In the previous post, I explained why I had been shocked at the way economist George Selgin—a leader in the “free banking” camp—responded to a series of thought experiments I had posed to him on Twitter. In the post, I described in some detail how Selgin’s admission on Twitter confirmed what the critics of fractional reserve banking (FRB) had been arguing: that the practice causes the boom-bust cycle as laid out by Austrian economist Ludwig von Mises. Furthermore, I showed why Selgin’s initial reaction to my case (which he emailed me after he heard a podcast episode I did on the topic) didn’t help him escape the trap.
Yet as I promised at the tail end of my prior post, there is actually a completely independent problem with Selgin’s Twitter response to my original hypotheticals. Namely, they are utterly irreconcilable with Selgin’s official position (as explained in his book and during our SoHo Forum debate) on FRB and saving. In this post, I’ll remind readers of how Selgin responded to me on Twitter, and then I’ll explain why those answers pose supreme difficulties for his views on FRB.
Selgin’s Answer to My Twitter Hypotheticals on Banking and Saving
In case the reader missed my last post, or simply to refresh the memory of those who saw it, here again is my list of simple questions to George that I posed on X:
In response, George readily admitted that scenario 1) constituted saving, but that the other scenarios didn’t constitute additional saving beyond the original $100. This didn’t surprise me; I had deliberately chosen my scenarios to be so simple that George’s answers were undeniable. Yet what floored me was that George went ahead and anticipated where I had planned on taking him:
So to be clear, here George was admitting that if commercial banks engage in FRB, then when a household deposits base money into a checking account, the banking system (other things equal) issues more loans which obviously don’t correspond to genuine saving on the part of the households. This is the essence of the “circulation credit theory of the trade cycle”—a.k.a. Austrian business cycle theory—that Ludwig von Mises developed. (I spelled out Mises’ views in this recent podcast episode.)
In my prior post, at this point I went to great lengths to spell out why George’s position above was incompatible with his stated views on the innocuousness of FRB. But now in this post, let me point out an independent problem. But to do that, I first need to explain why George thinks that FRB—so long as it is conducted in a free market without government or central bank subsidies—does not push interest rates to “artificially low” levels, as people like Mises (and me) argue.
Selgin’s Argument That FRB Equates Household Saving with Bank Lending
Here it is best to first quote extensively from George himself, in his 1988 book treatment of the topic:
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, The Theory of Free Banking: Money Supply under Competitive Note Issue, pp. 54–55, bold added.)
For those interested in a more detailed treatment, here is my journal article on the subject (where I also have the above quotation from George). For our purposes, a quick restatement will suffice: George is arguing that FRB, at least as practiced in a free market, can’t lead to a mismatch between household saving and the provision of credit from banks.
This is because (he argues) the only way banks can issue more banknotes or checking account balances (for a given amount of base-money reserves in the vault) is if the public is willing to hold that extra increment of bank-created money. Yet the very act of the public holding more bank-created money is itself a form of saving.
Therefore, George argues that if the public wants to hold more money, banks in an FRB system can accommodate that demand more efficiently than having to dig up more gold (if that’s what the underlying base money is). Increasing the stock of money through banks issuing more credit will (a) clear the market for money itself but also (b) equilibrate the supply of, and demand for, loanable funds because—to repeat—any additional lending by the banks in such a scenario is exactly mirrored by an increased willingness of the public to extend credit to the banks by holding more of their liabilities.
Why Selgin’s Twitter Response Contradicts His Position on FRB and Saving
With that extensive background, we can now quickly see the problem George faces. When he answered me on Twitter, he had no problem admitting that when someone deposits a $100 bill into his checking account, and the bank (if it practices FRB) then issues a new loan to someone because of the increase in reserves, that the bank has therefore issued credit in excess of the original household saving.
But how can this be possible? If the bank practicing FRB is able to issue more loans because of the deposit of new reserves, then the public must be holding more of the bank’s liabilities than was originally the case. And George told us in his block quotation above that to “hold inside [i.e. bank-created] money is to engage in voluntary saving.” If that’s the case, then how could any activity by FRB banks provoke the Austrian boom-bust cycle?
To be clear, I dispute George’s argument that holding bank liabilities is akin to granting a loan to the bank. Indeed, that was the whole point of my original, simplistic thought experiments; I was going to back George into a corner, and force him to admit that FRB caused a divergence between household saving and bank lending. To repeat, that’s why I was so surprised when he jumped headlong into the subtle trap I thought I was laying for him.
Conclusion
During his Twitter exchange with me, George Selgin agreed that FRB can facilitate a divergence between household saving and bank lending, and thereby set in motion the boom-bust cycle developed by Ludwig von Mises. Although George keeps insisting to me that his Twitter remarks are consistent with his official books, articles, and debate remarks, I do not see how they can be. In this post, I showed that George’s casual admission on Twitter seems to explode his book’s argument that FRB necessarily equates voluntary saving and investment in the community.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together the dependability of Whole Life insurance policies with the benefits of blockchain-based finance.
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