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I don't have the time to go into detail but here's three quick thoughts:

1. First, don't use the term "law of reflux." Both George and Larry reject that term, with its Banking School connotations. The right term is "principle of adverse clearings."

2. Why do people assume the "warehouse" function of banks is the most "basic" function? If you want a warehouse, get a warehouse, not a bank. I'd argue that *intermediation* is the most basic function of banks and then the question is how best to engage in that function.

3. As George so effectively explained to 25 SLU seniors on Tuesday, the reason that people like fractional reserve banking is precisely because it allows them to both supply investible funds and get an interest return on it AND use those same funds for expenditures in the convenient form of a demand deposit or banknote. Combining intermediation services with a convenient means of payment is an important entrepreneurial advance, as long as it is clear that the deposit is a loan to the bank and that the bank's obligation is to pay it back on demand.

Is that window 2 or window 3 in this proposal? How exactly would customers who preferred this arrangement be able to engage in it? And why do we need a separate "window" for warehousing when people can, right now, take their dollars (or pounds or euros) and put them in a safe deposit box at their bank, under current law?

I just don't understand what it is about this proposal that is necessary, other than, I guess, to say it's a nth best proposal in the world of central banking. I don't see how it's superior to free banking. If it's just another world of the second best proposal than it's hardly something that settles the ongoing debate, in my view.

As a Brit I'm very interested in the Cobden centre and their proposals.

I've written an article on their site which is here:
That article focuses on the problems I see with converting a fractional-reserve fiat-money system into a pure fiat money system.

I've also advocated free banking on the Cobden centre site and described some of the problems I see with 100% reserves. See the comment thread on this article (especially the end):

Guess I'll be the first anti-FRB commenting...

In what amounts to Steve's number two:

Well, banks are more convenient than a new warehouse network because they are already consolidated... We could imagine something like some new independent ATMs where you can insert a nickle or a dime, your network card and cash in... But banks are already in the business, the barriers to enter are high...

In what amounts number three:

Well, if you create more money (deposits in this case) through FRB you can surely lend out the initial cash deposited and still maintain available balances for the depositors... Maybe in monetary equilibrium theory creating more money out of thin air may be a good "entreprenurial advance", but I think that standard austrian theory shows that distorting relative prices and reducing artificially the purchasing power of money is not a good idea...

But the proposal is clear on those issues... If you want to let your bank inflate using your money, then let it be... No one will have that denied...

Another good proposal would be regularizing any business to have a banking branch... Any major corporation and large firm would have incentives to enter the game, and the very principle of adverse clearings would tend to raise the reserve ratio as competition rises...

The proposal isn't at all consistent with freedom of contract if it would rule-out demand deposits backed by fractional reserves with the reserve ratios set according to bankers' judgement of what is needed to meet occasional redemption and settlement demands. The question is whether the "saving" function is supposed to include such fractionally-backed demand deposits or just term deposits and such. If not--if it insists that demand deposits be attached to the "warehousing" function--then it is straight from Rothbard, and wrong for all the reasons that Rothbardian arguments against fractional reserve banking are wrong, that is to say: 1) wrong as a matter of ethics; 2) wrong with regard to its notions of what does and doesn't constitute a relevant (non-pecuniary) externality; 3) wrong in claiming that fractional reserves necessarily means excessive money creation or money creation not consistent with saving; 4) wrong in its interpretation of the legal nature of of bank deposits, including the legal doctrines pertaining to them in the distant past; and 5) wrong in claiming that in resorting to fractional reserves bankers create multiple "titles" to the same base money.

Please, Peter and others, don't be misled by the 100-percenters' claim that their position is consistent with freedom, either in banking or generally. It isn't. Fractional-reserve banking arises as the result of consensual transactions among consenting adults; and their ideal involves outlawing such consensual acts.

And suppressing fractional reserves will have real costs far beyond those of merely inconveniencing people who would rather not stuff their savings in a safety deposit box instead of having it in a fractionally-backed demand deposit. It will mean depriving businesses of an important source of credit--which, in the absence of central bank shenanigans, would be credit based on genuine savings. Want to further understand these benefits? Start with Adam Smith, book II, chapter II.

So let's please not endorse plans that would throw the fractional-reserve banking baby out with the central banking and government guarantees (and other bad regulations) bathwater.

Larry and I have responded have written at length concerning the various errors I point out above, and I've no wish to try and repeat all that we've had to say on this or any other blog. I urge Mr. Evans to have a look at what we say in those writings, and would welcome having him contact me concerning them and their contents.

I've asked George this question before, and will ask it again. What do you do TOMORROW?

No big state will refrain from bailouts. No Congress can bind a future Congress. (Time inconsistency).

It is not possible for an empire to operate without a central bank. The US is, in the words of the French, la hyperpuissance.

I have the greatest respect for the free bankers. But it is time for them to address the question of how we would get from here to there.

I do not see how the flat taxers, free bankers, and supply siders can expect people to take their reforms to heart until they sign on to downsizing government. If you do that, the reforms become easy. Absent downsizing, the reforms are blackboard exercises.

No offense intended.

You all need to read Ronnie J. Phillips, The Chicago Plan and New Deal Banking Reform, Armonk, NY: M.E. Sharpe & Co., 1995. Ronnie owns the franchise on narrow banking/100 percent reserves.

And I agree with Jerry O'Driscoll: The problem is the imperial wishes of the big government crowd (and revoltingly, Ron Chernow now has published a new biography of George Washington--Rockefeller and Hamilton were bad enough, but now he blackens the holy name of Washington by treating him as a fan of big government and central banking). All too often, self-styled free marketeers "assume the can opener" that government will shrink automatically to fit the new model once we commit to, in this instance, free banking (which I agree is the theoretically correct model for all the reasons that Peter summarizes accurately above). But once you admit central banking and fractional reserves, you are off to the big government and big bailout races.

I disagree with Steve Horwitz on the desirability of allowing government-chartered banks to engage in time-shifting (disintermediation) on deposit-taking and lending. That has the same defects as deposit insurance: It amounts to a taxpayer guarantee of private sector risk-taking. These defects are compounded under central banking and fractional reserves.

So, back to Larry and George: If we could have a gold standard, then free banking without government charters would tend to take care of itself. But if no gold is admitted into the system, then the narrow banking ideas of Ronnie Phillips and others are the way to go, IF you want to avoid taxpayer-funded bailouts (and I certainly do). The role of banks as payments system intermediaries and as stores of value (demand or time deposits) is the most important one. The more you admit risk-taking on the asset side of the balance sheet, then the greater will be the political pressure for discount windows and deposit insurance. In a non-gold world, narrow banking probably is the way to go.--Walker Todd

Isn't it possibly very, very dangerous to institute a form of narrow banking across the economy that has no mechanism to combat secondary deflations? If you assume Rothbard, narrow banking is a good first step to an ideal. But, to my somewhat dilettantish understanding, the purpose of free banking is to coordinate time and interest across the economy, and narrow banking is probably a WORSE mechanism than what we have now. There are monetary/financial regimes that are worse than status quo, in the same sense that there is no want for political leaders more evil than Obama or Bush. Just because narrow banking would strangle bubbles and destroy inflation doesn't mean it's better.

