The Fallacy of Inflation Targeting
Recently some Federal Reserve officials have voiced their support for setting inflationary targets, writes Frank Shostak. They believe that this will not only stabilize the rate of inflation but will also help to stabilize economic activity around sustainable levels. In short, setting targets could eliminate the menace of boom-bust cycles. This is only the latest in a long series of policy fashions at the Fed. They recycle old errors when the newer ones turn out to fail as well. FULL ARTICLE
Comments (223)
Very interesting. I have been reading Rothbards history of the Great Depression and Rothbard writes that this idea of price stabilization (inflation targeting) began with Irving Fisher right after WWI. As a result, the Fed believed it wasn't inflating during the 1920's because wholesale prices didn't rise, even though the stock market rose dramatically. It's odd that we're still fighting the same ignorance 100 years later. Many economists warned people throughout the 1990's that the Fed high stock market and housing values indicated that the Fed was inflating, but to this day the Fed doesn't believe it!
Published: May 16, 2007 8:56 AM
The only thing saving the Fed from really screwing up the economy is that it is so big and so diverse that only small portions of it get blasted.
There is no better example of this than the housing market. After years of easy credit, a large number of buyers were so over extended that small or large changes in their situations caused them to not be able to pay their loans.
As loan defaults increased the lenders become tighter on the next loans they make. As lenders become tighter (loan less) then buyers can loan less and sellers have to cut prices.
This happended to stocks in the late 90s, housing in the early 2000s and now back to stocks again for the late 2000s.
Published: May 16, 2007 10:20 AM
Shostak's biggest shortcoming in the article is his inability to provide evidence to support his conclusion. He concludes that inflation targeting makes things worse, and tries to explain why, but he doesn't provide a model or analysis of the alternative, thus no comparison can be made. In fact he doesn't even state what inflation targeting is supposed to be worse than.
Furthermore, his analysis of the inflation targeting practice contains fallacies of his own.
A lower interest rate does not merely 'increase the demand for goods and services' it specifically reduces the price of capital, the discount rate on capital assets (which consist of a risk free interest rate plus a capital asset risk premium). The reduced price increases the quantity demanded, and this is the so called 'transmission mechanism' of 'monetary policy.' It is the greater quantity of demand for constructing capital assets that bids up labour prices (wages) and property rents too, which shows up as localised inflation (consumer price increases).
The terminology of 'monetary pumping' is inappropriate, and fosters a misleading quasi-mechanical view of important economic matters. Central banks do not pump or inject money, they purchase assets on credit -- someone gives up an asset in exchange for another asset, a claim on the central bank. In practice this is the exchange of a non-monetary claim on the government (a government bond) for a monetary claim on the government (a central bank note or account balance). Thus changes in the quantity of monetary obligations of the government occur as capital transactions, and not income transactions. Of course this is the same as a private commercial bank that issues bank notes or accepts deposits on cheque account -- the funds raised or deposited are not income to the bank, rather give the bank an asset and an offsetting liability, a capital transaction. They do not exchange something for nothing in capital transactions, instead banks make money from the differences in the flows of interest between their assets and liabilities, i.e. from net interest margin income.
Aggregate demand for goods and services is not entirely funded from the production of final consumer goods and services. For example, suppose there was an hypothetical economy with a high savings rate: 50% of the net value of goods and services was saved, and 50% consumed. In this economy 50% of the demand comes from those who produce capital goods such as buildings, bridges, roads, tunnels, ports etc. that are not final consumer goods. Both those who produce final consumer goods and those who produce capital goods that are not consumer goods will demand a proportion of the production of each to consume or add to their wealth portfolios.
Central banks do not print money, in a legal or economic sense. All paper bank notes issued by central banks are issued as capital transactions, creating equal changes in the assets and liabilities of the bank of issue. Legally, promissory notes are 'made' (or issued), not 'printed' (bills of exchange are 'drawn' but most bank notes are promissory notes, not bills of exchange, despite American usage of the term 'bills').
For the record I do not support inflation targeting or central banking or fiat currency, I support the gold standard, free minting and free banking.
Published: May 16, 2007 11:07 AM
David,
I think your comments are helpful, but how can the so-called "amount of money in circulation" increase if there is no "pumping of money" into the economy? Why are housing markets and stock markings exploding in their upward surge in the boom-bust cycle if there is no injection of "fresh money"?
I will remind you that terms like "injection of money" and "printing of money" are probably used by Mr. Shostak the same way individualists refer to "society" where they really mean: Society = "a group of individuals living in some area, exchanging goods, services and conversations with one another on a daily basis". That is, as a concept which captures the essance without specifying every detail of it.
Published: May 16, 2007 2:13 PM
David Hillary,
that was terribly embarrassing. For someone who "support(s) the gold standard, free minting and free banking" your grap of gold standard (ie Austrian) economics is aweful.
I think you are an Ivy league liar.
Published: May 16, 2007 2:38 PM
David Hillary,
that was terribly embarrassing. For someone who "support(s) the gold standard, free minting and free banking" your grap of gold standard (ie Austrian) economics is aweful.
I think you are an Ivy league liar.
Published: May 16, 2007 2:38 PM
David Hillary,
that was terribly embarrassing. For someone who "support(s) the gold standard, free minting and free banking" your grap of gold standard (ie Austrian) economics is aweful.
I think you are an Ivy league liar.
Published: May 16, 2007 2:38 PM
(did not mean to post 3 times)
Published: May 16, 2007 2:44 PM
Today central banks around the world have “inflation targets” or the objectives of keeping inflation (inflation defined as decreases of the purchasing power of money) around 2% yearly.
I do believe that the origin of these policies during the post-war period can be derived from the influence of Milton Friedman during the 70s and 80s. The means and objectives of the central banks are not exactly what Friedman once proposed as he wanted zero inflations and monetary rules, but they are similar as they focus on central banks as the determinants of inflation and therefore also monetary policy. The “pioneering” countries of such inflation targeting were Germany and Switzerland.
Some people declare Monetarism dead but they miss the very point, Monetarism is stronger than ever and, de facto, this theory powerfully influences central banker’s monetary policies around the globe.
The years just before the breakthrough of Milton Friedman and Monetarism, I spotted the following.
A/ A general ignorance among central bankers and economists that inflation is a monetary phenomenon.
B/ Fiscal policy and not monetary policy were considered the main instrument to promote economic stability. The main focus was not, therefore, on central banks.
C/ Central banks did not enjoy the independence from parliaments as they do today.
D/ Floating exchange rates were considered something exotic and unknown as an instrument in balancing payments between nations.
E/ Milton Friedman recommended to cut the link altogether between money and gold.
Today the story is quite different and all of mentioned points have changed because of Milton Friedman and Monetarism.
Keynesianism is played in a playing field apart from reality and the real world and fiscal policy has nothing to do with the business cycle at all. Keynesians do believe, naturally, that fiscal policies highly influence the business cycle but they are utterly wrong and live in some kind of dream world wholly apart from reality.
Monetarism is different as it focuses on monetary policies. It does it superficially, but still the Monetarists see a connection between monetary policy, inflation and the business cycle. The Austrian business cycle theory is the correct one and its implementations of a 100% gold reserve money standard would eliminate the business cycle once and for all, but despite this fact, it is not excluded that monetary policies around the world guided with the aim of about 2% inflation annually and a steady growth of money could keep business cycles relatively small and completely hinder the occurrence of depressions.
To put it another way; mentioned policies could actually keep a firewall around the fires and destructiveness that central banker’s and fractional reserve banker’s cause and in doing so might be quite effective.
It is not impossible that we will enjoy relatively stability and also have done so already without eliminating the very cause of business cycles.
The Federal Reserve:
“Remarks by Governor Ben S. Bernanke
At the Annual Washington Policy Conference of the National Association of Business Economists, Washington, D.C.
March 25, 2003
A Perspective on Inflation Targeting
One of the more interesting developments in central banking in the past dozen years or so has been the increasingly widespread adoption of the monetary policy framework known as inflation targeting. The approach evolved gradually from earlier monetary policy strategies that followed the demise of the Bretton Woods fixed-exchange-rate system--most directly, I believe, from the practices of Germany's Bundesbank and the Swiss National Bank during the latter part of the 1970s and the 1980s.”
http://www.federalreserve.gov/Boarddocs/Speeches/2003/20030325/default.htm
“The Library of Economics and Liberty
An Interview with Milton Friedman
Russ Roberts: I was an undergraduate and a graduate in the 1970s and my textbooks at the undergraduate level—not the graduate level, because I attended a small university in the Midwest I think you used to have an affiliation with, the University of Chicago—but as an undergraduate, my textbooks talked about all the different theories of inflation—cost push, cost pull, the role of unions, the role of industrial concentration and, of course, the possibility that Milton Friedman, this maverick thinker was right, that money had something to do with it.
It's my impression that's not true anymore; that the intellectual environment understands today that inflation is caused by a rapid growth in the money supply.
Milton Friedman: I think it does. I think that's clear and the last 30 years, last 20 years I should say, has done a great deal to rub that in because every central bank has come to accept the view that it's responsible for inflation.
Russ Roberts: And you're suggesting that the Monetary History was the beginning of a revision toward a different perspective.
Milton Friedman: Well, I don't know. On the ideological side, there were other things at work. Hayek’s Road to Serfdom, which was published in 1945 made the ideological case. I don't know what role the Monetary History played in the public at large but in terms of the monetary authorities, in terms of money, there's no doubt that it played a considerable role.
Russ Roberts: And that chapter on the Great Depression must have alarmed them greatly about their potential for doing harm.
Milton Friedman: Exactly, exactly.
Russ Roberts: Focusing on the central bank role, going back again to the '70s when I was in school and shortly after your book came out, the focus was on the money supply—the quantity of money, counting it, controlling it through open market operations.
Something changed in the last 25 or 30 years. That's not what Alan Greenspan or Ben Bernanke talk about. They talk about other things and they play with that short-term interest rate, not the so-called stock of money that you focused on so intensely in the book.
Milton Friedman: That's what the talk about but that's not what they do.
Russ Roberts: What do they do?
Milton Friedman: They use the short-term interest rate as a way of controlling the quantity of money. If you look at the statistics, the rate of change of the quantity of money from month to month, quarter to quarter, year to year, it has never been so low as it has been over the last 20 years.
I don't believe there's another 20-year period in the history of the country in which you can find so steady a rate of growth in the quantity of money and that can't all be an accident. That's because they use the short-term interest rate. Look at it in the simplest possible way.
