Ryan Murphy has been helping me think through this one: is there anything that guarantees that a system of free banking is capable of achieving full employment? He's been thinking of it in terms of guaranteeing stable nominal GDP, which I suppose is comparable.
He pointed me to one of Selgin's articles in JMCB, titled "In-Concert Overexpansion and the Precautionary Demand for Bank Reserves" (sorry, no ungated link). I got the impression I was more comfortable with the article's conclusions than Ryan was. Selgin basically concluded that co-ordinated overexpansion wasn't possible because while more conservative banks would win out if any one bank tried to over-expand, a concerted over-expansion would result in increased precautionary demand for reserves in the entire system, which is contractionary.
This is related to the initial concern about free banking that I posed to Ryan, which was also related to the fact that free banks are not immune to the precautionary demand for money. I had initially posed the point to him in a simple IS-LM framework, which has proven to be a useful framework to think about in the current crisis. All free banking seems to do is change a vertical money supply curve to an upward sloping money supply curve. It doesn't seem to change anything else, so it doesn't seem to solve any of the problems that we (or at least I) worry about. Indeed, as Selgin points out banks demand reserves for precautionary reasons as well. You can see this right now with banks sitting on reserves. IOR is a big part of that story, but do we really think that's the only thing holding them back? Probably not. How can we expect a banking system as prone to precautionary savings as anyone else to guarantee full employment? How does an upward sloping money supply curve in an IS-LM model fix anything? These aren't accusations so much as genuine questions because I'm not expert on free banking and I'm trying to figure out why people think its so great.
You confound "precautionary savings" and "precautionary reserve demand". Selgin explains that very well in his book "The theory of Free Banking : Money Supply under competitive note issue" (1988), chapter 5 and 6.
ReplyDeleteFrom chapter 5 :
"To summarize, a general increase in the demand for inside money is equivalent to a general decline in the rate of turnover of inside money. Bank notes change hands less frequently, and holders of demand deposits write fewer (or perhaps smaller) checks. As a result, bank liabilities pass less frequently into the hands of persons or rival issuers who return them to their points of origin for redemption. The reduction in turnover of liabilities leads directly to a fall in the volume of bank clearings. When this happens banks find they have excess reserves relative to the existing level of their liabilities, and so they are able to increase their holdings of interest-earning assets, which they do by expanding the supply of inside money in a manner that accommodates the growth in demand for it. In standard textbook terminology, there is an increase in the reserve multiplier. Liability expansion continues so long as there are unfilled reservoirs of demand. Any issues in excess of demand, however, will lead to additions to the stream of payments, causing an increase in bank clearings and reserve requirements."
Chapter 6 :
"Both of these components of a free bank’s reserve demand are related to the total clearing debits it faces, and not necessarily to the total of its outstanding liabilities. Moreover, the quantity of a bank’s liabilities returned to it through the clearing mechanism depends just as much on their average turnover as on the quantity of them outstanding. Thus, to take the limiting case, additional liabilities with zero turnover would not add to an expanding bank’s reserve demand, and contraction of zero turnover liabilities by a bank would not add to its excess reserves. On the other hand, a bank’s reserve demand may increase even though it has not expanded its liabilities, because turnover of its liabilities has increased. Finally, a bank’s reserve needs may fall although its liabilities are unchanged because the average period the public holds its liabilities has increased."
"The total volume of clearings may also rise or fall because of an increase or decrease in the average size of individual payments where the frequency of payments is constant. (...) This results in an increase in precautionary reserve demand proportional to the increase in bank clearings."
Jonathan Catalan also have a good knowledge of Free Banking. You may ask him further questions.
Why should I care if an economy does or doesn't have stable total nominal spending? I'm perfectly fine with people deciding to spend less, even in the aggregate.
ReplyDeleteThat's a question best posed to Ryan himself or to someone like Lee Kelly. I can see why we might remark on an empirical regularity like NGDP as a guide, but I agree with you - there doesn't seem to be any inherent reason why we should care. That's why I offer "full employment" as an alternative (full employment is not, of course, synonymous with a high employment to population ratio - presumably it would be nice if that fell over time).
