Blogger “Lord Keynes” criticizes the use of the term “funny money” as being purposefully loaded. I agree, but I suggested separating Austrians between those who believe that fractional reserve banking is fraud and those who do not. It strikes me that the size of the latter group is growing, and the former dwindling (at the very least, more and more people are simply switching to supporting “free banking,” whether it be with fractional or full reserves).1 In response, LK writes the argument I would have least expected him to use. Paraphrased,
- Why would a fractional reserve free banking system not lead to recurring industrial cycles;
- According to LK, the “whole point” of Mises’ and Hayek’s work in the area was to show how fiduciary expansion leads to business cycles;
- In fact, how do promissory notes, bills of exchange, and checks not cause industrial cycles.
My purpose here is not to inflame another debate between full reservists and fractional reservists, but just to defend the White/Selgin (also referred to W/S here) model of free banking against LK’s claims. In fact, “defend” might be the wrong term, since what this really boils down to is an illustration of just how poorly LK understands both the Austrian theory of industrial fluctuations and the theory of free banking.
Allow me to begin at the middle: Mises’ and Hayek’s theory of severe intertemporal discoordination. Their ideas have to be understood in proper context and it also has to be accepted that they made mistakes — mistakes that do not invalidate the broad argument, but rather imperfections. The theory of intertemporal discoordination (which I have discussed at length elsewhere: 6 Jan. 2011, 26 July 2011, and 12 August 2011) can be summed up as arguing that growth in the supply of money will lead to the creation of malinvestment throughout the structure of production, if this growth takes place in the “arteries” (my own term) that channel savings from one person to another — as long as the growth is over and above the supply of “real savings.” Understanding this is crucial: what both Mises and Hayek were discussing is a distortion in the pricing process that makes capital goods seem more abundant and available than they actually are.
The basic idea behind malinvestment and the business cycle seems to be lost on a lot of people, and not just non-Austrians. We are not talking about a lack of consumer demand for the final product, because consumer output prices will adjust to reflect their marginal valuation. We are talking about the inability to complete investments, because the quantity demanded of capital goods outstrips the supply. When these “artificial savings” are no longer available, entrepreneurs can no longer afford to bid away capital goods which have risen in price as a result of the monetary expansion. This is why Austrians refer to the idea of investment over and beyond the stock of real savings.
In Hayek’s early writing (I have in mind his 1933  article “Monetary Theory and the Trade Cycle;” specifically, chapter four), he does actually believe that fractional reserve banking leads to recurrent business cycles. He thought that industrial fluctuations were an unfortunate side effect of a more efficient use of savings. Hayek’s beliefs with regards to the debate, I think, mature between 1929 and the 1970s (i.e. “Choice in Currency”  and “The Denationalization of Money” ). I think the Hayek of 1929 is correct to argue that the Austrian theory is an endogenous one, but I do not think he realizes what factors cause this recurring endogenous problem to be possible. That is, there are important institutional characteristics — one obvious one being the Federal Reserve — that makes endogenous business cycles possible. This is why, in later life, Hayek opted to argue that the banking system should be reformed, by means of full privatization and deregulation.
Hayek calls Mises’ version of the theory an exogenous one, but I think this is a mistake that originates from the lack of insight on the institutional characteristics of the banking system. Mises recognized that the problem is one of cartelization and regulation. Also, contra LK, Mises never opposed the issuance of fiduciary media. In Human Action , for instance, Mises calls fiduciary media an important tool, but highlights crucial limitations to a bank’s ability to extend credit (pp. 431–441). The mechanism by which this occurs is actually roughly similar to that in the White/Selgin model: excess notes are spent and ultimately returned to the bank for redemption, threatening a bank’s stability. Why do banks not seem to be affected by these supposed limits in most, if not all, modern banking systems? Government intervention.
I am not saying Mises was a fractional reserve free banker, although I do not think Mises was a full reserve absolutist, either (however, Mises did argue in favor of full reserves in lieu of free banking, to constrain the capabilities of a cartelized and regulated banking system). A pretty convincing and authoritative comparison between Mises and W/S is provided by Salerno’s May 2010 Mises Daily piece (although, his calling W/S free bankers part of a “Neo Banking School” seems to me a bit too broad).
