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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.

122 Responses to “More Dumb Anti-Fractional Reserve Stuff”

  1. avatar michaelsuede says:

    While I would never voluntarily chose to bank at a fractional reserve bank if 100% reserve banks also existed, the entire argument between the various Austrian camps over this issue seems rather ridiculous to me.

    I assume we are all voluntarists here, so I'm having a hard time understanding why there is any argument over this at all. The entire thing would be sorted out by free people making their own choices in a competitive system.

    Is the debate simply over what various economists think the market would ultimately produce? In reading Salerno's critique, he clearly states, "I gave another account of the likely outcome of a Selginian free banking system, which I advocated as the most practical means of getting rid of fractional reserve banking and suppressing the further issue of fiduciary media, that is, unbacked bank notes and deposits."

    So if Selgin thinks a system of free banking will operate indefinitely, great. And if it doesn't, that's fine too. Arguing about what the end result will be seems like waste of time. It doesn't matter. The only thing that matters is that people are being forced into one particular system or another. We know that the free market will work out the best possible system of bank on its own. What the economists have to say about it is simply hot air.

    Arguing about this is simply a battle of egos.

    • avatar michaelsuede says:

      Sorry, I meant to say, "The only thing that matters is that people are NOT being forced into one particular system or another."

      • avatar George Selgin says:

        Tell it to the Rothbardians: no one on the pro-FR side has ever suggested that the 100-percent reserve alternative should be illegal.

    • avatar George Selgin says:

      Michael, your claims are quite mistaken. Every proposition I have taken to task here and elsewhere on this topic has been a positive claim: "bank deposits are property titles"; "banks can lend many times their excess reserves"; "fractional reserves cause inflation," etc., etc. These propositions are either correct or not; and it is doing no more than not shirking my duty as an economist and educator to point out why they are incorrect in fact. This has nothing to do with either preferences or predictions; it isn't like me liking vanilla and the others linking chocolate, or like me thinking that X will happen and others thinking Y more likely. And while I agree that free markets can solve lots of problems, they cannot do our economics for us, much less tell us just what does or does not constitutes a truly free market arrangement.

      • avatar michaelsuede says:

        In a free market, it seems to me that contract would have to work out what "is or is not" a claim on property. Wouldn't contracts decide that on a case by case basis?

        As for the inflationary aspects, I thought we were all in agreement on that as well. We can see quite clearly how a system of free fractional reserve banking would operate, so I don't see how there could be any contention over this point.

        • avatar George Selgin says:

          I wish you were right about this, Michael. But I can assure you that there is no consensus about how free banking works, whether it causes inflation, and whether it contributes to business cycles. A perusal of Mises Institute publications and web pages ought to make this quite clear. As Dave Barry liked to say, "I am not making this up."

          • avatar michaelsuede says:

            The only issue I see between the two is the whether time deposits should be required or not, but to me that is an investment risk decision that should be born by the people choosing to bank with a fractional reserve bank.

            Ya know, here's a question that I haven't bothered to dig up the research on, so perhaps you could answer it for me.

            Are there differences in the interest rates a fractional reserve bank would charge to borrowers vs 100% reserve? And, are there differences in interest that a depositor would earn between the two systems?

            I always assumed that a fractional reserve bank could offer lower lending rates, but then it struck me that it would conversely have to offer higher interest on deposits given the higher risk.

            Do the two cancel each other out, or am I way off base here?

          • avatar michaelsuede says:

            By "cancel each other out" - I mean does the bank's take on earnings differ between the two? Is a fractional reserve bank more profitable than a 100% reserve bank?

    • avatar Phillip Ng says:

      Michael,
      We do not, as you say, "We know that the free market will work out the best possible system of bank on its own." The Federal Reserve did not exist from 1837-1862. This could be called a free market system, but market did not sort out the best system. This is an example of a very legitimate objection that a central banker may have to simply unleashing bankers and whatever schemes those bankers may concoct unto the masses. Only by arguing it out and asking “Why?” may we find the truth of the matter.
      I don’t agree that these are simply dueling egos. These are important questions that we ought to know, if we desire to advance the cause of free banking. More importantly, it does seem to me that the Rothbardians are wrong and poorly educated to boot.

      • avatar George Selgin says:

        "The Federal Reserve did not exist from 1837-1862. This could be called a free market system, but market did not sort out the best system. This is an example of a very legitimate objection that a central banker may have to simply unleashing bankers and whatever schemes those bankers may concoct unto the masses."

        Oh no, Phillip: you forget that this so-called American "free banking" era was anything but!

        • avatar Phillip Ng says:

          I apologize for the opaqueness of my statement. I do not forget that this era was not in fact free banking. I was (apparently unsuccessfully) alluding an argument central bankers tend to take for granted as fact. As we learned in your class, if we actually studies the fact we will find that the era was “anything but free banking”.

          Follow that line of reasoning and it becomes apparent, at least to me, that there is value to economists bashing one another as they try to discover truths.

      • avatar michaelsuede says:

        "This could be called a free market system, but market did not sort out the best system.

        I would argue that, if left alone, it would have. Just because there were sporadic bank runs doesn't mean the market failed. As Rothbard points out, bank runs are a sign of a healthy competitive banking system getting rid of bad banks who made bad lending decisions.

    • avatar Martin Brock says:

      You can buy gold and keep it in a safe deposit box now, so I suppose 100% reserve banks do exist. What you want doesn't seem to be illegal.

      • avatar MichaelM says:

        Not quite: If you ever expected to do anything with that gold the IRS would show up at your door wanting their cut.

        That's why, despite his beliefs on this particular subject, Ron Paul seems to be the best hope for monetary freedom in the US regardless of whether or not you think 100% reserves or fractional reserves are the 'best' system. All he wants to do is make it easier to use gold (and a few other metals, I think) as a monetary substitute. As a few of the Modern Free Banking School guys have pointed out in the past, banks in the US already technically have the legal ability to emit paper currency, so re-allowing people to use gold money is the only thing we'd need to do besides winding the Fed up in order to make the US probably the freest monetary economy on the planet.

        Drop the taxes on capital 'gains' from holding gold, chain the Fed to some kind of extremely basic monetary rule (or stop it from creating new base money period), and we're most of the way there. Ron Paul's actual statutory pursuits on the subject seem to have been perfectly in line with the former of those goals and we all know he would love to accomplish the latter, too.

  2. avatar Martin Brock says:

    The comment doesn't seem ridiculous to me. If you deposit $50,000 in my bank, and if 9 other people have houses worth $50,000 each, I can issue banknotes promising $450,000 and lend these notes to borrowers purchasing the 9 houses as long as I hold the titles to the 9 houses as collateral.

    Sure, the homeowners will deposit my banknotes in other banks, and these other banks will present the notes to me. I tell the other bankers that I have titles to houses worth more than $450,000, and they can either hold my notes until I have the dollars instead, plus interest, or they exchange the notes for my house titles and the corresponding right to receive dollars directly from my borrowers.

    Other bankers can also ask a judge to order me to sell my houses for dollars immediately and likely receive a fraction of each dollar promised. I just don't see the point. Dollars are hardly the only thing of value on Earth, and the other bankers can spend my banknotes on whatever they want as easily as my borrowers spent them on houses.

    • avatar Martin Brock says:

      I should have said that the 9 houses are worth $60,000 each and that I require each borrower to pay $10,000 out of pocket for a house in addition to the $50,000 in my banknotes while I hold the titles as collateral.

    • avatar michaelsuede says:

      That's not how it works.

      That's how our present system works.

      A free banking, gold backed, fractional reserve bank could only issue loans based on the given amount of physical gold it holds in reserve. In your example, a deposit of 50G's worth of gold would result in the bank being able to make 25G's worth of loans given a 50% reserve ratio. It could not collateralize new money into existence like our present system does.

      • avatar George Selgin says:

        Michael is correct: Martin, I fear, also gets an F on the quiz, though he gets high marks for regular attendance.

        • avatar Martin Brock says:

          One man's F is another man's A, and if the "free" in "free banking" actually means what it says, then the banknotes I describe are permissible, and they are money as long as people freely accept them in trade only to exchange them later for something else.

          • avatar George Selgin says:

            It's not a question of whether or not the notes are permissible, Martin. It's a question of whether a bank that issues them so promiscuously can expect to survive.

          • avatar Martin Brock says:

            A bank issuing these notes can expect to survive, because valuable collateral backs the notes issued and because people will deposit the notes at the issuing bank in exchange for a portion of the interest paid by borrowers.

            Of course, a bank could issue notes not backed by valuable collateral on which borrowers against the collateral pay interest. These note issuers are promiscuous, but I haven't described this scenario.

      • avatar Martin Brock says:

        No. Our present system has a central bank. No central bank is necessary for a bank to issue notes as described.

        A free bank may issue promissory notes for gold, or any other standard of value, as long as people freely hold the notes, and people will hold the notes described because valuable collateral secures the notes and users of the collateral pay interest to holders on the notes on account at the issuing bank.

    • avatar MichaelM says:

      This is both right and wrong.

      Yeah, a bank might be able to get away with this. But it would be circumstantial and extremely risky to try. It would depend on other banks being willing to hold mature debt instruments that are at least partially illiquid in comparison to cash instead of simply converting them to cash right there and then.

      You are correct that it COULD happen.

      George is also right that a bank trying it would probably fail pretty quickly as nobody really feels like holding its liabilities if they could just get cash. It's usually only central banks with the implicit or explicit guarantee of the taxman having their back that enjoy such a luxury.

      Whether or not this would happen has actually been the subject of some of the more sophisticated debates on the FRBv100%RB issue. Credit expansion of the type that would drive an ABC style event could happen if banks started treating each other's liabilities as reserves. I've seen a discussion on the issue in several different places in the existing Modern Free Banking School's literature. It would be an extremely unstable situation, a kind of prisoner's dilemma I think, where the first bank to break and start cashing in the liabilities it is holding gains immensely at the expense of its fellow-banks.

      • avatar Martin Brock says:

        Suppose another bank converts my banknote to cash rather than holding a deposit in my bank. What does it do with the cash then? Melt it to make jewelry? Burn it for heat? Won't the bank lend this cash to earn interest?

        I'm already paying interest on the deposit. The bank could demand cash and then lend the cash back to me, but what's the point of that? The bank might lend the cash to someone else more profitably, but this scenario assumes that one bank has better lending opportunities than the other. This assumption can't be true in general. Every bank can't have better lending opportunities than every other bank.

        No. I don't see any general advantage for banks demanding redemption in this scenario.

      • avatar Martin Brock says:

        To make the point more explicitly, liquidity can't be a general advantage. If liquidity were a general advantage, no bank would ever lend. You're assuming that another bank is a particularly bad risk, and that can't be true in general.

      • avatar Martin Brock says:

        Correction: Another bank could be a particularly bad risk, compared to a non-bank, if the entire banking system is rotten, if practically every bank is a bad risk compared to non-banks. In this scenario, banks generally demand redemption, but in this scenario, the entire system is rotten anyway, and a collapse is arguably the best course. The last banks standing presumably are less rotten than the entire system, and new banks could then emerge. How is this resolution of the dilemma a problem?