ReplyDeleteFair enough, but I disagree with the casual equation of the stable NGDP and full employment(or deeming them "comparable").
ReplyDeleteIn any case, it still sounds like a strange question. Imagine me asking, "How would free bikemaking achieve full employment?" Now replace bikemaking with banking...
You do realize that free banking is a widely proposed solution to the problem of macroeconomic instability and underperformance, right? It doesn't seem like that strange of a question.
ReplyDeleteAlthough you word the biking example more strangely than it needs to be. Would you expect a free market in bikes to achieve efficiency in the market for bikes? In that case, you certainly would - and it's not an odd question to ask.
Money is a very different thing from bikes, of coruse - which is why this question is so important to answer.
And I honestly don't know the answer. In an IS-LM framework, all free banking seems to do is provide us with an upward sloping money supply curve (which isn't even to say anything about the very real likelihood that a macroeconomic shock might also shift that supply curve to the right - something that doesn happen with central banks). That doesn't seem to guarantee anything in the way of macroeconomic efficiency.
I was just commenting on this somewhere else...
ReplyDeletehttp://www.cobdencentre.org/2011/08/hayek-vs-keynes-debate-rebroadcast/comment-page-1/#comment-35089
I don't think that free-banking policies or monetary disequilibrium based policies really guarantee anything about employment. Employment is a derived demand that depends on output.
If we have monetary equilibrium then that means entrepreneurial planning and household planning would not be affected by unexpected changes in the price level from the money side. It doesn't guarantee that the demand for constituents of GDP will be stable, since they are only one portion of traded goods.
That said, I think monetary disequilibrium based policies are good because I don't think the stability of GDP is as important as Keynesians believe it is.
So cut off the derived demand for employment and just look at the rest of the IS-LM model. If you were to convince someone who thinks the IS-LM model is a reasonable first approximation to the world, how would you convince them that:
ReplyDelete1. Making the money supply curve upward sloping, and
2. Making the money supplying institution profit maximizing
does anything salutary in the context of the model? What does free banking guarantee? I'm not saying central banking "guarantees" anything, to be clear. We're living through proof that it doesn't right now. But it at least affords an opportunity.
The point is not simple to make the money supply curve upward sloping....
ReplyDeleteThe most important ideas in free banking theory are the theories of reserves and how they affect money supply and demand. At it's most optimistic the theory is that free banks would satisfy any excess demand for money without creating excess money and driving a change in the price level. The same applies in the opposite sense for a fall in demand for money. None of us really believe this "most optimistic" case, but we think it's closer to the truth than any other system for performing the same equilibriation. We think it's important that the monetary authorities don't have any reliable measure of money demand.
Now, as a Keynesian I don't think you're view is that same. You're not concerned with monetary equilibrium or with relative prices in the same sense that we are. As I understand your view, you think that moving the IS curve causes no problems that appear later. We disagree about that.
My view on this isn't necessarily representative of other free bankers. Selgin wrote that it can be consistent to be a Keynesian and support free banking, I don't really agree with him there.
OK, well the mechanism is still unclear to me but I would like to clarify that of course shifting the IS cuve can cause problems. You and I may disagree on the extent of those problems and the competing priorities governing those decisions, but I'd never say that it "causes no problems that appear later".
ReplyDeleteOn the IS curve, perhaps we don't disagree so much.
ReplyDeleteThe mechanism by which the money supply is determined under free banking is (broadly) explained in all the books on the subject. The essence of it is that as V in MV=PT rises the banks need more reserves to serve redemption demands because redemptions increase in frequency too. If reserves are fixed in the short-run then banks will reduce M corresponding to the increase in V. The reverse occurs when V falls, that means banks can safely use less reserves.
Right, OK. Now I'm stuck on whether this is just a movement up the money supply curve or whether it's an actual shift in the curve, and why any of this is expected to respond more effectively than a central bank.
ReplyDeleteThe other concern, of course, is that downturns that make people demand more money (decrease V) are precisely the sorts of downturns that might also make banks increase their assessment of a safe level of reserves.
If you're interested in the details then read a book. They're very cheap from the Mises institute.
ReplyDeleteI'm sure you would give me the same reply in an analogous situation :)