It seems that the Spanish edition of Theory of Free Banking, published as La Libertad De Emisión Del Dinero Bancario, is now available from Unión Editorial. Pass it on!

And yes, I am working on a real post.

(This is another piece originally written for the now-defunct Free Market News Network. Although the piece is mainly aimed at “Rothbardian” claims to the effect that fractional-reserve banking is inflationary, advocates of free-banking are sometimes also guilty of exaggerating the influence of banking-industry structure on inflation, as some do, for instance, by suggesting that bank deregulation alone will serve to combat inflation. Generally speaking, an economy’s rate of inflation is mainly a function, not of the reserve ratios kept by its banks or of whether banking is a free or heavily regulated industry, but of the nature of it’s base money regime.)

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Certain economists of the Austrian School, and followers of Murray Rothbard especially, oppose fractional reserve banking for at least three reasons. They claim that banks resorting to it defraud people, that they bring about business cycles, and that their activities cause inflation. This article addresses the last claim only: I hope to discuss the others separately.

The “Rothbardians,” as I’ll refer to them, recognize two distinct meanings of the word “inflation.” One meaning—which they prefer—defines it as any increase in the nominal stock of money, including fractionally-backed bank deposits and notes (which they, following Ludwig von Mises, prefer to call “money substitutes”). The other, which is in common use today, defines it as any ongoing increase in the general level of prices, that is, as a positive rate of change in one or more broad price indexes, such as the CPI. In calling fractional reserve banking “inflationary” Rothbardians often seem to have the latter, more conventional definition of inflation in mind, and my arguments are mainly aimed at responding to their complaint so interpreted. However, in doing so, I also hope to clarify the extent to which fractional reserve banking does or doesn’t promote “inflation” in the less conventional and more strictly Rothbardian sense of encouraging growth in the (broad) money stock.

Perhaps the simplest way to assess the price-level consequences of fractional reserve banking is to first imagine an economy in which such banking is prohibited, as many Rothbardians insist it ought to be. Such an economy would admit 100-percent reserve or “warehouse” banks only. To simplify the comparison further, let’s assume that all exchanges are conducted using warehouse bank certificates: in other words, the reserve medium itself—let’s assume it’s gold—doesn’t circulate. The price level adjusts so as to equate the supply of and demand for gold, including bank reserves.

Assuming fixed levels of demand for both money and non-monetary gold, there can be no inflation in this system, in either sense of the term, so long as the gold stock also remains unchanged. That stock could increase, however, as a result of gold mining. For the sake of argument, though, let’s assume that available gold mines have all been exhausted, and that no new discoveries are forthcoming. By assuming that available gold is not consumed—in the sense of being gradually used up—by industry, we can rule out deflation as well.

Suppose next that fractional reserve banking is legalized and that, Rothbardian warnings notwithstanding, it becomes so popular that all the old warehouse banks embrace it. Will inflation result? Of course it will—but only for a time. As fractionally-backed notes (or deposit credits) take the place of their 100-percent reserve predecessors, the demand for monetary gold, and hence the demand for gold in general, declines, causing the value of gold to decline with it. Because prices are expressed in terms of an (unchanged) gold unit, the price level has to rise. But as the demand for gold doesn’t drop to zero—banks still hold some reserves, and there is still a non-monetary demand for gold—the price level eventually reaches a new equilibrium. All this assumes, by the way, that the switch to fractional reserves is worldwide: if the switch was limited to a single, small country, then banks in that country would export their unneeded gold reserves to the rest of the world, and worldwide price level changes would be negligible.

The overall extent of the increase in prices, and of the underlying expansion of fractionally-backed bank money, will depend on the reserve ratio banks settle on. The lower the ratio, the higher the rise in prices. But whatever the ratio turns out to be, the system will eventually reach a point at which inflation ceases. The move to fractional reserves results, in other words, in a permanent, once-and-for-all price level change, but not in any permanent change in the inflation rate.

What’s to keep the banks from further reducing their reserve ratios? The answer is that, so long as they all compete on an equal footing, as in a free banking system, each will be inclined to routinely return claims, such as checks or banknotes, received from rival banks. The uncertain flow of such interbank “clearings” generates a demand for reserves for settlement, which (in the presence of positive costs of default) will vary with the volume of outstanding bank liabilities, even if bank customers never bother to withdraw gold. Although optimal reserve ratios are unlikely to remain perfectly constant over time, and may decline gradually as more efficient settlement procedures are discovered, for the most part the rate of inflation under an established and mature fractional reserve arrangement is unlikely to differ substantially from the rate that would prevail under 100-percent reserves.

