Mises and Free Banking -- Why Is There a Debate?

|Peter Boettke|

I realize this often leads to an unproductive debate, but I am in Indianapolis for a conference on monetary economics, and we are reading Mises's Human Action.  On p. 443, Mises makes the following argument:

"But even if the 100 percent reserve plan were to be adopted on the basis of the unadulterated gold standard, it would not entirely remove the drawbacks inherent in every kind of government interference with banking.  What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract.  If banks are preserved as privileged establishments subject to special legislative provisions, the tool remains that governments can use for fiscal purposes.  Then every restriction imposed upon the issuance of fiduciary media depends upon the government's and the parliament's good intentions."

Mises goes on to explain that this will only work during "normal times" but any situation deemed an "emergency" will lead to "extraordinary measures" to meet fiscal demands of the state.  So Mises follows up by stating quite clearly that:

"Free banking is the only method avaiable 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 the information required about their financial status.  But under free banking it would be 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."

Steve, I will hand this over to you, and I know you have pointed this out before, but why did this debate ever get started concerning Mises's ideas?

Comments

[Steve Horwitz]

I wish I had a good answer Pete. I think the best one is something like this:

There *are* passages in Mises where he argues against "fiduciary media." (I think those have to be read in context, as I argued in that series of posts last year.) Along comes Rothbard, taking on the mantle of Mises's student and interpreter, who reads his own 100% reserve position, derived, I would argue, at least as much from an ethical position as an economic one, into Mises and makes it part of the Austrian "canon" in MES and later writings. So, by transitivity, if Rothbard=100% reserves and Rothbard=Mises, then people read Mises that way too.

And "coming of age" as a libertarian in the late 70s and early 80s, (in the "Pre-White" years :) ), 100% reserves WAS the Austrian alternative to central banking. I believed in it at that time. If Murray said it was the Austrian position and you could find some quotes in Mises that appeared to back it up, then it must be Mises's position as well.

In the post-White years, the story is more complicated I think and is as much about the internal politics of the Austrian movement as it is about economic theory and the actual texts in question.

To read Mises as a 100% reserves supporter is to disrespect him as a historian of economic thought and a great monetary theorist. The guy knew his shit and he understood monetary theory better than just about anyone who claims his mantle on any side today. To think he rejected the basics of monetary theory that inform the ME/FB argument is to say that he didn't understand some pretty fundamental economics.

The Rothbardian reading of Mises, both on banking issues and the related issue of the cycle, has taken many folks down a particular path of understanding that seems to prevent them from stepping back and looking at what Mises actually said.

I also think it has distorted their understanding of how banks actually work. As I read consumers/fans of Austrian economics talk about these issues on the web, I'm just stunned at the combination of self-righteous certainty and utter ignorance they display about money and banking issues. And sorry if that sounds elitist folks, but this is about basic economics that you would learn in any monetary theory or money and banking course without which you cannot make any sense out of the FB/100% reserves debate. These folks are guilty of money and banking theory malpractice.

One final point: I also think it's part of what I've called "libertarian contrarianism." There is a species of libertarian who thinks libertarian requires that one take "contrarian" positions on as many issues as possible. Think of it as a politically correct anti-political correctness. The more contrarian, the better. 100% reserves fits this mindset much better than free banking, as the latter is rooted in both mainstream monetary theory in many ways and doesn't have the ethical piece to the puzzle. The 100% reserve argument appeals to this species of libertarian and those folks just assume that if Rothbard believes it and says Mises did, then it must be true.

So I think the answer to your question Pete has everything to do with the lived history of the American Austrian movement and the way in which Rothbard's reading of Mises became canonical and still dominates among the consumers, as opposed to the producers, of Austrian economics.

[Matthew Akin]

I never really understood the argument that we need 100% reserve banking, outlawing free people from a contractual fractional reserve under penalty (what penalty, exactly). Is that not an extremely draconian bit of regulation?

Of course, free banking does not remove the possibility of 100% reserve banking if people want it (and want to pay fir it), while it appears that 100% reserve banking would remove the possibility of any other form. How does this advance freedom?

[fundamentalist]

I agree with Steve that it's primarily an ethical issue. I think Rothbard made a grave error in creating his ethical system and injecting it into economics. As much as I like de Soto's book, he does the same thing. When people have ethical certainty, no matter how faulty the ethical system, they are hard to talk to. And with that certainty, they have a tendency to read into Mises, whom they admire, their own system, instead of using sound hermeneutics.

[Tom]

Can you guys answer a noob question for me? Isn't loaning out more money than you have fraudulent behavior?

I've read some Mises, Hayek, and Rothbard, and not very much but enough for my consumerish perspective. I also think that we should have a totally free currency and banking system, let the market figure out the winners.

But I do think there is one legitimate role of government, and that is the protection of the individual and their property against the use of force or fraud.

So, if you can make $1000 in loans when you only have $100 in reality, and then if those people don't pay on their loans you become the new owner of the property which they didn't pay for, how is that not fraud?

I'm genuinely interested in understanding the difference. I understand how FRB "works" in the economic practice sense, it's the philosophy that I can't get my head around.

[Gary Chartier]

Tom, it seems as if the practice is fraudulent if you inaccurately represent your financial position. If your customers know that you're a fractional reserve lender—and most people know that contemporary banks are, indeed, fractional reserve lenders—where's the fraud?

[Steve Horwitz]

Tom,

You are confusing several different things here: liquidity, solvency, and fraud.

Fractional reserve banks promise to pay liability holders "on demand." As long as any time you go to the bank and demand base money for your note or deposit they are able to pay it, they have lived up to their contract. The "contract" you sign for a checking account today makes this clear. You are loaning money to the bank and they are loaning it out to others. Failure to pay "on demand" constitutes breach of contract, not fraud. And it's not fraud because FRBs are not "inherently" unable to pay.

And this ties to liquidity. The challenge for fractional reserve banks is to ensure that they have sufficient reserves on hand to meet the demands of customers "over the counter" and other banks through the clearing process. If a free bank comes up short, then it will have to liquidate other assets to pay off liability holders. As long as it is *solvent* - that is, as long as its assets are equal to or greater than its liabilities, it can do this.

It might take some time. They may not be able to pay liability holders instantly (on demand), which is why many fractional reserve banks historically had things like "option clauses" that give them the ability to delay payment by compensating liability holders for the delay. This was a way for solvent but illiquid banks to get sufficiently liquid to meet depositor demands.

Again, no fraud here as the contract spelled all of this out. Fraud requires deception. There's no deception here. Historically, fractional reserve banks in very free (i.e. no central bank, little to no regulation) systems worked on about 2-3% reserves and had very few failures.

Here's a good place to start: http://mises.org/journals/rae/pdf/R92_5.PDF

[Jonathan Finegold Catalán]

Professor Horwitz,

Haven't you misrepresented Rothbard's and Huerta de Soto's arguments a bit? While Huerta de Soto does make a case for a banking system with 100% reserves by regulation, he does this under with the caveat that this system would exist within a banking system regulated by the state. In other words, he is proposing a banking system within the modern, regulated framework. This does not represent what he ideally wants, which is free banking.

Isn't the actual argument between free bankers and 100% reservists whether or not banks will be able to practice banking with fractional reserves without suffering from insolvency? Mises does explicitly suggest in much of his writing that the issuance of fiduciary media would be extremely limited with free banking.

[Steve Horwitz]

I didn't mention De Soto at all. Rothbard's preference is clear, however: the ideal system is 100% reserves because fractional reserve banking is fraudulent, even without a central bank. Pete's question was "how did we get to this understanding of Mises?" Rothbard's, and not DeSoto's, views are the key to that answer.

And that's not the "actual argument" among all in this debate. There are those who hold to the Rothbardian position that FRB is fraudulent and therefore the economics don't matter.

Yes, Mises does suggest that. That's an empirical/historical prediction about which I think he is incorrect. And in any case, fiduciary media are not something to be afraid of or think it is ipso facto good to "minimize." I don't know the right amount of fiduciary media to have or whether less is better - that's what the competitive market process is for, just like it's for figuring out how many pairs of shoes it is best to produce.

[Tom]

Thanks Steve. I will read that PDF.

I still am having trouble with the idea because it just seems like a path right back to where we are today. I mean what happens when more than one person demands their deposits and the bank says "well we don't have it now but we'll pay you back over time." Obviously the next step is that those people will tell all of their friends and a run on the bank will ensue. Then the bank will fail, and nobody will get their property back.

Now, in a free market, it's your choice to use an FRB or not, so that's a risk you're taking. But in a modern democratic society, if we were able to achieve a libertarian free market, how long would it last after banks start failing left and right? It seems like we'd be setting the stage for 1913 all over again.

[Mike Sproul]

"what happens when more than one person demands their deposits and the bank says "well we don't have it now but we'll pay you back over time.""

If a bank has issued 300 checking account dollars, against which it holds 100 green paper dollars, plus various IOU's worth a total of $200, then the bank can sell the $200 of IOU's for its own checking account dollars, then use its 100 paper dollars to buy back the remaining 100 checking account dollars. Fractional reserves is not a problem. Loss of assets is the problem. If the bank's assets total $299, that bank will face a run even if the whole $299 was held in green paper dollars.

Remember that the 'extra' 200 checking account dollars were issued in exchange for IOU's in the first place. There's nothing wrong with retiring the $200 with those same IOU's.

[Current]

Part of the problem here is that we're used to thinking of money as a store of value. We take that thinking and apply it to the banker.

But, to the banker the notes that he has created aren't really a store of value. They're a liability because he may be called on them.

What's difficult to understand is that in a free-banking system each note must fully backed by assets. Because if the liabilities of the bank exceed the assets the bank becomes insolvent and a bank-run and bankruptcy follow.

[Current]

Mises does sometimes quite clearly take the Rothbardian view. See page 194 of "The Causes of Economic Crises" for example, where he actually does say that creation of fiduciary media is creating money out of nothing.

[Peter]

I agree that fractional reserve banking is not fraudulent, but I'm not too sure if it would work without a lender of last resort. You probably know Mencius Moldbug and his ideas about maturity transformation. If not:

http://unqualified-reservations.blogspot.com/2008/09/maturity-transformation-considered.html

Professor Boettke, Professor Horwitz, I would really appreciate your opinion on this.

[Per Bylund]

Isn't the problem with this debate that fractional reserve banking *must* be fraud if it is conducted under secrecy? This is a point I never see raised; most people seem to say that fractional reserve banking is "not fraud" or that it "is fraud," as were they obvious and binary choices. I see no problem, from a libertarian law perspective, in "allowing" (whatever that means) FRB if the FR bankers don't keep their FRing a secret from their customers.

If bankers keep other people's money in a safe place and promise they can have it back at any time, and then turns to use that same money themselves without explicit permission (and perhaps risk losing them) - then this behavior is by definition fraudulent. If the parties have agreed contractually on this sort of thing I can't see how it would be fraud (but I do see some philosophical problems re: ownership and control). If they haven't agreed, then the bankers have no right to engage in such behavior.

[Steve Horwitz]

Peter,

FRB has worked just fine without a LOLR in a number of historical circumstances. There's lots of history out there to support that claim. In fact, it's the very existence of a LOLR that tends to DE-stabilize FRB systems.

Read George Selgin's piece in the new issue of Independent Review.

[Current]

Some of what Mencius Moldbug says is very good and sensible, a lot isn't. He's very uneven. It's worth reading more around everything he says.

He's a sort of amateur version of Tyler Cowen, who's similar.

[Lawrence H. White]

Pete asks why anybody thinks Mises favored 100% reserves. Few do. Rothbard himself recognized that Mises opposed 100% reserves. People who argue for 100% reserves rely on Rothbard (or Huerta de Soto, or other post-Rothbardians), not on Mises.

