A Question to Free Bankers

Economics Economics Questions
1

Hi, I don’t post very often, but I’m always browsing.

Anyways, I periodically return to the issue of FRB and the controversey associated with it.

One problem that I have not seen a sufficient answer to by “Free Bankers” has to do with the relationship betwen the interest rate and the demand for money.

So my understanding is that an increase in the demand for money on behalf of the public will generally increase the quantity of demand deposits held with banks, which in turn allows for a greater sum of fiduciary media to be lent to business. In order for these greater sums to be lent, ceteris paribus, the interest rate needs to fall. If I’ve made a mistake already please let me know.

Here’s my question. A rise in the demand for money does not necessitate a fall in one’s time preferences, i.e., one’s relative desire for immediate consumption vs. future consumption. Now, if a rise in the demand for money unconditionally results in a lower bank rate of interest, but does not necessarily result in a fall of the public’s desire for present/future consumption, will not a discoordination develop?

As an example, suppose you have a constant monthly income flow of $1,000. Of that $1,000, 80% is deposited into an immediately redeemable account and 20% is invested in a way such that that 20% cannot be recuperated for some extended period of time. Further suppose that the 80% is considerably drawn down for present consumption needs: food, gas, etc. Now, suppose that you change your allocation from 80%/20% to 90%/10% for reasons of uncertainty or pleasure. In this case an increase in immediately redeemable deposits will have the effect of reducing the interest rate, yet you have in fact changed your preference in the opposite way, that is, your new allocation of income reflects a greater desire for present consumption relative to future consumption.

So the general point is: changes in money demand do not reflect changes in time preference and hence changes in the natural rate of interest rate. This can be found in MES, Hoppe, De Soto, etc. Moreover, if anything, it empirically seems more consistent to say that increases in demand deposits reflect a greater desire for present consumption rather than future consumption.

In any case I can’t seem to reconcile this problem. References to other posts or responses would be appreciated.

2

I’ve had this very same problem for quite some time now.

An elevated demand for money (cash holdings) actually decreases the supply of money in the broader sense; that is, it slows down the money multiplier and elevates market interest rates (individuals begin to sell securities in order to satiate their demand for money). In other words, a fall in the demand for money increases the circulation of money which allows banks to create deposits at a faster rate (increasing the supply of money in the broader sense) and allows them to reduce their liquidity positions (how much cash [money proper] they actually have available at any given time). I’ll return to this problem later.

Indeed. An elevated demand for money does not, in anyway, affect time preferences or the "natural rate of interest,’ but it does affect market or money interest rates. It is important to distinguish between market interest rates (the ones you see in the market, which are affected by many variables), on the one hand, and the natural rate of interest (determined solely by time preference) on the other. Thus, an elevated demand for money (as money) will yield monetary disequilibrium, or an elevated market rate of interest above the natural rate of interest, if the supply of money remains constant/does not adjust to this elevated demand. This, in turn, will cause “bad deflation,” as opposed to the “good deflation” we see during periods of general economic growth/productivity gains. The Free-Bankers and Hayek, therefore, claim that this elevated demand for money, as money, should be satiated in order to prevent an arbitrary and destructive deflation (when savings>investment; when the market rate is greater than the natural rate).

Now here’s the problem: The free bankers say that we must elevate the supply of money in order to satiate the demand for money as money (as opposed to the demand for money as capital) and prevent temporary monetary disequilibrium. But the supply of money, in the broader sense, actually contracts precisely when the demand for money rises. The only possible remedy, that I can think of at least, is if the banks actually increased the supply of physical bank notes (which wouldn’t be considered “money proper” under a gold standard).

Unfortunately, I haven’t read any of the modern-day free-banking literature, but I’m sure they’ve dealt with this potential theoretical problem (Hayek merely states that the demand for money, as money, should be satiated in order to prevent “secondary phenomena”). But I have noticed a tendency, amongst some free bankers, to conflate an elevated demand for money with an elevated savings rate (or lower time preference). This is untenable if you accept Mises’ three-fold categorization of economic goods, namely consumer goods, producer goods, and media of exchange.

