Selgin Interviewed

by Don Boudreaux on May 9, 2009

in Monetary Policy

Here's an eye-opening interview with George Selgin, one of today's premier scholars of money and banking.   You'll not regret reading it in full.

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{ 49 comments }

dg lesvic May 9, 2009 at 7:08 am

If I recall another piece of his correctly, Selgin had distinguished between two different kinds of "deflation," i.e., a lowering of prices, the one caused by technological progress, and the other by central bank policy reducing the money supply.

The former was good, and should be left alone, and, the latter bad, and should be counteracted by the central bank, trying to get things back to where they were before it intervened.

But that clock cannot be turned back. The market has adjusted to the new quantity of money, and changing it again would just distort the market again, and not correct but compound the evil.

George Selgin May 9, 2009 at 7:31 am

Note to dg lesvic: In fact I've never said that "bad" deflation should be "counteracted." My position is that it is best _avoided_. In other words, I entirely agree that, once demand-driven deflation has happened, there's nothing to be gained by making prices rise again.

dg lesvic May 9, 2009 at 7:44 am

Prof Selgin,

Sorry for having misrepresented you, and thanx for the correction, and for all your great work.

vidyohs May 9, 2009 at 8:44 am

"Free banks compete, as it were, on an even playing field in issuing paper IOUs, which are basically what banknotes are. They have to redeem those IOUs on a regular basis: The competition among different issuers means that their notes will be treated the same way that checks are treated by banks today."

Great interview and I learned a lot from it. However in the quote above Prof Selgin makes this statement, "They have to redeem those IOUs on a regular basis:", my question is redeem them in what medium, precious metals, real property, if I held their notes and wanted to redeem them, what would I walk away with after having done so? What would make me feel I had real value on the redemption?

I realize this is probably a simple question to those who have studied economics, but to me here on the street it isn't obvious.

George Selgin May 9, 2009 at 9:01 am

For vidyohs: A perfectly good question. Bear in mind that, contrary to what some imagine, commercial (as opposed to central) banks aren't in the business of creating new monetary standards. Instead, they do business in whatever an economy's established standard money happens to be. In actual free banking arrangements of the past, this meant gold or perhaps silver coin and bullion. Today, of course, it would mean some standard fiat money issued by a central bank.

So, a Scottish bank ca. 1820 would have been obliged to redeem its notes in gold coin (though for interbank settlement purposes short-term bills payable in London were routinely accepted instead), while restoring the right to issue notes to U.S. banks today would oblige them to redeem those notes in Federal Reserve dollars, that is, in the same medium into which commercial bank deposits are presently redeemable.

vidyohs May 9, 2009 at 9:11 am

Thank you sir,

So if I did due diligence on the bank I chose to do business with, I would ask and determine in what medium they redeemed their notes, and satisfy myself that that redemption would be in some medium I value, even if it is in paper money from another bank that has known large precious metal reserves.

Makes sense to me. Again thank you.

George Selgin May 9, 2009 at 9:35 am

For vidyos: You would get back the same medium the bank received from you on deposit in the first place, that is, whatever happened to be the economy's most basic, generally accepted medium of exchange. If you've ever deposited money in a bank, you effected a transfer to it of FR$ (generally this transfer occurs on the books of the FRS, rather than through any actual movement of paper dollars). Then, when you wanted to take money out, you were entitled to the same stuff you gave the bank in the first place. I don't suppose you ever bothered to ask what you would get back–you simply took it all for granted. If today your bank were entitled to issue its own paper IOUS, you might exchange some deposit credits for them instead of taking actual FR$; but you or any other holder of those notes would also be entitled to claim FR$ with them.

vidyohs May 9, 2009 at 10:01 am

As depositer your explanation is logical. But, to help me out, if I come into possession of a particular bank's self issued notes, and wanted to redeem them, I would get what the original depositer placed on deposit, yes?

This would require me to do due diligence on a number of banks before I accept paper notes from any one of them.

I like your idea, but I must say that I think it would make people acutely aware of what they were doing with their wealth and/or in what they were accepting as payment for goods or services; which is not a bad thing when you get down to it.

Can we legitimately assume that it might well be difficult on a traveler to do business (food, lodging, entertainment, transportation) in regions he passes through, when there are a plethora of different currencies in play constantly?

