ECON 378
Lecture Eleven – Monetary Systems
Sources: John P. Cochran, “Can Central Banks Be Tamed?”; George Selgin, The Theory of Free Banking; Larry White, Competition and Currency; Rothbard, "The Case for a Genuine Gold Dollar” and “What Has Government Done to Our Money;” Steve Horwitz, “The Problem is Central Banking Not Fractional Reserve Banking;” White, “The Free Competition in Currency Act of 2011.”
The agreement among Austrian economists – no central bank: Although there are strong disagreements among Austrian economists regarding the exact kind of institutions would be best with respect to a monetary system – pretty much all agree that a central bank ran by the government does not lend itself to a stable and healthy economy.
It might be wishful thinking on the part of Austrians, but with all of the economic turmoil that we have seen in the past few years (both domestically and internationally) – many think that maybe mainstream economics will start reconsidering the status quo and actually look into alternative monetary systems.
Hayek:
"I do not believe that we would have major industrial fluctuations if it were not for the present banking system, which in turn depends on the government monopoly of the supply of money. I have been driven into proposing the denationalization of money. . . . Anyhow, depressions are not the result of the operation of the market. They are the result of government control, particularly in the sphere of monetary policy. (Conversations with Great Economists, p. 10).
Roger Garrison:
“The decentralization of money, as proposed by Hayek (1976) and explored by Selgin and White (1994), has an increasing strong claim on our attention. Concerns with political feasibility should be separated from the more fundamental reconsideration of a market based money supply. In light of our continuing experience with a bubble-prone central bank, we might well anticipate that a comparative-institutions analysis would favor a market solution to our money and credit problems. At the very least, a better understanding of the workings of a decentralized monetary system would help identify the perils and pitfalls of continued centralization.” ("Interest-Rate Targeting during the Great Moderation: A Reappraisal," CATO Journal, Winter 2009, p. 199).
Brendan Brown:
"Signore Draghi, why are we in Europe embarking on a monetary experiment which has already failed in the US and Japan? I mean by failure, the fact that this is the weakest economic expansion ever following a Great Recession in the US. And we are already witnessing the bursting of a huge oil and commodity bubble with, yet unknown but almost certainly, severe consequences, whilst in Japan there has been a second recession, not economic renaissance as Prime Minister Shinzo Abe promised." (Can Europe Recover From Its Easy-Money Obsession?, Mises.org, 2015).
It won't be easy - but then again, what is?
Gerald P. O'Driscoll:
"Plans to abolish central banks constitute an extreme reform. It is doubtful that such plans can succeed without broader institutional change, occurring either first or simultaneously. That is likely true regardless of the strength of evidence on central bank performance." (The Cato Institute, "Central Banks: Abolish or Reform?" 2012, p. 2).
Austrians still in the minority: However, while most (maybe all) Austrians favor replacing central banking with a market-based decentralized money, even those mainstream economists who oppose discretionary monetary policy (at the discretion of the central bank) do not want to get rid of the central bank.
They, instead, want rules to restrain central bankers' actions. Examples are monetary rules (inflation targeting, for example) or the market monetarists recommend nominal GDP targeting – all with the idea that the central bank would “have to” follow some kind of rule instead of just doing whatever it wanted, whenever it wanted.
So – the Austrians are still in the minority on all of this.
So what is a Central Bank?
The key feature of a central bank is that it has a monopoly on issuing money.
This is from Investopedia – with a lot of editing by me:
The central bank has been described as:
1. “The lender of last resort", which means that it is responsible for providing its economy with funds when commercial banks cannot cover a supply shortage.
2. A central bank also acts as the regulatory authority of a country's monetary policy and is-
3. The sole provider and printer of notes and coins in circulation (this is key – a central bank is the only institution that can “create” the money of the central bank). In that sense, it does have a monopoly on Federal Reserve Notes.
