17 May 2010

Believing Is Seeing: Free Banking Controversy

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[Three UPDATEs below…]

Joe Salerno launched a provocative assault on the Austrian “free bankers” (an unfortunate term since of course people who disagree with them are not in favor of unfree banking). In reply, both Steve Horwitz and Larry White offered quotes from Mises which they thought proved that the issue was at best ambiguous, and at worst showed Salerno was full of it.

The thing that’s hilarious (to me at least), is that I’m reading every single quotation they offer up (four in total) from Mises, and they are all perfectly consistent with what I took Salerno to be arguing.

Here’s what my own position is:

[Bob’s position on FRB.] Fractional reserve banking is inherently “weird.” It just doesn’t make sense that you can create money just by lending it out and then crediting both sides of the bank’s balance sheet. I’m not saying it’s necessarily fraudulent, I’m saying it’s weird. And it is intimately tied to the boom-bust cycle. The problem with central banking is that it eliminates the market’s normal checks on FRB. In a truly free market in banking, there would be a natural feedback mechanism that would severely limit “credit expansion,” which means an increase in the amount of loans when new commodity money hasn’t been produced.

Now with that understanding in mind, go look at all the “counterexample” quotes offered by Horwitz and White. Not a single one contradicts the above understanding which Salerno has convinced me, is what Mises’ position was.

At first I was tempted to say, “OK Horwitz and White just happened to pick poor examples, but surely they can’t be wrong when they say Mises was really ambiguous on this.” But I’m not sure, because in reference to his offered quotations White says: “These passages are plainly inconsistent with Salerno’s claim that “Mises looked with great disfavor upon the creation of fiduciary media by banks, whether ‘free’ or not, and strongly urged its elimination.”

Not only are they not “plainly” inconsistent, I don’t even think they’re subtly inconsistent. I don’t think they’re inconsistent at all.

The only possible confusion here, is if White thinks “strongly urged its elimination” means “wanted the government to make FRB illegal.”

But if instead we consider the possibility that Mises hated fractional-reserve banking per se, and thought a regime of “free banking” would curtail it, then Salerno’s story makes perfect sense.

And Mises isn’t ambiguous at all.

UPDATE: Let me add some balance to this post, so people don’t think I’m just picking favorites. In one essay (I forget where), Rothbard is ripping Hayek a new one on this stuff. He then tries to say that Mises agrees with his (Rothbard’s) position, and not Hayek’s nutjob private-fiat-money stuff, by saying, “One of Mises’ favorite quotes was from Tooke, who said ‘free trade in banking is free trade in swindling.'”

(I am paraphrasing, I might not even have the quotation-within-the-quotation exactly right.)

Now that borders on intellectual dishonesty. First, it wasn’t Tooke’s quote, Tooke was quoting a wag. And secondly, in Human Action if you look that part up, you’ll see Mises is mocking the sentiment. Mises is pointing to this quotation as something a layman would say, who has no understanding of how competitive entry into banking would work.

OK I purposely laid it heavy on Rothbard here, because I want Horwitz to really take me seriously when I say I think he is totally missing the boat on this one.

UPDATE 2: OK here’s the quotation from Human Action that I had in mind (p. 446 here):

It is a mistake to associate with the notion of free banking the image of a
state of affairs under which everybody is free to issue banknotes and to cheat
the public ad libitum. People often refer to the dictum of an anonymous
american quoted by Tooke: “Free trade in banking is free trade in swindling.”
However, freedom in the issuance of banknotes would have narrowed
down the use of banknotes considerably if it had not entirely suppressed
it. It was this idea which Cernuschi advanced in the hearings of the
French Banking Inquiry of October 24, 1865: “I believe that what is called
freedom of banking would result in a total suppression of banknotes in
France. I want to give everybody the right to issue banknotes so that nobody
should take any banknotes any longer.”

So two things jump out from the above passage:

(1) Rothbard was kicking Hayek below the belt when he cited that quotation about swindling to “prove” that Mises wouldn’t have endorsed Hayek’s plan for fiat money.

(2) Mises wants freedom in banking to eliminate the issuance of banknotes. Since Mises’ big problem with the Peel Act was that it failed to see that banknotes and demand deposits were economically equivalent, and since in the above quote he clearly wants free banking in order to suppress the issue of banknotes… Horwitz do you now see it?

