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Friedman and free banking

by Kurt Schuler July 31st, 2012 10:34 pm

Today is the centenary of Milton Friedman’s birth. (He died on November 16, 2006.) To honor it, Julio Cole, a professor at Francisco Marroquín University in Guatemala, compiled a bibliography of Friedman’s scholarly writings earlier this year. An earlier bibliography, which adds many of his newspaper articles and other more ephemeral writings, exists in The Essence of Friedman, an excellent collection edited by Kurt Leube.

Friedman’s ideas on monetary policy changed over time. He began as a convinced Keynesian. Then, of course, he became the leader of the monetarist school, and wrote with Anna Schwartz the groundbreaking Monetary History of the United States, 1867-1960. The most influential aspect of the book was how it changed the views of economists about what caused the Great Depression—and, by implication, many other economic disasters. Friedman and Schwartz blamed the Federal Reserve System, and to consider how completely their argument has been accepted it suffices to recall that Ben Bernanke, who at the time was a Federal Reserve governor though not yet the chairman, remarked at a 90th birthday celebration for Friedman, “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.”

Late in his career, Friedman switched from advocating a constant growth rate for M2 to a quite different approach: freeze the monetary base and deregulate financial institutions, including letting them issue currency (“Monetary Policy for the 1980s,” originally in John Moore [editor], To Promote Prosperity: U.S. Domestic Policy in the Mid-1980s, 1984, reprinted in the Leube volume.)

A bit later, in 1986, he discussed free banking in an article with Anna Schwartz, “Has Government Any Role in Money?” (Journal of Money, Credit and Banking, also reprinted in the Leube volume). Friedman and Schwartz cited Larry White’s work on free banking in Scotland, but claimed that the experience of the United States before the Civil War is much less favorable to the case for free banking. I think they understated the influence of the different legal frameworks in various states on the shape the U.S. banking system took, and therefore understated the extent to which the U.S. banking system was far less free than the Scottish system.

Friedman ended up being close to the free banking position as far as his ideas for contemporary policy were concerned, though not in terms of his interpretation of the history of the system. Friedman's later views remain obscure, even among monetary economists, compared to his middle-period advocacy of targeting M2, the view he held at the time he was awarded the Nobel Memorial Prize in economics.


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Notes for an Essay on Currency Competition and Counterfeiting

by George Selgin July 19th, 2012 5:18 pm

I’ve long been meaning to write something about the bearing of free banking on the problem of counterfeiting—a topic I addressed only very briefly in Theory of Free Banking. Since that time, although quite a lot has been written about the general subject of counterfeiting, hardly anything has been said about whether or not having competing banks of issue would make matters worse.

Conventional wisdom has it that having many banks of issue instead of just one makes life easier for counterfeiters. This wisdom draws heavily on the United States’ antebellum experience, while overlooking the experiences of arrangements more representative of genuine free banking, including those of Scotland between 1770 or so and 1845 and of Canada during the late 19th and early 20th century. Evidence from these other episodes points to a rather different conclusion, while suggesting that extant theoretical models of counterfeiting overlook ways in which competitive note issue can actually make counterfeiting less rather than more lucrative than it is when currency is supplied monopolistically.

I hope readers of this forum will forgive my setting forth, as a framework by which to gain a better understanding of the ways in which plural note issue bears upon the problem of counterfeiting, a very simple formal representation of a prospective counterfeiter’s anticipated profit, π. Let

π = ND – CcN – FP,

where P = g(Cc, Ca, N, D, T, B), Cc = c(Ca), F = f(N,B), Ca = d(B), and T = t(B). Here N stands for the number of counterfeits placed into circulation, D for their denomination, Cc for counterfeits’ average unit cost of production, F for the penalty or a counterfeiter incurs if caught (which may depend on the number of counterfeits he is found guilty of having uttered), P for the probability of detection, Ca for the unit cost of a genuine note, T for a note’s average “turnover” time, that is, time spent in circulation before returning to its (purported) source, and B, finally, for the number of legitimate banks of issue. The presumed derivatives are Cc’ > 0, f’(N) > 0, f’(B) < 0, g’(Cc) < 0, g’(Ca) > 0, g’(N) > 0, g’(T) > 0, g’(B) < 0, d’ > 0, and t’ < 0.

Standard treatments of the counterfeiting problem, to the extent that they allow for the possibility of plural note issue at all, have tended to treat the number of banks of issue, B, as increasing the anticipated profitability of counterfeiting by directly reducing the likelihood of prosecution, an effect allowed for here by the last element in P: this effect stems from the extra information costs that must be incurred by persons seeking to distinguish genuine from counterfeit notes as the variety of genuine notes increases. The practically exclusive emphasis upon this influence reflects the tendency of researchers to look upon antebellum U.S. experience, with its huge numbers of relatively small banks, and consequent need for “Counterfeit Detectors” to keep bankers and retailers informed of the correspondingly large numbers of known counterfeits, as representing the typical consequences of plural note issue.