The Fed says the short-term interest rate should be 4.5 percent. How do they keep it there? By buying and selling securities on the open market. Now you're Mr. Bernanke; you're Mr. Greenspan. You're watching that. And with the current short-term interest rate, you find that the quantity of money is starting to creep up more rapidly than you really want. Well, then you will tend to be favorable to raising to a higher rate of interest.
At that higher rate of interest, the demand for money is less and so the supply of money under that phenomenon, instead of having to sell government bonds to keep it there, they have to buy government bonds to keep it there or vice versa. Maybe I'm getting it mixed up. But in any event, the short-term interest rate is a tool with which you can control the quantity of money.
Russ Roberts: But they don't talk about it that way.
Milton Friedman: No, they don't talk about it that way.
Russ Roberts: Why do you think that is? Do you have any idea?
Milton Friedman: I don't know. I've always been puzzled by why they insist on using the interest rate rather than the quantity of money.
If you really carried out the logic concerning the quantity of money, you deprive the Federal Reserve of anything to do. Suppose the Federal Reserve said it was going to increase the quantity of money by 4 percent a year, year after year, week after week, month after month. That would be a purely mechanical project. You could program a computer to do that.
Russ Roberts: Like an indexed mutual fund takes away the fun of being a fund manager.
Milton Friedman: Right. That's part of the reason. But the main reason, I think, is different. It's that the central bank associates with banks. It regards itself as sort of a mentor of the banking system and, to the individual bank, it doesn't believe it creates a quantity of money. That doesn't make any sense to them.
What they deal with are interest rates and therefore, it's natural and so many of the central bankers are themselves from the banking industry. They're bankers. And so it's natural for them to think in terms of interest rates and, moreover, when they think in terms of interest rates, they've got all kinds of interest rates—short-term interest rates, long-term interest rates—all kinds of excuses for exercising power or thinking they're exercising power.
Russ Roberts: Taking credit for exercising power.
Milton Friedman: I've always been in favor of abolishing the Federal Reserve and substituting a machine program that would keep the quantity of money going up at a steady rate.
Russ Roberts: And over the last 20 years or so, they've approximated that.
Milton Friedman: Come closer to approximating it. Absolutely.
Russ Roberts: And I would argue, and I assume you would as well, that the relative stability of the U.S. economy over the last 20 years is a reflection of that steady growth in the money supply.
Milton Friedman: I think there's no doubt at all.
Russ Roberts: The non-erratic path.
Milton Friedman: It's a golden period. It's a period in which you had declining inflation but a fairly steady rate, a steady level. You had only three recessions, all of them brief, all of them mild. I don't believe you can find another 20-year period in American history. But it's interesting to note that so far as the international acceptance of monetary control is concerned, it was started by the Bank of New Zealand, not by the Federal Reserve Bank. It was some time in the 1980s when New Zealand essentially came close to privatizing its central bank. It set up a situation in which the governor of the Central Bank of New Zealand had a contract with the government in which he agreed to keep the price level—inflation—within a certain bound; 0 to 3 percent or 0 to 2 percent. And if he did not do so, he could be fired.
Russ Roberts: Not decapitated, merely fired.
Milton Friedman: Merely fired.
Russ Roberts: But it still concentrated his mind sufficiently.
Milton Friedman: Oh, yes. And Don Brash was appointed as the first governor of the Central Bank of New Zealand. He's now the leader of the opposition in the New Zealand Parliament. But at the time, he came from business. He was a businessman and he is an extraordinarily able and effective fellow and he took this job on at the time when New Zealand had a very high inflation rate and he succeeded in living up to his contract.
And that really set the pattern. It was the New Zealand experience, I'm sure, that had more to do with other central banks around the world adopting inflation targeting than the United States experience.
Russ Roberts: Because it was so dramatically effective in New Zealand?
Milton Friedman: It was the first time that anybody had explicitly adopted an inflation target. So that was something that everybody observed. And, secondly, it was so dramatically effective.
Russ Roberts: So are you optimistic about the role the central bank will continue to play in that inflation and price level story? You said we've had a golden era of 20, 25 years of stable prices, steady growth with only minor—by historical standards—minor recessions. Are you optimistic about the next 25 years?
Milton Friedman: I have great difficulty not being optimistic about it. All the evidence would seem to be optimistic. On the other hand, I can't hold back a doubt. Governments want to spend money and sooner or later, governments are going to want to spend money without taxing it and the only way to do that is to print money—to create inflation.
Inflation is a form of taxation. How long will governments be able to resist the temptation? And particularly as people become adjusted to being in a world of stable inflation. They will be bigger suckers as it were. It will be easier to get a lot out of it. If everybody anticipated inflation, you couldn't get anywhere by inflating.
Russ Roberts: But once you get people lulled into the expectation of a lack of it, there's the potential to exploit it. Let me ask the question in a different way. A lot of people credit Alan Greenspan with the expansion and success. They give Paul Volcker some credit as well at the early part of this period that we're talking about. But they make it sound like the key to success in monetary policy is you just got to get the right person in the job. When Ben Bernanke or whoever is following him comes in, there's this absurd microscopic examination of the aura and vapors around such a person. And you're suggesting it really has nothing to do with it.
Milton Friedman: Well, how is it that New Zealand can do it. How is it that Australia can do it. How is it that Great Britain can do it. These are all countries which followed New Zealand. New Zealand started it. But then Australia and Great Britain also adopted inflation targeting.”
http://www.econlib.org/library/Columns/y2006/Friedmantranscript.html
The Central Bank of Iceland:
Inflation target
The Central Bank of Iceland's main objective is price stability, defined as a 12-month rise in the CPI (Consumer Price Index) of 2½%.
http://www.sedlabanki.is/?PageID=179
Sveriges Riksbank (The Swedish Central Bank):
“The objective of monetary policy
According to the Sveriges Riksbank Act, the objective of monetary policy is to “maintain price stability”. The Riksbank has interpreted this objective to mean a low, stable rate of inflation.
More precisely, the Riksbank's objective is to keep inflation around 2 per cent per year, as measured by the annual change in the consumer price index (CPI). There is a tolerance range of plus/minus 1 percentage point around this target. At the same time, the range is an expression of the Riksbank’s ambition to limit such deviations. In order to keep inflation around 2 per cent the Riksbank adjusts its key interest rate, the repo rate.”
http://www.riksbank.com/templates/SectionStart.aspx?id=10602
ECB (European Central Bank)
“Quantitative definition of price stability
The ECB’s Governing Council has defined price stability as "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the medium term".
The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.”
http://www.ecb.int/mopo/intro/html/benefits.en.html
“Inflation – a monetary phenomenon
In the long run a central bank can only contribute to raising the growth potential of the economy by maintaining an environment of stable prices. It cannot enhance economic growth by expanding the money supply or keeping short-term interest rates at a level inconsistent with price stability. It can only influence the general level of prices.
Ultimately, inflation is a monetary phenomenon. Prolonged periods of high inflation are typically associated with high monetary growth. While other factors (such as variations in aggregate demand, technological changes or commodity price shocks) can influence price developments over shorter horizons, over time their effects can be offset by a change in monetary policy.”
http://www.ecb.int/mopo/intro/html/role.en.html
Bank of England:
“A principal objective of any central bank is to safeguard the value of the currency in terms of what it will purchase. Rising prices – inflation – reduces the value of money. Monetary policy is directed to achieving this objective and providing a framework for non-inflationary economic growth. As in most other developed countries, monetary policy operates in the UK mainly through influencing the price of money – the interest rate. In May 1997 the Government gave the Bank independence to set monetary policy by deciding the level of interest rates to meet the Government's inflation target – currently 2%.
Low inflation is not an end in itself. It is however an important factor in helping to encourage long-term stability in the economy. Price stability is a precondition for achieving a wider economic goal of sustainable growth and employment. High inflation can be damaging to the functioning of the economy. Low inflation can help to foster sustainable long-term economic growth.”
http://www.bankofengland.co.uk/monetarypolicy/more.htm
Bank of Canada:
“The Bank of Canada aims to keep inflation at the 2 per cent target, the midpoint of the 1 to 3 per cent inflation-control target range. This target is expressed in terms of total CPI inflation, but the Bank uses a measure of core inflation as an operational guide. Core inflation provides a better measure of the underlying trend of inflation and tends to be a better predictor of future changes in the total CPI.”
http://www.bank-banque-canada.ca/en/inflation/index.html
Reserve Bank of New Zealand:
“The Reserve Bank's primary function, as defined by the Reserve Bank of New Zealand Act 1989 is to provide "stability in the general level of prices."”
“The Reserve Bank Act requires that price stability be defined in a specific and public contract, negotiated between the Government and the Reserve Bank. This is called the Policy Targets Agreement (PTA). The current PTA signed in September 2002, defines price stability as annual increases in the Consumers Price Index (CPI) of between 1 and 3 per cent on average over the medium term. Previously, price stability was deemed to be 0 to 3 per cent inflation over 12 months.”
http://www.rbnz.govt.nz/monpol/pta/index.html
Reserve Bank of Australia:
“Since 1993, these objectives have found practical expression in a target for consumer price inflation, of 2-3 per cent per annum. Monetary policy aims to achieve this over the medium term and, subject to that, to encourage the strong and sustainable growth in the economy. Controlling inflation preserves the value of money. In the long run, this is the principal way in which monetary policy can help to form a sound basis for long-term growth in the economy.”
http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.html
The Swiss National Bank (SNB):
“Price stability
Price stability is an important condition for growth and prosperity. Inflation and deflation are inhibiting factors for the decisions of consumers and producers; they disrupt economic activity and put the economically weak at a disadvantage. The SNB equates price stability with a rise in the national consumer price index of less than 2% per annum. Monetary policy decisions are made on the basis of an inflation forecast and implemented by steering the three-month Libor.”
http://www.snb.ch/en/iabout/snb/id/snb_tasks
“Review of monetary policy based on the inflation forecast. If the inflation forecast indicates a deviation from price stability, monetary policy needs to be adjusted. Should inflation threaten to exceed 2% permanently, the National Bank would consider tightening its monetary policy. Conversely, it would loosen the monetary reins if there were a danger of deflation. The National Bank does not, however, react mechanically to the inflation forecast. To determine the nature and scale of its response, it also takes account of the general economic situation.
