18. The Redemption of Fiduciary Media

CHAPTER 18 THE REDEMPTION OF FIDUCIARY MEDIA

Summary

The confidence in a bank’s ability to redeem its fiduciary media is an all-or-nothing proposition: if a portion of the community panics and rushes to redeem their claims, then everyone does. By their very nature, fiduciary media cannot all be honored by the bank at once. Consequently, some writers suggest an outright prohibition on the practice. However, historically this requirement would have led to a much larger diversion of resources into the production of the precious metals as the demand for money increased.

A bank operating in a competitive environment can only issue as much fiduciary media as its own customers wish to hold, for transactions among themselves. Whenever a bank’s customer seeks to do business with someone outside the clientele of the bank, the customer must convert his claims into money in the narrower sense, because the other person will not wish to accept the bank’s promises to pay.

Solvency means that an institution (such as a bank) could shut down, sell off all of its assets, and raise at least enough money to pay off all of its creditors. Liquidity is a stronger condition, meaning that the institution’s assets deliver a cash flow allowing it to pay its liabilities on time. If a firm is liquid, it is solvent, but it might be solvent while illiquid. Banks issuing fiduciary media are always illiquid.

Chapter Outline

1. The Necessity for Complete Equivalence Between Money and Money Substitutes

So long as some people believe that a claim to money issued by a particular institution is absolutely reliable and can be redeemed upon demand, these people may pass such claims among themselves as if they were money. This is what makes them money substitutes. However, the issuing institution must always keep a reserve fund of money in the narrower sense to redeem the claims whenever they are presented, in order to maintain this trust. Such redemptions will be requested whenever the bank’s own clientele wish to use their claims to do business with someone outside the clientele, i.e., a person who does not consider the claim to be a substitute for money in the narrower sense.

2. The Return of Fiduciary Media to the Issuer on Account of Lack of Confidence on the Part of the Holders

The confidence in a bank’s ability to redeem its fiduciary media is an all-or-nothing proposition: if a portion of the community panics and rushes to redeem their claims, then everyone does. By their very nature, fiduciary media cannot all be honored by the bank at once. No matter how wisely a bank manages its assets, it will not be able to pay out money in the narrower sense for all of its outstanding claims, if customers show up en masse and demand redemption—assuming the bank has been issuing fiduciary media.

3. The Case Against the Issue of Fiduciary Media

Because of the internal contradiction of the nature of fiduciary media—which renders every issuing institution liable to ruin—some writers suggest an outright prohibition on the practice. However, historically this requirement would have led to a much larger diversion of resources into the production of the precious metals as the demand for money increased. The banks could survive even if they were legally required to maintain 100 percent reserves covering all note issues and deposits; it is not consideration for the practice of banking that led legislators to tolerate fiduciary media. Rather, it was the desire to avoid a large increase in the objective exchange value of money (i.e., a general fall in prices of goods and services).

4. The Redemption Fund

A bank operating in a competitive environment—where its rivals may pursue different policies and where its own clientele is only a fraction of the whole community using the same money—can only issue as much fiduciary media as its own customers wish to hold, for transactions among themselves. Whenever a bank’s customer seeks to do business with someone outside the clientele of the bank, the customer must convert his claims (whether in the form of notes or a checkbook deposit) into money in the narrower sense, because the other person will not wish to accept the bank’s promises to pay.

5. The So-called “Banking” Type of Cover for Fiduciary Media

Some writers suggest that “prudent” banks will invest in short-term assets, in order to remain liquid. Yet by their very nature, banks issuing fiduciary media are illiquid: their liabilities are immediately due if presented, while their assets are necessarily of longer duration. The best such banks can strive for is solvency.

6. The Significance of Short-Term Cover

Sometimes legislation, but always public opinion, compels the banks to give preference to short-term rather than long-term loans. This is a quite valid preference, backed up by centuries of experience. However, the explanation for its wisdom is not that it allows the banks to redeem fiduciary media in the event of a panic—the bank’s asset maturities are irrelevant if everyone shows up, demanding redemption. The actual benefit from focusing bank loans on short-term investments is simply that the constraint checks the bank’s ability to issue fiduciary media.

7. The Security of the Investments of the Credit-Issuing Banks

There is similar confusion when it comes to proposals seeking to guarantee the (eventual) redemption of all fiduciary media by means of reserve funds consisting of illiquid assets (such as mortgages). Even if the public is certain that they will be eventually paid in money (in the narrower sense) for the claims to money that they currently hold, even so, if there is any doubt about the immediacy of the payment, then the claims will no longer be money substitutes. Instead, the public will take into account the delay before receiving payment, and such claims will trade at a discount to the money itself. (Note that if the claims continue to circulate as generally accepted media of exchange, even though everyone knows that redemption at best will occur after some delay, then the claims will have become credit money.)

