That's the title of a paper I'm writing for this year's Cato Monetary Conference (the subtitle is "How the Federal Reserve Misrepresents Monetary History"). For it, I'd be very grateful to anyone who can point me to examples (the more egregious the better) of untrue or misleading statements regarding U.S. monetary history in general, and the Fed's performance in particular, in official Fed publications or in lectures and speeches by Federal Reserve officials.
George Selgin is a Professor of Economics at the University of Georgia's Terry College of Business. He is a senior fellow at the Cato Institute. His research covers a broad range of topics within the field of monetary economics, including monetary history, macroeconomic theory, and the history of monetary thought. He is the author of The Theory of Free Banking (Rowman & Littlefield, 1988), Bank Deregulation and Monetary Order (Routledge, 1996), Less Than Zero: The Case for a Falling Price Level in a Growing Economy (The Institute of Economic Affairs, 1997), and, most recently, Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage (University of Michigan Press, 2008). He has written as well for numerous scholarly journals, including the British Numismatic Journal, The Economic Journal, the Economic History Review, the Journal of Economic Literature, and the Journal of Money, Credit, and Banking, and for popular outlets such as The Christian Science Monitor, The Financial Times, The Wall Street Journal, and other popular outlets. Professor Selgin is also, a co-editor of Econ Journal Watch, an electronic journal devoted to exposing “inappropriate assumptions, weak chains of argument, phony claims of relevance, and omissions of pertinent truths” in the writings of professional economists. He holds a B.A. in economics and zoology from Drew University, and a Ph.D. in economics from New York University.
That's the title of a live radio program I took part in this Tuesday on KCUR, Kansas City's NPR radio station. Josh Zerlan, COO of Butterfly Labs (which manufactures Bitcoin mining hardware) also took part in the segment, as did several persons who called in with questions. The program was very ably hosted by Brian Ellison.
When I first took a good look at Bitcoin about a year ago, it could claim only about 1000 registered bitcoin-accepting merchants. Today the figure is 10,000. I wouldn't be surprised if it reached 100,000 in another year.
Having learned my monetary economics from both the great monetarist economists and their Austrian counterparts, I've always chafed at the tendency of people, including members of both schools, to treat their alternative explanations of recessions and depressions as being mutually exclusive or incompatible. According to this tendency, a downturn must be caused either by a deficient money supply, and consequent collapse of spending, or by previous, excessive monetary expansion, and consequent, unsustainable changes to an economy's structure of production.
During the 1930s and ever since, this dichotomy has split economists into two battling camps: those who have blamed the Fed only for having allowed spending to shrink after 1929, while insisting that it was doing a bang-up job until then, and those who have blamed the Fed for fueling an unsustainable boom during the latter 1920s, while treating the collapse of the thirties as a needed purging of prior "malinvestment." As everyone except Paul Krugman knows, the Austrian view, or something like it, had many adherents when the depression began. But since then, and partly owing (paradoxically enough) to the influence of Keynes's General Theory, with its treatment of deficient aggregate demand as the problem of modern capitalist economies, the monetarist position has become much more popular, at least among economists.
It is, of course, true that monetary policy cannot be both excessively easy and excessively tight at any one time. But one needn't imagine otherwise to see merit in both the Austrian and the monetarist stories. One might, first of all, believe that some historical cycles fit the Austrian view, while others fit the monetarist one. But one can also believe that both theories help to account for any one cycle, with excessively easy money causing an unsustainable boom, and excessively tight money adding to the severity of the consequent downturn. I put the matter to my undergraduates, who seem to have little trouble "getting" it, like this: A fellow has an unfortunate habit of occasionally going out on a late-night drinking binge, from which he staggers home, stupefied and nauseated. One night his wife, sick and tired of his boozing, beans him with a heavy frying pan as he stumbles, vomiting, into their apartment. A neighbor, awakened by the ruckus, pokes his head into the doorway, sees our drunkard lying unconscious, in a pool of puke, with a huge lump on his skull. "What the heck happened to him?," he asks. Must the correct answer be either "He's had too much to drink" or "I bashed his head"? Can't it be "He drank too much and then I bashed his head"? If it can, then why can't the correct answer to the question, "What laid the U.S. economy so low in the early 1930s?" be that it no sooner started to pay the inevitable price for having gone on an easy money binge when it got walloped by a great monetary contraction?
In insisting that one shouldn't have to blame a bust either on excessive or on deficient money, I do not mean to expose myself to the charge of making the opposite error. My position isn't that excessive and tight money must both play a part in every bust. Nor is it that, when both have played a part, each part must have been equally important. The question of the relative historical importance of the two explanations is an empirical one, concerning which intelligent and open-minded researchers may disagree. The point I seek to defend is that those who argue as if only one of the two theories can possibly have merit cannot do so on logical grounds. Instead, they must implicitly assume either that central banks tend to err in one direction only, or that, if they err in both, only their errors in one direction have important cyclical consequences.
The history of persistent if not severe inflation on one hand and of infrequent but severe deflations on the other surely allows us to reject the first possibility. What grounds are there, then, for believing that money is roughly "neutral" when its nominal quantity grows more rapidly than the real demand for it, but not when its quantity grows less rapidly than that demand, as some monetarists maintain, or for believing precisely the opposite, as some Austrian's do? New Classical economists, whatever their other faults, are at least consistent in assuming that money prices are perfectly flexible both upwards and downwards, leaving no scope for any sort of monetary innovations to affect real economic activity except to the extent that people observe price changes imperfectly and therefore confuse general changes with relative ones. Both old-fashioned and "market" monetarists, on the other hand, argue as if the economy has to "grope" its way slowly and painfully toward a lowered set of equilibrium prices only, while adjusting to a raised set of equilibrium prices as swiftly and painlessly as it might were a Walrasian auctioneer in charge. Many Austrians, on the other hand, insist that monetary expansion necessarily distorts relative prices, and interest rates especially, in the short-run, while also arguing as if actual prices have no trouble keeping pace with their theoretical market-clearing values even as those values collapse.
Of these two equally one-sided treatments of monetary non-neutrality, the monetarist alternative seems to me somewhat more understandable. For monetarists, like New Keynesians, attribute the non-neutral effects of monetary change to nominal price rigidities. They can thus argue, in defense of their one sided view, that it follows logically from the fact that certain prices, and wage rates especially, are less rigid upward than downward. That's the thinking behind Milton Friedman's "plucking" model, according to which potential GNP is a relatively taught string, and actual GNP is the same string yanked downward here and there by money shortages, and his corresponding denial of the existence of business "cycles." But "less rigid" isn't the same as "perfectly flexible" or "continuously market clearing." So although Friedman's perspective might justify his holding that a given percentage reduction in the money stock will have greater real consequences than a similar increase, other things equal, it alone doesn't suffice to sustain the view that excessively easy monetary policy is entirely incapable of causing booms. What's more, as Roger Garrison has pointed out, the fact that real output appears to fit the "plucking" story doesn't itself rule out the presence of unsustainable booms, which (if the Austrian theory of them is correct) involve not so much an expansion of total output as a change in its composition.