Admittedly this conclusion depends on the assumption of an unchanged real demand for money. If the demand for money grows over time, as it does in most healthy economies, that growth will in fact have different implications for inflation under the two regimes. Yet it still won’t promote inflation in either case. On the contrary: in the 100-percent reserve case, growth in money demand must cause prices to decline at a roughly corresponding rate (“roughly” because there may be some shifting of available gold from non-monetary employments to bank reserves). Under fractional-reserve banking, in contrast, there will be greater scope for monetary expansion, depending on how free banks are from legal impediments. Under free banking, for example, banks can “stretch” their reserves somewhat as the demand for money increases, provided that the increase takes the form of a fallen velocity of money. This happens because the fall in velocity translates, ceteris paribus, into a fall in both the volume of bank clearings and the demand for reserves. In other words, in the presence of economic growth, a free fractional-reserve banking system, although it won’t promote inflation, will be somewhat less deflationary than a 100-percent reserve system.

If fractional reserve banking isn’t to blame for inflation, what is? Inflation could break out because of new precious-metal discoveries, or cheaper means for extracting metal from existing mines. Experience suggests, though, that metal-driven inflations aren’t likely to be serious. The California gold rush, for instance, barely caused a blip in most measures of the price level (the monetary expansion it sponsored was quickly overtaken by offsetting growth in money demand). Likewise, the so-called “price revolution” of the 16th century—a quadrupling of European prices that was at least partly due to the inflow of gold and silver from the New World—translated into an average annual inflation rate of below two percent. Of course even normal gold production will tend, other things equal, to raise prices, but industrial consumption and secular growth in money demand will have the opposite effect. In the long-run, if history is any guide, these forces will tend to cancel out—and will do so whether banks hold fractional reserves or not.

Responsibility for really serious inflations belongs, with only rare exceptions, to central banks, and especially to central banks (or other government agencies) that issue irredeemable fiat money. The monopoly privileges central banks enjoy, and their monopolies of paper currency in particular, give them much greater powers of monetary expansion than ordinary commercial banks enjoy, by freeing them from the discipline of routine clearing and settlement. Because other banks are denied the right to issue their own notes, they treat central bank notes as reserve assets—and will tend to do so even under a gold standard. The central bank is then free to expand—and to encourage other banks to expand with it—until inflation proceeds to a point where gold can be had more cheaply by cashing in its notes than by buying it in the open market. A central bank that issues inconvertible fiat money can, of course, expand without running into any material checks. It is no coincidence that all of the world’s great inflations have taken place in fiat money regimes.

The claim that fractional reserve banking as such is inflationary is unfortunate, not merely because it is theoretically as well as factually wrong, but also because it diverts attention away from central banks and government authorities—the real culprits behind any serious inflation—while pointing a finger at ordinary commercial bankers, who are at most guilty of making use of new reserves that central bankers generate. In this way Rothbardians unwittingly give credence to central bankers’ claim that inflation isn’t their fault: that its cause rests in private-market developments that they—“inflation fighters” all—are doing their utmost to combat.

So it’s time to dump the rhetoric linking inflation to fractional reserves. Fractional-reserve banking may have its drawbacks, but a tendency to fuel inflation isn’t one of them, and the chief beneficiaries of claims to the contrary are none other than the world’s central bankers and their apologists.

For a couple of my books, actually, which have recently become available in new editions.

Good old Liberty Fund has made a Kindle version of The Theory of Free Banking, which you can download for free from its Online Library of Liberty.

And my pals at the Independent Institute have just released the paperback version of Good Money, which they sell for just $22.10. That might not seem terribly cheap for a paperback, but bear in mind that this one reproduces the hardback’s generous color-plate insert. Besides, it’s a damn good book.

Personally I think the relative prices are about right. Not that I don’t like The Theory of Free Banking.: it’s just that I’ve come to think that an ounce of convincing history is worth at least a pound of theory. And what writer doesn’t imagine that he’s learned a thing or two about writing in the space of two decades?

But you needn’t take my word for it. Just get them both, and decide for yourself!

Back in 2001, supermiddleweight boxer James Butler was heavily fined and barred from the sport for sucker-punching his opponent instead of congratulating him after being bested in a match.

Alas, there are no similar penalties for late sucker punches delivered after economics debates, or else the BBC-sponsored Hayek versus Keynes debate held at the LSE last month might have been Lord Skidelsky’s last. For yesterday his noble lordship delivered a most ignoble below-the-belt blow to his late opponents in the shape of a Project Syndicate column titled “The Keynes-Hayek Rematch.”

