Archive for the 'Izabela Kaminska' Category

What Is Free Banking All About?

I notice that there has been a bit of a dustup lately about free banking, triggered by two posts by Izabella Kaminska, first on FTAlphaville followed by another on her own blog. I don’t want to get too deeply into the specifics of Kaminska’s posts, save to correct a couple of factual misstatements and conceptual misunderstandings (see below). At any rate, George Selgin has a detailed reply to Kaminska’s errors with which I mostly agree, and Scott Sumner has scolded her for not distinguishing between sensible free bankers, e.g., Larry White, George Selgin, Kevin Dowd, and Bill Woolsey, and the anti-Fed, gold-bug nutcases who, following in the footsteps of Ron Paul, have adopted free banking as a slogan with which to pursue their anti-Fed crusade.

Now it just so happens that, as some readers may know, I wrote a book about free banking, which I began writing almost 30 years ago. The point of the book was not to call for a revolutionary change in our monetary system, but to show that financial innovations and market forces were causing our modern monetary system to evolve into something like the theoretical model of a free banking system that had been worked out in a general sort of way by some classical monetary theorists, starting with Adam Smith, who believed that a system of private banks operating under a gold standard would supply as much money as, but no more money than, the public wanted to hold. In other words, the quantity of money produced by a system of competing banks, operating under convertibility, could be left to take care of itself, with no centralized quantitative control over either the quantity of bank liabilities or the amount of reserves held by the banking system.

So I especially liked the following comment by J. V. Dubois to Scott’s post

[M]y thing against free banking is that we actually already have it. We already have private banks issuing their own monies directly used for transactions – they are called bank accounts and debit/credit cards. There are countries like Sweden where there are now shops that do not accept physical cash (only bank monies) – a policy actively promoted government, if you can believe it.

There are now even financial products like Xapo Debit Card that automatically converts all payments received on your account into non-monetary assets (with Xapo it is bitcoins) and back into monies when you use the card for payment. There is a very healthy international bank money market so no matter what money you personally use, you can travel all around the world and pay comfortably without ever seeing or touching official local government currency.

In opposition to the Smithian school of thought, there was the view of Smith’s close friend David Hume, who famously articulated what became known as the Price-Specie-Flow Mechanism, a mechanism that Smith wisely omitted from his discussion of international monetary adjustment in the Wealth of Nations, despite having relied on PSFM with due acknowledgment of Hume, in his Lectures on Jurisprudence. In contrast to Smith’s belief that there is a market mechanism limiting the competitive issue of convertible bank liabilities (notes and deposits) to the amount demanded by the public, Hume argued that banks were inherently predisposed to overissue their liabilities, the liabilities being issuable at almost no cost, so that private banks, seeking to profit from the divergence between the face value of their liabilities and the cost of issuing them, were veritable engines of inflation.

These two opposing views of banks later morphed into what became known almost 70 years later as the Banking and Currency Schools. Taking the Humean position, the Currency School argued that without quantitative control over the quantity of banknotes issued, the banking system would inevitably issue an excess of banknotes, causing overtrading, speculation, inflation, a drain on the gold reserves of the banking system, culminating in financial crises. To prevent recurring financial crises, the Currency School proposed a legal limit on the total quantity of banknotes beyond which limit, additional banknotes could be only be issued (by the Bank of England) in exchange for an equivalent amount of gold at the legal gold parity. Taking the Smithian position, the Banking School argued that there were market mechanisms by which any excess liabilities created by the banking system would automatically be returned to the banking system — the law of reflux. Thus, as long as convertibility obtained (i.e., the bank notes were exchangeable for gold at the legal gold parity), any overissue would be self-correcting, so that a legal limit on the quantity of banknotes was, at best, superfluous, and, at worst, would itself trigger a financial crisis.

