Category Archives: Banking

Fractional Reserve Banking Made Simple

I’m about to kick a dead horse, but every once in a while you see the horse’s ghost gallop about the internet. The notion that fractional reserve banking is “fraudulent” and “unstable” is a “brain worm” that deserves to be extinguished.

Part of what a bank does is intermediate between savers and borrowers. When you put your money into a savings account, the bank will lend it out. Fractional reserve banking works the same way, but deals with relatively liquid type of deposits. There’s nothing fraudulent about it.

I’m relatively young and I don’t make a big income, so I keep a good amount of money in a demand deposit. If I ever unexpectedly need it, it’s there. Most of the time, it just sits there. Anything not being presently consumed is being saved for future consumption, so those dollars are savings — just like a savings deposit, but (given regulatory rules) with no interest and greater liquidity. The bank will lend these savings out.

Are there two claims on the same money? In a sense, yes, but that’s true with just about any savings vehicle. The money you’re lending is yours, you’re just not currently spending it, so it can be lent out. You might argue that the problem with fractional reserves is when depositors go to the bank to withdraw their money. This isn’t an issue unique to deposit banking. It’s called a maturity mismatch and it can happen with any kind of asset. In fact, it’s something that is inherent to banking: banks borrow short and lend long.

The “trick” is to manage these different assets and rely on the law of large numbers to make sure you always have the sufficient liquidity to pay-off short-term liabilities. That’s what successful banks accomplish. Without the ability to juggle assets of different term lengths, the intermediation industry is going to be very inefficient.

What’s the relationship between fractional reserves and economic crises? Some see that many financial crises are preceded by bank runs, so they conclude that it must have been the maturity mismatch that was at fault. It’s strange, actually, that some Austrians would believe this, because they’re the ones always stressing about their peers mistaking the symptoms (the crash) for the cause (credit expansion). Business cycles are caused by excess supplies of money, which change the distribution of profits. When money supply growth begins to slow down this distribution changes — thus, the sudden loss in profitability for large swaths of industry.

Just because too much sugar is bad for you doesn’t mean all sugar is bad. There’s nothing inherently destabilizing with fractional reserve banking as long as excess money is minimized. What’s the difference between “excess money” and lending on fractional reserves?

Like with any other economic good, there is a point at which demand and supply are equal. Unlike many other economic goods, money has to clear in multiple markets. When the demand for money increases, ignoring for a minute the ability to increase supply, the prices of other goods that exchange for money have to decrease in order to clear against the higher relative value of the currency. If prices don’t clear and exchange suffers, we call that a shortage of money. On the other hand, if there’s more money than people are willing to hold, this is called excess money. It will continue to circulate (the “hot potato” effect) until it returns for redemption or the price level increases, the relative value of money falls, and demand and supply are again equal to each other.

That a bank lends on fractional reserves doesn’t really say anything about whether there is excess money. When the demand for money increases, the volume of deposits might swell (the amount of liabilities returning to the bank for redemption will fall) and it will allow the bank to issue credit. In this case, the banking system is increasing the supply of money to meet the heightened demand. That’s why, if you’re worried about the business cycle, blaming fractional reserve banking is the wrong way to go. What you should really be worried about is surplus money.

How do we accomplish limiting the ability of banks to create liabilities, without enforcing full reserves? Through coordinating monetary institutions (rules or constraints), which may include:

  • In a competitive banking system, banks holding other banks’ liabilities will send them in for redemption, draining on the issuing bank’s assets. If a bank over-issues money, it will suffer from illiquidity. If a bank under-issues money, they will be foregoing the revenue they could have earned had they maximized the use of their assets.
  • If banks could pay competitive interest on demand deposits, they’d have to raise this rate to attract new deposits to fund their lending. But, as the supply of loanable funds increases, the rate of interest on these loans will fall. If the latter rate (on loans) falls below the former (on deposits), the bank is making a loss.

That’s why it pains me when I read Austrians cheering for recent IMF studies and old Chicago research papers supporting 100 percent reserves. They’re worrying too much about the symptom and they don’t realize that they’re supporting the cause: bad monetary institutions (after all, it’s not like these IMF and old Chicago School economists are advocating for free banking).

Leverage and Efficient Finance

I recently read an argument along the lines of,

Under conditions of ‘sound money,’ taking out loans for purchases like houses, [small?] businesses, et cetera, were much more infrequent. Instead, these things were purchased outright.

