Every once in a while I get this sudden urge to smash my fist into a nestfull of Rothbardian hornets, as I did with my last blog, causing a cloud of them from the Econ​Pol​i​cyJour​nal​.com hive to rush to the defense of the Queen Wasp. As the venom of vespa rothbardbro has a curious molecular struture that may interest students of economic entomology, I here offer some samples from among those I garnered by means of my brave sacrifice to the cause of science:

“George Selgin has the mind of a child. I am almost embarrassed for him. It comes from hiding in a University environment where you don’t ever have to grow up and be an adult in the real world so you can spend your life as a freakish governemnt (aka, mommy-n-daddy) worshiper. It sometimes is appealing…Especially with the young coeds.”

“Rothbard’s writings are as popular as ever, and we can all learn from them. Friedman’s book sales are pretty much limited to required readings that appear on reading lists of Keynesian [!] economics professors.”

“Selgin is dealing in the never, never land where accurate price indexes and productivity levels can apparently be determined with the snap of a finger. In other words, Selgin’s monetary policy prescription can’t be executed in the real world. It is fairy tale stuff.”

“Check out that blog of Selgin’s. Fractional Banking. IP-socialism. Attacks on LRC “cult”. Attacks on Rothbard and Rockwell. Koch economists.”

“Here is Selgins’s “sophisticated” and “non-naive” version of the “Austrian” credit cycle theory: ‘many Keynesians might accept the framework of monetary equilibrium offered by me. Those who do not regard liquidity trap as important factual possibility would probably accept it as entirely adequate’ (Theory of Free Banking, p. 59).”

“There are no “policies” in a free market. Readjust your premises.”

“Your criticism of Rothbard is desperate and reeks of nothing but mindless antagonism.”

“Did you know that your name is constantly used as a straw man by anti-Austrian Keynesians and other statists who say things like “Even George Selgin agrees with me.”? It’s people like you who are hampering change for the better. You compromising fools perpetuate the very systems you claim to be against, and you don’t even know it, because you’re too busy worrying about tenure and being accepted by the establishment.”

“Someone who manages to tell you in line one that he was debating “Lord xyz…” and in his concluding lines disses you and the blog with the condescension befitting one who banters with the British upper-crust, should maybe know the difference between elicit and illicit?” (NB: I did indeed type “illicited” in my original post. You can’t be too careful.)

Being only a field researcher I must leave it to others to determine the precise damage done to me by all this poison. But for whatever the amateur observation may be worth, I’m feeling perfectly chipper.

Addendum. I somehow overlooked the following barb, which deserves a place of honor among the others:

“I knew Selgin was a fruit loop when he denied Austrian methodology and epistemology by ignoring inevitable unintended consequences and the violation of subjective value theory with his central bank efficiency policy recommendations.”

I’m not sure just how I violated subjective value theory, but if I did I hope that the right sort of counseling will help it to recover from the trauma.

While I was debating Lord Skidelsky in London yesterday, Milton Friedman’s son David posted this response to Lew Rockwell’s assertion that his father “is almost nobody outside of mainstream economics.”

David’s reply has elicited many responses, including a few referring to yours truly not, thank goodness, as a Rothbardian, but as a self-styled “Austrian” economist. As David seemed to be under the impression that that characterization was correct, I added my own comment, which I reproduce here for the sake of further distancing myself from Austrian disparagers of the late, great Uncle Milty:

David, for the record, I don’t “describe myself as an Austrian,” and haven’t done so since graduate school. Indeed, I consider myself no less a fan of your dad’s work than I am of work by Hayek and Mises. I think a good economists [sic] cannot concern himself or herself with belonging to any school, or being loyal to one. I’m pretty sure your dad would have said the same. It was others who labelled him a “Chicago” economist, while the only label he sought was “good” economist.

Rothbard, on the other hand, was only too determined to identify himself with the Austrian School and, more than that, to both take part in a personality cult, built around von Mises, and attract such a cult himself. One sign of the presence of such a cult is precisely the scorn its members heap on potential rivals to the cult figure.