If inflation temporarily exceeds the 2% ceiling in extraordinary circumstances, for example following a sudden massive rise in oil prices or in phases of strong exchange rate fluctuations, monetary policy does not necessarily need to be adjusted. The same applies to short-term deflationary pressures.”
http://www.snb.ch/en/iabout/monpol/id/monpol_strat/9
Video:
http://www.snb.ch/e/welt/video/mov/mpeg/snb-p-e.mpg
INTERNATIONAL MONETARY FUND
Inflation Targeting and the IMF
Prepared by Monetary and Financial Systems Department, Policy and Development Review
Department, and Research Department1
Approved by Mark Allen, Ulrich Baumgartner, and Raghuram Rajan
March 16, 2006
http://www.imf.org/external/np/pp/eng/2006/031606.pdf
Inflation targeting in New Zealand, 1988-2000
By Donald T Brash
Governor of the Reserve Bank of New Zealand
to the Trans-Tasman Business Circle
Melbourne
9 February 2000
http://www.rbnz.govt.nz/speeches/0086932.html
Central banks pursuing a 2% yearly inflation rate is not and far from a perfect substitute for a 100% gold reserve money standard. Such a system will probably still cause stock market crashes and will also and this surely, promote some malinvestments in the economy that never will be fully liquidated. In other words, new doses of credit will prevent their liquidation. I believe that despite this inbuilt destructiveness of such a system it will “only” cause minor recessions and probably also stock market crashes but deep recessions and depressions will be avoided. Such a system combined with flexible prices and wages, is therefore preferable to what we experienced during the 70s and will be stable compared to what we then experienced. Such a system will not cause riots in the streets and could keep the public from demanding any further actions and also something which they can live with and accept.
My points are not that that the Austrian business cycle theory is correct or not as I believe it is, but that the world is to a great extent ruled by Monetarist ideas and despite of the errors in such systems, they can still be quite successful.
Credit expansion cannot increase wealth only real savings can increase investments and wealth, and a controlled inflation of 2% per year can only give rise to a relatively stability compared to a less controlled inflation like during the 70s.
As a libertarian I cannot accept Monetarist ideas and we can always be proud of supporting true economic and ethical principles which will deliver a system without any business cycles and stock market crashes combined with true justice. The Federal Reserve and fractional reserve banking is, of course, also based on fraud. But knowing all this does not mean that we need to propagate that a Monetarist system will inevitably fail and cause a world depression as this is not true. As mentioned, the truth is on our side, but is that not also enough? Do we need to say anything more than what we can rationally justify?
Björn Lundahl
Published: May 16, 2007 2:47 PM
good post...
re:
"But knowing all this does not mean that we need to propagate that a Monetarist system will inevitably fail and cause a world depression as this is not true."
... ever since I read Ian Gordan's "Long Wave Analyst" which David Tice has called "an historical masterpiece" I have thought the opposite of what you say.
http://www.thelongwaveanalyst.ca/pdf/V5_1.pdf
and then I read Mr Duncan's book and it seems to affirm these ideas...
http://www.business-in-asia.com/dollar_crisis.html
Published: May 16, 2007 3:19 PM
Whether we believe in the conclusion I made in my above comment or not that is believe that a 2% inflation targeting pursued by central banks or Monetarism can bring relative stability compared to none targeting as, for example, during the 70s, I think it is important that we supporters of the Austrian economics and Austrian business cycle theory debate this very thing.
It is easy to see that it will be an extremely bad substitute for a 100% gold money reserve standard, but will it bring relative stability compared to rest of the post-war period?
Björn Lundahl
Published: May 16, 2007 7:34 PM
Björn says "The Federal Reserve and fractional reserve banking is, of course, also based on fraud". He does not explain that fraud. Let me try to explain it.
Can we agree that to "give credit" is not the same as to "lend money"? To see how the two are confused, let's examine a specific example - I'll try to defraud Björn of money by giving him credit!
If I give Björn credit, I am trusting him to fulfil a commitment [within a specified time]. If I lend him money (or anything else), I may trust Björn to fulfil a commitment to REPAY me (perhaps with interest). I may trust him only because I have (or he gives me) "security". So! Would Björn give me a commitment to pay me some money in future, if all I did was trust him to pay me (& keep a record of his commitment to pay me some money as a "debt" owed - with interest!)?
If Björn would give me a commitment to pay me money on such terms, then I accept! How much money [even fiat money) can Björn commit to pay me in future (and with how much interest)?
If Björn gives me a written commitment to pay me (or someone authorised by me) say USD 100,000 in 2 years, I am sure I could find a buyer to exchange say USD 80,000 now, for his [secured] written commitment to pay me later. The buyer would be "giving credit" - trusting him to fulfil his commitment - and I would immediately be 80,000 USD richer!
The obvious question is why would Björn give me a commitment to pay anyone money in future?? Did he believe I did, or would, "lend money" to him? Why? Did I say so? Or did I trick him into giving me a written commitment to pay me, by misleading you (with terms like interest &
repayments) to believe I was "lending money"? Bankers know the difference between when they "give credit" and "lend money", but do they ever tell customers (even US presidents) which type 'transaction' they have entered in their accounts, & we have 'agreed' to?
Published: May 16, 2007 11:51 PM
Geir asks 'how can the so-called "amount of money in circulation" increase if there is no "pumping of money" into the economy?'
The stock of money in a free market economy consists of two forms: coin, a non-financial capital asset, and bank liabilities (bank notes and cheque account balances), a financial asset of the holder. The former can be increased by mining metal and minting it into coin. The latter can be increased by a banking transaction such as a bank issuing a bank note or accepting a deposit on a cheque account of a customer. The latter, as discussed, is a capital transaction involving financial intermediation, whereby the bank has, generally, an interest bearing asset (e.g. a loan, promissory note or commercial bill of exchange) and a non-interest bearing liability (a bank note) or interest bearing liability (cheque account balance (sometimes not interest bearing)). Thus people can use bank liabilities for indirect exchange, rather than coin.
The non-financial capital stock is thus allocated between coin and other forms such as buildings, and the financial capital structure enables non-financial non-coin capital assets to be partly financed by bank loans that are partly financed by monetary liabilities of banks (i.e. bank notes and cheque account balances).
Eric Lansing makes some disparaging comments including a claim that gold standard economics is equal to Austrian school economics. While Austrian school economists generally support the gold standard, gold standard supporting economists don't all support Austrian school economics. Perhaps it is Eric Lansing here who is the one who doesn't understand what he is talking about.
Published: May 17, 2007 12:05 AM
The main reason why central bankers and governments have chosen to pursue 2% inflation rates yearly instead of a zero inflation rate as Milton Friedman suggested is that they are afraid of deflations. They want to be sure that deflations will be avoided and wants to have a margin.
The main reason why they have not chosen a strict monetary rule as Milton Friedman recommended, is that they are not convinced that the demand for money is stable (in their terms; velocity of circulation) and if the central banks mechanically injects a certain amount of money, prices could still fall or rise (more than 2% yearly). By pursuing a 2% inflation rate yearly, the central banks, for example during deflations, could inject more money into the system and make up the difference. The other reason might be that they do not know which monetary definition they should be guided by. To master a certain inflation rate “solves” the problems handsomely.
I think that they logically and cleverly are reacting in a rational manner as they believe that the condition is true and that is that business cycles are caused be changes in aggregate demand.
For an Austrian economist the business cycle is caused by increases of the money supply (bank credit) through the process of fractional reserve banking and create an artificial economic boom that misleads businessmen to invest as if savings have increased and the solution of the problem is therefore quite different or in other words; stops injecting money into the system at once. You cannot either trust central banks and governments that they will ever do that so we should adopt a 100% reserve gold money standard. This would also be extremely more fixed and difficult to later alter than a change in the constitution would be.
Over the longer term when the economy is adjusted to a very slow growth of the money supply as under a 100% gold reserve money standard (not accomplished, though, through increases of bank credit) or adjusted to a faster growth of the money supply as under a fiat monetary system with a yearly inflation rate of 2% accomplished mainly through increases of bank credit (again inflation here is defined as decreases of the purchasing power of money), I do believe that the demand for money would also be quite stable. That is also why Jesús Huerta De Soto in his masterpiece Money, Bank Credit, and Economic Cycles, page 776 wrote that “there would be slight annual “deflation” of approximately 2 percent” under a gold standard. He too expects, therefore, the demand for money to be quite stable. The expectation that the demand of money being quite stable is only an observation and not a praxeological fact and the demand for money can always, therefore, change.
As so many nations today pursue a policy of a yearly inflation rate of 2%, it will be quite interesting to observe what the effects this will have on the world economy.
During the 80s, for example, when Switzerland pursued that policy it had, if I remember it correctly, some severe recessions. Today when all “important” economies follow a similar policy, external negative impacts on each other will be much smaller. So what we have in front of us is really a great laboratory test of Monetarism and floating exchange rates.
We could expect only minor recessions and therefore relative stability of employments and economic outputs compared to other periods during the post-war area but still, stock market crashes, won’t probably be avoided. An imperfect monetary system can at best deliver this mentioned scenario.
Björn Lundahl
Published: May 17, 2007 2:13 AM
My view is that fractional reserve banking should be considered fraudulent because of the reason that bankers cannot fulfil their obligations against all their depositors. This is a logical proof by itself.
It does not matter if bank depositors are well educated in fraudulent banking procedures or not. Reality and logic sets the limit and real laws should be in accordance with reality. Otherwise they are destructive and wrong. No contracts can invalidate reality and logics.
It is not, logically, possible to contract terms that are contradictory. For what is contracted if the terms are contradictory? This is essentially my point. If we have a “libertarian view” is beside the point: contradictions cannot be contracted as contacts are voluntarily agreements between the parties involved and all terms should harmonize with each other.
If, for example, someone rents a commercial facility and the lease stipulates that the landlord should maintain the ceiling, it is not, logically, possible in the same lease to contract that the landlord has no responsibility if he has been careless in his maintenance and the ceiling leaks. That is also a logical contradiction. Maintenance and some minimum responsibility go hand in hand.
Fractional reserve contracts are a contradiction in terms as they are demand deposits that are redeemable on demand and are at the same time also “regarded” as monetary “loans” to the banks and on top of this absurdity, these “loans” are lacking any maturity dates.
A true monetary loan is an exchange of present goods for future goods, whereby “the future” is defined as an agreed upon time between the parties when the loan expires.
If a “depositor” really wants to lend out his money, he should also comply with what a true loan is and “not try to eat his cake and still try to keep it.”
An Austrian economist has all the reason in the world to be against fractional reserve banking as he wants the economy to correspond to a true voluntarily saving ratio and not to a vague (and therefore fraudulent) one. Because of the fact that fractional reserve banking is relied upon this vagueness and therefore swindle, he also knows that this very vagueness and swindle are the really causes of horrible and anti social depressions and business cycles, which he therefore wants to end once and for all.