As it turned out, the legal limit on the quantity of banknotes proposed by the Currency School was enacted in the Bank Charter Act of 1844, and, just as the Banking School predicted, led to a financial crisis in 1847, when, as soon as the total quantity of banknotes approached the legal limit, a sudden precautionary demand for banknotes led to a financial panic that was subdued only after the government announced that the Bank of England would incur no legal liability for issuing banknotes beyond the legal limit. Similar financial panics ensued in 1857 and 1866, and they were also subdued by suspending the relevant statutory limits on the quantity of banknotes. There were no further financial crises in Great Britain in the nineteenth century (except possibly for a minicrisis in 1890), because bank deposits increasingly displaced banknotes as the preferred medium of exchange, the quantity of bank deposits being subject to no statutory limit, and because the market anticipated that, in a crisis, the statutory limit on the quantity of banknotes would be suspended, so that a sudden precautionary demand for banknotes never materialized in the first place.

Let me pause here to comment on the factual and conceptual misunderstandings in Kaminska’s first post. Discussing the role of the Bank of England in the British monetary system in the first half of the nineteenth century, she writes:

But with great money-issuance power comes great responsibility, and more specifically the great temptation to abuse that power via the means of imprudent money-printing. This fate befell the BoE — as it does most banks — not helped by the fact that the BoE still had to compete with a whole bunch of private banks who were just as keen as it to issue money to an equally imprudent degree.

And so it was that by the 1840s — and a number of Napoleonic Wars later — a terrible inflation had begun to grip the land.

So Kaminska seems to have fallen for the Humean notion that banks are inherently predisposed to overissue and, without some quantitative restraint on their issue of liabilities, are engines of inflation. But, as the law of reflux teaches us, this is not true, especially when banks, as they inevitably must, make their liabilities convertible on demand into some outside asset whose supply is not under their control. After 1821, the gold standard having been officially restored in England, the outside asset was gold. So what was happening to the British price level after 1821 was determined not by the actions of the banking system (at least to a first approximation), but by the value of gold which was determined internationally. That’s the conceptual misunderstanding that I want to correct.

Now for the factual misunderstanding. The chart below shows the British Retail Price Index between 1825 and 1850. The British price level was clearly falling for most of the period. After falling steadily from 1825 to about 1835, the price level rebounded till 1839, but it prices again started to fall reaching a low point in 1844, before starting another brief rebound and rising sharply in 1847 until the panic when prices again started falling rapidly.


From a historical perspective, the outcome of the implicit Smith-Hume disagreement, which developed into the explicit dispute over the Bank Charter Act of 1844 between the Banking and Currency Schools, was highly unsatisfactory. Not only was the dysfunctional Bank Charter Act enacted, but the orthodox view of how the gold standard operates was defined by the Humean price-specie-flow mechanism and the Humean fallacy that banks are engines of inflation, which made it appear that, for the gold standard to function, the quantity of money had to be tied rigidly to the gold reserve, thereby placing the burden of adjustment primarily on countries losing gold, so that inflationary excesses would be avoided. (Fortunately, for the world economy, gold supplies increased fairly rapidly during the nineteenth century, the spread of the gold standard meant that the monetary demand for gold was increasing faster than the supply of gold, causing gold to appreciate for most of the nineteenth century.)

When I set out to write my book on free banking, my intention was to clear up the historical misunderstandings, largely attributable to David Hume, surrounding the operation of the gold standard and the behavior of competitive banks. In contrast to the Humean view that banks are inherently inflationary — a view endorsed by quantity theorists of all stripes and enshrined in the money-multiplier analysis found in every economics textbook — that the price level would go to infinity if banks were not constrained by a legal reserve requirement on their creation of liabilities, there was an alternative view that the creation of liabilities by the banking system is characterized by the same sort of revenue and cost considerations governing other profit-making enterprises, and that the equilibrium of a private banking system is not that value of money is driven down to zero, as Milton Friedman, for example, claimed in his Program for Monetary Stability.

