 Our next speaker is the Murray Rothbard Memorial Lecturer. I'm gonna give him a very good introduction because he deserves it, number one. But number two, a few years ago he poured some water over my head in a restaurant for no apparent reason. So I don't wanna give him any reason now because whatever might happen might be even worse. I'm just, there is some water here. I'm getting out of here. Okay, David Howden is a former Mises Fellow and Associate Professor of Economics and Chairman of the Department of Business and Economics at St. Louis University at its campus in Madrid, Spain. He has published articles in the Journal of Business Ethics, Austrian Journal of Economic, Cordly Journal of, I'm sorry, American Journal of Economics and Sociology, Economic Affairs, Review of Austrian Economics, Business and Society Review, Libertarian Papers, Cordly Journal of Austrian Economics, and other scholarly outlets. And he's a co-author with Philip Bagus of Deep Freeze, Iceland's Economic Collapse, which I highly recommend as an illustration of the financial crisis. And he's also the editor of Institutions in Crisis, European Perspectives on the Recession. So I present David Howden. Thanks, Joe. Well, what I wanted to talk to you all about today was the world seems pretty content or pretty set, I suppose, that there's a problem with banking, and in particular, there's a lot of angst against central banking. Now, if there's a lot of problems with central banking, and if many people all agree on this, it's one thing to criticize it, but it's another thing to come up with a workable alternative, right? If that's the best that we have and we can't come up with something better, then that's what we're stuck with. Over the last 25 years, there's been one movement which especially over the last few years has been gaining a lot of steam, a lot of support is what we call Fractional Reserve Free Banking. Fractional Reserve Free Banking is competitive banks all issuing notes against one another, all issuing their own notes, but they're all fractionally reserved. What I want to talk about is what I call some trivial objections to this theory, some trivial objections in the sense that I think that it's not a good alternative to central banking, and indeed what I want to show is that it incentivizes economic agents to actually institute and create a central bank. So if your original intent is to try to get rid of this institution, if you replace it with something which ends up causing it in the end, it's not a good alternative. And I hope to end with a historical example here with the creation of the Federal Reserve to just illustrate how this happened over time. So the first thing that I really want to show to you all is how does this Fractional Reserve Free Banking system actually develop or evolve over time? Imagine a banking system with several private competitive banks all issuing notes against the reserves that they have. The notes that they issue, we call inside money, the reserves that they have is what we call base money. Any note that a bank issues, if you take that note back to the bank, you can redeem it for the base money. The base money could be anything, it doesn't really matter, we could call it gold for the sake of argument, although it wouldn't necessarily have to be. So the inside money is just a claim to that gold. Well, banks issue inside money against these reserves. And if it's fractionally reserved, you can issue more of this inside money than you actually have base reserves hiding in your vault for it. So what actually happens when banks issue all this inside money and it goes out into the economic system? Well, if I issue inside money to somebody, they take it and they deposit it in their bank. The bank ends up with this claim that's not their own. So they take it to the clearing system or to the payment system and that goes back to the bank that actually issued the original note and that bank is supposed to send over the base money to clear the debt or to pay it off. As a result in a free banking system, we have all of these claims or all this inside money that circulates and then through the payment system, it gets transmitted back to the bank that originally issued it in exchange for base money as the case may be. So how do banks actually issue this base money or what's the mechanism behind it? Well, the way that they issue it is they look at the velocity of money or how often all of these claims come back to their own banks and then using that they can gauge what the demand for money is and how much inside money they can actually issue against the base that they have. If velocity of money goes up, money is circulating more quickly, it's coming back to your bank more quickly or the inside money is being returned for a claim on your base money, which means that you have to keep more base money and reserves to actually meet these demands when they come due. If the velocity of money is slow or is low, that means that money is circulating slowly through the economy, it's coming back to your bank more slowly so you don't have to keep as much base money to honor these reserve requirements when they come due. Well, what happens with a fractional reserve free banking system in what we could call a mature stage? A mature stage is one which is restability where all banks have issued as much money, as much inside money as they possibly can for a given amount of base money. Let me give you a good example of this. Everybody would agree that one problem with the banking system that's on fractional reserves is what happens if too much inside money gets issued? Well, in a fractional reserve free banking system, so the theory goes, there's two types of problems we could talk about. The first is what happens if one bank in isolation decides to issue too much inside money, too many claims to the underlying base money? Well, if it's only one bank doing this, it's not really such a problem, it's a self-correcting problem, in fact. You'd have one bank doing it and there would be too much base money, too much inside money going out into the system, this would all come home, all the chickens come home to roost, and then if they don't have enough base money, they go bankrupt. So it's self-correcting in the sense that no single bank can actually do it. But what would happen if every bank decided to do such an action in concert, or they all decided to do it at the exact same time? If, for example, every bank decided to issue inside money at an increasing rate of 10% a year, let's just say, but they all did it at the exact same rate, or at the exact same time, all the claims coming back would cancel it with all the other claims to all the other banks. So nobody would really be losing any base money, right? As long as everybody expanded at the exact same rhythm, we wouldn't really have any need to hold this base money as a reserve. And then you would think, well, these banks can just expand, they can keep issuing inside money as much as they want, or as quickly as they want. Well, if such a thing happened, you think that's problematic for this fractional reserve free banking system because there'd be an over issuance of inside money, right? We'd have high levels of inflation and all the ensuing problems that go along with it. The theory of fractional reserve free banking, as far as it goes, it says, well, this actually isn't a problem, and it's not a problem for a very clearly defined reason. Think about what defines the reserve requirement for all of the banks in the system. They have to hold on to base money in the form of what's called a precautionary reserve. It's precautionary in the sense that you need some on hand for all of these redemption requirements, for all your inside money when it comes due. The precautionary reserve requirement comes from, well, there's two ways you could look at it. In the long run, it's zero. In the long run, it's zero because if everybody expands in concert, if everybody expands at the exact same time, all of your redemption demands cancel out with one another. So nobody would actually need to hold on to any base money. That's the bad case scenario that we look at. And that would be the scenario that would lead to all of these banks over issuing all of this inside money. Luckily, even if you expanded in unison, and in the long run, all of these claims fully offset one another so that you could expand, there's a problem in the short run. And the short run problem is the variance of all the