Austrians, in contrast, tend to attribute money's non-neutrality, not to general price rigidities, but to so-called "injection" effects. In a modern monetary system such effects result from the tendency of changes in the nominal quantity of money to be linked to like changes in nominal lending, and particularly to changes in the nominal quantity of funds being channeled by central banks into markets for government securities and bank reserves. The influence of monetary innovations will therefore be disproportionately felt in particular loan markets before radiating from them to the rest of the economy. It is not easy to see why monetary "siphoning" effects, to coin a term for them, should not be just as non-neutral and important as injection effects of like magnitude. To the extent that the monetary transmission mechanism relies upon a credit channel, that channel flows both ways.
A division of economists resembling that concerning the role of monetary policy in the Great Depression has developed as well in the wake of the recent boom-bust cycle. Only this time, oddly enough, several prominent monetarists and fellow travelers (among them, Anna Schwartz, Allan Meltzer, and John Taylor) have actually joined ranks with Austrians in holding excessively easy monetary policy in the wake of the dot-com crash to have been at least partly responsible for both the housing boom and the consequent bust. With so many old-school monetarists switching sides, the challenge of denying that monetary policy ever causes unsustainable booms, and of claiming, with regard to the most recent cycle, that the Fed was doing a fine job until until house prices started falling, has instead been taken up by Scott Sumner and some of his fellow Market Monetarists.
Sumner, like Milton Friedman, forthrightly denies that there's such a thing as booms, or at least of booms caused by easy money, to the point of taking exception to a recent statement by President Obama to the effect that, among its other responsibilities, the Fed should guard against "bubbles." But here, and unlike Friedman, Sumner basis his position, not merely on the claim that prices are more flexible upwards than downwards, but on a dichotomy erected in the literature on asset price movements, according to which upward movements are either sustainable consequences of improvements in economic "fundamentals," or are "bubbles" in the strict sense of the term, inflated by what Alan Greenspan called speculators' "irrational exuberance," and therefore capable of bursting at any time. Since monetary policy isn't the source of either improvements in economic fundamentals or outbreaks of irrational exuberance, the fundamentals-vs-bubbles dichotomy implies that monetary policy is never to blame for changes in real asset prices, whether those changes are sustainable or not. If the dichotomy is valid, Sumner, Friedman, and the rest of the "monetary policymakers shouldn't be concerned about booms" crowd are right, and the Austrians, Schwartz, Taylor, and others, including Obama and his advisors, who would hold the Fed responsible for avoiding booms, are full of baloney.
But it isn't the Austrian view, but the bubbles-vs-fundamentals dichotomy itself, that's full of baloney. That dichotomy simply overlooks the possibility that speculators might respond rationally to interest rate reductions that look like changes to "fundamental" asset-price determinants, that is, to relatively "deep" economic parameters, but are actually monetary policy-inspired downward deviations of actual rates from their genuinely fundamental ("natural") levels. Because actual rates must inevitably return to their natural levels, real asset price movements inspired by "unnatural" interest rate movements, though perfectly rationale, are also unsustainable. Yet to rule such asset price movements out one would have to claim either that monetary policy isn't capable of influencing real interest rates, even in the short-run, or that the temporary interest-rate effects of monetary policy can have no bearing upon the discount factors that implicitly inform the valuation of amy durable asset. Here again, the burden seems too great for mere a priori reasoning to bear, and we are left waiting to set our eyes upon such empirical studies as are capable of bearing it.
In the meantime, it seems to me that there is a good reasons for not buying into Friedman's view that there is no such thing as a business cycle, or Sumner's equivalent claim that there is no such thing as a monetary-policy-induced boom. The reason is that there is too much anecdotal evidence suggesting that doing so would be imprudent. The terms "business cycle" and "boom," together with "bubble" and "mania," came into widespread use because they were, and still are, convenient if inaccurate names for actual economic phenomena. The expression "business cycle," in particular, owes its popularity to the impression many persons have formed that booms and busts are frequently connected to one another, with the former proceeding the latter; and it was that impression that inspired Mises and Hayek do develop their "cycle" or boom-bust theory rather than a mere theory of busts, and that has inspired Minsky, Kindleberger, and many others to describe and to theorize about recurring episodes of "Mania, Panic, and Crash." Nor is the connection intuitively hard to grasp: the most severe downturns do indeed, as monetarists rightly emphasis, involve severe monetary shortages. But such severe shortages are themselves connected to financial crashes, which connect, or at least appear to connect, to prior booms, if not to "manias." That the nature of the connections in question, and the role monetary policy plays in them, remains poorly understood is undoubtedly true. But our ignorance of these details hardly justifies proceeding as if booms never happened, or as if monetary policymakers should never take steps to avoid fueling them. On the contrary: the non-trivial possibility that an ounce of boom prevention is worth a pound of quantitative easing makes worrying about booms very prudent indeed, and prudent even for those who believe that monetary shortages are by far the most important proximate cause of recessions and depressions.
Does my saying that Scott and others err in suggesting that monetary policymakers ought not to worry about stoking booms mean that I also disagree with Scott's arguments favoring the targeting NGDP? Not at all. I'm merely insisting that a sound monetary policy or monetary system is one that avoids upward departures of NGDP from target just as surely as it does downward ones. Nor do I imagine that Scott himself would disagree, since his preferred NGDP targeting mechanism would automatically achieve this very result. But I worry that other NGDP targeting proponents have allowed themselves to become so wrapped up in recent experience, and so inclined thereby to counter arguments for monetary restraint, that they have allowed themselves either to forget that a time will come, if it hasn't come yet, when such restraint will be just the thing needed to keep NGDP on target, or to treat Scott's boom-denialism as grounds for holding that, while there can be too little NGDP, there can't really be too much. (Or, what is almost as bad, that there can't be too much so long as the inflation rate isn't increasing, which amounts to tacitly abandoning NGDP targeting in favor of inflation targeting whenever the the latter policy is the looser of the two.) I urge such "monetarists" to recall the damage Keynes did by taking such a short-term view, while disparaging those who worried about the long run. "Keynesiansim" thus became what Keynes himself never intended it to be, which is to say, a set of arguments for putting up with inflation. Let's not let Market Monetarism become perverted into set of arguments for putting up with unsustainable booms.
Addendum: Scott has responded, claiming that I am wrong in portraying him as a money-induced unsustainable boom denialist. I appreciate his attempts to reassure me, and yet can't help thinking that he has nevertheless supplied some reasons for my having characterized his thinking as I did. For example, when Scott writes that "asset prices should reflect fundamentals. Interest rates are one of the fundamental factors that ought to be reflected in asset prices. When rates are low, holding the expected future stream of profits constant, asset prices should be high. Bubbles are usually defined as a period when asset prices exceed their fundamental value. If asset prices accurately reflect the fact that rates are low, then that’s obviously not a bubble," he certainly seems to accept the bubbles-vs.fundamentals dichotomy about which I complain above, with its implicit exclusion of the possibility of a boom based on lending rates that have been driven by "unnaturally" low by means of excessively easy money. Scott only reinforces this interpretation by further observing, in the same post, that "[i]t’s not clear what people mean when they talk of “artificially” low interest rates. The government doesn’t put a legal cap on rates in the private markets, in the way that the city of New York caps rents." Now if that isn't sweeping aside the whole Wicksellian apparatus, with its distinction between "natural" and "actual" interest rates, then I don't know what is.
