Advertisements for Myself

by George Selgin August 30th, 2011 5:04 pm

For a couple of my books, actually, which have recently become available in new editions.

Good old Liberty Fund has made a Kindle version of The Theory of Free Banking, which you can download for free from its Online Library of Liberty.

And my pals at the Independent Institute have just released the paperback version of Good Money, which they sell for just $22.10. That might not seem terribly cheap for a paperback, but bear in mind that this one reproduces the hardback's generous color-plate insert. Besides, it's a damn good book.

Personally I think the relative prices are about right. Not that I don't like The Theory of Free Banking.: it's just that I've come to think that an ounce of convincing history is worth at least a pound of theory. And what writer doesn't imagine that he's learned a thing or two about writing in the space of two decades?

But you needn't take my word for it. Just get them both, and decide for yourself!


What modern free banks might look like

by Kurt Schuler August 29th, 2011 11:45 pm

It has not been discussed so far in this blog what modern free banks might look like. Partly that is because several of us who blog here have the same picture in mind. It would be good for the rest of you to know what it is and decide what you think of it.

What activities would banks be allowed to engage in? Anything they wanted. In particular, they would be allowed to combine banking with commerce, so if Wal-Mart or Facebook wanted to start a bank or if a bank wanted by them, it could. If banks wanted to combine banking with brokerage or insurance, they could. In practice, some combinations of commercial banking with other lines of businesses would be common and others would not. I would not expect any bank-restaurant combinations, for example, because the businesses are so dissimilar. Even much closer combinations such as bank-plus-hedge fund might be rare because the businesses are not as alike as many people think.

How would banks be regulated? There would be no special regulations on banking, and in particular no minimum capital requirements or requirements that assets be invested in specific ways unless the bank itself promised to do so. There would continue to be some special features of law that apply to banking, just as there are some special features that that apply to other industries (fishing, trucking, warehousing, retailing, etc.) because of industry-specific features. In banking, two such features might be requirements to ensure that financial statements state certain assets and liabilities in detail to give an accurate picture of the business, and a bankruptcy regime that, one would hope, improves on the cumbersome procedures currently in place in most countries.

Advocates of free banking see no need for special regulations because they think bankruptcy would provide the ultimate check on imprudent behavior, as it does in other industries. Whether that would be the case in reality, or whether on the contrary governments would still treat some financial institutions as too big to fail, is a hugely important question that is a subject for another time.

What liability arrangements would banks have? Banks would have the choice of operating under limited liability of stockholders, unlimited liability, or combination arrangements where some shareholders would have limited liability and others would have unlimited liability. As long as the liability arrangement was clear to people who did business with the banks, there would be no special need to force banks to follow a uniform arrangement. Today, almost all banks have limited liability. Until the mid 1800s, limited liability was a privilege granted only to select companies, often in return for bribes or other favors. Then the principle became established that limited liability should be a matter of choice for stockholders. Partnerships with unlimited liability do persist, though, such as the venerable English bank Coutts and Company and many hedge funds.

What would be the monetary base? One possibility is the current fiat monetary base, frozen, as Milton Friedman proposed in an essay in a 1984 book called To Promote Prosperity. Under this proposal, banks would be free to issue notes, so over time, Federal Reserve notes would likely go out of circulation as currency and be used mainly by banks as reserves.

Another possibility is a return to gold. The gold standard has received much scorn from economists who don’t understand that the gold standard under free banking works differently from the gold standard under central banking.

Other possibilities seem far less likely. Banks could adopt a standard based on some unit not currently in use, such as the economic value of a frequent flyer mile or a British thermal unit or a basket of goods. Or they could issue currencies not tied in any set way to a good, as central banks to now and as Friedrich Hayek imagined in his pamphlet Denationalisation of Money. In a system of Hayekian banks there would be nothing corresponding to the monetary base as it now exists. No such arrangement has ever existed in any historical free banking system.

These are my educated guesses based on historical experience. Advocates of free banking would be content to allow whatever arrangements emerge through competition, and not to push the monetary system towards in one direction or other through restrictions. If people wanted to use gold, or frequent flyer miles, or adopt a Hayekian system of competing fiat currencies, it would vain for economists to protest that they were wrong to do so. It would be like saying that people are wrong to want to speak English instead of the supposedly more “rational” Esperanto (or even the truly more rational Interlingua [see page 307 of this for a speech in Interlingua by Leland Yeager, who has also written on laissez faire banking]).

