Sunday, October 10, 2010

Historical data in the fractional reserve banking debate

Previous writing on FRB Revisited:
Part One
Part Two
Part Three

First up, I did not think I was going to be original in the details. I got the two core elements of my own opinions from Bawerk and Mises, which along with other discussions of theory and history (eg Salsman) I integrated into my own thoughts. I did NOT get any of my thoughts from Rothbard. Any correspondence of mine with his will lie in the common reference to Mises plus clear thinking (to the extent possible to Rothbard), not of me reading Rothbard. Moreover, the modern debates have been formally raging for two centuries. I am fairly confident that someone somewhere, probably also now long dead, and perhaps now obscure, has already said what I have come to think as a result of my own judgement. If that includes by people I would otherwise hold in contempt, so be it, and I’ll not apologise for publishing thoughts of my own that others may wrongly presume be sanction of everything that those other people had to say.

(Edit: grammar + bad URL + a few expression faults + the three back-links)

The hormesis-versus-LNT comparison
There was a definite reason why I did not begin with a literature review. Aside from that I was not writing an academic paper, and that I did not want to bog the issue down with who said what and I was concerned to focus strictly on fundamentals, much of the literature and the on-going debate is shot through with absolute drivel and even worse. As far as I can see the extremely-high energy and frequently vicious nature of the discussion about fractional reserve banking looks distressingly similar to nature of arguments regarding exposure to ionising radiation between those who posit the hormesis effect and those who posit linear-no-threshold.

For those who don’t know it, the hormesis idea is that a little bit of radiation exposure is actually good for you because the body’s detection of that little bit triggers more vigorous error-correction mechanisms in protein coding etc such that it also better deals with non-radiation-caused faults as well, and that only when the ionising-radiation goes beyond the capacity of the error-correction mechanisms to cope with does harm develop and radiation sickness begin to appear. The linear-no-threshold idea is that ionising radiation is harmful full-stop, that the higher the level the greater the harm that comes from exposure (after adjusting for various individuals’ peculiarities, of course), and that the implications for evolutionary theory that claims regarding error-correction mechanisms posited by the hormesis advocates have present questions that raise serious doubts about those claims.

I draw this comparison because the violent debates on both controversies share many of the same critical features:

- nobody worth taking seriously thinks that heavy exposure is not a problem and instead that everyone with a lick of sense recognises that the real debate regarding beneficial outcomes is smidgeon-versus-none,

- both arguments have prima-facie plausibility,

- the proper addressing of the issue requires sophisticated technical knowledge that most people just don’t have and that as a consequence of this fact the politicians et al who have to decide on legal responses have no choice but to take submissions from people on both sides and make judgement on what they are otherwise generally unable to judge on their own unless they have themselves been immersed in the field,

- there is considerable public support on both sides, wherein people are loudly agitating for the above politicians to act one way or the other and are also in furious debate with each other, almost none of whom are in any position to say something actually meaningful,

- amongst those who do have the capacity to say meaningful things there are good people on both sides yet there are likewise on both sides people who are dissemblers, have axes to grind, have ulterior sociopolitical motives and agendas, and have various types of large vested interests where possibly-unearned revenues are at stake on the outcome of the legal responses to the issue,

- and that as a consequence of all the foregoing and people’s knowledge of it the debate ranges from polite and reasoned discussion (though frequently lacking the benefits of objective epistemology and value theory) through to vicious name-calling, ad-hominem, accusations of evasion and dishonesty (sometimes warranted sometimes not), and general emotion-fuelled spittle & mayhem.

For the record as to the particular issue of radiation exposure itself, I am not competent to offer anything definitive. All I can say is that both hormesis and no-threshold do have plausibility, I am not remotely in any position to be more assertive than that, and that the only thing I am dubious about is the “linear” part because it strikes me as simple-minded nonsense contrary to what is prevalent in nature, manufactured by or otherwise for regulatory bureaucrats setting exposure standards etc without having to go to the trouble of hearing arguments and making reasoned judgement. That is all I have to say about this issue in the concrete.

Yet the issue of fractional reserve banking does have one thing in its favour that the issue of radiation exposure does not: the sophisticated knowledge required to address the latter is of a degree both qualitatively and quantitatively considerably greater than that for the former. It takes decades of dedication spent learning, gaining experience, and conducting complex medical research to have a ghost of a chance of properly dealing with the nature of radiation exposure and determining how man ought deal with it. Only the dedicated professionals with access to expensive laboratories are capable of achieving this. In contrast, the sophisticated technical knowledge required to dispense with fractional reserve banking does not even require an academic qualification to acquire, nor access to materials any more expensive or hard to come by than the books and periodicals detailing principles and histories as one finds in a decent library. It does take years of good observation and thoughtful integration to generate a definite conclusion, but unlike medical matters the effort required for economics is within the capabilities of the diligent non-professional who resolves to put his mind to it.

