by the multi-trillion dollar bailout of U.S. and foreign banks by the Federal Reserve.

Even more than the unprecedented financial crisis of 2008, however, recent events in Cyprus may have struck the mortal blow to fractional-reserve banking. For fractional-reserve banking can only exist for as long as the depositors have complete confidence that regardless of the financial woes that befall the bank entrusted with their “deposits,” they will always be able to withdraw them on demand at par in currency, the ultimate cash of any banking system.

Ever since World War Two governmental deposit insurance, backed up by the money-creating powers of the central bank, was seen as the unshakable guarantee that warranted such confidence. In effect, fractional-reserve banking was perceived as 100-percent banking by depositors, who acted as if their money was always “in the bank” thanks to the ability of central banks to conjure up money out of thin air (or in cyberspace).

Perversely the various crises involving fractional-reserve banking that struck time and again since the late 1980s only reinforced this belief among depositors, because troubled banks and thrift institutions were always bailed out with alacrity—especially the largest and least stable. Thus arose the “too-big-to-fail doctrine.” Under this doctrine, uninsured bank depositors and bondholders were generally made whole when large banks failed, because it was widely understood that the confidence in the entire banking system was a frail and evanescent thing that would break and completely dissipate as a result of the failure of even a single large institution.

Getting back to the Cyprus deal, admittedly it is hardly ideal from a free-market point of view. The solution in accord with free markets would not involve restricting deposit withdrawals, imposing fascistic capital controls on domestic residents and foreign investors, and dragooning taxpayers in the rest of the Eurozone into contributing to the bailout to the tune of 10 billion euros.

Nonetheless, the deal does convey a salutary message to bank depositors and creditors the world over. It does so by forcing previously untouchable senior bondholders and uninsured depositors in the Cypriot banks to bear part of the cost of the bailout. The bondholders of the two largest banks will be wiped out and it is reported that large depositors (i.e., those holding uninsured accounts exceeding 100,000 euros) at the Laiki Bank may also be completely wiped out, losing up to 4.2 billion euros, while large depositors at the Bank of Cyprus will lose between 30 and 60 percent of their deposits. Small depositors in both banks, who hold insured accounts of up to 100,000 euros, would retain the full value of their deposits.

The happy result will be that depositors, both insured and uninsured, in Europe and throughout the world will become much more cautious or even suspicious in dealing with fractional-reserve banks. They will be poised to grab their money and run at the slightest sign or rumor of instability. This will induce banks to radically alter the sources of the funds they raise to finance loans and investments, moving away from deposit and toward equity and bond financing. As was reported Tuesday, March 26, this is already expected by many analysts:

One potential spillover from the March 26 agreement is the knock-on effects for bank funding, analysts said. Banks typically fund themselves with some combination of deposits, equity, senior and subordinate notes and covered bonds, which are backed by a pool of high-quality assets that stay on the lender’s balance sheet.

The consequences of the Cyprus bailout could be that banks will be more likely to use contingent convertible bonds—known as CoCos—to raise money as their ability to encumber assets by issuing covered bonds reaches regulatory limits, said Chris Bowie at Ignis Asset Management Ltd. in London.

“We’d expect to see some deposit flight and a shift in funding towards a combination of covered bonds, real equity and quasi-equity,” said Bowie, who is head of credit portfolio management at Ignis, which oversees about $110 billion.

If this indeed occurs it will be a significant move toward a free-market financial system in which the radical mismatching of the maturities of assets and liabilities in the case of demand deposits is eliminated once and for all. A few more banking crises in the Eurozone—especially one in which insured depositors are made to participate in the so-called “bail-in”—will likely cause the faith in government deposit insurance to completely evaporate and with it confidence in the fractional-reserve banking system.

There may then naturally arise on the market a system in which equity, bonds, and genuine time deposits that cannot be redeemed before maturity become the exclusive sources of finance for bank loans and investments. Demand deposits, whether checkable or not, would be segregated in actual deposit banks which maintain 100-percent reserves and provide a range of payments systems from ATMs to debit cards.

While this conjecture may be overly optimistic, we are certainly a good deal closer to such an outcome today than we were before the “Cyprus deal” was struck. Of course we would be closer still if there were no bailout and the full brunt of the bank failures were borne solely by the creditors and depositors of the failed banks rather than partly by taxpayers. The latter solution would have completely and definitively exposed the true nature of fractional-reserve banking for all to see.