My guess is that the implication is that the amount of debt held by the average person today is, in part, owed, directly or indirectly, to ‘unsound’ money. And by ‘unsound’ money, my guess is that this person means the Federal Reserve. I don’t know what period of history he is referring to, but I’d guess the late 19th century. I don’t know if the claim is true, but I think it sounds right, and it doesn’t really matter for the point I’m making. Whether money is ‘sound’ or ‘unsound,’ we should expect, and welcome, the income margin at which people gain access to credit to fall over time.

After the Great Recession, it’s easy to get carried away with looking down on debt. A term that became widely used after the financial crisis is ‘deleveraging,’ which refers to the drawing down of debt. Consumers lived beyond their means; relatively poor people bought houses outside of their budget constraints; businesses took on debt to expand, only to be hit by malinvestment and a demand shortage. But, over-leveraging only makes sense if there is a reference point — an optimal amount of debt —, and we have to remember that this reference point is always moving up.

The optimal amount of debt today is not the same as the optimal amount of debt in 1880, or even 1920 or 1960. Prior to the U.S. Civil War, for example, banking was just beginning to expand westward, and prior to that expansion credit was not really available to large swaths of American society. But, as the banking system grew, and financial intermediation became more efficient and cheaper, new parts of society gained access to credit. Growing the pool of borrowers was an important facet of American growth, because it allowed businessmen to acquire others’ savings to fund investments.

This was one of the main ideas behind securitization, when it was innovated in the 1980s. By pooling loans, and distributing risk, the idea was to make credit cheaper, giving access to credit to poor families, which beforehand had little access. Of course, it seems as if this backfired on the finance industry, given the Great Recession. But, we shouldn’t throw the baby out with the bathwater. That credit was over-expanded, and that these securities would be the very assets that collapsed, warns us against inadequate institutional constraints on banking. But, otherwise, financial innovation is a good thing, and we should be open to it.

Another example of the benefits of growing access to credit is any developing economy. These markets are generally relatively primitive, and this includes their banking sector. Most people in developing countries — even in economies as large as that of Mexico, for example — do not have access to credit, and this is a limit on growth (on their ability to borrow and invest). One sign of progress is financial growth. A country “graduating” to a higher stage in the development process usually does so because they have established some type of credit market; not necessarily for their poorest, but for large business (stock and bond markets) and for government.

Credit markets have, historically, been very volatile. But, this volatility is caused by institutional problems. We shouldn’t look back at some long-gone period of history, when finance was relatively primitive, as the golden age. Instead, we should embrace the positive aspects of financial innovation — which are many —, and be wary of policies that cause instability and capital consumption…policies such as central banking.

Bank Assets and Bank Runs

[This is part one of a three part series on the financial crisis and banking.]

An insolvent bank is not the same thing as an illiquid bank. Insolvency has to do with an imbalance between all assets and liabilities; illiquidity refers to the inability to meet short-term obligations, because the firm cannot quickly sell some of its relatively illiquid assets at par (to generate the sufficient liquidity). Systemic banking crises, such as the classic bank run, usually have more to do with illiquidity than insolvency. Noah Smith writes a bit about illiquidity versus insolvency in the context of the 2007–09 financial crisis. But, Noah distinguishes the two by drawing a distinction between events that include a deterioration of the asset side of banks’ balance sheets and those that don’t. Can’t negative shocks to bank assets, however, create liquidity crises?

Noah distinguishes between two explanations of the recent financial crisis. The first is the one proposed by economists such as Gary Gorton and Andrew Metrick (ungated),1 who argue that the crisis was a result of a run on investment banks through wholesale credit markets (e.g. repo). In a nutshell, wholesale funding allow banks to borrow large sums of money from agents with high cash savings, offering an asset — prior to 2007–08, this asset was typically the mortgage backed security or a derivative of it — as collateral. Wholesale credit is a very short-term loan that provides banks with the liquidity to carry out day-to-day operations. They can be described as large, short-term deposits that earn interest. Between 2002–07, wholesale credit markets were active and growing, but then collapsed during the crisis.2 Gorton and Metrick argue that the housing market collapse caused concern about the health of banks’ assets, even those not directly related to housing, inducing a run on the banking system. Lenders were worried that banks would not be able to repurchase the posted collateral at full price, this collateral took a haircut, banks were unable to borrow on the same terms to repay their obligations, and the system suffered a liquidity crisis.