As anyone who is familiar with the free banking literature, or simply with more informed writings on U.S. banking history, knows, the U.S. case was a by-product of legal restrictions, chief among which were laws prohibiting most banks from having branches, while prohibiting banking altogether in some states and territories. These circumstances turned under-banked regions into dumping grounds for the worst of the authentic banknotes from other parts of the country, while in turn creating easy opportunities for counterfeiters to add their products to an already disorienting melange.

But the U.S. experience was unique. Other plural note issue systems, like those of Scotland and Canada, involved not thousands or even hundreds but no more than a few dozen banks of issue, most of which had extensive branch networks. The number of distinct banks was small enough to allow retailers to familiarized themselves with legitimate note varieties. Yet in combination with branching it was more than large enough to provide for notes’ active redemption, that is, for their regular absorption by the clearing and settlement system, by which they were sent back to their reputed sources. In the Scottish system, for instance, it took eleven days or so for a note to return to its source after having first been paid out—a speed not so different from that for modern checks. This translated into a high annual turnover (T) of about 33. In contrast, notes of a monopoly issuer might remain in circulation for several months, if redeemable in specie. If not, they might remain afloat until too badly worn to circulate, which could mean years.

What difference does turnover make? That it matters a great deal becomes apparent as soon as one considers that in the vast majority of instances counterfeits are discovered, or at least discovered and then reported, not by members of the general public or by non-bank merchants, but by bankers themselves, and especially by the banks whose notes have been counterfeited. There are two simple reasons for this. First, the tellers at these banks are the persons best equipped to distinguish their banks’ authentic notes from even clever counterfeits. Second, they have the strongest incentives both to be on the lookout for fake notes and to report fakes that they discover instead of merely refusing them or attempting to fob them off on others. The last point is true in part because, if persons other than a bank's employees report a counterfeit of a bank’s notes, they may suffer a loss equal to the value of the reported notes. (Importantly, although this last deterrent has generally been in effect in monopolistic currency arrangements, it was sometimes absent in competitive ones.)

The significance of turnover, then, is that, the higher the rate of turnover of any bank’s notes, the greater the risk a counterfeiter faces of having, first his counterfeits, and then himself, discovered. High turnover means a greater chance that counterfeits will be detected within any given span of time, and consequently a greater chance of them being detected after a small number of transfers only, which increases the odds of their original “utterers,” and therefore the counterfeiters themselves, being caught.

A second, indirect way in which currency competition deters counterfeiting, which also has something to do with turnover, is by inducing note issuers to devote more resources to making their notes counterfeit-resistant. This follows from the fact that especially convincing counterfeits can fool even a bank’s own expert tellers, causing it to suffer losses by redeeming counterfeits. The extent of such losses will be greater, for any given volume of counterfeiting, the greater the turnover (and hence the lower the float) associated with an issuer’s currency. In the extreme case of a monopoly issuer of fiat money, which is of course never called upon to redeem its notes, the risk in question is nonexistent, and the incentive to invest in counterfeit-resistant notes is correspondingly low.

Finally, the presence or absence of competing issuers can influence would-be counterfeiters’ expected profits in at least one other way. This is by having some effect on the penalties or fines to which successfully prosecuted counterfeiters are subject. Here the difference is not so much economic as political, consisting of the fact that counterfeiting of the notes of a monopoly bank of issue has often been treated as a crime equivalent to the counterfeiting of official coin, and often, therefore, as a capital offense, whereas the counterfeiting of competitively-supplied banknotes has in contrast generally been a misdemeanor, if indeed it has been considered a crime at all.

The upshot of all this is that competition in currency can serve either as a deterrent or as a stimulus to counterfeiting. Whether it serves one way or the other depends on the importance of the “turnover” and “anti-counterfeiting investment” effects on one hand and those of “information cost” and “reduced penalty” effects on the other. Theory alone—at least the sketch of a theory considered here--therefore doesn't warrant the conventional conclusion that currency competition means more counterfeiting. The matter calls for a closer look into the historical evidence, to which I will turn in a second installment of these “notes.”


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Banknotes Are Not, and Have Never Pretended to Be, Warehouse Receipts

by George Selgin July 17th, 2012 5:38 pm

"[B]anks have habitually created warehouse receipts (originally bank notes and now deposits) out of thin air. Essentially, they are counterfeiters of fake warehouse-receipts to cash or standard money, which circulate as if they were genuine, fully backed notes or checking accounts. Banks make money by literally creating money out of thin air, nowadays exclusively deposits rather than bank notes. This sort of swindling or counterfeiting is dignified by the term 'fractional-reserve banking,' which means that bank deposits are backed by only a small fraction of the cash they promise to have at hand and redeem."