This article was previously published at


Good riddance to deposit ‘insurance’

Once the public furor and shrill media coverage have died down it will become clear that events in Cyprus did not mark the death of democracy or the end of the euro but potentially the beginning of the end of deposit ‘insurance’. If so, then three cheers to that. It may herald a return to honesty, transparency and responsibility in banking.

Let us start by looking at some of the facts of deposit banking: When you deposit money in a bank you forfeit ownership of money and gain ownership of a claim against the bank – a claim for instant repayment of money but a claim nonetheless. In 1848 the House of Lords stated it thus:

Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it…The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted.

This is not legal pedantry or just a matter of opinion but logical necessity that follows inescapably from how deposit banking has developed, how it was practiced in 1848 and how it is still practiced today. If ownership of the money had not passed from depositor to banker than the banker could not lend the money to a third party against interest and he could not pay interest to the depositor. If the depositor had retained full ownership of the deposited money, the banker would only be allowed to store it safely and to probably charge the depositor for the safe-keeping of his property. Money stored in a bank’s vault earns as little interest as money kept under a mattress. It is evidently not what bank depositors contract for. If interest is being paid – or ‘free’ banking services are being provided – the depositor must have agreed – at least implicitly – that the banker can ‘invest’ the money, i.e. put it at risk.

For more than 300 years banks have been in the business of funding loans that are risky and illiquid with deposits that are supposed to be safe and instantly redeemable. When banks fail, depositors lose money, although in former times, sturdier and more honest, no rational person claimed that the depositors were unfairly ‘bailed in’ or were the victims of ‘theft’.

Although the mechanics of fractional-reserve banking have not changed in 300 years the public’s expectations have evidently changed greatly.  Today banks are expected to lend ever more generously while depositors are supposed to not incur any risk of loss at all. This means squaring the circle but it has not stopped politicians from promising just such a feat: Enter deposit insurance. State deposit “insurance” is not insurance at all. Insurance companies calculate and calibrate risks, charge the insured party and set aside capital for when the insured event occurs. A state deposit ‘guarantee’, by contrast, is simply another unfunded government promise, extended in the hope that things won’t get that bad. When they finally do the state does what it always does: it will take from Peter to pay Paul. Cyprus is a case in point: Private insurance companies would have pulled the plug on a ballooning banking sector long ago while the Cypriot state, still the local monopolist of bank licensing and bank regulation, evidently looked on as the banks amassed deposits of four times GDP. In the end Cyprus’ government ran out of ‘Pauls’ to stick the bill to – and ‘Hans’ in Germany refused to get ‘bailed in’ completely (although he is still providing the lion’s share of the bailout).

Cyprus is just an extreme example of what the institutionalized obfuscation of risk and accountability that comes with state-protected banking can lead to. Deposit ‘insurance’ masks the risks and socializes the costs of fractional-reserve banking. Unlimited state paper money and central banks that assume the role of  “lenders of last resort” have the same effect. If the original idea behind these innovations was to make banking safer, it has not worked, as banks have become bigger and riskier than ever before, although I suspect that the real purpose of these ‘safety nets’ has always been to provide cover for more generous bank credit expansion.

Under present arrangements there is little incentive for banks to position themselves in the marketplace as particularly conservative. Depositors have been largely desensitized to the risks inherent in banking. They no longer reward prudent banks with inflows and punish overtly risky banks with the withdrawal of funds, and even if they do, the banks can now obtain almost unlimited funds from the central bank, at least as long as they have any asset that the central bank is willing to ‘monetize’. This is a low hurdle indeed as banks have become conduits for the never-ending policy of ‘stimulus’ and are thus being fattened further for the sake of more growth. Once a bank has ‘ticked the boxes’ and meets the minimum criteria of regulatory supervision, any additional probity would only subtract from potential shareholder returns. Our modern financial infrastructure has created an illusion of safety coupled with an illusion of prosperity thanks to artificially cheapened credit. The risk of the occasional run on an individual bank has now been replaced with the acute and rising risk of a run on the entire system.

This would change radically if we reintroduced free market principles into banking. Bankers would again be answerable to all their lenders, including small depositors, who would no longer be lulled into a false sense of security but, in their correctly-understood role as creditors to the banks, would become ‘deposit vigilantes’ and would help keep the banks in check. The banks would again have to communicate balance sheet strategy and risk management to the wider public in order to gain and maintain the public’s trust, and not just to a handful of highly specialized bureaucrats at the central bank or the state’s bank regulator. Banking would become less complex, more transparent and less leveraged. Conservative banking would again be a viable business model. And the wider public would begin to appreciate how dangerous the populist policies of cheap credit and naïve demands for ‘getting banks lending again’ ultimately are. The depositors are underwriting these policies and carry a lot of their risks.