So, what option does the honest man with an interest in this topic have but to begin by ignoring everyone to start with, do his own research and thinking, make his own judgement independent of anyone’s alleged authority, and, while paying due attention to and making honest judgement of the calmer arguments offered by others, being so diligent as to make that conclusion definitive enough for him to make a stand on?

Publius on Objectivist Answers
The particular occasion for this post was me searching out a particular paper written by Lawrence White and George Selgin, as referenced by one "Publius" over on Objectivist Answers. I think it is this one. Publius claims that White and Selgin proved that history clearly shows that laissez-faire leads to fractional reserve banking, not as a sad inevitablity or whatnot but as something benign and positive. Actually, neither history nor that particular paper prove any such thing. That paper may not be the one Publius had in mind, and it may well be that Publius had two separate works by each in mind instead, but Publius' claim is still wrong, and the critical sub-conclusion implied by White and Selgin here and which I imagine Publius is relying upon is not supported by the evidence they provide (nor can it ever be).

The history of FRB stretches back WELL beyond just the 19th century American experience, an era so commonly referred to by fellow laissez-faire advocates but who are also pro-FRB. For instance, in his book "Money, Bank Credit, and Economic Cycles," Jesus Huerta de Soto recounts the history of repeated bank failures, going all the way back to Ancient Greece, and how they caused significant economic distress that was repeatedly partly ascribed to improper lending from what was not bankers’ to lend. Additionally, he also tells of how the Bank of Amsterdam came to be founded and why there was the vehement demand that it keep 100% reserves – people had discovered the hard way (again, that is) that when fractional reserve banking gets full swing and reserve ratios are permitted to fall markedly the result is the chaos and destruction of boom and bust cycles. (Hat-tip: Pater Tenebrarum)

Of course, the point about de Soto’s recounting of history is to show a litany of actual frauds and the disasters that followed, along with the thoughts of learned men of the past regarding law and justice, in the attempt to support a claim of inherent fraud in the practice: “is fraud, so, therefore, is destructive,” is how we can paraphrase him. I will, however, point out that I have already demonstrated that the claim of fraud today is nonsense. As I said, the past is now the past, and irrespective of grave breaches of bailment contracts in the past the contracts for bank accounts we have today are of a credit nature and have legally been recognised as such for well over a century now (eg in England starting with Foley v Hill, 1 Ph. 399; 2 H. L. C. 28; 9 ER 1002, in 1848, with further details sorted out by 1921 in N. Joachimson v Swiss Bank Corporation [1921] 3 K.B. 110). The claims of present-day fraud from people who have the intellectual capacity and academic resources to know better, in brazen defiance of more recent history and the subsequent continued existence of due legal notice and precedent established long before any of us was born, are getting very tedious. The plain fact today is that bank customers are creditors and have absolutely no business complaining about not knowing this to be so when they joined up as depositors, and thus I say bluntly to the fraud-ranters, deal with it.

But I am not so ready to pin down most the economic ills of Renaissance Spain or Italian City-States et al to just the practice of fractional reserve banking as de Soto is. Still, while how selective de Soto has been in his recounting of history I am not capable of saying, what he does show (particularly the story of the Bank of Amsterdam) certainly puts Publius’ claim in bad light. Nevertheless, even treating de Soto as an impartial observer, the merit in this White and Selgin paper is to show that when one has access to more details about historical events and examines them, it is clearer that a much more influential culprit is government interference – in regards to the European experience, not exactly a shining beacon of laissez-faire, it can be said that moral-hazard has a long and sordid history, and so I would suggest (as would White and Selgin were they to mention him by name) that de Soto is trying to claim too much. de Soto overstates his case and draws too strong a conclusion: a lesser one would have been valid, but that wouldn’t have suited his agenda.

The problem with this White and Selgin paper is that they are guilty of the same excessive conclusion-drawing, albeit on the other side from de Soto. Whereas de Soto makes the assertion that history alone says reserves should be 100%, White and Selgin incorrectly imply – at least as Publius would have us believe (again the caveat on which work he has in mind) – that history shows that a little extent is safe and even a positive to be welcomed, and that problems only arise because of departures from laissez-faire. In the 19th century US, the closest we came to laissez-faire, the reserve ratios then and there hovered around the 30-50% mark, in contrast to today’s 5% area. If there were genuine free markets and the market discipline to match, and indeed with our even better communication and transport facilities compared to then, Publius would have us believe not simply that fully private banking would return to similar figures, and that we have nothing to worry about, but also that history shows it is proper that they should return and proper that fractional notes issued by sound banks facing strong market discipline always trade at par.

