The Problem is Central Banking not Fractional Reserve Banking

by Steve Horwitz June 27th, 2011 8:00 am

Back in December, I used one of my weekly Freeman Online columns to address what I saw as a common misunderstanding of how fractional reserve banking works, at least among many who comment on various Internet sites devoted to Austrian economics, especially ones critical of fractional reserve banking.  Below, I reprint that column with a few minor changes.  Interested readers might also wade through the (70!) comments on the original column if they wish to explore this issue in more detail.


In some free-market circles fractional reserve banking (FRB) is blamed for everything from business cycles to bad breath.  Defenders are seen as apologists for inflation and fraud.  Thankfully these views remain a minority because they are gravely mistaken.  As I, and other Austrian monetary theorists, such as George Selgin and Larry White, have argued, there’s nothing wrong with FRB that getting rid of a central bank can’t cure.  Fractional reserve banking works just fine in a free market.

I don’t want to rehearse the whole debate in this column, but I do want to address a claim made by opponents of FRB.  They often say something like: “If I deposit $1,000 in my bank and it has to hold only 10 percent reserves, it can create $10,000 in new money.”  This claim is ambiguous at best and downright wrong at worst. As stated it betrays a lack of understanding how fractional reserve banks (whether under free or central banking) actually work.  Let's assume we have a fractional reserve banking system in which banks face a 10 percent reserve requirement.  (Note now that we are not talking about a free banking system - I want to make a point about fractional reserve systems in general and show how the problem is that the system isn't free, not that it's based on fractional reserves.)

First of all, this claim is ambiguous about where the deposit comes from and what it consists of.  For example, if I deposit a $1,000 check in my bank that you’ve written on your bank, what happens?  It’s true that my bank gets $1,000 in new reserves, but it cannot create $10,000 in new loans with the money.  Why not?  Imagine it credited $10,000 to the borrowers’ accounts.  What would they then do?  They would spend it because that’s why people borrow money!  And what happens when it’s spent?  The banks in which the funds are eventually deposited ask the original bank for $10,000 in reserves.

The problem is that if the bank was at its 10 percent requirement before the $1,000 deposit came in, it cannot lose $10,000 in reserves without falling below its minimum requirement (or its desired level, in a free-banking system with no such requirement, which would be unacceptably risky without deposit insurance).  What can the original bank afford to lose?  Well, it has my new deposit of $1,000 against which it has to keep 10 percent, or $100.  Therefore it has $900 to loan out.  And that’s all.  As I call it when I teach "Money and Banking," this is Banking Rule #1: No individual bank can lend more than its excess reserves, in this case $900.

Now you say, “Yes, but that $900 will be spent and deposited at another bank, which will keep $90 and lend out $810, and so on.”  And you are quite right, which leads us to Banking Rule #2:  The banking system can expand by a multiple of those original excess reserves.  Assuming 1) all banks face a 10 percent requirement, 2) no one takes wants outside money, and 3) no banks hold excess reserves, the system will create $10,000 based on that original $1,000 deposit.  So perhaps the problem with the original statement is that it focused on one bank only rather than the banking system as a whole.

But this is hardly the whole story — and we need the help of our old friend Monsieur Bastiat to see the unseen.  If the $1,000 I deposited came from your bank, it loses the $1,000 in reserves transferred to my bank.  That forces your bank to call in loans to make up the lost reserves, which leads to reserves being lost by other banks, which then have to do the same thing.  The result is that the $10,000 created by my bank’s gain in reserves is canceled by the $10,000 destroyed by your bank losing those reserves.  When you write a check to me and I deposit it, there is no bank multiplier on net (assuming the three conditions above hold). Thus we see the reverse of Banking Rule #2, as the system simultaneously contracts by a multiplied amount of the original deposit/withdrawal.

So how does new money ever get created and multiplied on net?  By injections of new reserves.  Only one entity can create new reserves on net in a fiat money system with a central bank:  the central bank.  When the Fed conducts open-market operations it adds new net reserves to the system, which enables the money-multiplier process with no offsetting loss in reserves elsewhere.  The central bank and only the central bank can do this.

A clever fellow might now say, “Well, what if I deposit currency into my bank?  There’s no offset then, right?”  That is indeed true.  But where did the currency come from?  At some point, you or someone else had to withdraw it from the banking system, which caused a multiplied contraction in the total money supply because currency counts as reserves.  The two halves of the process are separated in time, unlike with the deposits, but the net effect in the long run is still zero.

Injections of new currency can cause the money-multiplier process, but guess what is the only thing that can create new currency in a system with a monopoly central bank?  You got it:  the central bank. If you want to know whom to blame for setting off the money-multiplier process, you need only look there.  The monetary base, which corresponds to the total level of potential bank reserves (being the sum of the total supply of currency plus the the supply of bank deposits at the Fed), is totally under the control of the central bank.  No one else can create currency and no one else can create net additions to the total amount of deposits at the Fed.

As Robert Higgs points out in a recent blog post, for increases in the monetary base to become increases in the supply of money, the banks have to cooperate by lending out their excess reserves.  Banking Rule #1 does not say that fractional reserve banks must lend out their excess reserves, only that they cannot lend more than their excess reserves.  Higgs argued in an earlier post that the reluctance of banks to lend out those excess reserves is what is preventing the remarkable increase in the monetary base since the fall of 2008 from turning into significant inflation.  Factors such as the Fed choosing to pay interest on bank reserve deposits, the large cash holdings of big firms, and the persistent regime uncertainty that makes lending/investing seem particularly risky these days can together explain the reluctance of the banks to turn the monetary base into money via the multiplier process.  Still, it remains the case that only the central bank is responsible for the expansion of that base, even if the banks balk at lending it.

But what about free banking?