  3. avatar Mike Sproul says:

    Martin is right. George is wrong. Here's the T-account from a private bank that issues only checking account dollars, but the same would be true of a note-issuing bank.

    ASSETS..........................................LIABILITIES
    1) $50,000 paper deposited......................$50,000 checking account dollars issued
    2) $450,000 IOU, +$450,000 lien on property.....$450,000 checking account dollars issued

    Presumably, the property offered as collateral in line 2 is worth considerably more than $450,000. The bank has not created $450,000 out of thin air. A better description is that it has coined $450,000 of the property into money.

    • avatar George Selgin says:

      F for you also, Mike. We are now talking about banks issuing convertible notes. You confuse what a central bank, and especially one issuing inconvertible paper, can do, with what ordinary banks can do. You also imagine that a deposit balance credited to a borrowers account just sits there.

      Don't take my word for it: read any decent money and banking text; read Chester Arthur Philips' pioneering book on Bank Credit, or try actually running a bank and find out the hard way!

      • avatar Mike Sproul says:

        George:

        I already read Phillips, and I also read Crick's 'Genesis of Bank Deposits', which set the pattern for the silly textbook view of loan expansion and the money multiplier. (I have to admit I haven't run my own bank.)

        The loans I described in the T account could be done by both central banks issuing inconvertible money (notes or computer blips) and by private banks issuing convertible money (notes & blips).

        It is irrelevant whether the deposit sits there or is spent. Spending the $450,000 of checking account dollars only transfers ownership of them from the original borrower to the merchants from whom the borrower bought $450,000 of goods.

        The new holder of the $450,000 deposit might spend it again, and it might keep changing hands for years, without ever being presented to the bank for redemption in base money. That's just the money multiplier in action, and we all understand that $50,000 of base money (+ $450,000 of other assets) can support $500,000 of bank money.

        If the $450,000 is presented to the bank for payment, the bank will either sell the $450,000 IOU for $450,000 of base money, or the bank can use the $450,000 IOU directly to buy back the $450,000 of checking account dollars that he issued. Either way the bank is able to buy back every dollar it issued at par.

        My gradebook is still showing Martin: A, George: F.

        • avatar Martin Brock says:

          Are you the USC Economics professor?

          • avatar Mike Sproul says:

            Yup.

            Fight on, for old 'SC...

          • avatar Martin Brock says:

            That's reassuring. Thanks.

            I can receive both an A and F on the same answer to the same question from two different Economists. If George doesn't vindicate me, at least both of you vindicate Russ Roberts.

            As a historian, George presumably refers to particular banking systems operating in the past. For the record, I am not repeating historical claims about fractional reserve banking made by conspiracy theorists. I am not asserting that FRB emerged from crooked gold warehouses issuing bogus claim checks. The sort of monetary system I describe seems completely legitimate to me. I associate it with nineteenth century anarchists like Proudhon, not with crooked gold warehouses.

            I have no formal training in economics myself, only casual, self-directed reading, and I know even less about the history of finance; however, I am a trained mathematician with an excellent academic record, so I know that what I'm saying makes logical sense at least.

            Seems to me that people commonly confuse money with an elemental substance like gold, obeying some sort of conservation law. My conception of money is very different. Money is continually being created and destroyed. A particular dollar may exist for a moment, just long enough to enable a transaction between property holders, and then cease to exist, and this dollar may or may not reappear later if the seller decides he wants money for another transaction.

            "Saved money" is a misnomer in this sense. "Saved money" is not money at all, because money by definition is not saved, not for long anyway. Saving turns money into something else, like a rent-to-own contract. This process doesn't simply move money from one place to another. The saver doesn't buy the contract from someone else who then has the money instead. Money ceases to exist altogether in the process, possibly to reappear later, possibly not.

            In principle, a central bank only regulates this sort of monetary system. I don't oppose central banking because it "creates money" money as it does. I oppose central banking because in practice it fuels too much state spending, including spending by promiscuous issuers of inflationary credit.

          • avatar Mike Sproul says:

            Martin:

            This is not the first time that economists have disagreed. Like the old joke says, if you laid all the world's economists end to end they still wouldn't reach a conclusion.

            George is thinking of the textbook explanation of the money multiplier, where a bank initially gets a $1000 deposit of paper money, lends $800, and keeps $200 as 20% reserves. That 800 gets deposited at another bank (or the same bank), which lends 640 and keeps 160 as 20% reserves. The process continues indefinitely and you are left with three infinite series. The first is "deposits" which total $5000 (=1000/.20). The next is loans totaling $4000, and the last is reserves of bank notes totaling $1000. That's the way all textbooks describe it, but it would have been easier, and more correct, to show the banking system receiving a $1000 deposit of paper money, then directly lending $4000 of newly-created deposits (checking account dollars) backed by $4000 of IOU's from the borrowers. Either way you think of it, the banking system (or a hypothetical monopoly bank) ends up with a T account showing $5000 of deposits (i.e., checking account dollars) on the liability side, while the assets side shows $1000 of paper money plus IOU's totaling $4000. The thing I don't like about the textbook explanation is that it's easy to end up thinking that the $5000 of checking account dollars rests only on the $1000 of paper money, and forget about the $4000 of IOU's which also back the checking account dollars. I'm not sure, but I think George is slipping into this error, even though he knows better.

            From this explanation of the money multiplier process, the quantity theory (which is, unfortunately, the mainstream view) claims that the banking system has created "more money chasing the same goods", and so causes inflation. This is what leaves Rothbardians with the misguided idea that banks are no better than counterfeiters.

            The other theory is the backing theory (whose adherents I could count on 1 hand), which says that the multiplier has no effect on inflation, since any expansion of the money supply is matched by an equal expansion of the issuing banks' assets. If you start with $100 backed by assets worth 100 oz, and then issue new money until you have $300 backed by stuff worth 300 oz, each dollar remains worth 1 oz.

            Historically, the quantity theory won because during the Bullionist debates of 1810, David Ricardo was a better debater (and worse economist) than Charles Bosanquet. If you are interested in that long story, google my paper entitled "Three False Critiques of the Real Bills Doctrine".

          • avatar Martin Brock says:

            I've heard the money multiplier story many times from anti-FRB people. These people typically ignore the role of collateral in lending. If a banker may lend, then he will lend, oblivious to whether he'll ever be repaid, and his lending will be inflationary.

            The money multiplier you describe depends upon a reserve requirement. If the reserve requirement is ten percent, the expansion of the money supply is even greater. If it's one percent, the expansion is greater still. If the reserve requirement is zero, the expansion is infinite. This dependence of money and credit and prices on some arbitrary reserve requirement never made sense to me, so I've never taken these anti-FRB arguments seriously.

            I'm less concerned with what happens to $1000 in the reserve/lending model you describe than with the source of the $1000 in the first instance. In my way of thinking, money is a medium of indirect exchange. People who want to trade indirectly create as much money as they need as they need it. They need not obtain money from a banking system or some other monetary authority, or from a gold miner for that matter, before trading indirectly.

            Money itself is an accounting device with no intrinsic value. To trade indirectly, people only need things of real value, other than money, to trade. If people have valuable goods to trade, money can appear spontaneously to enable them to trade indirectly, without any central bank, without any gold, without any banking system multiplying deposits, without anything but the traders' desire to trade indirectly and their own accounts.

            If I have apples and you have oranges and George has milk, and if I want milk while George wants oranges and you want apples, we don't need anyone to deposit any money in any bank anywhere to provide us money for the indirect transactions satisfying all of us. We can create this money ourselves by an act of will.

            Rather than offer George apples for his milk, I offer him a promise of silver. George doesn't want silver any more than he wants my apples, but that's beside the point. He accepts the promise of silver, because silver is a standard of value that the three of us accept.

            George doesn't immediately demand silver from me, because he doesn't want silver. He wants oranges. He instead exchanges my promise of silver for your oranges. You don't want silver either, but that's beside the point. You accept my promise of silver only because you want my apples. You then accept apples from me in lieu of the promised silver, and we all have what we want, and no one owes anyone any silver. None of us ever wanted silver, and none of us ever had any silver. As long as we can rationalize prices somehow, our standard of value could be completely fictitious, like manna from Heaven or Bitcoins.

            That's money in a nutshell, and we can have as much money as we need whenever we need it. Of course, having money is not equivalent to having valuable goods to trade. We can have as much money as we need to trade what we have, but money itself is not a valuable good to trade. Money is a social network.

            I've read a bit about the real bills doctrine, and it seemed consistent with my understanding, but I didn't follow some of the arguments I read before, so I look forward to reading yours. Your article is on my Kindle.

          • avatar Mike Sproul says:

            Martin:

            I'm in full agreement. I want a loaf of bread so I write an IOU that says "IOU 1 quart of molasses" and hand it to the baker. That IOU, and others like it, start to circulate as money, and eventually banks accept them as deposits, then make loans, and that misleading and misunderstood money multiplier process begins. Mises was wrong when he said that all money starts out convertible into some base money, but he wouldn't have been too far off if he had said that all money starts out DENOMINATED in some base money.

            Your description of money popping in and out of existence is what economists mean when they speak of the law of reflux. People who misunderstand the real bills doctrine usually misunderstand the law of reflux too.

          • avatar Rob R. says:

            But if you write an IOU for 1 quart of molasses then you have to either have a quart of molasses or be prepared to buy one in case someone wants to redeem against the IOU. This would be particularly likely to happen if there were too many "IOU 1 quart of molasses" in the economy and their value was falling. So in effect you would end up with a FRB system based on Molasses. In a competitive currency world molasses would prove a poor choice of commodity (compared to say gold) to use as money and so molass-backed notes would likely not find wide circulation.

          • avatar Martin Brock says:

            Why couldn't there be too many gold IOUs in an economy? Why does your argument apply only to molasses IOUs?

            A non-durable commodity with elastic supply seems a better standard of value than a durable commodity with inelastic supply. If many people promise too much molasses, the supply of molasses can more easily expand, enabling people to keep these promises without disruptive bankruptcies. Why is that a problem? The supply of molasses doesn't expand indefinitely, because people only demand molasses if they want molasses. If people aren't demanding molasses, the problem doesn't occur.

            If I have apples and promise a quart of molasses, I must exchange my apples for a quart of molasses if it comes to that, so I shouldn't promise more molasses than I can obtain with my apples. If I err by promising too much molasses, I might obtain molasses now by promising apples next season; otherwise, I'm bankrupt. No system of money and credit is immune to risks of this sort. Any monetary system claiming to eliminate these risks is fraudulent.

          • avatar Mike Sproul says:

            Rob:

            Molasses was a commonly used money in the American Colonies. Naturally, I must have some assets to back my promise to deliver 1 quart. But I'll take the precaution of putting a suspension clause in my IOU that gives me an extra 60 days to either deliver molasses, or something of equivalent value. Sometimes I'll go bankrupt and my IOU will be worthless, which is a risk people knowingly take. If there are to many IOU's in circulation, so that their value drops to .99 quarts, then I will eagerly buy my IOU's on the open market for .99 quarts, thus avoiding having to pay out 1 quart.

