Category Archives: Banking

The Theory of Free Banking

[This is an old post that was lost when the first version of this blog was hacked back in 2011. I found it using the Wayback Machine, so I wanted to re-post it. Do not click the footnote links, they do not work.]

The current financial crisis has inspired growing concern over the ability of the Federal Reserve to handle the money supply and juggle the number of objectives it has been tasked with.  While opinions vary wildly, including many who would like to see the Fed’s activities expanded, there has been an unprecedented growth in the movement to outright abolish the United States’s central bank.  Popular opinion has begun to shift against the Fed due to its inability to properly accomplish any of its general objectives, including stabilizing prices and fighting unemployment.  Furthermore, its role as a general supervisor of banking activity has come under close scrutiny, and it is beginning to be seen more as a cause of moral hazard more so than as an efficient oversight mechanism — (for worse) the state has been forced to jump into the role of regulator.

While recent events have ballooned anti-Fed sentiment, the intellectual movement against monopolized currency systems is not new.[1] The modern debate has been led by the Austrian school, and the theoretical argument has been sealed by Ludwig von Mises and Friedrich Hayek.  Both intellectuals went through great lengths to prove how industrial fluctuations — business cycles — are caused by currency monopolies,[2] guaranteed by means of government authority.  Unfortunately, the Austrian lesson fell on deaf ears.  For the majority of the economics profession, business cycles were caused by deficiencies in aggregate demand, whether caused by unbridled speculation or an insufficient quantity of money.  For these economists, the Federal Reserve became a key tool for the restoration of prosperity.

Friedrich Hayek’s 1974 Nobel Memorial Prize and the consequent publishing of two major monographs, Choice in Currency[3] and Denationalisation of Money[4], led to a major revival in interest in Austrian ideas during the mid-1970s. Hayek reminded those willing to listen that a monopolized currency regime was not the only choice, and that free banking is a theoretically established alternative.

Broadly speaking, two branches of the Austrian school have formed respective of the question of what a free banking industry would look like.  The first can be referred to as the “full reserve bankers”, believing that a bank’s supply of money substitute[5] should be fully backed by commodity money.  The second, usually considered opposed to the first, are commonly referred to as “free bankers” — even though it should be realized that both branches argue in favor of deregulated banking — and believe that an unregulated banking industry would practice fractional reserve banking, and that it is the central banking regime that corrupts the issue of fiduciary media.[6] The bevy of literature that represents both branches is too large to refer to in detail, but it suffices to say that the past forty years has seen a flourishing of theory on the issue.

The main literary representative of the free banking school is George Selgin’s The Theory of Free Banking, published in 1988.[7] It was inspired by earlier work written by Lawrence White, Kevin Dowd, and others.  In it, Selgin provides a very complete theory of banking in an unregulated, competitive industry.  While Selgin has not managed to persuade all his peers, and in fact there are powerful and equally as convincing arguments against fractional reserve banking theory, Selgin’s model deserves to be understood.

While the academics who lead the debate may know exactly what they are talking about, many of the interested followers have been left in the dark.  The present essay is an attempt to paraphrase the free banker’s argument, as presented in Selgin’s The Theory of Free Banking, in an effort to clarify just what exactly the “fractional reserve bankers” are supporting.

Free Banking Theory

Before delving into the meat and bones of George Selgin’s free banking model it is worth to first briefly explore the development of a banking system in a free society.[8] Preceding the development of banking banking is the emergence of a medium of exchange, which occurs as a result of the problematic nature of barter — it is difficult, transitioning towards the impossible, in a larger division of labor to consistently find others with what is called a “double coincidence of wants”.  Sooner or later, indirect barter will necessarily be adopted, where individual A exchanges his goods for another set of goods with which individual A will use to barter for what he actually wants, allowing him to primitively circumvent the lack of an initial double coincidence of wants.  Progressively, individuals find that there are certain goods that people generally want more than others, and ultimately the good that best fulfills the qualities of money emerges as the medium of exchange.[9]Historically, while many different types of goods have been used as money, the ones which ultimately emerged from an early period of trial and error have been metallic commodities, especially gold and silver.  For our purpose, we can assume that the medium of exchange of our free society is gold.  We can also assume that merchants begin to first mark, and then stamp, coins as a means of minimizing the necessity of weighing and assessing coins — competition forces merchants to strive towards reliability, minimizing the opportunity for fraud.

