Is the banking dilemma eternal? It doesn’t have to be, writes James Grant. We could desocialize credit risk and let the bank runs take their toll. Absent federal meddling, the bottom line would be simplicity itself. The proof that banks have created excess credit would be found in the action of markets. It would be a fascinating picture if not a pretty one. FULL ARTICLE
Source link: http://blog.mises.org/9541/bring-back-the-bank-run/
Bring Back the Bank Run!
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Joe,
I just noticed that this site has already cover the real bills doctrine with an article by Robert Blumen titled “Real Bills, Phony Wealth”
In the article he calls John Law a “monetary crank” and says about real bills:
Real bills (like fractional reserve banking) is a complex rationalization by intelligent monetary cranks.
The problem with fractional reserve banking is exactly the same as with real bills. No true savings back the scheme.
With fractional reserve banking there is a production of claims against money (bank deposits) that doesn’t exist. This means that those who believe they have cash holdings that they don’t. This is inflationary and causes it to appear that there is more money in circulation that there actually is.
True savings, the actual goods saved in order to accumulate cash holdings ends up running behind the actual savings that people have. This leads everyone to believe throughout the system that there is more savings than truly exists. Thus savers end up saving less, and borrowers end up borrowing more.
So you end up with a financial boom but unfortunately there is just not enough saved goods to match the borrowers plans, nor the money supply at the original prices. Eventually their plans collapse as the inflated money supply bids up the goods they were planning to get at the original cheaper prices before monetary inflation lead to price inflation. They then cannot pay their loans and the whole pyramid scheme collapses.
Then the depositors, bankers, and borrowers all run to the government to force others to pay for their scheme.
I know there are libertarians who believe in “free banking”. I just think that they are monetary cranks. The system is unstable and given human nature will naturally lead to the expansion of the government.
When you associate fractional reserve with free markets you are claiming that freedom entails the right to defraud. This ultimately will cause people to reject true freedom when they get defrauded. That’s because most people are not intelligent enough to make the connections even after it’s been explained to them, and even fewer will figure it out on their own.
I’m a really sharp guy and I don’t think I would have been able to figure it out had I not rested on the shoulders of intellectual giants of the past.
what’s more, john law died penniless.
That’s right, freedom does not entail the right to harm or defraud. that would be anarchy, which may be what we already have.
When banks create or use funds intended for other purposes such as “storage” they gain from the result of other’s labor. They demean other’s labor and goods and create unearned wealth for themselves.
When the risk is removed, either thru the FDIC or bailouts, it not only facilitates this fraud but causes malinvestment that only increases unearned wealth.
A libertarian who believes in freedom from harm and injury cannot support reserve banking.
If the depositor wants the money stored that is fine, if he wants it invested that is also fine, but it is his money and his choice and he should reap both the risk and the reward. As it is now, he experiences the risk as a taxpayer funding the insurance and the bank receives the return on the depositor’s funds which represent his product.
If you let a house represent the depositor’s funds, the bank says it will “manage” and care for the house to prevent damage. The bank then rents the house returning an amount equal to a month’s rent to the depositor and keeps the rest. By this and other activities the bank lowers the value of the house by increasing the quantity of money.
If say a hurricane comes along while the bank is renting the house out, and destroys the house, the bank turns to the government to get its “rent profit” back and maybe even the depositors money, if necessary.
The example shows the depositor’s value has been “rented out”, devalued and any catastophic occurence is paid for again by the depositor taxpayer. If this is a fair and just system, then so be it!
The real bills critics seem to miss at least three points:
1) If a bank issues 100 paper guilders, backed by various assets with a market value of 100 oz. of silver, then those guilders will trade in the market for 1 oz. each. If the assets fall to 90 oz., the guilders will trade for 0.9 oz. If the assets rise to 95 oz., the guilders will rise to .95 oz. This is a risk people take. Requiring the bank to hold only silver is unnecessary and unlibertarian.
2) If that same bank issues 200 new guilders, and receives various new assets worth 200 oz. in exchange, then the bank now has 300 guilders backed by 300 oz. worth of assets, and each guilder remains worth 1 oz. each. There is no inflation. The additional guilders might displace barter or other currencies, or they might be kept in mattresses.
3) If other banks issue 500 florins, backed by various assets worth 500 guilders, then each florin will trade in the market for 1 guilder. But the issue of florins will not change the fact that the original bank still has 300 oz. worth of assets backing 300 guilders, and so the issue of florins (which can be thought of a ‘derivative’ guilders) will not affect the value of guilders. No inflation is caused the the issue of either kind of money. Inflation only results when the amount of backing per unit of money falls, as would happen with counterfeiting.
Brian Macker:
Thank you for your thought-out response. You wrote much that is worth considering though I take exception with some of it. I will respond in due course.
