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« Is Expanding the Money Supply Costless for Free Banks? | Main | Reply to Salerno's Four Propositions on Mises and the Free Banking School »

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I am fresh from a Liberty Fund conference where we discussed the issue at length with the texts in front of us. Mises is ambiguous on this issue (and others), and that is the source of the confusion.

Mises was 100% clear about was his criticism of the Peel Act and the failure of the Currency School to understand that deposits were money. Limiting only fiduciary issue of currency merely accelerated the growth of demand deposits.

Now we must credit Mises with being a good economist and understanding the logic of his own criticism. If banks were required to hold 100% reserves against not only currency but also demand deposits, then one of two things would happen. Either regulated banks would create a new liability that circulated and was not subject to 100% reserves. Or nonbanks would create circulating liabilities.

Of course, both have happened in fact merely to arbitrage the differences in reserve requirements against demand deposits and other forms of bank liabilities (MMDAs, MMFs, etc.). One can borrow against 95% of a CD. The options are limited only by the entrepreneurial zest of bankers, and the craftiness of well-paid lawyers.

The proposals for 100% reserve and narrow banking are solutions to an early 19th century problem, not a 20th century problem, and certainly not the present dilemma. Shadow banking (e.g., Bear Stearns, Lehman, bank subsidiaries) blew up the financial system. Now how would narrow banking (if it were even economically feasible) have pevented that?

This debate has exceeded the bounds of what the blogosphere can handle. One of the Austrian Econ Journals needs to invite a representative of each position to write an article and a rejoinder to one another's articles for an upcoming issue. Solerno's the editor in chief of one, and Boettke is of another. So we know they're abreast of all this back-and-forth. Make it happen.

Steve, I'm so sorry, we are still training our comment filtering software. It might have been the length or the number of links that caused it to land in spam, but, in any case, your comment has been manually approved, and we can hope that the software will know to approve you automatically next time.

I'm not sure I'm reading this right, but I think you're attacking somewhat of a straw man. I didn't read Salerno's article as saying Mises was pro or con free banking or 100% reserves, but that Mises claimed that FRB would create boom-bust cycles (and that this is a bad thing). That's a different argument; as far as I can tell, one can theoretically be in favor of (or, which is probably more likely in the case of Mises: be allowing for) a system that will/can create boom-busts.

Also, I'm not very sure what you are really saying about Mises's view. I'm not attempting to take sides or anything, but I am not sure what this means:
"apparently Mises thought that even 'systems of fiduciary media' are fine as long as issuers of notes are required to fulfill their legal obligations to redeem. No free banker would disagree. But boy that sounds a lot different than the claim that Mises was never okay with fiduciary media or that only 100% reserves was acceptable."

The way I see it, one can be "fine" with fiduciary media as long as bankers fulfill their legal obligations to redeem even if one advocates 100% reserves. I would certainly prefer a system where banks fulfill their obligations to pay me back my money to one where they don't. But is this even an argument? This is not my field of expertise, but I fail to see how fulfilling the obligation of always paying back the money to whoever so demands is practically different from 100% reserves. Either you have the money and can pay back or you don't; only in the former case can you be expected to be able to fulfill the obligations.

Also, if we adopt the anarchist perspective, then there would be no (legislated) law making such requirements. There would only be contracts and, hence, law in the customary, Hayekian sense, and then it seems pretty obvious to me that fractional reserve banking is fraud unless the bank's customers have been informed of the value of their savings being inflated. It is fraud simply because the bank is consciously, and without the customer's approval, not holding reserves to such a degree that it can fulfill its contractual obligations.

But, again, I may be confused about the issue at hand.

You are confused Per.

The contract in question is to redeem bank liabilities "on demand." If a bank keeps fractional reserves yet every time a customer walks in to demand redemption (or another bank through the clearinghouse) it is able to meet that demand, it has fulfilled the terms of the contract. That is what Mises is referring to by "their legal obligations to redeem." His point in that quote was that as long as banks are held to that and not released from that obligation through government intervention, free banking is fine (including fiduciary meida).

As far as the fraud point you make later on goes, I'm not going to go far into that debate other than to say that, yes, fractional reserve banks should lay out the conditions of their contractual relationship with their depositors (as they do today). But all the bank is promising is that it will redeem on demand (with whatever possible exceptions are agreed upon in whatever standard agreement is signed when an account is opened). That's all. There's no issue of inflating away value or any of that. It's a loan you make to the bank, which then loans your loan back out. That simple.

If there were an "I Like" option as in FB, I'd use it for O'Driscoll comments (here and in the previous post).

However, this raises an issue: why are banks suicidal? They can circumvent every regulation, of course, through financial innovation. Attempts to curbs financial innovation through strictre regulations, of course, will also damage good innovations, reducing the efficiency of the market process.

However, the question remains: why are banks so fool? Why do they overstretch themselves to the point of going bankrupt with a sistematicity that has reached new heights in the last ten years, but has always systematically characterized banking throughout its history.

Why do adults do without laws outlawing putting a hand on the barbecue, whereas banks are so systematically prone to masochism?

That's what financial and monetary theory should be about. I'm convinced that to a large extent this is due to the safety net, and that proper responsible market condition may be obtained by reintroducing the forces of losses and bankruptcies in the banking and financial markets.

However, I'm not 100% sure this would eliminate the financial sector's suicidal tendencies, although it would surely reduce them a lot. Besides, it would eliminate most of the fuel out of which bubbles can be created.

Thanks for setting me straight, Steve.

A problem with what you say, though, should be uncertainty, since one can never know if there will be a bank run, an unforeseen "cluster" of demand for the bank redeeming its liabilities, etc. That a bank is able to fulfill its obligations during "normal times" should be expected and it seems to me (correct me if I'm wrong) that there would be no difference for bank customers between free banking and 100% reserves under such conditions.

The difference should be if there are sudden changes in when bank customers demand their money back. I mean, if a big chunk of savers suddenly show up at the bank's doors and demand their savings back, then (1) in a 100% reserves bank they would get it all back but (2) in a fractional reserve bank some of them might have to come back the next day (or whatever). In the latter case, then, the bank has *not* fulfilled its obligations. So I guess one could claim that if banks should/must always fulfill their obligations, then free banking would be no problem during "normal times" (if there is such a thing) but not if, for any reason, there is turbulence, great fluctuations in the demand for savings at hand, etc. Is this a fair interpretation?