A baby step to reform I would suggest is a constitutional amendment against bailouts of financial institutions. That isn't even altogether unrealistic given the political climate.

"Banks [...] would have no special privileges provided by law or politics."

As a goal, I'm sure White, Selgin and Horwitz would agree with Baxendale that this is the right answer. I see the Cobden Centre proposal as serving two other important purposes :
- it offers a way to go there
- this route might be politically feasible

We should therefore stress the agreements between the various proposals, rather than ask "what is wrong" with this or that. As an example, there a many elements of Kotlikoff and Kay's narrow banking / safe banking / boring banking proposals that resemble the ones above.

Best regards,

I see no way to differentiate or wall apart functions 2 and 3.

Jerry, Walker, and others: how would abolishing fractionally-reserved demand deposits have averted the recent crisis? It wouldn't have had any bearing at all on the investment banks, which only performed Baxendale's function No. 2! Had it been an old-timey banking panic, that would have been another matter. But it wasn't. It would have taken a lot more "narrowing" of financial institution asset choices than Baxendale's proposal contemplates to have made any difference.

I tell you, going down this road will end with outlawing intermediation altogether--a "solution" to our financial ills that amounts to curing the disease by killing the patient. (Some Rothbardians, by the way, have already been arguing that time deposits should also be subject to a 100-percent reserve requirement.) As I've pointed out elsewhere (to no avail, it seems), bank demand deposits remain crucial sources of funding in many parts of the world today, so that suppressing them will have very severe consequences (cf. the vast literature on financial development--Cameron, McKinnon, Fry, Levine et. al, and all those others dreamers who, it would seem, share the free-bankers' starry-eyed naivete.).

And if you don't imagine that a reform like Baxendale's, carried out in any major industrial nation, won't spread to other countries, consider what happened with central banking and deposit insurance.

I simply can't understand Walker's claim (to Steve) that "allowing government-chartered banks to engage in time-shifting (disintermediation) on deposit-taking and lending...has the same defects as deposit insurance: It amounts to a taxpayer guarantee of private sector risk-taking." How are taxpayers on the hook for a bank's losses unless some sort of insurance is in play? Also, for the zillionth time, fractional reserves, Walker, aren't a departure from free banking: they are an inherent part of it. It's nonsense to suggest, for instance, that the Scottish banking system ceased to be free once fractional-reserves were "admitted" into it--they were there from the get-go! (And by the way, though I once desperately wanted to be a _Mouseketeer_, I have never, ever styled myself a "free marketeer.")

And what's all this about free bankers needing to "sign on to downsizing government"? Since when have any of us argued for anything else?

Jerry, admitting realistically as you do that "no big state" will resist bailouts, how many other arguments for market liberalization are you prepared to dismiss on similar grounds? I say, big states do what they do, not merely because it serves their interest, but because people who ought to aggressively challenge the legitimacy of their actions instead acquiesce to and apologize for them, sometimes because they have been bamboozled into thinking that the actions really are necessary, and sometimes on realpolitik grounds. It is the job of economists to reduce the number of people who are bamboozled, not to join the chorus of realpoliticians.

And finally, I have said what I would do "tomorrow": like Mr. Murphy I would promote legislation to limit or eliminate, not banks' (and depositors') ability to take risks, but governments' ability to bail them out.

Here is the answer I gave Jerry to his "tomorrow" question as posed to me on a previous Coordination Problem discussion:

"As for the way out of the present morass: for me, it consists of insisting, as you do, on the harm done by implicit and explicit guarantees, and on finding ways to limit them, instead of simply destroying the industry they've crippled. Instead of narrow banks, let's have banks with living wills that are expressly denied access to guarantees. _Then_ we can narrow the rest to death far as I'm concerned."

What happens in Baxendale's proposal if a time deposit (function #2 of the reformed banking system) with three months duration is invested in fixed capital goods of twenty years duration and, after three months, there won't be any creditor available for debt rollover because of a spike in consumption?

The answer is: malinvestment liquidation. Are thus demand deposits really so important? After this crisis, in which commercial paper (3-month liabilities) has been malinvestment in mortgages (20-year assets), I'd think that demand liabilities are only part of the problem: carry trade need not start at zero maturity.

A more relevant question is: what causes miscoordination? If it is moral hazard, then policymakers must be constrained (no discretionary monetary policy, no deposit insurance, no bailouts) in order to start a virtuous albeit painful process of learning how to really take care of risks throughout the financial sector. This would be a reform.

Pietro appears to buy into into the latest "maturity mismatching" fad from the Mises Institute types. Of course maturity transformation (the correct non-value-laden term for it) needn't be problematic when there are large numbers of depositors so that banks can reckon upon new deposits taking the place of others that are withdrawn. Past banking crisis have been triggered not by "spikes" in consumption but by exceptional rates of default. It isn't the term of bank loans that matters here, but their riskiness, which is another matter. In the 30s insufficient diversification opportunities contributed to excessively risky bank portfolios. Today guaratees are the main problem.

I side with George Selgin. The Selgin-White approach is also consistent with the fact that the role of commercial banking has diminished over the last decades. As to the question of what to do tomorrow: Steven Horwitz favors the monetary equilibrium approach (stabilizing Mv). In modern parlance, this is called NGDP level targeting at a zero growth path. George Selgin calls it the 'productivity norm'. It is something you can do with central banks, i.e., it neatly fits the current institutional setting, and something modern macro folks could agree on (at least on a low rate of NGDP growth).


If you assume that there will always be sufficient funds to roll over the debts, of course, there won't be any problem with maturity mismatch. But is it relevant? Does this prove that maturity mismatch can be solved by the law of large numbers and is never a problem?

The law of large number has little to do with a problem which depends on the relation between the aggregate supply and demand of credit. What's the point in having a million depositors if you need one billion and depositors only want to give you half of it?

The law of large numbers says that the variance of the average will be (ideally) zero. It doesn't say that the average has the right value (demand = supply).

Maturity "transformation" is not a problem when the supply of credit is not lower than the demand for it.

So I would say: today guarantees are the main problem, and one of the many dimensions of risk they affect - which can't be assumed away by assuming that there will always be sufficient new creditors to roll over the debts - is maturity mismatch, or transformation.

PS Mises Institute? I was criticizing 100% banking.

PPS A spike in consumption is not required to have the problem, I was imprecise in the previous comment. The problem is insufficient funds to perpetuate investment plans. Default rates are the effect of this. (If ABCT is correct).

Pietro: I meant merely to point out that your arguments against maturity mismatching are the same ones voiced in several recent works by economists associated with the Mises Institute. I didn't mean to suggest that you were merely towing the MI-Rothbard line, or (for that matter) that everything from the MI is bad!