            Martin:
            Agreed, again. The law of reflux assures that we won't have too many of any kind of IOU's circulating, since the extra IOU's would reflux to their issuers. Think of of silver spoons. If the world wants more spoons, then someone will find it profitable to stamp silver into spoons. If the world has too many spoons, someone will find it profitable to melt the spoons. The spoons reflux to bullion. In the same way, people will bring silver bullion to be minted into coins when coins are wanted, and if there is a surplus of coins they will be melted and reflux to bullion.

            A smart mint operator will then have a bright idea: When people deposit silver, he will issue paper (or electronic) IOU's for 1 oz of silver, instead of issuing silver coins. This saves the minting expense, plus wear on the coins. Reflux will still work the same way. Excessive IOU's will return to the mint (now a 100% reserve bank) just like the coins did. Then he'll have an even better idea: When people come in wanting silver IOU's, they no longer have to bring in actual silver, but rather he will accept any assets that are worth at least 1 oz. He is now a fractional reserve bank, but reflux still works the same way.

          • avatar Rob R. says:

            Indeed in an FRB system there will be more IOUs for gold than actual gold. However as long as each bank only creates new IOU's that are backed by IOU's it has on deposit from its customer, and has enough reserves on-hand to meet requests for withdrawal of these IOU's by it customers then this is not a problem.

            Your observation that "A non-durable commodity with elastic supply seems a better standard of value than a durable commodity with inelastic supply" seems wrong. You want something that is inelastic and durable precisely because this will hold a more constant value over time - hence gold and not fish has been more commonly chosen as money.

          • avatar Rob R. says:

            "When people come in wanting silver IOU's, they no longer have to bring in actual silver, but rather he will accept any assets that are worth at least 1 oz."

            I submit that if he did this , and the asset he was accepting was the loan itself, then he will quickly drain his reserves unless he sells on these loans to banks that do have deposits to lend out or borrows these reserves as a lower rate than he is giving on his loans.

            Its interesting that molasses were used as currency during the colonial period - but I don't think that changes the discussion much.

          • avatar Martin Brock says:

            Rob: Fish makes little sense as a standard of value. One pound of fish is not equivalent in value to any other pound of fish. One unit of a commodity, by definition, has the same value as another.

            A standardized molasses or grain alcohol might work. Precious metals have worked in the past, but valuing everything relative to the value of a single, scarce, durable element with inelastic supply, like gold, is problematic. Concentrating possession of gold is relatively easy, and states will concentrate it. Look at Roosevelt in '33.

            But as long as a state does not impose gold, as a legal tender for example, I have no problem with it as money or as a standard of value for extending credit. As long as people may switch to another standard at will, gold is fine with me, and gold might be the most popular standard most of the time. I'm skeptical that it would be, but I want free markets choosing money.

          • avatar Mike Sproul says:

            Rob:

            Reserves might become inadequate to cover daily demands for redemption, but in that case a solvent bank can always buy more reserves. If the bank somehow needs more gold than exists in the world, then they can use other commodities as reserves. Or better yet: a landlord normally collects 50 oz. of silver per year in rent. When he buys his groceries, he pays the grocer with his own paper IOU's, which he agrees to accept in lieu of 1 oz for rent. As long as the landlord is solvent, his IOU's will be worth 1 oz, but he needs zero reserves of actual silver.

          • avatar Rob R. says:

            I think the important point about a FRB system is that at its base is real commodity money that ultimately constrains the amount of lending possible.

            So yes, its possible that banks might offer notes redeemable in silver when they don't actually have silver but other assets with a value equal to silver (such as in your example). They would however need to have access to real silver reserves should they need to transfer them to other banks to meet claims when the notes actually get spent and this would constrain that bank to limit is issuing of such notes. It would also constrain total note issue in the system for the same reason.

    • avatar Martin Brock says:

      You get an indecent A at least, Mike, if it makes you feel any better.

    • avatar Martin Brock says:

      Certainly, nine homeowners may write nine rent-to-own contracts with nine buyers and then allow the buyers to move into their houses. Each homeowner holds the title to his house until its buyer has met the terms of purchase. The terms of each contract are equivalent to a homeowner lending money to a buyer, with interest, and then receiving the same money in exchange for his house. I don't see any promiscuous lending going on here. We can say that no money changes hands when these contracts are signed, or we can say that money exists only long enough for the transaction to take place. The outcome is the same.

      In the scenario we're describing, the nine homeowners and nine buyers out-source the accounting for their rent-to-own contracts to a financial intermediary, and the intermediary holds the titles. This arrangement benefits both the sellers and the buyers. The sellers avoid the accounting/collecting and also pool default risk while the buyers have a third party holding the titles. I don't see how this out-sourcing turns non-promiscuous lending into promiscuous lending.

      If the sellers want to use banknotes, representing the buyers' obligation to pay the intermediary, as money instead of receiving interest payments from the intermediary, then as long as others will accept these notes in trade, I don't see anything indecent about this money either. The notes are money only while they circulate. If I accept a note in trade only to deposit it with the intermediary in exchange for interest that one of the homeowners would otherwise receive, this note ceases to be money when I deposit it, as surely as it is never money at all in the rent-to-own scenario.

      So what is promiscuous and indecent and F-worthy here? I really don't get it.

  4. avatar michaelsuede says:

    Oh by the way, I'm a software developer and I run my own wordpress blog. You guys should consider implementing the DISQUS comment system. It's pretty easy to install and configure (I could do it for you if you like), and it would allow for a smoother flow of comments without having to worry about nesting limits.

    Also, it allows people to login directly from a facebook account, and it allows people to see responses to comments across all the websites that use the system. You can see it in action on my blog:

    http://www.libertariannews.org/2012/07/12/why-political-arguments-dont-matter/

    It's also free.

  5. avatar BillWoolsey says:

    Brock:

    Why would the other banks hold the notes (or checks) if they bear no interest?

    There is nothing stopping a bank from making loans with nearly created money if it is willing to borrow money to cover the reserve shortfall. It could borrow from the other banks--say over night loans.

    But when the other banks make these loans to the first bank, they aren't making loans to other people, and so the quantity of money doesn't increase. The deposit at one bank is used to fund a long to another bank, and the bank that borrowed the money uses it to fund loans for houses.

    If the bank insist on payment for the checks or banknotes, they don't just have a claim against the loans against the houses, but also against the bank's capital.

    And, of course, a bank that has the attitude of wait, we will pay you when will feel like it, will most likely not get its not accepted for deposit.

    And a bank whose notes are not accepted for deposit by other banks, will find that sellers won't accept the notes. In particular, those selling the houses (and who the borrowers are paying) won't take the notes or checks of the bank that refuses to pay them off. Which, of course, makes borrowing them pretty useless.

    • avatar George Selgin says:

      Bill, in the first part of your comment I think you must have intended to write "willing and able".

    • avatar Martin Brock says:

      The notes do bear interest on deposit at the issuing bank. The people living in the houses securing the notes pay this interest. If you deposit a note at a different bank, your bank then deposits the note at the issuing bank in order to receive the interest.

      Banks don't need to borrow money from anyone to issue these notes. The notes are valuable and worth holding, because valuable houses secure them. A bank needs a reserve, of something other than titles, only to satisfy note holders who distrust the bank's accounting for the value of the houses.

      • avatar Rob R. says:

        I don't think that "The notes are valuable and worth holding, because valuable houses secure them" is sufficient. Suppose I decided to start a business based on that principal under the current system (ignoring regulatory issues). I offer you a loan of $50,000 that you use to buy a house. I create a bank account for you with $50,000 credited , you find a seller willing to accept a check from My Bank and we have a deal. However the seller will take your check to his bank , which will then expect me to transfer the $50,000 to him. I can then (assuming I can't find the money from anywhere else) borrow the money from someone else in which case I become just an intermediary, or sell the loan (or other asset). In either case the business plan does now work well.

        I suppose one can envisage a case (under free banking) where rather than opening a checking account I issue 50,000 bills redeemable in gold. The demand for currency is high and the notes stay in circulation as people know that I do actually have backing for the notes and could really redeem them if I have to. I get interest on the loan and my business model works. However I think this could only happen if FRB was not working efficiently. An efficient FRB system would mean that the supply of money matches the demand so all newly issued notes (even if accepted in circulation) would end up being returned for redemption to the issuer sooner or later and cause the issuer to either borrow money or sell assets and cause the business model to fail.

        • avatar Rob R. says:

          "does NOT work well" not "does NOW work well."

          • avatar Rob R. says:

            If your notes offered a high rate of interest relative to the risk then I am sure banks (and others) would love to buy them to keep in their portfolios. But that wouldn't make them money - just a good investment. The historical record shows that commodities like gold and silver are commonly chosen as money precisely because they tend to be durable and have a relatively fixed value.

        • avatar Martin Brock says:

          You don't loan me $50,000. You issue notes promising $50,000, and the seller of a house agrees to exchange the title to his house for these notes plus my $10,000 down payment. There is no $50,000 in your bank, and the seller understands this fact. The seller accepts the notes in lieu of $50,000, because you will pay the bearer of your notes principal and a portion of interest that I pay to you. The notes are valuable for this reason. The notes are worth precisely $50,000 at the point of sale, and they're just as portable and negotiable as $50,000, so they might as well be $50,000, but they aren't $50,000.

          The seller of the house takes your notes to another bank. This other bank also accepts the notes understanding that there is no $50,000 in your bank, but the other bank may also claim principal and interest from your bank by returning the notes to you, so it does. If the other bank wants $50,000 now, rather than your notes, it doesn't accept your notes from the seller of the house, but since the notes are actually worth $50,000, the other bank does accept them. The other bank has no fetish for dollars. It only cares what the notes are worth, not which dead, white male is pictured on them.

          Returning the notes does not cause your business model to fail, because people returning the notes to you don't demand the $50,000. They don't demand the $50,000, because you pay them not to demand it. You can pay them not to demand the $50,000, because I am paying you interest that you can pay to them. Your capacity to pay people not to redeem your notes for dollars (or whatever the standard of value is) makes your notes just as valuable as dollars, and because your notes are just as valuable as dollars, people have no reason to exchange them for dollars.

          • avatar Rob R. says:

            So rather than me taking out a loan to buy your house you accept some interest-bearing notes that you think you could then use as money?

            Well, as the notes do have value there is no particular reason in principal why they could not be used as hand-to-hand currency. However I think this is unlikely in practice. People who only planned to hold them for a while would not want the nuisance of having to claim their share of the interest. In a competitive note issuing environment notes promising instant redemption for a fixed value of gold would trump those offering redemption in the future plus interest (even if the issuers were of equal credit-worthiness.

            You may find that people who wanted to hold interesting-bearing assets may be prepared to buy the notes to hold in their portfolio. However this would limit the things you could buy with the notes. You could I suppose sell them for real $ but this would in effect be just the sale of part of a loan and this would not really the same as using them as money. In any case you would almost certainly be better off having sold your house for cash or to someone with a bank loan rather than carrying out this scheme.

            So again I don't think the business model holds up.

          • avatar Martin Brock says:

            No one holds money for long. They deposit it in a bank. When I deposit a note in a bank, the bank worries about claiming principal and interest due the note holder, so this business is not a nuisance for me. That's what banks are for.

            I don't value instant redemption for gold. I have no use for gold myself. Even my wedding ring is platinum. If my banknotes promise gold, I'll demand gold only if I distrust the bank's accounting. I can distrust my bank's accounting regardless of any commodity it holds in reserve.