Banks develop from two major early roles.  Merchants who engage in long range exchanges find it convenient to have foreign-exchange brokers settle debts by means of ledger-account transfers.  Wealthy individuals who begin to form relatively large sums of commodity money begin to prefer to hold these stocks in much safer deposits.  Thus banks form as money warehouses and as institutions capable of settling debts between merchants.  While at first banks tend to lend only their own wealth, earned from the services provided to their clientele, they ultimately begin to loan out their customer’s deposits — initially, time deposits.  As explained below, ultimately banks may begin to lend out their customer’s demand deposits, usually offering interest on those accounts in return.

Together with the changing role of banks, these financial institutions begin to progress towards the invention of the bank note.  Initially, banks offer promissory notes transferable by endorsement and nonnegotiable checks.  These evolve into negotiable notes and checks, and bank-issued paper notes become money substitute, circulating in the market as a legitimate substitute to gold coin.  From here on out, bank notes may be referred to as “inside money” and gold money as “outside money”.  Money substitute begins to replace outside money with greater frequency due to its advantages, including bulk and weight.  The greater circulation of inside money also eventually forces competing banks, through the profit motive, to accept competing notes, creating the need for inter-bank clearings, which leads to the development of clearinghouses.  Clearinghouses serve the purpose of allowing multilateral clearings of debt between multiple banks, further reducing the necessary quantity of commodity money held in reserve by individual banks.  Clearinghouses eventually take on greater responsibility, as the banking system evolves, including becoming credit information bureaus — archiving information on particular bank clients who may have poor credit histories, and sharing this information between banks — and as a limited banks of last resort, lending to individual banks in times of crisis.

Here we begin to see one way by which banks may begin practicing fractional reserve banking.  The greater demand for inside money as a substitute for outside money decreases demand for outside money in circulation.  We begin to witness a greater use of bank notes and a greater amount of gold money sitting idle in bank warehouses.  This surplus of commodity money allows banks to export gold or sell it for nonmonetary use, causing many of the circulating bank notes to become fiduciary media.  In Selgin’s model of free banking, this method of outside money substitution becomes the principle cause behind falling reserve ratios, as banks find it profitable to sell their gold reserves — the fall in demand for outside money allows them to do so without repercussion, with banks and clearinghouses maintaining only enough gold to clear debts and meet obligations with their customers. This does not entail the creation of more money.  At this point, the quantity of money in circulation remains the same, as gold is taken out of circulation in exchange for bank notes — any increases in the supply of money are caused by an increase in the quantity of gold used as a medium of exchange.

It is important to realize that in a free banking industry we would see the emergence of competing currencies, with banks issuing their own notes and striving to establish methods by which the consumer can tell their note apart from others.  Given this competition, it is within the banks’s interest to guarantee the reliability of their note, especially in terms of the possibility of fraud (counterfeiting).

If we assume that for some period of time the replacement of outside for inside money has completed in accordance with consumer demand, we can begin to investigate possible changes in the supply of fiduciary media.  Banks profit by increasing their holdings of interest-earning assets, which it does by either increasing clientele or by losing reserves.  Banks are liable to a liquidity cost, where the bank must maintain sufficient reserves to meet obligations, and to costs related to their effort to maintain demand for their liabilities (interest offered on deposits, for example).  The former cost is represented by the principle of adverse clearings, guaranteeing that banks which over-issue fiduciary media will see an increase in returning liabilities (or immediately payable obligations) forcing them to reduce the quantity of outstanding fiduciary media.  The principle of adverse clearings depends on the following assumptions,