Would there be fractional reserve banks or 100% reserve banks? In principle, both side by side. In practice, I know of no past banking system where the two have long coexisted. Fractional reserve banking has always outcompeted 100% reserve banking. By 100% reserve banking which I mean an arrangement where the bank holds assets for clients as a kind of warehouse and does not grant credit.

What about coins? Like the business of issuing notes, the business of issuing coins would be open to all comers. Banks might issue competing brands of coins; they might issue a common coinage through a cooperative arrangement; or they might leave coinage to other issuers. Coins might have substantial value as metal, or, as I think more likely, they might be mere tokens. Historically, where people trusted in the financial system, coins having substantial value as metal tended to be reduced to minor importance as currency over time because it is inconvenient to carry a lot of metal around in purses and cash registers. The tokens might not be redeemable in notes and deposits, or, as I think more likely, they might be. Again, historically tokens that were redeemable typically found greater acceptance than those that were not.


Greg Ip's Voodoo Economic Journalism

by Steve Horwitz August 20th, 2011 11:24 am

In a piece titled "The Republicans' New Voodoo Economics?" Greg Ip writing in The Washington Post tries to connect up the current GOP with a whole variety of what he sees as wrong-headed ideas, including those of the Austrians.  What's most frustrating about the piece is his description of the Austrian view of recessions:  "Austrians considered recessions a natural feature of capitalist economies, and efforts to suppress them via monetary or fiscal policy were apt to distort investment, worsen booms and busts, or lead to inflation."

It's certainly true that Austrians believe that using monetary and fiscal policy will make matters worse, but Ip makes it seem as though recessions just appear from nowhere (a "natural feature of capitalist economies"), when the strongly dominant view among Austrians is that recessions are caused by government monetary policy via the central bank. This misrepresentation makes it look like Austrians are pure fatalists about recessions and their human toll, when in fact a great deal of ink has been spilled as to how better monetary institutions can prevent recessions in the first place, and obviate the exacerbation of those problems that comes from government monetary policy.  Ip's version of Austrian macro nicely fits into the now common narrative (see Lord Skidelsky's comments in the LSE debate and subsequently - see also George Selgin's brand new response) that Austrians simply don't care about trying to prevent recessions and minimize their human toll.  It also likely plays to the pre-conceptions the Post's readers have about critics of activist policy.

And yes, I'm well aware that Hayek argued that you can get the cycle without activism by the central bank, hence my language of "strongly dominant."  But in the larger rhetorical context, that's some intellectual hair-splitting when the vast majority of Austrian arguments about the source of recessions (rightly or wrongly) have focused on the expansionary policies of central banks.  Greg Ip is utterly unaware of these intra-school debates and his version of the theory is the result either of not bothering to engage with the actual work of the Austrians or intentionally fudging the theory to make it fit the narrative that drives the story.  Whichever it is, it's voodoo journalism.

Putting aside that it might be self-serving, the thing that really bothers me about so many media treatments of the Austrians, is that they focus almost solely on work written 75 years ago, making it seem like there's no modern work in the tradition and that Austrian arguments haven't been advanced and refined in light of subsequent criticisms and other schools of thought.  If journalists are going to discuss or interview living Keynesians and their work, then is it really that hard to Google "Austrian economics" and find some actual, living Austrians who have written on monetary and macro as part of your attempt to understand the role that these ideas might be playing in current policy debates? No one says journalists have to pay attention to Austrian ideas, but if they are going to do so, shouldn't they feel an obligation to talk to actual people who are working on the ideas? Not doing so seems to me to be another example of voodoo journalism.

Cross-posed from Coordination Problem.


Lord Skidelsky's Late Punch

by George Selgin August 20th, 2011 10:46 am

Back in 2001, supermiddleweight boxer James Butler was heavily fined and barred from the sport for sucker-punching his opponent instead of congratulating him after being bested in a match.

Alas, there are no similar penalties for late sucker punches delivered after economics debates, or else the BBC-sponsored Hayek versus Keynes debate held at the LSE last month might have been Lord Skidelsky's last. For yesterday his noble lordship delivered a most ignoble below-the-belt blow to his late opponents in the shape of a Project Syndicate column titled "The Keynes-Hayek Rematch."