Now in fairness to Horwitz et al., they can come back and say, “Huh? Did you just ‘prove’ that Mises doesn’t even want 100%-backed banknotes? Of course not. And by the same token, Mises isn’t against fiduciary media, he’s just against over-issuance of fiduciary media above the optimal level.”

So then to deal with that, we’ve got the juicy quotes Salerno dug up, about FRB being the seeds of its own destruction etc.

UPDATE 3: OK finally someone has supplied Mises quotes that appear to support the Horwitz/White position as much as the quotes Salerno dug up appear to support his position. Ironically, it was neither Horwitz nor White who supplied these quotes, but Nicolas Cachanosky in the comments at Coordination Problem. So I am now prepared to say that Mises was definitely ambiguous on the subject, at least in that he recognized there were costs and benefits of banks issuing fiduciary media.

In closing on this exhausting subject, let me just say this: My own position is that fractional reserve banking is like shoplifting: the “optimal” amount is zero in one sense, but actually the economically optimal amount is actually positive when you take into account the institutional constraints. For sure, it would be absurd to empower the government to tax people in order to pay a monopoly police force to crack down on shoplifters; this would cause more theft (if you count taxes) per year than the alternative. In particular, if you just let the market deal with it, store owners would install security cameras etc. and minimize theft. They wouldn’t literally drive it down to zero theft per year, but we could say, “The problem of theft from stores in this society has been solved by the free market.” It would be wrong to read such a statement as saying, “Aha! So we see it’s not really theft per se that is a problem, but excessive theft fueled by government intervention!”

41 Responses to “Believing Is Seeing: Free Banking Controversy”

  1. TGGP says:

    Rothbard seemed to actually desire that FRB be suppressed, so perhaps he should be considered an advocate of “unfree banking”:

    Rothbard’s idea there reminds me of Bakunin’s “invisible government” of anarchist revolutionaries. I’ve never actually read Bakunin and first heard of that through Bob Black:

    Roderick Long wrote something a while back on Maoism and “Egalitarianism as a Revolt Against Nature” that seemed relevant, but I can’t find it anymore.

  2. Dan says:


    Is it just me or is the Mises quote provided by Steven for challenge #2, basically means that Steven is now defending fiduciary media so that he can remedy a problem (market rate above natural rate) originally caused by fiduciary media? That is, the contraction of fiduciary media, which now can sort of cause the reverse effects described during the boom phase, is being somehow used to condemn 100% reserves?

  3. Bob Roddis says:

    Professor Murphy:

    My daughter just came home from college with 90 cents in her checking account. With that as reserves, I think I should help her start her own bank making jumbo $10 million loans at 8% interest. Sounds like a license to print money to me. What would Mises say?

    • bobmurphy says:

      I can help you market the loans here, for a cut.

  4. Beefcake the Mighty says:

    Bob, you need to tell these GMU guys to come to grips with the arguments made by Gertchev in the JLS
    a few years ago, discussing the change in Mises’ monetary thought between TMC and HA, and in particular
    arguing that HA represents a correction of some problems with TMC. These guys think TMC is the friggin
    gospel, they need to be set straight. And when they sniff about the JLS not being “presitigious” enough, tell
    them to piss off.

    • bobmurphy says:

      Beefcake, I think my opinion on journals carries only slightly more weight with them than your opinion does.

      • Beefcake the Mighty says:

        That low, huh?

  5. Jeremy H. says:

    Do you think homeowner’s insurance is “weird”? I mean, these companies have enough cash on hand to cover maybe 2% of their clients. Clearly, if all the houses in the country burned down, they wouldn’t be able to pay on every policy and would go bankrupt, so their activity is both weird and fraudulent!

    • bobmurphy says:

      (1) I specifically said I wasn’t claiming it was fraudulent,

      (2) Homeowner’s insurance doesn’t create money out of thin air.

      So no, I don’t think it’s weird, since the reason I gave for the weirdness of FRB isn’t present in homeowner’s insurance.