Free banking intrigues me because anything with the word free on it is more agreeable to me than that which is regulated. However, as you see, I have some degree of wonder about its actual workings.

K Ackermann May 9, 2009 at 10:35 am

That was interesting on the bank-to-bank raids. Even depositors could band together to try and force their notes to bear interest.

What eventually led to the disbanding of free banking in Scotland?

Jesus DeSoto wrote something about a strucural flaw in free banking that, if not handled correctly, will eventually nessesitate a central bank. I forget what it was, though.

Martin Brock May 9, 2009 at 11:23 am

I've been Selgin's champion here since his appearance on EconTalk, but needless to say, I'm a skeptic by nature, so I can't just come here and agree with him.

The very fact of the bank’s invoking the clause tells panicking customers that it’s solvent, because if it weren’t, it would make more sense for its owners to go ahead and wind it up.

What about Madoff? If I deposited a FR$ in his "bank", he promised me a 10% annual yield as long as I didn't withdraw the dollar, and this policy worked for decades.

If Madoff didn't want to go to jail ultimately, it made more sense for him to wind up his fund much earlier, but he didn't, so either 1) he wasn't so bothered by the prospect of jail time in the indefinite future as he lived like a king and passed around billion after billion of fresh deposits or 2) he wasn't sensible. Either way, the result is the same.

I'm not arguing for a state bank regulator or a central bank here. I'm only suggesting that Madoffs will appear in a free banking system. Proponents of free banking must acknowledge this reality. Losses in a free banking system are not simply theoretical. Some depositors will lose. A free banking system presumes and requires these losses. Human beings have a great capacity for denial. Fear of loss quickly subsides if no one ever loses.

So Selgin may argue only that losses in a free banking system would be modest and less destructive than the other sorts of loss experienced in the U.S. system with its deposit insurance and other state guarantees.

Why can't statesmen somehow eliminate even the modest losses of a free banking system through some mandatory "insurance" scheme, by making taxpayers liable for the loss? Why can't politicians spread the pain or limit it to factors that suffer it least?

TrUmPiT May 9, 2009 at 1:15 pm

"I'm only suggesting that Madoffs will appear in a free banking system."

Thieves will appear wherever and whenever they think they can get away with it, and the cost of getting caught are minimal or perceived as such. Bluecollar crime like actual bankrobbing with a gun is usually punished much more than whitecollar crime by the bank president when the amount stolen is usually much much higher and the victims are more dispersed. That is part of the reason we have scandals like Enron, Worldcom, etc.

The extraction of gold is usually very destructive to the environment. A recent issue of the National Geographic laid this fact bare. No one with any concern for the environment or people's heath, should considered using gold for anything short of for dental restoration purposes. That means that gold jewelry should be heavily taxed like cigarettes or better still outlawed. Any suggestion of a return to a gold standard is obscene for environmental reasons if not for purely economic ones.

Sam Grove May 9, 2009 at 2:19 pm

The extraction of gold is usually very destructive to the environment.

The extraction of any substance can be destructive to the environment. The key is to make sure the costs of destruction exceeds the cost of avoiding the destruction.

IOW, internalize the externalities.

Lee Kelly May 9, 2009 at 3:09 pm

Jesus DeSoto wrote something about a strucural flaw in free banking that, if not handled correctly, will eventually nessesitate a central bank. I forget what it was, though. – K Ackerman

Politicians?

Lee Kelly May 9, 2009 at 3:20 pm

I like Selgin. This is a good interview. Thanks for posting!

Cheers May 9, 2009 at 5:11 pm

"Why can't statesmen somehow eliminate even the modest losses of a free banking system through some mandatory "insurance" scheme, by making taxpayers liable for the loss? Why can't politicians spread the pain or limit it to factors that suffer it least?"

Because any attempt to spread or insure even minor losses results in changes in behavior that cause massive compounding of the loss. Even when a person has to bear the consequences personally. A great example of this is dental insurance. It's actually extremely common for individuals entering a sponsored dental insurance plan to go to the dentist LESS frequently, despite the potential for painful operations to fix cavities, root canals, etc. The same applies to regular dental work. Individuals with comprehensive irrevocable health insurance take more risks with their health.

Just like Russ/Don re-posted a few days ago regarding the meal choices at a restaurant. Even the smallest of redistribution or cost avoidance causes massive changes in preferences and increases in costs.