This article was previously published at


Reforming fractional reserve banking

This article was included as an expert submission to Ron Paul’s Monetary Policy Anthology.

“When you’re one step ahead of the crowd you’re a genius. When you’re two steps ahead, you’re a crackpot.”[1]

-Rabbi Shlomo Riskin

Lincoln Square Synagogue, February 1998

“I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency and managing the currency I look upon to be an absurdity; the currency should regulate itself; it must be regulated by the trade and commerce of the world; I would neither allow the Bank of England nor any private banks to have what is called the management of the currency.

I should never contemplate any remedial measure, which left to the discretion of individuals to regulate the amount of currency by any principle or standard whatever… I should be sorry to trust the Bank of England again, having violated their principle [the Palmer rule]; for I never trust the same parties twice on an affair of such magnitude.”[2]

-Richard Cobden

Report from the Select Committee on Banks of Issue

British Parliament, April 1840



It is a great privilege to write this essay on money and banking reform to mark the retirement of Dr. Paul from Congress. We in the United Kingdom have much to thank Dr. Paul for his tireless campaigning on these issues, especially those raised in the full public glare of two Presidential campaigns, making money and banking reform resonate here as well more than it otherwise would have.

At the Cobden Centre, we have two great parliamentarians, like Dr. Paul also inspired by the Austrian School of Economics: Steve Baker, Member of Parliament (MP) for High Wycombe (my co-founder of the Cobden Centre); and Douglas Carswell, MP for Clacton. Taking the idea of full-reserve free banking, currency competition, honest accounting, and full open liability for bankers, they have produced four bills in Parliament which we will discuss next in summary.

The Financial Services (Deposit and Lending) Bill – 2010

Carswell describes the Deposit and Lending bill as follows:

My bill would give account holders legal ownership of their deposits, unless they indicated otherwise when opening the account. In other words, there would henceforth be two categories of bank account: deposit-taking accounts for investment purposes, and deposit-taking accounts for storage purposes. Banks would remain at liberty to lend on money deposited in the investment accounts, but not on money deposited in the storage accounts. As such, the idea is not a million miles away from the idea of 100% gilt-backed storage accounts proposed by other hon. Members and the Governor of the Bank of England.[3]

Currency and Banknotes (Amendment) – 2011

Carswell describes the Currency and Banknotes Amendment as follows:

That leave be given to bring in a Bill to amend the Currency and Banknotes Act 1954 to allow banknotes in addition to those issued by the Bank of England to be legal tender; and for connected purposes. … My Bill would amend the Currency and Banknotes Act 1954 to enable a range of different currencies to be used as legal tender in Britain. The idea comes from a 1989 Treasury paper from when John Major was Chancellor. What the Treasury proposed as theoretically possible 22 years ago, the internet now makes practically achievable.

The internet has given people unprecedented choice. We have access to a greater range of music, financial services, groceries and books than ever before, so why do we have legal tender laws that create a monopoly currency?[4]

In an email to me, Carswell expressed the influence Congressman Paul has had on his work:

Reading Ron Paul’s End the Fed gave me the confidence to speak out.  I suddenly realised it wasn’t just a few of us Brits who doubted the whole fiat money/candy floss currency scam.  He has given hope to those of us throughout the West.

Financial Services (Regulation of Derivatives) Bill

Steve Baker compiled the Regulation of Derivatives Bill with the help of Gordon Kerr, Tim Bush, and Kevin Dowd. [5] When he introduced the legislation on 15 March 2011, he described the Bill as requiring “certain financial institutions to prepare parallel accounts on the basis of the lower of historic cost and mark to market for their exposure to derivatives; and for connected purposes.”[6] Baker explained how the accounting rules for banks incentivize trading in derivatives by enabling unrealized profits to be booked up-front, leading to large but unjustified bonuses and dividends.

More broadly, banks are producing accounts that grossly inflate their profits and capital in three ways:

(1)     Using mark-to-market and mark-to-model accounting, banks record unrealized gains in investments as profits.

(2)     International Financial Reporting Standards (IFRS) prevent banks from making prudent provision for expected loan losses by allowing recognition only of incurred losses.

(3)     IFRS encourages banks not to deduct staff compensation from profits.