In a free banking system, matters are a little bit different.  Two factors can, effectively, change the ability of the banking system to initiate that multiplier process.  Changes in the supply of the outside money are one such factor.  In a commodity-backed free banking system, an influx of that commodity into the banking system brings in reserves and enables the banking system to expand.  On the margin, however, the quantity of new commodity money entering such systems will be small compared to the total supply of the commodity in any given period of time.  In practice, this has not posed an inflationary problem for (mostly) free banking systems.

Second, in a free banking system, the reserve ratio is determined by the banks themselves, not by the central bank.  The ratio need not be treated as an exogenous variable.  Free banks can lower their desired reserve ratios which will enable them to create more liabilities off of a given amount of outside money.  And it is here that we move from the mechanics of banking to the thornier theoretical issues.  If free banks see an opportunity to safely reduce their reserve ratios to enhance their profitability, it's likely because they have perceived that the demand to hold their liabilities has increased, reducing the demand for their reserves via inter-bank and over-the-counter redemption.  With fewer claims being made on their reserves, some of their reserves that were previously "desired reserves" are now seen as "excess reserves," and Banking Rule #1 is in play:  these now excess reserves can be lent out in the form of a larger supply of bank liabilities (most likely in the form of new deposits granted to borrowers).

From a monetary-theoretic perspective, if free banks create more liabilities when the demand to hold those liabilities has increased, the results will not be inflationary, rather this warranted increase in the total money supply will prevent a deflationary excess demand for money from setting in.  The increased demand to hold the bank's liabilities (i.e., the falling demand for its reserves), is a form of savings that drives down the natural rate of interest.  When the free bank responds by lowering the market rate it charges to attract the marginal potential borrower on the demand for loanable funds curve, it is not inflating but maintaining the all-important Wicksellian coordination of the market and natural rates of interest.  So even if free banks do start to create more money by lowering their desired reserve ratios, this decision faces the test of profit and loss in the marketplace, which will determine if the entrepreneurial judgment of the bankers is correct.

The bottom line is that it is not fractional reserve banking per se that is the cause of inflationary increases to the money supply due to the money multiplier process but rather the ability of central banks to override market signals, thanks to their monopoly status, and add reserves to the banking system at their discretion and independently of the public's preferences.  Again, there's nothing wrong with fractional reserve banking that getting rid of the central bank and other government interventions wouldn't cure.


More on models

by Kurt Schuler June 26th, 2011 3:15 pm

George Selgin wrote a post on expressing ideas in words rather than mathematics. Here are my two cents of commentary.

Math is useful when we want to know “how much?” How much is the U.S. economy growing? How much is the value of the dollar changing against a trade-weighted basket of other currencies? How much more revenue would income taxes raise if their rates were doubled?

The math that is useful for answering such questions is often nothing more advanced than what college-bound high school students learn, combined with some accounting identities. Deirde (formerly Donald) McCloskey and Arjo Klamer have made the case that accounting rather than higher mathematics is in fact the master metaphor of economics, because so much of applied economics is about what to count and how to account for it.

At bottom, a model is a device for isolating and examining what we consider to be important features of a situation. A model need not be a forest of equations. A verbal description can be a model. So can a balance sheet. So can a historical case—that’s why we say, for instance, “Bank X’s lending practices were a model of good risk management.”

A verbal model is more appropriate than a mathematical one in cases where generality is more important than extreme precision. A small change in the assumptions need not lead to a big change in the conclusions, as can happen with mathematical models (another favorite theme of Deirdre McCloskey).  Economists continue to rely heavily on verbal models in practice. But rather than following Alfred Marshall’s habit of favoring verbal exposition even for results derived from mathematical inquiry, they express insights that were originally verbal only in mathematics. Readers waste much time mentally translating the math back into words.



Hyperinflated Hyperinflation Reserve Concerns

by Bradley Jansen June 24th, 2011 7:01 pm

I am, generally, a big fan of Robert Higgs, but I have some quibbles with this analysis (though this analysis is common among other people I like).

Higgs outlines his arguments in a blog post here.  His main argument is that

Since late December 2008, the bank prime lending rate — the interest rate banks charge their best corporate customers — has remained steady at 3.25 percent. . . Meanwhile, during the same period, the excess reserves that commercial banks hold at the Fed have increased from $2 billion in August 2008 to $1,513 billion in May 2011.  [He has the quite striking graphs to go with it.]  Ordinarily, one would have expected this development to produce hyperinflation of the general price level. However, the price level has increased quite moderately, and for a while many analysts warned that deflation was the greater risk.

In short, I think Higgs has hyperinflated the hyperinflation concerns on the reserves question.  I think the effect of the allowing the Federal Reserve to pay interest on reserves is overblown and much less of a factor in an alleged increase in (onshore) reserves.

Regarding my first point, for a long time, money center financial institutions (and later smaller ones) used "sweeps" software to "sweep" their deposits overnight from the US (to avoid the reserve requirements which didn't pay interest) to offshore havens where they got a higher rate of return--and back again the next morning (consumers never knew).  Companies followed the capital markets dictum that "money goes where it's welcome and stays where it's well treated."  Our bad policies here forced our money offshore.  By removing some bad laws here (prohibition on paying interest on reserves), some of the reserves that went offshore now stay onshore (Higgs has a dramatic graph of this).  But I question just how great the increase in overall reserves (domestic and what used to get swept offshore overnight) has been and how much of the dramatic graph can be explained by the marginal change from keeping on deposit at the Fed reserves that previously had been swept offshore.

Higgs' second main point with which I question is his contention that there is something fishy about banks not lending to their best corporate customers for a greater return on their money:

Moreover, they are doing so notwithstanding that they appear to have the option of lending at 3.25 percent to their best corporate customers and at higher rates to their less creditworthy customers. Why are they forgoing the opportunity to earn huge sums by switching out of excess reserves at the Fed into commercial loans and investments? The answer would seem to be that that are so frightened of the risk associated even with loans to their best customers that they are loath to lend.