Jonathan Finegold Catalán's writes that Huerta de Soto favors a 100% reserve requirement only within the current government-regulated system, but such a requirement is not "what he ideally wants, which is free banking". That's news to me. Could you direct me to where he say that in print?

[Classical liberal]

If I'm not mistaken, Johnatan Finegold Catalán means that Huerta de Soto argues for a state-enforced outlawing of FRB within the current statu quo. Ideally, he would favor a private-enforced 100% reserve banking on the basis of principles of law. He considers 100% reserve banking as a matter of - sort of - natural law, which could be imposed by private agents. He defends that a 100% banking system would be 'free' because it would be in accordance with principles of law; a contrario, he believes that FRB is a state privilege, non-complient with those principles of law, which surged from spontaneous evolution and so on.

So, no news at all. I don't find these arguments compelling from either a legal/etical or economic point of view.

"I also think it's part of what I've called "libertarian contrarianism." There is a species of libertarian who thinks libertarian requires that one take "contrarian" positions on as many issues as possible. Think of it as a politically correct anti-political correctness. The more contrarian, the better. 100% reserves fits this mindset much better than free banking, as the latter is rooted in both mainstream monetary theory in many ways and doesn't have the ethical piece to the puzzle. The 100% reserve argument appeals to this species of libertarian and those folks just assume that if Rothbard believes it and says Mises did, then it must be true."

Mr Horwitz makes a very good point here. In my opinion, a bias towards contrarianism helps to understand most of the libertarian and AE flaws. Take, for example, those who want to end the limited liability for corporations, or those who promote absolute monarchy as a remedy to the 'decline of the Western civilization'.

[Othyem]

Perhaps much of the hostility toward Free Banking from the Austrian (or should I say, Rothbardian) camp stems from the assumption that with Free Banking we would have FRB and with FRB we would get business cycles. Thus, beneath it all, there is a serious reluctance by some to grant that power to the unhampered market if it is it--the unhampered market--that is *also* capable of touching off a boom that results in a bust. And, of course, this doesn't bode well for those who take it for granted that the "unhampered market" is inherently stable, and business cycles can only be precipitated by an exogenous force, such as government. This *might* have been why Rothbard was so against FRB and therefore it explains why he would need to equate it with fraud in order for it to be outlawed in a Libertarian society.

[Current]

Othvem,

That's quite right. According to Rothbard a bank isn't capable of estimating when it's depositors will call on their gold. Rothbard considers that to be properly _uncertain_ not a matter of probability.

[Peter]

Professor Horwitz,

thanks for the hint. I just downloaded Selgin's piece.

[Current]

I think that the limited liability thing is also about perspective more than contrarianism. Few have their own businesses and understand how other businesses can build the risks of limited liability into their prices.

[Andres Guzman]

Although I rarely comment I am tempted to do so.

I am not a Rothbardian, just to be clear. But I am also not an extremist, in the sense of putting free banking on a pedestal, like some here do.

To be sure, Adam Smith described free banking as a good thing WHEN well regulated, and dismissed central banking as something totally unnecessary. But by "well regulated" he meant a lot of things which I doubt today's free bankers would like.

First, he argued that banks should not lend long term. If one follows the argument carefully, it boils down to Smith saying depository institutions should not be investment institutions. Sure banks can lend their short term deposits (because most of their deposits are short term), but only for short term loans (cash accounts, etc). Basically: banks should match the maturities of their balance sheets and for that reason they cannot be long term lenders (indeed what I mean by investment institutions).

Second, Smith did not like option clauses, he saw them working in practice in his time, and he said they DON'T work. I don't know why people who did not live back then keep on insisting they do work.

Third, the borrowing market has a strong tendency to want to get easy money from banks, and device ways of outsmarting banks in order to get them to over issue or increase the velocity of money beyond what's needed. Drawing and re-drawing being one example.

Fourth, businesses across all trades attempt to combine, and Smith specifies which businesses will tend to be successful in doing so and which won't. According to Smith's specifications, banks will (and banks have, we call it the Fed).

Fifth, before I go over this one I need to briefly say that the so called bank-deposit multiplier which Rothbardians use is a myth, they are just describing the velocity of money. Under a legal tender system private banks do not create money. Period. That said, under any system, legal tender or not, free banking or not, there is no market mechanism which can control the velocity of money. Smith describes how the deed of assignment can represent a greater amount of loanable capital than its own number, indeed by describing a bank deposit multiplier without reserve requirements. And this is not an issue of issuing more or less money: once again, no money need be issued, we are speaking of the velocity of money here. So with a banking system where depository institutions also lend long term (and assuming one bank for simplicity, although assuming many banks doesn't change the conclusions not even a bit) we get borrower A getting a loan from the bank and paying B for a purchase by transferring A's deposit (the money the bank gave him is at the bank in his account)to B's account. The bank decides how long it will go by before it gives out another loan. If it decided to let two weeks go by, then the velocity of money would be x, if it let one week go by, then the velocity of money would be more than x. No money was created. As long as the bank can manage to have B's money when B wants to take it out, within that period the Bank can extend an amount of loans of a wide range in size. There is no mechanism which will control this in the type of free banking which some here have in mind. And if the demand for loans has a strong tendency to over-borrow, which Smith says it does, then we have a problem. One way of solving this problem is to divide between depository and investment institutions.

Sixth, Smith's position on the legal rate, you all know this so I need not mention it. But I will note that the purpose of the legal rate, once again, was to avoid loans going to that part of the demand for loans which is prone to over-borrow (projectors and prodigals).

100% deposit banking might be a joke, or might not. But free banking is no strawberry either. So let us not put it on a pedestal, let us be realistic. That said, I a for free banking, but not any type of free banking.

Best,

Andres Guzman

[David Tomlin]

Classical liberal:

Take, for example, those who want to end the limited liability for corporations . . .

AS with FRB, there is nothing wrong with limited liability by voluntary contract. But limited liability for tort claims would seem to be a market distorting subsidy. Am I wrong? How so?

[Current]

Andres Guzman,

What did Smith say against option clauses? Why?

[TGGP]

"There is a species of libertarian who thinks libertarian requires that one take "contrarian" positions on as many issues as possible"
Reminds me of something Robin Hanson has written:
http://www.overcomingbias.com/2007/06/how_to_be_radic.html

Also, this from Eliezer Yudkowsky:
http://lesswrong.com/lw/1kh/the_correct_contrarian_cluster/

[Andres Guzman]

Current,

I assume you are trying to make a joke, or a point about something, since I assume you read this stuff already. Asides from the paragraph where Smith specifically mentions optional clauses, you also have the concluding paragraph by Smith on the subject of money:

"If bankers are restrained from issuing any circulating bank notes, or notes payable to the bearer, for less than a certain sum, and if they are subjected to the obligation of an immediate and unconditional payment of such bank notes as soon as presented, their trade may, with safety to the public, be rendered in all other respects perfectly free."

In view of paragraph 98, paragraph 106 above, where we read "immediate and unconditional" has no other interpretation. Like it or not.

Furthermore, note the order of the specifications above regarding first, the restriction of notes to large sum notes (in order to avoid over-issuing and frauds caused by beggarly bankers on poor people) and second, the call for immediate and unconditional payment. Now see this sentence from paragraph 98:

"The same Act of Parliament which suppressed ten and five shilling bank notes suppressed likewise this optional clause."

Again, indisputable interpretation.

Best,

Andres Guzman

[Toby Baxendale]

I see the current debate of pitching Fractional Reserve Free Banking (FRFB) and 100% Reserve Free Banking (100FB) as being against each other as not being very productive. We in the Austrian School become like the Marxist who discuss the canonical works of their founder(s) and argue the toss on a few sentences here and a few there. This is perhaps why the Austrian School is still a backwater of academia. If the Austrian School could put the wealth of their intellect to use to focus on providing the world with solutions to their immediate problems , as the Keynesian and Monetarists think they are doing, the world would be better for it.

De Soto does this. In Chapter 9 of his book, convert demand deposits into cash by the state printing enough money to do this. The money supply is made up of both demand deposit and cash, swapping one for the other does not increase the money supply i.e. this is not inflationary. As banks would then have no current liabilities to customers, they would be very heavily impregnated with assets only. Take these assets into mutuals and pay off the national debt. In the UK, where I write from, this would be transformational for the finances of the nation. THIS IS A MAGNIFICANT PLAN. IT IS A ZILLION BILLION TIMES BETTER THAN ANY OF THE MAINSTREAM RUBBISH ON MORE REGULATION, TIGHTER CAPITAL CONTROLS, MONETISING THE DEBT TO SOLVE OUR NATIONS PROBLEMS.

Require banks to hold 100% reserve and make depositing customers custodian clients as this is what the majority of people (mistakenly) think they are getting involved with when they place a deposit in a bank. This is clearly confusion on the depositors part. However a basis tenant of the law of contract is that two parties must have the same intentions to create legal relations. This area of confusion could be cleared up very quickly. Clients, who want interest on their deposits, allow them to lend to the bank on a long term basis, so the banks can lend long to their entrepreneurial clients in security of not having a mis match of security problem. Another easy contractual arrangement to codify. Allow hedge funds or indeed banks to set up high risk deposits whereby you knowingly pool resources when you deposit into these high risk funds that they are lending with leverage. All should be satisfied by this system as they are contractually very clear positions or products on offer that are all consistent with a liberal run system i.e. a custodian contract for safe keeping, a lending contract to facilitate a contract of the granting of real credit out of savings and a leverage contract. I spell out my position more here, http://www.cobdencentre.org/2010/03/free-banking-the-balance-sheet-and-contract-law-approach/ .

Concerning the latter, Mises was very aware as you can see from Pete’s first quote that for the current fractional reserve arrangements to stay in place, it does require a grant of privilege from the state to keep the whole system running. This allows a current creditor to have their money used and no provision made for it. All solvent companies are 100% reserve in character. We as business people are required to keep our current creditors whole (currently in my business, if I did not, I could take a £9m dividend – that would set me up nicely!) , a fractional reserve bank is not. As hopefully a consistent liberal, I cannot countenance a grant of legal privilege to one class of person at the expense of another. This smacks too much like a grant of privilege to a trade union to run a closed shop or some such other monstrosity. A leveraged account can work to satisfy both the Rothbardian tradition and the FRFB tradition. If the leveraged account is always audited to the normal standards of the commercial law and assets held on the other side of the balance sheet of the leveraged account, are continuously valued to market, up and down, and notes (I would suggest shares in a mutual environment as Kotlifoff does with Limited Purpose Banking http://www.cobdencentre.org/2010/04/jimmy-stewart-is-dead/ ), but the fixation of the FRFB School on notes will be continued here) are issued, could be issued that would get their own trading value, I would have no problem with this, nor would I expect Rothbard or any of the FRFB School.

Talking of fraud is un productive. We should aim to sort our contractual confusion that exist within the client / banking arrangements, make all parties work within the normal commercial law and I cannot then see what the fuss is about. More importantly, once this clarity is gained, the Austrian School should get is great powers behind providing solutions to today’s massive economic problems, as De Soto has suggested and do something great with their / our knowledge and talk to the world and not to ourselves.

[Classical liberal]

"AS with FRB, there is nothing wrong with limited liability by voluntary contract. But limited liability for tort claims would seem to be a market distorting subsidy. Am I wrong? How so?"

That's a borderline case, indeed. Limited liability for tort cases has been critizised by mainstream legal and economic scholars. So, it's arguable.

Others say that it's not the corporation who inflicts the tort, but concrete people related to it. That is, an oil spill in the sea can't be caused by the oil corporation as a legal entity. The tortfeasor would be, say, the person who was controlling the ship negligently.

It goes without saying that many tort cases could be channeled by contracts. For example, a surgeon could rule liability out through a contract with his customer in exchange for a shorter price. The same could be applied to any potential tortfeasor who is linked to a potential victim by a contractual relation.

