Larry White


Larry White is Professor of Economics at George Mason University. He specializes in the theory and history of banking and money, and is best known for his work on free banking. He received his A.B. from Harvard University and his M. A. and Ph.D. from the University of California, Los Angeles. He previously taught at New York University, the University of Georgia, and the University of Missouri - St. Louis.

Professor White is the author of The Clash of Economic Ideas (Cambridge, forthcoming); The Theory of Monetary Institutions (Basil Blackwell, 1999); Free Banking in Britain (2nd ed., Institute of Economic Affairs, 1995; 1st ed. Cambridge, 1984), and Competition and Currency (NYU, 1989). He is the editor of F. A. Hayek, The Pure Theory of Capital (Chicago, 2007); The History of Gold and Silver (3 vols., Pickering and Chatto, 2000); Free Banking (3 vols., Edward Elgar, 1993); The Crisis in American Banking (NYU, 1993); William Leggett, Democratick Editorials (Liberty Press, 1984); and other volumes. His articles on monetary theory and banking history have appeared in the American Economic Review, the Journal of Economic Literature, the Journal of Money, Credit, and Banking, and other leading professional journals.

In 2008 White received the Distinguished Scholar Award of the Association for Private Enterprise Education. He has been Visiting Professor at Queen's University of Belfast, Visiting Fellow at the Australian National University, Visiting Research Fellow and lecturer at the American Institute for Economic Research, visiting lecturer at the Swiss National Bank, and a visiting scholar at the Federal Reserve Bank of Atlanta. He co-edits a book series for Routledge, Foundations of the Market Economy. He is a co-editor of Econ Journal Watch, and hosts bi-monthly podcasts for EJW Audio. He is a member of the board of associate editors of the Review of Austrian Economics and a member of the editorial board of the Cato Journal. He is a contributing editor to the Foundation for Economic Education's magazine The Freeman and lectures at the Foundation's annual seminar in Advanced Austrian Economics. He is an adjunct scholar of the Cato Institute and a member of the Academic Advisory Council of the Institute of Economic Affairs.


David Wessel on low inflation

by Larry White June 17th, 2014 5:32 pm

Ex-Fed chair Ben Bernanke is currently a resident fellow at the Hutchins Center on Fiscal & Monetary Policy at the Brookings Institution. The Center’s director, David Wessel, appeared on NPR’s Morning Edition yesterday to express views on inflation and deflation that are essentially indistinguishable from Bernanke’s.

In particular, like Bernanke, Wessel spoke as though inflation below 2% per annum, and a fortiori deflation, is always bad.

Asked to explain why it should be bad to have less of a bad thing like inflation, Wessel first responded: “I mean it sounds appealing, prices going down, people paying less at the store. But when inflation is low that means wages are going up very slowly too. That's of course not very popular.“ This sort of answer would earn an undergraduate a poor grade from any instructor who emphasizes the distinction between real and nominal variables. Workers should not applaud rising nominal wages per se; what matters for them is their real wages. When inflation is low, so too are nominal wage increases ordinarily. But that says nothing about the path of real wages, which in the long run are not determined by monetary policy.

Wessel continued: "There are a couple of problems with too little inflation. It can be a symptom of a lousy economy, one in which demand for goods and services and workers is anemic."

A key word here is symptom. A condition that can be a symptom of a problem is not the problem itself, and can also appear under healthy conditions. Wessel failed to note that low inflation need not be a symptom of a lousy economy, because he spoke only of variation in the aggregate demand for goods and services. Low inflation (or even deflation) can instead be the benign result of abundant growth in the real supply of goods and services. Under the gold standard, as Atkeson and Kehoe (2004) have reported, periods of lousy economy (recession) were not more common during deflation periods, nor vice-versa.

If the Fed were today targeting the path of nominal income, because the growth rate of nominal income is the sum of the inflation rate and the real income growth rate, low inflation would be a sign of a healthy economy with high real economic growth. Thus Wessel would have provided a more accurate analysis if he had spoken of problems with growth in nominal aggregate demand being weaker than anticipated, not inflation being below its target. (In terms of dynamic AD-SRAS analysis, unexpectedly low growth in AD moves the economy below the natural rate of output.)