Here, among other things. Lord Skidelsky suggests that Keynes "savaged him [Hayek] while he was still alive," and that Hayekian ideas have only succeeded in gaining popularity since thanks to Hayek's having long outlived Keynes--as if Hayek's growing popularity wasn't itself mainly posthumous, and as if Keynesian ideas have lacked huge battalions of defenders, both in and out of the academy, since his death. He writes as well that only "Hayekian fanatics" could possibly not believe that the "global stimulus of 2009 stopped the slide into another Great Depression"--a statement that, besides dismissing as "fanatics" a large number of persons, including some pretty good macroeconomists who are no more Hayekian than Lord Skidelsky himself, seems rather brash. He repeats the slur, which I took pains to expose as such during the debate, that Hayek favored doing nothing to combat a post-boom collapse of spending, likening Hayek's stand to one of "denying blankets and stimulus to a drunk who has fallen into an icy pond, on the grounds that his original trouble was overheating." He also repeats the claim, refuted in my last post, "that public-sector austerity at a time of weak private-sector spending guarantees years of stagnation, if not further collapse." Finally, Lord Skidelsky declares that "Hayekians have nothing sensible to contribute" (my emphasis) to the debate concerning the extent to which "strengthening the tools of macroeconomic management"--meaning (presumably) further expanding government spending and indebtedness as well as further strengthening central banks' powers--is likely to prove beneficial and prudent.

To the last assertion, an astute commentator offers a most appropriate reply. "It's hard to believe," he observes, that the observation in question, among others noted,

was written by the same man who, half a dozen years ago, said of Hayek, “The particular threats to liberty that he identified may be on the wane—his book has done its work well—but there are other threats, and the victory of liberty is never secure. Hayek's key message for us today is surely this: every new restriction or regulation should be judged by its effect not just on the problem that it is designed to solve or the danger that it is designed to avert but by its effect on the system of liberty as a whole. If we are blind to this, we will be left with a damaged system of liberty long after the particular problem or danger has passed away."

"That, however," the commentator continues, "was upon receiving the Manhattan Institute's $50K 'Hayek Prize.' Perhaps they ought to have spread out the payments!"

It turns out that, when Lord Skidelsky was given it back in 2005, the Hayek Prize was worth only $10 thousand. I leave it to readers to decide whether to wish it had been more, or that it had been less.


Walter Bagehot, father of central banking and supporter of free banking

by Kurt Schuler August 19th, 2011 10:37 pm

Walter Bagehot (1826-1877) was the most famous editor of The Economist. (His last name, by the way, is pronounced “BADGE-it.”) For his wisdom on financial matters, he was dubbed “the spare chancellor,” a reference to the Chancellor of the Exchequer, the British minister of finance. His book Lombard Street (1873), named after the English equivalent of Wall Street, criticized the Bank of England for not using its powers to alleviate financial crises. Bagehot argued that the Bank’s monopoly position gave it both the responsibility and the ability to do so, and that the Bank should not conduct itself as if it were an ordinary commercial bank.

For its explanation of how the Bank of England should act, Lombard Street became the foundation document of modern central banking. As I explained in an earlier post, Henry Thornton had anticipated some of Bagehot’s ideas about 70 years earlier, but by the time of Lombard Street Thornton’s monetary thought had faded into obscurity, and would not be rediscovered for another half-century. The Bank of England followed Bagehot’s prescription during the worldwide financial crisis that occurred later in 1873, establishing a pattern that other central banks would imitate.

It is worth recalling, though, that Bagehot did not view central banking as the natural monetary system. Here are his words:

We are so accustomed to a system of banking, dependent for its cardinal function on a single bank, that we can hardly conceive of any other. But the natural system—that which would have sprung up if Government had let banking alone—is that of many banks of equal or not altogether unequal size. In all other trades competition brings the traders to a rough approximate equality. In cotton spinning, no single firm far and permanently outstrips the others. There is no tendency to a monarchy in the cotton world; nor, where banking has been left free, is there any tendency to a monarchy in banking either. In Manchester, in Liverpool, and all through England, we have a great number of banks, each with a business more or less good, but we have no single bank with any sort of predominance; nor is there any such bank in Scotland. In the new world of Joint Stock Banks outside the Bank of England, we see much the same phenomenon. One or more get for a time a better business than the others, but no single bank permanently obtains an unquestioned predominance. None of them gets so much before the others that the others voluntarily place their reserves in its keeping. A republic with many competitors of a size or sizes suitable to the business, is the constitution of every trade if left to itself, and of banking as much as any other. A monarchy in any trade is a sign of some anomalous advantage, and of some intervention from without.