Anyway, I don't believe excluding limited liability for tort claims would have a significant effect disencouraging big corporations, as some people says. Limited liability for debts would surge through contractual arrangements in the 'libertarian utopia'. In the present system, creditors accept tacitly or implicitly the limited liability, asking for higher interest rates and/or guarantees.

By the way, as a spanish, there's something I have to say about Jesús Huerta de Soto. Spanish naming traditions are different from american: "Jesús" is the name, "Huerta de Soto", the first surname, and "Ballester", the second surname. "Huerta" isn't like the "Newton" in "Murray Newton Rothbard", so it can't be supressed. "De Soto" is just the second half of his first surname. Hence, the proper way to call him is "Professor/Mr Huerta de Soto".

[Current]

Andres Guzman,

I wasn't joking I haven't read that part of Smith. Thanks for the reference.

[Current]

Toby Baxendale,

I'm not sure about the plan you propose. Have you read about the practical problems with running 100% reserve banks that Selgin and Horwitz mention.

I also don't like the idea of expropriating the assets of banks.

[Peter Boettke]

Folks,

Toby Baxendale makes an important point about relative alternative policy options. We need to remember that we cannot let the best be the enemy of the good, and we also have to remember that we begin from the here and now, not some ideal start state, and we have to think about ways to transform the existing situation into a more sustainable one.

And saying our current situation (here, in Greece, in the UK) is "hopeless" is in effect to say it is "ideal", since we know we are not in an ideal state, we have to propose reforms to change the situation.

Rather than continue to engage the unproductive debate about who or what is the true Misesian position, it might be useful to think about what would be the better policy adjustment in the world we live in --- one of monopoly supplier of money, and one where the fiscal restraints have been lifted for all practical purposes. We can, and must, do much better.

Pete

[Toby Baxendale]

To the blogger “Current”
To make matters simple, I propose my own plan – the Baxendale Plan.

Main Title: The Three Door Bank

Subtitle: Pay of the National Debt and Give a 28.5% Tax Cut

Main Title

Door 1 “The 100% Door,” cash is kept as cash.

Door 2 “The Lending Door,” savers lend their money to the bank to on lend to borrowers.

Door 3 “Financial Innovation Door,” the be housed in a Mutual wrapper i.e. you place your money in the open ended or closed end mutual and in effect take shares when you deposit, the fund manager / banker can then to whatever the remit of the Mutual is including leverage (if allowed by the terms and conditions), so long as the standards of the normal commercial law are exactly applied to this vehicle. As it is a mutual, if it goes bust, it goes bust only on itself and requires no Central Bank support to keep its activities alive. It cannot wipe out Door 1 and Door 2 custodian account cash or lent savings.

Subtitle

Pay of the National Debt and Give a 28.5% Tax Cut
Inspired by Huerta De Soto (thank you blogger “Classical Liberal” for the naming correction), convert all demand deposits: £850 billion to cash. Banks have no current deposit liabilities, to the extent that they did in the past, to that exact same amount, remove the equivalent assets from the banking system and place in Mutuals that are run by their former owners for a fee. The banks have the same net worth prior to the reform and post the reform. These pay off the national debt.

With no national debt, in the case of the UK some £850 billion, we would not have to pay the £40 billion in interest service. This is more than we spend on education and defence.

Give and immediate 28.5% income tax cut. Income tax currently raises £142 billion per year.

Peter and your readers let us do something amazing for our countries and do a reform like the above and set us on a much sounder financial footing. From there we can then argue about various fine free market tuning to the financial system points of order.

[Steve Horwitz]

Andres,

Yes, Smith was against option clauses and small denomination notes. This is not news to those of us who think free banking is desirable. Bottom line: Smith was wrong. The "argumentum ad Smithum" is a logical fallacy. ;)

[Current]

Toby Baxendale,

I understand your plan, but I disagree. Think about the current role that money is playing in the economy.

I'm a Brit too, until recently I had £35K on deposit in savings with a building society. That money is money stock.

Consider what would happen if we did what you were proposing. A 100% reserve bank cannot give interest. When my savings & checking account money is converted into monetary base I can't recieve interest on it.

However, I want interest. I'm not holding it in a savings account because I care about being able to access it frequently, I'm saving it because it pays interest. So, what would I do when your plan or Huerto De Soto's plan is implemented? I would take my money and buy bonds or assets. Everyone in my position would do the same.

As things stand bank account money fulfills two functions, it is a medium of exchange, and it is a means of saving and earning interest. If the latter function were abolished then the use-value of holding bank account money would drop sharply. The demand for bank account money would consequently fall. What monetarists call the velocity of money would rise steeply and price inflation would result. Especially asset price inflation as people invest more in bonds and stocks.

That inflation could well be high enough to negate the benefit of paying off part (or all) of the national debt. I think in practical terms the only way to deal implement a plan like this would be to replace deposits with a mixture of money and bonds. In that case it wouldn't be possible to a large amount of assets from banks and use them to pay the national debt.

[Dan]

Steve,

"To read Mises as a 100% reserves supporter is to disrespect him as a historian of economic thought and a great monetary theorist."

Where did Rothbard actually claim that Mises was for 100%? I think you're misrepresenting Rothbard.

The original comment by Peter Boettke about Mises' quote is a bit frustrating.
I don't know how you guys manage to interpret Mises in such a way. I think it was pretty clear that Mises would argue for a free banking system but only because it can best restrict credit expansion. And that was his goal: to restrict fiduciary media. 100% was often rejected because of practicality problems; not trusting the government,or enforcement issues, etc.. I think the quote from HA, in its full context is fully compatible with this view.

[Steve Horwitz]

Dan,

I didn't mean for that comment to be about Murray. It was more about anyone who does that. My argument is more that in the "Austrian public's" eyes, because Rothbard is perceived to be the faithful interpreter of Mises, they tend to read Mises as supporting 100% reserves.

As for your interpretation of Mises, you might want to read these three posts of mine from last September along with the comments there. The last post is the most directly relevant.

http://austrianeconomists.typepad.com/weblog/2009/09/mises-defining-inflation-the-monetary-equilibrium-way-in-1951.html

http://austrianeconomists.typepad.com/weblog/2009/09/is-it-white-is-it-selgin-is-it-horwitz-.html

http://austrianeconomists.typepad.com/weblog/2009/09/mises-and-his-call-for-100-reserves.html

[Current]

Steve Horwitz,

I know you have an RSS feed for each comment thread. The problem with that though is that it's necessary to subscribe to each thread individually. Is there a comment feed that contains all comments for the whole blog?

Also, do you think that I'm writing in my criticism of Huerto De Soto's plan?

[Dan]

Steve,

I am familiar with those posts. But I don't buy the idea that Mises was leaning towards some Monetary Equilibrium theory. I am well familiar with all of Mises' main works, and in my opinion, as far as what distorts the structure of production, I think Mises was unambiguous (at least most of the time) that any amount of fiduciary media will distort the structure.

Maybe you can help me here.
There seems to be a big difference of opinion regarding much more fundamental economic issues. One of them is Capital Theory and even the essence of money. I am in the opinion that Monetary Equilibrium is flawed. It seems plausible at first, but under careful scrutiny, it seems to make many of the same errors of Monetarists. For example, I am mostly in agreement with the criticism of the theory as presented by de Soto on page 688 - The Theory of "Monetary Equilibrium" in Free Banking rests on an exclusively macroeconomic analysis.

http://mises.org/books/desoto.pdf

I have searched endlessly for an adequate response to this criticism. Selgin has recently been confronted with this line of criticism here:

http://mises.org/Community/forums/p/16302/328296.aspx#328296

And I have found his responses to be unsatisfactory. Perhaps you have some other responses that you can offer. perhaps someone has already addressed and responded to these issues and I am not aware of it.

[Current]

Here's my plan...

In the short run spreading austrian ideas to economists is important. I think that if Central bankers were more aware of the ABCT they would perform better. Though they are challenged by the knowledge problem, so they still wouldn't perform as well as they could.

In the long run we want free banking, but that's not possible directly.

So, what about the medium run? There are two problems, firstly, central banks can inflate and don't know how to manage the demand for money. Secondly, commercial banks are backed by the central bank and their depositors by government insurance. That means commercial banks and depositors are not really incentivised to do a good job.

These can be dealt with together by gradually eroding their privileges. Let's start with legal tender, I think that legal tender law could be quite easily repealed. The problem is taxation. Even this though could be dealt with by modern technology. The state may continue to only accept one currency, but computer systems could be used to do conversion whenever taxes need to be paid.

The protection provided by deposit insurance and the Fed could be eroded by charging banks and customers for them. In Britain many people have moved over to savings bonds recently from savings accounts because of much better rates. A similar thing would happen if savings accounts at central-bank backed banks were taxed but savings bonds (and perhaps accounts) issued by other business weren't. If that happened first then people would become used to the odd bond supplier going bankrupt. After a few years they would become aware that any financial institution could fail and would shop around for sound one.

After that I think that central banks would naturally diminish in importance. Insitutions completely separate from the central banks would emerge, clearinghouses would emerge. Big existing banks would reincorporate themselves. A few legal changes would be necessary to allow chequing accounts to function without the central banks.

[Nikolaj]

Professor Boettke, the reason why this debate started was that Steve denied that Mises considered 100% system superior to the fractional reserve system in terms of eliminating the business cycle. And he cited as an "argument" for this the passages you quoted from Mises, where he advocated the free banking. Steve just forgotten to mention that Mises believed that fiduciary media is causing the business cycle in whatever system it is emitted. The reason why Mises advocated the free banking is that he believed that it would expressly eliminate ALL new fiduciary media from the system, and not because he believed that free banking will somehow manipulate the fiduciary media supply better than CB in order to dampen the business cycle (as Steve and other free bankers today believe). Even George Selgin conceded this and criticized Mises for that doctrine. Steve is still in denial. But, I am wondering why is that so important now when you are not the Austrian economists anymore?

Let me quote Mises himself in order to refresh your memory what the debate really was about:

"The possibility of causing temporary fluctuations in the exchange ratios between goods of higher and of lower orders by the issue of fiduciary media, and the pernicious consequences connected with a divergence between the natural and money rates of interest, are circumstances leading to the same conclusion. Now it is obvious that the only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media. The basic conception of Peel’s Act ought to be restated and more completely implemented than it was in the England of his time by including the issue of credit in the form of bank balances within the legislative prohibition."

Steve's rather bizarre interpretation of this passage from TMC was that Mises required 100% only for CB system, and not for free banking. In other words, when fractional reserve free banks emit the fiduciary media, according to Steve's "Mises", that would not create any malinvestment whatsoever but would have the beneficial effects compared with the zero emission in the 100% system. However, Mises himself in HA repudiated directly and unequivocally this Steve's interpretation, reiterating that any amount of fiduciary media leads to business cycle.

"The notion of “normal” credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle. Of course, if the additional amount issued is not large, neither are the inevitable effects of the expansion."

Mises Human Action pp 442.

Those were the reasons for the debate.

[Steve Horwitz]

Dan,

FWIW, my own analysis of monetary equilibrium theory is explciitly grounded in Austrian microeconomics/capital theory in my 2000 Routledge book. A quick glance through that section in Huerta de Soto indicates no references to my book. I don't know if you've read it either.

More generally I would argue that the ways in which the ME argument might overlap elements of monetarism is a feature not a bug. The monetarist tradition and the the Austrians share some common roots in 19th century monetary theory (as Mises rightly understood), so such overlap would not be a surprise. And I make no apologies for making use of, for example, MV=PY as a convenient shorthand. Again, I think if you read my book, which has a whole chapter on capital theory, you might see the ME argument a little differently.

I'm not interested in what's purely Austrian; I'm interested in what's right. And I think MET can be built upon an Austrian microeconomic foundation, which is what the whole book is about.