K Ackermann May 9, 2009 at 5:51 pm

@Lee – LOL! Politicians would qualify as structurally flawed, that's for sure.

K Ackermann May 9, 2009 at 5:55 pm

Just like Russ/Don re-posted a few days ago regarding the meal choices at a restaurant. Even the smallest of redistribution or cost avoidance causes massive changes in preferences and increases in costs.

I think CDS's have a large effect in the same way. Instead of doing the homework when evaluating risk, investors get lazy and hedge. It might all come out in the wash, but it still may play a subtle roll in forming bubbles of risk.

Cheers May 9, 2009 at 7:30 pm

I can see the possibility, particularly if they are inappropriately discounted. But if their price was to realistically represent long-tail risk (or whatever you want to call it) I would imagine that the cost would be painful enough for an investor to consider the cost savings by doing additional homework.

I say this, because on any hedge, an investor (at least one with a reasonable financial background) is essentially spending his return, and outside of an arbitrage situation, you're desperately trying to hold onto that number with both hands.

To be honest, I wish I had a little more practical experience with the CDS market over the past 2-3 years. I still hear these stories from people about everyone following the ratings agency, or a single risk number. When I studied finance a few years ago under one of the better market analysts, he had us breaking down the numbers within stock risk and market risk, and stock to stock/market/portfolio risks for each combination in a portfolio till our fingers bled. The notion of using a ratings agency or even just relying on a single alpha and beta calculation was considered absolutely ridiculous.

Martin Brock May 9, 2009 at 7:41 pm

Because any attempt to spread or insure even minor losses results in changes in behavior that cause massive compounding of the loss.

You're suggesting that market insurance also causes massive compounding of the loss? Do you have quantitative evidence supporting this assertion? Are Canadians massively sicker than Americans?

Cheers May 9, 2009 at 7:58 pm

I'm suggesting that costs become compounded by the customer's "bad" behavior. The examples given were anecdotal.

If I had to state a thesis it would be that when involuntary insurance or risk spread occurs (ie: any mandatory system), it causes consumers to behave more riskily by a proportion of the costs that are covered (but reduced by the personal impact that can't be spread – ie: personal pain/inconvenience).

Insurance doesn't make a person sicker, it makes them utilize resources that they don't normally consider "worth it".

Something like Canadian healthcare is a great example. The consequence of provincially-provided healthcare is overuse. In the healthcare-center of Canada (Ontario), the average hospital wait time to triage is 7.3 hours, and time to admission is on average 35 hours. One of the main 2 causes of this is because 50% of ER visits are non-urgent cases that can be taken to a family doctor or a clinic.

Cheers May 9, 2009 at 8:00 pm

oh, for reference, the data comes from the EDRS Data Review, April 2008

Referenced via Ontario's eHealth strategy at http://www.ehealthontario.on.ca/

Martin Brock May 9, 2009 at 8:34 pm

Thieves will appear wherever and whenever they think they can get away with it, …

So the very fact of a bank’s invoking a clause offering depositors additional interest if they don't withdraw does not tell panicking depositors that the bank is solvent. This fact might only tell depositors that Madoff is their banker.

This point raises another issue with Selgin's description. Why are depositors the bank's "customers" rather than the bank's "investors", particularly if they're receiving interest?

Rothbard is right about one thing. If a gold depositor only wants security from his banker, then he pays the banker to guard his gold. The banker doesn't pay him. If the banker pays interest to the depositor, the banker must get something out of it. The depositor must bear some of the risk of the bank's inherently risky business. Right?

So what is the bank's business? The bank monetizes valuable assets, i.e. it creates a monetary record of an asset's current market value at a point in time. This record of value is currency. This valuable service enables market participants to deal in monetary abstractions rather than barter.

So what is money, and how does a banker create it? Money is a record of the value of an asset relative to other assets. Within a commodity banking system, money is a record of the value of an asset relative to a particular commodity (or commodities). This commodity is the standard of value.

A banker creates money by extending credit. For example, I own a house, and you need a house. You don't currently possess sufficient gold or anything else of value to exchange for my house, but I will extend you credit against the value of your labor.

I could extend this credit directly. For example, I could entitle you to occupy the house while paying me installments of gold for a period of time until you've paid the price of the house plus the value of occupying it while I still own it. In this scenario, I collect regular payments from you, and I accept the risk of your default.

