In the first of this series of posts, I explained that the mere presence of fractional-reserve banks itself has little bearing on an economy’s rate of money growth, which mainly depends on the growth rate of its stock of basic (commodity or fiat) money. The one exception to this rule, I said, consists of episodes in which growth in an economy’s money stock, defined broadly to include the public’s holdings of readily-redeemable bank IOUs as well as its holdings of basic money, is due in whole or in part to a decline in bank reserve ratios.

In a second post, I pointed out that, while falling bank reserve ratios might in theory be to blame for business booms, a look at some of the more notorious booms shows that they did not in fact coincide with any substantial decline in bank reserve ratios.

In this third and final post, I complete my critique of the “Fractional Reserves lead to Austrian Business Cycles” (FR=ABC) thesis, by showing that, when fractional-reserve banking system reserve ratios do decline, the decline doesn’t necessarily result in a malinvestment boom.

Causes of Changed Bank Reserve Ratios

That historic booms haven’t typically been fueled by falling bank reserve ratios, meaning ratios of commercial bank reserves to commercial bank demand deposits and notes, doesn’t mean that those ratios never decline. In fact they may decline for several reasons. But when they do change, commercial bank reserve ratios usually change gradually rather than rapidly. In contrast central banks, and fiat-money issuing central banks especially, can and sometimes do occasionally expand their balance sheets quite rapidly, if not to a dramatic extent. It’s for this reason that monetary booms are more likely to be fueled by central bank credit operations than by commercial banks’ decision to “skimp” more than usual on reserves.

There are, however, some exceptions to the rule that reserve ratios tend to change only gradually. One of these stems from government regulations, changes in which can lead to reserve ratio changes that are both more substantial and more sudden. Thus in the U.S. during the 1990s changes to minimum bank reserve requirements and the manner of their enforcement led to a considerable decline in actual bank reserve ratios. In contrast, the Federal Reserve’s decision to begin paying interest on bank reserves starting in October 2008, followed by its various rounds of Quantitative Easing, caused bank reserve ratios to increase dramatically.

The other exception concerns cases in which fractional reserve banking is just developing. Obviously as that happens a switch from 100-percent reserves, or its equivalent, to some considerably lower fraction, might take place over a relatively short time span. In England during the last half of the 17th century, for example, the rise first of the goldsmith banks and then of the Bank of England led to a considerable reduction in the demand for monetary gold, its place being taken by a combination of paper notes and readily redeemable deposits.

Yet even that revolutionary change involved a less rapid increase in the role of fiduciary media, with even less significant cyclical implications, than one might first suppose, for several reasons. First, only a relatively small number of persons dealt with banks at first: for the vast majority of people, “money” still meant nothing other than copper and silver coins, plus (for the relatively well-heeled) the occasional gold guinea. Second, bank reserve ratios remained fairly high at first — the best estimates put them at around 30 percent or so — declining only gradually from that relatively high level. Finally, the fact that the change was as yet limited to England and one or two other economies meant that, instead of resulting in any substantial change England’s money stock, level of spending, or price level, it led to a largely contemporaneous outflow of now-surplus gold to the rest of the world. By allowing paper to stand in for specie, in other words, England was able to export that much more precious metal. The same thing occurred in Scotland over the course of the next century, only to a considerably greater degree thanks to the greater freedom enjoyed by Scotland’s banks. It was that development that caused Adam Smith to wax eloquent on the Scottish banking system’s contribution to Scottish economic growth.

Eventually, however, any fractional-reserve banking system tends to settle into a relatively “mature” state, after which, barring changes to government regulations, bank reserve ratios are likely to decline only gradually, if they decline at all, in response to numerous factors including improvements in settlement arrangements, economies of scale, and changes in the liquidity of marketability of banks’ non-reserve assets. For this reason it’s perfectly absurd to treat the relatively rapid expansion of fiduciary media in a fractional-reserve banking system that’s just taking root as illustrating tendencies present within established fractional-reserve banking systems.

Yet that’s just what some proponents of 100-percent banking appear to do. For example, in a relatively recent blog Robert Murphy serves-up the following “standard story of fractional reserve banking”:

Starting originally from a position of 100% reserve banking on demand deposits, the commercial banks look at all of their customers’ deposits of gold in their vaults, and take 80% of them, and lend them out into the community. This pushes down interest rates. But the original rich depositors don’t alter their behavior. Somebody who had planned on spending 8 of his 10 gold coins still does that. So aggregate consumption in the community doesn’t drop. Therefore, to the extent that the sudden drop in interest rates induces new investment projects that wouldn’t have occurred otherwise, there is an unsustainable boom that must eventually end in a bust.

Let pass Murphy’s unfounded — and by now repeatedly-refuted — suggestion that fractional reserve banking started out with bankers’ lending customers’ deposits without the customers knowing it. And forget as well, for the moment, that any banker who funds loans using deposits that the depositors themselves intend spend immediately will go bust in short order. The awkward fact remains that, once a fractional-reserve banking system is established, it cannot go on being established again and again, but instead settles down to a relatively stable reserve ratio. So instead of explaining how fractional reserve banking can give rise to recurring business cycles, the story Murphy offers is one that accounts for only a single, never to be repeated fractional-reserve based cyclical event.

Desirable and Undesirable Reserve Ratio Changes

Finally, a declining banking system reserve ratio doesn’t necessarily imply excessive money creation, lending, or bank maturity mismatching. That’s because, notwithstanding what Murphy and others claim, competing commercial banks generally can’t create money, or loans, out of thin air. Instead, their capacity to lend, like that of other intermediaries, depends crucially on their success at getting members of the public to hold on to their IOUs. The more IOUs bankers’ customers are willing to hold on to, and the fewer they choose to cash in, the more the bankers can afford to lend. If, on the other hand, instead of holding onto a competing bank’s IOUs, the bank’s customers all decide to spend them at once, the bank will fail in short order, and will do so even if its ordinary customers never stage a run on it. All of this goes for the readily redeemable bank IOUs that make up the stock of bank-supplied money no less than for IOUs of other sorts. In other words, contrary to what Robert Murphy suggests in his passage quoted above, it matters a great deal to any banker whether or not persons who have exchanged basic money for his banks’ redeemable claims plan to go on spending, thereby drawing on those claims, or not.

Furthermore, as I show in part II of my book on free banking, in a free or relatively free banking system, meaning one in which there are no legal reserve requirements and banks are free to issue their own circulating currency, bank reserve ratios will tend to change mainly in response to changes in the public’s demand to hold on to bank-money balances. When people choose to increase their holdings of (that is, to put off spending) bank deposits or notes or both, the banks can profitably “stretch” their reserves further, making them support a correspondingly higher quantity of bank money. If, on the other hand, people choose to reduce their holdings of bank money by trying to spend them more aggressively, the banks will be compelled to restrict their lending and raise their reserve ratios. The stock of bank-created money will, in other words, tend to adjust so as to offset opposite changes in money’s velocity, thereby stabilizing the product of the two.

This last result, far from implying a means by which fractional-reserve banks might fuel business cycles, suggests on the contrary that the equilibrium reserve ratio changes in a free banking system can actually help to avoid such cycles. For according to Friedrich Hayek’s writings of the 1930s, in which he develops his theory of the business cycle most fully, avoiding such cycles is a matter of maintaining, not a constant money stock (M), but a constant “total money stream” (MV).

Voluntary and Involuntary Saving

Hayek’s view is, of course, distinct from Murray Rothbard’s, and also from that of many other Austrian critics of fractional reserve banking. But it is also more intuitively appealing. For the Austrian theory of the business cycle attributes unsustainable booms to occasions when bank-financed investment exceeds voluntary saving. Such booms are unsustainable because the unnaturally low interest rates with which they’re associated inevitably give way to higher ones consistent with the public’s voluntary willingness to save. But why should rates rise? They rise because lending in excess of voluntary savings means adding more to the “total money stream” than savers take out of that stream. Eventually that increased money stream will serve to bid up prices. Higher prices will in term raise the demand for loans, pushing interest rates back up. The increase in rates in turn brings the boom to an end, launching the “bust” stage of the cycle.

If, in contrast, banks lend more only to the extent that doing so compensates for the public’s attempts to accumulate balances of bank money, the money stream remains constant. Consequently the increase in bank lending doesn’t result in any general increase in the demand for or prices of goods. There is, in this case, no tendency for either the demand for credit or interest rates to increase. Instead of being self-reversing, the investment “boom,” if it can be called such, is not inevitably self-reversing. Instead, it can go on for as long as the increased demand for fiduciary media persists, and perhaps forever.

As I’m not saying anything here that I haven’t said before, I have a pretty darn good idea what sort of counterarguments to anticipate. Among others I expect to see claims to the effect that people who hold onto balances of bank money (or fiduciary media or “money substitutes” or whatever one wishes to call bank ‑issued IOUs that serve as regularly-accepted means of exchange) are not “really” engaged in acts of voluntary saving, because they might choose to part with those balances at any time, or because a bank deposit balance or banknote is “neither a present nor a future good,” or something alone these lines.

