ABSTRACT: The extensive debate over fractional reserve
free banking (FRFB) has spanned decades and includes volleys from many
contributors. Consequently, relative newcomers to the controversy often wish
to extend the conversation on several fronts. In this spirit, Bagus and
Howden (2010) is a 27-page paper detailing numerous objections to FRFB, which
they modestly entitled, “Fractional Reserve Free Banking: Some Quibbles.” The
present paper continues in this tradition, elaborating on some of the key
critiques of FRFB raised by others earlier in the debate. In particular, I
critically explore two key claims of the FRFB camp: that holders of banknotes
implicitly lend funds to the issuing bank, and that the historical periods of
relatively free banking illustrate the stability of the system.
JEL Classification: B53, E32, E42, E58, G21
Robert P. Murphy (Robert.P.Murphy@ttu.edu) is a Research Assistant Professor
with the Free Market Institute (FMI) at Texas Tech University.
I thank Vincent Geloso for references on early Canadian economic data. I
also thank an anonymous referee for helpful suggestions on including more of
the debate in my discussion.
Quarterly Journal of Austrian Economics 22, no. 1 (Spring 2019)
full issue, click
here.
I. INTRODUCTION
The debate over fractional reserve banking predates the Austrian School.
David Hume favorably cites the bank of Amsterdam (Hume 1987 [1742],
II.III.4), while Adam Smith explains this famous case of 100 percent reserve
banking in The Wealth of Nations. The early 19th century British Currency
School was so influential that it achieved a legislative insistence on 100
percent reserves in the issuance of banknotes (though not demand deposits) in
the famous Peel’s Act of 1844. (Salerno 2012, p. 98)
Besides some economists in the Austrian tradition, the Chicago School is
also known for a streak favoring 100 percent reserves (e.g. Fisher 1935), and
in the wake of the financial crisis some prominent Real Business Cycle
economists are reconsidering the proposal (Prescott and Wessel 2016). Yet the
present paper falls squarely within the Austrian School, critiquing the
practice of fractional reserve banking from the perspective of Mises-Hayek
business cycle theory. Some representative works in this vein include Mises
([1912] 2009), Hayek ([1925] 1984), Rothbard ([1962] 2001), and Huerta de
Soto (2006).
The foil for this paper’s perspective is the framework of “fractional
reserve free banking” (FRFB) advanced for example in Selgin (1988), Selgin
and White (1996), and Horwitz (2001). The free bankers endorse the
Mises-Hayek theory of business cycles, but they deny that fractional reserve
banking per se is the problem. Instead, the advocates of FRFB blame various
types of government interference with money and banking.
As with Bagus and Howden (2010), the present paper joins this
long-standing yet vigorous debate, seeking to address several of the key
controversies. Although Bagus and Howden modestly label their contribution as
a collection of “quibbles,” in fact their discussion of money demand and
credit expansion highlights a devastating flaw in the FRFB position. In this
paper, I elaborate on this problem, showing that the FRFB claims are demonstrably
incompatible with the Misesian approach to money and banking. Beyond that, I
show that Selgin’s two highlighted examples of the best historical
cases of FRFB (namely, Scotland and Canada) are, if anything, poster children
for the Rothbardian warnings against fractional reserve banking.
In Section II, this paper establishes that Mises and Hayek both believed
that fractional reserve banking per se is instrumental to the business cycle.
Section III extends the Bagus-Howden approach to demonstrating the problem
with the FRFB claim that fiduciary media need not disrupt the loan market.
Section IV critically analyzes the historical examples of FRFB nominated by
Selgin. Section V concludes.
II. MISES (AND HAYEK) THOUGHT FRB PER SE WAS DISRUPTIVE
Setting aside the potential legal and conceptual problems with fractional
reserve banking in order to focus on the economics, one of the key areas of
dispute is whether FRB necessarily leads to an unsustainable boom as
described first by Mises ([1912] 2009) and elaborated by his disciple Hayek
(e.g. [1931] 1967). It is significant that both of these developers of what
is sometimes called “the Mises-Hayek theory of the business cycle” thought
that FRB was a central element of the story. To be sure, Mises and Hayek may
have been mistaken, but it is worth documenting their position
because in the debate over FRB, one often hears (especially in informal
venues) casual claims that only dogmatic Rothbardians could find fault with
fractional reserve banking per se.
We find an unambiguous statement of Mises’s position in Human Action.