As a monetary economist (I don’t pretend to judge Rothbard’s other economic contributions) Rothbard was mediocre to bad. His version of the Austrian business cycle theory was naive–in essence it equated behavior of M consistent with keeping interest rates at their “natural” levels with the elimination of fractional-reserve banking, an equation that holds only with the help of about a dozen auxilliary assumptions, all of which are patently false. He then went on to conjure up an equally false history of banking and of bank contracts designed to square his theory of the cycle, with its implied condemnation of fractional reserve banking, with his libertarian ethics.

Thanks to all this nonsense people like myself and Larry White (who does still call himself an Austrian) have to waste oodles of time debunking his ideas–we most certainly haven’t simply “ignored” them–that we’d rather spend attacking central bankers’ shenanigans.

To add to the record, I had the privilege of getting to know both Murray and Milton. Like most people who encountered him while in their “Austrian” phase, I found Murray a blast, not the least because of his contempt for non-Misesians of all kinds. Milton, though, was exceedingly gracious and generous to me even back when I really was a self-styled Austrian. For that reason Milton will always seem to me the bigger man, as well as the better monetary economist.

Follow-Up: A blog styling itself the EconomicPolicyJournal insists that my blog and comments together amount to a logical muddle. For the record (and in case the “EPJ” (sounds even better, doesn’t it!) finds it unworthy of…er…publication, I replied by noting that if there was an error of logic the esteemed journal itself was gulty of it, since, far from being the same as Rothbard’s ideal, Friedman’s frozen base proposal did not (1) call for a gold standard, (2) call for abolishing fractional-reserve banking, or (3) call for a constant stock of money in the usual sense meaning a constant stock of public money holdings.

Anyone who peruses my work on free banking—or my other writings for that matter—will notice that I’m not especially inclined to express my ideas mathematically. To put the matter more positively: I prefer plain English. The preference has if anything grown more marked over time. While writing Good Money, for example, I at one point let an equation slip into the first, expository chapter. But as soon as it occurred to me that a sentence would serve as well, while being a damn sight prettier to look at, out went the symbols. Likewise, when Liberty Fund decided to put The Theory of Free Banking in their Online Library of Liberty, I asked them to take out the few equations (and the one figure) found in the print version, as if they were so many blemishes (which, indeed, they were).

To resist using equations isn’t a strategy calculated to make life easy for an academic economist today. Yet it isn’t entirely for want of ability to do otherwise that I‘ve resorted to it. In fact I like math and was pretty darn good at it once upon a time. I just happen to think it wildly overrated as a means for “doing” economics—that is, for communicating ideas concerning how an economy works. For whatever its champions may think, mathematics is a language, and as such is a fit device for economic analysis only to the extent that the symbols it consists of are more capable of accurately conveying meaning than words themselves are. Of course mathematical expressions have their advantages: most obviously they tend to be less ambiguous than verbal ones; and it’s relatively easy to combine and manipulate bunches of them so as to ferret out implications or inconsistencies that might not otherwise be evident. Some ideas–Newton’s laws of motion naturally come to mind–can’t readily be stated at all, let alone figured out, using ordinary language. But math (by which I mean mainly algebra and calculus) has disadvantages also, the most obvious of which is that its limited grammatical repertoire simply doesn’t allow it to convey many subtleties of meaning of which properly-handled words are capable. Despite what some mathematical economists seem to suppose, it isn’t merely owing to a general lack of facility with algebra that people mainly communicate using words: it’s because you can say lots of things that way that you can’t possibly say with equations. Or maybe you can sort of say it with equations, but it’s dorky to even try.

Which brings me to free banking. Might greater resort to formal modeling enhance the theory? Of course it might. Like I said, equations can reveal things that mere words obscure. When Carl Christ reviewed The Theory of Free Banking for George Mason’s Market Process newsletter, he did so by writing down a formal model by which to examine my verbal reasoning. That reasoning was all O.K., according to Christ, except that his formal analysis made explicit an assumption that was only implicit in my own discussion, to wit: that by an increase in the volume of real activity I had in mind an increase in the number of transactions per period, rather than an increase in average transaction size. (In the former case reserve scale economies are realized, whereas in the latter they aren’t.) This is just the sort of thing math is good for, and it is why it’s worth trying to concoct formal models. Indeed, I later made Christ’s model the basis for one of my own, rare forays into mathematical economics, my 1994 paper “Free Banking and Monetary Control.”