            People who want to hold interest bearing assets accept notes from me every day for every conceivable thing. They immediately deposit these notes in interest bearing bank accounts. The notes aren't even physical anymore. They're electronic, so they can find their way to an interest bearing account at the speed of light. You seem to be saying that what I have experienced throughout my life can't hold up.

          • avatar Rob R. says:

            "No one holds money for long. They deposit it in a bank. When I deposit a note in a bank, the bank worries about claiming principal and interest due the note holder, so this business is not a nuisance for me. That's what banks are for."

            Banks would generally prefer notes that are redeemable immediately so they can send them back to the issuing bank and get real reserves that they can lend out themselves. Plus interest bearing notes would not be good for hand-to-hand currency because their value would vary with the market interest rate (and as they get close to redemption date) and would hence be a lot less acceptable than notes immediately redeemable for a commodity that held a reasonably constant value (even if as you say individuals might not actually want to redeem them very often)

          • avatar Martin Brock says:

            If banks generally prefer to redeem and lend, then every bank always has an opportunity to lend on better terms than other banks. How could that be true?

            Rather than redeem my note and incur the cost of making another loan, you can claim a share of performing loans that I have already made. If you always redeem, you assume that your lending is always better than everyone else's lending. Banks making such a delusional assumption can't be the most successful banks.

            You don't need to redeem my notes to make a loan anyway. You only need to issue your own notes. You don't need a specie reserve to issue a sound note. You only need sound collateral.

            In specific cases, you're right to demand redemption, because the issuing bank's capital is worth less than the par value of its circulating notes, but everyone (except the issuing bank) wants you to demand redemption in this scenario.

            Notes in circulation don't pay interest, so their value does not vary with interest rates. I can't pay interest on a circulating note, because I don't know who to pay. If you want interest on my note, you must deposit it in my bank.

        • avatar Martin Brock says:

          Circulating notes are not investments if their value is fixed. I can't pay interest on circulating notes, because I don't know who to pay. If a bank deposits a circulating note in my bank, only then has the bank invested, and the note then is no longer circulating, so it is no longer money.

          Gold and silver and copper and other commodities have been money and standards for extending credit historically, but I don't expect precious metals to play the same role in the future. The future evolves from the present, not from the distant past. Electronic money already predominates, and gold has no obvious advantage over other commodities as a standard of value in this context. Unless a state declares gold a legal tender and otherwise favors it as money, I don't expect it to become a common medium of exchange again. I'm happy for a free market to prove me wrong, but since I don't expect a free market either, we're left only to speculate theoretically.

  6. avatar Steve Horwitz says:

    George is fighting a battle that I've been fighting recently as well.

    It is STUNNING to me how so many (though not all) defenders of 100% reserve banking would indeed flunk the first exam in any money and banking course and have no clue how banks really operate. If you want to make arguments about how banking should be structured, the least you could do is have this basic knowledge.

    Everything George has said here is, of course, absolutely correct. I tried to cover this ground here, but I too have been banging my head against the wall: http://www.thefreemanonline.org/headline/fractional-reserve-banking/

    • avatar George Selgin says:

      Glad to have you ring in, Steve, and especially by supplying further proof of how, in opposing the critics of FRB,our side finds itself having to repeat over and over again the same points.

    • avatar Joe Esty says:

      If you are banging your head against the well, that's your fault. You're not doing a good job of persuading the opposition. I'm an Austrian, but when I hear this "I'm right, everyone else is wrong" argument, I'm reminded of Krugman et al, which makes me think even more, you might be wrong.

  7. avatar Major_Freedom says:

    I had the suspicion before, and I think there was something to it after this post. I can't help but be convinced that Selgin's FRB worldview is a case of cognitive dissonance.

    Selgin wrote:

    "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"

    The commonly understood meaning of the term "get away with" implies some sort of illegal, immoral, or at least questionable action is taking place. Is Selgin perceiving fractional reserve banks as "getting away with" something?

    The name calling is probably justified in his mind as there is only so much one can take when it comes to hearing falsehoods all the time, but if the accusation of fraud isn't going away, then maybe we're not getting to the heart of the matter. Maybe neither pro-FRB nor anti-FRB folks are presenting their cases so convincingly that one side will finally concede to the other. I do not think it's a matter of stupidity and that there is no hope and that all we can do at this point is for one side to say the other side is too stupid to be given any effort.

    I will attempt to reconcile the two sides, and show what I think is the core issue at stake here.

    -----------------

    Selgin writes:

    "That is, it is limited to lending rather less than the savings brought to it, which means there's no "thin air" lending."

    For the anti-FRB crowd, the lending out of thin air does not arise when a bank lends more than the cash they physically possess. They believe a bank lends out of thin air when it lends more than the money lent to it, or in general more than the cash the bank owns. Selgin believes that when you deposit money into a demand deposit account, the money becomes the bank's property, and the demand deposit claim becomes the property of the depositor. Tit for tat. The demand deposit claims that depositors own are not instantly transferable claims to a given fungible sum of money, but are rather instant "requests" for a sum of money that the bank promises in accordance with the dollar equivalents inherent in the demand deposit claim. Pro-FRB says this is justified, anti-FRB says it's not.

    Since I don't think we're getting anywhere the way things are going, since I don't believe either side is doing a good job explaining their cases, I am going to try to explain what I see going on in the debate, and then give my own assessment.

    I will invoke the analogy of a car park. Demand deposits for a bank are like time invariant (hereafter referred to as TI) tickets for a space at a car park, where the car park owner has sold more TI tickets than there are spaces available, but (typically) not more than the number of customers needing a space at any given time.

    Imagine the car park owner notices that each day there is a roughly constant percentage of empty spaces. The owner sold 100 TI tickets for 100 spaces initially, but every day he notices his lot is roughly 90% empty. Only 10% of the customers are ever parking their cars at the same time.

    So the owner figures if he sold more TI tickets, he can get more customers into his car park. By "balancing" the number of TI tickets sold with the number of customers who want to park their cars at any given time, the owner can "get away with" selling more TI tickets than there are spaces.

    If things go well with this balancing act, we should say it is all "voluntary" (please do not read too much into the scare quotes). After all, it could very well be the case that every single customer knows what the car park owner is doing, and they could all realize that on "normal" days, when they want a spot, they'll find one available, since they all know that very rarely does every customer want to park their car at the same time. Each customer can reason that the times he wants a space will not be the same times when every single other customer wants a space.

    I mean we go to baseball games and expect to find a parking spot, right? Who would believe the entire city population's drivers want a parking spot at the same time? Why not sell more TI tickets than spaces?

    If we stop here, and we just look at it in this self-contained way, it seems like a strong case. The car park owner and the car park's customers can all in principle be aware of what is going on, so one cannot possibly insist there is any "fraud" taking place.

    So far so good?

    I submit that there is a very subtle, almost imperceptible flaw in this reasoning. The flaw I think becomes apparent when we no longer isolate our attention on only the car park owner and the owner's customer base, i.e. all the TI ticket holders for that car park. It becomes apparent when we also give attention to third parties.

    Let's start to ask questions about externalities. Are there any? I say yes. Here's my reasoning: If we take this car park analogy and fit it into the real world banking system, then we are going to have to include those not party to the contracts signed by that car park owner and that car park's customer base. Why? It is because TI tickets are legal tender enforced by the state. Everyone uses TI tickets as a medium of exchange because the state forces them to pay taxes in TI tickets.

    Now, at this point, the free banking theorist can chime in and say hey wait a minute, I am not calling for any state intervention into car parking. Not legal tender laws, and not taxes in TI tickets. So if we consider a free parking world, then the reference to state intervention no longer applies, and so there won't be any affected "third parties" who want to only deal with 100% reserve car parks. Third parties don't have to use the fractional car park owner Mr. Smith's TI tickets as a medium of exchange. No state will force them to. They can use 100% reserve car park Mrs. Smith's TI tickets if they want. Let the market process decide the complex of circulating TI tickets.

    So the reasoning goes: If such free parking competition can exist without state intervention, then we can distinguish between central parking systems with free parking systems. Yes, let's grant that central parking systems are worse than free parking systems, because the extent of selling more TI tickets than there are spaces is exacerbated with central parking systems. With free parking systems, the ability of competing car parks to sell more TI tickets than spaces will be far more contained and minimized. After all, what's so bad about a few extra TI tickets if drivers are willing to take the risk of not getting a space when they want one? Can we not say that having more spaces with cars actually in them is a more "efficient" car park system? Can we not say that car park owners who sell way too many TI tickets relative to spaces, i.e. "bad managers", will be driven from the car park market as they go bankrupt, and "good managers" will replace them?

    ----------------

    I think the flaw in this reasoning is that it deftly switches from contract rights arguments, to "economic efficiency" arguments. Yes, more car park spaces can be filled by selling more TI tickets than there are spaces. But is economic efficiency really the road we want to go down? It might be "efficient" to murder all AIDS patients, so as to eliminate the disease. But in terms of rights, it is not permissible. So suppose the following:

    Suppose that one of Mr. Smith's car park customers paid for a computer with a Mr. Smith TI ticket. I am going to make a key pair of assumptions here: I will first assume the computer seller is aware, then I will assume he is not aware, that Mr. Smith is running a fractional reserve car parking operation. Suppose first that the computer seller knows Mr. Smith's TI tickets are more plentiful than there are spaces. If this is the case, then the computer seller knows that the Mr. Smith TI ticket he is being offered has a risk associated with it. The seller knows that if he wants to park his car at Mr. Smith's lot, he MIGHT not find a space when he wants a space. Indeed, he might NEVER find a space because he knows Mr. Smith might go bankrupt (more customers show up looking for a space than there are spaces at the same time). He knows this risk, and he accepts it.

    So far, I am on board with fractional reserve parking.

    But...what if the computer seller doesn't know Mr. Smith is running a fractional reserve car park operation? I think everyone, even pro-FRB advocates, have to accept that this is in principle possible. Empirically, I will add that there was a study done in the UK, and, shockingly, upwards of 70% of the population surveyed believed that their respective banks actually had their demand deposit money on hand. It is my contention that this is not an accident. I believe that fractional reserve banks have a huge incentive NOT to educate their customers and to make them aware that the banks don't actually have the depositor's money on hand, that they only carry a few dollars on hand for day to day withdrawals and transactions.

    Is it not justified then to say that while FRB might not be fraud (since within the dozens of pages in a typical demand deposit contract there is one line that says something to the effect of the bank not being able to meet the client's on demand obligations, which bank managers RARELY make an effort to point out to their prospective clients), then should we at least say that demand deposit clients are being misled in some way?

    How many grocery store owners, how many automotive dealers, how many "regular" folks really know that when customers pay them using their debit cards or by check, that they are not receiving a transferable claim to money that actually exists at the bank, but rather a bank's promise to pay that they might not be able to fulfill for whatever reason? I submit that to the extent people are not aware (which in the UK is 70% of the entire population), then this is borderline non-fraud, but is definitely a case of the majority of people, or at least a large number of people, being misled and operating under impressions that are not realistic.