(As I said before, this is not my area of expertise - I'm just trying to figure out the issue at hand.)

Per,

The scenario you lay out is why free banks, historically, added clauses to their notes/deposits that gave them the right to suspend redemption temporarily in order to deal with the sort of liquidity crisis you point to. Note and deposit holders were compensated with interest for the period of the redemption suspension. These "option clauses" weren't perfect, but they were quite successful in enabling banks temporarily facing a liquidity crisis to get liquid.

And note, this was simply part of the contractual arrangement between banks and their customers, so invoking the option clauses does not violate the principle that banks must live up to their contractual obligations.

Steven: "It's a loan you make to the bank, which then loans your loan back out. That simple."

So if I increase my demand to hold money, I am really increasing my demand to make loans. It doesn't compute.

When I increase my cash holding due to uncertainty, I am attempting to avoid the risk of investment by just hoarding my cash. But then you insist that bank deposits are loans/investments. So which is it? If they are loans/investments, it makes no sense to talk about "demand to hold money", and banks responding to "demand for money". They are in fact, according to you, just responding to loans, in which case, ME is nothing more then saying the obvious; banks are intermediaries in loan market.

Dan,

When you increase your holding of bank liabilities, you are demanding less of the bank's reserves as you are not redeeming those liabilities through the clearinghouse or directly over the counter. As a result, the bank can now lend more because its reserves are greater thanks to you not redeeming your liabilities as frequently as you did before.

Your act of holding bank liabilities (i.e., not Federal Reserve Notes or gold in free banking) means you are giving the bank more funds to lend, thus you are supplying loanable funds.

Look at it this way: if you normally keep $1000 on average in your checking account (in today's world) and then decide, for whatever reason, to up that to $1500, what exactly do you think happens to the additional $500 you have given to the bank? Remember that $500 finds its way into the bank's reserves either through your increased deposits of checks or cash (and/or your reduced spending). The bank now has that $500 to lend out. When you increase the balance in your checking account (i.e., you hold more bank liabilities), you are giving the bank more reserves to lend out. In other words, your saving in the form of holding a larger balance translates into their ability to bring more loanable funds to borrowers (i.e. increase the level of investment).

What banks do is borrow money from you and in return give you a more convenient means of payment. They then take those borrowed funds and re-lend them, just like any other intermediary does. Your bank deposit (or note under FB) can be both a loan and a form of money *because that's exactly what fractional reserve banks were created to do*: take in loanable funds and provide the customer with a more convenient means of payment (e.g., a checking account rather than cash, or checking or notes rather than gold) that the customer preferred, especially because, in the case of deposits, they could now pay interest on them.

Entrepreneurship, baby.

Put one other way Dan:

Your demand for bank liabilities is simultaneously a supply of loanable funds. That is the "loan us the money and we'll give you a more convenient form of payment, possibly with interest" deal that fractional reserve banks offer.

Thanks, Pietro.

I will return the favor by saying you have asked the central question of banking. It is one that the best economic minds need to address seriously.

The safety net is at the top of my list also. The regulatory structure is also important. Historically in America, we are accustomed to bank runs and large numbers of failures due to crazy regulations. In Britain, by contrast, until Northern Rock, there had not been a bank run since the 1870s. Most important is whether bank failures lead to taxpayer-funded bailouts. That leads to moral hazard and more risk-taking.

Still, banks have engaged in herd behavior and reckless risk taking throughout their history. (Think of manias and bubbles in the 18th and 19 century.) It is a puzzle. Our game theory friends might have ideas.


Steve,

Yes, I understand your position on this matter. But you cannot escape the fact that the increase in holding bank liabilities becomes nothing more then holding IOUs, which you fully acknowledge. Holding IOUs is the result of demand to spend on investments. It's not compatible with demand to hold money, which is nothing more then lack of demand to spend on anything; consumption or investment.

Look, here is my point again. If you equate people's demand to hold cash to people's demand to hold IOU's (although a particular type of IOUs), then you can't be saying that you are talking about demand to hold money without completely rejecting the notion of demand to hold money as a separate type of demand from demand to invest.
You're having it both ways here. It doesn't compute, and in my opinion, it doesn't sit well with Misesian theory at all, which I only bring up because this is what this discussion was all about.

I agree with Jerry O'Driscoll. If you favor a 100% reserves requirement for banks, what are you going to do about the shadow banking sector? You are going to have to regulate that out of existence, more or less.

In any event, I like the history of economic thought and do care what Mises thought. However, either way, his analysis has been surpassed by Selgin, White, Horwitz, O'Driscoll, et al.

Pietro:

I don't think fractional reserve banking is suicidal.

Think about the restaurant industry? Restaurants fail frequently.

Many business borrow money and then invest the proceeds in risky endeavors. And they don't get the money back and lose all of their investment.

Further, there are many businesses that have loans that come due, and then need to borrow new money to pay off the old money.

The "problem" with banking isn't the risk of the activity. It is risky, of course. But all business is risky.

The problem is that banking system can impact the demand for the monetary base, and so its value. These complaints about fractional reserve banking being risky are really about a wish that the demand for the monetary base would not be subject to large, irregular fluctuations.

No individual bank is in a position to do anything about that. No more than any other business. And if such changes do occur, it is devastating to banks, but other businesses as well.

Dan,

What we are talking about is demand to hold money in the broader sense. Agents hold money as a hedge against uncertainty, as we have discussed previously. Whenever you know you have to make a payment at a certain time it can be arranged to sell and asset at that time and make the payment, it's not necessary to hold money, only to tranfer it. But, holding it allows a person to engage in trade they cannot predict, or where it would take excessive effort to predict. For this purpose a money substitute is just as good as money proper. If that money substitute is also a loan to a bank then that isn't particularly important to the money holder.

As Jacob Viner wrote that Keynes assumed that "liquidity preference can be satisfied only by the holding of non-investment assets". But, though that idea may be right for some monetary systems, it's wrong in general.

Dan:

This is where you go wrong.

The demand for to hold money is not a demand to spend on nothing.

It is a demand to spend on money. Because money is the medium of exchange, "spending on money" happens by taking money earned and not spending it. Still, it accumulates more money.

