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I thought you were just asking good questions. Apparently we now have a Austrian orthodoxy on some topics, and questions are dangerous.

Pete, here are Anthony Evans proposals in a nutshell:


The only objectionable items are 8 and 9, at least from a free banking perspective. You can see that 6 is George Selgin's idea.

Whoa. Who is enforcing an orthodoxy? Pete asked some good questions and specifically asked George, Larry, and I what we thought. We responded by saying we thought the proposal was problematic. Isn't that how science progresses? Isn't the very fact that Pete has put up a new post evidence to the contrary? What are you referring to Jerry?

@Pete: I agree that banks should operate according to the same rules as everyone else. If so, then why argue for a proposal that *appears* to eliminate the freedom of contract to offer fractional reserve demand deposits? (It's interesting that Larry, George and I all read it that way, I think.) If we really want everyone to play by the same rules, then why are we restricting the sort of contracts banks can offer their customers when we don't do that for other firms (assuming consenting adults etc of course?)

I find the language of "ordinary principles of property and contract" to be slippery here. It's a nice way to make it seem like we're restricting banks from having an unfair advantage of some sort, but it's never specified exactly what that is and why it's unfair. It's a beautiful piece of rhetoric that ends up doing the opposite of what it promises: restricts banks from engaging in a long-accepted, perfectly voluntary, contract with their customers.

Now maybe there are reasons for wanting such a restriction, but let's call it what it is and make the explicit case for why banks have some sort of privilege that others don't that must be restricted.

BTW, my tour of Europe this January will include a stop at the Cobden Centre to give a talk and Toby and Tony have been nothing but gracious and polite to me on email over the last year or two. I disagree with Toby (though not with Tony!) but he has been very willing to engage these issues, as have I with him.

There's no orthodoxy being promoted, nor is either side trying to exclude the other. This is a legitimate debate between two views of what is the best monetary reform. I think Toby is wrong, and I'll keep saying so, but that's how knowledge progresses, is it not?

Whoa, Steve! My comment was intended as tongue-in-cheek.

Since you asked, however, I'll clarify.

Pete posed some interesting questions and got such a reaction, he posted "a correction to a wrong impression." There is a sensitivity to folks, be it Pete, or Pietro, or me appearing to question any aspect of free banking. Or suggesting there may some reform, other than pure free banking, that might be a step in a transition from a bad to a better system.

Just asking Pete's political economy question gets accusations of deviation from the plumb line. I have never advocated narrow banking, but have a couple of times made comments about it that were not totally hostile. Today George responded by placing me in the pro-100% reserve group. He accused Pietro of buying the Mises Institute line. I'd call that sensitivity to questions.

I also think that the vital distinction between rights and privileges is not being made. Banks have loads of privileges, starting with being licensed. Just try to take deposits w/o a license and see what happens. Then there is deposit insurance.

For the largest banks, the creditors are guaranteed by the taxpayer. Dodd-Frank now puts in statute what was heretofore merely policy: the special status of the largest banks. Dodd-Frank may have created a entire new set of GSEs, much like Fannie and Freddie before they were put into conservatorship.

The very much privileged institutions do not have a right to those privileges. If such institutions are told they can't actually bet insured deposits at a casino, I'd hardly call that an assault on property rights.

I got the impression that the argument sparks some animosity, too. So let's focus on the basics. Here's my summary of the "truths" I hold to be "self evident". Unfortunately I only have negative results.

1. Given that moral hazard has reached the status of the organizing principle of economic policy, the unrestricted market process can be given no presumption of optimality.

2. The first best would be to remove the fundamental causes of the mess, but there are at least a dozen complex causes to remove, so that no quick solution exists.

3. It is structurally impossible to avoid a worsening of the recession in case of a serious reform, because there is no path to a recovery which does not pass through widespread deleveraging and malinvestment liquidation.

4. Second best solutions to limit the amount of damage that the unrestricted distorted market process begets can be thought of, but agents under moral hazard will have incentives to circumvent regulations, increasing enforcement costs. However, not all second-best regulations need be so difficult to enforce.

5. Second best regulations both reduce the damage of the distorted market process (if effective) and reduce efficiency by hampering the "good" market process. For instance, narrow banking would reduce intermediation efficiency, especially in case of shifts in the demand for money.

6. Almost alll good policies are politically impossible. For instance, all non-interventionist policies are time inconsistent in case of systemic crisis, and this reason alone suffices to create a crisis as a self-fulfilling prophecy.

What now? I have no idea. I just described a small subset of the policy constraints, and I have the impression that neither me nor Bernanke and Obama have any idea of what to do. Neither of the two things come as a surprise. :-)

I probably forgot something of relevance, but the discussion should start from these problems, and any reform proposal should consider them.

I liked the Anthony Evans piece. I view #9 as a call for transparency. My objection to #8 is the price control.

From Toby,

"To all you fine distinguished economists commenting on this site, shame on you, you comment without even knowing what I am suggesting.

The Baxendale Plan.

Let me be clear, if there is a plan, it is emerging. It is work in progress. It is based around my understanding of your work, Selgin, White, Horwitz and Mises, Hayek, Rothbard, Dowd, Huerta De Soto and Fisher. I would also like to add, talking to Anthony Evans on this is like pulling teeth out and being dragged backwards naked though a thorny bush. He is very challenging and a big defender of the Selgin, White, Dowd , Horwitz type of view on this matter. Most importantly what I think I can add to the debate, not being an academic is my 20 years experience as a wealth creator who deals with banks and the legal system every day . I think you (FRFB School) neglect some important contract law and accounting law facts in your assessment on fractional reserve free banking. I will not bring these up here, but am happy to via email should you wish – see email at the bottom, as I address what you perceive my plan to be without knowing what it is.

I have a lot of sympathy for the comment as to why a leader in his field should have to comment on blogs when he has written A, B and C works that set out the case. One day when I have time I will put out my definitive case and hopefully I will not have to do the same.

I short the Bill I inspired and had written; none of you know what it says, so commenting on it shows you who do must be fantasists. It was not read in Parliament at first reading and it is only required to be laid before the house in short form at the Second Reading on Nov 19th. So watch this space and you will find out what it does say so long as I am involved with it.

With one week to prepare it, as the legislative timetable was changed on the Member introducing it, we covered off the very easy areas of banking;

Safe keeping of money = “Custodial Accounts.”The money, as it is stored does not form part of the balance sheet of the bank. The rental income does or does not if the bank chooses to levy for this service . As I have said countless times before, we all in business run loss leaders to get the profitable aspects of trade we can out of the customer and I suspect this might be one of those cases.

Lending of saved money = “Lending Intermediary Accounts”The status of the depositor is that of lender to the bank. This very much forms part of the balance sheet of the bank.

The third principle area of banking is what to do about demand deposits. Remembering that we are living in a world of the Central Bank i.e. the current status quo and not in a free bank environment, one has to be careful with what one chooses to suggest in a legislative format that will be scrutinized to the nth degree. Not having the time nor brain power to knock this up in the week, I have left for another day.

I am minded to suggest the following;

In the third window/door/department/legal entity, whatever you wish to call it of the bank, I would propose that a closed end mutual structure existed with a big sign saying “Fractional Reserve Accounts.”To the depositor this looks exactly like his/her normal bank current checking account today. A deposit is taken and lent to the bank. The bank, should it have prospective borrowers it wishes to finance, it can then, if it chooses, create credit ex novo and lend to the borrower. FYI, in the UK there is no reserve requirement unlike in the USA. I am debating with my own corporate lawyers as to does the new FSA capital requirements constitute a reserve requirement or not.

The bank statement that the depositor receives acknowledges this debt obligation form the bank to him. In effect, this is his share certificate in what is in effect a closed end mutual. When he wants to redeem, just as if you redeem in a closed end mutual, you sell your shares, or in this case the debt obligation or whatever part of the said obligation you wish to redeem. To the depositor this is a seamless transaction as it is with a closed end mutual. A buyer may pay more or less than the value stipulated as with any tradable product. M ore than likely, a recipient of the exchange of this bank debt obligation for some goods and services would neither know nor care and just accept face value. Dare I say it on this site, before I get shot down with poisonous words; this fractional reserve account is in fact a 100% reserve closed end mutual! Have I squared the circle of the FRF Bankers who wish to let people engage in fractional contracts should they be over 18 and of sound mind + consenting etc with the 100% desire for a no bank run situation and banks to work to the normal commercial law with no legal privilege? By the latter current creditors, as with all business match current debtors?

In the eventuality of a bank run /panic like we had in 2007-09, the closed end mutual can’t have a run on it as in reality the value of the tradable debt obligations will just go down if confidence is not there and redemption is too high. Just like in my fish business there can be no “fish run.”Here in the system we operate in, there could not be a bank run with this structural amend.

From this solid platform, I am of the opinion we would then be in a better position or argue for the eventual abolition of the Central Bank. Why do we need it if we can’t have a bank run right?

From this we can then advance the cause of free banking. We are not even on the agenda of any politicians anywhere at the moment unless we move forward slowly, step by step building a coalition of interested parties at each juncture until we become unstoppable.

All the names mentioned on this blog are most welcome to come and work with us at the Cobden Centre either on line or in person if you are in the UK. I seek to answer Hayek’s call in the last page of the Denationalization of Money for a Cobden to come and as with the Corn Law movement , create a sound money movement which I label “Honest Money, “and deliver up the reform to free money that we all want. I intend to achieve this.

Whilst your books and others have been and no doubt will continue to be great inspiration, I am in the business of getting things done. If you are a true lover of liberty, get behind this, through your intellectual might behind this and let’s try to take a little bit of power away from the state and more to the people. One step at a time, in unity, we can do this. All are welcome to participate. There is no ideological divide in my mind. Not interested in that. Results are all I am interested in.

My email is tbaxendale@seafoodholdings.co.uk . Be brave, become a doer as well as a thinker, help me do this. All serious suggestions welcome.

Kind regards,

Toby Baxendale

A fantastic opening paragraph from an article from Larry White captures what should, in my opinion, unit all of us in our efforts:

"The aim of this essay, unlike so many works on monetary policy, is
not to ‘argue that the government monetary authorities ought to behave
in a proper manner rather than the improper manner they have so
often behaved in, Instead, it argues that the public ought not be
forcibly subject to the vagaries of government monetary control. The
way in which Federal Reserve officials choose to act is by no means
a matter of indifference. It is, on the contrary, a matter of grave
concern for anyone concerned about the values of his assets and the
health of the economy. Monetary policy matters very much, But
precisely because the public is so vulnerable to the errors ofmonetary
policy, it is vital that some means of real protection be available.
Attempts to elicit better behavior from the Fed do not go far enough
in the way of vindicating the public’s interest. Members of a free
society should not have to suffei’ government control over their money
at all."

