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Current,

Say some specific individuals in the market demand to hold bread. The baker bakes more bread but instead of selling them to those who demand to hold them, he sells them to entrepreneurs in exchange for IOUs. All of the new bread then finds its way into wage earners. Those wage earners will mostly not comprise of exactly all those who have increased their desire to hold the bread.

Here is the question for you: Do you acknowledge that at least some of that new bread will therefore likely be consumed?

"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."

Nobody denies this. But that doesn't prove that people knowingly accept IOUs as money. It could well be that they do but it is not the only possibility as Horwitz, Selgin, and White insist it is. It is also possible that Rothbard is correct. That they accept them because the IOUs "masquerade" as 100% backed money substitutes. That's all I was trying to say.

Rothbard talked about there being a money multiplier, and I believe someone else brought this up earlier in the thread.

That doesn't sound right to me. When money is withdrawn from one bank and deposited into another--whether it be through check payment or note redemption--the base money is removed from the first bank and deposited into the other. That means that that base money is no longer available to the first bank to loan out. Therefor it can no longer issue any IOUs on top of it. The ratio of IOUs to base money would stay consistent.

Am I missing something?

The money multiplier comes into play when new base money enters or exits the system. Rather than starting with a check clearing from one bank to another, which doesn't change the total money supply, assuming both banks face the same marginal legal reserve requirements (or choose to keep the same desired reserve ratio), start with someone taking FR notes or gold out from under their mattress and depositing that into the banking system.

In *this* case, the recipient bank will keep some fraction against the new deposit and loan the rest out. As that loan ends up in a different bank, it has new base money and loans most of it out, etc.. The result is a total money supply that is a multiple of the original change in base money. But this requires that base money enter (or exit) the banking system.

Steve Horwitz and Mikeikon,

Doesn't the money multiplier also require that the banks have good loan opportunities with the right maturities? That is, it's the reserve constrained case but there is also a client constrained case too.

Current,

my sentence you did not understand simply means; "its not clear how the absence of the monetary expansion could initiate or exacerbate the misalllocation of resources, when the PRESENCE of the monetary expansion is a sole cause of misallocation"?

Dan,

>> "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.

The problem with what you've written here is that a change in
demand for money isn't a change in time preference. A rise or
fall in demand for money may come associated with a rise or fall
in time preference. The two aren't linked.

> Say some specific individuals in the market demand to hold
> bread. The baker bakes more bread but instead of selling them
> to those who demand to hold them, he sells them to
> entrepreneurs in exchange for IOUs. All of the new bread then
> finds its way into wage earners. Those wage earners will mostly
> not comprise of exactly all those who have increased their
> desire to hold the bread.
>
> Here is the question for you: Do you acknowledge that at least
> some of that new bread will therefore likely be consumed?

Only if there is a demand to consume bread. The problem with
this example is that other goods aren't like money. We have to
consider money as a separate case, which is exactly what
Rothbardians and Free-bankers do.

> Nobody denies this. But that doesn't prove that people
> knowingly accept IOUs as money. It could well be that they do
> but it is not the only possibility as Horwitz, Selgin, and
> White insist it is. It is also possible that Rothbard is
> correct. That they accept them because the IOUs "masquerade" as
> 100% backed money substitutes. That's all I was trying to say.

In that case I agree, I don't think people today know
very much about bank operations. They don't need to either because of deposit insurance. However, as George Selgin
pointed out to me once things were very different in the past
when only rich and financially literate people held banknotes.
They did so knowing that the reserves used were fractional.

Nikolaj,

> my sentence you did not understand simply means; "its not clear
> how the absence of the monetary expansion could initiate or
> exacerbate the misalllocation of resources, when the PRESENCE
> of the monetary expansion is a sole cause of misallocation"?

It all depends on the demand for money. According to the
FRFB view what is dangerous isn't issue of money per se, but
issue of money beyond the demand to hold it. This is the case
in booms and busts. But, it is in busts that the demand to hold
money generally rises.