Taken together, these flaws mean that banks’ accounts under IFRS are at once rule-compliant and dangerously misleading. The Regulation of Derivatives Bill[7] deals with this broad problem. For much more detail, see Gordon Kerr’s Adam Smith Institute pamphlet, “The Law of Opposites.”[8]

Financial Institutions (Reform) Bill[9]

Baker compiled the Financial Institutions Reform Bill with the help of Gordon Kerr and Kevin Dowd. The bill was introduced on Wednesday, 29 February 2012. The key provisions of the bill would:

(1)     Enforce strict liability on directors of financial institutions;

(2)     Enforce unlimited personal liability on directors of financial institutions;

(3)     Require directors of financial institutions to post personal bonds as additional bank capital;

(4)     Require personal bonds and bonuses to be treated as additional bank capital;

(5)     Make provision for the insolvency of financial institutions; and

(6)     Establish a financial crimes investigation unit.

The purpose of this Bill is to minimise moral hazard within the financial system by ensuring that those who take risks are held personally liable for the consequences.  Since rules can usually be gamed by financial institutions, a principle underlying this Bill is to minimise scope for evasion.

Baker said,

The public are rightly incensed at the injustices we see across the financial system but our economy must have responsible, innovative and enterprising financial services.  It is essential that commercial freedom is maintained while creating a system in which remuneration is a just reward for success, not the unjust product of unrealised profits and bailouts.

My Bill would make directors of financial institutions personally liable for losses.  It would ensure that losses came first out of institutions’ bonus pools then directors’ personal bonds before hitting equity.  Directors would also be exposed to unlimited personal liability long before any suggestion of taxpayer bailout.

With key decision makers’ own wealth at risk, they would take responsible decisions instead of expecting rewards for failure.

It’s time to tell bankers, “Yes, innovate. By all means earn large rewards for providing valuable financial services. But bear your own commercial risks. Don’t expect the rest of us to bail you out.”[10]

Public Attitudes to Banking: A Survey Commissioned by the Cobden Centre (2010)[11]

When we started the Cobden Centre, we all thought we knew about money and banking and all thought we knew what our fellow Brits thought about it all. To the great credit of Prof. Anthony Evans, he said let’s do some empirical testing. And so the Cobden Centre commissioned a survey. This research formed the basis of much of the work our parliamentary friends have embarked upon.

The survey was conducted by the market research company ICM with 2,000 participants.  The results offer us a rather confusing array of views as to what people think banking is about.

  • 74% of respondents thought that they were the legal owner of the money in their current account, as opposed to the bank being the legal owner.
  • 66% of respondents answered “don’t know” when asked what proportion of their current account was used in various ways by their bank.
  • 15% wanted safe-keeping services.
  • 67% wanted convenient access.
  • 8% knew correctly that they had lent money to the bank.
  • 33% think it is wrong that the bank lends out what they view as their money.
  • 61% said they would not mind the bank lending if it was done safely.
  • 26% wanted reserves to match deposits.

It would seem a sizeable minority percentage would want some form of safe-keeping services.  Most would want easy access, which would imply short-term borrowing matched with short-term lending, so as to avoid runs, rather than the current practice of lending long and borrowing short.

The needs of savers and borrowers would be better aligned by requiring depositors to choose, at the time of making a deposit, how much money they wished to put into plain saving (i.e., savings set aside for safe/precautionary holding as opposed to investment purposes — a distinction made by the Austrian scholar Ludwig von Mises) and how much into capitalist saving (i.e., savings set aside for investment gain as opposed to safe/precautionary savings). This would provide the setting for, and lead to, much more stable and substantial growth.

In a modern setting, the ability for banks to distinguish between plain savings, those savings that people want for safe keeping, and savings for capitalistic investment via the normal savings bonds, time deposit accounts, and so on and so forth, would allow the banking system to mediate more accurately the diverse time preferences of all savers and borrowers.  (The Manchester/Lancashire system of full reserve banking and private money creation that we will discuss in the last part of this essay is a good historical example of how mediating only capitalistic savings, and not plain savings, created a system of safe credit—until it was interfered with by the Stamp Act.)

The ICM survey showed all of us that there is a need to sort out what people actually think happens with their money and banking and what actually does happen—as the two things are very different.

The Jesus Huerta De Soto Monetary Reform Proposal in Summary

Some three years ago I was fortunate enough to introduce both of our Parliamentarian friends to the greatest of all the living Austrian School economists in the full reserve tradition, Professor Jesus Huerta De Soto.  His 1998 book, translated into English in 2006 as Money, Bank Credit, and Economic Cycles, is the seminal treatise on the matter.