redemption demands that come back to you increases. In any given time period in the short run, you don't know if you're gonna have a million dollars in claims coming back to you or a thousand, or if you're going to be a net debater or a creditor in the clearing system. And because the variance of these redemption demands coming back to you varies increasingly in the short run, even if everybody expands at the exact same rate, banks still need to hold on to these precautionary reserves. And that creates a break in the fractional reserve free banking system to stop all of these banks from expanding their money supplies or their inside money issuances in unison. Well, what does a mature free banking system actually look like? Or how could we define such a thing? Well, once stability is reached, we define stability as as soon as all of these banks have issued as much inside money as they can against some amount of monetary base. Inflation has increased and then it's leveled off because we've increased the money supply as far as we can, given our precautionary reserve requirements. Demand for money changes a little bit. All of a sudden there's no demand for the base money anymore. In the mature fractional reserve free banking system, all the demand for money that we can speak about is the demand for inside money. And it comes for two reasons. The only people who can demand money are depositors or clients of banks. Well, the only reason you would possibly demand base money is if you didn't have faith that inside money was actually redeemable for that amount. But in the mature fractional reserve free banking system, nobody worries about its stability, so nobody demands to have base money. We're all content using the inside money that gets issued by the banks. Banks, for their part, in the mature fractional reserve free banking system, they don't demand base money anymore either. And that's because they know that they've reached this mature stable level of issuances. And they don't worry that the inside money is not going to be worth something. So nobody demands to actually get base money back out of the system. We're content just exchanging inside money. For reasons that we'll look at later, this is a very important point in the development of the fractional reserve free banking system. Now, if the stability of it relies on the fact that you reach some amount of precautionary reserves that are going to limit your issuance of inside money, what we have to look at is, are there ways that banks can actually evade or get around this precautionary reserve requirement? Remember, the only reason banks hold on to precautionary reserves is to guard them against all of these redemption demands that come back to them in the clearing system. Well, the redemption demands, we said in the long run, they net out to zero, so you don't actually have to hold on to anything. And it's only a problem in the short run, because even if everybody expands in unison, remember the variance of all of these redemption demands increases in the short run, creating a need to hold on to these precautionary reserves. If banks want to continue issuing base money then, they need to do one thing. They need to be able to limit the need to hold precautionary reserves, or they need to reduce the amount of precautionary reserves that they need to hold on to to limit these redemption demands. Another way to put it is that if banks want to continue issuing more and more inside money, they need to get rid of the need to hold on to these reserves. There's a couple different ways that we can do them, and I want to talk about three ways in particular that banks can eradicate or get rid of the need to hold on to these precautionary reserves. The first one is through what we could call an interbank lending market, an interbank loans market. The big problem for banks is they need to hold on to precautionary reserves to take care of all the redemption claims that come to them. Well, what if instead of, let's say that I get the inside money of some other bank, it comes to me. The money on its own is not all that good to me, right? It's the money that's been issued by another bank. I could send that back to the bank and get base money in return, which I could use, right? That would be base money that I could use in my own payment system. Or I could just hold on to that money and pyramid the money that I issue on top of it. It wouldn't qualify as base money. It could if I put it back into the clearing system and God asked for base money in return, but on its own it's not really worth anything. It doesn't stop me from issuing money on top of it, although it's probably not likely that I would do this. More likely what would happen is that an interbank lending market would develop. Banks with excess reserves too much would just loan money to banks which don't have enough reserve. Now, you would think that this would take care of the need for precautionary reserves, right? In that case, even banks that have negative clearing balances, even banks that don't have enough money in their reserves would still be able to issue money because they could just borrow it from those banks which have too much in their reserves. In fractional reserve free banking literature, there's a thread which says, well, this is possible, but it's just not very likely. The reason it's not a very likely course of action is because if a bank held onto another bank's inside money, it's a big opportunity cost. Money by definition is zero interest yielding, so you can't make any money by holding onto it, but if you exchange it back to the original bank of issuance, then you get your base money back which allows you to either partake in some loaning, some lending rather, or increase the amount of inside money that you're issuing. Well, the fact of the matter is if you think about how banking, about how this payment system work, it actually doesn't have an opportunity cost because in the long run, remember that your reserve balances always net out to zero. All credits and all debits net out to zero. The money that you would have to pay if you were in a negative balance to borrow money to settle your redemption demands perfectly offsets in the long run, the money that you would make by lending to other banks to clear their own balances. So in the long run, there's actually no cost for banks to organize into an interbank lending market. To give you some examples of these cases where they actually pop up. Let's think about China today. China has accumulated a massive amount, I suppose massive is a good word, of US dollars and US treasuries. Now they don't actually return these to the states in order to get base money or goods and services back in exchange, right? They hold onto them as their own reserve balances and then use that to pyramid their own issuance of inside money on top of. Incidentally, I don't use this as an example of fractional reserve free banking. I just use it to illustrate that the incentive structure actually does exist for somebody to not return money when it comes to them in order to get base money in return. A more maybe likely example or an easier example for most people to think of is just the modern banking system. Let's look in the Federal Reserve where there is an interbank lending market, right? That's what the discount window is or that's what the discount rate is for the banking system in the states. Banks that don't have enough reserve balances can borrow from other banks that have too much money in their reserves in order to shore up their reserves at the end of the day. These are good examples of one system or one method that banks can use to try to evade the precautionary reserve requirement. Well, how else can banks get around this requirement? Well, think about how the clearing period works. It's not a long run problem, it's just a short one. In the long run, all of your clearing balances net out to zero, so you don't actually have to keep any precautionary reserves. It's only in the short run with an increased variance in clearing balances that you need to keep something in the vault to honor the redemption demands. Well, if that being as it may, one way that you could reduce the need for precautionary reserves is just to lengthen out your clearing period. If you just make it longer and longer, so you hold on to inside money for a longer period of time before you put it back into the payment system to be cleared, you shouldn't net out increasingly to zero or to 10 to