On the other hand Christ’s review also convinced me that I was capable of doing reasonably “rigorous” economics using “mere” words; and I personally believe that, by making use of metaphors and other devices that have no exact mathematical counterparts (though equations are themselves metaphors of a sort), I added more to my theory’s intuitive appeal than I sacrificed in rigor.

The point is that both mathematical economics and the verbal kind have their place; neither is intrinsically better than the other; and each can serve as a useful test of the other. A formal model can reveal deficiencies or omissions in a verbal argument; but a few well-chosen words are just as capable of exposing an absurd argument or false assumption lurking in some seemingly innocent equation. The claim that “it takes a model to beat a model” would be just plain goofy were it not so effectively employed by mathematical economists anxious to insulate their work from criticisms by persons who know less math—but perhaps more economics—than they do.

Finally, I come to Larry Sechrest’s (1993) Free Banking, much of which is devoted to offering a formal interpretation of my own verbal theory. Larry’s book came up in comments on a previous post; and having made a brief remark upon it there I offered to expand upon it in light of a quick rereading. My recollection had been that Larry misinterpreted some of my arguments; in fact the misinterpretations are minor and are mainly confined to Larry’s own “verbal” exposition, as when he states (p. 14) that I argue “that a bank’s demand for reserves depends not only on the total volume of transactions but also on the frequency of those transactions.” (He presumably ought to have written “total volume of bank money outstanding and its turnover” or something like that.) But Larry’s formalization, unlike Carl Christ’s, contains no microeconomic refinements or revelations: it merely restates in symbols the comparative static conclusions I reach using words. If some find Larry’s approach more compelling (and it appears that some do), that’s lovely. But let’s not be guilty, as so many mathematical economists seem to be, of confusing a difference in rhetoric with a difference in rigor.

(This one’s especially for GPO.)

In the aftermath of the U.S. banking crises of the 1930s, it became common for American economists to speak of the “inherent” instability of fractional-reserve banking and of the “perverse elasticity” of money supply in fractional-reserve banking systems.

What the economists in question had in mind was the tendency in existing fractional reserve banking systems for any increase in the public’s preferred ratio of currency holdings to holdings of bank demand deposits to result in a decline in bank lending, and hence in a decline in the overall money stock, and to do so despite the lack of any decline in the public’s overall desire for money balances of one kind or another. It was chiefly owing to this phenomenon that, during the first few years of the Great Depression, the U.S. (M2) money stock collapsed to just two-thirds its pre-depression level.

It was in response to this supposedly inherent drawback of fractional reserve banking that several prominent economists—including Henry Simons, Irving Fisher, Loyd Mints, and (eventually) Milton Friedman—began offering or endorsing proposals for “100 Percent Money,” meaning money consisting either of basic money itself or of bank deposits fully backed by basic money. Although these proposals closely resembled later proposals for 100-percent reserve banking forwarded by Murray Rothbard and his Austrian-School followers, they differed in treating either fiat or “commodity-bundle” central bank money rather than either gold or silver as the ideal form of basic money, and also in not basing their arguments on any appeal to ethics: unlike their Austrian counterparts, the “Chicago” 100-percenters (for want of a more accurate designation) did not claim that fractional-reserve banks swindled their customers. Instead they condemned them solely for contributing to monetary instability.

But were the “Chicago” arguments for 100-percent money any sounder than their “Austrian” counterparts? Is it true that fractional reserve banking is “inherently unstable” in the manner they claimed? As even a careful reading of their own writings shows, it is not. In truth what the Chicago 100-percenters treated as an “inherent” problem of fractional reserve banking isn’t inherent to it at all. Instead it is a problem stemming from government regulations interfering with or altogether prohibiting banks from issuing their own circulating banknotes on the same terms as those by which they are allowed to create exchange media that consist of demand deposits. In the U.S., banknote issue has almost always been subject to special restrictions. But these restrictions became increasingly severe after the outbreak of the Civil War, finally culminating in the complete suppression of commercial banknotes in 1935. Consequently, on the eve of the Great Depression it was impossible for most commercial banks to issue any banknotes at all, and it was very difficult for the rest to do so. Banks therefore had to count heavily on the Fed to meet any considerable increase in the public’s demand for circulating money by creating more units of basic money. Otherwise the banks might be stripped of cash reserves, and forced either to severely contract their lending or to close their doors, if not to do both.