8. Foreign Bills of Exchange as a Component of the Redemption Fund

A bank cannot increase its issue of money substitutes (consisting of both money certificates and fiduciary media) beyond the demand of its own clientele, for use in their dealings with each other. However, to the extent that sometimes its clients need to exchange their money substitutes when dealing with foreign citizens, the bank has the option of keeping some of its reserve fund in the form of foreign money substitutes, as opposed to money in the narrower sense. (This is because the foreigners with whom the bank’s clients wish to do business, will accept money substitutes issued by institutions from their respective countries.) Yet this practice means that the original bank’s reserve fund has a smaller proportion of money in the narrower sense, and hence that its own money substitutes consist of a higher fraction of fiduciary media (versus money certificates).

Technical Notes

• In modern times, one of the major controversies within the Austrian School concerns the legitimacy of fractional reserve banking. Some Austrians follow Murray Rothbard who argued that bank issuance of fiduciary media leads to the boom-bust cycle and is inherently fraudulent—akin to a warehouse manager renting out the goods that were supposedly placed with him for safekeeping. Other Austrians such as George Selgin and Steve Horwitz call their position “free banking” and believe that there is no reason for banks to necessarily keep 100 percent reserves of money in the narrower sense, in order to fully cover all outstanding customer deposits. The free bankers argue that market forces will determine the proper ratio of money certificates to fiduciary media in a competitive banking system. (Virtually all modern Austrians agree that government-sponsored central banking and fiat currency are both economically destructive and morally illegitimate. The dispute concerns the proper practice of private banks operating in a laissez-faire environment.)

• Continuing with the above note, both groups point to passages in Mises’s writings to lend credence to their position. Even within this very chapter, Mises offers statements that—viewed in isolation—would seem to definitively side with one camp versus the other. (Two of these quotations are the opening selections for the study questions below.) Although Mises agrees with the Rothbardian, 100-percent reserve camp that there is a paradox in the very nature of what fiduciary media claim to be, on the other hand he also agrees with the free bankers that the historical development of fiduciary media economized on resources (that would have otherwise gone into the socially wasteful production of more gold and silver for monetary purposes). Thus Mises does not clearly fall into one camp or the other. (Of course Mises’s own view wouldn’t settle the modern dispute: he could have been simply mistaken, regardless of his position.)

New Terminology

Free banking (among modern Austrians): The doctrine holding that a free market in banking will pick the optimal fraction of reserves, which may be below 100 percent. Free banking theorists do not believe that the issue of fiduciary media per se causes the business cycle, only that excess quantities of fiduciary media do, and that such an outcome is almost always associated with government-supported issues of fiduciary media.

Solvency: The situation in which the market value of an institution’s assets exceeds its liabilities.

Liquidity: The situation in which an institution’s assets will deliver a cash flow allowing it to pay its liabilities on time. (All liquid enterprises are also solvent, but not necessarily vice versa.)

Cash flow: The stream of money payments over time due to an asset or collection of assets.

Hypothecary loans: Loans granted with an asset such as real estate serving as collateral.

Study Questions

1. Explain: “Thus there lies an irresolvable contradiction in the nature of fiduciary media. Their equivalence to money depends on the promise that they will at any time be converted into money at the demand of the person entitled to them and on the fact that proper precautions are taken to make this promise effective. But—and this is likewise involved in the nature of fiduciary media—what is promised is an impossibility in so far as the bank is never able to keep its loans perfectly liquid.” (p. 322)

2. Explain: “The issue of fiduciary media has made it possible to avoid the convulsions that would be involved in an increase in the objective exchange value of money, and reduced the cost of the monetary apparatus.” (p. 323)

3. When Mises says of coins that their “smooth faces tell no tales of the methods by which they have been acquired,” is he making an argument for or against the possibility of customers paying banks for providing them with (fully backed) deposit and checkbook services? (p. 324)

4. Why does Mises say that a single bank with no competitors, or an industry of banks operating with uniform policies, would suffer no limitations on their ability to issue fiduciary media? (pp. 325–26)

5. Explain: “Whether the assets of a credit-issuing bank consist of short-term bills or of hypothecary loans remains a matter of indifference in the case of a general run.” (p. 333)

Study Guide to the Theory of Money and Credit