Institutions, Gold, and Banking

Originally, I was going to write a post on the recent volatility of gold prices and what this means for gold standard advocates. Pondering the subject, I became more interested in what this means for free banking advocates, specifically those who think that gold (or similar commodity monies) would be the primary backing asset. Since paper notes are circulated in place of gold, the relative scarcity of gold is no longer an advantage in constraining the money supply. From here, it’s not a big jump to come to the conclusion that gold loses some of its purpose. If what matters is limiting fiduciary expansion, the choice of backing assets broadens, because the bank only needs a capital reserve to make good the liabilities that its circulating banknotes represent. Many people, incorrectly, assume that it’s the “backing” that decides the sustainability of a currency. It’s not, what give sustainability are the institutions of banking.

To see my particular angle of approach, let’s quickly look at this hypothetical history of banking in hypothetical Ruritania. After some time, gold emerges as the principal medium of exchange, and people begin depositing their gold coins at specialized businesses, or money warehouses. Not only is this for safety, but these warehouses also preform the function of financial intermediaries, settling debts on net and in bulk. In place of actual gold coin, people trade with redeemable warehouse receipts. At first, any lending by part of these warehouses comes from their own retained earnings, and not the deposits of their customers. Over time, though, these firms begin loaning their customers’ deposits, as they realize that some fraction of total liabilities aren’t redeemed at any given point in time. This system slowly becomes more sophisticated, as standards are developed and new types of promissory notes are introduced Ruritanian banks eventually begin circulating the banknotes we’re most familiar with — imagine U.S. dollars redeemable for gold at your local bank branch. Gold is relegated to a reserve asset used to settle interbank clearings (when bank A goes to bank B with a large stack of B’s notes and redeems them).

Bank notes, or inside money, are circulating in place of gold coin, meaning they essentially become just as good as the commodity money they’re substituting for. To keep things simple, let’s assume that all notes trade at par (a $1 bill is worth the full amount of the assets it represents). It’s the circulation of these notes that forms part of the process of competitive price formation, so any change in the quantity of bank notes will affect prices. In this banking system, changes in the quantity of bank notes are bound to occur. The substitution of inside money for gold is essentially an act of abandoning a relatively rigid money for a much more elastic one. If banks wanted to, they could print an unlimited number of bank notes — well, until Ruritania ran out of trees (or until the saw and paper mills decided to stop working because hyperinflation had caused the pricing process to break down). This seemingly presents a dilemma.

The main argument against central banking is precisely that this state of affairs makes it too easy for a monopoly to exploit the elasticity of the currency. But, free banking doesn’t suffer from the same problem. To paraphrase Douglass North, free banking is a case of being able to conquer ourselves once we conquered nature — we gradually make the uncertain more certain. As competition in banking increases, rival bank notes (assumed to be imperfect substitutes) will circulate in competition with each other. Banks will accept rival notes to accommodate their customers, but will then take them to rival banks for redemption. This makes for a relatively fast feedback mechanism for each bank to gauge the health of its balance sheet. An increase in the number of returning notes will force a bank to constrain loans, perhaps borrowing in the short-term to temporarily shore up its assets (waiting for loans to be repaid). Even a competitive banking system of this type is bound to suffer periodic instability, but the institutions also get more complex over time. For example, specialized banks, or clearinghouses, may arise that deal solely with the inter-bank clearing process. Ultimately, these can act as central banks of sorts, loaning to banks in times of temporary distress. Banks would have to conform to certain standards to be eligible for aid.

Usually, when we think of a commodity standard we consider one of its qualities to be the physical scarcity of the commodity, like gold. But, in reality, society decided that the relative inelasticity of gold was too costly, so it adopted the more elastic system of inside money circulation. But, in doing so it abandoned one of the most important safeguards against inflation. What took their place were certain institutions, such as competitive banking. What this means to gold standard advocates is that they should stop advocating the gold standard and instead ask for competitive banking. Any gold standard that’s left unconstrained will eventually evolve into the more modern system of money substitute. The natural qualities of gold are therefore irrelevant. What matters are the institutions developed to not only take the place of these qualities, but to do the job in a superior way. Even a full reserve banking system has to develop institutions to constrain the elasticity of inside money.