While I digest your posts and formulate a response, I would like to draw your mind to a request that I have now twice made to you. While we have both written quite a bit, I had hoped that I made clear that this is what I would most like to hear from you. But you have remained silent on it.
I respost something that I first directed to you on March 9:
As I see it, there are two primary facts about current money. 1) It is not convertible into gold or any other base money, and 2) it is managed by a government granted monopoly.
You seem focused on 1). Your focus has some merit. A free market bank that indefinitely suspended convertibility should be challenged. Indeed, I don’t believe that it would survive long. But don’t you think that 2) may have an important role to play?
While the other points that you raise are worthy of discussion, this is of most interest to me. I am disappointed that you have not addressed it.
[As an aside and prelude to one point on which I will respond, I was aware of the history of the Mississippi Bubble but was unaware of John Law's connection to RBD. If I may be taken as an adherent of RBD, it is through personal reflection and not through a devoted study of its literature. In any case, what I most want to say here is that any history that you find of this character will very clearly tell of formal monopolies granted by the French government.]
Not defending John Law nor his theories, I have some comments on his relation to this discussion. People have raised his bad reputation as supporting their position against his theories. Now, it is worth considering the reputation of a person who tells you something. I won’t deny that. But it is nothing compared to careful direct analysis of the theories in question.
For the lack of direct knowledge that I am confident all of us have here, John Law’s bad reputation may be unearned. Earned or not, I expect better of the people posting here than character assassination.
Hi Mike,
I have a problem with #2 in your comment above.
2) “If that same bank issues 200 new guilders, and receives various new assets worth 200 oz. in exchange, then the bank now has 300 guilders backed by 300 oz. worth of assets, and each guilder remains worth 1 oz. each. There is no inflation. The additional guilders might displace barter or other currencies, or they might be kept in mattresses.”
Now, correct me if i am misunderstanding this, but if the bank “issues” 200 new guilders, there will be inflation.
Any asset that the bank receives is already represented by some currency. The asset is represented by labor and resource or someone who “paid” for these and the bank is “issuing” or creating the money. How would this not cause inflation?
How can an asset be “new”? If you percieve it as “new” and representing new value to be backed by new currency, you have to completely discount the labor and resource that creates the “new” value. They must be valued at zero for each of the guilders to remain at 1 oz.
Isn’t this the same logic that banker’s use to “discount” the depositor’s funds?
Brian Macker:
Thank you for your link. I first read the article written by Nelson Hultberg that prompted Blumen’s piece. I highly recommend it though don’t necessarily agree with everything in it. I will reference sections of it later with comment.
I am still working through Blumen’s article. I have only one interesting observation for now. Blumen attributes RBD (or “many of the key concepts”) to John Law. Meanwhile, Hultberg attributes RBD to Adam Smith!
Anyway, a search turned up a paper written by Antal Fekete, the primary source for Hultberg’s paper. I have not read it in its entirety. But it appears to be appropriate reading for us. This paper is a rebuttal to Blumen’s article.
Joe:
A quick summary of John Law: (See my “Quick History of Paper Money”) He and the French regent started a company that owned, among other things, the land we nowadays call the Louisiana Purchase. The company issued stock, which soared in value, and paper money, which initially held its value. After a few years, people realized that the land would never be developed. At the same time, the company issued more paper money than it could redeem. Assets went down while liabilities went up, leading to a crash in both the stock and the paper money, exactly as the real bills doctrine would predict. When a company fails and its stock falls, you wouldn’t claim that it proved that stock’s value was not determined by its backing. Yet real bills critics point to episodes where money lost backing, and hence lost value, as a proof that the value of money is not determined by its backing.
There is money in the form of bank notes and coins, and money in the form of « money substitutes». Those last ones can be used as money, that is to say, to be used as an intermediary of exchange in markets transaction.
When we deposit a certain amount of bank notes and coins in a bank, this amount is inscribed in an bank account in our name. This «account-money» can be used as an intermediary of exchange in markets transaction i.e. as money, but only if in this account we can withdraw and put money as we wish, wich account is often called a transactional account. A demand deposit account is one of this kind.
Another way to see it, it’s to say that with one 100 $ we make two !