Murray Rothbard, "Fractional Reserve Banking."

A clear, testable implication of the above quote--one of the loci classici of the belief, now widespread among fans of a certain sort of Austrian economics, that fractional reserve banking is fraudulent--is that the notes issued by fractional reserve banks have been indistinguishable from warehouse receipts. After all, if you are going to swindle people by "counterfeiting" something, you wouldn't be inclined to make the fakes obviously unlike the genuine articles, right?

Here are some images of (1) various warehouse receipts and (2) various banknotes. I draw my readers' attention to the language common to the specimens in each set. They will note how items in the first all make specific mention of the fact that valuables have been received "for storage" (or something like that); while those in the second merely "promise to pay" a sum on demand, making no reference to storage at all.

I leave it to those readers to then determine for themselves whether the evidence is consistent with the "clever swindle" theory of fractional reserve banking.

1. Warehouse Receipts:

2. Banknotes


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100% reserves: confusion about “money”

by Kurt Schuler July 17th, 2012 12:01 am

The idea that fractional reserve banking is fraudulent comes partly, I think, from confusion about different senses of the word “money.” Money in the narrow sense is the monetary base, which, at least from the standpoint of the domestic monetary system, is a pure asset and not somebody's IOU. Payment with the monetary base extinguishes IOUs.

(Asides: From the standpoint of the international monetary system, the monetary base may not be a pure asset if it is convertible at a set rate into something else, whether a commodity or a foreign currency, but ultimately, in all the cases I can think of, the trail ultimately leads to a pure asset. A government-issued pure fiat money is not an IOU because, though the government typically accepts it in payment of taxes, there is  no fixed relationship between the fiat money unit and the tax paid or with any good.)

“Money” in the looser, broader sense includes IOUs, particularly those issued by banks, that are readily convertible at 1:1 into the monetary base.

A 100% reserve bank would be a kind of warehouse. Many banks offer warehousing services: they are called safe deposit boxes. I am aware of no bank for which safe deposit boxes are anything more than a side line of business, though. Because 100% reserves preclude lending funds out at interest, a 100% reserve bank would have to charge storage fees just as banks do for safe deposit boxes. Customers’ acceptance of interest paid by banks, or of “free” services offered by banks in lieu of interest, is an implicit recognition that customers are not warehousing assets, but allowing banks to act as their agents in lending out funds.

When we talk about “money in the bank,” we are talking not about the monetary base but about bank IOUs. It would be more accurate to use the phrase “credit in the bank,” because that’s what most of it is: IOUs by bank borrowers to which bank depositors are claimants.

The use of the word “money” to cover both things that are pure assets and those that are IOUs leads to confusion in other aspects of monetary economics also, especially when defining and discussing the money supply. That is a topic for another day.

ADDENDUM: Thank you for the comments, some of which raise issues I will address in the future (particularly Mike Sproul's point about the balance sheets of fiat money issuers). By a "pure asset" I mean something that is not a claim to something else. A lump of gold is a pure asset. So is perhaps the starkest example of fiat money: occupation currency, where an occupying army comes into a country, prints up notes, and forces people at gunpoint to accept the notes in payment for goods. Typically the notes are not freely accepted for payments to the home country of the occupying army. (I didn't say they were a good asset.) A "pure asset" is distinguished from an asset that is a claim to something else, such as a bond, which is a claim to a stream of future payments.


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More Dumb Anti-Fractional Reserve Stuff

by George Selgin July 13th, 2012 10:55 am

Over at the ultra-Rothbardian EconomicPolicyJournal one finds the following among other comments (some favorable to yours truly):

So, Selgin calls fractional reserving deposits 'Monetary Freedom'. This is a very interesting position.

So, I have $50,000 in a savings account. The bank can lend $45,000 out of my money and still maintain a 10% reserve.

It could also arguably loan out $450K while holding the entirety of my $50K as the 10% reserve. It would simply expand the balance sheet for $450K in liabilities for the loan, $50K liability to me and $450K receivable as an asset from the loan plus the $50K cash asset from me. The result is a 10% cash reserve either way...

...Selgin says this is Monetary Freedom?

Actually I say it is wretched economics, involving the elementary error (one that would earn any student in my undergrad Monetary Economics class an F) of confusing what individual, competitive bankers can get away with with what ordinary central bankers get away with on a routine basis. An individual bank can't get away with lending more than its excess reserves; in the example, if our ultra-Rothbardian makes a fresh deposit of $50,000, and his bank seeks to maintain a 10% reserve, it can in fact only lend $45,000. That is, it is limited to lending rather less than the savings brought to it, which means there's no "thin air" lending. As for lending $450K, the possibility is "arguable" only in the sense that anyone who doesn't argue with it doesn't know how banks work. For their sake: when banks make loans, the borrowers tend to spend the proceeds. In a competitive banking system that means writing checks that are likely to end up with other banks, which then return them to the lending bank for settlement in reserve money. All this tends to happen within days. So our banker in this case would soon be confronted with a $450K clearing debit, which he'd have to cover somehow. He can't cover it with a mere $50K of new deposits. So unless he was sitting on another $400K of excess reserves beforehand (which possibility of course begs the question, why hadn't the greedy shyster lent those already?), his bank will go bye-bye, or at least would do so in a free banking system in which there was no alternative of a central bank rescue.

