December 28, 2011

Editor
The New York Times

Sir,

As you claim that Ron Paul’s belief that the Federal Reserve should be abolished disqualifies him for the presidency (“Mr. Paul’s Discredited Campaign,” December 27), and thereby appear to be convinced that no alternative to the Fed could possibly do better, we wish to alert you to our recent research reaching the opposite conclusion (“Has the Fed Been a Failure?” Cato Institute Working Paper no. 2, forthcoming in the Journal of Macroeconomics). We wonder as well about the grounds, apart from mere a priori convictions, for your contrary opinion.

Sincerely,

George Selgin, professor of economics, the University of Georgia;
William Lastrapes, professor of economics, the University of Georgia;
Lawrence H. White, professor of economics, George Mason University.

I meant to do so weeks ago, but I only just got around to reading the little flurry of posts concerning NGDP targeting that was set off by John Taylor’s critical remarks on the topic. And now, despite the delay, I can’t resist putting-in my own two cents, because it seems to me that much of the discussion misses the real point of targeting nominal spending, either entirely or in part; what’s more, some of the discussion is just-plain nonsense.

Thus Professor Taylor complains that, “if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting.” Now, first of all, while it is apparently sound “Economics One” to begin a chain of reasoning by imagining an “inflation shock,” it is crappy Economics 101 (or pick your own preferred intro class number), because a (positive) P or inflation “shock” must itself be the consequence of an underlying “shock” to either the demand for or the supply of goods. The implications of the “inflation shock” will differ, moreover, according to its underlying cause. If an adverse supply shock is to blame, then the positive “inflation shock” has as its counterpart a negative output shock. If, on the other hand, the “inflation shock” is caused by an increase in aggregate demand, then it will tend to involve an increase in real output. Try it by sketching AS and AD schedules on a cocktail napkin, and you will see what I mean.

Good. Now ask yourself, in light of the possibilities displayed on the napkin, what sense can we make of Taylor’s complaint? The answer is, no sense at all, for if the “inflation shock” is really an adverse supply shock, then there’s no reason to assume that it involves any change in NGDP. On the contrary: if you are inclined, as I am (and as Scott Sumner seems to be also) to draw your AD curve as a rectangular hyperbola, representing a particular level of Py (call it, if you are a stickler, a “Hicks-compensated” AD schedule), it follows logically that an exogenous AS shift by itself entails no change at all in Py, and hence no departure of Py from its targeted level. In this case, although real GDP must in fact decline, it will not decline “much more than with inflation targetting,” for the latter policy must involve a reduction in aggregate spending sufficient to keep prices from rising despite the collapse of aggregate supply. A smaller decline in real output could, on the other hand, be achieved only by expanding spending enough to lure the economy upwards along a sloping short-run AS schedule, that is, by forcing real GDP temporarily above its long-run or natural rate–something, I strongly suspect, Professor Taylor would not wish to do.

If, on the other hand, “inflation shock” is intended to refer to the consequence of a positive shock to aggregate demand, then the “shock” can only happen because the central bank has departed from its NGDP target. Obviously this possibility can’t be regarded as an argument against having such a target in the first place! (Alternatively, if it could be so regarded, one could with equal justice complain that similar “inflation shocks” would serve equally to undermine inflation targeting itself.)*

But lurking below the surface of Professor Taylor’s nonsensical critique is, I sense, a more fundamental problem, consisting of his implicit treatment of stabilization of aggregate demand or spending, not as a desirable end in itself, but as a rough-and-ready (if not seriously flawed) means by which the Fed might attempt to fulfill its so-called dual mandate–a mandate calling for it to concern itself with both the control of inflation and the stability of employment and real output. And this deeper misunderstanding is, I fear, one of which even some proponents of NGDP targeting occasionally appear guilty. Thus Scott Sumner himself, in responding to Taylor, observes that “the dual mandate embedded in NGDP targeting is not that different from the dual mandate embedded in the Taylor Rule,” while Ben McCallum, in his own recent defense of NGDP targeting, treats it merely as “one way of taking into account both inflation and real output considerations.”