See "Competitive Money, Inside and Out," in CATO Journal.

Professor Boettke, everybody else,

As far as I understand just from reading the above, it seems the proposal is pretty similar to something Steve Hanke advocated at least once, in this op-ed for instance - in short, seprating different bank accounts and transforming the demand deposit accounts of banks into a legal money market mutual fund


Baxendale cannot post for himself??? He must have someone (Pete) do it for him?

For some reason, he says he can't post here. I do not know why.

In reference to Professor Boettke's addendum-

Aren't the various suggestions of how to fix the system mutually exclusive of each other? The Free Banking story of the monetary norm would tell you that 100% reserves lead to discoordination and chaos, while the Rothbardian story tells you that that anything short of 100% reserves does so. One of these stories is right and one of them is wrong (or they are both wrong). But if we apply one story where it is wrong, the result will be completely unpredictable, and with the gravity of the situation being what it is, may bring about discoordination to an extent previously unseen in human history. The current system, as ugly as it is, doesn't have anywhere near the same degree of uncertainty attached.

What we need to do isn't to jump on board with a similar story's solution, but to unwind the culture of leverage and moral hazard. It doesn't take very sophisticated arguments to understand why things like deposit insurance screws things up. I don't think anyone in any camp will defend Dodd-Frank. If you or Professor O'Driscoll desire a plan of action, there are plenty of low-hanging fruits. But I can't disagree more with the statement that "any step in that direction whatsoever is a step in the right direction in my opinion". Going from status quo to free banking in my mind is like jumping across steel girders at a construction site; anything short of the proper institutional mechanism is a long way down.

Thanks for the clarification Pete

I'd like to add that "my" reform proposal is a deliberate effort to mediate between both schools. Indeed the bill that was put in the UK parliament (which isn't public information but I have seen) is really about the elimination of deposit insurance. Toby believes that existing demand deposits should be converted to 100% reserve accounts prior to this reform, whilst personally I advocate mandating them as an option for customers to opt into if they wish.
But really this is just a debate about framing effects and what should constitute the status quo in a world of second best, given existing political constraints.

I encourage you to all listen to this interview with Steve Baker MP, who responds directly to the concerns raised on this blog:


@ Jerry
Thank you. I appreciate that No. 8 and 9 are problematic. I included them in an attempt to have a proposal that Rothbardians would be able to endorse. The more I think about it the more I feel that this should be re-written such that those banks that are controlled by the government should open such accounts, and remaining private banks should be free to decide whether they think this would be of commercial value

In addition, my proposal is written as an emergency measure - i.e. on the assumption that we have another Lehman and a banking meltdown is imminent.

If I were to rewrite it as a proposal for reform, to be enacted now, I would bring these items before eliminating deposit insurance. Indeed I think there is a massive opportunity here. In the UK during the crisis deposit insurance went up from £30k to £50k as an emergency measure. If we can make the public remember this, and have a discussion about removing it, we have an opportunity to advocate scaling back significantly.

I second Toby Baxendale´s comment: „I think you (FRFB School) neglect some important contract law and accounting law facts in your assessment on fractional reserve free banking.”

I agree that it seems that FRFB (fractional reserve free bankers) ignore the legal arguments made against FRB. FRFB have not responded yet in academic journals to the strong case made by Huerta de Soto in his book “Money, Bank Credit and Economic Cycles”.

I recommend that they study Huerta de Soto´s argument in depth and once that they really understand it, they or agree with it or if they don´t they write up a response and submit it to a peer reviewed (not in-house) academic journal. Some contributors of this blog may actually argue that Huerta de Soto´s legal arguments may be ignored because they have not been published in a peer reviewed academic journal but only in a book. Fair enough.

Yet, David Howden and I have published an article titled: The Legitimacy of Loan Maturity Mismatching: A Risky, but not Fraudulent Undertaking, published in Journal of Business Ethics (a highly respected journal), 2009, 90 (3), pp. 399-406. http://www.springerlink.com/content/pn81764318674wv0/ In this article we also summarize the legal argument against FRB.

So I really think that these arguments cannot be ignored anymore. (By the way, we have another article forthcoming on the issue using common law legal principles to show that FRB is highly problematic from a legal point of view).
I still hope that if FRFB really study the arguments at the current edge of research on FRB they will agree and abandon the naïve attitude of: “In a free society I can do what I want even if it is against legal principles.”
If not, I am looking forward to their responses (in peer reviewed journals).

Can I echo Philipp's broad point here.

Last year I organised a conference with Philipp and also Dave Howden in attendance. I don't agree with their take on this but we had a scholarly and civil discussion. As Philipp says they have been publishing in very good peer-reviewed journals on this topic, and have ideas that deserve to be read, considered, and responded to.

I have working papers that are under peer-review that try to do this. This is where we should be - and are - having the debate.


Did you see Selgin's working paper I linked too that is posted at ssrn? I believe that would be the response. Also, let me be clear the RAE is not an in-house journal. We pay no money to publish it, they pay us to edit it. Look at the ssrn journal rankings, etc. And finally we have no plumb line we promote on any issue. All articles are sent to 2 blind referees that pass an initial editorial review. The RAE is a peer reviewed journal in the same way the AER is, though with far less professional impact.

I do hope a good exchange on these issues can be aired, not in a business ethics journal but either in the Journal of Money, Credit and Banking, or the Journal of Law and Economics. Then we would know we were making an impact by raising the scholarly bar of discourse.



I don’t think Philipp was commenting on the RAE, but rather echoing your drive to publish in the best (peer reviewed) journals. Selgin (and others) have done that successfully for many facets of the debate, while other points are still ignored.

The working paper linked to, for example, comments on legal issues (actually, issues of fraudulence) addressed only by Rothbard as recently as 1983. It’s pretty clear that at least one side of the debate has moved far beyond the issue of fraud, so it’s unclear why this is still paraded as the defining characteristic of the other side’s argument.

I think we can all agree with you that we need to not only move our ideas to the most visible (and credible) venues, but also to attack the most recent and relevant literature.

Bagus : "I still hope that if FRFB really study the arguments at the current edge of research on FRB they will agree and abandon the naïve attitude of: “In a free society I can do what I want even if it is against legal principles.”
If not, I am looking forward to their responses (in peer reviewed journals)."

Howden: " It’s pretty clear that at least one side of the debate has moved far beyond the issue of fraud, so it’s unclear why this is still paraded as the defining characteristic of the other side’s argument."

Interesting: Philipp chides the free bankers for insisting on people's right to break the law (using a made-up quote none of us have ever even approximated), while urging people to read Huerta de Soto's recent tome, large chunks of which are devoted to claiming the fractional deposits are fraudulent; David chides us for wasting our efforts by not realizing that the critics of fractional-reserve banking have moved beyond the matter of fraud! It seems the free bankers just can't win!

The question of what is and isn't legal or fraudulent in banking is obvioulsy not settled or an unimprtant part of current arguments for outlawing or severely restricting it. As for other arguments against FRB, David: Larry and I have also written oodles concerning them. Must I be accused of ignoring them because I don't address them in every paper I devote to the general topic?

Pete, Let me also make a clarification: I do see merit in Baxendale's proposal. My comments to your earlier post were simply directed at answering the question: is this reform not consistent with perfect reedom of contract. I argued that it wasn't, and I explained why--which meant elaborating my reasons for holding that such freedom would require a place for fractionally-backed demand deposits. In effect, I was not answering or trying to answer a policy question at all. I think you and Jerry both misunderstood me a bit on that score.

So to answer a different question: do I think Baxendale's proposal is a good step compared to anything else that's likely to be put before the legislature? Maybe. But, as I've already indicated, I think it would be better if it allowed an exemption from the 100-percent or "narrow" banking requirements to banks that foresake government insurance and other guarantees. Completely ruling out the latter would, presumably, also require some additional legislation. (No, I don't have a blueprint.)

> Indeed the bill that was put in the UK parliament (which
> isn't public information but I have seen) is really
> about the elimination of deposit insurance.

I didn't know that. Someone should mention that on the Cobden centre website, I didn't see it anywhere.

I think abolishing deposit insurance in Britain would be quite feasible. Unlike the US Britain has only had large guarantees for a short period of time.

Maybe another interesting comment (besides the ones already mentioned) coulde be:

Yeager, L. B. (2009). Bank reserves: A dispute over words and classification. The Review of Austrian Economics, 23(2), 183-191. doi: 10.1007/s11138-009-0102-8.

I don't see why the RAE should not be considered a good standing professional outlet to debate this issue, specially having strong roots on Rothbard/Huerta de Soto.


PS: Prof. White also has an interesting review of Huerta de Soto's book.

I've had a few debates with Toby and various people at the Cobden centre about applying "normal commercial law" to banks. Below is an bit of one of them, which I submit to this peer reviewed comment thread ;). The part quoted is Toby and my reply is below:

> Legal and Accounting Privilege: The Balance Sheet and Contract Law
> Problem
> It relies on legal and accounting privilege to get off the ground in
> the idealised world of the Free Banking School.
> Accounting
> It requires a different accounting standard to all other businesses
> in the world to not provide liquidity for their current
> creditors. This allows the maturity mis matching , borrowing short
> and lending long. The butcher, the baker and the candle stick maker
> can’t do this, a bank can. This sets a bank up in a unique way with
> a gigantic competitive advantage to a normal commercial operation as
> it has substantially more resource at its disposal to then compete
> resources away from others. Only today, I was with a very senior
> partner at PWC who was telling me that now the banks are back in
> business, they are significantly competing away at the graduate
> recruitment level, where the London office needs 1,000 graduates per
> year and the banks can simply pay more. This means that the playing
> field is not that of a free market. It is odd that the Free Banking
> School call themselves free market people when their system needs
> PRIVILEGE to get it up and running in the first place.
> The solution is to have free banks audited to the same standard as
> any other commercial organisation. If this is the case, they need to
> maturity match like any other commercial organisation. This means
> short borrowing with short lending, long with long, medium with
> medium etc. In fact, call a spade a spade, a free bank, working
> within the commercial law, can only ever be a full reserve
> bank. Just like a solvent company is always a full reserve company –
> other than a bank!
> No one in the free banking School has answered this critique. Either
> it is not credible, then fine, tell me why, or the onus is for this
> to be disproved.

Firstly, we must be clear about what maturity mismatching is. Maturity mismatching is not directly connected to debts that are payable on demand. Debts payable on demand are mearly one sort of maturity mismatching. Let’s suppose that I borrow 100 ounces of gold from Tom and agree to pay it back with interest in two yeasr. I then lend 90 ounces of gold to Jill, she agrees to pay me back in three years. So, the schedule of my lending in longer than that of my borrowing. That means that I must find someone else to lend me 100 ounces of gold to pay back Tom, to cover the time until Jill pays me. This is not illegal, but I must do two things. I must not misrepresent myself to any party, and I must be able to show that I had good reason to think that I would be able to role-over my debt.

