Lawrence White on Fractional Reserves

Economics Economics Questions
21

AEN: What area of Austrian economics is most and least advanced?

MNR: Methodologically, we are pretty advanced, thanks to the work of Hoppe. But we can always use more since that is what sets us apart from the rest of the profession. And Salerno is doing great work on calculation.

Banking theory, however, has taken a very bad turn with free banking. We have to show that this is the currency and banking school argument rehashed. They have adopted the banking school doctrine, that the needs of business require an expansion of the money supply and credit. Moreover, the free banking people violate the basic Ricardian doctrine that every supply of money is optimal. Once a market in a money is established, there is no longer a need for more money. That is really the key point.

AEN: What about the argument that 100% reserves requires government intervention?

MNR: I regard fractional-reserve banking as an intervention in the free market, just as any crime against person and property is intervention. In the case of banking, the government is allowing the crime to be committed.

But how do we address the needs of trade argument, those who say that business has a demand for credit? Well, there are many things demanded on the market that are also crimes. There may be a demand for killing redheads. And there is certainly a demand for government loot. What’s so great about market demand? if it is not within a framework of non-aggression, there will always be a demand for fraud and theft.

The free bankers accept a kind of David Friedmanite anarchism, where there is no law, only people engaging in exchange and buying people out. If you have a group that wants to kill redheads, the redheads will have to buy them off if they value their hair. I think this is monstrous, the kind of anarchism would indeed be chaos. Just because there is a demand for something doesn’t mean it should be fulfilled.

AEN: One of the criticisms of this position is that it is normative and not economic.

MNR: Yes, but the response to 100% reserves is that bank entrepreneurs have the right to offer whatever fraction of deposits they want, which is also a normative position. Any discussion of policy is inherently normative. You can’t have free markets unless you have property rights,

AEN: Why isn’t private deposit insurance viable?

MNR: The same reason insuring any bankrupt industry isn’t viable. You cannot insure entrepreneurs because they engage in uninsurable risk. You can reasonably predict how many fires there will be in New York; the unlucky few who get burned can dip into the pool of resources. But entrepreneurship is not heterogeneous; it is completely unpredictable, and each attempt is non-random. The entrepreneurs assumes the risk. If an insurance company insures it, it becomes the entrepreneur. Who then insures the insurer? In the case of banks, either they don’t need insurance, since they are 100% covered, or they are uninsurable because they are taking entrepreneurial risk.

AEN: You have been critical of White’s book on free banking.

MNR: The White book says the Scottish banking system was more successful than the English system. But he doesn’t say one word about prices, inflation, or business cycles. His only statistic is that were fewer bank failures in Scotland than Britain. But what’s so great about not having failures? An industry that doesn’t have failures might be doing poorly. What if we applied this test to the Soviet Union, where no industries fail?

When you say one banking system is more successful than another, it seems the test should be less inflation and fewer business cycles. Yet this is never mentioned.

22

You are walking a fine line here with this argument and the only reason you can make it at all is because of the special nature of FRB.

Technically, when there is insufficient liquidity to cover due liabilities, any business is considered insolvent. This is why any sound business will rarely engage in a deliberate mismatch between the term structure of its liabilities and assets. Since FRB’s liabilities are due on demand, and there is always insufficient liquidity to cover them, it is not wrong to say that the bank is inherently insolvent, and will be discovered as such if enough of its customers should show up and demand their due money.

The only reason why you can make your argument at all is because of the nature of FRB, that is, most of its customers are convinced that their money is secured in the bank, or at least as is today, guaranteed by federal insurance. So FRB can take advantage of this and keep this going until some inevitable crisis that is just bound to occur at some point in the future.

Mises comes close to this conclusion also:

For the activity of the banks as negotiators of credit the golden rule

holds, that an organic connection must be created between the

credit transactions and the debit transactions. The credit that the

bank grants must correspond quantitatively and qualitatively to the

credit that it takes up. More exactly expressed, ‘The date on which

the bank’s obligations fall due must not precede the date on which

its corresponding claims can be realized.’ Only thus can the danger

of insolvency be avoided.