zero in the long run. Let's look at what actually determines the optimal clearing period length. Well, if you shorten up the clearing period, you clear your money quicker, right? If you have inside money from another bank, you're returning it to that bank to get the base money that you want in a shorter period of time. For banking system, this mitigates the default risk involved because as long as you have inside money issued by another bank, if it goes into insolvency in the midterm or in the meantime, you don't get base money in return. You're really exposed to default risk in this case. Banks have an incentive when at increasing amounts of default risk to shorten up the clearing period in the payment system. Now, at the same time, if you shorten up the payment system period, all of a sudden you increase the cost of the payment system as well, and that's for two reasons. First of all is clearing costs money, right? To actually go through this procedure to add up all the debits and credits as costly itself. The second reason is the balances that you have to clear are greater in the short run than they are in the long run. So if you're concerned with reducing the cost of clearing, you lengthen out the clearing period, but in doing so, you also increase the default risk that you face as an individual bank in the clearing period. Well, what I would look at is, let's look at what happened to clearing period lengths throughout history. If the default risk of the clearing process stayed constant, you would think that banks have an incentive to start lengthening out this period, right? That reduces the cost of the whole clearing process. If history is any guide, it's that the default risk of a banking system is not constant, right? In some periods it's really high, in some periods it's really low. Incidentally, right now the payment system in the States, the Fedwire payment system is the large value clearing system that we have in America. It's a real time clearing system in that when payments come into it, they are sequentially cleared or paid off as they come in. So there's no default risk essentially because they're all cleared instantaneously. One way that you could think about it right now, if anybody's been looking at excess reserve balances that banks have right now, part of it is that excess reserves allow you to actually make use of the Fedwire system. You can actually clear your balances instantaneously. If you had a banking system exposed to high amounts of risk, maybe like today's banking system has, you would think that there's a high demand to actually use Fedwire or to clear your transactions instantaneously or in real time. As to look at a historical example, when banking was first developing as it spread over wider and wider geographic areas, so as money that banks were issuing inside money were spreading over wider and wider geographic areas, they were getting returned through the clearing system to banks. But if you think about it, banks inside money which is issued from a bank far away from you, you don't know that much about it. You don't know if the bank has prudently run, you don't know what your odds are of actually getting the money back. You would think in these systems that there's a natural incentive for the clearing period to start being shortened in order to compensate for the increased default risk that the growing banking system has. As it grows, there's uncertainty or at least you have less knowledge about what all the banks are like in this system. So you start demanding to clear this money more frequently than you otherwise would. There's a natural incentive for the clearing period to start shortening up over time. Well, at the same time, banks have an incentive to start lengthening out the clearing period, right? Because that starts reducing the cost of doing the process. So we've got two battling costs involved or two battling incentives. On the one hand, you wanna shorten it to get rid of the default risk. On the other hand, you wanna reduce the cost and lengthen it. Even if you looked at the clearing period of a banking system, you said, oh, it's getting shorter. This must mean that banks are not getting together and organizing to increase the clearing period so that they can expand the amount of inside money that they're issuing, that's not necessarily the case, right? It could just mean that default risk is increasing quicker than the actual increasing quicker and causing them to shorten up the clearing period relative to what it otherwise would be. And at the same time, they could be lengthening the clearing period to reduce the cost of the clearing process. In one example, if you think about what would happen, think about this course of events. If you increase the clearing period, banks are able to start issuing more inside money. There's a big problem if banks issue too much inside money because that breeds instability in the banking sector. It also potentially could trigger an Austrian business cycle. Well, if you breed instability in the banking sector, all of a sudden default risk increases by the banks. So in response, those banks which originally increased the clearing period to reduce the cost of settlement, all of a sudden start shortening the clearing period to get rid of the default risk or to try to mitigate it. You have the two forces almost perfectly canceling each other out. The third way that banks can evade these precautionary reserves is through the actual issuance of inside money itself. As banks expand and start issuing greater and greater levels of inside money, we get a, well, we could have a boom which is propagated. A boom has two effects. On the one hand, it can increase the values of assets and on the other hand, it can also increase the negotiability or the ease of sale of those same assets. Both of those can potentially allow a bank to further increase the amount of inside money that it has. Let's look at an increase in the value of your assets if you're a bank. So you increase the, you issue more inside money and as a result, the value of the assets on your balance sheet increase in value. Well, that increase in value on your assets then allows you to issue even more inside money. So it's a self-propagating cycle. Now, some people might say this doesn't apply to banking because if you look at the assets on most balance sheets of banks, they don't involve assets that really necessarily go up in value in an inflationary boom. Most of them are fixed in value. Take a mortgage, for example. Most banks have mortgages as their assets and in a boom, the value of the mortgage doesn't necessarily go up. When the bank issues it to the borrower, it's a fixed value, right? It's a $200,000 mortgage, which is then gonna decline in value over the years as it's paid off. Well, some banking systems do have assets that increase in value during inflationary booms, although they're not as common. In my book with Philip Begas, Deep Freeze, Iceland's Economic Collapse, we document one of the peculiarities of Iceland's banking system throughout the recent crisis. The asset side of most banks' balance sheets in Iceland was composed of equity, stock in Icelandic companies. Now, during the boom, as they expanded the amount of inside money that they issued, it increased the value of stocks in companies in the Icelandic economy, thus increasing the value of the assets on these banks' balance sheets and thus allowing the banks to issue even more liabilities or inside money against them. It was a self-propagating inflationary spiral. Now, this was a peculiarity to the Icelandic economy. If you take a banking system like Ireland would be a good example, the assets in the Icelandic banking system were more of the conventional mortgages, right? They're fixed in value so you don't get this effect. That doesn't necessarily have to be an inflationary means that applies to all economies. One that will apply to all economies is, let's say we increase the amount of inside money we've issued and it increases the negotiability of the assets. In the inflationary boom, assets are easier to sell than they otherwise would be. Well, if your assets are easier to sell, that's the same thing as saying you have a lower cost of clearing in the payment system, right? If your assets are illiquid and difficult to sell, it's more costly. If you have an inflationary boom and they're less costly, it's easier for you to clear. So now we have a system where banks issue inside money, making their assets