Response to Horwitz on 100% reserve banking?

Economics Economics Questions
1

Having recently read Steve Horwitz’s Microfoundations and Macroeconomics, I noticed an argument against 100% reserve banking that I don’t think I have seen addressed by advocates of this system. I am interested to know if there have been any responses. The argument is as follows:

Under 100% reserves, savings are split into deposit and time accounts. The latter will have interest rates, which govern how money is allocated for investment purposes. The former will simply store money, probably for a fee. If there is an increase in demand for consumer goods, people will withdraw money from the banks to spend on them, thus reducing the amount of money in the banks and thus increasing the interest rates. This will discourage investment in capital goods and thus prevent malinvestments.

However, what happens if the amount of money withdraw to spend on consumer goods comes overwhelmingly from deposit accounts? This will mean that the amount of money in time accounts barely changes, therefore interest rates will not decrease and malinvestments will occur. Conversely, if there is a decrease in demand for consumer goods but people overwhelmingly store their money in deposit accounts, the interest rate in the time accounts will not decrease, thus deterring the necessary investments in capital goods.

It might be that I have misinterpreted Horwitz’s argument, for which I apologise if so. But in any event it strikes me as an interesting challenge to the system.

2

It’s a ridiculous argument. A ‘deposit account’ (DA) is cash. A ‘time account’ (TA) is cash lent out (i.e. a bond). You can easily use cash to buy bonds, and sell bonds to get cash, as your cash needs change. A DA is but a TA with zero-days to maturity. He needs to explain how/why a change of demand would/should strictly be limited to a single point on the maturity curve, and how is that assumption realistic or meaningful.

An analogy would be: If demand for cars grew but all the extra purchases were Fords, then the price of all other cars would not have changed. If car demand decreased but all the deferred purchases (or sales) were Fords, the prices of all other cars would remain unaffected. Sure, but is the assumption realistic or meaningful, to begin with?

3

However, what happens if the amount of money withdraw to spend on consumer goods comes overwhelmingly from deposit accounts?

Then the amount in the time accounts remains unchanged, right? Now, the pool of money available for investment is exactly what is in the time accounts. That is what people have made available to the banks to loan to businesses, because they will not be able to withdraw that money for a fixed period, and during that fixed period it will be lent to businesses by the banks. Since the amount of money available for businesses to use is unchanged, then it is exactly as it should be if interest rates are unchanged.

…therefore interest rates will not decrease…

I think you have a typo there, it should be “increase”. In any case, we have responded to the argument.

Conversely, if there is a decrease in demand for consumer goods but people overwhelmingly store their money in deposit accounts, the interest rate in the time accounts will not decrease

He is confusing two things. One is a decrease in demand for consumer goods, the other is an increase in money available for investing. In the usual model that ABCT talks about, the two go together. If I don’t want to buy stuff right now, I will put my money in a bank that pays interest for a while, and that money will be available to businesses. In the model he is discussing now, the two are seperated. People do not want to consume as much, and yet they do not want their unconsumed money to be invested. Fine. Since the interest rate is a signal of how much money is available for investment, it is just the right thing that it remain unchanged.

Looking at it from a larger perpesctive, he is introducing the old Keynesian topic of hoarding. Keynes built his whole system on the assumption that people will hoard in a wealthy society, and thought that will create problems. Since there was no way to hoard money in a bank, as the bank will lend it right out, he assumed thehoarding will be under ones mattress. Horwitz is pointing out that with 100% reserve banking, a deposit account will be a very comfortable mattress to hoard under.

Hazlitt has pointed out that historically, hoarding just doesn’t happen on a scale large enough to influence the economy.

jRight now there are safety deposit boxes, which serve the same purpose as Horwitz’s deposit account. I don’t see him arguing that they are messing anything up.

4

Thanks for this. You are correct about my error re increase/decrease: thanks for pointing that out.

I presume the minimum impact of hoarding also addresses the other argument I think he makes: that if people decide to decrease their hoarding and start spending on consumer goods, the resulting uneven price rises, as a result of an increase in the money supply, will be just as detrimental as uneven price rises coming from an increase in the money supply caused by the banks? (Or that, if people decide to increase their hoarding, the uneven price falls as a result of a decline of the money supply will also be detrimental, causing missallocations etc). I don’t have the book to hand at the moment so apologies again if I’ve misinterpreted him.

5

He makes it sound like people will hoard 90% of their cash under the mattress, just as 90% of the money supply now comes from FRB. Seems like an absurd assumption.

6

To go along with Z’s and Dave’s answers:

It depends on whether people withdraw the money from their deposit accounts or from their time accounts. If they withdraw only from the former, the interest rates on the latter won’t change, all other things being equal. However, an increase in demand for consumer goods with respect to money will cause the prices of consumer goods to rise and the purchasing power of money to fall, again all other things being equal.