23

The classical economists saw money as a veil which covered “real economic activity.” Money is not a passive agent–Austrians, more than any other school, should understand this. The demand for money and the demand for capital are intrinsically linked in a capitalistic market economy. Ricardo’s position is false.

False dichotomy. No Austrian believes that the banking system is a passive agent which only reacts to demand conditions. Both Mises and Hayek never denied the organic automatic adjustment mechanism–they merely elucidated the fact that this mechanism must necessarily break down when there is a banking cartel or a central bank (Mises explicitly says that this process exists when there is actual competition). The argument is that 100% reserves (never mind the fact that it’s impossible to implement and regulate) must necessarily elevate the market rate above the natural rate causing persistent deflation (bad and unnatural deflation). I can’t see the connection between the Banking School and Hayek. Furthermore, Mises readily acknowledged the problems of an invariable currency, and Hayek explicitly states the need for an elastic currency.

  • “In fact, the development of the clearing system and fiduciary media has at least kept pace with the potential increase of the demand for money brought about by the extension of the money economy, so that the tremendous increase in the exchange value of money, which otherwise would have occurred as a consequence of the extension of the use of money, had been completely avoided, together with its undesirable consequences.” (pp. 333) Theory of Money and Credit
  • “A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy. If regard to the behavior of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then–apart from an extension of its clientele–it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even f it has also completely misapprehended its cause.” pp. 347 Theory of Money and Credit.

This was a direct response to Wicksell’s so-called “hypothetical construct” (one bank representing the entire banking system). Mises showed that this scenario is not hypothetical at all. The Rothbardian’s seem to forget that Austrian monetary theory began with Wicksell in 1896. The argument is that a free banking system is better because (a) 100% reserves are impossible to implement, and (b) will keep the market rate at or near the natural rate (while 100% reserve elevate the market rate above the natural rate). No one says that free banking is perfect.

Bankers have always chosen fractional reserve banking, going back all the way to the Medici’s. In fact, the only region to ever accept 100% reserves was the middle east, and this was forced upon the banking system by Sharia law (and even then they got around it).

At least he acknowledges that. Either way, the free bankers have some theoretical problems, but the Rothbardian’s arguments against fractional reserve banking are never economic in nature. Their defense is entirely contingent upon their own personal ethical judgments (and people don’t care about Rothbardian ethics).

24

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25

No, he doesn’t come close at all. In fact, he flatly denies this assertion:

  • "The expressions solvency and liquidity are not always used correctly when they are applied to the circumstances of a bank. They are sometimes regarded as synonymous; but orthodox opinion understands them to refer to two different states. (It must be admitted that a clear definition and distinction of the two concepts is usually not admitted.) A bank may be said to be solvent when its assets are so constituted that a liquidation would necessarily result at least in complete satisfaction of all its creditors. Liquidity is that condition of the bank’s assets which will enable it to meet all of its liabilities, not merely in full, but also in time, that is, without being obliged to ask for anything in the nature of a moratorium from its creditors." -pp. 368, Theory of Money and Credit.

I don’t know where you got your definition from.

26

You misinterpret this statement completely. It’s unbelievable that you can do this, given the quote by Mises that I had just provided above from the same book! (pp. 263, online version of Money & Credit).

“also in time” means precisely what I have said above - That there must be a match between the time structure of liabilities and assets. The maturity of both should match in time.

"without being obliged to ask for anything in the nature of a moratorium" -without having to break the terms of the contract by seeking legal autority to defer payments.

This isn’t a statement of support for Fractional reserves, it’s a condemnation!

Reread this quote by Mises together with the quote that I had provided by him above, and perhaps it will be more clear of how you have grossly misinterpreted Mises.

This argument is a fallacy. It amounts to the same old myths about the detrimental effects of holding money.

Mises refutes this terrible fallacy and you are somehow managing to revive it by sprinkling around quotes that you insist on misinterpreting.