    What about bank tellers who open up bank accounts for new clients? Sometimes even they believe the bank has the cash on hand. What if a customer asks the teller whether the bank will always have their money on hand, and the teller was honest (but incorrect) and told them they will? Is that an instance of fraud? A customer being given false information concerning the thing he is buying? Certainly this has happened at some bank in the many thousands of them? How many bank tellers and account managers make it clear to their clients of what they do with the demand deposit money?

    I tested a bank manager once when I opened a new demand deposit account, after I learned about FRB. I was not prompted by the manager at all as to what happens to the money. I was simply told the rate of interest I will earn on the demand deposit, what transactions I am allowed to do for free and what will have fees associated with them, and so on. No mention of "We might not be able to honor this obligation because we don't keep your money on hand with us. We lend it." I even prompted the bank manager about the safety of the deposit, and what the risks are. He said "Don't worry, it's insured." I prompted him again about the status of the money I deposit. I said everything I could without directly saying "fractional reserve" or "you are going to loan this money out, aren't you?", and...nothing.

    I signed the contract anyway because I knew I wasn't going to get him to say what I think every bank account manager OUGHT to say since it is so crucial to the nature of demand deposits. Just before I left, I finally asked him directly whether or not the money is going to be held at the bank or lent out. And guess what? He didn't even answer my question directly. He said something about "Your money is safe and insured." I could only surmise that A. He was lying, or B. He simply didn't know the economics of demand deposits because nobody ever told him, and so he was one of the 70% who don't know.

    If I didn't know, if I was one of the 70% of those in the UK (it's probably just as high in the US), then I think there is a strong argument to be made that while FRB is not in principle fraud, it is often the case that in practise it is one of people being misled.

    --------------------

    So where do I stand on this issue? Is FRB fraud? In principle, I say no, because it is in principle possible for it to exist with everyone being aware of what is going on. In practise? It can in practise be fraud in those certain instances where bankers outright misrepresent the bank's policies to demand deposit clients (which I think was the case in my "testing" of the bank account manager). I think FRB is definitely not transparent and definitely misleading for the majority of people who don't really understand what they are getting themselves into when they open up a bank account, and when they accept payments from other demand deposit owners.

    I think FDIC demand deposit insurance has lulled too many people into not even considering these things. So when loony crazy kooky Rothbardians cry "Fraud!", there is some small tiny kernel of reasonableness to their position. Some might be totally wrong, some might be making outright errors, but I think they're in the right hemisphere. FRB isn't exactly explicit and transparent.

    I suspect that the above is something Selgin at some unconscious level would agree with, which is I suspect why he used the phrase "get away with" to describe the practise. People who say "get away with" know that it is something that is not exactly honest and upfront.

  8. avatar CT says:

    Hello Prof Selgin,

    I am new to your theories on money and banking, but I would appreciate if you could elaborate on 2 very specific questions that I have:

    1) Do you consider demand deposits to be part of savings and hence fair game for bank lending?

    2) Do you consider FRB to be the cause of the business cycle as other 'Austrians' do?

    I apologize for my ignorance but I have not yet had time to read any of your books (but they are on my list).

    Thank you for you time.

  9. avatar Peter Surda says:

    Dear professor Selgin,

    Please address the following:

    In full reserve banking, transaction costs have no effect on the money supply. In fractional reserve banking, they do. However, your model does not contain this variable. Therefore your model is not a correct representation of fractional reserve banking and needs to be rejected.

  10. avatar JimM47 says:

    Hmmmm. I'm not sure if I get an F on this one too (though I never took more than econ 101 in undergrad). Here's the way I would formulate the problem:

    I go to Bank #1 and give it 50,000 gold doubloon coins, in exchange for which it gives me an entry for 50,000 doubloons in demand deposits. Bank #1 then issues a 45,000 doubloon loan to someone else, which it pays to the borrower in gold doubloon coins. The borrower then deposits the coins in a different bank, or buries them in a treasure chest, or whatever — we don't really care.

    Bank #1 has short term liabilities worth 50,000 doubloons in the form of demand deposits, long term assets worth 45,000 doubloons in loans payable, and the remaining 5,000 gold doubloon coins in liquid assets sitting in reserve. It's reserve ratio is 5,000:50,000, or 10%.

    Now I go to Bank #2 and give it 50,000 gold doubloon coins, in exchange for which it gives me an entry for 50,000 doubloons in demand deposits. Bank #2 then issues a 450,000 doubloons of loans to others, which it pays to the borrowers in demand deposits entered at one of its own branches — no second bank, no treasure burrying.

    Bank #2 has short term liabilities worth 500,000 doubloons in the form of demand deposits (50,000 redeemable by me and 450,000 redeemable by the recent borrowers), long term assets worth 450,000 doubloons in loans payable, and all of the original 50,000 gold doubloon coins in liquid assets sitting in reserve. It's reserve ratio is 50,000:500,000, or 10%.

    So both banks have 10% reserves. But is that enough? 10% isn't magic, right? To the extent there is a magic number, it should be whatever amount is required to counter the risk that someone will attempt to redeem a doubloon-denominated demand deposit for actual doubloon coins, and the bank will have to sell a long term asset in order to meet that obligation. So what is that number?

    Well, I wouldn't expect it to be the same for both banks, because the two banks have demand depositors with very different profiles. Bank #1's depositor is me, a saver, so my account will be relatively stable. My balance is going to go up and down as checks for my expenses go out and income I deposit goes in, but in any given period the actual amount of deposits I redeem will be much lower than the potential amount of deposits I am entitled to redeem. Bank #1 can keep a low percentage of reserves.

    Bank #2's depositors are mostly the borrowers it has just lent to, so their deposits are much more likely to be redeemed. The reason they borrowed is probably to spend in the near term and replenish further in the future. So in any given period the actual amount of deposits they redeem will be close to the potential amount of deposits they are entitled to redeem. Bank #2 should keep a high percentage of reserves.

    In this story there is nothing magic about whether a demand deposit originated as gold doubloon coins or with a loan and a bookkeeping entry. What matters is the profile of the depositors — how likely are they to redeem their deposits — and that could vary independently of where the deposit came from. And there is nothing wrong with having depositors that are more likely to redeem, it just means a bank with those depositors needs to keep higher reserves in order to avoid needing to sell long term assets at a loss.

    Of course, it isn't the end of the world to have some risk of having to sell long term assets at a loss in order to meet deposit demand. So if —as in the story the other commenters are telling — the bank thinks it won't take any significant loss from having to sell something to replenish its reserved, it need not keep as many reserves around to protect against that risk. Conversely, if none of its long term assets can be sold without taking losses that would render the bank insolvent, then the bank should keep a very large amount of reserves on hold.

    So, in the end, the reserve levels of the bank (and the banking system) should go up and down depending on the risks the banks have taken, and the frequency with which depositors spend/move their holdings. And that means the amount of deposits/notes/etc. created by the system should go up and down as those factors change (or information about the changes) over the course of a business cycle.

    Indeed, I rather thought that this flexibility was the whole point. This way the banks have an incentive to send all sorts of information about risk allocation, money velocity, and the size of monetary aggregates into various price mechanisms.

    • avatar George Selgin says:

      That's worth an A for effort alone! Really it is very thoughtful. To see an economist's working out of such details, I recommend Alex MaCleod's Principles of Financial Intermediation. McLeod is (was?) a Canadian bankers who, among other things, understood the difference between a system with competitive note issue and one with a monopoly (or central) bank of issue. I fell in love with it when I first read it.

      • avatar von Pepe says:

        Hi Professor,

        If I had to guess you came across the McLeod book in the NYU library? Well, I went to look it up today (HG173.M397 1984) at the NYU library. From my grad school days at NYU I still get happy feelings going to the H section of the library.

        I was annoyed like have been lately that the book was not there. I think they store these lesser used books off-site. It drives me crazy.

        Anyways, It looks like McLeod was born in 1911. I was wondering if you could elaborate a little on the book and let us know if you know more biographical info on Mr. McLeod. I like the biogrpahical stories you and others post on the people who influenced you or who you have met during your academic career.

        Thanks

        • avatar George Selgin says:

          von Pepe, I have my own copy of the book, though I may have once consulted NYU's copy. I'm afraid I know nothing about Macleod. Of the book I can only say that it is the most painstaking discussion I know of the mechanics of bank intermediation, including reserve posses, money growth, and such, and that it actually treats of the difference between a competitive currency system and one dominated by a monopoly bank of issue. (Probably Macleod appreciated the difference because of his knowledge of how the Canadian system worked before 1935.)

          • avatar von Pepe says:

            Thank you for taking the time to answer my question.

            The book is about $60 on amazon so I will put aside $5 every paycheck and order a copy.

            If MacLeod is still alive, it would be great if someone interviewed him and was able to get some of his historical knowledge.

            Thanks again

          • avatar George Selgin says:

            Alas, McLeod (my apologies for having misspelled his name incorrectly above), died in 2007. Here is a memorial notice that appeared at the time:

            "McLEOD, Alexander Norman, in his 96th year, on Sunday morning, February 25, 2007. Beloved husband for 65 years of Rosalind, dear father of Norman (Elaine), Bruce (Marian), Keith, and Ronald (Yvonne); grandfather of Heather, Kirstie, Alexander, Rory, Brynne, Cameron, Andrew, William and Michael; great-grandfather of Rebecca and Ella Rose. Professor Emeritus (Economics), York University, scholar and author, scout master and sailor; followed his passion for economic justice in the early, promising years of the International Monetary Fund in missions to Libya, Central America, and Saudi Arabia. First Chief Economist of the Toronto Dominion Bank, chair of the Bankers’ Committee of the Porter Commission; Governor of the Central Bank of Trinidad and Tobago. A memorial service will be held on Friday, March 2 at 2:00 p.m., at Richmond Hill United Church, 10,201 Yonge St., Richmond Hill. In lieu of flowers, please make a donation to the charity of your choice. The family wishes to express their appreciation to the staff at Leisureworld Ellesmere for the wonderful care he received in his last months."

            Elsewhere I've learned that McLeod earned his doctorate at Harvard in the '40s. He was active right up to the year of his death, and his many writings, on a broad range of subjects mainly dealing with monetary and macro-economics, generally seem well worth reading.

          • avatar von Pepe says:

            Thanks for the follow-up. Sounds like a great life and an interesting scholar. I will start with The Principles of Financial Intermediation and see where he takes me!

            Thanks again

  11. avatar danm1130 says:

    Hi George. This is Dan Martin from AIER, summer 2009. I remember you as one of our most interesting lecturers, despite our disagreements. I've caught you once or twice on podcasts I listen to you, and happened to come across your "Good Money" book in the library. I know we're technically facebook friends, but this seemed like the more appropriate spot to message you on this topic.

    I'm curious what your freebanking perspective would be on this post from Nick Rowe's blog: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/do-we-need-a-bubble.html. My apologies if this is something you've written a lot on in the past--it's completely standard, basic macro, but as I read it I found myself thinking "I wonder what George Selgin would make of this..."