Balderdash. To “save” is merely to refrain from spending one’s earnings; and one can save by holding on or adding to a bank deposit balance or redeemable banknote no less than by holding on to or accumulating Treasury bonds. That persons who choose to save by accumulating demand deposits do not commit themselves to saving any definite amount for any definite length of time does not make their decision to save any less real: so long as they hold on to bank-issued IOUs, they are devoting a quantity of savings precisely equal to the value of those IOUs to the banks that have them on their books: as Murray Rothbard himself might have put it — though he certainly never did so with regard to the case at hand — such persons have a “demonstrated preference” for not spending, that is, for saving, to the extent that they hold bank IOUs, where “demonstrated preference” refers to the (“praxeological”) insight that, regardless of what some outside expert might claim, peoples’ actual acts of choice supply the only real proof of what they desire or don’t desire. According to that insight, so long as someone holds a bank balance or IOU, he desires the balance or IOU, and not the things that could be had for it, or any part of it. That is, he desires to be a creditor to the bank against which he holds the balance or IOU.

And so long as banks expand their lending in accord with their customers’ demonstrated preference such acts of saving, and no more, while contracting it as their customers’ willingness to direct their savings to them subsides, the banks’ lending will not contribute to business cycles, Austrian or otherwise.

Of course, real-world monetary systems don’t always conform to the ideal sort of banking system I’ve described, issuing more fiduciary media only to the extent that the public’s real demand for such media has itself increased. While free banking systems of the sort I theorize about in my book tend to approximate this ideal, real world systems can and sometimes do create credit in excess of the public’s voluntary savings, occasionally without, though (as we’ve seen) most often with, the help of accommodative central banks. But that’s no reason to condemn fractional reserve banking. Instead it’s a reason for looking more deeply into the circumstances that sometimes allow banking and monetary systems to promote business cycles.

In other words, instead of repeating the facile cliché that fractional reserve banking causes business cycles, or condemning fiduciary media tout court, Austrian economists who want to put a stop to such cycles, and to do so without undermining beneficial bank undertakings, should inquire into the factors that sometimes cause banks to create more fiduciary media than their customers either want or need.

German foreign minister Heiko Maas recently penned an article in which he said that "it’s essential that we strengthen European autonomy by establishing payment channels that are independent of the US, creating a European Monetary Fund and building up an independent Swift system."

So what exactly is Maas's quibble with SWIFT, the Society for Worldwide Interbank Financial Telecommunication? SWIFT is a proprietary messaging system that banks can use to communicate information about cross border payments. This November, U.S. President Trump has threatened to impose sanctions on SWIFT if it doesn't remove a set of Iranian banks from the SWIFT directory.

For Heiko Maas, this is a problem. Iran and Germany remain signatories to the same nuclear deal that Trump reneged on earlier this year. The deal committed Iran to cutting back its uranium enrichment program and allowing foreign inspectors access to nuclear sites and, in return, obligating signatories like Germany to normalize economic relations with Iran, including allowing the unrestricted sale of oil. If Iran is bumped from SWIFT, it could prevent Germany from meeting its side of the deal, potentially scuppering the whole thing. So, a fully functioning SWIFT, one that can't be manipulated by foreign bullies, is key to Germany meeting its current foreign policy goals.

SWIFT is vital because it is a universal standard. If I want to send you $10,000 from my bank in Canada to your bank in Singapore to pay for services rendered, bank employees will use SWIFT terminals and codes to communicate how to manipulate the various bank ledgers involved in the transaction. If a bank has been banished from SWIFT, then it can no longer use what is effectively a universal banker's language for making money smoothly flow across borders.

It would be as-if you were at a party but, unlike all the other party-goers, were prohibited from using words to communicate. Sure, you could get your points across through hand gestures and stick drawings, but people would find conversing with you to be tiring and might prefer to avoid you. Without access to SWIFT, Iranian banks will be in the same situation as the mute party-goer. Sure, they can always use other types of communication like email, telex or fax to convey banking instructions, but these would be cumbersome since they would require counterparties to learn a new and clunky process, and they wouldn't necessarily be secure.

It seems odd that Maas is complaining about the SWIFT's independence given that it is located in Belgium, which is home territory. Even though it is one the other side of the ocean, Trump can still influence the network. The way that he plans to bend SWIFT to his will is by threatening members of its board with potential asset expropriations, criminal charges, travel bans, as well as punishing the companies they work for by restricting them from conducting business in the U.S.

How credible is this threat? As I pointed out here...

If SWIFT doesn't comply with US requirements that Iranian banks be cut off from its network, SWIFT board members (such as Yawar Shah) will face asset freezes & travel bans, and the banks that employ them (Citigroup) will be cut from the payments system: https://t.co/tVntv3USzs pic.twitter.com/XAiLOKPdtk

— JP Koning (@jp_koning) June 6, 2018

...SWIFT's board is made up of executives from twenty-five of the world's largest banks, including two Americans: Citigroup's Yawar Shah and J.P Morgan's Emma Loftus. No matter how erratic and silly he is, I really can't imagine Trump following up on his threat. Would he ban all twenty-five banks, including Citigroup and J.P. Morgan, from doing business in the U.S.? Not a chance, that would decimate the global banking system. Requiring U.S. banks to stop using SWIFT would be equally foolish. Would he risk ridicule by putting two American bank executives—Shah and Loftus—under house arrest for non-compliance? I doubt it.

No, the SWIFT board is TBTP, or too-big-to-be-punished. But even if Trump's threat is not a credible one, surely SWIFT will fall in line anyways. Large international businesses generally comply with the requests of governments, especially the American one. But there's a kicker. European law prohibits European businesses from complying with foreign sanctions unless they have secured EU permission to do so. This leaves SWIFT in an awfully tight place. Which of the two jurisdictions' laws will it choose to break? Assuming it can't get EU permission to comply with U.S. sanctions, then it can either illegally comply with U.S. law, or it can legally contravene U.S. laws. Either way, something has to give.

Europe can win this battle, a point that Axel Hellman makes for Al-Monitor. After all, SWIFT is is located in Belgium, not New York, and jurisdiction over SWIFT surely trumps lack of jurisdiction. Indeed, on its website SWIFT says that its policy is to defer to the EU on these matters:

"Whilst sanctions are imposed independently in different jurisdictions around the world, SWIFT cannot arbitrarily choose which jurisdiction’s sanction regime to follow. Being incorporated under Belgian law it must instead comply with related EU regulation, as confirmed by the Belgian government."

Consider too that SWIFT itself is supposed to be committed to a policy of non-censorship. Chairman Yawar Shah once said that “neutrality is in SWIFT’s DNA.” So from an ideological perspective it would seem that SWIFT would be aligned with Europe's more inclusive stance.

Of course, SWIFT's stated commitment to neutrality conflicts with the fact that it has banned Iran from the network before. In early 2012, U.S. pressure on SWIFT grew in the form of proposed legislation that would punish the messaging provider should it fail to ban Iranian users. SWIFT prevaricated, noting in early February that it would await the "right multilateral legal framework" before acting. In March 2012, the EU Council passed a resolution prohibiting financial messaging providers from servicing Iranian banks, upon which SWIFT disconnected them. It was only in 2015, after passage of the nuclear deal, that SWIFT reconnected Iran. (I get this timeline from the very readable Routledge Global Institutions book on SWIFT, by Suzan Scott and Markos Zachariadis).

The takeaway here is that SWIFT only severed Iranian banks in response to European regulations, in turn a product of a conversation between American and European leaders. SWIFT will seemingly compromise its neutrality if there is a sufficient level of global agreement on the issue followed up by a European directive, not an American one.

If Heiko Maas wants an "independent SWIFT," the above analysis would seem to illustrate that he already has it. Thanks to its European backstop, SWIFT is already independent enough to say no to U.S. bullying. As long it is willing, European officials can force a showdown over SWIFT that they can only win, thus helping to preserve the Iranian nuclear deal.

But maybe European officials don't want to go down this potentially contentious path. Perhaps they would prefer to preserve the peace and grant SWIFT an exemption that allows the organization to comply with U.S. sanctions, thus cutting Iran off from the messaging network, while trying to cobble together some sort of alternative messaging system in order to salvage the nuclear deal. Maybe this alternative is what Maas is referring to when he talks of a building an "independent SWIFT."

An alternative messaging service would have to be capable of providing bankers with sufficient usability so that Iranian oil sales can proceed fluidly. In a recent paper, Esfandyar Batmanghelidj and Axel Hellman give some clues into what this system would look like. During the previous SWIFT ban, several European banks were able to maintain their relationships with Iranian financial institutions by using "ad hoc messaging systems." These ad hoc solutions could be revived, note Batmanghelidj and Hellman.

