This is incorrect. Unless you mean that in theory, it doesn’t have to necessarily originate with FRB - then I agree. But then you are just trying to prove too much here.
Not quite. I think his response is a bit misleading.
The issuing of loans unbacked by real savings is what sets in motion the business cycle. All such loans originate in the banking system when banks engage in joint credit expansion that is coordinated by the Central Bank, and is further exacerbated by Central bank injection of new liquidity into the system so that bank can further expand on. However, there were business cycles before Central banks, precisely because banks operated with fractional reserves, although they were always privileged by the State.
It is true that if we had a free banking system that still allowed to operate with fractional reserves, that the natural checks of the free market, i.e., bank runs and inter-banking clearance mechanisms, would keep the amount of fiduciary media to a minimum. This would be a far more stable system.
“You can have a real endogenous change which elevates the natural rate above the market rate”
This implies a market failure of some sort.
Ensuric insists that a purely hypothetical radical change (I would say very unlikely to occur in the absence of government interference) in either demand for money or influx of new money can cause similar intertermporal distortions in the market rate. But the error in his reasoning is the failure to recognize that such a radical scenario is the outcome of voluntary action on part of the individual participants in the market. If market participants lower their time preferences only temporarily and entrepreneurs were deceived, then yes, there would need to be corrections. However, if banks had not operated with fractional reserves, no wide scale banking crises would occur, and no contraction of the money supply could possibly take place, as always does today following the credit expansion of FRB.
“or you can have some exogenous authority suppress the market rate below the natural rate”
As in a government authority issuing the loans directly with fiat money. I would agree, although I think that such bubbles would take on different forms from today’s typical ABCT.
Have you ever read anything Hayek has written? Because whenever I express Hayekian ideas, you seem completely shocked.
"The situation in which the money rate of interest is below the the natural rate need not, by any means, originate in a deliberate lowering of the rate of interest by the banks. The same effect can be obviously produced by an improvement in the expectations of profit or by a diminution in the rate of saving, which may drive the “natural rate” (at which the demand for, and the supply of, savings are equal) above its previous level; while the banks refrain from raising thier rate of interest to a proportionate extent, but continue to lend at the previous rate, and this enable a greater demand for loans to be satisfied that would be possible by the exclusive use of the available supply of savings." -Hayek, Monetary theory and the trade cycle, pp. 77-78
This is basically the main theme of the book. Also, here is talking about increasing the supply of money as capital.
This is how I understand free banking (I have never read anything from the modern day free bankers):
There are three types of economic goods: “consumer goods” (current goods), “producer goods” (future goods), and “media of exchange,” or what is commonly understood as money. No good is trapped within these classes for any definite period of time. They can freely move from one class to the next (classes are not fixed). The rate of interest is expressed by the time preferences of society—that is, by the ratio of demand between current goods and future goods. But there is also a demand for money, the facilitator of exchange. And stable economic activity will exert an influence over this demand, as normal and day-to-day transactions become routinized. When the demand for money increases, and if it is not met by a corresponding increase in the supply of money, then market actors will adjust their purchases and sales in order to achieve the level of liquidity they deem necessary. This will exert an influence on the demand side in the markets for loanable funds, which will elevate the market rate of interest above the natural rate (prices fall faster than costs). Notice, though, time preferences have not truly changed–just the demand for money has changed (ratio of demand between current and future goods remains unchanged). The banking system can also move funds so that the ratio between the demand for current goods and future goods remains basically unchanged (no inter-temporal misallocation). This leaves us with two options (when the demand for money experiences dramatic changes): allow prices to adjust (painful), or satiate the demand for money as money and prevent the unnecessary (bad) deflation.
This is why Hayek says that satiating the demand for money as money is legitimate (but satiating the demand for money as capital is illegitimate). Hayek, though, doesn’t appear to be as optimistic as the free bankers when it comes to free banking itself. But, he makes it clear that it is the best practical option. Also, Bohm-Bawerk states that the entire subsistence fund does not need to be available during the process of production due to its inter-temporal nature. Since capital must flow incrementally, there is no need for a 100% supply of capital for the process of production at all times (I’ve only heard Bohm-Bawerk mention this though).
The key, though, is that I’ve never heard 100% reserves mentioned in any of the pre-Rothbard books/articles I’ve read (Hayek mentions it in Monetary Nationalism and International Stability, but he calls it the “Chicago plan,” and says it’s untenable and “overly simplistic.” Another Issue I have with Rothbardians is that they seem to have moved away from the fact that money, by its very nature, can never be neutral. It always exerts an influence over “real” economic activity, as the demand for money and capital are intrinsically connected in modern economies (Mises stresses this point). Thus, the Rothbardian claim that “any supply of money is optimal” only makes sense in the very long run, when prices completely adjust. Cutting the money supply by 75% will have dramatic and negative consequences. And, again, Hayek mentions that the money supply may fall too dramatically during the cyclical downturn (secondary phenomena).
This is what happens today. The FED buys bonds on the open market, with money it creates, and then increases reserves and pushes down the rate of interest.
