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Free Banking and NGDP Targeting

by George Selgin June 19th, 2013 6:20 pm

Kurt's recent post on NGDP targeting just happens to come right on time to introduce one I'd been contemplating concerning the connection between such targeting and free banking. While many readers may suppose the two things to represent alternative, if not antagonistic, approaches to monetary reform, I have always regarded them as complementary. Yet I also agree with Kurt in regarding NGDP targeting as "a form of central economic planning."

Am I contradicting myself? Much as I'd like to compare myself to Walt Whitman, I don't think so. Instead, I think that it is those who would insist on the incompatibility of free banking and NGDP targeting whose reasoning is faulty. They fall victim, I believe, to a category error, namely, that of conflating banking regimes with base money regimes.

A free banking system is, as the name suggests, a particular banking regime. A fiat money so managed, by a discretionary central authority or otherwise, as to achieve a specific NGDP target, is a particular monetary base regime. The former entails freeing banks from all manner of special regulations and guarantees, as distinct from their obligation to honor contracts voluntarily entered into with their customers or other banks. To set banks free is therefore not to commit them to any particular base regime. On the contrary, it leaves entirely to them and their clients decisions regarding which base money (or monies) to receive and to offer in exchange for deposit credits or notes; and those decisions will tend, overwhelmingly, to be dictated by custom. Is the prevailing base medium--the medium in which final payments are made--gold, or silver? Then the usual if not universal practice will be for banks, given the opportunity to do so, to receive and pay gold or silver. Is the prevailing medium some kind of fiat money? Then the banks will go on dealing in fiat money. Schemes such as Hayek's, in Denationalisation of Money, in which competing private "banks" introduce base monies of their own design, fiat or otherwise, though they provide for interesting thought experiments, are entirely at odds with the part that competitive banks play, or have ever played, in real world monetary systems. In the real world, such banks, unlike central banks, take the base regime as given. Their task is, not to encourage their clients to try some new base money of their own devising, but to get as much of an established base money directed their way as they are able to put to profitable use.

In short, free up the banks all you like; today, in the U.S., they will continue to receive and pay fiat Federal Reserve dollars, so long as no steps are taken to actually demonetize such dollars. Banks might, of course, also offer notes and deposits denominated in other less popular but still well-established currencies; and a few might even offer gold accounts and notes. But such non-dollar bank monies will be but tiny sideshows compared to the main act. And it will be a rare bank indeed that dares to enter the base-money-creation business, the rest remaining content to leave that business to central banks.

It follows that, because it leaves the base regime largely unaltered, a move from regulated to free banking today would not serve to eradicate inflation or otherwise guarantee monetary stability. Such a move would have led to improved stability a century or more ago, because it would have entailed depriving central banks of their role as currency suppliers: so long as gold and silver were economies' final settlement mediums, to deprive central banks of their paper currency monopolies was equivalent to reducing if not eliminating altogether any tendency for other banks to treat central bank paper (or other central bank liabilities) as a reserve medium, and hence as what might be termed "pseudo" base money. The strict dichotomy of bank- and base-regime that applies today did not, in other words, pertain to specie-based monetary systems. Today, however, the strict dichotomy is quite valid; and this means that freedom of banking alone will no longer suffice to make our (or any) monetary system sound.

Something else is needed, then. And that something must of course consist of a reform of the base regime itself. Broadly two alternatives exist for such reform. These are: (1) the restoration of a base medium consisting of some form of specie, or perhaps of some other commodity; and (2) reform of the existing fiat regime. Both options have advantages and disadvantages. A major advantage of the second is that it is likely to be less disruptive. This advantage isn't itself decisive. But it does supply one important reason for not simply dismissing out-of-hand proposals for imposing strict rules upon fiat-money issuing authorities, including rules that call for targeting NGDP. Where people have become long accustomed to using fiat money, the scarcity of which necessarily depends on some sort of "central planning," to suggest a better central plan, instead of merely insisting that people "ought" to use gold (or forcing them to use it when doing so may seriously disrupt their plans), doesn't make one a pinko--not, at least, so long as one also insists that there be no barriers in the way of people switching to gold voluntarily. It's easy enough to say, in hindsight at least, that Imperial Russian authorities screwed-up when they decided on a railroad gauge broader than that used elsewhere in Europe. But it doesn't follow that ripping up the old tracks post-haste, or just neglecting them, is a good idea. With base monies likewise, there is such a thing as sunk costs.

That banking reform and base-regime reform are two very different things does not mean that they cannot be complementary. On the contrary, they can be very complementary indeed; and I have long been convinced that this is particularly the case with regard to free banking and NGDP targeting. The complementarity here arises from the fact that free banking makes for an especially stable relationship between the stock of base money on the one hand and the level of spending (or NGDP) on the other.

How does free banking help? It does so, first, by allowing for a completely market-determined bank reserve ratio and, second, by allowing commercial banks to issue their own currency to take the place of publicly-held central bank notes. To the extent that commercial banks are able to "capture' the market for paper currency, the public's preferred "currency ratio" (that is, it's preferred mix of currency to bank deposit balances) ceases to influence the money multiplier, that is, the relationship between the stock of base money (B) and that of broad money (M). In the limit the multiplier, instead of having its usual, textbook formula of [(1 + c)/(r + c)], where r is the system reserve ratio and c is the currency ratio, becomes simply 1/r, making M = B(1/r); while the quantity of bank reserves, R, becomes equal to the stock of base money. The reserve ratio, in turn, will rise in proportion (though not necessarily in strict proportion) to the volume of gross bank clearings, that is, of payments, which will themselves depend on the velocity of money. As total payments increase, so does the demand for bank reserves. It follows that, for any given B (or, equivalently, any given nominal quantity of bank reserves) there will be a unique volume of payments consistent with equilibrium in the reserve market. Changes in V will tend, therefore, to give rise to such changes in r as will keep MV relatively stable.