Also of mention:
4. Time has proved that the central bank can best function in these capacities by remaining independent from government fiscal policy and therefore uninfluenced by the political concerns of any regime. In other words – when the government goes into debt – the central bank should not be there to print money to pay for this debt. Is it wishful thinking that we can separate the central bank from politics?
5. The central bank should also be completely divested of any commercial banking interests. Again, can the central bank be completely uninfluenced by political forces - especially now that it deals with more than just "financial institutions"?
6. And many believe that the primary goal of a central bank is to provide their countries' currencies with price stability by controlling inflation. (That is controversial – many economists would give the central bank a much larger and expanded role).
Austrian Criticisms of a Central Bank
The Austrian critique of central banking developed in the 1920s and 1930s.
1. Knowledge problems!
Example: A central bank (like the FED) often shoots for price stability. The prices that are looked at are prices given by such measures as the CPI. It tells us nothing about asset prices (capital goods prices) and nothing about changes in relative prices of various groups of goods, services and assets. These are very important in the Austrian view – as we have seen – changes in these relative prices changes resource allocation – between markets and between capital and consumption goods. There is no way the FED can use this information in making its monetary policy decisions.
For the Austrians a stable economy might be consistent with prices gently falling.
Shooting for price stability can mean economic instability created by the central bank!! More on this later.
2. Signal distortion problems:
3. No competition – incentive problems:
4. Moral Hazard problems:
5. Political problems (overlaps with incentive problems):
So given than Austrians generally do not want a central bank – what do they want?
They do want money out of the hands of the government. But there is not agreement on the precise system that should be put in place.
In some circles the disagreement is between a gold standard vs. a free-banking (or competing currency) system.
In other circles the disagreement is between a fully-backed reserve free banking system vs. a fractional reserve free banking system.
To some – this is the same argument.
Let’s review the current system in the United States – the FED. Which is a Central bank – with a fractional reserve banking system.
Review of Fractional Reserve Banking and open market operations:
Assume an initial deposit of $1000 with a 10% required reserve ratio.
But this is hardly the whole story: What is unseen?
If the $1,000 I deposited came from Bob’s Bank, it loses the $1,000 in reserves transferred to Deb’s bank.
That forces Bob’s bank to call in loans to make up the lost reserves, which leads to reserves being lost by other banks, which then have to do the same thing.
The result is that the $10,000 created by Deb’s bank’s gain in reserves is canceled by the $10,000 destroyed by Bob’s bank losing those reserves.
When you write a check to me and I deposit it, there is no bank multiplier on net (assuming the conditions above hold).
Thus we see that the system simultaneously contracts by a multiplied amount of the original deposit/withdrawal.
So how does new money ever get created and multiplied on net?
By injections of new reserves.
Only one entity can create new reserves on net in a fiat money system with a central bank: the central bank. When the Fed conducts open-market operations it adds new net reserves to the system, which enables the money-multiplier process with no offsetting loss in reserves elsewhere. The central bank and only the central bank can do this.
But you might say, “Well, what if I deposit currency into my bank? There’s no offset then, right?” That is true. But where did the currency come from? At some point, you or someone else had to withdraw it from the banking system, which caused a multiplied contraction in the total money supply because currency counts as reserves. The two halves of the process are separated in time, unlike with the deposits, but the net effect in the long run is still zero.
The monetary base, which corresponds to the total level of potential bank reserves (being the sum of the total supply of currency plus the supply of bank deposits at the Fed), is totally under the control of the central bank. No one else can create currency and no one else can create net additions to the total amount of deposits at the Fed.
As economic historian Robert Higgs has pointed out, for increases in the monetary base to become increases in the supply of money, the banks have to cooperate by lending out their excess reserves.
Nothing says that fractional reserve banks must lend out their excess reserves, only that they cannot lend more than their excess reserves.
Higgs also argues that the reluctance of banks to lend out those excess reserves is what is preventing the remarkable increase in the monetary base since the fall of 2008 from turning into significant inflation.