      • Beefcake the Mighty says:

        Bob, I love the “created out of thin air metaphor,” I often use
        even when I’m not stoned, but the GMU gang will pounce on
        you for using it. I think a better way of phrasing it, as de Soto
        and even the Mises of TMC do, is to say that the FRB banks’
        supply creates its own demand (since the banks can influence
        demand for their product by their ability to lower the rate at
        which they charge for loans). They lend money into existence,
        which they are able to do at will unlike other entities in the
        economy since they do not have to bid away factors of production
        from other entrepreneurs. I bitch-slap Horwitz over this point
        on one of the ongoing threads at the Mises blog.

  6. Lawrence H. White says:

    Bob wrote:

    White says: “These passages are plainly inconsistent with Salerno’s claim that “Mises looked with great disfavor upon the creation of fiduciary media by banks, whether ‘free’ or not, and strongly urged its elimination.””

    Not only are they not “plainly” inconsistent, I don’t even think they’re subtly inconsistent. I don’t think they’re inconsistent at all.

    Here’s one of the passages in question I quoted from Mises:

    If the government had never interfered for the benefit of special banks, if they had never released some banks from the obligation, incumbent upon all individuals and firms in the market economy, to settle their liabilities in full compliance with the terms of the contract, no bank problem would have come into being. The limits which are drawn to credit expansion would have worked effectively.

    Mises is saying here that under free banking credit expansion would be effectively contained. There would be no problem of excessive creation of fiduciary media. How is this not inconsistent with his looking “with great disfavor on the creation of fiduciary media” by free banks?

    • bobmurphy says:

      Hi Larry,

      We’re moving in circles here. 🙂 You are assuming that by “excessive expansion” Mises means, “Expansion beyond the fiduciary note issue required by the supply and demand for money” (or something like that), whereas Salerno thinks Mises means, “Expansion beyond 0.” Salerno has offered a few quotes bolstering his view that Mises thinks fiduciary media per se are bad, and so ideally banks would issue zero unbacked banknotes.

      I myself offered the Mises quote where he says he likes the spirit of the guy claiming to want freedom in banknote issue, in order to eliminate all banknotes.

      Let me put it this way: Salerno thinks that “credit expansion” is caused by ANY issue of fiduciary media, right? So in your quotation from Mises, the fact that Mises says free banking would have drawn effective limits to “credit expansion” is totally consistent with what Joe is claiming. Joe is saying Mises and Rothbard both wanted 100% reserves, while Mises thought free banking would achieve it, whereas Rothbard thought legal enforcement against “fraud” was the best route.

      One last thing: I’m not denying that your Mises quote is consistent with YOUR position, I’m just saying it’s equally consistent with Salerno’s. So when you guys are saying, “What the heck, Joe, how do you explain this?” it makes me wonder if you are really getting inside Salerno’s head.

      • Lawrence H. White says:

        I think I get your point. Let me take one last shot. Perhaps the clearest statement by Mises favoring a non-zero volume of fiduciary media comes in the section of The Theory of Money and Credit titled “The Case Against the Issue of Fiduciary Media”. There Mises sets forth the main good reasons why proposals for 100% reserves have not been adopted:

        “The progressive extension of the money economy would have led to an enormous extension in the demand for money if its efficiency had not been extraordinarily increased by the creation of fiduciary media. The issue of fiduciary media has made it possible to avoid the convulsions that would be involved in an increase in the objective exchange value of money, and reduced the cost of the monetary apparatus. Fiduciary media tap a lucrative source of revenue for their issuer; they enrich both the person that issues them and the community that employs them.”

  7. Jon O says:

    My issue has always been that these accounts are called “demand” deposits and as far as I know banks claim that the funds are available on demand. Regardless of what the banks claim people believe this to be the case; they make economic plans based on those funds being there and completely accessible. Actually they believe this to be the case with savings accounts to, but that’s another issue.

    Clearly these accounts are investments depositors are making, much like if they bought a CD. I’m sure the banks are covered legally but the whole thing seems disingenuous to me. The banks aren’t really creating money, they are de-collateralizing (and then re-collateralizing w/ less liquid loans and securities) customer deposits. The customer is, in a sense, creating the money in his head when he mistakenly believes his deposit is being warehoused rather than re-lent, that it actually exists in a bank vault..