Had U.S. banks remained free to issue notes on the same terms, and subject to the same fractional-reserve requirements, as applied to their deposits, changes in the public’s demand for currency needn’t have had any such “perverse” consequences. On the contrary: so long as the terms are similar a bank has no reason to care what share of its outstanding IOUs consists of notes, and what share consists of circulating paper. The bank’s liquidity depends only on the sum of both sorts of IOUs, relative to its holdings of reserves of basic money. Whether “basic money” means gold or silver or claims against a central bank also doesn’t make any difference. Indeed, a bank might well prefer to have clients hold its notes, rather than keep deposits with it, since deposits sometimes bear interest, while notes do not. Confronted with a heavy demand for currency, a free bank happily disgorges more of its paper IOUs, while writing off some of its deposits. Because its reserves, reserve ratio, and liquidity all remain the same as before, it doesn’t have to stop lending, and therefore doesn’t contribute to any decline in the basic-money multiplier. In short, under free banking, in theory at least, an increased demand for currency doesn’t have any “perverse” consequences. Nor does it appear to have had any such consequences in fact in the relatively free banking systems of Scotland, Canada, and elsewhere. In these systems, although changes in the public’s preferred currency-deposit ratio happened frequently—the ratio always rose during the harvest season, for one thing—credit crunches and banking crises were extremely uncommon.

When, on the other hand, banks aren’t free to issue their own notes, or can do so only to a very limited extent, they have no choice but to satisfy customers’ demand for more currency by handing over scarce reserves, and thereby reducing their liquidity. To restore that liquidity, they must then restrict their lending, which, other things equal, means reducing the banking-system money-multiplier. If the central bank in turn fails to make compensating additions to the stock of basic money, the equilibrium money stock must decline. In the U.S., in the early 30s, the public’s preferred overall currency-to-deposit ratio rose sharply, while the Fed for the most part stood by. Hence the Great (Monetary) Contraction.

Some will object to my suggestion that freedom of note issue would have avoided the Great Contraction by noting that currency withdrawals at the time, instead of being routine withdrawals such as were then still typical of the harvest season, reflected distrust of the banks. In that case, a bank’s own notes might have been considered no safer than its deposits, so that central bank money would have been preferred to either. But while the notes of certain banks would undoubtedly have been distrusted, there’s no evidence that banknotes would have generally fallen out of favor: plenty of banks remained both trusted and solvent, and their notes could have supplied the needs of the country as a whole, since notes (unlike bank deposits) can travel wherever they are most wanted. The sole exception to this occurred in late February 1933, when a general run broke out. But this was, as Barry Wigmore has shown, actually a run for gold based, not on any general loss of confidence in the nations’ commercial banks, but on (justified) fears that the incoming president would devalue the dollar.

Further evidence that freedom of note issue would have helped comes from the one step taken in that direction during the banking crisis. This consisted of a rider to the Federal Home Loan Bank Act known as the “Glass-Borah Law.” That law briefly and modestly relaxed the regulatory limits on national banks’ ability to issue national banknotes, by extending the sorts of collateral the banks could have backing those notes. The Glass-Borah Law resulted in a substantial and much needed increase in the supply of currency, although it still left the banks too restricted to avoid massive reserve losses. Just how far a more generous measure, including steps to allow state as well as national banks to issue their own currency, might have gone in limiting or even preventing the crisis is a question crying out for further research.

Why, then, did “Chicago” 100-percenters insist on treating the “perverse” behavior of the U.S. money stock in the 30s as a problem inherent to fractional-reserve banking rather than as a consequence of government regulation? As their own writings make clear, at least some of them actually admitted that freedom of note issue was a theoretical solution to the problem. In his A Program for Monetary Stability (1960, p. 69), for instance, Milton Freidman observed:

To keep changes in the form in which the public holds its cash [that is, money] balances from affecting the amount there is to be held, the conditions of issue must be the same for currency and deposits.… The first solution would involve permitting banks to issue currency as well as deposits subject to the same fractional reserve requirements and to restrict what is presently high-powered money to use as bank reserves.