Using this ad hoc system, so-called gateway banks—those that have access to the ECB's large value payments system Target2 and also limited exposure to the U.S. financial system—would conduct euro transactions on behalf of buyers and sellers of Iranian oil. Since presumably only a few gateways would be necessary to conduct this trade, it would be relatively painless for them to learn the new messaging language and the set of processes involved. For instance, instead of using SWIFT bank identifier codes to indicate account numbers, Batmanghelidj and Hellman point to the possibility of using IBAN numbers, an entirely different international standard.

This independent ad-hoc system would probably work, on the condition that the European monetary authorities continue providing gateway banks that serve Iranian clients with access to the ECB's Target2 payments system. This is a point I stressed in my previous blog post. It isn't access to SWIFT that is the linchpin of the nuclear deal, it is access to European central banks. But as long as folks like Heiko Maas get their way, I don't see why this sponsorship wouldn't be forthcoming. In response, Trump could always try to sanction the European central bank(s) that allow this ad-hoc system to continue. But an escalation of U.S. bullying from the mere corporate level (i.e. SWIFT) to the level of a friendly sovereign nation would constitute an even more nutty policy. I just don't see it happening.

At stake here is something far larger than just Iran. As I recently wrote for the Sound Money Project, financial inclusion is a principle worth fighting for. If one bully can unilaterally ban Iran from the global payments system, who is to say the next victim won't be Canada, or Qatar, or Russia, or  China? Europe needs to stand up to the U.S. on this battle, either by forcing a SWIFT showdown or by sponsoring an ad hoc alternative—not because Iran is an angel—but because we need censorship resistant financial utilities.

This material originally appeared on JP Koning's Moneyness blog, we thank him for the permission to re-post it here. 

Introduction

Understanding what caused the Great Depression of 1929-39 and why it persisted so long has been fairly characterized by Ben Bernanke as the “Holy Grail of Macroeconomics.” The fear that the financial crisis of 2008 would lead to a similar Depression induced the Fed to use its emergency powers to bail out failing firms and to more than quadruple the monetary base, while Congress authorized additional bailouts and doubled the national debt. Could the Great Recession have taken a similar turn had these extreme measures not been taken?

Economists have often blamed the Depression on U.S. monetary policy or financial institutions.  Friedman and Schwartz (1963) famously argued that a spontaneous wave of runs against fragile fractional reserve banks led to a rise in the currency/deposit ratio. The Fed failed to offset the resulting fall in the money multiplier with base expansion, leading to a disastrous 24% deflation from 1929 to 1933. Through the short-run Phillips curve effect (Friedman 1968), this in turn led to a surge in unemployment to 22.5% by 1932.

The Debt-Deflation theory of Irving Fisher, and later Ben Bernanke (1995), takes the deflation as given, and blames the severity of the disruption on the massive bankruptcies that were caused by the increased burden of nominal indebtedness.  Murray Rothbard (1963) uses the “Austrian” business cycle theory of Ludwig von Mises and F.A. Hayek to blame the downturn on excessive domestic credit expansion by the Fed during the 1920s that disturbed the intertemporal structure of production (cf. McCulloch 2014).

My own view, after pondering the problem for many decades, is that indeed the Depression was monetary in origin, but that the ultimate blame lies not with U.S. domestic monetary and financial policy during the 1920s and 30s. Rather, the massive deflation was an inevitable consequence of Europe’s departure from the gold standard during World War I --  and its bungled and abrupt attempt to return to gold in the late 1920s.

In brief, the departure of the European belligerents from gold in 1914 massively reduced the global demand for gold, leading to the inflation of prices in terms of gold -- and, therefore, in terms of currencies like the U.S. dollar which were convertible to gold at a fixed parity. After the war, Europe initially postponed its return to gold, leading to a plateau of high prices during the 1920s that came to be perceived as the new normal. In the late 1920s, there was a scramble to return to the pre-war gold standard, with the inevitable consequence that commodity prices -- in terms of gold, and therefore in terms of the dollar -- had to return to something approaching their 1914 level.

The deflation was thus inevitable, but was made much more harmful by its postponement and then abruptness. In retrospect, the UK could have returned to its pre-war parity with far less pain by emulating the U.S. post-Civil War policy of freezing the monetary base until the price level gradually fell to its pre-war level. France should not have over-devalued the franc, and then should have monetized its gold influx rather than acting as a global gold sink. Gold reserve ratios were unnecessarily high, especially in France.

However, given that the U.S. had a fixed exchange rate relative to gold and no control over Europe’s misguided policies, it was stuck with importing the global gold deflation -- regardless of its own domestic monetary policies. The debt/deflation problem undoubtedly aggravated the Depression and led to bank failures, which in turn increased the currency/deposit ratio and compounded the situation. However, a substantial portion of the fall in the U.S. nominal money stock was to be expected as a result of the inevitable deflation -- and therefore was the product, rather than the primary cause, of the deflation. The anti-competitive policies of the Hoover years and FDR’s New Deal (Rothbard 1963, Ohanian 2009) surely aggravated and prolonged the Depression, but were not the ultimate cause.

Contemporary economists Ralph Hawtrey, Charles Rist, and Gustav Cassel warned throughout the 1920s that substantial deflation, in terms of gold and therefore the dollar, would be required to sustain a return to anything like the 1914 gold standard.[1]  In 1928, Cassel actually predicted that a global depression was imminent:

The post-War superfluity of gold is, however, of an entirely temporary character, and the great problem is how to meet the growing scarcity of gold which threatens the world both from increased demand and from diminished supply. We must solve this problem by a systematic restriction of the monetary demand for gold. Only if we succeed in doing this can we hope to prevent a permanent fall in the general price level and a prolonged and world-wide depression which would inevitably be connected with such a fall in prices [as quoted by Johnson (1997, p. 55)].

War and Peace

War is a very expensive enterprise, and governments often resort to printing money to help finance them. Under a gold standard, this may require a temporary suspension of convertibility to gold.  After the war, the government will ordinarily have to either deflate back to the pre-war price level to restore the pre-war parity, or else devalue in proportion to their wartime inflation to get back on gold at a new parity (or some combination of the two). A credible promise to restore the pre-war standard after the war will increase the demand for paper money during the war -- and will reduce the inflation necessary to achieve a given real spending goal. Returning to the pre-war parity is thus more like a compulsory, interest-free loan to the government than pure inflationary finance.

Figure 1 [2] shows two centuries of the U.S. price level. Major wartime experiences, marked in red, coincide with major inflations. Prior to World War II, these were followed by deflations, marked in green, which largely reversed the wartime inflation.

Figure 2 zooms in on the 19th century. From 1840 to 1900, the price level mostly hovered in the range 8.0 to 10.0 (1982-4 = 100), with the significant exception of the Civil War and post-Civil War period 1861-79. During the war (1861-65), the federal government printed paper money or “greenbacks” to pay troops and suppliers. At first, these were convertible at the Treasury for gold at the long-standing gold price of $20.67 per troy ounce. By the end of 1861, however, the Treasury was forced to suspend conversion. Paper dollars quickly fell to a discount, relative to gold, but Congress made them legal tender early in 1862. Gold coin and bank reserves were not seized by the government, as in 1933, but gold was nevertheless driven out of circulation by Gresham’s Law. By 1865, the volume of greenbacks had expanded to about $400 million, the general price level in terms of the greenback had risen by 85%, and a $1 gold coin sold for as much as $2.50 in paper.

To restore the greenback to gold at the pre-war parity, it was necessary to bring the price of gold back down to $20.67, and therefore to reduce the general price level back to approximately its 1861 level. Under the Contraction Act of 1866, the Treasury began retiring greenbacks at a rate of up to $4 million per month. If this had continued, there would have been a very sharp, if brief, deflation and a major post-war depression.

However, this act was repealed in 1868 and the quantity of greenbacks was simply frozen at $347 million. As the economy grew with a constant monetary base, there ensued a relatively gradual deflation (averaging 3.4% per year) until the “Resumption” of 1879, when the Treasury resumed gold conversion of the greenback at the pre-war parity of $20.67 per ounce. This gradual, yet substantial deflation was undoubtedly difficult for debtors and the labor market, but it was not as traumatic as a sudden deflation would have been.

World War I

Figure 3 looks at the 20th century. From 1900 to 1914, U.S. inflation averaged 1.3% per year, even with a peacetime gold standard. This “gold inflation” was primarily due to new gold discoveries in South Africa and elsewhere, along with the new cyanide process for extracting gold from low-grade ores.

In 1914, World War I broke out in Europe, and the belligerent countries did essentially what the U.S. had done during the Civil War -- they printed money, suspended gold convertibility, and then printed even more money, with the promise that they would restore the pre-war standard after victory. The European nations then used their gold stores to buy war materials from countries like the U.S., which remained neutral for the first three years of the war and remained on gold at $20.67 an ounce throughout. The resulting gold influx expanded the U.S. monetary base and money supply, leading to an “imported inflation” in the U.S. and in other countries remaining on gold.