Because there really isn’t one! Rothbard is attacking White and his followrs. Not Hayek!

You are attributing to Hayek ideas that he did not support. I too can start to sprinkle around quotes by him that show he is a supporter of 100% reserves.

When someone examines the operation of banking in the absent of government interference and concludes that there are built in mechanisms to curb and limit expansion, it doesn’t follow from this that he sees a benefit to Fractional reserves.

27

A free banking system with no government, FDIC or central bank intervention would be a vast improvement over what we have now here in the U.S. Modern banking did evolve from fraud in my opinion, but this is not to say that it is without benefit or that it currently remains fraudulent. As a funny, yet poignant example, professional wrestling was born of fraud as well, but it provides a valuable entertainment benefit to society nonetheless. Modern banking is not fraudulent because banks do not engage in deceit of deposit holders.

In free banking, individual banks would be compelled to police themselves because with the FDIC and it’s implicit government backing gone, depositors would have a strong preference for banks with high reserves and sound balance sheets. In cases where the books were cooked, the government would have a role in criminally prosecuting those responsible.

It’s neither possible nor feasible to completely eliminate risk. A free banking system that inherently promotes sound lending and high reserve ratios is preferable to a government mandated 100% reserve requirement.for banks.

One other note to Clayton’s argument: you state that only 100% reserve banks would survive in a free banking system - do you really think that a 90% reserve bank would fail? I mean, what’s the probability that 90% of depositors all run to the bank within a short time frame and liquidate their accounts? Given that 5.7% of people don’t watch TV, 1% of people can’t read, half a million people are in the hospital, many more in nursing homes, etc. Even for a small bank, it would take a monumental effort to deliberately round up 90% of depositors and convince them to liquidate all their funds. My point is that there is some natural point that reserve ratios would gravitate towards, quite a bit less than 100%, and certainly more than the small percentage seen today.

28

I’m not talking about fractional reserve banking (I did that in my other post); I’m talking about the definition of liquidity and solvency. Fractional reserve banks are not “inherently insolvent,” period (they are inherently illiquid).

Your never ending stream of empty assertions, and your general dismissal of Austrian theory (in the broader sense), is extremely irritating. There are no detrimental effects of holding money–I don’t believe in the “paradox of thrift.” There are detrimental effects of selling goods you don’t want to sell and limiting purchases (when your time preference remains unchanged) in order to get the level of cash you deem necessary (past a certain level). You conflate your own interpretation of Austrian economics with actual Austrian economics (Austrian economics is not homogeneous).

29

Okay. So what? They are still going in front of a bankruptcy judge.

30

If you must insist, they are insolvent the moment the customers show up to exercise their contractual right to cash out their deposits. As long as they don’t, you can consider them inherently illiquid.

Do you know of any other business that conducts its business in this way on a regular basis, except for government welfare schemes and madoff sytle Ponzi-schemes?

Here is another question for thought. You don’t have to reply.

Money is unique in its characteristic of perfect liquidity, according to Manger and Mises. Not high liquidity, but perfect liquidity. So how can individuals in a free market possibly accept the use of liabilities in the form of bank notes or demand deposits, as money (perfect liquidity), when even according to you, they are backed by assets that are not perfectly liquid?

???

Good. So there is no need for any elasticity of money to relieve some alleged demand for money, or more accurately, demand for fiduciary media.

You always imply this by insisting that there is some inherent problem with 100% reserve banks.

What’s actual Austrian economics, I have no idea. I can just say that the notion that some elasticity is required, whether provided by government or free market fractional reserve banks,is a very serious deviation from Misesian economics.

31

I already gave you a word-for-word quote, from the Theory of Money and credit, which explicitly defines both terms, and elucidates the differences between them. If Mises’ isn’t an authority on this, then I don’t know who is. When liabilities > assets (not money proper), you are insolvent.

