Full Reserve Banking

Conclusion

Although he himself is a supporter of the dead horse of fractional reserve banking, George Selgin in 1989 made the following forward-looking statement concerning the real bills doctrine: “It would be a mistake to think of the real‐bills doctrine as a ‘dead horse.’ The dead horses of economic theory have a habit of suddenly springing back to life again, which is why it is necessary to beat them even when they appear lifeless” (Selgin 1989, 489).

Rallo’s Una crítica a la teoría monetaria de Mises is one such sudden revival of the real bill dead horse. In his idiosyncratic version of the banking school and with references to Antal Fekete, Rallo combines the “needs of trade,” the “law of reflux,” and the real bills doctrine to attack the currency-school approach of Ludwig von Mises.

The flaws and misconceptions of Rallo are numerous and related to the fundamentals of economic science. Like Keynes, Rallo deduces from the equality of assets and liabilities on the balance sheets of banks that fractional reserve banks are engaged in genuine credit intermediation. He confuses the holding of fiduciary media with the granting of credit and genuine savings.

Rallo brings forward three neoclassical arguments in favor of a real bill fractional reserve banking system. First, such a system would prevent a cash-building deflation. Price deflation would bring coordination problems because of price rigidities. Second, such a system would achieve price stability, which would be advantageous because it would make entrepreneurial forecasting easier. Third, it would reduce the unnecessary resource costs of a pure metallic standard. All three arguments fail.

(1) Not only does cash-building deflation have an important social function that is disturbed by the production of fiduciary media, but it is also unnecessary to fight cash-building deflation with increases in fiduciary media because prices can and do adjust in accordance with the needs and preferences of market participants. Ignoring price adjustments and focusing on quantity adjustments is typical of Keynesian thinking. A mechanistic view of the pricing process induces Rallo to believe that price rigidities cause problems, even though prices are dynamically predicted, renegotiated, and adjusted all the time. The changes in relative prices in a time of cash-building deflation deliver important price information. Stabilization through injections of additional money distorts that information.

(2) A price-stabilization policy in response to an increase in the demand for money is destabilizing because it lowers interest rates artificially and leads to an unsustainable boom. Moreover, the origin and evolution of money do not come with price stability but usually with strong increases in the purchasing power of the good that evolves into money.

(3) Any monetary standard comes with subjective costs of maintenance. Market participants must decide whether they are willing to bear these costs. A commodity standard chosen by freely interacting individuals in a free market cannot, from a scientific point of view, be said to have too-high resource costs.

Rallo believes that the supply of money must be regulated in such a way that the supply of money follows the demand for money. Arguing in the aggregate terms of the monetary-equilibrium approach, he cannot appreciate the microeconomic adjustment processes that come along with individual changes in the demand for money.

He also invokes unrealistic neoclassical instruments and concepts such as the elasticity and inelasticity of demand and supply curves and the constant marginal utility of money. He contends that the flexible money supply of a real bill fractional reserve banking system allows the money supply to adjust to the aggregate demand for money and to stabilize the general price level. Yet, when the demand for money increases, the intensity of the increase may vary among individuals. Individuals will use subjective strategies to attain higher cash balances by abstaining from buying specific goods and services or by increasing their sales of specific goods and services. This implies changes in relative prices and price adjustments throughout the entire structure of production. The demand for money never rises in the same proportion for all individuals.

The change in the demand for money may also come along with a change in the time preference. All these relative price changes and adjustments remain unseen and hidden when looking at the aggregate supply of and demand for money. Besides, increases in the money supply through the production of fiduciary media do not reach those individuals who demand a higher cash balance directly.

The use of orthodox neoclassical instruments explains why Rallo employs well-known arguments that have been employed to justify the intervention of the government in monetary affairs. The neoclassical critics of Austrian monetary-reform proposals claim that cash-building deflation would cause problems because of price rigidities and that, therefore, the central bank must ensure that the money supply increases. Critics also argue that there is a lack of stability in market processes and that the government is needed to stabilize the market system. Moreover, critics claim that a free market money entails too-high resource costs. While Rallo does invoke all three arguments, he does not present the government as the solution. Rather he sees the solution in a banking system that discounts real bills (and operates with the government privilege of holding fractional reserves).

The real bills doctrine is a quite old dead horse. The idea of connecting the money supply to real output can be traced back to John Law and Adam Smith. The antibullionists developed the real bills doctrine further and were subjected to demolishing critiques. The most important one points out that the real bills doctrine links the money supply to a nominal variable—namely, the market value of consumer goods—which is itself not independent of the money supply. When the real bills doctrine was common banking practice, numerous banking crises occurred. The real bills doctrine also involves an objective turn away from subjectivevalue economics. It distinguishes between productive credit expansion (based on real bills) and unproductive or speculative credit expansion (based on securities).

