[Editor’s Note: this is from the World Dollar Foundation, and can be found here]
Part 1: The Bank Run Incentive
There is an incentive to start bank runs due to a) the fallacy of fractional-reserve banking, and b) the fallacy of deposit “guarantees”.
A. The Fallacy of Fractional-reserve banking
A fractional-reserve bank issues more property titles than there is actual underlying property. The total value of property titles cannot exceed the total value of actual underlying property. Therefore, holders of property titles have an incentive to act quickest in withdrawing the actual underlying property. Those who act slowest are the losers, as they fail to withdraw any of the actual underlying property.
B. The Fallacy of Deposit “Guarantees”
In the event of a systemic run on fractional-reserve banks, all of the actual underlying property is withdrawn. Therefore, no actual underlying property exists with which the government could fulfil deposit “guarantees”, unless new underlying property is created.
However, the government does not create new underlying property at will. Only the central bank can create new underlying property, doing so on the expectation that it is to be repaid, for its subsequent destruction. Therefore, the central bank will not issue the government with the new underlying property to fulfil the deposit “guarantees” with, unless it believes the government can credibly repay it. In other words, the deposits are not “guaranteed” at all by the party that actually has the power to create new underlying property.
If the central bank determines that the government cannot credibly repay, it is a concession that the risk is too high that the central bank cannot meet its own liability to destroy the property (upon its intended repayment). Therefore, the government that forces the central bank (against its wishes) to issue it with new underlying property can perceivably drive the central bank into declaring bankruptcy, jeopardising the entire monetary system.
However, even if we reject the idea that deposit “guarantees” are a fallacy, there is still a big problem. The entire monetary system is jeopardised by the reality that the business model of the central bank is, in fact, bankrupt. This fact is seemingly unbeknownst to even the central bankers themselves, and is covered next in Part 2.
Part 2: The Bankrupt Business Model of the Central Bank
The business model of the central bank is bankrupt due to a) the impossibility of making a profit in the long run, b) the virtual certainty of making a loss in the long run.
A. The Impossibility of Making a Profit in the Long Run
The central bank lends money into existence, and destroys it upon its repayment. It is impossible for more money to be repaid than is lent into existence. Therefore, it is impossible for the central bank to make a profit in the long run.
B. The Virtual Certainty of Making a Loss in the Long Run
All money lent into existence carries the risk of not being repaid. Therefore, it is virtually impossible for the central bank to recover 100% of the money it lends into existence. Therefore, it is virtually guaranteed that the central bank makes a loss in the long run.
In terms of the balance sheet (a “snapshot” of the present affairs) of the central bank, it must be the case that it its liabilities always exceed its assets, provided that the provision for doubtful debts is correctly factored in.
However, in order for the central bank not to be declared bankrupt, it must be held that there is no virtual certainty of making a loss in the long run. Therefore, it must be held that the central bank can recover 100% of the money it lends into existence (with virtual certainty). This incorrect belief is based on a fallacy called the credit theory of money, covered next in Part 3.
Part 3: The Fallacy of the Credit Theory of Money
According to the credit theory of money, the value of money ultimately rests on the obligation of the debtor to pay his debt. It is held that money must, in the long run, return to the creator of the money, for the money keeps being chased by those debtors who have an obligation to pay their debt to the creator of the money.
However, the credit theory of money is a fallacy. The value of money ultimately rests on its use as a medium of exchange, eliminating the inefficient “double coincidence of wants” present in barter. Money can circulate among members of the trading public (in perpetuity) for precisely this reason.
There is no rule that money must eventually return to those who have debts to pay, and indeed this is a highly unrealistic assumption, due to a) market forces in the supply of goods and services, b) market forces in the supply of money.
A. Market forces in the supply of goods and services
In the market economy, there is no rule that those who receive a greater amount of loans must outcompete those who receive a lesser amount of loans. Those who who receive a lesser amount of loans can win in market competition by being more efficient in meeting the demands of the trading public.
In addition, when investment is financed by credit not backed by true saving, it is termed “malinvestment”, as it tends to be inconsistent with the tastes and preferences of consumers and producers, and of the availability of scarce resources, thus increasing the likelihood of defaults.
B. Market forces in the supply of money
By having a (credit) money creator, winners and losers are created as a result of artificial barriers or prejudices or preferences. The recipients of greater amounts of loans tend to be benefitted, but the key winner is, of course, the (credit) money creator itself, as it canperpetually misappropriate wealth from the rest of society.
This fundamentally unfair system means there can be legitimate demand for heterogeneity to be introduced into the money supply. For instance, if in a given time period, the (credit) money creator expands the supply of money by a disproportionately large amount, the market could decide to scale down the value of these monetary units, as it amounts toexpropriation of the existing holders of money. Alternatively, new monetary units could be rejected entirely. There is simply no need to have a growing supply of money in order to have a growing economy. Instances such as these would make it highly challenging for the money to assuredly go back to the debtors of the (credit) money creator.