It is this operation that can give the impression that «money can be in two places at once». In fact, we can say that it is the case if we talk about «money» as bank notes and coins + money substitutes, instead of money as bank notes and coins only.
to joe stoutenberg:
if you research john law carefully, you’ll find his actions betrayed him as a scoundrel, so i’m not indulging in gratuitous character assassination. elisabeth currier has a good podcast on him: http://mises.org/media.aspx?action=search&q=currier
i thought macker addressed your queries just fine, and i can’t see that the blumen article missed anything, but yes, a central bank is going to worsen any inflationary tendencies through cartelization of the banking sector.
fekete’s version of the rbd (from memory, his is pretty much along adam smith lines) makes less sense (more arbitrary limitations) that mike sproul’s, but i don’t think sproul correctly described his critics views of rbd.
we’ve argued this endlessly over the blogs: the problem of banks issuing credit against the value of the collateral posted is the positive-feedback loop this sets up. that is, if banks target real estate as acceptable collateral, and loan accordingly, the freely available credit impacts on the price of property, which goes up, the higher valuation allows successive credits to be increased, and so forth. bubble, bubble, toil and trouble.
sorry for mangling your name, joe.
Gerry, yes i see what you are saying. The only reason this is permitted is to allow banks to “profit” on money they didn’t earn or truthfully manage. It is money creation.
newson:
“Character assassination” may have been the wrong term. Really, there is a term for a logical fallacy based upon rejecting an argument because you can find something wrong with a person espousing. I don’t care to look it up. But that’s what I meant. No reason to dwell on that issue.
I still haven’t had a chance to finish my reading. I’ll hold off on further comments until I do.
Joe,
Adam Smith was six years old when John Law died. So Blumen is correct.
Why didn’t you accuse me of character assassination with regards to Marx? I spoke the truth about John Law. He was a money crank.
The reason I’m not focused on 2) is because I believe we all agree on 2) already.
I think it should be obvious that if I think fractional reserve banks are problematic that adding governmental ad-hoc non-fixes is going to be worse. In fact, a central bank exacerbates the problem already inherent in FRB, as does a fiat currency.
If you car is running slow because of a flat tire then of course adding nitro to the fuel mix isn’t the way to go. Mike claims we should let air out of all the other tires, so I’m disputing that, not the fuel.
That’s why I wasn’t focused on 2). In reality I’m not focused on 1) either in this particular conversation. One could use a stable quantity of paper money as a “base money”, although the temptation to print is too much for politicians to handle.
Fractional reserve banking fails even with a fixed quantity of fiat money. I only used the example of convertibility into gold order to make the problems easier to grasp. Fractional reserve doesn’t magically start working with fiat currency. One can still have bank runs with such a system. It’s still fraudulent to claim one has the paper to back deposits when one doesn’t.
Fiat currency has it’s own problems however. As Zimbabwe shows.
“Yet real bills critics point to episodes where money lost backing, and hence lost value, as a proof that the value of money is not determined by its backing.”
The value of money isn’t determined by it’s backing. It’s determined by it’s value as a medium of exchange.
Gene:
You seem to be saying that the 200 oz. worth of new assets backing the 200 new guilders was already spoken for by some other claim. If this were true the bank would not have accepted it in exchange for the money–just as a bank will not lend you money on your house when you’re already loaned up on it.
Newson:
“if banks target real estate as acceptable collateral, and loan accordingly, the freely available credit impacts on the price of property, which goes up, the higher valuation allows successive credits to be increased, and so forth.”
–The initial issue of money is adequately backed, so it does not drive up the price of anything. The self-perpetuating cycle never gets off the ground.
Brian Macker:
“The value of money isn’t determined by it’s backing. It’s determined by it’s value as a medium of exchange.”
–That, of course, is the very point in dispute. You claim that money, alone among all financial securities, is valued independently of its backing. I claim that money is valued just like any other financial security–because of its backing. Your theory implies, among other puzzles, that if the US dollar starts being used in Mexico, then the peso will fall, and the US government will get a free lunch. You’d have a hard time explaining how so many so-called fiat moneys manage to survive rivalry from other currencies. The real bills view has no such problem. It implies that all moneys have value according to their backing, and so do not lose value as rival moneys appear.
mike sproul says:
“–The initial issue of money is adequately backed, so it does not drive up the price of anything. The self-perpetuating cycle never gets off the ground.”
the first loan may well be adequately collateralized (naturally, it’s the start of the boom), but each successive loan’s valuation refers backwards to most recent prices of the asset in question, which have been affected upwards by the easy availability of credit directed towards that asset etc.
Newson:
At first, there are 100 guilders backed by various assets worth 100 oz. After a new issue of money there are 300 guilders backed by various assets worth 300 oz. Each guilder must remain at 1 ounce, or there will be arbitrage opportunities. For example, if guilders fell to .9 oz., the banker would eagerly buy them back for 270 oz and walk away with the remaining 30 oz., or speculators would eagerly buy them all for 270 oz., then claim the 300 oz. worth of assets held by the bank. I assume that you’d say that the prices of goods in general would remain the same when measured in silver. But if the guilders are unchanged relative to silver, then the guilder still buys as many goods as before. Price inflation never gets off the ground.
to mike:
first, as the bank of amsterdam instance showed, arbitrage doesn’t operate smoothly, nor is information flow perfect (especially if the directors run a good smokescreen: think madoff’s ponzi). the boa notes only came to be traded below par years after the bank had breached its 100% reserve charter. as long as this misinformation persists, the bank’s loan-book can be grown, feeding into higher prices for whatever assets it’s using as collateral.
second, your rbd example shows an isolated bank, missing the big picture. the inherent fragility of the model means bankers band together through mutual interest and expand their liabilities in unison, and more gravely, use political means to enforce suspension of specie payment when arbitrage does eventually take place (bank run).