Joe Salerno has written an article about this on the Mises institute site.

Article:
http://mises.org/daily/4389

Blog:
http://blog.mises.org/12713/white-contra-mises-on-fiduciary-media/

If Salerno admits that fractional reserves are not fraudulent, then what he is saying is that the business cycle is caused by the free market (or would be if it were fully free).

Not a very libertarian point of view, if you ask me!

This whole issue seems like it should be so fundamental to economic understanding--It's almost frightening to me that we can't even come to a consensus on it.

Would it be correct to say that fractional reserves reduce the amount of resources lying unused? Would it also be correct to say that this is both a good thing (since there is higher productivity and efficiency) AND a risky thing (since borrowers may over-promise and over-consume and not be able to repay their loans)?

If so, wouldn't it follow that the ideal solution is to have a balance in the economy in which there is BOTH savings in the form of fractional reserves (investment) AND savings in the form of 'cash stuffed under the mattress?' It seems like this should provide for an economy that is efficient and productive, but not at the expense of stability.

"The problem with
this example is that other goods aren't like money. We have to
consider money as a separate case, which is exactly what
Rothbardians and Free-bankers do."

Money is a commodity. We can argue whether it qualifies as a "future good", "present good" or neither. But it is a commodity, albeit, it is the most marketable commodity.

Now what you have done now is take the Monetarist view that money is somehow different from all other commodities with respect to the economic laws that govern it. You missed the whole point then of the Mengarian, Misesian and Austrian revolutionary insight into money. The same micro-economic laws govern the money commodity as all other commodities.

"The problem with what you've written here is that a change in
demand for money isn't a change in time preference. A rise or
fall in demand for money may come associated with a rise or fall
in time preference. The two aren't linked.f"

Haven't we already discussed this. I don't think you're paying much attention to what I'm writing anyway. I'll just say that you're stuck in a pure macro-analysis of the system. This is you blunder. I think for now I have made my case. Think it over.

"Now what you have done now is take the Monetarist view that money is somehow different from all other commodities with respect to the economic laws that govern it. You missed the whole point then of the Mengarian, Misesian and Austrian revolutionary insight into money. The same micro-economic laws govern the money commodity as all other commodities."

There is huge demand for fiduciary media, but it is better if non are supplied. This is the Rothbaridan position. Hardly what they say about other goods.

> Money is a commodity. We can argue whether it qualifies as
> a "future good", "present good" or neither. But it is a
> commodity, albeit, it is the most marketable commodity.

I agree that money is the most marketable good.

> Now what you have done now is take the Monetarist view that
> money is somehow different from all other commodities with
> respect to the economic laws that govern it. You missed the
> whole point then of the Mengarian, Misesian and Austrian
> revolutionary insight into money. The same micro-economic laws
> govern the money commodity as all other commodities.

The Austrian view isn't that money is the same as other
commodities. See p.268-271 of "Man, Economy and State", the
section on money regression.

In your example above using bread you suggest that some of
the bread will be consumed. Money isn't generally consumed,
though sometimes commodity money may be melted down if it's
worth more as bullion.

I think your point though by analogy is that some of the money
will be spent on consumption. Your point is that the injection
of money isn't necessarily towards those who need it. So,
microeconomically if must find it's way from those who first
recieve it to those who demand it. During that process there
will be a cantillon effect, as various markets tighten due to the
greater spending power. Businesses inbetween the money suppliers
and demanders will take their cut and profit. I agree. Also,
those demanding money will cut back on their expenditures and
cause the markets they deal in to slacken, which in turn ripples
through other markets.

But, all of this is happening all the time. As Lee Kelly pointed
out earlier, even with a steady overall demand for money that
doesn't mean that there is a steady demand from every agent.
There are constant small Cantillon effects crossing the economy
as injections and withdrawals occur, just like Hayek's price
signals. (Cantillon effects are rather like price signals for
money). If this caused major macroeconomic instability then
there could never *be* stability.

