Blogs > Liberty and Power > My FEE Lecture on Fractional Reserve Banking

Aug 7, 2008 1:11 pm

My FEE Lecture on Fractional Reserve Banking

At another Foundation for Economic Education event in mid-July, the Young Scholars Colloquium, I gave a lecture provocatively entitled"Why Fractional Reserve Banking is More Libertarian than the Gold Standard." Since both Bryan Caplan and Larry White have given it nice plugs on their blogs, I might as well do so myself. You can find it here, along with all the other podcasts from this summer's FEE seminars, including some by Bryan and Larry, and all those from the History and Liberty seminar mentioned in my previous post.

returned to the subject of my lecture, discussing a question he had posed to me during the seminar's recorded Q & A:"Agree or disagree: In developed countries during the last 10-15 years, central banks have become (close to) the most efficient state enterprises." After some hesitation, I had to reluctantly agree, despite my unequivocal advocacy of the Fed's abolition. But I throw the question open to discussion: what is your candidate for the least inefficient state enterprise?

Bryan of course approves of my answer, which is why he posed the question. But his reasons are somewhat different than mine. He gives two in his post: (1) the public's exaggerated fears of inflation partially offset the time-inconsistency problem that would otherwise cause central banks to generate higher inflation; (2) central bank independence allows them to rely more on economists, who do a better a job than mere mortals.

I have already questioned the claim that the public exaggerates the danger of inflation relative to economists in an ECON JOURNAL WATCH article. Economists only consider inflation's deadweight loss, ignoring inflation's transfer, which bothers the public just as much and just as reasonably as the transfer from the income tax. Does it really make sense to say that the public hates taxes too much because most of the extracted revenue is just a transfer?

Bryan's second reason really combines two points, one with which I agree and one with which I disagree. I do think central bank independence is important but not because it results in employing more economists. The economists I know seem to be just as susceptible to incentives as the general public. They may cast more intelligent votes, where as Bryan argues incentives are weak, but I don't see how it follows that they will make more public-spirited (i.e., welfare enhancing) decisions when faced with the temptations of power.

Here are my three reasons, given somewhat sporadically in my lecture, for the better performance of central banks in developed countries since the 1980s:

1. Highly developed financial systems with widespread fractional reserve banking have reduced government seigniorage, even at double-digit inflation rates, to a trivial source of revenue. (During the Great Inflation of the 1970s, direct seigniorage never covered more than 2 percent of the U.S. government's outlays.) This greatly diminishes the incentive for central banks to generate high inflation.

2. Globalization and international competition have approximated Hayek's world of competing private banks issuing fiat money. The major difference is that we have competing central banks. Investors can fairly easily move from one currency to another, which means the market immediately prices changes in central bank policy and punishes them when necessary. Central banks are still the major noise traders in the interest-rate and foreign-exchange markets. But whenever a central bank goes up against speculators and tries to seriously misprice its currency, the central bank almost always loses and the speculators almost always win. This tends to discipline central banks.

3. Central banks are freer to respond sensibly to this growing international competition and market discipline because of their political independence.

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Anthony Gregory - 8/9/2008

Then what has been the impetus for the massive devaluation of the dollar since 1913? Do you believe in a free market we'd see a similar devaluation?

Anthony Gregory - 8/9/2008

What I mean is, given that there is a state (which is the only reason to defend fractional reserve banking on the basis that it limits the state's willingness to inflate), would not a state banking system bound to 100% gold reserves limit inflation more?

And what do you mean that total government spending is lower than in most of the world's welfare states? In per capita terms? Government in the US spends more in absolute terms than any other government.

Jeffrey Rogers Hummel - 8/9/2008

Fred Foldvary emailed me an intriguing answer to the question of what is the least inefficient State enterprise. He suggested “the production and sale of postage stamps to collectors. Collectors are able to buy mint stamps from the postal services of many countries, subscribe to automatic orders, and view the stamps in beautifully produced catalogs and web sites. The USPS has booths at stamp shows and always has eager customers. The USPS sells mint stamps to collectors at face value without having to provide postal services. It costs a few pennies to produce a stamp that sells for 42c. That's better margins than most businesses. The topics on stamps are crowd pleasers--cartoons, space, art, state flags, Christmas designs. If all government were run like the sales of stamps to collectors, we really would love Big Brother.”

