Regular readers may recollect Philipp Bagus and David Howden’s recent publication in the QJAE, where they provide a critique of fractional reserve free banking. They place particular emphasis on the work of George Selgin, and he has responded with “Mere Quibbles: Bagus and Howden’s Critique of The Theory of Free Banking“.
Steve Horwitz and I have also written a response, touching some of the same ground as George but intending to focus on different points. Here is the abstract:
In their recent article in the Quarterly Journal of Austrian Economics, Bagus and Howden (2010) present “quibbles” with fractional reserve free banking. Or specifically, what they call “unaddressed issues” in this system, with a particular emphasis on Selgin (1988). We deem their arguments to be more substantial than “quibbles” and are part of a longstanding debate about fundamental aspects of monetary theory. We respond to their objections and attempt to specify how debate between the two sides might proceed more productively.
It’s called “An Appeal for Better Scholarly Discourse: How Bagus and Howden Have it Wrong on Free Banking“, and can be downloaded here.
Fractional reserve banking wouldn’t be as risky if all economic participants were allowed to build up real capital (tools, housing, even precious metals etc), then if the debtor runs into difficulties they always have goods that can be liquidated.
But the economy is skewed in favour of the unproductive, we hand homeowners massive unearned freebies and to pay for we tax production. This encourages house price speculation, forces our collective fixed costs up and prevents the “poor” from accessing the fruits of their production, before they can even eat they must first satisfy their landlord’s demands for rent. This ongoing liability adds to their credit risk profile.
This is why banks like to lend against housing, it mitigates the risk. Just as governments are considered safe(ish) debtors because they have a guaranteed stream of income (the taxpayer) housing/land is also seen as a safe bet because it has a guaranteed stream of income; rent.
There are no easy answers, but when the economy has it’s hands tied it makes it very difficult for lenders to make the right decisions.
The question in your linked piece asking “how will a bank know when to increase the money supply ?”, is easily answered if the currency is gold backed. If the bank watches the price of gold in that currency and if the price of gold fell that would signal that the bank could increase the money supply proportionally. The reason being that gold correlates(inversely) to the REAL interest rate , which in turn tracks the real growth of the economy.(see Summers and Barskey’s paper proving this, and also Keynes conclusion after studying 200 years of gold prices when investigating Gibson’s Paradox)
This has to do with the fact that gold satisfies more criteria for a sound money than any other substance known to man, portability, durability, fungibility, divisibility, non-counterfeitability, relatively fixed supply, relatively scarce, not consumed etc. So, the yardstick to tell a bank when to supply more money can only be measured by looking at the demand for the most perfect money that we know of : gold. On a pure gold standard, no paper, the ever smaller fractions of gold will be spontaneously demanded by the market as demand for currency increased and hence the value of one std measure of gold increased.
Bagus & Howden: “an increase in the demand for money services (real cash balances) cannot be satisfied by an increase in the production of money because an increase in the money supply decreases, ceteris paribus, the purchasing power and consequent services of each and every monetary unit”
Evans & Horwitz: “… increases in the money supply will not decrease the purchasing power of each unit if there has been an increase in the demand for money services”
E&H’s reply is wrong in the terms of B&H’s analysis, and suffers of the same uncertainty in the meaning of “inflation”: if inflation is “money supply more than demand” which involves purchasing power as “inverse of prices” – E&H’s definition – the reply is right; in B&H analysis “inflation” means money supply increasing then purchasing power as “goods per money unit”, which is far different from E&H.
With no common ground, a comparison is not possible.
E&H’s point of view comes from Monetary Equilibrium Theory, it’s consistent thereto, then it is not wrong when seen within their kind of analysis.
But if money demand increases we must admit that money gains a higher “value” to money holders than other goods or instruments – it is the same when demand for a certain goods increses: its money prices increases too. Then “the economy” says that money has got a higher value, people want more goods to give their money away or – better said – people prefer more money and less goods, which will force prices downwards. If you increse money supply, you alter this new “equilibrium” thus making money lose some of its newly gained purchasing power.
Here lies the difference in B&H and E&H’s analyses, which must be understood before a critic is expressed.
p.s.: this view on inflation and purchasing power, I think, is the only one point I agree with Bagus.
You’re right. The issue here is why do Bagus and Howden want the value of money to rise in this scenario.