In chapter nine, he outlines his reform proposal. (All quotes in this section are taken from chapter nine and the full book can be downloaded at The aims of the reform, as summarized by Prof. Huerta De Soto himself, are as follows:

[O]ur proposal is based on privatizing money in its current form by replacing it with its metallic equivalent in gold and allowing the market to resume its free development from the time of the transition, either by confirming gold as the generally accepted form of money, or by permitting the spontaneous and gradual entrance of other monetary standards.

This second element of our proposal refers to the necessity of revoking banking legislation and eliminating central banks and in general any government agency devoted to controlling and intervening in the financial or banking market. It should be possible to set up any number of private banks with complete freedom, both in terms of corporate purpose and legal form. …

Nevertheless the defense of free banking does not imply permission for banks to operate with a fractional reserve. At this point it should be perfectly clear that banking should be subject to traditional legal principles and that these demand the maintenance at all times of a 100 percent reserve with respect to demand deposits at banks. Hence free banking must not be viewed as a license to infringe this rule, since its infringement not only constitutes a violation of a traditional legal principle, but it also triggers a chain of consequences which are highly damaging to the economy. [12]

The crux of his reform proposal is as follows (the description is mine and made UK-specific by me — read chapter nine in full for the complete version in the Professor’s own words):

(1)     All demand deposits are immaterial money, and are not the depositor’s money but a liability from the bank they deposit with to pay them back money in the same amount as deposited, on demand.

(2)     Let the government back all these demand deposits for physical cash and place them as reserves against the existing demand deposits. This is virtually a costless activity on behalf of the state. It is also not inflationary, as the backing, the physical cash, cannot be spent, as it sits in reserves.

(3)     The money supply can neither expand nor contract at this specific point.

(4)     The banks, where they had current liabilities, now no longer have them as they are fully reserved.

(5)     This generates a one-off gain to the banks in terms of their net worth. In short, so much as they had these current demand liabilities, now they have these backed with paper notes for the same value, so their net worth has gone up by the equivalent amount.

(6)     The asset side of the balance sheet, their loan portfolio, stays intact.

(7)     As there are over £1 trillion of demand deposits in the UK banking system, the banking system’s net worth would have risen by £1 trillion.

(8)     Why give this one-off gift of largesse to the shareholders and bonus-hungry bankers? Well, don’t. Form special purpose vehicles to hold the asset side of the balance sheets of the banks to collect on these outstanding loans and you can contract out the management of this to the existing banks.

(9)     By doing this, the banks’ net worth on the day after the reform is still the same as the day before the reform, but the £1 trillion loan repayments are now paying off our national debt obligations. This is a unique one-off gain and is a byproduct of this reform.

(10)     The gold price would need to rise to back all the deposits with gold and then you fix all money in one of its historic anchors: gold (you could also use silver or other successful monies). Since gold increases in physical supply at the rate of approximately 2% per year, if productivity gains run at about this rate you will have stable prices; if productivity rates are greater, then a benign price deflation.

(11)     Let the people spontaneously discover what their most favoured money actually is.

I have suggested my own reform proposal along this line of reasoning here:

In short, I would have no-reserve banking, not 100% reserve. By this, I have suggested that all demand deposits should actually be swapped out for physical cash and the current liability of the bank just rubbed out. Then the people would actually own their own money on deposit and not be current creditors, thus I would question the need to perform point number two and substitute along the lines of what I just suggested.

Would 100% Reserve Free Banking be the End of Lending and the End of Commerce as We Know It?

This is the question that gets asked when most people have understood that 100% reserve banking would be the end of bank-created credit. Many credible and distinguished people attribute the creation of bank credit as the source of the Industrial Revolution itself. Such a powerful thing is alleged.  The noted Daily Telegraph writer Ambrose Evans-Pritchard says in his 21 October 2012 column:

One might equally say that this opened the way to England’s agricultural revolution in the early 18th Century, the industrial revolution soon after, and the greatest economic and technological leap ever seen. But let us not quibble.[13]

For those followers of Dr. Paul and those generally interested in monetary reform in this tradition, I did some research into the genesis of the Industrial Revolution to see if this assertion held any merit. I have focused my research into the County of Lancashire and what became the first industrial city of the world, Manchester.[14] In this concluding historical section, I will show that in the first third of the Industrial Revolution, private credit, bills of exchange, backed by the goods and services that were being traded for and by gold and silver, was the preferred modus operandi. The taxation of this private money by the 1815 Stamp Act led to their slow decline in favour of the privileged note issue of, in particular, the Bank of England. However, by late 1874 some 45%[15] of all credit was still private credit in the form of bills of exchange. Private credit was the preferred medium of the Industrial Revolution, and not bank-created fiduciary credit.