Of course maturity transformation can go wrong. But some risk isn't the problem. The question is whether risk taking is excessive ex-ante and, if so, why.

Perhaps you will indulge a bit of "irrelevancy" from on non-expert in banking. But -- to me -- the Cobden Centre seems like the Mises Institute Lite. Have they ever invited Larry White or George Selgin to their functions or to help in policy formulation? (I do not know). Is this just Baxendale's hobby-horse? Of course, the idea proposed here might be quite good. But I would feel more confident if the Austrian big guns were involved from the get-go.


1. A bill has been written and introduced to parliament.

2. Toby is very much involved, but also Kevin Dowd and Tony Evans have argued with Toby and worked with him as he develops his ideas which have then been introduced.

3. This is, as I see it, a "big tent" proposal and not an effort to outlaw voluntary contracts, but instead to make the terms of that contract more explicit.

4. George and Steve have written some responses that I am learning from but I get the sense that they are talking in a way that misses the opportunity for engagement with Toby and others. I understand the frustration they have on these issues, I have experienced both in my own discussions on calculation and the socialist calculation debate, and over the actual substantive content of Mises's ideas. But frustration is not _always_ the appropriate response. Instead, a reasoned and measured response would do better. And a start for that would be stating your opponents position in as accurate a way as possible and as charitable an interpretation as possible, and then criticizing it. Toby's idea, at least as I read it, is NOT the same as arguments that have been made by Walter Block.

5. To George --- I actually think Jerry has an important point about the interconnectedness of fiscal and monetary policy that demands all our attention. I come at this more from the fiscal side and the political economy of fiscal policy.

6. To Arash --- it is the political economy side of the equation that I think causes the problems for NGDP targeting. I am writing a paper on this right now. This solution is not "creative" enough to solve our problems in my opinion. I think it "might" be better than our current system, but only if political functionaries were eunuchs rather than real life and blood human beings. There is the trick. Again I think it would be wise to re-read Hayek's "Individualism: True and False" as well as Hume's essay on parliament, and pass all proposed political reforms through the test of robustness against "knavish" behavior. We have learned too much from public choice and political economy to continue to treat these questions as exogenous, and we must treat politics as endogenous to any model of public policy. Unless, of course, we take that public policy out of the realm of politics!


You have often described two types of deflation: one driven by an increase in the supply of goods relative to money, and the other caused by an increase in the demand for money relative to other goods. The former you have described as "good deflation", and the latter you have called "bad deflation". You often describe the case for MET and FRB in terms of preventing "bad deflation".

But it occurs to me that a free market in money and banking might well prevent both "good deflation" and "bad deflation". Moreover, this may not be such a problem, because I am quite sceptical that "good deflation" is actually very good at all.

I have tentatively come to this view based on the simple observation that both appreciation and depreciation tend to frustrate a good's ability to function as a medium of exchange. This is especially so when changes in a money's exchange ratio for other goods are irregular and unpredictable. In short, in a competitive market for money, any appreciation or depreciation of one money will tend to be offset by a rival money, and so prevent even "good deflation".

To illustrate my point, consider an economy with both gold and silver money. And suppose that while the supply of gold remains constant with rising productivity, the supply of silver increases proportionally (so as to maintain constant exchange ratios). Wouldn't any appreciation of gold, even if it is driven by "good deflation", tend to favour silver as a medium of exchange? That is, wouldn't people shift to holding more gold for investment purposes and start using silver more regularly as money?

This is a very simplistic way of expressing the argument -- it is something I want to think about more. But is seems to me that a free market in money and banking would tend to prevent all types of inflation and deflation, merely as a consequence of competition among monies. I would appreciate any feedback on the matter -- from you, Selgin, Horwitz, White, or anyone else.

It would be interesting (for me at least, but I guess I'm somehow too nerdy to be representative) to summarize, maybe in a couple of posts, two related issues:

1. Which of the many problems of the actual economy can be solved by a proper (whatever it means: everything except perpeuating malinvestment and "malintermediation", if we want a financial equivalent to the former) monetary policy?

2. Under which microeconomic conditions is it possible to increase the broader money supplies (M2 or M1, not M0) or NGDP (MV, PY if you prefer :-D)?

For what concerns #1, of course a proper monetary policy can solve the problems created by an excessive demand for money: it can't solve, however, balance-sheet problems, or malinvestment. So we remain we an awful lot of problems that would precipitate a more or less severe recession under any possible proper monetary policy.

For what concerns #2, both monetary multipliers and monetary velocity are mainly endogenous phenomena: when banks' balance sheets are in a bad shape, risk aversion is high, or return rates on available investments are low, than they will tend to fall quite naturally, if not unavoidably. In this case, I wouldn't even say that there can be a broad money target, or a NGDP target, because the target would be unobtainable.

Greg is correct to raise the question of how one would wall off these funcctions. And it gets to George's reply to me.

George wants us to believe that fractional reserve banking had nothing to do with I-banking. But a substantial portion of funding for I-banks consists of overnight lending from those fractional reserve banks. Plus backup lines of credit from them.

I-banks could not operate w/o being financed by commercial banks. And, even before the crisis, some of the biggest commercial banks (e.g., Citi and JPMorgan Chase) were also I-banks. Now all the major I-banks are BHCs (e.g., Goldman). Where's the distinction?

I never endorsed narrow banking. Apparently, for George, questioning how fractional reserve banks actually operate today either makes you in favor of 100% reserves, or a nut from the Mises Institute.

I must also point out that George's "answer" to my tomorrow question is non-responsive. We have what Allan Meltzer has described as "giganticism," huge institutions capable of bringing down the financial system and the economy. They operate with the backing of the government. While we all debate the right banking reform (a subject on which not even participants in CP agree), what can be done to protect capitalism from the bankers?

If George says "nothing," then he defends the status quo including privileged banks (not lasissez-faire). Somehow free banking in theory becomes corporatism in practice.

Sorry I'm late to the discussion, but I was teaching last night. I second what Steve and George have said.

The Baxendale proposal is not a proposal for free banking. As others have noted, it restricts freedom of contract by not allowing for demand deposit contracts. It implicitly embraces the following non sequitur: (1) Warehousing contracts are legit. (2) Time deposit contracts are legit. (3) Demand deposits are neither warehousing nor time deposits. (4) Therefore demand deposit contracts are not legit.

To point this out is not to take a position on the merits of "narrow banking", i.e. restricting the asset portfolios of banks to protect taxpayers in an nth-best world where banks are sheltered from the consequences of their own foolish decisions by central bank bailouts, deposit insurance, and other implicit guarantees that put taxpayers on the hook. IF we regard those interventions as untouchable, then calling for restrictions on sheltered banks' portfolios to protect taxpayers does potentially make sense as a way to move up to mth best. Of course we shouldn't be so naive as to think that politically connected banks won't try to game such restrictions.