Wessel’s second concern is harder to interpret favorably. Low inflation, he said, "can make it hard for the Fed to spur borrowing because it's hard for them to get the interest rate below the inflation rate." Two responses: (a) The Fed should not be trying to “spur borrowing.” Fed efforts to spur borrowing helped to fuel the housing bubble. (b) The Fed is not in fact currently finding it hard to get the interest rate below the inflation rate. The interest rate on 1-year T-bills has been below the CPE inflation rate for more than four years, since 2009’s dip into deflation (in that case due to weak demand for goods following the financial crisis).

Wessel went on the cite the problem of rising real debt burdens in deflation. That can indeed be a problem in an unanticipated deflation (Wessel never distinguished anticipated from unanticipated), but again, only to the extent that the deflation is driven by unexpectedly weak aggregate demand growth and not by robust aggregate supply growth. In the latter case, borrowers have more real income with which to repay.

In his answer to the interviewer’s last question, Wessel declared: “So it used to be that economists believed that a central bank can always create inflation by printing more money. But lately it's been -seems harder to do that than the textbooks had told us.” But what is the evidence that expanding the stock of money does not still generate inflation the way the old textbooks tell us? Surely not the experience of the Fed undershooting its target of 2.0% growth in the PCE by 0.4%, which only implies that the broad money growth rate was 0.4% lower than the rate that would have hit the target. Fortunately or unfortunately, it remains the case that the Fed can always raise the PCE inflation rate by engineering a higher rate of broad money growth, just as the textbooks explain.

By the way, today’s announced number for the May CPI raises year-over-year CPI inflation to 2.1%. The increase of 0.4% over April’s CPI, compounded twelve-fold, implies an annual rate of 4.9%. At this rate the “problem” of an undershooting PCE-deflator inflation rate will be “solved” before long.

(HT to David Boaz)


New working paper on Bitcoin

by Larry White June 16th, 2014 10:24 am

Will Luther and I have a brief new SSRN working paper entitled "Can Bitcoin Become a Major Currency?"


The Federal Reserve System at 100

by Larry White December 23rd, 2013 12:28 pm

Today is the 100th anniversary of the Federal Reserve Act. In this talk I discuss how the Fed has done over the past century.


"Can the Monetary System Regulate Itself?"

by Larry White September 28th, 2013 10:44 pm

Here's audio of a talk I gave at CEVRO Institute in Prague earlier this month.


Krugman on Friedman, Hayek, and Liquidationism

by Larry White August 12th, 2013 4:31 pm

In a blog post yesterday, entitled “Friedman and the Austrians” , Paul Krugman quotes Milton Friedman’s charge that in the “London School (really Austrian) view,” i.e. the view held by F. A. Hayek and Lionel Robbins,

the depression was an inevitable result of the prior boom, that it was deepened by the attempts to prevent prices and wages from falling and firms from going bankrupt, that the monetary authorities had brought on the depression by inflationary policies before the crash and had prolonged it by “easy money” policies thereafter; that the only sound policy was to let the depression run its course, bring down money costs, and eliminate weak and unsound firms.

Krugman then remarks:

I have, incidentally, seen attempts to claim that nobody believed this, or at any rate that Hayek never believed this, and that characterizing Hayek as a liquidationist is some kind of liberal libel. This is really a case of who are you gonna believe, me or your lying eyes.

One of the "attemps" Krugman may be referring to is my June 2008 article in the Journal of Money, Credit, and Banking, “Did Hayek and Robbins Deepen the Great Depression?” (Ungated pre-publication version here). Or he may be referring to subsequent discussion of the question on Brad DeLong’s blog -- if you follow this link, please scroll down to see my comments on DeLong’s post.

In either case Krugman’s remarks call for a reply.

In the 2008 article I point out that Hayek enunciated a monetary policy norm of stabilizing nominal income (aka nominal aggregate demand, or MV in the equation of exchange) in the face of a declining money multiplier or declining velocity of money. Under a gold standard, a high price level driven unsustainably high (by the boom-creating inflationary policies that Friedman references) needs to return to the sustainable level, but there is no virtue in “secondary” deflation going beyond that point. Thus, according to Hayek, the central bank should expand its liabilities H to offset an increased bank reserve ratio or public hoarding that reduces M/H or V. In yet other words, it is better to remedy an unsatisfied excess demand for money balances by supplying the called-for money balances than by putting a burden of downward price adjustment on the economy.

Overlooking Hayek’s stable-MV norm, Friedman and others have mischaracterized Hayek as prescribing only “to let the depression run its course.” Hayek did oppose cheap-money policies that distort the economy, and did counsel policy-makers not to obstruct the process of correcting the mistaken investments made during the boom. But quoting such statements doesn’t show that he said nothing else about depression policy.