What that means depends on monetary institutions.

With a system where IOUs serve as moeny, an increase in the demand to hold those IOUs is a demand to make loans. It is like a demand to hold bonds.

In my view, one of the greatest errors in "laymen's" or "common sense," macro is the notion that the demand for money is like a black hole.

As an aside, none of the 100% reserve banking advocates make that kind of error. That the demand for money is a demand for "not spending."

The way the economy returns to equilibrium if the nominal quantity of money is fixed is that the prices of goods and services fall, so that the real quantity of money rises to meet the demand to hold money.

That argument depends on people demanding more money because they want to hold more money.

The free bankers argue that there is a market process by which fractional reserve banks will increase the nominal quantity of money if there is an increase in the demand to hold money.

If that process is prohibited, and the nominal quantity of money doesn't change, then the price level falls enough so that the real quantity of money rises to meet the added demand to hold money.

The naive Keynesian approach is that people want to spend less. And while that entails that they are holding more money, they really don't want to hold more money. They want to spend less. And so, increases in the nominal quantity of money do no good. And further, decreases in the price level and increases in the real quantity of money do no good. The only answer is to convince people to want to spend. Perhaps tax cuts will help. Or deficit financed government spending.


Bill: "The demand for to hold money is not a demand to spend on nothing. It is a demand to spend on money"

And what is money according to you? IOUs of course. And what are IOU's? - a claim to future goods.
And how does one obtain such a claim? - By buying it! That is, by spending on investment goods.

Now, clearly, demand to hold money for you is the same as demand to spend on investment goods. You continue to try to obfuscate this fact, but it won't work. You are flat out rejecting the concept of holding money as presented by Mises. holding money is refraining from spending. period!
Somehow you are claiming both. It's like magic. You both hold your money but you also spend it at the same time. Impossible. You theory is incoherent and inconsistent.

Prof. Woolsey: I didn't mean that FRB is suicidal. I agree that fractional reserve banking is a form of entrepreneurial risk not unlike any other risky venture.

I meant that the financial sector in the last ten years, and dozens of times in the last two centuries have shown a disregard for risk that is to be explained. It's not about isolated bankruptcies, but widespread clusters of errors: it's not a choice on the efficient risk-return frontier as Cowen suggests in his book, but inefficient and unlimited risk taking.

I see nothing efficient in the risk taking choices of financial markets as they actually are: it is as if all restaurants at once decided to serve only fried cat legs and failed en masse because no one eats them.

The last crisis, for instance, is only indirectly, and probably marginally, related to FRB. The core of the systemic problem was widespread financial leverage and maturity mismatch based on commercial paper (instead of demad deposits) on the liability side of the balance sheet.

Of course there is no independent yardstick to evaluate the efficiency of risk taking, so that it is possible for Fama to say that bubbles don't exist and for Prescott to say that cycles don't exist. My understanding (I mean, Verstehen) is that financial markets are totally crazy, and that's something of theoretical interest which can be explained by the pooling of risk imposed by countercyclical policies and safety nets.

Current,

"Whenever you know you have to make a payment at a certain time it can be arranged to sell and asset at that time and make the payment, it's not necessary to hold money, only to tranfer it. "

So basically now you are resolving the alleged paradox by claiming that there is no real demand to hold money. This is precisely what I was saying. You must reject the concept of holding money entirely. You now adopt a "not necessary to hold money" theory. That's different from demand to hold money.

I wonder if Steve agrees with the above quote by Current.

Current would be correct in a world without transactions costs, but such a world does not exist. So no, I don't agree with him Dan. We hold money, among other reasons, precisely because we cannot costlessly liquidate other assets even if we know we have a reason to spend coming in the future.

BTW, in response to your response to Bill W: note that Bill put "spending on money" in quotes in the sentence after those you quoted. He was being metaphorical. To be precise, what we do when we hold money is we keep some of our portfolio of wealth in the form of money. If that money is also a bank liability, that portion of our wealth is a loan we've made to the bank (an asset) that also has the feature of being instantly recallable in small denominations and used as a medium of exchange.

What we are "spending" on when we invest some of our wealth in bank liabilities is an interest-bearing IOU (if a deposit) that also happens to be a convenient means of payment. Holding more or less money is a portfolio shift.

If you're like me, you get paid through direct deposit. What's the first thing you do when you get paid? Pay some bills. When you pay those bills you *reduce* your demand for money by choosing to "spend" less of your wealth on money and more of it on having a cell phone, renting an apartment, and owning a car or whatever else you pay each month. Buying groceries is reducing your 'spending" on money and increasing it on groceries. Selling your bicycle is the reverse.

Once you see that money holdings are one way of allocating one's wealth, the position Bill and I (and pretty much every other monetary economist of any sort) are taking becomes clearer.

lol austrians are soo dramatic.

We learn a lot by understanding errors ... thinking hard about where economic thinking goes wrong or is incomplete often helps us understand thing better than does the memorization of a logically valid formal construction.

Mario writes:

" I like the history of economic thought and do care what Mises thought. However, either way, his analysis has been surpassed by Selgin, White, Horwitz, O'Driscoll, et al."

Steve,

You don't need to convince me of the benefits in bank deposits, i.e., convenient means of payment, checkbook money, etc.... But that doesn't prove the deposits are loans, and even if they are, then my original point is still valid; an increase in demand to make loans (hold IOUs) is not tantamount to an increase in demand to hold money.

Regarding the use of "spending on money", why does Bill need to be metaphorical here at all, when it would be entirely accurate to say that holding money is equivalent to "investing in money"? It sounds like he's trying very hard to make all the parts fit in nicely with the theory. I'm not convinced at all that he's shown how they do. Because no matter how you slice it, the banks are acting as intermediaries in the loan market. They are not storing your money for safekeeping and payment conveniences (for a fee). Now, since we are, for the sake of this debate, rejecting the Rothbardian explanation of deception and fraud, we are left with the conclusion that people increasing their demand for bank liabilities is tantamount to people increasing their desire to make loans. Fine, but this means, by definition, that they are spending on investments goods. They're not holding money. What you and Bill are doing is basically trying to claim that both operations, refraining from spending and spending, are miraculously achieved simultaneously by the operation of Fractional Reserve banking. That's the end result so that is in effect what your theory amounts to. An increase to refrain from spending (investment or consumption) is somehow also and increase in spending (on investment or consumption depending on the type of loans).