Looked at differently, before the war, there were three primary sources of demand for gold: monetary demand in Europe, monetary demand in the U.S. and other neutral countries, and global non-monetary demand for uses like jewelry. When Europe went off gold, European monetary demand for gold temporarily disappeared. This abrupt reduction in the global demand for gold temporarily depressed the value of gold, and also the value of the dollar, in terms of commodities. Since U.S. real money demand was not directly affected by the inflation, a portion of the gold released by Europe temporarily went into the nominal money stocks and central bank reserves of the U.S. and other neutral countries and the remainder went into global non-monetary uses.

From 1914 to 1917, the U.S. inflation was not due to domestic inflationary finance, but was primarily an indirect consequence of the inflationary policies in Europe. It did not matter for U.S. inflation how much the European countries inflated, but rather how much gold they exported after they went off the gold standard.

The U.S. was in the war from 1917 to 1918, and the new Federal Reserve System began adding domestic inflation to the global gold inflation by discounting War Bonds. From 1914 to 1920, the U.S. price level roughly doubled, and inflation averaged 12.2% per year.

The Gold Exchange Standard

After the war, in order to stay on gold at $20.67 an ounce, with Europe off gold, the U.S. had to undo its post-1917 inflation. The Fed achieved this by raising the discount rate on War Bonds, beginning in late 1919, inducing banks to repay their corresponding loans. The result was a sharp 16% fall in the price level from 1920 to 1922. Unemployment rose from 3.0% in 1919 to 8.7% in 1921. However, nominal wages fell quickly, and unemployment was back to 4.8% by 1923, where it remained until 1929.[3]

The 1920-22 deflation thus brought the U.S. price level into equilibrium, but only in a world with Europe still off gold. Restoring the full 1914 gold standard would have required going back to approximately the 1914 value of gold in terms of commodities, and therefore the 1914 U.S. price level, after perhaps extrapolating for a continuation of the 1900-1914 “gold inflation.”

However, the European countries did not seriously try to get back on gold until the second half of the 1920s. The Genoa Conference of 1922 recognized that prices were too high for a full gold standard, but instead tried to put off the necessary deflation with an unrealistic “Gold Exchange Standard.” Under that system, only the “gold center” countries, the U.S. and UK, would hold actual gold reserves, while other central banks would be encouraged to hold dollar or sterling reserves, which in turn would only be fractionally backed by gold. The Gold Exchange Standard sounded good on paper, but unrealistically assumed that the rest of the world would permanently kowtow to the financial supremacy of New York and London.

Like the U.S. after the Civil War, Britain felt honor-bound to restore its pre-war parity, but unfortunately this was done prematurely in 1925 -- before prices and wages had adequately deflated. This left the pound overvalued and the Bank of England (BOE) saddled with a balance of payments deficit as it struggled to retain gold reserves. The UK fought back with very tight money, but then offset the deflationary effect with protective tariffs. Tariffs, by taxing the import of everything but gold, do raise the equilibrium domestic commodity price level relative to gold. However, the whole advantage of having a currency unit that is convertible into a lot of gold is that it allows consumers to purchase a lot of foreign goods with their money. Taxing those imports to support an unrealistic exchange rate thus defeats the very purpose of a strong currency.

Relieved of the moral obligations of victory, Germany and Austria hyperinflated in 1919-23, instead of making any attempt to restore their pre-war parities or even stabilize their price levels. France deflated somewhat between 1919 and 1922, but then inflated to almost double 1919 wholesale prices by 1926 (Johnson 1997, p. 74). It does appear, however, that these inflations did give the public an understandable distrust of paper money and a sense of urgency to get back on gold as soon as possible.

Germany stabilized the Reichsmark in 1924, with a legal requirement of 40% foreign exchange or gold reserves, at least 3/4 of which had to be in gold, contrary to the spirit of the Gold Exchange Standard. The following year, Reichsbank president Hjalmar Schacht independently went even further by announcing that the bank would henceforth accumulate only gold rather than dollar or sterling reserves (Johnson 1997, p. 115).

In 1926, under Raymond Poincaré, France stabilized the franc after a 5:1 devaluation. However, it overdid the devaluation, leaving the franc undervalued by about 25%, according to The Economist (Johnson 1997, p. 131). Normally, under the specie flow mechanism, this would have led to a rapid accumulation of international reserves accompanied by monetary expansion and inflation, until the price level caught up with purchasing power parity. But instead, the Banque de France sterilized the reserve influx by reducing its holdings of government and commercial credit, so that inflation did not automatically stop the reserve inflow. Furthermore, it often cashed dollar and sterling reserves for gold, again contrary to the Gold Exchange Standard.  The Banking Law of 1928 made the new exchange rate, as well as the gold-only policy, official. By 1932, French gold reserves were 80% of currency and sight deposits (Irwin 2012), and France had acquired 28.4% of world gold reserves -- even though it accounted for only 6.6% of world manufacturing output (Johnson 1997, p. 194). This “French Gold Sink” created even more deflationary pressure on gold, and therefore dollar prices, than would otherwise have been expected.

The Second Post-War Deflation

By 1931, French gold withdrawals forced Germany to adopt exchange controls, and Britain to give up convertibility altogether. However, these countries did not then disgorge their remaining gold, but held onto it in the hopes of one day restoring free convertibility. Meanwhile, after having been burned by the Bank of England’s suspension, the “Gold Bloc” countries -- Belgium, Netherlands and Switzerland -- also began amassing gold reserves in earnest, raising their share of world gold reserves from 4.2% in June 1930 to 11.1% two years later (Johnson 1997, p. 194). Despite the dollar’s relatively strong position, the Fed also contributed to the problem by raising its gold coverage ratio to over 75% by 1930, well in excess of the 40% required by law (Irwin 2012, Fig. 5).

The result was a second post-war deflation as the value of gold, and therefore of the dollar, in terms of commodities, abruptly caught up with the greatly increased global demand for gold. The U.S. price level fell 24.0% between 1929 and 1933, with deflation averaging 6.6% per year for 4 years in a row. Unemployment shot up to 22.5% by 1932.

By 1933, the U.S. price level was still well above its 1914 level. However, if the “gold inflation” of 1900-1914 is extrapolated to 1933, as in Figure 3, the trend comes out to almost the 1933 price level. It therefore appears that the U.S. price level, if not its unemployment rate, was finally near its equilibrium under a global gold standard with the dollar at $20.67 per ounce, and that further deflation was probably unnecessary.[4]

The 1929-33 deflation was much more destructive than the 1920-22 deflation, in large part because it followed a 7-year “plateau” of relatively stable prices that lulled the credit and labor markets into thinking that the higher price level was the new norm -- and that gave borrowers time to accumulate substantial nominal debt. In 1919-1920, on the other hand, the newly elevated price level seemed abnormally high and likely to come back down in the near future, as it had after 1812 and 1865.

Thus, although the onset of the Depression was monetary in origin, it was not the fault of the Fed’s domestic monetary policy as per Friedman and Schwartz or Rothbard, but rather was caused by the European countries’ resolution of their World War I inflations. To be sure, the debt/deflation bankruptcy mechanism of Fisher and Bernanke aggravated the Phillips Curve effect of the deflation.  Furthermore, the resulting loan defaults led to bank failures, loss of confidence in the banks, and a rise in the currency/deposit ratio per Friedman and Schwartz. However, it is not clear that the ensuing contraction of the U.S. nominal money supply was any more than was appropriate, given the externally caused and inevitable deflation. As Rothbard (1963) and Ohanian (2009) have pointed out, the Depression was needlessly aggravated and extended by the anticompetitive “New Deal” policies of the Hoover and FDR administrations, but these policies were in response to the pre-existing Depression rather than its cause. Deficit-suppressing, protective tariffs, including pre-eminently America’s Smoot-Hawley Tariff, greatly compounded the depression -- but these were often an outcome of the struggle to get or stay on gold.

How It Could Have been Different

In retrospect, the UK could have successfully gotten itself back on gold with far less disruption simply by emulating the U.S. post-Civil War policy of freezing the monetary base at its war-end level, and then letting the economy grow into the money supply with a gradual deflation. This might have taken 14 years, as in the U.S. between 1865-79, or even longer, but it would have been superior to the economic, social, and political turmoil that the UK experienced. After the pound rose to its pre-war parity of $4.86, the BOE could have begun gradually buying gold reserves with new liabilities and even redeeming those liabilities on demand for gold, subject to reserve availability. Once reserves reached say 20% of its liabilities, it could have started to extend domestic credit to the government and the private sector through the banks, while still maintaining convertibility. Gold coins could even have been circulated, as demanded.

If other countries had followed a similar policy, with or without first devaluing, the global demand for gold would have only grown gradually, rather than abruptly. The U.S. would have had a steady gold outflow and/or deflation, as other countries built their gold reserves and coinages. And the episode would have been an historical footnote rather than the defining economic catastrophe of the inter-war period.