    • avatar George Selgin says:

      Hi Dan. Rowe's post introduces a host of issues. But most of them, I think, are (despite his claim to the contrary) artifact of his (or Samuelson's) assumption that "money" is the onloy asset people can use to carry wealth across generations. Introducing bonds into the model is just one of many ways to may the "necessity" of bubbles go away. This is the sort of stuff the Minnesota school peddled with its overlapping generations models--essentially beefed-up versions of Samuelson's. Concerning those see if you can did up a copy of my 1987 article, "The Yield from Money Held Revisited," reprinted in Peter J. Boettke and David L. Prychitko, eds., The Market Process: Essays in Contemporary Austrian Economics (Aldershot, U.K.: Edward Elgar, 1994), pp. 139-65.

  12. avatar Sam Grove says:

    Is it trying to be decided here how banks should operate in a real free market?
    I thought the pursuit of a free market meant that banks would be left to establish whatever policies will work as long as they don't engage in fraud or theft.
    I imagine there would be a wide variety of banks offering different degrees of risk and reward depending on factors specific to the time and territory.

    • avatar George Selgin says:

      No Sam. This is a debate concerning matters of fact. But as for your prediction: why do you not allow the historical record to inform it? Why imagine that there would be a substantial interest in 100-percent reserve banks among prospective depositors when in all of banking history, including a great variety of legal settings, there hasn't been one in the past? Why should the future be so different?

      In the Scottish system, which was free in all respects pertaining to this issue, no 100% banks operated; nor did 50% banks, or even 20% banks. The universal preference was for banks that made due with the very narrowest cash reserves, but with plenty of capital. True enough, some banks were more risky than others, but that was a matter, not of very different cash reserve ratios, but of different degrees of capitalization and different sorts of non-cash assets.

      By the way, the 100 percentists seem not to be able to appreciate the role of capital, as opposed to reserves, in banking, and so imagine that a bank's riskiness is only a matter of the latter, which is of course quite incorrect.

      • avatar Sam Grove says:

        I don't predict any particular thing, except that any historical success in free banking would be replicated in some fashion.

        I don't don't see how a bank COULD operate with a 100% reserve policy. I don't think such a thing would allow for profit making (unless it was a fee based system). No profit, no bank.

  13. avatar Joe Esty says:

    George, you come off as way too prickly on this issue, Paul Krugman like. No need to.

    I used to be for full 100% reserve banking, but you and Larry White have made some good points on currency, particularly small change. I would take that even to large denominations. If storing money, and let's say a gold is money, incurs a cost. How do you deal with currency on that money? The bank will putatively charge a warehousing fee, but who does it charge that fee to, particularly if currency is frequently changing hands (and many people like to deal in currency even with large purchases)?

    Some amount of fraction reserve banking is needed to give banks an incentive -- to earn a profit and to cover costs -- to issue currency. If everyone is freely and completely aware of the amount of fractional reserve banking that's occurring, it's not a fraud. With no government guarantee, markets will figure the tolerable percentage of fraction reserve banking.

  14. avatar mike_mike says:

    As a regular reader of this blog and EPL/LRC/etc., I am really disappointed in the level of discourse. As someone who hasn't quite concluded on which side I fall (though admit to favor FB), having one of the leading advocates of an idea acting like a child doesn't help persuade anyone of the intellectual superiority of that side.
    Grow up, George.

    • avatar George Selgin says:

      Mike, I'm genuinely sorry to find you so disappointed. But I'm rather surprised to think that a regular reader of those other forums, which routinely resort to much stronger language than I do, not to mention frequent argumentum ad hominen, in attacking roundly whatever views they disagree with, would fault me for merely calling some of their own economic doctrines and theories silly.

  15. avatar Peter Surda says:

    Dear professor Selgin,

    you get an F from me, not as a student, but as a scientist, because you're dodging questions. And it's not like you missed them, I pointed them out several times at several occasions.

    Your economic model about fractional reserves is not a correct representation of fractional reserve banking, because it does not contain a variable representing transaction costs. It should therefore be rejected.

    You can only refute my argument by proving one of the following:
    - whether a debt instrument is or is not "inside money" (or money substitutes as the Misesians say) is not influenced by the difference in transaction costs of this debt instrument vs. outside money (money proper as the Misesians say)
    - your model does contain a variable representing transaction costs and I missed it
    - you do not understand my point

    Which one is it going to be?

    • avatar George Selgin says:

      Peter, I can't answer all of your questions, though I tried to answer some, because my time is limited, and because at some point I found myself completely unable to understand what you are driving at when speaking of missing variables and such.

      • avatar Peter Surda says:

        Dear professor Selgin,

        you do not have the time to answer questions that concern the fundamentals of your theory, but you do have time to complain on your blog, repeatedly, how everyone else is stupid? Pardon me if I don't take that seriously.

    • avatar Martin Brock says:

      We don't need to impugn personal motives here. Let's take for granted that George has limited time. I'll take up the mantle he drops if you want.

      My defense of "fractional reserve banking" seems even more radical than George's, because I argue that free banks can effectively create all money, that no "base money" held by the banking system is required at all in principle, that a reserve ratio of zero is conceivable and that this ratio implies no inflationary explosion. I'm not saying that free banks would never hold a reserve in practice, only that the theory requires no reserve. A free banking system could emerge on a frontier without any gold or silver for example, and though I'm no historian, I'm sure this must have happened often on the American frontier.

      In a more modern context, people could use Bitcoins as a standard of value, and banks circulating notes promising Bitcoins could obtain them only when needed to satisfy (ultimately infrequent) demands of note holders by selling bank capital for Bitcoins in the open market. Most of this buying and selling could be automated and occur almost instantaneously.

      Bitcoins themselves are simply imaginary constructs, limited only by the agreement of their users, so they hardly qualify as "base money" at all in the conventional sense. They scarcely exist outside of the banking system only to generate prices.

      [George clearly understands all of this, so I'm not sure why he flunks me above.]

      Obviously, a system of this sort requires complex technology and financial expertise, and such a system would inevitably encounter snarls at first, but a stable system could emerge in which banks hold few if any Bitcoins in reserve. Successful banks maintain a sufficiently liquid market in their capital by maintaining sound capital, by not inflating the price of their collateral in their own notes.

      To be clear, in a free banking system, each bank issues its own notes, and a bank's notes are equivalent in value to other bank's notes only if the bank's accounting is sound. There is no single dollar note that everyone knows to be "really worth a dollar" because a dollar monopoly issues it. This multiplicity of note issuers has existed, and modern technology makes the accounting more practical than ever.

      To address your question, a bank doesn't transfer all of the interest paid by borrowers to depositors, so it can absorb transaction costs through the interest it retains. A bank can also charge other fees.

      Why do you see a problem here? What is your point about transaction costs?

      • avatar Martin Brock says:

        I didn't intend to overdo the italics above. I apparently missed a closing tag somewhere, and I can't correct the problem now. That's another reason to upgrade the comments section.

      • avatar Peter Surda says:

        Money substitutes only exist because they have lower transaction costs than money proper. If they didn't have lower transaction costs, they would be merely bank liabilities, but not money substitutes. Professor Selgin is apparently the only Austrian that does not understand this. Even White appears to understand it.

        Money substitutes typically provide feature like:
        - electronic balance clearing
        - payment processing and integration with merchant's accounting
        - ledger
        - various forms (e.g. paper or card)
        - safe storage
        - quick speed

        and so on. But Bitcoin already has all of this (or at least it is possible to implement the features natively), and it does not require a third party to carry the cost of storing specie and allowing it to be redeemed (as Bitcoin IS specie). Therefore, Bitcoin-denominated liabilities are not accepted as a medium of exchange, a substitute for Bitcoin. I argue that they probably never will, and even if they did, it probably won't be very widespread and it is possible that a hypothetical system that is even better than Bitcoin emerges which will have even lower transaction costs and there will be no substitutes for it.

        With Bitcoin (or this hypothetical improved system), the transaction costs will be so low that there will be no demand for money substitutes, therefore the money supply will be inelastic, irrespective of whether banks operate at full or fractional reserves.

        Professor Selgin errs because his model does not take transaction costs into account, even though they clearly do influence the structure and size of the money supply. A fractional reserve system with gold vs. Bitcoin would result in a different money supply structures, and interest rates, whereas in a full reserve system, they would be the same. While that does not mean that the full reservists are correct, it means that professor Selgin is wrong.

        It is extremely simple to understand. If there were no ebooks, then the supply of books would be limited to paper books. But because ebooks act as substitutes to paper books from economic point of view, the emergence of ebooks increases the supply of books in the broader sense. If someone invented "bitbooks", which could be copied and transferred electronically and displayed at various surfaces at negligible costs, even if there could be things that are technologically equivalent to ebooks, they would not act as substitutes to "bitbooks" and they would have no effect on the supply of books in the broader sense.

        Technological progress changes economic relationships, and makes some of them obsolete. Professor Selgin does not understand that whether a bank liability is or isn't accepted as a substitute for money is an empirical issue.

        • avatar Martin Brock says:

          To be clear about my usage of "money", a circulating bank note is not a "money substitute". If people freely choose to exchange banknotes for things, only then to exchange the banknotes for other things they want, then the banknotes themselves are money by definition, not money substitutes.

          Bitcoins are not "specie" in any classical sense, but they do play the role of specie in the system I describe. I'm not a Bitcoin proponent by the way, but I agree with Hayek that a purely abstract "base money" is possible in theory. Bitcoin seems to be establishing this theory; however, we've already seen a Bitcoin bubble, and it's too early to predict the ultimate outcome of this experiment.

          I don't agree that Bitcoin-denominated liabilities are unacceptable as a medium of exchange. The current value of a note promising one Bitcoin can be equal to one Bitcoin. The issuer can pay this interest on the note, because the note itself represents a borrower's obligation to pay interest to the issuer.

          A Bitcoin held in reserve is not similarly valuable to the bank. When a bank pays interest on a deposited Bitcoin held in reserve, the interest is a cost. When the bank pays interest on a deposit of its own note, the interest is passed through. Interest the bank pays to its depositors comes entirely from its borrowers, not from its reserve depositors. A 100% reserve bank must charge depositors a fee rather than paying them interest.

          Gold itself could be a more costly medium of exchange than Bitcoins, never mind any banking system issuing "substitutes". "Hard money" is archaic. Electronic money is the future.

          Bitcoin itself will never be the only money, because the supply of Bitcoins does not respond to the demand for credit.

          If bitbooks correspond to other valuable goods on which people are effectively paying rent and if holding a bitbook entitles me to a portion of this rent, then I may prefer the bitbook to the ebook.

          Also, there's Gresham's law. "Bad money" drives out "good money". If one medium of exchange depreciates faster than another, I'll actually prefer the faster depreciating medium up to a point. Holding both, I'll trade the faster depreciating good first. The faster depreciating good is more often exchanged and held only subsequent exchange, so this "bad money" is actually the better money.

          I only receive interest on a circulating banknote that I accept in trade once I've deposited it in the banking system. It's a hot potato 'til then. I needn't deposit it in the issuing bank, because any other bank quickly redeposits it in the issuing bank. If only the issuing bank will accept a note at par value, you know it's not worth par value.

          Of course, in this system, a healthy bank typically pays another bank a higher rate of interest than it pays an individual depositor.