3

Interesting topic. Now, how exactly could people demand more money while, say, at the same time experiencing falling time preferences? If more money are drawn from (lapsing) time deposits, how on earth could natural rates not rise? (assume a constant monetary supply) In general, how do we claim that the demand for money, money having no use-value of its own, is independent form one’s time preferences? Sure, the reasons for rising time preference might be related to security issues or else. But these factors still influence the demand for monetary medium. So I don’t see the issue here. One is simply naming the same thing in different manners.

4

There is absolutely no way to reconcile this problem. MET proponents do so by simply avoiding such problems (among others) in the first place and making gross and inappropriate assumptions in their reasoning.

I recommend to you Steven Horwitz’ book, “Microfoundations and Macroeconomics” if you want to better understand the ME position.

5

Because it is independent from time preference. It’s just that changes in demand for money is likely to be accompanied by changes in time preference also in the real world, but it doesn’t necessarily have to be so. There is no praxelogical way to determine if time preference will change, and to which direction, when changes in demand for money occur.

6

This does not reduce the interest rate. You supply less funds for the bank, as it cannot use the redirected 10% as freely as previously, but it has to keep some of it on hand. Thus it can invest less.

7

You are making several mistakes in your thinking. First, you’re assuming all saving takes the form of time deposits, or some such form where any decrease or increase in saving will immediately affect the bank market rate of interest. On the one hand, this type of saving is only a portion, in fact a small portion, of the total saving that takes place in the market. And secondly, even if it were the case that all savings were in the form of time deposits, so that any decrease would reduce the bank loan rate, by transferring those savings from time deposits to demand deposits, there would be no net change in the bank rate of interest, despite the fact that such a change from the view point of the person signifies a change in their time preference and hence the natural rate of interest.

I think changes in the demand for money can be separated into three cases.

1.) You increase your average cash balance (demand deposits) by saving less, but maintain the same level of consumption. That is, your consumption/saving ratio goes up. You seem to think this can only occur if money is withdrawn from time deposits. But saving takes many forms besides that of time deposits; among them are direct investment in one’s own project, the financing of some othe project not through a bank, and so forth. These mediums don’t necessarily affect the “bank” market rate of interest which is distinct from the natural rate.

2.) You increase your average cash balance but maintain the same ratio of consumption to saving. In this case the natural rate remains constant yet the loan rate would fall.

3.) You increase your average cash balance by reducing expenditure on consumption, but maintain the same level of saving. This would reduce the natural rate as well as the loan rate.

As far as I can tell only case #3 is consistent with the arguments put forth by Free Bankers. And empirically speaking, I don’t think most people increase their checking balances by reducing the consumption/saving ratio. In fact, the opposite is more often the rule; especially during times of uncertainty, when the individual is apprehensive about sinking cash into something.

8

You’re also conflating saving with something that necessarily enters the bank market. A reduction in saving does not directly necessitate a reduction in funds availabe for banks.

I can reduce the amount I save (e.g. not renew some machine) without withdrawing any funds from some bank. Yet that money can in turn be placed into a demand deposit, which will in turn reduce the bank rate of interest, contrary to the fact that my action signifies a rise in the natural rate of interest.

9

“So my understanding is that an increase in the demand for money on behalf of the public will generally increase the quantity of demand deposits held with banks, which in turn allows for a greater sum of fiduciary media to be lent to business. In order for these greater sums to be lent, ceteris paribus, the interest rate needs to fall. If I’ve made a mistake already please let me know.” - edward_1313

Maybe I’m misunderstanding the point, more than likely, but how does an increase in demand deposits equal an increase in loanable funds? I can certainly see how it’s technically possible in free banking as I understand it, but would it be sustainable? Throwing demand deposits into the loanable funds market along with time deposits just means the bank will increase it’s risk for not being able to meet demand deposit claims. My guess is there’d be some of it going on, but barring facilitation or government protection it would end up settling at some market acceptable level. Whatever discoordination this would cause would probably be no more of an issue than standard mistakes made in business all the time. No resources are ever coordinated perfectly, but so long as the system is self correcting via market forces the discoordinations become noise far overshadowed by the truly productive actions.