The big problem here is not these changes by themselves, but when
they prevail in one particular direction or another. That's why
we should look at the situation when the supply of money exceeds
the demand to hold it, not simple rises in the supply.

> If Salerno admits that fractional reserves are not
> fraudulent, then what he is saying is that the business
> cycle is caused by the free market (or would be if it
> were fully free).
>
> Not a very libertarian point of view, if you ask me!

No it isn't. But, though I disagree with Salerno I don't think that preference for liberty should get in the way of economic work too much. If an economist finds that a certain process has an externality that the market hasn't identified then he should own up and say so.

"According to the FRFB view what is dangerous isn't issue of money per se, but issue of money beyond the demand to hold it."

How can you empirically know whether money supply exceeded the demand to hold it or not? All that boils down to the Banking School's doctrine of "needs of trade".

Nikolaj,

As I expect you know, the mechanism of reflux informs free banks of the turnover rate of money. I agree that this part is similar to banking school ideas.

nteresting discussion.

I want to focus on a serious error made by Dan.

Too often in these discussions, the assumption has been that households choose to reduce consumption and hold money. If the banking system generates monetary equilibrium, the banks expand the quantity of money and make additional loans. Perhaps the borrowers purchase capital goods. The ME theorists argue (correctly) that this is an decrease in time preference and the resulting shift between the demand for consumer goods and capital goods reflect consumer preferences.

Dan argues that perhaps those who are demanding less money are instead demanding fewer "future goods." This is, of course, completely possible. Rather than reduce purchases of consumer goods to accumulate money, perhaps fewer corporate bonds are purchased. The firms that would have issued new corporate bonds to fund the purchases of capital goods don't make those purchases of capital goods.

I suppose we could imagine that a business that had been directly purchasing capital goods out of current cash flow (profit and depreciation) might instead accumulate money.

Regardless, if the added demand for money results in a decrease in the purchases of financial or real assets, there is no decrease in time preference. However, if the banks increase the quantity of money by creating new loans, and those borrowing the money fund the purchase of capital goods, then the demand for capital goods is unchanged.

In the case of the corporate bond approach, the disruption is insignificant. Those firms that would have sold the corporate bonds borrow from the banks instead. (Actually, the most direct way to deal with the issue is for the banks to purchase the corporate bonds that the households accumulating money don't buy.)

In the case where the firms were directly financing capital goods but instead hold money, I suppose it is possible that the prices of capital goods could fall, and so borrowing from banks becomes more attractive to other firms even at the same money rate of interest.

However, in reality, there is not just "the" money rate of interest, and decreases in interest rates charged by banks while there are increases in say, corporate bond rates, or the internal rates involved in self-financed projects are in no way symptoms of a market rate below the natural interest rate.

One final note. In mainstream macro, including Keynesian monetary theory, it is normal to treat the allocation of wealth between money and other assets as a stock decision separate from flow of intertemporal allocation. To the degree banks adjust the quantity of money to accommodate shifts in the desired composition of asset portfolios, it is not interfering with the intertemporal flows.

In the simplest scenario, the nonbanking public wants to hold more money and less bonds. The banks hold more bonds and issue more money. There is no impact on the market interest rate. There is no distortion of intertemporal coordination.

The problem occurs when the banks purchase bonds with money. People take the money planning to spend it. The demand for bonds rise and the yields fall. The market interest rate is lower. But the intertemporal flows have not changed, and so the lower market interest rate creates a signal and incentives that cause distortions in the intertemporal flows.

Maybe that was all too Keynesian or mainstream, but Dan, take my word for it, this notion that people might demand for money and less future goods is no argument against banks accommodating increases in the quantity of money.

Oops!

Perhaps those who are demanding more money are demanding fewer "future goods."

Nikolaj asks:

"How can you empirically know whether money supply exceeded the demand to hold it or not? All that boils down to the Banking School's doctrine of "needs of trade"."

