Comments (242)

• DixieFlatline

  Great job Prof. Salerno. I find that when intellectuals get petty and pedantic in debate, it means their position may be very weak.

  Published: May 18, 2009 5:58 PM

• Stan Kwiatkowski

  Usually I don't like when the big guns smash each other in blog posts, but this confusion seemed ridiculous, so thanks for posting this.

  I heard the lecture in Prague and this part wasn't confusing at all. There was however a part that struck me somewhat non-Austrian if not just plain false, and the first moment I've seen a debate over the article starting, I really hoped someone would address it:

  When prof. Hoppe writes:

  the crisis has led to heightened uncertainty. People want more certainty vis-à-vis a future considered far less certain than before. Accordingly, their demand for cash increases. With the quantity of money given, the higher demand for money can be satisfied only by bidding down nonmoney goods' prices. Consequently, as the overall "level" of prices falls, the purchasing power per unit money correspondingly rises. Each unit of money is productive now of more certainty, and the desired level of uncertainty protection is restored. The crisis is ended.

  does he mean by this, that the crisis is an uncertainty crisis, not a real economy, wrong-allocation-of-production-goods type crisis? Monetarism strikes back?

  Published: May 18, 2009 6:04 PM

• George Selgin

  Sorry, Joe, but Larry's right: HHH clearly mixes up "excess demand for money" with the holding of "excess" money balances, and to that extent appears to be confused. Under the circumstances Larry's brief clarification (hardly a "lecture," ponderous or otherwise) seems perfectly appropriate. What's more I should think that it is understood that such posts are aimed, not solely at the author of the original piece, but at all blog readers, who shouldn't mind a little "lecturing" by an expert.

  On the other hand, HHH surely deserves to be "chastised" for accusing me, of all people, of overlooking or even rejecting Hutt's insights on the yield for money!

  For the record: I like money; think it a good thing that people hold it, and believe it provides it's holders with a valuable stream of exchange-related services. On the other hand, I see no advantage in "excess" money holdings, because they are...excessive!

  Published: May 18, 2009 6:08 PM

• Alexander Villacampa

  Absolutely fantastic argument.

  Published: May 18, 2009 6:13 PM

• John

  What is a hasty generalization for an ounce of gold, Joe?

  @George; Do you see no advantage of excess corn holdings, or excess shoe holdings?

  @Stan I _think_ this misallocation causes the uncertainty in the first place. People aren't sure that their assets are as valuable as money(due to initial malinvestments), so they trade their assets for money until enough assets have been liquidated that investors are confident that only sound assets are available and production is renewed.

  Published: May 18, 2009 6:27 PM

• Samuel

  I’m puzzled by all the wrangling over “excess demand.” Now, “excess supply” certainly can be determined by measuring the size of the business-sector inventory for a particular good, or by counting the number of people seeking a particular kind of employment. However, I understand that wants can be infinite. I would choose a trillion dollars to a billion dollars. I would choose a ton of good apples to an apple, because I could hope to sell most of the ton and get some money. One may indeed infer excess demand for a particular good if its inventory is particularly small and has been so for some time. However, I don’t see that a quantitative estimate is possible in some cases. Can’t we just say that wants are infinite and let it go?

  I agree with Hoppe that people may want to hold some money to buffer their fears about what the future may bring. Isn’t it true that some kinds of stress may cause medical problems? If holding money reduces those kinds of stress, that would be a social benefit, no?

  Published: May 18, 2009 6:50 PM

• Joe Salerno

  George,

  Thanks for your scholarly and temperate reply.

  Think about it George. In four of the five consecutive sentences quoted by White, Hoppe is clearly talking about an "(unanticpated) increase in the demand for money," requiring, according to the free bankers, "a compensating money-spending injection from the banking system" or "help . . . from a system of freely competing fractional-reserve banks." Why then would he suddenly, in the fifth sentence, shift to a scenario wherein people are holding excess balances. How would injections of new money from competing fractional reserve banks be presumed to cure such a situation? It makes no sense. No, by "the holding of 'excess' money," Hoppe means what Keynesians mean by "excess saving," an excess of planned or ex ante saving over investment which is excessive in relation to the full employment level of saving. For free bankers, although they may not prefer this terminology and it may be a bit awkward, I do not think it misepresents their position to say that ex ante or planned cash holdings are in excess of the level necessary to ensure the free banking level of employment in the short run, that is, over the duration of the monetary adjustment process.

  Joe

  
  

  Published: May 18, 2009 6:52 PM

• Jeremy

  This debate is interesting, although I can't say that I totally understand it. But I also do not completely understand its use. Both sides agree that there should be a free market in money and banking, right? So, any voluntary contract would be permissible in the absense of fraud or coercion.

  Is the debate then merely conjecture re: what would happen in a free market? Or are there implications regarding which types of contracts would be permissible?

  I don't want to derail the debate here and I am very possibly misunderstanding things. If I am way off just ignore me please....

  (p.s. I appreciate your politeness Joe. Another reason why I prefer the Mises crowd to those like Steve Horwitz).

  Published: May 18, 2009 7:02 PM

• Steve Horwitz

  Four quick points Joe:

  1. I stand by my (and George and Larry's) interpretation of Hoppe. Nothing you say here convinces me to the contrary.

  2. I also stand by my contention that it was egregiously bad form for Hoppe to suggest that the free bankers are anti-Hutt when George and I have separately written pieces on "The Yield from Money Held" that praise it and articulate its importance for free banking. That bad form is made even worse by Hoppe's apparent ignorance of the articles in question. One would think that if he were going to adopt this line of argument, he would have checked out the Austrian literature on Hutt and those articles, esp. George's given its almost identical title.

  3. I stand by this sentence as well, which was genuinely a question: "do the other Rothbardian critics of free banking really understand the concept?" I'm curious to read back through some of the criticisms of free banking and see. The answer might be yes.

  4. All of that said, I'll apologize for my overreaction in my last sentence of my original blog post. Joe is correct that one error does undermine all that someone should say on a subject. I think Hoppe's wrong on free banking of course, but his arguments deserved to be treated each on their own merits. My sweeping generalization was born mostly of my frustration out of number 2 above, and it was wrong.

  Published: May 18, 2009 7:09 PM

• Jule Herbert

  I think what Selgin or White are saying (or at least White is saying) is that Hoppe has placed them in the wrong camp and that they agree with his (and Hutt's) point: That the holding of cash balances is productive and not something that needs remedying by inflationary policies. Is this not an occasion for celebration?

  On the other hand, Horwitz seems to miss the point completely and makes it clear that he disagrees with Hutt.

  Published: May 18, 2009 7:26 PM

• vc

  "It can indeed be alleviated by an injection of additional units (or, alternatively, by an increase in the purchasing power per unit of money). "

  That one is priceless.

  So, if I understand this, the "excess demand for money" can be alleviated by

  1)"injecting additional units"- which decreases the purchasing power per unit of money.

  2)"(or, alternatively, by an increase in the purchasing power per unit of money)"

  Obviously, I would have to include myself in the category "other Rothbardian critics who don't understand free banking". And I am proud of it!

  Published: May 18, 2009 7:39 PM

• Masonite

  "Steve, my answers are: 1.The Rothbardian critics you address went to real graduate schools like Columbia, Rutgers, VPI, Berkeley, etc, and do not need a Heyne-level lecture from you on the meaning of excess demand for money or for anything else."

  So Joe, whaddya know? How do the CV's of those folk (eg: you) look alongside the CV of someone who did not go to a "real graduate school" (eg: Pete Leeson)?

  Published: May 18, 2009 8:11 PM

• Joe Salerno

  Steve,

  Regarding your first point: Do I understand your position to be that Hoppe is imputing to free bankers, within the compass of five sentences, the absurd position that monetary injections by competing fractional reserve banks cure both an excess demand for money conventionally understood (first four quoted sentences) and excess money balances (fifth quoted sentence)? Or is it just possible that Hoppe is referring to "excess" money balances already being "hoarded" by some via a reduction of demand for goods and services from others? In this case, if prices are "stuck," there results a progressive redistribution of money balances and an incipient condition of chronic excess demand for money, a condition you free bankers find socially detrimental.

  This brings me to your third point. It just struck me after reading your posts here and on The Austrian Economists that it is free bankers who hold a purely notional concept of an excess demand for money in which the demand for cash balances increases BUT NOTHING ACTUALLY HAPPENS, until banks, central or free, ride to the rescue by increasing the supply of money or the economy collapses into depression. In the Mengerian world, in which values and preferences give rise instantaneously to actions, an increase in the demand for money will impinge on the market immediately. There is never an instant when the monetary adjustment process is not operating. In this world, specific people increase their demand for money by reducing their demands for a variety of goods and building up their cash balances. As Hayek brilliantly pointed out in his book on Monetary Nationalism this immediately precipitates reductions in product prices, incomes and cash balances of those initially affected. The latter in turn struggle to replenish their cash balances by cutting their own demands for the products of still other sets of market participants causing yet another round of falling prices, incomes and cash balances, and so on down the line. There are two implications of this analysis that are worth highlighting for free bankers. First, during this time consuming process of adjusment of the purchasing power of money, there exists an ACTUAL condition of excess monetary demand. At the same time people who believe that this process is socially detrimental may claim that it results from an "excess" build up of cash balances by those who initiated the process and there would be no conradiction. Second, it is not necessary to explain the temporal dimension of this adjustment process by recourse to ad hoc New Keynesian/Old Monetarist explanations like menu costs, relative price misperceptions, the "who goes first problem," long term contracts etc, as many free bankers unfortunately do. In fact as Mises and Hayek showed, the temporal dimension of the process is perfectly consistent with flexible prices in a world in which adjustment to the change in the money relation takes place in sequential or step-by-step fashion. So contrary to the free bankers, we are ALWAYS living in a world of excess monetary demand or supply, of never ending adjustment, because monetary equilibrium like all other equilibrium concepts is simply an imaginary construct that can never exist.

  Joe

  Published: May 18, 2009 8:12 PM

• Steve Horwitz

  No Jule, I don't. I agree totally with Hutt and have said so in print multiple times. The holding of cash balances provides the holder with the subjective return of availability services. Purely *holding* cash balances requires nothing from monetary institutions. See “A Subjectivist Approach to the Demand for Money,” Journal des Economistes et des Etudes Humaines, 1 (4), December 1990, pp. 459-71.

  What the free bankers (all three of us in this case) are saying is that *excess* demands for money, that is, when actors' desired real balances exceed their actual real balances, can be remedied one of two ways: by waiting for prices to fall or by increasing the nominal money supply.

  We argue the former is problematic and the latter is not. To call the latter "inflationary" is to beg the question. The *question* is whether increases in the nominal money supply needed to maintain monetary equilibrium (i.e., meet those excess demands) are, in fact, inflationary. The free bankers argue they are not.

  Again, the mere HOLDING of cash balances certainly requires nothing of the monetary system. It is having actual holdings less than desired that does. It seems to me Jule is possibly making the same mistake we're suggesting Hoppe has made: confusing an "excess demand" as "desired > actual" with actually holding large cash balances. These are two different phenomena.

  Published: May 18, 2009 8:15 PM

• Ohh Henry

  Sounds like the opponents of the Austrian economists, if people desired to store a certain number of potatoes for winter and an insufficient supply existed, would fix the problem by providing more but smaller potatoes.

  In other words they think that an individual's desire to hold more cash than exists in their hands at the moment can be satisfied by providing more (but devalued) money.

  This argument for making bread from stones is in the Bible associated with the sophistry of the devil (Matthew 4:3). Just saying.

  Published: May 18, 2009 8:46 PM

• John

  I find the tendency of factions within Austrian economics to criticize each other like this to be offputting. Argue your side, say why you think the other side is mistaken, then let the reader decide. Something may or may not be a "vicious or gratuitous swipe," but we can figure that out on our own.

  (This isn't directed at Joe, but is a broader point. We obviously see this in blogs rather than in scholarly work, and for good reason.)

  Published: May 18, 2009 8:51 PM

• Jule Herbert

  Steve: By "agreeing with Hutt" I meant his well known emphasis on price flexibility and the need of institutional reforms to free up downward price rigidities. In your book on Microfoundations and Macroeconomics, you state "Hutt glosses over too lightly ... the role that alternative banking institutions might play in aggravating or remedying increases in the demand for money." [p.186] Hutt was always insistent that increasing the money supply was a poor substitute for increased price flexibility and his view is fairly presented by you in the cited work. It does not seem to be your view however.

  Published: May 18, 2009 8:56 PM

• Steve Horwitz

  Jule,

  Okay, that clarifies it. I still agree with Hutt, however. We should do all we can to remove downward price rigidities. Hutt is quite right that any institutional reform we can muster to do so is right and good. My point, however, is that even if we got rid of all the ways in which the state makes prices rigid, especially downward, it would not eliminate *all* downward price rigidity as some is inherent in the ways in which markets operate.

  My point about Hutt glossing over monetary issues can be reframed in that context: even in a truly free market, if there is an irremovable degree of downward price rigidity, then it might well be the case that increases in the nominal money supply are the preferred way of dealing with excess demands for money. I think Hutt rejects/ignores that possibility a bit too quickly, but this is the crux of the issue between the pro/anti- free bankers.

  The irony of this whole dust-up is that I think Hutt is one of the most under-appreciated economists of the 20th century. I've written several pieces on Hutt (on the money held question, the book chapter, a piece in the Journal of Labor Research, not to mention several on his quite correct understanding of Say's Law), all of which were attempts to, no pun intended, rehabilitate him in the eyes of the profession, including Austrians and fellow travelers.

  Part of what's frustrated me in all of this is being implicitly (and now explicitly) tagged as a critic or opponent of a man whose work I have tried to hard to bring back into the conversation. I'm willing to submit that there isn't an Austrian of the post-revival generation who has published more on Hutt, and heaped more praise on him, than I have. I have nothing but admiration for, and agreement with, Hutt's work and for his courage in being one of the lonely voices for good economics and liberty during the darkest hours for both.

  Published: May 18, 2009 9:15 PM

• Steve Horwitz

  Joe,

  Your response to me deserves and requires a longer, careful reply. Unfortunately, I'm at a workshop most of tomorrow and out of town for several days after that. I will try to reply if I can, but if I don't get to it, don't take that as my not having seen it or think it deserving of a serious reply.

  Published: May 18, 2009 9:18 PM

• Don Lloyd

  Steve,

  "What the free bankers (all three of us in this case) are saying is that *excess* demands for money, that is, when actors' desired real balances exceed their actual real balances, can be remedied one of two ways: by waiting for prices to fall or by increasing the nominal money supply."

  I don't think that talking about 'real' balances makes sense, at least in the practical world.

  Let's say that I am routinely holding an nominal average of $4000 in cash, replenished at the beginning of a monthly pay period, and adequately stretching over that one month period.

  If I now expect a short term inflation rate of 20%/month to appear over the next month, do I try to increase my cash balance to restore my desired 'real' balance? Of course not. I would try two things. First I look for short term investments, if any, to partially offset the inflation, and, secondly, I would attempt to spend cash as early as possible for goods that I can use and for goods that I can eventually resell. This is, of course, exactly what happens in countries experiencing hyper-inflation. Money is spent immediately for almost any good possible to avoid holding money as its purchasing power collapses.

  In a more normal economy, the amount of inflation damage to a cash balance within a pay period is down in the noise. There will be no attempt to adjust the cash balance for predicted inflation. Instead, the cash balance will be dynamically adjusted on a trial and error basis. The cash balance will be increased if money runs short before the next paycheck and it will be decreased if a surplus amount remains. This is effectively an after-the-fact adjustment for inflation, if any, and it requires no prediction of inflation and it tracks actual purchases made rather some general index number.

  Regards,Don

  Published: May 18, 2009 9:35 PM

• Jule Herbert

  One more point to Steve: What is the mechanism by which free banks can make more money for "hoarding" available, given this supposedly unrealized excess demand for money?

  Let's say that during a downward episode accounted for by ABCT, or regime uncertainty, or whatever, liquidity preference or the desire to increase cash balances rises. And let's say the choice for most would be, at best, between reducing consumption purchases or by borrowing -- at interest -- from banks and then holding the borrowed sums as deposits in these same banks -- or currency under the bed. Surely borrowing for this purpose makes no sense.

  So if the banking system is to be of use here it must be by lending increased sums to persons who wish to use the new money to buy (and bid up the value of) resources and labor. How does that satisfy the supposed "excess demand" to hold money?

  Published: May 18, 2009 10:01 PM

• Samuel

  After posting my request to be enlightened about “excess” holdings, I tried to figure out how someone may determine when the economy’s aggregate money holdings are excessive. Would not surveying the whole world be necessary? But surely an impossible endeavor to do timely enough. So, I guess you guys are just being theoretical. I do see the point about the economy’s not being in equilibrium except in a few instants of time in a period of say three days. Hence it’s conceivable that every now and then the holdings will be excessive. I can see that the economy will try to restore excesses or deficiencies toward equilibrium or optimum. Eventually, however, who cares, as long as the economy is not too far from optimum?

  Whether excess or not, surely the point is that holdings are beneficial, as Hoppe showed. Indeed, I wonder why he made the crack about excess holdings at all?

  Published: May 18, 2009 10:05 PM

• newson

  professor horwitz says:
  "My point, however, is that even if we got rid of all the ways in which the state makes prices rigid, especially downward, it would not eliminate *all* downward price rigidity as some is inherent in the ways in which markets operate."

  for me, this is the critical point of disagreement, as this is the justification for the free-bankers monetary expansion. i see no reason why downward adjustments (absent political rigidities) are more subject to stickiness that upward adjustments.

  many would accept wage cuts if it meant saving the business or jobs (my pop-psychology comment is that fear is a stronger emotion than greed).

  bear markets typically last much less bull markets, which gives lie to the downward stickiness argument (for prices other than labour).

  Published: May 18, 2009 11:21 PM

• newson

  anyone aware of whether the original hutt article is downloadable?

  Published: May 18, 2009 11:22 PM

• Karlos

  Mr. Salerno's answer from "8:12 PM" is so clear and ultimate, that it's absolutely puzzling for me that the great economic minds like White or Horowitz cannot understand it.

  If higher demand for money occurs, its price (interest rate) will go up, in which case people will start to save more - i.e. supply the money through banking system to the market (no need to create more money). That also means they spend less and the prices of products will go down. At some point they will be so low that people will start spending again and save less.

  And that is the eternal market adjustment process Mr. Salerno is talking about. In fact, the "equilibrium", or at least something as close as possible to it, is achievable only if the market is allowed to function. New money injections is precisely the kind of intervention that CREATES the imbalances (resulting in excess this or excess that) people like Mr. White of Mr. Horowitz want to cure.

  Published: May 19, 2009 3:21 AM

• Anonymous

  "do the other Rothbardian critics of free banking really understand the concept?"

  Steve Horwitz can only hold this view if he's never read Rothbard. Steve Horwitz should read Rothbard's chapter on free banking in "The Mystery of Banking" to familiarize himself with the Rothbardian position:

  "Free banking, even where fractional reserve banking is legal and not punished as fraud, will scarcely permit fractional reserve inflation to exist, much less to flourish and proliferate. Free banking, far from leading to inflationary chaos, will insure almost as hard and noninflationary a money as 100 percent reserve banking itself" (Mystery of Banking, pg. 117).

  Rothbard was opposed to free banking for mostly ethical reasons. More specifically, Rothbard argued that fractional reserve banking is fraud:

  "fractional reserve banking is at one and the same time fraudulent and inflationary" (The Mystery of Banking, pg. 97).

  Steve Horwitz is clearly being hypocritical: he lambasted Hoppe for making uninformed accusations, and then proceeded to do the same thing himself. I hope Horwitz picks up the new edition of "The Mystery of Banking", it is beautiful.

  Published: May 19, 2009 4:56 AM

• Anonymous

  Karlos,

  "If higher demand for money occurs, its price (interest rate) will go up, in which case people will start to save more - i.e. supply the money through banking system to the market (no need to create more money). That also means they spend less and the prices of products will go down. At some point they will be so low that people will start spending again and save less."

  An increase in money demand will not lead to an increase in the interest rate like you suggest. This was Keynes's view and it is incorrect. An increase in the demand for money will lead to a fall in the price level (increase PPM). This alone will alleviate the shortage of cash balances (excess demand for money).

  I think you intuitively knew this because you allude to it in the second part of your paragraph.

  Published: May 19, 2009 5:10 AM

• Steve Horwitz

  Anon at 456am:

  "The concept" in question was not "free banking" but "excess demand for money." And I said "Rothbardians" not Rothbard. Trust me, I've read the book and have no doubt that Murray understood free banking. You're complaining about an argument I didn't make, so you can put your hypocrisy sword back in its holder.

  Published: May 19, 2009 7:05 AM

• DNA

  What's wrong with the free bankers? They have some pretty piss-poor attitudes.

  Published: May 19, 2009 7:24 AM

• Anonymous

  "You're complaining about an argument I didn't make, so you can put your hypocrisy sword back in its holder."

  I pulled out the hypocrisy sword because you clearly don't understand the party you criticize, whether it be on free banking or excess demand for money. To paint all Rothbardians with the same brush because of what Hoppe may (or may not) have said is utterly "egregious". I think it is hypocritical.

  You're distinction between Rothbard and Rothbardians is question begging. If ROTHBARDians don't refer to ROTHBARD on such questions, who do they refer to? If you believe all Rothbardians refer to Hoppe on such matters, than those Rothbardians wouldn't been Rothbardians, they would be Hoppeians. Thus, your original comment should have been: "do the other Hoppeian critics of free banking really understand the concept?"

  Published: May 19, 2009 7:46 AM

• Current

  Newson: "for me, this is the critical point of disagreement, as this is the justification for the free-bankers monetary expansion. i see no reason why downward adjustments (absent political rigidities) are more subject to stickiness that upward adjustments."

  I don't think that anyone is saying that upwards stickiness is generally greater or lesser than downward stickiness.

  Newson: "bear markets typically last much less bull markets, which gives lie to the downward stickiness argument (for prices other than labour)."
  Those are capital markets though, they earn interest.

  Besides, they are also extremely deep and extremely liquid. They do not represent the sort of market that exists elsewhere.

  In practice it is not just labour markets that are sticky. As I mentioned in the other thread producers goods of high orders are often exchanged by long-term contracts too. Rents are also sticky.
  

  Published: May 19, 2009 8:12 AM

• DNA

  I'm not sure if the issue is really about stickiness of prices, which may simply be the nature of things (i.e., neither good nor bad as such). The issue is the means of alleviating such stickiness if market participants so desire such alleviation. The free bankers cannot seem to envision any other method besides monetary inflation, which of course just redistributes property, it doesn't get to the nature of the stickiness of prices.

  Published: May 19, 2009 8:25 AM

• Current

  No. There are other mechanisms.

  The point that free bankers make is the changing the supply of money is a particular mechanism that can be used.

  I don't entirely agree with the Free bankers, especially with their views on the agreements that banknotes constitute. But I think they are right about this.
  

  Published: May 19, 2009 9:14 AM

• George Selgin

  John asks, "@George; Do you see no advantage of excess corn holdings, or excess shoe holdings?"

  No, I don't! Really, it's a matter of the plain, English meaning of "excess"! Do you think excess means "greater than zero"?

  When people have "excess" money balances, they have more than they wish to hold, and so will spend them off. If the excess is an aggregate excess, and the nominal money stock is fixed, then it can only be eliminated (and eventually will be eliminated) by a general increase in prices. The increase in prices reduces the real value of each outstanding money unit until the available real stock of money (M/P) no longer exceeds the real quantity demanded. If there's an excess demand for money, on the other hand, prices must decline so as to raise the real value of the existing nominal money stock.

  Surely Austrians should be the last to deny that an excessive quantity of money is both possible and undesirable!

  vc objects to the claim (White's, I believe) that an excess demand for real money balances can "be alleviated by an injection of additional units (or, alternatively, by an increase in the purchasing power per unit of money)," calling it "priceless," as if it to declare it absurd. He then says that he's proud of his inability to understand us free bankers.

  Well, vc, you are entitled to be proud of anything, I suppose. But the statement you find so absurd is one that no competent monetary economist, Austrian or otherwise, would object to. For instance, I'd eat my hat if my good buddy Joe Salerno didn't think it perfectly unobjectionable.

  Joe: I don't doubt that Hoppe meant what you say he meant. But his wording was certainly confusing, and the confusion, in my opinion, warranted Larry's clarifying response.

  Published: May 19, 2009 9:54 AM

• newson

  current says:
  "Those are capital markets though, they earn interest.
  Besides, they are also extremely deep and extremely liquid. They do not represent the sort of market that exists elsewhere."

  coffee, cocoa, sugar, pick virtually any traded asset (not necessarily yield-bearing) and you'll find the corrections are invariably sharper than the preceding rises, but that's by the by.

  i think you're confusing illiquidity with stickiness. illiquidity may increase volatility, but i take stickiness to mean that prices don't adjust quickly. i see no evidence of this, nor does your example qualify. you may not be happy about copping a savaging, but c'est la vie.

  and if you read carefully my citation of professor horwitz, you'll see he maintains prices are especially sticky on the downside, hence my objection.

  Published: May 19, 2009 10:33 AM

• Masonite

  "Steve, my answers are: 1.The Rothbardian critics you address went to real graduate schools like Columbia, Rutgers, VPI, Berkeley, etc, and do not need a Heyne-level lecture from you on the meaning of excess demand for money or for anything else."

  So Joe, whaddya know? How do the CV's of those folk (eg: you) look alongside the CV of someone who did not go to a "real graduate school" (eg: Pete Leeson)?

  
  What Joe - you make the snide swipe at GMU & then have nothing to say on this?

  I guess adjuncting somewhere does not really match up to Pete Leeson's job does it? I guess you might have done better to have not gone to a "real graduate program"!!!

  Published: May 19, 2009 10:39 AM

• George Selgin

  I doubt that Joe Salerno can take much comfort from Anonymous who, in pretending to agree with him, observes that "If higher demand for money occurs, its price (interest rate) will go up." In pretending that the interest rate and the "price of money" are one and the same, Anonymous subscribes to one of the crudest of all monetary fallacies--and one central to bone-headed Keynesianism. If the fallacy were correct, then logically it would follow that (to paraphrase Anonymous) "If higher _supply_ of money occurs, its price (interest rate) will go _down_"!

  Wrong--dangerously wrong! The sound view treats the "price of money" as the reciprocal of the general level of money prices.

  If Joe can't take much comfort in Anonymous's endorsement of his thought, Steve Horwitz might well wear Anonymous's rejection of his own as a badge of honor!

  Published: May 19, 2009 10:46 AM

• newson

  professor selgin:
  i'm still chasing you for an elaboration on your previous quote -
  "Even a pure gold system allows some scope for ABCT, as when there's a new gold discovery, and in fact I suspect that such a system would do a worse job of keeping interest rates at their "natural" levels than a fractional-reserve free banking system would do, because of its limited ability to keep nominal money supply in line with demand."

  i don't get it. why would the higher inflation subsequent to a gold discovery create the business cycle. i fail to see why there would be a bust phase.

  Published: May 19, 2009 11:01 AM

• Maciej Jarosz

  To sum up the argument:
  Too much terminology, too little content.

  FB argue that excess demand for money is bad. Excess is defined as desired cash balances larger than real balances.

  Can someone please take some time and precisely define what "DESIRED CASH BALANCES" are?

  Published: May 19, 2009 11:51 AM

• Current

  Newson: "coffee, cocoa, sugar, pick virtually any traded asset (not necessarily yield-bearing) and you'll find the corrections are invariably sharper than the preceding rises, but that's by the by.

  i think you're confusing illiquidity with stickiness. illiquidity may increase volatility, but i take stickiness to mean that prices don't adjust quickly. i see no evidence of this, nor does your example qualify. you may not be happy about copping a savaging, but c'est la vie."

  I'm fine with copping a savaging if I deserve it.

  I see your point about the commodities you mention, coffee, cocoa and so on.

  I see what you mean about the difference between liquidity and stickiness. However the two are linked.

  In your argument against the stickiness of prices you point at the bulk commodity markets and the capital markets. These though are not representative of all markets.

  It is not the case that each business buys things like oil, cocoa, sugar and coffee as inputs and sells things like them as outputs. Many businesses work very differently.

  For example, in the past I have acted as a "technical buyer" for a very large electronics company. In doing so I worked with the commercial buyers.

  In this situation a great deal is different. To begin with we deal with *products* not commodities. The product of one supplier will not necessarily be as good as the product from another. It is my job to assess which meet the specification. Simply performing that assessment costs tens or hundreds of thousands of dollars and takes months in many cases.

  Then bids must be collected from the various suppliers and compared. A contract must be negotiated. This takes the commercial buyer a great deal of time and effort. This must then be checked by the legal team.

  This buying process is costly. What it means is that a business can't move quickly and easily. Renegotiating a contract is only done in quite extreme situations.

  There is a link between liquidity and stickiness. If a market is very large and homogeneous then it pays to create a sort of uniform commodity market like nymex. That provides low transaction costs. It also encourages all players to provide goods that can be treated as commodities. That is by-the-by though.

  As Joe Salerno points out in some ways I don't need to rely on the conventional New-Keynesian stickiness arguments. Austrian recognize that changing prices is an entrepreneurial act and therefore requires planning. So they must recognize that it cannot be done instantaneously.

  Newson: "and if you read carefully my citation of professor horwitz, you'll see he maintains prices are especially sticky on the downside, hence my objection."
  You are correct, I apologise.

  I think that we can't say from first principles in what direction prices are likely to be most sticky. I think that it probably is downwards, but I can't prove it. Statistics would likely not be of great help here either.
  

  Published: May 19, 2009 11:54 AM

• Maciej Jarosz

  Professor Horwitz writes:

  "What the free bankers (all three of us in this case) are saying is that *excess* demands for money, that is, when actors' desired real balances exceed their actual real balances, can be remedied one of two ways: by waiting for prices to fall or by increasing the nominal money supply.
  We argue the former is problematic and the latter is not."