[Current]

Dan,

Rather than discuss a whole lot of complaints and a huge thread on mises.org, why not say what particular issue you have with MET.

[Toby Baxendale]

To the British Blogger Current

I fear you either do not understand what I say or I do not make clear enough for you to understand, if it is the latter, I apologise.

Door 1

This is the nice and simple safe deposit where the bank is a custodian to you and at all times is a fiduciary. If you went to Harrods rented a safe deposit box you would have to pay for it. This could be one option. Second option, you could have your cash converted into a government bond with a same day repurchase order attached to it. This would give you immediate access and safety. Notice it is only as safe as your government and your currency, but then even in a 100% world where currency is in paper, if your government goes bust, your paper is worth zippo anyway. This would give you a rate of interest.

This door does what it says on the tin – keeps you money safe.

Observe no Austrian Theory of the Business Cycle (ATBC) implication arise from this with respect to credit creation.

Door 2

If your appetite for risk is higher as you say, you want both immediate access and a coupon on your money then depending on how “immediate” your demand for cash in your hand is, you can currently today lock your money away in multiples as low as one month to many years in multiples of months, quarters, half yearly, yearly etc. In the UK, half of all savings are conducted in this fashion in a nice safe matched way.

This door does what it says on the tin – the bank intermediates between lender and borrower in a safe time matched way.

Observe no ATBC implication arise from this with respect to credit creation.

Door 3

Should your appetite be for higher risk and instant conversion to cash in the hand, then depositing and becoming a shareholder in a mutual will give you this.

Open Ended Mutual

I am a director and shareholder in one of these. We channel deposits into various asset classes. If a shareholder wants a redemption, we sell the underlying asset and redeem in cash. This can happen instantaneously as the underlying assets are liquid. A coupon us paid or rolled over.

Closed End Mutual

These are usually quoted vehicles on a liquid market such as the stock exchange. You deposit and become a shareholder. You sell your shares when you want redemption into cash. A coupon could be paid of rolled over .

Contractually there is no confusion as to how owns “your” money this way. I commissioned a survey with IMC and 75+ people of the 2,000 people questioned did not know that when they deposited they lent money to the bank and that “their money” was the banks. They were also confused and a slightly smaller majority were aware that the banks lent “their money” out. The three door approach solves this contract law and property rights issue.

Observe no ATBC implication arise from this with respect to credit creation.

Foot Note

Door 4

You could have a door four which is called the “Casino Door,” this is where you surrender your property right to your purchasing power, pool your resources with others and suggest to some financial intermediary, “go invest and issue me a promissory certificate that I can redeem on demand in the full knowledge that you may not be able to,” and take your chances and look for a higher return. Not having to protect creditors i.e. suspending their fiduciary duty and requiring legal privilege to let them do this as it goes against all the principles of commercial law, would be fine if all consent expressly to lose the protection of the law, just as no gambling debt is enforceable. The “reflux” mechanism would be in place to stop over issue of money certificates, but it must only be conducted in the present regime i.e. with a central bank lender of last resort with no bail outs and as a facet of gambling and not banking, with no legal enforcement what so ever.

I think your point in velocity is misplaced. If your demand to hold cash in your hand as opposed to in a bank account happened, your ability to use that money , or stored purchase power to buy other goods and service has not changed. Consequently I see no price inflation. Even if you spent it all, all this would mean, would be that you have exchanged cash for goods and services or bonds or whatever you wanted to and the recipient would now have cash and not the goods they sold you. Yes, for sure I see no inflation. It is faulty reasoning that only academics are capable of dreaming up that still pollutes sound economic thinking lie this.

You say you would replace deposits with a mixture of money and bonds, this is what I suggest. By money I presume you mean cash, well I have spelled that out in the above. With regards to bonds, Irving Fisher suggested this in 1935 in his book 100% Money. Bonds would 100% back as I have mentioned in the above cash deposited. They also provide the opportunity for the 100% system to provide a coupon for the depositors in a safe environment. Well I qualify, as safe as it can be within the realms of a paper money system.

[Steve Horwitz]

Nikolaj:

Funny how you forget to mention that Richard Ebeling had the same interpretation of Mises's calls for 100% reserves. I'll take Richard's reading of Mises over yours any day.

Also, here is what I DID say about Mises:

"[ADDENDUM: To be clear, I am not arguing that Mises was clearly and unambiguously a MET-fractional reserve free banker. The evidence is not that clear. What I am arguing is threefold: 1) the preponderance of the evidence is that Mises was more or less a MET-FR-FB; 2) there is very little evidence at all that Mises thought a Rothbard-style 100% reserve system was the first-best ideal monetary system; and 3) where Mises does recommend 100% reserves, it is almost always in the context of a program for monetary reform given that government is deeply entwined in the banking system.]"

As you have done throughout our "relationship," you continue to have some reason to make me the target of your ire by ignoring those who agree with me and by misreading my arguments.

[Dan]

Steve,

I am familiar with ME from other sources, for example:

http://www.auburn.edu/~garriro/horwitz.pdf

and I am familiar with your lectures on FEE.

No. I haven't read your book. But from the shorter expositions of the theory presented by you, there is nothing to suggest that the criticism I've referred to is incorrect. I've pondered on ME for quite some time now only to be more and more certain that the theory is absolutely flawed. (sorry) So I ask you in all honesty, do you really believe that your book presents the theory in such a different manner then all of the other sources?

[Nikolaj]

Steve,

I was not intending to start any new conversation with you on this. I just reminded prof Boettke how the debate came about and tried to explain to him how anyone could be so stupid to deny that Mises was FRB proponent.

As for Mises himself, you are countinuing to do what you were doing all the time; ignoring a direct, unequivocal textual evidence against your claims and to repeat tirelessly unsupported mantras in the hope they will become the truth somehow.

1) arguments please.
2) Mises unequivocally and in many repeated occasions claimed that fiduciary media creates the business cycle, and the only way to avoid the "human influence on monetary system was to abolish the fiduciary media". You don't have any counter-argument whatsoever to this, apart from your personal feelings and beliefs.

3)arguments, please. He never said what you ascribe to him, never. When he said that 100% should be accepted only in the system with the CB? On the contrary, he explicitly rejected that model advocated by Fisher and Simons. You are just making stuff up. I quoted him saying that ANY amount of fiduciary media leads to credit cycle. Please, enlighten me - where Mises said that 100% reserve system was not the first-best solution, but only reserved for CB system?

I must admit that this again becomes slightly comical; after trowing the Austrian economists title of the blog under the bus this Winter, becoming the "Coordination problemists" who only value good and bad economics (down with the Austrian sectarianism and outdated Mises and Hayek's version of the ABCT), you are again in the upward swing of the "cycle"; propagating vigorously your neo-Banking inflationism on the one hand, while fighting to preserve your "Misesian" credentials like Leonidas at Termophyle (Saleno:)) on the other.

[Steve Horwitz]

For Dan and Nikolaj:

If you think MET is so wrong, write up your criticism, or convince Professor Huerta de Soto to do so, and submit them to the RAE. We'd love to have a paper that's a really good criticism of MET from a different Austrian perspective. We'd be happy to send it to two knowledgeable referees (and I would refuse to referee it). And if they think it's worth publishing, perhaps Pete and Chris would ask me or George or Larry to write a reply.

Having seen the recent discussion George entered into on the Mises board, I think he would also be very interested to see a careful, detailed criticism of MET and his work specifically.

And no, Huerta de Soto's book does not suffice. I'd love him to take that chapter and write it up as a paper and submit it to the RAE and start that discussion. Same for the two of you.

Bottom line is that this is not a conversation that can be settled in blog comments, as George notes. If you want me to spend my time refuting arguments, then the proponents have to spend some time writing them up and submitting them to the scientific process.

So fire away with your charges of ducking the debate or arrogance or whatever, I do not care. Do what everyone else has done: write it up, submit it, get it refereed, and then published. (And yes, my book's central argument appear in a refereed journal - and not even an Austrian one.)

[Devin Finbarr]

In his "Theory of Money and Credit", Mises writes:

For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, "The date on which the bank's obligations fall due must not precede the date on which its corresponding claims can be realized." Only thus can the danger of insolvency be avoided.

I think he is pretty clear here: this golden rule means 100% reserves for demand deposits. It potentially allows for 0% reserves for all time deposits, as long as the loans the bank extends do not exceed the term of the deposits.

[Harrison Searles]

Just because Mises realized that the existence of fiduciary media would cause boom-bust cycles is not evidence enough that he was for 100% reserves. Indeed, Hayek realized the same thing in "Monetary Theory and the Trade Cycle", yet went on to essentially say that the benefits of an elastic currency outweighed its disadvantages:

"So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles. They are, in a sense, the price we pay for a speed of development exceeding that which people would voluntarily make possible through their savings, and which therefore has to be extorted from them."

The fact that Mises stated that fiduciary media are a cause of the trade cycle is not a sufficient condition for interpreting him as an advocate of 100% reserves. Yes, one could argue that he ought to have been such an advocate, but making the judgment that he held such a position is horrendous hermeneutics.

[Andres Guzman]

Dear Steve,

Thanks for replying. Smith's abhorrence for optional clauses went beyond a personal taste. There is a big difference between the ballet type of checks and balances which force banks not to over issue presented by the average free banker, and the war type of checks and balances presented by Smith. The classical theory of competition was not a ballet, it was a war. Optional clauses are instruments which prevent that war, and so the mechanism breaks. Here is how Smith explains the check and balance mechanism caused by war type competition:

"The late multiplication of banking companies in both parts of the United Kingdom, an event by which many people have been much alarmed, instead of diminishing, increases the security of the public. It obliges all of them to be more circumspect in their conduct, and, by not extending their currency beyond its due proportion to their cash, to guard themselves against those malicious runs which the rivalship of so many competitors is always ready to bring upon them. It restrains the circulation of each particular company within a narrower circle, and reduces their circulating notes to a smaller number. By dividing the whole circulation into a greater number of parts, the failure of any one company, an accident which, in the course of things, must sometimes happen, becomes of less consequence to the public. This free competition, too, obliges all bankers to be more liberal in their dealings with their customers, lest their rivals should carry them away. In general, if any branch of trade, or any division of labour, be advantageous to the public, the freer and more general the competition, it will always be the more so." (II, 2, 106).

So this is not a logical fallacy. Furthermore, you restrained your reply to small issue notes and optional clauses, which among the points I raised I'd say are the least harmful to the free banking argument you espouse. I appreciate your reply, and I know you are not in the mood to get in a debate of this sort (according to Pete an unproductive debate). But if you know the answers so well that you can dismiss me so easily, how long would it take you to reply? In view of your expertise it would be a matter of less than 5 minutes, and I am not joking. Perhaps it would be unproductive for you, but you'd do me a great service because you would expand my knowledge on the subject.

Best,

Andres Guzman

[George Selgin]

"Even George Selgin conceded this and criticized Mises for that doctrine." For the sake of those on this list not familiar with Nikolaj's practices, this is not an accurate statement of my view, although it is true that in my first book I did refer to and criticize a passage from Mises in which he seems to endorse the 100% percent reserve position, I agree with Richard Ebeling that Mises is simply not consistent in his claims about fractional reserves. In places he appears to suggest that 100% reserves would be desirable; in others he suggests that they are desirable. Rothbard and his followers are wrong to suggest that Mises' stance was one that consistently favored 100% reserves. I think it important as a matter of history of thought that we resist making the opposite error. Reasonable people can of course disagree concerning whether a preponderance of Mises' statements point one waqy or the other.

[George Selgin]

The second "desirable" in my last post should of course have been an "undesirable." Pardon the error.

[Niko]

@Selgin:

"In places he appears to suggest that 100% reserves would be desirable; in others he suggests that they are desirable."

My English is not very good, but from what you are saying it seams he was in favor of 100%. From what I've read in Rothbard he discusses why FRB is wrong.