Here, among other things. Lord Skidelsky suggests that Keynes “savaged him [Hayek] while he was still alive,” and that Hayekian ideas have only succeeded in gaining popularity since thanks to Hayek’s having long outlived Keynes–as if Hayek’s growing popularity wasn’t itself mainly posthumous, and as if Keynesian ideas have lacked huge battalions of defenders, both in and out of the academy, since his death. He writes as well that only “Hayekian fanatics” could possibly not believe that the “global stimulus of 2009 stopped the slide into another Great Depression”–a statement that, besides dismissing as “fanatics” a large number of persons, including some pretty good macroeconomists who are no more Hayekian than Lord Skidelsky himself, seems rather brash. He repeats the slur, which I took pains to expose as such during the debate, that Hayek favored doing nothing to combat a post-boom collapse of spending, likening Hayek’s stand to one of “denying blankets and stimulus to a drunk who has fallen into an icy pond, on the grounds that his original trouble was overheating.” He also repeats the claim, refuted in my last post, “that public-sector austerity at a time of weak private-sector spending guarantees years of stagnation, if not further collapse.” Finally, Lord Skidelsky declares that “Hayekians have nothing sensible to contribute” (my emphasis) to the debate concerning the extent to which “strengthening the tools of macroeconomic management”–meaning (presumably) further expanding government spending and indebtedness as well as further strengthening central banks’ powers–is likely to prove beneficial and prudent.

To the last assertion, an astute commentator offers a most appropriate reply. “It’s hard to believe,” he observes, that the observation in question, among others noted,

was written by the same man who, half a dozen years ago, said of Hayek, “The particular threats to liberty that he identified may be on the wane—his book has done its work well—but there are other threats, and the victory of liberty is never secure. Hayek’s key message for us today is surely this: every new restriction or regulation should be judged by its effect not just on the problem that it is designed to solve or the danger that it is designed to avert but by its effect on the system of liberty as a whole. If we are blind to this, we will be left with a damaged system of liberty long after the particular problem or danger has passed away.”

“That, however,” the commentator continues, “was upon receiving the Manhattan Institute’s $50K ‘Hayek Prize.’ Perhaps they ought to have spread out the payments!”

It turns out that, when Lord Skidelsky was given it back in 2005, the Hayek Prize was worth only $10 thousand. I leave it to readers to decide whether to wish it had been more, or that it had been less.

As I pointed out in a previous post, in the course the BBC/LSE “Hayek versus Keynes” debate the Keynesian side made some claims to which I had no opportunity to respond. My earlier post addressed some of them, but left another alone. This was Lord Skidelsky’s claim, aimed at Great Britain’s current riot-provoking austerity campaign, that no government has ever achieved a speedy recovery from a recession by clamping down on its spending or reducing its indebtedness.

But there is at least one instance of economic recovery–and hardly a trivial one–that contradicts, or at least very much appears to contradict, Lord Skidelsky’s claim. This is the United States’ rapid recovery from the deep recession into which it sank in the last half of 1920.

In many respects the boom-bust cycle that started in April 1919 was typically “Hayekian”: during the boom year ending in April 1920 the Fed held its rediscount rate at 4 percent despite rising money market rates. Commercial banks took advantage of the low rate–as they’d actually been encouraged to do by the Fed–by borrowing from the Fed in order to re-lend at a profit, causing bank loans and investments to increase by just over 25 percent. General prices, and prices of commodities and land and other factors of production especially, in turn rose more rapidly than they had since the Civil War, exacerbating a gold drain that had begun with the armistice. Under the circumstances a reversal was only a matter of time.

When it came, the reversal was both sudden and sharp. Commodity prices tumbled from an index value of 248 in May 1920 to one of just 141 the following August, while consumer prices witnessed their greatest rate of deflation ever. Businesses were unable to pay their bills, industrial production fell by an unheard of 30 percent, and almost 5 millions workers lost their jobs, bringing the unemployment rate, which had been less than 2 percent, to just below 12 percent. Yet by August 1921 recovery was well underway. What’s more, it was so swift that by the spring of 1923 unemployment had given way to a pronounced labor shortage, while industrial production reached a new peak.