Hayek may not have been a 100-percent reservist, but it’s obvious in Monetary Theory and the Trade Cycle that he considers fractional-reserve banking the root of the business cycle. I don’t want to look through the book now, but here are some quotes I’ve written down in an old blog post:
The determining cause of the cyclical fluctuation is, therefore, the fact that on account of the elasticity of the volume of currency media the rate of interest demanded by the banks is not necessarily always equal to the equilibrium rate, but is, in the short run, determined by considerations of banking liquidity.
He does consider 100-percent reserves as “utopian”:
If it were possible, as has been repeatedly asserted in recent English literature, to keep the total amount of bank deposits entirely stable, that would constitute the only means of getting rid of cyclical fluctuations. This seems to us purely utopian. It would necessitate the complete abolition of all bank money—i.e., notes and checks—and the reduction of the banks to the role of brokers, trading in savings.
But nevertheless concedes that fractional reserve banking is the problem:
The stability of the economic system would be obtained at the price of curbing economic progress.
These are not the best quotes, but that Hayek considered fractional reserve banking the problem should be obvious by reading Monetary Theory and the Trade Cycle.
The elasticity of the money supply is a necessary but not sufficient cause of trade cycle fluctuations. When the money supply expands beyond the demand of cash holdings then it will exert an active influence over the demand for consumer goods and investment (producer goods), necessarily altering the ratio between the demand for current goods and future goods. Thus, fractional reserve banking is not the root cause of anything. You have to read Monetary Theory and The Trade Cycle with Prices and Production. The books are somewhat vague (had to read both of them twice). And reading Wicksell is extremely useful since he laid down the framework for Austrian monetary theory (and he’s frequently ignored/dismissed, for whatever reason).
That’s only one condition: "It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, first, the total money stream remained constant, and second, all prices were completely flexible, and, third, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy." –Page 304, Prices and Production.
It also has to be noted that a 100% RR on a gold standard would not keep the supply of money absolutely fixed. This means it will not satisfy any of the three conditions stated by Hayek.
The book is not vague at all. It clearly considers the “current credit organization” as what is responsible for business cycle fluctuations. He spends at least ten pages [at least from p. 79 to p. 90] explaining the process of credit expansion through fractional reserve banking.
Okay, cool, but that doesn’t disprove what you quoted, and in fact reinforces it.
In your article (about the book) you said it was extremely vague, but okay.
The credit organization is the indirect mechanism. You obfuscate the question at hand by taking this unnecessary step backwards in the causal chain. We may as well ask, “what causes fractional reserve banking,” and so on and so forth. Do you agree that if the money rate is equal to the natural rate then there cannot be an inter-temporal misallocation of resources? If yes, then the only logical conclusion is that trade cycles are caused by an artificially depressed market rate relative to the natural rate (the necessary and sufficient condition).
Reinforces what exactly? That 100% reserves cannot prevent cyclical fluctuations? I agree.
Even most prominent free bankers such as Selgin concede the point that 100% eliminates the possibility of the boom/bust cycle.
You just keep ignoring 2 very important aspects of ABCT, which I have already brought to you attention several times:
The bust always reveals a severe mismatch between liabilities and assets causing the bank to be almost instantly insovent.
As credit tightens, a reversal process of credit contraction begins to take place. As the crisis becomes more severe, bank failures accelerate the process of monetary contraction.
Both 1 & 2 are nonexistent in the absent of Fractional Reserve banking. They are a very important part of ABCT.
You are concentrating all your effort on 1-3 papers and that is all. But even those papers should not lead you to such spactacular assertions such as FRB does not cause the business cycle.
That Hayek may have occasionally used terms such as “above natural rate” to describe voluntary action does not prove the entire Austrian perspective as you portray it to be. It certainly doesn’t prove that the choice of words were indeed accurate. you are trying to prove too much with very little.
I said it was poorly written, not that the ideas were vague or unclear themselves.
Then Hayek committed the same mistake, although I don’t see it as a mistake. In the book, Hayek is clear when saying that fractional-reserve banking is why the deviations from the natural rate of interest take place.
If there were other methods by which to depress the rate of interest under the natural rate of interest [and mass immigration is not a means of doing this, as wherever the interest changed to it would still be natural] then one couldn’t suggest that fractional reserve-banking is the only cause of malinvestment. Even if it wasn’t the only cause of malinvestment, Hayek nevertheless makes it clear that it is a cause. So, when somebody says “fractional reserve banking causes business cycles” they would have made an accurate statement.
That a cycle-less economy requires a constant money supply [or, in the case of the constant money “stream”, a money supply which responds only to changes in the demand for money, or the demand to hold cash]. Whether it is the only condition, or one of three conditions, is irrelevant as long as it’s still a condition. It is true, however, that Hayek’s opinions changed quite a bit between Monetary Theory and Prices and Production:
In 1937, Hayek’s stance at the gold standard had changed from his early position. White (1999) suggests that this was due to his switch from the “constant money stock” to the “constant money stream” norm in Prices and Production. This theoretical improvement altered his critique of the gold standard. In 1928, dissenting from Mises’s view, he rejected the gold standard entirely on the grounds that it allows the quantity of gold to vary. Later, in Prices and Production, when warning that an attempt to “drastically … reconstruct our monetary system, in particular to replace the semi-automatic gold standard by a more or less arbitrarily managed currency” poses dangers “much greater than the harm which is possibly done by the gold standard” his position is akin to his teacher’s ([1931 ]1935:127). However, in Monetary Nationalism and International Stability, similar to Schumpeter, he indicates that they are merits in “any mechanical principle (such as the gold standard),” which at least has equilibrating mechanisms for distributing the global money stock among countries (1937:93). Finally, the arguments developed in The Denationalization of Money (1978) led Hayek to again modify his position with respect to the gold standard. He now favors free banking and predicts that in a free competition among different types of money, the public would choose stable-valued private fiat-money over gold.