Mises defines “fiduciary media” as bank-issued claims to money, payable upon
demand, that are not covered by base money in the vault, and then
declares:
The notion of “normal” credit expansion is absurd. Issuance of
additional fiduciary media, no matter what its quantity may be, always sets
in motion those changes in the price structure the description of which is
the task of the theory of the trade cycle. Of course, if the
additional amount issued is not large, neither are the inevitable effects of
the expansion. (Mises [1949] 1998, 439, n. 17; bold added.)
Regarding Hayek, even the FRFB writers admit that his understanding of
commercial bank behavior is inconsistent with their claims. For example,
Larry White (1999, 761) writes that Hayek ([1925] 1984, 29) “suggested in one
of his earliest writings a radical solution to the problem of swings in the
volume of commercial bank credit: impose a 100 percent marginal reserve
requirement on all bank liabilities….”
Mises too at some points in his career called for an explicit prohibition
on additional issuance of fiduciary media, though he also wrote (for example in Human
Action) in favor of “free banking” as the best practical way to
restrain the issuance of fiduciary media. (Salerno 2012, 96–97) Readers
should therefore not misinterpret Mises’s praise for laissez-faire in banking
as an endorsement of the modern “free banking” claim that fractional reserve
banking, at least under certain conditions, promotes economic stability.
To appreciate the specific problem of fiduciary media in the eyes of
Mises, it is very instructive to consider where he placed the
business cycle discussion in Human Action. One might have classified
the periodic boom-bust cycles plaguing market economies as a result of
political intervention, which would mean placing the discussion (as Rothbard
did in Man, Economy, and State) in the same section of the book that
handled minimum wage laws and taxation. Yet Mises rejects this plausible
approach, and his explanation illuminates his broader views on fractional
reserve banking:
It is beyond doubt that credit expansion is one of the primary issues of
interventionism. Nevertheless the right place for the analysis of the
problems involved is not in the theory of interventionism but in that of the
pure market economy. For the problem we have to deal with is
essentially the relation between the supply of money and the rate of
interest, a problem of which the consequences of credit expansion are only a
particular instance.
Everything that has been asserted with regard to credit expansion
is equally valid with regard to the effects of any increase in the supply of
money proper as far as this additional supply reaches the loan market at an
early stage of its inflow into the market system. If the additional
quantity of money increases the quantity of money offered for loans at a time
when commodity prices and wage rates have not yet been completely adjusted to
the change in the money relation, the effects are no different from those of
a credit expansion. In analyzing the problem of credit expansion,
catallactics completes the structure of the theory of money and of interest….
What differentiates credit expansion from an increase in the
supply of money as it can appear in an economy employing only commodity money
and no fiduciary media at all is conditioned by divergences in the quantity
of the increase and in the temporal sequence of its effects on the various
parts of the market. Even a rapid increase in the production of the
precious metals can never have the range which credit expansion can attain.
The gold standard was an efficacious check upon credit expansion, as it
forced the banks not to exceed certain limits in their expansionist ventures.
The gold standard’s own inflationary potentialities were kept within limits
by the vicissitudes of gold mining. Moreover, only a part of the
additional gold immediately increased the supply offered on the loan market.
The greater part acted first upon commodity prices and wage rates and
affected the loan market only at a later stage of the inflationary process.
(Mises [1949] 1998, 571–72; bold added.)
The above excerpt from Mises is extraordinarily important in understanding
what role he thought the commercial banks played in a typical
boom-bust cycle. Yet to correctly parse it, we should first remind ourselves
what Mises means precisely by the phrase “credit expansion” (since he is
contrasting it with “an increase in the supply of money proper”). Earlier in
the book, Mises does not yet explain the trade cycle but defines the
terminology that he will later need. He explains:
The term credit expansion has often been misinterpreted. It is
important to realize that commodity credit cannot be expanded. The only
vehicle of credit expansion is circulation credit. But the granting of
circulation credit does not always mean credit expansion. If the amount of
fiduciary media previously issued has consummated all its effects upon the
market, if prices, wage rates, and interest rates have been adjusted to the
total supply of money proper plus fiduciary media (supply of money in the
broader sense), granting of circulation credit without a further increase in
the quantity of fiduciary media is no longer credit expansion. Credit
expansion is present only if credit is granted by the issue of an additional
amount of fiduciary media, not if banks lend anew fiduciary media paid back
to them by the old debtors. (Mises [1949] 1998, 431; italics in
original, bold added.)