But again I think he fails to put the issue in a greater context: companies are hoarding cash in record numbers.  According to CNBC, the "best corporate customers" for the banks in Higgs' examination are sitting on a record hoard of $800 billion themselves.  Why would they be beating down the doors of the banks to borrow more money?  Explains the CNBC article:

The current members of the S&P 500 are sitting on about $800 billion in cash and cash equivalents, the most ever, according to data by Birinyi Associates, even as the unemployment rate has ticked back above 9 percent. Most of this cash and cash equivalents are likely yielding at or below the current 3.6 percent annual rate of inflation, giving it a negative real return.

So why would any profit-seeking corporation go to one of Higgs' banks with "excess" reserves and borrow at 3.25% when it is already hoarding record cash?  Is the Fed just "pushing on a string?"  More importantly, the question is not as Higgs alludes ("The answer would seem to be that that are so frightened of the risk associated even with loans to their best customers that they are loath to lend.") but one that needs to go to the unwillingness of creditworthy businesses to invest.

The CNBC article implies that companies are not hiring because there is no demand.  This raises questions about economic theory.  Some Rothbardians might argue that any increase in the money supply (and I'm purposefully trying to generalize on people and terms here) is inflationary while others even in the Austrian school (generally those on the free banking side unconcerned with the full reserve question) have said that under non-governmentally regulated market conditions (certainly not what we have now), money supply increases would (generally) match market demand for new money.  I posit that the question Higgs tries to answer wrestles with this question.

I would welcome comments, insights, corrections and importantly better numbers on aggregate US bank reserves including marginal changes in aggregate sweeps.


Auditing Gold Reserves

by Bradley Jansen June 23rd, 2011 12:08 pm

US Rep Ron Paul will be holding a long awaited hearing today at 2 pm on his Gold Reserve Transparency Act of 2011 (HR 1495). I'm offering my own little cheat sheet for the hearing here.  Witnesses to include

  • The Honorable Eric M. Thorson (testimony in PDF), Inspector General, Department of the Treasury
  • Mr. Gary T. Engel (testimony in PDF), Director, Financial Management and Assurance, Government Accountability Office.

The official link is here. Here's the text of the bill. And here is the live webcast link.  Submit questions for the hearing here.

From the GAO's testimony:

H.R. 1495 also provides for GAO to prepare and transmit to the Congress, not later than 9 months after enactment of the act, a report of GAO’s findings from such review together with the results of the assay, inventory, audit, and analysis conducted by the Secretary of the Treasury. According to Treasury officials, because of the enormous quantity of gold that would need to be inventoried and assayed, there is uncertainty regarding the ability of Treasury to complete such actions within the 6-month period provided in H.R. 1495. If Treasury’s efforts are not completed within the 6- month period, there would be limitations on the scope of GAO’s work if GAO were required to report within 9 months after enactment of the act.

The Treasury IG makes clear he sees the requirements of the bill as unnecessary and redundant.  There are a few other observations:

  • In all, these compartments hold 699,515 gold bars with fineness, or purity, ranging from 0.4701 to 0.9999 with an average fineness of 0.9006. Fort Knox houses 60 percent of the fine troy ounces of the deep storage gold reserves, Denver 18 percent, and West Point 22 percent. [nb, that seems like a great range for fineness.]
  • In 1974, in response to public and Congressional inquiries, the General Accounting Office (GAO), known as the Government Accountability Office since July 2004, in cooperation with the Department of the Treasury, conducted an audit of about 21 percent of the gold bars stored at the United States Bullion Depository, Fort Knox, KY, and concluded that the gold stored at that facility agreed with the records of the depository. [nb, 21% is not really a full audit.]
  • In should be noted that the audit by GAO followed a Congressional visit to the Fort Knox facility. [Last one in 1974? Sounds as if it's time for field trip!]
  • The testimony includes some interesting graphics at the end of the seals, etc. used.

Auditing the gold reserves has been an important issue in the gold bug community, for example with the GATA folks:

“There hasn’t been an independent audit of US gold reserves since 1955,” he says. “Don’t you think that’s a bit suspicious?” Murphy is not alone in calling for a public audit of the gold supplies held by central banks and the International Monetary Fund (IMF). Ron Paul, a Republican congressman who ran for president as a Libertarian candidate in 1988, has been calling for an audit of the gold held by the US Federal Reserve since 1982, when he served on the US gold commission – set up to examine the role of gold in the monetary system.

Not only has Dr. Paul has been agitating for an audit of the US gold reserves for a long time, but he's been consistently trying to raise the issue's profile.  Reported Kitco last year:

This is not the first time the congressman has made his pitch. “In the early 1980s when I was on the gold commission, I asked them to recommend to the Congress that they audit the gold reserves – we had 17 members of the commission and 15 voted not to the audit,” said Paul. “I think there was only one decent audit done 50 years ago,” he said.  Though Paul did not say whether there is any truth to claims that there is no gold in Fort Knox or the New York Federal Reserve, he said, “I think it is a possibility.”“If we ever get around to deciding we should use gold in relationship to our currency we ought to know how much is there,” said Paul.  “Our Federal Reserve admits to nothing and they should prove all the gold is there. There is a reason to be suspicious and even if you are not suspicious why wouldn’t you have an audit?” he said.

Now, when I was Dr. Paul's banking and monetary policy staffer a dozen years or so ago, I went on a private tour of the New York Fed's gold vault and can vouch that back then there was an impressive store of what sure looked like gold bars to me.  How much of that belonged to which account, I have no idea.  The NY Fed stores gold for other central banks and the IMF but does not disclose how much is in which account.  (On  side note for those concerned with the logistics of returning to a gold standard and the "shipping" of gold around to clear accounts: gold bars are routinely now simply moved from one storage account in the NY Fed gold vault to another with little difficulty or cost.)