In any case let's not lose sight of the first-best goal of eliminating the "untouchable" interventions. Let those who call for narrowing the activities of guaranteed banks simultaneously call for opening the field to unguaranteed caveat-emptor banks that are -- like money-market mutual funds until recently were -- explicitly NOT guaranteed or protected by the government in any way from the consequences of their errors.

I've been following the Cobden centres work quite closely. A few comments on what has been said so far...

The ten-minute rule bill that was introduced to parliament is tangentially related to the Cobden centre. It was introduced by the Tory MP Douglas Carswell who isn't really affiliated with the Cobden centre. But it has the support of another Tory MP Steve Baker who is. That bill isn't about Toby Baxendales plan. It's about revealing the fractional-reserve nature of banks to their customers. It would make it law that banks would have to give account holders the choice of a fractional-reserve account or a 100% reserve account.

Toby Baxendale's plan is quite different, it's inspired by Mises & Rothbards plans as well as by the Chicago plan. He proposes that all current accounts should become 100% reserve by converting them into pure fiat money. Toby's plan is described here:

I wrote a criticism of this which the Cobden centre published here:

What I focused on what the potential for inflation. The plan involves removing assets which banks rely upon to fund account services. That would mean that banks would have to charge for services, that is likely to cause a disruption in the demand for money. (Bill Woolsey has also argued this on the Cobden centre site).

I understand the problems that free-banking would have with bank bailouts. But, I don't think they are really any different to the problems that 100% reserve banking would have. Let's suppose that Britain converts to using 100% reserve fiat money with a constant money supply. Then there is a recession in the US which triggers a recession in Britain. Surely in that case the government would give up their pledge to a constant money supply and raise the money supply? I think they would. I doubt any 100% reserve system would last more than a few years.

As George Selgin mentions above a great quantity of savings would be forsaken by a 100% reserve system. The immediate consequence of this would be that capital would be imported from countries using fractional-reserves. That would make any country that embraced 100% reserves uniquely sensitive to global recessions.

I think that free-banking could be protected to some degree against state interferences. I wrote this on the Cobden centre site:

"The second problem is bankruptcy. During the Great Depression the money supply contracted sharply after the collapse in 1933 of the thousands of bank I mention above. Superficially this looks like an obvious flaw. If a bank collapses then it’s bank accounts cease to be money substitutes, so the money supply falls. But, the real problem here is the liquidation procedure, which is a form of temporary nationalization. The bankrupt bank has assets including reserves and loans. Once through the liquidation procedure the good assets will be sold to other banks, so those other banks can use them to expand the money supply to it’s previous level. When GM went bankrupt the supply of cars was not interrupted because the bankruptcy procedure was quick and in three weeks the “new GM” was formed. Let’s suppose we have free-banking and a bank the size of RBS fails. Maybe free-banking would never produce a bank that size, but let’s suppose it did. In that case the money supply would drop during the liquidation period. There are several ways this could be dealt with. One possible solution would be for the government to require that banks must file detailed documents explaining how to “disassemble” themselves every month or so. (It would be best if the bank were required to file these documents with people who would examine them closely, such as shareholders, big creditors and other big counterparties rather than with a regulator). Then if a bankruptcy did occur the appointed administrator would have a guide to act on quickly. Dowd has suggested that on bankruptcy the ownership of banks should switch immediately to their creditors. That would mean that account holders would immediately become shareholders. I’m not sure that would really help.

The final problem, and probably the worst is the potential for government bailouts. Banks may continue to be “too big to fail”. The failure of a large bank with very many depositors may be too big a political issue for governments to ignore. That means that large banks may take risks as they do today, in the knowledge that they have implicit backing from government. As with the issue of money supply the solution may be quicker liquidation procedures. Free banking couldn’t really survive in an socialist leaning society where arbitrary bailouts are seen as acceptable."

If we're looking for a way to avoid political interference we should look towards the insurance industry. There is no government "central reinsurer" or "reinsurer of last resort". The problems in banking and insurance are similar but somehow they have been solved much more satisfactorily in insurance (except health insurance).

I want to endorse Pete's call for "engagement." That is the flip side of Burke's famous admonition that all that is necessary for evil to triumph is for good men to do nothing.

Mr. O'Driscoll,

What precisely does it mean for an institution to "bring down the financial system and the economy?" I've heard a lot of heated rhetoric pushing this claim (e.g. Bernanke/Paulson testimony), but not so much regarding the nuts and bolts details of how it actually would happen.


What do you think just happened?

Why do we need a law to force banks to offer a 100% reserves alternative to fractional reserves? If that's what people want, they can use a safe deposit box and simply withdraw their cash as they need it. That option is available now.

Of course that's a very inconvenient means of payment.... which, once again, is a major reason we have fractional reserves in the first place!

Safe deposit boxes charge fees, you can't write checks off them, etc.. Once we realize that what banks primarily do is to engage in intermediation and the provision of convenient means of payment, we can understand why people choose fractional reserves all the time.

I've seen the data from Tony Evans's study of what people think about the property status of their deposits and the results are ambiguous at best, and the questions were not sufficiently clear in some cases. That evidence is not sufficient to make a claim that banks are somehow being duplicitous or not operating by generally recognized business rules (at least with respect to *those* issues).

@Jerry: I'm all for engagement, but I'm not convinced this proposal is any sort of improvement on the status quo. George's "living will" idea might be. Other ideas might be.

Asking Steve, Larry, and George to "engage" with Baxendale is odd. Baxendale argues for theories that the free bankers have been opposing for most of their careers. FRB and anti-FRB are diametrically opposed, absent some new unifying theory, there can be no hugs and kisses at the end.

But I suppose you (Pete and Jerry) are talking about some sort of “hold your noses” political alliance between free bankers and anti-FRBers against the central banking majority. Ain’t going to happen, the battle lines have been drawn sharp and bitter.

Next generations might be more open to compromise; or the poorer argument will just shrivel up and die (which is, in my opinion, the anti-FRB one), thereby precluding any need for "engagement". Or some third theory that manages to satisfactorily incorporate the two sides under one unified theoretical banner might be discovered. Until then, engagement is unlikely, which may be for the best.

Last time I checked (pun intended), the financial system was still here. Oh, and the economy, too.

I guess it might have disappeared w/o the bailouts, though.


I think it would be a good thing to make it clear to bank account holders exactly what sort of relationship they have with their bank.

I don't think it should be law that every bank that offers FRB accounts must also offer 100% reserve accounts. But, I don't think it would hurt to require banks to be absolutely clear with their customers.

@Current: I don't necessarily disagree, although I just want to know what falls under "require banks to make absolutely clear."

What I mean is they must say somewhere on the paperwork, in language that normal people can understand, that their current account is a debt.

Mario Rizzo wrote:

"Of course, the idea proposed here might be quite good. But I would feel more confident if the Austrian big guns were involved from the get-go."

I second Mario's concern. Does anyone know if Joe Salerno or Guido Hulsmann were consulted on this legislation?