Though Rothbard himself never dove to quite the depths of silliness involved in this example, the example is nonetheless representative of poor grasp of basic theory typical among those of Rothbard's devoted followers who swallow his facile equating of fractional reserve banking with fraud.


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Reply to Salerno

by George Selgin July 12th, 2012 12:56 pm

Oh no: I've gone and punched the 100-percent wasp's nest again, and the wasps are responding predictably. Among them Joe Salerno stands out like a hornet among gall wasps, for Joe is an outstanding historian of monetary thought, and no mean monetary economist generally. Besides, you just can't dislike the guy. Were I forced by a libel suit to defend my claim about 100-percent reservers constituting a "moronic cult," he would probably be defense exhibit F, to be resorted to only if exhibits A through E all managed somehow to evade the process servers.

One reason why Joe woudn't do my case much good, besides the fact that he doesn't come across as a moron and is capable of charming jurors, is that he is not among those 100-percenters who insist that fractional reserve banking is fraud. On the contrary: he'd rather not talk about that, and goes so far to avoid doing so as to claim, at the end of his post, that the fraud argument is something I'm "fixated" on, as opposed to one that Rothbard himself and Salerno's MI colleagues have repeatedly raised, as well as one that has been particularly influential in building popular opposition to fractional reserves. Just search "fractional reserves" and "fraud" on Google and you will see the vast harvest of misunderstanding that this Mises-Institute fractional-reserves = fraud campaign has yielded. Even Congressman Paul has been taken in.

So why doesn't Joe want to talk about the fraud argument? My hunch, based in part on some past exchanges with Joe on the subject, is that he doesn't want to talk about it because he himself doesn't subscribe to it. But if that's the case, instead of pretending that it hasn't been a prominent and particularly influential component of his colleagues' criticisms of fractional reserve banking, why does he not join myself and others in discrediting it? His criticism would, after all, go much further in debunking the absurd claim than my own or that of other non-MI insiders.

In any event, it is the fraud argument that I particularly have in mind when I speak of a moronic cult. What I mean by "moronic" is what everyone means by it. A "cult," if you ask me, is a group that defines its members-in-good-standing as those who never publicly question certain core beliefs, where the core beliefs are in fact irrational or otherwise false. The last requirement is crucial, for otherwise the beliefs would not serve to distinguish loyal members from the great unwashed. You can't, for instance, form a cult around the belief that 2 + 2 = 4 or that that the earth is a sphere. But you can form one around the claim that space aliens are about to save the chosen from Armageddon, or that a drug-addicted commie charlatan is really Mahatma Gandhi's reincarnation, or that banknotes are really property titles.

Another sign of a cult is that, when publicly confronted with irrefutable evidence against their core claims, members respond, if they respond at all, by presenting modified versions of the claims designed, like so many planetary epicycles, to evade the original falsification, though only by erecting a different falsehood. Thus when the patent absurdity of their original fraud claim, to the effect that bankers were ripping-off their own depositors, was exposed (e.g., by pointing out that the "ripped off" depositors were receiving interest on their supposedly embezzled funds, and that were fraud really in play entrepreneurs ought to have been able to make a killing by exposing it while offering ironclad 100-percent alternatives), the "fraudists" (as I'll call them to save space) responded with a new theory, to the effect that, rather than defrauding their own clients, bankers and clients together took part in a conspiracy to defraud the rest of the money-holding public, by reducing money's equilibrium purchasing power. (Those conversant with welfare economics will recognize in this argument, among more obvious absurdities, a confusion of pecuniary and non-pecuniary externalities. In plain English, if by coming up with a new mousetrap, A reduces the market value of old-fashioned mousetraps owned by B and C, that effect is a "pecuniary" externality, and as such would generally not be considered evidence of a violation of B and C's property rights.) Confronted by arguments to the effect that the difference between either demand deposits or demandable bank notes and time deposits is a difference not in kind but merely in degree, the fraudists reply by claiming, as Rothbard himself never did, that fractionally-backed time deposits are also fraudulent, and should therefore be banned as well. (Cf. Emerson on foolish consistency.) By hook or by crook, in short, the fraudists remain wedded to their core beliefs, shrinking from no argument or ground-shifting, however fatuous, that might appear to rescue them from otherwise damning criticisms, if only by exposing them to others equally if not more damning.