Of course there have long been rumors that "there's no 'there' there" (as Gertrude Stein once quipped about her hometown of Oakland) after President Ford in 1974 issued Executive Order 11826, revoking paragraph (d) of Section 2 from EO 10289, pertaining to gold.  According to one report:

On July 19th an article appeared in the Los Angeles Times and other media outlets that the gold in Fort Knox had been stolen by the Rockefeller family. The claim made by Dr. Peter Beter was that part of the gold was flown to Mexico on the Rockefeller family jet. This prompted a Congressional tour of Fort Knox by the Treasury Department. During this tour no experts on gold were allowed, no assays on any of the gold was run, some of the witnesses complained that they were only allowed to look at the gold through small peepholes, and a few of the witnesses added that the color of the gold seemed to be wrong. This tour ended the scandal and no other investigation was done.

Explains Annex D of the US Gold Commission report (PDF):

“On June 3, 1975, Treasury Secretary Simon issued Treasury Department Order No. 234-1 authorizing and directing the Fiscal Assistant Secretary, with the cooperation and assistance of the Director of the Mint, to conduct a continuing audit of United States Government-owned gold for which the Department of the Treasury is accountable.”

In addition to the rumors that the gold in Fort Knox was removed, there is the more contemporary rumor that the "gold" bars there have been swapped with gold plated tungsten bars instead which Dr. Paul's Campaign for Liberty has been spreading.

So, where do we stand now?  The US Treasury gives some guidance on terms and holdings.  According to their site:

Deep Storage: Deep-Storage gold is the portion of the U.S. government-owned Gold Bullion Reserve that the U.S. Mint secures in sealed vaults, which are examined annually by the Department of Treasury's Office of the Inspector General. Deep-Storage gold comprises the vast majority of the Reserve and consists primarily of gold bars. This portion was formerly called "Bullion Reserve" or "Custodial Gold Bullion Reserve."

At the end of last month, the US Treasury official holding of US gold was 261,498,899.316 fine troy ounces for a book value of just over $11 billion ($11,041,058,821.09)  according to their status report.

Department of the Treasury
Financial Management Service
May 31, 2011

Summary Fine Troy Ounces Book Value
Gold Bullion 258,641,851.485 $10,920,427,976.14
Gold Coins, Blanks, Miscellaneous 2,857,047.831 120,630,844.95
Total 261,498,899.316 11,041,058,821.09
Mint-Held Gold - Deep Storage
Denver, CO 43,853,707.279 1,851,599,995.81
Fort Knox, KY 147,341,858.382 6,221,097,412.78
West Point, NY 54,067,331.379 2,282,841,677.17
Subtotal - Deep Storage Gold 245,262,897.040 10,355,539,085.76
Mint-Held Treasury Gold - Working Stock
All locations - Coins, blanks, miscellaneous 2,783,218.656 117,513,614.74
Subtotal - Working Stock Gold 2,783,218.656 117,513,614.74
Grand Total - Mint-Held Gold 248,046,115.696 10,473,052,700.50
Federal Reserve Bank-Held Gold
Gold Bullion:
Federal Reserve Banks - NY Vault 13,376,961.126 564,804,727.98
Federal Reserve Banks - display 1,993.319 84,162.40
Subtotal - Gold Bullion 13,378,954.445 564,888,890.38
Gold Coins:
Federal Reserve Banks - NY Vault 73,808.979 3,116,377.47
Federal Reserve Banks - display 20.196 852.74
Subtotal - Gold Coins 73,829.175 3,117,230.21
Total - Federal Reserve Bank-Held Gold 13,452,783.620 568,006,120.59
Total - Treasury-Owned Gold 261,498,899.316 $11,041,058,821.09

For another look at the government's audit of our gold reserves, the US Mint reported its Schedule of Custodial Deep Storage Gold and Silver Reserves as of September 30, 2010 and 2009 (PDF here).

Gold Reserves of the United States as of September 30, 2010

Gold reserves in the custody of the Mint:

Deep storage  248,046,116

Working stock 2,783,219

Total gold reserves in the custody of the Mint  248,046,116

Gold reserves in the custody of the Federal Reserve Bank of New York 13,452,784 261,498,900

Total gold reserves of the United States 261,498,900

Source: GAO analysis of Treasury financial reports.


The Mint also reports some "fun facts" about the United States Bullion Depository Fort Knox, Kentucky:

  • Amount of present gold holdings: 147.3 million ounces.
  • The only gold removed has been very small quantities used to test the purity of gold during regularly scheduled audits. Except for these samples, no gold has been transferred to or from the Depository for many years.
  • The gold is held as an asset of the United States at book value of $42.22 per ounce.
  • The Depository opened in 1937; the first gold was moved to the depository in January that year.
  • Highest gold holdings this century: 649.6 million ounces (December 31, 1941).
  • Size of a standard gold bar: 7 inches x 3 and 5/8 inches x 1 and 3/4 inches.
  • Weight of a standard gold bar: approximately 400 ounces or 27.5 pounds.
  • Construction of the depository:
    Building materials used included 16,000 cubic feet of granite, 4,200 cubic yards of concrete, 750 tons of reinforcing steel, and 670 tons of structural steel.
    The cost of construction was $560,000 and the building was completed in December 1936.
  • In the past, the Depository has stored the Declaration of Independence, the U.S. Constitution, the Articles of Confederation, Lincoln's Gettysburg address, three volumes of the Gutenberg Bible, and Lincoln's second inaugural address.
  • In addition to gold bullion, the Mint has stored valuable items for other government agencies. The Magna Carta was once stored there. The crown, sword, scepter, orb, and cape of St. Stephen, King of Hungary also were stored at the Depository, before being returned to the government of Hungary in 1978.
  • The Depository is a classified facility. No visitors are permitted, and no exceptions are made.

It'll be interesting to see if the testimony or questions and answers illuminates the issue more than we already know (for those of us who have been following the issue).

We'd have a lot more if Congress implemented my suggestion of getting our gold back from the International Monetary Fund too!