I'm not sure, Jerry, why you think I'm in favor of the status quo or of doing "nothing" about powerful bankers. I want to put an end to guarantees; and (like Larry--and as I also indicated in my "non" answer) I'm happy to institutions that depend on such to "narrow" banking, and would be prepared to endorse a bill doing so. But also like Larry I believe that banks that dispense with insurance while also establishing living wills that prevent them from being "too big (or interconnected) to fail should not be subjected to heavy-handed regulation.

The thing that troubles me about this thread is that you and some others seem bent on portraying the free bankers' ideas as merely "quaint"--as if they pertained to a bygone era and not at all to today's world. That's a big mistake: our ideas are as fundamental to sound banking reform today as those derived from the theory of free trade--another "quaint" concept that, let's face it, big business will never tolerate!--are fundamental to trade reform.

Nor am I trying to turn clocks back. I long ago conceded, for instance, the need to accept the reality of the fiat dollar and to work around it, although I wish we could restore the classical gold standard; and I am as suspicious of the desires of established bankers as Adam Smith was of those of businessmen of all kinds when they convened behind closed doors.

Finally, the facts Jerry mentions concerning how I-banks depended on commercial bank loans and how they later became bank holding companies, though perfectly true, don't come close to showing that Baxendale banking would have prevented the subprime crisis. Of course, there couldn't be investment banks if commercial banks didn't exist, or couldn't make overnight loans, but that's not what Baxendale is proposing.

I will grant, nonetheless, that a complete ban of commercial banking would have avoided the crisis. Perhaps this suggestion will inspire some legislation. But don't you see: any fool can "fix" an economic problem by identifying and banning some activity that enabled it (while perhaps also enabling many useful things). The trick is to solve problems without ruling out potentially welfare-enhancing exchange.

Hello all.

I am familiar with the Cobden centre proposals and also with some of the ideas of free banking that you at this website prefer.

While the Cobden centre people have laid out a plan for transition to their preferred system, I have not seen an equivalent one for a transition to free banking.

Could I ask what you might propose in order that the system is moved onto a fractional-reserve free-banking arrangement?

Thanks for the trouble.

Pete: Your post asked me to tell _you_ whether I thought you were right in believing that Baxendale's proposal was consistent with free banking. I answered accordingly. So if my language didn't appear well-designed for engaging Baxendale and his associates, that is because it wasn't intended for that purpose. Rest assured that, should I communicate my thoughts to those concerned directly with the legislation in question, I will first give them a good sugar-dusting.

"banks that dispense with insurance while also establishing living wills that prevent them from being "too big (or interconnected) to fail should not be subjected to heavy-handed regulation"

The problem is that no one will enforce this living will: the no-bailout strategy is time inconsistent in case of a systemic crisis. Government wouldn't be credible if it promised this policy, and banks would flock to cause a systemic crisis anyway.

It's the existence of the very power of saving banks that destabilizes the system.

Toby couldn't get this to be accepted so he asked me to post:

"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 [email protected] . Be brave, become a doer as well as a thinker, help me do this. All serious suggestions welcome.

Kind regards,

Toby Baxendale


I believe that the lack of credibility you mention depends on the authorities' understanding that they can continue to hoodwink the public into believing that bailouts are essential to avert crises. The living will makes the hoodwinking a lot harder, though still possible. So I agree that more steps are needed to rule out TBTF. What I don't agree with is the suggestion that the only solution is to ban either large banks or fractional deposits. For many decades the problem in U.S. banking was too many small banks--that's what led to deposit insurance. Let's please not go there again.


I don't believe free banking is quaint, and don't understand why you think that. I don't think free banking necessarily tells you what to do about privileged banking (referencing Pete's original post and my exchange later with Steve). The latter is the thrust of my questions to you.

And I have asked questions here and at TM, because I don't have the answers. Your recent reply to me is responsive and I appreciate it.

Toby Baxendale's comments are quite good. His call for a sound money movement is stirring.

The idea of different "windows" at banks -- insured and uninsured deposits -- has been around for some time. In the 1990s I served on a committee at the then Bankers Roundtable and we activly discussed the idea. I am not slighting Toby, but suggesting it is certainly not radical.

In Milton Friedman's 1960 update of the Chicago Plan for narrow banking, he devised a way to pay interest on the 100% reserved deposits. The Fed could pay interest on reserves from its earnings. At the time Friedman wrote, the law would have had to be changed. The Fed now in fact pays interest on reserves.

I love you too, Jerry.

Jerry writes:

"I-banks could not operate w/o being financed by commercial banks."

I disagree; why couldn't they issue bonds, which they do?
As far as getting from here to there, if memory serves, George wrote a "how to get from here to there" paper for Cato around 1985 (correct me if I'm mistaken). Has it been brought up to date?

Bill Stepp,

I-banks lived on the spreads: borrow short and lend long, and borrow at a low-risk rate and lend at a risky rate. There is no money to be made your way.

Certainly I-banks like being subsidized (2nd hand) by borrowing from the implicitly (and lately explicitly) subsidized C-banks, no question about it. But they can operate without such subsidies, albeit in a different form.
After all, hedge funds and other players in the shadow banking system don't need commercial banks to exist, although some of them do avail themselves of their lending services. They don't need to be that heavily leveraged, and some aren't.

Pr. Selgin writes "The proposal isn't at all consistent with freedom of contract if it would rule-out demand deposits backed by fractional reserves". Does Toby Baxendale's proposal prohibit fractional bank money as a legal possibility ?


Tyler Watts;

'What precisely does it mean for an institution to "bring down the financial system and the economy?" I've heard a lot of heated rhetoric pushing this claim (e.g. Bernanke/Paulson testimony), but not so much regarding the nuts and bolts details of how it actually would happen.'

It means the systemic risk scenario. The failure of a large bank either through (1) a liquidity shock, (2) direct knock-on counterparty contagion, or (3) informational contagion, would push financially healthy institutions into financial distress on a very large scale. Empirical evidence only support the third kind of scenario (and not very strongly IMO).

Jerry O'Driscoll,

C-banks live on the spread by borrowing short and lending long. They also have fee-based income from selling mortgages, etc., but they live on the spread. I-banks make their money from fees (advising clients on M&A and recapitalizations, etc., as well as by selling equity and debt in the primary and secondary markets, and derivatives); and from trading income and other investments. C-banks make some income too from forex and bond trading.
Unlike Citi, Bank of America, J.P. Morgan Chase, Wachovia, and Wells Fargo, Goldman Sachs never had a C-bank operation, but still has done nicely for its partners and shareholders from its fee-based and trading operations.

2nd to last sentence should read:
The failure of a large bank would push financially healthy institutions into financial distress on a very large scale through either (1) a liquidity shock, (2) direct knock-on counterparty contagion, or (3) informational contagion.

Like Stepp, I was a bit puzzled by Selgin and O'Driscoll's claim about investment banks.