To which the sorely needed response is: no; No; and NO.

We should not wish to see spending stabilized as a rough-and-ready means for “getting at” stability of P or stability of y or stability of some weighted average of P and y: we should wish to see it stabilized because such stability is itself the very desideratum of responsible monetary policy. The belief, on the other hand, that stability of either P or y is a desirable objective in itself is perhaps the most mischievous of all the false beliefs that infect modern macroeconomics. Some y fluctuations are “natural,” in the sense meaning that even the most perfect of perfect-information economies would be wise to tolerate them rather than attempt to employ monetary policy to smooth them over. Nature may not leap; but it most certainly bounces. Likewise, some movements in P, where “P” is in practice heavily weighted in favor, if not comprised fully, of prices of final goods, themselves constitute the most efficient of conceivable ways to convey information concerning changes in general economic productivity, that is, in the relative values of inputs and outputs. A central bank that stabilizes the CPI in the face of aggregate productivity innovations is one that destabilizes an index of factor prices.

We shall have no real progress in monetary policy until monetary economists realize that, although it is true that unsound monetary policy tends to contribute to undesirable and unnecessary fluctuations in prices and output, it does not follow that the soundest conceivable policy is one that eliminates such fluctuations altogether. The goal of monetary policy ought, rather, to be that of avoiding unnatural fluctuations in output–that is, departures of output from its full-information level–while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability.

*Over at TheMoneyIllusion Bob Murphy remarks that this part of my criticism of Taylor is “too glib.” He’s right: central bankers can’t be faulted for failing to abide by a rule when that failure stems from their having failed to anticipate what is, after all, a “shock” to demand. But the main point of this part of my criticism is simply that, understood as referring to the consequences of an AD shock, Taylor’s criticism is, not a criticism of NGDP targeting as such, but a criticism of any sort of nominal level targeting that doesn’t allow “bygones to be bygones” when it comes to shock-based departures from the level target (12–1‑2011).

Persons familiar with my writings on monetary reform know that, far from being anyone’s idea of a gold bug, and despite my conviction that those monies work best that governments govern least, I’ve always shied away from arguing that we ought to re-establish a gold standard. Instead, I’ve favored reforms aimed at preserving our existing fiat standard while eliminating the role of bureaucrats, and increasing that of competitive market forces, in regulating that standard.

I respect nonetheless those who, having given serious thought to the matter, conclude that gold remains our best hope. Alas, such people make up but a small fraction of self-described gold bugs. My standard reaction to finding myself within earshot of any of the rest is to look for a more remote and unoccupied bar stool.

But there’s one thing that’s guaranteed to bring out the gold bug in me, and that is ill-informed arguments against the gold standard. No, make that stupid arguments, because the ones I have in mind aren’t merely ill-informed. They are ill-informed in a way that suggests that the persons who make them don’t even think about what they’re saying.

An example of the sorts of arguments I have in mind is this opinion piece from yesterday’s New York Times, in which Eduardo Porter responds to recent pro-gold testimonials of various Republican presidential candidates and conservative talking heads. Such persons aren’t exactly heavyweights when it comes to making good arguments for returning to gold. Yet in trying to show just what lightweights they really are, Mr. Porter mainly succeeds in revealing his own featherweight grasp of monetary economics and history.

For his opening salvo Mr. Porter turns to R.A. Radford’s famous article on the employment of cigarettes as money in German P.O.W. camps, noting how, according to Radford, the prices of other goods sometimes fluctuated dramatically in response to new cigarette deliveries or to cigarettes’ gradual disappearance in the absence of such. This experience, we are assured, proves that a gold standard is a dumb idea since gold, “as money,…share’s tobacco’s basic drawback” of being a commodity.