The accounting issue Toby is talking about here is a bit different. Accounting rules require that for a company to be legally solvent it must be able to pay short term debts. It must be able to cover “current liabilities”. The principle behind this idea is that a business must be able to pay it’s debts and other commitments as they become due. In my opinion this doesn’t mean what Toby thinks it means.

Let’s suppose that I own a small shop. In that shop, if I were careless while washing the floor, someone could slip and fall. If they did I would have to pay damages. Those damages could put me out of business. Let’s suppose that hasn’t happened, does the possibility of it happening make a difference to my accounts? Let’s suppose I don’t have enough short-term assets to deal with being sued, does that mean that I can’t cover my current liabilities? I would argue that the answer is no. The probability of such an accident occurring is low and that must be taken into account.

The same principle applies to banks. There could only be one reason for forcing a bank to keep enough liquid assets to cover all of it’s liabilities from current accounts: a reasonable probability that that would be necessary. It would only be necessary if it were likely that a large proportion of account holders were to withdraw large sums or close their accounts, but that isn’t likely for a bank. In banks planners monitor the use of accounts and monitor redemptions. They estimate the amount of the reserve asset that will be needed at a given time to pay customers and use in transfers. In the old days the reserve asset was gold, now it’s fiat money, but in both cases the principle is similar.

The situation is different for a normal business. For a non-banking business it would be quite normal for counterparties to exercise their right to payment when it comes due. That’s because the liabilities of normal businesses don’t fulfill a service to their customers. If I have an account with Mises.org with £200 in it then I can use that to buy books on Austrian economics, but that’s about all. If I have an account with RBS then I can use that for a wider range of purposes.

The insurance industry is in a similar position to the banking industry. A company could insure 20000 houses against fire, one day all of those houses could burn down. That doesn’t mean though that the company must keep assets to the value of all 20000 houses in reserve, if it did then insurance would be impossible. It means that the insurer must keep a prudent amount of funds available, how much that is depends on the circumstances, just like a bank’s redemption fund. Neither insurance companies, nor banks, use a special legal privilege.


Let's suppose for a moment that Toby is right and the law should require that if a bank promises on-demand payment then it should be fully reserved. That doesn't prevent a bank from providing fractional reserve accounts. A bank may legally promise to pay in a year, but it may *in practice* always pay on-demand. All that's needed is an option clause to push the liability into the right accounting category. An account like that is likely to be attractive to many customers.

I just want to echo the general thrust of Current's criticism of Toby's concern with the supposed accounting "privilege" of fractional reserve banks. It seems to me that an accountant looking at an FRFB bank to see if it can cover its current liabilities would have to make a probabilistic calculation based on past redemption rates, much like an insurance company would have to demonstrate sufficient reserves based on past patterns of claims. That is how the business works, so that would be the reasonable standard.

This is the sort of thing I noted earlier that I worry about: the language of making FRFBs operate by "normal business principles" sounds fine in the abstract, but can easily be interpreted to actually do the opposite by holding them to a standard that is actually unfair and abnormal.

I do think there has been a lot of writing at cross-purposes on this thread. I propose some principles of reform.

(1) Perfection does not exist in human institutions, only tradeoffs.

(2) Monetary and banking reform (two issues, but closely linked) will never proceed from where we are to the "best" system of money and banking (finance) in one step.

(3) As a corollary, two steps forward and one step back may be better than standing in place.

With these in mind, there is a logic to moving through a kind of narrow banking to get to free banking. Especially so in the kind of emergency or crisis conditions described above.

My own view is that we are not nearly over the financial crisis.(1) There is continued "deflation" in housing in the US as a consequence of overbuilding. (2) Assets related to housing and real-estate finance have not been marked down on banks' balance sheets nearly enough. (3) Commercial real estate is a time bomb on banks' balance sheets. (4) The EU temporarized on the Greek financial crisis.

I buy Wolfgang Munchau's analysis in the FT on Greece: relative calm today, default next year. On the sham of banking reform, I think Martin Wolf had an epiphany and is correct.

In short, in banking and finance we must hope for the best and plan for the worst. No more dithering.


Kotlikoff takes the oppositie position to yours. He specifically cites insurance as being operated unsafely and unsoundly because the companies could not pay off on quite reasoanble disaster scenarios. (He gets almost Rothbardian at one point, but that is a side issue.) He wants not only narrow banking, but narrow insurance and narrow finance overall.

The more general point is that gov't regulation has been substituted for market forces. Banks are both illiquid and undercapitalized relative to what competition would compel.

I'd add that Ireland is now apparently in serious troubles.


Besides, franco-german banks are still heavily exposed in countries, as in Ireland, where they are likely to suffer heavy losses.


I should have been clearer. What we should do about banks NOW in the current mess is one question, but how we should treat them in general is another. No doubt that current banks are a mess by any accounting standard, but I'm not convinced that is a reason to adopt Toby's approach as a general reform.

Frankly, Tony Evans' 2-2-2 plan is a very good place to start to talk about a transition to a better system. I have my concerns about the two points that others have raised, but I could live with those as the price for getting all the other good stuff in there.

We should not let the perfect be the enemy of the much better, that's for sure.

@Steve -- We agree. -- Jerry

A bit off-topic but; has there ever been political support for dismantling the FDIC? Has a private sector alternative ever been suggested? Seems to me like even the non-free-banking mainstream literature on depositor discipline and such is aware of the incentives it is creating..


I believe private clearinghouses once aided member-banks when illiquid. I do not know whether this involved paying insurance premiums or not. Bannk that was deemed too risky could be banned from the clearinghouse -- thus preserving helping to preserve banks that were sound in the long run. Perhaps you should try asking George Selgin -- his book on free banking mentions this matter.

I know, I mean recently.

Anthony, problem, the Bill you have seen is proscriptive and not retrospective , so what you say about my views on existing demand deposits is wrong.

Steve, let’s cut to the chase here regarding the balance sheet (b/s) of a bank.

All b/s that I have looked at in all the banks I use have assets and liabilities. In all commercial vehicles other than banks that I look at have current assets, assets and liabilities or some such variants. I have to provide (redemption when agreed) for my current creditors as well as for my long term creditors. A bank does not have to do this. My current creditors today were in excess of £11m. If I was a bank audited under the accounting standard for banks, I would be able to use that £11m at my will to be able to pay myself a bonus, to build myself a megalomaniac office, to build a vain glorious reception to my building to make it look like I am a bigger and more serious player than I am and all sorts of other things banks do with their current creditor money.

You may have over looked this in your research work. I may have been looking at balance sheets incorrectly for 20 years. The facts that Banks do not appear to be audited by the GAPP that I and all other commercial organisations appears odd.

No being in favour of a closed shop of any sort as it is antithetical to my pro liberal , liberty loving bones, I seek to make the playing field level for us to trade in the commercial world.

Now a fractional reserve account is an account on demand. The bank does not provide on demand for all on demand accounts, but only a fraction (I can put some contract law arguments as to why this should not be so if you like). If I was allowed to do this, I would be £11m better off. That is a great head start in life! One rule for all of us and one rule for bankers. You gentlemen in the FRFB School miss something very important here.

So, my idea to have a closed end mutual wrapper , wrapped around a FR on demand account is the only way these can exist with me and all other commercial organisations being on the same level playing field. There may be other ways, I am not aware of them yet.

I seek to ban nothing, just get a level playing field and adjust an inequitable arrangement that is certainly not conducive to a free market.

Supporting it, or not being aware of it, you will be inadvertently propping up a bit of crony capitalism.


> He specifically cites insurance as being operated
> unsafely and unsoundly because the companies could not
> pay off on quite reasoanble disaster scenarios.

Do you think that's actually true? I've seen no evidence that insurance is in particularly bad shape. That's why I was suggesting that we should learn from it. If it is then that changes things.

One more from Toby:

Forgot to say, if you classify a demand deposit with an option clause as Current suggests, this is fine if there is a meeting of the minds of the parties i.e. a binding contract freely entered into by consenting adults. In effect an on demand liability becomes conditional , thus no longer on demand. I suspect this would be enough to move this out of being a current liability of the institution. I do not know for sure and would have to seek some professional advice on the matter. Once again, this FRB would then indeed become a full reserve bank as the former demand deposits could always become timed at the whim of the bank. Hence I think a FRFB becomes a full reserve bank in most of the examples I have seen of this being argued. Naturally, having run a full reserve company as all solvent companies are for 20 years, I would be supportive of this honest move. Anthony Evans and I have spend untold hours arguing about this and I think the actual gap between the FRFB School people and the Full Reserve School people is very small indeed. I will continue to encourage all to attempt to bridge this.


I think the question is whether all of the bank's demand deposits should reasonably be considered "current liabilities" in the same way that, for example, contracts whose payments are due in 30 days are for a non-bank business. The fact that the proportion of demand deposits that come due in any 30 days period is but a fraction and IS stable over time, suggests that it makes more sense to treat some fraction of that total as "current liabilities" and the rest as longer-term.

And this is what banks do: they keep liquid assets for the fraction that is truly current and they keep less liquid ones for the larger portion that is longer-term.

Fractional reserve banks do accept some liquidity risk, but they still must remain solvent by having assets to match their liabilities. Option clause type arrangements have historically been how banks attempted to deal with the possibility of a liquidity shortage. Banks who used them and customers who accepted them appear to have known exactly what was involved.

Toby is working on the correct side of the balance sheet, but is on the wrong line. Banks do all those things with profits, retained earnings and possibly excess capital. They can also borrow against future profits for those new buildings. But deposits fund loans, securities, etc. In normal circumstances,banks basically lend out 100% of deposits.

The one exception to this is for insolvent institutions being kept open by central bank support. Then banks use deposits to fund daily expenses. In short, they operate a legal Ponzi scheme.

Banks are exempted from the bankruptcy code. Indeed, banks operate under special law and not general commercial law. Commercial law has common law concepts, but banking law is basically regulation and a kind of administrative law. Think of the ability of even "free banks" to suspend paying their current liabilities.

So it is not true that banks are "just like" any other business. They have not operated under the same law and rules as other commercial enterprises. That may be justifiable under some theory; it may be appropriate to the special nature of banking; and it may be even efficient in some sense. But banks are different.


Kotlikoff makes a case that insurance companies are under-reserved against big catasphroess. I think he cites a pandemic as one example. Such events have happened historically (e.g., the Black Death). His solution will strike some as overkill, but he identifies a real issue.