It’s a question of who you gonna believe, a one-sided quoting of only some bits of Hayek by people unaware of the rest, or the full story of what Hayek wrote about depression policy?

I’m sorry that Krugman didn’t call me out by name. It prevents his readers from finding and reading the other side of the debate.

I might also mention that my article treats the question of what Hayek really said as a matter of getting the intellectual history right. I do not suggest that mischaracterization of Hayek’s position is limited to left-liberals. Indeed, as Krugman’s blog post does, my article prominently quotes Milton Friedman’s criticism of Hayek for supposed liquidationism. Friedman is no left-liberal. Thus I would never call it “some kind of liberal libel.”


Hugh Rockoff on free banking history (podcast)

by Larry White April 4th, 2013 7:06 pm

I interviewed Prof. Hugh Rockoff of Rutgers University for the latest installment of the Econ Journal Watch Audio podcast. We chat about his research on episodes of lightly regulated banking, and his take on others' research. Along the way we discuss Milton Friedman's views on free banking, and the recent banking debacle in Cyprus.
Listen or download here.


How not to rethink money

by Larry White February 10th, 2013 10:51 pm

I have a book review now up on of Bernard Lietaer and Jacqui Dunne's Rethinking Money: How New Currencies Turn Scarcity Into Prosperity. I wanted to like the book more, because I too like alternative currencies. Unfortunately Lietaer and Dunne make some very crankish arguments, suggesting that the phenomenon of a positive interest rate creates problems for the economy, and that a proliferation of free currencies will ameliorate those problems.


The real problem today is not so much nominal

by Larry White September 23rd, 2012 10:28 pm

Scott Sumner told us in September 2009 that "the real problem was nominal," that is, the recession and its high unemployment were primarily due to an unsatisfied excess demand for money (combined with real effects on debt burdens of nominal income being below its previous path). In AS-AD terms, the AD curve (representing combinations of M times V equal to a given level of nominal income Py) had shifted inward, and the economy was sliding down the SR aggregate supply curve. The price level had not yet adjusted enough to clear the market of unsold goods corresponding to deficient money balances. This was a reasonable – almost inescapable – diagnosis in 2009, when the price level and real income were both falling.

Market Monetarists who have been celebrating the Fed’s recent announcement of open-ended monetary expansion ("QE3') seem to believe that Sumner’s 2009 diagnosis still applies. But what is the evidence for believing that there is still, three years later, an unsatisfied excess demand for money? Today (September 2012 over September 2011) real income is growing at around 2% per year, and the price index (GDP deflator) is rising at around 2%. If the evidence for thinking that there is still an unsatisfied excess demand for money is simply that we’re having a weak recovery, then as Eli Dourado has pointed out, this is assuming what needs to be proved. Dourado writes (I take his “in the short run” to mean “in a situation of unsatisfied excess demand for money”):

So what is the evidence that we are still in the short run? I think a lot of people assume that because unemployment remains above 8 percent, we must be in the short run. But this is just assuming the conclusion. There are structural hypotheses for higher unemployment, but even if unemployment is cyclical, it doesn’t mean that monetary adjustment has failed to occur—real sector recalculation may just take longer than monetary recalculation.

… If we view the recession as a purely nominal shock, then monetary stimulus only does any good during the period in which the economy is adjusting to the shock. At some point during a recession, people’s expectations about nominal flows get updated, and prices, wages, and contracts adjust. After this point, monetary stimulus doesn’t help.

While saluting Sumner 2009, like Dourado I favor an alternative view of 2012: the weak recovery today has more to do with difficulties of real adjustment. The nominal-problems-only diagnosis ignores real malinvestments during the housing boom that have permanently lowered our potential real GDP path. It also ignores the possibility that the “natural” rate of unemployment has been hiked by the extension of unemployment benefits. And it ignores the depressing effect of increased regime uncertainty.
To prefer 5% to the current 4% nominal GDP growth going forward, and a fortiori to ask for a burst of money creation to get us back to the previous 5% bubble path, is to ask for chronically higher monetary expansion and inflation that will do more harm than good.


How much dodgy debt will the ECB buy?

by Larry White September 7th, 2012 2:38 pm

The European Central Bank yesterday, in the words of The Washington Post, "announced that it would buy the bonds of struggling governments without limit" (emphasis added). But that can really only mean “without an announced limit.” There is an implicit limit so long as ECB sticks to its also-announced promise to neutralize the monetary-base-expanding effects of its struggling-government bond purchases by selling, euro for euro, other bonds from its portfolio, because its current portfolio is finite and only some of it is not already struggling-government debt. It is difficult to discover exactly what this implicit limit is in billions of euros.