This would be an unanswerable argument against the gold standard were it not for two minor issues: first, gold isn’t tobacco; second, P.O.W. camps aren’t ordinary economies. Those who plead for a return to gold have a right to be understood to be extolling the merits of a gold standard rather than those of a tobacco standard or a cowrie shell standard or some other commodity standard; and the instability exhibited by any standard in a P.O.W. camp might not supply an accurate indication of the same standard’s likely performance in a more usual economic setting. I would bet, for example, that the real price of cigarettes was subject to more violent changes within the confines of Stalag Luft III than in the surrounding German economy; and after the war the real price of a pack of cigarettes net of taxes, in the U.S. at least, was more-or-less constant until the early ’80s, when it started to rise gradually. (It is now about twice what it was then). Finally, there isn’t even any good reason for supposing that cigarettes were a poor monetary medium for P.O.W. camps, given the available options. Indeed, having often assigned Radford’s article myself in teaching monetary economics, I have always understood its lesson to be, not that cigarettes make crummy money, but that markets are remarkably clever when it comes to expediting exchange. The logical implication of Mr. Porter’s argument, on the other hand, seems to be that by relying on the market the P.O.W.s blew it: it would have been wiser, according to his point of view, for them to have invited their captors to supply, in exchange for some of their precious Red-Cross parcel contents, fiat money especially designed for their use, and backed by a solemn promise to manage the stuff scientifically, so as to best provide for the prisoners’ macroeconomic well-being.

And gold itself? Is its supply in fact subject to the sort of shocks to which P.O.W. camps’ cigarette endowments were exposed? Though Mr. Porter seems to assume so, he offers no proof. Had he bothered to inquire into actual facts he might have learned that by far the most notorious of all precious metal “supply shocks”–the one following Spain’s conquest of the New World–led to the sixfold increase in European prices that has since come to be known as the great European “Price Revolution.” Q.E.D. for Mr. Porter? Well, not quite, because that sixfold increase occurred over an interval of over 150 years, which translates into a continuous rate of inflation of just 1.1 percent–a rate that would have Ben Bernanke and many other modern central bankers squawking about being on the brink of a deflationary crisis.

And what about that other famous gold supply shock started by a lucky discovery at Sutter’s Mill? Well, have a look if you will at a chart showing the progress of the U.S. CPI since 1800 or so, and see if you can pick out the rise in prices this discovery caused. Unless you happen to be on drugs, you can’t, because it isn’t there: there are price jumps, sure enough–in or around 1812, 1862, and 1918–but they all mark moments when the U.S. temporarily abandoned the gold standard, which is to say moments when it embraced the sort of paper standard Mr. Porter thinks so obviously superior to gold. (During WWI, although the U.S. didn’t suspend the gold standard outright, it limited gold exports.) Wars are exceptional, of course. But then what about the CPI lift-off after 1971, when the dollar’s last link to gold was severed once and for all? Is the CPI a Republican plot?

If not, are we not entitled to wonder why Mr. Porter, in assuring us that “the Fed can print dollars at will to meet the growing demand for money as the economy grows,” does not seem to realize that it can, and often does, “print” too many dollars? Are we not entitled to wonder why, in making a case against gold and in favor of paper money, he supplies us with an almost perfectly irrelevant story about tobacco-plus-paper inflation, without so much as hinting at the many far more serious inflations fueled by paper alone? Is “Zimbabwean” inflation to him nothing other than a bogeyman invented by some right-wing talking head? Perhaps Mr. Porter was so absorbed by his vision of P.O.W.s struggling to carry on despite occasional cigarette windfalls that he managed to overlook the damage irredeemable paper monies have done at one time or another to the entire populations of Angola, Argentina, Bolivia, Brazil, Bulgaria, China, France, Germany, Greece, Hungary, Israel, Mexico, North Korea, Nicaragua, Peru, the Philippines, Poland, Romania, Yugoslavia, and Zaire–to offer but a very incomplete list.