Mike,
“That, of course, is the very point in dispute. You claim that money, alone among all financial securities, is valued independently of its backing. I claim that money is valued just like any other financial security–because of its backing.”
Money isn’t a financial security silly. Empirically you are wrong because after Saddam fell and therefore the old Iraqi notes were completely unbacked they continued in circulation, and in fact became more valuable as they were reduced in quantity. They should have become worthless immediately according to your theory.
Likewise the US dollar. Why hasn’t it immediately fallen to it’s current backing. Same with the paper monies of the past. All of which were “unbacked” long before people stopped using them, or devalued them.
“Your theory implies, among other puzzles, that if the US dollar starts being used in Mexico, then the peso will fall, and the US government will get a free lunch.”
The first is not necessarily true empirically because there are so many other impinging factors, like Mexican law. The second is empirically true for other countries. We are getting a free lunch by reducing the backing of the dollar (running up debt), look at the trade deficit.
We did so in the past also by printing more money that we had gold deposits. Foreigners only caught on later and as they tried to redeem we closed the window.
Individual banks can and do the same as newson pointed out.
Hi Mike,
I am simply saying that there are no “new” assets.
Whatever “new” asset you are talking about is a product of labor and resource. These two building blocks of all assets have to be accounted and paid for. They have a “cost”.
You are [by the example] permitting banks to do exactly what they do on a daily basis, print money and pay for assets that have been previously paid for with real money, labor and resource, by others. This is the fundamental fault of reserve banking and fiat money. It doesn’t matter that the money is “backed”, it is of no use if the money is backed by other’s work or assets and printed by the bank, it is still theft, if the money came from nowhere.
When the fed imagines new money and when the banks use reserve banking to double[almost anyway] the amount of depositors funds, they are “purchasing” goods and paying for them with play money. Someone else, the depositor or whoever had to pay for the asset originally, had to use “real” money that represented labor and resource.
Any printing of money is receiving payment without work. It is breaking the rules of exchange, exchanging something for nothing.
Newson:
If a bank loses backing, and people don’t know it, then the bank’s money won’t fall. Similarly, if the Ford factory were hit by an asteroid, and stock traders didn’t know it, Ford stock would hold its value until the word got out. This does not invalidate the theory that money, and stock, are both valued according to their backing. It just means that uncertainty and information play important roles.
And so what if bankers expand their liabilities in unison, if they expand their assets as well?
Brian:
When a loss of backing is undiscovered for awhile, money holds its value for awhile. Speculators can also make the opposite mistake of under-valuing a currency–just like with any financial security.
Gene:
If you collect rent on some land, and if you pay your grocer with your own IOU (a ‘gene dollar’), then that gene dollar could circulate as money, because everyone knows that you will accept it in payment of rent. There is no theft occurring here. The gene dollars are backed by your land, even though that land was ‘produced’ long ago and is not ‘new’.
We must not forget that money itself is a creation.
In a primitive economy based only on barter, there is no money. Money is a creation, an invention, of a more advanced economy.
Thus, money creation by itself is not necessarily a bad thing: it’s even a very good thing !
Hi Mike,
you are right but it is a completly different example than your first. I did at some point “pay” for the land, right? That would be an example of resource only but still holds. The land has value and the person issuing the money [me] owns it and has paid for it, if someone wants to accept the paper I hand them as value, that is their choice. Either way, you are saying that the money I issue is backed up by the land that I own. This example would be the same as, the bank owns a piece of land and issues a note to someone as payment backed up by the land the bank owns. i would agree to that as totally kosher if both parties agree.
Conversely, the new money the bank issues is not backed up by anything, if i understand your previous example [#2]. It is printed and exchanged for something someone else paid for with real money. The bank has bought something that is real for something that is imaginary [new money].
It would be analagous to me printing money and not owning the land. Why would anyone accept that money?
“When a loss of backing is undiscovered for awhile, money holds its value for awhile.”
The fact that the Iraqi bills were un-backed was common knowledge. They had no other medium of exchange so the used the bills.
Besides, US treasury bills are currently completely “unbacked” yet people use them.
You are confusing money with bank deposits. Your banking scheme backs deposits and banknotes with collateral backed loans.