Where’s My Model?

by George Selgin June 22nd, 2011 2:20 pm

Anyone who peruses my work on free banking—or my other writings for that matter—will notice that I’m not especially inclined to express my ideas mathematically. To put the matter more positively: I prefer plain English. The preference has if anything grown more marked over time. While writing Good Money, for example, I at one point let an equation slip into the first, expository chapter. But as soon as it occurred to me that a sentence would serve as well, while being a damn sight prettier to look at, out went the symbols. Likewise, when Liberty Fund decided to put The Theory of Free Banking in their Online Library of Liberty, I asked them to take out the few equations (and the one figure) found in the print version, as if they were so many blemishes (which, indeed, they were).

To resist using equations isn’t a strategy calculated to make life easy for an academic economist today. Yet it isn’t entirely for want of ability to do otherwise that I‘ve resorted to it. In fact I like math and was pretty darn good at it once upon a time. I just happen to think it wildly overrated as a means for “doing” economics—that is, for communicating ideas concerning how an economy works. For whatever its champions may think, mathematics is a language, and as such is a fit device for economic analysis only to the extent that the symbols it consists of are more capable of accurately conveying meaning than words themselves are. Of course mathematical expressions have their advantages: most obviously they tend to be less ambiguous than verbal ones; and it’s relatively easy to combine and manipulate bunches of them so as to ferret out implications or inconsistencies that might not otherwise be evident. Some ideas--Newton's laws of motion naturally come to mind--can't readily be stated at all, let alone figured out, using ordinary language. But math (by which I mean mainly algebra and calculus) has disadvantages also, the most obvious of which is that its limited grammatical repertoire simply doesn’t allow it to convey many subtleties of meaning of which properly-handled words are capable. Despite what some mathematical economists seem to suppose, it isn’t merely owing to a general lack of facility with algebra that people mainly communicate using words: it’s because you can say lots of things that way that you can’t possibly say with equations. Or maybe you can sort of say it with equations, but it’s dorky to even try.

Which brings me to free banking. Might greater resort to formal modeling enhance the theory? Of course it might. Like I said, equations can reveal things that mere words obscure. When Carl Christ reviewed The Theory of Free Banking for George Mason’s Market Process newsletter, he did so by writing down a formal model by which to examine my verbal reasoning. That reasoning was all O.K., according to Christ, except that his formal analysis made explicit an assumption that was only implicit in my own discussion, to wit: that by an increase in the volume of real activity I had in mind an increase in the number of transactions per period, rather than an increase in average transaction size. (In the former case reserve scale economies are realized, whereas in the latter they aren’t.) This is just the sort of thing math is good for, and it is why it’s worth trying to concoct formal models. Indeed, I later made Christ’s model the basis for one of my own, rare forays into mathematical economics, my 1994 paper “Free Banking and Monetary Control.”

On the other hand Christ’s review also convinced me that I was capable of doing reasonably “rigorous” economics using “mere” words; and I personally believe that, by making use of metaphors and other devices that have no exact mathematical counterparts (though equations are themselves metaphors of a sort), I added more to my theory’s intuitive appeal than I sacrificed in rigor.

The point is that both mathematical economics and the verbal kind have their place; neither is intrinsically better than the other; and each can serve as a useful test of the other. A formal model can reveal deficiencies or omissions in a verbal argument; but a few well-chosen words are just as capable of exposing an absurd argument or false assumption lurking in some seemingly innocent equation. The claim that “it takes a model to beat a model” would be just plain goofy were it not so effectively employed by mathematical economists anxious to insulate their work from criticisms by persons who know less math—but perhaps more economics—than they do.

Finally, I come to Larry Sechrest’s (1993) Free Banking, much of which is devoted to offering a formal interpretation of my own verbal theory. Larry’s book came up in comments on a previous post; and having made a brief remark upon it there I offered to expand upon it in light of a quick rereading. My recollection had been that Larry misinterpreted some of my arguments; in fact the misinterpretations are minor and are mainly confined to Larry’s own “verbal” exposition, as when he states (p. 14) that I argue “that a bank’s demand for reserves depends not only on the total volume of transactions but also on the frequency of those transactions.” (He presumably ought to have written “total volume of bank money outstanding and its turnover” or something like that.) But Larry’s formalization, unlike Carl Christ’s, contains no microeconomic refinements or revelations: it merely restates in symbols the comparative static conclusions I reach using words. If some find Larry’s approach more compelling (and it appears that some do), that’s lovely. But let’s not be guilty, as so many mathematical economists seem to be, of confusing a difference in rhetoric with a difference in rigor.


What’s new in the last 15 years

by Kurt Schuler June 16th, 2011 11:41 pm

In a previous post I listed what I consider to be the most important ideas on free banking that have been well known for at least 15 years among those of us interested in the subject. During the 20 years from Friedrich Hayek’s revival of interest in free banking in 1976, researchers on free banking made great progress rediscovering the past and melding old ideas with newer ones. They succeeded in bringing the theory of free banking up to date from the mid 19th century, the last time it had enjoyed development by a group of keen minds rather than just by scattered individual thinkers.

In the last 15 years the earlier pace of progress has not continued. Partly it is the nature of scholarship: creative ideas come in bursts, and every discipline has its slow periods after the ideas have been digested. Partly it is because the core group of researchers, including some of the other bloggers on this site, is nearly the same as it was 20 years ago; new ideas usually require fresh blood. Here are what I consider the most important ideas that have been developed since those I mentioned in the earlier post.

  1. George Selgin explored how the ideal of neutral money fit with the fashion for inflation targeting among central banks. His monograph Less Than Zero argued that compared to the ideal of neutral money, inflation targeting would tend to produce inflation that was too high during booms and too low during busts. Selgin also argued that free banking approached the ideal of neutral money more closely than central banking.
  2. The ideal of neutral money provided a basis for researchers on free banking and fellow travelers among the Austrian economists to criticize the monetary policy of the Federal Reserve and some other central banks over the last five or six years. Before the global recession they were among the few to worry that monetary policy was too expansionary. After the recession began, they were among the first to be persuaded by Scott Sumner, or to conclude on their own, that the policies of the Federal Reserve and the European Central Bank in particular were too contractionary. Many researchers on free banking consider that nominal GDP targeting or something similar would more nearly approach the ideal of neutral money for central banking policy than inflation targeting does, though not as closely as free banking would. And now, a step down in importance from the top two ideas, two others:
  3. Note issue by federally chartered banks is legal in the United States.
  4. There has been more research on and argument about historical cases of free banking, such as Anders Ögren’s research on Sweden and Ignacio Briones’s research on Chile (links are to only to bits of their larger bodies of research).