So much for fraud and cults. What about the criticisms Salerno aims at me? He says that I've become a sort of "'standing joke" among young students of Austrian economics. Perhaps I have become such among students who have been drinking too much MI kool-aid; but most of the comments and correspondence I get after doing one of my wasp-nest acts, itself mainly from students, suggests a rather different reaction. Unless I'm mistaken what Salerno is observing is evidence of a self-selection process that is, shall we say, not lighting-up Mises Institute seminars and forums with only the brightest of sparks. (I've no doubt that for the same reason any reference to "globe-ists" at Flat Earthers' annual conventions is always good for a belly laugh.)

Turning to a (somewhat) more substantive criticism, Salerno tries his best to blacken me with the "Keynesian" brush by observing that I believe in money wage rigidities. Although the observation itself is perfectly true, the Keynesian tag is a calumny, and one that for once has Joe displaying a very faulty grasp of the history of economic thought. For as he ought to know, and as Auburn's own Leland Yeager has gone to great pains to make clear in his usual, eloquent manner (see his essay "New Keynesians and Old Monetarists," in The Fluttering Veil), Keynesians didn't discover or invent the idea that wages may be inflexible, which was a commonplace long before the General Theory was published, and one that played and continues to play a central role in the writings of both "Old" and "Market" Monetarists. What's more, if Axel Leijunhufvud is to be believed, Keynes himself based his own, peculiar arguments for expansionary monetary and fiscal policies not on the (then conventional) assumption that wages were sticky downward, but on his claim that, even if they weren't sticky, full-employment could not be recovered by simply letting them adjust downward. (As Yeager points out the beliefs of "New" Keynesians in this respect resemble not those of Keynes himself but those of "old" Monetarists.) Finally, Rothbard, who before the advent of New Classical economics was almost unique in supposing that there was nothing to prevent wages from quickly moving to their new equilibrium values following an adverse demand shock, was never able to hold this view consistently. In America's Great Depression, for example, he dishes it up in his early, theoretical chapters, only to go on to claim that Hoover contributed to the depression by resorting to policies that...kept wages from falling! Well, wage rigidities didn't suddenly make their appearance during Hoover's term, although he certainly made them worse, as did FDR to a still more destructive degree. Nor did they disappear when Truman took office. That wages did come down rapidly, along with other prices, following the post-WWI boom, thereby making for a short-lived bust of 1920-21, was partly due to the far less important role of labor unions in those days, and partly due to the fact that people had good reason to anticipate, and to therefore go along with, a post-war decline in equilibrium prices and wages.

The question whether wages are in fact rigid or not is, in any case, not one that can be settled by simply labeling the claim that they are rigid "Keynesian." It is an empirical claim, and as such one that can be settled only by referring to empirical evidence. I happened so supply some such evidence in the course of a recent exchange with the Market Monetarists, in which I posted the following graph:

Here, it seems to me, is rather compelling evidence of wage stickiness, as indicated by the utter failure of hourly compensation to adjust downward in response to a massive collapse of spending--a collapse that presumably ought to have meant a corresponding re-alignment of other equilibrium nominal values. If what Joe calls the "Keynesian" view of things is correct, the failure of wages to adjust with spending should have been associated with a corresponding rise in unemployment; if on the other hand Joe's own view is correct, there should be no close correlation between the "gap" between the series above and the rate of unemployment. I suppose my readers can guess which view squares most readily with the evidence, but here for good measure is the unemployment plot:

Don't get me wrong: I know that one can also tell a story about labor mis-allocation and consequent structural (as opposed to ordinary cyclical) unemployment; moreover I believe that that story gets to part of the truth. But why make it the whole story? Why pretend that unemployment only did what it would have done even if nominal spending had never collapsed?

As for the collapse in spending itself, allowing that it reflected "the voluntary decisions of individuals to alter the amount of money they desire to hold," it hardly follows that that made it harmless. On the contrary: the increased demand for money would, unless accompanied, and accompanied relatively swiftly, by a compensating decline in prices and wages, would necessarily imply a shortage of real money balances. By Walras' Law that money shortage would have as its necessary counterpart a matching surplus (excess supply) of things-other-than-money, including goods and labor. In other words, it would mean recession and unemployment.

As for my seeing ("like any garden variety Keynesian"--ouch!) "fluctuations in aggregate demand as a market failure that must be offset by Fed policy"...well Joe, I'm afraid that's really quite a howler, isn't it? I might have expected it from some others of the anti-fractional reserve persuasion, but from you? Say it ain't so Joe! Say that you haven't forgotten that I've written a thing or two about how AD wouldn't be so unstable were ours a free banking system. Say that you really do know the difference between a claim of market failure and one of government failure! Admit that when you suggest that I "want" the Fed to manage the money stock, it's to score a cheap point against me in the hope of impressing gullible reader's of The Bastiat Circle, and not because you really aren't aware of my desire to see the Fed abolished, along with all other central banks. As for my betraying my cause by endorsing Fed activism as a second-best solution, if that seems so, it is only because it's damn hard to point out that the Fed has screwed up without implying some "ideal" conduct that would have been better, which is surely not the same thing as imagining that the Fed can ever be expected to behave in such an ideal fashion. If that's betraying my ideals, call me guilty.