The Eurosystem (the ECB plus the eurozone’s national central banks) can purchase bonds of the struggling GIPSI (Greece, Ireland, Portugal, Spain, or Italy) governments in two ways: directly, or indirectly by making additional loans to commercial banks that purchase GIPSI bonds (and collateralize said loans with said bonds). To sterilize purchases of either kind, the ECB will have to sell its non-GIPSI bonds (or shrink its loans to banks collateralized by non-GIPSI bonds). The Eurosystem’s reported balance sheet shows €3085 b in total assets. It does not reveal what percentage of its current assets are in GIPSI sovereign debts and GIPSI-collateralized loans. We can assume that the €279b of securities acquired under the ECB’s two “covered bond purchase programmes” consists entirely of GIPSI bonds. For the sake of argument let’s assume that gold assets (€434b) and foreign-currency assets (€312b) won’t be touched. We can break the largest asset category, “Lending to euro area credit institutions related to monetary policy operations denominated in euro” into two parts: what was on the balance sheet two years ago (€592b) and what’s been added in the last two years (€618b). Assume that half of the former and one-fourth of the latter is neither GIPSI debt nor the debt of borderline-struggling sovereigns like France and Belgium, but is debt that could be sold for sterilization purposes. That gives us a total of €450b as the upper limit of ECB purchases of the bonds of struggling governments under a policy of full sterilization.

This number is purely a guesstimate. But it probably isn’t off by a factor of two. If the ECB finds itself wanting to make €1000b of GIPSI bond purchases, it is clear that the ECB will have to switch from sterilization to some other strategy for keeping M2 from ballooning, like the Fed’s QE1 strategy of paying higher interest on reserves. Note that the ECB is already paying interest on reserves, and has been since its beginning, whereas the Fed started at zero.

For as long as it lasts, sterilization means that as the ECB buys more GIPSI sovereign debt, it will be shrinking Eurosystem credit to other borrowers, namely to private borrowers and to less-irresponsible sovereign borrowers. Starve the productive and the relatively prudent to lend to the unproductive and imprudent. That is not what anyone could consider a prudent mix of Eurosystem assets, nor a promising way to promote economic growth.


Testimony on fractional-reserve banking

by Larry White July 2nd, 2012 11:03 am

Here is a link to video of Ron Paul's subcommittee hearing Thursday on fractional reserve banking. Below it is the text of my written statement.

Hearing June 28 2012 Fractional Reserve Banking

Statement of
Lawrence H. White
Professor of Economics, George Mason University
before the
House Subcommittee on Domestic Monetary Policy and Technology
United States House of Representatives
June 28, 2011

Chairman Paul and members of the subcommittee: Thank you for the opportunity to discuss the fractional-reserve character of modern banking, its positives and negatives, its relationship to financial instability, and to offer my thoughts on how to promote greater banking stability. I will begin by describing the historical origins of fractional-reserve banking (hereafter FRB), then move on to the effect of FRB on the money supply process, its connection to bank runs and financial instability, and finally the reforms needed to improve our banking system.

The origins of fractional reserve banking

A “bank” is a firm that both gathers funds by taking in “deposits” (or creating account balances) and makes loans with the funds gathered. A moneylender who draws only on his own wealth is not a banker, nor is a warehouseman who does not lend. A “deposit,” in ordinary modern usage, is a debt claim, an IOU issued by the banker and held by the “depositor,” which the banker is obliged to repay according to the terms of the contract. We can distinguish between a “time deposit,” which the banker is obliged to repay only at a specified date in the future, and a “demand deposit,” which gives the customer the legal right to repayment “on demand,” that is, whenever the customer chooses (on any day the bank is open).