Because they’re money substitutes and not money. People don’t like carrying around bars of gold, so they deposit them at banking institutions, get paid interest, and use notes. The note circulation cannot exceed the demand for notes, for if it does, the bank will compromise its own position and the credibility of its notes (and its competitors will hoard its notes and seek redemption).

The works of Menger, Bohm-Bawerk, Wicksell, Hayek, Mises, Kirzner, Rothbard, Lachmann, Hazlitt, Reisman, ect.

The theory of money and credit took the Wicksellian framework (laid out in Prices and Interest) and showed that (a) neutral money is illusory, (b) the organic adjustment mechanism breaks down when there is no competition amongst banks (Wicksell’s “imaginary construct”), (c) explained the origins of money (solved the so-called “Austrian circle”), and (d) took Wicksell’s insights and developed an exogenous theory of business cycles (this is debatable–Hayek says that Mises’ position is purely exogenous, but I don’t agree). He did not, in anyway, attempt to refute Wicksell or his framework. You can have bad deflation–it exists.

32

I don’t need a lesson in how money substitutes evolved. I was referring to Fractional reserve banking and not warehouse banking so why are you evading the question with a lesson on money substitutes.

So they use notes backed by assets that are not perfectly liquid as money. There goes Manger’s and Mises’ theory on money out the door, right there!

This doesn’t address at all the contradiction of people using money substitutes that are not backed by perfect liquidity. I don’t need an explanation of why free banking can work better then the present system.

You can have a lot of bad things that exist. So? It doesn’t follow from this that Fractional reserve free banking can alleviate some alleged problem with holding money. You are so inconsistent on this matter. Is holding money detrimental or not? If not, then you don’t need FRB regardless of whether there is such a thing as “bad deflation”.

Anyhow, here is the biggest fallacy of them all: That demand for fiduciary media always amounts to a demand to restrict consumption on the part of the individual, as contended by the modern free bankers.

33

Well, good riddance!

The problem is excessive demand to hold money.

34

What? I mean, I don’t know how to respond to this. Can you please tell me what you’re trying to say. What is Mises and Menger’s theory of money? How does the introduction of money substitutes invalidate their theories?

What contradiction? They wouldn’t be “money substitutes” if they were money proper.

The world isn’t as simple as you would like it to be. If everyone held all of their money for an extended period of time, starting tomorrow, it would be very bad; if the money supply was cut by 75%, for example, it would also be very bad (worse then it needs to be). The point of the market is to assure that prices (including the interest rate) move towards the level determined by the interplay of subjective valuations.

35

I meant this to be some food for thought. that is all.

I am not talking about any money substitutes but specifically fiduciary media. They are not the same.

Money is not a high liquid asset but a perfect liquid asset. To claim that people knowingly accept notes backed by assets that are not perfectly liquid is to also claim that it must not be true that one of money’s primary characteristics is its perfect liquidity. You cannot have it both ways. This is why it is quite unlikely that fiduciary media can evolve in a free market without deception.

The use of fiduciary media as money doesn’t necessarily invalidate this fact about perfect liquidity if and only if the market participants are

  1. tricked into thinking that they are backed up by perfect liquidity

or

  1. government guarantees liquidity by its power to use force.

You are evading the question.

How can it possibly be above the natural rate when everything you are describing is directed by voluntary action?? Natural rate is the market rate, and market rate corresponds to voluntary action. Your assertion doesn’t make any sense. Natural rate is the result of whatever the voluntary action of market participants is. Don’t try to evade this by saying that “the world is not as simple as is”.

This is the modern free banking position. It is their sophisticated way to enjoy both worlds; Mises and theories about elasticity.

I thought you said that you do not hold the position of the modern free bankers. (I saw that comment before you removed it before).

I can easily put a hole in monetary equilibrium theory based on the works of other Austrians. Would that satisfy you? You can then evaluate the validity of their criticism on your own.

Again, I don’t want to argue about the concept of bad deflation. The market is run by humans and they could be behaving in some stressful way for what ever reason.