Jeffrey Rogers Hummel - 8/9/2008

Bank created money does not contribute directly to government seigniorage. So, yes, most of that money does in fact end up on Main Street. Of course, by making the inflation rate higher for any given level of real seigniorage, fractional reserve banking could marginally increase both real government tax revenue, through bracket creep, and the real reduction of government debt, to the extent the inflation is unanticipated. But this hardly gives the general public an incentive to clamor for higher inflation.

Jeffrey Rogers Hummel - 8/9/2008

What do you mean, Anthony, by being bound by hard money? 100 percent reserves or fractional reserves? Government-managed gold standard such as under the Federal Reserve before the Great Depression, or a completely privatized monetary system such as the U.S. has never enjoyed?

As for your second question: if the dollar were not the world’s reserve currency, whatever exactly you may mean by that, my answer is “yes, the U.S. government could easily get away with as much warfare and welfare.” Total government spending in the U.S.-national, state, and local--is lower than in most of the world’s welfare states, and until the Euro’s success, none of their currencies competed with the U.S. dollar as a reserve currency in any sense I can think of.

Bill Woolsey - 8/9/2008


I think hummel did a good job of giving an explanation why the "free banking" view is correct in comparison to the "100% reserve banking view."

I was lucky enough to have David Friedman teaching my money and banking course in 1976 (or 1977.) So I came to understand the flaws in the "fractional reserve banking is fraud" view early.

Bill Woolsey - 8/9/2008

If money is measured narrowly, as currency and fully checkable deposits, the money multiplier is about 1.6 (nothing like 10.)

The actual reserve ratio for banks against checkable deposits is about 7% (not 10%, though that is the legal marginal rate.)

The currency depsit ratio is about 110%. (Yes, there is more currency outstanding than total checkable deposits.) About 800b of currency vs. 600b of "checkable deposits."

However, there are tremendous problems with the measurement of checkable deposits. Most importantly, sweep accounts move funds out of checkable deposits before the amounts are reported.

Savings accounts are more like 4 trillion. And CDs about 2 trillion.

I mention this for two reasons. From the point of view of the banks, the sorts of "checkable deposits" against which the 7% reserves are held are only a small part of the funds raised by banks. Require 100% reserves for those funds isn't quite the same thing as imagining banks as storage facilities for currency.

Savings accounts are payable on demand in practice. There are no legal reserve requirements for them. They are the major source of funds for banks today. But, of course, most are subject to limitations on withdrawals too. (I think I can make 3 per quarter without paying a fee.)

The MZM measure of the money supply counts all money market mutual funds and savings accounts along with currency and official checkable deposits. The money multiplier there, oddly enough, is close to 10. But nearly all of those deposits have no required reserve ratio at all.

Anyway, I teach the 10% reserve requirement, money multiplier as 10, imagining banks finance their loans with checkable deposits scenario. I do review all of these figures as well with my students.

Anthony Gregory - 8/8/2008

Do you think the government could get away with as much warfare and welfare if it were bound by hard money? If the dollar were not the reserve currency of the world?

Jeffrey Rogers Hummel - 8/8/2008

Past Fed monetary policy, in my opinion, had little to do with the current financial crisis. The Fed played a bigger role through its lender of last resort activities and promises to counter asset-bubble collapses, but this fostering of moral hazard was still not the primary causal factor. The answer to your second question is an emphatic "no"! The Fed's contribution to current U.S. imperialism has been negligible to non-existent.
By the way, Bryan Capaln has responded to my post on his own blog.

Anthony Gregory - 8/8/2008

You say that governments have less incentive to inflate the money stock under fractional reserve systems because for every dollar they create, ten (or however more) dollars are now available to the public. But doesn't the government inflate and spend much of that new money on its own interests? It doesn't all end up on Main Street. And doesn't this give even more people an incentive to see inflationary spending and monetary policy — doesn't it democratize the incentives for inflation?

David T. Beito - 8/7/2008

I have listened to the entire lecture and it has much food for thought. Do you think that the Fed has produced significant economic distortions in the last decade? Do you think that there is any merit to the argument that the Fed has been used a device to subsidize foreign empire?