Historically, deposit-taking grew out of the coin-changing and safekeeping businesses. Medieval Italian money-changers would (for a fee) swap coins from one city for those from another. Some traveling merchants, who brought in coins of one type, would chose to hold balances “on account” for the time being, preferring to receive coins of another type later when it was more convenient. The earliest deposit-takers in London were goldsmiths, artisans who made gold jewelry and candlesticks, who were also coin-changers. Like the Italian coin-changers, they provided safe-keeping in the vaults where they kept their own silver and gold.
A key to the development of fractional-reserve banking was that vault-keepers (money-changers and goldsmiths) began to provide payment services by deposit transfer. The earliest record of payment by deposit transfer is from Italy around 1200 AD. Before deposits became transferable, suppose Alphonso wanted to pay (say) 100 ounces of coined silver to Bartolomeo, both of them customers of the same vault-keeper. Al would go to the vault-keeper, have him weigh out the requisite amount of coins, and transport the coins to Bart, who would then have to transport the coins back to the vault-keeper to have them weighed again and placed back in the vault. There was great inconvenience, not to say risk, in transporting the coins across town and back. And there were fees to pay for weighing the coins. At the end of the day, Al’s account balance or claim on the vault-keeper would be down by 100 ounces (plus transaction fees), and Bart’s would be up by 100 ounces (minus transaction fees).

A less burdensome and safer way to accomplish such a payment was for Al and Bart to meet at the bank, and simply tell the banker to transfer 100 ounces on his books by writing Al’s account balance down and Bart’s up. No coins had to be weighed or moved, or even touched at all. Payment was now made not by handing over coins, but by handing over claims to coins.

Other methods for authorizing deposit transfer were often more convenient and soon displaced the three-party meeting in the banker’s office. For example, Al could sign a written authorization, what we now call a check. Today we have electronic funds transfer, but all of these methods accomplish the same end, which is to make a transfer funds from one account to another.

Some of the earliest deposit-taking was simple warehousing, in which the coins deposited were merely stored, and the exact same coins would be returned to the depositor on demand assuming all storage fees had been paid. (In legal parlance such a claim on the warehouseman is a “bailment” and not a debt.) In the early Middle Ages a customer who wanted this kind of storage would bring the coins to the vault in a sealed bag. The bag was not to be opened by the warehouseman. For each specific bag of coins that could be claimed by Al or Bart, those specific bag of coins were always in the vault. Supposing that the bags’ contents were recorded on the books (which they need not have been), we could say that for each ounce of coined silver claimed by depositors there was always an ounce of coined silver in the vault. This arrangement, which resembles the business today of renting safety deposit boxes, is sometimes described as “100 percent reserve banking,” although strictly speaking it isn’t banking at all, but simply warehousing.
As payment by deposit transfer became popular, goldsmiths and coin-changers found that they could offer a different kind of contract to customers who primarily wanted not storage but economical payment services. In a “fractional reserve” contract, the vault-keeper becomes a banker, able to lend out some of the funds deposited. In the early Middle Ages a customer who wanted this kind of account would bring loose coins to the vault. The coins could be mingled with other depositors’ coins, whereas in money warehousing there is no evident rationale for mingling. The customer would receive a redeemable claim, entitling him to get back equivalent coins on demand, but not to receive back the identical coins he brought in. The account is now a debt claim and not a bailment. Now the coins in the vault are a fraction of immediately demandable deposits. We can describe them as a reserve for meeting the redemption claims that will actually be made.

Later, beginning perhaps in the 1400s, banks began to issue deposit receipts that could be signed over, making them something like traveler’s checks today. For their customers’ convenience, they soon provided them in bearer form (no signing-over necessary) and round denominations. These we call banknotes, paper currency claims on banks that were payable to the bearer (whoever presented them), typically on demand. As currency, they could be transferable anonymously, and without bank involvement (unlike deposits transfers, which need to be recorded on the books). London goldsmiths were issuing banknotes in the mid-1600s. Banks also held fractional reserves against the total of their banknote liabilities.

When is a fractional reserve feasible?

For a unique or specific coin, which the customer wants to have back, it isn’t. A specific coin lent cannot be instantly recalled from the borrower who has spent it. But for coins that customers regard as interchangeable with other coins, it is. Likewise, you count on a coat check stand to keep your specific coat there all evening, and not to lend it out, because you don’t want back just any coat of the same size. Unlike coat-checkers, most depositors are willing to treat coins as interchangeable. Depositors do not insist on getting the very same coins back, so any equivalent coin in reserve will be satisfactory.

To avoid defaulting, or breaching the contractual obligation to repay, the bank obviously needs to keep enough coins in reserve. How can the bank count on having enough coins to meet all requests? It is a matter of practical calculation: the bank needs to know from experience the probability of any given amount of coins being demand on a given day. If it wants to be 99.99% safe, it needs to hold a reserve (or have ways of replenishing its reserves) sufficient to cover 99.99% of cases.