  1. Bank notes issued in surplus of the demand for that particular note will result in the expenditure of the surplus notes;
  2. The majority of spent surplus notes will end up in possession of competing banks;
  3. Banks return rivals’s notes for redemption;
  4. The majority of notes entering the clearing mechanism are of the over-issued kind.[10]

Individuals tend to demand a certain amount of money, meaning that they hold a given quantity of money as a means of making expenditures in the short-term.  Notes received in excess of that demanded are spent, and, perhaps not immediately deposited, remain in circulation for a short amount of time.  Ultimately, merchants will deposit bank notes in surplus of that necessary to make change — checkable deposits are more convenient than loose bank notes and earn interest.  Banks which hold rivals’s bank notes will return these for redemption in inter-bank clearings.

The fourth assumption is more difficult to defend and ultimately relies on the concept of note-brand discrimination.  It is within a bank’s interest to give their clients reason to holdtheir notes and instead spend their rivals’s notes.  Bank notes represent an interest-rate free loan to the bank, and thus banks look forward to maximizing the amount of time that loan remains in effect.  Furthermore, without such discrimination excess creation of fiduciary media by one bank will result in the bearing of a larger portion of the returning liabilities by non-expansionary banks.  The principle of adverse clearings does not require perfect or absolute note-brand discrimination, only that customers commonly discriminate between bank notes.  We can see, though, that there are multiple reasons why banks would attempt to incite such discrimination, as it is within their financial interests to do so.[11]

Knowing that an individual bank’s ability to issue fiduciary media is strictly governed by the amount of liabilities the bank has to clear at any given moment in time, we can deduce that the opportunity to issue more fiduciary media arises only when the quantity of returning liabilities falls.  This opportunity presents itself when the demand for money rises.  Imagine that the aggregate quantity of money held increases, reducing the quantity of money in circulation for a certain period in time.  For certain banks — those which notes are being held —, this leads to a fall in the amount of liabilities returning for redemption, or a fall in the volume of obligations that bank must meet at that moment in time (a “decline in the rate of turnover of inside money”[12]).  This temporary fall in returning liabilities allows relevant banks to increase the volume of outstanding liabilities by issuing fiduciary media through the loan market.  Free bankers illustrate this principle through the notion of a money equilibrium, or by what they refer to as — indirectly — meeting the demand for money.

In theory, an increase in fiduciary media as a result of a rise in demand for money does not constitute a rise in the quantity of money in circulation.  The individual who increases his cash balances decreases the quantity of money in circulation for the amount of time in which he fails to allot that bank note towards present expenditure.  In a world of where equilibrium is attainable — an ideal, non-existent world — the amount of money issued by banks would equal the amount of money temporarily removed from circulation.  In reality, we can expect minor fluctuations in the quantity of money in circulation, as banks either under-issue or over-issue in response to a fall in the rate of turnover of liabilities.

Understanding that the demand for money fluctuates on an individual by individual basis, as the demand for money is decided by the individual market agent, the ability to issue fiduciary media as a result in the increase in the demand for money ultimately rests on the rule of large numbers.  In other words, there is a difference in the time that an individual may temporarily increase his cash holdings and the time allotted for the repayment of a newly issued loan.  The individual may decrease his cash holdings within a matter of days, while the new loan may have been issued for a period of months, or even years.  To cope with this disconnect, banks rely on the fact that the actions of independent market agents will largely offset each other.  For example, one individual may decrease his cash holdings while another individual increases his.