A banker extending credit enables to me outsource this debt collection. The banker issues me notes promising me gold, say, in exchange for my house. [The banker issues these notes to a borrower who then exchanges the notes for my house.] The banker need not possess the promised gold. He must only believe that he can exchange my house for the promised gold if necessary.

Although the banker need not possess any gold to provide this outsourced credit service, he needs some reserve of gold to meet demands of his note holders as a practical matter, for two reasons.

First, the banker cannot exchange houses and other assets securing his credit for gold immediately. Liquidating these assets takes time.

Second, the banker possibly cannot exchange particular assets securing his credit for the gold he promised at all, since he can promise more gold than the assets ultimately are worth.

By providing gold, a bank depositor enables the banker to meet demands of his note holders, and the depositor thus shares the risk inherent in the second stipulation.

Although depositors receive banknotes for their gold, the banker's note holders are not only or even primarily his depositors. The note holders are the persons outsourcing their credit to him. The banker's notes do not represent the gold of his depositors at all. The notes represent the value of other assets that the bank has monetized by extending credit.

So these persons outsourcing their credit to the bank are the bank's customers, not the depositors. The depositors are among the bank's investors; otherwise, they cannot expect real interest.

Bill Stepp May 9, 2009 at 8:43 pm

Regarding Madoff, we might point to the SEC's auditors' seal of approval (over the strenuous objections of one outside money manager, who had done considerable diligence on Madoff's fund). We can't rerun history, but I can't help but think that without the SEC, investors might well due more rigorous due diligence on publicly traded firms and mutual funds. In this regard, the SEC might create a sort of investors' moral hazard, akin to that created by the FDIC in the banking system.
Granted, there are differences–depositors are insured for up to $250,000 per bank account, whereas none of Madoff's clients had such (or any) guarantee of getting back lost funds. Still, to the extent that investors drop their guard and think of the SEC as bestowing a seal of approval on the firms they oversee, this might cause problems thaat would be mitigated with no SEC.
In the pre-SEC era investors were defrauded to be sure, but none on the scale of Madoff or Enron, to the best of my knowledge.
So abolish the SEC!

Martin Brock May 9, 2009 at 9:22 pm

We can't rerun history, but I can't help but think that without the SEC, investors might well do more rigorous due diligence on publicly traded firms and mutual funds.

We can remember history. Ponzi existed before the SEC.

Freer banking could be more useful than the current system, but a utopian pretense is intellectually dishonest. Proponents of free banking must argue that occasional losses are a price worth paying. Persuading the losers themselves is practically impossible, but if we simply pretend that free banking produces no losses, we're hardly more honest that than the Madoffs and Ponzis.

Bill Stepp May 9, 2009 at 9:29 pm

Ponzi was a piker compared to Madoff.
Just as business cycles were worse under cental banking than under free banking, so too was fraud bigger and badder in the SEC era than before. At least so I'm semi-educated guessing.

Gil May 9, 2009 at 11:40 pm

I think M. Brock practically hits the nail on the head. The problem is implied in George Selgin's article – there's not enough gold so people start issuing paper that's "as good as gold" which is impossible since there wasn't enough gold in the first place. So even in the hypothetical nature of 'free' money, it will go from gold to gold standard to paper standard to fiat money. Bank runs and people realising they're holding worthless paper will both still occur. After all, the purpose of commodity money is the way the money is valuable in itself. If a country issues one-ounce gold coins as currency but the country goes belly-up then, at the very least, you are still holding one ounce of gold that valued almost all around the world. However, if you are holding a piece of paper regardless of what, if anything, it redeems then, at the end of day when the issuer has gone belly-up, you're holding nothing but a piece of paper that no one finds valuable.

BTW: The answer I have read as to "what is the purpose of banks?" is to taking the money of savers and giving it to investors with which banks hope to make a profit and pay the saver interest. It's amazing the people even today get surprised when they hear the money listed in their bank statement isn't sitting on a table and the bank statement isn't a inventory list but an I.O.U..

Martin Brock May 10, 2009 at 12:44 am

The problem is implied in George Selgin's article – there's not enough gold so people start issuing paper that's "as good as gold" which is impossible since there wasn't enough gold in the first place.