Putting together all three of the block quotations from Human Action
that we have provided above, we can summarize Mises’s position as follows:
The unsustainable boom occurs when a newly created (or mined) quantity of
money enters the loan market and distorts interest rates, before other prices
in the economy have had time to adjust. In principle, this process could
occur even in the case of commodity money with 100 percent reserve banking.
However, in practice Mises believes such a theoretical
possibility can be safely neglected, because (a) the quantity of new gold (or
other commodity money) entering the economy will likely be relatively small
over any short period and (b) whatever the stock of new commodity
money entering the economy as a whole, typically only a small fraction of it
would be channeled into the loan market upfront.
Thus, even though in principle Mises’s theory of the boom-bust cycle is
fundamentally about new quantities of money hitting the loan market early on,
in practice the explanation revolves around newly-created fiduciary media
being lent into the market. That is why Mises described his explanation as
the “circulation credit theory of the trade cycle.” When we understand how
Mises thought (in principle) newly mined gold could conceivably set in motion
the boom-bust cycle, it becomes crystal clear that he thought any amount
of newly-issued fiduciary media—i.e., a credit expansion—would do the same.
(Remember, our earlier quotation shows Mises claiming that “[i]ssuance of
additional fiduciary media, no matter what its quantity may be,
always sets in motion” the processes that cause the unsustainable boom.) Thus
there are no caveats or other conditions to consider, on this narrow
question. Mises thought fractional reserve banking per se would set in motion
the business cycle.
III. EXCHANGING MONEY PROPER FOR A MONEY SUBSTITUTE IS NOT
LENDING FUNDS TO THE BANK
In contrast to the view of Mises and Hayek, the modern free bankers deny
that FRB per se causes a deviation of market and natural interest rates. In a
free market with no central bank or government-provided deposit insurance,
profit-maximizing commercial banks will—so the free bankers claim—only issue
fiduciary media in the case when the public increases its demand to hold bank
money, and this is precisely the scenario in which we should want
them to do so. The free bankers argue that an insistence on 100 percent bank
reserves in the face of a sudden increase in the public’s demand to hold
bank-issued money will lead to a period of monetary disequilibrium (in the
sense of Yeager 1997).
With this approach, the free bankers apparently turn the 100%-reserve
critique on its head. Selgin and White (1996) argue:
We aspire to be consistent Wicksellians, and so regard both price
inflation and deflation as regrettable processes insofar as they are
brought about by arbitrary changes in the nominal quantity of money, or by
uncompensated changes in its velocity, and not by changes in the real
availability of final goods or the cost of production of money. It is
therefore an attractive feature of free banking with fractional reserves that
the nominal quantity of bank-issued money tends to adjust so as to offset
changes in the velocity of money. Free banking thus works against short-run
monetary disequilibrium and its business cycle consequences. (Selgin and
White 1996, 101–02; italics in original.)
Selgin (1988) makes the point in greater detail. He first recognizes that
the balance between money supply and demand is conceptually distinct from
equality between the market and natural rates of interest, but he claims that
under a regime of free banking the two will be synchronized:
As used here “monetary equilibrium” will mean the state of affairs that
prevails when there is neither an excess demand for money nor an excess
supply of it at the existing level of prices. When a change in the (nominal)
supply of money is demand accommodating—that is, when it corrects what would
otherwise be a short-run excess demand or excess supply—the change will be
called “warranted” because it maintains monetary equilibrium.
This view of monetary equilibrium is appropriate so long as matters are
considered from the perspective of the market for money balances. But it is
also possible to define monetary equilibrium in terms of conditions in the
market for bank credit or loanable funds. Though these two views of
monetary equilibrium differ, they do not conflict. One defines
equilibrium in terms of a stock, the other in terms of the flow from which
the stock is derived. When a change in the demand for (inside) money
warrants a change in its supply (in order to prevent excess demand or excess
supply in the short run), the adjustment must occur by means of a change in
the amount of funds lent by the banking system.
An important question, one particularly controversial among monetary
economists in the middle of this century, arises at this point. Are
adjustments in the supply of loanable funds, meant to preserve monetary
equilibrium, also consistent with the equality of voluntary savings and
investment? The answer is yes, they are. The aggregate demand to
hold balances of inside money is a reflection of the public’s willingness to
supply loanable funds through the banks whose liabilities are held. To hold
inside money is to engage in voluntary saving.