The economist Ludwig von Mises offered the following illustration. Consider a baker who issues 100 tokens, each stamped “good for one loaf of bread.” Leaving aside lost tokens, it is clear that the baker will need 100 loaves. All the tokens will be redeemed, because using them to get bread is their only use. By contrast, transferable claims to coin (bank deposits or banknotes) are useful even without being redeemed. Unlike bread tokens, which cannot be eaten with butter and jam, transferable bank accounts or banknotes can do the job of the coins in making payments. Once payment by deposit transfer and banknote becomes popular, the banker will reliably find that not all deposits notes or deposits are redeemed for coins on a given day, even if all are used to make payments. Thus a banker who issues $100 in demand deposits or notes will need less than $100 in coin to meet all the redemptions that will actually be demanded.

How much less than 100% the banker can hold, and still meet all the redemption demands that he does face, is a problem that the banker must solve by practical statistical calculation. There is no reason to think that a central authority can do the calculation better, and can improve matters by imposing an arbitrary percentage requirement. To provide the right incentive to hold enough reserves, it is important that the imprudent banker who miscalculates, holds too little in reserves, and fails to pay when obligated to pay, be subject to the ordinary legal penalties for breach of contract.

Advantages and disadvantages of fractional reserves

The advantage to the bank from keeping fractional reserves is clear: it earns interest on the lent-out funds. A few commentators have declared that FRB must be a fraud: the gain is all on the bank’s side, and no customer would agree to it if she realized what the bank was up to. But this claim assumes that there are no advantages to the bank’s customers. In fact there are clear advantages to the bank’s customers, at least under competition. To compete for customers, all experience shows, banks offering fractional-reserve accounts charge zero storage fees and even pay interest on deposits, up to point where the interest they pay falls short of the interest they earn only by just enough to cover the bank’s operating costs for safekeeping and payment services. In this way FRB creates a synergy between payments services (checkable deposits, banknotes) and intermediation (pooling savers’ funds for lending to selected borrowers). When the deposited funds that are not needed as reserves can be lent out, depositors enjoy lower (or zero) storage fees and interest on checking deposit balances.

By contrast to money warehousing, the savings of fractional-reserve banking do carry a disadvantage in the form of greater default risk. If the bank’s investments go sour, the depositor may not be repaid in full. The warehouse, by contrast, makes no investments. So the customer choosing between a bank account contract and a warehousing contract needs to consider: is the saving in storage fees and the interest paid on deposits high enough (relative to the increased risk of not being paid promptly)? Historically, in competitive systems where banks were free to diversify and capitalize themselves well, the answer was yes for most people. Thus well informed consumers who want economical payment services typically prefer a fractional-reserve bank to a warehouse. In sound banking systems historically, before deposit insurance, the risk of loss was a small fraction of one percent, while the interest was more than one percent, and the sum of interest and storage fee savings was even higher. Thus FRB can arise and survive without fraud.
The economist George Selgin has examined the record of the London goldsmith bankers, and debunked the myth that they pulled a fraudulent switcheroo, promising 100% reserves but holding less, at the beginning of the practice of FRB. Goldsmith bank accounts became enormously popular in the mid-1600s because they offered interest on demand deposits. The offer of interest is a clear signal that the contract is not a warehousing contract.

For payment by account transfer, FRB offers a more economic way of providing payment services. A money warehouse or 100% reserve institution could also offer payments by account transfer, but its services would be significantly more expensive. The other bank payment instrument, redeemable banknotes circulating in round denominations, simply cannot exist without fractional reserves. Banknotes are feasible for a fractional-reserve bank because the bank doesn’t need to assess storage fees to cover its costs. It can let the notes can circulate anonymously and at face value, unencumbered by fees, and cover its costs by interest income. An issuer of circulating 100% reserve notes would need to assess storage fees on someone, but would be unable to assess them on unknown note-holders. There are no known historical examples of circulating 100% reserve notes unemcumbered by storage fees.

Under a gold or silver standard, the introduction and public acceptance of fractionally backed demand deposits and banknotes means that the economy needs less gold or silver in its vaults to supply the quantity of money balances (commonly accepted media of exchange) that the public wants to hold. Thus money is supplied at a lower resource cost, that is, with less labor and capital devoted to mining or importing precious metals and fashioning them into coins or bars. Looking at the change in balance sheets from money warehouses to fractional reserve banks, the economy can now fund productive enterprises where before it only held metal. Gold can be exported, and productive machinery imported. This development in Scotland was praised by Adam Smith as a source of his country’s economic growth. As the economist Ludwig von Mises put it, “Fiduciary media [fractionally backed demand deposits and banknotes] … enrich both the person that issues them and the community that employs them."