What I don't get is that argument that if the client is in agreement, then FRB is OK. From what I see it, instead of one guy engaged in fraud, now we have two. Maybe I don't understand what FRB is than.

[Andres Guzman]

Dear George,

Good to have you around, I highly esteem your work. I'm looking forward to reading "Good Money" this summer.

Best,

Andres Guzman

[Current]

Toby Baxendale,

I understand your proposal to split banking into three parts. It preserves most of the flexibility of banking while removing the complaints that Walter Block and Mencius Moldbug have about maturity mismatching.

My main point was about the proposal to make all of the money stock into monetary base. An idea common to your proposal, Heurta De Soto's proposal and the old Chicago plan.

You write:
"I think your point in velocity is misplaced. If your demand to hold cash in your hand as opposed to in a bank account happened, your ability to use that money , or stored purchase power to buy other goods and service has not changed. Consequently I see no price inflation. Even if you spent it all, all this would mean, would be that you have exchanged cash for goods and services or bonds or whatever you wanted to and the recipient would now have cash and not the goods they sold you. Yes, for sure I see no inflation. It is faulty reasoning that only academics are capable of dreaming up that still pollutes sound economic thinking lie this."

Think about this carefully. I agree that initially there will be no changes in prices. However, it will cause a rapid increase in prices.

Think about the demand for money and the purpose of holding stocks of it. There is an equation J.T.Salerno gives for this which comes from Austrian ideas:

Money demand = Transactional money demand + Demand for money to hold

George Selgin writes something similar.

Now, what is the source of "demand for money to hold"? Austrian economists have always held that this is about uncertain future trades.On p.170-171 of "The Theory of Money and Credit" (Liberty Fund Edition) Mises writes:
"What is called storing money is a way of using wealth. The uncertainty of the future makes it seem advisable to hold a larger or smaller part of one’s possessions in a form that will facilitate a change from one way of using wealth to another, or transition from the ownership of one good to that of another, in order to preserve the opportunity of being able without difficulty to satisfy urgent demands that may possibly arise in the future for goods that will have to be obtained by way of exchange. So long as the market has not reached a stage of development in which all, or at least certain, economic goods can be sold (i.e. turned into money) at any time under conditions that are not too unfavourable, this aim can be achieved only by holding a stock of money of a suitable size."

Our current form of banking allows demand deposits to serve this purpose while also paying interest. That gives an extra incentive for people to hold bank account money. The proposal you make is to "convert demand deposits into cash". Doing that would remove the possibility of demand deposits also paying interest.

As it is savings accounts compete with short dated bonds. Last year I moved most of my savings from savings accounts into short dated bonds because the interest on the latter is better. If there could be no such thing as an interest bearing savings account then short dated bonds would be the only sensible option for savings. So, a conversion of demand deposits into cash will cause the demand for money to fall.

As people spend their cash buying bonds and other goods that will bid up the prices of those other goods. This is the Cantillon effect. To put it in monetarist terms (which are useful here) a fall in the demand for money results in a rise in velocity.

The process I've described here is quite similar to the effect of expected inflation. If price inflation is expected then it make sense to economise on holding money to prevent loss of wealth. Similarly, if holding money pays interest then it makes less sense to economise on doing so. However, if holding money no longer pays interest then it makes more sense to economise on doing so.

[Steve Horwitz]

I'm posting the following on behalf of Toby Baxendale:

Steve Horwitz and George Selgin are intellectually honest people. They see factual things about Mises one way and a group of other intellectually honest people view it another way.

So Nikolaj, I do find your stance needlessly aggressive.

I sit in a Magistrates court as a magistrate in judgement of events which we then judge as fact. When often two parties present the same “facts” in good faith and colleagues on the bench (we sit for the most as three) will hotly debate the facts, in our retiring room, with differing view, in all honesty emerging. It never ceases to amaze me why people do not see the facts my way!

Mises said yes to 100% reserves and yes to fractional reserve free banking.

All of those mentioned like Socrates would go where the evidence took them I do not doubt that at all.

I cannot conceive that for both Hayek and Mises , as both said both positions at various times, when you read the whole corpus of their work, especially when you take into account their work on business cycle theory could really want to advocate non central bank fractional reserve free banking. This is my interpretation of the facts as far as I see it.

If a binary choice was offered to me today, the current arrangements versus fractional reserve free banking without a central back, in an instant I would take the latter as a massive improvement on the former. Is it my ideal model? No. Would it prevent boom and bust, malinvestments etc? No, however the credit creation process would be very severely limited. I would prefer a freezing of the money supply today via 100% reserve and the implementation of what I call the Baxendale Plan above with the full use of Mutual, both open ended and closed ended so that lending an financial innovation can take place just as before, just not with credit created via the banking system + plus normal timed lending , which in the UK is just over 50% of all lending anyway. By the way, this is the way vast amounts of business are currently conducted, well in the majority if you add the Mutual element to the timed lending. Needless to say on blog, with limited time and no academic standard, one can only hint and where one wants to go with this.

By the way, as I have now advocated FRFB as a much better solution to the problem of today, does this make me a FRFB unequivocally? Or does the spirit of my whole work count for anything?

The sensational political and economic effects of adding Huerta De Soto’s proposal to my plan to pay off the national debt and my tag on that with no debt service we could do a 28.5% tax cut and to compelling to ignore.

Steve Horwitz does have a fair point, read his and others work and respond with at least the same high standards. Fair enough, you can’t argue with that. Also, I am wondering, Steve, if you have read Professor Huerta de Soto’s criticism of monetary equilibrium theory (by the way , I presume this is what MET means)? In his book which he sent me called “The Theory of Dynamic Efficiency, Routledge Foundations of the Market Economy series 2009, Chapter 11 seems to be a reprint of the QJAE , winter 1998, he presents his case against the likes of Selgin and White. Was this ever answered in detail? Forgive the ignorance on this matter. So Steve, if this was not answered, is not the onus over to both Selgin and White, our yourself who is also mentioned, to respond back?

My own quick rough and blog friendly take on MET

1. The Misean use of “the money relation” is more useful than the tautological Quantity Theory of Money.

2. Velocity is a derivative of demand i.e. if you demand to hold more cash, the corresponding effect is you are buying and selling less goods and services, demand less cash and you must be demanding more goods and services, all other things being equal. Velocity can have meaning in this respect. It does not stand alone as a single definable measure. So velocity can be viewed as a proxy for the demand for money. Indeed it is inversely proportional to the demand for money.

3. If demand stays the say and supply goes up, it follows that all other things being equal, people will spend away the excess notes, causing prices to go up and a new money equilibrium will be settled upon.

4. In a world of central banks, if they allow private sector credit creation to go rampant by setting the money market interest rate to low, they should either buy up securities and retire them, or make the money more expensive. Better still; do not mess about with the supply of money in the first place.

5. If there is a massive deflation, such as a depression, as Hayek said in Prices and Production, a central bank could issue more money to hopefully bring the supply back to its old equilibrium position.

6. In a FRFB world, the banks facing more demand for the services of money would issue more money to satisfy the need for more transactions, but like goldilocks, only just the right amount, as the reflux mechanism will kick in if anyone bank is abusing their privilege to create money. Conversely , if demand to hold cash balances has gone up and we are in a serious deflation, FRFB, I cannot remember what it does off the top of my head, though I guess it would retire notes once they had been presented for redemption.

Leaving aside the Huerta De Soto work and his criticisms, which may well have been answered, that I am not aware of, I would add the following;

1. If we did as Hayek reluctantly suggested in Prices and Production now and increased the money supply to overcome the current monetary disequilibrium, would that not mean that the recipients of the new money, now have the ability to buy goods and services that they have not had to do any prior production (work) for? Will this not mean that real wealth i.e. the goods and services that are exchanged for money are now exchanged for bits of paper with diminishing purchasing power? Has not nothing, well a new bit of government mandated paper now given the recipient of this largess by the taxpayer new purchasing power to buy real goods and services i.e. to effect a wealth transfer from a deserving producer of goods and services to a government appointed recipient of new purchasing power? If the money is created in the private sector, why should the bankers be able to do this?

2. Why do you assume there is a monetary disequilibrium anyway? If the demand to hold cash balances goes up in a recession, why is this not just a new temporary equilibrium level? All levels being temporary as we know as each second creates a new set of arrangements, what we study is not fixed by live and dynamic.

3. Are you advocating a Soviet style planning board for deciding what is and is not money equilibrium? Or are you just saying that if we are to work in this system, central planning of money, then we might as well try to work with it the best we can?

Observations of an Entrepreneur During this Bust

I have never seen such a fall off in demand in my life. We have a new level of demand. I sell meat and fish for a living. The top end specie and cuts are not in demand so much and as we all demand the same levels of protein on the whole, the protein demand has moved to cheaper specie and cuts. So we sell the same tonnage per day, but in lower value things. This is the new state of affairs or new equilibrium that I have to live with and adjust all the capital and people skill in the business to meet that new demand. I have no Keynesian “output gap,” as I have to craft my existing capital physical, money and human to the new demand and retire / fire sale / make redundant those that do not want to painfully change. Why would an adjustment of the overall money equilibrium bring back the old ways of doing things? Would they just not be more money units chasing the existing goods and services i.e. being inflationary?

As a blog post goes, I hope this is constructive as it is written in that spirit.

[Nikolaj]

Harison Searles,

There is only one problem with your argument - Mises openly said he was an advocate of 100% reserve system. Many, many times. Here are just a few examples:

"it is obvious that the only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media. The basic conception of Peel’s Act ought to be restated and more completely implemented than it was in the England of his time by including the issue of credit in the form of bank balances within the legislative prohibition." (TMC, pp. 408)
,
"The main thing is that the government should no longer be in a position to increase the quantity of money in circulation and the amount of checkbook money not fully—that is, 100 percent—covered by deposits paid in by the public." (TMC, pp 438), or

"No bank must be permitted to expand the total amount of its deposits subject to check or the balance of such deposits of any individual customer, be he a private citizen or the U.S. Treasury, otherwise than by receiving cash deposits in legal-tender banknotes from the public or by receiving a check payable by another domestic bank subject to the same limitations. This means a rigid 100 percent reserve for all future deposits; that is, all deposits not already in existence on the first day of the reform" (TMC, pp 448)

If you say, like Steve often does, that Mises thought 100% reserve system should be applied only in the CB regime, while he advocated the fractional reserve system for free banking, you are wrong. Mises dixit:
"But the two shortcomings of the Currency School vitiated this famous act. On one hand, the system of government interference with banking was preserved. On the other hand, limits were placed only on the issuance of banknotes not covered by specie. The fiduciary media were suppressed only in the shape of banknotes. They could thrive as deposit currency."

So, the error of the Currency school (at least according to Mises) were BOTH their reluctance to eliminate the central bank and other forms of government interference on the one hand, and their failure to suppress the fiduciary media for demand deposits, on the other (in other words to impose a 100% reserve system for demand deposits). In order to even imagine the conditions in which Mises would prefer FRB to 100% reserve system one must come upp with some evidence that he believed that fiduciary media issuance in free banking could have some beneficial effects in alleviating the business cycle (like neo-Banking inflationists believe today). However, Mises didn't seem to believe anything of the sort. On the contrary he believed that fiduciary media emission is precisely what CREATES the business cycle:

"The notion of “normal” credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle. Of course, if the additional amount issued is not large, neither are the inevitable effects of the expansion.
"(Human Action, pp 442 third edition)

[Steve Horwitz]

I would really like to respond to Toby's comments above, but unfortunately I have several deadlines this week as well as a bunch of other things going on, so I'm not sure I'll have the time to give it the depth it deserves. I'm hoping that at some point late in the week I can respond at length with a new post. Thanks for the thoughtful and constructive comments Toby and I will try to address them at length sooner than later.

