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Still unanswered quibbles with fractional reserve free banking

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Anthony Evans and Steven Horwitz readily admit that their own understanding of monetary theory is imperfect, and do not even “attempt a rebuttal of [our] claims.” George Selgin accepts that some of the arguments we put forward in Bagus and Howden (2010) make for “interesting theory”. He fails to rebuff our claim that precautionary reserves are unable to constrain credit creation in a fractional reserve free banking system. While calling for us to provide historical evidence to validate the quibbles we put forward, Selgin himself overstates the evidence. He also claims that we have distorted what he has written, and that we use incorrect monetary theory. These allegations are false.

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  1. We should note that Evans and Horwitz actually refer to this as their definition of “savings”, which we take them to mean as “saving”.

  2. Selgin cites Norman et al. (2007) as “proof” that interbank settlement systems strove for reduced clearing periods. Yet the theory and evidence provided in the citation in question is not as strong as Selgin believes. He brings attention to one important sentence—namely, that clearing periods occurred “typically more frequently than before” (ibid.: 11)—the operative word being “typically”. We have never argued that banks would never not lengthen clearing periods, unlike Selgin who must rely on this fact to prove a free banking system stable. If the citation Selgin provides demonstrates anything, it is that the possibility for lengthened settlement periods remains open, and that historical cases do, contrary to his claims, exist.

  3. While reducing the cost of clearing liquidity diminishes or minimizes the costs of holding reserves for “unproductive uses” (Evans and Horwitz 2011), there are good reasons why intraday credit should be costly. Rochet and Tirole (1996) and Mills (2006) argue that a positive intraday interest rate compensates the clearinghouse (or central bank) for monitoring and enforcement costs. Kahn and Roberds (1998) show that costs of default are reduced as banks choose less risky portfolios with costly intraday credit. That the costs of this default may not even be borne by the insolvent bank (i.e., in Lester 2005) further supports the case for costly liquidity, and hence, for banks to hold greater amounts of idle and liquid reserves.

  4. Selgin mistakenly attributes to us the claim that credit expansion increases asset values, and that this is useful in collateralizing credit expansion. We actually noted that credit expansion increases the negotiability of some assets, thus reducing the costs of liquidating them, thereby aiding credit expansion. If anyone questions whether negotiability matters for credit expansion, he needs to look no further than the liquidity crisis of 2008. The Fed swapped the illiquid assets of Bear Stearns for highly liquid (and negotiable) assets, primarily Treasury debt. During the boom this was never a problem, as the negotiability of the investment bank’s assets allowed it to inflate in excess of what could otherwise be possible with illiquid assets.

  5. Selgin does note that our theory of central bank emergence is similar to that provided by Charles Goodhart (1988). In a subsequent footnote (fn13), he goes on to criticize the theory, as it does not explain why not every industry faces the same incentives, nor is cartelized in the same result. This point seems curiously contested among our opponents, as Evans and Horwitz advise us to look into Goodhart (1988), in an attempt to see how central banks emerge naturally. The crux of our original argument is that central banks do emerge naturally in response to some very well defined motives. As for why these motives are distinct from other industries, we address that point below.

  6. This period only partially encompasses the period commonly defined as free banking in the United States, 1837–62.

  7. Selgin does not understand why we find his assumption that inside money is not converted for outside money in a fractional reserve free banking system to be problematic. Indeed, if one wants to build a theory of unregulated banking on some key assumptions, those assumptions should be, as Selgin (1988: 16) notes, “realistic” and “based on actual experience.” The failure of all free banking regimes to continually convert inside to outside money casts doubt on the realism or historical accuracy of this assumption. For those who doubt how germane the assumption that demand for money signifies only the demand for inside money is to Selgin’s arguments, we refer the reader to Selgin (1988: 37, 60fn18, and passim).

  8. Another plausible source of this regulatory role being centralized is the appearance of deposit insurance. In America’s case, however, deposit insurance did not make its appearance until 1933, 20 years after the Federal Reserve.

  9. In this respect, then, the private clearinghouse went one step further than the current Fed. As the loan certificates were the predecessor of today’s discount window, we see one key difference. Any observer can identify which modern bank makes use of the Fed’s discount window while the private clearinghouses of the past kept this information wholly private.

  10. The latter two sources refer to fractional reserve central banking regimes. When speaking of entrepreneurial forecasting, it is difficult to see how having a myriad of free banks altering the money supply is any easier to plan around then having one centralized agency doing so (and making the figures publically available soon thereafter) (Bagus and Howden forthcoming : section 3).

  11. Yeager (1997) remains the best defense of the rational of price stickiness, as well as providing a foundation for much monetary disequilibrium theory. We address whether sticky prices really warrant nominal adjustments to the money supply to combat their ill effects in Bagus and Howden (forthcoming).

  12. A similar issue arises whereby Selgin requests that we provide the historical evidence theory we provide in Bagus and Howden (2010). Instead of answering (which we have in this paper) why banks allow themselves to succumb to being monopolized one could just as easily pose a similar question back to Selgin: Why would free banks not freely elect to not make use of a central bank’s credit facilities or discount window, instead of allowing themselves to become subordinate to them?


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Bagus, P., Howden, D. Still unanswered quibbles with fractional reserve free banking. Rev Austrian Econ 25, 159–171 (2012).

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