Toby: "Now a fractional reserve account is an account on demand. The bank does not provide on demand for all on demand accounts, but only a fraction (I can put some contract law arguments as to why this should not be so if you like). If I was allowed to do this, I would be £11m better off. That is a great head start in life! One rule for all of us and one rule for bankers. You gentlemen in the FRFB School miss something very important here."

No sir: it is simply intermediation; banks "provide" for all their deposits so long as they pay amounts due or requested on demand. Your argument (like Rothbard's) is based on the premise that bank deposits are bailments rather than debt contracts, which (as my working paper linked by Pete above shows) wasn't even true in the 1650s and has certainly never been true since. Simply put: in English law, when someone hands a banker some money in exchange for a "deposit" of any kind, the title to the cash passes to the banker along with the cash. The depositor in return gets the banker's promise to pay back the amount, or any part thereof, on demand. The promise is _not_ a "title" to the cash but an IOU, no matter how many times the Rothbardians pretend otherwise. Consequently the banker can do whatever he pleases with the deposited cash, his sole obligation being that of honoring his debt. A law compelling the banker to store the cash--all of it--does not thus protect the property of the depositor. Instead, it interferes with the property right of the banker. (And also, since the debt contract is voluntary, that of his clients, who chose _not_ to put the cash on safety deposit, as they have always had the option of doing.)

And no single bank in a competitive system can afford to lend more than, let alone a multiple of, what it takes in in reserves, as adverse clearings would quickly destroy it. The banking business isn't so magical and easy as all that, in other words, unless you get to be a central banker. The system-wide multiplication of IOUs beyond total bank reserves is not a symptom of any unique lending power of individual commercial bankers.

In any event the quote shows the fact the the reform, whatever its merits, has been shaped in part by Rothbardian fallacies. Maybe these don't matter much. But bad theory seldom helps to make good policy.

Banks, and financial institutions generally, keep next to no liquid assets. They operate on the assumption that they can liquify illiquid assets in securities markets. As we have just learned, once again, that works except when it doesn't work. And it doesn't work more often than theory suggests.

Volcker just spoke eloquently on this issue. We have 100-year systemic failures every ten years.

Henry Simons diagnosed the problem as the peverse elasticity of short-term credit (close to his words). It went beyond maturity-mismatch at banks to the entire financial system. He identified the phenomena of shadow banking before it had a name.


I don't think you understand the question about legal privilege. Certainly modern banks enjoy legal privileges we all agree on that. I think we also all agree that those privileges should end.

The question though is if banks were normal companies then would they be able to use fractional-reserves while promising to pay on demand.

My argument is that they would (see my post at 9.59am).

George, I am well aware of what the law is. Here is a post form a few weeks ago when I have updated our UK readers, http://www.cobdencentre.org/2010/09/the-legal-relationship-between-the-banker-and-his-customer/

Before I posted I asked my commercial lawyers to confirm it was up to date and accurate as far as they were concerned.

Now I believe that the majority of people do not know this is the case. This was evidenced when we did a survey of 2,000 people - see here http://www.cobdencentre.org/2010/06/public-attitudes-to-banking/ .

So I seek to get this sorted out. Safe keeping, saving and borrowing and fractional reserve lending in a environment conducive to the commercial law (closed end mutual as I see it).

Why can you not support that?

Steve, if you know that more times than not a FR bank will be able to always redeem cash on demand as most liabilities are not claimed on demand, why not call a spade a spade and ask the customers, "customer, would you like this in a on demand account or would you like it put away for savings to earn you interest?" Would that not be a more honest approach? Then current liabilities would match current assets as the cash could be left in the vaults and long term cash could be put away to work for long term return. This just happens to be a fully reserved solvent company right? Would this not once and for all put this issue to bed? Am I missing something here?

For George and Steve, I spoke this week to the CEO of one of the UK's largest banks the other day, he is a mate. I asked him did he know that he will be able to issue credit in unlimited amounts by creating a bank IOU or journal entry, which all bank credit is, and could buy the entire share capital of a competitor bank, without having to have any cash (M0) at all as there is no reserve requirement in this country. The other part of the bank (retail and investment combo bank) business, will then have a liability to pay the bank back this credit.
Over night, this new private sector mint will have increased money supply by £Xbn (M4) and reduced all of our purchasing power by the same amount.
Using another bank as an example is bad as in the real world, the Competition people would block this, but I am sure you get the point.
He had no real understanding of this unique privilege and ability.
He thinks like the majority of people in this country, that when someone places a deposit into a bank, it is their money. The law since 1811 says it is the banks money. This came as a surprise to him. He is a very competent CEO, but he as with many of the other Banking CEO's actually have no idea how their businesses operate.
I deal with many senior bankers with all the main banks and this staggering level of ignorance is not uncommon.

I see no fraud in this whole banking debate. I see negligent misrepresentation.

Do you not think it is a worthy effort we make in our Bill to clear this fact up and liberty lovers all over the world should be supporting it and blogging for it?


I responded to your question to me about insurance comapnies. I didn't respond to your other posts.


Yes, I know, thanks for that response. I think the argument about the black death is a bit strange.

Toby, I'm glad that you posted the links above, and I urge people to look at them. The first shows that the law is precisely what I claimed in my own comment here. So we both agree completely regarding it. (The Rothbardians, on the other hand, claim that the English courts simply kept getting it wrong.)

The survey shows, on the other hand, that people are confused about this. That they are is sad testimony regarding the poor state of public education in England. But leaving that aside, the question is whether your solution of making all "demand accounts" into bailments (even though people already can chose a safety deposit option) is an appropriate solution to that problem. I don't think so, first of all, because it punished those intelligent enough to know what a demand deposit really means, and to appreciate the advantages of such deposits (please let's set guanatees aside for the sake of this point), and, second, because if ignorance is the problem the straightforward solution is to hand every depositor sign a document declaring "I understand that my "demand deposit" is actually a debt contract and not a bailment, and that the banker is therefore under no obligation to hold cash reserves fully backing it" or whatever. For good measure the banks could also be required to hand their customers dictionaries for the purpose of looking up fancy words like "debt."

But seriously: there is already too much legislation designed to protect the ignorant at the expense of the less ignorant. Let's by all means help the former--but not at the latter's expense.

By the way, I pole my money and banking students, at the beginning of class, on the subject of bank reserves, and seldom do I get anyone who believes that deposits are fully backed by cash. They are, admittedly, college students.

For the record, that's "poll," not "pole," though I have also had students I'd like to "pole."

For George and Steve again now I have your attention - I do indeed feel privileged.

In the pure state of the FRFB world, when a bank issues new money to accomodate the needs of trade, why is this not counterfeiting?

As an entreprenuer, the only way I create wealth is to make things my customers want in better and cheaper ways. I do this by holding off some consumption now, I save, to invest in better kit to make my existing factors of production work in more productive ways. This is done over time. I use money , the final means for which all goods exchange , to exchange for other goods and services I want.

So when there are more money units introduced, what should have been an increase in my purchasing power of my money units is now taken from me, by the FRFB issuing more notes.

So I can only conclude your MET ends up advocating counterfeiting which is incompatible with liberty.

By the way, in the round, I do accept that the FRFB system will not over issue / under issue in the long run. I like the Theory very much. It is the short run immediate effect of theft of my purchasing power that I am concerned with here.

Have I misunderstood you?

Have I misrepresented you?

I am on this blog to deepen my knowledge and not through stones.

> I asked him did he know that he will be able to issue
> credit in unlimited amounts by creating a bank IOU or
> journal entry, which all bank credit is, and could buy
> the entire share capital of a competitor bank, without
> having to have any cash (M0) at all as there is no
> reserve requirement in this country. The other part of
> the bank (retail and investment combo bank) business,
> will then have a liability to pay the bank back this
> credit.

That's not how it works. Let's suppose bank X wants to buy bank Y. Bank X can only do that if it has the assets pay the shareholders of bank Y. It can't simply write a huge balance into it's own account if it did it would be bankrupt.

In systems that don't use a fractional reserve (such as New Zealand and Sweden) the amount of M1 is controlled by OMOs and by rules on the quality of assets (or capital regulation of some sort). Britain doesn't quite work that way. There is an optional reserve requirement, I understand a bank gets some special privileges if it obeys that requirement.

Selgin: "Your argument (like Rothbard's) is based on the premise that bank deposits are bailments rather than debt contracts, which (as my working paper linked by Pete above shows) wasn't even true in the 1650s and has certainly never been true since."

"Rothbardian fallacies" can be debatable, but the above is definitely an undebatable fallacy. A logical fallacy - appeal to tradition.

You cannot refute his (Toby's) claim about demand deposits with a logical fallacy.

Just to go back to the current liabilities issue again...

Toby says that he has £11 million in current liabilities, and that accounting rules mean he must hold a similar amount of money against them. Toby then points out that banks don't have to do this.

The reason for this is that the situation is quite different, though the rules aren't really very different. If a bank has £11 million of liabilities in current accounts then most likely it will have a similar amount in the next operating period or the next year. It's customers will roll-over their liabilities. As Steve said above a bank only needs to keep an allowance for the largest likely outflow.

The situation is different here because an account at a bank offers a general service to customers. It can be used to buy or sell many things. An account at Seafood holdings can, as far as I know, only be used buy fish and meat from Seafood holdings. As such, it's very likely that those who have lent money to seafood holding through their dealing with them will request it back.

Let me try, Toby.

Banks get "deposits," that is, as I explained (and as English law recognizes) they receive transfers of cash (legal tender or base money), which becomes their property, offering in exchange their IOUs that can be cashed or transferred in part or in whole on demand.

Bankers profit by lending most of the cash surrendered to them--they cannot lend more than what they get, individually, because borrowers tend to draw quickly on the loans, and so exhaust the bankers' cash to the tune of the amounts extended in short order. (That borrowers initially take their 'loans" in the form of more bankers' IOUs doesn't matter--the point is that those "lent IOUs" tend to be redeemed quickly.)

There's no counterfeiting here, Toby. Nor is there any promotion of inflation, assuming we are talking about an established FRB system, rather than one in which banks are still "discovering" that they can lower their reserve ratios further than was previosusly the case, e.g., due to some new innovations in clearing arrangements.

Nor is there any hanky-panky going on w.r.t. purchasing power: banks can lend deposits only in so far as original depositors refrain from redeeming their IOUs. So we have a transfer of purchasing from depositors to borrowers. That's a change in the distribution of demand for goods, not in total demand. The number of IOUs can also grow without inflation being provoked, because it is the spending of money (which always involves redemption of IOUs) that puts pressure on prices, not the mere holding of claims to money.