Apart from mentioned logical proof of why fractional reserve banking is fraudulent, another logical proof should also be mentioned and that is that the Austrian business cycle theory by itself proves that “savings” through fractional reserve banking does not harmonize with true voluntarily saving ratios of individuals as business cycles are still existent in a fractional reserve economy and are, also, the very cause of them. The Austrian business cycle theory teaches “that recessions and depressions are caused by initially lowering of the rate of interest which do not correspond to true saving ratios, but by increases of the money supply. When the economy adjusts to true saving ratios, malinvestments are liquidated.”
Well, if demand deposits are not true savings they cannot be true loans.
In other words the depositors have been deluded that is being exposed of fraudulent actions by the banks.
We could, also, say that slave contracts should not, in a libertarian society, be allowed for the same reason i.e. they are contradictory and not in accordance with reality and logics as;
“A man cannot renounce his right to self-ownership, since a man in his very nature controls his own mind and body (natural disposition), that is, he is a natural self-owner of his own will and person (having a free will) and he will still be so even if he has “tried” to renounce his natural self-ownership to another person. He cannot renounce something which is a biological and physical fact of his very own life and which will never, as long as he lives, leave him.”
Björn Lundahl
Published: May 17, 2007 2:28 AM
I do not consider, though, that the demand for money in regards to the business cycle is important at all.
But in a world economy “based” on targeting a 2% inflation rate it will indirectly so be.
If the demand for money increases and the inflation rate falls below the target of 2% because of this, central banks will accelerate the rate of growth of the money supply which in turn will create an artificial boom. If consumers later on and for whatever reasons, decrease their demand for money and inflation rises above the target of 2% because of this, monetary authorities will decelerate the growth of the money supply and the mentioned boom will be ended by a bust.
Björn Lundahl
Published: May 17, 2007 3:20 AM
David Hillary,
Are you a banker? or follower of the Real Bills Doctrine, sometimes referred to as the Banking School? If not, what do you think of franctional reserve banking?
The reason I ask is that I find that bankers get really offended by the Austrian condemnation of fractional reserve banking and the role of banks in artificially inflating/contracting the money supply.
Published: May 17, 2007 9:20 AM
It looks like that the same debates are comming up in different threads - due to the postings being on much the same thing (there is is a similar odd thing above - where there are three postings all on the same Ron Paul incident).
Still I will repeat here what I have said elsewhere.
No Austrian economists do not have to support gold as money (using the words "the gold standard" can use to confusion).
If people want to use silver (or any other commodity) as money and their contracts are drawn up that way, this is fine.
It is even possible (perhaps) that government fiat money could be "Austrian" - if there was never any increase in the supply of fiat money (which does not seem likely - but there we go).
As for the boom-bust cycle:
The basis of this is the effort to reduce inerest rates (for borrowing) below the level that would come about by time preference.
So instead of borrowing being 100% financed from real savings (i.e. people choosing not to consume all of their income and lending part of it out), some borrowing is financed by complex credit expansion schemes (which sometimes involve the misuse of the word "savings").
Normally fractional reserve banks (and other enterprises) look to government from time to time to prop them up (in various complex ways).
But such practices go back before the Federal Reserve Board in 1913. Government support for credit expansion was sometimes in different forms (such as trying to protect banks from people comming to them and demanding the gold or silver they claimed to have in the vaults covering all bank drafts and other such).
There were boom-bust events before 1913. Indeed even before the National Banking Act of 1861.
Murry Rothbard's first major book was (after all) "The Panic of 1819".
Published: May 17, 2007 10:18 AM
RogerM asks some questions:
Are you a banker? Yes, I operate a business that endeavours to engage in the business of banking later this year. I'm a free banker both in business and in theory. I don't accept the real bills doctrine. Fractional reserve banking is, as far as I see it, the regular and ordinary form of banking, since banking is about credit intermediation as well as conducting current accounts with balances payable to the customer's order. Although many Austrian school economists are hostile to fractional reserve banking, not all are, and I don't subscribe to the Austrian school in any case. I don't get offended by Austrian school anti-fractional reserve bankers, and their claims, I just disagree with them and their analysis.
Published: May 17, 2007 12:11 PM
RogerM:
Of course a bank or any other entity in the business of loaning out money can engage in "fractional" banking. No Austrian is demanding law to ban this. The whole point is that IF a fractional banker/lender gets trapped in a bank-run, there should be no tax-funded escape for him. A fractional banker could buy insurance (probably at a very high cost) or take his chances, but that's it. His business entirely.
Fractional banking is a very understandable risk taken by businesses who attempt to increase their clientele without having the 100% back-up for loaned out money. In a free market however, banks will tend to stay close to the 100% backing, or else face bankruptcy in the case of a bank-run.
Published: May 17, 2007 6:10 PM
No one could accuse me of being a fanatical follower of Murry Rothbard , but his arguments against the idea that there can be any free market "insurance" for fractional reserve banking are sound (I advice people to look them up - sorry I am no good at "links").
But we go back to the basic point that borrowing must be from savings.
The whole point of fractional reserve banking (and all the other games) is to try and lend out more money than there is in REAL savings.
Violating the borrowing must be entirely from real savings rule is asking for trouble.
"But not all Austrians opposed fractional reserve banking" - but Mises and the others did oppose efforts to reduce interest rates (below the rates time preference would lead to) and reducing interest rates for borrowers ("having more money to lend") is the whole point of games like fractional reserves.
"But I am a free banker, I oppose Federal "insurance" and all other subsidies open or hidden".
Jolly good - but there is still the problem of the bust (for credit expanision must lead to a boom-bust cycle).
Will not people demand all sorts of statism during a bust?
Published: May 17, 2007 9:32 PM
When Björn said yesterday "The Federal Reserve and fractional reserve banking is, of course, also based on fraud", I tried to explain it by pointing how banks by confusing giving credit with lending money have been defrauding "borrowers". While my example did not say so, that is how fractional reserve banking works.
For some reason, none of the subsequent posters have even acknowledged the point of my 1st post, which I'll repeat below. Please comment.
Björn says "The Federal Reserve and fractional reserve banking is, of course, also based on fraud". He does not explain that fraud. Let me try to explain it.
Can we agree that to "give credit" is not the same as to "lend money"? To see how the two are confused, let's examine a specific example - I'll try to defraud Björn of money by giving him credit!
If I give Björn credit, I am trusting him to fulfil a commitment [within a specified time]. If I lend him money (or anything else), I may trust Björn to fulfil a commitment to REPAY me (perhaps with interest). I may trust him only because I have (or he gives me) "security". So! Would Björn give me a commitment to pay me some money in future, if all I did was trust him to pay me (& keep a record of his commitment to pay me some money as a "debt" owed - with interest!)?
If Björn would give me a commitment to pay me money on such terms, then I accept! How much money [even fiat money] can Björn commit to pay me in future (and with how much interest)?
If Björn gives me a written commitment to pay me (or someone authorised by me) say USD 100,000 in 2 years, I am sure I could find a buyer to exchange say USD 80,000 now, for his [secured] written commitment to pay me later. The buyer would be "giving credit" - trusting him to fulfil his commitment - and I would immediately be 80,000 USD richer!
Published: May 17, 2007 10:00 PM
Gier,
Bank assets in a gold standard and free market for banking services consist of:
1. Metallic legal tender reserves
2. Bank notes and demand deposits with other banks
3. Marketable securities (e.g. corporate bonds)
4. Net loans and advances
5. Other assets such as land and buildings, plant and equipment, either used by the bank or from the realisation of security.
The reserve ratio is the ratio 1. to demand deposits and bank notes payable.
Obviously a bank's liquidity position is not as simple as the reserve ratio. The bank also gets liquidity from items 2-3. The bank's liquidity position is normally assessed by using a maturity ladder, where the bank's assets and liabilities are put into maturity buckets e.g. today, tomorrow, 2-5 days, 6-30 days, 31-60 days, 61-90 days, 91-180 days etc. Assets are placed in the earliest bucket they can be reliably liquidated or will contractually mature, while liabilities are put into the bucket of their contractual maturities. This allows the bank to smooth out its net funding (re-borrowing) requirements. The actual management of liquidity operates by monitoring various liquidity ratios, and progressively escalating the responses to reduced liquidity. The responses are to borrow funds and to sell assets.
Since the bank's primary function is credit intermediary, most of a bank's assets will consist of net loans and advances. For example ANZ National Bank Limited's assets as at 31/03/2007 were listed as:
Liquid Assets $5741m
Due from other financial institutions $3067m
Trading securities $1917m
Derivative financial instruments $3041m
Available for sale assets $45m
Net loans and advances $82258m
Shares in subsidiaries $190m
Current tax assets $28m
Other assets $800m
Deferred tax assets $353m
Premises and equipment $225m
Goodwill and other intangible assets $3292m
Total assets $100958m
Thus over 80% of the banks assets is net loans and advances, and about 10% of the bank's assets appear to be liquid.
On the liability side of the balance sheet, the bank owes $21659m in demand deposits bearing interest, and $3953m in deposits not bearing interest (presumably repayable on demand). This gives a broad liquid assets to demand deposits ratio of about 39%.
The bank has $19061m in assets maturing in less than three months, and $54889m in liabilities due within three months, a ratio of about 35%.
Legal tender reserves (in this case central bank notes) are only $245m, that is just 0.24% of assets and 0.1% of demand deposits.
So, one may conclude that in an advanced and free market financial system, the bulk of bank assets will be net loans and advances, and that banks will get most of their liquidity from demand deposits with other financial institutions, and marketable securities, rather than metallic reserves. I'd expect under a gold standard banks would hold about 1% of their assets and 3% of their demand liabilities as gold coin, and about 10-15% of their assets as other liquid assets (30-45% of their demand liabilities), with the bulk of the remainder of their assets being net loans and advances.
Published: May 17, 2007 10:14 PM
What Has Government Done to Our Money? By Murray Rothbard:
“Defenders of banks reply as follows: the banks are simply functioning like other businesses—they take risks. Admittedly, if all the depositors presented their claims, the banks would be bankrupt, since outstanding receipts exceed gold in the vaults. But, banks simply take the chance—usually justified—that not everyone will ask for his gold*. The great difference, however, between the "fractional reserve" bank and all other business is this: other businessmen use their own or borrowed capital in ventures, and if they borrow credit, they promise to pay at a future date, taking care to have enough money at hand on that date to meet their obligation. If Smith borrows 100 gold ounces for a year, he will arrange to have 100 gold ounces available on that future date. But the bank isn't borrowing from its depositors; it doesn't pledge to pay back gold at a certain date in the future. Instead, it pledges to pay the receipt in gold at any time, on demand. In short, the bank note or deposit is not an IOU, or debt; it is a warehouse receipt for other people's property. Further, when a businessman borrows or lends money, he does not add to the money supply. The loaned funds are saved funds, part of the existing money supply being transferred from saver to borrower. Bank issues, on the other hand, artificially increase the money supply since pseudo-receipts are injected into the market.