I shall be at once asked—Do you propose a revolution? Do you propose to abandon the one-reserve system, and create anew a many-reserve system? My plain answer is that I do not propose it. I know it would be childish. Credit in business is like loyalty in Government. You must take what you can find of it, and work with it if possible. A theorist may easily map out a scheme of Government in which Queen Victoria could be dispensed with. He may make a theory that, since we admit and we know that the House of Commons is the real sovereign, any other sovereign is superfluous; but for practical purposes, it is not even worth while to examine these arguments. Queen Victoria is loyally obeyed—without doubt, and without reasoning—by millions of human beings. If those millions began to argue, it would not be easy to persuade them to obey Queen Victoria, or anything else.

Those who believe Bagehot thought that “there were responsibilities in emergent capitalism that only governments could assume, centralized control of the banking system chief among them” should be aware of this passage. And given that the Queen of England no longer reigns over millions of square miles teeming with hundreds of millions of subjects, but merely over the 80th largest country in the world plus some tiny outlying islands and a patch of frozen wasteland in Antarctica, we should consider that a return “the natural system” of free banking is likewise more possible than Bagehot imagined.

Concerning my last post, stating that central banking is a form of central planning, note that I did not state that it is the whole of central planning. As a commentator remarked, one of the ten key economic policy measures to implement communism that the Communist Manifesto proposed was “centralization of credit in the hands of the State, by means of a central bank with State capital and an exclusive monopoly.” Marx and Engels had in mind what was later called a monobank system, unifying central and commercial banking functions under one management. A central bank that is not also a monopoly commercial bank does not go nearly as far as Marx and Engels would have liked, but within its sphere, it is undoubtedly a form of central planning. And it is not like a government monopoly of, say, tobacco sales because monetary policy has effects that pervade throughout the economy, rather than being confined to a single industry.


An Austere Recovery

by George Selgin August 18th, 2011 3:17 pm

As I pointed out in a previous post, in the course the BBC/LSE "Hayek versus Keynes" debate the Keynesian side made some claims to which I had no opportunity to respond. My earlier post addressed some of them, but left another alone. This was Lord Skidelsky's claim, aimed at Great Britain's current riot-provoking austerity campaign, that no government has ever achieved a speedy recovery from a recession by clamping down on its spending or reducing its indebtedness.

But there is at least one instance of economic recovery--and hardly a trivial one--that contradicts, or at least very much appears to contradict, Lord Skidelsky's claim. This is the United States' rapid recovery from the deep recession into which it sank in the last half of 1920.

In many respects the boom-bust cycle that started in April 1919 was typically "Hayekian": during the boom year ending in April 1920 the Fed held its rediscount rate at 4 percent despite rising money market rates. Commercial banks took advantage of the low rate--as they'd actually been encouraged to do by the Fed--by borrowing from the Fed in order to re-lend at a profit, causing bank loans and investments to increase by just over 25 percent. General prices, and prices of commodities and land and other factors of production especially, in turn rose more rapidly than they had since the Civil War, exacerbating a gold drain that had begun with the armistice. Under the circumstances a reversal was only a matter of time.

When it came, the reversal was both sudden and sharp. Commodity prices tumbled from an index value of 248 in May 1920 to one of just 141 the following August, while consumer prices witnessed their greatest rate of deflation ever. Businesses were unable to pay their bills, industrial production fell by an unheard of 30 percent, and almost 5 millions workers lost their jobs, bringing the unemployment rate, which had been less than 2 percent, to just below 12 percent. Yet by August 1921 recovery was well underway. What's more, it was so swift that by the spring of 1923 unemployment had given way to a pronounced labor shortage, while industrial production reached a new peak.

Did the U.S. government hasten the recovery by means of deficit spending and other "stimulus" programs? Not in the least. instead, it stuck to conducting business as usual which, in those naive days before Keynes revealed that prudence and thrift were shopworn Victorian shibboleths, meant reverting to its prewar budget and retiring its wartime debt. In other words, it followed what would today be called an "austerity" policy, and did so to a degree that makes recent austerity measures in Great Britain and the U.S. seem downright profligate. Instead of spending more than it had been, the Harding administration steadily cut expenditures, exclusive of debt retirement, from just over $6.4 billion in fiscal 1920 to just under $3.3 billion in fiscal 1923--a whopping 45 percent! As a percentage of GNP, Randy Holcombe shows, Federal outlays fell from just over 7 percent to well under 4 percent.* And although its revenues also declined over the same period, from about $6.7 billion to about $4 billion, the government nevertheless devoted a large share--almost $1 billion--to reducing its indebtedness. As Benjamin Anderson, who was at the time an economist employed by Chase National Bank, observes in Economics and the Public Welfare (1949),