My Theory of Free Banking explains in considerable detail how competitive forces keep the amount of IOUs ("bank money") in line with the demand to hold onto rather than cash (or spend) the IOUs. The theory applies, mutatis mutandis, to modern competitive commercial banks.

As for central banks: yes, they engage in operations that are the economic equivalent of counterfeiting on a routine basis.

Dan, give me a break. I pointed out that Baxendale's argument is "like Rothbard's." In truth, it is. If there's a "logical fallacy" here, it's a new one you just came up with!

Centaris paribus, an increase in the supply of money reduces the purchasing power of cash balances. But the principle of adverse clearings means that all else is not equal when FRBs increase the money supply -- assuming profit-maximising behaviour. An FRB bank can only increase the supply of money when demand for its liabilities (chequing accounts and banknotes) increases, i.e. when its "depositors" choose to increase their cash balances. This reduction in monetary expenditures would create deflation, and frustrate the medium of exchange, but for the expansionary response of FRBs.

For the economy as a whole, FRBs help coordinate the plans of savers and borrowers by redistributing purchasing power in response to changes in money demand (a form of saving). Without such a mechanism, an increase in demand for money is likely to become an excess relative to prevailing prices. This will force a painful deflation and associated disuse of scarce resources -- the so-called paradox of thrift. ("Paradox of thrift" is a misnomer, because the problem has nothing to do with thrift per se, but rather an inelastic money supply, inelastic prices, and a fluxuating demand for money).

The emission of additional "inside money" by FRBs has little in common with counterfeiting.

A counterfeiter does not wait for customers to begin saving before increasing the supply of money, and nor does he necessarily direct his additional spending toward investment projects. Moreover, the counterfeiter has no intention and no means of paying interest to those he surreptitiously denies of consumption.

A counterfeiter typically spends his money on particular goods and services in some region or industry. The information of the illusory increase in demand then spreads slowly and unevenly through the price system, temporarily misallocating resources and ultimately denying cash balances of some purchasing power. But when an FRB increase its emmissions of credit (or when its "depositors" demand more of its liabilities), the first change occurs to interest rates. That is, the first information the price system receives is not illusory, but real -- people are foregoing something to hold greater cash balances, i.e. saving. Since almost every price, regardless of geographic or sectorial proximitry, is influenced by interest rates, the new information is transmitted relatively quickly and evenly through the price system.

In short, it ain't counterfeiting.

On a related note (and in no way is this related to FRB), counterfeiting isn't always so bad. Check out Selgin's "Good Money" for a case where some counterfeiters were practically doing a public service. For want of better small denomination money (which the Royal Mint refused to supply), obvious counterfeits were all that England's poor had to use. And they would have surely been worse off had these counterfeits not existed -- which were, after all, satisfying a genuine demand for some kind of money.

It's a little more complicated than that, of course. Just get the book. Good economics and good history -- definitely worth it.

That was a joke, btw -- the "on a related note" followed by "[this is] in no way related to FRB". Too subtle? I just realised that readers might think I made a gaffe.

George's post from 606pm is precisely the point that so many opponents of fractional reserve banking utterly miss. This is the core of the argument for why FRB is neither inflationary nor counterfeiting. Before anyone rises to the defense of 100% reserves, PLEASE read that post one more time to make sure you understand the argument.

That includes YOU Boettke. :)

If fractional reserve banking is not considered fraudulent, what is the libertarian justification for requiring banks to make efforts to insure that depositors are aware of information about bank reserves? How does this proposal differ from laws that require sellers of foods and drugs to disclose the ingredients in their products? I'd have thought the usual libertarian view leaves it to consumers and producers to arrive at their own arrangements on such matters, without the helping hand of government. Given his view of fractional reserve banking, George Selgin seems to me perfectly right in opposing the disclosure sections of the proposed bill.

David Gordon: George Selgin seems to me perfectly right in opposing the disclosure sections of the proposed bill."

I do nothing of the sort, David. Evidently you overlooked my earlier comment in which I wrote:

'[I]f ignorance is the problem the straightforward solution is to hand every depositor sign a document declaring "I understand that my "demand deposit" is actually a debt contract and not a bailment, and that the banker is therefore under no obligation to hold cash reserves fully backing it" or whatever. For good measure the banks could also be required to hand their customers dictionaries for the purpose of looking up fancy words like "debt."'

I'm not against full disclosure (though I do not agree that banks mislead people about fractional reserves--some ignorant people are capable of believing anything and it is not necessarily because they've been misled or proof that the market needs to be regulated--I am reminded of a lawsuit lodged by someone who injured his back by running with a refrigerator on it, who claimed that the fridge ought to have had a warning label saying that it wasn't safe to use it that way). I am against outlawing fractional reserve deposits. If Toby's law allows them, then I have no issue with it; but my impression is that it only allows time (savings) deposits or warehousing.

Toby's arguments about accounting for ordinary firms don't apply in the U.S. Or, at least, the accountants on the Faculty at The Citadel, don't see it that way.

First of all, the current liabilities (coming due in one year,) don't have to be matched by what we economists would call "money," (currency or zero maturity deposits.) The only thing they must be matched by would be current assets. Current assets include accounts payable, liquid securities, and unsold inventories of goods. A security is "liquid" if you don't say you plan to hold it more than a year and call it for "investment." When it was explained to me that goods that have not been sold "count" as a current asset, the relationship to 100% reserve banking was shown to be an illusion. Anyway, a bank could fund one year loans with demand deposits and it would have current assets matching current liabilities. As long as the demand liabilities were no greater than the amount of loans and securities coming due in one year (along with securities that actually are marketable,) this rule would not be violated.

In the imaginary banking system that solely uses banknotes or checkable deposits to fund loans, then loans over a year and securities that are not easily saleable would be a problem. Of course, saving accounts today in the U.S. are very much a grey area because of sweeps, and they are effectively payable on demand anyway, so most bank loans would need to be less than a year (or have less than year to go.) Those loans that are more than a year (or portions of installment loans) would need to be funded by longer term certificates of deposit, equity or bonds due in more than a year. With this current asset = current liability rule.

OK, so, after all of that about the great "current assets must match current liabilities" business, what is the status of that rule? There is no such rule in the U.S. When I heard that I was puzzled. Why can't Microsoft fund the purchase of a building by selling 1 year commercial paper and rolling it over for 10 years? Why should there be some law prohibiting that practice? Well, in the U.S., there is no such law. But those lending to U.S. firms might include covenants that put restrictions on other borrowing. This loan is senior to all other long term debt, but short term debt can be issued but no greater than current assets. The contract on the long term debt is based on the notion that the firm may need to borrow short for a variety of reasons, and that it won't be able to borrow short except at high rates if the long term debt is senior, but by limiting this to no more than current assets, it keeps a firm from using short debt (which can be senior) to substitute for long term debt which would then be made junior, contrary to the point of the contract.

As Jerry has already explained, bankers cannot create deposits and declare dividends, pay bonuses to management, purchase buildings, and the like. When the money is spent, the bank will have to pay off the checks. To come up with the funds, they must sell new issues of stock, sell bonds, or convince more people to make deposits in the bank. If a bank buys something from someone who chooses to hold more money in the bank, then they got the new deposit by making the purchase. No bank can depend on that.

And of course, that is to fund assets, including buildings. Payments of dividends or bonuses are not capital expenditures and they reduce capital--net worth. Banks aren't allowed to operate with no capital. And so they cannot be funded by deposits.

Banks have income--revenues and expenses and make profits.

Profits add to capital, losses take away from capital.

The banks have assets and liabilities. Buildings, loans, securities and reserves are assets. Liabilities are bonds, and deposits. Checkable deposits are important forms of bank liability because the serve as money. Banknotes would be important as well if they were still legal. Assets minus liabilities is capital or net worth. If people are willing to hold more bank deposits, the bank can expand its liabilities and use it to fund assets. Usually we think of loans, but securities and buildings are assets.

A bank uses its revenue to cover expenses and hopefully make profit. Bonuses to executives are expenses. Dividends is paying out the profits to the owners.

Now, just because a bank can always use its own banknotes or checks as medium of exchange doesn't mean they can create money and pay dividends or bonuses to management without reducing capital.

While banks are not subject to the same rules as other businesses, the rules that do apply are often more stringent. Regular business don't have to hold currency or deposits equal to a fraction of their short term borrowing. Ordinary businesses don't have a legal requirement to keep capital at a certain fraction of total assets (based on their risk.)

And, in the U.S. anyway, ordinary businesses can continue to operate when they fail to make payments on their debts. Which chapter of bankruptcy is it? I think FDIC resolution is usually harder on senior management than bankruptcy.

The notion that if a normal business fails to pay any debt immediately on time, it is immediately shut down and liquidated, with the owners getting only any remainder and the business is gone--is wrong. That isn't what happens in the U.S.

All of this business about banking law is confounded with monetary economics (and that is usually confused) showing that banking increases the quantity of money and causes a lower purchasing power of money (or higher price level.) That is true, ceteris paribus. But that doesn't have much to do with the legal status of bank assets and liabilities.

For an ordinary business, it is like introducing a new product that makes a competitor's product less valuable.

Thank you George for your comment of 10/01/10 @ 6.06 PM, this is the heart of the matter. The meaty stuff.

I have a problem with this

"Nor is there any hanky-panky going on w.r.t. purchasing power: banks can lend deposits only in so far as original depositors refrain from redeeming their IOUs. So we have a transfer of purchasing from depositors to borrowers. That's a change in the distribution of demand for goods, not in total demand. "

To me, I submit, you are looking at the Marco level, you are not looking on the micro level.

So I work my nuts off and save and invest and become more productive in the process. I sell more for the given amount of factors of production I deploy. Absent state messing around with the money unit, my purchasing power should go up. With my increased purchasing power, I go and buy say a shop for $1m with my money units. Then a competitor who has the confidence of his FRFB bank manager comes along and issues a new FRFB IOU for $1.10m. Happy days for the shop vendor and sad days for me. The new created bank IOU , which is created on a fraction of money IOU's out bids me and allows the bank's client to buy the shop.

I have saved. My command over the $1m of money represents the fruits of the sales of real goods and services , the bank IOU represents a fraction if the production of real goods and services, the cash reserve and something created out of nothing, the bank IOU. This to me is counterfeiting.

So from my point of view, as the worker bee in this situation, I could not care less that this would happen in the idealised FRFB world,

"The number of IOUs can also grow without inflation being provoked, because it is the spending of money (which always involves redemption of IOUs) that puts pressure on prices, not the mere holding of claims to money."

In the mean time, in this great macro equaling out, I have been royally stuffed!

This disconnect distrubs me in your theory.

Please tell me why I am wrong?

David Gordon, thank you for posting on October 02, 2010 at 12:49 AM . It is a great honour to be attacked by you.