But why harp on inflation? After all, fiat money at least has the virtue of hardly ever being in short supply, so that economies need not fear being unable to grow for want of it. In contrast under a gold standard, Mr. Porter assures us, “the economy couldn’t grow faster than the supply of gold.” Evidently Mr. Porter here overlooks another relevant episode in economic history. This episode is known as “the 19th century.”

It’s hardly surprising under the circumstances that Mr. Porter should share the very widespread opinion that the gold standard was to blame for the United States Great Depression. Yet even by his own telling it wasn’t the gold standard as such, but the particular rules by which the Fed administered that standard, that led to the Fed’s failure to prevent the post-1930 collapse of the U.S. money stock. In fact the Federal Reserve’s requirement of a 40 (not 60) percent gold cover for its outstanding notes was not a necessary part of the gold standard but a regulation based on naive ca. 1840 British Currency-School thinking. (In Scotland’s free-banking based gold standard, in contrast, banks managed quite well with specie reserve ratios that varied little from one or two percent.)

The stipulated gold minimum was, moreover, something that the Fed itself had statutory authority to lower, had it considered doing so worthwhile. In fact, it didn’t, because (as Dick Timberlake points out) the Fed never ran up against the 40 percent limit during the crucial, early years of the depression: in August 1931 the Fed’s gold holdings of $3.5 billion were over twice what it needed to meet that requirement; and even at the time of the Bank Holiday in March 1933, despite having endured a run on gold triggered by fear of an impending devaluation, the Fed was sitting on more that $1 billion in excess gold reserves. What the Fed was short of wasn’t gold but what clueless Fed officials, subscribing to the bogus “real-bills doctrine,” considered good private securities, which until 1932 were the only assets eligible for backing its notes other than gold. If Mr. Porter knew his Friedman and Schwartz, he’d know that those authors, among several others, conclude on the basis of such facts that the gold standard was not the cause of the Fed’s failure to combat the Great Depression. Since Christina Romer is among the authors in question, I trust that Mr. Porter will not be tempted to declare that they must all be Republicans.

While the general thrust of Mr. Porter’s essay is that one has to be daft to say nice things about the gold standard, he is generous enough to allow that this might not be the only reason for Ron Paul’s defense of gold. After all, Porter informs us, “much of his [Paul’s] wealth is tied up in gold-mining stocks.” Consequently, Porter reasons, Paul “would certainly benefit if even more American’s caught the gold bug.” But would he? Have a look at any plot of the real price of gold, and ask yourself whether, if you had “much of your wealth” in gold mining, you would be pleading for a return to the gold standard, or pulling hard for a continuation of the fiat-money status quo. Besides not making sense, and being nasty, Porter’s argumentum ad hominem is profoundly silly. Would he have us conclude that Paul is pro-life only because he’s a pediatrician an obstetrician, or that, since he favors drug legalization, he must be long on marijuana, coca, and poppies?

What I find most obnoxious about Mr. Porter’s arguments isn’t that they are arguments against reviving the gold standard (for I recognize good arguments for not attempting such) or even that they are bad arguments. It is that they are both bad and smug; indeed they are bad because they are smug. Starting from the premise that only idiots can favor a gold standard, Mr. Porter imagines that no great effort is required to prove that such a standard is deeply flawed. He then cobbles up his proof, by plucking up a fistful of old anti-gold canards from the murky bottom of google​.com, by recalling an old article describing inflation that wasn’t the fault of some central bank, and by simply asserting his own a priori beliefs. After all, he reasons, why bother to use a tower or ram or even a ladder to assail something that mere wind ought to topple? In fine, Mr. Porter falls victim to the tempting but evidently mistaken assumption that he surely knows more about money than the average right-wing nut.

In case anyone wonders why I haven’t posted for a while, it’s because I’m supposed to be working on my Little Fed Book. I say “supposed to be” because it isn’t the actual writing of that book that’s kept me from posting here. It’s the writer’s block that’s had me in its grip, as it does for a while each time I’m supposed to start a big project.