As a result, I am saying the following:

1. My original point: It makes no sense to claim that you are talking about "holding money" and then proceed to show how it is being spent. It is a logical impossibility for which, in my opinion, you are unable to resolve in any satisfactory manner.

2. Just to consider the ramifications of overlooking #1, the creation of fiduciary media will [predictably] set off an intertemporal distortion for various reasons which I can elaborate on further if you request it, of course.

Dan,

You are the confused one. Demand deposits are, in fact, a means of payment (money) and an IOU. That's the nature of fractional reserve banking. You keep insisting that being both makes no sense, but the evidence is right in front of your eyes that entrepreneurs figured it out.

Holding a demand deposit is, as I've argued plenty, supplying loanable funds (saving) the purchasing power of which is then transferred to the person the bank lends to. I'm the ultimate saver and the borrower is the spender.

The bank owes me the amount of the deposit and my ability to use it as a medium of exchange means that it is money, and the portion of it I am not using at the moment is being spent by someone else. Negotiating that process is the entrepreneurship banks are engaging in.

You want to deny by definition what reality shows you is otherwise, much like Huerta de Soto wants to deny a deposit is a loan by asserting a definition that runs in contrast to historical reality.

You can't make the world conform to your definitions. That's called begging the question.

It's not clear to me what Mises got wrong: in the chapter on indirect exchange in Human Action he defended free banking with the very same arguments of modern free bankers. In a note, he also criticized Vera Smith's book for not having acknowledged the importance of the interbank clearing mechanism in preventing inflation.

Mises's theory of business cycles had unfortunately no role for velocity and although I'm not satisfied with the free banker's too aggregate approach this is a clear limitation in Mises's theorizing.

He believed that credit creation would be limited under free banking, and probably he thought this would limit the issuance of fiduciary media. However, from the point of view of Mises's distinction between credit inflation and simple inflation this is a non sequitur: under free banking banks will refrain from creating credit (if the system works), not necessarily from creating means of payments: if they can find a way to inject money without falsifying the monetary interest rate, there is no problem, on a purely misesian ground (although I'm convinced he said the contrary somewhere).

PS Mises is at risk of being a collateral damage in the process of purging Austrian economics from some of the worst theoretical and above all sociological consequences of the rothbardian hegemony.

Steve (Horwitz), for what it's worth, I thought Salerno's article was pretty convincing. Now if trust Ebeling and Selgin for sure, they are no spring chickens on this stuff, so if they say Mises was not consistent, OK I am ready to believe that.

But in this post, you didn't give me anything, whereas Salerno made a very strong case that at least the guy who wrote those passages thought FRB per se was bad.

Your one quote from Mises in this blog post, is perfectly consistent with the 100% reserve position, if we think that under free entry and contract enforcement, the "profit-maximizing" reserve ratio would be close to 100%.

For an analogy, I am an an-cap of the Rothbardian variety. I would say, "The government police don't need to punish theft. In fact, the great danger on this issue is giving the gov't the power to steal money from people in the name of fighting theft."

Now you could quote the above to imply, "Murphy doesn't think theft per se is bad; only if the government does it," but that's not what I mean. I mean that the market will punish private sector theft just fine, thank you very much.

So back to banking, that quote you have from Mises could simply mean, "All government needs to do is enforce contracts, and competition will eliminate FRB."

I'm not saying you and Ebeling and Selgin are wrong, just saying so far Salerno's case seems a lot stronger to me than yours.

Bob,

Did you read the links from last September where I did present plenty of textual evidence?

Steve: "As far as the fraud point you make later on goes, I'm not going to go far into that debate other than to say that, yes, fractional reserve banks should lay out the conditions of their contractual relationship with their depositors (as they do today). But all the bank is promising is that it will redeem on demand (with whatever possible exceptions are agreed upon in whatever standard agreement is signed when an account is opened). That's all. There's no issue of inflating away value or any of that. It's a loan you make to the bank, which then loans your loan back out. That simple."

Steve, agreed on this -- except for your comment that it's laid out today. People keep saying that b/c there is interest paid of course depositors know that their money is being lent out. This is putting too much faith in people's economic literacy. I don't think most get this. They are told and think of "their" money being "in" the bank.

That said, I don't even think *this* is fraud, for a few reasons. First, caveat emptor. Second, they should be more economically literate and I don't mind holding people to such a standard. Third, even if frb is type of ponzi scheme, I don't think ponzi schemes should be outlawed any more than gambling. Fourth, as I think Salerno has pointed out the federal insurance in a way makes the banking system not unbacked. The feds' backing of the money supply is criminal, but not really fraudulent.

Steve: "You are the confused one. Demand deposits are, in fact, a means of payment (money) and an IOU. That's the nature of fractional reserve banking."

This doesn't prove that they are equal anymore then that the real interest rate can be lowered by expanding the money supply. You could say just as well:
'interest rates are, in fact, lowered by central banking. You keep insisting that it makes no sense, but the evidence is right in front of your eyes that government has figured it out.'

So no, I'm not confused since I'm not denying that they are in fact currently being used in that way.

"You can't make the world conform to your definitions."

They're not my definitions. I'm not that original :). But the issue is this, it's more of a problem of logic then abstract definitions. It is logically impossible to claim that the same money is both held and spent simultaneously. One can certainly transfer his purchasing power to somebody else either in the form of a loan or gift. But according to you, that's the same as holding money. Are you really suggesting that Mises referred to money transfers (loans) when talking about "demand to hold money"?


"Holding a demand deposit is, as I've argued plenty, supplying loanable funds (saving) the purchasing power of which is then transferred to the person the bank lends to. I'm the ultimate saver and the borrower is the spender."

But since people can increase their cash holdings by cutting their spending on consumption goods, investment goods, or both, it is not possible to determine from the mere increase in bank liabilities, the new preferred proportion of spending between consumers goods and investments goods. The explanation of how "the portion of it I am not using at the moment is being spent by someone else" is unsatisfactory in explaining how the amount of loans remains aligned with societal time preference and how the new fiduciary media is consumed and reinvested precisely in the correct proportions so that the structure is sustained.