If the UK and other countries had all simply devalued in proportion to their domestic price levels at the end of the war, they could have returned to gold quicker, and with less deflation. However, given that a country’s real demand for money -- and therefore its demand for real gold reserves -- depends only on the real size of the economy and its net gold reserve ratio, such policies would not have reduced the ultimate global demand for gold or lessened the postwar deflation in countries that remained on gold at a fixed parity. The significant downside of such a devaluation, or of a similar policy in the U.S. after the Civil War, is that it would have betrayed the confidence of the note holders and bondholders whose trust helped finance the war. If correctly foreseen, such a policy would have reduced the wartime demand for paper money, and therefore caused even higher wartime inflation.

Lower gold reserve ratios for central bank liabilities could have greatly reduced the total global demand for gold, and therefore the gold deflation that was necessary to restore a global gold standard. Unfortunately, however, there was often a misguided assumption that central banks (and private banks) should suspend redemptions whenever the legal reserve requirement was not met. This gave them an incentive to hold a substantial amount of excess, or “free,” reserves over and above the legal requirement. Instead, it should have been understood that a bank is obligated to meet its demand liabilities, so long as it has any reserves at all, and that a “reserve requirement” means that it may extend or renew credit to the government and/or the private sector only if it has reserves in excess of the “required” level. This would automatically freeze the base, and even contract it as assets were repaid, whenever there was a reserve deficiency. It would put real teeth into the reserve requirement without unnecessary suspensions. The central bank could permanently maintain a small inventory of excess reserves by appropriately raising or lowering its discount rate whenever this inventory became excessively small or large.

H. Clark Johnson views the non-monetary demand for gold as a destabilizing factor during the 1920s and points a particularly accusatory finger at India (pp. 46-8). However, the non-monetary demand for gold actually stabilizes prices under a gold standard, since it will reduce the inflation that occurs when monetary demand is reduced (as during the early 1920s), and its reversal will mitigate the deflation that occurs when monetary demand has increased (as at the end of the 1920s and early 1930s).

Johnson repeatedly argues that the problem was the “undervaluation” of gold at $20.67 an ounce, and calls for the U.S. to have devalued the dollar in 1922, or even 1919, to prevent deflation (e.g. p. 157). However, had the mint price of gold been increased to around $35 an ounce in 1922, with the rest of the world still off gold, even more gold would have poured into the U.S. from all over the world. This would have raised the U.S. price level again roughly in proportion, making it that much more difficult for the rest of the world to acquire gold reserves. As the world did eventually get back on gold at whatever parities, gold demand would have risen again, and the U.S. would still have experienced a deflation, albeit from its newly elevated price .

In fact, the problem was not that gold was “undervalued” (as Johnson puts it) or that there was a “shortage” of gold (as per Cassel and others), but that the price level in terms of gold, and therefore dollars, was simply unsustainably high given Europe’s determination to return to gold. In any event, it was inconceivable that the U.S. would have devalued in 1922, since it had plenty of gold, had already corrected its price level to the world situation with the 1920-22 deflation, and did not have the excuse of a banking crisis as in 1933.

2008 Revisited

This leads to the question of whether the 2008 financial crisis would likely have spiraled into another Great Depression in the absence of the extraordinary monetary, fiscal, and financial measures that were taken. The unequivocal answer is No. In 2008, the U.S. was not on a gold standard, and the world had not just gone through the unique historical experience of World War I, so that there was absolutely no reason to expect a reprise of the Great Depression.

For several years before the 2008 crisis, the financial sector, led by the Government Sponsored Enterprises, Fannie Mae and Freddie Mac, had indulged in reckless mortgage underwriting standards, with the result that by 2008 several large firms were economically bankrupt. The simple solution would have been to wipe out the equity of the responsible firms -- including Fannie, Freddie, and a few large financial holding companies -- and then mark down the debt held by the creditors who carelessly enabled this lending. The flagship commercial banks whose shares were held by these financial holding companies might have had new owners, but their own operations and capital would not have been interrupted, so long as the “firewalls” promised by the 1999 Gramm-Leach-Bliley Act were actually in place. Wall Street would have been sadder, but wiser, and life would have gone on.

The panicky monetary, fiscal, and financial measures that were actually taken in response to the 2008 financial crisis therefore cannot be justified by the experience of the Great Depression.

____________________
[1]  Johnson (1997), Mundell (2000). I am thankful to George Selgin for calling my attention to Johnson’s very informative book.

[2]  David-Solar consumer price index pre-1912, linked to BLS after, via Historical Statistics of the United States.

[3]   Christina Romer (1986).  Stanley Lebergott’s often-quoted 1964 figures are more extreme: 1.4% in 1919, 11.7% in 1921, 2.4% in 1923, but Romer makes a good case that his limited data over-stated the fluctuation.

[4]  Johnson (1997, pp. 53-4) points out that gold production was somewhat discouraged during the 1920s, and in particular before 1922, by the low real value of gold. However, once discoveries like the Witwatersrand and innovations like the cyanide process were in place, they continued to produce abundant quantities of gold cheaply, so that the underlying gold inflation trend likely continued, though perhaps at a slower rate than before the war.

References

Ben Bernanke (1995), “The Macroeconomics of the Great Depression:  A Comparative Approach,” Journal of Money, Credit and Banking 27, No. 1.

Milton Friedman and Anna Schwartz (1963), Monetary History of the United States, NBER, esp. Ch. 7, “The Great Contraction.”

Milton Friedman (1968), “The Role of Monetary Policy,” American Economic Review 58: 1017.

Douglas Irwin (2012), “The French Gold Sink and the Great Deflation of 1929-32,” Cato Papers on Public Policy 2: 1-41.

H. Clark Johnson (1997), Gold, France, and the Great Depression, 1919-1932. Yale University Press.

Huston McCulloch (2014), “Misesian Insights for Modern Macroeconomics,” Quarterly Journal of Austrian Economics 17: 3-18.

Robert A. Mundell (2000), “A Reconsideration of the Twentieth Century,” American Economic Review 90 (3): 327-40.

At the end of my first post in this series, I observed that assessing the claim that fractional reserve banking causes business cycles meant asking two questions: first, “To what extent have historical money-fueled booms been associated, not with growth in the supply of either commodity money or central-bank supplied bank reserves, but with declining banking system reserve ratios?” and, second, “When a banking system does manage to operate on a lower reserve ratio, does its doing so necessarily contribute to an unsustainable boom?” I answer the first question here, leaving the second to a third and final installment.

The Myth of Bank Lending “Manias”: the 19th Century

That first question is empirical, so answering it means consulting the historical record. It happens that I did just that some years ago, in response to claims to the effect that bankers, far from being immune to bouts of what Alan Greenspan famously called “irrational exuberance,” often play a lead part in fueling unsustainable booms, leading the more common herd of speculators, not to mention many perfectly innocent parties, to their ultimate undoing.

I eventually published my findings in an article on “Bank Lending ‘Manias’ In Theory and History. Although I didn’t attempt anything approaching a comprehensive review of historical booms and busts in that brief survey, I did look at several of the most notorious cases of booms and busts commonly blamed on excessive commercial bank lending.

I also made a point of selecting those cases in which commercial banks were free to issue their own notes, so that they did not have to rely on notes supplied by a central bank to meet their customers’ demands for currency. The episodes that fit that description best are the Ayr Bank Crisis of 1772, the English Panic of 1825, the U.S. Panic of 1837, the Australian Crash of 1893. After carefully reviewing each episode, I concluded that

Available evidence from less restricted banking systems does not support the banking mania tradition. Banks not subject to legal limits on their issues have not taken advantage of this to allow their reserve ratios to fall during booms. Banks have tended to hold higher than usual reserve ratios in the aftermath of crises, perhaps in anticipation of extraordinary “leakages” of high-powered money. In short, if banks have behaved in any procyclical fashion, they have leaned in the direction of exceptional conservativism during slumps. When monetary expansion has “fanned the flames” of euphoria and planted the seeds of an eventual crisis, the expansion has generally been caused not by falling reserve ratios for competitive banks (as the mania thesis claims), but by exogenous injections of high-powered [i.e. “basic”] money. These injections have sometimes consisted of specie inflows; at other times they have consisted of the expanded liabilities of a central bank of issue.

The 20th Century

But what about other famous booms? Because fans of the Austrian cycle theory often refer to the 1920s boom as fitting the theory, let’s first consider it. Doing so is made difficult by the lack of any consistent figures for bank demand deposits and reserves: while data for total bank demand deposits go back to 1914, data for bank reserves are available only for Federal Reserve System member banks. Yet there are no data for demand deposits of member banks alone! Consequently, and most frustratingly, it’s impossible to know precisely what was happening to the overall reserve ratios of either commercial banks taken as a whole or of Fed member banks only.

As an alternative way to gauge the role of fiduciary media in the lead-up to the Great Depression, the chart below shows, for 1914 (the first year for which consistent data are available) until 1930, the behavior of the following: (1) the U.S. money stock (demand deposits plus currency) (red line); (2) the stock of monetary gold (purple line); (3) total Federal Reserve “fiduciary” money creation, as measured by its holdings of commercial bills and Treasury securities (turquoise line); and (4) the relationship, expressed as a percentage, of the monetary gold stock to the broader money supply (blue line).