A bank, then, is not taking the usual business risk. It does not, like all businessmen, arrange the time pattern of its assets proportionately to the time pattern of liabilities, i.e., see to it that it will have enough money, on due dates, to pay its bills. Instead, most of its liabilities are instantaneous, but its assets are not.
The bank creates new money out of thin air, and does not, like everyone else, have to acquire money by producing and selling its services. In short, the bank is already and at all times bankrupt; but its bankruptcy is only revealed when customers get suspicious and precipitate "bank runs." No other business experiences a phenomenon like a "run." No other business can be plunged into bankruptcy overnight simply because its customers decide to repossess their own property. No other business creates fictitious new money, which will evaporate when truly gauged.
The dire economic effects of fractional bank money will be explored in the next chapter. Here we conclude that, morally, such banking would have no more right to exist in a truly free market than any other form of implicit theft. It is true that the note or deposit does not actually say on its face that the warehouse guarantees to keep a full backing of gold on hand at all times. But the bank does promise to redeem on demand, and so when it issues any fake receipts, it is already committing fraud, since it immediately becomes impossible for the bank to keep its pledge and redeem all of its notes and deposits. [15] Fraud, therefore, is immediately being committed when the act of issuing pseudo-receipts takes place. Which particular receipts are fraudulent can only be discovered after a run on the bank has occurred (since all the receipts look alike), and the late coming claimants are left high and dry. [16]”
http://www.mises.org/money/2s12.asp
Björn Lundahl
Published: May 18, 2007 1:21 AM
I quote from the book For a New Liberty, by Murray Rothbard:
9 Inflation and the Business Cycle: The Collapse of the Keynesian Paradigm
The Federal Reserve and Fractional Reserve Banking
”By far the most important route for the Fed's determining of total reserves is little known or understood by the public: the method of "open market purchases." What this simply means is that the Federal Reserve Bank goes out into the open market and buys an asset. Strictly, it doesn't matter what kind of an asset the Fed buys. It could, for example, be a pocket calculator for twenty dollars. Suppose that the Fed buys a pocket calculator from XYZ Electronics for twenty dollars. The Fed acquires a calculator; but the important point for our purposes is that XYZ Electronics acquires a check for twenty dollars from the Federal Reserve Bank. Now, the Fed is not open to checking accounts from private citizens, only from banks and the federal government itself. XYZ Electronics, therefore, can only do one thing with its twenty-dollar check: deposit it at its own bank, say the Acme Bank. At this point, another transaction takes place: XYZ gets an increase of twenty dollars in its checking account, in its "demand deposits." In return, Acme Bank gets a check, made over to itself, from the Federal Reserve Bank.
Now, the first thing that has happened is that XYZ's money stock has gone up by twenty dollars—its newly increased account at the Acme Bank—and nobody else's money stock has changed at all. So, at the end of this initial phase—phase I—the money supply has increased by twenty dollars, the same amount as the Fed's purchase of an asset.
"If one asks, where did the Fed get the twenty dollars to buy the calculator, then the answer is:
it created the twenty dollars out of thin air by simply writing out a check upon itself. No one, neither the Fed nor anyone else, had the twenty dollars before it was created in the process of the Fed's expenditure".
But this is not all. For now the Acme Bank, to its delight, finds it has a check on the Federal Reserve. It rushes to the Fed, deposits it, and acquires an increase of $20 in its reserves, that is, in its "demand deposits with the Fed." Now that the banking system has an increase in $20, it can and does expand credit, that is, create more demand deposits in the form of loans to business (or to consumers or government), until the total increase in checkbook money is $120*. At the end of phase II, then, we have an increase of $20 in bank reserves generated by Fed purchase of a calculator for that amount, an increase in $120 in bank demand deposits, and an increase of $100 in bank loans to business or others. The total money supply has increased by $120, of which $100 was created by the banks in the course of lending out checkbook money to business, and $20 was created by the Fed in the course of buying the calculator.
In practice, of course, the Fed does not spend much of its time buying haphazard assets. Its purchases of assets are so huge in order to inflate the economy that it must settle on a regular, highly liquid asset. In practice, this means purchases of U.S. government bonds and other U.S. government securities. The U.S. government bond market is huge and highly liquid, and the Fed does not have to get into the political conflicts that would be involved in figuring out which private stocks or bonds to purchase. For the government, this process also has the happy consequence of helping to prop up the government security market, and keep up the price of government bonds”.
“So here we have, at long last, the key to the mystery of the modern inflationary process. It is a process of continually expanding the money supply through continuing Fed purchases of government securities on the open market. Let the Fed wish to increase the money supply by $6 billion, and it will purchase government securities on the open market to a total of $1 billion (if the money multiplier of demand deposits/reserves is 6:1) and the goal will be speedily accomplished. In fact, week after week, even as these lines are being read, the Fed goes into the open market in New York and purchases whatever amount of government bonds it has decided upon, and thereby helps decide upon the amount of monetary inflation.”
* The reserve requirement set by the Federal Reserve on banks is exemplified by the ratio 6:1 (the required maximum multiple of deposit to reserves).
http://www.mises.org/rothbard/newliberty9.asp
Björn Lundahl
Published: May 18, 2007 1:29 AM
Björn Lundahl quotes Rothbard:
'The great difference, however, between the "fractional reserve" bank and all other business is this: other businessmen use their own or borrowed capital in ventures, and if they borrow credit, they promise to pay at a future date, taking care to have enough money at hand on that date to meet their obligation. If Smith borrows 100 gold ounces for a year, he will arrange to have 100 gold ounces available on that future date. But the bank isn't borrowing from its depositors; it doesn't pledge to pay back gold at a certain date in the future. Instead, it pledges to pay the receipt in gold at any time, on demand. In short, the bank note or deposit is not an IOU, or debt; it is a warehouse receipt for other people's property.'
Unfortunately this analysis is based on an incorrect understanding of the legal character of bank notes. Bank notes are a form of promissory notes, as documented below.
Promissory Notes
Definition
The legal definition and required components of notes have been codified in legislation: ‘A promissory note is an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person or to bearer.’ (Bills of Exchange Act 1908 (NZ), Section 84).
Characteristics
A note is a number of different things:
1. It is a species of contract
2. It is a formal obligation to pay a money, with a standard and exhaustive set of terms – sum, to whom, when, where, by whom
3. It is a documentary intangible – the right to be paid requires possession and presentation of the document
4. It is a negotiable instrument.
As a species of contract, any person with capacity to contract has capacity to make or indorse a note. ‘Capacity to incur liability as a party to a bill is co-extensive with capacity to contract:’ (Bills of Exchange Act 1908 (NZ), section 22).
As an obligation to pay money, the note is a credit contract, with the payee being the creditor and the maker (and any indorsers) being the debtor (or joint and several debtors). ‘The maker of a promissory note, by making it,— (a) Engages that he will pay it according to its tenor: …’ (Bills of Exchange Act 1908 (NZ), Section 89). Because the note has a standard and exhaustive set of terms, there are no further obligations on the maker other than to pay the specified sum to the payee/holder, on demand or at the fixed or determinable due date in the future. Any other financial covenant or security for the obligation is considered a separate collateral contract.
As a documentary intangible, ‘A promissory note is incomplete until delivery thereof to the payee or bearer.’ (Bills of Exchange Act 1908 (NZ), Section 85), and the rights to payment require possession of the instrument. Negotiation requires physical delivery of the document (see below). This is different from a written contract evidencing a debt, where the debt exists independently of the document, which has no value in and of itself. A promissory note is a valuable document in and of itself, nominally worth the sum payable on the instrument.
As a negotiable instrument, a note can be negotiated by indorsement and delivery, in the case of a note payable to order (that is, to a specified person), or by mere delivery, in the case of a note that is payable to bearer.
Negotiation enables the holder to sue in his own name and to have good title to the instrument even if it is obtained in good faith for valuable consideration from someone who had defective title. (Bills of Exchange Act 1908 (NZ), sections 31 and 38). Negotiation is therefore a superior transfer and delivery of the right to payment on the instrument, and enables the instrument to be easily sold or pledged as security. Another characteristic of negotiable instruments is standardisation and simplicity – because these instruments can and are intended to be bought and sold in trade, they must conform to a simple and standard form.
Usage
Promissory notes are commonly used to document loans and other money debts. For example financiers advance money in exchange for promissory notes, and then use the notes as security to borrow money from a bank. Loans documented as notes can also be sold ‘as is’ or sold to a special purpose vehicle that issues asset backed securities, as a means of securitising the loans. Thus the use of notes provides maximum flexibility to the financier in funding, liquidating or repackaging debts into more marketable, liquid or investable forms.
The other major usage of notes is bank notes, which are addressed in the next section.
Bank Notes
Definition
A bank note is a promissory note issued by a bank, payable to bearer on demand. Although the definition strictly does not admin non-banks to issue bank notes, non-banks issued metal (copper, tin or lead) disc tokens, payable to bearer on demand, and intended for use as small change.
For the purposes of regulation, the definition is also frequently extended to include bills of exchange as well as promissory notes, however the ‘payable to bearer’ and ‘on demand’ character of bank notes should be considered essential.
In supporting this definition evidence from both contemporary and historical sources will be presented.
Contemporary bank notes in Hong Kong are issued by three bank note issuing banks in Hong Kong: HSBC, Bank of China , and Standard Chartered Bank. In each case the notes contain an explicit promise to pay to the bearer on demand the sum of money printed on the note. The Bank of China also issues bank notes in Macau, which also contain an explicit promise to pay the bearer on demand (in Chinese and Portuguese). Images of contemporary bank notes from each note issuing bank in Hong Kong are available on request.
Under Hong Kong legislation the terminology used is ‘bank notes payable to bearer on demand’ which in turn are defined as ‘a bill of exchange or promissory note, issued by any bank, payable to bearer on demand’ (Legal Tender Notes Issue Ordinance, Section 3).
The mention of bills of exchange is a ‘catch all’ to avoid banks structuring what have traditionally been promissory notes as bills of exchange instead. This type of catch all extension is also used in the restrictions on bank note issue in the UK, New Zealand and some other commonwealth countries, but the definitions all state that bank notes are negotiable instruments comparable to promissory notes, and most of them restrict the definition explicitly to instruments payable to bearer on demand.