No. The promissory notes in the example above represent the value of a house, not the value of gold on deposit in a bank. The notes say "pay so much gold on demand" only because the value of everything is measured relative to the value of gold, because gold is the standard of value.

The bank's gold reserve only exists to meet the current demands of note holders for gold. If a bank runs out of gold to meet these demands, it's insolvent, but its notes are note then worthless, because the notes represent real assets, other than gold, securing the bank's credit, assets like the house.

To obtain the value in gold of its currency, the bank must liquidate its assets. For example, it could require the mortgagor on a house to provide the gold, possibly by selling the house for gold. In principle, if the bank is sound, it can raise sufficient gold to cover all of its notes this way.

All banks can't raise sufficient gold to cover all circulating notes at the same time, but this fact is irrelevant. If everyone, all at once, decides that they want to hold gold and only gold, then the price of gold essentially becomes infinite, and a gold standard is simply meaningless.

In other words, a bank is sound if the current value of all of the assets securing the bank's credit is at least the value of all of its circulating notes. This value is not the value of the bank's deposits. It's the total serviceable debt owed by the bank's borrowers. These serviceable debts are the bank's capital. The bank's deposits are not its capital.

In principle, every circulating banknote represents some specific asset of real value. In principle, banks could account for these assets, so if you wanted to know what real asset your dollar represents, you could enter a serial number on the note at some web site and retrieve the asset. The query might return "0.001% of the house at 123 Main St. in Albuquerque, NM" or "2 minutes of the labor of John Smith of Cedar Creek, AK". Monetary authorities presumably don't keep these records, but they could in principle.

… the bank statement isn't a inventory list but an I.O.U.

In a sense, it is an inventory list, but under a gold standard, the list includes many valuable assets other than gold.

Gil May 10, 2009 at 1:57 am

There's nothing wrong with calling a certain piece of paper an 'I.O.U.'. Unfortunately, goldbugs in particular, talk of dollars as 'nothing more than I.O.U.s' – i.e. something that is pretty much worthless. But an I.O.U. is merely a promise to pay and if the would-be payer does make good on the I.O.U. then it's all good. However, the commodity value (which I pointed out before) is the only difference between commodity currency and token currency. Hence if the contract of whatever makes the currency valuable is broken then a person with a goin coin is still holding something valuable whereas someone who is holding paper money isn't. In other words, commodity money has 'collateral backing' in the sense there's a mystical value tied to gold that almost everyone around the world holds it to be valuable.

andy May 10, 2009 at 3:33 am

Martin: "Proponents of free banking must argue that occasional losses are a price worth paying. Persuading the losers themselves is practically impossible, but if we simply pretend that free banking produces no losses, we're hardly more honest that than the Madoffs and Ponzis."

Gil: "Thieves will appear wherever and whenever they think they can get away with it, …"

I think you didn't counter that point. Madoff occured now, when there is no free banking. You would have to argue that there would be MORE successful thieves in free banking system then now. You do not claim such thing, do you?

Gil May 10, 2009 at 7:42 am

Um, it was Trumpit writing about "thieves will appear wherever . . ."

Audrey the Liberal May 10, 2009 at 9:50 am

Dear kind folks at Cafe Hayek,
I have the attention span of a gnat, could some one please sum-up the article for me?
Love,
Audrey the Liberal

Patrick Barron May 10, 2009 at 11:17 am

With all due humility, I disagree with Selgin. Specifically I disagree with his statement that "they overlook overwhelming proof of the benefits that fractional reserve banking has brought in the way of economic development by fostering investment." There is no theory behind this statement to support his claim that fractional reserve banking fosters investment, and there is the excellent theory of the Austrian Business Cycle that fractional reserve banking leads to credit expansion not supported by real savings, which leads to the boom/bust business cycle. Prior to central banking, which was designed as a means for banks to escape the consequences of their fraud, customers made "runs" on their banks when they thought that their banks had engaged in fractional reserve banking. I think the proof is the fact that the definition of a unit of a money substitute, such as the dollar, is that it represents a definite amount of gold, the real money, on deposit. If there are more dollars, the money substitutes, issued than gold, the real money, then those excess dollars circulate as lies. They claim to be dollars (that is, worth one thirty-fifth of an ounce of gold, for example), but they represent less than that. Furthermore, as for Selgin's claim that fractional reserve banking fosters development, he is making the fundamental mistake that an expansion of the money supply not backed by the legal commodity conveys a social benefit. How? If everyone woke up and their nominal money had doubled, would we have more mines, factories, farms, businesses, etc.? Of course not. Would we create twice as many? Of course not. So how does more money foster these things? Money is merely INdirect exchange. Its use in indirect exchange does not change the essential nature of the economic transaction, which is an exchange of things of value. The first recipients of the new money not backed by the legal commodity get something for nothing, the very essence of theft. It is the responsibility of government to protect us from theft; therefore, it is the responsibility of government to prosecute fractional reserve banking.