Gold had no “backing” and is used as money. Wampum had no “backing” and was used as money. Rocks had no “backing” and was used as money.
Gerry,
I agree, money certainly augments trade and exchange. It is “profiting” on money creation that I don’t agree with [aside from printing costs that is!].
That’s right, freedom does not entail the right to harm or defraud. that would be anarchy
Please don’t misuse the term “anarchy” like that. Anarchy means only “no leaders” – anarchy is what we want. It does not mean “chaos”.
A libertarian who believes in freedom from harm and injury cannot support reserve banking.
[Presumably you mean "fractional reserve" here]
Peter, yes I meant “fractional”, I only left out the most important word!
I believe I misunderstand “anarchy”.
If no leaders, no government at all, not even minimalist?
What or who prevents harm and injury [which I would see as the minimum]?
The word “anarchy” in its original sense means “no leader” or “no ruler”, but in its current sense means “disorder”, “confusion”, “trouble”.
The sense to give to the word “anarchy” depends on the context in wich it is used, as for many other words.
http://www.merriam-webster.com/dictionary/anarchy
mike sproul says:
“This does not invalidate the theory that money, and stock, are both valued according to their backing.”
actually that’s not what i see as the weakness of rbd. it’s problem is that collateralizing certain assets feeds into the future pricing of those very same assets, setting up the bubble dynamic.
for example, the “backing” of many hi-tech stocks in the run-up to the 2000 collapse was perfectly adequate, until it wasn’t!
us banks two years ago had plenty of “backing” (at traded values) supporting their sharemarket valuations.
Newson:
“that’s not what i see as the weakness of rbd. it’s problem is that collateralizing certain assets feeds into the future pricing of those very same assets, setting up the bubble dynamic.”
You’ll find I said something similar in my “No Such Thing as Fiat Money” paper, under the heading of ‘inflationary feedback’. For example, the fed issues dollars backed by bonds denominated in dollars. The bonds lose some value, which makes the dollars fall, which makes the bonds fall still more, etc. The same thing would happen if a corporation owned some call options on its own stock. This does not invalidate the theory that stocks, and money, are valued according to their backing. It confirms it.
This is why its risky for banks like the fed to hold assets denominated in the same currency that the bank itself issues. For example, the Mexican central bank would be wise to hold US government bonds, rather than Mexican Government bonds. That way, a fall in the value of mexican government bonds would not lead to a fall in the value of the peso.
(None of this means that I agree that using assets as backing drives up the price of those assets. That’s another story.)
mike sproul says:
“None of this means that I agree that using assets as backing drives up the price of those assets. That’s another story.”
well, that was the particular aspect i was contesting.
to mike sproul:
i think brian macker actually raised the wrong question. he was talking about saddam dinars, but i think these may have retained value on the expectation that the us occupying would fix an exchange rate.
the question should be raised about swiss dinars that were used in the kurdish territory for quite some years, and which were completely unbacked.
oh, i forget to mention the most pertinent thing – the plates for the swiss dinars had been destroyed. the money supply was fixed and the kurds were spared the high inflation of the saddam dinars.
in fact, the notes were in very poor shape, many stuck together with sticky-tape.
I’ve had a very interesting time studying. To anyone interested, I reiterate the following reading recommendations (in order):
Hultberg’s “The Future of Gold As Moneyâ€
Blumen’s response to Hultberg titled “Real Bills, Phony Wealthâ€
Fekete’s counter titled “Detractor’s of Adam Smith’s Real Bills Doctrineâ€
I have discovered a vital distinction between something that I was promoting (and that I think that Mike Sproul accepts) and what Fekete and Hultberg advocated. I have written about the possibility of mortgages or other similar instruments to enter as reserves. In essence, an IOU may back money. As long as the IOU is made good by production or is backed by real collateral that could be seized in the case of default, then inflation will not occur. In addition, I have always insisted that some kind of physical convertibility (gold or similar) must exist. If a free market for gold, IOUs and other assets is allowed to exist, then I trust the market to manage the kinds of assets that enter as reserves. My central thesis is that a government managed monopoly does not allow such a market to exist.
Before moving on to the distinction promoted by Fekete et al, allow me to give credit to newson for an argument to which I had not given adequate answer. Quoting him:
[The problem with RBD] is that collateralizing certain assets feeds into the future pricing of those very same assets, setting up the bubble dynamic.
Up to now, I have only figured that a free market could keep check on the “bubble dynamicâ€. However, that is hand waving, and I’ve known it. So I’ve kind of kept quiet. But this will only happen if the IOU reserves are not “self-liquidatingâ€.