Analyzing Rallo’s own version of the banking theory as presented in his critique of Mises, I find that he fails to distinguish between titles to present goods and titles to future goods. Both are financial assets for him. His dichotomy of real assets and financial assets does not permit him to see the problems inherent in fractional reserve banking. He declares fiduciary media to be financial assets. Yet fiduciary media are titles to money. And titles to present goods may have the same function as present goods themselves, as is the case for fiduciary media, which function as perfect substitutes for money proper.

The issue of fiduciary media gives rise to a double availability and intertemporal price distortions when the fiduciary media are injected into credit markets first. Rallo’s classification, however, makes him believe that holding financial assets is a form of saving. And as he regards fiduciary media as financial assets, he arrives at the conclusion that an increase in fiduciary media entails an increase in savings. Yet money is not a financial asset. And as fiduciary media are perfect money substitutes, fiduciary media are not financial assets either. While buying financial assets such as stocks and bonds entails giving up purchasing power (and the exchange of present goods for future goods), holding fiduciary media does not involve giving up purchasing power.

Holding cash is not saving even though economists such as John Maynard Keynes, George Selgin, and Juan Ramón Rallo fall for this error. Saving is the reduction of consumption spending and manifests itself in consumer goods that can be used to sustain the owners of the factors of production involved in the production of capital goods. Savings must be available until the very end of the production process and not only to the very end minus 30 days (which is a term of real bills).

The main insight of capital theory is that production takes time. The owners of the factors of production must be sustained during the whole production process. This insight is one of the main differences between the Austrian school and macroeconomic schools such as the Keynesians, the monetarists, and the defenders of the real bills doctrine.

Holding fiduciary media does not create more consumer goods. The demand for cash holdings (demand for money) may increase and real savings fall. In other words, an increase in the demand for money is compatible with an increase in time preference, while the defenders of the real bills doctrine interpret it as an increase in savings.

Also telling in the neo–banking school’s analysis is the artificial distinction between the discount rate and the interest rate. This allows the neo–banking school to argue that real bill credit expansion only lowers the discount rate or short-term interest rates and not long-term interest rates, giving support to their claim that the type of credit expansion is what matters: With only the right kind of credit expansion (real bill credit expansion) there would be no distortions in the structure of production. However, credit markets are interconnected, and the injection of fiduciary media into credit markets affects the whole yield curve, also lowering long-term rates. It is not the quality or type of loan that is created by credit expansion that matters, but the quantity of credit created. Credit always finds its way to the investment projects that are seen as the most profitable.

As another problem, the neo–banking school and Rallo subscribe to the error of the “needs of trade” argument. Yet the banking system is not just passively responding to increases in the production of real goods but may endogenously affect the demand for loans by lowering interest rates or weakening credit criteria. The demand for loans is not independent of the interest rate.

Rallo not only fails to see the problems of real bill fractional reserve banking but also erroneously believes that maturity mismatching is a problem in a free market. Yet the maturity of savings is not essential, as short-term savers can always replace each other. What is essential to sustain production is the quantity of gross savings. Maturity mismatching can support a sustainable structure of production and be dynamically efficient. Estimating the future availability of savings is indeed an important entrepreneurial activity. In the practice of maturity mismatching, someone is saving and giving up purchasing power for the short run, while with real bill credit expansion no one is giving up purchasing power and the money supply increases.

On the positive side, Rallo’s work portrays well the differences between Austrian monetary theory as developed by Mises and the neo-banking-school theory as developed by Fekete and Rallo himself. It has the merit of providing a well-written summary of Mises’s Theory of Money and Credit, with some misrepresentations as we have discussed. The book nudges the reader to scrutinize his arguments. It has the virtue of obliging the critical reader to go deeper and reexamine some basic concepts, such as the nature of money, the demand for money, interest rates, price deflation, real savings, and capital theory. Unfortunately, the book is wrong about each and every one of these basic concepts.

Rallo’s theory suffers from important flaws and shortcomings regarding these concepts. Most importantly there is a misunderstanding or neglect of capital theory. There is no need for a flexible money supply. Indeed, a flexible money supply in the sense of the real bills doctrine inevitably brings forward forces that cause a business cycle. The crucial point is that real bill credit expansion creates purchasing power without the renunciation of purchasing power by someone else. Without prior savings the investments that follow this newly created purchasing power are destabilizing.

Thus, Rallo’s theory is erroneous, and Mises’s and the Austrians’ money, banking, and capital theories stand firm. This revival of the real bill dead horse obliged us to reexamine, clarify, and elaborate some of the theory’s basic elements.