Joe's account of my ideas concerning how free banks evolve also bristles with misrepresentations. True, I say that eventually the banks might make do with very little monetary gold. But the transition to such a state of affairs would presumably be a very gradual one, and would proceed, not from some fictional 100-percent reserve starting point, but from that of established fractional-reserve ratios already in low double-digit (if not single digit) territory. So there's no reason to assume that it would involve substantial, let alone "massive," inflation. Neither is there any reason to suppose that bank money would "in effect become" fiat money. Nothing in the evolutionary process I describe points to a change in the status of note and deposit contracts as redeemable claims to standard money, and it is impossible to see how competing banks might convince their customers to voluntarily agree to any such change.

Fiction is also the word for Joe's predictions concerning other likely consequences of a move to free banking. Like many of his MI colleagues and followers, he here speculates as if the possibility being contemplated were a perfectly hypothetical one, for which actual empirical evidence is lacking. But that's just not so. Free banking has existed, not in some pristine version of course, but in approximations close enough to allow reasonable conclusions to be drawn about unregulated reserve ratios and such. So, did the most free of all banking systems, lacking central banks but also lacking any barriers to 100-percent reserve banking or subsidies to fractional reserve banks, exhibit the high reserve ratios to which Joe referred in testifying to Congress? Not at all. On the contrary, the freest systems, including Scotland's (ca. 1750-1845) and Canada's (ca. 1873-1914), had remarkably low reserve ratios. If 100-percent reserves are your thing, freedom in banking doesn't appear like a good way to have them. Better to call out the anti-bank vigilante squads, or just have the law itself set things right (as the fraudists would presumably empower it to do).

Concerning Joe's frenzied final paragraph, all I can say is that I hope he had himself a good stiff drink after writing it, and that he's feeling a lot better now.


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China; currency boards

by Kurt Schuler July 10th, 2012 9:02 pm

Here is my review of a book that was written half a century ago but is little known to English speakers: A Monetary History of China. China had periods of free banking at various times and places from 995 A.D. to 1941. Free banking in China has not received the systematic study it deserves, although George Selgin wrote about one case of it in a book Kevin Dowd edited, The Experience of Free Banking, and some other writing on the subject exists.

Three undergraduate students from Johns Hopkins University have compiled a new bibliography of scholarly writings on currency boards. One of their sources is a bibliography I compiled 20 years ago. I became interested in currency boards after seeing how many countries that once had free banking had replaced them with currency boards, which in retrospect was typically an intermediate step towards establishing central banks. Perhaps, I thought, the process could some day work the other way, with currency boards serving as stepping-stones from central banking to free banking. It was with that possibility in mind that George Selgin and I wrote papers in 1990 and 1991 proposing a currency board system in Lithuania. Lithuania moved from a central bank to a quasi currency board in 1994. We are still waiting for the move to free banking.


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100-Percent Censorship?

by George Selgin July 10th, 2012 9:06 am

Yesterday Brad Jansen alerted me to this post on Congressman Paul's website, in which Paul approvingly summarizes--not for the first time of course--Murray Rothbard's take on fractional-reserve banking. I responded with a comment, only to learn from Brad today that my comment had disappeared along with others (mostly laudatory) that had been posted on Paul's page.

It may be that the comments were deleted inadvertently; and if they were deleted on purpose this was almost certainly done by someone on Paul's staff, rather than by Paul himself, perhaps without Paul even being aware of it. The disappearance of the comments soon after I submitted my critical remarks is nevertheless disconcerting. (NB: Please see the postscript below for a follow-up.)

Fortunately Brad had in the meantime posted my comment on the Facebook Free banking page, saving it from utter oblivion, and allowing me to post it again here, minus a couple typos:

It is unfortunate that Congressman Paul has chosen to accept Rothbard's characterization of fractional reserve banking, thereby wedding his call for monetary freedom with an extremely mistaken idea of what such freedom would entail in practice. In fact bank "deposits" have been recognized both in practice and in common law since early modern times to consist of debt claims to money (coin, back then), ownership of which was in fact transferred, along with possession of the coins, first to the banker and then to the banker's borrower-customers. The original depositors retained a right to reclaim an equivalent sum of coin, sometimes on demand, and the banker's only obligation was to have sufficient coin on hand to meet any such demands, the normal penalty for failure to do which was failure. The contrary Rothbard view that bankers must be stealing whenever they lend part of their "deposits" is the sheerest poppycock, legally, historically, and economically, and has been exposed as such in numerous forums. That many persons, who apparently lack real knowledge of these subjects subscribe to it doesn't make it any less false.