  Increase of nominal money supply is not problematic when people demonstrate their real desires to hoard more cash? It is problematic when they don't, but it is not prolematic when they do?

  Mises:

  "It may happen that the effects of a change in the demand for and supply of money encounter the effects of opposite changes occurring by and large at the same time and to the same extent; it may happen that the resultant of the two opposite movements is such that no conspicuous changes in the price structure emerge. But even then the effects on the conditions of the various individuals are not absent. Each change in the money relation takes its own course and produces its own particular effects. If an inflationary movement and a deflationary one occur at the same time or if an inflation is temporally followed by a deflation in such a [p. 418] way that prices finally are not very much changed, the social consequences of each of the two movements do not cancel each other."

  Published: May 19, 2009 12:04 PM

• George Selgin

  Jarosz: "FB argue that excess demand for money is bad. Excess is defined as desired cash balances larger than real balances."

  Correct, understanding that "excess" here means "excess _demand_." (Normally the term "excess" used without a qualifying noun refers to what in general equilibrium jargon is known as "excess supply.")

  To say that actual balances = "desired" balances is equivalent to saying that there's no tendency for the general level of prices to rise or decline. As for the determinants of desired balances, well, that's the subject of a huge body of literature and so is not easy to summarize in a line or two. A good place to start is David Laidler's classic book, _The Demand for Money_.

  Published: May 19, 2009 12:07 PM

• Maciej Jarosz

  Dear Dr. Selgin,

  Thank you very much for taking the time to respond to my question.
  Because of your clarification I think I finally understood the issue in this terminological battle, which got me completely lost for a while.

  Excess demand for money is money held by the people in balances which without an increase in the nominal money supply would lead to a decrease in the general level of prices.

  Published: May 19, 2009 12:34 PM

• George Selgin

  Jarosz: "FB argue that excess demand for money is bad. Excess is defined as desired cash balances larger than real balances."

  Correct, understanding that "excess" here means "excess _demand_." (Normally the term "excess" used without a qualifying noun refers to what in general equilibrium jargon is known as "excess supply.")

  To say that actual balances = "desired" balances is equivalent to saying that there's no tendency for the general level of prices to rise or decline. As for the determinants of desired balances, well, that's the subject of a huge body of literature and so is not easy to summarize in a line or two. A good place to start is David Laidler's classic book, _The Demand for Money_.

  Published: May 19, 2009 12:42 PM

• Coury Ditch

  What an interesting debate.

  I find it elucidating to come back to the big picture, it is too often we become lost in myopia with our pedantry. It seems there are some fundamental questions that have yet to be adequately addressed.

  @ Prof. Horwitz
  The second and third paragraphs of your 8:15pm post encapsulate my contentions to the tee.

  "What the free bankers (all three of us in this case) are saying is that *excess* demands for money, that is, when actors' desired real balances exceed their actual real balances, can be remedied one of two ways: by waiting for prices to fall or by increasing the nominal money supply."

  How is one to define 'excess'? Is this not a subjective valuation? If "excess demand for money" is defined as a persons 'desired real balance' exceeding their 'actual real balance', then is there not always excess demand for money? My 'real balance' is $100, but my 'desired real balance' is seemingly infinite. Of course I desire $1,000 over $100, or $100,000 over $1,000. Following this logic, there would be a need to constantly increase the supply of money as to fulfill the demands, thus massive credit expansion leading to massive amounts of leveraging with fraudulent fractional reserves backing it all up -- the very thing that causes business cycles, is it not? I realize this logic is refutable if the premise, based on my interpretation of your terminology, is faulty. Something tells me you will say it is indeed faulty.
  (After typing this I read the posts between Selgin & Jarosz, but I still feel confused)

  "We argue the former [price adjustment] is problematic and the latter [monetary expansion] is not."

  It seems to me quite the opposite, for the latter has ethical implications which pose as much more problematic: the redistribution of wealth inherent in the expansion of money.

  Would not falling prices benefit all consumers? Especially those who saved, for the purchasing power of their piggy banks would increase with the general decrease in consumer prices. Would not an increase in the money supply only benefit those who are willing to go into debt? (Unless there is a way, other than lending (credit, debt), to increase the supply of money.)

  "To call the latter 'inflationary' is to beg the question."

  Yes, to beg how one defines 'inflation'.

  "The *question* is whether increases in the nominal money supply needed to maintain monetary equilibrium (i.e., meet those excess demands) are, in fact, inflationary."

  If you agree that inflation is defined as 'an increase in the supply of money', then yes, "increases in the nominal money supply" are, in fact, inflationary.
  If there is fallacy in this logic, please correct me, for this seems fairly rudimentary.

  It also seems your entire premise is based on the notion that fractional reserve banking is legitimate. Your remedy to fulfill the demand for increased balances is to inflate the supply of money, something possible only with fractional reserve banking. As a free banker I assume you are against a central bank, yet a central bank is the very institution that lets fractional reserve fraudulence "work"; without the central coordinator, fractional reserve banking becomes quite precarious, as we have seen especially in the late 19th century and early 20th century.

  To sum up, if my logic is sound, non-monetary intervention would benefit all (especially savers), while 'fulfilling the excess money demands' through monetary expansion would, more or less, benefit debtors. One involves letting the market work itself out by way of price adjustment, while the other tries to cure the ills with monetary manipulation.

  In a way this debate is somewhat irrelevant. If such an instance were to occur in a 'free banking' society, then the market would show us what it prefers. If the banks prefer to stabilize excess demands by issuing unbacked notes through, what I view, as fraudulent practices, then so be it; if the free-banks would rather act scrupulously, then prices would naturally go down., and so be it. When it happens, we shall see how the market will react -- it will be a reflection on the acceptance of fraudulence, or at least the degree to which some can get away with it.

  Published: May 19, 2009 1:05 PM

• Steve Horwitz

  Coury asks:

  "If "excess demand for money" is defined as a persons 'desired real balance' exceeding their 'actual real balance', then is there not always excess demand for money? My 'real balance' is $100, but my 'desired real balance' is seemingly infinite."

  Think of the demand for money as a demand to hold some portion of your existing wealth in the form of money. That demand is not infinite because your wealth isn't infinite. The conventional understanding of the demand for money is that it's one way we allocate our wealth. You clearly don't want ALL of your wealth as money (given that you spend your money on other assets that you view as preferred forms of wealth). The idea of an "excess demand for money" simply means that individuals would like to hold more of their existing wealth in the form of money but cannot because there is not enough money to satisfy that finite demand.

  "If you agree that inflation is defined as 'an increase in the supply of money', then yes, "increases in the nominal money supply" are, in fact, inflationary. If there is fallacy in this logic, please correct me, for this seems fairly rudimentary."

  It's not a logical fallacy, but a definitional disagreement. I do NOT agree that inflation should be defined as increase in the supply of money. I would define it as an *excess* supply of money, i.e., a supply of money greater than the demand to hold it at the existing price level. (BTW, so did Mises in Theory of Money and Credit.) Increases in the money supply that bring that supply up to match the demand to hold real balances at the current price level are not inflationary. They prevent deflation.

  Again, it is issues such as these that are at the center of this debate.

  "It also seems your entire premise is based on the notion that fractional reserve banking is legitimate."

  That is correct. And I believe FRB is quite legitimate and have long been unpersuaded by arguments that it isn't. You should check the long thread here a couple of weeks ago on this topic for a really good conversation about this issue.

  "Your remedy to fulfill the demand for increased balances is to inflate the supply of money, something possible only with fractional reserve banking."

  Yup.

  "As a free banker I assume you are against a central bank,"

  I am.

  " yet a central bank is the very institution that lets fractional reserve fraudulence "work"; without the central coordinator, fractional reserve banking becomes quite precarious, as we have seen especially in the late 19th century and early 20th century."

  Nope. There are plenty of examples (see the earlier thread, or see White and Selgin's work, among others) of fractional reserve banking working just fine in the absence of central banking. You don't need a central bank for FRB to work. Both theory and history tell us otherwise.

  It is certainly true that central banks, or other problematic forms of government intervention, can destroy fractional reserve systems. But that is not a fault of FRB but a fault of central banking/regulation. The history of US banking in the National Banking System era is a great example of how bad regulations can undermine the stability of an FRB system, not FRB itself.

  Published: May 19, 2009 1:23 PM

• Joe E. Dorner

  Lord John M. Keynes' influence continues! You can see it in the terminology we have to deal with. Hoppe had to use the phrase "excessive demand for money" around which so much of this discussion-dispute revolves. As I read through Hoppe's original article and this blog I keep translationg the phrase "excessive demand for money" into "increased demand for money." I think it helps to clarify some of the differences.

  I do this because the value ladden term "excessive" is confusing. "Excessive" to who? From a subjective perspective certainly not to the one who has decided to save more, but perhaps to those who have to lower the prices of some of their goods/labor because of the resulting increased demand for money.

  If only we could throw out some of the less than ideal terminology economics is ladden with. Maybe we can work toward that over time.

  Great conversation.

  J.E. Dorner

  Published: May 19, 2009 2:21 PM

• Sag

  George Selgin,

  Thanks for your responses. This debate came at the right time! I will soon be ordering your latest book.

  Can you explain your objection to Joe Salerno's latest post? Steve Horwitz said he'll respond later so I'll look forward to that. What's yours? Apart from possible slights, I'm not sure I understand exactly what your disagreement is with Joe Salerno's position (or Rothbard's himself for that matter).

  As I understand it, you and the free bankers are saying that when there is an excess demand for money (relative to demand for other goods and services presumably), this disequilibrium can not be (efficiently?) eliminated by the downward adjustment of prices. Is this a special (monetary) case of inefficient market adjustment? If so, why would this be different than other cases of market adjustment to disequilibrium on the free market?

  Apart from this, how would a free fractional reserve bank go about determining if there's excess demand for money? Don't we know it only through people's demonstrated ordinal actions (increasing demand for money vs. other goods and services), that is historically? How would the bank then determine what the optimal amount of money is and who to give the new money to? Would the bank also monitor for an excess supply of money and how would it then remedy that?

  If I have completely misunderstood your position, please correct me. Suggestions welcome if I should read longer articles etc. Thanks...

  Published: May 19, 2009 2:36 PM

• Coury Ditch

  Thank you very much for your point by point reply! Much has been elucidated.

  I think I understand now what you mean by 'an excess demand for money': an excessive demand to allocate more of your existing wealth into cash balances. Yet I am still confused, as who is to define what 'excessive' is? Someone may prefer to hold all their wealth in money, while another may prefer to hold a majority in diamonds, gold, bubble gum, etc.

  "Increases in the money supply that bring that supply up to match the demand to hold real balances at the current price level are not inflationary. They prevent deflation."

  It seems you are now defining deflation as a decrease in prices, and that this is something you fear?

  Either way you handle it, price adjustment or money expansion, people want to increase their more immediate purchasing power. While price adjustment seems justified to me, as it is a natural market process, the ethical aspects of wealth redistribution which are inherent when one inflates the money supply has been left untouched -- this is the fundamental contention I have with your argument, and FRB in general.

  Rothbard's relation of FRB to grain warehouses in 'The Case Against the Fed' is the best attack against FRB I have heard (pg. 37-38,43-44). Much like you, but on the contrary, I have yet to hear a justification of FRB that is satisfactory. The creation of money out of thin air seems completely indefensible, why should anyone have this power?

  I shall definitely look into the history of FRB a bit more, thank you for the inspiration. I would like to see the cases in which it 'worked'. Although, even if it did work, the efficacy of it's practice hardly justifies it on ethical grounds; perhaps you can point me to some readings that put forward a defense of FRB, or at least attempt to refute the already wide spread moral refutations of it. Do you have a link to the thread you mentioned from a few weeks ago?

  This is why I love economics!! For I love the search for what feels to be truth, to be persuaded by the soundest arguments, to constantly think critically and incessantly revise ones beliefs! And in no other subject have I found such an abundance of strong persuasion from all sides. And in no other subject are there such subtle sophistries we must root out!

  Published: May 19, 2009 2:40 PM

• Steve Horwitz

  Coury,

  The earlier thread is here: http://blog.mises.org/archives/009873.asp

  The cases where FRB worked, at least according to the free bankers, are several, with Scotland of the 18th century being the best example. Check Larry White's *Free Banking in Britain* for more on that.

  Last thought: you argue as if the belief that frb is immoral is the standard view and that the view of the free bankers is the odd man out with the burden of proof. Nothing could be further from the truth. The overwhelming consensus of economists is that there's nothing fraudulent or immoral about frb and that the burden of proof is on its critics to make the case.

  Consensus does not equal truth of course, so my point is not to offer a counting heads theory of truth. However, understand that the reality of the economics profession and most other folks who have looked at these issues is that claims of frb as being immoral or fraudulent sound strange to them and is a real outlier position. Again, that doesn't by itself make it wrong, but it does suggest that the critics will be seen as bearing the burden of proof as their position is the unusual one.

  It's understandable that those whose monetary and banking education has come from reading Austrian economics alone would think the debate looks differently, especially if your reading has mostly been Rothbard and 100% reserve folks, but outside of our circle, there's no real debate.

  Published: May 19, 2009 2:51 PM

• DNA

  Steve Horwitz concedes that consensus does not equate to truth, yet scarcely a post of his goes by without him appealing to it in some way. Please make up your mind. State your case and never mind how many of your professional colleagues share it.
  

  Published: May 19, 2009 3:04 PM

• Anonymous

  George Selgin,

  "I doubt that Joe Salerno can take much comfort from Anonymous who, in pretending to agree with him, observes that "If higher demand for money occurs, its price (interest rate) will go up." In pretending that the interest rate and the "price of money" are one and the same, Anonymous subscribes to one of the crudest of all monetary fallacies".

  Apparently you didn't read the entire post. Those are not my words. I was quoting another post (Karlos at 3:21). Karlos suggested that the price of money and the interest rate are the same thing. I was correcting his error. You'll find my words if you read the whole comment, where I say:

  "An increase in money demand will not lead to an increase in the interest rate like you suggest. This was Keynes's view and it is incorrect. An increase in the demand for money will lead to a fall in the price level (increase PPM). This alone will alleviate the shortage of cash balances (excess demand for money)."

  George, I have to point out that this is hypocritical of you. You've lambasted Hoppe for (apparently) making a similar mistake.

  Published: May 19, 2009 3:08 PM

• DixieFlatline

  Whether or not FRB works, it does involve the duplication of property titles, which is in my understanding, counterfeit.

  I hope we see the day when FRB can be exposed to all methods of banking and warehousing in a free market, and then the theoretical debate can be settled with market action.

  Published: May 19, 2009 3:26 PM

• Sag

  George Selgin,

  Further clarification: what I'm interested in is the theoretical argument for free fractional reserve banking. I will also look at the history but I'm interested primarily in the theory at this point. I see from an earlier blog post you have a book called "Theory of Free Banking". Perhaps you answer all my above questions there. I would truly appreciate a response to the above either way. But I'll now read this book before "Good Money". Thanks...

  Published: May 19, 2009 3:27 PM

• Coury Ditch

  A burden is upon you, for I have put forward the case for why it is immoral. I have yet to hear one from your end. I will review the interview, and the posts on that blog and see if there are any good arguments for FRB (or at least refutations of Rothbardian moral views).

  I have no problem with 'fractional reserve banking' per say, as long as the bank customers are not deceived, as long as they know there money is being lent out and therefore their accounts are not advertised as 'demand deposit'. On the contrary, if they are under the deluded assumption that all of their wealth resides within the vaults of their bank, as bailment, and it is not so, such practice is blatant deception (i.e., fraud).

  The indefensibility of fractional reserve banking resides on the factor of whether or not the customers are being deceived, and if their accounts are portrayed as 'demand deposit' or not.

  You have yet to touch on the questions I, and now Sag, have posed.

  How is the bank going to increase the supply, by how much, and how will they know this? To whom will the supply go to? etc. etc.

  Published: May 19, 2009 3:31 PM

• Current

  Coury Ditch: "The creation of money out of thin air seems completely indefensible, why should anyone have this power? "

  As I have said earlier I don't entirely agree with the fractional reserve free bankers.

  However, I think in some circumstances the production of money is justified. I outlined one in the discussion on the Austrian Economists blog ( http://austrianeconomists.typepad.com/weblog/2009/05/larry-white-on-hoppe-on-the-yield-on-money-held.html#comments ) and I'll repeat it here. In this example I also try to create a more libertarian definition of "drug money" ;).

  Debt certificates can become acceptable media of exchange.

  Consider the legitimacy of the following hypothetical....

  I move to the deep west of Ireland where marijuana is acceptable currency. I setup in business and become very rich.

  My friends come to me one day and say that they need some money. Some other come to me saying that they have too much. I respond by writing a set of notes.

  "This note is a debt Current owes to the holder. Current promises to try to pay the holder on demand the sum of 10 grammes of hashish. In the case that Current cannot meet that demand when presented with the note he promises to pay 12 grammes of hash in three months from that time."

  Now, I keep reserves of hash. I also keep assets of other sorts. Growing plants for example.

  Over the years my bills are reliable and I always pay them. I never smoke the reserve. So, they come to trade on a par with actual hash. Nobody can really complain that my notes aren't backed by real dope since I haven't promised that.
  

  Published: May 19, 2009 3:34 PM

• Current

  Joe E Dorner: "I do this because the value ladden term "excessive" is confusing. "Excessive" to who? From a subjective perspective certainly not to the one who has decided to save more, but perhaps to those who have to lower the prices of some of their goods/labor because of the resulting increased demand for money."

  A lot of folks seem confused about this.

  Demand is constituted by *ability to supply*. To demand X I must have available one of the things that is tradable for X at the current market price.

  The point about "excessive demand for money" in this context is that a person can be in the situation where.
  A) They want a higher cash balance
  B) They have an asset that could finance that desire if sold.
  C) They agree to sell that asset at the current market price
  D) Nobody takes them up on that offer.

  This could happen because the market is illiquid for example. This case is described by Steve Horowitz and others as an excessive demand for money.
  

  Published: May 19, 2009 3:46 PM

• Sag

  George Selgin,

  Unfortunately, I could only find your book "Theory of Free Banking" on amazon.com for $84. Any suggestions? If you're still reading, anywhere I can find a (moderately priced) theoretical explanation that is pro free fractional reserve banking would be appreciated. Thanks...

  Published: May 19, 2009 4:38 PM

• scineram

  A refutation of the fraud issue is here.

  Published: May 19, 2009 4:41 PM

• Private-Freedom

  Steve,

  How can you defend FRB when it is clearly a violation of the first rule of property: That two different people cannot be the simultaneous owners of the same dollar?

  For that is the what happens in FRB. There are more property right contracts over dollars than there are dollars in existence.

  FRB is therefore *fraud*. The fact that throughout history, governments have sanctioned this banking behavior does not mean that it is justifiable as a legitimate institution.

  Published: May 19, 2009 4:49 PM

• Current

  As I said on the debate on this topic on the Austrian Economist blog the question is whether you consider a deposit to be a debt or a possession.

  As I said in this post
  http://blog.mises.org/archives/009973.asp#comment-545951

  If something is debt it would not be unethical. Larry White told me that he thinks banknotes are debt:
  http://austrianeconomists.typepad.com/weblog/2009/05/larry-white-on-hoppe-on-the-yield-on-money-held.html?cid=6a00d83451eb0069e20115708f528a970b#comment-6a00d83451eb0069e20115708f528a970b

  I think that misrepresenting the situation is clearly fraud. I have not met any person who is not an amateur economist who clearly understands that their deposit account is used as a source for loans.

  Whatever the situation was in Scotland in the past I think that we can do better now. If free banking is ever reinstituted the notes should bear a clear description of their nature as debt. There can be no promise to pay the bearer "on demand" unless that can be done in any concievable situation.
  

  Published: May 19, 2009 5:37 PM

• George Selgin

  Joe Dorner writes, "As I read through Hoppe's original article and this blog I keep translationg the phrase "excessive demand for money" into "increased demand for money." I think it helps to clarify some of the differences"

  Not quite right, Joe: an "excess demand for money" (the terminology isn't Keynes's, by the way--it is standard General Equilibrium stuff) means a demand greater than the existing stock, which isn't the same thing as an "increased" demand. For example: suppose everyone is happy with their (constant) real money balances, and then the stock of money shrinks somehow. So long as it takes the general price level time to adjust downward (and it generally does take time for this to happen) there will be an "excess demand for money." An "excess demand for" something is a shortage of that thing, in other words.

  For Anonymous: I did indeed blunder! I had in fact read Karlos's original remark, but then when I went back to copy and paste it, I lit upon your response instead, not realizing the difference, and then confused the one for the other. My sincere and humble apologies.

  For Sag: Well, I can only surmise that, at a price of less than $84, there would be an "excess demand" for my book! Still, it's highway robbery. I am in fact working toward having it published online. In the meantime I think your best bet is interlibrary loan, assuming that you have access to a university library or know someone who does.

  DixieFlatline writes: "I hope we see the day when FRB can be exposed to all methods of banking and warehousing in a free market, and then the theoretical debate can be settled with market action." Well D-F, there has _never_ been a law outlawing warehousing banking; the only government regulations concerning reserve ratios have been ones imposing _minimum_, not maximum, ratios. What's more, there have been instances when banking was free of any substantial government regulations, and particularly of regulations that might have served to favor fractional reserve banks over 100-percent reserve banks, including mandatory deposit insurance. In short, the "day" you look forward to seeing has already come and gone--in Scotland from 1765 to 1845; in Canada from, say, the mid-1800s to 1914 or so; and in several other places, as surveyed in Kevin Dowd's _The Experience of Free Banking_. In these instances the debate was in fact "settled by market action"--and that action declared fractional reserve banking the winner, while dealing the warehouse-bank alternative a thorough drubbing.

  And before you shout out, "fraud and deceit!" bear in mind that in those days only relatively well to do and therefore financially savvy people dealt with banks at all--people, in other words, who were just as smart as you. A few might even have been smarter! In any event, they were certainly smart enough to figure out that their bankers weren't paying interest on their "deposits" instead of charging warehousing fees to maintain them out of the goodness of their hearts. The Scotch have many virtues, but munificence isn't one of them!

  Finally, for all those who raise the "fraud" argument, the free bankers have responded at some length to it, in its various forms, in a number of different publications, for which see Walter Blocks bibliography, available on this site.

  Published: May 19, 2009 5:40 PM

• Sag

  scineram: Stephan Kinsella does not agree that fractional reserve banking is a good idea. He states that it is not specifically a species of fraud. Not that you disagree...

  What I'm interested in is the theoretical economics of free fractional reserve banking. What is the market demand that it is satisfying? If it is excess demand for money, is this demand unrelated to the purchasing power of money? If not then how would creation of new (unsaved) money not then lead to the diminished purchasing power of money? If it does, why would this not lead to the business cycle? Would market participants be aware of when and how much new money was being created? Who would get the new money? Why would this lead to more (real) economic growth than 100% banking etc.?

  Published: May 19, 2009 5:40 PM

• Sag

  George Selgin,

  "at a price of less than $84, there would be an "excess demand" for my book": that can't be right. Everyone loves economics!

  Thanks for your suggestion. I hadn't thought of that! I live near a university so I'll see if I can get hold of it. In the meantime, I hope you get the online version up soon!

  Published: May 19, 2009 5:47 PM

• George Selgin

  Sag: While you hunt for a copy of my TFB, you might read Adam Smith's excellent discussion of money in Book II, chapter 2 of _The Wealth of Nations_ :
  http://www.econlib.org/library/Smith/smWN.html

  There you will find Smith's classic discussion of the role of (fractional reserve) banks in economic development. Smith's discussion can be regarded as one that assumes a free banking system, as Smith basis it on the Scottish system ca. 1776.

  If you can stand a more technical treatment, here's one by myself and Bill Lastrapes, one of my UGA colleagues. Beware: lots of equations and numbers here: http://www.terry.uga.edu/~last/papers/working/draft7.pdf

  Published: May 19, 2009 5:50 PM

• Sag

  George Selgin: thank you! I will read both.

  Published: May 19, 2009 6:09 PM

• Private-Freedom

  George,

  Regarding your recommendation to refer to the free banker's publications concerning the accusation that FRB is fraud, exactly who has proven that it is not fundamentally fraudulent for more than one person to own the same dollar?

  I have never seen this point proven by any free banker, and for good reason: It is inherently fraudulent for any business firm to grant ownership rights for the same good to two different people.

  Could the reason that free bankers refuse to see the inherent fraud in FRB be a result of the fact that money is fungible? A long term storage facility commits fraud by selling his client's furniture, and a banker commits fraud by "selling" his client's money.

  I noticed that you are against central banks, but FRB will eventually create the perceived need to create a lender of last resort because of the inherent instability that institutionalized fraud creates.

  I, as a cash account owner, do not want to invest in risky projects. I want a bank to keep my money with them, safe and secure. If I wanted to invest money, I would invest money.

  It is the free banking advocates that provide the intellectual impetus for bank failures like Northern Rock to occur. If banks did not commit fraud by misappropriating their client's money, then should the investment side of the bank suffer losses, then the cash account holder's money would be safe.

  Oh, but we have deposit insurance don't we! Well, can't you see how FRB leads to the perceived need for government intervention in the form of both central banking *and* inflation financed deposit insurance?

  Your stubborn and persistent stance that FRB is not fraudulent is the fundamental reason we have a central bank and deposit insurance, and other forms of government intervention. Once you sanction fraud, by outright government action or business-related privilege, there will be terrible consequences. The (government controlled) market's inability to handle legalized fraud creates more government intervention, because people do not stop to think that FRB is fraud, because there are intellectuals who say it isn't.

  The legacy of FRB is dark. The claim that FRB worked in the past, but government intervention messed it up, fails to understand that it contributes to the business cycle. FRB causes more investments to be made in the economy than there are available voluntary savings in the economy. Why you cannot see this is beyond reason.

  Published: May 19, 2009 6:45 PM

• Private-Freedom

  George,

  Regarding your recommendation to refer to the free banker's publications concerning the accusation that FRB is fraud, exactly who has proven that it is not fundamentally fraudulent for more than one person to own the same dollar?

  I have never seen this point proven by any free banker, and for good reason: It is inherently fraudulent for any business firm to grant ownership rights for the same good to two different people.

  Could the reason that free bankers refuse to see the inherent fraud in FRB be a result of the fact that money is fungible? A long term storage facility commits fraud by selling his client's furniture, and a banker commits fraud by "selling" his client's money.

  I noticed that you are against central banks, but FRB will eventually create the perceived need to create a lender of last resort because of the inherent instability that institutionalized fraud creates.

  I, as a cash account owner, do not want to invest in risky projects. I want a bank to keep my money with them, safe and secure. If I wanted to invest money, I would invest money.

  It is the free banking advocates that provide the intellectual impetus for bank failures like Northern Rock to occur. If banks did not commit fraud by misappropriating their client's money, then should the investment side of the bank suffer losses, then the cash account holder's money would be safe.

  Oh, but we have deposit insurance don't we! Well, can't you see how FRB leads to the perceived need for government intervention in the form of both central banking *and* inflation financed deposit insurance?

  Your stubborn and persistent stance that FRB is not fraudulent is the fundamental reason we have a central bank and deposit insurance, and other forms of government intervention. Once you sanction fraud, by outright government action or business-related privilege, there will be terrible consequences. The (government controlled) market's inability to handle legalized fraud creates more government intervention, because people do not stop to think that FRB is fraud, because there are intellectuals who say it isn't.

  The legacy of FRB is dark. The claim that FRB worked in the past, but government intervention messed it up, fails to understand that it contributes to the business cycle. FRB causes more investments to be made in the economy than there are available voluntary savings in the economy. Why you cannot see this is beyond reason.

  Published: May 19, 2009 6:46 PM

• DNA

  George Selgin warns:

  "Beware: lots of equations and numbers here."

  I'm a quant on Wall Street, so I don't find this kind of thing particularly daunting, quite honestly. This is basically a neoclassicist paper, do you dispute that?

  Published: May 19, 2009 6:50 PM

• Steven Allen

  Current said:
  "The point about "excessive demand for money" in this context is that a person can be in the situation where.
  A) They want a higher cash balance
  B) They have an asset that could finance that desire if sold.
  C) They agree to sell that asset at the current market price
  D) Nobody takes them up on that offer."
  -----

  
  Isn't this exactly the point? The demand for money exceeds the current stock, and there are two possible "solutions":

  1) The price of goods drops such that the demand for money falls, freeing up the money. The reason you can't sell your good for money at the "current market price", is because your good is specifically NOT at the current market price, but is, in fact, too high. To turn your good into cash the price has to fall, whether you admit it today or wait 6 months (either because you value the good higher than the market does, or you have previous contracts and refuse to sell your good for less than you paid for it or the sum of the inputs, including your labor). The increased demand for money has cause (or will) a decrease in prices. This might seem "problematic" as previously stated by someone else, but the price of others good will be dropping too. Admittedly, not at the same rate and time, but will eventually drop. If one is going to argue (and Current, I'm not saying you are) that this price drop is "problematic" and not "undesirable", then they need to provide evidence and argument for that. I fail to see such argument in this thread. I only see an assertion that increasing the supply of money is "not problematic" or "less problematic". Again, exactly why?

  or

  2) We *fool* people into thinking that their demand for money has been satiated by increasing the money supply (inflating it). The money supply has increased, but real wealth (aka goods) have not increased, and the purchasing power of a unit of their money will decrease. They have a nominal number of units of money that they think has met their demand for money, but in relation to the price of other goods (purchasing power), it hasn't. At least it hasn't in the long term, unless they got the money first (and this would constituent a transfer and the wealth that could be derived from the money, from one person to another, without their "knowledgeable" consent, aka theft). It has ONLY met their demand for money because they don't yet realize that their demand (in terms of units of money) needs to increase to maintain their desired/demand ratio of money to goods that they own. It has ONLY "met" their demand for money because they have been fooled into thinking their money is more valuable that it actually is.