Taken strictly on its own merits, the White and Selgin paper has valid points to make and which ought be widely disseminated. They demonstrate that proper laissez-faire in banking would be stable and also that we have nothing at all to fear in the private issuance of banknotes under such a condition even when issued by sound banks with only fractional reserves. That is their main conclusion, and it is sound. It is the implied assertion of inherent positivity and propriety of sensibly-fractional notes that is the too-strong conclusion. It is certainly true that at the time, when men were free and communications were good, even fractional notes from sound banks traded at par, and that should the same conditions arise again the same par will likewise probably arise again. The problem however lies in a superficial approach to why men of good sense did so voluntarily in the past and why they may do so again in the future. There are the assumptions that the actuarial value of the notes actually placed on them by men of good sense was and will be automatically at par, that men who in fact did or will do so were or will be automatically correct to do so, and the ignorance of the possibility that there were or will be non-actuarial factors militating against bothering to mess around with discounts on the part of men who did not or will not do so. Even were there testimony from every single man who did genuinely calculate par values, no amount of merely empirical reference to history will by itself ever demonstrate the rightness of what they did. The only way you can ever answer that question is to go into valuation theory itself, which requires one first go into investment and capital-formation theory, which is exactly what I did and why I did it.

In regards to the non-actuarial factors, commonsense should have kicked in, especially given the reference to other reasons for non-par valuations. It takes effort to calculate and to work with the resulting numbers. It takes effort to have administrative systems to handle non-par valuations that just don’t exist when accepting par and washing one’s hands of what is usually trivial differences. This is no mere idle speculation, but a problem that has a long history and still plagues discussion of theory and practice today. In the past, the English Penny-Post was developed – one penny to post a regular letter to anywhere in England – because someone figured out that the administration involved in calculating the costs for different destinations was way more trouble than it is worth and it was more profitable to charge just one penny uniformly and be done with it. Today, we hear of the rabid complaints about the gouging interest rates charged by microfinanciers and pay-day lenders – complaints that are sometimes oblivious to the high proportion of the principal that is incurred as costs of administering such small debts, and complaints that sometimes whine incessantly about separately-charged administration fees sending effective interest rates up to gouging levels. And I recall a story I read once about some left-wing lecturer offering to borrow some trivial sum – $10 I think – from anyone in his audience at a 150% pa interest rate, then finding that nobody was interested, and using this finding as ‘proof’ that interest rates don’t perform the allocation role that free-marketeers claim they do, never for one second allowing for the possibility that chasing someone half way across the country for them to pay back $25 a year later wasn’t worth it. Given how those banknotes of old would have present-day values ranging from $20 to maybe $10,000, you should get the picture.

But anyway, this is the fundamental issue that is truly at the heart of the fractional reserve banking debate: where, if anywhere, is the decision on the part of the ultimate beneficial owners of investible resources – not merely intermediaries but the free-and-clear owners themselves – to shift their preference on what is to be physically produced away from consumption goods and towards capital goods? The answer is: there is no such decision being made. It is that issue, the rock-hard reality of input physical resources and what arrays of material goods are actually wanted by the owners of those inputs to them, not the garbage about fraud or theft or voodoo, that brings fractional reserve banking down in a crashing heap.

As I said, however, no amount of mere empiricism and historical reference will get you to that. Until that fundamental issue is addressed and integrated with proper concepts of money, demand for money, account types, saving, investment, and capital, mere historical empiricism will only net you that which had already been pointed out by level-headed economists from Smith onwards: that low reserve ratios are indicated as one of the efficient-causes of economic disaster but that under proper laissez-faire the self-interest of bank customers will see to it that reserve ratios are kept high. Those who say that history shows that reserves must be 100% and those who say that history shows that it is perfectly proper that they may not be 100% are both reading into the historical record that which is not there.

Still, we can turn that historical empiricism into a proper induction by integrating it with morality and politics, and without needing sophisticated economic training to do so (basics will do): the moral is the practical, laissez-faire is both moral and practical, and so it is no surprise that history shows that departure from laissez-faire has negative consequences. The induction to be drawn is simply this: interference in the finance industry leads to bankers increasingly getting away with risk-taking with others’ money that is beyond what those others would voluntarily permit by preventing these others from exerting proper market discipline, and that since the finance industry is one of the commanding heights of the economy the consequences of this lack of discipline are apt to be catastrophic. When markets are free, bankers (like everyone else) are made subject to proper market discipline and their activities (also like everyone else) contribute positively to the health of the economy. There are no grounds for singling out bankers as especially prone to evil and for attacking them in the manner of drooling and angry junkyard dogs going after scrap pilferers.