Also, while Scott protests that he does not deny a possible role for easy money in fueling booms, it's far from evident that he considers this something other than a merely theoretical possibility. He denies (appealing again to the bubbles-vs.-fundamentals dichotomy), that monetary policy played any part in the Roaring Twenties (while asserting that NGDP per capita fell during that decade, though that isn't my understanding*); and he denies that it played any part in the recent housing boom. With respect to the latter boom he observes, in response to a commentator, that "a housing boom is just as likely to occur with 3% trend NGDP growth as 5% NGDP growth. Money is approximately superneutral. I completely reject the notion that Fed policy is mostly to blame for the housing bubble–it was bad public (regulatory) policies plus stupid decisions by private actors. I’m not saying Fed policy had no effect, but it was a minor factor." Scott's claim here, though not altogether wrong as a claim about comparitive steady states, might nonetheless be taken to suggest that there's little reason to be concerned about adverse effects, apart from inflation, of faster than usual NGDP growth. And this view in turn encourages people to think that, when NGDP grows more rapidly than usual, there's no harm in sitting back and enjoying it so long as it doesn't raise the inflation rate much. That is, it encourages them to favor replenishing the punchbowl whenever the party get's dull, but not removing it when the party starts getting wild.**
Regarded as empirical claims only, Scott's assertions may of course be valid. But I think the evidence from these and other quotes from him suggests that, while he clearly believes that easy money can influence interest rates, he does not believe, as a matter of theory, and based largely on his acceptance of the bubble-fundamentals dichotomy along with the EMS, as well as his related inclination to brush-aside Wicksell's arguments as to the possibility as well as the unsustainability of "unnatural" changes in interest rates, that by doing so it can contribute to an unsustainable asset boom.
*Here, for what it's worth, is the plot I get when I divide nominal NGDP (millions) by population (thousands) using stats from FRED's macrohistory data base:
**Previously I put the matter here in stronger terms that I now see were unjustified. Sorry, Scott! (Added 10/3/2013 at 9:36PM).
As part of my relentless (some will say obsessive) quest to stamp-out fallacies perpetrated by the 100-percent reserve bunch, I found myself engaged in a discussion with some of them in the comments section of my last post. As the discussion took place some days after that post was published, I hope I may be pardoned for reproducing parts of it, in the hope that doing so might further my overarching objective.
The discussion was prompted by a remark from 100-percenter Paul Marks, who insisted (with his usual emphasis) that "Total borrowing (of all types) must never be greater than total REAL savings of PYSICAL [sic] money. ...I repeat that I am NOT making a legal point - I am making a moral and logical one." In reply I wrote as follows:
Paul, what you are saying makes no sense at all. It is the very nature of lending and borrowing of "physical" assets through intermediaries that the value of financial assets or IOUs tends to exceed that of the physical assets involved. I lend a cow to A, an intermediary, in return for A's promise to return the cow to me with interest; A lends the same cow to B, in return for a like promise from B. So: one cow, two promises, no harm, no foul.
I then added,
Just to be clear, Paul, in case the "morality" of intermediated lending should not be sufficiently evident: In the example above, I understand that A is acting as my agent; because I am not in a position to expend resources to discover a worthy borrower to whom I may lend my cow, with reasonable assurance of having it returned with interest, or because I am otherwise unable or unwilling to execute the necessary contracts myself, I allow A to take on these tasks for me, in return for his own commitment to repay my principle with interest.
Where loans of "physical" money are involved, the fungibility of that money allows a bank--which is just a name for an intermediary of money loans--to assemble loans from numerous creditors, and to lend funds so assembled to an equally diverse set of borrowers, all of which serves to reduce, ceteris paribus, the banker's prospects of being unable to meet his various commitments, lowering in turn the credit risk borne by individual bank creditors.
For centuries persons with idle base money balances have found it convenient to relinquish them to bankers as a means for earning interest on such balances with less risk than they would incur by lending them directly, while also (in cases in which deposits are made in exchange for a bank's demandable debt instruments) having access to means of payment often far more convenient than physical (narrow) money itself.
Of course, as with all forms of lending, lending through banks is not risk free. But that hardly makes such lending either unethical or imprudent. Those who, rather than wishing merely to oppose such regulatory interventions as serve to augment artificially the prospects of bank failures and financial crises, plead instead for banning bank-intermediated lending altogether, though they affect to argue as proponents of freedom and morality, in fact seek to arbitrarily limit the scope of freedom of contract, and by doing so make themselves far more deserving of the charge of immorality than the bankers whom they so loftily--and so uncomprehendingly--criticize.
Reacting to my first remark, perhaps without having read the second, Mike Sproul wrote:
Except that if B doesn't pay A, and A doesn't pay you, there is both harm and foul. If the only security for A's IOU is A's possession of B's IOU, then you would insist that B's IOU be signed over to you when A lent the cow to B. Either that, or you would have placed 1 cow's worth of lien on A's other property before accepting A's IOU in the first place. Try it with a house sometime, and see if you can get lenders to carry $200,000 worth of IOU's based only upon a $100,000 house.
To which I observed:
Like I said, all lending is risky. And of course (in the absence of government bailouts) intermediaries don't survive if they continue to make excessively risky or insufficiently secured loans. The tendency, when it comes to banking, for some to hold the industry to be either inherently untenable or immoral or both because banks will occasionally fail is frankly silly. Applied to industry in general, this tendency would have it that we should put an end to all business activity, on the grounds that some people are bound to lose their shirts otherwise!
No one, in any event, is "forced" to transact with a fractional reserve bank. No law, so far as I am aware, has ever prohibited the establishment of 100-percent warehouse alternatives. (Please don't bring up deposit insurance: what I am saying goes for the long history predating both that and TBTF.) No law prevents anyone from keeping cash in a safe or safety deposit box. To the extent that the law has ever had any say regarding bank's [sic] reserve-holding decisions, that say has ever been one commanding banks to maintain some minimum positive reserve ratio--never a "maximum" ratio! And of the few important 100-percent "banks" ever established, almost all have been government sponsored arrangements, usually subsidized or otherwise propped up by laws banning would-be fractional reserve rivals.
I do sympathize with those younger students of economics, and of Austrian economics especially, who, having fallen under the sway of anti-fractional reserve propaganda disseminated by Rothbardians and their fellow travelers, have been tempted to jump on the anti-FRB bandwagon. But for the grown-ups responsible for so tempting them, I confess I have nothing but contempt. The a-priori grounds upon which they condemn FRB are utterly without merit, while a superabundance of empirical evidence flatly contradicts their positions. They are to Austrian economics what the Flat Earth Society is to geology, which is to say (to employ Leland Yeager's expression): an embarrassing excrescence.