  Now, it seems that some of the arguments in the thread, which I may be mistaken on, are claiming that this increase in quantity of money is not inflation. Specifically because it won't cause a general price increase, and it won't cause this price increase exactly because it won't be spent as there was an excess of demand for money. (As an aside: If it won't be spent, and it is expected by the FRB that it won't be spend, what's the point of creating it in the first place?)

  Everyone now has their the money demand satiated (assuming we could drop the "new" money into just the right places to exactly meet demand). Not necessarily everyone's demand for money was "excessive", nor likely by the same amount, so even if we could place it just right as to meet demand, it will still cause a decrease in purchasing power for some people and not for others once the demand for money decreases, and it starts to be spent. Inflation as defined by a general increase in price of goods was just delayed longer than if the money was loaned and spent immediately, and with the same distorting effects on the economy, as per the ABCT.

  One more thing, how exactly will the FRBs "know" the exact amount of excessive demand by each individual person, or in aggregate? How will they know "in time" to make, in their view, the correct adjustments in the supply of money?

  Published: May 19, 2009 7:06 PM

• ajax

  I think the institute should hold an online blog debate between the heavyweights on both sides: Horwitz, Selgin, White and Garrison on one side, Block, Salerno, Hoppe and Hulsmann on the other. Only these individuals would be allowed to post. Let the debate run for a week, say Mon thru Fri, while the rest of us watch in anticipation for the next post. After the online debate, a new blog thread can be posted titled Your Reactions for us featherweights to chime in on. This is facinating stuff and I'm intrigued by the arguments on both sides. The winner of the debate would be the person who posts last on Friday....haha just kidding.

  Published: May 19, 2009 7:39 PM

• newson

  professor selgin:
  i'm still chasing you for an elaboration on your previous quote -
  "Even a pure gold system allows some scope for ABCT, as when there's a new gold discovery, and in fact I suspect that such a system would do a worse job of keeping interest rates at their "natural" levels than a fractional-reserve free banking system would do, because of its limited ability to keep nominal money supply in line with demand."

  i don't get it. why would the higher inflation subsequent to a gold discovery create the business cycle? i fail to see why there would be a bust phase.

  Published: May 19, 2009 8:50 PM

• newson

  to professor horwitz:
  by only referring to tmc, you're selling mises short.

  "Inflation, as the term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check...But people today use the term 'inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise." (Economic Freedom and Intervention: An Anthology of Articles and Essays by Ludwig von Mises, 1990, p 99.)

  "What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates" (Human Action p. 423).

  Published: May 19, 2009 9:24 PM

• Joe E. Dorner

  George Selgin writes, "So long as it takes the general price level time to adjust downward (and it generally does take time for this to happen) there will be an "excess demand for money." An "excess demand for" something is a shortage of that thing, in other words."

  Building on my original post, I would put that this way: "So long as it takes the general price level time to adjust downward...there will be an unsatisfied demand for money. An unsatisfied or increased demand for money may be partially caused by the unwillingness of sellers to lower their prices.

  I would avoid the common economic terms "excess" and "shortage" because they seem to imply the merit of creating/printing more money or the idea that the desire to hold more money(or more monetary buying power) is unhelpful to the economy in some way.

  Published: May 19, 2009 10:40 PM

• Lawrence H. White

  Joe Salerno calls my blog piece on Hans-Hermann Hoppe’s article “silly and petty,” “pedantically” written, “ponderous,” “uncharacteristically unperceptive and uncharitable,” and (worst of all) “slipshod if not downright disingenuous”. I honestly don’t think my piece deserves these descriptions any more than Salerno’s comment on it does. I regret that Salerno uncharacteristically did not stick to criticizing the arguments, which I tried to do regarding Hoppe's piece.

  But on to the substance of our disagreement. Salerno writes: “The first sentence of the second paragraph [of HHH’s that LHW quoted] follows logically from the first paragraph, ... There is no reference, explicit or implied, to the holding of excess money balances up to this point.”

  Not so fast. Hoppe’s sentence in question is:
  “Here it is again: an ‘excess demand for money’ (Selgin & White) has no positive yield or is even detrimental; hence, help is needed.”
  
  I read this as clearly a reference to the holding of money balances. What sense does it make for HHH to criticize the supposed view that “an ‘excess demand for money’ has no positive yield,” unless he thinks here that an “excess demand for money” does have a positive yield? To have a positive yield, must not an “excess demand for money” refer to an amount of money balances being held?

  The whole theme of Hoppe’s article is to criticize the view of those who think that the holding of money balances has no positive yield. That view being criticized is the “it” of “Here it is again”. Thus the sentence’s message is that the free bankers’ concern with the problem of an excess demand for money is a variety of the view that money-holding has no positive yield. The sentence makes sense only if the author thinks that the problem of an “excess demand for money” is a problem related to money balances currently held, not a problem related to a current deficiency of money.

  Salerno goes on to defend the last quoted sentence of Hoppe's passage. That sentence is: "However, the idea involved is the same: the holding of (some, 'excess') money is unproductive and requires a remedy.” Salerno claims that this sentence’s meaning is “pellucidly clear in light of the entire passage”. What is undeniably clear is that this sentence refers to the holding of money, not to a deficiency of money.

  Salerno, however, offers this interpretation: “Hoppe uses the term ‘excess’ in scare quotes to refer to the actual condition of excess demand that ensues upon the increased demand for money and which entails a Misesian process of a step-by-step reduction in prices and the (ex post and trivial) money spending stream.”

  Really? Let’s try to substitute this reading into Hoppe’s sentence. We get something like: “the holding of (some, as-yet-unsatisfied increased demand for) money is unproductive”. This makes no sense. It makes no sense to speak of the “holding” of something not being held but only being wanted. To answer Salerno's rhetorical question, that is the contradiction I see.

  Salerno continues: “Similarly the free bankers, Hoppe argues, consider the holding of cash balances by some of the public to be in ‘excess,’--at least during the time-consuming monetary adjustment process--of the level of money holdings necessary to ensure what we might call the ‘free banking’ level of output. (Indeed if no one actually increased his cash balances by reducing his demands for various products, the condition of excess demand that the free bankers fear so much would never actually be set in train).”

  I don’t get this. We free bankers (and other monetary disequilibrium theorists) don’t consider the holding of cash balances by some of the public to be in excess during the monetary adjustment process set in train by excess demand for money. Our concern is a situation where the level of real money balances at a point in time (during the monetary adjustment process) is too low for monetary equilibrium. How does this imply that we “consider the holding of cash balances by some of the public to be in ‘excess’” of the level necessary for equilibrium? How does deficient money holding in the aggregate imply excess holding by some members of the public? It doesn’t. Those who actually increase their money balances do not thereby hold excess balances relative to their new levels demanded.

  Published: May 20, 2009 10:44 AM

• Lawrence H. White

  Private-Freedom writes:

  "... concerning the accusation that FRB is fraud, exactly who has proven that it is not fundamentally fraudulent for more than one person to own the same dollar?

  I have never seen this point proven by any free banker, and for good reason: It is inherently fraudulent for any business firm to grant ownership rights for the same good to two different people."

  Nobody denies that a warehouse commits a fraud when it deceives A by giving B possession of a gold coin that it has contractually obligated itself to keep in storage for A.

  What free bankers deny is that ordinary banks are warehouses. Banks did not, under the gold standard, contractually obligate themselves to keep gold coins in storage for checking account or banknote holders. They issued debt claims, not bailments. They obligated themselves to repay their account-holders and banknote holders in coin, not to store their coins. Look at a bank account's or banknote's contractual language, and you'll see that it is very different from a warehousing contract's language.

  Thus a bank does not grant ownership rights to the same coin to two people when it lends to B a coin that A brought in. A no longer owns that coin, or any coin in the bank's vault. He owns a debt claim on the bank, a right to be repaid.

  Published: May 20, 2009 11:26 AM

• DNA

  Lawrence White:

  "Thus a bank does not grant ownership rights to the same coin to two people when it lends to B a coin that A brought in. A no longer owns that coin, or any coin in the bank's vault. He owns a debt claim on the bank, a right to be repaid."

  As you know from de Soto's magnificent book (which you reviewed), the ownership question does not concern specific physical coins, but specific weights or volumes of the deposited coins. But never mind that.
  You say that A has a right be repaid the amount (presumably) that he brought in. How can he be repaid, if the bank has lent out his deposit? I assume you're talking about a deposit, and not a loan, where A has no claim for some specified time? Do you mean he has the right, at some point in the future? What if C also makes a deposit? Let's assume the bank holds in reserve half of the money A and C have deposited. How can *both* A and C have the right to be repaid at some future point? One must clearly come before the other. Just because A and C may be aware of what the bank is up to, it doesn't follow that they've entered into a valid contract if it creates two separate claims to the same piece (amount) of property. Block, Hulsmann, and Hoppe have all dealt with this issue quite handily. It's an issue of simple logic, not history.
  

  Published: May 20, 2009 11:42 AM

• Steven Allen

  Perhaps I don't get it, but it doesn't seem to have been answered by the FRBs:

  What is it about an "excess demand for money" that free bankers think needs a solution other than letting the prices fall? Are people keeling over dead from the stress of not having their money holdings met?

  
  The free bankers whole argument of solving the problem of "excess demand for money" by supplying more money is, in fact, based on one big logical fallacy, as Mr. Hoppe tried to point out. This logical fallacy is the strawman fallacy. They are claiming that the cause of their "problem" is an "excess" demand for money. Logically then, supplying more money will fix that problem. The problem for them is that real "problem" and not their substitute problem, is the increased demand for future goods as opposed to current goods. Printing/creating more money doesn't solve this "problem".

  I think that what has been missed by many people in this thread is what Hoppe actually saying that people have an increased demand for future goods because of uncertainty. They don't really have a direct increased demand for money. Money is just the means to ensure that they can purchase future goods when they need them. What people are actually trying to do is increase their purchasing power in the future, by increasing their cash holdings.

  If we do, as the free bankers are implying, increase the supply of money, then we may "meet" the secondary increase in cash holdings demand. Remember, that's not what people are really demanding though, and increasing the supply of money only works to lower the real demand of future goods by fooling people.

  It's like saying to someone, "Oh, you want more potatoes for the winter because you think it will be longer or they'll be more difficult to come by? Ok, here's 1000 200g potatoes for your 800 250g potatoes. You have more potatoes." This might fool some people, but it certainly won't fool all. However, if you could substitute those 250g potatoes for 200g potatoes, include more of them, all the while keeping the potato owner thinking he still has (more) 250g potatoes, then all you've succeeded at is fooling him into thinking that his demand is met. He really had an increased demand to store more calories worth of potatoes (what the potatoes really mean for him).

  The intermediate of money makes this con game easier to pull off. His money looks the same has it has, and he appears to have more of it. It's only when he tries to exchange it for goods in the future, does he the realize it's not the same as what he though it was. All because there is now more nominal units of money for the same number of goods.

  Repeat: There is no real, primary demand for money, just demand for the goods that money could buy in the future. This is the same problem we have through most government action (and, BTW, a lot of current medical treatment) where we treat the symptoms/effects of something and not the root cause. Their are only two ways to truly meet the increased demand for ability to obtain goods in the future. One, to produce more goods of all types, or two, lower the price of those goods so that the stored purchasing power (money) can really purchase more future goods.

  Published: May 20, 2009 12:51 PM

• Current

  Steve Allen and Joe Dormer

  I'll answer you in parts. To begin with I'll talk about the microeconomic situation.

  Steve Allen says: "Isn't this exactly the point? The demand for money exceeds the current stock, and there are two possible 'solutions'"

  Here is what I said: "The point about 'excessive demand for money' in this context is that a person can be in the situation where.
  A) They want a higher cash balance
  B) They have an asset that could finance that desire if sold.
  C) They agree to sell that asset at the current market price
  D) Nobody takes them up on that offer.

  This could happen because the market is illiquid for example."

  Here I was talking about *one person*, a single actor. Not necessarily a whole group of actors who are all drawn to acting in the same direction. In this situation I think that I am correct.

  To clarify, in my view, there is a difference between ex ante demand and ex post demand.

  Suppose that I have a desire. That desire clearly isn't a demand. There may be several ways to fulfill that desire. For example, if I want to eat a brassica I could be cabbage, brussel spouts or brocolli. I can make the decisions about which I look for first or afterwards. The same is true on the supply side. I may got to market with several things I wish to exchange, but use only one of them.

  Suppose I have decided that I want money to hold. Ex-ante I may demand that money with several different sets of goods. To perform the transaction I can only exchange on particular good.

  Suppose that I have a violin and a flute. I know the market price of each. I travel to the local music shops. I offer the market price at each of them. Most of the shopkeepers tell me "I don't need a violin or flute". One however agrees to purchase the flute. Once this has happened I have ex post transferred only the flute. That doesn't change the fact that I wanted to sell the violin but couldn't. I may have preferred to sell the violin.

  You could say I had an excess demand for money I intended to fulfill using a violin. I was frustrated so I sold a flute instead.

  In this situation the pawnbroker can help. If the pawnbroker knows the price of something I can hand it over to him and get money.

  Just as the pawnbroker can help, so can the provider of credit money I described earlier (May 19, 2009 3:34 PM).
  

  Published: May 20, 2009 2:56 PM

• Current

  I've taken a bit of a "middle of the road" position in this debate. I'll clarify that a bit.

  DNA asks Laurence H. White:
  "You say that A has a right be repaid the amount (presumably) that he brought in. How can he be repaid, if the bank has lent out his deposit? I assume you're talking about a deposit, and not a loan, where A has no claim for some specified time? Do you mean he has the right, at some point in the future? What if C also makes a deposit? Let's assume the bank holds in reserve half of the money A and C have deposited. How can *both* A and C have the right to be repaid at some future point? One must clearly come before the other. Just because A and C may be aware of what the bank is up to, it doesn't follow that they've entered into a valid contract"

  You may not be interested in my view, but anyway.

  My view in this question is that if the banknote holder is aware that what he holds is *debt* then this is reasonable. What we have is mearly credit money.

  Credit money that should have a contract like:
  "This note is a debt Current owes to the holder. Current promises to try to pay the holder on demand the sum of 10 grammes of gold. In the case that Current cannot meet that demand when presented with the note he promises to pay 12 grammes of gold in three months from that time."

  If that is the case since the banknote holder is supplying debt to another he is agreeing to what is implied by debt. When one person loans something to another he does not require (unless he specifies) that loan to be kept in a particular form. The reciever is free to do whatever he likes with it. This includes taking on risk (by doing something such as starting a new business).

  The bank is compelled to keep debts on it's books to back up the credit notes. It must keep loans and gold reserves such that the sum of the loans and gold equal 100% of the value of notes in circulation. If it knowingly does otherwise it is defrauding it's owners.

  Now, I'm not sure if banknotes issued by free fractional reserve banks have been so explicit. I'm not sure that the holder have understood them, though Selgin & White say so.

  But, regardless of the historical facts. If credit money were issued with a contract as above it would be completely legitimate.
  

  Published: May 20, 2009 3:51 PM

• DNA

  Current:

  "My view in this question is that if the banknote holder is aware that what he holds is *debt* then this is reasonable. What we have is mearly credit money."

  Well, I think this is really what a lot of this debate comes down too. Opponents of FRB dispute that there can be any kind of banking function other than warehousing on the one hand or lending on the other. Supporters of FRB disagree, and believe that there is some kind of "third way." However, when the nature of such contracts is made truly explicit, they fall into one of the two previous categories, at which point allegedly compelling historical events are appealed to (to support the claims of a third way).

  Published: May 20, 2009 4:05 PM

• George Selgin

  Steve Allen writes: "how exactly will the FRBs "know" the exact amount of excessive demand by each individual person, or in aggregate? How will they know "in time" to make, in their view, the correct adjustments in the supply of money?"

  Really, Steve, these questions betray your complete ignorance of free banking theory. Under free banking, market forces (described in detail in my book and more tersely and formally in my Economic Journal article "Free Banking and Monetary Control") dictate changes in the money stock. We aren't talking here about central planning of the money supply: that's called "central" (not "free") banking!

  DNA: I'm glad you can handle my math, and, yes, the formal modelling in that paper is perfectly "neoclassical." Mind you, I don't think "neoclassical" a dirty word. Austrian economics isis itself, by many accounts at least, a special off-shoot of neoclassical economics, considering the latter as the economics that came into being with the great "marginal revolution" of the 1870s. As for the math, I'm usually happy to do without it; but some economists like it, and I don't mind trying to reach out to them so long as I don't have to depart from sound theorizing to do it.

  Anyway, I hope you find the paper somewhat compelling, whatever sort of label you assign to it.

  Private-Freedom asks me, "exactly who has proven that it is not fundamentally fraudulent for more than one person to own the same dollar?" Well, I don't suppose anyone has tried to prove that. Free bankers instead reject the premise that fractional-reserve banking involves some replication of titles to the same property. It's a simple point, really: banknotes and deposit credits aren't titles: they're IOUs; and it isn't fraud to hand out more IOUs than one has ready cash on hand, or else most borrowing would be fraudulent!

  So, it isn't free banks that pull the wool over their customers' eyes. It's De Soto and company who do so, by proferring a bogus analogy under the guise of a sound legal argument. Perhaps their writings should be bear a warning label to that effect!

  Finally, concerning the suggested debate, I say: Let me at 'em!
  

  Published: May 20, 2009 4:08 PM

• George Selgin

  Steven Allen writes: "There is no real, primary demand for money, just demand for the goods that money could buy in the future. "

  Thus we come full circle, with Steven defending Hoppe by invoking the very view that Hoppe (echoing Hutt) was objecting to, to wit: the view that no one wants money for it's own sake, because it yields no services except when actually exchanged for goods. (And I know my Hutt, dagnabbit!)

  Pardon me for finding this almost knee-slappingly funny. I bet even the very staid Joe Salerno is having trouble suppressing a giggle. Go on, Joe--let it out!

  Published: May 20, 2009 4:19 PM

• George Selgin

  Newson asks me to elaborate on my statement: "Even a pure gold system allows some scope for ABCT, as when there's a new gold discovery, and in fact I suspect that such a system would do a worse job of keeping interest rates at their "natural" levels than a fractional-reserve free banking system would do, because of its limited ability to keep nominal money supply in line with demand."

  I'm simply summarizing the insights of Richard Cantillon, who is often said to have anticipated the ATBC, but who considered the case of a gold discovery as the cause of relative price distortions. See, for starters, the Wikipedia article on Cantillon, section on "Classical Monetary Theory" (and no, I didn't write it).
  

  Published: May 20, 2009 4:25 PM

• Steven Allen

  Current,

  I'm not buying (no pun intended) your argument. What does various shopkeepers' demand for your violin have to do with and excess demand for money? Or that fact that you sold a flute instead of a violin? How exactly would creation of money "out of thin air", so to speak, help you sell your violin? (Other than, of course, fooling you into lowering your price without you know it).

  Wait a minute... is that the argument the free bankers are making here? If prices are "sticky" or don't fall fast enough, the free bankers can fool people into making their prices fall by devaluing the unit of money without the primary exchangers of goods realize it? So if they increase units of money by 10%, but people don't realize it yet, they can trigger a drop in price by approx. 10% (they're still asking the same number of units of money, but the units are worth less, so the price is lowered)? BTW, I'm not necessarily saying that this is the argument they are trying to make, but it does seem to me that it is logically equivalent or logically consequent to their argument.

  A pawnbroker would help, really? If there was a general excess demand for money, would not the pawnbroker also have a greater demand for money and not your violin? If he did, he wouldn't buy it or would value your violin lower. Or, let's say the pawnbroker didn't have an excess demand for money and was willing to buy your violin, what's really different than a music shop with a lower demand willing to buy your violin at the price you want? I really doubt that the music shops would really not want to buy your violin at some price (their valuation), but might not want to at your price.

  If you're trying to draw an analogy to the role a pawnbroker plays in your exchange of music instruments and money to general economic exchanges, I'm still not buying it. The pawnbroker will only help you if he's willing (based on his subjective valuation of your violin) to pay the price your asking. Money can't perform subjective analysis and choose to buy something.

  We're still back to having a general "excess" demand that will, in aggregate and over time, lower the price. You were not offering your violin for the market price at that time and place. The problem was your over-valuation of your violin based on the market conditions. Your demand for "money", which I actually believe is a primary demand for money, but for future goods that you don't know now which you'll need. How will just increasing the number of units of money truly lower demand for future goods?

  The answer is it won't, unless those with the "excess" demand don't perceive the overall lower purchasing power in the future, of their units of money. You've only fooled them into believing their demand is met, not actually met their demand.

  I believe, in your argument, you have used (unintentionally) the informal logical fallacy of weak analogy.
  

  Published: May 20, 2009 4:27 PM

• DNA

  The utility function approach adopted by neoclassicists (and George Selgin in his linked paper) is in pretty serious conflict with both Mises' value theory and the nature of knowledge as discussed by Hayek (just ask Steve Horwitz). So, I'm not sure what kinds of insights can be gleaned from it, if the underlying approach is questionable from an Austrian viewpoint.

  Published: May 20, 2009 4:36 PM

• Joe Salerno

  I appreciate Larry White's thoughtful and measured response to my post. Had his original piece on Hoppe's article taken this tone and been as carefully elaborated, I would not have been provoked--perhaps without sufficient forethought--into characterizing it as I did. For one economist to accuse another of not understanding the concept of the excess demand for money or anything else is like one mathematician accusing another of not understanding the concept of a right triangle--it may be true but the burden of proof lies heavily upon the accuser.

  I will now try to repond to Larry's substantive points in turn, leading with his words in quotation marks.

  1. "What sense does it make for HHH to criticize the supposed view that “an ‘excess demand for money’ has no positive yield,” unless he thinks here that an “excess demand for money” does have a positive yield? To have a positive yield, must not an “excess demand for money” refer to an amount of money balances being held?"

  The offending sentence by Hoppe to which White's series of question refers reads in part, "an ‘excess demand for money’ (Selgin & White) has no positive yield or is even detrimental; hence, help is needed.” Hoppe's sentence is certainly consistent with the free bankers' contention that an existing state of an excess demand for money, that is, unsatisfied desires for additional cash balances that are not being satisfied because the purchasing power of money is stuck, is socially "detrimental." If Hoppe was indeed referring to "an amount of money balances being held," as White maintains, why in the the world would Hoppe's second clause read, "hence, help is needed." It is clear, from the previous sentences, that the "help" being referred to is a monetary injection by the banking system. White does not give us a coherent explanation of how, in Hoppe's mind, a monetary injection will cure the problem, if, as White claims, Hoppe is imputing to the free bankers concern for "a problem related to money balances currently held, not a problem related to a current deficiency of money."

  2. "Salerno, however, offers this interpretation: 'Hoppe uses the term ‘excess’ in scare quotes to refer to the actual condition of excess demand that ensues upon the increased demand for money and which entails a Misesian process of a step-by-step reduction in prices and the (ex post and trivial) money spending stream' Really? Let’s try to substitute this reading into Hoppe’s sentence. We get something like: 'the holding of (some, as-yet-unsatisfied increased demand for) money is unproductive'. This makes no sense. It makes no sense to speak of the 'holding' of something not being held but only being wanted. To answer Salerno's rhetorical question, that is the contradiction I see."

  As I tried to explain in detail in my response to Steve Horwitz earlier in this thread, the monetary disequilibrium approach to an excess demand for money (EDM), which derives from Walras, is very different from the Mises-Hayel approach. For the former, the EDM is purely notional, it never really is actualized. In the extreme, either (central or free) banks adapt the supply of money to the demand instantaneously or, if not, a depression ensues and, as real income spirals downward, the demand for money collapses back to the existing supply at the prevailing price level, until prices become "unstuck." This is overstating things a bit for analytical purposes. In the Mises-Hayek, view, however, prices are as flexible as entrepreneurs and resource owners find mutually beneficial and the equilibration of the increased demand for money with the existing supply of money takes place step-by-step or sequentially over time as demands and supplies in different markets are effected with different lags. There thus exists for a period of time an actual condition of EDM during which money's purchasng power progressively adjusts. We must bear in mind that the specific market participants who initiated the EDM did so by actually increasing their cash holdings (at the expense of those the demand for whose products have declined). As I say in my comment on Steve, "At the same time people who believe that this process is socially detrimental may claim that it results from an 'excess' build up of cash balances by those who initiated the process and there would be no conradiction." I do not claim that this is the terminology that would be employed by free bankers or that they would deny that "excess" cash balances in this specific sense is productive on the indivdual level.

  3. "I don’t get this. We free bankers (and other monetary disequilibrium theorists) don’t consider the holding of cash balances by some of the public to be in excess during the monetary adjustment process set in train by excess demand for money. Our concern is a situation where the level of real money balances at a point in time (during the monetary adjustment process) is too low for monetary equilibrium. How does this imply that we “consider the holding of cash balances by some of the public to be in ‘excess’” of the level necessary for equilibrium? How does deficient money holding in the aggregate imply excess holding by some members of the public? It doesn’t. Those who actually increase their money balances do not thereby hold excess balances relative to their new levels demanded. "

  My reponse to White here is that he misinterprets what I say in the paragraph of mine that he is reponding to. I did not deny that free bankers believe that EDM implies a shortage of cash balances for at least some people as well as an overall shortage of cash during the course of the monetary adjustment process. What I said and what White quotes is, “the free bankers, Hoppe argues, consider the holding of cash balances by SOME OF THE PUBLIC [emphasis added] to be in ‘excess’. . . .of the level of money holdings necessary to ensure what we might call the ‘free banking’ level of output." Those who may be construed as holding excess cash balances, as I point out in my response to point 2 above, are precisely the market participants with increased liquidity prefeences who have started the entire process by cutting expenditures on goods and services relative to their incomes and have thereby actually increased their cash balances, while leaving others with a shortage that will induce further price adjustments and pass the shortages down the line. In this disaggregated sense, I think it is theoretically unexceptionable--although maybe rhetorically awkward--to say that the ACTUAL cash balances held by those who initiated the increase, at any point during the adjustment process, are in excess of the level consistent with monetary equilibrium. Absent the realized accumulation of cash holdings by people with increased liquidity preferences, monetary equilibrium would remain undisturbed.
  
  Joe Salerno
  

  Published: May 20, 2009 4:43 PM

• Lawrence H. White

  DNA @11:42 writes:

  "As you know from de Soto's magnificent book (which you reviewed), the ownership question does not concern specific physical coins, but specific weights or volumes of the deposited coins. But never mind that."

  That's why I wrote not just "A no longer owns that coin," but added "or any coin in the bank's vault." Here's another way to put it: When A exchanges a one-ounce gold coin for a debt claim on the bank, he relinquishes his ownership of one ounce of coined gold.

  DNA: "You say that A has a right be repaid the amount (presumably) that he brought in. How can he be repaid, if the bank has lent out his deposit?"

  Simple. He can be repaid out of the bank's reserves. Fractional reserves will normally be sufficient because only a fraction of claims will be redeemed on any given day. See Mises, the Theory of Money and Credit, (http://mises.org/books/tmc.pdf), p. 267. As Mises wrote:

  "it is quite possible for these claims to pass from hand to hand without any attempt being made to enforce the right that they embody. The obligee can expect that these claims will remain in circulation for so long as their holders do not lose confidence in their prompt convertibility or transfer them to persons who have not this confidence. He is therefore in a position to undertake greater obligations than he would ever be able to fulfil; it is enough if he takes sufficient precautions to ensure his ability to satisfy promptly that proportion of the claims that is actually enforced against him."

  "... mature and secure claims to money ... are complete substitutes for money, and, as such, are able to fulfil all the functions of money in those markets in which their essential characteristics of maturity and security are recognized. It is this circumstance that makes it possible to issue more of this sort of substitute than the issuer is always in a position to convert."

  DNA: "I assume you're talking about a deposit, and not a loan, where A has no claim for some specified time?"

  As you know from my review of Huerta de Soto's book, I'm talking about a demandable debt, which is neither a fixed-term loan nor a "deposit" in HdS's sense of a warehousing contract. It is a callable loan.

  DNA: "It's an issue of simple logic, not history."

  Yes. Your logic appears to be the following non sequitur: A warehousing contract is legitimate. A fixed-term loan is legitimate. A callable loan is neither. Therefore a callable loan is not legitimate.

  Perhaps you recall, from my review of HdS, my parody of this logic: A dog has four legs. A cat is not a dog. Therefore a cat cannot have four legs.

  DNA @4:05pm: "Opponents of FRB dispute that there can be any kind of banking function other than warehousing on the one hand or lending on the other. Supporters of FRB disagree, and believe that there is some kind of 'third way.'"

  Agreed so far.

  DNA: "However, when the nature of such contracts is made truly explicit, they fall into one of the two previous categories, at which point allegedly compelling historical events are appealed to (to support the claims of a third way)."

  How does an explictly demandable debt fall either into the category of a warehousing contract or into the category of a loan contract without callability? You are assuming what you need to show, which is that there can be no legitimate third contractual option.

  Published: May 20, 2009 5:32 PM

• Lawrence H. White

  I thank Joe Salerno for his thoughtful response to my post. I will be relatively brief.

  I wondered why Hoppe included “has no positive yield or” in his much-parsed sentence that reads in part “an ‘excess demand for money’ (Selgin & White) has no positive yield or is even detrimental; hence, help is needed.” It makes sense to talk about money held either having or lacking a positive yield. It does not make sense to talk about such a property with respect to money wanted but unheld. To rescue Hoppe's sentence, Joe emphasizes “detrimental” and “hence, help is needed,” but this cannot and does not resolve the problem with “has no positive yield”.

  Salerno: “White does not give us a coherent explanation of how, in Hoppe's mind, a monetary injection will cure the problem, if, as White claims, Hoppe is imputing to the free bankers concern for ‘a problem related to money balances currently held, not a problem related to a current deficiency of money.’"

  I think Hoppe’s sentence is confused. It and the two paragraphs around it make no sense when read as a whole. Can one give a coherent explanation of how someone else arrived at a confusion?