This time ‘round part of the problem is that I decided to begin by writing about an episode concerning which I knew relatively little: the story of the Second Bank of the United States. Once that was out of the way, I figured, the rest would be downhill. I hadn’t reckoned on the slogging it would take to get elevated in the first place.

I knew the basics well enough from teaching them: the post-1811 state banking boom and subsequent suspensions; the calls for a new Federal bank to see to a quick resumption of specie payments and to supply a “uniform” paper currency; Jackson’s famous veto aimed at foiling its supporters’ attempt to renew the Bank’s charter; and the subsequent “Bank War” in which Jackson and Biddle traded blows aimed in the one case at assuring the Bank’s demise and in the other at undermining the Bank’s opponents by making their actions appear responsible for plunging the country into a depression. I also knew where to look for evidence concerning the Bank’s actual conduct. But the more I studied those sources, the more I realized that I needed a better framework by which to understand the Bank’s relations with state-chartered banks. In particular, I needed to better understand why its relations with Northeastern banks tended to differ from those with banks elsewhere, as well as why its conduct toward other banks changed over time.

When, while straightening up the mess in my office (my favorite writer’s‑block therapy), I happened to come across a paper I wrote in grad school called “A Game Theory Illustration of Bank Competition,” it occurred to me that game theory might be a good way to come to terms with the Second B.U.S. In the paper I represented the banking “game” as one in which a player might choose either to cooperate with a rival by accumulating or reissuing the rival’s notes, or to defect by returning those notes for redemption in specie. When the players are equally privileged, the payoffs are symmetrical. Moreover, because mixed strategies (that is, those in which one bank cooperates while the other defects) involve persistent reserve gains by the defecting bank, and persistent losses by the cooperative “sucker,” the payoffs are those of a Prisoner’s Dilemma. All-around defection is therefore the unique Nash Equilibrium:

The banks end up, in other words, taking part in the routine (say, daily) exchange and settlement of claims, including checks as well as notes, with specie alone being treated as a reserve asset. The system’s capacity for expansion will then depend solely on the available stock of specie reserves and what banks determine to be their optimal specie reserve ratios.

To appreciate the strategies employed by the second Bank, it helps to first consider the situation faced by a “pure” currency monopolist, meaning a bank that enjoys an irrevocable, exclusive privilege of issuing paper money. Because the public ordinarily finds paper more convenient than gold, the privileged bank’s monopoly causes other banks to treat its notes and other claims against it that are readily convertible into its notes as superior substitutes, in “normal” times at least, to specie. The relative payoffs to the less privileged bank or banks for cooperating versus defecting are then more or less the reverse of those for the game involving equal rivals, giving rise to a mixed-strategy Nash Equilibrium in which the less privileged banks hold and reissue the privileged bank’s notes, perhaps even lodging their specie with it, while it nevertheless continues to redeem any items it collects from them:

In what ways did the situation confronting the Second Bank of the United States differ from that faced by our “pure” currency monopolist? First of all the Bank’s charter, rather than granting it irrevocable privileges, was to lapse after two decades unless renewed by a Congressional vote. That meant that the Bank had to take into account the political consequences of its actions, including the possibility that, by making life difficult for state banks, it might discourage legislators in the affected states from voting for its renewal. Concern about renewal prospects would incline the Bank to assign lower payoffs for defection than those a pure monopolist might anticipate. This change alone might suffice to give rise to a cooperative Nash Equilibrium, that is, one in which the state and Federal banks elect to “live and let live”:

Second, the Bank’s privileges did not include an outright currency monopoly. Instead they consisted mainly of its status as a government depository, together with its ability to establish branches anywhere, which allowed its notes to command the same value everywhere, and therefore to be uniquely useful in interstate commerce. The notes of state chartered banks, in contrast, tended to be discounted as they traveled beyond their place of issue.