This is, admittedly, a crude argument. (It is a little less crude as presented in The Theory of Free Banking and in this Economic Journal article, but not much.) For starters, it does not allow for changes in the ratio of income to total (income and non-income) payments; it does not allow for any influence on interest rates on the demand for bank reserves*; it does not allow for economies of reserve demand connected to changes in the composition of payments (e.g., from fewer large transfers to more numerous but smaller ones); and it does not allow for the potentially disruptive effects of changes in interbank clearing arrangements or technology. In short, it only describes a tendency.

But that tendency is, I think, important--and it is important in a way that should be taken to heart, not just by free banking fans, but by all proponents of NGDP targeting. Because the prospects for such targeting are only as good as those for holding central bankers accountable for their failure to abide by it. Doing so becomes much easier to the extent that achieving any prescribed NGDP target is simply a matter of maintaining a stable growth rate for the monetary base itself, that is, to the extent that changes in the base aren't needed to offset fluctuations in either the currency ratio or the velocity of money. The less need there is for central bank activity (meaning activity apart from that consistent with a predetermined schedule of open-market purchases), the stronger the case for a corresponding clipping of central bankers' wings such as will curb their capacity for mischief-making.

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*This elasticity will, however, differ from that noted for centralized currency systems, in that the demand for reserves under free banking does not include a substantial "vault cash" component that itself varies along with the public's preferred currency ratio. In a centralized arrangement lower interest rates, besides reducing the opportunity costs of reserve holding, are associated with an increase in the currency ratio and, hence, in bank's vault cash requirements. Under free banking the "vault cash" effect is reduced or eliminated. Consequently reserve demand is not likely to be as interest-elastic.

53 Responses to “Free Banking and NGDP Targeting”

  1. avatar BillWoolsey says:

    I agree.

  2. avatar Rob R. says:

    "Schemes such as Hayek's, in Denationalisation of Money, in which competing private "banks" introduce base monies of their own design, fiat or otherwise, though they provide for interesting thought experiments, are entirely at odds with the part that competitive banks play, or have ever played, in real world monetary systems. In the real world, such banks, unlike central banks, take the base regime as given"

    I agree that private banks would indeed do business using whatever base currency is commonly in use. I believe that in a free market private currency issuers could also emerge and their currencies would become the base for private banks to do fractional reserve banking with (perhaps charging a small transaction fee). The private currency issuers would be something like "private central banks" who would operate policy rules (aimed at attracting banks and end customer to use their product) that would have the macroeconomic effect of adding additional monetary equilibrium stabilizers to that provided by free fractional reserve banks. For example should the banking system ever got into a situation where banks increased reserve requirements at the same time as demand to hold money was elevated (perhaps due to depressed expectations) then private currency issuers (who had for example committed to maintaining price stability, or even to maintaining NGDP) would act counter-cyclically in a way that would maintain monetary equilibrium.

    In addition, I think it could be shown that in this model banks and currency issuers would be able to work together to allow the public's preferred "currency ratio" to emerge , driven by market forces and not by central planning, as the currency issuers would have an interest in making sure their currency was available in a form (notes or bank balances) that the public wished to hold it.

    • avatar George Selgin says:

      Like I said, Rob, it is indeed interesting to speculate about private issuers of fiat money. But the possibility remains entirely hypothetical; there are, moreover, many reasons for doubting that it can work as Hayek imagined it might. On this see the chapter 12 of Larry White's Theory of Monetary Institutions.

      As for your last point, I'm not sure what you mean by banks and currency issuers "working together to allow the public's preferred 'currency ratio' to emerge." That ratio "emerges" whether the money issuing agencies go along with it or not. Under central banking changes in it can have destabilizing effects on the total money stock. Under free banking the changes tend instead to be accommodated by changes in the relative nominal quantities of currency and deposits, with no change in either total M or total B.

  3. avatar Rob R. says:

    Thanks for the reply.

    On the last point: I meant that they would work together to allow changes in the public's preferred 'currency ratio' not to be de-stabilizing. In the model of free banking based on commodity money where banks issue their own currency this will work as you describe above. If private fiat currencies exists then this could happen either by the currency issuer allowing free banks to have a "franchise" for issuing notes in the currency, or through the currency issuer varying its supply in pursuit of its chosen policy.

  4. avatar Mike Sproul says:

    This post makes the usual error of supposing that the fact that federal reserve notes are not convertible into the Fed's gold means that they are not backed by the Fed's assets. This mistaken belief has caused quantity theorists to oppose fractional reserve banking, on the grounds that a private bank's issuance of checking account dollars would reduce the demand for FRN's and thus reduce their value. This has given us the strange spectacle of professed libertarians like Lloyd Mints, Milton Friedman, and Murray Rothbard, all advocating some very unlibertarian restrictions on fractional reserve banking.

    But let's back up, and suppose that FRN's are valued according to the Fed's assets and liabilities, just like stocks and bonds. In this case, the private bank's issuance of checking account dollars would have no affect on the Fed's assets and liabilities, and therefore no effect on the value of FRN's. The Rothbardian objections to fractional reserve banking evaporate. Libertarian economists can then drop their silly opposition to fractional reserve banking, and can stop supporting misguided proposals like NGDP targeting.

    • avatar Rob R. says:

      Mike,

      Are you saying that even in normal time (non-ZLB) that a CB could buy trillions of dollars worth of assets with newly printed FRNs and this would not be inflationary as all the new FRNs would be fully backed by the assets they had been swapped for ?

      • avatar Mike Sproul says:

        Correct. Similarly, the state of New York could issue trillions of dollars of new bonds, and as long as NY used the proceeds to buy trillion of new assets, NY's bonds would hold their value. General Motors could issue trillions of new stock, and as long as it got trillions of new assets, its stock would hold its value.

