Are there any articles that demonstrate (either theoretically or, better yet, with data) that fractional reserve banking would either be limited or impossible under free markets?
A friend of mine commented that since banks would always loan out some of the deposited money, this way money supply would always grow, even under free markets. Any comments?
There are a lot of articles and sections of books devoted to this is too lazy to look up.
The basic argument is that while a small degree of fiduciary media can certainly come into existence, if it is extensive then the solvency of the bank will be questioned and people will withdraw their cash deposits/gold from the banks. As a result “run” on the bank there will no be enough cash/gold that banks can exchange in return for checks and the like. This means that banks will become insolvent and they will be forced to shut down. The fear of this will prevent banks from issuing out much unbacked money.
Edit
There’s a section on this at the end of the money chapter in Human Action.
Interbank competition is also a limiting factor. If banks inflate at various rates, the more inflationary banks will gradually lose reserves to the less inflationary banks until there’s a default. Hence, for any prolonged inflation to be possible, the banks have to inflate at the same rate. They have to form a cartel to coordinate their inflation, but voluntary cartels are effectively impossible.
It seems like you’re hoping that laissez-faire and full reserve banking are necessarily intertwined. Do you have anything against free banking a la George Selgin?
Jargon,
I’ve never actually heard the argument for FB, although I know it’s one of the major debates in Austrianism today. Could you summarize it for me?
I haven’t actually read Selgin’s “Free Banking” but I like to hear what he has to say on the internet.
The gist of free banking ethics is this: Fractional Reserve Banking is not fraud insofar as each depositor is aware that his deposit only has an immense likelihood of being available for withdrawal, insofar as it is known that a deposit certificate is not money proper. Therefore any attempt to shut down or prohibit someone from creating an institution of fractional reserve lending is a violation of property rights.
The gist of the free banking prescription is this: Fractional Reserve Banking, when completely unregulated and demonopolized, would be an excellent deterrent to the business cycle, though it can do nothing about the actions of foreign central banks, which may have secondaryeffects on domestic private banking. Each private banks ability to issue credit is hampered by the circulation of its own notes into the hands of non-clientelle. Mises’ explanation of the phenomenon is here http://mises.org/Books/humanaction.pdf on page 434. Free Banking is also a more robust system should systemic shocks occur. Selgin substantiates this claim by comparing the Canadian and American economies after the crash of 1929. The former permitted branch banking and the latter did not. The former had a miniscule amount of bank closures in response. In sum, Free Banking is a stable system which would exhibit an interest rate representative of societal time preference, deter business cycles, resist shocks, and experience the slow and steady deflation caused by productivity gains (Selgin writes a lot about a gradually declining price level).
How does the existence of free banking prevent the business cycle? He adheres to ABCT, does he not?
Austrian free bankers don’t consider changes in the money stock to accomodate changes in the demand for money as distortionary.
Why? Wouldn’t that have the same effect? And also why would banks only increase the money supply when there was a change in money demand?
IMO, the reason that FRB is not inherently fraudulent is simply that a “demand deposit” is a loan from the depositor to the bank: not a bailment. Specifically, it’s a call loan: i.e. a loan which can be called in by the lender (depositor) at any time. The bank borrowing money on call loans and then lending it out to profit on the spread is no different than the bank borrowing money on term loans and doing the same.
If inflation is a sufficient condition for the business cycle, then there will be business cycles in free banking, but they should be muted and localized, since banks won’t be inflating as much and won’t be inflating in unison.
Neodoxy writes,
Why? Wouldn’t that have the same effect? And also why would banks only increase the money supply when there was a change in money demand?
I’ll answer the third question first. Inside money should be thought of as liabilities to the banks. To issue liabilities, banks need to have certain capital reserves; that is, a bank’s ability to increase the liabilities side of its balance sheet depends in its assets side. As inside money, bank notes are a liability. The ability to issue bank notes is therefore constrained by claims on the banks’ assets. In a market with competitive money, there will be an adverse clearings mechanism between banks, where a bank’s notes will be returned for outside money (and outside money will be used to meet net incoming liabilities [incoming liabilities minus outgoing liabilities, the latter referring to other banks’ notes]). An increase in the demand for money, or an increase in cash balances, will cause a fall in the “velocity” of money, which here simply refers to either being in or out of circulation. A reduction in incoming liabilities allows the banks to increase the liabilities side of its balance sheet. On the other hand, a fall in the demand for money will increase the amount of incoming liabilities, forcing banks to contract that side of their balance sheet. (Excess money issued will be spent, since it will be in excess of individuals’ preferred cash balances.)