“Factors such as the Fed choosing to pay interest on bank reserve deposits, the large cash holdings of big firms, and the persistent regime uncertainty that makes lending/investing seem particularly risky these days can together explain the reluctance of the banks to turn the monetary base into money via the multiplier process. Still, it remains the case that only the central bank is responsible for the expansion of that base, even if the banks balk at lending it.” (Horwitz)
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The Austrian Alternatives
Free Banking (or Competing Currencies): No Central Bank but Keep the Fractional Reserve
Let’s first talk about those Austrians who don’t mind the fractional reserve part of the system (but don’t like the fact that there is a central bank controlling the money supply) – this is Hayek, Selgin, White, Horwitz, (contemporary Austrians).
For most of U.S. history, competing private banks issued paper currency redeemable for coins of gold and silver. So this is not a radically new idea that has never been tried.
http://www.youtube.com/watch?v=cMn9pc-aTDQ
How the system works:
Basically – think of it as the commodity money emerging (let’s say gold). Then the goldsmith offices start giving people pieces of paper that represent gold (instead of the gold itself) for convenience reasons. At this point there is a one to one relationship between the amount of paper and the gold.
This is what your reading talks about with respect to returning to making sure the amount of gold and the amount of dollars that represent that gold are in line.
There are more than one goldsmith’s offices issuing their own IOU’s, in a sense. This introduces the idea of competition. Which is important to the theory.
Competition brings forth knowledge – and the incentive to come up with something better. Many people believe that to be true when it comes to goods and services – why not in money?
Currency or money users could also benefit from competition.
An example: “private gold and silver mints during the American gold rushes provided trustworthy coins until they were suppressed by legislation. Scientific appraisals have found that the privately minted coins were produced even more precisely than the coins of the US Mint. Private bank-issued currency was the most popular form of money around the world until government-sponsored central banks, with few exceptions, gained exclusive note-issuing privileges.” (White)
But – what if the goldsmith office’s begin to produce more IOU’s than there is gold reserves? In a sense, this would be similar to the idea of a fractional reserve banking system. The deposits NOW are all in federal reserve notes – that is what is held in reserves. But with a commodity based free banking system – the reserves are in the form of the commodity backing.
So what would be different? Let’s continue with the fractional reserve banking story we talked about earlier (the initial deposit of $1,000, etc.)?
Remember where we left off – that the loan created by one bank (from excess reserves created by a deposit) does not actually create more money in the system. It is offset by a decrease in deposits somewhere else in the system.
With free banking - two factors can, effectively, change the ability of the banking system to initiate that multiplier process.
1. Influx of the commodity. In a commodity-backed free banking system, an influx of that commodity into the banking system brings in reserves and enables the banking system to expand. On the margin, however, the quantity of new commodity money entering such systems will be small compared to the total supply of the commodity in any given period of time. In practice, this has not posed an inflationary problem for (mostly) free banking systems.
2. Second, in a free banking system, the reserve ratio is determined by the banks themselves, not by the central bank.
Reserve ratio:
The ratio need not be treated as an exogenous variable (as it is in the current system). Free banks can lower their desired reserve ratios which will enable them to create more IOUs off of a given amount of commodity.
IOUs are now called “liabilities” in the banking industry.
Here is where the disagreement comes in but also where it gets complicated. We will discuss the disagreements later. Let’s just talk about how the system would work.
If free banks see an opportunity to safely reduce their reserve ratios to enhance their profitability, it's likely because they have perceived that the demand to hold their IOUs or liabilities has increased.
This perception comes from the fact that the demand for their reserves via inter-bank and over-the-counter redemption has gone down. Fewer people are coming in and asking for the “gold” for example. People are simply using the IOUs.
With fewer claims being made on their reserves, some of their reserves that were previously "desired reserves" are now seen as "excess reserves" (if we use the same language that is used when discussing the FED) by these free banks.
These “excess reserves” can be lent out in the form of a larger supply of bank liabilities or IOUs (most likely in the form of new deposits granted to borrowers) – as with the current system.