As you point out there are various means of saving/investing, the bank rate is and should simply be a reflection of what people are willing to save and invest via that means, so why should the bank rate ever be expected to have such a link to time preference or other forms of saving? It’s merely a reflection of the market conditions for loans specifically made through the banks. And while people may deposit more money while not changing their time preferences, this money will not necessarily hit bank rates because the bank managers themselves need to make the decision of whether or not to risk an increase in liabiliy on those demand deposits.

Now it follows from your reallocation example that if people change their allocations because of this or that they will also have to make a judgement as to whether or not they were correct and again reallocate resources, so it’s a continuous process. As such the extra money that may or may not show up in demand deposit accounts is not necessarily going to have the same ‘rating’ as time deposits in terms of security to lend out. There will likely be a margin that managers see in terms of how much they might be able to get away with lending without getting screwed, and only that portion of the change in demand deposits would then affect bank rates.

So it isn’t the raw change in spending/savings on the part of consumers which could be very substantial that affects the bank rates, it’s the portion of that reallocation that bank managers would feel comfortable ‘embezzling’ and for how long that would affect the bank rate. And given the nature of those funds relative to their security to lend out, I’d wager the amount the managers were willing to risk would be a lot smaller than the total change in spending/savin, and given it’s nature probably more likely to affect shorter term rates. There is still a mechanism/means to determine the nature of the deposit and the risk to lending it out on a group level if not for each individual account even if it hasn’t been technically allocated to a time deposit. So the long term rates more relevant to higher order capital markets would likely see little to no effect. Unless bank managers make bad decisions, but then that’s what the broader market weeds out a corrects for.

“In general, how do we claim that the demand for money, money having no use-value of its own, is independent form one’s time preferences?” - Merlin

Technically speaking I’ve had a problem wih money having no use value other than exchange. Actual money, as in money that arises on the market, does have use value. It gains value as an exchange medium because it has use value. So this disconnect has always seemed false to me. Fiat notes have no use value, money does.

10

No. Altering your cash balances does not (cannot) affect the natural rate of interest. The natural rate is independent of all monetary influences; it is determined by the ratio of demand between consumer goods (consumption) and future goods (savings). Limiting sales in order to increase your cash balance =/= savings (because you’re not demanding future goods but rather trying to satiate your demand for money).

Also, do you understand that an increase in the demand for money actually reduces the supply of money in the broader sense?

11

Case 1 and 3 indicate an obvious change in time preference.

Of course, 1 and 3 don’t imply that changes in cash balances=changes in time preference. They simply describe that scenario where both a change in cash balances and a change in time preference occur simultaneously.

What, people can’t have more then a single preference change simultaneously? Like increasing demand for both hamburgers and ketchup at the same time.

12

How does case 2,

Indicate a change in time preference?

We cannot know, a priori, if an individual is reducing purchases and increasing sales because his time preference fell (elevated demand for future goods relative to present goods) or because he desires to increase his cash balances. That is, we do not know if he’s thinking (a) “I wish to put resources on the side for the future, for reason x” or (b), “I need more cash to facilitate transactions” or (c) “I need more cash for security” (during an economic crises). But (b) and (c) do not affect time preferences and therefore do not alter the natural rate of interest, but they will alter market interest rates.

Again, think of Mises’ three-fold distinction of goods: (a) consumer, (b) producer, and (c) media of exchange (money is a good and a class in itself). The natural rate is determined by the ratio between (a) and (b), but market interest rates are affected by all 3.

13

Ensuric,

I mixed up the numbers. I meant 1 and 3.

And yes, we cannot know, a priori, …what ever you said. I believe I stated precisely that up thread.

The point of showing the 3 possibilities is to show that by a mere increase in cash balances, you cannot determine what the intention is of those who are increasing their cash balances. If a monetary regime creates money to offset any increase in demand to hold money, as the ME proponents will have, it will also put the structure on an unsustainable path. But this is just one crude method among several others to debunk ME.

14

This is a valid point. MET does not really explain how it will funnel fiduciary media to those who really want to increase their cash balances (money as money), and those who demand money for investments (money as capital). But I just wanted to elucidate the point that changes in the demand for cash balances can not affect, in itself, the natural rate of interest (independent of all monetary factors). I also don’t understand how banks can elevate the supply of money during an economic crises, when the demand for money rises (mentioned this earlier).