The modern discovery (or rediscovery) that banks are not inherently disposed to debase their liabilities was made by James Tobin in his classic paper “Commercial Banks and Creators of Money.” Tobin’s analysis was extended by others (notably Ben Klein, Earl Thompson, and Fischer Black) to show that the standard arguments for imposing quantitative limits on the creation of bank liabilities were unfounded, because, even with no legal constraints, there are economic forces limiting their creation of liabilities. A few years after these contributions, F. A. Hayek also figured out that there are competitive forces constraining the creation of liabilities by the banking system. He further developed the idea in a short book Denationalization of Money which did much to raise the profile of the idea of free banking, at least in some circles.

If there is an economic constraint on the creation of bank liabilities, and if, accordingly, the creation of bank liabilities was responsive to the demands of individuals to hold those liabilities, the Friedman/Monetarist idea that the goal of monetary policy should be to manage the total quantity of bank liabilities so that it would grow continuously at a fixed rate was really dumb. It was tried unsuccessfully by Paul Volcker in the early 1980s, in his struggle to bring inflation under control. It failed for precisely the reason that the Bank Charter Act had to be suspended periodically in the nineteenth century: the quantitative limit on the growth of the money supply itself triggered a precautionary demand to hold money that led to a financial crisis. In order to avoid a financial crisis, the Volcker Fed constantly allowed the monetary aggregates to exceed their growth targets, but until Volcker announced in the summer of 1982 that the Fed would stop paying attention to the aggregates, the economy was teetering on the verge of a financial crisis, undergoing the deepest recession since the Great Depression. After the threat of a Friedman/Monetarist financial crisis was lifted, the US economy almost immediately began one of the fastest expansions of the post-war period.

Nevertheless, for years afterwards, Friedman and his fellow Monetarists kept warning that rapid growth of the monetary aggregates meant that the double-digit inflation of the late 1970s and early 1980s would soon return. So one of my aims in my book was to use free-banking theory – the idea that there are economic forces constraining the issue of bank liabilities and that banks are not inherently engines of inflation – to refute the Monetarist notion that the key to economic stability is to make the money stock grow at a constant 3% annual rate of growth.

Another goal was to explain that competitive banks necessarily have to select some outside asset into which to make their liabilities convertible. Otherwise those liabilities would have no value, or at least so I argued, and still believe. The existence of what we now call network effects forces banks to converge on whatever assets are already serving as money in whatever geographic location they are trying to draw customers from. Thus, free banking is entirely consistent with an already existing fiat currency, so that there is no necessary link between free banking and a gold (or other commodity) standard. Moreover, if free banking were adopted without abolishing existing fiat currencies and legal tender laws, there is almost no chance that, as Hayek argued, new privately established monetary units would arise to displace the existing fiat currencies.

My final goal was to suggest a new way of conducting monetary policy that would enhance the stability of a free banking system, proposing a monetary regime that would ensure the optimum behavior of prices over time. When I wrote the book, I had been convinced by Earl Thompson that the optimum behavior of the price level over time would be achieved if an index of nominal wages was stabilized. He proposed accomplishing this objective by way of indirect convertibility of the dollar into an index of nominal wages by way of a modified form of Irving Fisher’s compensated dollar plan. I won’t discuss how or why that goal could be achieved, but I am no longer convinced of the optimality of stabilizing an index of nominal wages. So I am now more inclined toward nominal GDP level targeting as a monetary policy regime than the system I proposed in my book.

But let me come back to the point that I think J. V. Dubois was getting at in his comment. Historically, idea of free banking meant that private banks should be allowed to issue bank notes of their own (with the issuing bank clearly identified) without unreasonable regulations, restrictions or burdens not generally applied to other institutions. During the period when private banknotes were widely circulating, banknotes were a more prevalent form of money than bank deposits. So in the 21st century, the right of banks to issue hand to hand circulating banknotes is hardly a crucial issue for monetary policy. What really matters is the overall legal and regulatory framework under which banks operate.