Per, you may be interested in this, regarding how banks can maintain their liquidity even in the face of stress to the point of failure:
http://www.lostsoulblog.com/2010/01/how-faltering-financial-institutions.html

I have posted a response to Joe Salerno's piece on the Division of Labour blog: http://divisionoflabour.com/archives/007130.php


White in his response piece concludes with the following:

"The important question that Salerno raises, and that remains, is what to make of Mises’ statements that seem to condemn any and all expansion of fiduciary media as unwarranted, in contrast to other statements that seem to recognize a category of warranted expansion."

One obvious possibility is that nearly everything that White has quoted in that piece is more in line with Salerno's interpretation.

[centris paribus]When a bond is purchased, money is transferred from lender to borrower. If the lender purchases the bond instead of consumer goods, then the composition of total spending shifts in favour of producer goods. If the lender purchases the bond instead of producer goods or other investor assets, then the composition of total spending between producer and consumer goods does not change. In both cases, the total quantity of money and total spending remain constant. The decrease in spending by the lender is offset by an increase in spending by the borrower.

Now suppose that instead of purchasing the bond, the lender purchased bank liabilities (hereafter called "money"). In this case, money is not transferred from lender to borrower. Instead, the bank creates new money and lends it out to the borrower. If the lender purchases the money instead of consumer goods, then the composition of total spending shifts in favour of producer goods. If the lender purchases the money instead of producer goods or other investor assets, then the composition of total spending between producer and consumer goods does not change. In both cases, the total quantity of money increases but total spending remain constant. The decrease in spending by the lender is offset by an increase in spending by the borrower.[/centaris paribus]

The difference between purchasing bonds and purchasing money is that one results in an increase in the quantity of money and the other does not. However, so far as the allocation of resources between producing producer or consumer goods is concerned, the composition of total spending is what matters. Purchasing bonds and purchasing money achieves much the same thing. All that differs (at this simplistic level of analysis) is the mechanism by which an increase (or change) in savings is translated by the price system into an increase (or change) in the production of producer goods.

One might claim that when people save money (i.e. bank liabilities) that they do not actually mean to finance new investment spending, but then they are merely erring when choosing to save bank liabilities. Such people, recognising their error, would do better to redeem their bank liabilities for base money instead. If the base money were subject to frequent volatility in its demand, then I am sure it would cease to function as base money for long.

Folks,

Just as Bill Woolsey raised the important point that what matters is not the historical accuracy point, but the truth content of the various propositions, Larry White in my mind has nailed the intellectual history points -- starting from his discussion of the classic monetary debates where he shows that there were 3 schools and not 2 (free banking, banking and currency) and he shows that Mises clearly understood both the political economy issues with banking, was addressing policy reforms within the context of a central bank, and also advocated a preferred position which was one of free market in money. It would be productive if all discussion went forward by starting with Larry's point about the intellectual history and Bill's point about the ultimate test --- which is the truth content of the claims being made.

As I said in an earlier post, this debate often moves in very unproductive directions, and it certainly doesn't often add to the ability to engage the professional elite in economics. The blogosophere does a lot of things, but it doesn't come without certain significant costs when you engage it and those who jump into it with both feet. I am not sure that this is at all the best place to discuss the fine points of monetary theory, including the history of monetary economics. I am sure it is a good place to discuss the problems with inflation, etc. For sophisticated discussions of the fine points of theory, there is a case to be made for specialized discourse among experts and in scientific periodicals. For general public awareness of the damage of inflation and the problems of central banking it does seem appropriate that experts interact with concerned citizens in newspapers, radio, TV and blogs. The confusion of the two realms and the two discourses is the source of my frustration, not that both discourses go on.

As Larry White and others acknowledge, there is ambiguity in Mises. But Mises' defense of applying laissez-faire to banking was stirring. I lean to Larry's position.

Let us consider the irony, however. We know that Rothbard favored 100% reserve banking. And what contemporary of his also favored that system?

Milton Friedman.

Friemdan didn't say much about it in later years, but as late as the 1967 Henry Simons lecture he reaffirmed his spupport for the Chicago Plan for 100% Reserve Banking. In his 1959 Fordham Univesrity lectures (published in 1960 as A Program for Monetary Stability), he discussed his version of the plan extensively. He even said fractional reserve banking was inherently unstable.

Interest in 100% reserve banking has been rekindled because of Larry Kotlikoff's new book, Jimmy Stewart is Dead. We'll see how the argument plays out.

Dan said:

"But since people can increase their cash holdings by cutting their spending on consumption goods, investment goods, or both, it is not possible to determine from the mere increase in bank liabilities, the new preferred proportion of spending between consumers goods and investments goods. The explanation of how "the portion of it I am not using at the moment is being spent by someone else" is unsatisfactory in explaining how the amount of loans remains aligned with societal time preference and how the new fiduciary media is consumed and reinvested precisely in the correct proportions so that the structure is sustained."

I'd like to know the free-bankers response to that...

"In his 1959 Fordham Univesrity lectures (published in 1960 as A Program for Monetary Stability), he discussed his version of the plan extensively."

My reading of the Fordham lectures are quite different, Prof. O'Driscoll. Perhaps I've read too quickly, but I think of Friedman's "A Program for Monetary Stability" as an endorsement of fiat money managed by a central bank--not as reaffirming his support for the Chicago Plan as you suggest.

I understand that one could argue for a 100% reserves in a fiat standard, where reserves are central bank notes. Hence, Friedman could have pushed both arguments in the lectures. My recollection, however, is that Friedman stressed the fiat standard and not the 100% reserves.

I do not have the text with me this evening, but would like to re-read the sections you are referring to if you recall precisely what sections you have in mind. Thanks for your time.

Will Luther,

By all means, re-read the sections for yourself. I just did myself today, esp. pp. 65-76. Friedman concludes the section by quoting himself: "'For a long time,' I said in 1954, 'I have been a proponent of 100% reserve banking....'"

He didn't favor fiat money so much as he thought it inevitable. He thought a gold standard with fiduciary currency would break down due to overissue.

Dan. Steve Horwitz,

Earlier I wrote:

> What we are talking about is demand to hold money in the
> broader sense. Agents hold money as a hedge against
> uncertainty, as we have discussed previously. Whenever you know
> you have to make a payment at a certain time it can be arranged
> to sell and asset at that time and make the payment, it's not
> necessary to hold money, only to tranfer it. But, holding it
> allows a person to engage in trade they cannot predict, or
> where it would take excessive effort to predict. For this
> purpose a money substitute is just as good as money proper. If
> that money substitute is also a loan to a bank then that isn't
> particularly important to the money holder.