  Salerno: “As I say in my comment on Steve, ‘At the same time people who believe that this process is socially detrimental may claim that it results from an “excess” build up of cash balances by those who initiated the process and there would be no contradiction.’ I do not claim that this is the terminology that would be employed by free bankers or that they would deny that "excess" cash balances in this specific sense is productive on the indivdual level.”

  In a nutshell, to rescue Hoppe from the charge of confusion or incoherence, Salerno here proposes that Hoppe is criticizing the free bankers for a position that the free bankers do not take.

  Published: May 20, 2009 6:14 PM

• newson

  to professor selgin:
  nice dodge! i was actually hoping from an answer from you, not from the ghost of richard cantillon. do you subscribe to this view or not? and why should changes in gold supply under a pure gold standard generate the abc? where would the systemic error arise from? systemic errors do not result from changes in the price of oil or wheat, although gains and losses may be large on an individual level.

  Published: May 20, 2009 9:56 PM

• Joe E. Dorner

  Could somebody provide me with an outline of the various different "schools" within the Austrian school? We have the "Mises site" Austrians and the Free Bankers that Hoppe is criticizing? Correct? Are there others? As I read through this discussion this question comes to my mind. I'm just an avid reader of Austrian economics but do not know much of the recent development/divisions of the school. Thanks.

  Published: May 20, 2009 10:12 PM

• newson

  the argument that the scots were too shrewd to be taken in by frb is interesting in the light of the madoff case, where many of the investors were supposedly quite astute players. perhaps his defense lawyers will be able to use your argument as mitigation.

  you say common usage of "depositor" and "deposit" has mutated over the years, so that everybody is aware of the economic/legal implications of the new meaning. how many lawyers do banks employ? do they idly gloss over important details, preferring to rely on vernacular? i think not. when you open an account with the bank, i'm not aware of any explanatory document that tells you exactly how the contract is to be fulfilled under all eventualities (if you open a futures trading account the potential risks are listed and must be acknowledged by the client). now, why would this be? perhaps the banks are happy with ambiguities and the popular confusion.

  Published: May 20, 2009 10:16 PM

• Phil

  @newson - Are you implying that inflation alone generates a business cycle? An increase in the money supply as far as I understand it does not cause business cycles unless it affects the factors of production. If you are able to increase capital structure for example with an increase in the amount of coins that have been minted, this may cause a business cycle if no other factors are given. If a new plant is built for making Tesla autos (which I do think look very cool by the way... sorry - off topic) with a newly minted enviro-dollar then the misallocation is obvious. A business cycle may result and a boom/bust may happen.

  Hopefully the analysis is correct, but please let me know if I need to improve my logic. I am a bit of an Austrian noob, and definitely need to learn more. :)
  

  Published: May 20, 2009 11:37 PM

• newson

  to phil:
  i'm actually taking issue with selgin, who wants to have me believe that gold inflation can also set off a trade cycle along austrian lines. but inflation can only trigger the business cycle if it occurs via the banking system (through the fractional reserve mechanism).
  i can recommend this podcast by bill barnett, which should shed light on the issue.
  http://mises.org/multimedia/mp3/ASC2009/ASC09_Block_Barnett.mp3

  Published: May 21, 2009 1:15 AM

• Carlos Novais

  newson . "i'm actually taking issue with selgin, who wants to have me believe that gold inflation can also set off a trade cycle along austrian lines."

  That´s my position too. I think the "trade cycle" arises from the pretense of funding not through previsous and voluntary savings but from the printing of new money (with very low marginal cost).

  New mining discoveries and production have a real marginal cost and also new capital is needed to fund it.

  Relative prices will be affected but not the relation between "previous and voluntary saving" and investment.

  Published: May 21, 2009 4:33 AM

• Current

  Newson: "i'm actually taking issue with selgin, who wants to have me believe that gold inflation can also set off a trade cycle along austrian lines."

  I'm sceptical about this claim too. But I don't know enough about this part of the argument to comment.
  

  Published: May 21, 2009 4:33 AM

• Gil

  Theoretically, yes, a large bountiful gold find where the metal can be easily extracted on the cheap would cause hyperinflation under a gold economy (and if it isn't the gold price would plummet). But, then people might as well ask "What if someone could extract gold from seawater cheaply?", "Mine asteroids?", "Create a transmutation device?". But the harsh reality is that gold is extremely rare and in now only exist in extremely fine quantities and otherwise hypothetical technology is extremely unlikely. All the gold that was lying in rich quantities has been mined. Gold also lies on the periodic table after Iron such that gold can only be transmuted in large quantities through the sheer gigantic energy input of supernovae. A sudden explosion of large gold quantity is a very, extremely unlikely event.

  Published: May 21, 2009 5:25 AM

• Current

  The issue is Gil that a large gold find of that sort represents real resources.

  Imagine if it were not gold but rather something like platinum or nickel. Something that is useful to industry. This actual increase in wealth would cause the value of already existing goods to fall because new goods could be made at a lower price.

  What the argument must rely on in this case is that the new gold would be turned into gold money rather than being used by other industries that consume gold. In my view it is very difficult to tell before the event which would happen.

  That said I'll seek out Selgin's writing on the subject when I have the time.
  

  Published: May 21, 2009 7:30 AM

• George Selgin

  Newson writes: "to professor selgin:
  nice dodge! i was actually hoping from an answer from you, not from the ghost of richard cantillon. do you subscribe to this view or not? and why should changes in gold supply under a pure gold standard generate the abc? where would the systemic error arise from? systemic errors do not result from changes in the price of oil or wheat, although gains and losses may be large on an individual level."

  Not a "dodge," Newson. I'm happy to endorse Cantillon's theory, along with the other Austrian's, including Murray, who have endorsed it. As for oil and wheat: by mentioning them, you show that you obviously don't get the theory. Gold discoveries had unique business cycle consequences because gold was _money_. If oil were an economy's medium of exchange, a major oil shock would also lead to short-run distorion of relative prices, including real interest rates.

  No, I don't need to "dodge" the anti-free banking arguments on this list. Little bbs bounce of me. It takes heavier ammo than that!

  Published: May 21, 2009 7:39 AM

• DNA

  A callable loan represents either an ordinary demand deposit or an ordinary loan. Presumably Lawrence White envisions a situation where a depositor demands payment, and the banker must call in early some loans he had previously made. But the question is, what if those loans can't deliver (lending money is risky, don't forget)? Must the banker make whole the depositor out of some other property owned by the banker? If so, then he is effectively performing a warehouse function. If the banker can say to the depositor, too bad, I don't have the money right now, then effectively the depositor has made a loan to the banker; he has surrended (or rather transfered) ownership for some period of time. There is no middle ground here. The free bankers seem to think that because future circumstances dictate which course of action the banker will take in the latter scenario (either honor the request or say too bad, you've got to wait), that a third kind of banking function has been established. But that ignores the key point that, *at contract inception,* the banker has discretion over honoring (early) payment requests. That is, this contract has the primary feature of an ordinary loan. If free banking is to be legitimate, such contractual issues must be clearly spelled out, in which case the banks functions can only be warehousing or lending.

  Published: May 21, 2009 8:11 AM

• Current

  Steve Allen: "I'm not buying (no pun intended) your argument. What does various shopkeepers' demand for your violin have to do with and excess demand for money? Or that fact that you sold a flute instead of a violin? How exactly would creation of money "out of thin air", so to speak, help you sell your violin? (Other than, of course, fooling you into lowering your price without you know it)."

  In my previous post I said I will deal with the macroeconomic points later after I have dealt with the microeconomic ones. You are mixing the two. In this post I'll talk about the microeconomic arguments again first....

  What I am supposing here is that *one person* feels the need to hold more money. The general tendency amongst other may be the opposite, or may be similar.

  The demand of the various shopkeepers for a violin is connected to my demand for money. Whenever a trade occurs there are two demands and two supplies. Each from the point of view of the participants.

  My point is that I have a demand for money I can satisfy in various ways. From the point of view of some of these markets I can have an excess demand for money.

  Opponents of this view often point out that in one of the many markets a person trades in their demand for money can be satisfied. Certainly this is usually true. A wage earner may cut back on expenses to accumulate more money, for example. But it is not really the point.

  My point about pawnbrokers is that they provide a service in this circumstance. A person negotiates a loan from the pawnbroker. The pawnbroker loans them money and in return takes an asset as collateral. The pawnbroker allows people to borrow small amounts without going to the trouble of selling an asset (which may be illiquid otherwise) and having to buy back a similar asset later.

  The pawnbroker is similar to a bank, that is why I brought up pawnbroking. Rather than supply an asset to a pawnbroker a person could agree to a loan. In that case a contract is negotiated. The lender pays money to the borrower. The borrower agrees to pay back the lender according to a contract.

  Now, if the bank says that it's banknotes are titles to money it must make them so. They must be backed entirely by the real commodity.

  However, the bank can do otherwise. The bank can give a note saying "This note is a debt Foo bank owes to the holder. Foo bank promises to try to pay the holder on demand the sum of 10 grammes of gold. In the case that Foo bank cannot meet that demand when presented with the note he promises to pay 12 grammes of gold in three months from that time."

  Such a note a bank is not required to back fully by commodity. It may back it by debts, such as the loan the bank makes to the person involved. (If there is not 100% coverage when debts are added to gold reserves then fraud is involved - defrauding of the bank owners). Such notes may circulate as money. Similarly they may not we don't know what the market will decide.

  I'll deal with the question of whether this will have adverse social consequences at the macro level in another post.
  

  Published: May 21, 2009 9:09 AM

• Current

  DNA: "he has surrended (or rather transfered) ownership for some period of time. There is no middle ground here"

  I think that is correct. A note may be either credit or it may be a warehouse bill.

  If it is credit then the owner of the note is - in a sense - an entrepreneur. He bears risk.

  (The owner of a warehouse bill also bears risk, but of a different kind. He bears the risk that the bill is not made honestly by the warehouse. The owner of a credit note bears that risk and another sort, that the debtors honest attempts to do his best to pay may fail).
  

  Published: May 21, 2009 9:24 AM

• Gerge Selgin

  DNA: "Presumably Lawrence White envisions a situation where a depositor demands payment, and the banker must call in early some loans he had previously made."

  No: the "callable" nature of bank demand deposits and notes doesn't mean that banks must have callable loans among their assets. Usually available (fractional) reserves supply needed readed cash enough, with readily marketable securitities suppllying a back up for when reserves are running low. Ordinary commercial loans are in turn constantly maturing, so that bankers can also replenish their reserves, while reducing their liabilities, simply by choosing not to replace all maturing loans with new ones. Reserves will then increase by the same extent as outstanding loans diminish.

  Published: May 21, 2009 9:51 AM

• DNA

  George Selgin is missing my point. Whether or not the bank has "adequate" reserves at any point in time, or whether or not it can drum up extra funds in the security markets in the face of claims for redemption, the issue is whether they are *obligated* to do so, much as a warehousing bank is obligated to turn over the demanded sum. If they *have to* cough up property when the depositors demand it, they are no different from warehousers, it doesn't matter what they did with the originally deposited (gold) money, or what they have to do to make good. If they don't have to acquire the demanded sum (eg, through some sort of option clause), then they are effectively the owners, much as a loan bank who take control of a lent sum for some period of time. (I assume neither Selgin nor White would envision that banks can permanently refuse redemption, that they accept that the banks must be held to some limit on how much they can "opt out.")
  

  Published: May 21, 2009 10:07 AM

• Robert Groot

  Lawrence H. White writes (in response to P-F):

  "What free bankers deny is that ordinary banks are warehouses. Banks did not, under the gold standard, contractually obligate themselves to keep gold coins in storage for checking account or banknote holders. They issued debt claims, not bailments. They obligated themselves to repay their account-holders and banknote holders in coin, not to store their coins. Look at a bank account's or banknote's contractual language, and you'll see that it is very different from a warehousing contract's language.

  Thus a bank does not grant ownership rights to the same coin to two people when it lends to B a coin that A brought in. A no longer owns that coin, or any coin in the bank's vault. He owns a debt claim on the bank, a right to be repaid.

  That can't be true because a debt claim represents a transfer of ownership rights *across time*, for a set period of x days or years. A debt contract is a loan. Loans are transfers of ownership rights over a given amount of dollars.

  But it is clear that I person who opens up a checking account with a bank is not loaning money to the bank because the right of ownership has not been transferred. It stays with the depositor. For if the depositor really were loaning money to the bank, then the bank could not possibly claim that the depositor has the right to withdraw his money at any time the depositor wants.

  If the checking deposit were a loan, then you would fall into the contradiction of holding two mutually exclusive positions at once. You would be saying that the depositor both owns and does not own his money at the same time.

  Ordinary banks must be warehouses because ordinary banks promise to keep deposits available "on demand" to their clients at all times. This means that the bank must be prepared to have with them gold coin should the depositor want them. Clearly the act of loaning this money out to third parties violates this agreement.

  This violation becomes manifest any time a bank is faced with all their checking account clients asking for their money all at the same time. But wait a minute, should this occur, then the depositors will not get their money because the bank doesn't have it. But the bank promised via contract to have available their client's money at any time.

  Your argument does not hold up.
  

  Published: May 21, 2009 10:15 AM

• newson

  professor selgin says:
  "If oil were an economy's medium of exchange, a major oil shock would also lead to short-run distorion (sic) of relative prices, including real interest rates."

  no one is denying this; naturally the increased gold production is going to push interest rates up as this effect filters through the economy in the way that cantillon describes. however, the austrian business cycle is engendered not by inflation as such (which business can predict as they might do with the oil or wheat price), but by inflation through the credit markets (here you disagree with rothbard).

  i really think you should read hulsmann's "towards a general theory of error cycles". unfortunately for some reason i can't paste juicy bits for others to read, but needless to say he takes a completely different view to you on specie money and the business cycle, and corrects some flaws in the conventional austrian approach, or at least how mises elaborated it.

  anyway, where could the deflative part of the cycle occur if gold were the sole money?
  

  Published: May 21, 2009 10:29 AM

• newson

  i should have been more clear when i said that business could predict inflation in the same way as it does oil or wheat. of course many businessmen do get predictions wrong, but these must be netted off against the good predictions. bottom line: no cluster of errors.

  Published: May 21, 2009 10:39 AM

• newson

  ...and of course, if the business cycle even occurs in the absence of frb, then indeed the boom/bust is an inherent flaw of capitalism, as marx retained. nice.

  Published: May 21, 2009 10:43 AM

• DNA

  Newson:

  Kudos for recommending Hulsmann's outstanding rendition of ABCT. The flaw with the analogy to an oil shock is that, although clearly such a shock will lead to distortions and re-adjustments, there is no reason why it should lead to *mass error,* the defining characteristic of crises like we see now. The reason of course is that supply shocks to a commodity do not entail illusions (and so can be foreseen, if only imperfectly), as do banking systems that able to present increased claims to property as being actual increases in property. (It is this illusory nature of FRB that explains why entrepreneurs do not recognize monetary inflation for what is and bid up price spreads that are higher, as opposed to lower, in the structure of production at the beginning of monetary easing.)

  Published: May 21, 2009 10:51 AM

• Joe E. Dorner

  Newson,

  I think Gil puts it best when he acknowledges that a large gold find would produce inflation or even hyperinflation. But this is just a hypothetical. The chances of governments printing more money is much much much greater than any possibility of a great gold find. So no conclusion should be drawn from this that commodity money is e.g. problematic. All that one can conclude is that nothing is perfect when it comes to human action.

  Dr. Rothbard in his excellent work, The History of Economic Thought, records the great inflation that Spain suffered and then Europe in general because of all the gold they brought from the New World. What are we to conclude from this? Not that gold is a poor choice of money, but that when you increase the money supply, prices tend to rise, whether that money is a commodity money or a fiat money. The same impact is brought about: the beginning of a business cycle.

  As a corollary, I would add that inflation is the increase of the money supply. The rise in prices, if they occur, are an effect of this increase in the money supply. Sometimes the rise in prices is hidden in that prices stay the same when they otherwise would have dropped.

  One last point. According to Rothbard, and it makes perfect sense to me, there is no benefit to increasing the money supply. Any supply will be optimal (excluding absurd hypotheticals like only having 2 fiat dollars or three atoms of gold etc.). When the supply is changed, then there is the tendency to start a business cycle. The interest rates are effected because of the new supply of money. These new interest rates temporarily do not accurately reflect the amount of saved capital in the economy. Businesses and consumers are temporarily deceived and so take actions they otherwise would not have done. The resulting costs eventually are revealed either through the rise in prices of resources businesses or consumers need, or the fall in prices of the goods they sell (for consumers that may just be their labor.) I find this economic fact, to be very thought provoking, that the increase in the supply of money has no economic value. All other economic goods, when increased, do bring economic benefits. I should qualify what I said with the statement that the increase of the supply of commodity money qua money is of no benefit, in fact, the contrary, but qua commodity, it would be a benefit.

  Anyway, just that I would make these points and see if I am perceived as being in the "ballpark" here.

  Published: May 21, 2009 11:16 AM

• newson

  to jed:
  yes, inflation, no, business cycle. see the hulsmann paper. please bear in mind that modern frb has been around since the late 12th century in europe. (huerta de soto makes mention of examples in the ancient world).

  Published: May 21, 2009 11:29 AM

• George Selgin

  Newson: "...and of course, if the business cycle even occurs in the absence of frb, then indeed the boom/bust is an inherent flaw of capitalism, as marx retained. nice."

  The logic here is flawed, because it supposes that frb makes things worse. It doesn't: it actually helps keep nominal money supply in line with real money demand.

  But of course I agree as an emprical point that the "cycles" under a pure gold system would never achieve the amplitude of cycles common to central-bank based fractional reserve systems.

  As for credit markets, they play a role in the pure gold case. Imagine that the gold is deposited in time accounts (no demand deposits). That would boost the short-run supply of real loans, driving down interest rates. But as new new gold makes its way to more and more markets, costs rise, driving up the demand for credit, until the interest returns to its natural level.

  Dorner is convinced by Rothbard that it is never desirable to have an increase in the nominal money stock. Well, any money stock is as good as another _in equilibrium_. But to argue as Rothbard does that deflation is always just as good a means for getting from one equilibrium to another following an increase in money demand is just plain wrong.

  Or consider a severe money contraction. Do you think that would just cause a painless and rapid decline in prices, with no intervening harm to industry?

  
  

  Published: May 21, 2009 12:29 PM

• Nicolas Cachanosky

  That any quantity of money "could" be optimal does not mean that any quantity of money "is" optimal.

  If the actual money supply is not "optimal" an adjustment is needed. This can be two ways, a fall in prices or an increase in money supply.

  Free-banking solves this problem better through fractional reserves than imposing a 100-percent requirement. Under free-banking there cannot be excess of issuance, so there is limited space for inflation (and no business cycle as described in the ABCT takes place). In free-banking banks can issue money-substitues only if their specific demand has increased.

  The point is that this process affects relative prices less than a forced deflation through an imposed 100-percent requirement.

  Forced deflation is as bad as forced inflation. One of the good things of free-banking is that there is no room for neither of them.

  Published: May 21, 2009 1:30 PM

• Robert Groot

  Nicolas,

  Under free banking (fractional reserve), there *can* be excess issuance. In fact at all times, fractional reserve banks have over-extended themselves because they broke their promise to keep deposit money available at all times. The proof of this broken promise is that a fractional reserve bank cannot honor it's commitments should more than 10% (or whatever) of their clients withdraw all their money at the same time.

  If a fractional reserve bank promises each individual client that their individual deposits can be withdrawn at any time, then how can you justify a bank that cannot hold that promise because they loaned out deposit money, and hence no longer have it available at all times?

  You have this strange notion that a 100% reserve requirement is a *forced* requirement. It is not *forced* any more than a buyer expects that a seller to honor their promise via contract.

  The gold standard is not "forced deflation", because there is no initiation of force that makes prices fall. There is simply voluntary trading against gold that does it. Besides, once gold comes into existence, it stays in existence.

  Your claim that there is no room for neither forced inflation nor forced deflation in free banking is flat out incorrect. Loaning out another client's deposit money is forced inflation, because the deposit holder is the owner of dollars, and the borrower is the owner of the same dollars. The force is the fraud committed against the depositor. Similarly, there is forced deflation with free (fraudulent) banking because as soon as a depositor withdraws all his cash from the bank, then someone else, somewhere in the economy, has to be left with his hat in his hand, because the bank that paid the withdrawal money now can't pay one (or more) of their other customers who were granted a checking account using the fractional reserve money.

  100% gold reserve is the only true remedy for deflation and inflation, because no physical force or fraud has to take place for gold to be both mined, and hoarded.

  Published: May 21, 2009 2:40 PM

• Nicolas Cachanosky

  Robert,

  This is a good example of differences in concepts and words.

  1-. What there cannot be in free-bankins is a constant excess of issuance. The bank that issues in excess looses reserves. This is the market signal to stop expansion of money-substitutes. If not, the bank must close its doos. Of course a "one-time" error can happen, but over expansion cannot become a regular error.

  2-. By inflation I mean an expansion of money supply (in the broad sense) higher than the increase in demand of money (in the broad sense). And this is what in free-banking cannot regularly happen. In free-banking inflationary issuers cannot last. That's why I suggested that in free-banking "cannot" be inflation as a regular problem.

  3-. I think the seller analogy might be innacurate. The money-substitute of the issuer is not a private property title as can be one of a home or a car. It is a promise or claim on demand (not on carry). Is a complex (not irregular) contract without a specific maturity date nor specific callable days, etc. The analogy could be more appropiate to the case of warehouses, not so sure on banks.

  In a free society individuals should be free to decide new kind of contracts to perform as those of money substitutes. I see no fraud in here.
  As bank client I benefit by the banks management of reserves and bare the risk of such investment. If I do not want such risk I turn to a warehouse and resign to its benefits.
  To not have it available all times is not a breach of contract as is not on any other industry (common example is insurance companies). The breach of contract happens when the claim on demand cannot be respected; like in an insurance company that cannot comply to all its clients at the same time.
  Free-banking does not justify the breach of contract, it says that fractional reserves are not the breach of contract, but to not be able to respect the claim when presented.

  4-. By forced deflation I mean the case when fractional reserves are suggested to be prohibited based on the fraud argument. If that is the case, then an increae in demand of money cannot be satisfied by more money supply; which could also be the result of free individuals and banks interacting with each other. What will be a better adjustment, a fall in prices or an increae in money supply is for the market (free-banking) to solve, not us.

  5-. I would differentiate gold standard and free-banking. The former is a normative to stop the easy expansion of money by central banks, not by banks in free-banking. Central banks with gold standard and free-banking are two different scenarios.

  6-. I think one of the roots of differences rests in the fraud argument. When going to bank I do not see the money-substitue I recieve as a property title, but as a promise of payment on an unespecified date. Why may I resign money for a money-substitute? Because 1) it circulates as good as money and 2) I have benefits like a small interest payment and the use of a clearing system to manage my payments. The cost? A risk that the bank may go banckrupcy as my insurance company can. If I value that risk to high, then I do not put all my monny in the same banks or even don't put it in anyone.

  Published: May 21, 2009 4:03 PM

• Joe E. Dorner

  I did a little research and came across this very interesting essay by Jorg Guido Hulsmann about the various free banker schools of thought. I read sections of it and plan on reading the rest. It answered some of my questions about the different schools of thought.

  I post it hear because I think it may be illuminating although some of us will definitely disagree.
  http://mises.org/journals/rae/pdf/RAE9_1_1.pdf

  When I began following this discussion, I was puzzled by the term "free bankers." In my reading of Dr. Rothbard, I came across the idea of free banking and thought there was one common understanding of what this was to be. The Suffolk bank experience is what I thought of when I heard the term "free banking." But thanks to this article, I understand there are conflicting ways some here would want to set up such "free banking."

  Needless to say, I see the best free bank system as being a 100% gold coin reserve banking system, as did Dr. Rothbard.

  Published: May 21, 2009 5:49 PM

• Current

  Steve Allen, now I'll tackle the macroeconomic aspects a bit.

  You are concerned about people being fooled that more resources exist than exist in reality. You suppose that anything other than a banknote that is backed 100% by a commodity is unacceptable. You consider anything other to be creating more titles than goods.

  This though isn't true of credit money. A debt is not a title.

  Consider the following. Firstly, something alarming and troubling happens. This leads to a portion of the community increasing their demand for money. In theory this could mean that each agent demands an equal additional amount of dollars. That is extremely unlikely. What is more likely is that many people will demand more money and some will not. Some will spend money and hold less. There may though be an overall propensity.

  As I have described earlier, it can be difficult to supply an excess demand for money. This demand though may be furnished by a bank supplying credit money.

  Those who want money go to the bank, they obtain loans. The bank pays using notes which are it's debts. These notes may circulate as a media of exchange.

  In this case the amount of money in existence has risen. But, there has been no increase in the number of titles to property. For every note of credit money in circulation someone is in debt.

  This situation will be rectified once everyone has a money holding close to what they desire. Economic stability will recommence. When that happens people will pay off their debts and go back to holding the approximately the same amount of money they had previously held.

  It's important to notice what happens here in the case of an inflexible money stock as Hoppe proposes. Here I'm just restating what Steve Horowitz says elsewhere.

  As Mises says:
  "Deflation and credit contraction no less than inflation and credit expansion are elements disarranging the smooth course of economic activities." Mises Human Action p.567

  Hoppe is right that if the demand for money rises then the price of goods will fall. Real cash balances will then increase. This though is a distortionary process just as price inflation is. It requires price setting at each stage, which takes time, a basic fact which ensure prices are somewhat sticky. Like inflation it takes it's time to move through the economy.

  Whatismore price inflation must come next. Once people realise that the situation has been normalised they have no reason to hold the real amounts of money they are then holding. So, they will seek to spend them and drive the prices of goods upwards again.

  Published: May 21, 2009 6:37 PM

• newson

  to professor seglin:
  as bill barnett mentions in the podcast i cited, distortions come about where borrowers' and lenders' intertemporal dispositions aren't matched. so yes, even absent frb, distortions could arise from banks' loan books.
  however, i imagine that these distortions would be an order of magnitude less as fewer people use term deposits than current deposits. a monetary deflation under a pure gold standard is impossible - how could gold stocks drop to any degree?

  i think rothbard is contradictory on deflation (ditto for mises). i've been higly influenced by bagus in his review of austrians and deflation -
  http://mises.org/journals/qjae/pdf/qjae6_4_3.pdf
  

  Published: May 21, 2009 9:46 PM

• Joe Salerno

  Bob,

  You should be careful here. A monetary deflation, although highly unlikely, could occur under a 100 percent gold standard as a result of a large increase in the nonmonetary demand for gold which, at the current purchasing power of money, absorbs more than the flow of newly mined gold minus the gold necessary to replace the monetary gold physically lost through normal wear and tear on the coins and in fire and other natural disasters. The result would be that the value of gold in nonmonetary uses would temporarily exceed the value of gold as money, that is that an additional ounce of gold in industrial uses would add more to firms' revenues than one ounce of monetary gold. The incentive would be to shift some gold from the existing money supply to nonmonetary uses, causing the money supply to contract and the purchasing power of money to rise until a new equilibrium was established between the monetary and nonmonetary uses of gold. In equilibrium the marginal ounce of gold in nonmonetary uses would again generate exactly one ounce of gold of monetary revenue. We could imagine the invention and production of a new piece of life-saving medical equipment in which gold is a significant input or merely the emergence of a fad for gold consumer goods such as jewelry, trinkets, plumbing fixtures (as in the Vanderbilt mansion) etc. fueling a large increase in the nonmonetary demand for gold that exceeds the net flow supply from the mines. Again, I think it a highly unlikely, although not an impossible, scenario.

  Joe Salerno

  Published: May 22, 2009 9:31 AM

• newson

  yeah, good point. i'd taken it as a given that non-monetary demand is fairly stable. silly oversight on my part.

  but returning to selgin's question - "Or consider a severe money contraction. Do you think that would just cause a painless and rapid decline in prices, with no intervening harm to industry?"

  i can't see why the deflation should give rise to the cluster of errors any more than its mirror-image, the pure gold standard inflation. and as for "industry", on aggregate there should be no effect. winners should net out losers.

  if the non-monetary demand for gold is that high as to shrink the money supply, i'm sure that information about the new demand would be transmitted (read all about it: miracle cancer cure - nano-gold-particles!) far more rapidly than under the free-banking model, where punters have to second-guess how effective bankers actions will be in stemming the unfolding deflation. (instead of just bernanke's, we'd have hundreds of bank chairmens' words to parse and analyze.)

  Published: May 22, 2009 11:49 AM

• Lawrence H. White

  The contract found on the face of a typical nineteenth-century banknote reads as follows: “Bank of X will pay the bearer on demand $5,” i.e. 5 silver dollar coins or a 5-dollar gold coin. That’s the entire contract. This is the language of a debt contract, not of a warehousing contract. The bank legally binds itself to repay the debt on demand. Unlike a coin warehouse, it does not bind itself to have $5 in coin on hand for every $5 claim it issues.

  In response to the argument that banknotes and checking account balances are debts, and not warehouse contracts, Robert Groot writes:
  “That can't be true because a debt claim represents a transfer of ownership rights *across time*, for a set period of x days or years. A debt contract is a loan. Loans are transfers of ownership rights over a given amount of dollars.”

  Mr. Groot, you are assuming what you need to show, namely that a debt cannot be contractually repayable on demand at the lender’s option (“callable”) because it must have a set period. Why must it have a set period?

  Note that a home mortgage loan typically allows prepayment, so the term is not set but can be shortened at the borrower’s option. Is that an impossible loan contract? An interest-only home equity loan doesn’t even have a default-value period, and can be repaid at any time the borrower chooses. Is that an impossible loan contract?

  Groot: “But it is clear that [a] person who opens up a checking account with a bank is not loaning money to the bank because the right of ownership has not been transferred. It stays with the depositor. For if the depositor really were loaning money to the bank, then the bank could not possibly claim that the depositor has the right to withdraw his money at any time the depositor wants.”