I must also add that no amount of monetary theory alone will do the job either. It is in vain to try to construct a theory of how money and fiduciary media will pan out in a market without reference to that physicality of resources and material production. That’s the sort of idiocy that lead to the idea that money is neutral and the over-stating of the importance of the money equation. As I said, the only place I can find for the practice of monetising credit is in remote locations with poor external communications and which have a bona-fide dearth of physical specie. The idea that fractional reserve banking is needed to stave off crises and depressions in whole sophisticated economies is arrant nonsense that is completely upside down - to the extent that an economy is predisposed to such crises and depressions the practice will make matters worse, not better, whereas to the extent an economy is not so predisposed the practice will be a mostly harmless and completely worthless distraction.

Me as a mildly-Cernuschian free-banker
I have long thought and said that under laissez-faire that the economic effects of the practice would be negligible, yet I must confess to having incorrectly given the impression of sharing the Chicken-Little attitude should there be the slightest deviance from 100% reserves – to the extent I gave such an impression, I was wrong. Under laissez-faire, without the requisite sophisticated technical knowledge coming into the hands of influential persons in the treasury departments of major corporations and governments, economies with reserve ratios once again in the 30-50% mark can be stable and prosperous with only a few obsessives (eg me) capable of and interested in pointing the pointlessness of the practice and its slight detraction from stability. If there are booms and busts in a laissez-faire economy, I wouldn’t finger FRB in principle and would be first inclined to look for government interference domestically and abroad – but I would however also wonder if a few key bankers dealing with an economic bottleneck of some kind had lowered their reserve ratios quietly and significantly. The circumstances of each case would give its own indications of where to look first.

In terms of simple retail banking practice alone, its existence under laissez-faire is thus almost a non-issue, where what is of much greater concern under such conditions is the correctness of economic theory. This is because the failure to understand the pointlessness of fractional reserve banking implies failure to understand capital-formation theory and monetary theory properly, and that in turn is bad news for those of us with practical interests in hiring graduates to apply these theories to real-world financial matters. Of course, such erroneous thinking by others also opens the door for us to exploit opportunities for profit...

I am therefore technically a free-banker... but in the vein of Cernuschi as applied to demand deposits as well as banknotes, though I would not be so cynical as to think that the events that would drive fractional deposits or notes to extinction would be tumultuous – sociopolitically controversial perhaps, but not economically troubling. Banks should be left free to offer both fractional savings and transaction accounts (as they do today, and which blurs the distinction between them), wherein customers holding them are creditors, and also to offer both non-monetised savings accounts and non-fractional transaction accounts (which returns the distinction to sharpness), wherein customers holding the latter are bailors. Laissez-faire also means that the rest of us should be free to discriminate against others based on their choice of accounts (hence that controversy), to demand that payments be made to and from only non-fractional transaction accounts, and so on – and that, the strong hand of major-corporate third-party influence (more controversy) and not retail second-party depositor revolt alone, is what I think the mechanism for the death of fractional banking under laissez-faire will consist of. Let freedom reign - laissez-faire first, full-reserve later.



  1. I urge you, Mr. McVey, to look a bit harder! The article you link isn't at all germane to the topic, though plenty of other works written by White and myself (as well as White's book, _Free Banking in Britain_)are. In fact, fractional reserve banking has flourished under a great number of settings in which there was no hint of artificial government support for it, or of barriers to 100-percent reserve banking. (Look, for instance, at Canada's experience before 1935, or that of Sweden before 1901; or that of Switzerland in the 19th century; or..well, the list really is very long.) It is, rather, the 100-percent reserve folks who are hard-pressed to find _any_ historical instance in which their preferred system actually prevailed. Nor, so far as I'm aware, has any of them ever identified a law imposing a _maximum_ rather than a minimum reserve ratio on banks.

    In other words, wondering about whether there's any historical evidence of fractional reserve banks operating under relatively laissez-faire conditions, while suggesting that 100-percent reserve banks ever did so, is rather like wondering whether jet planes could ever prove as successful as the Hindenberg.