As George Clayton notes, whoever elects to hold bank liabilities received
in exchange for goods or services “is abstaining from the consumption of
goods and services to which he is entitled. Such saving by holding money
embraces not merely the hoarding of money for fairly long periods by
particular individuals but also the collective effect of the holding of money
for quite short periods by a succession of individuals.” (Selgin 1988, 54–55,
bold added.)
Steve Horwitz echoes these sentiments, arguing that “demanding bank
liabilities is an act of savings” (1996, 299, qtd. in Bagus and Howden 2010,
40). Horwitz explicitly combines the bank function of credit intermediary
with fractional reserves when he writes:
Savers supply real loanable funds based on their endowments and
intertemporal preferences. Banks serve as intermediaries to redirect
savings to investors via money creation. Depositors give banks
custody of their funds, and banks create loans based on these deposits. The
creation (supply) of money corresponds to a supply of funds for investment
use by firms. (Horwitz 1992, 135, qtd. in Bagus and Howden 2010, 39; bold
added.)
More generally, the FRFB writers see nothing special about demand
deposits, that would make them qualitatively different from other forms of
credit instruments. The FRFB writers can ask rhetorically: If Rothbardians do
not object to a man lending $1,000 to the bank by buying a 12-month CD, then
why do they object to a man effectively lending $1,000 to the bank by keeping
it in his checking account for a year? Yes, it is true that if the bank lends
out some of the funds and then the man tries to withdraw his money, there
could be a problem. But by the same token, there could be a problem if the
bank lends out the $1,000 from the CD sale to fund a project that will not be
repaid for (say) two years. According to the FRFB writers, all this shows is
that commercial banks need to pay attention to maturity matching. It is not
fraudulent and it does not cause the business cycle if banks sell (say)
12-month CDs and lend the funds out for 2-year projects (hoping to roll over
the CDs when they mature). So by the same token, there is nothing
especially risky or distortionary if we look at one end of the spectrum,
where savers lend their funds to the bank for a loan that matures in “zero”
time even though the bank uses those funds to invest in longer maturity
projects. According to the FRFB writers, that is one way to appreciate the
benignity of demand deposits or checking accounts: consider them as buying
CDs that mature instantly and that the saver continuously rolls over.
As we have seen, it is essential for the FRFB position that people adding
“inside money” (i.e. bank-issued claims to money payable upon demand) to
their cash balances are engaged in an act of saving and furthermore are
lending their savings to the bank. There is much controversy on this point.
Some critics of FRFB (e.g. Hoppe 1994, 72) have denied that the accumulation
of cash balances is a form of saving. However, I agree with Hülsmann
(1996, 34) that the accumulation of cash is a form of (gross) saving. What I
deny is that this act of saving, if performed using the vehicle of a banknote
or demand deposit, represents an implicit loan to the commercial bank. Thus
my position is compatible with Selgin’s (2012) response to Bagus and Howden
on money balances and saving (p. 139); savings can take the form of an
accumulation of bank notes. But admitting this does not mean that
accumulating bank notes is the same thing as lending funds to the bank
that issued them. The following thought experiment will illustrate the
distinction.
Imagine a young boy who receives a weekly allowance of $10 for his
household chores. Each week his parents give the boy a crisp $10 bill, which
he promptly stores under his mattress. After eight weeks, the boy buys an $80
video game. Does anyone want to deny that he “saved up for” the purchase?
Both plain language and—I would argue—economic definitions must conclude that
the boy consumed less than his income for the eight-week period, and engaged
in saving. He invested in the accumulation of a very liquid financial asset,
namely fiat money.
Things would not change if the boy (week after week) exchanged his fiat
dollars for instantly demandable notes issued by a reputable bank. The
accumulation of these banknotes would still represent saving and investment
on the part of the boy. But they would not constitute a loan to the
bank, any more than a man who checks his coat at a restaurant (and receives a
claim-ticket) is lending his garment to the establishment. Even though a
Martian observer might think the man was engaged in a credit
transaction, our understanding of the true situation informs us that the
coat-checking process is not a loan.