The idea that an unbalanced budget with vast pump-priming government expenditure is a necessary means of getting out of a depression received no consideration at all. It was not regarded as the function of the government to provide money to make business activity. It was rather the business of the United States Treasury to look after the solvency of the government, and the most important relief that the government felt that it could afford to business was to reduce as much as possible the amount of government expenditure, which had risen to great heights during the war; to reduce taxes--but not much; and to reduce public debt.*

Turning to monetary policy, although easy money did contribute somewhat to the recovery, the contribution was minor and largely unintended. Thus while the Fed banks gradually lowered their discount rate from 7 to 4 percent between 1921 and 1922, 4 percent was not especially low in light of the rapid deflation then in progress. And despite the rate lowering commercial bank rediscounts declined, as banks preferred reducing their indebtedness to the Fed to taking advantage (as they regretted having done earlier) of opportunities to re-lend borrowed funds at a profit. The Fed also made what was at the time an unusually large open-market purchase of government securities. But this only served to further reduce commercial bank rediscounts, and was moreover done, not with any intent of stimulating recovery, but solely so that the Fed could earn enough revenue to cover its expenses and pay promised dividends to its commercial-bank shareholders.

Proponents of Keynesian pump-priming often berate the Hoover administration for its "liquidationist" strategy for dealing with the outbreak of the Great Depression--forgetting that it was Hoover himself who caricatured Andrew Mellon, his Secretary of the Treasury, as someone who wished to "liquidate" the stock market, farmers, real estate, and so forth, and who took pride in not having followed his advice. But Mellon was also Harding's Secretary of the Treasury; and Harding, unlike Hoover, trusted him. It is one of the greater ironies of economic history that "liquidationist" policies, including government austerity, are blamed for prolonging a depression for which those policies were set aside, while being denied credit for perhaps helping to end one in which they really were put into practice.

*Sentences added 8/20/2011


On very rare occasions, when it regards a broadcast as having been particularly well-received, BBC Radio 4 rebroadcasts the same program for a third time. I'm very pleased to say that it has chosen the Hayek versus Keynes debate for this honor, and will therefore air it again, for the sake of regular listeners who missed it (and can't be bothered with podcasts) on August 24th. Yo Hayek!


Give Credit Where Credit is Due

by George Selgin August 14th, 2011 2:47 pm

This morning over breakfast at the neighborhood bakery, I read a very nice article in the New York Times concerning the "unconventional" views of Kansas City Fed President Thomas Hoenig--views that have made Hoenig my own favorite Fed insider for some years now. Hoenig's beliefs, as summarized there, struck me as being virtually the same a those I'd put forward in London in what I considered to be a defense of Hayek's thinking about business cycles. Consider:

“The central bank has to be, in a way, a neutral player, and yet we find ourselves trying to stimulate, and the effect is further leveraging,” he said. “If I thought zero rates would bring jobs, I’d want it forever. But it distorts the economy.”

He continued, “In 2003, when we lowered rates and kept them there because unemployment was 6.5 percent — look at the consequences.” Those consequences included the nation’s mortgage feast, followed by its current economic famine.

Returning home, I read this comment from Bill Woolsey on David Beckworth's blog:

I am a bit of an ABCT skeptic, but I am more and more concerned that using a committment to keep interest rates low in the future is the most likely way to generate malinvestment. In my view, the way to avoid malinvestment despite errors in monetary policy is for people to understand that future short term rates will reflect future conditions. An investment project that is only profitable if short term rates are maintained into the future, is an error. And, by the way, having the Fed purchase long term bonds to directly lower long term rates has a similar problem.

Although I don't call myself an Austrian economist, and am more than happy find fault with arguments by self-styled "Austrians" that I think unsound, I can't help feeling that Hayek deserves a lot more credit than he's getting for having put forward a theory which, whatever its general merits may be, seems to fit the recent boom-bust experience so well. So far as I'm aware, Mr. Hoenig never mentions Hayek, and may not even be aware of the overlap between his own thinking and Hayek's theory. Bill Woolsey, on the other hand, knows about the ABCT, sees the fit to recent experience, but remains a "skeptic." I wonder whether he is merely indicating his disagreement with those more fervent proponents of the theory who seem to insist that it is the only valid theory of cycles.

