George Selgin Misunderstands Rothbard's Position on Fractional-Reserve Banking
George Selgin has a 3-part series (I, II, and III) at Alt-M taking people (like me) to task for claiming that fractional-reserve banking per se causes the boom-bust cycle as described by Mises/Hayek. To be clear, George is putting aside the issue of whether FRB is fraud, and is just focusing on the economics. (He thinks the people claiming it’s fraudulent are akin to flat-earthers and beyond hope at this point.)
Let me say at the outset that I was initially frustrated with George’s posts, because it didn’t seem he even grappled with our perspective until the latter half of the third post. But, at that point he did put up a fight.
Furthermore, he then posted an excerpt from Fritz Machlup which is very pertinent to the debate; I will have to get Machlup’s book (which I haven’t read) and study this. So, after reading Part III of George’s series, and especially after seeing his post about Machlup, I’m relieved that we’re not just talking past each other.
However, right now I’m dealing with just Part I of his series, and I was underwhelmed.
In the first place, George totally misunderstands Murray Rothbard’s position. George writes:
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…
George then quotes Rothbard saying that any quantity of money is sufficient to provide money-services to the community.
Then, George goes on to discuss the (alleged) other view:
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.
…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.
So to repeat, George has misunderstood Rothbard’s position. Rothbard would agree with the position attributed to Shostak, namely, that an increase in the quantity of gold in the economy won’t set off the boom-bust cycle. Here’s Rothbard from ME&S:
The process of issuing pseudo warehouse receipts or, more exactly, the process of issuing money beyond any increase in the stock of specie, may be called inflation.106
And then if you follow the footnote to this sentence you find:
106 Inflation, in this work, is explicitly defined to exclude increases in the stock of specie. While these increases have such similar effects as raising the prices of goods, they also differ sharply in other effects: (a) simple increases in specie do not constitute an intervention in the free market, penalizing one group and subsidizing another; and (b) they do not lead to the processes of the business cycle.
So yes, Rothbard doesn’t think the community ever “needs” the stock of gold to increase, in order to fulfill its functions as a money, but if the stock of gold does increase, it won’t cause the business cycle (according to Rothbard). The only thing that fuels a credit expansion is issuing claims on money that are not backed up by genuine specie.
(Ironically, an economist who does allow for the possibility of newly mined gold causing the boom-bust cycle is Mises. If you read his sections on the business cycle in Human Action, you’ll see that he places them in the section dealing with the pure market economy, because he thinks in principle if newly mined gold hits the loan market relatively early, it could cause the market loan rate of interest to fall below the correct originary rate. In practice however Mises thinks this is negligible for empirical reasons, and the real cause of business cycles in our world comes from the banking system.)
Rate of Money Growth
The main point of Selgin’s first post is to argue that the rate of money growth and the reserve ratio are largely independent of each other. For example, suppose we have a fiat dollar money system, where the banks practice 100% reserves. If the Fed creates base money at the rate of 5% annually, then the overall quantity of money grows by 5% annually too. (This is obvious.)
However, suppose the commercial banks only maintain a reserve ratio of 10%. This means that when the banks are fully “loaned up,” the stock of checking account balances can be 10x the amount of reserves. So it seems like there will be a lot of extra inflation in this scenario, right Rothbard and Shostak?
Not so, says Selgin. Here too, the total amount of checking account balances only grows at 5%, assuming the Fed has the base money grow at that rate as before. Indeed, it’s only when a banking system lowers its reserve ratio–in our example, moving from 100% down to 10%–that you get a fleeting increase in the stock of broad money aggregates. Once we settle down into the new equilibrium, the rate of monetary inflation is equal to the growth in reserves, regardless of the reserve ratio.
This is all correct, insofar as it goes, but it doesn’t bear on the claims of those Austrians who think FRB is inherently problematic. Before I say why, let’s switch to an analogy: Suppose I take 50% of George’s paycheck each month. In other words, if his employer pays him $10,000, I pocket $5,000 and George only gets to keep $5,000.
Now George gets upset and says I am ripping him off each month. He is earning less, month after month, than what he is producing.
I correct George, though, by pointing out that the growth rate in take-home pay is just the same as it would be, if I hadn’t started swiping half of his loot. For example, in the original timeline, if George would normally enjoy a 3% annual raise, then that’s just what he’ll enjoy in this new scenario, too. In fact, the only time where I could kinda sorta see why he would be upset, is during the initial transition phase, when the ratio of his take-home paycheck drops from 100% down to 50%.
Now does this make sense? Of course not. By the same token, the Austrians in this tradition–and it’s not just Rothbard and Shostak, I would argue it’s quite plainly Mises (and probably Hayek too, though I’m not as familiar with his work)–are saying that there’s a mismatch between the level of genuine saving and the funds made available for investment. So if the central bank creates $1000 in new base money, and out of that the community voluntarily saves $5 by depositing it in the commercial banks, then if the banks go make loans of $50, there is a mismatch between the aggregate saving and lending. It’s the creation of new, unbacked money per se that is causing the problem (if there’s a problem at all, which George thinks might not be true under certain circumstances). If the commercial banks issue, say, $1 billion in new fiduciary media in 2018, this causes discoordination in the capital structure, period. You don’t need to inquire whether the banks had injected $100 million, $110 million, $120 million…$990 million in the previous years, to determine whether this year’s injection of $1 billion is benign or disruptive.