Under a fiat money standard, as we have today with the Federal Reserve dollar, things are different. There are no mining or minting costs saved by holding fractional rather than 100% reserves in the form of fiat money. For commercial banks to hold 100% reserves in the form of fiat money issued by the federal government would, however, change drastically the function of the banks. Instead of funding productive enterprises, the banks would instead only fund the federal government. Fewer loanable funds would be available to the private economy, and more to the government. Private investment would be suppressed, and public spending enlarged.

The effect of FRB on the money supply process

With banks holding fractional reserves of Federal Reserve dollars (notes and deposit claims on the books of the Fed, whose sum is called “the monetary base”), when the Fed increases the quantity of Federal Reserve dollars by $1 billion, the banking system ordinarily creates a multiple amount of deposit dollars. The total stock of money held by the public (“M1”) increases, say by $2.3 billion. At the moment, however, we are in an anomalous situation. Banks are sitting on such vast quantities of excess reserves – paid to do so by the Federal Reserve as it pays a relative high interest rate on reserves – that the monetary base is larger than M1. Thus the US banking system today actually has more than 100% reserves against its demand deposits.

The problems of financial instability, bank runs, and crises

Perhaps the leading leading argument made in favor of government regulation of banks is the argument claiming that a fractional-reserve banking system is inherently fragile and so needs deposit insurance. The argument rests on three underlying propositions:
(a) An uninsured fractional-reserve banking system is inherently prone to runs and (due to “contagion”) panics. (A run means that many depositors seek to withdraw at the same time, out of fear of a reduced payoff if they wait. A panic means that many banks suffer runs at the same time.)
(b) Runs and panics have net harmful effects.
(c) Deposit insurance can reduce runs and panics below their laissez-faire level at a cost less than the benefit of doing so.

My research into banking history convinces me that (a) and (c) are actually false, and even proposition (b) requires some qualification.

A run is always possible against fractionally backed bank deposits that are unconditionally redeemable on demand. Against such deposits, a run can even, in theory, be self justifying: if a run forces the bank to conduct a hasty sale of illiquid assets, the bank may receive such a reduced value for its assets that it becomes insolvent (liabilities exceed assets), so that all depositors can no longer be paid in full. From this theoretical possibility, some economic theorists have jumped to the conclusion that fractional-reserve banks are in practice inherently run-prone. (The best known statement is a 1983 article by Douglas Diamond and Phillip Dybvig.) According to this view, a run can happen at any time, in any place, on any bank, triggered by nothing more than random fears or events that have no basis in the target bank’s solidity.
But are real-world deposit contracts so fragile? Historical evidence says no. Please consider: If real-world deposit contracts really were as fragile as the self-justifying-run theory supposes, it would be a mystery how they survived centuries of Darwinian banking competition before the first government deposit insurance schemes began. Wouldn’t a more robust arrangement have come to dominate the field?

The theory of runs that better fits the historical record is that runs occur, not randomly, but when depositors receive bad news indicating that their bank might be already (pre-run) insolvent. Receiving such news, depositors run because if assets are already be too small to pay all depositors back, the last in line get little or nothing. Unlike the self-justifying-run theory, the bad-news theory explains why runs typically occurred at onset of recessions (when bad news arrived about the banks’ borrowers declaring bankruptcy), and explains why countries that did not weaken their banks with legal restrictions (e.g. Scotland, Canada) very seldom experienced runs and almost never panics.

What makes a deposit contract run prone? Assume that depositors are rational. There must be a greater expected payoff to arriving sooner rather than later to redeem one’s deposit. This implies that the deposit is unconditionally redeemable on demand (and that the bank pays on a first-come-first-served basis), and that default is likely on last claim serviced. To make an account non-run-prone it suffices to modify either one of these two conditions. First, the deposit contract can make redemption conditional rather than unconditional. An important historical example was the “notice of withdrawal clause” that many savings banks and trust companies included in their deposit contracts. If withdrawals were too great for a bank to satisfy without suffering severe losses from hasty asset liquidation, the banker had the option to defer redemption for 60 or 90 days by requiring notice of intent to withdraw to be given that far in advance.