In any event it seems to me that anyone who believes that the recent bust is to some important extent a consequence of past malinvestment that was sponsored by easy monetary policy ought to acknowledge the fact that F.A. Hayek spent much of his early career warning against this very possibility, and later won a Nobel prize for the work in question. That something akin to his theory, if not the very thing itself, is now subscribed to by many non-Austrians, either with no mention of Hayek's contribution or with somewhat grudging acknowledgment of it only, seems to me both strange and unfair.


Central banking is a form of central planning

by Kurt Schuler August 12th, 2011 11:35 pm

Central banking and the debate over central planning passed each other like two ships in the night in the early 1900s. Central banking was becoming the standard monetary system that economists recommended. Financial conferences held by the League of Nations in Brussels in 1920 and Genoa in 1922 proposed that countries, as least independent countries, should have central banks. The idea was that politically independent central banks would take control of monetary policy from government treasuries that had become the de facto monetary policymakers during World War I and had created substantial inflation in many countries.

At the same time, Ludwig von Mises published an article in 1920 called “Economic Calculation in the Socialist Society” and a 1922 book, Socialism: An Economic and Sociological Analysis, arguing that comprehensive central planning of the economy would be disastrous because central planners lacked market prices and market institutions to inform their actions, hence they would waste resources on a vast and even fatal scale.  Because most economists did not understand the depth of Mises’s challenge, economists generally did not acknowledge his argument as valid until communism collapsed from 1989 to 1991.

Not until Lawrence H. White’s 1984 book Free Banking in Britain and George Selgin’s 1988 Theory of Free Banking did economists confront these two powerful currents of thought directly with each other. And even though mainstream economics now blames the Federal Reserve and the Bank of France for the intensity of the Great Depression and acknowledges that too many central banks have created runaway inflations, mainstream economists have been slow to answer the challenge that free banking theory now poses to central banking. The only real exception has been Charles Goodhart, the world’s leading expert on central banking. Goodhart’s writings on central banking and his criticisms of free banking are well worth reading, but such an important issue needs multiple thinkers on both sides working to bring out its many facets.

Central planning failed as a comprehensive economic system; why should we expect central planning limited to particular fields of economic activity to do better? Central banking is a form of central planning. Rather than leaving the selection and production of the monetary base open to competition, it concentrates them in a monopoly sponsored by and nowadays almost always owned by government. As part of this monopolization, it typically prohibits would-be competitors from issuing notes and coins that might displace those the government has issued.

David Glasner has two posts claiming that central banking is not central planning. I do not find them convincing. Central banks are government monopolies that consciously try to steer the economy. If that is not central planning, nothing is. (And by the way, it will not do to cite the younger Hayek in support of central banking when the older Hayek in Denationalisation of Money wrote about “the obvious corollary that the abolition of the government issue of money should involve also the disappearance of central banks as we know them” [page 105].)

I think, however, that pointing out that central banking is a form of central planning is not sufficient by itself as an argument. Monetary theory and practice have for decades been built on the idea that ultimate power in monetary matters properly rests with governments. Displacing ideas and institutions that are now long established is not merely a matter of writing a few books, much less a few blog posts.

In my next post I will discuss a surprising advocate of free banking.


Free Banking and Economic Development, Part 2

by George Selgin August 9th, 2011 3:44 pm

(Both parts of this article originally appeared, under the title "Fractional Reserves and Economic Development," on the short-lived Free Market News Network.)


When Adam Smith first drew attention to the benefits of fractional-reserve banking, those benefits were but a glimmer of far more impressive gains to come. In 1776, the year of the appearance of Smith’s Wealth of Nations, Scotland had only 10 note-issuing banks, the two oldest of which, the Bank of Scotland and the Royal Bank of Scotland, were but 81 and 49 years old, respectively. The note-exchange and settlement system was still in its infancy, so metallic reserves still accounted for about a fifth of issuing banks’ liabilities. By the time of the passage of the Scottish Bank Act of 1845, which placed restrictions on further Scottish note issues, Scotland had almost twice as many note-issuing banks, with coin reserves often amounting to less than two percent of their liabilities. Scottish banks’ had thus achieved a substantial improvement in their ability to invest Scotland’s money holdings productively, and had done so without engendering the least loss of public confidence in their notes.

Although Scotland offers an especially impressive example of the gains to be had from fractional-reserve banking, such banking has also played a crucial role in worldwide economic development. Persuasive evidence of this can be found in two collections of studies, Banking in the Early Stages of Industrialization (1967) and Banking and Economic Development (1972), both edited by economic historian Rondo Cameron. Surveying the findings of the first volume, Cameron concludes that banks, through their “substitution of various forms of bank-created money for commodity money,” played an essential part in fostering industrial development, and that they were most effective in so doing in places, like Scotland in the early 19th century, where they were least hampered by government regulations, including regulations limiting banks’ right to issue circulating notes.