One final point. In our hypothetical world of free banking, gold is relegated to the task of paying net debts through the inter-bank clearing process. Why couldn’t alternative assets take the place of gold? A bank could transfer ownership of another asset, such as a securitized loan portfolio. One thing that decides the quality of an asset, though, is its information sensitivity. An asset that varies in value is going to be more information sensitive, because the counterparty is going to have to track changes in price. For example, a $1,000 securitized loan portfolio with a 90 percent repayment probability may, at first, be valued at $900 by the counterparty (.9 × $1,000). As it turns out, this asset is volatile, with default probability fluctuating between 10 and 30 percent. If a bank is is using volatile assets as a capital reserve, then there will be a relatively greater likelihood that this bank is going to be unable to make good of all short-term liabilities (if the value of its “backing assets” falls). The banknotes of these banks are going to be circulating at less than par. Competitive pressures are going to force them out of business, and customers are going to choose more stable currencies. Another consideration is liquidity. Counterparties, or rival banks, are hardly going to want to be repaid in relatively illiquid assets. The advantage of gold as a backing asset is that it’s relatively information insensitive (if the money supply is constrained enough) and it’s relatively liquid. But, there are a broad range of assets, and new assets are likely to be developed over time, so we can’t discount the possibility of other assets being mixed with, or replacing, gold.

As I write above, it seems to me that what I argue here is true whether you advocate for a free fractional reserve or full reserve banking system. If inside money is circulating in place of outside money, what matters is constraining the supply of inside money. Banks can still choose amongst different backing assets, but even full reservists are interested in constraining money supply volatility. Ultimately, the end goals of the two approaches aren’t too different. Fractional reservists look to competition as a means of developing means of restricting excess money creation. Full reservists look to legal constraints, or some simply claim that a competitive banking system would be forced to full reserves because of instabilities allegedly inherent in fractional reserve banking. Whatever the case, what matters are the institutions, not gold.

11 thoughts on “Institutions, Gold, and Banking

  1. Silvano IHC

    Very nice post. I just disagree a little about the effects of widening competition. Credit and fiduciary media are based on confidence. Exploitative behaviours damage confidence toward banking and its institutions. Free riding hurts everyone. While enlarging the network of users and producers has surely positive consequences,and scale economies at the same time it makes the market more vulnerable. Private agents can solve this problem creating coalitions and setting up entry barriers. Reducing the degree of competition is both compatible with private and public interest. It can happen and indeed it happened,without state intervention.

    1. Robert Mróz

      That’s a very interesting point. As I see it, many people tend to think that unhampered market means more and more competition, meaning that there is a necessary tendency towards a theoretical ideal (of course no-one in his right mind would say that “perfect competition” can actually come into existence, I’m just talking of a general direction), or at least some opponents of markets tend to picture free-marketers to advocate such strange things. Yet, it is entirely possible that, as you say, unhampered market will result in some restrictions on competition understood in this way, like clearinghouses and temporary suspension of payments in face of a run in relatively free banking systems in 19th century. That’s why I think the best way to argue for free banking, whether with fractional or full reserve, is on the basis of Hayek’s knowledge argument, and not really on the basis of standard economic efficiency considerations (by which I mean standard microeconomic “monopoly vs. perfect competition” diagrams and formulas). Of course I think that it is not so very hard to show that free banking actually increases efficiency (vide: ABCT), but adherents of central banking may still point to the fact that this ideal, so beloved by theoreticians, is nonetheless far away. Then you, i.e. proponent of free banking, may present a really powerful argument, that is knowledge argument.

    2. JCatalan

      I know some of the literature on the instability of (usually non-price) competition in banking, and most of it has to do with the “franchise value” of the bank. I don’t necessarily buy much of it. I think that the more competitive the better, because even if individual pieces are unstable, the effects of the instability will have a smaller impact on the economy as a whole. But, I agree there are “natural limits” to competition (economies of scale, et cetera). I also agree with Robert’s point above — the structure of the market has to be decided based on certain constraints (e.g. instability, economies of scale, knowledge problems, et cetera). Another thing is that what seems uncompetitive may not actually be uncompetitive. Ronald Coase, in an article I can’t remember the title of right now (I don’t think it’s either his 1937 or 1960 piece), makes this point: things that seem uncompetitive can really be changes that make the market more competitive (e.g. clearing houses segmenting the market).

      1. Silvano IHC

        I didn’t mean to say less competition is better. I wanted to point out the fact that a kind of oligopolistic competition it’s likely to emerge by itself. The introduction of a new technology and the creation of institutions able to substain confidence and cope with uncertainty is costly. Financial innovators have a private interest in providing a public good which is financial stability. They need also to show to their users they have a long term commitment in what they are doing and while they are expanding the network they need to ban Ponzi-style competitors to protect their investments. Coalitions based on reputation, some kind of barriers to entry, formal and informal regulations fulfill this purpose. Obviously, they reduce the degree of competition, but – given the constraints of real world – what matters it’s the final result: an increase of the volume of trade and a better allocation of resources.

        But another important insight it’s the fact that the private interest in providing a public good helps to explain why a collective action toward central banking was rationale during the shaping of modern democracies of XIX-XX centuries. The political demand for Central Banks and/or new banking regulations usually happened as a consequence of banking crisis, not viceversa. Moreover, compared to the primitive forms of taxation, expropriation, debasement, sales of public offices which were quite common up to XVII-XVIII century in Europe,central banking gave a contribution toward a rationalization of public finance management and rebalanced powers from monarchs to bourgeoisie. In this case what I don’t marry it’s the idea that Central Banks appeared just to exploit the monopoly of currency issuing. No one denies the existence of revenues from seignorage, but “the fiscal side of the story” in my opinion played a minor role in explaining the development of state runned central banks. Especially because its abuse is self-defeating.