    I don’t know if its fraud but it’s certainly a problem when a giant credit bubble deflates. And now it’s even worse because of shadow banking w/ securitizations, repos etc and the use of derivatives where only a small portion of notional value is held as capital reserve.

  8. Stephan Kinsella says:

    Bob, in your third update, you say “In closing on this exhausting subject, let me just say this: My own position is that fractional reserve banking is like shoplifting: the “optimal” amount is zero in one sense, but actually the economically optimal amount is actually positive when you take into account the institutional constraints. ”

    If I understand you, this means you agree with the *economic* arguments against FRB of Hoppe et al., correct? That there is no economic problem that frb is needed to solve? But that if companies want to try it, fine, and if they get away with it to a small degree, fine?

  9. Ludwig von Hayek says:

    “. And when they sniff about the JLS not being “presitigious” enough, tell
    them to piss off.”

    Not prestigious enough? Leeson published in the Journal of Legal Studies too you know! Wait, we are talking about the Journal of Legal Studies, right?

  10. Murray de Soto says:

    “If I understand you, this means you agree with the *economic* arguments against FRB of Hoppe et al., correct? ”

    Why do you always feel the need to plug your boyfriends work? Plenty of other people have written pieces again FRB you know (no surprises, none of them were publishes in JMBC but not everybody is

  11. Sag says:

    Bob Murphy,

    Thank you for this post. I wasn’t at all convinced by the quotes the free bankers dug up from Mises. I couldn’t understand what the basis for their disagreement with Joe Salerno was (on Mises’ views on free banking). I now see a) why they thought those quotes convincing while I didn’t b) due to Nicolas Cachanosky’s quotes why Mises was indeed ambiguous on FRB v. 100% reserves. I think Joe Salerno is correct and the free bankers are right too to see support for their positions in Mises.

    Like you, I find Rothbard’s economic arguments against FRB thoroughly convincing and agree with your shoplifting-in-a-free-market analogy. Luckily, the free bankers are in complete agreement on the correct framework (unrestricted market freedom, no special privileges for the banks, no central banking, making terms of contract clear to customers).

    I will look at White’s Free Banking book to try to get a better idea of the FRB position. I just don’t see the problem they have with Rothbard’s position (his slights against the free bankers aside although I understand why that particular issue upsets them but that’s not the economics issue). “The needs of business” seems entirely arbitrary to me; an excess demand for money that the bankers would have to discover (and which is separate from increased PPM due to increased production) and then solve by e.g. issuing extra deposits in excess of reserves. This seems like a deus ex machina way to circumvent savings and thus to inflate. The free bankers agree this would be limited by the threat of bank runs but this seems a problem of how much inflation the banks can get away with.

    In short, I don’t see the problem they’re trying to solve; the desperate need for banking in excess of reserves procured through their own and their customers’ savings. As you said, the fact that shoplifting would survive the state is no argument for its efficacy.

  12. cargocultist says:

    A large part of the problem – and this is very evident here – is the ‘weirdness’ of fractional reserve banking to those unfamiliar with distributed, recursive processes.

    Or to put it another way, what evidence do we have that economists such as Mises, Keynes, Hayek, or for that matter Horwitz and White, in fact understand what they’re talking about.

    We certainly know Rothbard didn’t. We know that because he appears to be responsible for the claim that individual banks can lend a multiple of their deposits. If that’s how you believe FRB works, then his subsequent economic arguments make sense, but it isn’t – individual banks can’t do that, the multiplication occurs within the banking system, and should be constrained by the reserve requirement.

    De facto, there is no single ‘fractional reserve banking system’. There are a set of systems, based on the fractional reserve process, whose individual evolution over time will vary considerably depending on details of implementation. There have been major differences in implementation over historical time, and even today significant differences between individual countries.

    What i would personally like to see from any economist claiming the expertise to discuss any part of the monetary system, and especially the full reserve folks, is a detailed description of their understanding of how this system works and behaves, as a system.

    Rather than these highly politicized and ultimately pointless arguments, let’s just concentrate on how this thing actually works, how it evolves over time, and its possible failure characteristics. Then discussions on how to change it to something more suitable will be founded on a basis of reality and common understanding – rather than common misunderstanding, which appears to be the case today.