State banks thus had some incentive for retaining and reissuing the Second Bank’s notes instead of redeeming them, just as in the pure monopolist case; but the strength of this incentive differed in different parts of the country. In particular, northeastern banks tended to treat B.U.S. notes as relatively poor substitutes for specie, which they were frequently called upon to supply for international transactions (and, starting in 1818, for Suffolk Bank settlements), while banks elsewhere tended to treat them as good substitutes, which (so long as they traded at par) could be readily employed to offset the (typically adverse) flow of trade with the northeast. Forbearance by the B.U.S. toward northeastern banks would therefore have made a “sucker” of it. Consequently a non-cooperative “hard money” equilibrium tended to be prevail between the Bank and northeastern state banks, while a cooperative “soft money” equilibrium tended to prevail elsewhere:

And so things went during the Bank’s first years, with its non-northeastern branches playing “live and let live” with neighboring state banks, and generously expanding their own lending, and its northeastern ones aggressively redeeming local notes, and having local banks redeem theirs just as aggressively.

Murray Rothbard offers an excellent summary of the situation in The Panic of 1819. Before the panic, Rothbard observes, the Bank on the whole served

as an expansionary, rather than as a limiting force. The expansionary attitude of the Bank was encouraged by the Treasury, which wanted the Bank to accept and use the various state bank notes in which the Treasury received its revenue, particularly its receipts from [western] public land sales… In New England, on the other hand, both the private banks and the branches of the Bank of the United States pursued a conservative policy.

The catch was that things simply couldn’t go on this way for very long. The general expansion led to rising U.S. prices, which eventually worsened the trade deficit, increasing the demand for specie, especially in the northeast. Also, because the Bank’s various branches were collectively responsible for receiving and redeeming its notes, regardless of where the notes came from, and with no arrangements for any eventual inter-branch reckoning, the Bank’s northeastern branches found themselves hemorrhaging reserves. Eventually specie was commanding a premium even relative to B.U.S. notes, reflecting the public’s doubts concerning its continuing ability to meet demands placed upon it.

At last the Bank of the United States had no choice but to take steps to stem its reserve losses, which it did by calling on its non-northeastern branches to abandon their live-and-let-live policy toward state banks while aggressively contracting their own lending. It was this inevitable reversal of the Bank’s politically-motivated policy of forbearance–a reversal that would continue under Biddle’s presidency–that triggered the Panic of 1819.

Apologists for central banks like to portray them as conservative institutions that serve to keep other (“commercial”) banks on tight leashes; and although central banking doctrine was hardly developed at the time, the same thinking played a prominent part in the decision to establish a new federal bank in 1816. But though the new B.U.S. was certainly capable of being a conservative presence that would help to rein-in reckless state banks, in practice the Bank followed the state banks’ lead, behaving conservatively only where state banks were themselves already inclined to be conservative, while fostering expansion elsewhere. The events leading to the Panic of 1819 suggest that competition among co-equal banks was both a sufficient and a necessary condition for the avoidance of excessive bank lending. The presence of a privileged federal bank, in contrast, appears to have been neither sufficient nor necessary. That presence was, on the other hand, uniquely responsible for the extent of excessive expansion that ultimately occurred. In light of such considerations the Panic of 1819 deserves to be regarded as the United States’ first central-bank inspired financial crisis.

It seems that the Spanish edition of Theory of Free Banking, published as La Libertad De Emisión Del Dinero Bancario, is now available from Unión Editorial. Pass it on!

And yes, I am working on a real post.

(This is another piece originally written for the now-defunct Free Market News Network. Although the piece is mainly aimed at “Rothbardian” claims to the effect that fractional-reserve banking is inflationary, advocates of free-banking are sometimes also guilty of exaggerating the influence of banking-industry structure on inflation, as some do, for instance, by suggesting that bank deregulation alone will serve to combat inflation. Generally speaking, an economy’s rate of inflation is mainly a function, not of the reserve ratios kept by its banks or of whether banking is a free or heavily regulated industry, but of the nature of it’s base money regime.)