        Naturally, GM and NY (and the Fed) reach a saturation point where the next trillion of stocks, bonds, or FRN's will buy only 0.99 trillion worth of assets. If they continue to issue at or beyond this point, then their assets will fail to keep up with their liabilities, and the stocks, bonds, or FRN's will lose value. The "Law of Reflux" has a lot to say about this.

        • avatar Rob R. says:

          Suppose the CB buys lots of bonds in exchange for dollars and this has no effect on the value of the dollar as you suggest. Then later interest rates rise so bond values falls and reduces the value of the CB bond holding. Do we get inflation then ?

          • avatar Mike Sproul says:

            Yes; if the fed's assets lose value, then FRN's (the fed's liability) lose value as a result. This can cause what I call 'inflationary feedback'. To the extent that the fed's bonds are denominated in dollars, inflation will cause the bonds to drop more, which makes the dollar drop more, etc. This process is limited by the fed's holdings of 'real' (non-dollar-denominated) assets.

          • avatar George Selgin says:

            Mike, during 2008-10, as I've noted before, the Fed acquired large quantities of sub-prime securities of very doubtful value, and made loans to numerous banks of doubtful solvency, while selling off some of its Treasury securities in an effort, early on, to sterilize its MBS acquisitions. During that same period, the CPI inflation rate declined dramatically. How can these facts be reconciled with the "backing" theory?

          • avatar Rob R. says:

            Mike,

            Many central banks around the world have successfully targeted inflation over the past 2 decades. Leaving velocity out of the picture then most monetary theorists think that the way to hit the inflation target is to slowly increase the money supply over time by having the CB exchange dollars for assets. If I understand your theory correctly then you must think they would have to reduce the value of their assets over time in order to hit the inflation target (by burning them or selling them off below their true value).

            Would not empirical evidence support the standard theory here against your theory ?

          • avatar Mike Sproul says:

            George:

            Bank notes are normally the senior claim against the assets of the issuing bank, just as bonds are senior to stocks as a claim against the issuing firm's assets. A firm's assets can rise and fall all over the place, and its bonds might hold steady while only its stock fluctuates. In the same way, the fed's assets can be volatile, while its bank notes are stable. This would be especially the case if the public believed that Congress would bail out the fed if push came to shove.

            So I'd say that the backing theory explains the value of bank notes just as well as it explains the value of bonds. Of course, nobody doubts that the backing theory explains the value of bonds (and stocks), but my friends in finance tell me that it is almost impossible to confirm empirically that the value of stocks and bonds is determined by the assets and liabilities of their issuers. I expect it would be harder still for money.

          • avatar Mike Sproul says:

            Rob:

            Start with a central bank (the fed) that holds assets worth 100 oz. of silver, as backing for $100 of FRN's it has issued. Each FRN will be worth 1 oz. Here are a few scenarios that would cause the FRN's to fall by 2% over the following year
            1. The fed prints $2 of FRN's to pay to its useless employees, assets remain at 100 oz.
            2. The fed pays 2 oz. worth of its assets to its useless employees while the number of FRN's stays at $100.
            3. The fed has to print $2 to pay for the printing costs of the notes that wore out over the year.
            4. The fed somehow gets the idea that 2% inflation is optimal, so it announces that at the end of this year, each dollar will be redeemable for .98 oz worth of assets. It pays the leftover 2 oz to congress as 'profit'.

          • avatar Mike Sproul says:

            Rob:

            Oh yes; about empirical evidence. There have been very few attempts to directly compare the two theories, but I list them in my paper entitled "There's no Such Thing as Fiat Money", which you can find by clicking my name above. The studies that come to mind are by Bruce Smith, Thomas Cunningham, Charles Calomiris, Thomas Sargent, and Bomberger & Makinen.

          • avatar Mike Sproul says:

            Rob:

            What's missing is a proper definition of "convertible". You'd agree that if each dollar was convertible by the issuer into 1 oz of silver, then the question of how many dollars are chasing how many goods would be irrelevant, and each dollar would be worth 1 oz. If the issuer printed another $10 and got 10 oz of new assets, then that unwanted $10 would simply reflux to the issuer, to be redeemed for 10 oz., and each dollar would remain worth 1 oz.

            Now just play with the word 'convertible' a little. What if each dollar was instead convertible into an amount of wheat that is worth 1 oz of silver? I think you'd agree that the reflux would work the same. What if each dollar was instead convertible into something, like a bond, that was itself denominated in dollars? Again, reflux works the same. The point is that dollars can be convertible into many things. Convertibility might be instant, delayed, certain, uncertain, etc. Of course, if the money issuer stops absolutely every possible kind of convertibility, then that is an effective default and loss of backing, and the money will lose its value. But modern paper money is not like that. You can use it to pay taxes to the government, to pay back loans from the fed, and probably hundreds of other things that I'm not thinking of at the moment.

          • avatar Rob R. says:

            "Now just play with the word 'convertible' a little. What if each dollar was instead convertible into an amount of wheat that is worth 1 oz of silver? I think you'd agree that the reflux would work the same"

            Yes, if this was offered by the currency issuer (or someone else) and resulted in the dollar disappearing from circulation then that would be "reflux". If people just buy wheat (or bonds) from other people then that's not reflux - the dollar is still part of the money supply in that case.

            (Yes, it very hard to work out which "respond" button to use on this blog !)

        • avatar George Selgin says:

          I won't change Mike's mind, but I can at least try to explain to others why I disagree with him.

          Suppose that an economy using fiat paper "dollars," has three goods only--say, wheat, coal, and platinum. The money issuer "backs" its issues with equal portions of each, but does not offer to redeem its money in any of the assets. For the sake of argument, assume that all three goods are equally common, that their quantity is fixed, that all have the same initial money price, and that a representative basket initially contains $33 worth of each. Dropping the unit makes the initial price index 100.