More importantly, banks made default unlikely by providing their depositors with credible assurances that the bank would maintain solvency, that is, assets sufficient to pay in full even the last in line, even under adverse circumstance. To provide credible assurance, banks before deposit insurance held much higher capital than they do today, in the neighborhood of 20%. They invested much more conservatively, so that they faced much less risk of large asset losses. They avoided loans with high default risk, high risk of loss from interest-rate movements, and loans that were illiquid (hard to resell). Banks that relied on demand deposits and banknotes did not make long-term fixed-rate housing loans, for example. They invested primarily in short-term, high-quality, liquid business IOUs, what were then called “bills of exchange” and is today called “commercial paper.” In some countries, banks had an additional backstop in the form of the right to call for more capital from their shareholders if otherwise depositors would go unpaid. Shareholders had extended liability, and in some systems unlimited liability, for the bank’s debts.

The historical record does of course indicate that runs and banking panics were a problem in United States during the pre-Fed or “National Banking” era (1863 1913), and also under the Fed’s watch during the early years of the Great Depression. But few other countries have had similar experiences. It is therefore clear that run-proneness and panics are not inherent to fractional-reserve banking. If we look for a pattern across countries, this is what we find: countries like Canada, Scotland, Sweden, and Switzerland, where the banking systems had no more than minimal restrictions on entry, note-issue, branching, and capitalization, had virtually no problem from runs and none from panics, in contrast to the more restricted and hence weaker banking systems of the United States and England.

The US banking system was made fragile by the federal and state ban on interstate branching, and even branching within many states. Branch banking limits reduced diversification of assets and deposit sources, indirectly limited capitalization, and hampered the effective allocation of reserves. Poorly diversified and poorly capitalized banks could not offer credible solvency assurances, which made them more vulnerable to “bad news” runs.

The US system was also made fragile by federal restrictions on banknote issue that prevented banks from meeting peak demands for currency. Because of those restrictions, seasonal demands for currency became scrambles for reserve money that occasionally escalated into panics.

Reforms to strengthen our banking system

The weakness in the US banking system today stems from a different set of government policies than the ban on branching (eroded in the 1980s and finally eliminated in 1995) and restriction on banknote issue (commercial banks stopped being allowed to issue any notes in the 1930s). Today the weakness is due not to restrictions, but to privileges. One indication of that is that the weakest banks today are not the smallest, but the largest banking companies.

Federal deposit insurance, since its birth in the 1930s, has meant that a comparatively risky bank (one with capital less adequate to cover potential losses on its asset portfolio) no longer faces a penalty in the market for retail deposits. Insured depositors have no incentive to shop around for a safe bank, so they no longer demand a higher interest rate to give it their deposits. Risk-taking is thereby effectively subsidized. Attempts to price deposit insurance according to risk, so as to recreate a penalty for holding on a risk bank portfolio, were mandated by the FDIC improvement act, but the attempt has failed. The FDIC insurance fund has been exhausted by bank failures, and now has a negative balance. Taxpayers are on the hook for the morally hazardous banking that the FDIC has fostered. Some way of rolling back and ultimately ending federal deposit insurance must be found.

The “too big to fail” doctrine compounds the problem. It gives even blanket protection even to a bank’s legally uninsured depositors and subordinated debt holders, removing their incentive to shop around for a prudently managed bank. “Too big to fail” treatment went from the exceptional event to the routine event during the last five years, as the Federal Reserve and the FDIC have deliberately declined to close several large insolvent banks. If no large bank is ever allowed to fail, then large depositors flock to the large banks that have the privilege of an implicit guarantee for all. On such a tilted playing field, an unnaturally large a share of deposits flows into the largest banks. We are already there. Some way of ending “too big to fail” must be found – quickly.


The evidence shows that a fractional-reserve banking system is not unstable when the banking system is free of hobbling legal restrictions and free of privileges. The US banking system in the 19th century was weakened by legal restrictions. In response to that weakness, rather than let the banking system become robust by repealing its restrictions, Congress in the 20th century patched over the problem by creating the Federal Reserve system (to act a “lender of last resort”) and federal deposit insurance. As a result, the US banking system in the 21st century is chronically weakened by government privileges (especially taxpayer-backed deposit insurance and taxpayer-backed “too big to fail” bailouts) that generate moral hazard. Banks take advantage of these guarantees by holding asset portfolios too full of default risk and interest-rate risk. They finance their portfolios with excess leverage (too much debt, not enough equity). Rather than trying to come up with another patch, Congress should seek to dismantle the restrictions and the privileges that have left the American people saddled with an unhealthy banking system.

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