The second interpretation of the crisis is the one given by economists such as Paul Krugman and Anna Schwartz. This position is a little bit more ambiguous in the details. Schwartz argued that credit markets dried up, because investors were unsure if banks would be able to meet their obligations. Both Krugman and Schwartz allude to the deterioration of bank assets. But, there is a difference between maturity mismatch and the event where all of a bank’s assets are worth less than its liabilities, and a negative shock to part of a bank’s assets does not necessarily imply the latter. For Krugman and Schwartz to be right, there must have been a systemic imbalance between total assets and total liabilities.

One issue worth highlighting is that both sides may be getting at the same general point — the bank run —, and that the differentiation between insolvency and illiquidity is, to some extent, semantic. We can take an alternative approach and differentiate between “currency runs” and “redemption runs” (Selgin [1988]3, pp. 133–139). The former are cases in which depositors want to convert deposits into banknotes (or cash), and the latter describes events where customers want to redeem a bank’s liabilities for its assets (although, usually in liquid form). If a bank faces legal restrictions in issuing money, currency runs can lead to liquidity crises; redemption runs can lead to liquidity or insolvency crises. In any case, Gorton and Metrick, Krugman, and Schwartz all explain the 2007–09 crisis as a redemption run.

Coming back to the debate on illiquidity versus insolvency, the 2007–09 was most likely a liquidity crisis, but one that could have very well turned into a solvency crisis. While there were probably a number of banks that did suffer solvency issues, the question is whether insolvency was systemic.

It needs to be clarified that insolvency is not necessarily the same thing as bankruptcy, which is a legal definition of insolvency. Legally, bank solvency is related to its capital adequacy ratio, or the amount of equity, retained earnings, and certain debt instruments a bank holds in proportion to its total assets, which are weighed by measured risk. When the mortgage backed security market collapsed, the risk associated with these assets increased, forcing banks to scramble to meet the capital adequacy requirement. This caused banks to hoard liquidity, making it more difficult to meet short-term obligations (Friedman and Kraus [2011],4 pp. 91–96). Related, mark-to-market laws exacerbated the crisis, because the original downward revision of asset values was exaggerated; the actual losses over these bonds’ lifetime were smaller (and the revenue stream associated with these assets had not necessarily shrunk). But capitalization laws required banks to take the exaggerated loss when judging the solvency of their balance sheets (Ibid., pp. 97–100).

During the crisis, banks did not necessarily suffer an imbalance between total assets and total liabilities. The problem was one of maturity mismatching. Prior to the crisis, mortgage backed securities were considered low-risk, low-return assets, and they were relatively liquid. Banks could post these assets as collateral and borrow from wholesale depositors, using this liquidity to deal with day-to-day transactions. When the housing market turned, the risk-weighted value of these assets became uncertain, and they lost their liquidity. Banks were not able to turn them into cash, without taking an immediate loss that was much greater than the actual loss in the bonds’ values. Further, whatever liquidity banks could get their hands on was, in a way, tied down by the scramble to meet minimum capital adequacy requirements, even though it can be argued that meeting these minimum standards should not have been a priority. Banks were unable to meet short-term obligations with the liquid assets (e.g. cash) their depositors were demanding.

Why did the Fed buy $1.25 trillion worth of agency securities in 2009? The Fed was aware of these assets’ illiquidity, therefore they essentially built a new wholesale credit market, becoming their sole buyer. This interpretation is supported by Ben Bernanke’s 2009 lecture at the London School of Economics. Bernanke draws a distinction between quantitative easing and credit easing, where the former focuses on the banking system’s reserves, influencing the composition of banks’ assets indirectly. Credit easing, by contrast, is a program to specifically target bank assets and change their composition. The likely rationale behind the Fed’s program was that credit channels had deteriorated and the intermediation of liquidity had been consequently compromised, making it more difficult for all parties to access the liquidity necessary to meet short-term obligations (Bernanke [1983], pp. 263–268). We could ask whether the Fed paid too much for these assets, implying that part of the “credit easing” program was an implicit subsidy, but, with the above point on lifelong value of the bond in mind, this subsidy was probably not the difference between solvency and insolvency.