          Now suppose that the money issuing authority, being entirely ignorant concerning the "backing" theory of money, decides to double the money stock, not buy acquiring more wheat, coal, or platinum, but simply by dropping a nominal quantity of new paper dollars equal to the old quantity from helicopters. According to the backing theory, this expansion of the stock of paper money with no corresponding increase in the issuer's asset holdings should mean that the dollars will depreciate--and indeed, that is almost certainly what will happen, with the price index rising to a new equilibrium of 200. That outcome is also, of course, consistent with the predictions of the quantity theory. So far, then, it appears that either theory is as good as the other.

          But wait: the depreciation in question implies a doubling of the equilibrium, nominal market value the money issuers' initial, unchanged asset holdings. So the new stock of dollars ends up being just as fully "backed" as the old stock had been to start with. And that will be the case, in equilibrium, for any nominal expansion of the dollar supply. In other words, there is no unique equilibrium for either the money stock or price level implied by the rule that "every dollar of money must have a dollar's worth of assets behind it." (There is a unique equilibrium for the rule that every dollar must have some real quantity of assets behind it--say, so many bushels of wheat, tons of coal, and troy ounces of platinum. But the backing theory refers to assets' equilibrium nominal market value only.)

          Of course real central banks don't hold portfolios representative of the general assets of the economies in which they operate. Instead, they limit themselves to small subsets of available assets. But far from resolving the problem this makes it worse, for it means that central banks' actions are likely to influence disproportionately the prices of those particular assets they deal in.

          The above "nominal indeterminacy" problem is why the "backing" theory, in its various guises (including the real bills doctrine and Fullarton's "reflux" idea) is considered discredited by most economists.

          • avatar Mike Sproul says:

            George:

            Suppose your money issuer holds 33 1/3 oz of each of your 3 goods, that 1 oz of coal buys 1 oz of wheat or 1 oz of platinum, and that the money issuer has initially issued 100 paper dollars. On backing theory principles, $1 will buy 1 oz of any of the 3 goods. No indeterminacy so far.

            Next, the issuer helicopter-drops another $100, getting no new assets in return. On backing theory principles, $1 will now buy 0.5 oz of any of the 3 goods. Still no indeterminacy. Of course if they had behaved normally, they would have gotten another 100 oz worth of the 3 goods in exchange for the 100 new dollars, and $1 would still buy 1 oz of any of the 3 goods.

            But this isn't the scenario you were thinking of. You had been thinking of the bank's assets as being denominated in dollars, not ounces. So let's make a step in this direction. Suppose the money issuer starts with 100 oz of wheat. (or an equal value of all 3 goods. It doesn’t matter.) They have issued $100, so $1=1 oz. Now, let them issue another $200, not in exchange for 200 oz of wheat, but in exchange for 200 DOLLARS WORTH of wheat. Let E=the value of a dollar, measured in oz. /$. The total value of the issuer’s assets would thus be 100 +200E, and the total value of the issuer’s liabilities would be 300E . Setting assets=liabilities yields 100+200E=300E, or E=1 oz/$.

            There is no inflation and no indeterminacy. We do, however, get increased volatility of the dollar. For example, suppose the bank is robbed of 30 oz. of wheat (a 10% loss of assets.) The above equation would become 70+200E=300E, or E=0.7 oz/$ (a 30% inflation, caused by only a 10% loss of assets. This is what I call inflationary feedback.)

            Here’s one case where we would agree: If the issuer held no ‘real’ assets, so that all of its assets are denominated in dollars, while all of its liabilities are also dollars, then the price level is indeterminate. But of course when Lloyd Mints and his followers spoke of an indeterminate price level, this is not what they meant. Mints told a story where
            1. Bank loans create more dollars
            2. More dollars cause all prices to rise
            3. A homeowner whose house just rose in value is able to borrow still more on his new equity.
            4. This creates even more money, more inflation, more loans, etc.

            The trouble is that step #2 assumes the correctness of the quantity theory, which is the very point in dispute. On real bills or backing theory principles, those new dollars, being adequately backed by new collateral, will not cause inflation. Mints’ “self-perpetuating cycle” of loans, money, and inflation, never gets started.

          • avatar Rob R. says:

            MIke,

            Imagine an economy with a 1000 identical goods and 10000 dollar bills. Assume each good changes hands each year for $10.

            If the CB gives everyone a newly printed $1 gift for each good they purchased the year before, then this might increases the price of goods by 10%.

            What happens if rather than giving people money the CB increases the money supply by buying 10% of the goods directly themselves ?

            Surely there will now be more money chasing fewer goods and the inflation rate will > 10%?

            This will be the case unless the CB offers convertibility at $10 per good. Then no-one will pay more than $10 and they will instead get the good from the CB by returning some notes.

            If the CB doesn't offer convertibility then I do not see what will prevent the price rising above $10, backing or no backing. There is more money and less goods.

            What am I missing ?

          • avatar Mike Sproul says:

            Rob:

            What's missing is a proper definition of "convertible". You'd agree that if each dollar was convertible by the issuer into 1 oz of silver, then the question of how many dollars are chasing how many goods would be irrelevant, and each dollar would be worth 1 oz. If the issuer printed another $10 and got 10 oz of new assets, then that unwanted $10 would simply reflux to the issuer, to be redeemed for 10 oz., and each dollar would remain worth 1 oz.

            Now just play with the word 'convertible' a little. What if each dollar was instead convertible into an amount of wheat that is worth 1 oz of silver? I think you'd agree that the reflux would work the same. What if each dollar was instead convertible into something, like a bond, that was itself denominated in dollars? Again, reflux works the same. The point is that dollars can be convertible into many things. Convertibility might be instant, delayed, certain, uncertain, etc. Of course, if the money issuer stops absolutely every possible kind of convertibility, then that is an effective default and loss of backing, and the money will lose its value. But modern paper money is not like that. You can use it to pay taxes to the government, to pay back loans from the fed, and probably hundreds of other things that I'm not thinking of at the moment. (Sorry this appeared twice. I placed it under the wrong reply the first time.)

