Quibbles with Fractional Reserve Free Banking

Anthony Evans and Steven Horwitz readily admit that their own understanding of monetary theory is imperfect, and do not even “attempt a rebuttal of [our] claims. ” George Selgin accepts that some of the arguments we put forward in Bagus and Howden (2010) make for “interesting theory”. He fails to rebuff our claim that precautionary reserves are unable to constrain credit creation in a fractional reserve free banking system. While calling for us to provide historical evidence to validate the quibbles we put forward, Selgin himself overstates the evidence. He also claims that we have distorted what he has written, and that we use incorrect monetary theory. These allegations are false. Introduction One would normally be alarmed when faced with wild allegations of academic dishonesty and economic ignorance from not just one opponent, but three. Fortunately in our own case, George Selgin (forthcoming) and Anthony Evans and Steven Horwitz (forthcoming) have enough differences between them that it is uncertain if they can reach agreement among themselves on the issues at stake even without our intervention. After all, the particular flavor of “free banking” that we found quibbles with should be identified before moving on. Selgin is bewildered that we would consider any literature other than his own; Evans and Horwitz cannot believe that we have not consulted the more fringe free banking material, in an appeal that we should have included everything ever written on the topic (while failing to do so themselves). Evans and Horwitz charge that we “impose” our own definitions to bolster our case, and wish to refrain from engaging debate over what definitions other economists use. They eventually recant, and fall back on the use of definitions (especially those used by others) throughout their paper (see especially their section 3: Agreeing on terms). They also think that our article does not warrant “serious academic attention”, while taking the time to write a response to it for a peer-reviewed academic journal and while knowing that there is already a response forthcoming from George Selgin. While Evans and Horwitz deem everyone to have found common ground (at the least) on what the proper definition of savings is, it is clear that they cannot even find agreement with Selgin on the matter. Selgin quite clearly regards saving as the act of holding cash, Evans and Horwitz claim that saving, 1 properly understood, implies non-consumption. The definitional difference is slight but essential. For one can consume a larger portion of his real income when 1 We should note that Evans and Horwitz actually refer to this as their definition of “savings”, which we take them to mean as “saving”. he disinvests while simultaneously holding constant or even increasing his cash balance; cash balances do not have to mirror consumption patterns. (Our own definition of saving, incidentally, agrees with that of Evans and Horwitz.) Besides the quibbles that Selgin, Evans and Horwitz have between them that are largely of no concern to us, both papers in question take us to task for some of the things that we say. We address these points in Bagus and Howden (2011). This paper will largely focus on the things that these authors did not say – not said in the sense that they were the points of our original paper that have been avoided or evaded. In-Concert Expansion: Take 2 Selgin (1988) outlines the limits to credit expansion in a fractional reserve free banking (FRFB) system. The main brake is through precautionary reserves – the need of which increases as banks expand credit, regardless of whether this is done in-concert or alone. We (2010: 34-36) provided three reasons why precautionary reserves may prove insufficient at halting an in-concert expansion. To briefly recap, banks can: 1) use an interbank loan market to cover non-zero clearing balances, 2) lengthen the clearing period so as to reduce non-zero clearing balances (as they tend to zero in the long run), and 3) use credit expansion to increase the negotiability of reserves, thus reducing the risks of illiquidity during credit expansion. Any one of these methods renders precautionary reserves insufficient at constraining inflation. Selgin briefly dismisses the first two methods, while misinterpreting the final method (consequently defending himself against the wrong claim). Let us give this all another try. Can banks make use of an interbank loan market to minimize the amount of precautionary reserves needed? This is the question we posed, and the one that Selgin seems to cautiously affirm. While claiming that we confuse “possible” actions with ones that are in a bank’s best interest, Selgin dismisses the option on grounds that holding on to rival banks’ notes costs a bank foregone interest. He takes a much stronger stance on the issue than he has in the past, whereby he (1988: 117) has only tentatively dismissed interbank lending, as banks “may or may not” choose to lend their excess reserves. Yet, as long-run excess reserves net to zero, there is no interest foregone from interbank lending. Interest that one could earn by remitting their excess reserves cancels out with the interest implicitly gained by not having their notes returned. If we start from an assumption that banks strive to maximize profits, and that they are concerned with not just short-term profits, we see that it is entirely possible that a bank would not redeem its rivals’ notes, and could instead use them to issue fiduciary media. Foregone interest payments may not necessarily concern the bank in question, especially if it focuses on the long run when these interest payments will sum to zero. In response to our claim that banks have an incentive to lengthen the clearing period for reserve balances, Selgin claims that both theory and history agree that no such incentive exists. As we will show, the theory is ambiguous on this (but does not preclude that the incentive exists), while there is historical precedent for just such a strategy. The clearing period used for interbank settlements is concerned with two dueling costs. On the one hand, a higher frequency of clearing reduces the risk of default. On the other hand, higher frequencies increase the costs to clear balances. This increased cost comes as the clearing process itself is costly, and also because clearing balances will be higher the shorter the clearing period. At one extreme of the spectrum, we have a clearing system that never redeems notes (unlikely as it is), and at the other we have a real-time settlements system. Only in a scenario with zero default risk will a real-time settlements system unambiguously dominate a deferred settlement system (Lester 2005). The preferred clearing period depends on the particulars of the economy of interest – in particular, the trust banks have in one another, and the stability of the relevant financial institutions. If default risk remains constant, banks may opt for longer clearing periods to decrease precautionary reserves with no fear that this longer period will increase the costs of default. Alternatively, if it is undesirable to increase clearing periods, the clearing system can achieve much the same result (the reduction in precautionary reserves) by the provision of less costly credit. Hence, banks with negative clearing balances can seek external funding provided through the clearing system to cover their balances in the short run, instead of relying on these balances internally (and which tend to zero in the long run). Does the evidence suggest that banks never pursued this option, as Selgin suggests? Like much historical interpretation, this question is only ambiguously answered. While historical cases of absolute lengthening of the clearing period may be difficult to come by (Norman et al. 2006: 11), this does not imply that clearing periods were not lengthened relative to what they would have been lacking alternative measures. For example, there is a natural tendency for the banking system to shorten the clearing period as it matures. As a banking system develops, notes are accepted over both a broader geographic areas as well as by an increasing number of banks and clients. While the clearing system develops to mitigate the costs of such note exchanges, there is a natural tendency for the clearing period to shorten in response to the wider usage of notes. With an increasing number of banks spread over a wider area exchanging notes, there is an increase in default risk that can be reduced through shorter periods. Thus, even though banks are absolutely shortening their clearing period in response to the growth of their presence, they could be simultaneously relatively lengthening the clearing period in an attempt to reduce the amount of precautionary reserves needed to clear their balances. The appearance of a shortened clearing period for some banking processes is not evidence that banks are not also (paradoxically or not) lengthening the clearing period for other processes. 2 Alternatively, the costs of default can be reduced through a clearing system ready to accommodate liquidity to the necessary individual banks. Incidentally, this is one long-standing theory for the banking system’s own preference for a central bank (Goodhart 1988: chap. 3). If it is undesirable to increase the clearing period of the settlement system (i.e., because default risk also increases with the clearing length), one alternative is for the primary or most liquid clearinghouse to gain the facility to act as the lender of last resort – i.e., become a central bank, by at least some definitions. Incidentally, the expected reserve ratio is also reduced as the cost of intraday credit is reduced, thus allowing for increased amounts of credit to be issued. A central bank coordinating the provision of clearing liquidity reduces the cost of such lending, and increases bank profitability through the facilitation of increased credit channe