Yet Friedman went on to reject this solution in favor of the 100-percent reserve alternative. He did so because he believed then that freedom of note issue itself raised insuperable problems. This stance, which was presumably shared by other “Chicago” 100-percenters, was itself due to misinterpretation of the American “free banking” experience. Friedman himself eventually came to admit his mistake in light of research by modern free bankers (see Friedman and Schwartz 1986), though his reversal was somewhat half-hearted (see my “Milton Friedman and the Case Against Currency Monopoly”). Whether Simons or Mints or Fisher or any of the other “Chicago” 100-percenters would ever have done likewise is of course something we shall never know.

Over at Cafe Hayek, some comments made concerning my last Free Banking post suggest that Murray Rothbard, though opposed in principle to fractional-reserve banking, did not wish to see it prohibited. That’s not really correct. As I pointed out there:

“Actually in arguing that FR banking was fraudulent, Rothbard could hardly escape implying that the polizei, or some anarcholibertarian equivalent, ought to shut it down. And he certainly did argue for setting up “anti-bank vigilante squads” charged with organizing runs and otherwise making life impossible or at least miserable for such bankers. I always wondered about this: if Rothbard believed people were being systematically duped, then wouldn’t just informing them suffice to make them run on their banks–why speak of “squads”? And then wouldn’t it make still more sense to organize, not “anti-vigilante” squads, but rather 100-percent banks that could thrive on the money withdrawn from the FR banks whose fraud was being revealed? Finally, if that would be a good idea, why hadn’t any of those excellent entrepreneurs Rothbard and other Austrians are always telling us about ever figured it out? (Please don’t answer by appealing to deposit insurance: before 1967, only one country had it; and before 1934 none did. That leaves plenty of time in which the entrepreneurs might have made hay.)”

Larry White and I had already pointed out this tension between the “fractional-reserve-banking-as-persistent-fraud” argument and the Austrian theory of entrepreneurship, which treats the latter as serving to systematically spot and exploit profit opportunities, in our 1996 Review of Austrian Economics article, “In Defense of Fiduciary Media.”

Free bankers have been fighting a war on two fronts. On one they face champions of central banking and managed money. On the other they struggle against advocates of 100-percent reserve banking. Although the second front is a lot smaller than the first, it’s far from being unimportant, in part because the battle there is being fought against people who generally favor free markets, who might have been expected to join rather than to oppose our cause.

They oppose it for a variety of reasons, one of which is their belief that, in a truly free-market setting, fractional reserve banking wouldn’t survive. Instead, they insist, 100-percent reserve banks would prevail. That they haven’t is due, in their opinion, to a banking industry playing field slanted in favor of favor fractional-reserve banks, especially by either implicit or implicit deposit guarantees financed through forced levies upon all banks, and sometimes by taxation or inflation. In short, fractional-reserve banking has been nurtured by government subsidies.

Free bankers have tried responding to this argument by noting how fractional reserve banking has prevailed under every sort of bank regulatory regime, from the earliest beginnings of banking, not excepting regimes that involved very little regulation, like those of Scotland, Canada, and Sweden, and that lacked even a trace of government guarantees or other sorts of artificial support. But since some 100-percenters seem unmoved by this approach, I here take a different tack, which consists of pointing out that every significant 100-percent bank known to history was a government-sponsored enterprise, which depended for its existence on some combination of direct government subsidies, compulsory patronage, or laws suppressing rival (fractional reserve) institutions. Yet despite the special support they enjoyed, and their solemn commitments to refrain from lending coin deposited with them, they all eventually came a cropper. What’s more, it was these government-sponsored full-reserve banks, rather than their private-market fractional reserve counterparts, that were the progenitors of later central banks, starting with the Bank of England.

So far as records indicate, the very earliest banks were private institutions that began as sidelines to other businesses. The very first bankers may have been the trapezites or money-changers of ancient Athens, or their later Roman counterparts. But the earliest concerning which any details are known were the “banks of deposit” that arose during the 12^th century in Italy, especially in Genoa and Venice, and the record clearly indicates that these banks were credit-granting institutions rather then mere coin warehouses. Indeed, it was almost inevitable that they should have been so, because in order to efficiently undertake to make payments by bank transfer, and so spare their clients the necessity of dealing with the shoddy coins then available, they were bound to promise to return on demand, not the very coins deposited with them, but coins of equal value, which in effect meant becoming debtors rather than bailees. Moreover, overdrafts were bound occasionally to result in credits in excess of cash reserves, while the interest to be earned from additional lending allowed bankers to reduce the fees they charged for their payment services, and even to occasionally pay interest on their “deposits.” In any event the lending was never concealed. In London goldsmith banking took a similar course, though not until the mid-17^th century. In short, so far as records indicate, all of the earliest private banks operated on a fractional-reserve basis.