Most bank runs, whether of wholesale or commercial deposits, are usually precipitated by negative shocks to a bank’s balance sheet. Bank runs are not sunspot phenomena, they are usually induced by some prior event.5 Consider bank runs during the mid-19th century United States. Redemption runs on banks were typically caused by negative shocks to collateral. Free banking laws required banks to back their privately issued banknotes with state bonds, which were considered risk-less by regulators. As it turned out, these bonds were actually not risk-less, and when states defaulted on their debts it put into question the ability of banks to meet currency redemption demands, inducing bank runs (Gorton [2012], pp. 16–17). Similarly, there is reason to believe that the bank runs of the Great Depression were caused, at least in part, by a deterioration in the value of some of the banks’ assets, specifically loans (White [1984], p. 126–128).

We cannot use negative shocks to bank assets as a way of distinguishing between solvency and liquidity crises. The two are probably related in cause, and may represent different equilibria — depending on how depositors react to new information about banks’ asset values and the actual financial position of the banking system (whether a bank’s total assets are valued at least the value of its total liabilities). But, negative shocks to banks’ assets can occur without causing an insolvency crisis. The 2007–09 financial crisis was probably a systemic liquidity crisis, although there may have been a significant number of financial institutions which were also insolvent. AIG Financial Products (AIG FP) offers us an example that helps distinguish. AIG FP had accepted a large pool of liabilities in the shape of credit default swaps. When the crisis occured, this triggered a ballooning of the value of AIG FP’s liabilities, triggering bankruptcy. This liability-side cause of its bankruptcy stands in contrast to the asset-side cause of the run on wholesale deposits.

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Notes:

  1. If you are interested in bank theory and/or the financial crisis, I recommend reading Gorton and Metrick (2009). I don’t think there is anybody who can explain the bank run theory as clearly, and as detailed, as them. The final version of their paper, published by the Journal of Financial Economics, can be found here — I’m not sure how different this version is from the NBER working paper.
  2. FRED has data on the total value of repurchase agreements and asset backed commercial paper.
  3. A free version of George Selgin’s The Theory of Free Banking can be found here.
  4. See my review of Friedman and Kraus’ Engineering the Financial Crisis.
  5. This is an admittedly controversial issue. See, for example, Ennis (2003) for an argument in favor of the opposite conclusion. My challenge is that the existence of multiple equilibria — say, one where there is a bank run and another where there is no bank run — is not inconsistent with the idea that there is a causal relationship between some prior event and liquidity and solvency crises. Banking crises are complex events; there are typically many (mostly unpredictable, only observable) factors that contribute to its occurrence. Which factors are relevant (at some point in time) is an empirical question. But, depending on which factors are relevant, the “system” can end up at different equilibria. Multiple equilibria do not imply that bank runs are “random,” except maybe in a trivial sense of the word.

Bitcoin’s Demand Problem

Cathy Reisenwitz responds to an article on bitcoin’s “image problem.” The article she responds to pretty much argues that bitcoin users are a bunch of misogynistic nerds, and that people outside that narrow community see that as a reason not to invest in that asset. The fact that bitcoin is largely unregulated (and the bitcoin community’s aversion to regulation) is also used as a reason for mistrust that outsiders have in the asset, and why they might decide to not buy into it. I like Reisenwitz’ response; I particularly like this line from her piece, “…illegal narcotics make up about half a percent of bitcoin transactions” (strong proof that there’s more to bitcoin than black markets).

In any case, Reisenwitz’ article got me thinking about bitcoin and its scope for growth. I say growth, and what I have in mind are the opportunities for the demand for bitcoin to grow — for the number of people who hold it for transaction purposes to increase. I think, right now, these opportunities are limited, largely because the reasons to demand bitcoin are still relatively narrow. Allow me to explain what I mean.

Before I proceed, I should clarify that I am not opposed to bitcoin, nor do I have a specific interest in discrediting it. In fact, I support bitcoin and I see it as a natural consequence of government’s attempt to monopolize currency. Throughout history, we have seen people try to get around these legislated constraints. When note issue was restricted, banks focused on their deposit service. When interest on demand deposits was made illegal, the market responded with assets like mutual funds and eurodollars. Markets tend towards competition — not perfect competition, but still competition —, and that is what we are seeing in currency markets with bitcoin and other digital currencies. Will bitcoin succeed or fail? Who cares? The uncertainty of Amazon.com’s future doesn’t bring anybody to emphasize their opposition to its existence. Entrepreneurial projects sometimes fail and other times they succeed. But, this trial-and-error process is what allows our society to progress, for new ideas to implemented and tested, and for the good ideas to be rewarded.