So the question is – what keeps a check on this process? That is – why don’t these banks decide on a reserve ratio of 100%, for example?
Here’s where we have to interject some interest rate theory:
The first thing we have to understand about Austrian interest rate theory is the concept of:
Positive Time Preferences (as per Bohm-Bawerk):
BB’s two reasons for positive time preferences:
1. People’s marginal utility of income will fall over time because they expect higher income in the future. So the day we get paid, the marginal utility of our income is high – so we want to use that income now. As time goes by – and we think we will make more money in the future – our marginal utility declines and we don’t spend as much of it.
2. Psychological reasons the marginal utility of a good declines with time. So we prefer to have it now vs. later (now – the marginal utility is higher).
Now we have to relate this to saving vs. consuming. And there is a time element here as well.
Saving today = future consumption.
If someone has relatively high time preferences:
If someone has relatively low time preferences:
So basically time preferences will determine how much saving will take place in the economy.
If there are a lot of people with low time preferences:
Consumer vs Capital goods:
Let’s relate this back to the Austrian capital structure. What this means then is that people are saving NOW in order to consume future goods. So in terms of what should be happening with resources is that more should be going into capital goods and fewer consumer goods. Remember, production takes time. So the entrepreneurs should be starting the roundabout production processes by investing in capital goods now.
Hayekian Triangle should shift like this:
In other words, the demand for capital goods (investment) should be high since the demand for consumer goods is low (people are saving).
The interest rate then is determined by this interaction of the supply of savings (often called loanable funds) and the demand for loanable funds (which is coming from borrows who want to invest in capital goods).
If savings increases (time preferences decrease) – then the interest rate will go down (the supply of loanable funds has increased).
If you want to graph it:
The interest rate as a signal to entrepreneurs: This lower interest rate is a signal to entrepreneurs that people are saving now to consume in the future and that they should start investing in capital goods.
The demand for the savings increases and so does the amount of investment in capital goods.
(Sometimes this is called the “natural” rate of interest - as per Wicksell).
OK, let’s get back to our banks:
An increased demand to hold the bank's liabilities or IOUs (i.e., the falling demand for its reserves), is a form of savings. People are leaving their money in the banks – so to speak, not withdrawing it.
If people were coming in and turning in the IOUs for gold, for example – this would mean that they do not want to use this banks currency. The demand for the currency is low. But if people aren’t doing that – the demand for the currency remains high.
Therefore, this is a signal to banks that people are saving more and that therefore a lot of people have low time preferences. Reserves in the banks remain high.
Example:
Bob deposits one ounce of gold in Deb’s bank. Deb’s bank gives him an IOU worth 1 oz. of gold.
Bob spends the IOU by buying something from Bill.
Bill spends the IOU by buying something from Bud.
Bud spends the IOU by buying something from Betty.
Betty, however, is a saver. She does not spend the IOU, she holds on to it (she can deposit it in the bank for safe-keeping if she wants to). Either way – the IOU is not being spent. She is saving her IOU’s (gold) for future consumption of a car, for example.
There are a lot of savers in the economy doing what Betty is doing.
This means that there are fewer IOU’s in circulation - but it also means that reserves are not being withdrawn - there is more demand for IOUs but less demand for the reserves commodity.
Given that the velocity of money and productivity (the pie) has not changed – then this means that deflation would take place. Basically, the circulating currency has decreased, causing prices to fall (value of the currency to increase).
But, since the free banks are seeing this happen (since they are getting fewer withdraws and more deposits) – they see this as a demand for more IOUs (since there are less in circulation) and they create more IOUs (so the 1-1 IOU to gold ratio no longer exists).
Furthermore, since savings have increased (as we have seen, this brings down the interest rate).
The increased demand to hold the bank's liabilities (i.e., the falling demand for its reserves), is a form of savings that drives down the natural rate of interest.
When the free bank responds by lowering the market rate it charges to attract the marginal potential borrower on the demand for loanable funds curve, it is not inflating but maintaining the all-important Wicksellian coordination of the market and natural rates of interest (moving to the market clearing rate – otherwise the market would remain in a situation where the supply of funds is greater than the demand).