more negotiable, thus reducing their cost of liquidation and allowing them to hold on to fewer precautionary reserves as opposed to before. These three methods of reducing the amount of precautionary reserves that a bank is holding onto, so developing an interbank loans market, lengthening out the clearing period of the banking of the payment system, rather, and endogenously increasing the negotiability of bank assets through issuing greater amounts of inside money, all of those work to reduce the amount of precautionary reserves that a bank would need to hold on to in a fractional reserve free banking system. And if you reduce the need to hold on to precautionary reserves, all of a sudden you allow banks to start issuing greater amounts of inside money. Well, if banks are issuing greater amounts of inside money, the stability of such a system is called into question. It might not be self-stabilizing. The self-stabilizing aspect is that banks hold on to a finite amount of precautionary reserves and this limits the amount of inside money that they can issue. If you don't hit that limit, banks continue issuing more and more inside money and instabilities get bred. To have a mature or a stable fractional reserve free banking system, all three of these methods would have to be met in the sense that no bank could be using them to try to reduce the amount of precautionary reserves that it's holding on to and thus over issue the amount of inside money at the same time. In other words, any free banking system to be stable or anybody advocating such a system would have to show that all three of these or rather none of these three methods can actually be used by the system in order to expand the amounts of inside money that it has. That's the first big problem that we have with a fractional reserve free banking system. The actual stability of it is easily evaded or at least there's three easy methods that the banking system can actually use to evade it. And later on we'll look at some historical examples to illustrate how this was actually done. So what are some other objections that we might have with a fractional reserve free banking system? Well, if you're issuing inside money, you're stimulating investment, right? Investable funds have increased. And as we know in an Austrian business cycle, one of the problems is a mismatch between the investment that's taking place and the supply of real savings that's available in the economy to finance these investment projects. The definition of savings or what actually is savings in the economy is really an integral part in any fractional reserve free banking system then. We only wanna issue additional amounts of inside money when the supply of real savings is increased as well. Now there's a little bit of a disagreement about what savings actually are in the fractional reserve free banking literature. There's two ways you can really look at it. One way is to say that savings is just holding on to cash. If you have a bank account and you deposit your cash in it, that is a form of savings. It would be a form of savings not dissimilar from depositing or investing money in a bond or in equity, right? It's just a different form of savings. That's one way you could look at it. Incidentally, I think that's an incorrect way to look at it for some reasons we'll look at here shortly. A more correct way to look at it is to say that the active saving is non-consumption, right? You have income and whatever you don't consume is what you have available for investable funds. Now in most fractional reserve free banking literature, the actual form of your savings doesn't have any consequence on the system. To give you a good example, imagine that you had bought a $1,000 bond, you held onto it for several years and then it reached maturity so it was cashed out to you. You end up with $1,000 which you then deposit in the bank as a deposit. The form of savings has changed in this economy but the total level has not. There's still $1,000 of savings. It was just in the form of a bond before and now it's in the form of a bank deposit. Now there's several problems with viewing savings in such a way. The first problem that we might look at is what happens if we actually change the physical location of savings in a fractional reserve free banking system. Imagine that you had $1,000 at home in your vault. For whatever reason, all of a sudden you decided that your neighborhood was not safe anymore so you decided to take your money to the bank to deposit in its vault there. The second you deposited in the vault, it goes into the fractional reserve free banking system. The bank sensed that there is now an increase in the reserves but no need for that increase in reserves so they issue increasing amounts of inside money against it. The amount of inside money is increased but the amount of savings hasn't in the system. You've just taken $1,000 which was in cash in your pocket or in your vault at home or any other location and deposited in the banking system and the banking system has now increased the amount of money that is issuing against that same amount of savings. Maybe not all savings are created equally. What's the difference between lending money to a company in the form of a bond versus depositing that money in a bank? Well, when you lend money to a company in the form of a bond, that company spends the money. Let's just assume that they use it to pay their employees and those employees use that money to finance consumption expenditure and the money doesn't necessarily end its way back into the bank. It could just continually stay in circulation of financing consumption expenditure forever. Now the second if you did the same saving activity but instead of buying a bond you just deposited your money in the bank all of a sudden there's an issuance of inside money against it, right? Once again, we have inside money increasing an issuance just because the form of savings has actually changed but what's different about the actual savings? In both case, we still have $1,000 worth of savings whether it's in a bond or whether it's in a bank account. How about what it actually means to hold cash in order to save? Holding cash or holding inside money in a banking system is the same thing as saying you demand bank liabilities. Your cash is just a liability for the banking sector. If you're holding onto bank liabilities so if you're holding onto a deposit at a bank you're really demanding one of two things. On the first hand, you're not spending income, right? You're saving money in other words. At the other time or at the same time you are not demanding to redeem bank liabilities that you already hold onto, right? The act of holding money in the banking system is not spending your money but also not demanding to convert the money that you already have back into base money or trying to redeem it from the banking system. Now in fractional reserve free banking systems this is a little bit interesting because it's assumed or assumed to be proven that nobody actually demands to hold to withdraw their base money from the banking system, right? They take away one of these demands completely. They say anybody who holds a bank account or inside money doesn't want to redeem that for base money in the system. But in fact, of course that is one of the main reasons that somebody could want to reduce their cash holding in the economy. The final problem with this savings debate is cash holdings, you can actually increase it not by necessarily increasing your savings or your real savings, but just by divesting in real investment projects. Take maybe take an easy example here. Let's assume that you own 10 machines, one of which depreciates every year and they each yield an income of $10 a year. So every year you end up with $100 but you have to replace one of those machines to stay even. Of that $100 let's say that you consume $50 and you spend, you save or reinvest $50 every year. So we're in some equilibrium where there's no cash holdings. And then let's say that one year for whatever reason your uncertainty increases so you start reinvesting only $30 of that hundred. Let's say that your consumption stays the exact same so you still consume 50, you buy a smaller machine and you only save or reinvest $30. Now you have some cash holdings of $20, right? What's actually happened in the system? Well, evidently enough cash holdings have increased. They increased from zero to $20. Not surprising, what happened to