A footnote says:
The argument runs as follows. Having moved toward the “constant money stream” norm, Hayek now regards the gold’s supply elasticity as a virtue rather than a vice (1948:210-211), providing that the gold stock responds to money demand shifts with an adequate speed and that there exists a “central monetary authority for the whole world” or its equivalent in policy cooperation among national banks (1937:93). See White (1999), p. 114.
This is from: Festré, Agnes, “Money, Banking and Dynamics: Two Wicksellian Routes from Mises to Hayek and Schumpeter”, American Journal of Economics and Sociology, Vol. 61, No. 2. This journal article is also really interesting and covers Hayek’s theories and changes: http://mises.org/journals/qjae/pdf/qjae8_1_1.pdf
How do you know? Mises spoke to you from the grave?
It seems that at least Dr. Selgin is the only modern FRB proponent that has enough courage and self confidence to not claim that Mises was a proponent of fractional reserve free banking. He openly rejects this idea and admits that Mises talked about free banking only as a 2nd best alternative to the current system.
In this first period of reform it is imperative that the American government and all institutions dependent upon it, including the Federal Reserve System, keep entirely out of the gold market. A free gold market could not come into existence if the administration were to try to manipulate the price ceiling by underselling. The new monetary regime must be protected against malicious acts by the Treasury and Federal Reserve System. There cannot be any doubt that officaldom will be eager to sabotage a reform whose main purpose is to curb the power of the bureaucracy in monetary matters.
This obviously isn’t an ideal system hes proposing.
I didn’t know you were a fan of Dr. Selgin, regardless most don’t say he was a proponent of fractional reserve banking what they generally say is that he clearly wasn’t a full reservist.
First of all, the first 2 quotes are not proposals.
Second, if you read the full context, you cannot possibly infer from any of it that he was a proponent of FRB or sees any potential economic benefit. Yet somehow when Mises does propose a reform, he just happens to propose a restriction on the issuing of fiduciary media.
Then what his ideal proposal. Here is his chance! Where in your full “Context” does he propose anything else as some ideal?
I think you have gotten it all backwards.
Fractional reserve free banking out of pragmatic considerations, but 100% reserves as an ideal.
The word “ought” just jumps out at me, its really pretty simple, at no time in any of his work does he call for 100% reserve outside of the current government dominated system. Obviously not a full reservist.
“most don’t say he was a proponent of fractional reserve banking what they generally say is that he clearly wasn’t a full reservist.”
“Only free banking would have rendered the market economy secure against crises and depression.”
Don’t get mad at Mises for not writing everything in one book now, he needed to eek out a living after all.
No, at least, not according to many free bankers out there, maybe Sechrest.
This is not relevant to the issue at hand. This is a result of a government induced artificial expansion, and then deflationary contraction. I’m not talking about, nor do I care about our current system. Our current system is easily understood. I’m talking about pure theory.
First of all, you don’t know what I’ve read. But if you actually paid attention to our last two conversation’s, that is, if you read my comments, you would have noticed that my arguments don’t merely come from “1-3 articles.” I have quoted and cited at least 7 major works: Interest and Prices, Monetary Theory and the Trade Cycle, Prices and Production, Contra Keynes and Cambridge, Monetary Nationalism and International Stability, Theory of Money and Credit, and Positive Theory of Capital (+ whatever I forget to mention).
You, on the other hand, simply dismiss my arguments (fail to address them in anyway), and are shocked (confused) when I raise positions explicitly stated in the works I’ve mentioned above.
I don’t know how to respond to this. Again, you don’t address my argument in anyway whatever. It’s true that our current system (and the system before) tends to (understatement) reduce the market rate below the natural rate. But this has nothing to do with theory. Bad deflation has happened in the past, and many economists have spent a lot of time trying to remedy it. Hayek explains both situations, but focuses on inflationary induced trade cycles (for obvious reasons).
I’m not an American so you are going to have to explain this a bit more for me. (Also if you could quote where Mises calls for 100% reserves outside of the central banking system that would be great.)
And government induces this expansion by means of Fractional Reserve banking.
Why are all the banks insolvent when the bust is revealed? Why does the moneys supply contract? Just because it expands, doesn’t mean it has to contract. Why?
ANS: Fractional Reserve Banking
Remarkable, it’s all a matter of terminology. Mises uses the terms Fiduciary media when describing the business cycle. How does Fiduciary media come into existence if not by Fractional Reserve banking?