  Again, you’ve simply assumed your conclusion. The checking account customer has relinquished ownership over the coins he used to open his account. He has lent them to the bank to do with as it will. The bank can and does offer the same customer the right to withdraw his money at any time. Demandable debt is in fact conceivable, feasible, has existed for hundreds of years, and does exist.

  Groot: “If the checking deposit were a loan, then you would fall into the contradiction of holding two mutually exclusive positions at once. You would be saying that the depositor both owns and does not own his money at the same time.”

  Not at all. I’m saying the depositor owns an IOU. He does not own the coins he gave to the bank in exchange for the IOU that is his account balance.

  Groot: “Ordinary banks must be warehouses because ordinary banks promise to keep deposits available ‘on demand’ to their clients at all times. This means that the bank must be prepared to have with them gold coin should the depositor want them.”

  Not so. Read the banknote contract. The bank promises to repay on demand. Unlike a warehouse, it does not make a promise about how many coins will remain in the vault. The bank must be prepared to meet all the redemption requests that are actually made. Otherwise it will breach its contracts. So long as not all potential requests are actually made, it need not be a warehouse (hold 100% reserves) to meet all actual requests.

  Groot: “Clearly the act of loaning this money out to third parties violates this agreement.”

  How? Lending it out doesn’t violate the agreement to repay on demand. There is no agreement to warehouse the money and not lend it out.

  Groot: “This violation becomes manifest any time a bank is faced with all their checking account clients asking for their money all at the same time. But wait a minute, should this occur, then the depositors will not get their money because the bank doesn't have it. But the bank promised via contract to have available their client's money at any time.”

  Should any demand depositor or banknote holder not get the money he is owed back on demand, the bank will be in breach of contract. It will have defaulted and must face the legal consequences. Otherwise there is no contract violation.

  How can a fractional reserve bank not default? How is fractional-reserve banking feasible? See my earlier post quoting Mises' Theory of Money and Credit. For good reason, not all potential requests are actually made on any given day. There is not a bank run every day. If bank runs were sufficiently frequent, fractional-reserve banking could not have long survived. But they weren’t, so it could and did survive.

  Published: May 22, 2009 12:27 PM

• newson

  lawrence white says:
  "Not at all. I’m saying the depositor owns an IOU. "

  then he's not a depositor, he's a creditor. language counts, as i remember clinton was at pains to show - "It depends on what the meaning of the words 'is' is."

  Published: May 22, 2009 8:48 PM

• George Selgin

  Newson: "then he's not a depositor, he's a creditor. language counts."

  Yeah; indeed. But sensible people agree that it "counts" in the sense that we ought to allow words their commonly accepted as well as legally-assigned meanings. So, what is the legal meaning of "depositor"? I searched "depositor defined" on Google and here are the relevant passages from the first entry that came up: "The 'Lectric Law Library's Lexicon":

  DEPOSIT - Usually defined to be a naked bailment of goods to be kept for the bailor, without reward, and to be returned when he shall require it. A contract, by which one of the contracting parties gives a thing to another to keep, who is to do so gratuitously, and obliges himself to return it when he shall be requested. [HOWEVER] There is another class of deposits ...called irregular deposits. This arises [sic] when a party having a sum of money which he does not think safe in his own hands; confides it to another who is to return him, not the same money, but a like sum when he shall demand it. The usual deposit made by a person dealing with a bank is of this nature. THE DEPOSTOR IN SUCH CASE, BECOMES MERELY A CREDITOR OF THE DEPOSITORY FOR THE MONEY OR OTHER THING WHICH HE BINDS HIMSELF TO RETURN" [My emphasis.].

  OK, the guy can't write worth beans; but that just proves he must be a real lawyer.

  A couple more items lower, we find a pdf for "The Civil Code for the State of New York," 1865, containing a long section on deposits, including the following paragraph (section 947): "A deposit for exchange transfers to the depository the title to the thing deposited, and creates between him and the depositor the relation of debtor and creditor merely."

  Turning to Google Books, I find among the first items, the following, from Joseph Story's 1878 _Commentaries on the Law of Bailments_ --a presumably unassailable source, given its author and subject--, p. 47, n.2:

  "It should be carefully borne in mind that the word 'deposit' as...used (whether wisely or no) in the law of Bailments, has a technical meaning, far more restricted than our English word as commondy applied. The ordinary bank deposit, sometimes styled a _general_ deposit, is no bailment at all, for the identical thing delivered is not to be restored... (87) In the ordinary cases of deposits of money with banking corporations, or bankers, the transaction amounts to a mere loan... ."

  Such examples are easily multiplied.

  So, Newson, who is playing around with language? You, who deny that the word "depositor" can mean what an untold number of legal sources say it can mean, or those of us who assign to the word precisely the meaning these references give to it?

  Oh, I know: you are about to come up with some fancy answer. But no: enough's enough. I am tired, all reasonable people must be tired, of the discussion. The simple fact is: the 100-percent reservers, who claim to be so diligently attempting to stamp out fraud, have been peddling ream upon ream of phony legal theory, all the while pretending that it's their critics who don't understand the law, or even the English language. Shame on them all.

  Published: May 22, 2009 11:15 PM

• Stephan Kinsella

  Dr. Selgin:

  "So, Newson, who is playing around with language? You, who deny that the word "depositor" can mean what an untold number of legal sources say it can mean, or those of us who assign to the word precisely the meaning these references give to it?

  Oh, I know: you are about to come up with some fancy answer. But no: enough's enough. I am tired, all reasonable people must be tired, of the discussion. The simple fact is: the 100-percent reservers, who claim to be so diligently attempting to stamp out fraud, have been peddling ream upon ream of phony legal theory, all the while pretending that it's their critics who don't understand the law, or even the English language. Shame on them all."

  Dr. Selgin, in my view, as a lawyer, provided the bank makes it sufficiently clear to the customer that his funds will be lent out and he is merely a creditor, there is no fraud. However, as an Austrian, I do believe that if the bank makes this sufficiently clear, they will not be able to get away with establishing a money system based on these promissory notes. But who knows--even pyramid schemes can last for a while. And as a libertarian, I cannot say I feel too bad for the investors reft of their investment--caveat emptor and all that.

  Dr. White notes above,

  "The contract found on the face of a typical nineteenth-century banknote reads as follows: “Bank of X will pay the bearer on demand $5,” i.e. 5 silver dollar coins or a 5-dollar gold coin. That’s the entire contract. This is the language of a debt contract, not of a warehousing contract. The bank legally binds itself to repay the debt on demand. Unlike a coin warehouse, it does not bind itself to have $5 in coin on hand for every $5 claim it issues."

  To call the words printed on a banknote a contract seems a bit question-begging to me--maybe it is, maybe it isn't. As I noted in my Liberty reflection from a while back, The Bank of England and Me, when I lived as a grad law student in London 1991-92, one day I decided to visit the Bank of England to see what they would do if I presented a 5-pound note for redemption of the promise to pay the bearer "five pounds" on demand. I didn't get five pounds of silver. Instead, they booted me out for impertinence, and sent me to the Bank of England Museum around the corner.

  Published: May 22, 2009 11:44 PM

• Lawrence H. White

  newson writes:

  "lawrence white says:
  'Not at all. I’m saying the depositor owns an IOU.'

  then he's not a depositor, he's a creditor. language counts, as i remember clinton was at pains to show -"It depends on what the meaning of the words 'is' is.' "

  Are you really citing Bill Clinton as the epitome of how one should argue? You probably mean it as a joke, but it's actually appriopriate if your aim is to divert us from the substantive issues into terminological issues.

  Anyway, I'm sorry about my lapse. I forgot that in discussions of FRB since the publication of Huerta de Soto's book, one may no longer use the word "deposit" in its ordinary modern sense of a debt claim on a bank (e.g. "time deposit") but only in its ancient sense of a bailment. Please substitute "bank creditor" or "bank account holder" for "depositor" in my previous post, and proceed to any substantive objection you'd care to make.

  Stephan Kinsella comments: "To call the words printed on a banknote a contract seems a bit question-begging to me--maybe it is, maybe it isn't."

  I reply: I presumed that it was a contract because the obligation to pay expressed on a banknote was legally binding. A bank that didn't pay could be sued for breach. In Scotland, the noteholder automatically received a summary judgment against the bank. Perhaps it is also relevant to appraising their contractual status that the banknotes were individually hand-signed in ink by bank officials.

  Published: May 23, 2009 7:23 AM

• DNA

  Perhaps after a good night's sleep George Selgin is in a better mood; his post at 11:15 last suggests he's in need of one.

  Lawrence White writes:

  "The contract found on the face of a typical nineteenth-century banknote reads as follows: “Bank of X will pay the bearer on demand $5,” i.e. 5 silver dollar coins or a 5-dollar gold coin. That’s the entire contract. This is the language of a debt contract, not of a warehousing contract. The bank legally binds itself to repay the debt on demand. Unlike a coin warehouse, it does not bind itself to have $5 in coin on hand for every $5 claim it issues."

  Regardless of whether the bank is bound to keep $5 in coin *on hand* for the $5 claim, if it *must* produce the $5 *on demand* (ie, it can't opt out), then it has to get that $5 from somewhere (ie, the banker's pocket, the tellers' wages, etc). In that sense, the relationship between claim holder and banker is essentially that of the depositor and warehouse bank. The bank in Lawrence White's example (which likely is very different from the one that actually functioned in England at the time) is effectively practicing 100%, wareshouse banker. The relationship can be called a debt relationship all one wants, but the note holder has a claim *at all time* on the amount of money *on demand.* It's irrelevant, again, what the banker has done with the originally submitted money (lent it, spent it, melted it, etc).

  Published: May 23, 2009 7:24 AM

• George Selgin

  Kinsella writes: "However, as an Austrian, I do believe that if the bank makes this sufficiently clear, they will not be able to get away with establishing a money system based on these promissory notes."

  This is missing the point entirely, Stephen: The legal definitions are what they are because historical banks "did" make the meaning they attached to the term "deposit" sufficiently clear. The sources don't say that the meaning of bank deposit is ambiguous. They say it's a credit. So what you claim banks can't possibly succeed in doing--namely, keeping notes and deposits outstanding that are _understood_ to be debt contracts rather than bailment contracts--is in fact what they have long gotten away with!

  Now, you may respond, "Well, the law understood them this way, perhaps--but some depositors themselves don't." Even if that were the case, it would prove nothing: the contracts were legal, and the depositors' ignorance of their nature was their (the depositors') fault, not the bankers!

  It amazes me to see some otherwise intelligent people ignoring so much banking history and law.

  As for my getting in a bad mood about this stuff, well, yes I do, and here's why: Larry and I and some others have been trying our damndest to battle the central bankers and fight for abolishing their currency monopolies, and all the while we have to waste effort fighting a rearguarad action as well against ill-informed 100-percent reservers who, besides diverting us from our main efforts, give both the free-banking movements and Austrian economics as a whole a bad name, by associating them with bad history, bad law, and bad economic theories. If I express disgust with some of the arguments coming from the 100-percent reserve camp, consider that I am at least engaging those arguments--often the same ones repeated again and again despite all manner of contrary argument and evidence. Doing this is exhausting and sometimes feels futile. I can only hope that doing so is making some people reconsider the merits of the Rothbard-DeSoto-Hoppe position.

  Published: May 23, 2009 9:48 AM

• Gene Callahan

  At several points in this thread, someone has said, in effect, "Fractional reserve demand deposits are inherently fraudulent, because there are circumstances (e.g., all depositors show up at once) in which the bank cannot fulfill its promise to pay on demand."

  Let's accept this argument for a moment and see where it leads us.

  First of all, life insurance can easily be seen as equally fraudulent. There are clearly circumstances (e.g., a nuclear war) in which too many people would die at one time for an insurance company to pay all of the claims coming in. In fact, after a little more thought, it seems all insurance is fraudulent, since the same is true of any insurance policy.

  But, wait, as I follow this a little further, it strikes me that all financial futures contracts are fraudulent: you know, there's always the possibility that, say, the government might nationalize the oil supply, and the person who sold oil forward won't be able to deliver.

  Now a great light is dawning upon me, and I see even more revealed! In fact, all business contracts whatsoever are fraudulent: they all involve the future, don't they, and so they all contain clauses that might not be fulfilled. And work for hire is clearly fraudulent if the employer doesn't fill the worker's bank account continuously as work progresses, since otherwise there is some possibility the wage won't be paid!

  This is surely the mark of a fertile principle: from what we at first thought was an argument only rejecting a very particular business practice, we have managed, using only our original logic, to shut down the world economy!

  Published: May 23, 2009 10:51 AM

• Current

  Surely what we should do now is to come up with clear terms that can be used for future economic discussions?

  The term "deposit" is fairly murky. Many think it means bailment. The legal definitions George Selgin mentions show it means a bailment for everything that's not money and a loan for money. I think "bailment" is clearer for a bailment and "loan" clearer for something else.

  The term fiduciary media is fairly murky too. If I understand George Selgin and Larry White's definitions fiduciary media must always be backed by debt. Though the reserve fraction of commodity may be any amount no matter how small. I think that the anti-FRB side consider it to mean a note backed by a fractional reserve only.

  On the subject of legal wording I think this is a question of what folks think of devious lawyerly tricks.

  I'm a bit surprised by George Selgin and Larry White defending the term "deposit" so strongly. In a previous discussion George Selgin said:
  "As for the number of naive bank depositors who think their money is absolutely safe, I think it is you who are now relying on evidence from a post-government guarantee world. Yes: many people now think "deposits" are in some sense fully backed, but these days the belief isn't so naive, as governments have in fact given them the impression that this is so, if not thanks to bankers' own efforts, then thanks to government guarantee funds and treasuries. I doubt that the same belief was so widespread in the days before insurance."

  Despite the current legal definition of deposit I think it should change if free-banking is ever re-instituted.
  

  Published: May 23, 2009 12:20 PM

• Nicolas Cachanosky

  Should it be allowed in a free society (without central banks or monetary regulations) for free individuals to develope a contract as FRB describes? To give away money in exchange of a promise to pay on demand, not to warehouse it at all times. And use the "promise" as a medium of exchange (contracts like those of short-selling, insurance, put options, etc. that can be sold before maturing shuld also be considered fraudulent?).

  One thing is to say that banks are actually commiting fraud, another thing is to say such agreement is always legally imposible in all times at all places.

  If these contracts are possible in a free society, then it seems that all this "fraudulent" discussion is just about how naive we think people is!

  But even if this is the case, it really doesn't matter how naive we think people is regarding banking. This is a problem of justice and jurisprudence to solve, and I think it was Selgin and/or White who cited how this was solved hisorically by judges. Our opinion "doesn't" matter, judges opinions do.

  The fraud contracts like those of FRB cannot be done between free individuals seems weak; those types of contracts are among all the economy, not only banking. So, does the 100-percent position just turns around how naive (or stupid?) we think people are?

  Published: May 23, 2009 12:24 PM

• Current

  George Callahan....

  Common law inserts certain clauses into every contract. That is it takes certain things as understood.

  For example, I was once involved in drawing up a contract to have something built. As the buyer we inserted a clause that said that if the seller did not complete the job we would refuse to pay the final payment. The seller did not like this clause. Our lawyer said we can take it out though, because the stiputlation already exists is Irish common law. We do not have to write it down. We took it out and explained the legal situation to the seller.

  The same is true about "acts of god" and various other things. If a premise promises to be open at certain times that does not mean it must do so if there is a flood or fire nearby that would prevent it. This doesn't have to be written into the contracts. (This would apply to a full reserve bank, fractional reserve bank or a insurance company).

  The same is not true however for things which are under the control of one of the parties. If an insurance company cannot pay because it is not adequately backed then it is in breach.

  If a bank has promised to pay at any time then it must take steps to ensure that it can always do that. That means it must be able to pay for an entire bank run. A bank run or note raid is not an "act of god" it is an act of the other parties the bank is contracted to.

  In my opinion if the bank says "I promise to pay the bearer on demand" then it must have full reserves. No matter if the note represents is debt or ownership.

  However, if the bank adds a rider to that, saying that if they can't pay then they'll pay later, that is fine.
  

  Published: May 23, 2009 12:36 PM

• Gerry Flaychy

  "Groot: “If the checking deposit were a loan, then you would fall into the contradiction of holding two mutually exclusive positions at once. You would be saying that the depositor both owns and does not own his money at the same time.”

  Lawrence H. White « Not at all. I’m saying the depositor owns an IOU. He does not own the coins he gave to the bank in exchange for the IOU that is his account balance. »"

  
  Here is another way to see it.

  When we deposit money, say a 100 $ fed note, at a bank, in exchange of an amount of 100 $ in a bank account, we then lose the right to use the fed note, but we gain the right to use the amount in the bank account.

  We may then transfer our account-money into the bank account of somebody else, but we cannot in the same time transfer the 100 $ fed note into the hands of this somebody else. Or we use the fed note, or we use the account-money: we cannot use both.

  That means that all the time that we maintain our 100 $ account-money, the right to use the 100 $ fed note, or its equivalent in fed notes and coins, is not ours. If it were, we would be able to spend both moneys: the account-money AND the fed notes. But it is evidently not the case.

  To regain the right to use the amount of 100 $ in fed notes and coins, we have to regain possession of the 100 $ fed note, or its equivalent, and to do so, we have to abandon possession of our account-money.

  Thus, or we own the fed notes, or we own the account-money. We cannot own both at the same time.
  

  Published: May 23, 2009 12:52 PM

• Steve Horwitz

  Current writes:

  "In my opinion if the bank says "I promise to pay the bearer on demand" then it must have full reserves. No matter if the note represents is debt or ownership."

  Why? The promise is to "pay on demand." The promise is not "to warehouse your money." Gene's reductio makes a really important point: there are many cases in markets where if the really unexpected happened, promises couldn't be kept. I think the insurance one is closest: look what happens to small insurers after a really major natural disaster.

  If a large enough number of claims comes in, the company can't possibly pay them all, certainly not in its current state of liquidity. Is the insurance contract fraudulent? Of course not. George and Larry's point is that deposits (and notes!) have always been understood both economically and legally as promises to pay on demand, not bailments. And trying to redefine terms as Current suggests only demonstrates a desire to centrally plan what can't be planned: the evolution of language.

  It's always been clear (even my intro students know this) that reserves aren't 100% and there's some small chance the bank won't be able to pay. That's a risk people have historically been willing to take to gain the benefits of FRB (interest payments and greater "throughput" of credit).

  I will confess, unsurprisingly, my strong agreement with George's crankiness and his reasons for it. "Fractional reserve banking is fraudulent" has the feel of a spiritual mantra that, if repeated enough, will somehow magically become true. It won't, because, as George said, the overwhelming weight of legal and economic history suggests strongly otherwise.

  Finally, I have posted my "A Subjectivist Approach to the Demand for Money" article that starts from Hutt's work on the yield on money held to offer a more complete treatment of the demand for money from a subjectivist/Austrian perspective. Just the first few pages should convince you that free bankers not only don't reject Hutt's view, we positively embrace it.

  http://myslu.stlawu.edu/%7Eshorwitz/Papers/Subjectivist%20Money%20JEEH%201990.pdf

  Published: May 23, 2009 12:58 PM

• Carlos Novais

  We can accept that it´s possible to have "promisses of payment" issued (partial reserve notes and deposits) honestly/clearly.

  But take in account todays requirements of disclosure (think about consumer protection, or new issue of securities, etc.)

  The real question is if those "promisses of payment" will not get a discount comparing to physical gold and 100% reserve certificates (notes).

  The question is if i would exchange 100 gold coins for 100 partial reserve notes at par - we at least know that FR theorist would exchange theirs physical gold coins at par for my FR promisses of payment from FR_Bank X.

  But would not a risk arbitrage take place by the process of taking credit (expanding it´s notes and decreasing its reserves relation, at leat i suppose till a minimum reserve disclosed in such honest FR contract) from Bank X and buying physicall gold at par?

  Published: May 23, 2009 1:22 PM

• Carlos Novais

  We can accept that it´s possible to have "promisses of payment" issued (partial reserve notes and deposits) honestly/clearly.

  But take in account todays requirements of disclosure (think about consumer protection, or new issue of securities, etc.)

  The real question is if those "promisses of payment" will not get a discount comparing to physical gold and 100% reserve certificates (notes).

  The question is if i would exchange 100 gold coins for 100 partial reserve notes at par - we at least know that FR theorist would exchange theirs physical gold coins at par for my FR promisses of payment from FR_Bank X.

  But would not a risk arbitrage take place by the process of taking credit (expanding FR notes and decreasing its reserves relation, at leat i suppose till a minimum reserve disclosed in such honest FR contract) from Bank X and buying physicall gold at par?

  Published: May 23, 2009 1:24 PM

• DNA

  The false analogy between insurance companies and fractional reserve banking has been adequately dealt with by Block et al. Before the free bankers complain that their opponents are unfamiliar with the relevant literature, they should take their own advice.

  Gene Calahan's humor is commensurate with his intellect.

  Published: May 23, 2009 1:55 PM

• Steve Horwitz

  Just because one disagrees with it doesn't mean one hasn't read it. And just because Block et. al. wrote it, doesn't mean it's right.

  And let's note that Gene's reductio, while sarcastic was not "uncivil". One can't say that for DNA's response, which offers no argument but that of authority and ad hominem.

  Published: May 23, 2009 2:09 PM

• Grad student

  
  As ever, Boettke cuts to the chase:

  
  http://austrianeconomists.typepad.com/weblog/2009/05/a-subjectivist-approach-to-the-demand-for-money.html#comments

  "Reading through our blog and also the discussion at the Mises Blog and I have to say that I find Selgin's response from this morning to be the one I most relate to. But I was also struck by something very strange with the Austrian community --- why do people employ professional/technical jargon ladden conversations with people who are NOT professionals, rather than limit their professional/technical jargon ladden discussions to their interactions with peers, and instead when talking to non-professionals focus instead on the problems of inflation and bad monetary policy? You have laymen in this discussion raising questions to Selgin about fine points in monetary theory which they are not qualified to discuss.

  On the other hand, there would be a good discussion that would be worth looking at IF the main characters decided to discuss in a serious way these issues outside the purview of the mass of "everyone thinks there is their own economist" and instead confined to the debate among professional economists.

  When you go to an NBA game, I don't think people in the stands come dressed ready to play and at timeout they go down to the court to tell LeBron James how he should dribble the ball, or better yet suggests to LeBron that he should play in his place. That would be absurd, right? Well that is what is going on when "anonymous" tries to tell George Selgin about monetary history, law, and economics. As Selgin says, it is exhausting to get attacked by bad history, bad law, and bad economics. If by "Austrian economics" one means accepting these arguments that are bad history, bad law and bad economics, then I would prefer to not be labeled an Austrian economist. I would like to be seen on the side rejecting so-called "Austrian" economics. But while I would rejct "Austrian" economics, I would wholeheartedly accept the label Misesian-Hayekian economist. My reading of Mises and Hayek on monetary issues fits with the White-Selgin-Horwitz position.

  Pete"

  Posted by: Peter Boettke | May 23, 2009 at 03:03 PM
  

  Published: May 23, 2009 2:50 PM

• Joe Salerno

  I have always remained agnostic on whether current fractional reserve banking is fraud or not. I am much more interested in: 1. the positive evolution of its legal framework; and 2. in the claims made by the proponents of free banking for the economic performance of a competitive fractional reserve system. So I was gratified to see Larry White put ihis finger on the nub of the first issue.

  Larry wrote:

  "The contract found on the face of a typical nineteenth-century banknote reads as follows: Bank of X will pay the bearer on demand $5,'
  i.e. 5 silver dollar coins or a 5-dollar gold coin. That's the entire contract."

  Now imagine the following scenario. A development/ management company builds, sells, and maintains furnished vacation homes in a remote area of Montana. The contract reads: "The purchaser shall have full and unimpeded use of the home and all its contents and grounds anytime he shows up." That's the entire contract. Doesn't this at least strike you as legally ambiguous. Does the development company have the right to sell this home to multiple parties under this contract? And if so, how many? Is this a "time-sharing" lease/rental contract or a fee simple purchase? What legal remedy has the buyer against the seller if the former shows up and finds another family comfortably ensconced in the home? Can he bring criminal charges of fraud or does he have a general claim against the assets of the development/management company? Does it make a difference if the company has done its due diligence in selling the same property to buyers from different parts of the country (or world) or in different professions who tend to take vacations at different times in order to ensure that it has adequate assets to fully reimburse the occasional buyers prevented from occupying as per the language of the contract?

  But no one would ever sign such a ridiculously ambiguous contract you say and so therefore we do not see them coming into existence. And I agree with you. My point is that given the exact and elaborate language that has evolved in the formulation of contracts underlying financial instruments of all types (just read your mortgage contract or the contracts for mutual funds) such a contract is especially ridiculous when held up as the undergirding of fractional reserve banking.

  This is why I was espcially disappointed with Larry's review oif De Soto's book. "Larry is a careful scholar and we will get the other side of the story," I thought. Unfortunately, although I do not have the review handy, I do not recall one word being written by Larry about the first three chapters (165 pp.) of De Soto's book. It is in these chapters that De Soto deals in great detail with the evolution of the positive legal framework of deposit banking.

  The free bankers continue to justify their position that fractional reserve banking is not fraud by referring to the libertarian doctrine that any purely voluntary agreement is just and therefore nonfraudulent. But the real question that they should answer is what, precisely is being agreed to in a fractional reserve "contract." They can begin by carefully explaining: 1, how the "irregular deposit contract" historically evolved into the loan contract of fractional reserve banking; and why the fractional reserve contract is so different from those contracts referring to almost all other financial instruments.

  Joe

  Published: May 23, 2009 3:13 PM

• scineram

  It seems the issue is the home is not fungible. If it was a hotel or some resort, and the contract guaranteed the full and unimpeded use of an apartment the ambiguity would basically disappear. It would be like any overbooking. There would be no "this home" to be resold. Similarly with money or gold.

  Published: May 23, 2009 4:11 PM

• Current

  Current: "In my opinion if the bank says "I promise to pay the bearer on demand" then it must have full reserves. No matter if the note represents is debt or ownership."

  Steve Horowitz: "Why? The promise is to "pay on demand." The promise is not "to warehouse your money." Gene's reductio makes a really important point: there are many cases in markets where if the really unexpected happened, promises couldn't be kept. I think the insurance one is closest: look what happens to small insurers after a really major natural disaster."

  A business is not responsible for random externalities imposed upon it. It is not responsible for fire, flood, or war. This is a well accepted principle. However, accepting those particular exceptions it is responsible for everything that goes on within the bounds of it's premises.

  So, an insurance company that is unprepared for a natural disaster is still in breach of contract. It is *not* in breach of contract if the claimant can't reach the premise because of a flood, common law excepts that situation. however, it is in breach of contract if the flood means that the insurance company can't pay.

  The situation is of course completely different if the contract gives an alternative the bank is able to employ if it can't pay in commodity.

  Steve Horowitz: "And trying to redefine terms as Current suggests only demonstrates a desire to centrally plan what can't be planned: the evolution of language.

  It's always been clear (even my intro students know this) that reserves aren't 100% and there's some small chance the bank won't be able to pay."

  No I'm not. I'm simply talking about how language is currently used. You're intro students are probably in the top 5% most intelligent people in the US. I'm not surprised they have realised this. However, have you ever talked to normal people about their bank accounts? Most people consider them entirely safe and have no idea how they work. As George Selgin pointed out in the piece I quote, this is what deposit insurance has done.

  I agree that language is evolutionary and that a particular cabal should not be able to define it. However, I don't think that's what's happening here.

  Something to consider for comparison is the legal meaning of the word "shall". In some countries the legal meaning of this word is "may". So, if I write "I promise that I shall pay the bearer on demand the sum of £5" that means that the contract is entirely optional.

  Think about the future. If we were to reinstitute free banking today what would happen? If people don't know what their bank account actually are then everything will go disastrously wrong.

  Perhaps though you are right about the past. It reminds me of Shakespeare (as another poster pointed out): "Romeo, Romeo, wherefore art thou Romeo". Which means: "For what reason are you Romeo" - that is Romeo Montague.
  

  Published: May 23, 2009 4:39 PM

• Geeorge Selgin

  Joe Salerno writes: "The free bankers continue to justify their position that fractional reserve banking is not fraud by referring to the libertarian doctrine that any purely voluntary agreement is just and therefore nonfraudulent." I'm surprised to see you say this, Joe, as any reader of the full course of blogs above, ;et alone our articles on the topic, knows that we've offered much more than the simple argument you give--an argument more reminiscent indeed to the a-priori one liners that are the common fare of 100-percent reservers! We've repeatedly referred to empirical evidence from Scotland and elsewhere; we've discussed at length, with appropriate references to legal authorities, the nature of bank "deposit" contracts; and we've discussed at length the practical disadvantages of a 100-percent rule.

  Go ahead: take inventory of the blogs above, and see whether you agree that the repetitive one-liners are coming from the other side of the debate. Perhaps seeing that will nudge you our way!

  Published: May 23, 2009 4:54 PM

• Anton

  The GMU people are extremely lucky that a serious thinker, scholar, and gentleman like Dr Salerno is willing to go out of his way to try and educate them (some might say they are a lost cause) about monetary economics.

  Please try and show some gratitude you GMU guys. Thank the Lord that we have the Mises Institute to fight the good fight rather than leaving the struggle against our enemy the state to 'ingratiate themselves with the beltway establishment' types like Stephen Horowitz and Peter Boetke.

  Published: May 23, 2009 4:59 PM

• Steve Horwitz

  Yup, those "Beltway Establishment" types sure do love themselves some free banking. It really is the secret to ingratiating yourself to them. I've tried to keep it a secret, but the truth is that everytime I mention "the law of adverse clearings" or "excess demand for money" at a party on the Hill, people just get so excited that they start offering me all kinds of money and power. If you want access to the Beltway establishment, supporting free banking instead of 100% reserve is the way to go!