Early Banking in Manchester

The historian Arthur Redford in his book about merchants and foreign trade in Manchester described the early bankers of the town:

The first Manchester Bank, that of Byron, Sedgwick, Allen, and Place, was opened in 1771, in combination with an insurance office, and the Mercury welcomed it with the comment that “from the general Approbation the Scheme has met with amongst all Ranks of People, it is not questioned that it will be of infinite Utility to the Trading Part of the Town, and to the County in general.” …. It was not the only Manchester banking business, for in 1772 John Jones and Co. were “Bankers and Tea Dealers” and within thirteen years were to have offices in London from which Jones Lloyds sprang. In Liverpool also most of the early bankers, says their historian, “arose out of general merchants, some few from tea dealers, and one from linen merchants.” Even after declaring themselves bankers, the banking business was usually continued along with trading. But the use of the term banker was late, and until almost the end of our period the commerce of Liverpool, with its complex dealings in foreign exchange, and the internal trade of Lancashire seem to have been carried on mainly through the bill discounting side of the merchants’ and traders’ businesses. In Liverpool marine insurance broking was closely allied.”[16]

The key thing I observe here is that in the first part of the Industrial Revolution the issue of notes (which were the chief means of bank fiduciary credit) was a side issue and bills of exchange were the main mechanism to facilitate this massive explosion in trade. Also, this first bank in the UK’s main industrial area was nearly 100 years behind the establishment of the Bank of England and the Scottish public banks.

Data supplied by Prof. Angus Maddison shows us that from 1700 to 1820 there is 338.38% growth in measured economic activity. The next 130 years saw 960.06% growth when the Industrial Revolution was in full flow.[17] Nevertheless, with the initial explosion of activity in the mid- to late-1700s, to the early 1820s, we see the prime industrial county in the world exist with few or no banks and banks not providing credit services as we know them today, and clearly not to its detriment.

Economic historian T. S. Ashton quotes William Langton (a driving force behind the founding of the Manchester Statistical Society in 1833) writing later in the 19th century:

“It is exceedingly natural,” said Langton, “that those banks which still retain the privilege of issuing their own notes should desire to retain it, since it naturally adds to their profits; but it has always been recognised in the great industrial district of Lancashire that it is no essential condition to the wielding of manufacturing and commercial enterprise, and that the banks not possessing this privilege have not stinted their customers of any legitimate accommodation.”[18]

Langton also notes their usefulness vis-a-vis other modes of money:

My personal memory of trade only extends back to the year 1820; but at that time the Liverpool merchants received nothing but bills in payment from Manchester of their cotton invoices; every such payment, if in what was called promiscuous paper, requiring a calculation of interest to make a settlement per appoint. This practice gradually disappeared with the resumption of cash payments by the Bank of England and the lowering of the standard rate of interest; but if economy of interest of money is to be taken as the special recommendation of any particular kind of circulating medium, this one surely ought to bear the palm![19]

W.T. Crick and J.E. Wadsworth note the significance of Manchester and the nearby City of Liverpool by observing:

Yet, in spite of Lancashire’s advanced industrial organization, banking was rather later to develop than in some other areas. No banks are recorded in Manchester until 1771 or in Liverpool until 1774, and when eventually they were formed, they do not appear to have acquired note circulations except in a few unimportant instances.[20]

Ashton describes the special preference for bills of exchange over notes:

These are reasons explaining the ubiquity of bills of exchange at this period. The special preference of Lancashire for bills rather than notes is a matter deserving of research. It arose, no doubt, out of a high degree of commercial confidence, no less than out of a low degree of trust in note-issuers, and the fact that Lancashire bought raw material from distant places and sold products in distant markets must also have engendered a preference for a document the circulation of which was not confined to the sphere of operations of a local bank. As time went on the domestic bill came to play a smaller part in commercial transactions: the increase of the stamp duties after the Napoleonic War dealt a blow to the system; and the growth of large banks of deposits with many branches, together with the shortening of the customary terms of credit, led to a substitution of cheques for bills in inland trade during the later decades of the nineteenth century. But in the period with which we are concerned cheques were in their infancy and the bill had no serious rival as a medium of exchange between traders.[21]

Ashton also gives us clues as to why they have almost vanished today from the commercial idiom as the stamp duty applied to them was less advantageous vis-a-vis note or chequebook issue as the latter provided quicker redemption in money possibilities.