  2. I will, sir, and I'll get to your work when I can.

    Nor do I doubt that you are correct about historical instances of the practice being safely present in flourishing economies - it looks as though you think I am over-accepting of the kind of view of history shown by de Soto, which was only raised as a contrast to Publius' claims. The job I set for yours was in showing the questionable nature of that view of history. I am quite happy to accept that FRB can exist in stable and flourishing economies under laissez-faire indefinitely without causing any trouble, hence my apology for a previous Chicken-Little impression. The point is that history can only take one so far and no further, to the consternation of both sides of the issue. Taking the final step and coming to a definitive conclusion about FRB requires integration with concepts and principles drawn from observations of the natures of men and things, where the key ones in this topic are valuation and the drivers of real-capital formation. I've done that for myself to the point of being able to make a pronouncement of "This is so." and still leave room for legitimate fringe applications.

    Speaking of which, I have seen the argument regarding meeting an increase in demand for money with more supply by bankers - an argument that you and Professor White use, too, IIRC. So far as I have read of it (admittedly little), at best it indicates a place for merely occasional and short-term deviations from 100% in small communities wherein the market for specie is thin and its purchasing power overly volatile. It doesn’t support permanently fractional reserves under any circumstance, and will achieve the opposite of its intended purposes if attempted on the scale of a single moderately sized community on up.

    My thoughts about the latter are that bankers’ actions would “fuzzify” signals for fundamental market variables far more than they would facilitate smoothing, particularly (but not exclusively) the costs of capital and the purchasing power of a unit of money. I believe it impossible for bankers to obtain information quantitatively and timely enough to get ahead of an entire large economy. Subsequent to what action they do take, and to the extent that bankers are seen messing about with the money supply and not letting rates of credit-interest fluctuate the way they should, it will then increase uncertainties in proper determination of those key variables and so lead to additional risk-premiums. Capital providers and users will then change their minds about plans and strategies, engendering wholesale shifts in spending patterns, thus invalidating much of whatever information that bankers do have. For the idea to work on a systemic level it would require that bankers have information-gathering systems to rival even national-governments' Intelligence services and be able to make super-genius chess Grandmasters look like simpletons - and that's not even bringing the zig-zag of interbank competition into it. Of course, this is just the loose thoughts I have only had off the top of my head (and can cram in a comment) rather than properly worked though. And for all I know I mightn’t be in the slightest bit original here anyway (I have not read what you have had to say, for instance).

    So, Professor, I stand by my judgement: FRB is useful only for occasional fringe applications, but not whole economies on a permanent basis. If you think the thoughts of a nobody such as myself are worth addressing and me worth speaking to, I ask that you deal with what I hold as the fundamental issue: real-capital allocation decisions by free-and-clear beneficial owners of resources.

    Yours sincerely,
    John J McVey

  3. The advantages of a (properly regulated--which is to say not over-regulated) FRB system go far beyond those of a system capable of varying its reserve ratio to accommodate changes in money demand. They have to do with the lower opportunity costs and higher intermediation rates an FRB arrangement is able to achieve. For the basic arguments, see Adam Smith, Wealth of Nations Book II chapter 2. For the history see Rondo Cameron and coauthors, Banking in the Early Stages of Industrialization. According to these sources (and there's a lot more), to have restricted past economies to 100% reserves would have meant condemning them to permanent underdevelopment.

    I've said it elsewhere and I'll repeat it long as I have to: the Rothbardian-Huerta-De-Soto-Hoppe et al. 100-percent reserve arguments are as irresponsible as they are ill-informed, and the sooner free-market types distance themselves from them the better.

  4. I didn't say that was all there was to the argument for it, I was giving more detail on a particular argument you've written about and which I had briefly touched on in the main piece. It was, however, my mistake to presume people had seen that I'd written earlier material, so I have now included the back-links as I should have done before.

    There is a distinction between the past and the present. I have my doubts about its absolute necessity in the past, though maybe it was in eras when people lacked sophistication (I'm still dubious). But, as I said to the ranters about fraud and theft, the past is just that. In terms of individuals, I think most people more than sophisticated enough to handle different savings and transactions accounts without difficulty, and are more than capable of judging for themselves what kind of savings plans they will make and what monies they will expressly permit banks to lend from via non-monetised savings accounts. In terms of whole economies, in Australia as of June 2010 there are only about $A200b in demand deposits but outstanding capital held just by financial institutions of almost $A4T. The extra has been funded by non-fractional financial activity, spread across the whole range of product types and maturity lengths. There is simply no inherent need to borrow from the demand deposits in transaction accounts to provide funding, either in aggregate or in component, or to have a modern economy with an efficient financial sector.

    As to those authors, I can only again reiterate that I did not draw any of my thoughts from what they have had to say and that occasional correspondence is coincidental.