  Published: May 23, 2009 6:39 PM

• Joe Salerno

  George,

  So-called "empirical evidence" (I prefer the less pretentious term "history") can be interpreted in many different ways, as we know from the multitude of interpretations of the current financial crisis we hear everyday. And I never accused "your side" of repeating, Heaven forbid, "apriori one-liners." I expressed much different concerns which you haven't addressed and can be summed up in four reasonable questions which you should be able to easily answer:1. How and when did the demand deposit contract become explicitly transformed from a bailment to a loan contract? 2. Are you and Larry suggesting that the statement "Bank X will pay to the bearer on demand the sum of Y ounces of gold," which you characterize as a "call loan" and is the sum and substance of the fractional reserve contract, constitutes a meaningful and legally enforceable contract? 3. If so, why is this contract framed so differently from contracts carefully and precisely specifying the rights and obligations of parties to other financial instruments, such as, e.g., a broker's call loan? 4. Is the counterfactual contract I specified about the house in Montana a legally coherent and enforceable contract or would any claim pertaining thereto be thrown out of court as a joke?

  I do not see how the empirical evidence from Scotland and a few other times and places answer my questions. Nor are mine rhetorical questions designed to score debating points; your answering them would go a long way toward elucidating the nature of the fractional reserve bank call loan contracts. You make a comment about being fed up about "bad law" that is invoked in the criticisms of frb that have been made on this blog. Well, enlighten us then: what is the good law that undergirds these peculiarly framed frb contracts and from whence did it come?

  Published: May 23, 2009 7:45 PM

• Gene Callahan

  DNA writes that Block and others have an argument as to why fractional reserve banks are not similar to insurance companies. Well, so what? I was responding to an argument expressed HERE in this thread, not to some other argument made by some other people somewhere else! I take it, from his need to drag in some other argument, that DNA fully sees the effectiveness of my reductio against the argument I was actually addressing.

  But thanks for the compliment on my humour, DNA!

  Published: May 23, 2009 9:38 PM

• newson

  well thanks to professor white for a tardy and begrudging recognition that the vernacular usage of "deposit" may not correspond to the economic reality of the frb account.
  bill clinton did a walk-on because the free-bankers seem to have a view that contracts that govern billions of dollars seem to hang on whatever selgin/white et al can reliably tell us is understood by the public. this is disingenuous. as salerno says, every comma, every nuance in every other financial contract is weighed up, and explicitly defined. this is the contradiction that huerta de soto has exposed about free-bankers = that its proponents are comfortable about the moral aspects (informed consent), and yet remarkably lackadaisical (or in bad faith) when it comes to the precise language which should exactly mirror the economic reality of the underlying transaction. (bank balance sheets do correctly represent "depositors" as creditors).

  if i said i had a "cure" for cancer, rather than a "treatment", they'd gladly run me out of town as a fraudster: when i offer a "current account" rather than a "contingent account", they come back with the hamburgers-ain't-ham-line, we all know what we mean.

  second, frb causes the abc, and the free-bankers acknowledge this, as does mises in human action. the argument is that redemptions amongst competing frb's limits the extent of the cycle. so it's argument about harm minimization, at best. but none have convinced me by a thorough refutation of hulsmann's paper on error cycles that a specie money would give rise to the abct.

  "grad student"'s appeal that this remain an argument for academics is misguided as well as snobby. if austrian economics has been sidelined for so long, it's largely to be credited to academics (homework: read hayek on intellectuals). only a popular revulsion will change the monetary order, and academia will resist and squeal till the bitter end.

  finally, it strikes me that the austrian insight into business cycles is incredibly young historically, let's say a century. past instances of where frb prevailed have got to be viewed taking into consideration that even consenting, contracting parties weren't generally aware that their actions created the business cycle.

  Published: May 23, 2009 10:45 PM

• newson

  oh, i forgot my one-liner! to "grad student": check out how many academic economists in zimbabwe have stood up and denounced their country's monetary disorder. i rest my case.

  Published: May 23, 2009 11:00 PM

• newson

  ...and yes, we're all against the zimbabwean central bank.

  Published: May 23, 2009 11:02 PM

• jp

  For the curious, Hutt's paper "The Yield From Money Held" can be found here.

  http://www.terry.uga.edu/~selgin/ECON8610/documents/Hutt.pdf

  Published: May 23, 2009 11:45 PM

• newson

  thanks, jp. i'd like to recommend huerta de soto's critique of the "neobanking school" - http://mises.org/journals/qjae/pdf/qjae1_4_2.pdf

  Published: May 23, 2009 11:58 PM

• George Selgin

  jp indicates that he's found a link to Hutt's article. The link is in fact from my own site, and is there because I assign the article to my monetary economics students. Bear in mind that this whole debate got going in part because Hoppe accused me (among others) of not appreciating Hutt!

  Joe: those are good questions, and I don't say we've answered them all in detail. I merely say that the free bankers haven't merely settled for saying "frb transactons are voluntary QED!" And however murky the origins of the law on fractional reserves may be, the fact mains that those who insist that a bank deposit is "really" a bailment are not arguing consistently with how that law has stood for centuries.

  You criticize Larry for not finishing his critique of De Soto. Well, I sympathize with Larry. At one point I thought to respond merely to De Sotos chapter attacking my views. But soon I found that De Soto's misrepresentations of my work--passages lifted from context or willfully (I believe) misinterpreted and such--made me lose heart. "Where to begin?" I asked myself; and "Do I have time to write a reply that must end by being three times longer that the work I'm criticizing?" I did some back of the envelope cost-benefit calculations, and decided to work on something else.

  Perhaps I really don't get De Soto. But the explanation I'm giving is the honest truth of the matter. And I recall Larry telling me that trying to review the whole of De Soto's book had exhausted him in much the same way.

  Published: May 24, 2009 7:59 AM

• newson

  professor selgin says:
  "the fact mains (sic) that those who insist that a bank deposit is "really" a bailment are not arguing consistently with how that law has stood for centuries."

  true, but 100% reservers are not satisfied that the law has adequately mirrored the economic reality of the operation (and some may be so bold as to imagine that self-interest may have shaped the judicial treatment). old laws and rulings aren't above reproach, as the many anti-ip blogs evince.
  

  Published: May 24, 2009 8:22 AM

• Gene Callahan

  I will also note that it is very curious for several posters to have noted that "companies aren't responsible for things like floods or fires" when I explicitly mentioned insurance companies that may be insuring against... Flood or fire! Of course, if a bad flood comes and they can't pay all claims they are in default... Just as free bankers say a FRB would be if it can't pay all withdrawal requests.

  Published: May 24, 2009 9:39 AM

• Gene Callahan

  I will also note that it is very curious for several posters to have noted that "companies aren't responsible for things like floods or fires" when I explicitly mentioned insurance companies that may be insuring against... Flood or fire! Of course, if a bad flood comes and they can't pay all claims they are in default... Just as free bankers say a FRB would be if it can't pay all withdrawal requests.

  Published: May 24, 2009 9:39 AM

• Current

  Gene Callaghan, I think we agree that a bank is out of contract when it can't pay during a run. Just as an insurance company is if it can't pay during a flood.

  However, an insurance company is also breaching it's responsibility to contract holders if it does not make its best endeavours to prepare to fulfill those contracts. Why is a bank different?

  To give another example. Suppose I make a contract to supply bread to a particular shop. I am out of contract if I don't supply the bread. What is the situation if I don't make steps towards supplying the bread? Aren't I guilty of negligence even if I have always supplied the bread so far?

  It is different if the notes contain an option clause.
  

  Published: May 24, 2009 10:07 AM

• Joe Salerno

  George,

  Fair, enough, although I found De Soto's book clear and straightforward and did not think that there were any gross misrepresentations of your position in it. But I do admit that I wasn't as closely focused on De Soto's critique of frb in chapter 8 of the book as Larry appeared to be in his review.

  
  But one more point: if indeed the "entire contract" for free banking call loans/deposits is, as Larry said, summed up in the statement on the note, "Bank X will pay the bearer on demand Y sum of gold ounces," then this is a debt instrument and not a present claim to property. This means that the debt issuer as present owner of the uncalled loaned funds, given the lack of any explicit qualification about the use of the funds on the note, may do as he pleases with them without committing fraud. You and Larry would certainly agree with me up to this point. So then it would be perfectly legitimate under your interpretation of the contract for me to set up a limited liability Salerno Bank, and assuming I have been a successful and reputable businessman to begin issuing frb notes in exchange for gold deposits. Since there are no restrictions specified on my use of the funds, I may then nonfraudulently proceed to gamble a part or all of them away in Atlantic City. When the lenders/depositors come calling for their funds and find I no longer possess them, their only legal recourse is to file claims against the equity that I have invested in the bank. My point, once again, is NOT that this is likely to happen under free banking--although we have ample examples of wildcat banks--but that it is highly unlikely that such a silly contract could evolve in a free market without substantial government regulation and/or central banks already in existence. After all, mutual funds include in their contracts precisely how they will invest the funds of their shareholders. Now, you and Larry are the authors of very interesting speculations on "How the Invisible Hand Would Handle Money" in an ideal free banking future. As such I would think that you would be as eager to examine the past evolution of the seemingly anomalous frb contract with the same care De Soto devoted to studying the historical development of the irregular deposit contract. Such an article would go a long way toward resolving many of the issues raised on this blog.

  Joe

  Published: May 24, 2009 10:20 AM

• George Selgin

  Joe: I'm inclined to say that your imagined banker would not be committing fraud or any crime unless he stipulated some particular limits on how we was to invest or otherwise employ the "deposited" (that is, lent) funds. He would, as you say, be liable to have his equity attached, and perhaps his personal wealth if his liability were extended.

  Indeed, I have always insisted that, the reason why deposit insurance is such a dreadful idea, is that it makes depositors relatively indifferent concerning the use to which bankers put their funds. In a healthy banking system one expects to encounter a wide range of banking practices, with some bankers taking relatively large risks in return for larger promised returns to depositors and others pursuing relatively safe strategies. This means that, while the dangerous sort of bank you imagined wouldn't necessarily be illegal under free banking, it would hardly be the only game in town! Jim Grant, in his excellent book, _Money of the Mind_ talks about how "back in the day" (that is, before the FDIC and especially before the Fed) some U.S. banks were famous for their "no risk, no return" commitments--and did well based on this strategy (I believe that First National Bank of NYC was one of them--believe it or not!). They invested only in the highest-rated bonds--at a time when those ratings _meant_ something, and they advertised the fact, and to that extent had something of a limited contract as false advertising would I believe have constituted common law fraud. Banks also held oodles of capital as a way of assuring liability holders of their safety.

  In short, it isn't a question of customers having to choose between warehousing their money or lending it to gamblers. As a consistent believer in monetary freedom, I blieve that they should have both these extreme options, provided they understand that they gamble at their own risk. In practice, though, bankers offered better intermediate altrenatives, and had ways, short of expressly making their investment strategies part of their contractual terms, of making their general practices known, and making their commitment to those practices fully credible.

  Published: May 24, 2009 12:10 PM

• Carlos Novais

  But will the "promisses of payment" notes issued by FRBs be exchanged consistently at par with 100% reserve certificates or gold coins or not?

  We could even make the hypothesis that demand deposits with a proper interest could be accepted at par (a merchant would accept payment by a credit in a particular FRB demand deposit) in the same way that a risky loan with a proper interest will trade at nominal value, but would FRB notes issued without any interest bearing clause be exchanged at par with 100% reserve notes?

  Published: May 24, 2009 1:10 PM

• George Selgin

  Carlos asks again: "would FRB notes issued without any interest bearing clause be exchanged at par with 100% reserve notes?"

  Why do you continue to ask this question, having been made aware of evidence speaking to it from Scottish, Canadian, and U.S. experience? You may dismiss any one episode as a special case; but with respect to your claim that notes should bear discounts proportional to their "fiduciary" component (that is, the extent to which their aren't backed by reserves), the contradictory evidence comes from numerous different banking systems and is quite overwhelming. Thus, even in the antebellum U.S., which is one of the few cases in which banknotes didn't always trade at par, discounts usually were applied only in those markets far removed from where notes originated: locally (that is, near their place of origin) notes practically always circulated at par or (to use bankers' vernacular) were treated as "current" money. That's not at all consistent with the "discounts depend inversely on reserve ratio" theory. Yet the evidence clearly refers to situations in which the discounting of notes was perfectly legal--so you can't claim that some (unknown) government interference explains what was taking place.

  These and related facts have been pointed out to you. Yet you continue to insist on the possible validity of your theory that FR notes will be discounted in a free market. So, do you reject empirical (historical, if you prefer--they're the same to me) evidence altogether and, if not, just what sort of evidence would you regard as sufficient to convince you that your theory is wrong?

  Published: May 24, 2009 2:16 PM

• Lawrence H. White

  Joe Salerno writes:

  "This is why I was espcially disappointed with Larry's review oif De Soto's book. "Larry is a careful scholar and we will get the other side of the story," I thought. Unfortunately, although I do not have the review handy, I do not recall one word being written by Larry about the first three chapters (165 pp.) of De Soto's book. It is in these chapters that De Soto deals in great detail with the evolution of the positive legal framework of deposit banking."

  Joe, you can refresh your memory of my review of Huerta de Soto's book by clicking through to its three parts here:

  http://www.freemarketnews.com/Analysis/240/6709/case.asp?wid=240&nid=6709

  http://www.freemarketnews.com/Analysis/240/6827/soto.asp?wid=240&nid=6827

  http://www.freemarketnews.com/Analysis/240/6877/soto.asp?wid=240&nid=6877

  (These links are also available in Walter Block's bibilography of works in the FRB debate.)

  You'll find that EVERY word is about the book's first three chapters! You may again be disappointed with what I wrote, but it will have to be for another reason than failure to discuss HdS's legal history.

  Published: May 24, 2009 7:39 PM

• Lawrence H. White

  Anton writes:

  "The GMU people are extremely lucky that a serious thinker, scholar, and gentleman like Dr Salerno is willing to go out of his way to try and educate them (some might say they are a lost cause) about monetary economics.

  Please try and show some gratitude you GMU guys."

  Indeed, Joe Salerno is a serious thinker, scholar, and gentleman. In these respects his contributions to this blog discussion stand in sharp contast to those of several (not all) of the pseudonymous and one-named posters. I thank Joe for raising the level of the discussion.

  Published: May 24, 2009 7:52 PM

• DNA

  George Selgin's response to Carlos Novais reminds me of the observation that the empiricist thinks he believes only what he sees, but he is much better at believing than at seeing.

  Published: May 24, 2009 8:07 PM

• Lawrence H. White

  DNA: "Regardless of whether the bank is bound to keep $5 in coin *on hand* for the $5 claim, if it *must* produce the $5 *on demand* (ie, it can't opt out), then it has to get that $5 from somewhere (ie, the banker's pocket, the tellers' wages, etc)."

  Yes. It normally gets it, not from the banker's pocket, but from the reserves held for that purpose in the teller's cash drawer or in the vault. If reserves begin to run low, the bank can replenish them by selling some of its most liquid earning assets (commercial paper, bonds).

  DNA: "In that sense, the relationship between claim holder and banker is essentially that of the depositor and warehouse bank."

  In the sense of being payable on demand, yes. In the sense of being covered 100% by some kind of assets, yes. In the sense the being covered 100% by gold coins continuously held, no.

  DNA: "The bank in Lawrence White's example (which likely is very different from the one that actually functioned in England at the time) is effectively practicing 100%, wareshouse banker."

  No, it isn't practicing "warehouse banking", for the reason I just gave.

  DNA: "The relationship can be called a debt relationship all one wants, but the note holder has a claim *at all time* on the amount of money *on demand.*"

  Thank you for that terminological concession. Yes to the part after "but", absent an option clause.

  DNA: "It's irrelevant, again, what the banker has done with the originally submitted money (lent it, spent it, melted it, etc)."

  Irrelevant from the perspective of whether the bank has to repay on demand (absent an option clause), agreed. On these questions we're not very far apart after all.

  Published: May 24, 2009 8:12 PM

• Lawrence H. White

  newson writes:

  "well thanks to professor white for a tardy and begrudging recognition that the vernacular usage of 'deposit' may not correspond to the economic reality of the frb account.
  bill clinton did a walk-on because the free-bankers seem to have a view that contracts that govern billions of dollars seem to hang on whatever selgin/white et al can reliably tell us is understood by the public. this is disingenuous. as salerno says, every comma, every nuance in every other financial contract is weighed up, and explicitly defined. this is the contradiction that huerta de soto has exposed about free-bankers = that its proponents are comfortable about the moral aspects (informed consent), and yet remarkably lackadaisical (or in bad faith) when it comes to the precise language which should exactly mirror the economic reality of the underlying transaction. (bank balance sheets do correctly represent 'depositors' as creditors)."

  Bank balance sheets do indeed correctly represent "depositors" as creditors. That is the reality of the FRB account. I do not in fact recognize, tardily OR begrudgingly, any non-correspondence between this reality and the vernacular use of "deposit," because in the modern vernacular a "deposit" is a debt claim and a "depositor" is a creditor. What "depositum" once meant in Roman Law does not govern current English usage.

  This is what judges have long said about "deposit" contracts. Selgin and I appeal to their authority, not our own. I certainly agree that the precise language of contracts "should exactly mirror the economic reality of the underlying transaction."

  But I don't think the debate about language is really all that important. It only becomes important when a term's ambiguity is exploited to make a bogus argument like the following: "If you talk about a bank holding a fractional reserve against a deposit you are talking about a fraud, because a deposit is by definition a warehousing or 100%-reserve arrangement." This is a verbal trick and not a serious argument.

  To help us focus on substantive and serious arguments, I offer the following deal: I'll stop calling debt contracts like checking accounts and savings accounts "deposits" in discussions of FRB if FRB proponents will stop calling money warehouses "banks". Warehouses aren't "banks" in the way everyone else uses the term, because they don't make loans. (Anyone who now wants to defend calling a money warehouse a "bank" is missing my point.)

  By the way, newson, could you please stop tossing in ad-hominems like "disingenuous" and "or in bad faith"?

  Published: May 24, 2009 8:54 PM

• newson

  freebankers have still got to explain away the business cycle.

  Published: May 24, 2009 9:23 PM

• George Selgin

  DNA: "George Selgin's response to Carlos Novais reminds me of the observation that the empiricist thinks he believes only what he sees, but he is much better at believing than at seeing."

  Is this meant to be an argument of some kind? If so, then just what is it I fail to "see" in describing banknote pricing patterns in the U.S. and elsewhere? Is it that I fail to "see" the truth as revealed to you? Or do you have something to say about those pricing patterns? Perhaps you've read the antebellum "banknote reporters," as I have (see my 2001 _Economic Inquiry_ article, "The Suppression of State Banknotes," where you will find a full account of note discounts in the New York and Chicago markets in 1863); perhaps you've read Gary Gorton's excellent 1999 JME article, "The Pricing of Free Bank Notes." If so, why be coy about your superior command of the facts? Why not share your understanding with this list--explain to all these good people the specific nature of my defective powers of observation, instead of keeping them guessing about it!

  Published: May 24, 2009 9:40 PM

• George Selgin

  Newson: "freebankers have still got to explain away the business cycle."

  More foolish heckling. Free bankers don't claim there aren't business cycles! Our critique of central banking rests largely (though not entirely) on the fact that it promotes business cycles!

  Once again: it's really very bad to criticize a body of thought of which your so obviously and thoroughly ignorant.

  Published: May 24, 2009 9:55 PM

• George Selgin

  Newson: "freebankers have still got to explain away the business cycle."

  More foolish heckling. Free bankers don't claim there aren't business cycles! Our critique of central banking rests largely (though not entirely) on the fact that it promotes business cycles!

  Once again: it's really very bad to criticize a body of thought of which you're so obviously and thoroughly ignorant.

  Published: May 24, 2009 9:57 PM

• newson

  to professor white:
  i find it hard to explain how your argument on the legitimacy of the frb contract relies on what you, or professor selgin deem to be common understandings. when i put a deposit down for a hire-car, commonsense tells that me that this is not a loan to the rental-car business. but aside from what you or i think about meaning, contracts for all other financial transactions are defined word by word. why is this meticulous attention to detail absent in the frb contract? and how can your arguments for informed consent hold water with this glaring exception to business practice? i'm aware of the judicial precedents, but that still doesn't preclude that a contract be explicit.

  also, that judges understood the nature of the frb contract (apparently not knowing the trade cycle effects) doesn't mean there is popular understanding. otherwise rothbard would have chosen a different title for his "the mystery of banking".

  Published: May 24, 2009 9:59 PM

• newson

  to professor selgin:
  i'm quite aware of the pro free-banking arguments - like i said before, harm minimization. of course free-banking looks good in comparison to central banking (which i don't see anybody championing). your job is to explain why a pure specie standard creates the austrian business cycle ("distortion" won't do, every change produces distortion, i want a systematic distortion). in doing so, try avoiding phrases like "market failure".

  Published: May 24, 2009 10:07 PM

• newson

  in essence what free-bankers are maintaining is that the privileged relationship between free-banker and client (as first users of eroding currency) is to take precedence over those who suffer the ill-effects of the business cycle. a clear case of interpersonal utility judgement.

  Published: May 24, 2009 10:16 PM

• Nicolas Cachanosky

  I'm not so sure in a FRB scenario there will be business cycles as described by the ABCT (I guess this is the business cycle theory implicit in this debate).

  In FRB, it will be very difficult for any issuer bank to expand credit for time enough and in enough quantity to cause a business cycle as decribed by the ABCT. I'm not sure there is an interpesonal judgement theory between FRB and business cycle.

  Published: May 24, 2009 11:17 PM

• Mike Sproul

  Consider a landowner who collects rents denominated in silver. When the landowner buys groceries, he pays for them with his own IOU (for 1 oz. of silver), which he accepts in payment of rents. Assuming the landowner keeps himself solvent, those IOU's will sell for 1 oz, and could circulate as money.
  1) Q: Will the landowner's issue of IOU's cause price inflation?
  A: Normally not. A prudent landowner will not allow his issue of IOU's to outrun his assets. But if IOU's do outrun his assets, the IOU's will lose backing, and thus lose value.
  2) Q: If local banks use the IOU's as base money, and issue money of their own on fractional reserve principles, will that cause the IOU's to lose value?
  A: No. The actions of the banks do not affect either the assets or the liabilities of the landowner, so the IOU's hold their value. Assuming the private banks remain solvent (but not necessarily 100% liquid) their money will hold its value as well.
  3) Q: Will the IOU's or the banks' money cause a business cycle?
  A: No. Money will only be issued as people demand it, and it will hold its value as it is issued. Thus the first receivers of the new money do not receive any wealth transfer, and the rest of the Austrian Business Cycle theory never gets off the ground.
  

  Published: May 24, 2009 11:57 PM

• jp

  Newson: "your job is to explain why a pure specie standard creates the austrian business cycle"

  Easy. Put a government-run monopoly in charge of your pure specie standard. Have the king's men run all the kingdom's gold warehouses and administer the interest rate as they see fit.

  Of course, you'll better understand this once you read Hulsmann's paper on error cycles, specifically pgs 11-14 on government.

  http://mises.org/journals/qjae/pdf/qjae1_4_1.pdf

  Published: May 25, 2009 12:59 AM

• Carlos Novais

  The issues envolved here:

  1. the legal discussion about the nature of the contracts and labels - we can assume that a perfectly clear and honest contract takes place within the FRB notes and demand deposits framework.

  2. the historical evidence that points to at par exchanged notes and deposits. Although some critical review (like Rothbard about the Scotland FB period) might be possible about the "contract" and transparence in place.

  3. To enquire about this modern age of information and real time asset and credit valuation (in a future FB paradigm) where FRB notes and demand deposits would be subject to close monitoring by the market that would have to deal with several issuers of notes and clearing systems would have to take place (several FRBs with different minimum reserve policys and several 100% certificates and demand deposit warehouses).

  When a FRB issues (expanding supply) notes or demand deposits for the sake of a new credit, the creditor will spend this particular and identifiable FRB note (of this particular bank) or demand deposit (in this particular bank) that must be accepted by the market at par value (or not).

  PS: and let´s think about accounting standards, should gold coins and 100% certificates be registered in the balance sheet in the same way (or fungible with) promisses of payment?

  Please take in account that we already have in the market 100% certificates like the popular gold ETF traded in NYSE as several 100% reserve demand deposits services like "Goldmoney".

  Published: May 25, 2009 3:50 AM

• newson

  jp
  yes, i've read the hulsmann paper, which i cited earlier in this post. it illustrates the impossibility of the abc under a pure specie standard (by definition a free market, unless the government figures out a way to turn lead into gold!). professor selgin seemed to be suggesting that distortions could be produced under a pure specie standard that would somehow be similar to the systematic illusion engendered by frb.

  Published: May 25, 2009 3:51 AM

• Current

  On this question of the word "deposit". I'm prepared to go along with the fractional reserve free bankers on other points but not this one.

  I think that is still important, though it may not be to the strictly economic side of the debate. What if free banking were reintroduced?

  I've talked to normal people about banking before. They don't understand the relationship between themselves and their bank. They don't necessarily think of a deposit as being a loan to the bank. Equally though they don't necessarily think of it as being a bailment. I don't think people really know what it is.

  I think it would be very dangerous to let this confusion persist if free-banking were reintroduced.

  I don't think the point that free-bankers keep making about interest is really relevant. I think it's quite clear that a _savings_ account is a loan to the bank. But, at least where I have lived in the UK and Ireland those accounts are called savings accounts. The confusion is over the more normal current accounts.
  

  Published: May 25, 2009 6:03 AM

• Carlos Novais

  Current

  I would say that the confusion between "100% reserve demand deposit" and a current account of "promises of payment" that allow its expansion by credit expansion is even greater.

  One thing is for non-economists to realize that demand deposits are funding the assets of a bank (and so a maturity risk is perceived as being part of the game)...other thing is to explain that the bank also is able to create/issue new demand deposits (adding new claims to banks assets) to "fund" new credit (please take notice, this is the core argument for having ABC - new credit funding new capital where no previous and voluntary savings took place).

  The interesting problem is that the second effect (demand deposit expansion) is a consequence of the first (simple maturity risk) and gets fungible – it’s not possible to separate the first from the second, the moment a partial reserve is accepted its not only that the bank will lend part of its original demand deposits, but also create new previously non-existing demand deposits for credit expansion.
  

  Published: May 25, 2009 7:20 AM

• Current

  Stephen Kinsella: "To call the words printed on a banknote a contract seems a bit question-begging to me--maybe it is, maybe it isn't. As I noted in my Liberty reflection from a while back, The Bank of England and Me, when I lived as a grad law student in London 1991-92, one day I decided to visit the Bank of England to see what they would do if I presented a 5-pound note for redemption of the promise to pay the bearer "five pounds" on demand. I didn't get five pounds of silver. Instead, they booted me out for impertinence, and sent me to the Bank of England Museum around the corner."

  I'd just like to point out that Stephen Kinsella is correct here. I have a UK ten pound note in my wallet, it says on it "I promise to pay the bearer on demand the sum of ten pounds".
  

  Published: May 25, 2009 7:58 AM

• Lawrence H. White

  newson asks: "why is this meticulous attention to detail absent in the frb contract? and how can your arguments for informed consent hold water with this glaring exception to business practice? i'm aware of the judicial precedents, but that still doesn't preclude that a contract be explicit.

  also, that judges understood the nature of the frb contract (apparently not knowing the trade cycle effects) doesn't mean there is popular understanding."

  An FR checking account contract can be as meticulously detailed the contracting parties care to make it. (I don't know how detailed they actually were in the 19th century.) Likewise the contract on the face of a banknote. If the language on ordinary banknotes was simple, and remained simple for decades in competitive banking environments, my (rebuttable) hypothesis would be that simple language was sufficiently clear to satisfy noteholders. Contractual elaboration could have been printed on the back of the note, by any bank seeking to attract customers away from other banks, but wasn't.

  I trust you will agree that no contract can be fully explicit in the sense of covering all contingencies. Contracting parties weigh the benefit of adding more elaboration agains the cost. We economists can't observe a free-market contract and declare from on high that it has too little detail. If a contract persists and spreads, shouldn't we presume (absent evidence that the market discovery process was blocked) that it satisfies the contracting parties?

  What is your hypothesis about why banknote contracts were not more detailed? Is it that note-users were somehow stuck with disliked or illegitimate contracts for decades and decades, even though banks offering contracts preferred by the public could have competed the bad contracts away?

  I'm happy to see you grant that judges understood the nature of the frb contract. It was Rothbard's position (Mystery of Banking, pp. 90-94) that they misunderstood the bank "deposit", since they failed to consider it a bailment.

  Published: May 25, 2009 10:30 AM

• newson

  to gene callahan:
  insurance covers exogenous risk, not endogenous. frb suffers from the latter, so there is no comparison with the risk of a bank run to an event for which there are actuarially-determined probabilities. suicide is not covered by life policies for the same reason, nor is nuclear war, for that matter.

  Published: May 25, 2009 10:48 AM

• Current

  I think you mentioned earlier that option clauses were banded on Scottish banknotes in 1765. So, in that particular case there may have been a legal block.
  

  Published: May 25, 2009 10:50 AM

• Current

  Carlos: "would FRB notes issued without any interest bearing clause be exchanged at par with 100% reserve notes?"

  George Selgin: "Why do you continue to ask this question, having been made aware of evidence speaking to it from Scottish, Canadian, and U.S. experience? You may dismiss any one episode as a special case; but with respect to your claim that notes should bear discounts proportional to their "fiduciary" component (that is, the extent to which their aren't backed by reserves), the contradictory evidence comes from numerous different banking systems and is quite overwhelming. Thus, even in the antebellum U.S., which is one of the few cases in which banknotes didn't always trade at par, discounts usually were applied only in those markets far removed from where notes originated: locally (that is, near their place of origin) notes practically always circulated at par or (to use bankers' vernacular) were treated as "current" money. That's not at all consistent with the "discounts depend inversely on reserve ratio" theory. Yet the evidence clearly refers to situations in which the discounting of notes was perfectly legal--so you can't claim that some (unknown) government interference explains what was taking place."