    • bobmurphy says:

      I’m not throwing down the gauntlet, but I would be curious if you could tell me how Rothbard’s step-by-step description in, say, The Case Against the Fed, of FRB is wrong.

  13. cargocultist says:

    This is from Fractional Reserve Banking, Murray Rothbard (http://www.lewrockwell.com/rothbard/frb.html)

    “I set up a Rothbard Bank, and invest $1,000 of cash (whether gold or government paper does not matter here). Then I “lend out” $10,000 to someone, either for consumer spending or to invest in his business.”

    The rest of the paragraph reads:

    “How can I “lend out” far more than I have? Ahh, that’s the magic of the “fraction” in the fractional reserve. I simply open up a checking account of $10,000 which I am happy to lend to Mr. Jones. Why does Jones borrow from me? Well, for one thing, I can charge a lower rate of interest than savers would. I don’t have to save up the money myself, but simply can counterfeit it out of thin air. (In the nineteenth century, I would have been able to issue bank notes, but the Federal Reserve now monopolizes note issues.) Since demand deposits at the Rothbard Bank function as equivalent to cash, the nation’s money supply has just, by magic, increased by $10,000. The inflationary, counterfeiting process is under way. ”

    I agree with Rothbard in the sense that what he is describing is indeed counterfeiting and fraud – but that would be the whole point. If he did that with his bank, he would be guilty of exactly those things. Rothbard bank can only lend out $10,000 if somebody has deposited that amount, in fact it would need to be $11,000 to meet the then reserve requirements. That as a deposit, would come in from another bank, reducing that bank’s available loan supply. How much money is actually created would depend on a number of factors operating within the larger system.

    Not to say that there aren’t some serious problems with the current implementation of the system, and arguably with the system itself, but this ironically isn’t one of them.

    • Beefcake the Mighty says:

      Rothbard is being a bit sloppy, yes. He’s evidently assuming a reserve
      ratio of 10%. The initial $1000 deposit can form the basis of a $900
      loan; when *this* amount is redeposited somewhere else in the banking
      system, another $810 can be lent out, etc etc. Summing this infinite series,
      in principle the initial deposit can multiply 1/0.1 = 10 times.

      Again, Rothbard’s analysis is a bit sloppy, but NOT fundamentally unsound. Is
      this the best you can do?

    • bobmurphy says:

      Actually Cargo, I think you are the one who is a bit off here. If I may be so bold, I think you are assuming the money & banking textbooks are accurately describing the process, when an actual banker has told me that is all a myth.

      I’m not going to do a full argument here; I’ll probably write a mises.org on this at some point. But very quickly, to at least get you to possibly reconsider your extremely strong judgments below:

      * The banker said, “In all the years of sitting on a loan committee, never once did we say, ‘How many excess reserves do we have?’ We would make loans based on their merit, and then if we needed more deposits we’d go out and get them.”

      * Think through your example more carefully. Someone comes into my bank and deposits $1000 in currency. Now according to you, I only have the legal ability to lend out $900. OK let’s assume that’s true. When I grant someone else a $900 loan, I don’t actually reach into the vault and hand him $900 in currency. What I do is open a new checking account and credit it with $900–what you yourself seem to admit is pure fraud or at least “weird.”

      * In terms of the legal regulations, all the bank has to do is make sure its customer balances don’t exceed 10x the reserves. So if the bank instead of putting $900 in the new customer account, put in $9,000, the universe wouldn’t blow up. The bank would still be legally fine.

      * The reason in practice banks don’t automatically create the full 10x in new loans, is that presumably someone borrowing money is going to spend it. And if they write checks to people who are members of other banks, then that new loan will quickly get withdrawn. So it’s a matter of prudence–NOT a matter of avoiding what you yourself admit would be fraud and “creating money out of thin air”–that banks don’t operate exactly as Rothbard loosely described.

      • cargocultist says:

        Banks are audited by their regulatory authorities. The USA banks for example are required to submit extremely detailed call reports every 3 months. So if a bank did attempt this, it would be very rapidly shut down.

        As i said, there is a great deal wrong with this system – just not this particular problem.

        But please go and audit the FDIC call reports yourself on this point – they’re public domain since 2001.