Another strong market incentive is to switch to an alternative monetary system, such as one with the use of precious metals such as gold or silver, or one with the use of World Dollar, a new currency based on the idea that the ultimate basis for money, a social convention, is for it to be issued to everyone, equally. If the market does switch, the (credit) money risks declining rapidly in value, even to the extent of becoming entirely worthless.
[Editor’s note: the following piece was originally published by World Dollar at zerohedge.com]
In 2003, Jörg Guido Hülsmann, a senior fellow of the Mises Institute, published the essay “Has Fractional-Reserve Banking Really Passed the Market Test?” in a Winter edition of The Independent Review. The key conclusion drawn was that it is the obfuscation of the difference between fractional-reserve IOUs and genuine money titles which preserves the the practice of fractional-reserve banking.
It is the belief of this author that this essay has not received the acclaim that it so richly deserves. Indeed, its implications for the future of money and banking are monumentous. If those who advance the Austrian School of economics, the Mises Institute and Zero Hedge most prominently among them, were to grant its ideas a great renaissance, the worldwide return to sound money may happen far sooner than most could have believed possible.
J.G. Hülsmann explains why “in a free market with proper product differentiation, fractional-reserve banking would play virtually no monetary role” (p.403). The incisive reason given is that genuine money titles are valued at par with money proper, while fractional-reserve IOUs + RP (Redemption Promise) would be valued below par, due to default risk.
Here is the deductive argument being made:
1. Debt (IOUs + RP) is promised money.
2. A promise has the risk of not being kept (default risk).
3. Therefore, promised money, debt (IOUs + RP), is less valuable than genuine money titles (/money proper).
J.G. Hülsmann goes on to explain why the mispricing of fractional-reserve debt (IOUs + RP) persists. The reasons given include the outlawing of genuine money titles and deceptive language (“deposits”). This author would like to add one more reason, namely the myth that the government could actually “guarantee” deposits in the event of a systemic run. Systemic runs mean, by definition, most if not all money proper exiting the fractional reserve banking system, meaning the money proper with which the “guarantees” could be fulfilled doesn’t exist, short of unprecedented levels of new money printing and financial repression. This point is acknowledged on p.22 of the otherwise unexceptional “The Chicago Plan Revisited” by Jaromir Benes and Michael Kumhof.
The history of fractional reserve banking is, then, defined by informational inefficiency. Market participants have failed to reflect the price differential between fractional reserve debt (IOUs + RP) and genuine money titles.
Let us now extend the deductive argument:
4. Therefore, an arbitrage opportunity exists. All holders of Debt (IOUs + RP) have an economic incentive to make the redemption request for genuine money titles (/money proper).
Mervyn King, ex-governor of the Bank of England, once claimed that it is irrational to start a bank run, but rational to participate in one once it has started. While the second part of the claim is correct, the first is not. It is irrational not to start a bank run, due to the arbitrage opportunity that exists.
This, of course, holds the assumption that the market will become informationally efficient, and will therefore capitalise on the mispricing. But the holding of this assumption is only credible if this idea is spread. We live in a time with an unprecedented level of competing voices wanting to be heard, the unfortunate consequence of which is that we drown out the voices that are truly exceptional. It is no exaggeration to say that “Has Fractional-Reserve Banking Really Passed the Market Test?” may prove to be the most revolutionary essay in the history of monetary economics and banking, if only it receives the level of appraisal and promotion it deserves.
On this matter, the reasons given for the persistence of the mispricing of fractional-reserve debt (IOUs + RP) are unsustainable in the long run. The lack of legal protection for genuine money titles is no more than a technicality, for there is nothing in practice that can sustainably prevent the existence of full reserve banks. Awareness that “deposits” are not actually money being held for safekeeping is a matter of educating the public, as is awareness that government’s deposit “guarantees” are not actually credible in the event of a systemic run.
If we assume, then, that fractional-reserve banking will come to its logical ending, there is good reason to believe that the shock will herald the endgame for fiat money. It is in fact the case that all fiat money is the liability of the central bank, which also carries the risk of non-repayment (default risk). This, again, means an arbitrage opportunity for market participants to withdraw the fiat money from the fiat money banking system. This confirms that the original basis for fiat money is destroyed, for its repayment to the central bank is not credible.
Finally, at long last, we have a worldwide return to sound money. Will there be a new 21st century Gold Standard? Will we recourse to cryptocurrencies such as Bitcoin? Will we see the rise of the Equal Opportunity Standard, with everyone in the world being issued once with an equal amount of World dollars? Or will there be another innovation to come? What we must defend, as proud advocates of freedom, is that the free market will decide. That governments finally learn to stop their oppressive, damaging interference with the monetary system.
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.
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.
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 DetlevSchlichter.com.
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.
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.
This article was published yesterday at stevebaker.info.
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.
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.
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 Mises.org.
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 Mises.org.