Booms and busts before the Fed era?

Miscellaneous History
61

"Well, perhaps abolishing fractional reserve banks would eliminate booms and busts–just as abolishing authomobiles will eliminate traffic accidents.

Why don’t we leave it to liberals to solve economic problems by finding things to ban?"

Hi, Selgin. Thanks for participating here.

However, you misrepresent our position. We do not desire to ban any type of banking, we wish to unregulate all banking. We want to give everyone the power to print money. The point is not to ban notes, its to make notes so numerous that people no longer accept them.

Consider the massive amount of interventions intended to convince people that their money in a bank is safe; needed because the reality is, its not.

62

To JonBostwick: People didn’t need to be encouraged by means of government regulation to hold bank IOUs excepti in those instances–like the U.S.,–where other government regulations made such IOUs particularly risky. (I refer here especially to laws aimed at propping up small unit banks.) Where banking was relatively free, there was no clamor for insurance. Canada, the second country to establish nationwide insurance, didn’t do so until 1967. And it did so then despite the lack of any popular pressure.

63

Of course they do.

Governments have attempted to prevent bank runs, through various means, for centuries; often by simply suspending payment. Deposit insurance is merely the most recent, and happens to be portrayed as existing for the sake of depositors (instead of for the banks).

Deposit insurance is the result of the incorrect lesson that Americans have learned from crashes, to blame them on a “lack of confidence.” Of course, confidence is irrelevant to someone who can honor their obligations.

64

There were many US experiments with paper money before the Fed. I have written something about this at:

I would be interested in any feedback I can get.

– Vince

65

DD5,

Regarding demand for bank money and savings, I’m taking a similar position to Jesús Huerta de Soto’s between pp. 694–700.

66

Jonathan: “Regarding demand for bank money and savings, I’m taking a similar position to Jesús Huerta de Soto’s between pp. 694–700.”

Jonathan, Let me reiterate then. A demand to hold money (hoarding) by reducing one’s consumption always amounts to genuine savings. de Soto makes, what I believe is a valid point, that one can increase his cash balance by selling off investment assets with the intention of reducing his investments. The individual time preference cannot be simply determined by bank deposits. I think this is correct, although I admit, very confusing.

I was originally referring to what de Soto is describing on pp 448 , (b) The second type of deflation… or see foot note 48 (pp 449) of Mises quote from Human Action.

67

DD5,

A demand to hold money (hoarding) by reducing one’s consumption always amounts to genuine savings.

Let me be more specific, then. Free-bankers hold that an individual can demand money substitutes because they are easier to carry or use in transactions. So, a rise in demand for bank notes from a single individual would entail that individual exchanging these bank notes with gold. I don’t see that as a rise in the intention to save, because nothing in that transaction suggested a change in time preference.

So, instead of referring to an increase in demand for money in the sense that an individual is looking to hold money, I’m talking about an increase in demand for bank money and a proportional decrease in the demand to hold base money.

EDIT: So yes, my position is similar to that of Huerta de Soto’s (a decrease in investment assets).

68

Jonathan: “Free-bankers hold that an individual can demand money substitutes because they are easier to carry or use in transactions.”

Full reservists also hold this view.

Jonathan: “So, a rise in demand for bank notes from a single individual would entail that individual exchanging these bank notes with gold. I don’t see that as a rise in the intention to save, because nothing in that transaction suggested a change in time preference.”

I agree the transaction itself means nothing unless he surrenders the use over that gold for a given amount of time. But If he holds on to these notes and does not use them for consumption, he does release resources from consumption and makes them available for capital investments. It’s just that instead of those resources made available by direct investment, they will be made available [indirectly] by the relative price changes between consumer goods and capital goods that results from the accumulated [hoarded] bank notes. The bank need not issue loans to make those resources available. That was my point about savings. If the bank does try to respond by making loans, de Soto is putting fourth the argument that the bank can and will still distort the structure of production.

de Soto is reiterating Hoppe’s argument that if an individual is increasing his demand to hold money, the free bankers err in thinking that they can alleviate this demand by issuing fiduciary media (on the basis of that demand) because that media cannot possibly find its way into those individuals that actually wish to hold it. The new media will go to wage earners, some of who will spend it on consumers goods, and thus, distort the structure of production.