[Toby Baxendale]

Good Evening Current

Interest can be paid on cash balance in the “Door 1,” the 100% cash reserve door in a paper currency world if the cash is backed by a govt bond that is convertible on demand. The overnight money market rate would be paid.

“Door” 2, has interest paid on savings deposits of one month and more, the shortest bond I know of.

“Door” 3, has a coupon or return, call it interest if you like on your deposit which is in fact a share in a mutual that can be “withdrawn” in effect, redeemed on demand.

So I struggle to see why virtually the same depositing / savings pattern would not happen under my ideal banking world. I do not think you read what I say, or I do not make it clear.

When you have bought a bond, you have trasnferred your purchasing power to the bond holder. There is no new purchasing power.

Even if cash balances were all emptied and moved into assets, someone has to receive the cash in exchange for the assets, it cannot disappear.

Money inflation is when there were 100 units of money and then all of a sudden there were 101 units of money.

Demand deposits came from nothing and can disappear by the corresponding lending being repaid and not relent out again. This is what we have today - a rampant money deflation.

The “3 Door” bank model would stop this.

[Current]

I think that Dan and Toby Baxendale both have the same kind of problem with the monetary equilibrium theory.

Let's say we have a surprise event which makes people worried and increases the demand for money. Let's suppose too that prices cannot adjust quickly because of the entrepreneurial problems connected with making those adjustments.

Think about the normal situation of capitalist saving. I refrain from spending a sum of money. The purchasing power is transferred to another party who invests it. I think we agree this causes no distortion.

Now, consider what happens when the customers of bank X spend less and accumulate deposits. Now, from the point of view of every customer it may be unclear when they are going to use the money. This isn't so for the banker though who can watch the turnover rate of deposits and calculate averages and trends. This increase in deposits is equivalent to an increase in saving.

[Current]

Toby Baxendale,

"Interest can be paid on cash balance in the “Door 1,” the 100% cash reserve door in a paper currency world if the cash is backed by a govt bond that is convertible on demand. The overnight money market rate would be paid."

Yes, I realise that. However the rate paid on government bonds is quite low, and banks would have to cover their costs of operation too. I suppose they could pay that rate if they charged their customers fees.

"So I struggle to see why virtually the same depositing / savings pattern would not happen under my ideal banking world. I do not think you read what I say, or I do not make it clear."

I agree that the pattern would be the same. What I'm pointing to here is the disturbances caused by instituting the change.

"When you have bought a bond, you have trasnferred your purchasing power to the bond holder. There is no new purchasing power.

Even if cash balances were all emptied and moved into assets, someone has to receive the cash in exchange for the assets, it cannot disappear.

Money inflation is when there were 100 units of money and then all of a sudden there were 101 units of money. "

I think that this view of inflation is too simple. I'm not saying that money inflation would occur, clearly it cannot with a fixed money supply. What I'm saying is that velocity will increase, or equivalently that the demand for money will fall. That's because the current demand for money includes the demand for savings bearing significant interest. The stock of demand deposits has been adjusted to the demand for money for short-term purposes and the demand for interest bearing savings. After your proposed change when all deposits become like option 1 then they will only fulfill the demand for short-term holdings where interest isn't relevant.

So, those who were holding deposits as savings will spend them and cause an increase in prices. In the long run there will be adjustment to the situation, but that adjustment will come in the form of a one-off burst of price inflation.

[Dan]

Current: "Think about the normal situation of capitalist saving. I refrain from spending a sum of money. The purchasing power is transferred to another party who invests it. I think we agree this causes no distortion."

False! Capitalist saving - You cut your spending on consumption, while you increase the same amount on investments. Just reducing spending says nothing about the change in time preference of the individual. This is just one of the errors behind your false assumptions. The individual, for example, can increase his cash balance by cutting spending on investments, while keeping the level of spending on consumption the same, or even increasing consumption. This can all be shown and verified by numerical examples different changes in proportions between present goods(consumption) and future goods(investments) while increasing or decreasing total cash balances.

[Current]

Dan,

An individual's demand for money is quite separate from their time preference. I agree entirely.

But, think about this part:
"You cut your spending on consumption, while you increase the same amount on investments. Just reducing spending says nothing about the change in time preference of the individual."

Yes, but no illusory assets are being created. By reducing expenditure and demanding more money the bank's customers are abstaining. Their purchasing power can then be used by others - by the bank's loan customers. If this happens then it is a movement along the investment-consumption PPF.

But, think about what would happen otherwise. Consumers would abstain, but no other agent would replace their demand. Not until prices have adjusted downwards. Our choice is between a movement along the PPF, or one inside it that temporarily reduces output below potential. I would rather have that investment output, even though it may not be consistent with the long run interest rate, than forsake it.

Even this though assumes that the banks don't realise the situation is temporary. In practice I think that they would.

[Dan]

Current,

No such alternative exists. (That's my anti-ME stance)

The mistake is twofold.

"By reducing expenditure and demanding more money the bank's customers are abstaining."

(1)
abstaining from what? I can increase my cash balance by either cutting consumption or cutting investments. The proportion between present and future goods cannot be established by the mere increase of cash balances or deposits. The banks will then make loans on the basis of those deposits, which will not correspond to the new time preference of society.

(2) The new money will be issued as loans,most of it towards investments of producers goods, and it will reach wage earners. Some of that money will be spent on consumption. If that new money is not held (or saved) by the wage earners, the structure will be distorted and the new proportion between future and present goods, as altered by the issuing of the fiduciary media, will prove to be unsustainable.

"If this happens then it is a movement along the investment-consumption PPF."

No, you're ignoring the micro-effects of the fiduciary media as I've tried to explain above.

[Bill Stepp]

Dan writes:

Just reducing spending says nothing about the change in time preference of the individual. This is just one of the errors behind your false assumptions. The individual, for example, can increase his cash balance by cutting spending on investments, while keeping the level of spending on consumption the same, or even increasing consumption.

I disagree. Reducing consumption spending necessarily means a reduction in a person's time preference. The demand for an individual's cash balances has nothing to do with this.

Consider, Smith, who gets paid weekly and consumes 70% of his paycheck amount and saves the other 30%. If he decides to cut back his consumption to say 60% of his paycheck and save more, he reduces his time preference, no matter what he does with the rest of his portfolio. If he sells an investment and raises his cash balance, presumably that goes into savings and earns interest. And don't forget the lessons of W.H. Hutt's classic article, "The Yield from Money Held." Cash balances provide Smith utility or psychic income.

Suppose Smith's investment portfolio consists of $100,000 each in stocks, futures, and forex, with no leverage. He can buy more of each asset class by using leverage (stocks up to 2-1, and even more if he's day trading or using options; and still more with futures and forex). Using leverage for an investment (or taking out a home mortgage) doesn't change his time preference. Of course, if he borrows to facilitate greater consumption, his time preference increases, but it's the higher consumption/savings ratio
(savings out of current income), not the borrowing, that matters.

[Dan]

Current,

You're reading my responses too quickly. It's as if you're already presuming what I'm trying to say.

"I disagree"

What are you disagreeing about? I didn't deny that reducing consumption while retaining your previous level of investments is a lowering of time preference. Read that part again. What I said is that one can increase his cash balance by a variety of ways:

1. Cutting spendings on consumption only (lower time preference)
2. Cutting spendings on investments (higher time preference)
3. Cutting both consumption and investments (No change in time preference or lower or higher depending on new proportions relative to old)

So I fully agree 100% with W.H. Hutt's classic article, which is why hoarding is in no way detrimental.

Look, I'm just applying Austrian capital theory and it's corollary, ABCT. I say you are overlooking the cash induced micro effects of new money being injected into the system. That you are only issuing new money warranted by a previous increase in deposits doesn't change a thing.

[Bill Stepp]

Pt. 2. is incorrect, which I pointed out.
Cutting spending on investments doesn't by itself increase someone's time preference. Only an increase in someone's consumption/saving ratio increases his time preference.
Pt. 3 is also incorrect. If I cut consumption and increase saving, that is a decline in my time preference. My existing investment portfolio is independent of my consumption/savings ratio out of current income.
To increase my investment portfolio, I have two means: price appreciation, or putting additonal savings into it. Additional savings can be added with or without a change in my time preference. If I decrease my time preference (which means more saving out of current income), then I can put more capital into my portfolio.
If I sell an investment, this doesn't increase (or decrease) my time preference; it simply rearranges my investment portfolio.
See Rothbard's discussion of time preference.

[Dan]

Bill, (sorry for addressing Current)

Time preference is determined by the proportion between spending on present goods and future goods. It's the relative change in that proportion that changes the time preference.

"pt. 2. is incorrect"

Oh really? If the initial proportion between consumption and investment is: $100 for consumption and $300 for investment. Some people increase their cash balances by $20 by cutting investments only, so that the new proportions are $100 for consumption and $280 for investment. Clearly, the relative proportions indicate a change in time preference. $20 was taken out of investment, while $100 was maintained for consumption. How in the world does that not indicate a higher time preference? Do the triangle. The structure has become shorter and more present oriented. The slope of the interest rate has become steeper.

"If I sell an investment, this doesn't increase (or decrease) my time preference; it simply rearranges my investment portfolio."

I didn't say it necessarily did but it may. We are talking about increasing one's cash holding and it depends what my intentions are with respect to the 3 options to increase one's cash balance, as I've listed above. If you take out $20 out of investment and not reinvest but simply increase my cash holding, then all things being equal, there is $20 less of spending on investment. There is no "rearrangement of portfolio" but a withdrawal of $20 from investment.

[TGGP]

Hey, Toby, Bill Woolsey has a post responding to something you wrote for Cobden:
http://monetaryfreedom-billwoolsey.blogspot.com/2010/05/interest-rates-as-market-price.html

[Bill Stepp]

To clarify my point (sorry for the confusion), if I sell an investment and take out the proceeds as cash, my time preference increases if I spend (i.e. consume) the more of the new income than my l-t c/s ratio. If I spend all of it, for example, my time preference rises. If I spend less of it than my l-t c/s ratio, it falls. If I spend it in the same proportion, it stays the same.
Consumption is spending on present goods, and savings is spending on future goods, which can take various forms (stocks, bonds, money market fund, etc.)
And note that it has nothing to do with ACBT--it is true in a free banking system just as it is in a central banking system. Rothbard's discussion of time preference comes before his discussion of ABCT, and rightly so, even though he rejected free banking.
In your example, if you spend more of the $20 (for example, all of it) than your l-r c/s ratio, then I would agree it would raise your time preference.

[Current]

I agree with Dan about money holdings. This is where it gets complicated.

As I was writing above there are different reasons to demand (or hold) demand deposits. They can be demanded just to make a particular transaction on a particular date - the transactional reason. Or they can be demanded to hold as a fund against uncertainty (what Mises and Hutt pointed to). Since savings accounts are also demand deposits they can be held in order to earn interest too.

The latter demand, due to savings, is a demand for investment. The other two demands though are demands for money, which is neither an investment nor consumption good.

Now, Dan points out that demand for money rises and banks use this to expand the quantity of money then that will cause Cantillon effects. I agree. However, I don't think these can be avoided. Consider the alternative of deflation. In that case there are reverse cantillon effects whereever money is removed by increasing money demand. Then once the deflation has occurred and agents have a holding of money that satisfies them then the increase in uncertainty passes. That provokes a decrease in demand for money and as people spend down their holdings new inflationary Cantillon effects occur.

[Current]

There are enough books about the process of the boom. Has anyone written one about the bust?

[Dan]

Bill,

I don't exactly understand what you are attempting to deny here. If I withdraw $20 from investments while keeping the same level of spending on consumption, then my time preference increases regardless if I spend that $20 on consumption or just hold it as cash. It is true that the two processes are not identical and while both processes will end in a shorter structure of production, they will not be the same.

Draw the triangles and plug in the numbers.