The same way that producers of other goods learn how much to supply - they watch the market signals available to them and interpret them according to their best thymological judgment. This, of course, requires that genuine market signals exist, which is the whole argument for free banking.

And the ME view is most emphatically NOT the "needs of trade"/real bills doctrine. This point has been made over and over again by free bankers, as even a cursory familiarity with the literature would indicate. The RBD/NoT idea is quite mistaken.

Incidentally, with modern computer technology it may well be possible for a free bank to record every transaction performed with it's fiduciary media.

Measuring it for notes would be difficult, but bank deposits are a different matter. A carefully constructed software system could record every transaction and measure the relevant variables directly, the necessary information is probably already present in bank databases. Even for notes it may be possible if each note had a barcode on it. Though of course many people may choose not to use notes that don't provide anonymity.

This thread here is being debated over at the LvMI blog too...

http://blog.mises.org/12713/white-contra-mises-on-fiduciary-media/comment-page-1/#comment-688706

And Bill Woolsey has mentioned this on his blog...

http://monetaryfreedom-billwoolsey.blogspot.com/2010/05/was-mises-wrong.html

Has anybody mentioned Guido Hülsmann's proposal of contract differenciation yet? It offers an interesting lead to reconcile FRB and 100% supporters.

100% supporters should recognize that a fractional contract is possible, and can be satisfactory to the bank and the depositor (and courts!).

FRB supporters have already recognized that such a contract requires an option clause or some provision to take care of panics, otherwise the contract is incomplete.

What remains to be acknowledged, is that these are two significantly different contracts. In the first, the depositors sells his cash for a redemption promise. In the second, the depositor keeps his cash and purchases a safe box service.

If these two contracts were differenciated, we could observe whether users prefer this or that contract. I see no a priori argument to decide which of 100% or FRB money would be "objectively" superior. But FDIC and deposit guarantee suppresses the competition between those two contracts and gives FRB a clear advantage. Gresham's law...

Note that both contracts could coexist. Intuitively, we can very well think of a situation where deposit money is 100% (because the bank can easily charge a service fee), small change is FRB (read Selgin's Good money and the Problem of small change) and as for banknotes: one or the other.

I must add that I am very sympathetic to Huerta de Soto's proposal for a transition, which Toby Baxendale mentions.

FRB supporters have already recognized that such a contract requires an option clause or some provision to take care of panics, otherwise the contract is incomplete.

We of course never conceded anything like that at all. And all contracts are incomplete.

@ Slow Captain

Right. To avoid confusion I should have put it differently. The true FRB contract could be replaced by two contracts in order to differentiate between credit money and cash: the loan and the deposit contracts. Making this distinction allows the contractors to clarify their intentions and decide who retains the property of the cash: the bank or the depositor.

In this nomenclature, the option clause makes the contract a loan contract and no longer a deposit: the bank temporarily has ownership of the cash, and the customer has a limited claim.

What would be lost under contract differentiation is the possibility to have a demand deposit with a true FRB contract, low reserves, no panics, etc. The way I understand fiduciary media is that, under such a contract, the moment the bank cannot fulfill its redemption promise, it should go bankrupt. The depositor would then be senior during the liquidation process. A loan can get pretty close to that, so what would really be lost?

btw, the Guido Hülsmann article is "Has fractional reserve banking really passed the market test?" (2003)

Current: "However, note that your view is inconsistent at the beginning of this thread you claimed that Mises and Schumpter believed in "instantaneous market clearing in recession". But your quotes don't show that at all. Your argument now is different, you are now saying that deflation is painful but necessary."

What's the difference? You are really interested in that kind of hair-splitting? Whether the market clearing is "instantaneous" (again a nonsensical concept, just like "perfectly flexible prices" - what is "instantaneous", what is "perfectly flexible"?), or not, according to Mises and Schumpeter MET recipes to counteract deflation by currency debasement and printing money are the recipes for the prevention of readjustment and new economic distortions. That's the only important thing here.

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