Dan replied quoting the first part of the above paragraph saying:

> So basically now you are resolving the alleged paradox by
> claiming that there is no real demand to hold money. This is
> precisely what I was saying. You must reject the concept of
> holding money entirely. You now adopt a "not necessary to hold
> money" theory. That's different from demand to hold money.

To clarify... There are two components to the demand for money. The first is what Salerno calls the "transacational demand" and Selgin calls the "pseudo demand". I described it above by writing:

> Whenever you know you have to make a payment at a certain time
> it can be arranged to sell and asset at that time and make the
> payment, it's not necessary to hold money, only to tranfer it.

My point here is that sometimes people demand money *simply to spend it straight away*. They already have a debt or payment falling due, they liquidate assets into money in order to pay it.

However, this isn't the only case. The other possibility is that an individual keeps a stock of money. That's why I wrote:

> But, holding it [money in the broader sense] allows a person to
> engage in trade they cannot predict, or where it would take
> excessive effort to predict. For this purpose a money
> substitute is just as good as money proper.

People call this the "demand for money to hold" or "real demand for money". It is the component that is most important for our discussions here.

Can you not see that this is a pointless argument? Mises never LIKED fractional reserve at any time. He never thought it had magical powers to create new capital goods.

This was before the computer age. Mises thought that if every last shred of government support were taken away from fractional reserve it would either die out, or would be used with some discretion, in a non-harmful way.

This is a purist argument when you have bloody bloody bloody buildings BUILDINGS full of regulations and bankers stealing off us hand over fist.

In the end his point of view is probably now wrong. For starters we aren’t going to get this purist market, untarnished by any of the three layers of government. Secondly…. Under capitalist conditions, for practical purposes, fractional reserve is always fraud…..

…. Thirdly …. any pyramiding, whether it be bank-cash pyramiding, or broker-share-pyramiding, is a direct full frontal attack on pricing; On the distribution of price information throughout the entirety of the structure of production.

So as economists we ought to on this occasion, put aside these purist faux-libertarian hats and just stick up for economic science.

What is very clear is that Mises hated fractional reserve. But that he on this occasion, deferred to the general libertarian principle of "when in doubt, let it work itself out."

We ought to not be in doubt anymore. Not after all this time of being stolen off.

In the end it doesn’t matter what Mises thought.

What matters is that we have to win against the bankers and all they ally with. That means no fractional reserve. A total prohibition for all time.

Now I can see a productive exception to that. If you had a regulated and lincensed scenario for local money-providers. You could have a standard 66.6 recurring, reserve asset ratio, for money providers only. Not for bankers. Not for the rest of us. Only for money providers and only as a way of paying them for the service of keeping the localised coinage up to the highest levels of quality.

You would have one third in the coins themselves (which would be deonominated at three times the value of their actual weight....)

One third would be at the local money providers place of business and in bullion form.

And only one third would be lent out to pay for this service.

Other than this we are putting everything in jeopardy by not going after a blanker ban. Doesn't matter what Mises said.

"If the arguments for and against state regulation of the bank-of-issue system and of the whole system of fiduciary media are examined without the etatistic prejudice in favor of rules and prohibitions, they can lead to no other conclusion than that of one of the last defenders of banking freedom [cite to Horn]:

'There is only one danger that is peculiar to the issue of notes; that of its being released from the common-law obligation under which everybody who enters into a commitment is strictly required to fulfill it at all times and in all places. This danger is infinitely greater and more threatening under a system of monopoly.'"

Here we have Mises essentially cheer-leading for the power of total pure liberty to sort things out. Bear in mind this is before the computer age. But within a few short sentences Horwitz has used Mises to justify a free-for-all, for bank-cash-pyramiding.

Look. Do we have to set up a MACROMANCERS-ANONYMOUS for some of you guys?

Do you people still believe that bank-cash-pyramiding creates new wealth?

See this is MACROMANCY.

Thats what it is.

So you've got to back to school on the structure of production, and find out for yourselves that this total assault on the price mechanism, that bank-cash-pyramiding represents, can create no new wealth.

There is no point mixing this economic fact up with what Mises, did or did not say or what he meant or did not mean and so forth. There is no point trying to pull the leftist reversal, where you are claiming to be more libertarian than the others.

What you need rather is a twelve-step program to cure yourselves of macromancy. Don't be mixing the issue up with these other matters. The reason why the debates continue is the closet macromancy.

Get it seen to for goodness sakes. It appears that macromancy is a harder habit to quit then smack.

Steve wrote:

"Did you read the links from last September where I did present plenty of textual evidence?"

Yeah I read them at the time, and I thought at least a few of them looked pretty compelling, but the guy you were arguing with (not the Purple Haze Lord Bunghole guy, the other guy) came back with decent rebuttals to each one.

I am just making the modest claim that if I just read Salerno's latest, and this one, I think Salerno's case is pretty strong. Or to put it another way, if you really have smoking-gun Mises quotes showing he had no problem with private-sector FRB, then you should use those instead of the one you put above.

"See this is MACROMANCY."

Graeme, perhaps you would care to explain to those of us here on planet earth just what the hell you are talking about?

Well Gene it goes like this: The idea that banks are creating extra investment resources via the act of pyramiding on cash, deserves to be thought of as a pseudo-religious idea. For one thing its obviously not true, and yet so many people seem to believe it. Increasing nominal loanable funds is not the same as having more resources available for investment.

If we look at all the investment resources available to us, we find we are really talking about the proportion of resources that might be either consumed or invested, that are actually invested. So its a ratio of .....

Gross Investment/Gross Domestic revenue.

Creating extra loanable funds doesn't enhance this ratio. It does not cause us to consume less and funnel those resources to productive expenditure.

Yet people talk of this bank-cash-pyramiding as if it were an entrepreneurial exercise that expanded the amount of resources available to the community.

Dan:

I have covered this a couple of times and Lee Kelly did a good job as well.