Let’s come back to this article’s point.

Why is bitcoin demanded? There are probably various reasons. There is a significantly large libertarian community which distrusts government and any service provided by government, including the U.S. dollar. For years after the financial crisis, there was also a (most likely misguided) fear of runaway inflation. For libertarians with these preferences, especially if they have a service or goods they can provide in exchange, it’s sensible to be interested in a growing financial community which promotes the use of bitcoin for exchange. As the demand for bitcoin grows, it’s also reasonable to expect speculation. Many investors are going to put their money in bitcoin, because they expect its price to appreciate over some period of time — and the great thing is that bitcoin is relatively liquid.

According to Cato, 15 percent of Americans are libertarian (the Washington Post claims 22 percent). What induces the ~75 percent of other Americans (and other non-libertarians throughout the world) to demand bitcoin? The fact that there even many libertarians who haven’t invested in bitcoin is a strong signal that bitcoin is not necessarily a strong competitor to the U.S. dollar. Consumers differentiate between products, and right now the supermajority of people still prefer to hold U.S. dollars and other fiat currencies before bitcoin. This poses a serious limitation to the demand for bitcoin, and especially its demand for transactions. Increases in demand for transactions creates a network effect, because it increases the liquidity premium attached to bitcoin, but without other benefits the use of bitcoin might be restricted to people with certain ideological preferences.

Reisenwitz actually goes into some of the additional benefits to bitcoin,

  • Smart property: I don’t know much about this, but Reisenwitz describes it as a credit market, where credit can be extended to the worst off (who don’t have access to credit from firms with stricter requirements).
  • Remittances: She argues that remittances are easier and cheaper through bitcoin. I can’t verify, but if that’s true it’s a big advantage. Remittances are a big deal. According to the CBO, outward flow of remittances in the U.S., in 2009, totaled $48 billion. As the economy picks up, this flow will grow.
  • Charity: innovative and effective charity programs might induce people to give through bitcoin, rather than through traditional means.

I wonder, though, if a strong demand for bitcoin will arise if sophisticated bitcoin-using financial markets develop. Bitcoin is an asset — a commodity, if you will —, like gold. If it becomes money (or if it already is), it will be as “outside money.” The supply if bitcoin is relatively inelastic. It’s growth function is asymptotic, to mimic the physical scarcity of other highly liquid commodities. If the value of the asset is stable, or the risk of loss in value is low enough, financial firms can use it as capital and they will borrow it from bitcoin holders through deposits. The firm will most likely pay interest on these deposits (if it’s legal), to compete with other firms who are seeking the same means and ends.

These are demand deposits and they are liabilities to the firm. The latter can issue notes in exchange, or the depositor can spend all or part of the deposit through some other system, such as a debit card. These would all be bitcoin-substitutes. But, if these services are competitive enough, it creates a proxy demand, in a sense, for bitcoin. Customers who are interested in the firm’s notes or their debit cards will demand them and, in turn, there is a derived demand for bitcoin.

This brings me to a more important point. Right now, when we think digital commodities (or currencies, if you prefer — I don’t want to debate on what is money) we think bitcoin, dogecoin, et cetera. When we think about where the industry is going, we think about competing brands. We should also be thinking about spontaneous orders, and how these competing brands will lead to competition in more sophisticated financial markets, using digital currencies as assets. If these services are superior to those provided by firms who still use “traditional” assets — and the legislated rules that constrain how these assets are used —, the demand for bitcoin (and digital currencies in general) will grow.

The question is, will digital currencies become a sufficiently stable asset for these purposes? What I mean by stable is not necessarily constant value, but where the expected path of changes corresponds to the mean expectation. And, if they do, will they be competitive enough to offer a product superior over those already existing? The “answer” to these questions is: we will have to wait and see. But, while there is clearly a lot of exciting scope for growth, there are also serious obstacles that digital currencies have to topple if they plan on becoming widely used transaction assets.

Gender Regulation?

Some argue that financial crises are easier to mitigate if we increase capital requirements. Others argue that maybe financial crises would turn out differently if there were more women working in upper management in the financial sector,

Feminist economists have, for example, been looking at the causes of the current financial crisis and explored how far it would have happened if Lehman Brothers had been Lehman Sisters, arguing that although there are many myths and stereotypes about male risk-taking and female caution that need to be dispelled, there is evidence to show that companies that have larger numbers of women on their boards are more profitable.

 

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.

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.