1. Initial state:
$300 - investment $100 - consumption
2. $20 withdrawal from investment and increase cash holding
$280 -investment $100 - consumption
3. $20 transferred from investment to consumption:
$280 - investment $120 - consumption

Notice both 2 and 3 relative to 1 indicate a transition from a lower time preference to a higher one. Draw the triangles and watch the hypotenuse angle (interest) rise in both.

[Dan]

Current,

What do you mean they can't be avoided. In the first (no intervention by banks), prices begin to adjust as the market coordinates itself to the new state of societal time preference. In the second (banks intervene), prices begin to adjust but they are affected by cash induced temporal changes that will prove to be not allinged with the new state of societal time preference. The first is a necessary transition required to reflect market changes in preferences, while the second is a intertemporal distortion induced by the creation of the fiduciary media. I don't agree at all that you can compare the two.

Besides, I don't get this obsession with "Busts" or "bad deflation" in the absent of a previous credit expansion. These worries about people increasing or decreasing their demand to hold money, are reminiscent of Keynesian "paradox of thrift" more then about anything "Austrian". The changes in the structure in response to the various changes in time preference take place as Hayek described them to take place when he shattered the "paradox" myth. By price changes occurring at the individual micro-level.

[Nikolaj]

The problem with MET is that within that framework demand for money is used as an explanatory variable: once unanticipated increase occurs, that means the credit supply should be increased for an equal amount. The demand for money is a proxy for the real savings, ie. for the time preference.

On the other hand, in the Austrian theory demand for money is not a proxy for the real saving. You cannot reconcile this concept with the classical Austrian notion that the credit supply should correspond to the amount of voluntary saving, i.e. to the genuine market time-preference of the public. Once you recognize that increased demand for money could mean both increased or decreased (or for that matter, even unchanged) time preference, you understand that you cannot use the demand for money as a criterion, or "proxy" for assessing the time preference (increased "hoarding" does not necessarily means a lowering of the rate of time preference). You have basically two choices: either to abandon the MET, or to curtail the Austrian concept that the market time preference should determine the level of credit supply in an economy. Tertium non datur.

[Mikeikon]

If you give me a dollar and I give you an "IOU" in return with a promise to pay you back, I have neither committed fraud nor increased the money supply.

Fiduciary media are just IOUs.

[Current]

Nikolaj and Dan,

Haven't we already done this bit of discussion? If you read the above thread I have agreed that demand for money doesn't constitute a change in time preference.

The point is that holdings of money can be treated as savings by banks.

Dan,

"What do you mean they can't be avoided. In the first (no intervention by banks), prices begin to adjust as the market coordinates itself to the new state of societal time preference."

Yes, and how does that price adjustment effect take place? What happens is that unevenly spread across the economy there are agents who stop buying stuff and instead save money. This has an effect that ripples across the economy, like the Cantillon effect.

"In the second (banks intervene), prices begin to adjust but they are affected by cash induced temporal changes that will prove to be not allinged with the new state of societal time preference. The first is a necessary transition required to reflect market changes in preferences, while the second is a intertemporal distortion induced by the creation of the fiduciary media. I don't agree at all that you can compare the two."

Why is the second a distortion? Why will the "cash induced temporal changes" not align with the new state of societal time preference?

As I said previously, consider what happens in the case with no money supply increase... Once the uncertainty of the recession has worn off agents will find that they have a real cash balance too high for their purposes, so they will spend it and Cantillon effects will result. Why isn't this just as distortionary?

"These worries about people increasing or decreasing their demand to hold money, are reminiscent of Keynesian "paradox of thrift" more then about anything "Austrian"."

Hayek called this problem the composition problem and agreed that it existed. Both Mises work is full of stuff about the demand for money, see "The Theory of Money and Credit" for example.

[Lee Kelly]

An increase in money demand may not be a proxy for a change in peoples' time preference, but so what?

I am reminded of Hume's argument about gold flows in Europe. People in England demand more gold, the price of gold increases in England relative to the rest of Europe, and so gold begins flowing to where it is demanded: England. Whether or not peoples' "hoarding" of gold in England reflects a subjective change in time preference or not, Europeans are quite within their rights to sell gold at the best price they can find. The consequence is a change in the supply of money in England.

It doesn't matter whether people demand more money because they mean to increase savings or not. If they demand more money, then others have a right to supply what is demanded at the best price they can get. Thus, the consequence of an increase in money demand is equivalent to an increase in savings regardless of peoples' subjective misconceptions.

[Mikeikon]

The following is my attempt to make sense out of this issue of fractional reserves and fiduciary media, which I think is one massive misunderstanding that is in need of a simple explanation that isn't full of economic lingo. I would appreciate any feedback, corrections, etc on the following.

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

The first thing to understand is that bank notes and bank accounts (“fiduciary media”) are just claims to base money (gold, fiat currency) at some point in the future. For clarity and simplicity sake, I will refer to these claims from here on out as “IOUs.”

It is possible (and quite reasonable) that there will be more claims to future base money in the system then there is actual base money. This is because money moves around a lot, and it is possible for money to exchange hands fast enough to fulfill all of these future claims when they become due. How quickly money changes hands (in other words, how many market exchanges involving money are taking place in a given time) is known as the velocity of money.

The issuing of IOUs will not expand indefinitely if there is risk associated with holding IOUs as opposed to base money (which, in a truly free market, there would be). The number of IOUs will expand only if the velocity of money can keep up with their issuance. If it cannot, banks will not be able to pay their depositors (creditors) in time and will be forced to go bankrupt.

As a depositor, you are a creditor giving a loan to the bank. The bank issues you claims to future base money (IOUs, in the form of bank accounts or bank notes) in exchange for banking services and interest payments. Like any creditor, you are taking a risk in doing this,* but it is not fraudulent if the bank and its depositors have agreed to it.

Banks then lend out the funds that their depositors (creditors) have loaned to them. They do NOT lend out more than they have. Rather, they lend out as much as they can without being in danger of being unable to repay depositors at the rate at which they request their money. When a depositor requests repayment and the bank is unable to pay it is a breach of contract. However, it does not necessarily mean the bank is insolvent. The money the bank lent out is still an asset to the bank. In other words, unless the bank's borrowers cannot pay the bank back in full or the bank cannot be made whole by selling those loans on the market, the bank is not insolvent.

The very fact that banks do go bust on occasion (become insolvent) is the signal to the market that IOUs are not the same as base money, as they carry risk and may become an obligation unfulfilled at any time. If all bank IOUs were replaced by new base money (as some are fond of suggesting), the effect would be highly inflationary because more IOUs would be issued on top of this entirely risk-less new base money.** You could outlaw fractional reserves or increase reserve requirements in an attempt to stop this, but this would just cause more people to invest through other channels, resulting in IOUs issued from other sources. There is nothing wrong with this process..

What a bank does is no different from what an individual does when he issues you an IOU for something he cannot currently deliver. It would be intellectually inconsistent to outlaw fractional reserve banking without also outlawing these sorts of common exchanges between individuals. These exchanges neither increase the money supply nor are they fraudulent. Outlawing them would make for a highly inefficient economy.

As an aside, the ethical argument against any sort of price inflation is shaky. Property rights do not guarantee value.*** The value of money, like any other good, fluctuates depending upon the subjective valuations of individuals buying and selling in the market. If property rights were a guarantee of value, then dynamic, changing nature of the price system would have to immediately be condemned as unethical and the whole free market system done away with. So while real inflation is dangerous, undesirable, and distorts decision making, it is not outright theft. Having said that, the issuing of IOUs in a free banking system is not inflationary because it doesn't increase the money supply, it only increases the speed and efficiency of monetary exchange.

So the only ethical issue is whether or not depositors are actually aware that they are creditors taking on a risk by loaning to the bank. In a free market with well enforced contracts, it would be up to the individual to decide whether he or she wanted to invest money in the bank (earning interest and receiving free banking services in exchange, i.e. fractional reserve) or pay for the use of a money “warehouse” (full reserve).**** This is entirely a matter of investment strategy and personal risk. Presumably, what would emerge in the market would be a proper and sustainable balance between many different types of banking, investment, and money warehousing in which risk and prudence would balance each other out.

*When I say depositors are creditors taking a risk, I am referring to a free banking system without government guarantees. Government guarantees like the FDIC eliminate the risk of holding IOUs, which has the effect of turning IOUs into base money and lowering interest rates, thus leading to inflation. IOUs in the absence of government guarantees rely on others coming through on their obligations in a timely manner, and thus have corresponding levels of risk associated with them.

**This is essentially what the FDIC does—turning IOUs into the practical equivalent of base money and thus causing inflation.

***A guarantee of value would be a “right” to control the personal subjective valuations of other individuals, and thus a violation of those individuals' own rights to liberty and property.

****Currently there is no demand for full reserve banking because the FDIC has removed any personal risk involved in loaning money to the bank. Few people would choose to pay to have their money warehoused when they can put it in the bank for free without risk of incurring losses, even if the bank fails.

[Current]

Mikeikon,

I pretty much agree with you. However, I think that IOUs are money, they're money in the broader sense as Mises said.

[Lee Kelly]

The great thing about IOUs redeemable in base money (fractional reserve style), compared to something like gold, is that their objective exchange ratio is easier to keep constant, because the supply of IOUs is relatively flexible compared to other assets. That is, the IOUs neither appreciate nor depreciate in value, and thus continually serve as a medium of exchange despite fluxuations in demand to hold them.

Gold makes for very good money. Some Austrians like to say "gold is money." I think this is mistaken.

[Mikeikon]

Current,
Thanks for the feedback. I'm glad someone agrees with me and I'm not totally off in my own world or something.

Regarding whether IOUs are money or not, it helps me personally (and I think it would help a lot of other laypeople) not to think of them as money, but as, well, IOUs... money owed in the future.

I realize it is a type of money since it can be used as a medium of exchange, but the nature of its value is different. I think it throws people's logical thought process off track when they start thinking of it as one-in-the-same.

[Steve Horwitz]

Mike,

I agree with you as well. In fact, the section I'm quoting below is particuarly good as it recognizes that what depositors get by loaning their money to the bank is both interest and a more convenient form of payment. That is the key to understanding why fractional reserve banking is mutually beneficial. You also do a good job in separating the liquidity question from the solvency question, which is also often overlooked or misunderstood by critics of FRB.

Nice work.

"As a depositor, you are a creditor giving a loan to the bank. The bank issues you claims to future base money (IOUs, in the form of bank accounts or bank notes) in exchange for banking services and interest payments. Like any creditor, you are taking a risk in doing this,* but it is not fraudulent if the bank and its depositors have agreed to it.

Banks then lend out the funds that their depositors (creditors) have loaned to them. They do NOT lend out more than they have. Rather, they lend out as much as they can without being in danger of being unable to repay depositors at the rate at which they request their money. When a depositor requests repayment and the bank is unable to pay it is a breach of contract. However, it does not necessarily mean the bank is insolvent. The money the bank lent out is still an asset to the bank. In other words, unless the bank's borrowers cannot pay the bank back in full or the bank cannot be made whole by selling those loans on the market, the bank is not insolvent.

The very fact that banks do go bust on occasion (become insolvent) is the signal to the market that IOUs are not the same as base money, as they carry risk and may become an obligation unfulfilled at any time. If all bank IOUs were replaced by new base money (as some are fond of suggesting), the effect would be highly inflationary because more IOUs would be issued on top of this entirely risk-less new base money.** You could outlaw fractional reserves or increase reserve requirements in an attempt to stop this, but this would just cause more people to invest through other channels, resulting in IOUs issued from other sources. There is nothing wrong with this process..

What a bank does is no different from what an individual does when he issues you an IOU for something he cannot currently deliver. It would be intellectually inconsistent to outlaw fractional reserve banking without also outlawing these sorts of common exchanges between individuals. These exchanges neither increase the money supply nor are they fraudulent. Outlawing them would make for a highly inefficient economy."