If our hypothetical boy converts actual money (“money in the narrower
sense” in Mises’s terminology, or “outside money” in Selgin’s) into a
banknote or demand deposit (“money in the broader sense” for Mises or “inside
money” for Selgin), he has not altered his ability to command goods and
services immediately in the market. Therefore there is no additional
credit transaction, besides the accumulation of money per se. The boy’s
saving translates into the “investment” of an accumulation of dollars in his
cash balances. If he converts the fiat currency into banknotes, then his
prior acts of saving “correspond to” the banknotes now in his possession. It
was not his decision to convert the fiat dollars into banknotes that
represents saving; that decision merely altered the form in which he
holds his savings. There is no “excess saving” on the part of the boy that
could accommodate the creation of additional banknotes that the commercial
bank then lends out, with the boy’s $80 in fiat dollar deposits serving as
the reserves.
Our analysis here exactly mirrors that of Mises. In The Theory of
Money and Credit he begins a section titled “The Granting of Circulation
Credit” in this way:
According to the prevailing opinion, a bank which grants a loan in its own
notes plays the part of a credit negotiator between the borrowers and those
in whose hands the notes happen to be at any time. Thus in the last resort
bank credit is not granted by the banks but by the holders of the notes.
(Mises [1912] 2009, 271)
Those familiar with Mises’s rhetorical style can guess that things do not
bode well for the FRFB camp. After some historical references, Mises
continues the above train of thought by declaring:
Now this view by no means describes the essence of the matter. A
person who accepts and holds notes, grants no credit; he exchanges
no present good for a future good. The immediately-convertible note of a
solvent bank is employable everywhere as a fiduciary medium instead of money
in commercial transactions, and nobody draws a distinction between the money
and the notes which he holds as cash. The note is a present good just as much
as the money. (Mises [1912] 2009, 272, bold added.)
Now to be sure, just because Ludwig von Mises rejected a particular view,
does not suffice to demonstrate its error. Yet when it comes to arguments
over FRFB within the camp of economists who all endorse the Mises-Hayek
theory of business cycles, it is crucial to study Mises’s own view of
fiduciary media and the connection to an unsustainable boom.
Contrary to the FRFB writers, Mises does not think that banknotes
are simply a credit instrument with zero maturity. On the contrary, they are
a form of quasi-money because of their special nature. Indeed a few pages earlier
(p. 267) Mises explains that other types of claims are eventually redeemed;
you cannot eat a claim on bread. And this is why a “person who has a thousand
loaves of bread at his immediate disposal will not dare to issue more than a
thousand tickets” entitling the holder to a loaf of bread. But things are
different with instantly convertible claims to money, because these
claims (so long as their redemption is not doubted) perform the services of
money proper. That is why issuers of these claims can dare to create more
tickets than they can redeem.
Early in The Theory of Money and Credit (pp. 50–54), Mises weighs
the pros and cons of including fiduciary media in the category of “money”
itself. After all, a perfectly secure and instantly redeemable claim to money
is itself a commonly accepted medium of exchange. But Mises decides instead
to use the term “money-substitute” since he thinks it necessary to
distinguish between “money in the narrower sense” and “money in the broader
sense” in order to explain his circulation credit theory of the trade cycle.
I have stressed these aspects of The Theory of Money and Credit—and
earlier in the paper, I dwelled on the exposition in Human Action—to
show that the thesis of Salerno (2012) has firm roots. It is true that Mises
has kind things to say about free banking in Human Action, and his
section on “The Case Against the Issue of Fiduciary Media” (pp. 322–25) in TMC
is ambivalent. My modest point in this paper is that the entire Misesian
framework of money and banking denies the alleged ability of fractional
reserve banking to enhance equilibration in the loanable funds market.
However, in fairness Selgin could respond that in this case, the commercial bank would
not find it profitable to issue more notes than the ones that would be held
by the man (who first deposited his gold coins). It is only when the
community wants to increase its total money holdings broadly defined
(at given prices), Selgin would argue, that the profit-maximizing fractional
reserve banks would find it in their interest to issue new loans (or engage
in credit expansion, in Mises’s terminology).
Bagus and Howden (2010, 43) proceed along similar lines as the present
critique when they imagine an individual who originally holds some gold coins
under his mattress, but then—perhaps because of crime—decides to deposit them
with a bank in exchange for notes. Bagus and Howden argue that the
individual’s newfound willingness to hold banknotes should not be a signal to
the bank to issue more loans to the community, because there is no act of net
saving here.
Yet we can tweak the thought experiment to shore up Bagus and Howden’s critique.