  14. Sag says:

    Cargo doesn’t seem to have read Mystery of Banking. Rothbard describes fractional reserve banking in great detail. Correctly as Bob Murphy above points out. Cargo, the facts are in fact that bizarre. That’s the power the banks have, the entire point of the Federal Reserve system.

    Bob, I followed up to see if any more interesting comments were made as I wanted to see if the free bankers had anything else to say. I think the short debate between Dan and Steve Horwitz over at the coordiantion problem blog clarifies the issue for me.

    It seems, IF I understand Steve Horwitz correctly (big IF), the free bankers are claiming that demand deposits are loans to the banks understood as such by their customers. After everything, it seems the main disagreement with them and the Rothbardians on banking is they think deposits are loans which are payable on demand according to agreed upon terms. That’s how they can see fractional reserve lending as not necessarily inflationary. For them, the inflation would only be if banks didn’t keep enough reserves on hand to satisfy redemption claims.

    There are a bunch of problems with this theory but, if I understood Steve Horwitz correctly, the free bankers admit that production is limited by savings. No new money is created (per above conditions). For them, the demand to hold money in banks is not the same as the demand to hold hold money to the exclusion of consumption as well as investment. They think it’s really a demand to hold a type of liquid investment.

    If this is truly the issue, I’m amazed by the commentary (not from secondary bloggers but the principals themselves). I think Joe Salerno and other Rothbardians have been fair but simply mystified. The free bankers have described Rothbard’s positon as “crazy”. But it’s not that far off from theirs. Granted, the above issue is a big one but they agree: free banking, no central bank, no inflation beyond savings etc.

    But perhaps there’s more to the free banker (really the correct description would be “free banking fractional reservists” but granted a mouthful) position. Dan and Steve Horwitz’ discussion seemed to reveal the above as the basic issue.

    • Beefcake the Mighty says:

      “For them, the demand to hold money in banks is not the same as the demand to hold hold money to the exclusion of consumption as well as investment. They think it’s really a demand to hold a type of liquid investment.”

      This is spot-on, and it highlights the confusion at the heart of free banking theory. The free bankers assume that bank notes are a good as such, and they construct a theoretical rationalization for distinguishing good (free banking) vs bad (central banking) schemes for producing such “goods.” Obviously, a much better question would be, are these “weird” (to use Bob’s phraseology) entities even goods in the first place?

  15. cargocultist says:

    re: Beefcake

    One might similarly describe the lifeboat planning on the titanic, or the operation of the Chernobyl reactors as sloppy.

    I would also note that the misconception that individual banks can lend a multiple of their deposits is found in many places on the net, often attributed to Rothbard. So, a lot of people do take that meaning from what he’s written.

    However , leaving that aside, even the alternate interpretation that you give is also incorrect. If as you say, the money is transferred in from a deposit at another bank, then that bank has now lost some of its capacity to lend. Its deposits have been reduced by the deposit at Bank Rothbard, which also reduces its loan capacity. When Bank Rothbard creates its loan, it redeposits that money back in the system, and fills that hole in both the money and loan supply. There is no further expansion in that case, with the assumption that all the Banks have maxed out their lending capacity, and if the individual call reports for the USA Banks are examined, that is indeed the case. The expansion from initial conditions textbook example that you quoted does not apply, because the banking system is not at initial conditions, and hasn’t been, depending on what country you’re in, for several centuries.

    This also goes to the question of whether the textbook version of fractional reserve banking is inflationary. In theory, only during the initial expansion. Once it has finished expanding, then according to the textbook it would settle into a steady state, with loans being a fraction of deposits, and new loans only being made as existing loans are paid back.

    I would stress that as Bob Murphy points out, the textbook version doesn’t actually bear much resemblance to how things are implemented now. But that was my main point – I want to hear Horwitz, Krugman and anyone else who feels they have a theory about the monetary banking system and its behaviour, to first give their own detailed explanation of how they think it works. Because as I think we’ve all just demonstrated, this is not as simple a question as it might appear, and i think we’d probably also be rather surprised by the variety of answers.

    as has been said in many contexts, the devil is always in the details


    • Beefcake the Mighty says:

      Rothbard characterizes the $1000 in question thusly:

      “I set up a Rothbard Bank, and invest $1,000 of cash (whether gold or government paper does not matter here). ”

      So presumably, he is envisioning a situation where either the gold was
      newly extracted or had circulated as money previously, or where the
      State Treasury had printed more money certificates. He’s not assuming,
      it seems to me at least, that this $1000 came from another bank’s deposits;
      isn’t that why he refers to it as *cash*? In this case the new non-bank
      money would serve as the basis of an inverted pyramid of loans, would it
      not? If I understand your argument correctly, even the “initial conditions”
      expansion could not occur beyond the first lending within reserve limits.