I find Blumen’s article quite lacking to not even remotely address this principle. The Real Bills Doctrine (as presented by Hultberg and Fekete, notably not stressed by Sproul) concerns the discounting of bills of exchange. A bill of exchange, according to Fekete’s paper, “is not a credit instrument. It is a clearing instrument. It enables the market to clear goods in most urgent demand without needlessly invading the pool of circulating gold coins.†The natural question is to determine when an instrument crosses the line from a credit instrument to a clearing instrument. Fekete settles this satisfactorily in my opinion:
It is true that production and distribution of consumer goods, no less than that of producers goods, involve risks. However, there is a difference. Risks of dealing in consumer goods in urgent demand vanish as the “journey” of the “maturing” good is coming to an end, and the final cash-paying consumer is already in sight, so that the consummation of sale can no longer be doubted. From this point on the last leg of the journey can be financed with self-liquidating credit. By contrast, for producers goods, risks do not disappear even after the sale.
Of course, not every consumer good has the quality that risks disappear during the last leg of its journey. Luxury goods and specialty items, for example, fall into this second category. So do consumer goods sold on installment plans. The production and distribution of these have to be financed out of savings through loans, as is done in case of producers goods. Merchandise of the first category may occasionally have to be downgraded to the second, if demand for it slackens. Conversely, consumer goods of the second category could be upgraded to the first if demand for them picks up sufficiently. The bill market is the final arbiter to draw the shifting line of demarcation separating the two categories. If a bill can find takers and is readily discounted, then the underlying merchandise belongs to the first category. Otherwise it belongs to the second.
Both Hultberg and Fekete outline how clearing houses have developed spontaneously in the market for bills of exchange. They assert that these institutions developed during the Renaissance period outside of banks. The opponent of RBD must deal with these assertions. It is one thing for all of us to oppose oppressive central government mandates. But are you really going to oppose practices that arose out of voluntary market exchange? Fekete ascribes great benefit to the spontaneous exchange of these bills. While I think that his praise may be a bit hasty, are you really so sure of yourself as to ban such a practice that developed spontaneously in the markets? [This is something that I was addressing to Brian Macker regarding regulation. I let it lie for awhile. But I challenge him again in this regard.]
Okay, I’ve given a lengthy summary on some important points from the papers. I’m sure that I’ve missed some vital points. I hope that people wishing to engage me in debate will have the courtesy of reading the references that I suggested. They are somewhat lengthy, but it’s not like I just asked you to read de Soto’s “Money, Bank Credit and Economic Cycles†opus like one other poster did here.
In any case, I should get back to my point of distinction regarding “self-liquidating†bills and newson’s argument to which I had no good answer. I think that newson makes a valid argument regarding the “bubble dynamic†when assets enter reserves that do not liquidate. The value of a home, for instance, can rise to infinity if the monetary base does too. Having physical convertibility places a check on this. And I still say that we allow voluntary market exchanges to occur without substituting our own judgment. Yet we should have a voice in recommending the form of voluntary institutions. And I think that cautioning against the monetization of debts on appreciable property is wise.
Bills of exchange are self-liquidating though. Historically, they were only based upon consumer goods that were most urgently demanded. They can go no higher than the agreed upon amount of gold. It is for this reason that they would not be inflationary. While I think that claims to gold could possibly exchange quick enough (counter Fekete’s assertion), I do not think that it is unreasonable for bills of exchange as money nor to enter the balance sheets of banks. I have never seen an opponent of RBD (Blumen or others) address this principle.
When it comes down to it, my strongest position is simply to stress that we allow voluntary markets to form. Legal tender laws should be repealed. Upon being placed in a position of monetary liberty, you can set up what bank that you like. I’m not convinced (contrary to Fekete) that a 100% gold standard could not work. But we should also account for the fact that there has never been a 100% gold standard. People have always found multiple ways to carry out exchange. If anyone wants to outlaw any kind of voluntary exchange, I can find no agreement.
It seems like my links didn’t work. Let me try again:
Hultberg
Blumen
Fekete
to joe stoutenburg:
there is no problem whatsoever with the clearing house concept (no monetization). rbd (in the adam smith/fekete model) involves monetizing production goods/inventory.
the fact that bills are short-term, self-liquidating is irrelevant, long-term credits can be constructed with short-term securities.
the important thing to grasp is that rbd allows spending without economizing. the funds that the bank client receives for posting his inventory/or near-finished goods as collateral do not correspond to someone else’s belt-tightening. i thought blumen explained that well.
newson:
the fact that bills are short-term, self-liquidating is irrelevant, long-term credits can be constructed with short-term securities.
You are straying into territory covered by my professional expertise. I am aware of how short-term securities can be combined with futures or forward contracts to synthesize long-term credits. But that is not at all what we are talking about here. Rolling over short-term securities leaves you exposed only to short term credit. As explained by Fekete, markets for bills of exchange only arose around bills for which the credit risk was minimal.