Suppose we have a gold-using community that is at an initial monetary
equilibrium (in Yeager’s 1997 sense) and a loanable funds market equilibrium
where the market and natural interest rates coincide (in Wicksell’s [1898]
1962 sense). Now suppose every single person in the community becomes more
fearful for the future, and desires to increase his or her real cash balances
by 10 percent. Under 100 percent reserves, the only way this can happen is
through additional mining and/or falling prices (quoted in gold). Yet with
FRFB, this sluggish adjustment can be neatly sidestepped: Each individual
goes to the bank and takes out a loan, in the form of newly printed banknotes
(claims on gold), which he or she then adds to cash balances. The community
achieves its desired increase in cash holdings without “wasting” real
resources digging up more gold, and without the discoordination of
disequilibrium sticky prices.
The only odd thing about this scenario is that when asked to explain how
this maintenance of “monetary equilibrium” can avoid disrupting the loan
market, Selgin et al. would have to say, “Each individual in the community
lent himself the extra money he is now holding.”
IV. THE ALLEGED HISTORICAL SUCCESS OF FRFB
Besides the theoretical arguments, the proponents of FRFB claim that
history vindicates their position. For example, Selgin (2000) argues:
Episodes of systemwide bank failures and serious bank over- and
underexpansion have been less common than is often supposed. The
episodes that have occurred can generally be shown to have resulted not from
any problem inherent in fractional reserve banking but from central bank
misconduct or misguided government regulation or both…. Where
fractional reserve banks have operated free of both significant legal restrictions
and the disturbing influence of central banks, as in
nineteenth-century Scotland, Canada, and Sweden (to name just a few
cases that have been studied), serious banking and monetary crises
have been rare or nonexistent. (Selgin 2000, 98; bold added.)
In blog posts, Selgin has held up Canada and Scotland as epitomizing the
success of his vision of money and banking. For example in a 2018 post Selgin
begins:
As all dedicated Alt-M readers know, I am a big fan of
the Canadian banking and monetary system that flourished between
Canada’s Confederation in 1867 and the outbreak of the First World War.
Besides thinking it was a darn good system, I also regard it as the best
example, together with Scottish banking during the first half of the 19th
century, of a “free” (that is, largely unregulated) banking system.
(Selgin 2018; bold added.)
In the above quotation, Selgin’s phrase “I am a big fan of the Canadian
monetary and banking system” is hyperlinked to his earlier 2015 post praising
the Canadian system, saying it was “famously sound and famously stable.” This
claim is in turn linked to an endnote where Selgin informs the reader, “For a
very good review of the features and performance of the Canadian system in
its heyday, see” R.M. Breckenridge (1895), The Canadian Banking System:
1817–1890, which is a nearly 500-page book on the subject.
Thus we have Selgin himself singling out the two apparently best examples
of his brand of FRFB in action: Scotland and Canada, during the appropriately
defined years. And yet, as we will see, both examples hardly seem exemplary,
and if anything confirm the warnings of the Austrian critics of
fractional reserve banking.
Free to Refuse: Scotland During the Free Banking Period
We can quickly deal with the case of Scotland by quoting from Murray
Rothbard’s (1988) review of Larry White’s (1984) book on free banking in
Britain. Rothbard observes:
From the beginning, there is one embarrassing and evident fact that
Professor White has to cope with: that “free” Scottish banks suspended
specie payment when England did, in 1797, and, like England, maintained that
suspension until 1821. Free banks are not supposed to be able to, or want to,
suspend specie payment, thereby violating the property rights of their
depositors and noteholders, while they themselves are permitted to continue
in business… (Rothbard 1988, 230–31; bold added.)
The fact that the Scottish banks suspended specie redemption for more
than two decades and were not forced to close their doors, proves that
they were clearly not following the textbook exposition of a “free bank,”
which is allowed to maintain fractional reserves but of course is still
subject to standard legal rules concerning contract enforcement. As Rothbard
goes on to note, the fact that Scottish specie reserves fell to “a range of
less than 1 to 3 percent in the first half of the nineteenth century” hardly
clinches the case for fractional reserve banking. It is not surprising that
“free banks” in Scotland let their reserves dwindle so low, when they were
“free” to turn their customers away who demanded specie redemption.