15

My point is not that changes in the demand for money necessitate a change in the natural rate. On the contrary, I am in complete agreement with the three-fold classification of money, consumption, and saving, and I am trying to use this distinction to probe at the weakness of the free bankers argument.

My 3 case scenario says that we can say, a priori, that a change in money demand will either 1.) Change the ratio in favor of consumption, 2.)Not change the ratio at all, or 3.) Change the ratio in favor of saving. Of course, a priori, we cannot say which particular one will happen but we can say that one of those three must occur. Moreover, the point was that only in case 3 does a change in money demand give rise to both a falling bank rate of interest and natural rate of interest. Otherwise there will be discoordination.

And I’m not certain what you mean by the supply of money in the ‘broader sense’. My interpretation of a rise in the demand for money is an increased desire on behalf of individuals to hold cash balances. Thus, the inverse consequence of an increase in the demand for money, is that that money will in fact exchange hands less often as result of individuals holding onto it longer. And free bankers would argue that with more money sitting in demand deposit accounts for longer periods of time banks will be able to lend out more, i.e., the bank rate of interest would fall given a rise in the demand for money. And as for the “broader money supply” my only interpretation is that if the demand for money rises, and hence exchanges hands less rapidly, then the same amount of money will be taking on less transactions. What this means for a money supply in the broader sense depends on the definition, so let me know what you mean by it.

16

Even if you grant them the assumption that #3 only occurs, they still don’t avoid the interest rate distortion by injecting money via loans, even if the quantity exactly offsets the increase in cash balances. Do the numbers yourself. And we are able to show this by still talking in somewhat aggregates here. Once you drop the aggregate analysis completely and consider only the micro-effects, it becomes clear that the money can never make its way precisely to those individuals who wish to hold it and in the correct quantity. The problems of MET are then completely reduced to the typical problems explained by ABCT.

17

My point is this: Case 3 will actually lead to a higher bank or market rate of interest (since the demand for money has increased, which slows down the process by which banks create deposits, constricting the supply of money), and that the natural rate of interest will remain unchanged if individuals solely demand money as money (to facilitate transactions or for security, as opposed to a higher demand for future goods relative to consumer goods). Again, increasing your cash balances =/= a higher desire to save (higher demand for future goods).

Money “in the broader sense” includes credit money, money certificates, and fiduciary media (as opposed to Money proper).

If they hold (higher) cash balances then the circulation (or velocity/transactions) of money slows down, and this retards the process by which banks create deposits. If the demand for money is low, on the other hand, then money circulates quickly (because they’re not holding onto large cash balances), and banks are able to create deposits at a faster rate and can hold less liquidity. The demand for money can be low when the savings rate is relatively high.

That’s if they conflate savings with an increased demand for cash holdings. When the demand for money is high, banks need to hold additional liquidity in order to satiate withdrawals.

18

My interpretion is the opposite, and what I thought to be the interpretation of MET. That is, higher cash balances, or a lower circulation rate of money, means that individuals withdraw from their demand deposit accounts at a slower rate. This slower rate means a bank can operate on a lower reserve ratio; i.e., increase the amount of fiduciary media it lends.

Conversely, a fall in the demand for money has the effect increasing the withdrawal rate and hence increasing the reserve ratio, or decreasing the amount of fiduciary media.

In any case, this particular matter has no effect on the overall argument, it just flips the cases depending on which is right.

19

This is the key to the confusion here. You are both not arguing over the same definitions. When MET proponents integrate their theory with “free banking”, they assume that demand for money would be satiated by a demand to hold bank liablities, i.e., demand deposits. If for the sake of argument you grant them this assumption, then an increase in cash balances also means an increase in the bank’s balance sheet. Reserves are then increased and not decreased.

20

Well, it’s just a fact that the supply of money falls when the demand for money rises. Velocity is the reciprocal of money demand (1/k where K is the demand for money). That’s basically what I’m trying to communicate. The explanation for this is rather long, but it has to do with the circulation of money, and how banks create deposits. Also, demand deposits do satiate the desire to increase cash balances, but their creation slows precisely when the demand for money rises (which is the point I made earlier).

Increasing cash holdings =/= savings (this is the source of the confusion).