If we dig a bit further into the historical record we see that these bills arose spontaneously to fulfill a need to be able to facilitate the smooth transmission of trade. A wonderful book written by Alfred P. Wadsworth & Julia De Lacy Mann, The Cotton Trade and Industrial Lancashire 1600-1780, documents this history quite thoroughly:

We have seen Marsden as a manufacturer, putting out cotton and yarn through his agent and debiting the materials and wages against the value of the finished goods. On the other side he maintained a London house, through which he bought his raw materials and sold his fustians, and in connection with which he conducted extensive operations as a bill discounter. Between 1688 and 1690 he was involved in a maze of lawsuits, from which some account of his business may be constructed


Having “constantly great and considerable sums of money in his hands” [Marsden] lent money to other dealers in return for their bills on London; or he “furnished them with bills of exchange for payment of considerable sums of money at London to them or their order, or to such persons as they appointed to receive the same,” either receiving cash, or, generally, giving them credit at an agreed rate of interest. When they failed to pay him for the bills he had given them, he would take an assignment of their goods at Liverpool —cotton or linen yarn, promissory notes, or bills drawn on their London debtors. But apart from his own trading credit, he had “for many years past been intrusted or employed with greate parte of the monies retorned out of the county of Lancaster to London.”[22]

Marsden the industrialist had become the banker as well as the chief remitter of revenues back to Lancashire and the principal collector of taxes. Daniel Defoe, trader, writer, and journalist, remarked in 1727, that:

[A] very great part of the bills drawn out of the several counties in England upon the tradesmen in London, such as factors and warehousekeepers, are made payable to the General Receivers of the several taxes and duties, customs and excise, which are levied in the country in specie, and the money is remitted by those collectors and receivers on account of those duties; this generally appears by the bills or endorsements, which often mention it in these words for his Majesty’s use.[23]

Thus credit was granted and discounted bills accepted and paid with specie, not with notes or other such fiduciary credit. The Crown accepted these bills!

In commenting upon the various inaccuracies with traders being bankers, after an extensive investigation into the disputes listed in the court records, Wadsworth and Mann conclude:

Much might be said of the use of the bill in the general system of credit, but enough, perhaps, has been suggested in earlier pages to indicate its importance. The bill on London, then as a century later the dominant form, entered at every stage, and into every form of transaction, ran from the smallest to the largest sums, and passed even more freely than cash. The financial mechanism which turned on the bill, the promissory note, and other credit instruments, and has here been summarily illustrated, bulks large in all the commercial manuals of the time. … It is apt to be forgotten that the credit machinery of industries like the textile trades was hardly less extensive before the foundation of the country banks than it became after.[24]

Unwin, Hulme, and Taylor did a fantastic investigation into the affairs of Samuel Oldknow and his mill at Mellor. There is also some evidence to show why Lancashire rejected bills vs. notes:

Enough has been said to show the almost desperate condition of Oldknow’s affairs at the beginning of 1793. He had invested an immense capital—for those days—in the fixed forms of land, buildings, and machinery which could not yield any return without the assistance of commercial credit—and owing to the outbreak of war commercial credit had almost ceased for the time being to exist. No fewer than 872 bankruptcies were recorded between November 1792 and July 1793. The problem of credit currency became acute. The country banks, which had multiplied greatly during the previous decade, had produced an over-issue of notes, some of them for such small amounts as to provoke the derisive issue by a Newcastle cobbler of a note for two-pence. But the notes even of the sounder banks were now returned on their hands and many were obliged to close their doors.[25]

The instability that these free banks issuing fiduciary credit afforded the industrialist in the times of crises was very destabilising, as you did not want to become a creditor to a bankrupt banker. This is one way to accelerate your own potential to become bankrupt. So commercial credit, or bills backed by real goods, was sought in preference.

Why did these Lancashire Bills Decline?