I do not see FRFB or FRB as fraudulent but a case of negligent misrepresentation. Our banking survey of 2,000 just shows desperate confusion on the most http://www.cobdencentre.org/2010/06/public-attitudes-to-banking/ , so I would use the lower contract law charge rather than the higher and most emotive one. I do not agree with Rothbard on this point, I would water down the fraud aspect.

On a side point, do you use the word fraud in its civil or in its criminal meaning?

Do you hold there should be no law to regulate human behaviour?

With any scarce goods, we have to have private property rights (rights imply a duty to uphold those rights - right?) to economise the use of them.

I hold that when I and a large majority of people (see survey evidence) deposit, we think we deposit in the bank our money and we do not lend it to them.

I am only ever told by my bankers that the money is mine. That it is there. The language is always about my money and not their debt obligation to me. Do I think they are fraudulent? No. Most I deal with are utterly ignorant at best.

My most sacred of savings I believe are mine and not a debt obligation from the bank to me - I know de jure that is not the case. So I want this mess of confused language sorted out.

Thus , the hand of law to clarify my property rights and the counterparty duty to uphold this is called for.

Simply put, the Bill should allow clarity on custodial accounts and lending accounts. A fractional reserve style account could well be contemplated in a fully reserved closed end mutual type arrangement.

This is compatible with Liberty.

Toby wrote:

"Then a competitor who has the confidence of his FRFB bank manager comes along and issues a new FRFB IOU for $1.10m. Happy days for the shop vendor and sad days for me. The new created bank IOU , which is created on a fraction of money IOU's out bids me and allows the bank's client to buy the shop."

If I'm understanding you correctly, you have it wrong. The competitor who comes along to borrow $1.1m from the bank can only do so because the FRFB has already in its possession excess reserves of at least $1.1m that come from the prior savings of its customers.

The FRFB is not creating that new loan "on a fraction." On the margin, all new loans created at FRFBs are granted on the basis of the new savings provided by customers willing to hold its liabilities.

If a FRFB has $10m in demand deposits and $1m in reserves and wishes to keep a 10% reserve, the only way it can make a new loan for $1.1m is if someone comes along and provides it with new reserves of $1.1m. As George said in his post, the individual bank is limited in its lending to its excess reserves because those loans will immediately get spent (as in your example!) and return to the bank as a demand for redemption.

In order to dispense this loan, the bank MUST receive new reserves (i.e., deposits/savings by its customers). It cannot just create 1.1m in new loan assets out of thin air - even if it had $110K in excess reserves. It needs the full amount of the loan in excess reserves in order to make the loan you hypothesize. There's no lack of savings there.

I hate to break it to people sympathetic to Toby's position (if I've understood it right) but this is the very first thing covered in a standard money and banking course when we talk about the limits to bank lending. If you think a bank can just create $1.1m in new loans off of excess reserves of $110K, you do not understand how banks work at a very basic level.

As George also said, the people who are able to lend on the margin without savings backing it up are the central banks, not fractional reserve banks.

There are two camps in narrow banking. The first is what I'll call the Rothbardians. The second is everyone else: the Old Chicago School (e.g., Henry Simons), Irving Fisher and Milton Friedman. They proffer a purely economic argument that fractional reserve banking causes booms and busts. Call the latter by its original name, the Chicago Plan.

With fiat money, I consider the Chicago Plan a rational position. I am NOT saying it is preferable to free banking with gold (commodity money). But neither gold nor free banking is on the table. (I think gold is a possible, but not probable. Free banking is improbable at best.) So the Chicago Plan COULD be part of a reform plan.

I have listened to the Rothbardians make their case for 40 years. I first heard it from Murray himself. As the current discussion demonstrates, that argument has no traction except among the already converted. No one is convinced upon hearing it, and repetition produces ennui not conviction.

I strongly favor disclosure as the best approach to consumer protection. Disclosure addresses the Rothbardian argument. It is apparently all that Toby is asking. And George has agreed to it.

So could we all agree to agree on disclosure and move on? This debate will become sterile quickly otherwise.

"Then a competitor who has the confidence of his FRFB bank manager comes along and issues a new FRFB IOU for $1.10m. Happy days for the shop vendor and sad days for me. The new created bank IOU , which is created on a fraction of money IOU's out bids me and allows the bank's client to buy the shop." - Toby Baxendale

If an FRB can profitably increase its supply of credit by $1.1 million, then its depositors have worked their "nuts off" and refrained from consumption to provide those additional funds. The entrepreneur who outbids you with the borrowed money represents those savers.

In principle, the situation is hardly any different than if the borrower sold bonds to raise the $1.1 million. In the case that he receives a loan from an FRB the money supply increases, while in the case that he sells bonds the money supply remains constant. However, in both cases total spending remains the same and the allocation of resources is likely to be almost identical.

I agree with Steve Horwitz and Lee Kelly's replies above. But, I think to a Rothbardian it may appear that they are giving different theories. They're not really, they're just different parts of the same theory.

Let's suppose that a bank is operating normally. It's reserves are sufficient to meet normal redemption requirements. It has more assets than liabilities.

Then the customers of this bank decide to save more by holding larger balances in their current accounts or savings accounts. That means more capital is being loaned to the bank which it can lend out. In order to do that it finds someone who wants a loan and is a good credit risk, it offers him or her a loan. It then purchases reserves, such as gold or central bank reserves, on the market for reserves. The customer who took out the loan draws it down into his account. He then spends it on capital assets (or whatever purpose the loan is for). As he transfers balances from his bank account to the bank accounts of those he's buying assets from the transfer of reserves takes place. When bank X transfers money to bank Y that involves redemption, since bank Y has no interest in holding an account with bank X it will ask X to redeem, that's why bank X needed the redemption reserve up front.

After this the bank that made the loan is back in a similar state to how it started. It has a slightly larger quantity of liabilities (due to the extra saving that began the process), and a larger quantity of assets due to the new loan it has made.

Alternatively, a bank could make a loan out of it's own capital. But, doing so is simply exchanging one set of assets for another. These two ways are the only ways that free banks can create new loans.

I think Current's story is a better account of a banking system in equilibrium that Horwitz's. I suspect Steve agrees, really. Still, Steve's story is the one we start with. In the end, however, a bank need to attract deposits to match loans (well, there is capital funding.)

One criticism I have of Current, is watch your use of the term "capital." I am pretty sure that the way you used it was wrong--at least inconsistent with the standard usage of economists.

I do indeed agree Bill. I was doing the first day of class, he was doing the second. :)

Bill is correct. A deposit is not capital in either law or economics. The depositor brings cash or reserves to the bank.

Capital and deposits are both liabilities of the bank, but different items on the balance sheet.

I do wish folks would specify the conceptual experiment. Are they talking about an indealized world of free banking -- a model-theoretic exercise -- or do they wish to discuss how banks fund themsleves today.

It is commonplace in economics to discuss businesses as though they were operating in a perfect free market. It is from this abstract ideal that we interpret and understand the consequences of real-life conditions and institutions. Unless parties agree on these fundamental aspects of economic theory, they will interpret real-life conditions and instutitons differently -- and offer different policy advice accordingly.

A discussion regarding policy in a second-best world of state-controlled money and banking will likely be fruitless unless these theoretical disagreements are cleared up. Otherwise different laws and regulations will be interpreted relative to different abstract ideals.

> A deposit is not capital in either law or economics.
> The depositor brings cash or reserves to the bank.

Isn't cash a form of capital? I didn't know that "capital" wasn't supposed to be used in that way.

> I do wish folks would specify the conceptual experiment.
> Are they talking about an indealized world of free
> banking -- a model-theoretic exercise -- or do they wish
> to discuss how banks fund themsleves today.

To be clear, I was mainly describing how a free banking system works.

I should have added that things are different in a central banking system. In a traditional central banking system the required reserve is used to control the quantity of money. The commercial bank doesn't decide what the reserve is, the central bank does. That reserve may be more than the commercial bank needs for it's day-to-day operations. In some central banking systems a commercial bank is automatically granted more reserves (at a price) if it runs out.

In a central banking system savings are still needed to counterbalance assets. But, the commercial banks and their customers may rely on protection from various emergencies by the central bank and the government insurance scheme. As such, the values of the assets and liabilities on a commercial banks balance sheet don't correspond with what their values would be on a free market.

In a fiat money central banking system the central bank can create reserves by fiat.

Add on to previous comment:

One of the major problems with economics regarding money and banking is that it is an exception to this ordinary rule. Institutions like central banks, monopolised surrency, mandated resere ratios, and deposit insurance are assumed from the beginning. Few seem to have any concept of what money and banking might be like in an ideal free market.

Could you imagine trying to understand the U.S. healthcare industry without a model of how healthcare might be provided, in principle, by an ideal free market? It would be an intellectual mess to assume from the beginning all the peculiar laws, regulations, and expectations that currently shape the present system. Without an implicit free market ideal, interpreting the consequences of various conditions and institutions would lead to a very skewed and limited understanding.

Unfortunately, the economics of money and banking (as it is commonly taught) appears to have suffered this exact fate.


Please do not lecture me on how to do economics.

People have been communicating at cross purposes here because they have not been clear on whether they are discussing the "here and now" or analyzing models. Steve Horwitz made the same point earlier.

For example, except for George, people have ignored shadow banking. It was shadow banking that blew up. That is not a footnote.

For the record, I agree with Jerry that free banking is impossible. I also believe that free trade is impossible. But I also believe we have as much reason to favor reforms that take us toward rather than away from free banking as we do to favor reforms that take us toward rather than away from free trade. Baxendale's reform goes in the right direction in some respects, but not w.r.t. its treatment of demand depsoits (for I do not think that it merely asks that there be full disclosure about their backing--though perhaps I remain misinformed on this).

Even if I'm right, it may still be that the reform is the best we can hope for. But I think it nonetheless worthwhile to point out what I believe to be its shortcomings in the hope that doing so might contribute to the formulation of a still better plan.

So, for me it isn't a question of "free banking or bust," and it never has been. I think it's important to realize that, by writing about free banking and arguing its distinct virtues, I do not mean to endorse it as an immediately practical--let alone as the only acceptable--banking reform alternative. In fact, I never have: the aim of my work on free banking has always been that of trying to amend academics' understanding of how market forces work in money, so that they might then contribute to seeing that actual reforms go in the "right" direction, instead of merely making things worse.

Let me once again call attention to Anthony Evans's 2-2-2 plan which does provide a roadmap for going in the right direction: http://www.cobdencentre.org/2010/06/2-days/

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I think the Lee makes a good point. It may be better if people were first taught how a bank would plan it's reserves in absence of a central bank. Then later they are taught the effects of central banking and how that changes things. But, I suppose that would take a long time.