This list is not an exhaustive catalog of "new" ideas; it simply includes what I consider to be the top ones. There has been other very good work, such as Selgin's research on free-market coinage, that has expanded our knowledge of free banking but that does not seem to me to be as central to the development of the subject. I invite reactions from my fellow bloggers and from readers.


A Sound Euro, or Bailouts for Greece and Ireland?

by Larry White June 12th, 2011 10:07 pm

John Tamny in a column over at Forbes argues, rightly, that

there’s no reason that debt problems within certain euro countries should lead to the extinction of what is merely a “unit”, or a concept meant to put a money price on goods and investments.

A default by the Greek government on its euro debts would not bring down the euro any more than a default by the government of California on its dollar debts would bring down the US dollar.

Tamny is also right in arguing that a Greek exit from the Eurozone and adoption of a floating drachma would not improve Greek’s economic prospects.  It didn’t boost Argentina’s economy or solve its governement debt problems when its central bank de-linked from the US dollar and re-floated the peso.

Tamny suggests that Europe would be better off if the ECB “strengthens and stabilizes the euro unit” and in particular its best move “would be to define the euro in terms of gold, and make euros redeemable in the yellow metal.”  I agree that the ECB, while it exists, should keep the euro a strong, low-inflation currency. 

But Tamny unfortunately errs in thinking that a sound-euro policy “will stave off looming default for the euro bloc’s weakest countries.”   On the contrary.  A policy of restraining euro inflation means the end to ECB participation in the bridge-to-nowhere EU loans that are currently postponing Greek and Irish government defaults.  It also means the end to ECB purchases of Greek and Irish government bonds to hold their yields down.  Whatever prevents the ECB from bailing out the fiscally weak countries, and from inflating away their euro debts, makes outright default or debt restructuring (which appears to be unavoidable) arrive that much sooner.

Tamny writes:

For one, if the ECB were to give the euro a gold definition, the cost of servicing euro-denominated debt for Greece and Ireland would decline. With markets suddenly aware of the euro’s extreme credibility, investors would demand lower interest rates due to greater certainty about the value of the money being paid back. This on its own would reduce the pressure presently placed on the governments in Greece and Ireland.  Right now the euro’s weakness serves as a stealth default on euro-denominated debt, so a stronger currency would reduce the cost of a potential “haircut” for holders of Greek/Irish debt.  

The real interest rate a country pays includes not only an inflation-risk premium but also default risk premium. The nominal interest rate adds an expected-inflation-rate premium.  Any move that lowers and stabilizes expected euro inflation by restraining ECB monetization of Greek and Irish debt would reduce the inflation-rate and inflation-risk premia, but such a move would significantly increase the default risk for Greece and Ireland and thereby their bonds’ yield spread over German (low-default-risk) bonds.  In real terms the cost of servicing euro-denominated debt for Greece and Ireland would rise.  

If stealth default by inflation is barred, then outright default -- overt losses for holders of Greek and Irish debt –  becomes the alternative.

It would be better for the average Eurozone citizen to have outright defaults on Greek and Irish government debts than to debauch the euro--have stealth defaults--in order to stave off overt defaults, thereby loading the costs of Greek and Irish government profligacy onto euro-users in other countries.  But that's the choice.  Let’s not imagine that Europe can eat its sound-money cake and keep the Greek and Irish governments from defaulting too.


Capital and Cash Reserves

by George Selgin June 11th, 2011 1:14 pm

I promise to make this my last post for a while concerning the matter of 100-percent versus fractional-reserve banking. However, in addressing some comments on my recent posts it occurred to me that some very serious misunderstanding is at play concerning the difference between a bank's capital and its cash reserves. The distinction between these is important, because in an important sense, and particularly with respect to comparisons of fractional and 100-percent reserve institutions, the two are substitutes.

Capital serves as a cushion for the purpose of absorbing the effects of adverse shocks to a bank's asset portfolio, so that the bank's creditors won't suffer losses in connection with such shocks, except in rare instances. This in turn allows the bank's IOUs to continue to hold a fixed value in terms of the underlying reserve asset despite changes in the market value of the bank's non-reserve assets. The larger a fractional-reserve bank's capital cushion, the greater the adverse shocks it can handle without becoming insolvent, that is, without finding that it has run out of equity. In a free market, an insolvent bank ceases to be a going concern: it must either find a buyer or go into liquidation.

A 100-percent reserve bank hardly needs any equity capital, because the need for such capital arises only when the bank faces shocks that can reduce the value of its assets. By holding only cash reserves, such a bank eliminates most of the portfolio risks that fractional reserve banks encounter, making equity redundant. In fact past 100-percent institutions had very little if any equity capital.

In a world without insurance, on the other hand, a risky fractional-reserve bank can only attract deposits by putting its owners' capital at stake. Other things equal, the more capital a bank has, the more likely it will succeed in attracting risk-averse depositors. Fractional reserve banks can also attract such depositors by holding low-risk assets, such as U.S. government securities. In the past, banks used both sorts of strategies to gain market share, often taking out advertisements in newspapers in which they supplied pertinent balance-sheet details. (Although it deals only with the U.S. the best book to read about this, and how it all changed after deposit insurance was introduced, is Jim Grant's terrific Money of the Mind.)