Martin Brock May 10, 2009 at 11:45 am

Rothbardian Gold Fetishist to his banker: I wish to exchange this banknote for gold. The note reads, "Redeem on demand for one ounce of gold."

Banker: We're short of gold today, but I can give you 9/10ths of an ounce of platinum, and you may exchange this quantity of platinum down the street for an ounce of gold.

RGF: My note refers to gold. I will only accept gold.

Banker: I can't leave the bank now, but I can exchange the platinum for gold myself later today. If you'll return tomorrow, I'll exchange your note for gold then.

RGF: You're a thief.

Banker: I value your patronage and deeply regret your inconvenience, so I'll exchange a full ounce of platinum for your banknote, and you may exchange this full ounce for more than an ounce of gold down the street.

RGF: You're a fraud.

Banker: Sir, please help me to work through this temporary shortage in our inventory. How can I satisfy you?

RGF: You're a con man. I want you jailed.

Sam Grove May 10, 2009 at 12:41 pm

Monetary authorities presumably don't keep these records, but they could in principle.

The beauty of money.

Rothbardian Gold Fetishist to his banker: I wish to exchange this banknote for gold. The note reads, "Redeem on demand for one ounce of gold."

Is that what Rothbard advocated, that only notes with that claim on it may be issued by banks?

Was Rothbard an advocate of central banking or of government regulation of banks?

Martin Brock May 10, 2009 at 12:52 pm

I'll add a stipulation to the theory of banking I discuss above. If a gold depositor does not receive interest from a banker, then he differs little from the seller of a house accepting the bank's notes, i.e the bank exchanges its notes for some claim on an asset in both cases.

In a sense, the house seller also "deposits" his house in the bank in exchange for notes promising gold. The house deposit is riskier than the gold deposit, since the house is remote from the bank and is less easily secured.

The house seller makes a deposit expecting the banker then to extend credit to a home buyer, i.e. he outsources his own extension of credit to the bank.

The house seller expects no interest on his deposit, not directly anyway. He receives a service from the bank, because the bank services his credit, so the value of this service is his "interest" in a meaningful sense.

The house seller might deposit his notes in another bank (or even the same bank) expecting interest, but he presumably receives a different rate of interest in this case.

The rate of interest differs, because the risk differs. If my bank accepts a gold deposit, my redemption risk only involves the security of my own loans. If I accept a deposit of another bank's notes, the security of the other bank's loans compounds my risk.

Martin Brock May 10, 2009 at 1:07 pm

Is that what Rothbard advocated, that only notes with that claim on it may be issued by banks?

I don't think so. But he argued for a puritanical interpretation of the words. I don't think Rothbard objected in principle to what money is in practice, but he believed that "truth in advertising" would result in a full reserve gold standard in a free (anarcho-capitalist) market.

I think he was wrong about that, because "fractional reserve" banking is a profitable business model. Banks can profit by providing the credit extension service described above, so they can pay interest to gold depositors, and gold depositors will accept risks to their deposits in exchange for this interest. I see nothing wrong with any of that.

Was Rothbard an advocate of central banking or of government regulation of banks?

Neither. He was the original "anarcho-capitalist". I admire Rothbard by the way. I just think he was mistaken on this particular point.

Bill Stepp May 10, 2009 at 1:08 pm

To Audrey the Liberal,

Selgin is correct in writing about the benefits of fractional reserve banking.
FRB, far from being fraudulent, is perfectly consistent with freedom of contract and the rule of law.
Furthermore, there is no evidence that FRB leads to the business cycle. It didn't in Scotland during the free banking era.