Henry Thornton, an economist, banker, and Parliamentarian, commented on the demise of bills to the favour of notes in 1802: “Some Bank of England notes have also been recently employed in the place of small bills on London, the use of which has been discouraged by the late additional duty on bills and notes.”[26]

Redford discusses the response of Manchester merchants to the duties and taxes imposed on bills of exchange:

A much more protracted struggle, extending throughout the second quarter of the nineteenth century, was waged by the Manchester merchants against excessive stamp duties on various kinds of legal documents. … Bills of exchange and promissory notes were first subjected to stamp duties in 1782; a general Stamp Act of 1815 had increased the duties, which thenceforth discriminated between short-dated and long-dated bills. In the post-war period the average duty on all bills of less than £50 was 1/2 per cent.; but this charge was felt to be prohibitive, and had in Manchester caused bills to be almost completely replaced by bank notes. Bank notes, however, were considered to be a much more inconvenient and risky means of payment, since they were payable “to bearer” and not “to order.” The Manchester Chamber of Commerce therefore moved in 1822 for the reduction of the duties, and sent up several petitions on the subject, to the Prime Minister, the Chancellor of the Exchequer, and the Houses of Parliament. The petitioners described the serious inconvenience to business which had resulted from the virtual extinction of “a description of currency of great convenience and security”; they suggested a greatly reduced scale of duties, and argued that, if this were adopted, not only the business community but also the revenue would benefit greatly, because of the increased use of bills of exchange.[27]

The Bank of England (BoE) was still a private bank at the time. However, as the government’s favoured bank it had certain privileges and was always lobbying for more. The 1815 Stamp Act made the reissue of bills of exchange virtually impossible. Some were taxed up to 460% higher than Bank of England note issue, or subject to great penalty that made the issue of private credit by other banks more expensive than BoE note issue. In 1825 the Bank of England set up a branch in Manchester specifically to take advantage of the terrible taxation placed on private bill issue and make sure that those pioneers of the Industrial Revolution had to take BoE credit.

The significance of Manchester as the prime industrial area of the world at the time does make it a meaningful and worthy study area from which we can extrapolate, hopefully, our findings to the wider canvas of today and I submit that in the absence of bank-created credit we, like our ancestors, have nothing to fear. Indeed, like the pioneers of the Industrial Revolution, we should embrace private money solutions such as bills of exchange and rely on the lending of real savings to provide real capital to entrepreneurs and not bank credit created out of nowhere. Full-reserve systems are not only stable, but growth enhancing. Lending does not die as many advocates of fractional reserve banking dread.

[1] Arizona Jewish Post, 18 September 1998

[2] Report from Select Committee on Banks of Issue, Ordered, by The House of Commons, to be printed, 7 August 1840.

[8] Gordon Kerr, “The Law of Opposites: Illusory Profits in the Financial Sector.”

[12] Huerta de Soto, Jesus. Money, Credit, and Economic Cycles. 2nd edition. Auburn, AL: Ludwig von Mises Institute, 2009, pp. 739-740.

[14] Although the City of Manchester is now part of Greater Manchester or the Greater Manchester Urban Area, prior to 1835 it was part of the Salford Hundred of the county of Lancashire. By 1853, it had reached full City status.  So for the majority of this essay’s focus, when Lancashire is referred to, it certainly should be read to be synonymous with what is the heart of Manchester City today. Also, you will see Liverpool mentioned as well, often in the same light as Manchester. This is due to their close geographic connection and the Port of Liverpool being often the import and export venue for the Manchester manufacturers.

[15] Dun, John. British Banking Statistics. London: E. Stanford, 1876, p. 87.

[16] Redford, Arthur. Manchester Merchants and Foreign Trade. Manchester: Manchester University Press, 1934, p. 248.

[17] Maddison, Angus. Contours of the World Economy 1-2030 AD: Essays in Macro-Economic History, Oxford: Oxford University Print, 2007. (Table can also be found at

[18] Ashton, Thomas Southcliffe. Economic and Social Investigations in Manchester, 1833-1933. London: P.S. King & Son, 1934.

[19] Langton, William qtd. in Ashton.

[20] Crick, W.F., and Wadsworth, J.E. A Hundred Years of Joint Stock Banking. London: Holder & Stoughton, 1936, pp. 142-143.

[21] Ashton, Thomas Southcliffe. An Eighteenth-Century Industrialist: Peter Stubs of Warrington 1756-1806. Manchester: Manchester University Press, 1939, p. 139.

[22]Wadsworth, Alfred P., and Mann, Julia De Lacy. The Cotton Trade and Industrial Lancashire, 1600-1780. Manchester: Manchester University Press, 1931, pp. 92-93.

[23] Defoe, Daniel, qtd. in Wadsworth and Mann,  p. 93.

[24] Wadsworth & Mann, p. 96.

[25] Unwin, George, Hulme, Arthur, and Taylor, George. Samuel Oldknow and the Arkwrights: the Industrial Revolution at Stockport and Marple. Manchester: Manchester University Press, p. 79.

[26] Thornton, Henry An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802), London: George Allen and Unwin, 1939, note to p. 214.

[27] Redford, p. 209.