Why can't investment banks borrow by issuing 30 day commercial paper and use this to fund portfolios of stocks and bonds? Why must they borrow from commercial banks?

I realize it would be a bit tough for investment banks to operate with suitcases full of currency, and that being able to wire funds is helpful, but do they have to have lines of credit at commercial banks?

If deposit taking institutions were banned from lending to investment banks, surely finance companies could be developed that would use long term debt or equity funding to make short term loans to investment banks.

My understanding is that the traditional function of investment banks was underwriting securities. Rather than provide funds to clients as the client's securities were sold, they raise short term funds (perhaps borrowing from commercial banks) and give them to the issuers immediately, and obtain the funds to pay them back as the newly issued stocks or bonds were sold. As on going businesses, they were constantly borrowing short to fund the payments to the clients, or more exactly, to fund their holdings of yet unsold new issues of stocks and bonds.

Of course, when the investment banks determined that the stocks and bonds they had yet to sell were good investments, they began proprietary trading. (And this is made out to be some kind of evil in some circles.) They held stocks or bonds themselves and profited on the difference in yields.

But if there is anything about recent decades that I find remarkable it is that the investment banks didn't fund their operations by short term bank loans or even 3 month commercial paper, but rather by overnight repurchase agreements, which were held by money market mutual funds.

If commercial banks were prohibited from lending to investment banks, then it would seem likely that this sort of procedure, money market mutual funds "lending" to commercial banks by holding their commercial paper (which is a repurchase agreement if secured by some of the investment banks securities) would expand.

And of the securities being underwritten, and then held because they are a good investment are mortgage backed securities, then were are at the investment bank part of the crisis with no commercial bank involvement.

As I see it, the real involvement of the commercial bank sector was that they foolishly made large investments in the mortgage backed securities underwritten by the investment banks.

I will grant that some of them may have been in trouble because they had made loans to the investment banks, but that doesn't quite match with my understanding.

Maybe the claim is that I-banks wouldn't have expanded that much without the liquidity guaranteed by the C-banks, whose liquidity was guaranteed by the Fed, etc...

I haven't understood the linkages between banks and non-banks financial institutions sufficiently well to asses this claim, but it is my working hypothesis, too.

"As I see it, the real involvement of the commercial bank sector was that they foolishly made large investments in the mortgage backed securities underwritten by the investment banks."

And don't forget Merrill Lynch, which originated some of these securities, and infamously loaded up its balance sheet with them just before they took a powder. ML's CEO Stan O'Neal was ousted as a result. It was described in a front-pager in the WSJ.

@Steve Horwitz: "Why do we need a law to force banks to offer a 100% reserves alternative to fractional reserves? If that's what people want, they can use a safe deposit box and simply withdraw their cash as they need it. That option is available now."

People would of course use irregular deposits, not safe deposit boxes.

" Once we realize that what banks primarily do is to engage in intermediation and the provision of convenient means of payment, we can understand why people choose fractional reserves all the time. "

Well they choose it now because of deposit insurance. They get interest and their "deposit" is insured.

As I see it, the "closed end mutual structure" Baxendale discussed as a way to implement FRFB accounts with full disclosure would make the nature of such accounts clear. Mayhap some freebankers predict that shares held in such a vehicle could trade as money. I, personally, would love to see them free to try so that we could all witness that attempt.

@Bob, as for the big guns comment, yes, I do believe Huelsmann and Huerta de Soto were consulted, as were others on the FRFB side.


If this plan is ever made law I suggest we have a little wager ;)

Stephan Kinsella writes:

Well they choose it [fractional reserves] now because of deposit insurance. They get interest and their "deposit" is insured.

Fractional reserves existed long before deposit insurance did. And fractional reserves didn't come into existence because of deposit insurance.

Bill Stepp is correct. What's more, Kinsella's argument is one that's been made and refuted dozens of times, on forums to which he regularly contributes. He is one of those Rothbardians committed to to strategy of trying to "wear out" the free bankers instead of actually refuting them.

For the record: No nationwide deposit insurance anywhere before 1934; the U.S. only until 1967; gradually growing numbers of insured systems after that.

Professor Selgin, that is not my motive, I assure you. I have never argued that FRB is inherently fraudulent nor that it should be outlawed.

As for consumers choosing FRB, I was responding to Steve Horwitz's comment which I assumed concerned today's situation. I was not clear he was talking about former practices. I assume we all agree that consumers choosing FRB accounts now proves nothing. I did not and have never weighed in on the supposed historical cases that demonstrate FRB is in fact preferred. There are arguments for why these examples do not prove what they are said to--and there are counterarguments. But so what? At most these arguments about historical practices only support predictions about what practices are likely in the future. Do we really need to argue based on differences in prediction?

I agree with Guido Huelsmann in "Has Fractional-Reserve Banking Really Passed the Market Test?" ( ) that notes issued by FRFB's are IOUs; and I agree with him that IOUs can only serve as media of exchange, but only in special limited cases of limited scope and extent. But how limited? Who can say? As a libertarian my main interest is in eliminating deposit insurance, and ensuring that the nature of the banking relationship is clear to the customer. I have not been persuaded there is any economic problem that FRFB is a solution to, but if I am wrong, then in a free market, my error would soon be apparent.

Disagreements on economic aspects of FRFB primarily manifest themselves in different predictions about what type of banking practice would be common or preferred by customers in a free market--seems to me we don't all have to have the same predictions. We can work together to achieve a free system in which we can all watch and see whose predictions are borne out.

Stephan, all this stuff about whether FRFB notes can serve as media of exchange and to what degree being a matter for speculation is absurd. We have tons of evidence that they can and did do so, and to a very considerable degree. The money stocks of Canada and Scotland furing much of the 19th century consisted of little else, for starters.

I'm frankly tired of anti-FR people pretending that this evidence doesn't exists and that all statements about FRFB being possible are mere speculation. I hope readers of this blog are tired of it too. Once or twice, such statements can be excused as mere error; beyond that, and after repeated indications of the error, they become disingenuous.

And please spare me the claim that Rothbard showed the Scottish system to depend on the B of E etc. etc.--that, too, has been exploded repeatedly and at length.

Professor Selgin,

I cannot see how having disagreements about this matter indicates disingenuity. But in any case, I don't think they are very relevant here. Different views on this issue would simply affect one's prediction for what the monetary landscape would look like after the state's involvement in central banking is eradicated. If IOUs become widely used as money, fine by me. If not, fine by me. It seems to me we can all agree on abolishing state deposit insurance and protecting property and contract rights in a free market free banking system.

Stephan, what I find disingenuous is the suggestion that the different "predictions" of the FRFB and anti-FR sides have equal merit. In my opinion, they don't, because the abundant evidence to which i refer above from past episides in which central babks were in fact not present all testify to the feasibility and popularity of fractionally-backed banknotes and deposit credits. In contrast, there has _never_ been a historical instance of any importance of a competitive banking system that operated on a 100-percent reserves basis. Indeed, it's not even easy to identify a single bank that did so, for even the Bank of Amsterdam, which is the closest example, did not keep 100-percent reserves except for a relatively brief period (though its reserve fraction was usually quite high).