Regarding the capital structure, free bankers might see it this way (as I do): an increase in the demand for money, or an increase in preferred cash balances, will reduce the quantity of money in circulation. This also means less spending on consumption: savings. A common critique is that someone can also hold money that would have gone towards investment. I see it as being a similar case: suppose that at a point (t) in time x amount of money goes towards investment. At t+1 a quantity ‘y’ (that would have gone towards investment) is added to firms’ cash balances, meaning that x-y money is being spent on investment. A bank can issue ‘y’ quantity of fiduciary media to maintain the quantity of money in circulation, including maintaining the quantity of money being spent on investment.
But, this has all been debated to death, and I can understand why someone might disagree.
Yes. The time it takes for an expansionary bank to induce non-clientelle to redeem said bank’s notes is less than the time required for a business cycle. Why is this? A business cycle requires a steady acceleration of credit to bloom, so to speak. If a central bank decides to expand its credit issuance from N to N+1 as a general rule, some malinvestments will be made and there will be some inflation, but prices will be reasserted by consumer preferences as the money works its way through the economy. Consumers have not altered their time preferences so as to free up resources for an ‘capital structure elongation’ and the real ratios between goods will be unchanged. A steady of acceleration of credit is required to thwart the tendency of prices to reflect the underlying ratios between goods. Just as business cycles require acceleration of credit expansion, it is exactly acceleration of credit expansion which will force a bank, acting without the coordination of its peers, to raise its reserves to meet note redemption of non-clientelle (this is explained in Human Action, page 434 of the pdf). If there is no way to coordinate the inflation of each bank then business cycles could only occur from the unlikely coordination of credit expansion between competitors.
@Neo
How is it that ABCT won’t occur under free banking? Because capital scarcity is the heart of ABCT and there is not a way under free banking for that capital scarcity to be concealed by unilateral inflation. The inflation to which we all refer when discussing ABCT pertains to a unilateral inflation impossible in the free market. When the Fed lowers interest rates or buys a bunch of assets, it isn’t as though consumers have lowered their consumption at all. Nonspecific capital is still being employed in the lower stages of production to a degree does not permit new projects in the higher stages. Actors, under the artificially cheap credit, will start a bidding war for capital towards the higher stages of production. The higher purchasing power of new dollars does not alter the essential capital scarcity, which had after all prevented these types of ventures from occuring in the first place.
What is different under free banking is that that kind of unilateral inflation is not possible. The faster a bank tries to accelerate credit expansion, the faster it brings about a state of affairs in which it must redeem notes with money, meaning that any possible business cycle will be self-terminating. Unless all the banks freakishly, against their individual self interest, decide to inflate in coordinated acceleration.
Fractional reserve banking is no mysterious scheme of con artists. It doesn’t necessarily need a federal central bank or a printing press to “work”. It could be done in pure gold, provided that people could borrow or lend money to one another.
It’s really just risky business. People that don’t really need their cash right now deposit their money with a banker that pools it all. The banker separate a reserve, and lends the rest to people that really need cash right now.
The reserve is there just because some depositors may want to withdraw their accounts before the banker gets back the loans he made.
There’s no money creation here. Only a market model that shifts cash resources in time, from where it’s less urgently needed to where it’s more urgently needed.
Some people want money right now badly, and they’ll agree to pay interest for it later. And some people will gladly take the deal, because they aren’t in need of their cash presently.
This could be done over the counter, and it is between friends and relatives. But a big problem is to find a counter part. A corporation can make things much more effective by pooling resources at both ends of the transaction.
So the banker intermediate these transactions and tries to keep the books balanced. But since they are not coordinated in time he needs to keep an operational reserve of cash with him, in case some of his depositors come and cash out.
There’s always the risk though. If too many depositors come and take more money than there’s in reserves, or if too many loans default, the bank risks insolvency, and needs cash fast to pay out it’s depositors. So it takes loans from other banks or asks shareholders for capital injection bailout. If these measures are not available or are not enough to meet the obligations, it files for bankruptcy (bust) and has it’s remaining assets liquidated between his creditors following some priority criteria.