More recent research has reinforced Cameron’s conclusions by showing how “repressive” financial regulations—meaning regulations that prevent banks from functioning as efficient savings-investment intermediaries, such as statutory minimum reserve requirements—have impeded economic growth in less-developed countries. Oppressive banking regulations are especially harmful to poor countries, where money holdings represent are large portion of available savings. Of such oppressive regulations the monopolization of paper currency by central banks is perhaps the most oppressive of all, for it means that a substantial part of the public’s monetary savings is diverted from the private sector, which might employ those savings productively, to the government, which tends to squanders them instead.

As nations become wealthier, the relative importance of fractional-reserve banks diminishes, because the public becomes increasingly able to afford financial assets other than money, including stocks and bonds. Industry can then rely, to some extent at least, on funds acquired by selling securities, instead of having to borrow from banks. Yet bank loans remain a major source of business funding, and of small-business funding especially, even in wealthy nations with well-developed securities markets. In the United States, for instance, businesses today get more than twice as much credit from banks as they get by issuing their own bonds, and many times as many funds as they get by selling shares. In Germany and Japan bank loans account for a still larger share of business funding. And although commercial banknotes have been legally suppressed in most countries, demandable bank IOUs, in the form of demand deposits, remain banks’ own principal source of funds. Without fractionally-backed bank money, in other words, most businesses would have to go begging for credit—as they were forced to do, temporarily, during the banking crisis of the 1930s.

I realize that claims concerning how fractional-reserve banks promote prosperity will carry little weight among those who insist that such banking necessarily entails fraud. It would be tragic indeed if they were right, for then we would confront a stark choice between condoning fraud on one hand and enjoying economic prosperity on the other. Fortunately, though, we face no such dilemma: as I hope to make clear in a later essay, the claim that fractional-reserve banking involves fraud is just as untenable as the claim that it has contributed nothing to the wealth of nations.


The Keynesians Answer Back

by George Selgin August 5th, 2011 3:29 pm

Last week's debate has naturally generated some response from defenders of Keynes who have found fault with my and Jamie Whyte's characterization of Keynes's views, or who have simply found fault with our...personalities!

Over at Tax Research UK, for instance, Richard Murphy and some of his friends observe that, besides being humorless, Jamie and I must also lack the basic human ability to "empathize" with others (which is, when you get down to brass tacks, just a tiny step away from coming right out and calling us a couple of sadists), for how could we otherwise be opposed to unbridled government spending and bailouts? Concerning the last, Mr. Murphy takes for granted that in suggesting that insolvent banks ought to have been allowed to fail I meant that they ought to have been left to collapse, leaving depositors out in the cold. Murphy's implicit view that collapse is the only alternative to bailouts is of course one that insolvent bankers themselves are happy to see promulgated. Nevertheless it is perfectly unfounded, as I indicate in my contributions to the blog in question, where I refer to what some have styled the "Swedish" alternative.

At Social Democracy a post-Keynesian blogger who styles himself "Lord Keynes" similarly misinterpreted my "liquidationist" stand, inviting what became a long exchange with me there that was interesting in part because by engaging in it I learned that trying to argue with a dreaded Post-Keynesian can after all be a lot more rewarding, as well as a lot more pleasant, than trying to argue with many Rothbardians!

Finally, at Prime another post-Keynesian, Victoria Chick (who I reckon one of my favorite "Keynesian" economists, for what it's worth) accuses Jamie Whyte and me of committing eight serious "fallacies" in our part of the debate. As I only just finished replying to her post, and my answers--one for each of the supposed "fallacies"--still await moderation, I reproduce the latter here (you must consult the original blog for the accusations themselves):

1. Hayek as “an opponent of financial excess”

The suggestion that deregulation was responsible for the sub-prime excess is unfounded. The Glass-Steagall “repeal” of 1999 merely allowed investment banks to have commercial bank subsidiaries; since it was the investment banks themselves rather than their (smallish) commercial bank subsidiaries that got in hot water, the reform made no difference except by making it easier to rescue tottering stand-alone investment banks through bank mergers. As for deregulation in the ’80s, the supposed link to the sub prime boom here is too obviously tenuous to be worthy of comment.