I urge readers of freebanking.org who agree with me, and who know some of the misinformed students to whom I refer, to share this exchange with them, in the hope that it may contribute toward their eventual, successful deprogramming. We can, of course, never hope to purge Austrian economics entirely of the 100-percent-reserve bacilli by which it has become infected in recent years. But we can at least hope to build up such a core of well-informed antibodies as may eventually prevent those bacilli from doing any more harm to the main body of Austrian thought than the occasional e-coli does to an otherwise robust digestive tract.
Instances of self-styled Austrian economists bungling their banking theory seem almost as common these days as instances of theologians bungling their cosmology were six centuries ago. One such instance, by the Cobden Centre's Sean Corrigan, occurs in the course of a long and meandering series of posts inspired by a four-way debate he took part in, with yours truly attending, at Oxford's Divinity School this May:
[I]magine that I take your IOU to the bank and that [sic] peculiar institution registers my claim upon its (largely intangible) resources in the form of a demand liability of the kind which--by custom, if not by legal privilege--routinely passes in the marketplace as money. Your promissory note--a title to a batch of future goods [sic] not yet in being--has now undergone what we might facetiously call an 'extreme maturity transformation' which it [sic] has conferred upon me the ability to bid for any other batch of present goods of like value without further delay. It should, however, be obvious that no such goods exist since you have not had time to generate any replacements for the ones whose use I, their [sic] lender [sic], supposedly forswore until such a time as your substitutes are ready to used [sic] to fulfil [sic] your obligations, something we agreed would be the case only at some nominated [sic] point in the future.
More claims to present goods than goods themselves now exist...and thus the actions we may now simultaneously undertake have become dangerously incongruous [sic]. Our [plans] have become instead a cause of what is an inflationary conflict no less than would be the case if I had sold you my place at the head of the queue for the cinema only to try and barge straight past you in a scramble for the seat in question.
Even setting aside the typos and malapropisms, Corrigan's prose isn't likely to inspire anyone to twine a garland around him for his lucidity.* But one thing that is clear is that the bank lending that he has in mind involves three parties only: the banker, the borrower, and a debtor whose IOU to the borrower serves as the borrower's collateral. For the sake of concreteness, let's call them the banker, the miller, and the baker; and let's imagine further that the miller, having offered the baker a ton of flour in exchange for a $101 30-day promissory note, uses the note to secure a $100 loan from the banker.
According to Corrigan the loan thus secured is inflationary because it allows the miller to take part in the "scramble" for present goods, even though he got the loan in exchange for "a title to a batch of future goods not yet in being." In fact a promissory note or IOU isn't a "title" to anything, much as Austrians may like calling things "titles" that aren't such. It is, well, a promise to pay. And it is a promise to pay, not goods, but money. Let us grant, nevertheless, that the note in question stands for goods--loaves of bread, for instance--that have yet to be produced or put on the market, the presumption being that bread will only eventually be made from the flour that was exchanged for the promise, to be put on the market at some still later date. Consequently the loan, and the extra demand for goods that it unleashes, instead of coinciding with an increase in the supply of goods, anticipates such an increase, and to that extent seems bound to raise prices. Bank lending appears analogous to creating fake "tickets" to an already fully-booked performance, allowing the new credit recipients to secure present goods, despite a lack of voluntary savings, simply by bidding goods away from others, that is, by forcing others to consume less, just as holders of fake tickets might take up seats that ought to have gone to holders of legitimate ones.
But the appearance is deceiving, for it depends crucially on Corrigan's having failed to consider all of the parties that usually take part whenever a competitive bank makes a loan. To see this, we need only consider our imaginary banker's fate if he makes the loan in question without anyone's cooperation save that of the miller, who is supposed to repay the loan, and the baker, whose IOU secures the loan in case the miller defaults. The banker's fate hinges on the fact that bank borrowers borrow money, not to hold, but to spend. So once our miller has $100 credited to his account, he uses it to purchase wheat or other supplies, or to pay his workers, or to settle accounts due--in short, to make whatever payments he cannot afford to put off making for another 30 days--payments that compelled him to borrow money in the first place. So the miller writes checks, and writes them quickly, to the tune of $100. And those checks are paid to persons who, if the banking system is competitive, are likely to deposit them in rival banks. Those banks in turn return the checks for payment, directly or through a bank clearinghouse. So by lending $100 to the miller, the banker generates $100-worth of claims for immediate payment against his institution. Those claims, it goes without saying, cannot be settled directly using the baker's promissory note, which has yet to mature. They must be settled in cash, which means that the bank must either have such cash on hand, or fail.
If the bank fails, it obviously hasn't been able to get away with creating credit "out of thin air," and presumably there will not be many banks rushing to replicate its irresponsible behavior. If, on the other hand, the bank has the cash needed to avoid failing, the obvious question arises: where does the cash come from? Two answers suggest themselves. One is that it comes from the bank owners themselves, that is, from capitalists. The other is that it comes from persons who deposited it with the bank, presumably in return for services or a share of its interest earnings or both. In either case, it should be apparent that a competitive bank cannot lend, or rather that it cannot lend and profit by it, unless it has, or quickly gets hold of, cash reserves at least equal to the amount of the loan. That means, in turn, that for a bank to lend someone has to have engaged in prior voluntarily saving, by refraining from spending or from otherwise cashing in their own claims against it. Our banker cannot, in other words, simply create loans out of thin air, and thereby drive prices upward. Instead, if his business is to survive he must act as a go-between or intermediary, lending to the miller only what he has induced others to lend to him. These ultimate suppliers of bank credit, by refraining from consuming, place downward pressure on prices precisely equal to the upward pressure stemming from the banks' lending. By airbrushing them out of his account of the workings of a typical bank, Corrigan succeeds in painting a picture of the banking business that's as misleading as it is lurid.
All this, of course, refers only to ordinary commercial bankers--bankers who must do business the hard way, by competing head-on with dozens if not hundreds or even thousands of more-or-less equally privileged rivals. It doesn't apply to central bankers who, by being able to print-up arbitrary amounts of their economies' ultimate cash reserve asset, are indeed capable of making loans "out of thin air," without having to struggle to first gather funding from others. This distinction is what gives central bankers their extraordinary power to do either good (as their proponents imagine them doing) or harm (as they tend to do, more often than not, in fact). By suggesting, in short, that there is no difference between the credit-creating capacity of ordinary commercial banks and that of central banks, accounts like Corrigan's do a great disservice, by making it harder for people to recognize the unique threat posed by today's monopoly suppliers of irredeemable paper currency.
Addendum (8/12/13): A correspondent has alerted me to this post, accusing me of having joined Paul Krugman and others in making a "sport" of bashing Austrian economics, and suggesting that I have failed in the post above and elsewhere to recognize the difference between demand and savings deposits, only the last of which (according to the Austrians I criticize) represent true savings. In fact, the distinction in question is absolutely irrelevant to my argument above, the point of which is that a competitive bank cannot get away with creating credit out of thin air. Instead it can afford to lend only to the extent that others save with it. Whether the savings come to a bank in the shape of "demand" or "time" deposits matters only to the extent that it influences the length of time for which the savings in question are likely to remain at the bank's disposal. The bank is responsible for limiting its credits to amounts consistent with the total extent of credit supplied to it by its liability holders, allowing also for the timing of withdrawals. A banker that misjudges the timing in question exposes his bank to the same risk of failure that confronts one who attempts to extend credit without having received any prior deposits. So whether a bank derives its funding from demand or from time deposits, the conclusion stands: if the bank is to survive, the bank's lending must be limited to the amount of real savings it has on hand.