I am not against entrtaining different views--of course I believe that there are many things that reasonable people can disagree about. But with respect to the particular point at issue here, to maintain, in the face of available evidence, that in the absence of a central bank and other government interference a free market is more likely to give rise to a 100-percent reserve system than to a fractional one is to take one of those stands that frankly isn't very reasonable.

Having said this, I do appreciate that you yourself are not taking a stand against fractional reserve banking.

Professor Selgin,

I am not even suggesting the differing predictions have equal merit (I have my own views about this). I am trying to identify the main *relevant* difference for policy purposes. It seems to me this is a difference, even if you don't regard the two sides as having equal merit: it is still a key difference, but luckily, I think, it does not have a strong bearing on policy issues: it seems to me that even people who disagree on the likelihood of FRB IOUs becoming money can agree on the main policy issues: ending deposit insurance; ending bank regulation; recognizing property rights and contractual rights per the intent of the parties; distinguishing unalike things.

As for my own view about FRB: I am "against" FRB if it means the current system, because it is a statist system. As a libertarian I am not for or against any given financial arrangements people want to engage in, so long as there is full disclosure and no fraud. As a student of economics I have my views about whether FRFB makes sense or would thrive--I'm skeptical of it, but who knows. Having a different prediction does not make me "against" it.

"And suppressing fractional reserves will have real costs far beyond those of merely inconveniencing people who would rather not stuff their savings in a safety deposit box instead of having it in a fractionally-backed demand deposit. It will mean depriving businesses of an important source of credit--which, in the absence of central bank shenanigans, would be credit based on genuine savings." (George Selgin in an earlier comment).

Three brief comments before moving on to the main issue:

-Demand deposits would perform their payments and storage functions just as well under a 100% reserve system as under the current one so the first part of the above comment seems something of a red herring.

- The same applies to any contention that fractional reserve banking systems are validated because both customers and bankers freely choose it. Of course they do; it's clearly beneficial to both. Banks are given a significantly expanded funding base while depositors either receive for free (or are paid for) something which would otherwise carry a cost. None of this, however, addresses the question of whether there are longer-term systemic consequences of fractional reserve banking that outweigh these narrowly defined individual benefits.

- Doesn't the debate about 100% reserve banking at least in part ignore the question of what would happen were it introduced. Does anyone doubt the outstanding amount of demand deposits would radically shrink as a consequence (and that rather rapidly)? Wouldn't new forms of "time" deposits soon develop to provide very nearly the same degree of liquidity (and interest returns) to customers while leaving banks free to lend those deposits? It would be, I suspect, a relatively short lived and hollow "victory".

No, I wonder if the larger issue, which George Selgin alludes to in his next comment, isn't so much whether or not 100% reserves should be required on demand deposits but the whole business of maturity transformation itself.

That leads us to the second part of the initial quote which I think points to the true heart of this entire debate; is fractional reserve credit "in the absence of central bank shenanigans" really based on genuine savings (as Selgin et al maintain), or does it instead tend by its very nature to generate an illusion of savings? Or, putting the same issue in a broader and slightly different context, are savings increased by maturity transformation?

This is much too large a topic to be satisfactorily addressed here, even if I felt qualified to do so. Instead, for now I'd just like to offer up some fundamental questions and a few comments.

First, why have financial systems have been such a constant source of trouble (including long before the advent of central banks, deposit insurance etc etc). Unlike other markets, they don't have a particularly good record of looking after themselves.

At one level, the answer seems obvious; financial markets are chronically prone to self generated positive feedback. They can create their own weather as fresh credit sparks more economic activity and higher asset prices, both of which in turn appear to justify the creation of yet more credit. And so on in what appears to be an endless virtuous circle.

What's odd, though, is that this can carry on for so long and hence do so much damage. Why doesn't the rapidly growing demand for credit so raise its price (yield) that borrowers back off? That's what you'd expect with any other market. It's almost as if the potential supply of credit is infinite.

It seems to me the answers to these sorts of questions are likely to be found at a deep structural level. Something consistently prevents the normal forces of supply and demand from properly exercising their influence. FWIW, I've long wondered if at least part of the answer doesn't lie in the very process of maturity transformation.

Money in itself isn't savings; it only really becomes so (and then only indirectly) if and when its holders are able and willing to commit that money through making longer term loans (or equity investments obviously). When demand deposits (or, for that matter, shorter term time deposits) provide the means to make those loans, doesn't this effectively exaggerate the extent of available savings? When banks lend these sorts of deposits, the borrowers spend them, they end up back in the banking system as fresh deposits and are in turn (assuming an optimistic environment) lent out yet again and so on ad nauseam, as we all know. For the life of me, what I can't see is how all these freshly generated deposits in any meaningful sense constitute savings.

If that's so, doesn't it follow that fractional reserve (or otherwise maturity transforming) financial systems by their very nature tend to misrepresent a society's savings? Rather than intermediating smoothly between savers and investors, they continually transmit confusing signals, not only to the economy at large, but also to themselves.

Doesn't the debate about 100% reserves (and all of the other proposed structural reforms) vs fractional reserve banking need to be set in this broader context? Otherwise, it seems to me, there's a real danger of getting bogged down in inherently divisive details when the nature of the problem itself is less than clear.

The only way to get rid of the 100 % reserve argument is to have their advocates learn what a contractual commitment is in real business.
Why don't they go out and hector commodity futures traders to the effect that the volume of contracts traded shouldn't exceed the value of goods supposedly involved?

People use convertible money substitutes with the full knowledge that there is more of them than there is money, because they are superior substitutes to said money. Not only are they able to perform the same services, they perform others, which narrow money is incapable of.

It seems that the advocates of 10 percent reserve banking are willing to go to some lengths in denying the fact that a competitive monetery system would involve an extensive development of only partially covered money substitutes. This is another point on which their willingness to deny the obvious becomes an annoyance.

To their credit, the desperate attempts at proving that partial cover banking is "fraudulent" does imply an understanding that individual responsibility is the only means of regulating the economy.

But that a ban on partial cover banking (aka "banking") is a restriction on the freedom of contract and a departure from the free market is all too evident, both from an a priori and a historical perspective.

Yet the fundamental fallacy at the base of those normative misrepresentations seems to be the belief that in a free banking system, money substitutes could be created for any length of time without anyone being willing to hold them as part of his savings portfolio. This would involve some degree of incompetence in bank accounting.

Ingolf: "-Demand deposits would perform their payments and storage functions just as well under a 100% reserve system as under the current one so the first part of the above comment seems something of a red herring."

By "inconveniencing" I meant simply "depriving them of interest and forcing them to pay substantial maintenance fees." It's not a red herring unless you believe that know one would mind the extra cost. (History suggests otherwise.) But anyway, I treated this a point of secondary importance.