Did the U.S. government hasten the recovery by means of deficit spending and other “stimulus” programs? Not in the least. instead, it stuck to conducting business as usual which, in those naive days before Keynes revealed that prudence and thrift were shopworn Victorian shibboleths, meant reverting to its prewar budget and retiring its wartime debt. In other words, it followed what would today be called an “austerity” policy, and did so to a degree that makes recent austerity measures in Great Britain and the U.S. seem downright profligate. Instead of spending more than it had been, the Harding administration steadily cut expenditures, exclusive of debt retirement, from just over $6.4 billion in fiscal 1920 to just under $3.3 billion in fiscal 1923–a whopping 45 percent! As a percentage of GNP, Randy Holcombe shows, Federal outlays fell from just over 7 percent to well under 4 percent.* And although its revenues also declined over the same period, from about $6.7 billion to about $4 billion, the government nevertheless devoted a large share–almost $1 billion–to reducing its indebtedness. As Benjamin Anderson, who was at the time an economist employed by Chase National Bank, observes in Economics and the Public Welfare (1949),

The idea that an unbalanced budget with vast pump-priming government expenditure is a necessary means of getting out of a depression received no consideration at all. It was not regarded as the function of the government to provide money to make business activity. It was rather the business of the United States Treasury to look after the solvency of the government, and the most important relief that the government felt that it could afford to business was to reduce as much as possible the amount of government expenditure, which had risen to great heights during the war; to reduce taxes–but not much; and to reduce public debt.*

Turning to monetary policy, although easy money did contribute somewhat to the recovery, the contribution was minor and largely unintended. Thus while the Fed banks gradually lowered their discount rate from 7 to 4 percent between 1921 and 1922, 4 percent was not especially low in light of the rapid deflation then in progress. And despite the rate lowering commercial bank rediscounts declined, as banks preferred reducing their indebtedness to the Fed to taking advantage (as they regretted having done earlier) of opportunities to re-lend borrowed funds at a profit. The Fed also made what was at the time an unusually large open-market purchase of government securities. But this only served to further reduce commercial bank rediscounts, and was moreover done, not with any intent of stimulating recovery, but solely so that the Fed could earn enough revenue to cover its expenses and pay promised dividends to its commercial-bank shareholders.

Proponents of Keynesian pump-priming often berate the Hoover administration for its “liquidationist” strategy for dealing with the outbreak of the Great Depression–forgetting that it was Hoover himself who caricatured Andrew Mellon, his Secretary of the Treasury, as someone who wished to “liquidate” the stock market, farmers, real estate, and so forth, and who took pride in not having followed his advice. But Mellon was also Harding’s Secretary of the Treasury; and Harding, unlike Hoover, trusted him. It is one of the greater ironies of economic history that “liquidationist” policies, including government austerity, are blamed for prolonging a depression for which those policies were set aside, while being denied credit for perhaps helping to end one in which they really were put into practice.

*Sentences added 8/20/2011
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Addendum

On very rare occasions, when it regards a broadcast as having been particularly well-received, BBC Radio 4 rebroadcasts the same program for a third time. I’m very pleased to say that it has chosen the Hayek versus Keynes debate for this honor, and will therefore air it again, for the sake of regular listeners who missed it (and can’t be bothered with podcasts) on August 24th. Yo Hayek!

This morning over breakfast at the neighborhood bakery, I read a very nice article in the New York Times concerning the “unconventional” views of Kansas City Fed President Thomas Hoenig–views that have made Hoenig my own favorite Fed insider for some years now. Hoenig’s beliefs, as summarized there, struck me as being virtually the same a those I’d put forward in London in what I considered to be a defense of Hayek’s thinking about business cycles. Consider:

“The central bank has to be, in a way, a neutral player, and yet we find ourselves trying to stimulate, and the effect is further leveraging,” he said. “If I thought zero rates would bring jobs, I’d want it forever. But it distorts the economy.”

He continued, “In 2003, when we lowered rates and kept them there because unemployment was 6.5 percent — look at the consequences.” Those consequences included the nation’s mortgage feast, followed by its current economic famine.

Returning home, I read this comment from Bill Woolsey on David Beckworth’s blog:

I am a bit of an ABCT skeptic, but I am more and more concerned that using a commitment to keep interest rates low in the future is the most likely way to generate malinvestment. In my view, the way to avoid malinvestment despite errors in monetary policy is for people to understand that future short term rates will reflect future conditions. An investment project that is only profitable if short term rates are maintained into the future, is an error. And, by the way, having the Fed purchase long term bonds to directly lower long term rates has a similar problem.