  George Selgin:"In a healthy banking system one expects to encounter a wide range of banking practices, with some bankers taking relatively large risks in return for larger promised returns to depositors and others pursuing relatively safe strategies. This means that, while the dangerous sort of bank you imagined wouldn't necessarily be illegal under free banking, it would hardly be the only game in town! Jim Grant, in his excellent book, _Money of the Mind_ talks about how "back in the day" (that is, before the FDIC and especially before the Fed) some U.S. banks were famous for their "no risk, no return" commitments--and did well based on this strategy (I believe that First National Bank of NYC was one of them--believe it or not!). They invested only in the highest-rated bonds--at a time when those ratings _meant_ something, and they advertised the fact, and to that extent had something of a limited contract as false advertising would I believe have constituted common law fraud. Banks also held oodles of capital as a way of assuring liability holders of their safety."

  How did both of these things happen?

  I see why George Selgin is right about discounting notes. If someone were unsure of a bank's solvency they would redeem the note rather than discount it (unless traveling to the bank was too troublesome).

  I suppose there are three possibilities:
  * Risks to note holders were very similar.
  * High risk banks compensated by issuing fewer notes and using more of other sorts of finance.
  * High risk banks had owners that would cover loses.

  Is that what fractional reserve free bankers think?
  

  Published: May 25, 2009 11:25 AM

• Carlos Novais

  "If someone were unsure of a bank's solvency they would redeem the note rather than discount it"

  Yes, it makes sense, particularly in that time. And that is a cause, I guess, for the discounts observed in places distant from the issuing bank. The option of redemption was far away in time.

  The trust in an issuing bank is 100% (no bank run) or 0% (bank run), specially without the possibility of a real time information. So people would accept to use some particular notes at par value or not accept at all.

  But would that happen now? Would not the market require real time information to compare the use of certificates and physical gold (or silver) versus “promises of payment” with different reserve ratios? Would not the risk and cost of gathering data be a factor in evaluating the use of FRB notes?

  I think that we could expect that there would appear warehouses with demand deposits and clearing systems that would clear only against 100% reserve accounts.

  Take in account that a FRB economic system would have to deal with several issuers (or “currencies”) including several FRBs and several 100% reserve warehouses.

  So, for example, a merchant will have to define what are the currencies he accepts to be paid by a credit in is account being this account a demand account in a FRB or a 100% reserve warehouse. Would it be the price exactly the same?

  Today already are in place services like “goldmoney” [100% reserves obvously] that clears transactions between costumer’s demand deposits (some of them acting as merchants accepting gold payments) in gold and silver.

  As far as I know, no one is offering a FRB type of business model, but if and when that appears, I wonder if people will really accept clearing transactions at par value or will include in the pricing things like the cost of immediate redemption and transfer to a 100% reserve service.

  If "immediate redemption" would be the practice that would amount to, in practice, to force FRB into not being FRBs.

  FRB only exists in the sense that the expanding supply "circulates" inside it´s own balance sheet, between different demand deposits. If redemption is the rule no FRB will exist.

  Published: May 25, 2009 12:48 PM

• Steve Horwitz

  "Yes, it makes sense, particularly in that time. And that is a cause, I guess, for the discounts observed in places distant from the issuing bank. The option of redemption was far away in time.

  The trust in an issuing bank is 100% (no bank run) or 0% (bank run), specially without the possibility of a real time information. So people would accept to use some particular notes at par value or not accept at all."

  The trust is not binary in this way. If I'm "unsure" of a bank's solvency, that does not mean I definitively expect a run. It means I'm UNSURE. As such, wouldn't I just discount the value of the note or deposit by the risk my best guess attaches to it? Why assume that any expectation less than 100% equates to "expects a bank run?" Risk assessments run the range of 0 to 100%.

  George's point about the empirical evidence from bank note reporters is pretty devastating to the argument that people don't (or didn't) know what was going on with frb. There was plenty of information out there through various intermediaries.

  The basic question remains: 100% reserve "banking" has always been legal, yet we see (essentially) none of it, which suggests that people understand how it works and how FRB works (after all, FRB has never been legally *mandated* - reserve requirements are minimums and banks could hold 100% if they wanted) and they have chosen the risk/return combination offered by FRB over 100% reserves.

  It's interesting that George and Larry (and numerous other researchers on the history of free banking) have offered evidence of the market test and the radical defenders of the market who comment here keep rejecting it. Where FRFB notes have been allowed, they have never been out-competed by 100% reserve banks. And where such notes were not interfered with by government regulations, they have not produced significant bank runs or bank failures, nor has the business cycle been a problem of any notable sort.

  There's the evidence. Why the insistence on trying to explain it away? Why cling so hard to a position that both theory and history suggest is in error?

  Published: May 25, 2009 1:09 PM

• Joe Salerno

  Steve writes:

  "The basic question remains: 100% reserve "banking" has always been
  legal, yet we see (essentially) none of it, which suggests that people
  understand how it works and how FRB works (after all, FRB has never
  been legally *mandated* - reserve requirements are minimums and banks
  could hold 100% if they wanted) and they have chosen the risk/return
  combination offered by FRB over 100% reserves."

  But of course we have 100 percent reserve banking, and have had it, at least in the U.S., since the inception of the FDIC up to a certain maximum of bank deposits per individual per bank. This maximum is routinely raised during financial crises
  to create a headline event calculated to remind nervous depositors that their deposited funds are all and always "in the bank." Thus, in the latest crisis the maximum has been "temporarily" raised from $100,000 to $250,000 per depositor for a given bank. In fact such insurance has temporarily been extended even to MMMF shares to prevent them from "breaking the buck." From the viewpoint of individual depositors, the words "FDIC insured" is simply another way of saying "guaranteed 100 percent reserves." So at least in the post-World War 2 period, I think you will agree, no valid inference can be drawn from the fact that almost everyone chooses to deposit money in (nominally) fractional reserve banks.

  What do you think would happen to fractional reserve banks if tomorrow federal deposit insurance were completely abolished and the Fed was restricted from further bailouts of the banking system? How do you think the invisible hand would handle money for at least a generation or two afterwards, assuming that federal deposit insurance were not re-imposed and the Fed were stripped of its function of a lender of last resort?

  Joe

  Published: May 25, 2009 5:22 PM

• Steve Horwitz

  An interesting question Joe.

  I don't think the public would panic, if that's one possible outcome you're imagining. I don't think people are as confused about how banks work as some 100% reserve advocates seem to believe. My students, both intro and money and banking [at the beginning of the semester], understand the idea behind FRB and it doesn't bother them.

  I had a dinner conversation last week with group of mixed gender faculty spouses, all of whom understood that only a small percentage of their reserves were in the bank. When I raised just your question "how would you feel about that if your deposits weren't insured by the gov't?", I got mostly responses like "well I'd be a little more nervous with such a low percentage, but I'm assuming that the bank still legally has to pay me something if it has trouble" and "why couldn't they get other forms of insurance?" These were NOT econ spouses!

  In any case, I think the answer is that banks would have to do just what Larry (I believe) mentioned up thread - deploy all the ways they did before DI to demonstrate their trustworthiness and financial soundness. My SEJ paper on the Panic of 1907 offers some historical evidence on these sorts of techniques and how they helped prevent a systemic collapse in that situation. Banks might well end up, in the short run, with higher reserve ratios, but I'm totally certain of that.

  Given the way that information flows freely and quickly with modern communications technology, I'd think banks would have every reason to convey their soundness quickly and accurately and that there would be big business in information intermediation about such concerns.

  And are we also including the possibility that banks could issue their own notes and/or offer redemption in gold or some other commodity?

  Published: May 25, 2009 7:54 PM

• newson

  professor horwitz says:
  "I got mostly responses like "well I'd be a little more nervous with such a low percentage, but I'm assuming that the bank still legally has to pay me something if it has trouble" and "why couldn't they get other forms of insurance?"

  i think these answers prove the point - that average punters have a very poor understanding of the workings of frb. i'm not aware of any previous instance of insurers underwriting frb accounts, outside of government. how could an actuary assess the risk, when the model itself introduces the very same? it would be like life insurance covering suicide risk.

  Published: May 25, 2009 9:19 PM

• Stephan Kinsella

  Larry White:

  Stephan Kinsella comments: "To call the words printed on a banknote a contract seems a bit question-begging to me--maybe it is, maybe it isn't."

  I reply: I presumed that it was a contract because the obligation to pay expressed on a banknote was legally binding. A bank that didn't pay could be sued for breach. In Scotland, the noteholder automatically received a summary judgment against the bank. Perhaps it is also relevant to appraising their contractual status that the banknotes were individually hand-signed in ink by bank officials.

  Larry, I was speaking more as a libertarian, in response to the notion that "if it's written, that's the contract" etc. (I tried to go into a bit of this in my post The Libertarian View on Fine Print, Shinkwrap, Clickwrap.)

  George Selgin:

  Kinsella writes: "However, as an Austrian, I do believe that if the bank makes this sufficiently clear, they will not be able to get away with establishing a money system based on these promissory notes."

  This is missing the point entirely, Stephen: The legal definitions are what they are because historical banks "did" make the meaning they attached to the term "deposit" sufficiently clear. The sources don't say that the meaning of bank deposit is ambiguous. They say it's a credit. So what you claim banks can't possibly succeed in doing--namely, keeping notes and deposits outstanding that are _understood_ to be debt contracts rather than bailment contracts--is in fact what they have long gotten away with!

  Now, you may respond, "Well, the law understood them this way, perhaps--but some depositors themselves don't." Even if that were the case, it would prove nothing: the contracts were legal, and the depositors' ignorance of their nature was their (the depositors') fault, not the bankers!

  Dr. Selgin,

  I am not denying that the bank deposits were actually legally treated as credit. Nor am I arguing FRB is inherently fraudulent, so I am not trying to say it was really misunderstood by the "depositors" -- and I tend to agree with you on the caveat depositor issue -- as I specifically said in my post.

  Rather my point was that in my view it is unlikely for a fractional-reserve system to survive and prosper without some kind of state intervention and/or systemic fraud. You can point to the existence of FRB in an era but this does not prove it existed free of such defects.

  As Salerno pointed out later re a related issue, "it is highly unlikely that such a silly contract could evolve in a free market without substantial government regulation and/or central banks already in existence." -- Likewise, my contention was that if and to the extent fractional-reserve was widely adopted then it is not because the notes are not credit, but only because of some systemic non-market influence. As Salerno points out in what seems to me to be a crucially insightful comment, the very existence of the FDIC now in effect makes our current system "100% reserves" and this explains why the current fractional-reserve system can exist. Is the current system "fraudulent"? While libertarians often employ the term fraud loosely and uncarefully (as I discussed in my post The Problem with "Fraud"), and might call the current Federal Reserve-dominated system "fraudulent," I am not sure it is. Not all acts of aggression and crime are fraud. Sure, there is deceipt and propaganda, but fraud? I am not sure a case for fraud can be made out--in my view the federal government's huge monetary-regulatory apparatus as well as its welfare-state apparatus are nothing but variants of Ponzi schemes--but hey, I'm a libertarian--I would not outlaw Ponzi schemes and don't think they are necessarily fraudulent. The problem with the central banking system is not that it is fraudulent but that it is a type of systematic state regulation of the market, and amounts to various types of aggression.

  But just as the current FRB system survives only because it is backed by massive state theft and violence, it is coherent to maintain that any historical FRB systems also had to have some type of systematic state support or intervention.

  (In fact, in this connection, Salerno asked--again, extremely insightfully and incisively--

  What do you think would happen to fractional reserve banks if tomorrow federal deposit insurance were completely abolished and the Fed was restricted from further bailouts of the banking system? How do you think the invisible hand would handle money for at least a generation or two afterwards, assuming that federal deposit insurance were not re-imposed and the Fed were stripped of its function of a lender of last resort?

  I find it absolutely mind-boggling that Steve Horwitz replies:

  I don't think the public would panic, if that's one possible outcome you're imagining.

  It seems manifestly obvious to me that there would be wide panic and a huge financial collapse, virtually instantly. Steve could well be right, I admit; he is the professional economist. But I cannot even imagine how panic would not ensue. And such disagreements even on this kind of question only confirms my doubts about the FRBers calm reassurance that FRBs can avoid runs, runs are not necessarily inevitable--if they have such a view of fractional-reserve banking that they think even the current system would not succumb to panic and runs were deposit insurance abolished, then no wonder they have even more confidence in private FRBs. I can tell you one thing: I know for certain that I would run to the bank to withdraw my money, if I got wind of FDIC's abolition. Steve, you wouldn't?

  Dr. Selgin continues:

  As for my getting in a bad mood about this stuff, well, yes I do, and here's why: Larry and I and some others have been trying our damndest to battle the central bankers and fight for abolishing their currency monopolies, and all the while we have to waste effort fighting a rearguarad action as well against ill-informed 100-percent reservers who, besides diverting us from our main efforts, give both the free-banking movements and Austrian economics as a whole a bad name, by associating them with bad history, bad law, and bad economic theories. If I express disgust with some of the arguments coming from the 100-percent reserve camp, consider that I am at least engaging those arguments--often the same ones repeated again and again despite all manner of contrary argument and evidence. Doing this is exhausting and sometimes feels futile. I can only hope that doing so is making some people reconsider the merits of the Rothbard-DeSoto-Hoppe position.

  I view this solely as an economic discussion--more of a debate predicting who would win in a free market competition between warehouse-banks and FRBs. As a libertarian I would strongly endorse your right to set up an FRB, but it is my prediction based on my economic understanding that they would face recurring problems and would not survive. You can say "but they did survive!" but to my knowledge it has not been shown that they survived free of state propping and intervention.

  It seems to me you need not feel disheartened by this dispute--some of us see a common problem with the central banking system, and with freebanking: the common problem is fractional reserve banking, though of course a state-run, centralized FRB system is worse. As Bob Murphy writes in a recent article, "ABCT blames the boom-bust cycle on fractional-reserve banking" (as opposed to merely blaming it on central banking).

  Steve Horwitz:

  I will confess, unsurprisingly, my strong agreement with George's crankiness and his reasons for it. "Fractional reserve banking is fraudulent" has the feel of a spiritual mantra that, if repeated enough, will somehow magically become true.

  However, strangely, his "crankiness" was in a response to me, where I have denied the "FRB is inherently fraudulent" contention. To me, this is an economic not libertarian question.

  Joe Salerno had written:

  "Since there are no restrictions specified on my use of the funds, I may then nonfraudulently proceed to gamble a part or all of them away in Atlantic City. When the lenders/depositors come calling for their funds and find I no longer possess them, their only legal recourse is to file claims against the equity that I have invested in the bank. My point, once again, is NOT that this is likely to happen under free banking--although we have ample examples of wildcat banks--but that it is highly unlikely that such a silly contract could evolve in a free market without substantial government regulation and/or central banks already in existence."

  Dr. Selgin replied:

  Joe: I'm inclined to say that your imagined banker would not be committing fraud or any crime unless he stipulated some particular limits on how we was to invest or otherwise employ the "deposited" (that is, lent) funds. He would, as you say, be liable to have his equity attached, and perhaps his personal wealth if his liability were extended.

  I am not sure I follow this. It seems to me if it is not fraudulent, or even a contract breach, then he is not personally liable at all. Why should he be? Certainly the bank at which you deposit your money would be a corporation or other entity for whose debts the owners and employees are not personaly responsible, as the depositors know when they make the deposit. Again: caveat depositor.
  Current:

  Stephen Kinsella: "To call the words printed on a banknote a contract seems a bit question-begging to me--maybe it is, maybe it isn't. As I noted in my Liberty reflection from a while back, The Bank of England and Me, when I lived as a grad law student in London 1991-92, one day I decided to visit the Bank of England to see what they would do if I presented a 5-pound note for redemption of the promise to pay the bearer "five pounds" on demand. I didn't get five pounds of silver. Instead, they booted me out for impertinence, and sent me to the Bank of England Museum around the corner."

  I'd just like to point out that Stephen Kinsella is correct here. I have a UK ten pound note in my wallet, it says on it "I promise to pay the bearer on demand the sum of ten pounds".

  I asked about that when I was sent to the Bank of England museum around the corner from the front office, and was told that the Bank's position is that these words only mean, and only ever meant, that if the Bank retires an old form of note and issues new ones, and you later on find an old one in a mattress, they'll replace it with a new one. So if you find a 10-pound note from 1900 that is no longer in circulation or legal tender, the Bank will take it and give you a current 10-pound note. Pounds don't mean pounds, silly boy!

  Published: May 25, 2009 10:29 PM

• Current

  Steve Horowitz,

  I think it's fairly unlikely that there won't be widespread panic if the deposit insurance systems were abolished. When Northern Rock collapsed in the UK it was actually not in a very bad financial position, and it was been helped by the Bank of England. Most of the depositors were insured and only those with large quantities in their accounts were at risk.

  However, when the BBC correspondent Robert Preston stirred things up there was soon a run. Many people in it were actually fully covered by deposit insurance but did not understand that at the time.

  Something that FRB proponents must accept is that it is only safe to hold FRB notes if you can distinguish solvent banks from insolvent ones. *I* certainly can't do that. So without deposit insurance I would not hold any notes. I think the same would be true for more than 90% of the population if they thought about it carefully enough.

  I don't think that your discussion with faculty wives shows very much. Something I wish people in academia would do is realize that the world inside a university is much different to that outside. Almost everyone is very clever when compared to ordinary people. Talk to some ordinary people about the subject.
  

  Published: May 26, 2009 4:51 AM

• Current

  Stephen Kinsella: "I asked about that when I was sent to the Bank of England museum around the corner from the front office, and was told that the Bank's position is that these words only mean, and only ever meant, that if the Bank retires an old form of note and issues new ones, and you later on find an old one in a mattress, they'll replace it with a new one. So if you find a 10-pound note from 1900 that is no longer in circulation or legal tender, the Bank will take it and give you a current 10-pound note. Pounds don't mean pounds, silly boy!"

  The Governor of the Bank of England once said about the promise "A more sensible solution is to create institutions in which we can have trust. On the front of this Bank of England £20 note is written “I promise to pay the bearer on demand the sum of Twenty Pounds”. In essence, the promise is that the “stuff” that you can buy with this note does not change much from one year to the next. In other words, the general purchasing power of the note is broadly stable – we have price stability."

  Which is an interesting way of putting thing. ( http://www.bankofengland.co.uk/publications/speeches/2006/speech288.pdf )

  You are not the first to complain about the presence of the promise on the front of a fiat money note.
  

  Published: May 26, 2009 5:08 AM

• Carlos Novais

  "I don't think the public would panic"

  Well, we could saw several panics now in Europe and US although people knew something about insurance.

  Bank runs today are more silent, people just ask for electronic transfers online. Several banks would collapse without the gigantic money supply allocated now in the monetary base and waiting to be inflated. The truth is that the way the masses would panic could be something of a social reaction of magnitude never seen. So the present "regime" acted because it would probably mean a very nasty thing for all political and financial elites.

  
  It is a funny thing to see economists saying: "do not worry, all deposits in all banks are now insured by the state" and not finding any loophole in that reasoning. How the hell a state can insure all the money supply in all banks? People will realize the inflation problem with that promise. I saw several finance ministers stating in panic that all deposits are guarantee. It is not a written promise and no state have put that in the legal system but it’s done. How will they be able to undone? Let me guess, maybe stating that beginning next year the state will cease to guarantee all deposits? No way.

  Someday this social-democratic central banking regime will simply collapse in the verge of a major run from deposits to real assets. We have to look to history and we realize that the state can and will always try to postpone a problem and try to preserve the status quo. So, political elites will first try to create proto-world currencies, etc, … till a global ABC even greater than this one simply creates a inflationary global run.

  Well, and then we will get a (maybe chaotic) FRB system and check who is right :)

  Published: May 26, 2009 7:18 AM

• Carlos Novais

  Steve Horwitz : "The trust is not binary in this way. If I'm "unsure" of a bank's solvency, that does not mean I definitively expect a run. It means I'm UNSURE. As such, wouldn't I just discount the value of the note or deposit by the risk my best guess attaches to it? Why assume that any expectation less than 100% equates to "expects a bank run?" Risk assessments run the range of 0 to 100%."

  
  If this is true, the discount will appear after all...but my argument for discount in FRB notes is not only because of perceived risk but also of valuation - simple asset valuation and liquidity valuation comparing promises of payment with physical gold.

  The discussion about the possible binary risk assessment is very important. The argument for the binary case is that if people perceive a risk in a FRB note they will simply ask for redemption.

  That is the reason why many statists’ economists sometimes have said of people acting “irrationally”. The guilt of “bank runs” is … crazy people!

  But it’s not the case. I think it is the binary assessment. Every trusts or everybody tries to get the redemption. Why get a discount if I can run to a bank and get the full amount?
  

  Published: May 26, 2009 7:36 AM

• Current

  Carlos, if you take convenience into account that could explain a lot.

  The extra convenience of a note over a coin can make it more attractive. Also, there is disutility in going to the bank to redeem the note.

  Perhaps I receive £20 for a toaster. In that £20 there is a £1 note from Jelly bank. Jelly bank is unstable and I consider it has a 2% chance of failure in the next month. I plan to use the note within a month. In the next month it also has a 2% chance of failure.

  If my perceived extra use-value of the note over a coin is sufficiently high I may be prepared to take this risk.
  

  Published: May 26, 2009 9:16 AM

• Carlos Novais

  Current

  Well, what you are saying is again a validation of my argument for discounts in FRB notes – the question is: would the discount appear suddenly only after "some" risk of default or would be something progressive from 100% to X%?

  To begin with, my argument is that if there is a discount 100% RB will drive out bad FR banks (good money will drive out bad money in an honest FRB).

  But George Selgin has made the argument with historical evidence for no discount at all till… I would ask again … till a full Bank run?

  I think that could be the case like I said “in those times” (apart from the discussion about if perfectly clear contracts were the case “in those times”), but I am adding that could be not the case now by closer and real time information requested but the market assessing the asset and liquidity value of those “promises of payment”.

  And in a modern FRB system, people would simply redeem asking for an electronic transference in case of perception of any risk of a discount will appear, and now it would be the clearing system or the bank receiving the transference to decide if it would accept notes of the original bank at par or at discount or asking for redemption in physical gold.

  For sure, if a FRB client asks transference from a FR demand deposit to a 100%RB the only way to do it is by transference of physical gold, because 100%RB could not accept FRB notes (funny to realize how FRB could have reserves in 100%RB notes instead of physical gold!).

  What I am saying if in any case, if a discount appears people will treat that as a probability of partial default or illiquidity. People with demand deposits and notes now valued at 98% are now loosing.

  I think that if that happens in the long run:

  Good money will drive out bad money.
  

  Published: May 26, 2009 10:57 AM

• Current

  Perhaps I was exaggerating talking about a 2% chance of failure in a month. Maybe people wouldn't circulate those notes.

  Consider though a situation where the a person recieves 20 different notes. The person estimates that in the next month the chance of the banks of each failing is somewhere between 0.1% and 0.01% depending on the bank. Would someone refuse a set of notes like this or sort out the worst ones? I don't think so. It would be more convenient to take them.

  Also, as Larry White has pointed out elsewhere there are inconveniences with warehouse bills. Paying warehousing costs for example.

  I don't think it's certain that FRB notes would disappear in a free market. I may not take them myself but I think that others would.
  

  Published: May 26, 2009 11:19 AM

• George Selgin

  Stephen Kinsella confuses the non-survival of free banking with its inability to compete with 100-percent reserve banking, and even with its being inherently unsustainable.

  In doing so, he first of all repeats the same error of someone else on this blog, and so forces me to repeat myself. Lot's of this going on here!

  Second: if non-survival were proof of the badness of any regime, then I suppose we'd have to believe that any free-market arrangement that governments chose to snuff-out (for that is what happened to fre banking in fact) wasn't any good!

  Stephen, you believe that in a free market there won't be patents and copyright. But in fact most counties have them. So, is the presence of patents and copyrights proof that an economic system lacking such cannot work well? I think not.

  Published: May 26, 2009 3:02 PM

• Stephan Kinsella

  George Selgin:

  Stephen Kinsella confuses the non-survival of free banking with its inability to compete with 100-percent reserve banking, and even with its being inherently unsustainable.

  George, I am apparently not making my views clear enough here. I don't think the historical non-survival of freebanking implies any of this, nor did I mean to imply this. It is my economics views that leads me to believe that freebanking is both unsustainable, and that it cannot compete with 100-reserve banking.

  If I were to see a genuine counterexample I would have cause to doubt my views. But merely showing that freebanking *did* survive for some time in the past is not obviously a counterexample, just as the current fractional reserve system's existence is not a counterexample. I would need to be persuaded that fractional reserve banking did exist for some long period of time, without systematic fraud, and without state intervention and propping.

  Second: if non-survival were proof of the badness of any regime, then I suppose we'd have to believe that any free-market arrangement that governments chose to snuff-out (for that is what happened to fre banking in fact) wasn't any good!

  George, I do not believe it is, and do not know what I said to make you think this is my view. My view is pretty simple, I think:

  1. in a free market both FRBs and warehouse-banks are free to exist and try to prosper (so long as the FRBs are clear that they are not warehouse banks and make appropriate disclosures as to legal risks so as to avoid fraud charges);

  2. in such a market, my view is that the FRBs would not be able to survive, due to instability;

  3. past examples given as a supposed counterexample to 2 do not suffice (as far as I know) because they do not show that the conditions were sufficiently absent widespread state intervention that makes the example close to what would obtain on the honest, free market.

  Stephen, you believe that in a free market there won't be patents and copyright. But in fact most counties have them. So, is the presence of patents and copyrights proof that an economic system lacking such cannot work well? I think not.

  I quite agree. I do not mean to make a simialr mistake with respect to freebanking. In my view, to be honest, freebanking economic theory is based on a couple of flawed notions. One is an implicit conflation of money with wealth. Creating more money does not create more wealth. Second, is the market failure argument about stickiness of downward wage etc. adjustments. Perhaps it's b/c I'm just a layman in economics but this has never persuaded me. I see no "problem" that is to be fixed. I see only a bizarre attempt at monetary alchemy, the attempt to fix a non-existing market failure problem, by creating wealth by printing money. I mean no disrespect, but this is how it has always seemed to me.

  Published: May 26, 2009 3:20 PM

• Joe Salerno

  I apologize to Larry White for misrepresenting the contents of his review of De Soto's book as a result of my faulty recollection. Indeed Larry's entire three-part review, which he kindly posted, is devoted solely to the first three chapters of the book and he does grapple seriously and in depth with many of the issues raised therein.

  Rereading his review I remembered that my deep dissatisfaction with his review involved two issues, which I will briefly outline. First, at the very begining of the first part of his review White portrays De Soto's position as nothing more than a faulty syllogism. White boils De Soto's entire position down to the following syllogism

  1. Warehousing and fixed-term lending are legitimate.
  2. Fractional reserve banking is neither warehousing nor fixed-term lending.
  3. Therefore fractional reserve banking is not legitimate.

  This syllogism , White alleges, exemplifies the logical fallacy of "denyng the antecedent." White gives the following example,

  A dog has four legs
  A cat is not a dog
  Therefore a cat does not have four legs.

  Converting the latter simple syllogism into its conditional form clarifies what it means to deny the antecedent and why it is a logical fallacy,

  If an animal is a dog, then it has four legs
  A cat is not a dog,
  Therefore a cat does not have four legs.

  Denying the antecedent of the conditional ("if an animal is a dog") leads to an invalid inference ("therefore a cat does not have four legs"). Denying the consequent of the conditional (it has four legs) on the other hand leads to a valid inference. Thus

  If an animal is a dog, then it has four legs
  A cat does not have four legs,
  Therefore a cat is not a dog.

  Given the premises of this syllogism, the conclusion is perfectly valid--despite the fact that it is untrue in reality (most cats have four legs and a few amputee dogs do not). But what does this have to do with De Soto's position? Let us convert White's syllogism into a conditional:

  1. If fractional reserve banking is warehousing or fixed-term lending, then it is legitimate.
  2. Fractional reserve banking is neither warehousing nor fixed-term lending.
  3. Therefore fractional reserve banking is not legitimate.

  Now, if De Soto never argued that a loan by its very nature must have a fixed term then he would indeed be committing the fallacy of denying the antecedent. That is, even if FRB is not a warehousing or a fixed-term loan contract, it still may be legitimate if,say, loans without fixed terms (call loans, loans with prepayment agreements) could exist as legitimate contracts. If he did make such an argument (whether it is true or not) then he is not committing a logical fallacy and it is White who has constructed a faulty syllogism to represent De Soto's argument. And, lo and behold, we find White quoting precisely such an argument from De Soto two paragraphs after the syllogism.

  "In addition, a fixed term is an essential element in the loan or mutuum contract, since it establishes the time period during which the availability and ownership of the good corresponds to the borrower, as well as the moment at which he is obliged to return the tatundem [i.e. to repay the amount owed]. Without the explicit or implicit establishment of a fixed term, the mutuum contract or loan cannot exist." White even goes on to say that this is "not a slip of the pen" by De Soto by quoting the latter as saying "it is impossible to imagine a monetary loan contract without a fixed term".

  So if White were to construct a syllogism that truly represents De Soto's position, he would have written:

  1 Warehousing and fixed-term lending are the ONLY legitimate forms of banking contracts.
  2. Fractional reserve banking is neither warehousing nor fixed-term lending.
  3. Therefore fractional reserve banking is not legitimate.

  Rewriting this as a conditional syllogism, we see that De Soto is clearly making a perfectly valid argument by affirming the antecedent .

  If FRB is not warehousing or fixed term lending, then it is not legitimate.
  FRB is neither warehousing nor fixed term lending.
  Therefore it is ot legitimate.

  Now where does this get us in determining whose position (White's or De Soto's) is true? Absolutely nowhere. In fact White's attempt to accuse De Soto of logical error only muddied the waters and detracted from his review. It is difficult to see what advantage White thought he would gain from this tactic, which he repeats again at the beginning of the second part of his review.

  Since dinner calls and logic exhausts me, I will post my second major objection to White's review later.