inflation? Well, consumption prices have risen relative to prices in the higher orders of production. And the reason that is is because consumption expenditure has risen as risen relative to saving or investment expenditure, right? We must have a relative inflation happening on the consumption side of things. There's fewer goods available to sustain the structure of production, right? We've only reinvested $30 so we only have savings of $30 in the system. Time preference must have necessarily increased and the capital structure is also less intensive than it was before. What, how does a fractional reserve free banking system respond to such an event? Well, the amount of reserves that they have is increased, right? The cash holdings has increased by $20. So if cash holdings have increased, the banking system takes this as a sign that there is a decreased demand, an increased demand to hold onto cash and they start issuing more inside money against it. Well, that inside money is being loaned out in order to finance investment activity. Well, if it's financing investment activity, we have a little bit of a disconnect, right? Cash holdings actually increased because people wanted to invest less and the banking system is now responded by promoting more investment activity. It doesn't seem to make sense with what people originally wanted. There increased cash holdings to actually finance. Another problem that we might look at is asking the question, can a fractional reserve free banking as it issues inside money against base money actually get the money to where it's needed? Now, it's never a problem for a bank to sense if there is an increased demand for money, right? As velocity slows, the clearing system slows down asking for redemption demands for base money. So banks can issue more and more inside money against it. That's not problematic for a bank to detect. It is problematic for a bank to try to detect where that money is actually supposed to go. In fact, one way to look at it is to say this is just a bank's job, they're financial intermediaries. Their job is just to take money in and then find out the best place to possibly loan it on risk-adjusted terms. They just look for the very best bet that they possibly can. Well, what happens when you increase your cash holdings? There's actually two things that you're doing at the same time. Anytime you increase your cash holdings, you're aiming to increase your real cash balances. Your price-adjusted amount of savings, or cash holdings, rather. When you curtail your consumption and you start holding a greater cash balance, you've increased the nominal units of cash balance that you have. There's more money units sitting in your bank account than there was previously. But at the same time, if you're not consuming them, you also end up with some downward pressure on the price level, and that's increasing further your real cash balance. The two effects reinforce one another. You save more money, or you hold a greater amount of nominal cash units, and as prices fall, that further increases the real value of that cash balance. Well, let's assume that you've done this, but again, you haven't put that money or that increased cash balance in the banking system. So why don't we take it to the bank and see what happens? The second you see what happens, rather. You take it to the bank, you make your deposit, of course, reserves increase in the banking system, and in response, they issue more inside money against it. The interesting thing is what happens to that inside money? Who actually gets it? Well, they have to loan it out to somebody, or they have to find somebody to actually take on that inside money. That person that takes the inside money is gonna have to spend it. They might not spend it on something which is going to benefit you in any way. In fact, they're probably gonna spend it in a way which increases the general price level, and if the price level goes up because they're spending money, that is all of a sudden reduced your real cash balance. They've done something which has frustrated your original goal, right? You saved money in a bid to try to get a set amount of real cash balance, and then somebody has spent that money because it's been reissued through the fractional reserve free banking system to cause the price level to go up, which in turn reduced your real cash balance. Your original impetus has been frustrated as the case may be. Here's maybe a better example for the investors in the room. Think about an investor who one day looks at the market and thinks that the market is overbought, and in return they decide to cash out some of their equities, convert the money into cash and deposit it in their bank, and then maybe they'll get back in the market once they think that it's gone down to a reasonable level. While you cash out your equities, you take the cash, you deposit it in the bank. The bank sees its reserves go up. What does it do in response? It issues inside money against this. Now let's assume that inside money is borrowed from somebody and used to finance stock speculation. Now you've got an increase in equity prices. The original reason that you cashed out your equities has been frustrated. Notice it doesn't necessarily have to be an absolute increase in equity prices. It's probably gone down because you've withdrawn money and then it's only gone up a little bit because somebody else has reinvested that money in it. Still, prices will have relatively increased compared to where they were originally. Your original goal to cash out your equities was to have prices fall down and then get back in the market at a more reasonable level. But through the fiduciary abilities of the Fraction Reserve Free Banking System, we've actually put upward pressure on the prices of equities and frustrated your effort in the first place. We have a disconnect between what people are actually doing by increasing their cash balances and the results that the Fraction Reserve Free Banking System actually breeds. Now these examples, they're really just indicative of maybe a wider problem. The wider problem has to do with some of what some of the macroeconomic effects of Fraction Reserve Free Banking actually are. The idea of Fraction Reserve Free Banking is fairly simple to understand if we just maybe look at the equation of exchange here. Money times its velocity is equal to prices times real GDP or number of transactions or however you want to actually reckon why. Well, let's assume that the price level is sticky or fixed in place. In the short run, it seems to be a decent assumption, right? Prices don't instantaneously fall down or at least they don't necessarily always fall down. Well, in response, if you have a banking system that sees changes in velocity, decreases or increases, if P can't adjust and you don't do anything to the money supply, all of a sudden why is going to have to be the variable that adjusts. If you had a decrease in the velocity of money, this would translate into a decrease in real GDP or a decrease in real incomes. As a result, Fraction Reserve Free Bankers, they base at least part of their theory on this whole idea that we should alter the money supply to offset changes in the velocity of money in order to maintain nominal spending or nominal output, the right-hand side of that equation. There's important differences maybe between what free bankers are saying are gonna happen in this equation of exchange and what we might expect to happen. In particular, we might look if this is a consistent story with Austrian business cycle. Some free bankers or Fraction Reserve Free Bankers, I should say, allege that 100% reservers can't have their cake and eat it too. And by this, they mean that a price level can't be sufficiently flexible to allow monetary expansion to cause relative price maladjustments and ensuing business cycles and also maintain at the same time that the price level is sufficiently flexible that it would offset changes in velocity in order to maintain nominal expenditure. Yet there's important differences between the Austrian business cycle theory and this monetary equilibrium theory, the use of the equation of exchange that we should know. The first is just looking at the price level. What actual price level are we concerned with? Well, the Austrian business cycle theory never says anything about this capital P up here, capital P being the general price level that pervades throughout the economy. Austrian business cycle theory is, of