Of the two forces which operate to create fiduciary media, a fall in demand for outside money and a rise in demand for inside money, the former is likely to be the most important.  Given that changes in the demand for money between individuals are expected to offset each other, it could be argued that theoretically the aggregate demand for money should remain stable — the opportunities for individual banks to expand credit would be very slight and very temporary, with a long-run trend of a stable volume of outstanding liabilities.  Empirically, while after the 1970s the velocity of money (loosely related to the demand for money — a rise in demand for money usually translates into a fall in its velocity) has lost some stability, it usually had a historic tendency of remaining stable during periods of economic growth.[13] The issue of fiduciary media in response to changes in cash balances, therefore, would be extremely limited.

Short Macroeconomic Note

Given the nature of the free banking model, or of “meeting the demand for money”, free bankers also tend to support the theory of monetary (dis)equilibrium.  Roughly speaking, monetary equilibrium theory suggests that discoordination between demand for and supply of money can cause macroeconomic fluctuations, or the business cycle.  At the very least, a radical rise in the demand for money without an equal increase in the supply of money can exacerbate these industrial fluctuations, as it forces prices to adjust to changes in the quantity of money in circulation — it forces prices to fall, initially and temporarily pricing certain goods off the market and making some businesses unprofitable.  Some see the ability to increase money in the face of a rise in demand for money as a means of avoiding that painful downward readjustment of prices.[14]

Do changes in the demand for money cause business cycles?  It has been found that changes in the velocity of money usually follow changes in the supply of money, not vice versa.[15] In other words, the demand for money faces extreme increases only as a resultof monetary disturbances.  This is in line with Austrian business cycle theory, as the Austrians rightly attribute monetary disturbances to previous periods of severe intertemporal disequilibrium — usually caused by sustained over-issue of fiduciary media, which is a product of a monopolized currency system.  An increase in demand for money can be considered a secondary consequence of the causal factor behind industrial fluctuations, and that is malinvestment caused by intertemporal disequilibrium.[16] The dramatic fall in the quantity of money is caused by a credit contraction set off by necessary bankruptcies and the consequent radical reduction of outstanding bank liabilities.

Can an increase in the supply of money offset an otherwise necessary readjustment of prices?  For the sake of simplicity, let us assume an aggregate increase in demand for money that reduces spending towards industries A, B, and C.  This necessitates a fall in the prices of industries A, B, and C’s outputs, and therefore changes spending patterns on those same industries’s inputs (those industries now spend less on whatever capital goods were used for production of their own goods).  As a result of an increase in demand for money, banks issue an equal amount of money through the loanable funds market.  Will this prevent the readjustment of prices taking place as a result in consumer preference?  In order for this answer to be ‘yes’, all newly created money would have to be spent on exactly the same things the original money was bound to be spent on; in our example, all new money would have to be spent on industries A, B, and C, in exactly the same proportions as that sum of money would otherwise have been spent in lieu of an increase in demand for money.

Inflation, however, is not mechanical.  There is no mechanism which guarantees that new money will be spent in the same way as money held would have otherwise been spent.  The fact is that the new fiduciary media is likely to go to entirely different individuals, and thus preferences are likely to be entirely different.  The price readjustment will continue to occur, but the new money will allow different individuals to bid up prices by spending on industries D and E.

Is this inherently destabilizing?  If it was, then capitalism would be inherently unstable on account of the fact that individuals are constantly changing preferences — this is the source of dynamism on the market, and the entire reason why entrepreneurs can constantly profit by anticipating or best responding to these changes in preference.  Some industries face a fall in demand for their products, and others a rise; this is the nature of the market.

The attempt to vindicate monetary equilibrium theory by applying it to free banking is ultimately harmful to the accuracy of the theory behind the latter.  It confuses the microeconomic tenets of banking operations in a free market and the more controversial concept of monetary disequilibrium.  Free banking cannot stop changes in the structure of production — the changes are a natural part of an economy.

The Time Has Come

How a free banking industry would develop is a hotly contested issue.  George Selgin’s model is not universally accepted, and in fact has been the target of much criticism.  These criticisms are worthy of review, although given space limitations the present essay can only make brief reference to them (a short list of criticisms can be found on Economic Thought: “Fractional Reserve Banking Debate”).  Issues such as that of fraud and of the potential inherent instability of fractional reserve banking have been brought up.