Although the chart does indeed appear to show a clear example of a “fiduciary media”-based boom, that boom occurs, not in the years leading to the Great Depression, but in those leading to the previous sharp but short-lived recession of 1920–21. Between the end of the war and the start of that recession the percentage of gold cover for the total money stock declined from almost 17.5 percent to less than 11.5 percent. The chart also shows how that decline was largely driven by Federal Reserve lending, which increased tenfold during the same period, from under $300 million to over $3 billion.

There’s no similarly clear evidence, on the other hand, of a fiduciary-media boom during the mid-to- late 1920s. After the ’20-’21 crisis, the gold cover percentage quickly recovered from its post-war decline. By May 1924 it had risen above 18 percent, a level exceeding its wartime peak. From there it declined, rose slightly, and declined again, to a not remarkably low nadir, in December 1928, of 14.6 percent, from which it proceeded to rise again until Black Tuesday. Finally, were one bold enough to venture that the modest decline of the gold cover percentage between May 1924 and December 1928 contributed importantly to an unsustainable boom, one would once again have to blame much of that decline on a substantial increase in Federal Reserve credit, the quantity of which doubled during the period in question, rather than on any fall in commercial bank reserve ratios.

And what about the post-2001 subprime mortgage boom? Here the evidence is perfectly clear: the boom had nothing to do with growth in the supply of fiduciary media, as that term is conventionally defined. Another FRED chart should settle any doubts:

Remarkably, far from having been fueled by an increased in bank demand deposits unmatched by a corresponding increase in bank reserves, the great boom of the noughts did not even involve any substantial growth in the absolutely quantity of demand deposits, which for the most part fluctuated within the narrow range of $300 billion to $350 billion. (The series for “checkable” deposits behaves almost identically.) As for the percentage of demand deposits covered by bank reserves, including both vault cash and reserve balances at the Fed, instead of declining, it shows a distinct upward trend.

None of this is meant to deny that banks played some part in fueling the subprime boom. Bank lending and deposit expansion were certainly part of the story: by mid-2008 total bank deposits were half again their value at the start of 2002. But the deposits that grew during the boom weren’t demand deposits. Instead they consisted of various sorts of time deposits, which are not supposed, according to the standard Austrian account, to be particularly capable of causing unsustainable booms. It’s partly for that reason that most (though not quite all) Austrian-school calls for 100-percent reserve banking are calls for having banks keep 100-percent reserves against their demand deposits only, and not against time deposits

Maturity Mismatching: Healthy and Unhealthy

To his credit Philip Bagus — one of the Austrian-school critics of fractional-reserve banking — has argued quite correctly against the standard Austrian view that a 100-percent reserve system would not suffice to rule-out bank maturity mismatching and business cycles that result from it. That so-called “shadow” banks, none of which actually took part in the issuance of fiduciary media as Austrian economists define it, formed the epicenter of that crisis, supports’ Bagus’s claim.

However, Bagus himself errs in supposing that maturity mismatching itself is an inevitable cause of malinvestment. Here it helps to distinguish between what I’ll call, for want of accepted terms, “item-by-item” maturity mismatching from “aggregate” maturity mismatching. The difference is crucial in the case of financial intermediaries, the functions of which include gathering savings from large numbers of independent sources, and using those savings to fund various investments. How come? Well, suppose that I borrow $1000 from a friend, while agreeing to pay that friend back any time he or she wishes, and that I in turn lend the $1000 to someone who will not pay me back for a year. In that case, assuming I did not have any other assets or liabilities, I’d be engaging in a very risky act of one-on-one maturity mismatching.

But suppose I am a bank, with thousands of customers each of whom deposit (that is, lend the bank) $1000, also for undetermined periods, and that I have been receiving such deposits for a long time. In that case, over time I learn that, thanks to having so many depositors, the withdrawals of some tend to be made up for by the fresh deposits of others: in other words, the different depositors are like so many runners in a relay race, with those drawing on their balances passing the savings baton on, as it were, to others who are making new deposits.

The banks challenge, in that case, is not that of mismatching the maturity of any individual deposit with that of some corresponding bank loan, but one of matching the maturity of the banks assets with the expected availability of the totality of its deposits. In principal a well-managed bank only has to have loans enough being repaid on any given day to meet its net deposit withdrawals for that same day, where by adequately limiting the overall quantity of its lending it might in principal keep that expected net withdrawal right at zero.

In practice, though, bankers are bound often to lose more funds than they gain, if only on a day to day basis, with the opposite happening just as often. It’s precisely for that reason that banks have reason to maintain fractional cash reserves, while also limiting the maturity of the loans they do make — as they have every reason to do unless they or their creditors expect to be bailed out. The existence of fractional reserves in a competitive banking system subject to market discipline is, therefore, properly understood, not as a symptom of bankers’ tendency to engage in dangerous or excessive mismatching of the maturities of their assets and liabilities, but as a precaution taken against the risk of excessive mismatching.

Several times on these pages (e.g., here and here), and elsewhere (e.g., here and here) I’ve tried to refute the claim, championed by certain Austrian-school economists and their many fans, that fractional-reserve banking is inherently fraudulent, because whenever the sum of readily-redeemable bank deposit balances and (when they exist) redeemable commercial banknotes exceeds the quantity of bank reserves, the difference must consist of so many fake “warehouse receipts” or “property titles.”

Although the popularity of the “fractional reserves equal fraud” (FR=F) thesis seems to be on the wane, many still remain in thrall to it, and I’m pretty darn sure that no further exertions by myself, Larry White, or anyone else will ever suffice to change all of their minds. Although I wish this weren’t so, I worry less and less about it. After all, there are still several Flat Earth societies, complete with dues-paying members, yet reputable geographers don’t seem to be losing any sleep over it.

There is, however, a second “prong” to the Austrian attack upon fractional-reserve banking which has also won many adherents, and which hasn’t been so thoroughly debunked as to make one wonder about those adherents’ powers of ratiocination. I mean the argument that fractional reserve banking inevitably causes business cycles by allowing banks to finance levels of investment exceeding those warranted by voluntary savings, at interest rates driven below their equilibrium of “natural” levels. The ensuing “malinvestment” boom, financed by “forced” rather than voluntary saving, inevitably leads to a bust, when unsustainable investments are liquidated, and economic activity is painfully redirected along sustainable paths.

In fact this second “fractional reserves equal Austrian business cycles” (FR=ABC) prong of the Austrian assault on fractional-reserve banking is just as unfounded as the first. The difference is that, while trying to win over the last, staunch adherents to the FR=F thesis may be futile, getting many who now believe that FR=ABC to see the error of their ways may not be so difficult, because the counterarguments haven’t been aired as often.

Those counterarguments are, on the other hand, more involved than the ones that can be brought to bear against the against the FR=F argument. Consequently I’ve chosen to devote several posts to them. I begin this first post with a review of conventional “Austrian” arguments concerning the meaning of excessive monetary expansion. I then consider the bearing of fractional reserves on an economy’s rate of monetary expansion. In two follow-up posts I use this background information to critically assess the claim that fractional reserve banking is an important cause of Austrian-style boom-bust cycles.

Monetary Expansion and the Austrian Theory of Business Cycles

To asses the claim that fractional reserve banking is an important cause of booms and busts of the sort described by the Austrian theory of the business cycle, we have, first of all, to recognize at least two popular versions of that theory that supply grounds for this claim. Both versions attribute cycles to excessive monetary expansion. But each defines “excessive” monetary expansion differently. According to one version, a constant money supply alone is capable of averting cycles. As Murray Rothbard explains, in summarizing Austrian monetary theory,

once any commodity or object is established as a money, it performs the maximum exchange work of which it is capable. An increase in the supply of money causes no increase whatever in the exchange service of money; all that happens is that the purchasing power of each unit of money is diluted by the increased supply of units. Hence there is never a social need for increasing the supply of money, either because of an increased supply of goods or because of an increase in population. People can acquire an increased proportion of cash balances with a fixed supply of money by spending less and thereby increasing the purchasing power of their cash balances, thus raising their real cash balances overall… .

A world of constant money supply would be one similar to that of much of the 18th and 19th centuries, marked by the successful flowering of the Industrial Revolution with increased capital investment increasing the supply of goods and with falling prices for those goods as well as falling costs of production. As demonstrated by the notable Austrian theory of the business cycle, even an inflationary expansion of money and credit merely offsetting the secular fall in prices will create the distortions of production that bring about the business cycle (my emphasis).

The other version of the theory maintains instead that cycles are caused, not by growth in the money stock per se, but by growth in the supply of unbacked (“fiduciary”) bank money. According to Frank Shostak, one of several adherents to this view, what sets in motion these cycles is not fluctuations in the growth rate of money supply as such, but the fluctuations in the growth rate of money supply generated out of “thin air.” By money “out of thin air” we mean money that is created by the central bank and amplified by fractional reserve lending by commercial banks.