Of course, not all banks catered to depositors whose primary interest was safety: there was a market for riskier bank deposits also. But, despite what apologists for central banking and deposit insurance claim, it was not especially difficult to tell safer banks from less safe ones. The problem in places like the U.S. before 1934 and England before 1826 was not so much one of distinguishing relatively safe banks from relatively risky ones, but one of legal restrictions that prevented well-capitalized banks from emerging in many communities. In the U.S. the restrictions consisted of laws preventing branch banking; in England they consisted of laws preventing English banks other than the Bank of England from having more than six partners. (In 1826 other public or "joint-stock" banks were permitted, but only if they did not operate in the greater London area--itself a major limitation; while in 1833 other joint-stock banks were admitted into the London area, but only provided they gave up the right to issue banknotes.) These regulations limited the capitalization of U.S. and English banks while at the same time limiting those banks' opportunities for financial diversification--a recipe for failure. In both instances the regulations were products of politicians' catering to rent-seeking behavior on the part of banking industy insiders. Yet the resulting, unusual frequency of bank failures and substantial creditor losses stemming from such failures helped to sustain the belief that fractional reserve banking could only be made safe by means of further government intervention.

Where laws did not prevent banks from diversifying their balance sheets, especially by establishing widespread branch networks, or from securing large amounts of capital by "going public" (or, in the case of some Scottish and most Canadian banks, by making shareholders liable beyond the par value of their shares, which from creditors' point of view is equivalent to having more capital), bank failures have been relatively less common, and losses to creditors stemming from occasional failures that did occur have been relatively minor. Indeed, even such a spectacular failure as that of Scotland's Ayr Bank did not ultimately prevent the bank's creditors from being paid in full, without need for any sort of bailout.

What has all this to do with the question of 100-percent versus fractional reserves? First of all, the 100-percenters are in the habit of posing a simple choice between "safe" 100-percent reserve banks and "unsafe" fractional reserve banks. But, even putting aside the obvious fact that banks keeping the same reserve fraction may be more-or-less safe depending on the sort of non-cash assets they hold, the comparison overlooks the role of capital in limiting the risk borne by fractional-reserve deposit and noteholders, with banks that are both well-diversified and well-capitalized being capable of exposing their creditors to very little risk even despite maintaining slim reserves. More to the point, an entire range of risk-return options may exist even for banks holding approximately equal reserve ratios. Economists are generally suspicious, and rightly so, of "corner solutions." Yet 100-percenters have latched on to just such a solution in suggesting that it must be superior to the whole array of possible fractional-reserve alternatives.

Second, in suggesting that fractional-reserve banks exist only because their customers don't realize that they are engaged in lending, 100-percenters beg the question: if so, why do fractional-reserve banks bother (or why did they bother, in the good-old pre-insurance days) to hold capital, and often plenty of it? As I explained above, the reason for them having done so is precisely because they needed to assure their creditors that, although their money was at risk, the risk was limited, and perhaps made very small indeed, by the bank's capital cushion. To accumulate such capital cushions, let alone advertise them, would, of course, have made no sense at all to bankers who were determined to convince their customers that their money was all kept in a vault. On the contrary: it could only serve to give the game away.


Sir Walter Scott, advocate of free banking

by Kurt Schuler June 10th, 2011 10:50 pm

The library in my old hometown recently held a competition for the unofficial title of poet laureate of the city. They found two people worthy of the title. One is a high school buddy of mine. Seeing the newspaper story set my mind wandering down the byways of literature and I remembered that free banking counts among its advocates Scotland’s most famous novelist, Sir Walter Scott.

Under the pen name of Malachi Malagrowther, Scott wrote "letters"  — more accurately, short essays — defending the Scottish system of bank note issue. A banking crisis in England in 1825-26 led to a search for remedies, and some people argued that raising the minimum denomination of bank notes, then £1, would reduce the risk of future crises. Today, £1 is so little that there is no note for it, just a coin, but back then it was more than two week’s wages for many workers. Scott and other advocates of the £1 note pointed out that Scotland’s banking system had withstood the crisis much better than the more heavily regulated English system. They were successful in making their case: the British Parliament raised the minimum denomination of notes to £5 in England but kept it at £1 in Scotland. Although Scottish free banking ended in 1845, Scottish banks continued to issue notes under regulations that made them more or less Bank of England notes with distinctive designs. Fittingly, Sir Walter Scott’s portrait today adorns all notes issued by the Bank of Scotland.

As far as I know, Scott confined his advocacy of free banking to prose. Neither he nor Robert Burns ever wrote poetry on monetary matters; that was left to Monty Python’s fictional Scottish poet Ewan McTeagle. Burns is, however, on the £5 note issued by the Clydesdale Bank.

This concludes several posts on “what’s old” in free banking. My next post will discuss “what’s new,” that is, what we have learned in the last 15 years or so.



Those “Other” 100 Percent Reserve Banking Advocates

by George Selgin June 8th, 2011 9:47 am

(This one’s especially for GPO.)

In the aftermath of the U.S. banking crises of the 1930s, it became common for American economists to speak of the “inherent” instability of fractional-reserve banking and of the “perverse elasticity” of money supply in fractional-reserve banking systems.

What the economists in question had in mind was the tendency in existing fractional reserve banking systems for any increase in the public’s preferred ratio of currency holdings to holdings of bank demand deposits to result in a decline in bank lending, and hence in a decline in the overall money stock, and to do so despite the lack of any decline in the public’s overall desire for money balances of one kind or another. It was chiefly owing to this phenomenon that, during the first few years of the Great Depression, the U.S. (M2) money stock collapsed to just two-thirds its pre-depression level.

It was in response to this supposedly inherent drawback of fractional reserve banking that several prominent economists—including Henry Simons, Irving Fisher, Loyd Mints, and (eventually) Milton Friedman—began offering or endorsing proposals for “100 Percent Money,” meaning money consisting either of basic money itself or of bank deposits fully backed by basic money. Although these proposals closely resembled later proposals for 100-percent reserve banking forwarded by Murray Rothbard and his Austrian-School followers, they differed in treating either fiat or “commodity-bundle” central bank money rather than either gold or silver as the ideal form of basic money, and also in not basing their arguments on any appeal to ethics: unlike their Austrian counterparts, the “Chicago” 100-percenters (for want of a more accurate designation) did not claim that fractional-reserve banks swindled their customers. Instead they condemned them solely for contributing to monetary instability.

