Free Banking Q&A

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.

7 thoughts on “Free Banking Q&A

  1. Russell Lamberti

    A question: Surely third parties receiving fiduciary media in trade as if it were of the same risk profile, quality and essence of say, gold base money, are being defrauded? Surely these notes are posing as something they fundamentally are not. In a society governed by the rule of law, would fiduciary media be able to pass the fraud test in the courts?
    Obviously frac banking doesn’t have to be fraudulent to the depositor (he can agree to frac res lending), or other depositors (they can also agree to a kind of pooled gamble), or borrowers (they can agree to borrow media ex-nihilo). But doesn’t the problem come in with the third party, not party to the contracts, who is now duped into accepting something which is posing as something it is not?

  2. Russell Lamberti

    In other words, by all means have frac banking, but surely the fiduciary media needs to trade at the appropriate, transparent discount, in which case the whole thing will effectively gravitate to full res free banking?

    1. JCatalan

      If there is any doubt about the quality of the “backing asset” the note will trade at less than par (at less than the supposed face value of the backing asset). Currencies that people want to hold have to, by nature of competition, offer better quality backing assets. This is a type of market discipline of banks. Fraud would suppose, I think, that people are misled on the quality of the banknote, which could happen, but isn’t something inherent in fractional reserve banking. There may be some risk that over some period of time the backing asset will lose value, and therefore so will the note, but that’s why in free banking it’s likely that banks will pay some interest on deposits.

      A bank doesn’t have to approach full reserves to have good quality paper in circulation. It just has to be the case that nobody expects to run into problems if they ever redeem the note. That is, they have to expect that their note is good for whatever value is promised by the contract the note represents.

      1. Russell Lamberti

        I hear you, but is there not a fundamental problem here that a note
        claiming to give me essentially exclusive title on an underlying asset
        (say gold) when in fact the title is not exclusive but subject to multiple claims and counterparty risk, is in fact a basic (and
        fraudulent) misrepresentation of the nature of the media? If my
        claim is ‘fulfillable’ only on a conditional basis, then shouldn’t the
        note reflect this ‘gambled’ nature of the claim explicitly? In other
        words, if my claim on underlying gold is a fractional claim, then the note should reflect the portion of the claim on unconditional gold, and the portion on conditional gold. Participants are then clear on
        the nature of the claim, and can subjectively value it accordingly. Some might reject it outright, some might place a discount on it. Regardless of the probability of a bank run, surely the note I’m in possession of is contractually void if it claims unconditional title that is in fact conditional.

        So I guess I’m saying that people’s estimation of the underlying quality of the asset backing is one thing, and the fundamental nature of how the claim on the note is represented is another. Making this distinction may be where we differ. Quick example to illustrate my thinking here: I rate a fractional res bank’s asset quality and overall solvency as very strong, but its note is telling me I have unconditional claim on an underlying asset that in reality I do not (only conditionally). I may ultimately apply only a very small discount to this bank’s notes due to its excellent track record, but I still need the true information of the underlying nature of the claim to make my subjective pricing/valuation of the note.

        So people may very well be willing to trade with notes that are part unconditional claims and part conditional claims, but the key is they need to know that’s what they’re trading, not a full unconditional claim. In other words, they need to know they’re trading a claim on a particular, levered up bank balance sheet, rather than an ounce of gold proper. This way, fiduciary claims on gold would be clearly distinguished and priced at a discount to gold claims proper, and therefore they would be a completely separate currency from gold proper, and not effect per se the gold proper exchange rate.

        Would appreciate your response and will leave you with the final word.


        1. JCatalan

          Whether banks are defrauding their clients with fractional reserve banknotes depends on what their clients are expecting from the service and how the bank describes the service. I don’t think there is any bank contract which tells you that your deposit will be warehoused until you decide to withdraw it, without the bank touching it. The only thing the contract insures is that you can withdraw money from your deposit on demand. It would be the same thing if the bank promised to redeem your note on demand. (Historically, some contracts have also included “option clauses,” where banks reserve the right to reject your demand for redemption in return for a higher rate of interest paid on that note, such that when the bank can afford to redeem the note they will owe you a greater amount.)

          I don’t think there’s any issue regarding conditional vs. unconditional redemption. If there are any conditions to the redemption, they have to be expressed in the contract, as with the option clause. (Of course, contracts are rarely perfect, and we should come to expect that contracts will change over time as all parties become privy of other events they may need to consider.) This doesn’t mean, though, that sometimes contracts won’t be fulfilled, in the same sense that you may find that the painter you contracted with to paint your house may not fulfill his end of the bargain. Rather than fraud, what I think the problem here is deciding who is liable for whatever mistake was made (e.g. should the depositor be punished for the bank making bad business decisions?). I don’t think fractional reserve free banking can solve the problem of bad business decisions, but I do think that it can help solve the problem of systematic bad business decisions (e.g. bad business decisions induced by, say, price distortions).

          The issues you bring up are relevant and not just concerning the question of full reserves v. fractional reserves, but also regarding whether money can even be privately issued. Good private money requires a certain degree of “information insensitivity,” which basically means that people trust that the value of the note truly represents the value of the backing asset. This will place some constraints on the banks’ actions, as anything they do that threatens the stability of their assets will threaten the stability of their currency. But, this constraint will vary with the volume of foreseeable claims on banks’ assets, meaning that banks can take advantage of these variations to expand or contract business. A good bank will make sure always to have sufficient assets to meet redemptions at any given point in time. But, if people prefer holding banknotes to the actual backing assets most of the time, the bank may find that most of their capital reserves are unnecessary, because nobody wants to exchange for them.

        2. Dan (DD5)

          You have touched on a point that the FRB free bankers have simply refused to properly address whenever this is brought up. Jon below is not responding to your correct observation, namely, that the fiduciary notes cannot possibly maintain their par with the gold or with real substitute notes representing real tittles of ownership in a 100% full reserve bank. That is, if the law of supply and demand is not simply brushed away here, as it apparently is by the free bankers. You have multiple notes created on top of gold (or inside money as they like to call it), i.e., increase of supply of notes, yet somehow, magically, these notes maintain their face value. Simply amazing!

          1. JCatalan

            Nobody has “refused to properly address” any of these issues. There is a large literature on the importance of information insensitivity in influencing the demand for inside money. And, if anybody hasn’t written about the paradox between increasing the supply of money in response to an increase in demand for it and its value, it’s because this paradox doesn’t exist — your supply and demand analysis is incomplete. An increase in the demand for money, all else equal, implies an increase in the value of money. An increase in supply of money, then, would act to reduce its value, but these two forces, for simplicity’s sake, cancel out and the original marginal value is maintained.

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