      • cargocultist says:

        My speculation would be that the key word in that part is gold. Some of the various inconsistencies in economic thought as to how this thing behaves can probably be traced back to the differences between its implementation during the gold standard era, and the current rules, and although Rothbard was writing this post gold standard, his basic understanding would have been founded in the gold standard era. They didn’t completely understand how it worked then either though.

        However, where the equity capital (the $1,000 used to setup the bank) came from isn’t the real issue in that paragraph, it’s where the deposit for $10,000 comes from that the loan is created against.

        In the textbook example, no bank has any loans outstanding against it, which is why the expansion proceeds as you posted it. But that’s not the case in any developed banking system.


        • Beefcake the Mighty says:

          I know you haven’t replied to the quote from Horwitz that I provided below, but it seems to me you’re assuming that *none* of the $900 base money (to use the free bankers’ unfortunate terminology) that does not need to held in reserve makes its way back into the overall economy, and then back into the banking system, where it can then be the basis of new fractional reserve lending. I don’t see what the question outstanding loans in a developed banking system has to do with that.

          • cargocultist says:

            I’m not sure i understand what you mean here. They are required to hold a fixed ratio of their equity capital to their loans subject to their available deposits.

            It’s there to cover loan defaults that can’t be covered out of profits, and it’s part of their regulatory requirement.

    • Beefcake the Mighty says:

      For once Steve seems to make sense to me:

      The money multiplier comes into play when new base money enters or exits the system. Rather than starting with a check clearing from one bank to another, which doesn’t change the total money supply, assuming both banks face the same marginal legal reserve requirements (or choose to keep the same desired reserve ratio), start with someone taking FR notes or gold out from under their mattress and depositing that into the banking system.

      In *this* case, the recipient bank will keep some fraction against the new deposit and loan the rest out. As that loan ends up in a different bank, it has new base money and loans most of it out, etc.. The result is a total money supply that is a multiple of the original change in base money. But this requires that base money enter (or exit) the banking system.



      Is he wrong here?

      • cargocultist says:

        Well – what version of the system is he talking about? Again there appears to be some confusion with a gold standard system – “or gold out from under their mattress”. Also note that the traditional reserve requirement doesn’t apply any more to most accounts in the current banking system – they only apply to “net transaction accounts” in the USA. Some countries have abolished them completely.

        Bank notes themselves are printed on demand in today’s system, there isn’t a fixed supply or ratio any more – which makes sense, since the vast majority of transactions are now electronic. So digging up a few more of those would presumably stop the Treasury printing some new ones in the next month.

        Similarly if you take your newly dug up gold in, you’d get the spot price for gold. No money supply implications in the current implementation of the system, although it would certainly have had some in the gold standard era.


        • Beefcake the Mighty says:

          We are not talking the same language here, evidently, so let me simply ask: if Austrians have such a flawed understanding of the monetary system, what sources would you recommend for gaining a better understanding?

          • Beefcake the Mighty says:

            Actually, I retract this request, because after perusing your website, I’ve come to the conclusion that, you’re full of shit. It’s nothing personal, but what you say sounds impressive at first glance because of it’s technical nature, but once one peels through that layer, there’s nothing radical there. When I look at your discussion of fractional reserve banking, I don’t see much in conflict with my original understanding. E.g,

            “It bears repeating. Individual banks cannot do what Rothbard claimed, they can individually only lend a fraction of their deposits. They are required to file quarterly call reports demonstrating that. The recursive nature of the deposit, and redeposit of the money that they lend back into the system results in the banking system, which is to say all the banks, multiplying the original deposit into the system 10 times. But the implications of the system multiplying by 10 are completely different to any individual bank being able to do that.”

            at http://www.cargocultist.com/?cat=18

            Essentially what I said originally here, that you claimed was in error. (Also, I have a PhD in math, so fuck you if you think you can dazzle me with equations; again, this is not personal.)