I’m just saying, the argument put forward by him is not at all trivial. It is quite complex.

Jonathan: “So, instead of referring to an increase in demand for money in the sense that an individual is looking to hold money, I’m talking about an increase in demand for bank money and a proportional decrease in the demand to hold base money.”

I’m not sure what you mean here. de Soto clearly makes the distinction between demand to hold money and demand to hold fiduciary media. The bank cannot know and do anything about money under the mattress, and when we consider the case of an increase in demand to hold money, people would increase their cash holding via bank notes only to the extent that they view them as perfect substitutes.

69

DD5,

Full reservists also hold this view.

Well, my point was more to set up my argument with a premise (that this particular individual’s demand for fiduciary media is out of preferring bank notes to gold). Before responding to the main body of your post, I’d like to respond to the last comments first,

I’m not sure what you mean here. de Soto clearly makes the distinction between demand to hold money and demand to hold fiduciary media. The bank cannot know and do anything about money under the mattress, and when we consider the case of an increase in demand to hold money, people would increase their cash holding via bank notes only to the extent that they view them as perfect substitutes.

In my post I’m not referring to Huerta de Soto’s definition of a demand to hold base money versus the demand to hold fiduciary media, I am referring to the free banker’s use of the “demand for money” (i.e. based on what I learned here). Professor Selgin writes,

A person brings, say, 100oz of gold coin (base money) to a bank, and receives a 100oz note for it, redeemable on demand. The banker thus becomes the new owner of the gold. The depositor has traded present ownership of basic money for ownership of the note (a financial asset) plus the option of securing ownership of basic money again at some (indefinite) point in the future.

This is the basis of how banks would respond to an increase in demand for bank notes. They do distinguish between an increase in bank money and an increase in base money. For future reference, the above quoted paragraph ends with,

It is a standard debt transaction. Rothbard and his followers err in imagining that the depositor, in giving the bankers possession of the gold (if only temporarily) nonetheless retains ownership: that view goes against legal opinion on the subject dating back to ancient times!

You write,

I agree the transaction itself means nothing unless he surrenders the use over that gold for a given amount of time. But If he holds on to these notes and does not use them for consumption, he does release resources from consumption and makes them available for capital investments… That was my point about savings.

I think that there is some confusion. My argument is that the act of exchanging gold for banknotes does not within itself suggest that the individual is looking to decrease his time preference. I don’t see why an increase in demand for bank notes should be immediately equated with a decrease in time preference and an increase in savings, unless (as you mention) the gold is surrendered for a specific amount of time. In other words, free bankers argue that when the demand for bank notes rises and banks increase M to meet that demand, V will fall proportionally; I don’t recognize this as true.

It may be a confusion of terms; it may be that the demand for bank notes doesn’t necessarily represent an increase in the demand for money.

Further down you write,

de Soto is reiterating Hoppe’s argument that if an individual is increasing his demand to hold money, the free bankers err in thinking that they can alleviate this demand by issuing fiduciary media (on the basis of that demand) because that media cannot possibly find its way into those individuals that actually wish to hold it.

I’m not sure what the entire free banking argument is, despite my reading, but it seems to me that their argument is that banks would extend fiduciary media in exchange for gold deposits. So, those demanding money substitutes would need to offer gold in return. This is how they differentiate between demand for money and demand for loanable funds - free bankers are not referring to the latter.

Now, back to Professor Selgin’s quoted paragraph. Free bankers believe use of that gold has been surrendered to the bank, which is where the free banker’s agreement with fractional reserve banking arises from. They believe that by demanding bank notes an individual is preferring to save, but I don’t see that as necessarily true unless the deposit of gold made was a time deposit; i.e. I recognize the difference between a time deposit and a checking account in a money warehouse.