The term “free banking” does very little to shed light on most of these issues. For example, what kind of functions should banks perform? Should commercial banks also engage in investment banking? Should commercial bank liabilities be ensured by the government, and if so under what terms, and up to what limits? There are just a couple of issues; there are many others. And they aren’t necessarily easily resolved by invoking the free-banking slogan. When I was writing, I meant by “free banking” a system in which the market determined the total quantity of bank liabilities. I am still willing to use “free banking” in that sense, but there are all kinds of issues concerning the asset side of bank balance sheets that also need to be addressed, and I don’t find it helpful to use the term free banking to address those issues.


Does Macroeconomics Need Financial Foundations?

One of the little instances of collateral damage occasioned by the hue and cry following upon Stephen Williamson’s post arguing that quantitative easing has been deflationary was the dustup between Scott Sumner and financial journalist and blogger Izabella Kaminska. I am not going to comment on the specifics of their exchange except to say that the misunderstanding and hard feelings between them seem to have been resolved more or less amicably. However, in quickly skimming the exchange between them, I was rather struck by the condescending tone of Kaminska’s (perhaps understandable coming from the aggrieved party) comment about the lack of comprehension by Scott and Market Monetarists more generally of the basics of finance.

First I’d just like to say I feel much of the misunderstanding comes from the fact that market monetarists tend to ignore the influence of shadow banking and market plumbing in the monetary world. I also think (especially from my conversation with Lars Christensen) that they ignore technological disruption, and the influence this has on wealth distribution and purchasing decisions amongst the wealthy, banks and corporates. Also, as I outlined in the post, my view is slightly different to Williamson’s, it’s based mostly on the scarcity of safe assets and how this can magnify hoarding instincts and fragment store-of-value markets, in a Gresham’s law kind of way. Expectations obviously factor into it, and I think Williamson is absolutely right on that front. But personally I don’t think it’s anything to do with temporary or permanent money expansion expectations. IMO It’s much more about risk expectations, which can — if momentum builds — shift very very quickly, making something deflationary, inflationary very quickly. Though, that doesn’t mean I am worried about inflation (largely because I suspect we may have reached an important productivity inflection point).

This remark was followed up with several comments blasting Market Monetarists for their ignorance of the basics of finance and commending Kaminska for the depth of her understanding to which Kaminska warmly responded adding a few additional jibes at Sumner and Market Monetarists. Here is one.

Market monetarists are getting testy because now that everybody started scrutinizing QE they will be exposed as ignorant. The mechanisms they originally advocated QE would work through will be seen as hopelessly naive. For them the money is like glass beads squirting out of the Federal Reserve, you start talking about stuff like collateral, liquid assets, balance sheets and shadow banking and they are out of their depth.

For laughs: Sumner once tried to defend the childish textbook model of banks lending out reserves and it ended in a colossal embarrassment in the comments section

For you to defend your credentials in front of such “experts” is absurd. There is a lot more depth to your understanding than to their sandbox vision of the monetary system. And yes, it *is* crazy that journalists and bloggers can talk about these things with more sense than academics. But this [is] the world we live in.

To which Kaminska graciously replied:

Thanks as well! And I tend to agree with your assessment of the market monetarist view of the world.

So what is the Market Monetarist view of the world of which Kaminska tends to have such a low opinion? Well, from reading Kaminska’s comments and those of her commenters, it seems to be that Market Monetarists have an insufficiently detailed and inaccurate view of financial intermediaries, especially of banks and shadow banks, and that Market Monetarists don’t properly understand the role of safe assets and collateral in the economy. But the question is why, and how, does any of this matter to a useful description of how the economy works?

Well, this whole episode started when Stephen Williamson had a blog post arguing that QE was deflationary, and the reason it’s deflationary is that creating more high powered money provides the economy with more safe assets and thereby reduces the liquidity premium associated with safe assets like short-term Treasuries and cash. By reducing the liquidity premium, QE causes the real interest rate to fall, which implies a lower rate of inflation.