2. Keynesian policy as “promoting the big state”

It’s true that Keynes himself was what today would be considered a (long-run) fiscal conservative. This is a point I myself made in an excised portion of the debate. However it is also true that the Keynesian suggestion that expansionary policies are generally capable (see below) of combating non-trivial levels of unemployment has been seized upon by politicians as justifying government profligacy.

3. The inflation of the 1970s as “the fault of Keynesian policies”

I don’t recall myself blaming “Keynesianism” for the inflation of the 70s. On the contrary: in part of the debate that was edited I specifically observed that Keynes had been a consistent advocate of price-level stabilization. As for the 70s, in the U.S. inflation started creeping up in the 60s, partly because of the Vietnam war but also at the urging of prominent self-styled Keynesians who insisted that higher inflation would bring lower unemployment, as had appeared to be the case earlier in the decade. The so-called stable “Phillips Curve” is not something critics of Keynesianism invented: it was the brainchild of self-styled Keynesians themselves, and it did certainly play its part in the Vietnam-era escalation of U.S. inflation rates.

4. Keynes as “advocate of deficit spending”


5. Keynes as “a supporter of wasteful expenditures”

Whether he intended the consequence or not, Keynes’s “pyramid building” rhetoric licensed wasteful government spending. It’s a shame that he isn’t around to assail those who have abused his arguments so. But even a smallish dose of public-choice theory should have sufficed to predict what politicians would make out of the suggestion that any sort of spending is capable of combating depression and, indeed (if Lord Skidelsky is to be taken at his word) capable of promoting long-run economic growth!

6. Roosevelt’s New Deal as “trivial in scale and impact”

Romer wasn’t “compromised” by her earlier writings on the New Deal: she was simply embarrassed by them once she found herself leading the economic team of an administration committed to fiscal stimulus. The evidence and argument contained in her key writings on the 30s remain as solid as ever. Moreover, she is far from alone in having argued that major components of the New Deal, and the NRA especially, were either ineffective or actually counterproductive in ending the depression.

Indeed, Keynes himself believed that the NRA would impede rather than hasten recovery, and said so in a letter to Roosevelt written after the act’s passage. The letter reads in part,

“I am not clear, looking back over the last nine months, that the order of
urgency between measures of Recovery and measures of Reform has been duly
observed, or that the latter has not sometimes been mistaken for the former. In
particular, I cannot detect any material aid to recovery in N.I.R.A., though its
social gains have been large. The driving force which has been put behind the
vast administrative task set by this Act has seemed to represent a wrong choice
in the order of urgencies. The Act is on the Statute Book; a considerable amount
has been done towards implementing it; but it might be better for the present to
allow experience to accumulate before trying to force through all its details. That
is my first reflection–that N.I.R.A., which is essentially Reform and probably
impedes Recovery, has been put across too hastily, in the false guise of being
part of the technique of Recovery.”

(Interested readers can read the whole letter here.)

7. The 2008-9 financial rescue as “‘Keynesian”

Well, here is Keynesian support for bank bailouts. Q.E.D.

By the way, it has been suggested by some (not here) that in opposing such I in effect favored simply letting banks collapse. But the suggestion that collapse is the only alternative to bailouts ignores what some term the “Swedish approach”, which was the alternative I had in mind.

8. The failure of stimulus as “a failure of Keynesian policy”

Sorry, but it’s back to pyramids again: the Keynesian argument is that the problem is solely one of inadequate demand, so that, much as public works and such might be preferred, any sort of fiscal [stimulus] should help; and it was on such grounds that U.S. proponents of fiscal stimulus didn’t trouble themselves over just where stimulus money would go in arriving at their (ultimately very wrong) estimates of the “multiplier” effects we could all look forward to. If more orthodox Keynesians think that all this was a mistake, I am glad to hear it. But they still need to explain how to reconcile their ideal stimulus with the workings of real world (democratic) governments.

Addendum: Soon after this posting Mr. Murphy shut-down comments on his blog entry. Perhaps I'm being too uncharitable in supposing that this had anything to do with the accumulation of negative feedback he was receiving, much of which was evidently from sympathetic, regular readers. Mr. Murphy, in any event, allowed himself the following last words:

"Trouble is – I’ve never known an empathic person who can find a cent of sympathy for Hayek and Hayekians."

Meaning, I surmise, either (1) that he couldn't hear all those people shouting "Yo Hayek" in the BBC podcast or (2) that he maintains that every one of them was incapable of empathy.

Methinks the man doth protest too much.

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