70

If people choose to switch from holding gold to holding banknotes, then there’s no net change in the real volume of saving. Only the form of the saving vehicle changes, as it would if, say, someone sold a share and bought a bond. Such a change in demand will be inflationary under FB. But it isn’t the sort of case Larry and I have in mind when generally considering increases in demand for “inside money” by which we usually mean shifts in demand from non-money assets and consumption to money.

When in the sort of case referred to here, a bank responds by lending more, thereby causing the stock of bank money to grow with the increased demand for it, it is not a problem for the new money to go to employers and thence to workers who spend on consumer goods. There’s no net increase in spending on such goods, for the worker’s expenditures are matched either by the original saver’s own reduced consumption or (if he switched from holding some other asset) from reduced spending by workers in the adversely affected industries.

71

Jonathan*: "I’m not sure what the entire free banking argument is, despite my reading, but it seems to me that their argument is that banks would extend fiduciary media in exchange for gold deposits. So, those demanding money substitutes would need to offer gold in return. "*

I’m afraid the free banker’s argument is much more sophisticated then that.

If the media is simply “extended” in exchange for a gold deposit then we are not necessarily talking about fiduciary media but just a money substitute, and there wouldn’t be any disagreement. The whole point is that the bank then issues additional media by issuing new loans on the basis of that original deposit, thus, FRB then arises. But the free bankers maintain that under free banking, the fiduciary media is not extended beyond the amount of real savings because the bank doesn’t extend beyond what is being held by the original depositor, thus, no multiplier factor will tend to emerge. They justify the new “money” (fiduciary media) by claiming that this satisfies demand for that “money”, so that people’s demand to hold “money” [in the broader sense] can be alleviated by the production of more money (in the form of fiduciary media) instead of by just falling prices. This is what “Monetary Equilibrium Theory” is basically about, in a nutshell. I suggest you watch one of Steven Horwitz’ summer seminar presentations over at FEE for a quick intro. I’m pretty sure I did not misrepresent their position and if Selgin reads this he can affirm or object.

The above argument is not so trivial and I will bet you that almost everybody who either supports or rejects the free banker’s position doesn’t understand it.

If the issue was just a demand for “money substitutes” in exchange for gold, then any 100% reserve bank can meet that demand.

72

DD5,

For the most part, I think that’s what I said. I think the confusion is coming from disecting my posts into individual pieces. After what you quoted, I wrote,

Now, back to Professor Selgin’s quoted paragraph. Free bankers believe use of that gold has been surrendered to the bank, which is where the free banker’s agreement with fractional reserve banking arises from.

Admittedly, I used “fiduciary media” instead of “money subsitute”, but I understand the free banking position and how it leads to fractional-reserve banking. I think you aren’t understanding my objection to the free-banker’s argument.

73

Selgin: “There’s no net increase in spending on such goods, for the worker’s expenditures are matched either by the original saver’s own reduced consumption or (if he switched from holding some other asset) from reduced spending by workers in the adversely affected industries.”

Selgin, but there won’t be a reduced spending in the “adversely affected industries” precisely because the free banking system will create fiduciary media to offset any increase in demand to hold that money, by issuing loans to those capital industries. I think this is precisely the point de Soto is trying to make with that example. Unless that new money is going to reach (as wages) precisely all those people who have actually increased their demand to hold that money, at least some of that new money will be spent on consumer goods, and the amount of loanable funds to expenditure on consumption will not be aligned with society’s time preference.

I admit, I will have to think about this further, especially given the fact that you are flat out rejecting this example and its conclusions.

74

You haven’t followed my argument very carefully. I acknowledge in the first part the increased spending on the part of recipients of new bank loans. But if these were made possible by someone’s choosing to refrain from buying some other asset–say a corporate bond–in order to add to his or her money holdings, then the corporation that would otherwise have sold the bond must restrict its own spending accordingly.

These are very elementary points. To not spend on X, whatever X is, in order to accumulate money balances is to reduce the overall flow of spending, so that if bank balance sheets expand just enough to compensate for the increased money holding, total; spending is merely kept unchanged. It doesn’t rise merely by virtue of bank’s acting as intermediaries.