However, this disagreement should not be an impediment to the deregulation of the banking industry.  The beauty of both the fractional reserve banking model and the full reserve banking model is that they both can naturally grow out of a free market.  In other words, it is ultimately up to the market (the consumer) to decide whether preference lies with full reserves or fractional reserves.  If the latter is a stable form of banking then it is likely to be adopted, and if it is not stable then consumers will opt for banks which maintain full reserves.

What is clear is that the existing state of affairs, or that of a monopolized currency system and a cartelized banking industry, is a major source of macroeconomic instability.  Both the theoretical and empirical evidence suggest that the time has come to replace it with a much more stable form of banking, and the same evidence convincingly argues that this is a product of freedom and deregulation.  We are not arguing for some deregulation, or deregulation in favor of the banking class, rather full fledge deregulation which places the entrepreneur (the banker, in our case) at the mercy of the market (the consumer).  Only then can we enjoy the fruits of a stable, sustainable economy.

[1] For a review of the early literature on central and free banking see: Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative (Indianapolis, Indiana: Liberty Fund, 1990).

[2] For Mises and Hayek, the market represents a network of relationships of exchange between individuals of a society — the division of labor — coordinated through the pricing process; Jonathan M. Finegold Catalán, “The Foremost Austrian Contribution to Economic Science.”  Government intervention in this pricing process represents sources of severe discoordination, while intervention in the supply of money causes substantial intertemporal discoordination between savings and investment, leading to malinvestment and industrial fluctuations.

[3] Friedrich Hayek, Choice in Currency (Auburn, Alabama: Ludwig von Mises Institute, 2009).

[4] Friedrich Hayek, Denationalisation of Money: The Argument Refined (London, United Kingdom: Institute of Economic Affairs, 1990).

[5] Whereas money refers to the actual commodity which makes up whatever medium of exchange is being employed — commonly gold —, money substitute is “a perfectly secure claim to an equivalent sum”.  For example, a paper note represents a claim to a given sum of commodity money, and thus is a money substitute.  Ludwig von Mises, The Theory of Money and Credit (Indianapolis, Indiana: Liberty Fund, 1980), pp. 63–67.

[6] Fiduciary media is money substitute not backed by commodity money.  Ibid., p. 155, 525–526.

[7] George Selgin, The Theory of Free Banking (Totowa, New Jersey: Rowman & Littlefield, 1988).

[8] What is briefly explained in the present essay is devoted an entire chapter in Selgin’s book; ibid., pp. 16–34.

[9] Carl Menger, Principles of Economics (Auburn, Alabama: Ludwig von Mises Institute, 2007), pp. 257–262; Ludwig von Mises, Human Action (Auburn, Alabama: Ludwig von Mises Institute, 1998), pp. 405–407; Murray Rothbard, Man, Economy, and State with Power and Market (Auburn, Alabama: Ludwig von Mises Institute, 2009), pp. 187–195.

[10] Selgin (1990), pp. 40–42.

[11] Selgin offers a convincing case for note-brand discrimination; ibid., pp. 42–47.

[12] Ibid., p. 67.

[13] Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, New Jersey: Princeton University Press, 1963), p. 592.

[14] For an introduction to monetary (dis)equilibrium theory, see Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium (Indianapolis, Indiana: Liberty Fund, 1997).  Also, see George Selgin, Bank Deregulation and Monetary Order (London, United Kingdom: Routledge, 1996), pp. 142–162.

[15] Roger W. Garrison, Time and Money (London, United Kingdom: Routledge, 2001), p. 234.

[16] Murray Rothbard, in fact, makes this argument in his explanation of the causes of the 1929 business cycle which set off the Great Depression.  See Murray Rothbard, America’s Great Depression (Auburn, Alabama: Ludwig von Mises Institute, 2000), p. 15.


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.



  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’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.