I wasn't trying to lecture you. Although your comment inspired mine, it was not meant as a response; that is why I did not address it to you. I was just talking about economics. I agree that there has been some confusion about what is being discussed. I merely intended to say that I believe George, Steve, Current, and Toby were right to address theoretical disagreements, because not a whole lot of fruitful discussion can be had about practical reforms until that is settled.

We seem to have more agreement than seemed apparent at the beginning.I like George's statement of the pedagogic role of free banking. I endorse Steve's call to check out the Evans post.

Current is surely correct that economists should understand how money and banking would work w/o a central bank. Larry White has explained why that doesn't happen.

My apologies to Lee if I misunderstood him.

Steve, I am delighted you wrote this.
"If I'm understanding you correctly, you have it wrong. The competitor who comes along to borrow $1.1m from the bank can only do so because the FRFB has already in its possession excess reserves of at least $1.1m that come from the prior savings of its customers.
The FRFB is not creating that new loan "on a fraction." On the margin, all new loans created at FRFBs are granted on the basis of the new savings provided by customers willing to hold its liabilities.
In order to dispense this loan, the bank MUST receive new reserves (i.e., deposits/savings by its customers). It cannot just create 1.1m in new loan assets out of thin air - even if it had $110K in excess reserves. It needs the full amount of the loan in excess reserves in order to make the loan you hypothesize. There's no lack of savings there."
Does this not mean it is a full reserve bank then? If only savings are lent, then you suggest an arrangement that is totally in the Rothbard / Huerta De Soto tradition.
You say the following;
"I hate to break it to people sympathetic to Toby's position (if I've understood it right) but this is the very first thing covered in a standard money and banking course when we talk about the limits to bank lending. If you think a bank can just create $1.1m in new loans off of excess reserves of $110K, you do not understand how banks work at a very basic level."
Not being able to ask my Banker CEO as even though he has tens of millions of customers, he does not know how the private mint that he runs works, as you were talking about basic banking, I went back to the text book they gave me in my first year at LSE, An Introduction to Positve Economics, by Richard G Lipsey (6th Edition). One would hope the School and the text book could teach me something.
Page 574 - 580 It tells me as I suspected how "a multibank system creates deposit money when all banks with excess reserves expand their deposits in step with each other," it shows tables how this is done. This is by creating new loans. There is nothing about prior saved resourses.
So a loan is created out of nothing when a bank has someone to lend to. The new loan created gets redeposited in the system and new money has come into play, the debit and the credit side of the accounts balance.
So I think at a basic level I understand it. If not, this book must be wrong and all my education a waste of time. They did try and teach me how the Keynesian multiplier was the cure for all problems, so maybe this basic banking was a myth as well. The trouble with it though is that is how I see banks work. With the multiplier I paused and thought they have just told me how we must cure all world poverty, then it dawned upon me it is not that simple, what about where the money is taken from etc. With banking, I did believe and do believe what I have been taught.
So where am I wrong?
In a FRFB, still, I think a new issue of fiduciary media ex novo, will cause an act of counterfeiting to happen as it is not backed by prior savings all of the time. If it is backed, it is a 100% reserved business.
Where am I going wrong here? Baxendale

To George-- I'm sorry that I stated your position incorrectly, but on your view of fractional reserve banking, what would be the justification for full disclosure? Suppose, contrary to fact, that most tobacco smokers thought that smoking had health benefits and no detrimental effects. Would a law that requires tobacco sellers to issue health warnings be acceptable? I'm inclined to think that so long as rights are not violated, there isn't a duty to provide information, even in cases where people are likely to have incorrect beliefs.

To Toby---I didn't intend to attack your bill. Rather, I think it would be helpful to specify the circumstances in which one can be required to provide information to help remedy ignorance. Why must bankers try to prevent their customers from having wrong ideas about deposits? Must operators of a lottery try to make purchasers of tickets vividly aware of the astronomical odds against winning, in lotteries where this situation obtains? The case for your bill becomes much stronger if one adopts a Rothbardian view of fractional reserve banking.

To David Gordon: I actually meant to follow up, David, with a post saying that, on principle, I think your position is both the correct one and the genuinely libertarian one. The law shouldn't cater to the kind of fools who imagines that banks maintain deposits for them, fully backed by non-interest earning cash, free of charge--even paying them interest sometimes for the privilege--out of the goodness of their hearts. But if we have to have asterisks next to the word "Deposit" on every bank contract, with an explanation that says, "Do not take this literally: this is a debt contracts rather than a bailment" and accompanying stick-figure illustrations or whatever to sastisfy those who might otherwise suppress demand deposits altogether, I'm willing to put up with it as the lesser of evils.

I think it would be a good thing, by the way, for proponents of narrow banking to practice the sort of full disclosure they favor by supplying some figures concerning what sort of monthly fees clients of bank function (1) might be expected to pay for having their cash stored while also retaining (assuming it's part of the plan) the privilege of transfering the sums by check and such.

I really like Anthony Evans's plan, but why should banks be required to offer a 100% reserve service free of charge? Isn't that tantamount to subsidising 100% reserve accounts at the expense of fractional reserve accounts? And why not go further? Why not mandate that they offer 50% reserve accounts too, or any other reserve ratio customers might desire?

I don't see the point of a mandate like this. If people want it and are willing to pay for it, then banks will surely provide it.

Jerry is right to remind us of the Chicago plan and how it resembles but isn't the same as the "Rothbardian" one. In fact, the former will have lower real resource costs, ceteris paribus (the qualification is crucial for under a fiat standard fear of inflation can actually cause more wastful production of gold than ever, as is happening right now).

But the opportunity costs, considered in terms of intermediation opportunities forgone, are essentially the same in both cases. In this respect both plans are potentially wasteful, though I now think I had better explicitly add that this is assuming that the banks, left to their own devices (and with some encouragement from big brother) don't screw the pooch.


You're confusing two different things: the day-to-day operation of a FRB and how a loan is created.

Let's consider a free FRB. Every day some account holders take money out, at the desks or via transfers and other account holder put money in. Despite what some Rothbardians say about radical uncertainty the amounts are really not difficult to predict. Since more may be taken out than is put in the bank must maintain reserves to cover the difference and pay to. They use these reserves to pay to those who request redemptions. Banks maintain the levels they need by trading reserves between them.

A loan origination is quite different though. When a businessman wants a loan he doesn't really want an amount of money, he wants to spend the loan on assets. He wants assets to the value of £X not £X. That's why when loans are made they are normally spent very quickly. So, when a bank grants a loan that will quickly be followed by redemptions as the borrower spends the amount. To deal with that the bank must buy or borrow reserves. That means that someone must lend to it.

With free banking this means that money-substitutes such as bank balances are a form of saving. Any bank balance must correspond to some act of saving.

In a central banking system things are different. Traditionally the central bank controls the money supply using the required reserve ratio. This reserve ratio has little to do with the amount of reserve I talked about above. The reserve ratio is not about preventing banks from running out of cash, it's a tool to control the amount of money. The central bank sets things up so that (hopefully*) the commercial banks are always a little short of reserves so they can't make as many loans as they would like. The commercial banks have what could be called "potential assets", that is, loans that they would make if they could. Then if the central bank issues new reserves into the system the commercial banks will immediately be able to use them making loans. So, the money supply will rise in the way the monetarist "money multiplier" description gives.

Let's suppose we have a central-bank fiat-money system, the central bank creates £100K of reserves. It then buys bonds with it, thereby putting it into the hands of the banks that the bond owners use. Those banks then make a loan for a similar amount. As they have £100K of reserves they may legally make a loan for much more, maybe 60 times more. But they wouldn't do that because they know that loans will be rapidly draws down, so doing that would be reckless. Then after they have made a loan and the money has been drawn down another bank gets the reserves and does something similar. Each bank must keep a fraction along they way in order to obey the
reserve requirement.

* This doesn't always work since it depends on the potential assets existing at the prevailing interest rate. For this reason it isn't currently working.


The money multiplier process you describe only kicks in when there is a change in the quantity of outside/base money. As Current says, when the central bank engages in OMOs and creates new reserves ex nihilo, that is when we get new loans created without new savings (as I argued earlier as well - the problem is *central* banking, not fractional reserves).

In a fractional reserve free banking system, this multiplier process can happen when there is a change in the monetary base or outside money commodity (e.g. gold). This is one reason why George's earlier proposal to freeze the monetary base and make it the base money for free banks to issue liabilities is interesting.

That said, during the daily ins and outs of any fractional reserve bank, as long as the new deposits they receive are liabilities of other banks in the system (e.g., Toby writes me a check off his bank which I deposit at mine), the new loans created off that deposit are based on prior savings.

In a central banking system such as in the US today, deposits of currency into the banking system can start that process, but notice that under free banking, changes in the currency/deposit ratio affect the liability side only and have no effect on reserves, meaning they cannot start any multiplier process.

Whenever a fractional reserve bank accepts the liability of another such bank, it is acquiring the prior savings of the other bank into its own reserves, which it can then lend out.

It's true that the banking system *as a whole* can created a multiplied amount of any new reserves pushed *into the system as a whole*, but that's different from what Bank A can do when it acquires new reserves at the expense of Bank B.

One has to distinguish the effects of an addition to the total reserves of the banking system as a whole and an addition to the reserves of one bank that come at the expense of another bank in the system.

If someone reduces consumption out of current income, and purchases a newly issued corporate bond, and the firm issuing the bond purchases a capital good, then there is saving matched by investment.

If someone reduces consumption out of current income, and deposits the funds in a bank CD, and the bank makes a commercial loan, and the firm getting the loan purchases a capital good,then there is saving matched by investment.

If someone reduces consumption out of current income, and deposits the funds in a demand deposit at a bank, and the bank matches that deposit with a loan, and the firm getting the loan purchases a capital good, then there is saving matched by investment. Notice that the bank keeps no reserves in that story, but the investment was matched by saving.

The notion that if banks fail to keep 100% reserves then saving and investment necessarily are imbalanced is false.

The "problem" with the last scenario is that the demand deposit serves as money. Today, that means that the bank is now in competition with the central bank, which has a monopoly on issuing hand-to-hand currency, something too many economists take to be the ideal type of money. (Please try thinking of the deposit liability of the bank being the "core" idea of money, with the hand-to-hand currency being the add on. It really helps.)

In a gold standard,the bank is now in competition with the gold industry, for whom the demand for gold for monetary purposes could be important.

It has nothing to do with saving and investment. It has to do with a decrease in the demand for gold (or fiat currency today.)