"None of this, however, addresses the question of whether there are longer-term systemic consequences of fractional reserve banking that outweigh these narrowly defined individual benefits."

No, it doesn't: but my purpose was to indicate a cost of suppressing fractional deposits. (I have addressed the supposed costs of not suppressing them elsewhere, and repeatedly. Blog participants must understand that not every comment pretends to address every issue of importance!

The rest of your comment suggests lack of familiarity with the historical record. There have been FR systems that had lots of problems (e.g. U.S.); and there have been others that have done very well (e.g. Scotland pr-1845; Canada for most of 19th c.) Your suggestion that the fundamental problem is "maturity mismatching" (that is, maturity transformation, which goes on in all FR systems) ignores this.

So my challenge to you: explain how Scotland and Canada managed to have very well-behaved FR banking systems during the periods mentioned. And please don't tell me about Rothbard's or Sechrest's articles on the Scottish system, for the critical claims in those were exposed as false long ago.

> Money in itself isn't savings; it only really becomes so (and then
> only indirectly) if and when its holders are able and willing to
> commit that money through making longer term loans (or equity
> investments obviously). When demand deposits (or, for that matter,
> shorter term time deposits) provide the means to make those loans,
> doesn't this effectively exaggerate the extent of available savings?

When a person holds a fractional-reserve banknote worth 10 ounces of gold that person is saving that sum. When they hand that banknote over to another party when buying something they cease to save that amount, but that second party is saving 10 gold-ounces. That process only ends when a banknote is handed back to a bank to pay off a debt or when it's redeemed.


No argument that a 100% reserve system would impose additional costs on account holders. I only commented on this because of the reference to stuffing savings in safety deposit boxes.

As for the rest, it seems only indirectly related to the main question I was circling around; whether financial systems that perform significant maturity transformation by their very nature produce distorted signals about available savings.

Still, as you suggest, perhaps FBFR systems have already shown a capacity to adequately deal with these sorts of problems, and in a freer and more effective fashion then any alternatives. I did read some articles years ago (by Hulsman, Herbener, Salin, yourself and, yes, Sechrest and Rothbard), and came away with mixed thoughts. This whole thread, and your comments in particular, make me want to take another look at it.

Is there an article you'd particularly recommend?


If money is so directly equated to savings (as you seem to be doing), doesn't this render the word "savings" kind of meaningless?


This is how I understand it...

I think that when someone is saving they are deferring spending into the future. If I buy a debt certificate such as a fractional-reserve banknote, or a producer good such as a piece of gold then I'm saving. If a gold coin is melted down into jewellery then that is turning it into a consumer good.

Let's suppose that a businessman owns a field. If he borrows against that field then those who he borrows from are saving. If he spends the money he obtains from borrowing on capital then he is investing.


Broadly agreed. If someone retains a surplus from their current income after consumption, then that amount is of course savings. I think, however, it would be more accurate to say that in lending to your businessman, the lenders aren't saving, they're investing savings they've already made.

Similarly, as you say, a saver can choose to buy a fractional reserve bank note or a piece of gold with their savings. I only quibbled with your initial comment because my impression was it implied the holding of such a banknote in itself constituted saving.

> If someone retains a surplus from their current income
> after consumption, then that amount is of course
> savings. I think, however, it would be more accurate to
> say that in lending to your businessman, the lenders
> aren't saving, they're investing savings they've already
> made.

I see your point. Normal language is not very precise here. When we talk about a business and equity we say that the shareholders are investing and the managers are also investing. But, when we talk a bank it's said that the account holders are saving and the bank is investing.

As you say it's probably best to reserve the word saving for the act of retaining a surplus. Mises talked about "capitalist saving" by which he meant investment with a business or "plain saving" which is just stockpiling resources.

> I only quibbled with your initial comment because my
> impression was it implied the holding of such a
> banknote in itself constituted saving.

Yes, that exactly what I am saying. Holding a banknote is saving, because consumption is deferred until the time when the banknote is spent. When one person spends the note they cease saving that amount and the person they hand it to then saves that amount until the banknote changes hands again. This ends when the issuing bank removes the note from circulation, and it begins when the bank puts the note into circulation. This is what Adam Smith meant with his "roads through the air" metaphor.

Re.: principle of adverse clearings."

1. After reading the Theory of Free Banking, it appears that the above principle is the only feedback mechanism that constraints credit growth.

Is there a numeric model of the principle in action ? Does such model presuppose a fixed stock of base money to be used for settlement ?

2. Assuming the principle works, in what way its mechanism is any different from what we have today assuming a period during which the Feds do not conduct any open market operations ?


Current, we're probably just getting caught up in semantics on this business of banknotes and savings.

FWIW, as I see it, a banknote can represent a form of savings to its holder, but I don't see that it constitutes savings in itself. Each banknote is an asset in the hands of its holder but a liability to its issuer so, at a macro level (except for any possible effect on nominal prices) it seems a wash to me.

Anyway, I'm very happy to let the matter go.

> Each banknote is an asset in the hands of its holder but
> a liability to its issuer

*All* capitalist saving is like that. Timed saving is exactly the same. The only cases where this doesn't occur are direct investment or "plain saving" (aka accumulating durable goods).

> at a macro level (except for any possible effect
> on nominal prices) it seems a wash to me.

It can affect nominal prices. Just as importantly though, like other forms of debt, and other markets, it allows a socially productive match up between borrowers and lenders. It allows those who have investment plans - entrepreneurs - to borrow.


As I said earlier, I think we're mostly stumbling over semantics.

Savings, as I use the term, are what's left over after consumption is deducted from income in any given period. A society could save without any increase in money, or even with a decrease. Or, it can be dissaving while the stock of money is increasing.

As I see it, fiat money and fiduciary media are best viewed as nominal claims on goods, services or assets, not savings per se, and the growth of assets and liabilities through the financial system (whatever their maturity) can be destructive as well as productive.

In any case, I don't think I can put my perspective any more clearly so I'm going to bow out of this exchange.

> A society could save without any increase in money, or
> even with a decrease. Or, it can be dissaving while the
> stock of money is increasing.

Yes, certainly.

> Savings, as I use the term, are what's left over after
> consumption is deducted from income in any given period.

Ah, I think I see where the disconnect is. You are looking at it from an overall perspective and concentrating on addition. I'm looking more from an individual perspective and concentrating on the stock.

To be clear. The only additional saving involved in fiduciary media is when more of it is created. Circulation only makes it circulate between different individuals.

> the growth of assets and liabilities through the
> financial system (whatever their maturity) can be
> destructive as well as productive.

I certainly agree about that.

Bailouts are a relatively new phenomena. Everyone talks about TBTF as if it is a given, but it seems to me that in the past it was avoided.

What changed?

I guess I mean that TBTF wasn't a given in the past, so why are we assuming its a given wrt banks in this argument.

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