An increase in the money supply out of “thin air” provides a platform for non-productive activities, which consume and add nothing to the pool or real wealth. Money out of “thin air” diverts real wealth from wealth generators to non-wealth generating activities, thus weakening the wealth-generating process.

In this alternative version of the theory, what matters is whether new money is either made of or backed by some commodity, like gold, or not. In a gold standard system, growth in the stock of gold, no matter how rapid, can never set off a cycle; in contrast any decline in the ratio of gold reserves to readily-redeemable bank liabilities can set a cycle in motion. In the case of a fiat money system, the two versions of the Austrian cycle theory coincide, for in this case there is no question of any “commodity-money” driven growth in the total quantity of money, whether that growth is due to central bank expansion or to a reduction in commercial banks’ reserve ratios.

Fractional Reserves and Monetary Expansion

The next step in countering the FR=ABC thesis consists of showing that a banking system’s reserve ratio and its rate of monetary expansion are largely independent of one another. One might have a banking system that rests on slimmest of reserve cushions, in which the monetary supply doesn’t grow at all. Alternatively one could have a 100-percent reserve system in which the money stock grows at a rapid rate.

These conclusions follow from the simple fact that, in any banking system with a given reserve ratio, the growth rate of the supply of bank-created money (or, if one prefers Austrian terminology, money “substitutes”) consisting of readily-redeemable deposits and, perhaps, commercial banknotes, will be approximately equal to the growth rate of the supply of “basic” money or bank reserves. That will be so whether these reserves consist of some commodity like gold or of the liabilities of a central bank. Nor does it matter how low the reserve ratio is: as I’ll show in a moment, although the growth rate of the money supply does depend on whether and how rapidly the banking system reserve ratio itself changes, is doesn’t depend on the absolute value of that ratio.

I say “approximately” above because some basic money may also circulate outside of the banking system, in which case movements of basic money into and out of the banking system will also influence to total money supply. To simplify the discussion, let’s assume that “basic” money consists of gold coins, but that instead of actually using these coins, the public prefers to hold banknotes and deposits, so that the supply of bank reserves is always equal to the supply of basic money. Let’s also assume that there are no mandatory reserve requirements. These circumstance make life relatively easy for the bankers, who need never fear having customers withdraw gold, and can presumably expand their liabilities more readily as a result. The assumption is therefore meant to allow as much scope for fractional-reserve based monetary expansion as possible.

The banks still need some gold, however, to settle accounts among themselves, especially when the amounts involved are too small to cover with other assets. Consequently they must maintain some positive ratio of reserves, though the ratio may fall well below 100 percent. Letting r stand for that ratio, with R and M standing for the quantities of reserves and bank-created money, respectively. Then

(1) M = R(1/r).

Differentiating (1) with respect to time after taking logs gives

(2) M = R – r,

where the italics stand for rates of change. Equation (2) shows that the growth rate of the money supply depends, not on the absolute value of r, but on how that value changes over time. A falling reserve ratio will be associated with a growing money stock, other things equal; but a small reserve ratio, if constant, doesn’t imply a more rapidly growing money stock than a high one. Instead, if the reserve ratio is constant, the money stock will grow only as rapidly as the supply of bank reserves, regardless of the value of the reserve ratio.

Real and Pseudo Money Creation

Austrian accounts of the money-creation process often exaggerate the ability of fractional reserve banks to create money “out of thin air,” even while sticking to a fixed reserve ratio, by looking at only one part of the bank money creation process. Consider the following, typical account, from a paper by Walter Block and Kenneth M. Garschina. Banks, they write,

are able to increase the money supply due to the system of fractional reserve banking. For example, if a deposit is made of one hundred dollars, the bank is only required to hold “in reserve” or “on hand” a small fraction of this amount. The rest can be granted as credit to customers who will inevitably follow the same deposit process with their newly acquired funds. In this way, in a decentralized system, money travels from bank to bank, multiplying each time it is lent out. And the original depositor, of course, is still able to draw on the funds entrusted to the bank on demand. As the process continues, the volume of money increases, lowering the money rate of interest below the natural rate.

But is it really true that a deposit to any bank in a fractional reserve system leads to substantially greater increase in the total money stock, and a correspondingly large increase the the money stock’s fiduciary component, with all the business-cycle repercussions that follow from such?

Actually, it isn’t, for the simple reason that, more often than not, a deposit made at one bank involves a corresponding withdrawal of funds from another bank, as when the deposited sum takes the form of a check. In that case, the process of deposit expansion that Block and Garschina describe will have as its counterpart a like process of deposit destruction, where the ultimate result (assuming the simple case in which all banks maintain the same, given reserve ratio) is an unchanged total money stock, with the only actual change consisting of a change in the distribution of bank deposits among the various banks.

In order for the total money stock to increase, as Block and Garschina suggest it will, the initially deposited sum, instead of consisting of funds transferred from a different bank, must consist of basic money, meaning either cash that had been circulating outside the banking system, or basic money that has freshly entered the economy, in the shape of newly produced or imported metallic money or, alternatively, the fresh fiat money emissions of a central bank. But in that case the fundamental cause of growth in the money stock is, not the fractional value of r, but the increase in R, just as our previous equations suggested. Provided that the system reserve ratio itself stays constant, so long as the supply of bank reserves itself remains unchanged, the total quantity of bank deposits won’t change.

It follows from what’s been said so far that, to assess the claim that fractional reserve banking causes business cycles, we must ask two questions. The first question is, “To what extent have historical money-fueled booms been associated, not with growth in the supply of either commodity money or central-bank supplied bank reserves, but with declining banking system reserve ratios?” The second question is, “When a banking system does manage to operate on a lower reserve ratio, does its doing so necessarily contribute to an unsustainable boom?” I’ll answer these questions in subsequent posts.

A lot of ink was spilled last month over President Trump’s criticism of the Fed raising interest rates. Observers worried that those criticisms meant the President was prepared to directly meddle with U.S. monetary policy. But so far, at least, there’s no evidence that any such meddling has occurred.

The Trump administration’s fiscal policies have, however, indirectly influenced the Fed, by straining it’s post-crisis operating system. In particular, the large federal budget deficit has been putting upward pressure on short-term market interest rates; and those rising rates have, in turn, put pressure on the Fed’s “floor” system of monetary control. If the deficit continues to grow, as is expected, it might even bring an end to that system.

To see why, a quick review of the floor system’s workings is in order.

The Fed’s Floor System

In one of its more important but underappreciated crisis-era monetary policy innovations, the Fed switched from a corridor-like operating system to a floor operating system. It did so by paying interest on excess reserves (IOER) at a rate higher than going short-term market interest rates, thereby pushing banks onto the perfectly elastic region of their reserve demand curve. The change allowed the Fed to add reserves to the banking system, as it had been doing through various emergency lending programs, without loosening its monetary policy stance by causing the effective fed funds rate to fall below its target. Changes to the supply of money were thus “divorced” from the setting of monetary policy (Keister et al. 2008). This divorce was seen by some as a virtue of the floor system, for it allowed the Fed to manage bank liquidity and monetary policy independently, changing the size of its balance sheet to control liquidity, and the IOER rate to alter its monetary policy stance.

George Selgin, however, has noted a number of challenges facing the floor operating system, one of which is its inherent fragility. Maintaining a floor system means keeping the IOER rate at or above comparable market interest rates, so that banks will be willing to hold on to any reserves that come their way. Stated differently, the return on reserves needs to exceed the risk-adjusted marginal return banks might earn, net of their operating and other variable costs, on other assets.*

The figure below compares the Fed’s IOER rate to both the overnight dollar LIBOR rate and the 1‑month Treasury-bill yield for the period from 2009 until 2017, showing how the spreads between the IOER rate and these other representative market rates has almost always been positive. The IOER-LIBOR spread averaged almost 10 basis points, while the IOER-Treasury spread averaged about 20 basis points. Such spreads are what has kept the floor system running.

On a few occasions, however, the spreads in question, and other similar measures, have been very small, and in some brief instances negative. What’s more, the spreads have been declining. Since January 2018 the IOER-LIBOR spread has declined to about 5 basis points, while the IOER-Treasury spread average has fallen to 7 basis points. Were the decline to continue to the point where other short-term interest rates rise above the IOER rate for a sustained period, the Fed’s floor system would unravel: instead of having a practically unlimited demand for excess reserves, banks would start rebalancing their portfolios away from excess reserves and toward other, more profitable investments. Monetary policy would then cease to be “divorced” from money, for changes in the quantity of money and changes in the Fed’s monetary policy stance would once again tend to go hand-in-hand.

Though the floor system is still intact for now, we can already see in the figures below that the narrowing of the spreads is straining the floor system. The first figure plots the IOER-LIBOR spread against the banking system’s cash assets as a percent of all assets. This cash asset category comes from the Fed’s H8 database and has consisted mostly of excess reserves over the past decade. The shrinking of the IOER-LIBOR spread has coincided with a decline in the share of cash assets held by banks.

The next figure plots the same spread against the loan share of bank assets. It has been rising sharply as the spread has declined this year. Banks, in other words, suddenly began investing a larger share of their portfolios in loans starting in early 2018.