Those who may be inclined to dismiss what I'm saying as the remarks of an apologist for central banking or inflation or (for that matter) theft should know that like Congressman Paul I favor monetary laissez faire, and have long done so, and as such believe that the sort of "warehouse" banks Rothbard prefers should be perfectly legal. But I also know that where true freedom in banking has prevailed, as it has on numerous historical occasions, such warehouse banks (which aren't really banks at all, by any standard definition) have never succeeded, their potential clients having generally preferred to patronize fractional reserve banks, despite the extra risks involved, for the sake of avoiding storage fees whilst gaining interest and free payment-related services.

Rothbard, in contrast, would ban "acts of fractional-reserve banking among consenting adults," and so, apparently, would Congressman Paul. Whatever such a ban might accomplish, it certainly can't be squared with monetary laissez faire, or for that matter with plain old personal freedom.

Although the first priority of every believer in monetary freedom must be to combat bogus arguments for monetary central planning, we cannot do this effectively unless we are just as relentless in exposing the 100-percent reserve movement for the moronic cult that it is, to keep its clownish convictions from giving the entire movement for monetary freedom, if not free market economics more generally, a bad name.

Postscript: Immediately after publishing the above, I learned from Larry White that my comment was back up on Ron Paul's cite. So it appears the deletion was inadvertent after all, which is a big relief, since I consider myself a Ron Paul fan.

Needless to say, my beliefs concerning the 100-percent reserve perspective remain quite unaffected by this good news.


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...And my Own Attempt at an Answer

by George Selgin July 8th, 2012 9:30 pm

Earlier today I posed to Market Monetarists the following questions: "If a substantial share of today's high unemployment really is due to a lack of spending, what sort of wage-expectations pattern is informing this outcome?...Can it really be the case that NGDP (and equilibrium wage rate) expectations continue to race ahead of reality, even when that reality involves what would normally be considered a perfectly respectable, if not excessive, growth rate of overall spending? How can this be?"

When I posed these questions I had no answer in mind; on the contrary I doubted that they could be answered without appealing to some extremely odd labor market behavior.

Having done a bit more thinking since, I now believe I have a better grasp of why the combination of an NGDP growth revival and more modest wage inflation hasn't sufficed to eliminate cyclical (demand-shortage based) unemployment. My further reflections make me more inclined to see merit in Market Monetarists' arguments for more accommodative monetary policy. But they also leave me as puzzled as before regarding the expectations-formation processes driving observed patterns of wage-rate adjustment. More specifically, they bring to light a degree of wage-inflation inertia that seems, on its face, difficult to square with the usual assumption that market participants behave rationally.

Previously I observed that it has been about two years since NGDP recovered its pre-Lehman's level, and that it has been growing at between 4 and 5 percent ever since. I also noted that the rate of increase in hourly wages has fallen persistently since the crash, and is now half what it was before then. So, why haven't these facts together added up to the elimination of cyclical unemployment?

My partial answer to those questions is one best captured by the following graph, showing index values (with 1/1/2003=100) for hourly wages and NGDP since 2005:

Here one can clearly see how, while NGDP plummeted, hourly wages kept right on increasing, albeit at an ever declining rate. Allowing for compounding, this difference sufficed to create a gap between wage and NGDP levels far exceeding its pre-bust counterpart, and large enough to have been only slightly reduced by subsequent, reasonably robust NGDP growth, notwithstanding the slowed growth of wages.

The puzzle is, of course, why wages have kept on rising at all, despite high unemployment. Had they stopped increasing altogether at the onset of the NGDP crunch, wages and total spending might have recovered their old relative positions about two years ago. That, presumably, would have been too much to hope for. But if it is unreasonable to expect wage inflation to stop on a dime, is it not equally perplexing that it should lunge ahead like an ocean liner might, despite having its engines put to a full stop?

ADDENDUM (July 9, 2012): It turns out that the graph I concocted appears after all to have misled me (I confess I was apparently to willing to be convinced that there might be a case for further NGDP stimulus after all); playing around with it further (by using the same scale for both plots and letting 1/1/2005=100), I come up with another that actually reinforces the position I took in my original post:

Tom Dougherty, below and at TheMoneyIllusion, gets a similar result using a newer and more comprehensive hourly compensation index.

In light of these further findings, I'm back to my original question: has the Fed, despite the still high level of unemployment, already done all that it ought to do in the way of monetary easing despite the still high level of unemployment?