Contemporary bank notes in the Stirling zone are issued by 14 issuers: 1 central bank (the Bank of England), 3 Scottish commercial banks, 4 Northern Irish commercial banks, and 6 governments of British dependencies. Except for two British dependency government issued notes (Gibraltar and Falkland Islands) all Stirling bank notes are explicitly payable to bearer on demand. Images of contemporary Stirling bank notes are available on request. The Gibraltar and Falkland Islands bank notes are instead listed as being legal tender notes. This is also found in many other commonwealth countries. The absence of a payee legally makes the instruments inchoate (incomplete) and enables the holder to complete it however he thinks fit (Bills of Exchange Act 1908 (NZ) section 20). The absence of a payable date makes the instrument payable on demand (Bills of Exchange Act 1908 (NZ), section 10).
Some other commonwealth jurisdictions have more traditional definitions recited in legislation that is still in force as presented below.
‘“bank note” means a promissory note or engagement for the payment of money to bearer on demand issued by any person carrying on the business of banking.’ (Penal Code (Singapore), 498A. (see also Currency Act, section 14))
‘"Bank note" or "note" means the instrument commonly known as a bank note, that is to say: a promissory note (in whatever form or by whomsoever drawn or made) issued by a bank and entitling or purporting to entitle the bearer or holder thereof, without endorsement, or without any further or other endorsement than may be thereon at the time of the issuing thereof, to the payment on demand of the sum named therein’ (Banking Ordinance 1960 (Samoa), Section 2)
Historical sources include early bank notes and goldsmiths’ ‘running cash notes’ and early writings on the topic of banking, a selection of which is presented below.
The Bank of England was the first major joint stock commercial bank in England, established in 1694. According to the bank’s website, ‘Almost immediately the Bank started to issue notes in return for deposits. Like the goldsmiths’ notes, the crucial feature that made Bank of England notes a means of exchange was the promise to pay the bearer the sum of the note on demand.’ The bank’s notes remain promises to pay the bearer on demand to this day.
The first major Scottish joint stock commercial bank was the Bank of Scotland, formed in 1695, a year later than the Bank of England. The earliest preserved Scottish bank note was issued by the Bank of Scotland and it is a promissory note payable to bearer on demand dated 16th April 1716, is available as an image on request.
To this day the Bank of Scotland’s bank notes remain promises to pay the bearer on demand.
In Adam Smith’s Wealth of Nations, written in 1776, he states:
‘A paper money consisting in bank notes, issued by people of undoubted credit, payable upon demand without any condition, and in fact always readily paid as soon as presented, is, in every respect, equal in value to gold and silver money; since gold and silver money can at any time be had for it.’ (Book II, 2.95)
And elsewhere refers to them as promissory notes, e.g. ‘It is chiefly by discounting bills of exchange, that is, by advancing money upon them before they are due, that the greater part of banks and bankers issue their promissory notes.’ (Book II, 2.43)
Absence of officially minted small coins lead British traders to issue promissory notes in the form of copper discs, such as the one shown below dated 1795 (one halfpenny, payable at the India tea warehouse): (image available on request)
The Bank Notes (Scotland) Act 1845 refers to bank notes as ‘promissory note payable on demand to the bearer thereof’ (section 18).
Thus it is clear that bank notes have been both structured as, and considered as, promissory notes issued by a bank payable to bearer on demand for more than 300 years of English and commonwealth banking law and practice.
Characteristics
Bank notes, as a species of promissory note, have the same legal characteristics as other promissory notes.
Being bearer instruments, they are negotiated by mere delivery.
Usage
Bank notes are used by banks to borrow money and by holders for use as short term wealth holdings, negotiable by mere delivery, and useful as a medium of indirect exchange.
The basic market structure and characteristics will also be listed to document the usage where commercial banks are free to issue them and the notes are not subject to any statutory legal tender privileges.
Bank notes are issued by banks as an alternative form of obligation than cheque account balances, with transfer by delivery of the note rather than through the process of drawing a cheque which requires presentation. The bearer form of bank liability is a more immediate and flexible form of payment. The disadvantage of the bank note compared to cheques is the inability to restrict the instrument to safely pay an intended payee, as can be achieved by drawing a cheque to a named payee, and by crossing it and/or marking it non-transferable.
The market for bank notes is characterised by:
1. Standardised denominations to aid counting and in making change (although this feature took some time to develop, with early notes being for odd sums)
2. Security features such as special paper or polymer, threads, transparent windows, raised printing etc. to make counterfeiting difficult and verification easier
3. Maintaining branch networks to issue, bank and redeem bank notes
4. Large banks with high name recognition and trust in the community
5. Mutual recognition and acceptance of participating rival bank notes at par, typically by the leading banks in the market
6. Exchange and net deferred settlement of bank notes through a note exchange or exchanges operated by participating banks
This market structure enables bank notes of large strong banks to provide a proportion of the bearer form of money used by banks and non banks, with easy access to redemption, directly with the issuing bank, or indirectly through another bank.
Published: May 18, 2007 3:10 AM
Naturally, Rothbard´s example in my above post” What Has Government Done to Our Money?” refers to a gold standard, but indirectly the same principle is meant to apply for a fiat money reserve standard and that is when fiat money are deposited in a bank, the banker is obliged to pay in cash on demand.
Demand deposit=A bank deposit that can be withdrawn without advance notice.
Björn Lundahl
Published: May 18, 2007 7:34 AM
why are people responding to David Hillary?
The guy is an ivory tower crank.
Published: May 18, 2007 8:08 AM
Björn Lundahl is now talking about balances of customers with banks that are repayable to the customer's order, i.e. the core of the 'business of banking' legally defined. A bank, legally, is a person who conducts current accounts for customers, pays the customer's cheques and collects the cheques deposited by the customer to the credit of the customer's account. So let's examine them separately.
Current Accounts
Definition
A current account is an accounting record maintained by one person, the account keeper, of the credits, debits and the resulting balance owing from or owed to another person, the account holder, in the course of a relationship. Normally the account keeper makes a periodic statement of account to the account holder, showing the opening balance, record of debits and credits and what they were for, and the closing balance.
Current accounts are also called open accounts and other terms depending on the industry, country and/or type of account holder.
Characteristics
The current account records the transactions and resulting balance with a single counterparty from the perspective of the account keeper. Generally this is therefore, on its own, just the view of the account keeper and has no legal effect. However, inasmuch as the account records the transactions correctly and they are binding and valid on the parties, the balance of the account is the amount legally owing from one party to the other.
Under most circumstances, mutual debts between parties from separate transactions cancel out, and only the net amount is legally owed. The device of an account enables all the transactions to be recorded in a way that calculates the net balance.
For entries to be made on the same account, they should be between the same two persons in the same capacity. For example transactions with an account holder acting both in his personal capacity and in his capacity as trustee of a trust should be recorded on separate accounts, and in the same way the account keeper is a single person acting in a single capacity.
By stating an account on an account statement, the account keeper could be estopped from later backing out of its position to the disadvantage of the account holder, however this does not apply in all cases. For the account holder, an account statement is not, legally, an ‘account stated’ and binding on the account holder, as striking the definitive and agreed financial position between the parties, since the account holder is not obliged to check the accuracy of such account statements. This leaves an ongoing burden and risk for the account keeper to document each entry on the account and risk disputes about entries, and therefore, the balance.
Usage
Current accounts are normally used to provide or obtain short term credit and to administer transactions when the transactions between the account keeper and account holder are ongoing.
Many small companies survive on loans from their shareholders, and these loans are often made and repaid on an as needed and as available basis. For this type of transaction, the company’s accounting records show an account labelled ‘shareholder’s current account’, or ‘current account with [shareholder name]’ to record the advances and repayments, and interest charged (if any).
Many businesses that provide goods and services to customers on an ongoing but ad hoc manner conduct current accounts for their customers as follows. Sometimes the customer is required to place a deposit, which puts the account into credit, if the business is not willing to provide the goods or services to the customer on credit. Whenever the business delivers goods or services it charges the amounts payable to the customer’s account. The business sends the customers monthly account statement, which also operate as an invoice (often called an ‘invoice statement’) and the customer is required to pay the outstanding balance by a due date. Thus a current account enables for periodic net deferred settlement of the balances owing. When the relationship finishes, the customer settles the final amount owing or the business refunds any credit balance. If the customer overpays, or otherwise has a credit balance, the customer can demand repayment, but this demand is normally only made if the credit balance is substantial. A current account of this nature is to be distinguished from a trust account, which is a device to segregate the funds from the funds of the business accepting them.
Some businesses provide loans to their employees in the form of salary advances, which are repaid via deduction from the salary of the employee. These advances and deductions, and the resulting balances are shown on the employee’s payslip, and are recorded on the businesses accounting records under a current account.
Banks conduct current accounts for their customers in respect of deposits, withdrawals and payments which are addressed in the next section.
Cheque Accounts
Definition
A cheque account is a current account with a bank that can be drawn on by cheque, and to which cheques may be deposited for collection by the bank.
Characteristics
The cheque account, as a current account, has the same characteristics as other current accounts. The account keeper is the bank and the customer is the account holder. Unlike non-banks, banks often conduct more than one account for the same customer; however the bank retains the right to combine accounts for various purposes. The right of the bank to combine accounts shows that the different accounts of the same customer with the same bank have an administrative rather than a legal effect. Were the accounts in the nature of distinct trust funds, no right of combination would exist.
The transactions of paying and collecting cheques have their own particular characteristics, and it is the conduct of these transactions that make banking distinct from non-banking business.
The legal definition of a bank is ‘Banker includes a body of persons, whether incorporated or not, who carry on the business of banking’ (Bills of Exchange Act 1908 (NZ), section 2). This definition, although circular, nevertheless does define the term bank functionally rather than institutionally, that is to say a bank is someone who carries on a particular business, rather than a person with a special structure or licence.
The business of banking, at common law, involves three necessary elements:
1. The bank must conduct current accounts for customers
2. The bank must pay cheques drawn on the bank by its customers, from available funds on the customer’s current account
3. The bank must collect cheques deposited by its customers, for credit to their current accounts.
Clearly it is not the conduct of current accounts for customer alone that makes a firm a bank – as detailed above many non-bank businesses conduct current accounts for their customers – it requires the payment and collection of cheques from and to such accounts to constitute the business of banking.
The legal definition of a bank customer is person who has a cheque account of his own with the bank, rather than a note holder or a person who receives other services from a bank without having a cheque account of his own with the bank.