Of course this operation is complicated, since he makes money on the fraction he lends, and the greater this fraction, the smaller the reserve, and the greater the risk he goes bust. The banker needs to evaluate his expected shortfall and use this evaluation to size his reserve in order to accommodate the level of risk/reward he wants to set. This is not easy to do, and of course, it can’t be done if one’s goal is to make money with zero risk at all.
And, of course, any business corporation eventually ends.
That means that, maybe sooner, maybe later, that fractional reserve bank will either shut down loans, get payments and payback his depositors, creditors and shareholders, or be absorded by some other banking operation. But it is more likely that it will live in relative good health until it eventually collapses in a big bust.
Those are the many ways any business can “fail”. Some failures are more gracious and organized than others. And some are just inexplicable. Even a corner street hot dog van can end up being randomly destroyed by a wild meteor.
Fractional reserve banks tend to end that way.
But even when they fail spetacularly, that doesn’t mean their whole existence was a “mistake”. It could have been, but not necessarily.
As the bank exists, it provides useful services to the millions of people that use it one way or another. An enduring bank leads to returns and dividends to share holders, good deals to partners, good salaries to employees, and useful financial services to clients.
And throughout the bank’s successful existence it touches many share holders, partners, employees and clients, mostly positively, that is, in accordance with their expectations.
Of course, when the bank goes bust, all the extant financially related people may loose money and it’s of course a disaster for them. But once it occurs, it doesn’t mean that fractional banking “doesn’t work”, or even that that particular bank “didn’t work”.
That fractional reserve operation worked until the day it didn’t work anymore. Just like the ice-cream shop around the corner, that lasted 50 years and closed doors yesterday.
Bankruptcy of a given business is not some final testament of it’s failed market model and it’s pointless existence. It’s just the fate of almost every business. They work and make money until the day they don’t.
Some business can see bankruptcy coming from a distance. Falling sales and profits, lost market share, lost of technological edge, etc. Banking doesn’t have the same good fortune. A bank bust can come after a good run of profits, with no much warning.
Of course after the fact everybody can find some plausible explanation and causal relationships, but that doesn’t mean it was a strictly predictable scenario before the fact.
That randomness scares people, but that’s just how it is.
This is not so different from asset managers and hedge funds. The major difference being that in these funds the manager temporarily locks the capital of investors instead of counting on them not cashing out together due to his statistical assumptions on their behavior. They proceed to use these funds to do same thing as bankers, except that they more elaborated strategies and niches for investments.
Hedge funds go bust all the time. Just like banks did in the the past, before the central banking system managed to “correct” that.
And there’s no major problem with that. People investing on, working in, or running these funds know exactly what they are doing and what’s in stake.
Some austrians seem to argue that a bank issue paper certificates of (say) gold deposits to its depositors, and these papers worth “full gold” in that bank, and due to the banks credibility, are used as cash in transactions by depositors.
And then the bank “creates money” by issuing and lending new certificates, without deposits backing them.
So the extant money mass is “augmented” to account for this newly created certificates, if we decide to count money as paper certificates “in circulation”.
Well, you can see like things like that. But actually this new money created has a “negative counter part”, as the debt contracted against the bank which has issued it.
And both sides sum up to zero.
That is, once the bank gets payed back its loans, the corresponding amount in fiat certificates are accordingly destroyed.
And therefore there’s no runaway inflation.
If people actually do pay back their loans, they need to refrain from future consumption and save according to what they already owe plus interest.
So the net result is only time shifting of consumption behavior between people, mediated by the bank.
Of course, some of the loans can default, so the bank needs to destroy issued certificates accounting also for what’s been defaulted, otherwise he is reducing his proportional reserve, which may be undesired due to risk augmentation. But that’s one of their expected costs of doing business.
There’s no essential difference between this and the fractional system with pure gold checking accounts and no transferable cash substitutes issues, except that the depositors do not need to go to the bank to cash out, they can simply transfer their ability to go cash out at the bank to someone else, which may be convenient to them.
These papers are evidently risky and may be transacted at a discount face value due to that. Of course that discount depends on the comparison between the risk worth perception and the expected transaction costs of going cash out the face gold and using it as money or some alternative substitute.
If these costs are too high and the risk is low, these papers may even exchange at higher than face value.