          • avatar Peter Surda says:

            You ignore my point of transaction costs. Transaction costs are the reason why money even exists, and the reason why money substitutes arise. The interest does not play a role in that decision and that's why your claim that "Bitcoin itself will never be the only money, because the supply of Bitcoins does not respond to the demand for credit." is erroneous. You have the causality backwards. Economists erroneously thought that there is some sort of magical connection between debt and money supply, because that's what they observe happening with fractional reserve banking. They see, but they don't understand. And it's starting to look like Selgin is one of those that do not understand.

            Bitcoin is not yet empirically money, but it is treated as a commodity. If it became money, it would also be the equivalent to specie.

            Your analogy with "rent" on bitbooks is equally erroneous. It is possible to hold interest bearing instruments, but that does not make them into a substitute medium of exchange.

            Gresham's law requires that there is legally fixed exchange ratio which does not correspond to the market ratio.

          • avatar Martin Brock says:

            I don't ignore your point about transaction costs. Banks issuing circulating notes can bear transaction costs without reducing the par value of their notes, because performing loans back their notes.

            A note deposited in the issuing bank is not circulating and therefore is not money. I'll explain.

            Again, you and I may agree upon a rent-to-own contract. You occupy my house and pay me rent plus a bit of the contractual price of my house each month until you own the house. This contract does not increase the money supply. Right? These contracts exist. They're not hypothetical.

            A bank issuing banknotes is just an accounting firm to which people outsource "rent-to-own" arrangements of this sort. The seller of a house typically deposits the notes right back into the issuing bank. Notes that the seller immediately deposits back into the bank do not increase the money supply anymore than the entire cost of the house increases the money supply in the non-outsourced arrangement.

            If the seller then buys another house with the notes, they do increase the money supply, but the money supply decreases to its former level when the second seller deposits the notes back in the bank.

            A circulating note is suitable as money because it has a well defined value for the duration of its circulation. Nothing else is required.

            Gresham's law does not require a legally fixed exchange ratio. It only requires two different monies in circulation, one depreciating faster than the other. On the other hand, if you want to call the process I describe above "Martin's Law" instead, that's fine with me. You haven't disputed it.

          • avatar Peter Surda says:

            This is what Mises wrote:

            The fact that is peculiar to money alone is not that mature and secure claims to money are as highly valued in commerce as the sums of money to which they refer, but rather that such claims are complete substitutes for money, and, as such, are able to fulfill all the functions of money in those markets in which their essential characteristics of maturity and security are recognized.

            As you see, the issue is not whether they have the same market price, but whether they act as substitutes. De Soto, Hoppe, Salerno and even White argue that the reason why money substitutes act as substitutes is due to transaction costs, yet Selgin appears to be oblivious to this. You apparently also.

          • avatar Peter Surda says:

            Gresham's Law, from Wikipedia:

            Gresham's law is an economic principle that states: "When a government compulsorily overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation."

            Rothbard:

            But Mises has brilliantly shown that this formulation of Gresham’s Law is a misinterpretation, and that the Law is a subdivision of the usual effects of price control by government: in this case, the government’s artificial fixing of an exchange rate between two or more moneys creates a shortage of the artificially under-valued money and a surplus of the over-valued money. Gresham’s Law is therefore a law of government intervention rather than one of the free market.

            Regrettably, your post is a fail.

          • avatar Martin Brock says:

            Martin's Law is a generalization of Gresham's Law, but humility compels me also to credit Gresham with the more general formulation.

            A faster depreciating medium of exchange drives a more slowly depreciating medium of exchange out of circulation. You don't dispute this assertion at all. You only distinguish it from Gresham's Law and then quote Rothbard attributing Gresham's Law to a failure of state policy. I'm not discussing state money at all here, so Rothbard's observation is irrelevant.

            In a free market, without any state money at all, no money has a monopoly, not gold or silver or Bitcoins or banknotes promising Bitcoins secured by titles to mortgaged houses. In this competitive context, a medium of exchange need not have a constant value, and expecting any medium of exchange to have a constant value is nonsensical.

            Gold does not have a constant value relative to other goods in a free market, and units of a currency in a free market need not have a constant value relative to gold or any other standard of value. Where monies compete for use by free traders seeking indirect exchange, the same principle that Gresham describes in a specific context, involving state currencies, also applies for the same reasons.

          • avatar Martin Brock says:

            ... the issue is not whether they have the same market price, but whether they act as substitutes.

            That you label one money a "substitute" for another is irrelevant. A one ounce silver coin also substitutes for a stainless steel token promising an ounce of silver backed by adequate collateral. The two instruments are equally valuable, portable and negotiable, so the silver coin substitutes for the steel coin as easily as the steel coin substitutes for the silver coin. If I have no fetish for silver coins, I'm as willing to use one as the other. I don't refuse an attractive bargain because the one you label "substitute" is beneath my dignity.

          • avatar Peter Surda says:

            I am unfamiliar with Martin's Law, nor could I find it via a google search, so I do not know whether your portrayal of it is accurate. However, your statement that more depreciating money drives out less depreciating money even in the absence of legal tender laws and/or fixed exchange rates is false. Indeed Rothbard explains that the cause that you attribute to unexplained forces is the state and implies that in its absence no such effect would be observed.

            You ignore my arguments about transaction costs and divert attention elsewhere.

            The fact that there are bank liabilities that act as substitutes to money and others that do not act as substitutes is the core assumption of my argument. You cannot argue it away. Instead, you continue to repeat that sometimes bank liabilities are perceived to have same value as money, which I explicitly said is not the point.

            Learn how to argue and get your facts straight.

          • avatar Peter Surda says:

            Martin,

            in the absence of fixed exchange rate / legal tender laws, the decision which money to use is driven by transaction costs. Unless there is a great disturbance such as a hyperinflationary collapse, the rate of depreciation plays no role in the decision of usage of a medium of exchange (which is not necessarily the same as a store of value or unit of account). The reason is that the market participants react to the rate of depreciation/appreciation by adjusting the market price accordingly, i.e. they would only accept payment with the more depreciating currency with a premium corresponding to the expected rate of depreciation for the duration they expect to hold it.

            Whether "up to a point" or not is irrelevant as this is not how the decision works. If you want to pay with a more rapidly depreciating currency, you will be penalised by a higher price (on a free market).

          • avatar Martin Brock says:

            Absent hyperinflation, differing rates of depreciation have the effect that I described; however, I grant what I described is not Gresham's Law in the standard sense, so you win. I'm dropping the point about Gresham's Law or Martin's Law or whatever. Above, I write, "Also, there's Gresham's law." It was an aside. My point doesn't depend upon it anyway.

            Again, using an electronic banknote promising Bitcoins backed by sufficient collateral does not have a higher transaction cost than using Bitcoins themselves. The Bitcoins substitute for the banknote as surely as the banknote substitutes for the Bitcoins. Paying rent on the collateral need not be more costly to me than paying rent on the Bitcoins, so I will borrow the banknotes rather than the Bitcoins to purchase the collateral, and others will also accept the notes from a seller of the collateral. I need not borrow enough Bitcoins to purchase the collateral simultaneously.

          • avatar Peter Surda says:

            Please explain to me why the difference in depreciation rate would not be correspondingly reflected in the market price and counter any effect with respect to preference of which money to use.

            Using a Bitcoin-denominated debt instrument instead of Bitcoin has higher transaction cost at least for two reasons, I believe I already mentioned the first:
            - it is incompatible with the Bitcoin network
            - there is a redemption risk associated with it

            Also, since Bitcoin is form-invariant, most likely it is possible to implement a medium of exchange that has the same qualities as the said debt instrument. If it was possible to make gold paper notes, there would be no debt-instrument paper notes which are accepted as a substitute medium of exchange.

            Therefore, it is unlikely that a Bitcoin-denominated debt instrument will be accepted as a substitute medium of exchange. It is also hypothetically possible that another cryptocurrency can eliminate this demand for alternative media of exchange entirely due to extremely low transaction costs it has.

            None of this, of course, precludes these debt instruments from being used as an investment or loan.

            Your example with the rent-to-own contract does not create any debt instruments which are used as a medium of exchange, so it has no effect on the money supply.

          • avatar Martin Brock says:

            I explicitly dropped the depreciating currencies point. Let it rest.

            Using Bitcoin-denominated debt instrument instead of Bitcoin does not have a higher transaction cost for at least one reason that I know I've already mentioned: The debt instrument pays interest on deposit. Bitcoins on deposit pay interest only because debt instruments on deposit pay interest. The interest rate reflects the risk on both deposits.

            Debt instruments are not exactly like Bitcoins, because the debt instruments can pay interest without the Bitcoins, but the Bitcoins cannot pay interest without the debt instruments.

            The rent-to-own contract does not create a debt instruments that is used as a medium of exchange, so it has no effect on the money supply. That's right.

            Now, suppose I monetize one dollar's worth of my right to receive one dollar's worth of rent on my house. I essentially issue a share of my house worth a dollar. This share is not a fixed percentage of my equity. It is one dollar's worth of the equity regardless of any change in my equity.

            I exchange this share for a coke. The person accepting the share accepts it only to exchange it later for something else, so the share is money, and the money supply increases by one dollar. Right?

          • avatar Peter Surda says:

            Paying interest does not decrease transaction costs. Which was my point from the very beginning. There are plenty of examples of interest bearing instruments which do not act as substitutes to money (even though some of them might be highly liquid).

            In your example with the share being used for payment, unless it was a generally accepted practice, it would not affect the money supply. If only one person accepts it, it has no effect on the money supply as the only way to use it is to buy something from you or redeem from you, as noone else is accepting it.

          • avatar Martin Brock says:

            Paying interest offsets transaction costs. A circulating note itself is not an interest bearing instrument. The note bears interest only upon deposit, just like the reserve commodity. The commodity bears interest upon deposit only because the note bears interest upon deposit.

            If you assume that no one else accepts the note, you assume that the note is not money. Assuming that the note is not money implies that the note is not money, but this conclusion is trivial.

            The note is not money on deposit, just as the entire value of the house is not money while none of the value circulates, but banknotes do circulate, because people entitled to create them wish to spend them, and other people perceive no difference between them and commodities deposited as a bank's reserve, because no meaningful difference exists.

            I'll chat with you again tomorrow.

          • avatar Peter Surda says:

            Paying interest does not offset transaction costs, as they occur at different times, do not necessarily fall upon the same people, and empirically are probably too low for the duration of the transaction to offset them anyway. Unless they directly occur during the actual transaction, are borne by the same people, and are sufficiently high for the whole duration of the transaction (which could be very quick, like seconds) it is cheaper for the payer to redeem the instrument, make the transfer using the low-transaction specie, and then the buyer can make a new deposit at a place of his preference. This might be difficult to imagine if you are unfamiliar with Bitcoin, as it runs counter to what normally happens with fiat, but nevertheless this is what happens.

        • avatar Martin Brock says:

          I am Martin. "Martin's Law" is the assertion I label as such above after you insist that Gresham's Law requires a state debasing some legal tender coins and not others, as opposed to a competition among depreciating currencies more generally. Rothbard's assertion does not contradict mine, so it is irrelevant.

          Selgin makes a more compelling point about generalizing Gresham's Law here, but I'm not claiming that two goods with different rates of depreciation cannot coexist as currencies. I only claim that someone holding both trades the faster depreciating good first but will also accept this good in trade expecting to trade it again soon thereafter.