          • avatar Rob R. says:

            "Now just play with the word 'convertible' a little. What if each dollar was instead convertible into an amount of wheat that is worth 1 oz of silver? I think you'd agree that the reflux would work the same"

            Yes, if this was offered by the currency issuer (or someone else) and resulted in the dollar disappearing from circulation then that would be "reflux". If people just buy wheat (or bonds) from other people then that's not reflux - the dollar is still part of the money supply in that case.

            (Yes, it very hard to work out which "respond" button to use on this blog !)

      • avatar George Selgin says:

        "Each FRN will be worth 1 oz." Unless FR notes are fixed claims to silver, that's begging the question.

  5. avatar George Selgin says:

    Mike, I know that we have to agree to disagree on the "backing" question. Nevertheless your latest baffles me. Of course in a trivial sense FR notes are "backed" by Fed assets. But it doesn't follow that their value depends on the value of those assets in the same way as it would were FR notes redeemable claims to gold. In any event, if there is a "usual error" here it isn't on my part, for my opinion regarding the difference between the determinants of the value of a redeemable currency and those of an irredeemable one is (for once) perfectly orthodox. That orthodox view, moreover, has nothing to do with Mints' or Friedman's criticisms of fractional-reserve banking, which had to do instead with their belief that it led to perverse M changes in response to changes in the public's relative demand for currency ("c" in my exposition above). (Friedman actually recognized, by the way, that the problem was only such in systems lacking freedom of note issue.) Most quantity theorists, in any event, do not condemn fractional reserve banking at all.

    It is perfectly true, on the other hand, that fractional reserve banking lowers the demand for and hence the value of base money by supplying low cost fractionally-backed substitutes for it. But that is hardly a reason for condemning it (Adam Smith, for one, considered it a virtue, as do I), and it wasn't the reason given by any 100-percenters save some Rothbardians who, evidently, don't seem to get the distinction between pecuniary and non-pecuniary externalities. So one needn't resort to the "backing" theory to find fault with Rothbardian arguments against fractional reserves.

  6. avatar Mike Sproul says:

    George:

    The backing is not 'in a trivial sense' at all. The fed's assets are real, and the fed can and does use those assets to buy back FRN's all the time. Furthermore, if the fed were ever unwound, then it would first use its bonds to buy back an equal value of FRN's (and federal funds). If there were still FRN's in public hands, the fed could use its gold to buy back the rest. Compare that to the case of a central bank that had dumped all of its assets in the ocean and had nothing with which to buy back its notes.

    Or consider the suspension period of the Bank of England. On Feb 25, 1797, the day before the suspension, the BOE has enough gold and bonds to buy back all its notes at par, AND the BOE stood ready to convert notes into gold. On Feb 27, the day after the suspension, the only difference was that the BOE would not longer pay out gold on demand. All the assets were still there in the BOE, and the BOE would still buy back its notes at par, but only with its bonds and loans, not with gold. Would you claim that the pound was backed on feb 25, but suddenly became 'fiat' on feb 27? How about 24 years later, in 1821, when gold convertibility was restored? Would you say that the pound suddenly changed back again from fiat money to backed money? I suppose you might actually say that, but it makes much more sense to say that the pound was backed and gold-convertible before and after the suspension, while during the suspension it was backed and gold-inconvertible.

    • avatar George Selgin says:

      "Would you claim that the pound was backed on Feb 25, but suddenly became 'fiat' on feb 27?" I never denied, Mike, that central banks really do have assets. But the significance of those assets changes once a central bank's "liabilities" cease to be genuine credit obligations. (For this reason I'm not sure what you think it means to imagine the Fed being "wound up." I submit that it certainly wouldn't mean that every holder of its outstanding notes could look forward to "getting" something for those notes--unless, of course, some yokel offered to trade, say, a dollar bill for 96 pennies!)

      In the case of the Bank of England's 1797 suspension, its true that the paper pound held its value for some years; but that was merely a reflection of the Bank's not having taken advantage of the suspension to expand its issues aggressively. When the government later forced the matter, the pound depreciated relative to gold.

      Was the pound ever really fiat money between 1797 and 1821? That's a matter of semantics. Nobody believed that the suspension would be permanent, though neither did anyone initially imagine it would last as long as it eventually did last. The general expectation that convertibility would be resumed disqualified paper pounds from meeting the standard definition of fiat money. So what were they? They conform precisely to Mises' definition of a "credit" money, that is, a money that is expected to be made redeemable into a definite quantity of some reserve asset at some point in the future.

      • avatar Mike Sproul says:

        But the modern paper dollar, like the British pound, is a genuine credit obligation of its issuer. The only thing that suspension changes is that the obligation is no longer in gold, but in bonds, loan repayments, taxes, etc. A holder of a dollar has no reason to care if he can redeem his dollar for 1 oz of gold or for bonds worth 1 oz.

        The fed might or might not unwind itself and buy back its notes, but there is a probability that it will, and that alone can give the dollar value. But if there were truly no backing, as in the case where all the central bank's assets are dumped in the ocean, then that probability is close to zero.

        Back in 1933, people didn't know that the gold convertibility of the dollar would be suspended for 80 years and counting. Gold convertibility might be suspended for 80 years, 24 years, 30 days, or for a weekend. In every case, the money is backed but inconvertible. In no case is it 'fiat money'.