course, concerned with all of the little or lower case P's, right? All of the individual prices for all the goods and it's concerned with the relative misadjustments or mispricings of all of those lower case P's or individual prices. Monetary equilibrium theorem and fractional reserve free bankers as a consequence are really concerned with the general price level, right? They're concerned with changing the money supply to offset changes in V because that general price level is fixed in place. But nobody says anything about the price level being fixed in place. Nowhere in Austrian business cycle do we rely on this. We only rely on prices not perfectly adjusting or getting out of sync with one another. How about the idea that the fractional reserve free banking system can actually cause some instability in the demand for money that complicates the entrepreneurial process. If a fractional reserve free banking system has the ability to over-issue inside money and we already explained why that is, there's the three reasons that a bank can expand inside money beyond what its precautionary reserves would normally allow for, then all of a sudden you have financial or banking instability, right? Or banking prices even if you will. Now in a free market, the demand for money is relatively stable over time. The only thing that really upsets the balance are famines, plagues, wars, drastic events. But in a fractional reserve free banking system, all of a sudden you endogenously promote banking crises which then affect the demand for money, right? When people are uncertain or when you're in an uncertain economic atmosphere, you increase your demand to hold onto money or your cash balances as a response. Now as a result, entrepreneurs in a fractional reserve free banking system have a different variable to pay attention to. Now on top of all the other demands that they're looking at, they now have to also focus attention on the demand for money. In a free market banking system, you don't necessarily have to look at this because demand for money is more or less stable over time. What about the actual forces that are in play in this monetary equilibrium theory versus in the Austrian business cycle? In monetary equilibrium theory, we have a real force at play and the real force is the stickiness of that price level, right? The idea that prices are downward sticky or rigid so that they don't instantaneously adjust to offset changes in the velocity of money. In the Austrian business cycle theory, the forces that we're dealing with are mostly illusory. They're illusory in the sense that they're profits that we think are there that are actually not. One way that you could do it in corporate finance is to say if interest rates are artificially lowered below what the natural rate is, the discount rate that you're using to determine the present value of long dated projects is going to be decreased. And if you decrease the discount rate, you increase the present value of these projects. You haven't actually increased the present value of the projects. You've only given the illusion of doing so through an incorrect discount rate. Lastly, I should note that the Austrian theory of the business cycle doesn't rely on a general inflexibility of all prices but rather knowledge and incentive problems. Even if entrepreneurs knew that prices were inflexible or flexible or they knew all the effects of credit creation or fiduciary media creation, we could still have an Austrian business cycle. There's a couple of good examples of this in the literature. Jesus worked at a Soto, as far back as 1998, fit an Austrian business cycle into a prisoner's dilemma scenario. Entrepreneurs still have to make use of credit which is created in the banking system even if they know the ill effects because if they don't somebody else will regain and they lose relative profits. This is formalized a little bit later in a formal prisoner's dilemma scenario by Tony Corelli and Greg Dempster if anybody's interested. The last big problem that I wanna talk about is the incentive structure that actually gets created through the fractional reserve free banking system. Now the whole reason you would put it in place is because you have a problem with central banking and you wanna get rid of that problem. Well if you replace a central banking system with a fractional reserve free banking system that engenders an incentive structure that leads to the creation of a central bank, you haven't actually done anything. You've maybe offset a central bank for a couple years until it gets created. What I wanna show here is that the fractional reserve free banking system definitely does create the incentive structure to create a central bank or at least in some places. How do central banks emerge? There's a couple different theories we can look at this. Fractional reserve free bankers seem to favor the theory that the emergence of a central bank is in response to the fiscal needs of a state. This is evident in several countries. The creation of the Bank of England is a really good example. The King of England needed money to finance wars. He was unable to raise it on his own so he monopolized or created the Bank of England in order to finance his campaigns. What we offer here, what I'm going to offer you is an endogenous theory of central bank creation set up by two sets of clearly defined incentives. The first sets of incentives is all of your banks within the fractional reserve free banking system, they all want to expand in unison. This inconsert expansion that allows them to issue increasing amounts of inside money. We said there's three ways that they can do this to get around their precautionary reserve requirements. Set up an interbank loans market, lengthen out the clearing period of the payment system. Or endogenously increase the negotiability of the assets through an inflationary process. Well all of your banks in the fractional reserve free banking system then would like to have a coordinating agent or they have an incentive to set up a coordinating agent to make sure that everybody plays by the rules of the game and nobody expands faster than anybody else. In other words, we need somebody to ensure that everybody expands or increases their money supply at the exact same rate. At the same time, central banks can emerge in response to some of the instabilities that are bred in the fractional reserve free banking system. If you think about an over issuance of inside money, which we said is possible, that breeds banking crises, which then are problematic for depositors that aren't able to get all of the base money they originally deposited in the banking system. As a result, we have a need or a desire to implement a central bank in order to honor these deposits. There's two key differences between this incentive, between these two incentives. The first is in who demands them. In the first case, the actual bankers of the fractional reserve free banking system demanded the coordinating agent. In the latter case, depositors who were suffering the consequences of an unstable banking system demanded a central bank to protect their deposits. In the first case, the central bank was demanded to be the coordinating agent to make sure everybody played by the same rules. In the latter case, the central bank was set up actually to be a lender of last resort in order to bail out banks when they're illiquid or eventually insolvent so that depositors wouldn't lose any of the cash as they deposited in them originally. Because central banks can be notoriously difficult to define, what I want you to do is think in your mind of a spectrum. At two ends of the spectrum, what we're going to have is a pure fractional reserve free banking system on the right-hand side. And as you continue going over to your left, you're going to have greater and greater amounts of centralization in the banking system until you get to a fully centralized banking system. On the right-hand side you can imagine in the free banking system there's also rainbows and bunny rabbits and things like that. It's lovely and maybe on the far left-hand side there's Soviet block-style apartments and cloudy and gray skies, something like that. Well, as we go from right to left along the spectrum, as we increasingly approximate a central bank, what's going to happen? Well, we're going to see more and more central bank roles. These can be a coordinating agent, it can be setting the rules of the banking system, it can be acting as the