A recent QJAE paper by Bagus and Howden has reignited the controversy over Fractional Reserve Free Banking versus Full (100%) Reserve Banking. Per Toby Baxendale, “two very clear conceptions of money (have been) developed by Austrian School theorists past and present”. One is a Monetary Equilibrium Theory (MET) branch, favouring Fractional Reserve Free Banking, with “the rest of the Austrians favouring Full Reserve Banking.”
There are, however, some Austrians in neither camp; what I would call agnostic (Cochran 2010, p. 121-22) relative to free banking. As a long time contributor to developments of Austrian Business Cycle Theory (ABCT) with this view, I recognize the potential for a 100% banking system to eliminate the credit creation at the heart of the ABCT boom-bust process. However, I recognize the complexity of the saving-investment process in a capitalistic system with well-developed financial markets (including banks) which are heavily dependent on financial intermediation to funnel savings from ultimate savers to ultimate investors through what is often simplistically represented as a loanable funds market.
As hinted at by Baxendale, at the heart of many, if not most, of the controversies surrounding the role of money and banking in an advanced economy is the careful differentiation of dual services provided by banks: transaction services and intermediation. The issue is made more complicated by the possibility that the public may willingly and knowingly hold financial instruments that can be viewed by the holder as a transaction asset while, simultaneously, at least some of these funds may be a source of loanable funds; funds for which the bank intermediates between ultimate lender (depositor) and an ultimate borrower.
The ‘free bankers’ make an effective case that under proper conditions banking freedom is an institutional framework that would, given the great uncertainty and risk involved in any time-related planning, allow the voluntary interaction of agents to channel funds from savers to investors while minimizing trading at false prices, in this context deviations of interest rates from the natural rate(s).
In an earlier attempt to examine this issue rigorously, Cochran and Call (2000) concluded in favor of banking freedom:
A definition of commodity credit provided by Mises (On the Manipulation of Money and Credit 1978, p. 119), however, leaves the door open for a compromise. Commodity credit is “credit which a bank grants by lending its own funds or funds placed at its disposal by depositors.” Under what conditions are funds placed at the disposal of the bank by depositors? The problem is that the short run merges into the long run in gradations that are, as Marshall suggested, imperceptible. Money can be, and often is, both a present good and a future good, depending, in part, on the subjective evaluation of the depositor. As Friedman (“The Quantity of Money: A Restatement” 1956, p. 14) pointed out, economic agents hold cash balances because they derive utility from both sources and the same unit of money may provide both services. Where cash holdings are a form of saving, the holder may actually be willing to temporarily surrender the present for the future. Such funds (and the resources made available by the saving) can be made available for loans.
Here, the market, as it often does, provides a solution. Free banking is a process where the market makes the ultimate judgment on where to draw the line between money as a present good and money as a future good. Bankers must make a judgment on the proportion of their deposits that represent saving and the proportion that are currently serving as present money for the holders of the deposits. Only funds held as savings may be safely “invested” or loaned. Consumers of banking services make judgments about the safety and soundness of the banking institutions with which they deal. Successful banks will provide the mix of services that meet the needs of their clients. The market test makes it qualitatively difficult to distinguish the Mises from the Selgin outcome. While Mises expected the discipline of the market to move banks closer to the 100-percent-reserve position, Selgin anticipates lower levels of reserves and hence more intermediation and lending. Just as Marshall’s short run blends into the long run, the practical aspects of Mises’s theory of money, credit, and banking blend into the theory of free banking provided by Selgin.
A footnote provided the following caveat:
The above argument depends on the caveat that free banking means banks operate in an environment in which banks are subject to the general rules of commercial and civil law and are not the recipients of special privileges and protections granted by the state. As expressed by Mises (1998, p. 440 [Human Action: A Treatise on Economics. Scholar’s Edition]),
What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract.
In simpler words, those criticizing free banking, properly understood, on cycle grounds need to look elsewhere to justify a 100% reserve system.
Bagus and Howden represent the latest challenge and others (Selgin and Evans and Horwitz) have adequately responded. While applauding Bagus’s and Howden’s “abstaining from a discussion of legal and ethical issues”, both critiques expose the weakness of the arguments presented by Bagus and Howden. Evans and Horwitz then “attempt to specify how debate between the two sides might proceed more productively.”
Since my above-quoted article was penned, other touted challenges to the free banking argument have arisen particularly from De Soto (Money, Bank Credit, and Economic Cycles, 2009) and from Jörg Guido Hülsmann (“Has Fractional-Reserve Banking Really Passed the Market Test?”, The Independent Review, Winter 2003).
In correspondence with Larry Sechrest right before his untimely death, we agreed that we both had hoped these contributions would move forward the discussion and perhaps, especially for me, provide acceptable arguments in support of the 100% reserve position. We both were disappointed with the arguments presented, for reasons very similar to the criticisms by Selgin of the Bagus and Howden paper. Since Larry put his thoughts in writing, I’ll refer interested readers to the new preface in the Mises Institute reprint of his Free Banking.
The discussion generated both on the web and in academic writings by Bagus and Howden should be welcome in light of the recent crisis and its aftermath. It is more important than ever that “the question of banking freedom must … be discussed again and again, on basic principles” (Mises, On the Manipulation of Money and Credit 1978 p. 45).