These two figures suggest that the Fed may be already pushing the limits of its floor system. The banks appear to be shying away from holding so many excess reserves. That change suggests reserve demand is becoming less elastic at this narrowed IOER spread. The floor system may be more fragile than many Fed officials believe it to be.

The only way to ease this pressure on the floor system would be for the Fed to raise the IOER above these other interest rates. That, though, could lead to an undesirable tightening of monetary policy, putting the Fed in a bind: should the Fed raise rates to keep its floor system intact, at the risk of overtightening? Or should it avoid overtightening at the risk of seeing its operating system come unglued?

Trump’s Policies and Short-Term Interest Rates

But why have IOER-market rate spreads been narrowing? One answer is President Trump’s large budget deficits. His administration’s heavy spending is causing it to borrow a great deal. In addition, the shrinking of the Fed’s balance sheet and the restocking of Treasury’s General Account, which had been wiped out during the recent debt ceiling episode, have also contributed to the rising budget deficit.

To fund this growing deficit, the Treasury has been increasing its issuance of Treasury bills. The next figure shows this surge is evident in terms of both gross and net Treasury bill issuance. The black line shows the trend gross issuance and the blue line shows the net cumulative issuance.

Source: SIFMA

The recent burst of Treasury bill issues has a bearing on the IOER spread over other interest rates. In particular, the greater issuance of Treasury bills should drive up (down) their yields (prices), moving other short-term interest rates in the same direction through arbitrage. This should narrow the IOER spread over other interest rates.

The Federal Reserve agrees. From the June FOMC minutes, we learn the following:

The deputy manager [of the System Open Market Account at the NY Fed] followed with a discussion of money markets… Rates on Treasury repurchase agreements (repo) had remained elevated in recent weeks, apparently responding, in part, to increased Treasury issuance over recent months… Elevated repo rates may also have contributed to some upward pressure on the effective federal funds rate in recent weeks as lenders in that market shifted some of their investments to earn higher rates available in repo markets.

So some Fed officials themselves believe that the increased issuance of Treasury bills is pushing up short-term interest rates via arbitrage.

But is there any evidence for this claim? The figures below suggest the answer is yes, especially as it relates to interbank rates. The first set of figures plot the trend gross and cumulative net issuance of Treasury bills during the Fed’s floor system against the IOER-LIBOR spread. Both measures suggests a fairly strong, negative relationship. That is, a higher supply of Treasury bills shrinks the IOER-LIBOR spread.

One should be careful, though, in looking at the absolute dollar amount of Treasury bill issuance as it may grow secularly due to a rising economy. To account for this possibility, the next set of figures normalizes the two Treasury bill issuance measures by dividing them by total marketable Treasury securities outstanding. Now the relationship is even tighter and stronger. Relationships like these are not found for the issuance of Treasury notes and bonds against the IOER spreads.

President Trump, then, appears to be already influencing Fed policy by putting upward pressure on short-term interest rates and thereby causing pressure on the Fed’s floor system. The Wall Street Journal recently reported this budget pressure is only expected to increase:

Rising federal budget deficits are boosting the U.S. Treasury’s borrowing… [T]he Treasury plans to borrow $329 billion from July through September—up $56 billion from the agency’s April estimate—in addition to $440 billion in October through December. The figures are 63% higher than what the Treasury borrowed during the same six-month period last year.

To be clear, there are other explanations for the narrowing of the IOER spread. George Selgin, for example, points to the unequal distribution of bank reserves causing problems as the Fed winds down its balance sheet. That seems right and complements the above explanation. Both explanations point to increasing strains on the Fed’s floor system moving forward.

In short, its at least conceivable that the Trump administration’s fiscal policies could compel the Fed to rethink its floor system. Given this possibility, the Fed has yet another reason to start thinking now about its floor system and whether sticking to it will be worth the trouble. Far better for the Fed to leave the floor system on its own terms, than to be forced out by fiscal policy.

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^*Banks cannot control the total quantity of reserves, but they can control the form of reserves held. That is, banks can choose to hold excess reserves or invest in other assets like treasuries and loans that, in the aggregate, would lead to a rise in required reserves.

[Cross-posted from Alt‑M.org]

Ten years after the 2008 financial crisis we are again facing the possibility of economic turmoil as the Fed and other central banks exit their unconventional monetary policies by raising interest rates and shrinking their balance sheets. Although central banks will move gradually, unforeseen circumstances could trigger a flight to safety and a collapse of asset prices that had previously been stimulated by near-zero interest rates and large-scale asset purchases, popularly known as “quantitative easing.”

This book brings together leading scholars and former policymakers to draw lessons from the decade of unconventional monetary policies relied upon to stimulate the global economy in the aftermath of the financial crisis. The articles included in this book combine historical perspectives and forward-looking views of the Fed’s exit strategy and monetary normalization, along with the arguments for a rules-based monetary policy both at the domestic and international levels.

Kevin Warsh, a former member of the Board of Governors of the Federal Reserve System, reminds us in his article that, although the economy has improved since the crisis, the tasks facing the Fed are still large. “So we should resist allowing the policy debate to be small or push aside ideas that depart from the prevailing consensus. The Fed’s job is not easier today, and its conclusions are not obvious.” The contributors to this volume meet Warsh’s challenge by questioning the status quo and offering fresh ideas for improving monetary policy.

The financial crisis highlighted the uncertainty that confronts policymakers. Having failed to prevent the 2008 financial crisis and the Great Recession, the Federal Reserve and other major central banks all subsequently adopted similar policies characterized by near-zero interest rates, quantitative easing and forward guidance. Those unconventional monetary policies were designed to increase risk taking, prop up asset prices, increase spending and restore full employment.

While asset prices have risen and unemployment is at historic lows, the Fed’s balance sheet ballooned from about $800 billion before the crisis to more than $4 trillion today, and the long period of near-zero interest rates has created a series of asset bubbles, which risk being burst as interest rates rise again.

Moreover, the Fed has engaged in preferential credit allocation through its large-scale asset purchase program, in which it has acquired billions of dollars’ worth of mortgage-backed securities and shifted out of short-term Treasuries to longer-term government debt.

In order to expand its balance sheet, the Fed has radically changed its operating procedure. Instead of engaging in open market operations nudging the policy rate toward a single target rate by buying and selling short-term Treasuries, the Fed now establishes a target range for the funds rate—with the rate of interest on excess reserves (IOER), introduced in October 2008, as its upper limit and the Fed’s overnight reverse repurchase (ON RRP) agreement rate as its lower limit.

Because the IOER exceeds comparable market rates, some banks now find it worthwhile to accumulate excess reserves instead of trading them for other assets. The economy is, in other words, kept in a purpose-made “liquidity trap,” so that the traditional monetary “transmission mechanism” linking increases in the monetary base to changes in bank lending, overall spending, and inflation, no longer functions as it once did. Under the new operating arrangements, the Fed changes its policy stance by changing its IOER and ON RRP rates, thereby influencing not the supply of but the demand for the Fed’s deposit balances.

Meanwhile, the Fed’s regulatory powers have increased dramatically as well. The Federal Reserve System, which was intended to be decentralized so that policymakers would take account of divergent ideas, has become even more centralized with each new crisis. As a result, monetary policy has also become more politicized.

Finally, the lack of any systematic policy rule to guide long-run decisions has increased regime uncertainty. The so-called knowledge problem—and the limits of monetary policy—need to be widely recognized. Policymakers err by paying too much attention to short-run remedies and too little attention to the long-run consequences of current decisions. If human judgments were perfect, then purely discretionary monetary policy would be ideal. However, as Karl Brunner (1980: 61) wisely noted, the reality is that:

We suffer neither under total ignorance nor do we enjoy full knowledge. Our life moves in a grey zone of partial knowledge and partial ignorance. [Consequently], a nonactivist [rules-based] regime emerges … as the safest strategy. It does not assure us that economic fluctuations will be avoided. But it will assure us that monetary policymaking does not impose additional uncertainties … on the market place.*

Before serious consideration can be given to implementing any rules-based monetary regime, the Fed needs to normalize monetary policy by ending interest on excess reserves and shrinking its balance sheet to restore a precrisis federal funds market. Once changes in base money can be effectively transmitted to changes in the money supply and nominal income, the Fed can then implement a rules-based regime to reduce uncertainty and spur investment and growth.

The ideas put forth in this volume for monetary reform are meant to inform policymakers and the public about the importance of maintaining a credible monetary policy regime both for financial stability and economic prosperity. Ensuring long-run price stability, letting market forces set interest rates and allocate credit, and keeping nominal income on a steady growth path will create new opportunities and widen the scope of markets to promote economic performance.

This article originally appears as the Editor’s Preface in Monetary Policy in an Uncertain World: Ten Years After the Crisis

* Reference: Brunner, K. (1980) “The Control of Monetary Aggregates.” In Controlling Monetary Aggregates III, 1–65. Boston: Federal Reserve Bank of Boston.