            Also, elsewhere you complain that there is no economic account of what money *is*, rather only what money *does.* Austrians generally hold money to be a medium of exchange, ie, a good that permits more transactions to take place than would otherwise be possible; why is this not an acceptable understanding of what money is?

            So again, thanks but no thanks.

          • cargocultist says:

            Certainly i’m sure we can all admire the rational level of sophisticated discourse that you Ph.D in math is bringing to the discussion.

            For the record, I agree with the ‘medium (token) of exchange definition of money, in my world that maps onto something called Shannon information. However, it wasn’t the definition of money we were discussing, it was the mechanics of the banking system.

            If you go back to my original posting, the point i was making was that Rothbard clearly didn’t understand how the banking system worked. Even if you take the best possible interpretation of what he said – and i question that just on the amount of polemic he generated about it. We’ve also seen some evidence that Horwitz doesn’t understand it either, or is possibly writing about the gold standard system of the early 20th century, and didn’t bother to say so.

            Since i don’t want to be seen as picking on the Austrians here, if you go and look at Krugsman’s blog posting today, you’ll find some evidence that neither does he, (it’s the base money remark.)

            So we have a large number of people within different schools of economics, sneering at each other with the words – ‘fractional reserve banking’ – but actually meaning a great many different things, and none of those things being a correct description of the system to begin with.

            Getting all economists to describe their version of how they think this system works, would be at least be a way of highlighting that problem, and starting down the path to resolving it.

            Otherwise it won’t be a lost decade we’ll be looking at, it’ll be a lost century.


            • bobmurphy says:

              “Certainly i’m sure we can all admire the rational level of sophisticated discourse that you Ph.D in math is bringing to the discussion.”

              Let me get this straight. You come in with guns blazing and accuse Rothbard of being an absolute idiot, and then I point out that actually, it’s possible that the offending quotation is perfectly correct and your own understanding is wrong.

              And your response to that is to make a sarcastic compliment of my book smarts?

              Do you agree with my last post or not? If you do, then the correct move would have been to say, “Oops, I retract my rip of Rothbard. He actually understood the essence of FRB more than I did.”

              If you’re not willing to say that, then explain how my last post is wrong.

              • John says:

                First, I am not defending Cargo’s interpretation of things . . . I am wholly unsuited to adding to this discussion as my knowledge of the ins and outs of money and banking theory could fit into a thimble with room leftover for an elephant.

                That said, I believe that Cargo’s remark about the “Ph.D in Math” was in reference to Beefcake, not you.

            • bobmurphy says:

              BTW I have a PhD in economics. Mathematicians laugh at the math they teach us in econ programs (for real).

            • bobmurphy says:

              Let me make sure you understand what I was saying. The standard money & banking text says that if someone deposits $1,000 in paper currency in a bank, then in the next round the bank can make a new loan of $900. Then when someone deposits that $900 in a different bank, that bank in turn can make a new loan of $810 blah blah blah.

              Rothbard, on the other hand, in that quotation suggests that if someone deposits $1,000 in paper currency in a bank, then that bank in step one can make a new loan of $9,000 to someone.

              You indicated that this was simply incorrect. You agreed that if a bank COULD do that, then yes FRB would be “creating money out of thin air,” would be inherently fraudulent, etc. But since you claimed a bank can’t actually do that, you denied Rothbard’s sweeping condemnations.

              Now, I am saying that I think technically speaking a bank DOES have the right to do that under FRB. If a bank went ahead and made a new loan of $9,000 to someone, and for some reason that person never spent the money but just let it sit in his new checking account, then everything would be fine. The bank’s regulators wouldn’t swoop down and ding them for doing something illegal.

              (In practice a bank wouldn’t make such a big new loan on the basis of a $1,000 deposit in currency, because if someone takes out a loan it’s because he’s going to spend the money, since he’s being charged interest and needs to “put it to work.”)

              I am not 100% sure of my above claims, but I am 90% sure. I am giving you an opportunity to explain why I am wrong.

              But if you are conceding the point, then Rothbard was right about the nature of FRB, in particular about it being fraudulent.