Although I don’t call myself an Austrian economist, and am more than happy find fault with arguments by self-styled “Austrians” that I think unsound, I can’t help feeling that Hayek deserves a lot more credit than he’s getting for having put forward a theory which, whatever its general merits may be, seems to fit the recent boom-bust experience so well. So far as I’m aware, Mr. Hoenig never mentions Hayek, and may not even be aware of the overlap between his own thinking and Hayek’s theory. Bill Woolsey, on the other hand, knows about the ABCT, sees the fit to recent experience, but remains a “skeptic.” I wonder whether he is merely indicating his disagreement with those more fervent proponents of the theory who seem to insist that it is the only valid theory of cycles.

In any event it seems to me that anyone who believes that the recent bust is to some important extent a consequence of past malinvestment that was sponsored by easy monetary policy ought to acknowledge the fact that F.A. Hayek spent much of his early career warning against this very possibility, and later won a Nobel prize for the work in question. That something akin to his theory, if not the very thing itself, is now subscribed to by many non-Austrians, either with no mention of Hayek’s contribution or with somewhat grudging acknowledgment of it only, seems to me both strange and unfair.

(Both parts of this article originally appeared, under the title “Fractional Reserves and Economic Development,” on the short-lived Free Market News Network.)

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When Adam Smith first drew attention to the benefits of fractional-reserve banking, those benefits were but a glimmer of far more impressive gains to come. In 1776, the year of the appearance of Smith’s Wealth of Nations, Scotland had only 10 note-issuing banks, the two oldest of which, the Bank of Scotland and the Royal Bank of Scotland, were but 81 and 49 years old, respectively. The note-exchange and settlement system was still in its infancy, so metallic reserves still accounted for about a fifth of issuing banks’ liabilities. By the time of the passage of the Scottish Bank Act of 1845, which placed restrictions on further Scottish note issues, Scotland had almost twice as many note-issuing banks, with coin reserves often amounting to less than two percent of their liabilities. Scottish banks’ had thus achieved a substantial improvement in their ability to invest Scotland’s money holdings productively, and had done so without engendering the least loss of public confidence in their notes.

Although Scotland offers an especially impressive example of the gains to be had from fractional-reserve banking, such banking has also played a crucial role in worldwide economic development. Persuasive evidence of this can be found in two collections of studies, Banking in the Early Stages of Industrialization (1967) and Banking and Economic Development (1972), both edited by economic historian Rondo Cameron. Surveying the findings of the first volume, Cameron concludes that banks, through their “substitution of various forms of bank-created money for commodity money,” played an essential part in fostering industrial development, and that they were most effective in so doing in places, like Scotland in the early 19th century, where they were least hampered by government regulations, including regulations limiting banks’ right to issue circulating notes.

More recent research has reinforced Cameron’s conclusions by showing how “repressive” financial regulations—meaning regulations that prevent banks from functioning as efficient savings-investment intermediaries, such as statutory minimum reserve requirements—have impeded economic growth in less-developed countries. Oppressive banking regulations are especially harmful to poor countries, where money holdings represent are large portion of available savings. Of such oppressive regulations the monopolization of paper currency by central banks is perhaps the most oppressive of all, for it means that a substantial part of the public’s monetary savings is diverted from the private sector, which might employ those savings productively, to the government, which tends to squanders them instead.

As nations become wealthier, the relative importance of fractional-reserve banks diminishes, because the public becomes increasingly able to afford financial assets other than money, including stocks and bonds. Industry can then rely, to some extent at least, on funds acquired by selling securities, instead of having to borrow from banks. Yet bank loans remain a major source of business funding, and of small-business funding especially, even in wealthy nations with well-developed securities markets. In the United States, for instance, businesses today get more than twice as much credit from banks as they get by issuing their own bonds, and many times as many funds as they get by selling shares. In Germany and Japan bank loans account for a still larger share of business funding. And although commercial banknotes have been legally suppressed in most countries, demandable bank IOUs, in the form of demand deposits, remain banks’ own principal source of funds. Without fractionally-backed bank money, in other words, most businesses would have to go begging for credit—as they were forced to do, temporarily, during the banking crisis of the 1930s.

I realize that claims concerning how fractional-reserve banks promote prosperity will carry little weight among those who insist that such banking necessarily entails fraud. It would be tragic indeed if they were right, for then we would confront a stark choice between condoning fraud on one hand and enjoying economic prosperity on the other. Fortunately, though, we face no such dilemma: as I hope to make clear in a later essay, the claim that fractional-reserve banking involves fraud is just as untenable as the claim that it has contributed nothing to the wealth of nations.