regulator of the banking system or eventually as being the monopoly issuer of the base money which is used in the banking system. What I want to do is show how each one of these becomes engendered by the original free banking system and eventually turns itself into the central bank as the case may be. One long-standing theory by Gary Gorton for the emergence of the Fed in the States or the general emergence of a central, well, the specific emergence of the Fed in the States saw it as just the nationalization of the private clearing system. In fact, many of the Fed's functions today can be directly traced back to the functions that the private clearing system in the States had under its free banking period. The biggest similarity that we could maybe see is the use of the discount window and the discount rate today in the Fed, which evidently is a little bit less used now with the increase in excess reserves of the banking system has compared to several years ago but is still an important feature of the Federal Reserve nonetheless. The use of the discount window was actually first used in the panic of 1857, which was during the period of free banking in the States. There was a banking panic when depositors increased their demand for redemptions of base money from the banking system. The Fractional Reserve free banking system didn't have enough base money to honor all of these redemption demands. So in response to the private clearing house system under the free banking regime in the States issued what we would call clearing house loan certificates to aid in this process. The problem really was that there wasn't enough base money to go around to offset all of the demands for inside money in the system. Well, the demand for base money in the system came from two forms. One was from depositors, caching in their deposits to take out base money. The other was the need for base money in the clearing system itself, right? Banks were sending back their inside money to their banks of issuers and in return had to pay base money to settle these claims. Well, the clearing house system ended up issuing loan certificates. These were loans which were collateralized or backed by banking assets that the system had. And banks were allowed to use these in the payments or the settlement system. So they no longer had to use base money. They were allowed to use these loan certificates in order to settle their claims just as well. In this way, the clearing house loan certificates were an easy way for the banking system to economize on the amount of scarce reserves that it had. And in order to allow bank depositors the ability to continue withdrawing base money from the system. There was also a risk sharing agreement which was achieved. If one bank failed in the system all of the other banks would share this loss relative to the amount of remaining capital that they had. This risk sharing agreement was a form of agreement to offset any losses that one bank might have in the system. There's some important notes that we should make about this use of clearing house certificates in 1857. The free banking period in the States was the period defined as 1837 to 1862, that 25 year span. 1857 is evidently at the tail end of this period. It's in the free banking period but only at the very end of it. The interesting thing to note is in the Fractional Reserve Free Banking System there shouldn't be a demand for base money. That's what the theory says. All demand for money has to be the demand for inside money only. So no bank should actually have to hold onto any of this base money. And yet here we have a system that after 20 years of free banking in America there was a sudden demand for base money in the system. It wasn't caused by the Civil War because that wasn't until four years later, right? 1861. It was a banking panic that was started endogenously under a free banking regime that then created the need to solve the scarcity of base money in the system. 1857's an important panic in American history because it set the incentive structure or it was the precedent that was set rather to start changing the banking regime in place. Well, as panics continued, all of a sudden there was further needs to economize on the scarce amount of base money in the system. It was no longer apparent that the banking system could remain solvent or liquid just by using clearinghouse loan certificates in the clearing system. They also needed to issue them to the general public so that the public would not be withdrawing base money from the system. You had to get rid of this demand as well. As the case may be, later on in the banking panics of 1893 and 1907, these clearinghouse loan certificates were issued to the general public. This was actually illegal at the time, which was probably a good thing because it limited its use a little bit. Banks didn't want to do this unless it was absolutely necessary for fear of the legal repercussions that would happen. These panics were not part of the free banking era. That's notable. The precedent for using these loan certificates was used in the free banking era and it was used in the free banking era after it had 20 years of functioning. Now, if we looked at the mature free banking system, how many years do you think we need to give it in order for it to reach its long-term stable situation? I would suspect that 20 years of free banking is a sufficient period of time for this mature free banking system to emerge where we no longer have this demand for base money any longer. In the panic of 1857, just to revisit it, there was a prominent bank that failed and a massive drain on reserves that actually necessitated the need for these clearinghouse certificates. Now, in response, what the banking system actually wanted to do, or some of the banks in the system, the strong ones, was to start curtailing the amount of inside money that they issued and shore up their precautionary reserves. This is their rational response and it's what most free banking theory would actually suggest should happen. There was an interesting development where there was a voluntary agreement among all the banks though and it was mainly pushed forward by the weaker banks in the system to all pool their reserves together, put it at the disposal of the clearinghouse system in order to allocate to maintain liquidity among all the banks. Now, obviously strong banks in the system didn't like this idea. They were being punished for being prudent. Weak banks in the system did like this idea because they were being kept afloat at the expense of the stronger banks. It was voluntarily agreed upon despite the fact that the stronger banks didn't like it because it did benefit everybody at the end of the day. The way it benefited them was it allowed the banking system to continue issuing greater levels of inside money and the inflationary gains that would come from it. One notable feature of this reserve pooling fund was if we compare it, and remember it happened under a regime of free banking in America to the central banking schemes that existed in Europe at the time, at the exact same time, it was a much stronger, more centralized system than anything that occurred in Europe over that same time period. The pooling of reserves and the risk sharing agreements that were in place in America in 1857 were more centralized and more, a more closer approximation to what we would consider a central bank than even the official central banks operating in Europe at the exact same time had actually implemented. In fact, there's interesting quotes in historians of banking theory. Here's a quote from Canon. Clearinghouses became instruments for united actions among the banks in ways that did not exist even in the imagination of those who were instrumental in their inception. It's not that banking system necessarily wanted to approximate a central banking system, it's that the incentive structure that it created bred a closer approximation to a central banking system to emerge. Whether the banking system, the free banking system liked it or not, the clearinghouse increasingly took on roles that more closely approximated a central bank in ways that they didn't even foresee. Incidentally, when clearinghouse, when the clearinghouse issued loan certificates or started issuing loan certificates to the American banking system, it also simultaneously started putting suspensions on withdrawals of cash from the system. This is putting a redemption on the amount of base money that you can