But were the “Chicago” arguments for 100-percent money any sounder than their “Austrian” counterparts? Is it true that fractional reserve banking is “inherently unstable” in the manner they claimed? As even a careful reading of their own writings shows, it is not. In truth what the Chicago 100-percenters treated as an “inherent” problem of fractional reserve banking isn’t inherent to it at all. Instead it is a problem stemming from government regulations interfering with or altogether prohibiting banks from issuing their own circulating banknotes on the same terms as those by which they are allowed to create exchange media that consist of demand deposits. In the U.S., banknote issue has almost always been subject to special restrictions. But these restrictions became increasingly severe after the outbreak of the Civil War, finally culminating in the complete suppression of commercial banknotes in 1935. Consequently, on the eve of the Great Depression it was impossible for most commercial banks to issue any banknotes at all, and it was very difficult for the rest to do so. Banks therefore had to count heavily on the Fed to meet any considerable increase in the public’s demand for circulating money by creating more units of basic money. Otherwise the banks might be stripped of cash reserves, and forced either to severely contract their lending or to close their doors, if not to do both.

Had U.S. banks remained free to issue notes on the same terms, and subject to the same fractional-reserve requirements, as applied to their deposits, changes in the public’s demand for currency needn’t have had any such “perverse” consequences. On the contrary: so long as the terms are similar a bank has no reason to care what share of its outstanding IOUs consists of notes, and what share consists of circulating paper. The bank’s liquidity depends only on the sum of both sorts of IOUs, relative to its holdings of reserves of basic money. Whether “basic money” means gold or silver or claims against a central bank also doesn’t make any difference. Indeed, a bank might well prefer to have clients hold its notes, rather than keep deposits with it, since deposits sometimes bear interest, while notes do not. Confronted with a heavy demand for currency, a free bank happily disgorges more of its paper IOUs, while writing off some of its deposits. Because its reserves, reserve ratio, and liquidity all remain the same as before, it doesn’t have to stop lending, and therefore doesn’t contribute to any decline in the basic-money multiplier. In short, under free banking, in theory at least, an increased demand for currency doesn’t have any “perverse” consequences. Nor does it appear to have had any such consequences in fact in the relatively free banking systems of Scotland, Canada, and elsewhere. In these systems, although changes in the public’s preferred currency-deposit ratio happened frequently—the ratio always rose during the harvest season, for one thing—credit crunches and banking crises were extremely uncommon.

When, on the other hand, banks aren’t free to issue their own notes, or can do so only to a very limited extent, they have no choice but to satisfy customers’ demand for more currency by handing over scarce reserves, and thereby reducing their liquidity. To restore that liquidity, they must then restrict their lending, which, other things equal, means reducing the banking-system money-multiplier. If the central bank in turn fails to make compensating additions to the stock of basic money, the equilibrium money stock must decline. In the U.S., in the early 30s, the public’s preferred overall currency-to-deposit ratio rose sharply, while the Fed for the most part stood by. Hence the Great (Monetary) Contraction.

Some will object to my suggestion that freedom of note issue would have avoided the Great Contraction by noting that currency withdrawals at the time, instead of being routine withdrawals such as were then still typical of the harvest season, reflected distrust of the banks. In that case, a bank's own notes might have been considered no safer than its deposits, so that central bank money would have been preferred to either. But while the notes of certain banks would undoubtedly have been distrusted, there’s no evidence that banknotes would have generally fallen out of favor: plenty of banks remained both trusted and solvent, and their notes could have supplied the needs of the country as a whole, since notes (unlike bank deposits) can travel wherever they are most wanted. The sole exception to this occurred in late February 1933, when a general run broke out. But this was, as Barry Wigmore has shown, actually a run for gold based, not on any general loss of confidence in the nations’ commercial banks, but on (justified) fears that the incoming president would devalue the dollar.

Further evidence that freedom of note issue would have helped comes from the one step taken in that direction during the banking crisis. This consisted of a rider to the Federal Home Loan Bank Act known as the “Glass-Borah Law.” That law briefly and modestly relaxed the regulatory limits on national banks’ ability to issue national banknotes, by extending the sorts of collateral the banks could have backing those notes. The Glass-Borah Law resulted in a substantial and much needed increase in the supply of currency, although it still left the banks too restricted to avoid massive reserve losses. Just how far a more generous measure, including steps to allow state as well as national banks to issue their own currency, might have gone in limiting or even preventing the crisis is a question crying out for further research.

Why, then, did “Chicago” 100-percenters insist on treating the “perverse” behavior of the U.S. money stock in the 30s as a problem inherent to fractional-reserve banking rather than as a consequence of government regulation? As their own writings make clear, at least some of them actually admitted that freedom of note issue was a theoretical solution to the problem. In his A Program for Monetary Stability (1960, p. 69), for instance, Milton Freidman observed:

To keep changes in the form in which the public holds its cash [that is, money] balances from affecting the amount there is to be held, the conditions of issue must be the same for currency and deposits. . . . The first solution would involve permitting banks to issue currency as well as deposits subject to the same fractional reserve requirements and to restrict what is presently high-powered money to use as bank reserves.

Yet Friedman went on to reject this solution in favor of the 100-percent reserve alternative. He did so because he believed then that freedom of note issue itself raised insuperable problems. This stance, which was presumably shared by other “Chicago” 100-percenters, was itself due to misinterpretation of the American “free banking” experience. Friedman himself eventually came to admit his mistake in light of research by modern free bankers (see Friedman and Schwartz 1986), though his reversal was somewhat half-hearted (see my “Milton Friedman and the Case Against Currency Monopoly”). Whether Simons or Mints or Fisher or any of the other “Chicago” 100-percenters would ever have done likewise is of course something we shall never know.

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