          Money, by definition, is what people accept in trade only to trade it soon thereafter for something else. Money is not legal tender or gold or silver or Federal Reserve notes or anything else definitively. If we want a theory of stateless money, we can't formulate theoretical principles in terms of legal tender. I take "free banking" to describe this sort of money, so I come here to discuss the subject.

          I address your point about transaction costs and substitution repeatedly above. The words are still there, so I won't repeat them.

          I will repeat one question, because you'll never understand my point until you at least acknowledge the question, never mind the answer and its consequences.

          You and I may agree upon a rent-to-own contract. You occupy a house titled to me and pay me a bit of the contractual price of the house each month, plus a contractual rent on the portion of the house that you don't yet own, until you have paid me the entire contractual price, whereupon I transfer the title to you. Does this contract increase the money supply?

          "You fail", "learn to argue" and similarly vacuous statements bounce off of me. I'm much to old to take them seriously. You may write them all you like as far as I'm concerned, but they contribute nothing to the discussion.

          • avatar Martin Brock says:

            "Too old" that is.

          • avatar Peter Surda says:

            Martin,

            if your law was correct, everyone, or at least countries with weakly enforced legal tender laws such as Somalia, Iraq or Afganistan would be using the fastest depreciating currency available (which could be the Zimbabwe dollar, for example). However, that is not true. In fact, Selgin himself uses the examples of Iraq and Somalia (I think in Quasi Commodity Money), and adds that people in such case tend to use either the old legal tender (even if they don't have to anymore), or currencies from neighbouring countries. Levy Yeyati writes that people in some countries use dollars or euros (i.e. a stronger currency) for significant proportion of their trades or debt even if legal tender is something different.

            Furthermore, in the paper linked by you, Selgin writes exactly the same thing as I do claim:

            Where legal sanctions play no role (as was the case in California, where local authorities refused to enforce Federal legal tender legislation), market-based transactions costs alone may discourage the use of non-par money. However, because market-based transaction costs might systematically favor either good or bad money, depending upon which happens to function as a medium of account, such costs alone cannot account for the overwhelming number of historical instances in which bad money does in fact appear to have taken the place of good.

            So Selgin contradicts your claim too. What people use as money in the absence of legal tender laws is not determined by the speed of their depreciation, but by transaction costs. That may or may not favour "bad" money. Selgin however misses that the same mechanism that decides whether people accept money A or money B (transaction costs) also determines whether they accept a money A substitute for money A proper. He should contact professor White, whom he knows very well, and discuss with him his article from 1984 where White writes:

            Coinage reduces transaction costs compared to simple exchange, because of authentication and weighing. Bank liabilities also reduce transaction costs. But these are empirical factors, and not something inherent in all possible monetary systems.

            Since you do not specify in your example what is used to settle the balances, it is impossible to determine whether it has an effect on the money supply or not. What is the money supply and whether credit is used to buy houses are two separate questions, and that is my point from the beginning. Credit may or may not increase the money supply, depending on whether the credit instrument is accepted as a medium of exchange (i.e. whether it is a money substitute). This is determined by the transaction costs of this credit instrument compared to money proper, not whether people trust in the value of the houses.

            Since the transaction costs are borne by the users of money, not the issuers (banks), you still have not addressed my point. For the end-user, a bank note is more comfortable to use than a gold coin, and a debit card or online banking might be even more comfortable. That is why these instruments are accepted as substitutes for gold coins (or whatever fiat the central bank issues). However Bitcoin is form-invariant, and can exist in all these forms (coin, paper note, payment card) without the use of a bank liability. Furthermore, bank liabilities are technologically incompatible with Bitcoin, which penalises them on transaction costs compared to Bitcoin.

          • avatar Martin Brock says:

            I anticipate your objection above by qualifying "faster depreciating" with "up to a point".

            Selgin supports the narrower usage of "Gresham's Law" in the paper, but he also discusses broader uses. I have already agreed to limit "Gresham's Law" to your usage.

            I don't have more time to reply now, but I'll get back to you.

          • avatar Peter Surda says:

            I posted the reply in the wrong tree, hopefully you can see it at http://www.freebanking.org/2012/07/13/more-dumb-anti-fractional-reserve-stuff/#comment-1945

          • avatar Martin Brock says:

            Regardless of what anyone uses for money, you and I may agree upon a rent-to-own contract. You occupy a house titled to me and pay me a bit of the contractual price of the house each month, plus a contractual rent on the portion of the house that you don't yet own, until you have paid me the entire contractual price, whereupon I transfer the title to you. You pay me in whatever money commonly circulates. You name the money. It makes no difference to me.

            Does this contract increase the supply of the money you use to pay me?

  16. avatar Major_Freedom says:

    My post was turfed. Selgin is censoring his blog? How utterly delightful. No engaging of serious criticism for the true believers.

    • avatar George Selgin says:

      I'm not sure why that happened, but I have gone into comments on the dashboard, found it, and tried to save it. I am not the sole administrator of the site, but I think this was just a glitch or mistake.

  17. avatar Ben Kennedy says:

    One of the things MMT talks about (which I think jives perfectly with ABCT) is how modern day fractional reserve banking systems actually function. They challenge the standard Rothbardian money-multiplier account. A bank upon receiving a deposit does neither thing mentioned above. They don't see $50,000 and say "Aha! I can loan out $450,000", nor do they say "Aha! I can loan out $45,000". Rather, a bank seeks out credit-worthy customers and offers them loans completely independent of their reserve position. Later, after the end of some accounting period, they determine what (if any) reserves they need to meet the reserve requirement. A bank will never deny credit to a credit-worthy customer based on some reserve deficiency. They will always make any loan they can based on the spread between what the customer will pay in interest, versus the cost of obtaining reserve funds in the open market. The Fed of course manipulates this interest rate through open market operations that add or remove money from the system. The ultimate constraint on lending is the number of profitable, credit-worthy customers

    I'm not saying this system is good, but I do think MMT is useful for understanding how fiat currency systems work, and to understand how the Fed's actions manipulate the availability of credit and create the business cycle. The point is that the culprit here is the Fed, not just fractional reserve. If the fractional reserve requirement moved from say 10% to 5% (which would create excess reserves and lower the federal funds rate), the fed would compensate by siphoning funds from the system (draining reserves and raising the federal funds rate). Afterwards, the exact same people would continue to get loans at the exact same rate. The particular fractional reserve requirement is irrelevant and not a constraint on lending, once the actions of the central bank are considered.

    All this to say, I definitely think that the "fractional reserve is fraud" position is flawed. Banks just don't convert demand deposits into loans in the way the idealized way Rothbard describes

    • avatar George Selgin says:

      Ben, you are of course right to note that today especially banks practice "liability management," and that this makes the usual textbook view someone archaic. But that's thanks to the fact that they no longer have to first attract deposits: they can buy funds as well once they have good persons to lend to. In the end, though, that doesn't undermine the old story about the limits of deposit multiplication, and about competitive banks not being free to lend "out of thin air," or by some multiple of funds that they are able to acquire. Bankers cannot simply fund their lending using their own liabilities, unless they are (1) central bankers or (2) wildcats that have managed to outwit attempts to return their liabilities for payment.

      I suspect that you agree with these things, but say them to make my position clear to others.

      • avatar Ben Kennedy says:

        I'm not sure I fully get your point, if you could elaborate I'd appreciate it

        • avatar George Selgin says:

          Here's a summary of liability management, taken from Mark Perry's U. Flint online class notes; I hope it makes my point clear:

          Banks used to rely on demand deposits (no interest) for their main source of funds - 60%, in 1960s. Before 1980, banks were not allowed to pay interest on checking, so there was no competition for demand deposits. Also, the fed funds market was not developed, so inter-bank borrowing was rare, to meet reserve requirements. Therefore, banks used to focus on asset management (optimal loan portfolio), because liabilities (demand deposits) were stable and non-competitive.

          Starting in the 1960s, fed funds market developed, so banks had access to a new source of funds: other banks. Also, banks began to issue negotiable CDs, which allowed banks access to another source of funds besides deposits. Banks now placed greater emphasis on liability management, due to increased flexibility for attracting sources of funds. They no longer needed to rely exclusively on checking deposits. They now set goals for asset (growth) and then acquired funds (issuing liabilities) as they needed for new loans.

          Suppose Citizens Bank has an attractive $10m loan opportunity. It would take a long time to get $10m in new deposits, but it could issue a $10m CD to attract funds. Possible buyer: ?? ___________________ Usual amount $1m or more, 1 mo-1 year. Current rates: _____________

          Or suppose there is an unexpected deposit outflow, banks can now use the Fed Funds market to acquire sufficient reserves easily and efficiently.

          Important changes over the last 30 years in bank balance sheets:

          1. Negotiable CDs and bank borrowing (Fed Funds market) now account for 44% of bank liabilities, vs. 2% in 1960.

          2. Checking deposits have declined in importance as a source of bank liabilities: 11% now vs. 61% in 1960.

          3. Increased alternatives and greater flexibility in liability management, have given banks greater flexibility to manage assets profitably, banks have increased the percentage of assets held as loans to 66% in 1999, vs. only 46% in 1960.

  18. avatar Remarkl says:

    In a robust banking system, no single bank is reserve-constrained. A borrower comes along looking for $450k, and the bank makes the loan based on the borrower's credit (which may or may not be bolstered by collateral), knowing that it can FIND $500k to fund the $450k loan if, as, and when the borrower spends it and to put $50k in its checking account to meet its reserve requirements. The $500k may consist of deposits in the bank, or the bank may go out and borrow it in the interbank lending system or from money-market funds or from the Fed's discount window. The money is there, and a well-run bank has access to it. The result is that the banking system as a whole can have outstanding loans equal to 9x the system's reserves in a 10% reserve regime. Even loan proceeds that are "spent" are in SOMEONE's checking account overnight and so can be relent to a bank to fund another loan.

    Some industrialized countries (Canada, Australia among them) do not even have reserve requirements. Eurozone banks have a 1% reserve requirement, which sounds like a trick to keep the machinery oiled without actually doing anything. These countries recognize that liquidity and solvency are entirely different concerns. Therefore, if the central bank is willing to supply liquidity to meet deposit demands, it can leave the matter of solvency to the bankers, requiring only that their capital be sufficient to make the bankers care whether their loans are repaid.

    I have never understood what the fuss over FR was about. Long ago, some English court decided that gold deposits created a right to gold, and not to "the gold." If you don't like that deal, get a safe deposit box. There is no fractional reserve lending against the vault. Otherwise, be thankful that you are getting interest and/or cheap banking services rather than paying someone a custody fee to watch your money.

  19. avatar George Selgin says:

    Peter and Martin, as the comments have boiled down to an exchange between the two of you, I suggest you consider exchanging addresses and continuing it privately.

  20. avatar RalphMusgrave says:

    Prof Selgin,

    Re the “ultra-Ricardian” who deposits $50,000 followed by the bank lending on $45,000 of it, you say that no “thin air lending” is involved here. I suggest that the $45,000 loaned out has indeed come from thin air, and for the simple reason that the original $50,000 is still available to the depositor. I.e. immediately after the loan is arranged, there is a total of $95,000 in the relevant bank available to the bank’s customers.

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