Two main points that should be taken from what I have written so far,
- Austrian business cycles are caused by “artificial savings;”
- Neither Hayek, except very early on, nor Mises thought fractional reserve banking is the source of the problem — they thought it was fractional reserve banking by an institution which characteristics and abilities have been distorted by government intervention.
How does the White/Selgin model of fractional reserve banking fit in all of this? In Selgin’s The Theory of Free Banking (a book that, like most economic treatises, needs to be read from cover to cover), two general means of reserve reduction are presented. Quoting directly from my article “Prices and the Demand for Money,” these are,
- Over time, “inside money” — banknotes (money substitute) — will replace “outside money” — the original commodity money — as the predominate form of currency in circulation. As the demand for outside money falls and the demand for inside money rises, banks will be given the opportunity to shed unnecessary reserves of commodity money. In other words, the less bank clients demand outside money, the less outside money a bank actually has to hold;
- A rise in the demand to hold inside money will lead to a reduction in the volume of banknotes in circulation, in turn leading to a reduction of the volume of banknotes returning to issuing banks. This gives the issuing banks an opportunity to issue more fiduciary media. Inversely, when the demand for money falls, banks must reduce the quantity of banknotes issued (by, for example, having a loan repaid and not reissuing that money substitute).
The S/W model, therefore, assumes that none of these two phenomena will lead to a dramatic2 over-issue of fiduciary media. This is because, in principle, the supply of money in circulation3 is stable. In the case of (1) bank notes originally act as money-certificates, replacing outside money in circulation. The act of turning some of those money-certificates into fiduciary media by selling part of a bank’s reserve stock of outside money does not change the fundamental fact that (1) alone maintains the supply of money stable. The description for (2) above explains the mechanism, but I will reiterate: the idea is that money held (not spent) is no longer circulating, so it can be replaced by a new banknote (or equivalent unit of credit or what have you). What (2) does, though, (and this is the most controversial part, I think, within Austrian circles) is distribute this held purchasing power to entrepreneurs, shifting spending to the non-consumer stages of production. The W/S rationale is that holding money represents savings, because the individual holding money is deferring from present consumption.
This is my attempted reconciliation. Mises, as I have already said, was not a fractional reserve free banker in the same vein as W/S, et. al. He did not recognize any of the above two mechanisms. Mises is clear, though, that individual banks which over-issue will risk their stability, because when over-issued fiduciary media return to banks for redemption, banks will find their reserves too scarce. Again, this is the same mechanism present in the W/S model. The important difference is that free bankers who prefer Mises’ theoretical exposition tend to think that fractional reserve lending will be minimized by “market forces” and free bankers of the W/S kind — such as myself — tend to think that reason (1) behind fractional reserves will exert the most pressure in reducing the size of reserves of outside money and (2) will cause subtle fluctuations in the stock of fiduciary media. Whatever occurs, it is easy to see how free banking would not lead to recurrent industrial fluctuations, and any intertemporal discoordination that does occur will not be to the same degree as it occurs in cartelized/regulated banking system (with a government currency monopoly).
1. What this suggests is that the size of the population of well-read Austrians who really believe that fiduciary media is “funny money” is actually substantially low and dwindling. Those who use it in the media are either: (a) part of the small group of Austrians who are full reserve absolutists or (b) using the term precisely because it holds a negative connotation. An alternative reason could be that some of the people who use the term “funny money” are thinking specifically of fiduciary media created that would not have been created in an alternative free market banking system — in other words, it is a fuzzy term that has a nebulous meaning to encompass the entirety of the banking cartel. I actually suspect that it this last reason that explains most of the usages of the term, with a little bit of (b) mixed in as well (every Austrian knows “funny money” is not an academic term, but their intentions are not academic).
2. Remember, these theories are meant to be ideal types; they explain the workings of a system by abstracting from certain details. In this case, the abstraction is disequilibrium. This is why I write “dramatic over-issue,” since over-issuance (and under-issuance) will occur in a world characterized by disequilibrium and decentralized knowledge. It is also conceivable that some banks might fail due to over-issuance — entrepreneurs can make mistakes.
3. The idea of “in circulation” is key. Mises 1998 (1949), “The only vehicle of credit expansion is circulation credit,” p. 431.