Consider an extreme case, for the sake of argument. Suppose all payments are made by check–no currency. Suppose as well that at first the typical agent attempts neither to accumulate nor to reduce his average bank deposit balance, so that the “circular flow” of spending is stable (don’t dismiss the concept: it’s an aspect of Mises broader npotion of the “evenly rotating economy”). Banks here also maintain constant size balance sheets, replacing or renewing loans as they mature, and in that way contributingf their share to the circular flow of expenditures–a share corresponding to what depositors do not contribute by choosing to maintain bank deposit balances of a definite average value.

Now suppose–again, for the sake of argument–that our “'typical” agent decides to stop spending money until he has acquired a much larger bank balance–large enough in real terms to, let us say, finance a very large payment, such as a year’s worth of tuition at some Ivy league college. Remember, everyone is doing this at once. What happens if the banks continue to refrain from increasing their total loan portfolio? Well, since (for a time) no one is spending, that means a like reduction in firm revenues–a shrinkage in the circular flow. But it’s out of these revenue that people receive much of the income that they are presently attempting to accumulate. It is, therefore, impossible for everyone to succeed in accumulating the bank balances they need–impossible, that is, without deflation (which ultimately achieves the result, by reducing the price of college tuition, along with all other prices). But consider: even if prices fall relatively quickly, firms wll have suffered in the short run from the discrepency between their nomknal earnings and their (sunk) nominal costs. And even in the freest of free markets, it is unreasonable to suppose that the needed price adjustments will take place in a short spand of time. Remember, most sellers aren’t in a position to tell at once that demand is permanently declining, rather than merely experiencing a random movement; and there may be substantial costs involved in changing some prices, including those of laborers and salaried workers.

So, what happens under an ideal banking arrangement? Simply this: because no checks are being written against them, the banks find that their cash reserves, which are used for interbank settlements, are “underemployed”–tha is, that the aggregate supply of such reserves exceeds the banks’ demand. They respond by making more loans, expanding system deposits by a like extent. The increased lending serves to renew the circular flow, or (ideally) from keeping it from shrinking at all, by causing an increase of “spending by bank borrowers” that just serves to compensate for the reduced spending by bank depositors. Since the total flow of payments is maintained, people are in this case actually capable of accumulating nominal money balances (in effect, getting hold of and retaining the very deposit balances their own attempts to save allowed banks to create in the first place). So prices don’t have to decline in order for them to accomplish their plans, and firms do not have to suffer any transient loss of profit. This is, of course, true on the whole or on average, for the increased saving and lending will of course tend to alter the relative prosperity of different firms.

So, the question is, why would anyone prefer to live in the world in which deflation is the only means by which people’s increased desire to hold money can be accommodated? I know I’d rather not live in that world, much preferring the one in which banks are simply able to lend that much more in nominal terms.

75

Why can’t anyone just increase the true quantity of money- ie mine more silver, gold or pine needles? It is irrelevant that it takes time and resources- it simply can be done and if demand for money increases then there’s the incentive to produce more of it.

76

Cause it’s more expensive.

77

Physiocrat writes: “Why can’t anyone just increase the true quantity of money- ie mine more silver, gold or pine needles? It is irrelevant that it takes time and resources- it simply can be done and if demand for money increases then there’s the incentive to produce more of it.”

No, time isn’t irrelevant, for if it were then deflation would also be just dandy every time. Time is crucial, for the longer it takes to get to the new equilibrium, with higher real money balances, the longer the economy in question will remain depressed for want of an adequate real supply of same. In practice, gold supply is inelastic–costs of exploiting existing mines rare rising, and there can be no quick adjustment by this means. Pione needles would, admittedly, work better. But alas, they have other still more serious drawbacks.

Now, what is your positive complaint about the increased stock of bank money alternative?

78

Selgin,

First, thank you for the lengthy and detailed response.