As for my being just another anti-Austrian economist, that's a calumny: I am a fan of Austrian economics, as embodied in the works of such great Austrian pioneers as Menger, Mises, and Hayek, as well as in those of many living members of the school. What deserves to be ridiculed is the unending tide of junk written, mostly on the internet, by people who label themselves "Austrian economists" despite appearing to know only as much about economics as I know about string theory, which is to say, next to nothing.
*Some of Corrigan's more florid passages read as if concocted by tossing one copy each of Finnegans Wake, Sartor Resartus, and the Communist Manifesto into a blender and hitting "Pulse" once or twice. Consider: "Among other enormities, the fact that production must necessarily precede consumption and that it is the first which comprises the creation of wealth and the second which encompasses its destruction, was far beyond the ken of the spoiled Bloomsbury elitist who exhibited a life-long contempt of the aspirations and mores of the bourgeoisie and who hence imagined that policy was at its finest when, like an over-indulgent aunt, it was pliantly accommodating the otherwise ‘ineffective’ demand being volubly expressed by the old dame’s petulant nephew as he stamped his foot in the tantrum he was throwing up against the sweet-shop window." When I encounter such prose I cannot quite decide whether to throw up a tantrum myself, or simply to throw up.
To be specific, he confuses me by his response to Ezra Klein's column quoting former FRB vice chairman Donald Kohn's opinion that “It’s difficult, if not impossible, to create persistent inflation without demand exceeding potential supply over an extended period” along with Lawrence Summers' view that "inflation is mostly driven by demand, and when you increase demand, you increase inflation. And if you don’t increase demand, you don’t increase inflation. But if you’ve solved demand, you’ve solved your problem.” To the question implicit in such remarks, regarding why anyone would expect the Fed to succeed in raising the current rate of inflation despite being incapable of increasing the current growth rate of aggregate demand, Scott's response is "Um, maybe because the Fed promised a more expansionary policy in the future?"
I realize that Scott wants his readers to imagine Kohn and Summers, upon hearing this reply, smacking their lower palms against their foreheads while saying "Dope!" But at the risk of appearing to be a dope myself, I confess that I believe that the statements by Kohn and Summers make perfect sense, whereas Sumner's rhetorical response does not.
It doesn't make sense, first of all, because, assuming a non-declining AS schedule, an increase in the rate at which prices increase that is not accompanied by a corresponding increase in aggregate spending must be accompanied by ever-declining sales and ever-worsening unemployment, and is for that reason unlikely to persist. So it would seem to be true after all that a persistent increase in the rate of inflation requires a persistent increase in the growth rate of aggregate demand relative to that of aggregate supply.
Of course I don't doubt for a moment that Scott understands this last point perfectly well. Unless I'm mistaken, what bothers him about the opinions expressed by Kohn and Summers is their implicit failure to appreciate the possibility that, when it raises its announced inflation target, the Fed also increases the expected rate of inflation, and with it the velocity of money. Consequently the Fed is able to boost aggregate demand and to combat recession without resorting solely to the usual, more direct but less reliable means of more aggressive monetary expansion, and its higher announced inflation target becomes in this respect at least partly self-fulfilling.
But even this more sophisticated objection to Kohn and Summers, understood (as I understand it) to imply that those experts have overlooked a potentially effective means for combating recession, seems wrong to me. True, if prospective buyers expect prices to increase, that's a reason for them to spend more now. But if prospective sellers expect consumers to spend more, that is a reason for them to start raising prices now. So while a higher announced inflation target might be self-fulfilling, there's no reason to suppose that by announcing such a target the Fed can achieve anything other than a higher rate of inflation.
Inflation expectations, in other words, inform the positions and rate of change of both demand and supply schedules--as should be especially obvious to anyone familiar with Wicksteed's famous exposition in which the latter schedules are nothing other than flipped-over portions of total ("communal") demand schedules. Changes in inflation expectations will, in still other words, tend to affect in the same manner the decisions of both buyers and sellers. Consequently, if sellers' expectations have been excessively rosy, so that their pricing decisions have resulted in disappointing sales, there's no reason to suppose that an announced increase in the inflation target won't cause them to become rosier still, ceteris paribus. Expectations are a double-edged sword that policy tends to sharpen on both sides, or not at all.
None of this contradicts the view, which I share with market monetarists, that an increase in aggregate demand that is not merely the result of an increase in the expected rate of inflation can be effective in reducing unemployment. For in that case, and again assuming that sellers' expectations have been excessively rosy, the increase serves, not to boost those expectations further, but to bring reality closer to them. To my way of thinking this difference between a policy that works by fulfilling established demand expectations that have been overly-optimistic, and one that seeks to boost demand by raising the expected rate of inflation, is absolutely crucial. If an economy is depressed because its rate of NGDP growth falls short of sellers' expectations, then surely the best way to close the gap is by raising the actual rate of NGDP growth only, while either leaving NGDP growth and inflation expectations alone or, were it possible to do so, lowering those expectations. I'm not saying that doing this is easy, by means of monetary expansion or otherwise. But it is nonetheless what needs to be achieved, and it is unlikely to be achieved by raising the Fed's inflation target.
It seems to me that monetary economists who overlook this obvious truth risk adding to rather than subtracting from our current monetary troubles. Maybe Scott isn't among them; maybe I've misunderstood him. Or maybe my own reasoning is all wrong. Like I said, I'm confused. But whatever the reason for my confusion I hope that Scott, or someone, will help me out of it.
Addendum (July 24): As the argument of this post is not the easiest to get across, I hope I may be pardoned for adding, by way of clarification, the observation that believers in NGDP targeting who also endorse raising the target (and thus the expected) rate of inflation as a means to end recession appear to subscribe to view, which I think badly mistaken, that, if economic recovery can be encouraged by providing for adequate (but not inflation-enhancing) NGDP growth, then it can be encouraged still further by promising a rate of NGDP growth such as would serve to actually increase the equilibrium inflation rate.
Stephen Williamson, a well-known monetary economist with a blog of his own called New Monetarist Economics, was kind enough to draw attention there recently to my remarks concerning Gary Gorton's book. His post in turn elicited a sarcastic comment (anonymous, of course), the gist of which was that it was after all to be expected that a paid flunky of the "right wing" Koch brothers should be against regulating banks.
This isn't the first time someone has tried to tar me with that brush, and I don't suppose it will be the last. Nor do I suppose that by defending myself against such libels I will ever put a stop to them. Nevertheless the comments inspire me to do something I've meant to do for some time now, which is to explain the role that politics and ideology have played in my thinking generally and in my writings on free banking in particular.
First, for the record: I work not for any Koch-sponsored entity but for the University of Georgia, where I've been now for almost 25 years. (True, my first job was at GMU, but (1) my salary there was paid by the taxpayers of the Commonwealth of Virginia, and (2) I got the boot, and it wasn't for being insufficiently anti-Fed.*) Since I'm the only free banker at UGA, and I also haven't exactly been awash in roses and Valentine cards from its administrators, I trust that no one will be inspired by these revelations to claim that I'm a shill for the Georgia State Legislature, or the Board of Regents, or my University President, or any of the other persons responsible for my livelihood.