So even if free banks do start to create more money by lowering their desired reserve ratios, this decision faces the test of profit and loss in the marketplace, which will determine if the entrepreneurial judgment of the bankers is correct.
If they create more IOUs and loan them out at the lower rate of interest and a lot of entrepreneurs default on those loans – the bank loses money and they will stop creating IOUs (more loans). So profit and loss will tell bankers if more IOUs are demanded or not.
Of course the process is reverse if people are withdrawing a lot and not saving.
We are again, back to individual subjective ends (preferences) driving the whole system!!
Just like prices are a signal to entrepreneurs regarding consumer preferences – so are interest rates!!
So for those who support the commodity backed free banking system:
“The bottom line is that it is not fractional reserve banking per se that is the cause of inflationary increases to the money supply due to the money multiplier process but rather the ability of central banks to override market signals, thanks to their monopoly status, and add reserves to the banking system at their discretion and independently of the public's preferences. Again, there's nothing wrong with fractional reserve banking that getting rid of the central bank and other government interventions wouldn't cure.” (Horwitz)
OK, so what about those Austrians who want the same system – but do not believe in the “fractional reserve” part?
Arguments against free fractional reserve banking (and some responses):
There are ethical, legal and pragmatic economic arguments against the practice of fractional reserve banking.
Ethical and legal:
1. Some economists (Rothbard) and ethicists have concluded that the practice is fraudulent and therefore immoral, in that a bank promises to redeem deposits on demand when it is aware that, through this practice, it will never have sufficient funds to satisfy all depositors.
Some critics consider this fundamentally unethical, - basically they say it is no different than counterfeiting and/or embezzlement (that is the term Rothbard uses).
The simple reality is that no bank engaged in fractional reserve banking can pay its debts as and when they fall due, because a significant proportion of current liabilities (cash deposits) have been lent out and are no longer possessed by the bank. Rothbard basically says that these banks are inherently insolvent.
The idea is that a bank run is not an "extraordinary", "unusual", or "unexpected" event in finance, but a predictable event that merely reveals the reality of banking - that fractional reserve banking is inherently unstable and that such banks are inherently insolvent. Doesn’t matter if there is a government monopoly on the money or free banking.
So Rothbard (and others) wants a "full reserve" banking system.
A response: Selgin (for example) argues that no fraud is involved because depositors know perfectly well what banks do with their money.
Some economic arguments:
Fractional reserve banking can lead to expanding the money supply, (via government increasing the reserves out of thin air – but also due to free banks creating more IOUs) -
-this will lower the interest rates compared to a hypothetical full-reserve banking system.
So some Austrians argue that this change in the interest rate will affect the role of the interest rate in guiding investment decisions and will therefore necessarily create malinvestments throughout the economy.
A response: Obviously, the free bankers who support fractional reserve banking don’t see it that way. They see the banks as being a part of the process of providing loans or not, depending upon what is profitable.
Fractional reserve banking involves the creation of money by the commercial bank system, increasing the money supply. Austrian economists argue that this could cause inflation (and all that comes with it).
A response: Remember from above – the supporters say that the supply of money will only increase if there is an increase in the demand for money. Therefore – no inflation!
4. Full Reserve Banking will still allow for loans.
Full reserve banking allows for loans – without increasing the money supply. The theory is that "time" or "term" deposits could still be used for lending purposes in a full reserve banking environment and this would still allow more patient depositors to obtain interest on their savings.
In other words – when Betty buys a CD (Certificate of Deposit) - or some other time deposit – she promises to leave her savings in the bank for a certain period of time. During that time, the bank could lend her savings out to someone else. The actual amount of the deposit is not available to both Betty and the borrower – just the borrower (during the time of the loan).
A response: By increasing the funds available for investment, fractional reserve banking may speed economic development, allowing the economy to enjoy a higher level of investment than would exist in a full reserve environment.
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