I simply object to the claim that the rate is elevated above the natural rate when people hold money as oppose to some system providing elastic currency.

This is tantamount to saying that holding money is detrimental which is starting to be more in line with Keynes then with Mises.

36

What happens when the market rate is elevated above the natural rate?

This is the Austrian position. I don’t want to debate this bullshit with you anymore (which is why I edited my last comment). Mises and Hayek both supported an elastic money supply (though they acknowledge its problems).

  • “In fact, the development of the clearing system and fiduciary media has at least kept pace with the potential increase of the demand for money brought about by the extension of the money economy, so that the tremendous increase in the exchange value of money, which otherwise would have occurred as a consequence of the extension of the use of money, had been completely avoided, together with its undesirable consequences.” (pp. 333) Theory of Money and Credit

  • “A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy. If regard to the behavior of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then–apart from an extension of its clientele–it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even f it has also completely misapprehended its cause.” pp. 347 Theory of Money and Credit.

  • “No doubt that the statement as it stands only provides another, and probably clearer, formulation of the old distinction between the demand for additional money as money which is justifiable, and the demand for additional money as capital which is not justifiable.” -Hayek, Prices and Production, pp 297.

  • “The ultimate goal is to prevent the credit superstructure from running away in either direction.” -Hayek, Monetary Nationalism and International stability.

  • A possible, although perhaps somewhat fantastic, solution would seem to be to reduce proportionately the gold equivalents of all the different national monetary units to such an extent that all the money in all countries could be covered 100 percent by gold… Such a plan would clearly require as an essential complement an international control of the production of gold, since the increase in the value of gold would otherwise bring about an enormous increase in the supply of gold. But this would only provide a safety value probably necessary in any case to prevent the system from becoming all too rigid… I am afraid all this must be admitted, and it considerably detracts from the alluring simplicity of the 100 percent banking scheme. It appears that for this reason it has no also been abandoned by at least one of its original sponsors…" -Hayek, Monetary Nationalism and International stability, pp. 412

No you can’t.

If the demand for money skyrocketed, and if the money supply was cut by 75%, there would be enormous problems. What Hayek called “secondary shocks.”

37

Mises had made it clear from the beginning. That any supply of money is optimal. There is no social benefit from tempering with the supply. I don’t know how you can possibly reconcile that with your statement above.

You’ve basically only read Mises’ first work and you profess to know what the Misesian position is. You read 3 other papers by Hayek and you know the Austrian position. Give me a break! Move on.. Read at least Human Action before you declare what the Misesian position is.

Anyhow, all of the quotes that you have provided are out of context. Some of them don’t support anything you say at all. You are misinterpreting many of them.

For example:

They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even f it has also completely misapprehended its cause." pp. 347 Theory of Money and Credit.

In in its full context, Mises is showing the superiority of competitive banking vs central banking. That in the absent of a single uniform interest policy, banks will tend not to overextend their issuing of fiduciary media. That is all! This certainly doesn’t mean that Mises is in the opinion that elastic money is necessary. There are just so many other quotes, even in “Money and Credit” that don’t do justice to your assertions at all. So what, you just ignore the rest?

Good argument. Is that your reason talking or your pride.

And all of the references to Hayek about “secondary shocks” etc.. are all analysis of statist policies. It’s amazing that you are interpreting this stuff in any other way.

The obsession with the problem of the public’s demand to hold money is a curious one for people who supposingly attack Keynesians for their fallacious “pardox of thrift”.

But here is the main problem in your examples:

How can the money supply be cut by 75% with a 100% gold system??? You are simply all over the place misapplying and misquoting Hayek. (this tone is for your “bullshit” remark above).

I think somewhere in your analysis you tend to forget that the 100% gold standard is extremely inflexible to contractions and would render such violent and abrupt deflationary pressures practically impossible. As far as demand is concerned, it would likely decrease and not increase, as purchasing power is expected to gradually increase. I seriously think that you are misapplying Hayek, who is usually talking about contractions in the modern world of monetary expansion and contraction.