In the comments to a recent post, Bod Roddis asks why anybody would accept a banknote from a bank practicing fractional reserves, without an accompanying disclaimer that reads, “This is not a warehouse receipt.” I figure that the reason for this is that Roddis distrusts that a bank practicing fractional reserves can do good on the explicit promise of being able to swap outside (for the sake of simplicity, gold) for inside money (i.e. allow the note holder to redeem the note for deposited outside money). This fear makes sense only if you expect that all note holders, at some point, will redeem their banknotes for outside money.
This is why I think that everyone and anyone interested in the topic of free or full reserve banking should read George Selgin’s The Theory of Free Banking (available for free at the Liberty Fund website). Selgin’s theory necessitates as a precondition that not all note holders will, at some point, attempt to redeem their banknotes for outside money. In fact, even the circulation of banknotes (inside money) necessitates, to some degree, that this precondition is true.
First, let me define two terms. I am sure everyone is already familiar with them, but I will define them just in case,
- Money substitute: Relevant to the discussion are banknotes (so-called “inside money”), which act as ‘money substitute.’ Money is a widely accepted medium of exchange, and we attribute this term to whatever is considered “outside money” in our example — we said gold, to keep things simple. Banknotes are thus acting as substitutes for this outside money; instead of gold, people are using banknotes as a means of payment.
- Fiduciary media: Let us say that all bank notes — just to keep things simple — are worth an ounce of gold, and let us say that there are one million ounces of gold deposited throughout the banking system. Therefore, we know that one million banknotes are backed by one million ounces of gold (i.e. if all these notes were suddenly brought to banks for redemption, all promises for redemption could be fulfilled). Fiduciary media, then, are banknotes introduced into circulation beyond the total quantity of outside money held by banks; another way to put it is banknotes “unbacked” by outside money.
When banknotes are first introduced as a possible substitute for outside money their value is tied to this outside money only because those holding them know they can eventually redeem them for real money — without this knowledge, there would be no reason for people to accept banknotes in transactions. So, having this reassurance and knowing the qualities of banknotes that make them more desirable than carrying outside money (such as divisibility and weight), there is a steadily growing demand for inside money.
At some point, the knowledge that these notes are redeemable for gold begins to be taken for granted. The banks are trusted, because there have not been important instances where banks have not been able to fulfill their part of the deal. There is an increase in the demand for bank notes because people are generally accepting them as a means of payment. The demand for outside money falls; people are content with holding inside money, because it acts as a perfect substitute and they know they can redeem it for gold at any sign of trouble.
This gives bankers two opportunities for introducing fiduciary media into circulation,
- The most important source of fiduciary media actually does not involve further money creation. A fall in demand for outside money means that banks will be sitting on gold deposits (in our example) that have no use, since nobody is redeeming their notes for them. At some point, banks will figure that they can safely get rid of some of these gold deposits (in some profitable manner) without undermining their ability to fulfill the redemption demands that are being made (such as inter-bank clearings and whatnot). As gold deposits shrink, some of the banknotes in circulation (that were first introduced with full backing) will become fiduciary media.
- There is also the opportunity for banks to create more money, since to some degree there is a trust that allows these banknotes to maintain stability (this stability is, of course, undermined when the exchange value of inside money decreases [i.e. inflation]).
What kind of checks exist on further money creation in a free banking system? Banknotes act as a liability; the liability is that they may one day be returned to the bank for redemption. The more banknotes that return to a bank either for redemption or through inter-bank clearings the more outside money must be kept on reserve, and the less fiduciary media a bank can afford to maintain in circulation. The less banknotes that return to a bank, the more fiduciary media can be afforded. Thus, the cost of issuing fiduciary media is bank stability. As a rule, banks can only extend fiduciary media (through the loanable funds market) when the demand for money rises (when people are holding money, instead of spending it), since when the demand for money rises there are less banknotes being returned to a bank.
There is no physical difference between a banknote fully backed by outside money and one that is unbacked — the difference is an accounting one. People accept banknotes because they trust that it will be accepted by the people they exchange with.
So, the question is not why people would ever accept a note unbacked by outside money; rather, does the issuance of fiduciary media in the event of a rise in the demand for money lead to economic instability? In more Austrian terms, can an increase in fiduciary media resulting from a rise in the demand for money lead to the instability of the issuing bank? I, of course, say ‘no;’ a full reservist might say ‘yes.’