        I don’t know how much free banking and modern nation states, especially democratic ones, can coexist. I think free banking needs a more anarchic order and maybe we’ll start to see some hybrid forms of free banks at the beginning.

        1. JCatalan

          Yea, this market would have to be similar to a monopolistically competitive one, almost by definition — the products they’re offering are imperfect substitutes.

          On history, you write,

          The political demand for Central Banks and/or new banking regulations usually happened as a consequence of banking crisis, not viceversa.

          Both are true. Sometimes regulations were introduced just to make the market less competitive. Other times they were introduced as responses to crises (e.g. deposit insurance, et cetera), which made faults in the banking system obvious. Similarly, central banks were introduced in different countries for different reasons. The Bank of England gradually gained a monopoly because of the services it provided in funding the Crown’s public debt. The Federal Reserve was introduced in response to the Panic of 1907.

  2. Pingback: Institutions, Gold, and Banking: A case against the gold standard « Economics Info

  3. valueprax

    I’ve never understood why anyone, knowing that a note is fiduciary media (not fully backed by the requisite reserve), would accept it in payment as if it were fully backed? I understand how maybe once everyone was in the habit of doing that, the notes would trade as “good”.

    But why would that first individual accept it?

    1. JCatalan

      As long as that person believes that when he returns the note for redemption he’ll receive some asset (let’s say gold) in return, why shouldn’t he accept it? How do people form these beliefs? If a bank has a history of making good of its liabilities, a person may not have a reason to distrust the bank. Even if the person is aware that not the bank doesn’t have sufficient assets to cover all liabilities, if all liabilities had to be repaid immediately, the fact that the bank can still make good on whatever liabilities may require clearing allows it to build a reputation. Also, banks can offer interest on demand deposits. This interest includes a risk premium; e.g. banks offer customers interest to alleviate whatever worries that customer may have concerning the probability that the bank won’t be able to make good on its liability.

      1. valueprax

        It is odd for me to think that there wouldn’t be a discount involved in the price. I don’t know why I’d pay X for a note backed by X, and X for a note backed by X-Y.

        Maybe I’d pay a premium for an X note backed by X? But then that’s just another way to say I pay a discount for only paying X for a note worth X-Y.

        If the bank has to pay an interest rate to attract people to use it’s notes, then I guess it is another discount.

        So the conclusion is “There is no reason why an X note backed by X and an X note backed by X-Y, would trade for the same price, X.” The lesser note will be discounted. Which is what I understand.

        This still introduces confusions for me. I am not sure how “productivity gains” can come from this situation. The whole idea that by fractionating deposits one can increase productivity, comes across as a free lunch. If the notes trade at a discount, then they don’t “increase productivity” and therefore there is no free lunch to worry about because it’s a self-defeating dynamic.

        But if the notes don’t trade at a discount, then it appears that this note issuance does create a free lunch. Real productivity gains by “excess” issuance of notes. How fabulous! I can’t believe it doesn’t work when governments do it but it does with private banks.

        1. JCatalan

          If the prospective holder of the note has a reason to believe that the liability won’t be made good, then the note will trade at a discount (below par). But, if the prospective holder doesn’t have a reason to believe that, then the note will trade at par. Fractional reserve banking has to do with a bank’s entire balance sheet. The holder doesn’t care about the whole balance sheet; the holder only cares if the bank can make good on the liability at the specific moment in time the note returns for redemption. If not all notes return for redemption at the same time, then a bank can meet these liabilities, even if the bank is practicing fractional reserve banking.

          This still introduces confusions for me. I am not sure how “productivity gains” can come from this situation. The whole idea that by fractionating deposits one can increase productivity, comes across as a free lunch.

          An increase in the demand for money is synonymous with a reduction in present consumption; e.g. savings.

          I can’t believe it doesn’t work when governments do it but it does with private banks.

          The problem with a monopolized currency system is the lack of constraints on money supply expansion. In a free banking system, where notes are imperfect substitutes, the inter-bank clearing mechanism will act as a constraint on note issuance (a supply of notes over the demand for it implies that these notes will ultimately return to the bank for redemption, putting pressure on the banks’ assets).

          1. valueprax

            Yeah, I’ve got to think about this some more. I think there’s an error here but I am not sure I know how to explain it yet. Could mean I am wrong. Could also mean there is one and I haven’t figured out how to explain it.

            As it stands, I think you offer more tautologies as explanations. I don’t think you’re addressing the confusion I have with those tautologies. That’s okay, I’ll work on it.

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