Banking in the medieval and renaissance period was a notoriously risky business, so despite typically holding reserves of roughly a third of their deposits private banks often failed. It was partly in response to these failures, and partly out of fiscal motives, that governments first began venturing into the banking business, by establishing so-called “public” banks, which though government-sponsored were otherwise supposed to operate according to what we might call “Rothbardian” principles, offering a combination of payment and metallic-money custodial services, but without engaging in any lending. The first such bank, Barcelona’s Taula de Canvi, was established in 1401 with the promise that it would be a safe place to store coin. In fact the government intended from the start to draw on its resources to fund the city’s debt, and merchants saw through the scheme. The government then responded by awarding the Taula a monopoly of demand deposits. Still many merchants refused to take the bait, which was just as well since the government eventually drew so heavily upon the Taula that it went bankrupt.

Although Venice’s first public bank, the Banco di Rialto established in 1587, was modeled after the Taula, it actually did operate on a 100-percent reserve basis for some time, and was for some years Venice’s only bank. But far from having out-competed fractional reserve rivals on a level playing field, the Rialto Bank had its operating expenses, including normal returns, covered by customs duties, and was only for that reason able to offer risk-free payment services in exchange for only modest fees. Still the bank’s days were numbered when a rival public bank, the Banco del Giro, was established in 1619, and was initially allowed to operate on a fractional reserve basis. The new bank absorbed its full-reserve rival in 1637, and thanks to continued government demands upon it never did manage to convert to a 100-percent reserve basis. On the contrary: it twice had to suspend payments, in each case for many years.

The most famous of the public 100-percent reserve banks, the Bank of Amsterdam, is also the one most often cited as proof of the viability of that form of banking. But here again, a close look suggests that the proof is no proof at all. For starters, in establishing the Bank of Amsterdam in 1609, the Dutch government also banned the city’s private “proto-bankers”—the analogues of Venice’s medieval money changers and London’s 17^th-century goldsmiths—essentially giving the public bank a monopoly of non-coin payment services. The government also required that all bills of exchange worth 600 guilders or more be settled on the new bank’s books. Finally, rather than being true demand deposits, readily convertible into coin at no penalty, deposits at the Wisselbank could be converted into cash only for fees of up to 2.5% of withdrawn amounts, thus allowing it to cover its expenses while also earning a tidy profit without having to make any loans.

Yet, notwithstanding the widespread contrary belief and its solemn promise to “store” all deposits lodged with it, the Bank of Amsterdam did make loans. It did so, first of all, by allowing overdrafts. More importantly, it eventually did so, to a far greater extent, by making advances to the municipal government and to the Dutch East India Company. During the 1650s, for example, the city of Amsterdam borrowed a whopping 2 million guilders, which it never repaid; and after 1684 loans persistently amounted to 20 percent or more of the Bank’s total assets. Finally, in 1790, the failure of the bank’s heavy (and, as usual, clandestine) loans to the then-struggling East India Company forced it, in effect, to devalue most of its deposits by 10 percent, while altogether refusing to repay any of less than 2,500 guilders. At last, when the French invaded Amsterdam and got hold of the Bank’s books, these revealed that its reserves had fallen to less than 25 percent of its liabilities, with the Dutch East India Company alone owing it a grand total of 11 million guilders. Release of the last statistic at once caused the Bank’s famous bullion “receipts,” which were (since an 1683 reform) the only Bank liabilities that could actually be redeemed, to fall to a 16 percent discount.

The passing of the Bank of Amsterdam marked the end of governments’ attempts to establish, or to pretend to establish, 100-percent reserve banks, and therefore marked the end of all significant instances of that sort of banking. Yet it was far from being the end of government involvement in the banking business, for the early “public” banks, and the Bank of Amsterdam especially—thanks in part to the myth of it’s always having been solid—were the direct inspiration for another breed of government-sponsored banks, the prototype of which was the Bank of England. Where that development has taken us is too well known to be worth restating here. But let it not be forgotten that it all started with the cry that the public ought not to have to deal with fractional-reserve banks.