It's true that I'm also a "Senior Fellow" at the Cato Institute, and proud of it. But "Senior Fellow" is an honorary (that is, unpaid) title only. And though I have been paid to take part in Cato's annual monetary conferences, so too, at one time or another, have about four-fifths of the world's better known monetary economists and monetary policy makers. Finally, I've done some paid consulting for Mercatus and have lectured in the past for the Institute for Humane studies. But to have allowed the pittance I've gotten from both to suffice to turn me into a mere appendage of the so-called "Kochtopus," I'd have to have been a sucker all along.**
If I'm not actually paid, or paid enough, to espouse views not necessarily my own, then is it not at least correct to say that my own thinking has been shaped by my "right-wing" convictions rather than by any detached appeal to theory and evidence? Actually, it isn't. For starters "right wing" is hardly the right phrase for describing my convictions, such as they are, unless one thinks the expression applicable to someone who thinks, among other things, that carbon dating is more reliable than Genesis 1:1-5; that pregnant women are usually more fit than others to decide whether they should give birth or not; that the world would be less rather than more nasty were cocaine sold at Walgreens; and that the Patriot Act ought to be called the Scoundrel Act. In short, if you absolutely must label me, try "libertarian."
But the fact is that I'm not even much of a libertarian. In California back in 1979 I helped to get the Libertarian Party's Presidential candidate, Ed Clark, on the ballot. Since then, I've had nothing to do with politics, which I've come to regard as unseemly. That others can be enthusiastic about this or that politician surprises me in the same way that it might surprise me to learn that there is such a thing as an official streptococcus fan club with a list of dues-paying members. And although I can't claim never to have voted, I can at least say that I would hate to ever have to admit voting for any of the people I voted for. All things considered I'd much rather exercise what Herbert Spencer calls my "Right to Ignore the State."
Ideology admittedly played some part in the development of my views on money. But that part was much smaller than many may imagine. Back in 1980, when I was supposed to be working toward an M.S. in Marine Resource Economics at the University of Rhode Island, I instead spent my time either swimming at Charlestown Beach or reading books on monetary economics, the aim of the last having been that of understanding the double-digit inflation then in progress. I'd already read several dozen books on money when my former college chum Clint Bolick encouraged me to see what von Mises and Hayek, who I'd not yet heard of, had to say. So I read the Theory of Money and Credit, and it was as if someone had taken a broom and swept the cobwebs from inside my skull. Then I read Denationalisation of Money, and it was as if someone set off fireworks there. I wasn't instantly won over by Hayek's thesis. But that thesis got me seriously wondering whether the instability of the U.S. dollar might have its roots in government meddling with money.
That's when I first got involved with IHS. As I recall, they had placed a little ad in some libertarian magazine (yes, I read that sort of thing back then) offering summer grants for economics research. So I proposed to examine Hayek's thesis in light of U.S. experience (or was it the other way around?). Anyway, I got the grant and worked away at my essay and ended up discovering that getting the U.S. facts to fit Hayek's general hypothesis was easier than shooting fish in a barrel. It was while I was working on that project that Walter Grinder, IHS's long-time Academic Director, told me about Larry White's work, then still in progress, on the Scottish banking system. Of course I wrote to Larry and read his chapters as he sent them to me. Then I asked him to let me know as soon as he took a job offer, which is how we both ended up showing up at NYU at the same time. You know the rest.
So ideology pointed me in the direction that was to develop into my research program. But it did so, not by making me want to become an advocate for "libertarian" monetary ideas, but by equipping me with a working hypothesis that was long overdue for testing, and which seemed to me to survive such testing remarkably well, if not with flying colors. I dare say that any young professor finding himself armed with such a hypothesis would have done exactly what I did, which was to run with it as far as it would go. Naturally libertarian groups (but not genuinely "right wing" ones***) have found my research attractive, and have sometimes awarded me for it. But I didn't pursue it just to please them. Indeed I rather prefer having non-libertarians express interest in, if not agreement with, my ideas, because their interest is more likely to depend on the power of my arguments than on the propriety of my conclusions. It's hard, on the other hand, for me to really get a kick out of talking to hard-core libertarians since their way of thinking makes all my hard research seem like so much gimcrack ornament.
But even admitting this doesn't quite get to the bottom of the bearing of ideology upon my work. For after some years as an academic economist I came to think of ideology as an outright hindrance: one cannot, it seems to me, both subscribe to some preconceived "system" of beliefs (as opposed to assumptions that are merely tentative or working) and remain perfectly free to form beliefs of one's own. For that reason I long ago stopped describing myself as a libertarian economist or as an Austrian economist or as anything save a monetary economist or economist sans adjectif. More importantly I stopped thinking of myself as anything other than a plain-old economist or monetary economist, and so no longer concerned myself, if I ever did, with establishing my bona fides with anyone apart from other economists. If I reject or simply question arguments for government intervention in the monetary system, it's only because I don't find the arguments convincing or consistent with available evidence. It's not my fault that so many arguments for government intervention in money turn out to be nothing more than unfounded (though oft-repeated) assertions.
Finally, although I'm used to being called one, I don't even consider myself a "free banker," in the sense meaning an advocate of free banking. Of course I'd like to see a revival of the Scottish currency system, or something like it, because I'm convinced that such a revival would make most people, myself included, better off. But the prospect of changing the world wouldn't float my boat even if it weren't quite so teeny-weeny. What does turn me on, really and truly, is the feeling of having my hands on some truth no one else has yet managed to grab. I know that sounds corny, but I mean it. I think a lot of economists mean it. I just wish people wouldn't find it harder to believe when I say it than when some fan of the Fed does.
**Tyler Cowen, on the other hand, knows how to strike a hard bargain: although as Mercatus's General Director he is presumably on that Koch-sponsored institution's payroll, he nevertheless continues to hold out, even going so far as to defend the Fed against free bankers like myself. I do hope that the Koch Foundation will go ahead and give him the money he wants in return for changing sides. While they're at it, I hope they might also do something about all those monetary economists who are as yet in the Fed's pocket.
***I am still waiting for an invitation to speak at the Heritage Foundation, or the American Enterprise Institute, or the John Birch Society, or the Trilateralist Commission. Probably this post won't make the wait any shorter.
I've long considered Gary Gorton one of the best economists working in the fields of banking and finance, thanks in no small part to his excellent work on 19th-century U.S. financial history. Gorton's reputation was dealt a hard blow recently owing to his role in supplying AIG with the models it relied upon in assessing the riskiness of credit default swaps it wrote on mortgage-backed securities. Gorton's part in the AIG demise hasn't itself altered my high opinion of his work. I am disappointed, however, with his apology for playing that part, as given in his 2012 Oxford University Press book, Misunderstanding Financial Crises.