In other situations if the demand for something rises then we’re quite happy if the market supplies that demand and thereby prevents prices from rising too much. Why not though in the case of money?
“In other situations if the demand for something rises then we’re quite happy if the market supplies that demand and thereby prevents prices from rising too much. Why not though in the case of money?”
I imagine that if gold were money, they would be perfectly happy for gold miners to meet rising demand. The difference between this and money printing continues to elude me.
It’s not that I’m entirely comfortable with fractional reserves, or that I think money printing is a good idea, just that I can’t see why expansion of the money supply is ok when performed by gold producers.
The way that you have put those two quotes together is a blatant misrepresenation of our argument. Let me offer the subsequent section, which I think deals directly with your point:
“our aim is to avoid a debate about which is the most accurate definition. We
merely want to acknowledge that there is a difference. However Bagus and Howden do not acknowledge this. By referring to this process as “inflation” they are using their preferred definition, even though the whole debate is about what constitutes inflation! This is virtually the textbook definition of “begging the question,” which is, of course, an invalid argumentative strategy”.
You say that the difference between the MET approach and the one B&H use “must be understood before a critic is expressed.” But the whole point of our reply is to make that difference explicit.
yes, I read that part of course. And this is why i wanted to stress that such premises must be exposed in advance.
Nevertheless, with such different point of view, I think B&H and E&H’s positions cannot ever meet. Surely they cannot meet if each one keeps its vocabulary and aim.
I mean: B&H and E&H answer to different questions, and methink it is not proper for one to criticise the other if the question itself is different.
By a “B&H”-point of view, increasing money supply when demand has increased must involve stable prices, then stable purchasing power (as inverse of prices), which is the same MET conclusion; but does it involves a phenomenon of money depreciation? “B&H” point of view says “no” as ceteris paribus (given supply of goods) the ratio goods/money has lowered; “E&H” point of view does not answer – maybe because it is irrilevant in their conceptual construction – but the fact remains: the two underlying theories answer different questions.
I think you need to take a step back here. Recollect that B&H’s article is a critique of Selgin (1988). Steve and myself are accusing them of not making their definition of inflation explicit. I think you are actually echoing the argument we make in the paper, so I’m not sure what your point is.
Regarding your second paragraph, I apologise but I’ve read it twice and I don’t understand it.
Yes, I am partly echoing the argument you wrote and I recognise that clarity on the aims terms and definitions is necessary for any discussion; I was just saying that it must be exposed at the very beginning of any discussion. Anyway, and this is my point, B&H premises (what inflation is and what we must care of) are far from E&H, then it is for granted that you find parts to criticise. I mean, it’s not that their logic is faulted, they just start from somewhere else than you.
As the rest (I try expose it once again, then I must admit whether my english – “englian i.e. english-italian” – is horrible, or I see false problems):
a) B&H’s concept of inflation, even though some obscillations, is mere money supply increase. By what I have gathered from other Bagus’s works, B&H’s thought wants to reply to this question “what happens to the value of money, expressed in terms of goods, when money demand rises and supply too does to compensate?”. Thus I see that they separate two moments: 1) money demand rises, then people are valuing money more than before 2) money supply rises, then the Central Bank is devaluating money by altering the preceding ratio “available goods – available money”; Their conclusion actually disregards the theoretical variation of prices from moment 0 to moment 2 (via moment 1), but takes subjective valuations of the value of money into account.
b)Your thought, I gathered, wants to answer this question “what happens to the purchasing power of money in time 2 – measured as the inverse of prices – if the money equilibrium is altered in time 1 but restored in time 2?”. Thus you disregard the “subjective value” of the causes of an increase in money demand, and focus on the “resulting” prices; money and demand get back to their preceding equilibrium, so you say that nothing happened to the purchasing power.
I hope I have clarified the inconciliability of the two positions: even though both point of views not exclude the other (the subjective increase in the value of money may be unsatisfied even though prices stay the same, so we can have “B&H inflation” with the same “E&H purchasing power”). It does not mean you must not criticise Bagus, I just say you can never expect him to agree with you, because E&H and B&H are watching different parts of the same reality with different goals.
anyway, I admit, in my opinion the right question comes from B&H point of view, as it separates the contributions of money supply from and the individual decisions to demand more or less money, and involves the respect of scarcity ratios implied by subjective valuations (it is the one single case when Bagus’s orthodoxy meets my opinions, really fun).
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