Still unanswered quibbles with fractional reserve free banking

Abstract

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.

This is a preview of subscription content, access via your institution.

Notes

  1. 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. 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. 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. 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. 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. 6.

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

  7. 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. 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. 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. 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. 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. 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?

References

  1. Bagus, P. (2008). Monetary policy as bad medicine: the volatile relationship between business cycles and asset prices. The Review of Austrian Economics, 21(4), 283–300.

    Article  Google Scholar 

  2. Bagus, P., & Howden, D. (2010). Fractional reserve free banking: some quibbles. Quarterly Journal of Austrian Economics, 13(4), 29–55.

    Google Scholar 

  3. Bagus, P., & Howden, D. (2011). Unanswered quibbles with fractional reserve free banking. Libertarian Papers, 3(18), 1–24.

    Google Scholar 

  4. Bagus, P., & Howden, D. (forthcoming). Monetary equilibrium and price stickiness: causes, consequences and remedies. Review of Austrian Economics.

  5. Boyd, J. H. (2003). Commentary. In D. R. Altig & B. D. Smith (Eds.), Evolution and procedures in central banking (pp. 220–222). Cambridge: Cambridge University Press.

    Google Scholar 

  6. Checkland, S. G. (1975). Scottish banking: A history, 1695–1973. Glasgow: Collins.

    Google Scholar 

  7. Cannon, J. G. (1908). Clearing houses and the currency. In E. R. A. Seligman (Ed.), The currency problem and the present financial situation. New York: Columbia University Press.

    Google Scholar 

  8. Evans, A. J., & Horwitz, S. (2011). An appeal for better scholarly discourse: how Bagus and Howden have it wrong on free banking. Review of Austrian Economics.

  9. Goodhart, C. A. E. (1988). The evolution of central banks. Cambridge: The MIT Press.

    Google Scholar 

  10. Gorton, G. (1985). Clearinghouses and the origin of central banking in the United States. The Journal of Economic History, 45(2), 277–283.

    Article  Google Scholar 

  11. Gorton, G., & Huang, L. (2003). Banking panics and the origin of central banking. In D. R. Altig & B. D. Smith (Eds.), Evolution and procedures in central banking (pp. 181–219). Cambridge: Cambridge University Press.

    Google Scholar 

  12. Gorton, G. and D. J. Mullineaux. 1987 (1993). The joint production confidence: endogenous regulation and nineteenth century commercial-bank clearinghouses. Reprinted in (ed.) L. H. White, Free Banking, Volume II: History, pp. 318-29. Aldershot, UK: Edward Elgar.

  13. Horwitz, S. (1990). Competitive currencies, legal restrictions, and the origins of the fed: some evidence from the panic of 1907. Southern Economic Journal, 56(3), 639–649.

    Article  Google Scholar 

  14. Horwitz, S. (2000). Microfoundations and macroeconomics. An Austrian perspective. New York: Routledge.

    Google Scholar 

  15. Howden, D. (2010). Knowledge shifts and the business cycle: when boom turns to bust. Review of Austrian Economics, 23(2), 165–182.

    Article  Google Scholar 

  16. Huerta de Soto, J. (1998) 2006. Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stroup. Auburn, AL: Ludwig von Mises Institute.

  17. Kahn, C. M., & Roberds, W. (1998). Payment system settlement and bank incentives. Review of Financial Studies, 11, 845–870.

    Article  Google Scholar 

  18. Koppl, R. (2002). Big players and the economic theory of expectations. New York: Palgrave Macmillan.

    Google Scholar 

  19. Lester, B. (2005). A model of interbank settlement. University of Pennsylvania, working paper.

  20. Mills, D. (2006). Alternative central bank credit policies for liquidity provision in a model of payments. Journal of Monetary Economics, 53(7), 1593–1611.

    Article  Google Scholar 

  21. Myers, M. (1931). The new york money market: Origins and development (Vol. 1). New York: Columbia University Press.

    Google Scholar 

  22. Norman, B., R. J. Shaw, & G. Speight. (2006). The history of interbank settlement arrangements: Exploring central banks’ role in the payments system. Paper presented at the Bank of England’s Past, Present, and Policy conference, “The Evolution of Central Banks: Lessons for the Future”, Nov. 23–24.

  23. Rochet, J. C., & Tirole, J. (1996). Controlling risk in payments systems. Journal of Money, Credit and Banking, 28(4), 832–862.

    Article  Google Scholar 

  24. Rothbard, M. N. (1962) 2009. Man, Economy, and State. Auburn, Ala.: Ludwig von Mises Institute.

  25. Rothbard, M. N. (1988). The myth of free banking in Scotland. Review of Austrian Economics, 2, 229–245.

    Article  Google Scholar 

  26. Sechrest, L. J. (1993) [2008] Free Banking: Theory, History, and a Laissez-Faire Model. Auburn, AL: Ludwig von Mises Institute.

  27. Selgin, G. (1988). The theory of free banking: money supply under competitive note issue. New Jersey: Rowman and Littlefeld.

    Google Scholar 

  28. Selgin, G. (2011). Mere Quibbles: Bagus and Howden’s Critique of The Theory of Free Banking. Review of Austrian Economics.

  29. Shenfield, A. (1984). The Scottish banking system in the eigthteenth and nineteenth century. In P. Salin (Ed.), Currency competition and monetary union. The Hague: Martinus Nijhoff Publishers.

    Google Scholar 

  30. Sprague, O. M. W. (1910). “History of Crises Under the National Banking System”, Senate Document Number 538. 61st Congress, 2nd Session, National Monetary Commission.

  31. Timberlake, R. H., Jr. (1984). The central banking role of clearinghouse associations. Journal of Money, Credit and Banking, 16(1), 1–15.

    Article  Google Scholar 

  32. United States Congress. (1913). Congressional records of the 63rd congress, 2nd session.

  33. Yeager, L. B. (1997). The fluttering veil: essays on monetary disequilibrium. Indianapolis: Liberty Fund.

    Google Scholar 

Download references

Author information

Affiliations

Authors

Corresponding author

Correspondence to David Howden.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Bagus, P., Howden, D. Still unanswered quibbles with fractional reserve free banking. Rev Austrian Econ 25, 159–171 (2012). https://doi.org/10.1007/s11138-011-0163-3

Download citation

Keywords

  • Business cycles
  • Central banking
  • Free banking
  • Monetary equilibrium

JEL

  • B53
  • E32
  • E42
  • E51
  • G21