You’ll have to be more concrete if you think that I’m missing something here regarding converting short-term instruments into long term credit.
the important thing to grasp is that rbd allows spending without economizing. the funds that the bank client receives for posting his inventory/or near-finished goods as collateral do not correspond to someone else’s belt-tightening. i thought blumen explained that well.
I read all three papers closely and thought that Blumen provided very good arguments to issues that were irrelevant to the positions taken by the other papers. He completely missed the mark. In addition to Blumen’s article, have you read the other two? I can not respond better than they (especially Fekete’s article) to your claim that the monetization of bills of exchange do not require someone’s belt-tightening.
joe stoutenburg says:
“As explained by Fekete, markets for bills of exchange only arose around bills for which the credit risk was minimal.”
sounds familiar…similar things were said not so long ago about residential property! if the credit spigot is opened, and the flow directed at short-term, low-risk items, the bubble forms in those items (changing price and therefore risk). of course, the freely available credit for short-term needs frees up other resources that can now be channeled into longer time-frame uses.
i’ve read fekete some years ago and made my mind up on real bills. but on your invitation i had another look. here’s an example of what i mean:
“Strictly speaking a bill of exchange, pejoratively called “real bill” by Milton Friedman following his mentor Lloyd Mints, is not a credit instrument. It is a clearing instrument. It enables the market to clear goods in most urgent demand without needlessly invading the pool of circulating gold coins that would cause monetary contraction…”
flowery language, but wrong. a bill of exchange is a credit instrument. the fact that it may pass through many hands before redemption is irrelevant. there is no monetary contraction necessary in the provision of credit: one person merely transfers the use of money to someone else for a limited period.
newson:
similar things were said not so long ago about residential property!
Touche! I yield on that one. We should not miss, though, the strong arm of government in influencing the residential real estate market. Left to its own devices, I am much more willing to trust a spontaneous market institution to manage risk. We all understand that market participants misjudge risk and make mistakes. It seems to only be through the guiding hand of central management that bad risks cluster to impact society as a whole.
Regarding your re-read of Fekete, I see that you took exception to the very first lines of a long paper. I hope that you didn’t read those lines, disagree and stop. You did say that you had read him awhile ago and made up your mind. I have to trust that you put in the necessary effort. It’s hard to read something thoroughly that you are inclined to reject. Having made up my mind in the opposite to what you have, I was quite into Fekete while reading Blumen was excruciating for me. Maybe you had the opposite experience…
In any case, I don’t want to get too far into debating what should be the banking system. It is certain that, if not you, at least many people here insist that 100% reserves is the only acceptable system. I do not hold that position on RBD or any other system. I only insist that, like any market transaction, banking be a matter of voluntary exchange between two or more people.
I see currency backed by bills of exchange as a viable system though I don’t follow Fekete all the way when he claims that 100% reserves could not work. In a free market, I think that there could be room for myriad forms of systems. I am sure that some would prove to not work. People who choose to do business with banks in these systems should suffer the consequences of their own judgment. In that way, the market will lead toward the most optimal arrangements as it always tends.
That last post contains some of my core positions that I am least likely to abandon. On other matters such as the consequences of this or that form of banking, I am much more fluid and open to change. Indeed, a close reading of my posts on the subject should reveal such.
For the sake of continued argument, I’d like to push you on your bubble concerning short-term obligations.
if the credit spigot is opened, and the flow directed at short-term, low-risk items, the bubble forms in those items
It can be readily seen that monetization of appreciating assets might lead to bubbles. People mortgage their homes and receive new credit. They use that credit to buy other homes. While the original homes are still mortgaged, their values appreciate due to the rising demand in other homes. More is borrowed on the expanded equity of the original homes and the process repeats. While I would be willing to allow a free market institution to manage even that process (as opposed to a government money czar), I can see the pitfalls in such an arrangement.
On the other hand, say that you have a bill of exchange specifying an exchange of goods for a given amount of gold, say 100 oz. The contract specifies delivery within a short time frame of 91 days or less (Fekete explains why 91 days was custom though I don’t think that it need be that specifically – only that it be qualitatively short). Just what is it that will form a bubble for these bills? For example, how would they trade for 200 oz of gold one week before expiration?
Again, I see this as a feature of difference between an appreciable assets such as a home and a self-liquidating asset such as a bill of exchange. You made an attempt to respond to the concept of self-liquidation, but your answer did not hold for me. I need you to explain how a bubble can form in such assets.
to joe stoutenberg:
i did quite a bit of reading of fekete years ago when he first started to publish on gold-eagle.com. his appeal to authority (ie adam smith) leaves me cold. rbd leaves me cold. his silly insistence on 91 day-cycles leaves me cold. (mikes sproul’s version of rbd is at least free on these nonsensical provisions – if you’re attracted to rbd, you should click on his name and read his papers.)
if you can see how the bubble can form in housing via the positive feedback loop, how can you not appreciate it’s the same for any asset that is being financed by money created ex nihilo by banks? a 91 day credit can perfectly easily be extinguished and a new one established immediately so that the effective duration is extended (so the “self-liquidating” aspect is immaterial).