In my view, if we have a fiat currency operating under the appropriate rule (a target for the growth path of money expenditures,) then if the private sector develops instruments that can serve as money in place of fiat currency, then some fiat currency should be retired so that money expenditures will remain on target. The way I look at it, the government cannot borrow as much by the issue of zero-interest currency, and must fund its debt by interest bearing securities, if the demand to hold currency falls.

It doesn't matter why the demand for currency falls. If people want to shift from currency to deposits and banks accommodate the added demand for deposits by issuing more, then any excess supply of money is the fault of the government that failed to reduce the quantity of currency as the demand to hold it fell.

With a gold standard, this really isn't possible. The decreased in demand for existing stocks of gold will presumably lower the flow supply to some degree, but the largest effect would be a decrease in the relative price of gold. Since gold is the medium of account (and medium of exchange to some degree) with a gold standard, this involves higher prices in terms of gold and money for everything else.

But the same thing would happen if someone invents costume jewelry or ceramic dental work, or anything else that substitutes for gold.

If the banking system creates money, then this reduces the purchasing power of money--ceteris paribus. That doesn't mean the purchasing power of money necessarily falls between today and tomorrow or this year and next. It could be that the purchasing power of money would have risen, and the increase in the quantity of bank money partially or fully offsets those changes.

When Toby talks about being robbed by the process, he is counting on real capital gains on zero-nominal interest currency holdings that would have happened if the quantity of money were lower. But if we are talking about unexpected changes price level, then there would be inflations due to lower money demand as well. If we are talking about persistent, predictable changes, then nominal interest rates will be different, except, of course, on zero interest currency, or with a gold standard, investments in actual gold bullion or coins.

It is something like the entrepreneur getting a loan funded by the issue of bank money is grabbing resources that I should have received because if that hadn't happened, prices in terms of gold (or fiat currency) would have fallen and the real value of my gold investment (or currency holdings) would have risen. That real capital gain never appears. I've been robbed.

To me, this is no different than today if you went long on oil futures, and someone comes up with a way to greatly improve the mpg of cars. That capital gain you predicted goes away.

Again, with a gold standard, there is no nominal risk from holding gold, but there is real risk. Assuming that the purchasing power of gold always rises is just.. an error.

Again, with a fiat standard, there is no reason to treat the quantity as given, so that increases of bank money are increases in the quantity of money in total. The quantity of fiat money should decrease to offset decreases in the demand to hold fiat currency regardless of the source. And, the quantity of fiat money should rise to accommodate increases in the demand to hold it.

Blaming the banks because they create financial instruments that people are willing to use as money seems very wrongheaded to me.

The way I see it, the money that is most important--various sorts of financial instruments, has a nominal yield. The persistent rate of price change (whether it is deflation, nothing, or inflation) impacts the yields. There is no robbery of savers. If, on the other hand, we are speaking of unanticipated fluctuations because the quantity of money fails to accommodate shifts in money demand, then there is no reason to believe it is always inflation. A surprise deflation "robs" debtors to benefit creditors. A surprise inflation "robs" creditors to benefit debtors. Accommodating changes in the demand to hold money with changes in the quantity of money avoids both.

The way I see it, with a fiat currency, those holding it are lending money to the government. I don't think providing people with a good real rate of return on this form of loans to the government should be the goal of monetary institutions. If you think about it, not only would a regular deflation help those holding currency, occasional sharp surprise deflations would help them too. (and expectations of that...)

But even with a gold standard, I don't think the goal of monetary institutions should be to make sure that those holding gold coin or bullion have the best real return. To me, the "macro" end of the anti-FRB arguments (it is inflationary) is about protecting gold speculators from loss. I am sure that wheat speculators support efforts to keep up wheat prices too.

The micro analysis is always just awfully confused.

When George wrote of the nonpecuniary externalities, (or their absence) in this or the other thread, my thought was "exactly." But, I fear that hardly anyone follows that.

@ Lee Kelly
"why should banks be required to offer a 100% reserve service free of charge? Isn't that tantamount to subsidising 100% reserve accounts at the expense of fractional reserve accounts?

Step 8 and 9 are non-market interventions, therefore free bankers would rightly object. However "my" plan was written in the hope of getting 100% reservers and fractional reservers to agree. I don't see why Rothbardians couldn't accept my plan, so I think step 8 and 9 are a small price for fractional reservers to concede to gain consensus.


> Notice that the bank keeps no reserves in that story,
> but the investment was matched by saving.

Yes. Steve, Lee and I could just have pointed at the bank's balance sheets and the correspondence between assets and liabilities. But, I think that it's also important to show how everything in the system must be priced in relation to the reserve asset.

I think that everyone agrees that the price that is paid for a commodity standard is that fluctuations in the price of the commodity affect prices and accounts. The same applies to fractional-reserve commodity standards and full-reserve ones, the only difference being that a full-reserve standard would consume much more of the supply of the commodity(s).


The problem is if #9 means that banks can't differentiate between 100%-reserve and fractional-reserve accounts by charges. If it only means that there is no entry fee then that's reasonable. But, if it means that all fees must be similar then there would be no incentive for anyone to use a fractional-reserve account.


Obviously there's a gaping lack of detail in my proposal(!) but the idea was to make entry barriers as low as possible - in other words that customers would be able to transfer funds into a custodial account at no cost. The actual terms of those accounts regarding fees and subsequent details would be up to the banks to decide.

As I think I mentioned earlier, this becomes less problematic if we realise that a number of UK banks are effectively nationalised (and some outright), so this requirement can "merely" be adopted by government run banks, leaving those like HSBC to be exempt.

Here is one more attempt at explaining the situation. It is oversimplified, but this is a blog -- more thorough explanations can be found in various papers and books.

Consider 2 FRFBs, A and B, each with a 10% reserve ratio. Assume this ratio is optimal given the withdrawal rate of its depositors. That is, a lower ratio would leave the bank unable to satisfy the demands of its depositors, while a higher ratio would require foregoing profitable loans.

Now let us suppose that bank A decides to create additional loans. An entrepeneur receives the loan and buys capital goods, and the seller deposits the money is bank B. Since bank B has little incentive to hold bank A's money, it immediately demands base money in exchange. Bank A's reserve ratio now falls below 10%, and it is unable to satisfy the demands of its depositors. Bank A must now liquidate assets or await loan repayments (without making new loans) to rebuild its reserves and keep customers.

Now let us suppose that bank depositors reduce their withdrawal rate and lower the optimal reserve rato before bank A creates its additional loans. Everything occurs exactly as before. The entrepreneur buys some capital goods, the seller deposits the money in bank B, and bank A's reserve ratio falls below 10%. But this time it is still able to satisfy the demands of its depositors. Bank A need not liquidate assets or await loan repayments to build up its reserves, because they are now operating at the new optimum.

This story presumes the supply of reserves is held constant. Normally, bank A can only get more reserves if it reduces the reserves of bank B, and so the total supply of reserves is constant. But if bank A receives new reserves from outside the banking system, it means the total supply of reserves has increased. It can now make additional loans without a corresponding change in the spending habits of its depositors; the result is a general decline in purchasing power -- inflation.

This final point better describes the activities of central banks. With reserve requirements, banks are often unable to increase their loans when the withdrawal rate of depositors declines. The central bank must step in and increase the total quantity of reserves available to offset the difference. As you are no doubt aware, they do not always get this calculation correct, and nor do they even directly traget this goal!

Specifically on #9 and to repeat myself. If the BOE were to pay interest on reserves (from their earnings), competition would drive commercial banks to pay some interest on the 100% accounts. This is probably the least important issue in the plan.

It is ridiculous for people to worry about "compulsion" for protected and coddled banks. Switching to the US, folks should read Gretchen Morgenson's column in today's NYT Business section on how Dodd-Frank soldifies the relationship among large banks, the Fed and the Treasury (that's us). We've gone from 2 housing GSEs (Fan & Fred) to 20+ financial giants (the systemically important banks specified in Dodd-Frank).

Incidentally, does anyone know what the words were that were used on Scottish banknotes with option clauses? I'm asking because it relates to the discussion going on on the Mises institute blog.

Bank of Scotland L5 note, 1730-65: "one pound sterling on demand, or in the option of the Directors one pound and sixpence sterling at the end of six months after the day of demand."

Thanks George.

It occurs to me to mention to Jerry what I remember about the Chicago Plan, for it goes to the relevance of free banking theory for formulating good reform proposals.

As I recall (I believe I discuss this in Theory of Free banking, but haven't got a copy to consult here at home), the proposal was originally seen, not as a way of limiting bank risk taking, but as a way to make sure that commercial banks could always deal with unanticipated increases in the public's preferred currency-to-deposit ratio--something they were notoriously incapable of doing in the 30s. What the plan's proponents don't seem to have considered was that the problem was not so much a lack of sufficient reserves as (both state and national) banks' inability to issue their own notes on the same terms as those that regulated their creation of demand deposits. State bank had been preveted from issuing any notes at all by a 10% tax imposed during the Civil War, while National banks (also owing to Civil War era rules, aimed at funding the union war effort) were required to "secure" their notes with specific U.S. government bonds, most of which had been withdrawn by the early 30s, and all of which would be withdrawn by 1935.

A temporary relaxation of the National bank bond-backing law, allowed for by a rider to the 1932 Home Loan bank Act, allowed National banks to issue a lot more of their own notes than they might otherwise have been able to issue, and so protected their reserves to that extent. But it didn't nearly go far enough. Canadian banks, on the other hand, were relatively unrestricted in their note-issuing powers, and so were able to accommodate most of Canadians currency needs without having their cash reserves depleted. That's one reason why Canada's money stock fell just 13% during 1930-33, as opposed to 33% in the U.S.

As I mentioned, proponets of the Chicago Plan never could understand the merits of freedom of note issue, or how lack of such freedom was the real key to U.S. banks' inability to cope with big swings in the C/D ratio. Proponents of central banking suffered from the same lack of comprehension in some cases. The Federal Reserve Act, for instance, was at bottom nothing more than a plan to create 12 new banks posessing the unique ability to issue notes backed by ordinary commercial assets, as were assumed to be routinely held against bank deposits. The banks were in turn supposed to apply to the Fed for emergency currency by discounting their commercial paper with it. Prior to the passage of the FRA, many attempts were made to pass legislation that would simply have freed national (and perehaps state) banks from Civil-War era regulations that prevented them from directly issuing notes backed by the same assets. Unfortunately, the same plans generally called for branch banking, as a means for seeing to it that unwanted banknotes got "mopped up" quickly wehnt demand for them subsided. For this reason they were vigorously and successfully opposed by the unit bankers' lobby.

Here's a general rule to keep in mind: every time we take a step away from free banking, we end up with new problems and a consequent need for further reform. And then, if we step still further away, the same thing happens. And so on.

That's what the history looks like to me, anyway.

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