Don’t Blame Canada: Economic Volatility During the “Famously
Stable” Era
As we established earlier, besides the celebrated case of Scotland, Selgin
also held up Canada during the period 1867–1914 as the best example of FRFB
in action, saying its banking system was “famously sound and famously
stable.” In this subsection I will offer some evidence to the contrary,
relying (in part) on Selgin’s own cited source.
First we can get a sense of Canadian stability by looking at a recent
update (using a new method to calculate the GNP deflator) of estimates of GNP
per capita. The following figure is taken from Hinton and Geloso (2018),
contrasting the standard series by Urquhart (1993) with their slightly
revised version:
Figure 1. GNP per capita using different deflators
Note that the period covered in the figure (1870–1900) is a subset of the
period Selgin identified. And yet, as the figure indicates, the Canadian
economy exhibited nothing like smooth steady growth. Depending on which
deflator we choose, per capita GNP had a sharp or modest boom-bust cycle from
1872–78, at which point it soared, rising some 30 percent in a mere
four years (1880–84). Then in a single year (from 1884–85), real per capita
output fell a little more than 6 percent. (To get some perspective, during
the Great Recession—which of course is the worst economic calamity to hit the
world since the Great Depression—the biggest year/year drop in U.S. real GDP
per capita was 4.9 percent, which occurred in the second quarter of 2009.)
After the trough in 1886, there was another expansion through 1891,
followed by another multiyear contraction. Then from 1896–1900 we see the
beginnings of yet another massive boom, with real output per capita again
rising about 30 percent in four years.
Now in fairness to Selgin, 19th century economic data are notoriously
prone to exaggerate the volatility in real output during business cycles,
because of imperfect adjustment of the relevant price deflators. (This is why
I used a chart taken from a very recent paper, which itself quibbled with the
standard reference in the literature.) Yet even if Selgin and other FRFB
advocates want to claim that the wild swings in Canadian output were mostly
nominal, that still contradicts their claim of stability. Under the
classical gold standard, nominal prices rose during booms and crashed during
busts, but that was (at least partly) due to fractional reserve banking,
where the bankers fed the boom by inflating through credit expansion and then
starved the bust by deflating through credit contraction. The figure
above—whether we take it at face value or even if we generously suppose it is
partially mistaking nominal swings for real ones—is exactly what Murray
Rothbard would suppose a FRFB economy would look like. It is not how the FRFB
writers describe their vision.
Ironically, even if we turn to the very source Selgin cited—namely, R.M.
Breckenridge’s (1895) large book on the Canadian economy—we find decent
support for the claim that FRFB fosters the standard Mises-Hayek business
cycle.
For example, in the Table of Contents, this is how Breckenridge lays out
the topics in Chapter VIII:
Figure 2. Excerpt from Table of Contents of Breckenridge (1895)
Notice that the material in Chapter VIII covers the Canadian banking
system for the first 22 years after Confederation—all of this falls under the
period that Selgin singled out as epitomizing a sound, stable, fractional
reserve free banking system in operation.
Now surely one does not have to be a fuddy duddy Rothbardian to say that
the subject headings for Chapter VIII are inauspicious at best for the FRFB
camp. We see a six-year “expansion” followed by a five-year “depression,” and
a section devoted to the bank losses during the depression. The 100 percent
reservists can now add Selgin’s recommended text as further evidence that
FRFB fosters the Mises-Hayek boom-bust cycle.
Now to be fair to Selgin, Breckenridge is a fan of the Canadian banking
system that he is describing. For example, here is how Breckenridge concludes
his discussion of bank failures through 1889:
Here ends, for the present, the account of bank failures in Canada. If any
conclusion may be drawn from the study, it is that the disasters have been
due to faults of practice, rather than defects in the system. It is clear
that legislation, scientifically framed, has not prevented poor management,
bad management, or fraud. No one, probably, ever expected it would. It is
clear also that it has not saved shareholders from loss. A careful estimate
shows that, by reductions of capital, liquidations, failures, and
contributions on the double liability, shareholders have sunk at least
$23,000,000 in Canadian banking since the first of July, 1867. This sum, more
than 37 per cent. of the present paid-up banking capital, is independent of
the losses provided for out of profits, or met by reduction of rests [sic].
