Surely that’d be to do with the return FRB can give. If you are making interest on your deposits, you can pay interest to people who deposit.
Toward a General Theory of Error Cycles by Hülsmann has quite a bit on this.
http://homepage.newschool.edu/het//schools/bullion.htm
The Bullionist argument was straightforward. If banks are not required to convert notes into gold, then they will be tempted to issue notes in excess of the gold in their vaults. This will lead to an excess supply of money and hence, by their view, a cheapening of the price of money, i.e. inflation. They argued that to avoid inflation, required convertibility of notes into gold should be restored. Among the spokesmen for the Bullionists were Henry Thornton and, a bit later, John Wheatley and David Ricardo (1810, 1811).
In contrast, the Anti-Bullionists appealed to some form of the Real Bills Doctrine of John Law (1705), Sir James Steuart (1767) and Adam Smith (1776). Given the afore-mentioned peculiar, long experience of Scottish banking with inconvertibility, this authorship is not surprising. Banknotes, Smith had argued, were issued by banks in exchange for merchants’ bills of exchange. As long as the repayment of these bills of exchange is credible (i.e. “Real Bills” as opposed to “Fictitious Bills”), then no more banknotes will be issued than what is required by merchants. In short, the demand for banknotes by commerce is itself limited by the “needs of trade”, hence even without convertibility, the bank is not going to issue more notes than what commerce demands. Thus, there will never be excess note issue.
If there happens to be excess issue by accident, however, this still would not cause inflation as it would return immediately to the banks upon the liquidation of the bills of exchange. This was called the “reflux principle” and was part of the Real Bills Doctrine. Among the Anti-Bullionists who espoused this doctrine in the early 1800s, we find Richard Torrens, Bosanquet and James Mill.
…
The Bullionist Henry Thornton (1802) provided an admirable critique of the Real Bills doctrine. Namely, he asked, who guaranteed that the demands of commerce were limited? Suppose actual capital yields returns higher than the rate of interest (or discount) charged by the banks? Would not merchants’ demand an interminable amount of notes - however “real”? Bills offered for exchange into notes, he argued, might not readily be “limited” as the Real Bills advocates argued. Inflation must thus ensue. Thornton’s analysis formed the germ for the later “cumulative process” of Knut Wicksell (1898).
Thanks you for your responses.
There are still very fundamental issues that are the heart of this debate, which I don’t feel you have adequately addressed. At least not in any convincing manner.
Will the FRB system create new money? The standard analysis of credit expansion throughout the banking system suggests that the answer is clearly Yes. You at one point said No with the example of the single bank", but I think we then said (and you did not refute it) that with the entire system, there will be a credit expansion of 100 X M. If there is new money involved, I fail to see how this new money is different economically from the counterfeiter, except that the bank is given a special privilege. The counterfeiter is not just “something that is undesirable” as you suggest, is it?
The second fundamental issue is whether FRB could prosper to the extent of just 2% reserves in a true free market. If you suggest that it will, but perhaps to a minor extent, then I would think that it is compatible with the typical Austrian theory. Even with Rothbard’s. But I don’t see how as I believe you did mention before, along with White, that it could operate with as little as 2% reserves. You haven’t given a clear reason as to why the new money, as a result of the multiplying factor, does not cause the business cycle. You at one point claimed that no new money is being created, but I don’t think you have given a convincing explanation for why it doesn’t.
Professor Selgin,
I am relieved to read your thoughts on fractional reserve banking. Although I think very much like an Austrian economist, I have never understood the common Austrian objection to fractional reserve banking. Your piece Should We Let Banks Create Money? clarifies and expands upon some of my own thoughts. As soon as I heard Rothbard’s critique of fractional reserve banking, my spider-sense began tingling. Something was wrong; it just didn’t add up. I am surprised that more people here do not feel the same way.
Thanks!
the model proposed could readily be insantiated by an entrepeneur willing to relocate and do business from Vegas, i await the experiment with some anticipation.
I understand the model, but I still don’t like it. I just can’t understand if is possible that banks should start deflating (can it happen? what would its causes be?), and how banks could handle that.
Other thing I just don’t get:
You mean that more industrialization will be encouraged because rates of return “appear” greatest? What is the difference from a non FRB system where rates of return “appear” smallest but, adjusting to the increasing purchasing power of money because of more productivity, is actually the same that of those “higher” FRB rates of return?