        • avatar George Selgin says:

          "But the modern paper dollar, like the British pound, is a genuine credit obligation of its issuer." That simply isn't true Mike. You cannot get anything for a dollar, except another identical to it: it is a promise to pay...itself! A bond issuer cannot simply say, when the bond matures, "Oh, here is another bond," and call that a debt payment! What makes the bond a credit instrument is precisely that it constitutes a promise to eventually pay the holder something other than another identical instrument. To overlook, or to pretend not to recognize, this not at all subtle difference between a modern Federal Reserve "liability" and any genuine credit instrument, such as a bank note that is actually redeemable in a fixed real quantity of gold or silver, has all the appearance of being disingenuous.

          And as for your insisting that money that is "backed" cannot be "fiat" money: it is mere playing with words. For the zillionth but last time: no competent authority I know of, and certainly not I, has ever defined fiat money as money that is not "backed" by assets. Of course most central banks have assets, and the nominal value of those assets practically always exceeds the nominal value of fiat CB liabilities. The standard definition of fiat money refers and has always referred not to its lack of "backing" but to its not being a readily convertible claim to a given real quantity of some specific non-monetary asset.

          The Federal Reserve System has never been insolvent, or even close; it has, indeed, always paid a nice dividend to the U.S. Treasury, its true residual claimant. Its assets have, in other words, always been worth at least as much as its liabilities; thus those liabilities, in still other words, have never been less than fully "backed," according to your own understanding of that term. Yet since the Fed was established the U.S. dollar has lost over 95% of its value. How can this be? Simply, because the backing theory is poppycock.

          • avatar Mike Sproul says:

            George:
            " You cannot get anything for a dollar, except another identical to it: it is a promise to pay...itself!"

            Start with the fed having issued 100 paper dollars, backed by various assets worth 100 oz. The fed then prints a new dollar and lends it. One year later the borrower pays back a paper dollar plus interest, and the fed burns the dollar. That borrower didn't just get another dollar for his dollar. He got debt relief.

            The fed prints another paper dollar and spends it on office supplies. The receiver of that dollar pays it to the government and the government burns it (or re-spends it. It wouldn't matter.). That taxpayer got tax relief for his dollar.

            The fed prints another dollar and buys a $1 bond with it. Later, the fed sells that bond for $1 and burns the dollar, and the receiver of the bond takes the bond to the government and pays his $1 tax with it. The government burns the bond. That taxpayer also got tax relief for his dollar.

            Every "competent authority" that I know of says that the value of the paper dollar is determined by the intersection of the money demand curve and the money supply curve, and not by the fed's assets and/or liabilities. That's what everyone means by 'fiat money', and it's wrong. Modern paper money is always convertible into bonds, debt relief, or tax relief, and sometimes it is convertible into gold or other base moneys. The term "fiat money" is used by people who don't understand that there are many kinds of convertibility, and that those other forms of convertibility remain even after gold convertibility is suspended.

            The dollar has lost 95% of its value because the fed has taken 95% of its backing and either lost it or placed it off-limits to the holders of fed-issued money.

          • avatar George Selgin says:

            "Modern paper money is always convertible into bonds, debt relief, or tax relief, and sometimes it is convertible into gold or other base moneys. The term "fiat money" is used by people who don't understand that there are many kinds of convertibility, and that those other forms of convertibility remain even after gold convertibility is suspended." I'm afraid, Mike, that it is very hard to argue with someone who insists on assigning meanings to terms that are utterly unlike those normally attached to them. Thus a currency isn't, according to standard usage, "convertible" into gold simply because it can be traded for some (not fixed) amount of the stuff in the marketplace. Nor is a currency considered--again, according to standard usage--"convertible" into anything simply because one can acquire bonds or pay debts or taxes with it. No one can, of course, dictate to anyone else what meaning that person must attach to particular words. But neither can anyone be expected to persist in debating with someone who chooses to strip terms of their generally accepted meanings. I am thus free to say that the concept "cheese" applies to certain stones no less than it does to a wedge of cheddar or Stilton, and to then declare that all those self-styled experts are wrong in denying that the moon is made of cheese. But I should not expect anyone to indulge me for very long in a debate on the matter.

          • avatar Mike Sproul says:

            George:

            "Convertibility" is a widely misused term, and it needs to be corrected. At the simplest level, convertibility is not a simple yes/no proposition. One piece of paper might be convertible into 1 oz of silver on demand, while others are convertible subject to a delay of 16 hours, 2 days, 30 days, or 30 years. One piece of paper might be convertible tomorrow with 99% probability, another with 80% probability. There is no clear line to be drawn between convertible money and fiat money.

            You deny that currency can be called convertible by virtue of being able to pay debts or taxes with it. But if I owe 1 oz to the tax man, and that tax man will accept a green piece of paper in lieu of 1 oz, then that piece of paper is effectively convertible into 1 oz., just as if the tax man had actually paid me 1 oz for it. If standard usage does not consider this as convertible, then either standard usage needs to be changed or we need a new word.

            The mainstream view has particular trouble with denomination. A green piece of paper might be convertible into 1 oz of tax relief, and it might be called a dollar. A blue piece of paper might be convertible into a green paper dollar and might also be called a dollar. A red piece of paper might be convertible into a bond which is itself denominated in dollars. After a while, people think only in terms of dollars, and they forget the underlying ounces. At this point they can get the mistaken idea that the dollar is inconvertible, since "You cannot get anything for a dollar, except another identical to it: it is a promise to pay...itself!" A simple misunderstanding of the word "convertible" has lead to the mistaken conclusion that a tax-backed dollar is not backed.

  7. avatar George Selgin says:

    "or placed it off-limits to the holders of fed-issued money." What can this refer to unless it is the fact that dollars ceased at some point to be fixed redeemable claims to some specific real asset?