The contemporary legal definition is somewhat outdated, cheques having been largely overtaken by other payment instruments, especially those that enable the customer to order payments from the account via an authenticated electronic message, and which are processed in favour of the payee’s account with the payee’s bank without the need to receive and bank paper instruments (i.e. cheques). Thus banking law theorists have suggested that sending/receiving third party payments to/from a current account replace the cheque based definition.
The bank-customer relationship is contractual, and the key implied terms of the contract have been subject to extensive litigation over hundreds of years of banking disputes, and as a result, are well known and established. Implied terms are terms that are considered necessary to make the contract work and so obvious that they go without saying.
The key terms of the bank customer relationship are:
1. Debtor-creditor terms in respect of the balance of the current account(s) and deposits of the customer
2. Principal-agent terms in relation to the payment and collection of cheques, with funds debited from and credited respectively to the customer’s current account
3. Right of the customer to appropriate a deposit to a specified account with the bank
4. Right of the bank to appropriate a deposit to any account of the customer if the customer has not specified an account the deposit is to be appropriated to
5. Right of the customer to secrecy by the bank in respect of the balance of the account and the transactions that go through the account (subject to exceptions)
6. Right of the bank to set off different accounts of the same customer
7. Duty of the bank to pay the customer’s cheques up to the available balance of the customer’s account
8. Liability to pay on a debt of the bank (or of the customer) on current account does not arise until a demand is made
9. The bank must not close the current account of the customer without reasonable notice, as cheques are normally outstanding in the ordinary course of business for several days
10. In the case of an overdraft, the bank is entitled to charge interest and compound it periodically, and a cheque for more than the available balance of an account is construed as a request for an overdraft
11. Bank’s lien on cheques in the process of collection to the extent that the customer is indebted to the bank
12. Duty of customer to exercise reasonable care in drawing cheques to prevent forgery.
13. Duty of customers to customer to notify the bank immediately if a fraud is discovered affecting the account.
Numbers 1, 5-7 and 10-11 are the ones that explicitly or implicitly acknowledge the debtor-creditor relationship in respect of the current account of the customer with the bank. As this matter is dealt with and supported by banking law texts, an example of the relevant sections and supporting references from Tyree’s Banking Law in New Zealand, will be quoted in full to argue the point:
‘3.2 Implied Terms
3.2.1 Debtor/Creditor
The key implied term of the banker-customer contract established in the landmark case of Foley v Hill is that, in relation to a customer’s deposit with a bank, the bank is the debtor of the customer, not a trustee of the funds. Lord Cottenham said:
'Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it. Money paid into a bank is money known by the principal to be placed there for the purpose of being under the control of the banker; it is then the banker’s money; he is known to deal with it as his own; he makes what profit he can, which profit he retains to himself. He has contracted, having received that money, to repay the principal when demanded a sum equivalent to that paid into his hands.'
Accordingly, when a banker receives money from a customer or from a third party for the account of a customer, the banker does so as borrower, not as trustee, bailee, or agent. The bank obtains title to the money and the income it generates. On the insolvency of the bank the customer ranks as a mere unsecured creditor and at best can expect the return of a fraction of the original deposit. The roles of debtor and creditor are reversed when the account is overdrawn. This implied term is necessary for business efficacy of the banker-customer contract. So, for example, if a bank were a bailor [sic, should be bailee] of the customer’s money, the bank would hold and return all of the same notes and coins deposited and keep them segregated from any other money in the possession of the banker. As bailors [sic, should be bailees], banks would have found it difficult to carry out their basic function of intermediation by on-lending deposits to borrowers. Alternatively, if the banker were a trustee or agent in relation to the money deposited, the banker would be obliged to invest the money prudently or at the direction of the customer, and to account to the customer for the actual income earned rather than pay interest at an agreed rate.’
Usage
Cheque accounts are used to provide finance and fee revenue to the bank and to provide a form of wealth to customers that can be used for savings and third party payments by drawing and depositing cheques.
Cheque accounts over time have eroded bank notes in importance in the banking business:
‘The system of banking has recently undergone an entire change. Instead of the bank issuing its own notes in return for the money of the customer deposited with him, he gives credit in account to the depositor, and leaves it to the latter to draw upon him to bearer, or order by what is now called a cheque.’ (Stevens Elements of Mercantile Law, 5th Edition, Butterworth & Co, London, 1911, p 294)
Additionally, and like current accounts with non-banks, a cheque account with a bank is used as a means of providing credit to the customer. Such debit balances are called overdrafts, and are a common means of providing personal and business customers with short term finance.
So, as with bank notes, cheque account balances are simple debtor-creditor terms.
Published: May 18, 2007 9:08 AM
Eric Lansing
”why are people responding to David Hillary?
The guy is an ivory tower crank.”
I am at least not doing that.
Björn
Published: May 18, 2007 9:24 AM
David Hillary: "Fractional reserve banking is, as far as I see it, the regular and ordinary form of banking..."
Since Geir, Jim and others seem to hold David's position, this question is addressed to them as well. What to you think of the quantity theory of money and fractional banking's role in inflating/deflating the money supply?
Eric: "why are people responding to David Hillary?"
Because his position is the dominant one in the world.
Like many Austrians, I think fractional reserve banking is fraudulent, but I oppose it more because of its disastrous consequences. I firmly believe we would not have the welfare state we suffer today had we squashed FRB a century ago.
Published: May 18, 2007 9:47 AM
RogerM asks: 'What to you think of the quantity theory of money and fractional banking's role in inflating/deflating the money supply?'
This moves the discussion from the legal nature of the bank-customer or bank-note holder relationship to the economic impact of it.
The quantity theory is expressed as P*Y=M*V, where P is the price level, Y is the real economic output rate, M is the stock of money and V is P*Y/M. Thus V cannot be measured or considered on its own account, and it is merely the function of the three other variables. V is also not a constant and thus does not imply any relationship between the other three variables. Thus the tautology is not helpful in understanding P, or, for that matter, M or Y.
Many anti-fractional-reserve-bankers appear to tacitly or explicitly follow the quantity theory, however their views are not consistent with it. Anti-fractional-reserve-bankers typically argue that fractional reserve banking commits a sin of providing money not 'backed' by equivalent quantity of specie, however the quantity theory of money does not even reference the quantity of specie.
The term 'money supply' should be used with caution. Normally the word supply refers to a FLOW rather than a STOCK, however money is a stock. Normally if the supply (flow) schedule moves to the right or downwards (i.e. 'increasing supply') the price will be reduced, however this does not apply to stocks but to flows (or if it applies to stocks, it applies differently). For example if the stock of cars increases, this may be consistent with an increase in the price of cars (if the increase was due to greater popularity of owning cars) or a decrease (if due to an increase in the supply flow of cars without an increase in the demand flow, resulting in a build up of unsold cars).
In the same way the word inflation (and the word deflation) requires caution. Normally these words are not used for changes in stocks, but to changes in prices.
To really understand the economics of money, the interest rate, capital and the exchange rate of money, requires clear thought processes and proper analysis. In particular, stocks should be distinguished from flows, non-financial capital from financial capital, and the process of obtaining equilibrium over time should be modelled. I have a theory about this but it would take a long time to explain.
Published: May 18, 2007 11:11 AM
In my bookshelf I found an old book and looked into it “Dollars and Deficits, Inflation, Monetary Policy and the Balance of Payments”, by Dr. Milton Friedman published in 1968, chapter two, page 76:
“I cannot forbear a minor digression at this point. For a long time I have been a proponent of 100% reserve banking. Under this system, the depositary activities of banks would be separated from their lending and investing activities, and the depositary institutions would serve as pure warehouses of funds. For every dollar of deposits, they would be required to hold a dollar currency or its equivalent. Those of us who favour this scheme are accustomed to being labelled “unrealistic”; to being told that we are proposing a reform that has no chance of adoption and would require utterly impractical changes in the banking system if it were adopted.”
It seems that Milton Friedman gave up this idea of 100% fiat money reserve standard and instead proposed a monetary rule as this standpoint was more politically feasible.
Björn Lundahl
Published: May 18, 2007 12:18 PM
David Hillary: "To really understand the economics of money, the interest rate, capital and the exchange rate of money, requires clear thought processes and proper analysis."
That's what I thought. You disagree with it. Forget the formula and focus on the general concept of the quantity theory of money which was discussed by scholars at the School of Salamanca over 400 years ago: increases in the money supply cause a general increase in prices, all other things being equal. Everyone in Europe noticed this phenomenon in the 17th century as Spain shipped received boatloads of stolen gold and silver from the Americas.
The largest part of money today exists as loans that are deposited in checking accounts. If those loans come from the savings of other individuals, then no increase in the money supply takes place. That would happen only under a 100% reserve system. A fractional reserve system creates loans out of nothing (or gives two people claim to the same saving, depending on how you want to look at it.) 100% reserve banking would fix the stock of money supply. FRB allows banks to inflate the money supply by ten times the reserve amount with a reserve requirement of 10%.
Proponents of FRB have to find a way to deny the quantity theory of money in order to justify their position. But it's one of the most solidly established principles of economics. Without the quantity theory, we're left with no explanation for price inflation other than the random shocks of Keynesian and Neo-Classical econ. And we're left without an explanation for business cycles, except the silly "expectations" of neo-Classics and "sticky prices and wages" of the neo-Keynesians.
The only reason to focus on gold as money is that gold can't be printed at will by banks or the government. But monetary inflation can still happen under gold money, as has for centuries, because of credit expansion. The only way to stop the horrendous economic events like the Great Depression is to stop FRB. The first century and a half of the US was nothing but one financial disaster after another, every ten years about, all caused by FRB expanding credit, then contracting it when firms went bankrupt, and all under a gold monetary system.
Published: May 18, 2007 5:52 PM
RogerM
we're in agreement that this area of economics requires clear thought processes and proper analysis.
If the P*Y=M*V formula is incorrect, what is the correct formula?
Under a free banking and a gold standard there are two forms of money: non-financial (gold coin) and financial (bank notes and cheque account balances). The correct relationship in connection with the quantity of money is the quantity of gold coin and the interest rate: the interest rate is a decreasing function of the gold coin stock. The interest rate is the rate of return on, and opportunity cost of holding, gold coin. The gold coin stock is subject to diminishing marginal returns, like every other form of non-financial capital.