withdraw from the banking system. This was incidentally not unique to America during the free banking system. This is also quite common in the Scottish episode of free banking, right? In America it was unique because there was a withdrawal on redemptions or the use of clearinghouse loan certificates which was equivalent to it because it still wasn't allowing you to take your base money out of the system as you wanted. In Scotland, they used those famous option clauses to allow banks to legally not return base money that was deposited in them originally back to their depositors. Well, if you think about how depositors felt about all this, they were starting to get a little bit upset. All of a sudden they had made cash deposits in banks and they were no longer able to actually withdraw that cash from the banking system. So what do you think they started calling for? They called for a method that would solve this problem in the banking system and would allow them to always be able to make cash withdrawals as they fully expected to. Now, one way that you could do this is to implement some type of institution to act as a lender of last resort in the banking sector, right? If you have a lender of last resort when banks are either caught in a liquidity problem or eventually an insolvency problem, they can just allocate liquidity or capital to them in order to make sure that these withdrawals are possible from happening. In America, the implementation of the clearinghouse as a private lender of last resort really solved two problems. One was it solved the problem of suspending convertibility of bank deposits into base money and second, it solved an important legal issue. In America, the suspension of payments was actually considered illegal and amounted to default under banking law at the time. The final stage on the road to actually developing a central bank and the last one that I wanna look at is creating a central bank as a regulator of the banking system. Now, depositors under a full reserve banking system, they regulate their banks in the way that if they feel that it's not operating safely or prudently, they just don't deposit their money there in the first place. Or if they have money there and the bank is not acting prudently, they make their withdrawals, which causes it to drain on reserves and causes the bank to change its lending behavior. As soon as you implement a lender of last resort in a banking system, you take away this regulatory role from depositors. No depositor has an incentive anymore to monitor the solvency or liquidity position of their own bank. Now, obviously somebody has to monitor this. We just can't have the banks running with absolutely nobody paying attention or giving heed to how prudently they're actually managing their loans for portfolios. If the client base or the depositor base is not doing this in the banking system, somebody had to take over and that person as the case may be was going to be the lender of last resort. Now, more commonly we think of this regulatory role as being caused by the advent of deposit insurance, right? We're all well aware that deposit insurance removes our incentive to monitor our bank accounts or our banks to make sure that they're lending prudently. In America, this is probably not likely because deposit insurance didn't form until 1933, much later than the Federal Reserve and much later than when the private clearinghouse system has started acting as a lender of last resort. By the time the Fed was actually developed, so this is, let's say about how many years are we? We're about 50 plus years after the Panic of 1857, the creation of the Federal Reserve was seen as just making legal what the banking system was already doing illegally. It had gradually continually progressed from a free banking system and because of the instabilities that it had endogenously bred, it continued to altering itself until it more closely approximated a central bank. In fact, the creation of the Fed in many ways didn't change all that much from what was already happening in the American banking system. In fact, we have a quote on the congressional record and this is from the Senate sponsor of the, during the creation of the Federal Reserve, Robert Owen, who states, and I quote, this bill, for the most part, is merely putting into legal shape that which hitherto has been illegally done. The creators of the Federal Reserve actually didn't think that they were creating something which was a difference of kind, only a difference of magnitude. The key difference that Robert Owen talks about was the monopoly of note issuance, which incidentally didn't occur under the private clearing house system that existed in the States prior to the creation of the Federal Reserve. The monopoly on the issuance of currency is a very important stage that we have to explain because that's one of the key features that defines the Federal Reserve or any central bank in the modern world. Well, what we really have to look at is the stakeholders involved in the creation of the Fed and the incentive structure that all three of them faced. Depositors first. Depositors make up the majority of voters. In fact, I'm gonna guess that every single voter is also a cash depositor somewhere. Depositors were retiring or getting tired rather of the fact that there was a suspension of payments and they weren't able to withdraw base money from the banking system. They called on a lender of last resort or somebody with a monopoly on note issuance to shore up their banks to make sure they could always get base money out of the system. Banks had the incentive to have a coordinator to make sure that they all played by the rules to benefit everybody together and not just benefit any individual bank. They saw a central bank as the creator of this coordinating force, right? Somebody that would make them all function together. Government as a stakeholder, it was only really too interested in satisfying its voting base. In particular, making sure that depositors had access to their money as they had actually thought and also keeping the banking system functioning well by guaranteeing that they would be coordinated. The private banking industry was gradually transformed from a private fractional reserve free banking system into a central bank. Legislators only later actually formalized that into law. If you think about it, the behavior that the fractional reserve free banking system actually utilized is a little bit like a cartel. Now cartels are inherently unstable, right? Nobody thinks that cartels can last forever. Murray Rothbard in the back of Manneconomy and State has an interesting little part where he says if a cartel is unstable, what is the cartel supposed to do or what are they gonna do? And the answer that Rothbard gives is they monopolize themselves. Instead of having multiple companies all operating in one cartel, you monopolize into one company that then you don't have to worry about this instability. The private banking sector, the fractional reserve free banking sector had gradually transformed itself in the instabilities of maintaining its cartel called upon the creation of one centralized monopolist of no dissuance or the central bank, the Federal Reserve, in order to stabilize that cartel. I wanna just end where I start. I called this some trivial objections to fractional reserve banking and I should probably comment on that on why I think they're actually trivial. On the one hand, I think they're trivial because many of the objections should be second hat to all of us. The idea that price levels are not, that the price level overall is not what matters but the relative price adjustments, that's something that all Austrians always know where its second hat to us. It's an objection that I feel doesn't actually have to be made or shouldn't have had to be made to such a system in the sense that the system should never have been put forward in the first place. The second reason why I think these are trivial objections is because a fractional reserve free banking system can only be advocated if you actually think that it's going to replace with a better system the central banking system that we currently have. And yet if that very same system creates the central bank it can't be the preferred alternative which is why I can't support such a system and think that a free banking system operating under 100% reserves which eliminates all of these problems should be the preferable choice. Thank you. Thank you.