Apology? Well, sort of: throughout the book Gorton refers, not to "his" mistakes but of those of "economists" generally, as if the entire profession, rather than a small (though disproportionately influential) part of it, were to blame for the fancy risk models and associated rose-colored prognostications that sank AIG and so many other financial behemoths. His is, in other words, not an outright mea culpa but a mea culpa bundled with such a large number of sua culpas as to expose him to only a miniscule risk of having to shoulder much blame. Indeed, Gorton sees himself as a victim of his profession's errant ways, chief among which was its inclination to treat fancy statistical models as substitutes for a genuine understanding of the lessons of economic history.
That inclination, Gorton says, when combined with excessive reliance upon data limited to the "Quiet Period" since the establishment of the FDIC, caused economists, himself among them, to assume that the underlying causes of financial crises had been successfully eliminated, making such crises a thing of the past. More attention to history, Gorton suggests, would have made him and his peers less sanguine. It would have warned them that the data against which they were calibrating their models did not suffice to uncover the U.S. financial system's "deep parameters." It would, in short, have shown that the root causes of crises had yet to be dealt with.
One can only applaud Gorton for rejecting the view, which is indeed all too prevalent among today's economists, that little can be learned from history because it "comes from a different structure," and for regretting the deletion of economic history courses from PhD curricula that this view has encouraged. "The relevant past," Gorton insists, is the history of market economies, not an arbitrary recent period that is largely determined by data availability" (pp. 95-96):
The past, a rich laboratory for understanding the present, lacks data richness, which is needed for some models, but we need to add economic history to the Facts. Sophisticated econometric methods come at a large cost; the data requirements narrow our field of vision. In this trade-off the loser has been economic history (p. 97).
Amen and amen. But there is right as well as wrong economic history, and wrong economic history can be just as productive of mistaken policies as the most naive formal models. Alas, Gorton's own economic history, as presented in the first part of his book, is wrong in crucial ways.
In brief, that history goes like this: Before the Civil War, banks were set-up by state governments, either through charters or (starting in 1837) by means of so-called "free banking" laws. Notes issues by those banks, though the only paper currency available, circulated, not at their face or "par" values but at varying discounts reflecting the idiosyncratic and uncertain ("secretive") content of particular banks' asset portfolios. The National Bank Acts created a uniform currency, while eliminating banknote-based runs (that is, runs to exchange banknotes for specie or legal tender) by taxing state banknotes out of existence while requiring all national banks to fully back their own notes with safe U.S. government securities. Unfortunately demand deposits, which continued to be backed by idiosyncratic and "secretive" bank assets, become increasingly important, and panics could and did still happen when bank customers lost confidence in the assets backing those deposits. Although the Fed, established in 1914, was supposed to rule-out such panics, it was thanks to the FDIC, established two decades latter, that the U.S. finally entered a "Quiet Period" during which no panics occurred. But the quiet period proved to be something of a fool's paradise, because during it, and especially during its last stages, further financial innovations made it possible for new forms of financial-institution debt, including repurchase agreements, to play a role in payments and other transactions not unlike that once performed only by banknotes and checkable deposits. Because these new types of debt were issued by "shadow" banks operating outside of the limits of the Federal safety net, they in turn became the object of a systemic run--the "Panic of 2007."
From this history Gorton derives the lesson that "financial crises are inherent in the production of bank debt...and, unless the government designs intelligent regulation, crises will continue" (vii). As for what constitutes "intelligent regulation," Gorton's suggestion, informed by his understanding of the lessons of the free banking and National Banking eras, is that all forms of bank debt used to conduct transactions must be backed by collateral "produced in such a way that it is secretless," and all issuers of such transactable debt should have access to the Fed's discount window. In particular, in light of the recent crisis, so-called "shadow" banks should be converted into what Gorton calls "Narrow Funding Banks" (NFBs), which would be prevented from engaging "in any activity other than purchasing asset-backed securities, government [sic] and agency securities (p. 197). As for repos, they need to be more strictly regulated, in part by placing limits on how many repos nonbanks can engage in.
Gorton's recommendations are consistent enough with his understanding of financial developments leading to the 2007-8 crisis. However, that understanding warrants a judgement similar to the one Gorton himself offers regarding less history-conscious attempts to explain that episode, to wit, that it is a "superficial" understanding suggesting "a lack of institutional and historical knowledge" (88-9). The difference is that Gorton has the knowledge in question, as is apparent from his other writings and also from the works, with which he's evidently familiar, discussed in his "Bibiographical Notes." Nevertheless his book fails to make proper use of that knowledge.
Gorton is wrong, first of all, in claiming that financial crises are "inherent" and "pervasive" in market economies. He errs both by not allowing that different "market" economies have had very different kinds and degrees of financial regulation, and by not consistently heeding his own definition of a banking "crisis" as a "systemic" (or at least "widespread") "exit from bank debt," that is, a situation involving "en masse demands by holders of bank debt for cash" (pp. 6-7, my emphasis). According to this definition many of the "crises" listed on Gorton's Table 3.1 were not genuine financial crises at all. Canada, to take one example, did not have a genuine financial crisis in any of the years listed (1873, 1906, 1923, and 1983), though it did have to relax binding capital-based note issue regulations to avoid having a crisis in 1906.
I refer to Canada in particular because, with regard to Gorton's thesis, it is, not the only, but certainly the biggest, elephant in the room. Its record is especially revealing, because the Canadian economy of the 19th and early 20th centuries resembled the U.S. economy in many ways, though it differed in its banking structure and regulations. Unlike U.S. banks, Canadian banks could and did establish nationwide branch networks; they were also allowed to issue notes backed by their assets in general rather than by any specific collateral. It was, finally, no coincidence that the extra degrees of banking freedom that Canada enjoyed were associated with a much better record of financial stability. To put the matter differently, Canada's record suggests that the shortcomings of the U.S. banking system where not shortcomings "inherent" to all private banking and currency systems. They were shortcomings traceable to specific, misguided U.S. banking and currency laws.
Take those discounts on antebellum U.S. banknotes. Gorton attributes them to the fact that different banks, whether "free" or chartered, had different assets backing their notes, with some assets being more "suspect" than others (pp. 15-16). According to his understanding, nothing short of a rule forcing all banks to back their notes with identical, riskless assets could serve to make a uniform, par currency out of notes issues by numerous, otherwise independent banks. State "free banking" laws failed to achieve this result because different states allowed different assets to serve as note collateral, and because some of this collateral was anything but risk free. The problem was only solved when, during the Civil War, state banks were taxed out of the currency business, while new National ones had to back their notes with U.S. government bonds, which, once the war was over, were perfectly safe.
If Gorton's interpretation were correct, we should only expect to find commercial banknotes circulating at par where U.S. style backing requirements are in place. But by the 1890s Canada, despite being far less populous than the U.S., while occupying more square miles, had a uniform currency consisting mainly of private Canadian banknotes that were not subject to any special "backing" requirement. How could that be? That Canada's banking system was a "club oligopoly" may have helped. But there's another explanation, which also accounts better for other instances, such as Scotland's, of uniform currencies consisting of private banknotes backed by bank-specific assets. This is that Canadian banks, unlike their U.S. counterparts, were free to establish branch networks, and that such networks, together with note clearinghouses established in major trade centers, sufficed to eliminate note discounts, by reducing to trivial amounts the cost to banks of presenting rival banks' notes for payment. For a bank's notes to remain on the "current" list thus became a simple matter of its demonstrating a willingness to cooperate in regular (eventually daily) settlements. In the U.S. itself the Suffolk System manged to make all New England banknotes current throughout that region, even despite restrictions on branch banking, decades before the Civil War, not by telling its members what assets they could own or by otherwise monitoring their assets, but simply by insisting that they keep up their settlement accounts. These and many other examples I might cite make it clear that full backing by risk-free assets is not a necessary condition for a uniform private banknote currency.