    • avatar Mike Sproul says:

      It refers to a gradual removal of backing, as opposed to a sudden and complete removal. For example, if the Fed pays out 2% of its assets every year to its useless employees and to Congress, then that 2% is now off limits to the holders of FRN's, and FRN's will lose 2% of their value. After 100 years, each FRN will have lost 95% or so of its original value.

      • avatar George Selgin says:

        "For example, if the Fed pays out 2% of its assets every year to its useless employees and to Congress, then that 2% is now off limits to the holders of FRN's, and FRN's will lose 2% of their value. After 100 years, each FRN will have lost 95% or so of its original value."

        No, Mike, the Fed hasn't been drawing its capital down 2% every year! It has never spent more than the combined interest flow and gains on that capital, and has indeed routinely generated much more revenue than it has needed to cover its operating expenses--hence the rebates to the Treasury. It is no more correct to say that the Fed reduces its capital in incurring operating expenses or paying dividends when it keeps those payments within the bounds of its gross revenues than it would be to say that any corporation must be reducing its capital whenever it pays dividends!

        • avatar Mike Sproul says:

          I'm not enough of an accountant to speak with much confidence about the Fed's profits, (Where's JP Koning when you need him!) but the fed's profits look a lot like an illusion created by inflation, rather than an excess of real revenue over real cost. The interest earned by the fed is partly due to inflation, and so when interest (minus overhead) is paid to the Treasury, the Fed ends up poorer in real terms than before.

          If this real loss to the fed amounts to 2%, then FRN's will lose 2% of their value. The public's real balances would be 2% less than desired, so people would demand 2% more FRN's from the Fed. Assuming the Fed accommodates this demand, the money supply will grow 2%/year in response to the 2% inflation. Meanwhile, quantity theorists will think that the 2% inflation was caused by the 2% growth in the money supply, when actual causality was the other way around. (Thomas Tooke noticed this way back in the 1840's, and has been denounced for it ever since.)

          • avatar George Selgin says:

            Wrong again, Mike. The profits are perfectly real--there is no loss. The Fed covers its real expenses with real payments paid to real workers (etc.) and gives the Treasury real rebates that reduce its real debt burden. Yes, the Fed's profit is partly a function of the rate of inflation, but it is real profit nonetheless. There's no illusion.

            At some point, Mike, when the epicycles start piling up one on top of another, isn't it time to consider switching paradigms?

  8. avatar Mike Sproul says:

    If inflation causes the Fed's profits to appear bigger than they really are, then of course the profits are illusory, and the Fed could end up paying actual capital to the Treasury, rather than true profit.

    The epicycles did indeed pile up. That's why I ditched the quantity theory in favor of the real bills doctrine 20-odd years ago.

    • avatar George Selgin says:

      "If inflation causes the Fed's profits to appear bigger than they really are, then of course the profits are illusory." I did not say that inflation makes profits "appear" bigger: I said it contributes to the actual ("real"--used several times for emphasis!) profits greater. There's a huge literature on the profits from money creation and how these are positively related (at modest inflation rates) to the rate of inflation. Surely you have heard of it.

      I must say I'm pretty shocked by your manner of argument, Mike. You distort and dissemble and equivocate and arbitrarily redefine concepts well beyond the point that is consistent with honest debate. Yours seem to be the sort of assertions and logic one expects, not from a scholar seeking to show some misguided colleague the light, but from a shady lawyer trying to get a career criminal off the hook!

      • avatar Mike Sproul says:

        So far, I haven't said anything insulting, but you have. And as you spend more time expounding on my character defects, you spend less time addressing interesting issues like whether dollar bills are a genuine credit obligation of the Fed, or whether tax convertibility serves the same purpose as gold convertibility. This reduces the educational value of our discussion to almost zero, although it does provide a good example of how the guy with the weaker argument becomes the first to toss off unfounded and regrettable remarks.

        • avatar George Selgin says:

          I confess, Mike, that I ought not to have made that remark about your arguments--I ran out of patience and am sorry for that. But it was not any sense of the weakness of my position that drove me to that point, but rather my impression that you had misrepresented my argument in order to dismiss it. That sort of thing tends to put me in high dudgeon.

          And as a general rule, surely, it cannot be right to say that whoever loses his temper first must be on weaker ground, for in that case anyone might succeed in winning an argument, not by making better- founded claims, but by making more exasperating ones.

          • avatar Rob R. says:

            Mike, I have found your arguments entertaining if ultimately unconvincing.

          • avatar Mike Sproul says:

            Rob:

            Federal reserve notes are the liability of the fed, and are backed by the fed's assets, just like stocks and bonds and other liabilities are backed by the assets of their issuers. Bank of America's checking account dollars are backed by BOA's assets. Credit card dollars are backed by the assets of the credit card company. I find that highly convincing.

          • avatar George Selgin says:

            Stocks aren't liabilities by anyone's definition of the term. Or is this another case in which the backing theorists reject standard usage?

          • avatar Rob R. says:

            I think that:

            1, Without genuine convertibility a currency will lose value if more is issued
            than the public wish to hold at the current value no matter how much backing that currency has.

            2. By doing things like paying government workers in it, and insisting that taxes are paid in it, a government could probably give its currency some value even without backing

            For these reasons I think the backing theory is false.

          • avatar Mike Sproul says:

            Well, now it's my turn to apologize for a regrettable remark. You are correct. Shares of stock, even though they are placed on the liability side of the firm's balance sheet, are not liabilities in standard usage. I meant that stocks are liabilities in the sense that they are a claim to the firm's assets. So, for example, if a firm's only asset is $600 in a bank account, and if the firm has no liabilities, then if that firm has issued 10 shares of stock, then each share will be worth $60. If the firm printed up another 20 shares, and sold them for $60 each, then the firm would have 30 shares of stock laying claim to a bank account with $1800 in it, so each share will still be worth $60.