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A Question for the Market Monetarists

by George Selgin July 8th, 2012 1:17 pm

Although my work on the "Productivity Norm" has led to my being occasionally referred to as an early proponent of Market Monetarism, mine has not been among the voices calling out for more aggressive monetary expansion on the part of the Fed or ECB as a means for boosting employment.*

There are several reasons for my reticence. The first, more philosophical reason is that I think the Fed is quite large enough--too large, in fact, by about $2.8 trillion, about half of which has been added to its balance sheet since the 2008 crisis. The bigger the Fed gets, the dimmer the prospects for either getting rid of it or limiting its potential for doing mischief. Besides, a keel makes a lousy rudder.

The second reason is that I worry about policy analyses (such as this recent one) that treat the "gap" between the present NGDP growth path and the pre-crisis one as evidence of inadequate NGDP growth. I am, after all, enough of a Hayekian to think that the crisis of 2008 was itself at least partly due to excessively rapid NGDP growth between 2001 and then, which resulted from the Fed's decision to hold the federal funds rate below what appears (in retrospect at least) to have been it's "natural" level.

My third reason for hesitating to endorse proposals for doing more than merely sustaining the present 4-5 percent NGDP growth rate is the one I consider most important. It is also one that has been gaining strength since 2009, to the point of now inclining me, not only to keep my own council when it comes to arguments for and against calls for more aggressive monetary expansion, but to join those opposing any such move.

My third reason stems from pondering the sort of nominal rigidities that would have to be at play to keep an economy in a state of persistent monetary shortage, with consequent unemployment, for several years following a temporary collapse of the level of NGDP, and despite the return of the NGDP growth rate to something like its long-run trend.

Apart from some die-hard New Classical economists, and the odd Rothbardian, everyone appreciates the difficulty of achieving such downward absolute cuts in nominal wage rates as may be called for to restore employment following an absolute decline in NGDP. Most of us (myself included) will also readily agree that, if equilibrium money wage rates have been increasing at an annual rate of, say, 4 percent (as was approximately true of U.S. average earnings around 2006), then an unexpected decline in that growth rate to another still positive rate can also lead to unemployment. But you don't have to be a die-hard New Classicist or Rothbardian to also suppose that, so long as equilibrium money wage rates are rising, as they presumably are whenever there is a robust rate of NGDP growth, wage demands should eventually "catch down" to reality, with employees reducing their wage demands, and employers offering smaller raises, until full employment is reestablished. The difficulty of achieving a reduction in the rate of wage increases ought, in short, to be considerably less than that of achieving absolute cuts.

U.S. NGDP was restored to its pre-crisis level over two years ago. Since then both its actual and its forecast growth rate have been hovering relatively steadily around 5 percent, or about two percentage points below the pre-crisis rate.The growth rate of U.S. average hourly (money) earnings has, on the other hand, declined persistently and substantially from its boom-era peak of around 4 percent, to a rate of just 1.5 percent.** At some point, surely, these adjustments should have sufficed to eliminate unemployment in so far as such unemployment might be attributed to a mere lack of spending.

And so, my question to the MM theorists: If a substantial share of today's high unemployment really is due to a lack of spending, what sort of wage-expectations pattern is informing this outcome?

That the question badly needs an answer is evident from statements like the following recent one (attributed to a writer for Credit Suisse), that very much beg it:

With the low-hanging fruit of lower interest rates and debt service costs already having been harvested, restoration of margins is achieved mainly through keeping a lid on labor costs. To break this pattern, nominal GDP needs to grow considerably faster to foster strong gains in both labor income and profits. It’s hard to see where such growth will come from in the short term, with slowing global growth and fiscal restraint becoming stiffer headwinds.

If NGDP growth is inadequate, as the statement suggests, why is it necessary to "keep a lid on labor costs"? Can it really be the case that NGDP (and equilibrium wage rate) expectations continue to race ahead of reality, even when that reality involves what would normally be considered a perfectly respectable, if not excessive, growth rate of overall spending? How can this be?

I should admit that my puzzlement in part reflects my personal experience. Here at UGA we haven't had any raises for five years running. I know professors elsewhere with similar experiences. We are, bless our hearts, helping to eliminate the spending "gap," and doing so despite the lower NGDP path. So who the heck isn't helping, and why should the rest of us put up with, much less root for, a more bloated and dangerous central bank for their sakes?

P.S. (added 3:15 on July 8): There's been a lot of loose talk, it seems to me, about how curing unemployment calls, not merely for raising the level or growth rate of actual NGDP, but for raising NGDP growth rate or level expectations. Well, if I'm an employer, I might well welcome, ceteris paribus, the news that demand for my output is going to go up. But suppose I am an employee. How should I respond to the changed expectation? Does it not give me grounds for holding out for a faster rate of wage increases than I would have been inclined to insist upon otherwise? Does it not, in other words, cause me to delay a needed adjustment to my schedule of wage demands? And does it not, to that extend, hurt rather than foster recovery?

*My former student, David Beckworth, has on the other hand been one of the more prominent proponents of greater monetary easing. Though we disagree, I'm damn proud of him.

**Link added at 7:30 on July 8.


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