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Certain economists of the Austrian School, and followers of Murray Rothbard especially, oppose fractional reserve banking for at least three reasons. They claim that banks resorting to it defraud people, that they bring about business cycles, and that their activities cause inflation. This article addresses the last claim only: I hope to discuss the others separately.

The “Rothbardians,” as I’ll refer to them, recognize two distinct meanings of the word “inflation.” One meaning—which they prefer—defines it as any increase in the nominal stock of money, including fractionally-backed bank deposits and notes (which they, following Ludwig von Mises, prefer to call “money substitutes”). The other, which is in common use today, defines it as any ongoing increase in the general level of prices, that is, as a positive rate of change in one or more broad price indexes, such as the CPI. In calling fractional reserve banking “inflationary” Rothbardians often seem to have the latter, more conventional definition of inflation in mind, and my arguments are mainly aimed at responding to their complaint so interpreted. However, in doing so, I also hope to clarify the extent to which fractional reserve banking does or doesn’t promote “inflation” in the less conventional and more strictly Rothbardian sense of encouraging growth in the (broad) money stock.

Perhaps the simplest way to assess the price-level consequences of fractional reserve banking is to first imagine an economy in which such banking is prohibited, as many Rothbardians insist it ought to be. Such an economy would admit 100-percent reserve or “warehouse” banks only. To simplify the comparison further, let’s assume that all exchanges are conducted using warehouse bank certificates: in other words, the reserve medium itself—let’s assume it’s gold—doesn’t circulate. The price level adjusts so as to equate the supply of and demand for gold, including bank reserves.

Assuming fixed levels of demand for both money and non-monetary gold, there can be no inflation in this system, in either sense of the term, so long as the gold stock also remains unchanged. That stock could increase, however, as a result of gold mining. For the sake of argument, though, let’s assume that available gold mines have all been exhausted, and that no new discoveries are forthcoming. By assuming that available gold is not consumed—in the sense of being gradually used up—by industry, we can rule out deflation as well.

Suppose next that fractional reserve banking is legalized and that, Rothbardian warnings notwithstanding, it becomes so popular that all the old warehouse banks embrace it. Will inflation result? Of course it will—but only for a time. As fractionally-backed notes (or deposit credits) take the place of their 100-percent reserve predecessors, the demand for monetary gold, and hence the demand for gold in general, declines, causing the value of gold to decline with it. Because prices are expressed in terms of an (unchanged) gold unit, the price level has to rise. But as the demand for gold doesn’t drop to zero—banks still hold some reserves, and there is still a non-monetary demand for gold—the price level eventually reaches a new equilibrium. All this assumes, by the way, that the switch to fractional reserves is worldwide: if the switch was limited to a single, small country, then banks in that country would export their unneeded gold reserves to the rest of the world, and worldwide price level changes would be negligible.

The overall extent of the increase in prices, and of the underlying expansion of fractionally-backed bank money, will depend on the reserve ratio banks settle on. The lower the ratio, the higher the rise in prices. But whatever the ratio turns out to be, the system will eventually reach a point at which inflation ceases. The move to fractional reserves results, in other words, in a permanent, once-and-for-all price level change, but not in any permanent change in the inflation rate.

What’s to keep the banks from further reducing their reserve ratios? The answer is that, so long as they all compete on an equal footing, as in a free banking system, each will be inclined to routinely return claims, such as checks or banknotes, received from rival banks. The uncertain flow of such interbank “clearings” generates a demand for reserves for settlement, which (in the presence of positive costs of default) will vary with the volume of outstanding bank liabilities, even if bank customers never bother to withdraw gold. Although optimal reserve ratios are unlikely to remain perfectly constant over time, and may decline gradually as more efficient settlement procedures are discovered, for the most part the rate of inflation under an established and mature fractional reserve arrangement is unlikely to differ substantially from the rate that would prevail under 100-percent reserves.