What's more, it isn't a sufficient condition. For although Gorton claims that the National Currency and Banking legislation of 1863 and 1864 succeeded in finally eliminating banknote discounts by requiring full (or more than full) backing of all national banknotes by U.S. government bonds (p. 18), the truth is otherwise. National banks were no more willing than their state predecessors had been to bear the cost of sorting and shipping rivals' notes to thousands of other (unit) banks, many of them located long distances away, for payment. Consequently national banks did at first occasionally refuse to accept other national banks' notes at par. That changed in 1864, not because national banks suddenly realized that all their notes were equally good, but because a provision of the 1864 Act (sec. 32) required that every national bank receive every other national bank's notes at par.* Similar legislation, had it been imposed on antebellum banks, might also have made their notes current, though not without causing other, perhaps more serious mischief.
Remarkably, Gorton makes hardly any mention in his book of the role of unit banking laws either in preventing the emergence of a unified U.S. currency market or in contributing to the likelihood of bank failures and crises by creating a system consisting of many thousands of mostly tiny and under-diversified banks. In listing the provisions common to the so-called "free banking" laws, for example, he omits the one disallowing branching (pp. 12-13). (Neither "Unit banking" nor "Branch banking" appear among the terms listed in the book's index.) To say that telling the history of U.S. financial instability without mentioning the part played by unit banking is like staging a performance of Hamlet without the Prince of Denmark is to resort to a very tired cliche. But in reading Gorton's book I could not help having the cliche insistently come to mind.
The difference between Gorton's conclusion regarding the "inherent" vulnerability to crises of any economy having lots of bank debt and that of one of his occasional co-authors, Charles Calomiris, in his own recent study, is striking:
[E]mpirical research on banking distress clearly shows that panics are neither random events nor inherent to the function of banks or the structure of bank balance sheets....The uniquely panic-ridden experience of the U.S., particularly during the pre-World War I era, reflected the unit banking structure of the U.S. system. Panics were generally avoided by other countries in the pre-World War I era because their banking systems were composed of a much smaller number of banks operated on a national basis, who [sic] consequently enjoyed greater portfolio diversification ex ante, and a greater ability to coordinate their actions to stem panics ex post.**
Despite the debilitating effects of barriers to branch banking, U.S. panics prior to the passage of the Federal Reserve Act generally did not involve outbreaks of distrust of most, let alone "all" (p. 32) bank deposits. Instead, distrust tended to be confined to banks that had suffered from prior shocks, or to banks that were associated with others that had suffered from such shocks. Bank runs appear, in other words, to have been informed, if only imperfectly, by bank-specific information. According to George Kaufman, a general flight to currency appears to have occurred during one pre-Fed National Banking era panic only--that of 1893. And even in that case, as Gorton himself recognizes (p. 77), the general flight was a response to prior, exceptionally widespread industrial and mercantile failures which, given banks' limited opportunities for portfolio diversification, gave depositors good reason for anticipating similarly widespread bank insolvencies.
That most panics didn't involve general flights to currency doesn't mean that the public's desired currency ratio didn't increase on other occasions, or that those increases were not a cause of financial distress. Of such occasions the most important was the harvest and subsequent "crop moving" season, roughly from August through November, when currency was needed to pay migrant farm workers. Depositors' attempts to convert deposits into currency for the sake of making such payments, for which checks were unsuitable, had nothing to do with them fearing that their banks might be insolvent. However, thanks to binding national banknote collateral requirements such attempts could leave banks with no choice but to draw upon their legal reserves. Those reserves might consist--again thanks to unit banking laws, and also to national banking laws sanctioning the practice--of country-bank deposit credits at so-called "reserve city" banks, whose own reserves might in turn consist of deposits at New York ("central reserve city") banks. To pay out a single dollar of currency a country bank lacking any surplus bonds might, in short, find itself triggering a three-dollar decline in total banking system reserves, with the brunt of the burden being felt in New York. Consequently a sharp-enough rise in the public's desired currency ratio, though itself based on routine transactions motives, might nevertheless lead to a credit crunch and even, in extremis, to a currency famine. That credit tended to tighten every autumn under the pre-Fed national banking system, resulting in a marked seasonal pattern in interest rates, is well established, as is the fact that several panics took place during the harvest and crop-moving months, suggesting, not necessarily that harvest-related currency demands triggered the panics, but that such demands may have contributed to their severity.
Canada avoided both panics and any seasonal tightening of credit thanks again to its banks' ability to branch and also to their ability to give customers all the notes they wanted in exchange for their deposit credits, without having to make costly (let alone impossible) adjustments to their asset portfolios. Although entry into Canadian banking was very strictly regulated, established Canadian banks were genuinely (and not just nominally) "free." That many contemporary experts favored granting national banks Canadian-style freedoms, by allowing them to branch and by repealing the bond-deposit requirement of the National Bank Act, as the most straightforward way to put an end to U.S. currency shortages and panics, is yet more evidence contradicting Gorton's account. If Bordo, Redish, and Rockoff are right, even Canada's dodging of the recent financial crisis is attributable to a significant degree to the freedom it awarded its banks back in the 19th century:
Because of the fragmented US banking system, and because of various restrictions placed on the assets the banks could own, securities markets emerged to finance most economic growth,unlike Canada which developed a bank-based system. Mortgage markets and housing finance also developed differently in the two countries. Investment banks, which participated in the creation and marketing of securities, became an important part of the system. Thus the United States always had something like the ‘Shadow Banking system’ that has been the subject of so much recent discussion.
Unsurprisingly, the lesson taught by this different understanding of financial history itself differs dramatically from the one Gorton offers. It is that there are better ways to avoid financial crises than by trying to regulate risky bank debt out of existence. They are better both because they can actually succeed (whereas the war on debt Gorton proposes would probably prove as futile as the war on drugs) and because they get rid of the financial crisis bathwater without sacrificing the financial intermediation baby. For that reason I'm convinced that, should Gorton's version of history prove persuasive, it could end up proving no less misleading, and far more costly to society, than the models he concocted for AIG.
*The same law provided facilities--though very inadequate ones--for the centralized redemption of national banknotes. In 1874 a new and and better, though still far from adequate, redemption agency was established.
**In correspondence Professor Calomiris has alerted me to his forthcoming Princeton University Press book, with Stephen Haber, Fragile By Design: The Political Origins of Banking Crises and Scarce Credit, which "provides much more evidence that banking crises are the outcomes of political choices, not inherent fragility." The book is, as, Tyler Cowen might say, "Self Recommending." (Added 7-12-2013).
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