If those demanding more bank deposits are holding less bonds, then the total supply of credit (the demand for bonds plus the supply of bank loans) is not changed. The market interest rate is not lowered. The firms that would have sold the bonds don't buy capital goods. The firms that borrow from the banks buy capital goods. There is no shift in the allocation of resources between consumer goods and capital goods. Now is their a change in the market interest rate.

If, on the other hand, those demanding more money do so by purchasing fewer consumer goods--saving--then the the additional bank lending is an increase in the supply of credit and the market interest rate decreases. The firms borrowing from the banks buy more capital goods. The households buy fewer consumer goods (saving and freeing up resources) and the firms purchase more capital goods (investing and adding to the production of consumer goods in the future.)

IF there is a mix, where the demand for money involves less spending on consumer goods and less purchases of bonds, then while may the increase in the bank loans is an increase in the supply of credit, that part that matched the decrease in purchases of bonds partly offsets it. The supply of credit only increaces by net by that part of the increase in the demand for bank money that is a reduced demand for consumer goods. So, the decrease in the market interest rate is less. The firms that would have sold the bonds buy less capital goods. The firms that bet the bank loans buy more capital goods. The net purchases of capital goods must matches the decrease in the purchases of consumer goods.

It really isn't that complicated.

Well, it might not be complicated, but deciphering all my typos might be. Sorry.

Bill let me ask you direct: What is your fascination with bank-cash-pyramiding?

The modern "Austrian" support, for the whole scam, appears to rest on some set of circumstances, that are totally unachievable.

Suppose you come to ask my opinion. And you ask me if allowing fractional reserve can "work" supposing that everything else about the financial market, and the rest of the economy, is entirely free enterprise?

If my answer is "YES" its merely a subset of the reality that the market can work around any ONE DEBAUCH that is visited upon it.

But supposing I agree, that so long as not a single local government, a single state government, nor even a federal government, anywhere in the world, should ever accept fractional reserve money as payment.....

... Supposing if under those conditions, I would agree that the market would sort itself out even allowing bank-cash-pyramiding...

WELL SO WHAT?

Suppose me and you agree that in this make-believe world, that fractional reserve wouldn't do massive damage, as it is doing now. I DON'T agree by the way, but supposing I did?

So for your next trick you go along and get a similar admission from George Reisman (lets suppose). You interpolate another admission from Mises and another from Rothbard.

What would be the point of these undertakings?

We have to turn it all around and ask what you and other (un)FREE BANKERS see in this racket. What is it that you people SEE! in these various ponzi-schemes?

Any young undergraduate economist experiences the magic of macromancy. The idea that he is now a sophisticate, and he can create more loanable funds, straight out of his economically-sophisticated mind!....


.... and that this sophistication is all something for nothing.


You've come out in favour of what you call "free banking". Therefore you've come out in favour of bank-cash-pyramiding.

Why?

Let us hear it from you? Because you see I think I know the answer.

MACROMANCY.

Its macromancy that motivates you. You have not weaned yourself off undergraduate macromancy.

Thats what I'm getting.

Thats what I'm getting anyhow.

test

Graeme Bird, I don't understand your point. Calm down and say it again, preferably without the word "macromancy".

Do you have a specific question "CURRENT"?

Or are you just going to sit there with all that egg on your face?

If you were a serious scholar, rather than someone seriously trying to disrupt proceedings, you would have asked me, a question serious enough, for me to attempt a serious answer.

You are asking me a question are you not? Now that we know that you are asking me a question, its time for you to tell me exactly and specifically what it is that I said that you do not understand?

Macromancy never sleeps.

Bird,

Mises very plainly says that 100% reserves are a bad idea and the gold standard is good but free banking is the best guarantee against manipulation.

Free banking is sound. The arbitrage for the price of money and the asset-liability management considerations keep it as a stable, sustainable and low (tending to zero) inflationary system.

It worked where there were no bad policies like restricting branch capitalisation. It worked very well and saw periods of high growth, low inflation and political stability.

Those who support 100% reserve backing need to explain why I'd even bother going to a bank for a loan or operating as a bank.

Fractional reserve is a great idea. In fact, it's the idea that sustains modern banking. It's a system that creates and expands free money, and Mises was correct to support it. Besides, if anything goes wrong, it's not as if the government can't bail out the banks.

Ok Graeme,

Earlier you wrote:
"Increasing nominal loanable funds is not the same as having more resources available for investment.

If we look at all the investment resources available to us, we find we are really talking about the proportion of resources that might be either consumed or invested, that are actually invested. So its a ratio of .....

Gross Investment/Gross Domestic revenue.

Creating extra loanable funds doesn't enhance this ratio. It does not cause us to consume less and funnel those resources to productive expenditure. "

Now, consider what happens when commodity money comes into use. Society recieves the benefit of easier indirect exchange, that is a huge benefit and certainly worth the cost.

However, there is a cost. The commodity money remains in perpetual circulation. It cannot be used for other purposes unless it is taken out of circulation.

But, society can do something about that - fractional reserve banking. In such a system the circulating notes represent debts. We all save because the commodity that would have been used for money can be used elsewhere.

More importantly such a system provides a buffer against changes in the demand for money which would precipitate costly price changes in the economy.

Mr. Bird,

If anyone is disrupting the proceedings around here it is you. I will ask you nicely to please treat the other guests of this blog with some respect, both in your direct interactions with them and by helping them to understand your arguments by using some language that we are all familiar with.

You are a guest in our house and doing the blog equivalent of stamping your feet and yelling at the other guests won't be tolerated by your hosts for very long.

By the way, for those of you who are actually taking Mr. Bird seriously, you might wish to check out his blog and then decide whether you wish to continue this conversation:

http://graemebird.wordpress.com/2010/04/27/the-structure-of-large-murder-conspiraciescomparative-studykennedy-versus-911/

Now for a civil and productive contribution:

I challenge the 100% backing supporters to show me why the following is wrong:

*Assume a generous definition of money – broadly as possible.

MV = PY

Let’s look at MV first.

In each round of money creation, M can only be relatively greater than V if the reserve ratio falls below zero.

This can only happen if there is persistent disequilibrium in the market for currency.

Now, let’s look at PY.

P can only rise faster than Y if the continuing rounds of deposits are not put into viable projects, or the price signal gets distorted by continuing money market disequilibria, or fiscal disruption.

Under the broadest defintion of money, V always rises proportionally higher than M, and so fractional banking is not inflationary.

