A recent comment to an older post on this blog, “Why Accept Fiduciary Media,” asks a series of questions on free banking. I thought it a good idea to respond with a new post, to revive the subject on this blog. Any changes made to the questions ought to be minor, and I do not intend to change the meaning.
[H]ow is it possible that this increased fiduciary media will reach to the hands of those who actually want to save (and not to consume) any amount of new money?
I think an answer to this question requires a brief overview of the monetary (dis)equilibrium argument (see also “Theory of Monetary Gluts“). Assume we start in a society where the demand for money is satisfied, and at some point thereafter certain members of society increase their demand for money — all else equal, this implies an increase in the aggregate demand for money. Those who increase their cash balance preference will access this money by trading their non-monetary goods in exchange. An increase in the demand for money, though, means an increase in the relative value of money, implying a relative decrease in the value of some (or all) non-monetary goods. If prices adjust immediately, this is the end of the story. If prices don’t adjust immediately, however, what we find is that some people won’t be able to satisfy their cash balance preference, because those who have increased their demand for money are no longer willing to trade for non-monetary goods. This is where the concept of a shortage of money arises.
If monetary (dis)equilibrium is right, the problem is not issuing money to those who want to save. The key is to issue money to those who want to trade for non-monetary goods. As such, banks act as intermediaries. Money will be issued to borrowers, and this money will be spent either on consumers’ goods (consumers’ credit) or on producers’ goods — just as with any other kind of intermediation of savings.
How is it possible that the new money created (by means of fractional reserves) won’t increase spending on consumption of certain goods and services?
Consumer credit isn’t just a fractional reserve banking phenomenon. When people borrow to consume it implies that they are willing to sacrifice future income for present income. This could occur with any intermediation of savings.
(Below this question there is a related point made to the business cycle. Austrian business cycle theory doesn’t predict that business cycles are caused by consumer credit. Rather, the theory argues that excessive fiduciary media will increase the relative prices of producers’ goods [capital goods], and that production will take place without an increase in savings.)
“No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth.” — John Maynard Keynes, The General Theory of Employment, Interest and Money.
If all new deposits and bank notes created by banks are voluntary savings as Keynes said and as Selgin suggests, then there could be nothing like maladjustments and the Austrian theory of business cycles is completely useless.
Keynes is saying something very different, and for him to be right we would have to adopt a non-monetary theory of inflation. His point, if I understand it correctly, is that for banks to be able to issue new credit, the demand for money would have to increase. But, this would only be true in a world without inflation or in a world where inflation is not caused by an excess supply of money. To make this point clear, first assume a world where all prices adjust instantly and simultaneously. An increase in the demand for money, as aforementioned, means an increase in the relative value of money. Therefore, the relative value of non-monetary goods falls, and the price level will fall (deflation). Now, assume a world where price rigidity is an issue: an increase in the supply of money, as a response to an increase in the demand for it, will maintain the price level. For the price level to rise, there has to be an excess supply of money. (The price level can permanently increase if there is an upward adjustment in desired cash balances.)
A world in a stable equilibrium where everyone’s desired cash balances have been satisfied is a world without trade — nobody wants to trade non-monetary goods for money. The real world isn’t a world without trade. The real world is in disequilibrium, and so there’s no reason that someone couldn’t borrow money to buy non-monetary goods with it. This provides an opportunity for an excessive issue of money.
[The] Law of Large Numbers should not be applied on the issue of fractional reserves. While it is certainly not common that all deposit holders will go to bank to ask for outside money, but when there is no limit on fractional reserve[s], then it is very quite possible that “enough” number of depositors may go to a free bank to ask for “outside money” at any time.
The theory of free banking is really a study of the constraints a free banking system would put on the issue of inside money. You cant talk about free banking as if there is no limit on fractional reserves. The constraints on money issue are placed by the banks’ balance sheet. Inside money is a liability for the bank, because it represents a claim on the banks’ assets. In a society with competitive money, the historical average turnover for bank notes is ~7 people (if I remember correctly), implying that bank notes tend to circulate back to banks fairly quickly. The demand for banks’ assets by the banks’ liability holders is what constrains the money supply. In an economy where the money supply is monopolized this constraint is loosened.
At this point, it’s also useful to remember the differences between a limited over- (or under-) issue of money, but when speaking of the problem of the bank run, and of business cycles more generally, the issue becomes one of sustained over-issue of money. Banks may still fail, and some banks may overissue inside money and suffer from a deficiency of assets. But, this isn’t the same as the system-wide bank runs we saw during banking panics prior to deposit insurance (and, after deposit insurance, with wholesale deposits).
I wonder why many banks will not merge and/or collude with each other with a specific expansionary policy?
I think this point is much more contested. For a response, I suggest reading the section in chapter six of Selgin’s The Theory of Free Banking, titled “Credit Expansion In-Concert.” Also, if you have access to JSTOR, Selgin’s “The Stability and Efficiency of Money Supply Under Free Banking.” I have one of Larry Sechrest’s (author of Free Banking: Theory, History, and a Laissez-Faire Model) copies of Selgin’s book, and some may find it interesting that on the margin Sechrest notes, “Is this sufficient?” The gist of the argument is that interbank clearing will vary around a mean, and so banks will still be forced to increase their precautionary demand for reserves, implying a constraint on the issue of fiduciary media.