“monetization of appreciating assets might lead to bubbles.” – you’ve missed the point. it’s the easy availability of credit that causes the appreciation in the first place. frb always creates bubbles, only the object of speculation varies.
fekete (hultberg only rehashes his points) seems to ignore that credit (discounted bills) doesn’t have to affect monetary conditions at all. imagine you selling me your car for an iou. if my name is ok, you might be able to sell that iou to someone else, and get the money earlier. you initially economize by giving up the car with only a piece of paper in hand, when you sell the iou at a discount, someone economizes to pay you out etc. at any given point, there is always someone saving to allow someone else to consume.
i’m not going to labor any more on this topic, as it regularly gets aired regularly, except that having a central bank worsens immeasurably all the inherent problems in rbd.
de soto’s “money, bank credit and economic cycles” is the best, and most exhaustive work on frb in my opinion.
“I need you to explain how a bubble can form in such assets.”
Hi Joe. I would say that convertibility of paper into gold forces discipline on FRB banks. Once one bank begins to overpay for bills of exchange, the branded circulating notes that this bank has issued will be returned to and it will suffer a drop in reserves. This will also affect said bank’s most important asset: reputation. Both reputation effects and reserve declines provide discipline that prevent long term speculative bubbles from forming.
In a way, Newson is right that FRB always creates bubbles, but only on the margin. In a free FRB world, it would be a daily occurrence that some banks get aggressive and overpays for collateral, creating a short term bubble. But those efforts by the few will be corrected as their notes are converted to gold the day after.
The only way for large bubbles to be created in a free-banking FRB world is for all banks to begin buying and overpaying for bills of exchange simultaneously and equiproportionately. Because respective proportions of notes in circulation don’t change in this scenario, the notes aren’t returned to the banks and reserve discipline is short circuited (See Lawrence White on this).
Anti FRBers will often use this argument to campaign against FRB. The problem with this argument is that the only way for simultaneous and proportional increases in money supply to occur is via the formation of FRB bank cartels. In a free market cartels are unstable. Free-riding problems means they are doomed to fail. The only way to get one to work is getting the government to prop it up by force.
Newson:
Your example of apparently unbacked paper bills circulating as money would be an arbitrage opportunity for any producer of rival money. Just issue your own (unbacked) currency, make promises to limit the supply of it, and watch the Iraqi’s start to use it. This would reduce their demand for dinars, and hence reduce their value. Before starting this process, the issuer of rival money could sell dinars short, and profit from their fall.
Those examples of apparently unbacked currency can be explained by peoples’ belief in future backing, acceptance for taxes, or ignorance. It’s the same for any financial instrument. You also cited the fact that shells and rocks have value as a refutation of the claim that paper money needs backing to have value. Those things are commodities themselves, and don’t need backing.
As for your claim that banks that accept certain goods as collateral will drive up the price of thaose goods, this would imply that banks that accept land as collateral would make land more expensive relative to other goods. A moment’s reflection should convince you that relative prices of goods are determined by real forces of supply and demand, and not by a banker’s fountain pen. If you mean that the banks will raise all prices (in terms of their currency), that is answered by the fact that an adequately backed currency will hold its value.
jp says:
“In a free market cartels are unstable. Free-riding problems means they are doomed to fail. The only way to get one to work is getting the government to prop it up by force.”
whilst i agree with the rest of your post, the inherent frailty of frb banks makes the political pressure for state protection imperative. in an ordinary industry, a cartel-breaker will rob the cartel of profits. in a banking cartel, the first to break ranks and not redeem a fellow-cartel-member’s notes puts other institutions at risk of collapse.
mike sproul says:
“Your example of apparently unbacked paper bills circulating as money would be an arbitrage opportunity for any producer of rival money. Just issue your own (unbacked) currency, make promises to limit the supply of it, and watch the Iraqi’s start to use it.”
this scenario is in conflict with mises’ money regression theorem. the swiss dinar originally had some link to a commodity. the sproul dollar does not.
actually it wasn’t me who raised the value of rocks or shells as money, but macker.
credit availability can affect supply/demand for discrete items. if fr banks decide to target fountain pens for their collateralized loans, their relative value rises with respect to all other goods and services in the economy, assuming that the loan is made with fiduciary media. if it’s not, then of course the increase in pen demand will be offset by a decrease in demand for everything else.
Speaking of bringing back bank runs…
http://vipers-n-thieves.blogspot.com/
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