  9. avatar JP Koning says:

    Let's say that a central bank buys buys and sells gold at $35 to all comers. Then it drops convertibility but switches to buying and selling bonds in the secondary market at prices and amounts sufficient to enforce its promise to keep the $35 price. In both cases the $35 price holds. But according to your definition, George, one of them is "fiat" and the other "non fiat". But this distinction implies that they are entirely different structures whereas they are precisely the same outcomes, only that the first is a direct route and the second an indirect route. The reason, of course, that the second outcome is possible is because the central bank holds sufficient bond assets to make good on its promise.

    • avatar George Selgin says:

      JP, it is evident that if a central bank fixes the money price of a real asset the consequences will similar to what they would be were there free convertibility of its notes into that asset at the same price, save to the extent that the former scheme may appear less likely to endure (which will alter inflation expectations). But there is nonetheless a contractual distinction between a convertible currency regime and a fiat one. In the latter, there is no acknowledged legal obligation to redeem notes in any definite amount of gold.

      Admittedly all central-bank based convertibility schemes inevitably involve more tenuous obligations than those to which competing banks are likely to be held. In this respect I agree that the strict dichotomy of "fiat" and "convertible" overlooks a gray zone. (I acknowledge as much in my "Gold Standard" paper.) But it doesn't follow that the conventional distinction between an inconvertible and a convertible or fiat paper currency is otiose.

      • avatar Mike Sproul says:

        "it doesn't follow that the conventional distinction between an inconvertible and a convertible or fiat paper currency is otiose."

        But that's exactly what follows. Once you recognize the gray area, it becomes clear that there are huge variations in types of convertibility (into gold, taxes, debt relief, etc), and there are many gradations of each type of convertibility. It is also clear that convertibility of any type is only possible if the money issuer has enough assets to cover the money it has issued.

        • avatar George Selgin says:

          Not compelling. That some things are gray doesn't render the distinction between black and white meaningless.

          • avatar Mike Sproul says:

            Most people look at the typical modern paper currency, see that it is not convertible into a specific weight of gold, and conclude that it does not get its value from backing or convertibility, but from the intersection of the money supply and money demand curves. But look a little closer and we see that those currencies are still convertible into tax obligations, into the bonds and other assets held by the issuer, into a CPI basket, etc. We can also speculate that if the day ever came that electronic money made paper money obsolete, then the central bank would buy back those currencies with whatever assets it had, including gold. After all, a central bank that buys gold with newly-printed notes is also capable of selling gold for those same notes.

            Even when we find cases where, for example, dollars appear to be convertible into nothing but bonds that are themselves denominated in dollars, we have to recognize that as long as there is some small link somewhere tying the dollar to, say, 1 bushel of wheat, then that can be enough to make the dollar worth 1 bushel, even though most actual redemptions of dollars are just for dollar-denominated bonds.

  10. avatar George Selgin says:

    A bushel of wheat is a real quantity, not a nominal one. A money convertible into fixed a real quantity of some good is "convertible" in the standard sense. A money "convertible" only into a nominal quantity of another financial asset itself denominated in units of the money in question isn't. The presence of the latter sort of "convertibility" itself supplies no link at all, small or otherwise, to convertibility of the genuine sort, apart from that which exists in your own understanding. So your argument here is nothing other than a repetition of the very assertion that is the nub of the disagreement.

    Mike, the backing theory is evidently your hobby horse, from which no rational argument will get you to budge, and for the defense of which there is no rule of reasoning over which you aren't willing to run roughshod. That's not an ad hominem remark: it is a remark about your arguments themselves that is informed by the evidence from throughout this exchange. I don't mind a debate, but I do mind debating endlessly with someone whose arguments seem to consist of one sophistry after another.

    You may insist that my wishing to end the debate proves only that I have the weaker position. But I am happy to leave it to anyone who has the patience to work through the exchange above to determine for themselves whether they, too, would not find it worthwhile to continue.

  11. avatar vikingvista says:

    "To the extent that commercial banks are able to "capture' the market for paper currency, the public's preferred "currency ratio" (that is, it's preferred mix of currency to bank deposit balances) ceases to influence the money multiplier"

    Doesn't the textbook definition include commercial bank note obligations in "broad money"? Unless I'm misunderstanding, it sounds like you are saying M = D + C, and B = R + C, so that commercial bank notes are not a part of either C or M. Or are you just excluding commercial bank notes from M in order to explain how a transition to private notes way from a strict central bank monopoly would impact *central bank* currency?

    Thanks.

    • avatar George Selgin says:

      Vikingvista, the textbooks don't consider commercial banknotes at all, and so do not allow for the possibility that such notes might supplant central bank paper in satisfying the public's demand for currency. Of course, if "D" where defined to mean "Deposits plus commercial banknotes," and if the complete substitution of such notes for central bank paper in public holdings is also assumed, so that C=0 (with C still defined as public holdings of central bank paper), you would have the free banking case, with c = 0 and m = 1/r. But again, the textbooks don't allow for this possibility at all. Like most economists their authors for the most part seem to be quite unaware that commercial banks might issue their own circulating note; while those who may be aware of the possibility, dismiss it as impractical, usual on the (inadequate) grounds that it proved disastrous in the antebellum U.S. None of them appear to know about the Scottish and Canadian episodes in which competitive note issuers were not subjected to debilitating regulatory restrictions.

  12. avatar vikingvista says:

    That helps. Perhaps if I believed central banking was created by Odin on day 5, I'd be of a better mindset to read mainstream economists.

    I appreciate you bringing me up to speed on the basics. If you have time, I have just a few more questions about this:

    1. In your work, is C always exclusively some portion of the monetary base? If so, are both publicly held specie as well as publicly held central bank fiat base money properly included in C?

    2. Would you always include any redeemable commercial bank notes in D?

    3. Or, is the textbook money multiplier formula just not applicable outside the context of a central bank monopoly?

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