Kaminska thinks that this argument, which Market Monetarists find hard to digest, makes sense, though she can’t quite bring herself to endorse it either. But she finds the emphasis on collateral and safety and market plumbing very much to her taste. In my previous post, I raised what I thought were some problems with Williamson’s argument.

First, what is the actual evidence that there is a substantial liquidity premium on short-term Treasuries? If I compare the rates on short-term Treasuries with the rates on commercial paper issued by non-Financial institutions, I don’t find much difference. If there is a substantial unmet demand for good collateral, and there is only a small difference in yield between commercial paper and short-term Treasuries, one would think that non-financial firms could make a killing by issuing a lot more commercial paper. When I wrote the post, I was wondering whether I, a financial novice, might be misreading the data or mismeasuring the liquidity premium on short-term Treasuries. So far, no one has said anything about that, but If I am wrong, I am happy to be enlightened.

Here’s something else I don’t get. What’s so special about so-called safe assets? Suppose, as Williamson claims, that there’s a shortage of safe assets. Why does that imply a liquidity premium? One could still compensate for the lack of safety by over-collateralizing the loan using an inferior asset. If that is a possibility, why is the size of the liquidity premium not constrained?

I also pointed out in my previous post that a declining liquidity premium would be associated with a shift out of money and into real assets, which would cause an increase in asset prices. An increase in asset prices would tend to be associated with an increase in the value of the underlying service flows embodied in the assets, in other words in an increase in current prices, so that, if Williamson is right, QE should have caused measured inflation to rise even as it caused inflation expectations to fall. Of course Williamson believes that the decrease in liquidity premium is associated with a decline in real interest rates, but it is not clear that a decline in real interest rates has any implications for the current price level. So Williamson’s claim that his model explains the decline in observed inflation since QE was instituted does not seem all that compelling.

Now, as one who has written a bit about banking and shadow banking, and as one who shares the low opinion of the above-mentioned commenter on Kaminska’s blog about the textbook model (which Sumner does not defend, by the way) of the money supply via a “money multiplier,” I am in favor of changing how the money supply is incorporated into macromodels. Nevertheless, it is far from clear that changing the way that the money supply is modeled would significantly change any important policy implications of Market Monetarism. Perhaps it would, but if so, that is a proposition to be proved (or at least argued), not a self-evident truth to be asserted.

I don’t say that finance and banking are not important. Current spreads between borrowing and lending rates, may not provide a sufficient margin for banks to provide the intermediation services that they once provided to a wide range of customers. Businesses have a wider range of options in obtaining financing than they used to, so instead of holding bank accounts with banks and foregoing interest on deposits to be able to have a credit line with their banker, they park their money with a money market fund and obtain financing by issuing commercial paper. This works well for firms large enough to have direct access to lenders, but smaller businesses can’t borrow directly from the market and can only borrow from banks at much higher rates or by absorbing higher costs on their bank accounts than they would bear on a money market fund.

At any rate, when market interest rates are low, and when perceived credit risks are high, there is very little margin for banks to earn a profit from intermediation. If so, the money multiplier — a crude measure of how much intermediation banks are engaging in goes down — it is up to the monetary authority to provide the public with the liquidity they demand by increasing the amount of bank reserves available to the banking system. Otherwise, total spending would contract sharply as the public tried to build up their cash balances by reducing their own spending – not a pretty picture.

So finance is certainly important, and I really ought to know more about market plumbing and counterparty risk  and all that than I do, but the most important thing to know about finance is that the financial system tends to break down when the jointly held expectations of borrowers and lenders that the loans that they agreed to would be repaid on schedule by the borrowers are disappointed. There are all kinds of reasons why, in a given case, those jointly held expectations might be disappointed. But financial crises are associated with a very large cluster of disappointed expectations, and try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand. That’s what happened in the Great Depression, as Ralph Hawtrey and Gustav Cassel and Irving Fisher and Maynard Keynes understood, and that’s what happened in the Little Depression, as Market Monetarists, especially Scott Sumner, understand. Everything else is just commentary.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.


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