MV = PY

V>M if r>0 (r is the credit multiplier)

r –>0 in the extreme case.

That is, P can only rise faster than Y if Say’s law breaks down or Sm > Dm.

V>M as long as Say’s law holds. What this means is that the credit creation process is constrained by Say’s law so that if the monetary equilibra is maintained and fiscal largesse doesn’t significantly alter prices and the loanable funds market, that each round of credit creation can only ever continue if it is the result of previous productive economic activity. As r>0, then V must be > M.

There are two killer arguments against 100% backing:

1. Free banking constrains issue and tends to zero inflation due to the loan book constraint (on top of the competitive issue restraints).

2. Fractional banking is not inflationary without prolonged disequilibria and overssuply of the currency base through manipulation of interest rates by a central authority (or breaking down Say’s law for the same reason or continuing fiscal disruption, both distorting prices and resource allocation (from above).*

Ludwig von Mises’ take is below.

Human Action

Ch XVII. INDIRECT EXCHANGE
Sec 12. The Limitation on the Issuance of Fiduciary Media

” In carrying the idea implied in the Currency Theory to its full logical conclusion, one could suggest that all banks be forced by law to keep against the total amount of money-substitutes (banknotes plus demand deposits) a 100 per cent money reserve. This is the core of Professor Irving Fisher’s 100 per cent plan. But Professor Fisher combined his plan with his proposals concerning the adoption of an [p. 443] index-number standard. It has been pointed out already why such a scheme is illusory and tantamount to open approval of the government’s power to manipulate purchasing power according to the appetites of powerful pressure groups. ”

” Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular–one is tempted to say normal–feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.”

” It is extremely difficult for our contemporaries to conceive of the conditions of free banking because they take government interference with banking for granted and as necessary. However, one must remember that this government interference was based on the erroneous assumption that credit expansion is a proper means of lowering the rate of interest permanently and without harm to anybody but the callous capitalists. The governments interfered precisely because they knew that free banking keeps credit expansion within narrow limits.”

Mark Hill,

Though I disagree with the 100% reservists I can't agree with what you have said. Check out the Austrian criticisms of monetarism.

I don't think the monetarists own the qunatity of money relationship. I think it is rather beautiful when you can use the "standard" theories to back Austrian ideas.

Are you saying I'm wrong because I used a "monetarist" heuristic?

Mark Hill,

I don't disagree with the Quantity equation of money. It's a tautology, I can't disagree with it ;).

However, you have to be quite careful about using it.

Firstly, you write:
MV = PY

Now in this equation V isn't really a velocity in the microeconomic sense. Really it's a variable that relates the two sides of the equation. Only in MV=PT does V actually mean velocity.

Next you write: "In each round of money creation, M can only be relatively greater than V if the reserve ratio falls below zero. This can only happen if there is persistent disequilibrium in the market for currency."

What do you mean by M being "relatively greater" than V?

The idea that increasing or decreasing M allows for a particular real Y to occur is based on Monetarist assumptions. It's based on the "homogeneous fund" theory of capital and no Cantillon/Injection effects.

In Austrian theory Say's law isn't a theory that applies to macro aggregates. It's seen as a microeconomic theory. It cannot preclude the existance of misallocation of capital and recessions caused by it. All it demonstrates is that with price flexibility those recessions can't last forever.

To me, FRB just makes no sense, none whatsoever.

However, i can muster one argument against 100% reserves:

you're building a hut complex on a desert island after being shipwrecked, 20 people total on the island say. You need to know if you have enough food to take 10 people from food gathering duty for 1 month, the estimated construction programme. The new daily amount of food being produced during the constructino will be half what it was, but of course the consumption is the same.

So say previously there was a large food surplus resulting in 280 man days of food (28 days * 10 people of food) being stored. as the project is about to start. So the amount stored is almost enough to get the 10 men through the 30 day construction time.

The original large daily food surplus with 20 men gathering food is now of course not possible. Let's say with 10 men only gathering food (but 20 eating) that the daily surplus is S.

The clearly if S is large enough to make up the 2 man days of food that the islanders are missing, they can carry out the project. That is, if when we get to the 29th day, and have eaten the stored food, the islanders accumulated more than 2 days * 10 men's worth over the previous 28, then the project can be completed.

If S too small - if S is such that on the 29th day we look at our food storage and we have not over the previous 28 days accumulated 2 days worth of food (**) - then the project was not realisable ever.

But if you can only borrow existing funds (ie. we are in 100% reserves) then this means that there are some projects that are actually realisable which will not be undertaken, when they could have been undertaken with fractional reserves. that is, those occasions when S is small enough to mean that the full 30 days of food does not exist prior to starting the project but large enough so that the missing amount would be saved to be usable before it is required during the construction period.

I think that every single sensible argument for frb must ultimately boil down to this question - they must show that there are concrete cases when more desirable stuff gets made than does under 100% reserves.

Firstly, anyone got any complicating factors i have overlooked here?

Secondly, as it is, i don't think this is a very good argument, it doesn't convince me - frb is a joke and I want to say ban it outright. But this bugs me. I can think of ways to get round this argument eg. you could borrow in stages (ie. for periods shorter than 30 days); or you could say that this is all true but the ravaging of the price-system is not a price worth paying for slightly increasing the number of startable projects, and those projects will then just have to wait. But though the latter is absolutely true I'm sure, I'm not entirely happy with either of these rebuttals, they seem a bit weak.

Anyone have any thoughts.

(**) Smart alecs amongst you: I'm aware on the last (30th) day you can also consume what what gathered on the 29th day so this is not quite right but it only complicates things unnecessarily, the point is still the same.

John Malone,

I don't think you're right in detail. But, you are right in general principle...

There is a difference between 100% reserve banking and fractional reserves. At any given time there are people holding money and not spending it. In a fractional reserve system such an action is almost equivalent to saving. In a 100% reserve system it isn't, in such a system money isn't consumption or saving.

Now, using one or the other cannot affect the real supply of capital, and it doesn't. What it affects is the marginal cost of allocating it to different purposes. In a fractional reserve system all that's needed for saving is the holding of fiduciary media. In a 100% reserve system a timed bond must be purchased.

To use Sunstein and Thaler's terms from "Nudge" in fractional reserve systems saving is the "default".

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