Furthermore, money under FRB is a financial intermediary that fosters investment and econmic growth. Without it, we'd have a much lower standard of living and wouldn't have built the capital structure that we are fortunate enough to have.
Rothbard and his "hard money" epigones (and I was a follower of him on this topic until Selgin and White, among others, set me straight) are incorrect as to both the theory of banking and its historical development. Their rendition of the ABCT is also wide of the mark. Mises and Hayek were better on the subject, as are several contemporary writers, such as Steve Horwitz and Roger Garrison.

Sam Grove May 10, 2009 at 6:19 pm

I admire Rothbard by the way. I just think he was mistaken on this particular point.

Well, he didn't have the benefit of discussing that matter with you:)

Obviously, if we had free market banking, then whatever works for people in regard to banking would be provided by "the market".

Kevin May 10, 2009 at 7:36 pm

Banks' business is credit, not money. Fiat money is not necessarily more or less effective than commodity money. Insolvency and illiquidity are not the same. Priced by profit maximizers, insurance does not induce overconsumption.

Persuading the losers themselves is practically impossible, but if we simply pretend that free banking produces no losses, we're hardly more honest that than the Madoffs and Ponzis.

I think the free-banking folks who suggest that free banking eliminates scams and losses are, ironically, very like the SEC and its promise of fairness, transparency, etc.

Bill Stepp May 10, 2009 at 7:57 pm

I think the free-banking folks who suggest that free banking eliminates scams and losses are, ironically, very like the SEC and its promise of fairness, transparency, etc.

I challange you to name one free banking advocate who has claimed that such a system will eliminate fraud and losses. In fact no one has made this claim, at least no one who has studied it much. What we argue is that free banking will reduce them to a tolerable minimum. A free bank can be mismanaged, suffer losses, and indeed go bankrupt just like any other sort of business. No one thinks entrepreneurs in a free market are omniscient; they can make entreprenuerial errors and reap losses. But their calculations won't be adversely affected by the problems introduced under Soviet-style monetary planning, which is exactly what we have with central banking.
Seig heil, Ben!

As I recall the Ayr Bank had some problems in Scotland, for one.

Martin Brock May 10, 2009 at 8:56 pm

I think the free-banking folks who suggest that free banking eliminates scams and losses are, ironically, very like the SEC and its promise of fairness, transparency, etc.

I advocate freer banking myself, along with other reforms (like a marginal consumption tax and expiring titles to property), but I can't advocate it with rosy scenarios. Some bank depositors definitely lose money in a freer system. If not, the system isn't really free and can't possibly offer the advantages that a theory of free banking envisions.

Furthermore, I don't believe that a freer system would be without any system breakdowns. Maybe the systemic problems are less severe, but I'm not sure, because free bankers aren't really the rational, independent actors that an idealistic theory of free banking presumes.

Lots of nominally "independent" bank presidents commanding nominally "independent" banking organizations would still follow irrational rules that human beings tend to follow, even without a central monetary authority dictating these rules, rules like "do what worked in the past" and "hope for the best".

Ironically, the Full Reservists don't advocate free banking at all. They advocate a full reserve gold standard enforced by laws criminalizing fractional reserves as "fraudulent". This Full Reserve regime is an extremely restrictive, centrally imposed regulation of banking and does not constitute a decentralized monetary authority at all.

I definitely oppose this Full Reserve gold banking system, and one problem with a gold standard is that too many people believe that a gold standard is supposed to operate this way or operated this way historically. I'm happy that scholars like Selgin set them straight, but of course, scholarship often reaches few people.

Another problem with a gold standard, even the freer system that Selgin discusses, is that it fixes the price of a single commodity. Fixing the price of a single commodity just seems unstable to me intuitively.

If demand for gold suddenly increases system wide while the price of gold is fixed, all other prices must fall, and this systemic deflation seems destructive to me. Why force countless people to sell their houses for gold just because lots of other people want to hold gold for some reason?

I understand that Selgin doesn't refer to systemic deflation when he says that monetary authorities should worry less about falling prices, but I'd like him to address this point. If many prices fall in tandem for a long period of time, doesn't this deflation disrupt long term credit?

Does Selgin expect price stability with free banking, or does he expect a consistent low level of inflation (as we've had for decades) or a consistent low level of deflation, or does he expect nothing about the general price level and think it doesn't matter?

Martin Brock May 11, 2009 at 7:48 am

I think you didn't counter that point. Madoff occured now, when there is no free banking. You would have to argue that there would be MORE successful thieves in free banking system then now. You do not claim such thing, do you?