[Mikeikon]

Professor Horwitz,
I appreciate the response and am quite honored that you felt my comments were worth reposting.

I noticed I kind of fumbled those first couple sentences:

"As a depositor, you are a creditor giving a loan to the bank. The bank issues you claims to future base money (IOUs, in the form of bank accounts or bank notes) in exchange for banking services and interest payments."

Should read something more like:

"As a depositor, you are a creditor giving a loan to the bank. In exchange, the bank issues you claims to future base money (IOUs, in the form of bank accounts or bank notes) along with banking services and interest payments on the loan."

But I think you understood what I meant.

[Current]

"Regarding whether IOUs are money or not, it helps me personally (and I think it would help a lot of other laypeople) not to think of them as money, but as, well, IOUs... money owed in the future.

I realize it is a type of money since it can be used as a medium of exchange, but the nature of its value is different. I think it throws people's logical thought process off track when they start thinking of it as one-in-the-same."

I see what you mean. Normally though Austrian economics concentrates on money as the medium of exchange. And, as notes are a medium of exchange they are also money.

But, as you say, some sort of differentiation between the pure commodity money and the media derived from that also circulate like money is needed. So we get the differentiation in Mises between "money in the narrower sense" and "money in the broader sense". There are other terms that are used to do the same job.

[Dan]

Current,

"Yes, and how does that price adjustment effect take place? What happens is that unevenly spread across the economy there are agents who stop buying stuff and instead save money. This has an effect that ripples across the economy, like the Cantillon effect."

Oh excuse me. I wasn't aware that prices must change "evenly" in order for the market to adapt to change. Prices change and fluctuate unevenly all the time. Prices are not neutral! But also, Money is not neutral, which is why you cannot create fiduciary media in order to compensate for any "unevenness" or whatever is bothering you. You cannot inject new fiduciary media via loans market and not create an intertemporal distortion. I've shown you one good reason why not, for which you have not been able to argue against. Another reason is that you cannot supply the fiduciary media directly into the hands of those who want to hold it. Entrepreneurs receive the new fiduciary media as loans and ultimately distribute them via wages. Those people receiving the new money as wages are not necessarily those who want to hold the money. some of them will spend it. This is really elemnatry Hayekian Capital theory. Like Monetarists, you must reject Capital theory to make your claims. you must assume money neutrality and no regard to the time element of the Capital structure.

[Dan]

Current (some more)

"Regarding whether IOUs are money or not, it helps me personally (and I think it would help a lot of other laypeople) not to think of them as money, but as, well, IOUs... money owed in the future."

Money, in the Menger tradition,is perfect liquidity. Not highly liquid, put perfectly liquid. IOU's are obviously not perfectly liquid. ME Free bankers must reject this.

IOU's are claims to future goods, and not present goods. But Mises refuted that Money is a future good already in Money and Credit. Other subsequent Austrians make the compelling case that money is really a present good. ME free bankers must reject this.

People don't accept IOUs as money. Ask around if they are willing to get paid in corporate bonds or government bonds that "guarantee" redemption at face value! Try buying a house or paying to the local grocer with IOUs. But they do accept what they believe is cash (perfect liquidity) or what they believe are substitutes for that cash. It is obvious that people don't recognize that check book money is actually backed by IOUs. I'm not a Rothbardian. I resent the term. But it does make the compelling rothbardian case for deception, more then the Selgin/White case.

[Mikeikon]

Well, I already pointed out that bank IOUs issued under a government guaranteed banking system are just as good as base money because there is no risk. So how people treat IOUs today isn't really relevant to how they would treat them under a free banking system. Presumably the value of a banknote would depend upon the bank's reliability and history of paying up on demand.

"Money, in the Menger tradition,is perfect liquidity. Not highly liquid, put perfectly liquid. IOU's are obviously not perfectly liquid. ME Free bankers must reject this."

Why must they reject it? They could simply accept it and not refer to IOUs as money if that's the definition of money you want to use.

It sounds like there's too much semantics and not enough logic in this discussion.

(Or maybe it's just over my head).

[Current]

Dan,

You write: "Oh excuse me. I wasn't aware that prices must change "evenly" in order for the market to adapt to change. Prices change and fluctuate unevenly all the time. Prices are not neutral!"

I agree. However, why do you think that this change in prices will not cause intertemporal distortion itself?

Let's suppose that there has been a recession and no monetary expansion, deflation has occurred. The recession has passed and the need to hold higher stocks of money has passed, so agents spend some of those stocks of money. By what magic does this *not* produce intertemporal distortion?

[Current]

Dan,

The definitions I'm using here are the normal Austrian ones... I can't speak for Steve Horwitz of George Selgin but I think they take a similar view.

Dan: "People don't accept IOUs as money. Ask around if they are willing to get paid in corporate bonds or government bonds that 'guarantee' redemption at face value! Try buying a house or paying to the local grocer with IOUs. But they do accept what they believe is cash (perfect liquidity) or what they believe are substitutes for that cash. It is obvious that people don't recognize that check book money is actually backed by IOUs. "

Of course we can't call all IOUs "money in the broader sense", only a very specific set of them fulfill that criteria.

Dan: "Money, in the Menger tradition,is perfect liquidity. Not highly liquid, put perfectly liquid. IOU's are obviously not perfectly liquid. ME Free bankers must reject this."

Mises put fiduciary media into the category of "money substitutes". He then called "money in the broader sense" the sum of "money in the narrower sense" plus money substitutes.

See p.65 of "The Theory of Money and Credit" (Liberty Fund Edition):
"It is considerations such as these that have led the present writer to give the name of money-substitutes and not that of money to those objects that are employed like money in commerce but consist in perfectly secure and immediately convertible claims to money."
And p.66
"Claims to money are, of course, no exception. Those which are payable on demand, if there is no doubt about their soundness and no expense connected with their settlement, are valued just as highly as cash and tendered and accepted in the same way as money. Only claims of this sort - i.e. claims that are payable on demand, absolutely safe as far as human foresight goes, and perfectly liquid in the legal sense - are for business purposes exact substitutes for the money to which they refer."

That sort of definition means that when a bank starts to look wobbly then it's notes cease to be true money substitutes.

There are a couple of problems with this definition, it needs some refinement, but I don't think they have any bearing on this discussion.

Dan: "IOU's are claims to future goods, and not present goods. But Mises refuted that Money is a future good already in Money and Credit. Other subsequent Austrians make the compelling case that money is really a present good. ME free bankers must reject this."

It's a complicated point. I think that money is best described as a present good though.

On p.170-171 of "The Theory of Money and Credit" Mises writes:
"What is called storing money is a way of using wealth. The uncertainty of the future makes it seem advisable to hold a larger or smaller part of one's possessions in a form that will facilitate a change from one way of using wealth to another, or transition from the ownership of one good to that of another, in order to preserve the opportunity of being able without difficulty to satisfy urgent demands that may possibly arise in the future for goods that will have to be obtained by way of exchange. So long as the market has not reached a stage of development in which all, or at least certain, economic goods can be sold (i.e. turned into money) at any time under conditions that are not too unfavourable, this aim can be achieved only by holding a stock of money of a suitable size."

This is very similar to what other Austrian Economists have written, I generally agree with it. Money provides utility in the present because it can be used in an uncertain future.

[Steve Horwitz]

The evolution of checking accounts suggests that people are quite willing to accept IOUs in payment for groceries and pretty much anything else. Even before deposit insurance and the like, bank liabilities were happily accepted in payment based on the trust people had in the bank itself. To claim people won't use IOUs this way in the absence of government protection is to misread the history of the evolution of money.

[Dan]

Current,

"Mises put fiduciary media into the category of "money substitutes". He then called "money in the broader sense" the sum of "money in the narrower sense" plus money substitutes."

Because obviously, fiduciary media circulate as money. This doesn't prove that people accept IOUs as money and Mises certainly differentiated between fiduciary media and the other forms of money. He did associate fiduciary media as the direct cause of the trade cycle. So if you are suggesting that somehow Mises equated the two, then obviously, that is flat out wrong.

I don't understand the point of all of these quotes by Mises. We all know that fiduciary media is circulating as money. But quoting mises out of context is futile for your argument. Mises has been generally consistent throughout his career on this issue: Fiduciary media is the problem.

[Dan]

current,

"I agree. However, why do you think that this change in prices will not cause intertemporal distortion itself?"

Because that is the change that actually reflects the change in time preference. That is the change the reflects the intertemporal change taking place as a result of actors changing their preferences. It makes no sense to say that the real change is distortion.

It's like this. Suppose there is some change in time preference between hot dogs and hamburgers. Prices for Hot dogs increases while prices for hamburgers decreases.
Now suppose there is no change in preference and some new money finds its way more into those people who like hot dogs then hamburgers. Prices again, will increase for hot dogs and decrease for hamburgers.

Now, would you seriously argue that both examples are equivalent. One is a real change indicating a real increase in demand for hot dogs and the other is a clear artificial (and temporary increase in demand for them.

[Dan]

Steve,

"To claim people won't use IOUs this way in the absence of government protection is to misread the history of the evolution of money."

I would argue that there is a distinction to be made between "To claim people won't use IOUs" and "To claim people don't use IOU's". The latter would be clearly to misread the history, but the former (your own phrasing), I don't know?

I think when people accept a check, then yes, they trust the bank, but they have absolutely no clue that the dollar value on that check represents IOUs face values and not cash sitting in some vault. You can't just overlook fine distinction between perfect (100%) money substitutes and fiduciary media. How are the notes perceived in the market? as the former or the latter. I'm not at all convinced that you have a compelling case, as you say , that it is the latter.

[Current]

Dan,

I don't really understand your point here:
"Because obviously, fiduciary media circulate as money. This doesn't prove that people accept IOUs as money and Mises certainly differentiated between fiduciary media and the other forms of money."

But, Fiduciary media is a type of IOU which people do accept as money. When I agreed with mikeikon above about people using IOUs as money what I meant was that fiduciary media is used as money, not just any IOU.

I agree that Mises differentiated between fiduciary media and other forms of money. It's an important distinction, I'm not suggesting getting rid of it.

On the one hand we have money in the "narrower sense" such as commodity money. And on the other hand we have money in the "broader sense" which includes fiduciary media.

[Nikolaj]

current: "Let's suppose that there has been a recession and no monetary expansion, deflation has occurred. The recession has passed and the need to hold higher stocks of money has passed, so agents spend some of those stocks of money. By what magic does this *not* produce intertemporal distortion?"

You CANNOT suppose that recession occurred without the monetary expansion. Period. Or at least, if you don't want to accept the "explanations" such as "underconsumption" or "overproduction". Is that a kind of theory you offer to explain the inter-temporal misccordination? If so, then it's unclear what the ABCT is worth? Maybe the ABCT is just a special theory of business cycle? What would be like a "general" one then? I am curious.

[Current]

Nikolaj,

To be clear, I was talking about the situation during the recession, not the situation before it.

I think that the ABCT may be only one possible cause of a business cycle. However, that's not relevant for the discussion here which is about what happens after a bust has begun. My supposition above was that there is no monetary expansion after the boom has turned to bust.

[Nikolaj]

Current,

after the beginning of a bust, the only way to make sure that all previous mistakes induced by a monetary expansion are liquidated is to refrain from any additional credit inflation (monetary expansion). The monetary expansion creates the misallocation, and not the lack thereof. At whichever stage of the cycle it is effectuated.

having that in mind, I don't see how the absence of a cause of some phenomenon could contribute to the occurrence or severity of the phenomenon in question?

[Current]

Nikolaj,

I understand what your theory, though I disagree.

"I don't see how the absence of a cause of some phenomenon could contribute to the occurrence or severity of the phenomenon in question?"

I don't understand this though.