Correlation is not causation. The exchange rate of gold coin can fall because of increase supply flows (downward and/or rightward shift of the supply flow schedule), and not because of an increase of the gold coin stock. During an adjustment period, the increased supply flow will increase the gold coin stock, which reduces the interest rate, and makes investments in substitute forms of capital (e.g. buildings) more economic. Increases in demand for labour and materials for construction of buildings pushes prices up and thereby, the exchange rate of gold coin down, over time. The decrease in the exchange rate of gold coin makes mining and minting coin less economic, reducing the rate of production. At the same time the reduced exchange rate makes the rate of scrapping coin to make ornaments and equipment increase, which together with the reduction in production flows will eventually reduce the stock of gold coin. The reduced stock of gold coin will increase the interest rate on money and make investment in buildings less economic. Reduced demand for labour and materials for constructing buildings makes the prices of labour and materials reduced, increasing the exchange rate of gold coin. And so on. Thus the exchange rate and interest rate of money take time to adjust, and the adjustment is in a cycle. If all the underlying supply, demand and rate of return functions are linear, mathematical modelling shows that the cycles are sinusoidal, and thus provide an explanation for the business cycle. By incorporating some forward looking responses in the form of the 'yield curve' and making longer rather than short term interest rate driving the demand for construction of buildings, the cycles become attenuating (also known as 'damped harmonic motion' similar to an automobile suspension system consisting of springs and shock absorbers). I wish I could offer a less complex model for the interest rate and the exchange rate, but this is where my analysis has lead me to. Thus there are other explanations to interest rate and exchange rate other than 'silly "expectations" of neo-Classics and "sticky prices and wages" of the neo-Keynesians'
Bank notes and cheque account balances are savings of their holders or the bank customers, savings that are in the form of a loan to the bank, and that the bank uses as finance for its assets. For example, if a worker earns $1000 during a month, and during the same month he spends $500, he has saved $500 during the month. This is a flow of savings which supports a flow of investment. Savings are also a stock, being the value of his holdings at any point in time. If the man's savings are in the form of bank notes or bank deposits on cheque account, he has invested in a financial asset, being the right of repayment against the bank. The bank thus borrows his savings, and uses them to invest in coin (non-financial capital) and loans to customers (financial capital). Thus banking operations consists of borrowing and lending money. Bank note holders and customers would rather lend to the bank than to commercial and personal borrowers because the bank will repay more conveniently (though its branch network and through the cheque clearing system and other payments systems), and more reliably (most major banks have AA credit rating (0.03% probability of default in 1 year), whereas most commercial borrowers have BB (about 1% probability of default in 1 year).
100% reserve 'banking' would not fix the stock of money, the stock of money would increase and decrease with mining/minting and melting/scrapping of gold coin.
Fractional reserve banking allows for the form of savings to be changed but it does not allow for their quantity to be changed. For example, if bank customers buy corporate bonds, bank bonds, or even make term deposits with the same bank, the form of the customer's wealth holding changes from a monetary form to a non-monetary form. Since the bank holds corporate paper and similar assets in its own portfolio, it simply sells such assets to fund such customer withdrawals. Thus it is as if the bank had repaid some of its financial assets directly to its customers as repayment of amounts owed on cheque account. In the same way a goods intermediary can be cut out of the transactions by consumers buying direct from the factory, credit intermediaries can be cut out of the credit transactions by savers investing directly in the obligations of commercial and industrial (and for that matter personal) borrowers. However, as with goods production and sale, borrowing and lending will always have a place for intermediaries. No one says that a goods intermediary creates products 'out of thin air' since it sells them without ever producing them. In the same way a bank loan does not come 'out of thin air' simply because it didn't fund the loan through equity but rather it funded it through borrowed capital.
The great depression was caused by trade protectionism/tariff wars, wage and price controls, banking regulation that thwarted the emergence of large strong multi-state multi-branch banks, and many other causes involving government intervention.
Published: May 18, 2007 10:11 PM
Jim
I am sorry for not answering your comment. I thought some of my posts might give you answers and that I needed not, therefore, to directly answer your question.
Well, it is the depositors who are defrauded in a fractional reserve system and not the borrowers as fractional reserve bankers cannot fulfil their obligations against all the depositors. This is the main thing.
Björn Lundahl
Published: May 19, 2007 12:42 PM
Well, here is some more heavy artillery. I have named it “bombe surprise.”
100 percent gold reserve money standard
I quote from America’s Great Depression, by Murray Rothbard:
Preventing Depressions
“Private banks, it is true, can themselves inflate the money supply by issuing more claims to standard money (whether gold or government paper) than they could possibly redeem. A bank deposit is equivalent to a warehouse receipt for cash, a receipt which the bank pledges to redeem at any time the customer wishes to take his money out of the bank's vaults. The whole system of "fractional-reserve banking" involves the issuance of receipts which cannot possibly be redeemed”.
And:
“But a 100 percent gold reserve requirement would not be just another administrative control by government; it would be part and parcel of the general libertarian legal prohibition against fraud. Everyone except absolute pacifists concedes that violence against person and property should be outlawed, and that agencies, operating under this general law, should defend person and property against attack. Libertarians, advocates of laissez-faire, believe that "governments" should confine themselves to being defense agencies only. Fraud is equivalent to theft, for fraud is committed when one part of an exchange contract is deliberately not fulfilled after the other's property has been taken. Banks that issue receipts to non-existent gold are really committing fraud, because it is then impossible for all property owners (of claims to gold) to claim their rightful property. Therefore, prohibition of such practices would not be an act of government intervention in the free market; it would be part of the general legal defense of property against attack which a free market requires.[28], [29).”
http://www.mises.org/rothbard/agd/chapter1.asp#preventing_depressions
Björn Lundahl
Published: May 19, 2007 1:15 PM
David:"Thus the exchange rate and interest rate of money take time to adjust, and the adjustment is in a cycle."
Is this your own theory of business cycles or did you learn it from someone else? Essentially, you're saying that business cycles under gold money are caused by fluctuations in the production of gold mining. However, gold mining might fluctuate by +-3%, not nearly enough to cause the massive economic disruptions of the past. Still, the US hasn't been on a real gold standard since WWI, so how do you explain the Great Depression and the numerous recessions since then?
David: "100% reserve 'banking' would not fix the stock of money, the stock of money would increase and decrease with mining/minting and melting/scrapping of gold coin."
As I wrote earlier, 100% reserve banking would fix the stock of money, all other things being equal, that is, assuming no increase in gold from mining, melting, or scrapping. But the important point is that money supply increases from those sources are limited to about a 2-3% annual growth whereas credit expansion under FRB is unlimited. The unlimited expansion of money under FRB has resulted in the world's greatest financial disasters.
David:"The great depression was caused by trade protectionism/tariff wars, wage and price controls, banking regulation that thwarted the emergence of large strong multi-state multi-branch banks, and many other causes involving government intervention."
While those actions aborted the recovery from the Depression, they didn't cause it. Read Rothbard's account of the Depression for the best analysis of the causes. In summary, the cause was the malinvestment in the 1920's caused by massive credit expansion, and that was due to FRB.
David:"The bank thus borrows his savings, and uses them to invest in coin (non-financial capital) and loans to customers (financial capital). Thus banking operations consists of borrowing and lending money."
You're employing slight of hand here, as most bankers do. What does the bank do with the "borrowed" funds? It loans them out at interest to a borrower. If the bank were truly "borrowing" a depositor's savings, then the depositor would not have access to those funds until the borrowing customer repaid his loan. But in FRB, both the depositor and the borrower have access to the same funds. The banks then runs a shell game to cover demands for cash when two or more parties have claim to the same savings.
FRB is not unlike a car dealer selling the same car to two different people knowing that each consumer will only need the car a few minutes per day. So the dealer takes the car when one owner isn't using it and delivers it to the second owner. If both owners need the car at the same time, the dealer simply "borrows" one that looks like it from another unsuspecting customer who might not need it at the same time. The more customers the car dealer has, the easier it is to juggle cars and keep the shell game going. If all customers need their cars at the same time, the dealer goes bankrupt. In banking, we call it a run on the bank. The only difference between the car dealer and a bank is that the government will bail out the bank while it will send the car dealer to jail.
David: "No one says that a goods intermediary creates products 'out of thin air' since it sells them without ever producing them. In the same way a bank loan does not come 'out of thin air' simply because it didn't fund the loan through equity but rather it funded it through borrowed capital."
You may not think you follow the Real Bills Doctrine, but everything you write agrees completely with it. Banks are not intermediaries under FRB; they create money. If banks were intermediaries, they would charge a fee for storing people's money in checking and savings accounts and not loan out that money. They would pay interest only on time deposits.
Published: May 19, 2007 10:03 PM
RogerM asks several questions and makes several further comments.
The business cycle and monetary economics theory I mentioned before I didn't get from anyone else, and I can't find anyone else who has reached the same conclusion.
I'm not saying that business cycles under free banking and gold standard would be primarily caused by fluctuations in gold production schedules but by variations in any of:
1. gold production supply schedule
2. gold consumption demand shedule
3. demand schedule for holding gold coin for liquidity reserves etc.
4. the investment demand schedule for the construction of capital assets (e.g. buildings).
Variation can come from variation in any of these supply/demand factors. However the effect of such changes depends on which one changes. For example a change in the gold production supply schedule will not have an immediate effect on the short term interest rate, instead it will have an effect on the rate of surplus/deficit in the gold market, which impacts the stock of gold coin only slowly and over time. In the short run the system is not susceptible to volatility in the exchange rate of gold coin, since prices are not flexible in the short term, and there is no mechanism to foster across the board adjustments at the short term. Instead, any day to day variations show up in the short term market interest rate, which is perfectly flexible. For example, a change in the demand to hold gold coin shows up immediately in the short term interest rate: if banks and non-banks want to hold gold coin more urgently, since the gold coin stock can change only slowly over time, the existing stock is bid for at higher prices (interest rates), so allocates the holdings to those who are willing to forgo the highest returns for holding them. For example if some banks get into financial difficulty, the depositors and note holders of it will be less willing to maintain them or hold them, and some proportion of the funds will be re-deposited with other (stronger) banks, some proportion will be held as bank notes of other banks, and some proportion will be held as gold coin, thus increasing the overall demand for holding gold coin. This demand can only be met by other holders of gold coin (e.g. the bank in financial difficulty, other banks, and the public) being persuaded to hold less, something they will only do if the returns from holding less reserves or more bank deposits are higher. It takes time for the high interest rates to increase the exchange rate of gold coin, since the process of deflation takes time, and even when the exchange rate is higher, it takes time for the resulting surplus in the gold market to significantly increase the gold coin stock. This is why the process of adjustment can only be correctly understood as occurring through time. Of course it is possible that the more urgent demand to hold gold coin w