I claim not to know. That I don't know the answer is not evidence that you do know it.

I sympathize with the claim that Ponzi schemes might be less successful overall without a central monetary authority fueling a massive corporative state, and I'm extremely skeptical of the utility of the corporative state regardless.

Proponents of freer banking must be clear on several points, because if we aren't, opponents come out of the woodwork to call us "liars" when certain events inevitably occur.

First, "fractional reserve" banking is not a Ponzi scheme and would exist with free banking. We should avoid the term "fractional reserve" altogether by emphasizing that banknotes do not represent gold on deposit but instead represent a bank's capital, the assets securing its loans of money, like the houses and labor of borrowers. Gold on deposit is only a cushion against demands for redemption of the notes when a bank can't quickly liquidate its capital.

Second, people occasionally would lose bank deposits under free banking without any Ponzi schemes. These losses occur when banks extend credit for the purchase of assets with ultimately unsustainable prices.

Third, Ponzi schemes would also exist under free banking, though they might be illegal, so people would also lose money to Ponzis, as they do now of course.

We can't simply declare central banking guilty of every monetary ill, because if we do, we can't explain ills that inevitably occur without a central bank.

George Selgin May 11, 2009 at 10:19 am

Of course individual banks can fail in a free banking system, as they can (and indeed must) be expected to fail in any truly competitive industry. The Ayr Bank's failure was a spectacular example of this in Scottish banking, but the details of that episode only serve to suggest that the Scottish system worked precisely as the theory of free banking claims, with banks taking part in excessive and irresponsible credit expansion being hammered, and others surviving to pick up the pieces.

The problem with modern regulated banking, in case anyone hasn't noticed, is precisely that we don't allow badly managed banks to fail, and to fail as soon as they cease to be solvent. To regard the presence of bank failures (with occasional losses to bank creditors) under free banking as a "flaw" of free banking is thus to display a rather poor understanding of the requirements for long-run banking system stability.

Kevin May 11, 2009 at 12:14 pm

I challange you to name one free banking advocate who has claimed that such a system will eliminate fraud and losses.

My friend Ray does.

Martin Brock May 11, 2009 at 12:40 pm

I challange you to name one free banking advocate who has claimed that such a system will eliminate fraud and losses.

This positive claim is not what I typically see. I instead see free banking advocates dance around losses. They don't claim that losses cannot occur. They rather refuse to address the question of losses while always attributing losses in the current, central banking system to central banking.

This habit is apparent in this thread, and it creates an impression of utopianism even if we'll admit, amongst ourselves, that losses must occur and are even essential to the theory of free banking.

Sam Grove May 11, 2009 at 3:03 pm

Why should banking be regarded any different than other types of industry.

We often claim that failure is an essential aspect of markets because loss is as important a signal as profit.

Implicit in this is the idea that profit and loss, success and failure, are as essential to free banking as to any free industry.

People support centralized banking banking because they believe they will be protected from loss by central authority. Likewise, many oppose free banking because this centralized protection agency will be lacking.

The problem is that by socializing loss (thereby disguising failure), people are led to believe that they have attained total security…until the systemic pressure of these losses results in a systemic failure.

Therefore, the strength of free banking is not that there will be no failure, but that failures, and the signals they provide, will not be hidden from investors and customers, thus keeping them on their guard.

George Selgin May 11, 2009 at 4:27 pm

For Martin Brock: My views concerning "optimal" deflation, and how they jibe with my arguments in favor of free banking, are set forth in detail in my 1997 IEA pamphlet, _Less Than Zero_.

Rafi May 11, 2009 at 4:44 pm

I completely see how fractional reserve banking does good and creates both profits and losses. I also understand Rothbard's point about fraud, but that only exists when there is no explicit contract or when people aren't made aware of the nature of their deposit.

So my question is: Do investment bank depositors create risk for warehouse bank depositors? Is this the origin of 'systemic risk'?

Martin Brock May 12, 2009 at 10:05 am

Selgin's Hayek Lecture at the Mises Institute is a great supplement to the linked interview and the earlier EconTalk. It focuses on coinage rather than banking and credit, but the history is fascinating, and you can see the "three blockheads" coin.

http://www.youtube.com/watch?v=-gn55fTRXZw

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