The security of a group of banks, however, must be judged, not by the losses
of their proprietors, but by those of their creditors. We may see now how
well the Canadian system has minimized the creditors’ risks. Out of 56
chartered banks, some time in operation in Canada since the first of July,
1867, just 38 survive. Ten of those gone before have failed. But the total
loss of principal inflicted during twenty-seven years on noteholder,
depositor, government, or creditor whomsoever, has not exceeded $2,000,000,
or less than one per cent. of the total liabilities of Canadian banks on the
30th day of last June. (Breckenridge 1895, 314; bold added.)
And so we can see the sense in which Selgin could think the Canadian free
banking system was vindicated. After all, the restaurants on a busy downtown
strip (say) might be characterized by a high turnover, yet so long as
entrepreneurs enter the field with eyes wide open, this could be a healthy
example of cutthroat competition and Schumpeterian innovation. A high
percentage of restaurant failures in a certain area would not necessarily
prove that the market was failing consumers.
However, there are serious problems with such an attempt to rehabilitate
the Canadian experience. First of all, in our hypothetical restaurant
analogy, we surely would not say, “The disasters have been the fault of the
restaurants’ management, not the system.” When you have to use the word
“disaster”—as Selgin’s own preferred authority on the Canadian experience
did—it is hard to maintain the claimed badges of stability and soundness.
Furthermore, Selgin is moving the goalposts if he thinks loss of customer
deposits is the criterion for a desirable banking system. The claim—from
Mises and Hayek through Rothbard up to writers such as Salerno in the present
day—has always been that credit expansion sets in motion an unsustainable
boom. Breckenridge’s historical account confirms that claim beautifully. To
put the matter another way: By Selgin’s criterion, we could just as well
“prove” that the United States banking system from 2000–10 was perfectly stable
and sound. After all, no bank customers lost any deposits in
standard checking accounts, and there were no banking panics of the kind
witnessed during the 1930s.
As a final note, Breckenridge’s figure of a mere $2,000,000 in creditor
losses is misleading. As Breckenridge explains earlier in the book, troubled
banks had suspended note redemption, and in the consolidation process some
depositors had to sell their notes at a loss, even though those notes would eventually
be redeemed at par. This affected the public’s mood—imagine that!—when the
bank charters came up for renewal:
The expiry of all bank charters had been set for the 1st of July, 1881. In
accord with the policy adopted a decade before, Ministry and Parliament took
up… the question of what changes to make in the system at the time of the
first decennial renewal of charters.
They were anticipated both by the public and the banks. Among the people,
much dissatisfaction had been caused by the bank suspensions of the preceding
year. The notes of only one of the failed banks were finally redeemed at less
than their nominal value, but at that time liquidation in several cases was
still incomplete. To change the notes of failed banks into convertible paper,
the holder had to submit to a discount, and the brokers who took the risk
exacted ample pay for it. Many of those holding notes at the times of
suspension had only the option between this loss and physical want. They were
forced to realize at the time when the credit of their debtors was at the lowest
ebb. They could not even wait until the fears of the first week were quieted,
much less till the day of final payment….
The bankers understood the popular discontent with the security of the
currency. They saw their own interest, and the country’s interest, no doubt,
in calming it. For them, their privilege of circulation provided an easy,
convenient, and useful means of profit; to the country, it gave an elastic
currency, increased sources of discount, and through the system of branches
promoted by it, widespread and accessible banking faciliites. (Breckenridge
1895, 289–90; bold added.)
Whatever one might say about the block quotation above, it hardly sounds
like a description of a smoothly operating free market, bereft of political
favoritism, and where customer satisfaction is Job #1. On the contrary, it
sounds exactly like the negative picture painted by a Rothbardian critic of
fractional reserve banking.
Our brief sketches of Scotland and Canada have shown that the two examples
held up by Selgin were plagued by decades-long specie suspension on the one
hand, and depression coupled with bank failures on the other. It leads the
critic of FRFB to doubt the accuracy of Selgin’s assurances that all major
problems with banking in history were the fault of anything but
fiduciary media.
V. CONCLUSION
The intra-Austrian debate over fractional reserve banking is long and
contentious. In the present paper, I have focused on the specific issue of
whether fiduciary media per se set in motion the boom-bust cycle. I have
shown that even the very definitions Mises chose in his monetary theory
underscore this elemental fact. Furthermore, the FRFB attempts to reconcile
credit expansion with loan market equilibrium fall apart when subjected to
simple thought experiments. Finally, I have shown that Selgin’s two favorite
examples of the alleged stability of FRFB—Scotland and Canada—are in fact
textbook illustrations of the dangers of fractional reserve banking.