Admittedly this conclusion depends on the assumption of an unchanged real demand for money. If the demand for money grows over time, as it does in most healthy economies, that growth will in fact have different implications for inflation under the two regimes. Yet it still won’t promote inflation in either case. On the contrary: in the 100-percent reserve case, growth in money demand must cause prices to decline at a roughly corresponding rate (“roughly” because there may be some shifting of available gold from non-monetary employments to bank reserves). Under fractional-reserve banking, in contrast, there will be greater scope for monetary expansion, depending on how free banks are from legal impediments. Under free banking, for example, banks can “stretch” their reserves somewhat as the demand for money increases, provided that the increase takes the form of a fallen velocity of money. This happens because the fall in velocity translates, ceteris paribus, into a fall in both the volume of bank clearings and the demand for reserves. In other words, in the presence of economic growth, a free fractional-reserve banking system, although it won’t promote inflation, will be somewhat less deflationary than a 100-percent reserve system.

If fractional reserve banking isn’t to blame for inflation, what is? Inflation could break out because of new precious-metal discoveries, or cheaper means for extracting metal from existing mines. Experience suggests, though, that metal-driven inflations aren’t likely to be serious. The California gold rush, for instance, barely caused a blip in most measures of the price level (the monetary expansion it sponsored was quickly overtaken by offsetting growth in money demand). Likewise, the so-called “price revolution” of the 16th century—a quadrupling of European prices that was at least partly due to the inflow of gold and silver from the New World—translated into an average annual inflation rate of below two percent. Of course even normal gold production will tend, other things equal, to raise prices, but industrial consumption and secular growth in money demand will have the opposite effect. In the long-run, if history is any guide, these forces will tend to cancel out—and will do so whether banks hold fractional reserves or not.

Responsibility for really serious inflations belongs, with only rare exceptions, to central banks, and especially to central banks (or other government agencies) that issue irredeemable fiat money. The monopoly privileges central banks enjoy, and their monopolies of paper currency in particular, give them much greater powers of monetary expansion than ordinary commercial banks enjoy, by freeing them from the discipline of routine clearing and settlement. Because other banks are denied the right to issue their own notes, they treat central bank notes as reserve assets—and will tend to do so even under a gold standard. The central bank is then free to expand—and to encourage other banks to expand with it—until inflation proceeds to a point where gold can be had more cheaply by cashing in its notes than by buying it in the open market. A central bank that issues inconvertible fiat money can, of course, expand without running into any material checks. It is no coincidence that all of the world’s great inflations have taken place in fiat money regimes.

The claim that fractional reserve banking as such is inflationary is unfortunate, not merely because it is theoretically as well as factually wrong, but also because it diverts attention away from central banks and government authorities—the real culprits behind any serious inflation—while pointing a finger at ordinary commercial bankers, who are at most guilty of making use of new reserves that central bankers generate. In this way Rothbardians unwittingly give credence to central bankers’ claim that inflation isn’t their fault: that its cause rests in private-market developments that they—“inflation fighters” all—are doing their utmost to combat.

So it’s time to dump the rhetoric linking inflation to fractional reserves. Fractional-reserve banking may have its drawbacks, but a tendency to fuel inflation isn’t one of them, and the chief beneficiaries of claims to the contrary are none other than the world’s central bankers and their apologists.

For a couple of my books, actually, which have recently become available in new editions.

Good old Liberty Fund has made a Kindle version of The Theory of Free Banking, which you can download for free from its Online Library of Liberty.

And my pals at the Independent Institute have just released the paperback version of Good Money, which they sell for just $22.10. That might not seem terribly cheap for a paperback, but bear in mind that this one reproduces the hardback’s generous color-plate insert. Besides, it’s a damn good book.

Personally I think the relative prices are about right. Not that I don’t like The Theory of Free Banking.: it’s just that I’ve come to think that an ounce of convincing history is worth at least a pound of theory. And what writer doesn’t imagine that he’s learned a thing or two about writing in the space of two decades?

But you needn’t take my word for it. Just get them both, and decide for yourself!