I find your “circular flow” example to be totally inconsistent with Capital Theory. If we assume that people are trying to increase their cash balances, how can you simply “renew the circular flow” by extending loans without any regard to whether the agents are cutting back their spending on consumer goods(present goods) or capital goods (future goods)? For example, if the spending restriction is on consumption, then regardless if the bank extends loans warranted by the increase in reserves or not, resources are freed in the form of unsold consumer goods for the benefit of capital investment, and the process of the lengthening of the structure of production is set in motion. So I don’t see how there can be any renewal of some “circular flow”, or as you said “(ideally) from keeping it from shrinking at all”. The structure is changing and this will require some firms to suffer transient losses, or else, there can be no change.

Your “circular flow” example is more reminiscent of the Keynesian “circular flow” then anything remotely close to Mises’ “Evenly Rotating Economy”. I mean, didn’t you just conflate both consumer and investment expenditures in order to make that example?

79

DD5: I expressly provided that the process I described as “maintaining the circular flow” would not thereby necessarily maintain the revenues of particular firms or industries. (But alas, expressly taking a point into account doesn’t suffice to keep someone from claiming that you have overlooked it. ) The composition of new spending that makes up for former spending by persons who instead seek to build deposits will depend on who is both willing to and worthy of securing the loans in question. That may include both consumers seeking to finance durable goods purchases and businessmen seeking to make investments. Northing wrong with this. Nothing.

As for the circular flow being “Keynesian,” the notion predates Keynes. And as a notion referring to nominal values only, it is consistent with pretty much any capital theory you like.

80

DD5,

Here are the difficulties I have with the Rothbardian analysis: 1) he views money as neutral, that is, that it exerts no effects over the real economy (neutrality of money). This is why he makes the spurious claim that “any supply of money is sufficient.” 2) deflationary conditions are always considered to be optimal and socially beneficial; an elevated market rate of interest, above the natural rate, is never mentioned (that I know of). Hayek, Mises, and Wicksell reject both (1) and (2).

Mises says that goods can be broken down into three distinct categories: media of exchange, producer goods, and consumer goods. These categorizations are not fixed, that is, different goods are free to bounce around from one class to the next. The interest rate is determined by time preference, i.e., the ratio of demand between consumer goods and producer goods (also forms the dimensions of the capital structure). But money, as I’ve already pointed out, is both a class and a good in itself. When the demand for money rises, time preferences remain unchanged, but the market rate of interest does not remain unchanged, in fact it rises. When the market rate rises above the natural rate, you get depressed economic activity, which is only magnified by the effects of price rigidities.

The result of which resembles Keynesian analysis, but it has nothing to do with savings and underconsumption (since a higher savings rate alters the structure of production in beneficial ways, as long as the market rate follows). Therefore it’s not Keynesian, but more along the lines of monetarism. I realize the theoretical problems with this position, but I have never heard a coherent argument refuting this claim. If we (a) accept that money is a good in itself, and (b) acknowledge that it exerts no effects on the natural rate of interest, then it seems that monetarism explains one sort of economic phenomena (though a phenomena which hasn’t existed since the 30s, since the various central banks of the world have kept market rates below the natural rates).

Free banking, then, satiates the demand for money as money and prevents the Keynesian/monetarist contraction, but only insofar as there is actual competition amongst banks. In such a condition, no bank is able to charge a different rate of interest, or expand the supply of money and credit beyond the demand for them:

Though, of course, there is one big problem here: the money may not flow directly towards those who wish to increase their cash holdings. It may, in fact, flow towards those who which to increase consumption and/or investment. Therefore, we have only problems, and no resolutions. Rothbardians and free bankers have to acknowledge this. So, that being said, it seems as though we have two options: (1) we ban fractional reserve banking and the boom-bust cycle only to replace it with a condition of perpetual economic stagnation (way below PPF), where the demand for money continuously elevates the market rate above the natural rate, or (2) we eliminate the FED, allow markets to determine banking, and deal with some boom-bust. (Not considering the moral arguments for either).