  Joe Salerno
  

  Published: May 26, 2009 4:40 PM

• Geeorge Selgin

  Joe: "Rewriting this as a conditional syllogism, we see that De Soto is clearly making a perfectly valid argument by affirming the antecedent .

  If FRB is not warehousing or fixed term lending, then it is not legitimate.
  FRB is neither warehousing nor fixed term lending.
  Therefore it is ot legitimate."

  Surely, Joe, you mean only to conclude that the conclusion follows from the premises, not that the argument is "valid" in the sense of being correct. For the first premise is clearly false: there is such a thing as a call loan--that is, a loan with no definite time commitment. So De Soto's argument relies on a false dichotomy.

  Published: May 27, 2009 6:33 AM

• Joe Salerno

  George,

  Of course the argument is valid. There is a difference between logical validity and substantive truth. That was the point of my criticism of Larry. Regarding De Soto's argument, whether you agree with it or not, he claims that call loans are illegitimate not that they do not exist. So there is no false dichotomy.

  Joe
  

  Published: May 27, 2009 7:21 AM

• Gerry Flaychy

  To George Selgin.
  Here is another source for the definition of a bank deposit to add to your previous ones.

  "DEPOSIT, contracts. Usually defined to be a naked bailment of goods to be kept for the bailor, without reward, and to be returned when he shall require it.
  Jones' Bailm. 36, 117; 1 Bell's Com. 257. See also Dane's Abr. ch. 17, aft. 1, Sec. 3; Story on Bailm. c. 2, Sec. 41.
  Pothier defines it to be a contract, by which one of the contracting parties gives a thing to another to keep, who is to do so gratuitously, and obliges himself to return it when he shall be requested.
  Traite du Depot. See Code Civ. tit. 11, c. 1, art. 1915; Louisiana Code, tit. 13, c. 1, art. 2897.

  …
  ...
  
  6. There is another class of deposits noticed by Pothier, and called by him irregular deposits.

  This arises when a party having a sum of money which he doe's not think safe in his own hands; confides it to another, who is to return him, not the same money, but a like sum when he shall demand it.
  Poth. Traite du Depot, ch. 3, Sec. 3.

  The usual deposit made by a person dealing with a bank is of this nature.

  The depositor, in such case, becomes merely a creditor of the depositary for the money or other thing which he binds himself to return.

  7. This species of deposit is also called an improper deposit, to distinguish it from one that is regular and proper, and which latter is sometimes called a special deposit.
  1 Bell's Com. 257-8. See 4 Blackf. R. 395.
  …
  …
  A Law Dictionary, Adapted to the Constitution and Laws of the United States. By John Bouvier. Published 1856. "

  Source: http://legal-dictionary.thefreedictionary.com/Deposit

  Published: May 27, 2009 10:02 AM

• newson

  ha. i'd like to see banks promote "improper deposit accounts". that'd really be something.

  Published: May 27, 2009 10:19 AM

• Gerry Flaychy

  Or to promote "this bank is not a warehouse", or "a checking account is not a bailment", or "a depositor is a creditor", or "we loan the money you deposit", or others things like that.

  Published: May 27, 2009 10:52 AM

• newson

  in a pure specie monetary order cantillon effects will still observed in the event of a massive and unexpected gold discovery. early spenders of the new gold will enjoy higher purchasing power than later spenders. but importantly, other non-monetary users of gold will benefit by the increased availability of gold.

  now take the same situation with free-banking. assuming that bank notes are money and readily accepted, a monetary expansion will see both banks and their customers benefit. the former through the interest on the loans, the latter from being the early recipients of the money. but unlike the gold example, there is no other beneficiary to this expansion.

  to justify free-banking, one would have to be able to show why the frb banker and his client's relationship is worth more than the foregone non-monetary benefits to society of a more plentiful supply of gold, assuming the same degree of expansion takes place in both cases.

  Published: May 27, 2009 11:04 AM

• Current

  Newson - I've agreed with a lot that you've said, but I don't really agree with this.

  It is in the nature of markets that they are unfair. Effects quite like the Cantillon effect operate for other goods.

  For example, the work I do is used in wireless devices. The advancement in making chips for those devices has benefited me enormously. Other companies have beavered away making better chips and making them cheaper. I do other sorts of electronics for wireless. I have benefited greatly from the demand those chip folks have created for my skills.

  You see it works in the same way for goods as for money. As certain types of chip get cheaper the first buyers of those chips benefit. Then the buyers of those devices.

  The effect is of course much smaller than the Cantillon effect for money.

  Published: May 27, 2009 12:26 PM

• Lawrence H. White

  Joe Salerno asks what "advantage" I thought I could gain by my "tactic" of restating De Soto's argument as an (invalid) syllogism. I was simply trying to encapsulate the argument as I understood it.

  I accept Salerno's demonstration that I need not have summarized De Soto's argument as an invalid deduction from true premises. As Salerno shows, the argument can alternatively be summarized as a logically valid deduction from a false (or at best question-begging) premise. As Salerno puts it, that premise is: "Warehousing and fixed-term lending are the ONLY legitimate forms of banking contracts." Or in conditional form: "If FRB is not warehousing or fixed term lending, then it is not legitimate." Instead of invalidly denying the antecedent, in this version De Soto is merely beginning from a falsehood or begging the question.

  De Soto does indeed, as Salerno points out, assert that “a fixed term is an essential element in the loan or mutuum contract,” i.e. a loan contract by its very nature must have a fixed term. But De Soto doesn't explain WHY a fixed term is essential. De Soto writes: “Without the explicit or implicit establishment of a fixed term, the mutuum contract or loan cannot exist." But why cannot it exist? Why is a loan contract without a fixed term, e.g. a callable or prepayable loan contract, a non-starter? We do see such contracts, as George Selgin noted. They are, to all appearances, mutually beneficial for the contracting borrowers and creditors. So why are they illegitimate? De Soto never explains.

  Here again is De Soto’s full sentence: "In addition, a fixed term is an essential element in the loan or mutuum contract, since it establishes the time period during which the availability and ownership of the good corresponds to the borrower, as well as the moment at which he is obliged to return the tatundem [i.e. to repay the amount owed].” The "since" here is a non sequitur. Okay, a fixed term does establish a term and set a date for repayment. But it does not follow that a fixed term is “essential,” i.e. a mandatory requirement for the contract’s legitimacy. Why can’t the contract legitimately allow callability or prepayment? Why can’t the parties agree to leave the lender or borrower with the option of deciding at a later date when the amount owed is to be repaid?

  The only "explanation" I can find in De Soto's work for why a loan must have an invariably fixed term is the claim that a non-fixed-term loan isn't legitimate. The invalid syllogism was my best stab at understanding how De Soto had reached the view that something that isn’t a fixed-term loan (or a warehousing contract) isn’t legitimate. But maybe he never reached that view. Maybe, as Salerno's syllogisms suggest, he simply started with it.

  Published: May 27, 2009 12:35 PM

• Carlos Novais

  I think it would be possible to a FRB to transform the demand deposit contract in a contract of credit "overnight" and automatically renewable by the "depositor" and assume a mismatch between the overnight funding and the assets (credit to clients).

  But this will not settle the issue of expanding "demand deposits" by credit expansion.

  As i said before, the moment we accept a mismatch with "demand deposits" (in theory without expanding money supply by pure creation of demand deposits), the bank is able to also create demand deposits.

  So ... the solution is... to require demand deposit to be a warehouse contract and... FRB to sort of stamp clearly "promises of payment" to its notes and "demand deposits" (maybe "current account of promises of payment issued").

  And then we could check if it would be exchanged at par value, or in what conditions it would cease to be exchanged and cleared at par value.

  Published: May 27, 2009 4:11 PM

• newson

  how can intemporal misallocation not occur if there is no certain term for a loan, unless borrowers' time-frames magically match lenders'?

  Published: May 27, 2009 6:50 PM

• newson

  to current:

  what i'm driving at is the free-bankers wish to put their system on the same moral level as a pure specie money. as specie money is increased, early receivers of the gold do better in purchasing power than late receivers but non-monetary uses increase as well. here's why the fairness test is passed: the late receiver of the gold after a massive bullion discovery finds he's not getting as much for his gold in a monetary sense, but he's going to get a much cheaper gold cap for his tooth, and his fiance's ring is going to cost less, and maybe his electronic gadgets are going to use more gold.

  now with frb money, only the earlier receivers of the money benefit; inked paper confers no extra advantages on the broader community. so one expansion offers ancillary benefits, the other does not.

  now in order to maintain that the two systems are equally beneficial, one must argue that somehow the relationship between frb borrower and frb lender is as great, or greater than the "extra" added by the boost to non-monetary use of gold.

  how could such a interpersonal utility judgement be made, whilst still adhering to austrian fundamentals?

  Published: May 27, 2009 11:32 PM

• Current

  My point Newson is that the Free-bankers are taking the normal attitude of classical liberals.

  It is not necessary or possible to measure the overall benefit or cost of some innovation. That innovation will certainly redistribute wealth. Money is, in this situation, not an particularly special case.
  

  Published: May 28, 2009 7:42 AM

• Current

  On a lighter note. There is a Q&A section in a UK newspaper about homeopathy. In it someone asked the following question:

  "I’ve been soaking a £20 note in a bathfull of water for the last few days, is it ok to pay for an order using my new homeopathic money? I now seem to have rather a lot of it."

  (I'm not meaning to say this is similar to fractional reserve money.)
  

  Published: May 28, 2009 7:48 AM

• George Selgin

  Joe: If De Soto's position is in fact that callable loans are ipso-facto illegitimate, then that position is even less tenable than I once supposed. For now it isn't just a question of wishing to suppress fractionally-backed bank deposits, but of wishing to suppress all call loans, starting with brokers loans (which have long played a very important role in financing securities trades) but also including callable bonds and many other non-bank intermediated securities.

  With respect to these call loans, there is no question of the ambiguous or deceitful use of the term "deposits." What's more, the agents who deal with them include many of the most sophisticated players on the financial scene. Finally, it is well understood that while the "callability" of the loans in question exposes borrowers to an additional risk, the extra risk in question is compensated by lower interest terms than would accompany corresponding time loans. In other words, the call feature is part of a mutually advantageous exchange. (As it is, in my opinion, in the case of fractionally-backed demand deposits.)

  Yet De Soto, if he's to rely on his syllogism as a basis for suppressing fractionally-reserved deposits, must call for the prohibition of all callable loans--and yet do so in the name of achieving a truly free market! However "valid" his argument may be in the very strict, logician's sense of the term (and I specifically allowed for this possible meaning in my last post), I don't see that it has any _other_ merit!

  Still, the clarification of de Soto's position, if indeed it is accurate, is most helpful. For now the free bankers are able to insist that anyone who subscribes to "De Soto's" view (I use quotes to make clear that I refer to Joe's understanding of that view) be consistent, by declaring that they regard as illegal ("illegitimate") not only fractionally-backed demand deposits but every sort of callable loan that plays or has every played a part in financial market exchange. How many will be willing to do this, while still daring to say that they favor free financial markets?

  Published: May 28, 2009 8:21 AM

• Lawrence H. White

  George:

  De Soto's view would indeed outlaw every sort of callable loan, AND every sort of pre-payable loan, regardless of their mutual benefit to lender and borrower.

  Who would go so far "while still daring to say that they favor free financial markets?" That manner of speech goes back to Rothbard, who wrote (RAE 1992) that he supported “free banking within a firm matrix of demand liabilities (notes or deposit) grounded in 100 percent reserves".

  Walter Block and William Barnett II seem to go even farther than de Soto: even financial intermediation limited to fixed-maturity contracts is to be outlawed if it involves any maturity mismatch between the borrowing and lending sides. Here's the abstract of their article "Time Deposits, Dimensions, and Fraud" in the J. Bus. Ethics:

  "We stipulate, arguendo, that fractional-reserve-demand deposit banking is per se fraudulent. We ask whether or not time deposit banking can also be illicit, and answer in the positive, if there is a mismatch between the time dimensions of deposits and loans. To wit, if an intermediary borrows short and lends long."

  Published: May 28, 2009 12:55 PM

• George Selgin

  Indeed, I heard Block and Barnett's presentation at the Mises Scholar's conference. My thought at the time was that, if they kept this up, they'd soon be outlawing any and all intermediation.

  It seems to me that some people are inclined to confuse a free society, or at least a free society committed to a gold standard, with a society that suppresses all kinds of close substitutes for monetary gold, thereby keeping oodles of gold coin in circulation. If I didn't know better, I'd say they were all part of a great gold-mining industry conspiracy!

  Published: May 28, 2009 1:55 PM

• Joe Salerno

  George, Larry

  Fellas, let's not get carried away!

  Larry writes: "De Soto's view would indeed outlaw every sort of callable loan, AND every sort of pre-payable loan, regardless of their mutual benefit to
  lender and borrower."

  My previous response to Larry was not aimed at explicating, let alone defending, de Soto's position in toto. I was merely pointing out that it was not appropriately summarized in Larry's syllogism. Certainly I would not dispute Larry's follow up response to me that de Soto's position on call loans is ambiguous at best. But then again, de Soto was not the one who originally claimed that FRB notes and deposits were akin to highly specialized financial instruments such as broker call loans. In the case of the latter, the borrower-stock investor cedes to the broker-lender specific securities as collateral for the loan which can be "called" at any time by the broker. If the borrower cannot (or does not) meet the "call" then he forfeits to the lender title to the pledged securities--which are usually in possession of the lender.

  Are term and conditions of such contracts really no different from the "contract" written on FRB notes: "Bank X will pay to bearer etc."? I doubt it.

  Interestingly on pp. 158-59 de Soto discusses a variant of this in the form of callable time deposits issued by Spanish banks and specifically collateralized by national bond certificates. De Soto characterizes this operation, correctly in my view, as a loan backed by securities combined with a put option up to the specified maturity date of the time deposit. The client will only exercise the option (to prematurely sell back the "collateral" at a fixed price equal to his deposited funds plus accrued interest) if interest rates on newly issued time deposits maturing at the same date exceed the rate on his current time deposit, i.e., if the value of the collateral declines. Some banks even offer these contracts bundled with checking accounts and bill payment by direct debiting. De Soto is apparently "suspicious" of these "simulated deposit" contracts when they are issued by banks but he does not dismiss them as fraudulent out of hand. My surmise is that he would have no problem with straight-up broker call loans at all because they do not simulate "deposit" contracts. Furthermore, callable bonds and loans with prepayment options are completely irrelevant to de Soto's position because they endow the borrower, not the lender, with the option of terminating the loan early and can never be confused with a deposit contract.

  A fuller and more circumspect view of de Soto's position reveals that what he is most concerned about is the deliberate camouflaging of loan contracts as bailment contracts. He does not appear to be opposed to any type of loan contract, per se, including explicit call loans. So, I think Larry overreaches in his claim quoted at the ouset of this post. Larry's interpretation, I believe, goes completely off the rails when he claims that the difference between de Soto's position and that of Block and Barnet is a matter of degree only. Writes Larry:

  "Walter Block and William Barnett II seem to go even farther than de Soto: even financial intermediation limited to fixed-maturity contracts is to be outlawed if it involves any maturity mismatch between the borrowing and lending sides."

  That there is a categorical difference between the two positions is argued by two of de Soto's strudents, Dave Howden and Phillip Bagus. See The Journal of Business Ethics. http://www.springerlink.com/content/pn81764318674wv0/.

  Joe

  Published: May 28, 2009 4:48 PM

• Lawrence H. White

  Joe Salerno writes:

  “Certainly I would not dispute Larry's follow up response to me that de Soto's position on call loans is ambiguous at best. But then again, de Soto was not the one who originally claimed that FRB notes and deposits were akin to highly specialized financial instruments such as broker call loans.”

  Let us recall what De Soto wrote that Joe and I have both previously quoted:

  "In addition, a fixed term is an essential element in the loan or mutuum contract, since it establishes the time period during which the availability and ownership of the good corresponds to the borrower, as well as the moment at which he is obliged to return the tatundem [i.e. to repay the amount owed]. Without the explicit or implicit establishment of a fixed term, the mutuum contract or loan cannot exist."

  I don’t think I’m getting carried away when I say that this statement implies the illegitimacy of every call loan and every loan with a pre-payment option. To have a legitimate loan contract, in this view, a fixed term is essential. A “loan” without a fixed term “cannot exist,” i.e. is per se illegitimate. De Soto here speaks of “the loan or mutuum contract” quite generally, and does not restrict himself to contracts with banks or other intermediaries.

  We can all agree that a broker call loan carries terms and conditions different from those of the loans to a bank made by holding account balances or banknotes. But they are all loan contracts. I don’t see any escape hatch in de Soto’s view allowing collateralized loans from securities brokers an exception from the fixed-term requirement, as Joe suggests de Soto himself might allow. Maybe Joe can point to an explicit escape hatch in de Soto's text?

  Joe surmises that de Soto “would have no problem with straight-up broker call loans at all because they do not simulate ‘deposit’ contracts.” I don’t see de Soto anywhere limiting the fixed-term requirement to “deposit” contracts or simulated “deposit” contracts.

  Salerno’s discussion of de Soto’s pp. 158-9 is interesting. I wonder why, given the above, de Soto himself does not dismiss collateralized callable time deposits out of hand as illegitimate.

  Joe adds: “Furthermore, callable bonds and loans with prepayment options are completely irrelevant to de Soto's position because they endow the borrower, not the lender, with the option of terminating the loan early and can never be confused with a deposit contract.”

  I don’t see how prepayment options can be irrelevant when a fixed term is considered essential. De Soto never to my knowledge specifies “can be confusion with a deposit contract” as a precondition for the fixed-term requirement.

  Finally, I’m sorry if my reference to Block and Barnett’s position against maturity mismatching suggested that their argument is akin to de Soto's. I have no view on that; it may indeed be categorically different. I only meant to note that whereas de Soto would outlaw some common loan contracts, Block and Barnett would outlaw a common intermediation practice that does not per se violate de Soto’s strictures.

  Published: May 28, 2009 7:03 PM

• newson

  to current:
  i don't think i've explained myself: my point was that even the counterfeiter produces cantillon effects, but it's hard to argue that he's contributing to social good.

  selgin et al seem find that gold coins and electronic gold current accounts are either absurd, or motivated by some shadowy rothbardian presence, taking for granted the magnificence of bank notes, and the essential nature of same (if we didn't have frb, we wouldn't have them, but so what?). maybe there's a black-ink and linen cabal, too.

  Published: May 28, 2009 8:15 PM

• JP Koning

  Joe Salerno said:

  "Furthermore, callable bonds and loans with prepayment options are completely irrelevant to de Soto's position because they endow the borrower, not the lender, with the option of terminating the loan early and can never be confused with a deposit contract."

  That's true. But don't forget that the converse of a callable bond exists: a puttable or retractable bond. These instruments do indeed endow the lender - the bond holder - with the option to terminate the bond early and redeem it for cash.

  I think if you substitute "puttable bond" in each occasion in Larry's argument in which he says "callable bond", his argument still stands.

  Published: May 28, 2009 9:21 PM

• Current

  Newson: "i don't think i've explained myself: my point was that even the counterfeiter produces cantillon effects, but it's hard to argue that he's contributing to social good."

  I agree. But the counterfeiter's crime is to produce an imitation title. His production of cantillon effects is secondary.

  It is not normal for classical liberals to argue against cantillon effects that arise from legitimate transactions. So, if both sides know what a banknote is there is little we can complain about.

  Newson: "selgin et al seem find that gold coins and electronic gold current accounts are either absurd, or motivated by some shadowy rothbardian presence, taking for granted the magnificence of bank notes, and the essential nature of same (if we didn't have frb, we wouldn't have them, but so what?). maybe there's a black-ink and linen cabal, too."

  It seems that both sides are using a bit of the same argument here. Full reservists say that there must have been intervention to bring about fractional reserves. Fractional reservists say that full reserves aren't practical and bring up the "shadowy Rothbardian presence" you mention.
  

  Published: May 29, 2009 5:01 AM

• George Selgin

  Newson: "selgin et al seem find that gold coins and electronic gold current accounts are either absurd, or motivated by some shadowy rothbardian presence, taking for granted the magnificence of bank notes, and the essential nature of same (if we didn't have frb, we wouldn't have them, but so what?). maybe there's a black-ink and linen cabal, too."

  Another bit of foolishness, Newson. The FRB side doesn't go 'round calling gold coins "illegitimate" or immoral; nor have we ever suggested that the use of them should be legally restricted in any manner. So your comparison of our position with that of the 100-percent reserve proponents is itself absurd, or at least wrongheaded.

  Published: May 29, 2009 9:19 AM

• newson

  to professor selgin:
  no, because you would have no grounds to criticize the legitimacy of specie, however quizzical you may find the possibility of carrying around "oodles" of gold coins(there's no question of artifice, short of debasement).

  the free-banking argument seems to work backwards from the position that banknotes are inherently good or necessary and therefore frb is ok because it's the only practicable means of making them pay.

  it's pointless debating the morality about the actual use of fractional reserves (our views are irreconcilable). however, if it were the case that frb is an abuse of property rights, then i cannot see that commerce could not successfully accommodate a note-less payment system based on gold current accounts and metal coins. might be a small price to pay for no business cycle.

  Published: May 29, 2009 10:39 AM

• newson

  to current:
  in this instance, where both frb client and banker are perfectly informed and comfortable about the nature of their contract, the fraud is against the third parties, (not frb clients), who suffer loss of purchasing power as a result of the fiduciary media being emitted.

  Published: May 29, 2009 10:53 AM

• Current

  Newson: "in this instance, where both frb client and banker are perfectly informed and comfortable about the nature of their contract, the fraud is against the third parties, (not frb clients), who suffer loss of purchasing power as a result of the fiduciary media being emitted."

  Haven't we already discussed this point though?

  Many contracts made by others denude the value of assets held elsewhere. But what is wrong with that?

  We could make the interpersonal utility judgement that many practices of A & B should be banned for the benefit of C. It is obviously against the principles of Classical Liberalism and Austrian Economics to do so.
  

  Published: May 29, 2009 11:34 AM

• Current

  Having read back that post it sounds really rude. It wasn't meant to be. I apologize for that.
  

  Published: May 29, 2009 11:38 AM

• newson

  current, no offense taken. and i'm probably belaboring the point. but the gold-miner, by virtue of being the first to use the new money enjoys the higher purchasing power; this is likely to entice more to become miners and all things being equal will result in more gold available for non-monetary uses (which benefits all society, even non-gold-users). the frb money creation process does nothing to reduce the price of any goods, because it produces nothing of non-monetary value. this i why i believe frb is a morally inferior system to specie money (and this excludes the collateral damage caused by the abc from free-banking, which mises acknowledged though believed would be minimized by competition).

  Published: May 29, 2009 8:56 PM

• scineram

  And what about the gold converted to non-monetary uses? Frb reduces the demand for monetary gold, so more is available for other uses.

  Published: May 30, 2009 4:43 AM

• newson

  scineram says:
  "And what about the gold converted to non-monetary uses? Frb reduces the demand for monetary gold, so more is available for other uses."

  history shows this not to be the case. an emission of frb notes might just as well cause a rise in the demand for monetary gold as its fall (think of the extra demand for gold during and after a bank run).

  don't forget that the frb promise, prior to gold's demonetization in 1934, was to pay out the note-holder fully in gold. merely issuing frb paper doesn't magically conjure gold from the ground!

  Published: May 30, 2009 6:25 AM

• newson

  even though frb and fiat money are totally institutionalized, central banks still haven't divested their gold. why not sell fort knox' gold hoard and make gold fillings more accessible to the average punter?

  Published: May 30, 2009 7:00 AM

• Mike Sproul

  "where both frb client and banker are perfectly informed and comfortable about the nature of their contract, the fraud is against the third parties, (not frb clients), who suffer loss of purchasing power as a result of the fiduciary media being emitted."

  Unless, of course, the issue of checking account dollars by a private bank does not affect the value of the green paper dollars issued by the fed. A checking account dollar is a call option on a green paper dollar. The issue of calls does not reduce the value of the base security, for the simple reason that the issue of calls does not affect the assets or liabilities of the issuer of the base security. Fractional reserve banking does not cause price inflation.

  Published: May 30, 2009 8:06 AM

• newson

  to mike sproul:
  first, an frb note is not an option. a call option must have a definite life, otherwise it's not able to be valued. a company cannot have more call options granted than exist underlying shares, otherwise there is no guarantee that exercise can be honored.

  finally, i'm suggesting that the frb system can "defraud" the non-using third party only until the bank run, after which the mispricing is corrected. the erosion of purchasing power in the inflation phase is reversed in the deflation one. (the lag can be substantial, look how long enron was able to cook its books before the share price tanked.)

  Published: May 30, 2009 9:02 PM

• Mike Sproul

  A checking account dollar is a call option on a green paper dollar, but with an exercise price of zero and an indefinite expiration date. A checking account dollar is normally valued at one paper dollar. There is no problem of valuation. Whether or not there is a guarantee, people value those checking account dollars, and the value depends on their evaluation of the bank's total assets, including both paper dollar reserves, and other things of value that the bank owns.

  Since the issue of those checking account dollars does not affect the value of the paper dollars, there is no mis-pricing to correct. And even if a bank run occurs, a bank that has issued dollars in exchange for equal-valued assets will have sufficient assets to buy back all the dollars it has issued at par.

  Published: May 30, 2009 11:17 PM

• newson

  mike sproul says:
  "A checking account dollar is a call option on a green paper dollar, but with an exercise price of zero and an indefinite expiration date."

  such an option would be impossible to price by the grantor, therefore could not exist in a commercial sense.

  Published: May 30, 2009 11:25 PM

• Mike Sproul

  So a checking account dollar, which promises to deliver a paper dollar to its owner at some indefinite date, cannot be priced? They are priced all the time, and their price is $1.

  In any case, the main point was that the issue of checking account dollars by a private bank does not affect the assets or liabilities of the central bank, and therefore does not affect the value of the central bank's money. The simplest example would be a central bank that issues 100 paper dollars backed by 100 oz. of silver, and convertible into silver during specified times. If some private bank issued checking account dollars, convertible into those paper dollars, then the central bank still has exactly 100 oz., and there are still exactly 100 paper dollars in existence. Each of those paper dollars is worth 1 oz., no matter how many checking account dollars are issued by private banks.

  Published: May 31, 2009 10:04 AM

• newson

  to mike sproul:
  yeah, i know what you're trying to say, but comparing it to option is unhelpful as there is no option pricing mechanism that can help you if time isn't a known constant ("volatility" being a guesstimate).

  Published: May 31, 2009 6:29 PM

• Carlos Novais

  "Demand deposits" could be contractually designed as overnight loans to banks.

  So we could have in the market

  * demand deposits with 100% reserves
  * overnight loans to banks (it would replicate the actual current demand deposits)
  * and other time deposits (>1 day)

  But the question remains - demand deposits should be 100% reserve...if not... they should be named something like "promisses of payment of gold/etc at demand current account"

  Published: June 1, 2009 3:48 AM

• Current

  newson: "but the gold-miner, by virtue of being the first to use the new money enjoys the higher purchasing power; this is likely to entice more to become miners and all things being equal will result in more gold available for non-monetary uses (which benefits all society, even non-gold-users). the frb money creation process does nothing to reduce the price of any goods, because it produces nothing of non-monetary value. this i why i believe frb is a morally inferior system to specie money"

  I see your point now.

  What you are saying though is that producing something that has monetary value is not useful. I don't really agree with that. I think that is one of the things that economics has to show one way or the other.

  As well as acting as a money substitute a fractional reserve banknote is a debt. Your complaint doesn't really apply to the debt aspect of the note. Each note is a loan to a bank.

  Notice that loans never directly reduce the prices of other goods.
  

  Published: June 2, 2009 6:40 AM

• Niccolo

  I suppose my biggest issue here is on the need to basically balance the supply of money relative to its demand.

  Understanding the nature of prices for goods, it seems that, though money is non-neutral, it should be the policy of a macroeconomy to get as close to neutral money as possible. Whether this is possible or not, I do not know, I am not a banker.

  To balance the supply of money, it would seem an impossibility to do it any other way than through fractional reserve banks. For though inflation of prices is a great specter that haunts the economy from the west, deflation is just as bad in the east.

  Published: June 20, 2009 12:05 PM

• DNA

  Free bankers behaving badly:

  George Selgin writes:

  ""There is no market for money, because money is not commodity that is freely traded and valued against other goods."

  Honestly I couldn't decide which of Nikolaj's many wrongheaded assertions to choose to indicate his week grasp of monetary economics. But this seems like as good an example as any."

  at http://austrianeconomists.typepad.com/weblog/2009/06/what-monetary-policy-cannot-do/comments/page/2/#comments

  Now note Gene Callahan's observation:

  "This seems trivial, until we realize that the means by which most markets move toward equilibrium, a change of price for the single good in question, cannot work for money—as Leland Yeager points out, money has no market, and no price, of its own. After a disturbance in the supply of or demand for money, all prices in the economy must adjust."

  at http://www.thefreemanonline.org/departments/book-review-microfoundations-and-macroeconomics-an-austrian-perspective-by-steven-horwitz/

  Can the monetary equilibrium theorists even answer the simple question: what is the price of money?

  Published: June 22, 2009 9:55 AM

• newson

  ...and this, from mario rizzo:
  "The problem is the alternative. Uncontrolled deflation would be bad. Eventually, I am sure that the Pigou (real balance effect) would move things out but in the meanwhile things could get pretty rough. However, it is important point out that we might not want to do anything if average prices -- as measured in some suitable way -- began to decline just a little."

  shocking stuff. where is some proof of the "badness" of inflation? deflation is virtually always uncontrolled (working as it does against debtors, and the inflation-parasites, as well as a progressive tax system that just loves inflationary bracket-creep). this deflationphobia is just madness. but i guess if you're wed to frb, then deflation will always be the wet-blanket that spoils your party.

  Published: June 22, 2009 10:55 AM

• newson

  read "badness of deflation".

  Published: June 22, 2009 10:57 AM