 Welcome to this session on the economics of fractional reserve banking. Notice the title is intentionally excluding the legal and political aspects of fractional reserve banking, so we won't get into the debate about the legal status of fractional reserves and the private property issues that surround fractional reserve banking debate. I'll only mention a few details about this with respect to the economic analysis. We want to focus just on the economic analysis of fractional reserve banking. I might also make another remark about this. Most of you know that even if we confine ourselves to the economics of fractional reserve banking, that this is a highly contentious area where there's a huge literature of debate and so we can't cover every nuance of this debate. What I intend to do in the 45 minutes is to lay out the framework if we can see some basic principles that should be accepted on all sides and see what the implications of these basic principles of the framework of economic analysis happen to be. Okay, so let's start with what you already received from Lucas Engelhardt yesterday in talking about money. He discusses Menger's theory of the logic of the development of money, the origin of money, out of barter. So let's pick up the story there and then we'll see how banking enters into this. So money, we know, we can think about the logic of this, must have emerged naturally as an entrepreneurial innovation in a pre-monetary situation where there were certain persons who had the entrepreneurial foresight to see that trading goods that they had difficulty bartering for more saleable goods would permit them to make their exchanges indirectly and so from this beginning point we get the development of money itself. The next step in the development of money then would be the entrepreneurs would provide certification so they could run a business, in other words, stamping the metal and then guaranteeing with their imprimatur the fineness and weight of the metal. So coins would be a entrepreneurial innovation that could arise on the market. We don't need the state to provide these things to us, but this is just a natural development of people economizing on the market. Now of course the particular business arrangement organization by which coins would be produced, we could imagine different scenarios. So we might have, for example, entrepreneurs who just run minting companies. They buy the gold from mining companies and then they pay for the gold and then they mint the coins and then they charge a fee and the mining companies pay the fee and then you receive the gold coins and then they have money itself. We could imagine also vertically integrated business arrangements where an entrepreneur mines the gold or silver or whatever the commodity is and then mints the coins within his own organization. But in any case the point is that this production of money would be subject to the same procedure of economic calculation that Joe Salerno spoke about earlier today as a production of anything else. There'd be revenues and there'd be costs and there'd be a dynamic of production so if it was very profitable to produce money then the entrepreneurs would ramp up production of money and the asset values of mines would go up and they had to pull more workers into production and their costs would begin to rise and as they supply more money on the market the money's purchasing power would moderate and the profit would normalize to dissipate we should say and the rate of return would normalize to other production processes. So money production in a market economy would be regulated by profit and loss it would be normalized or integrated into the production of all other goods on the market. Okay now from here we can see the next development with banking. As with banking we could have other entrepreneurs who start up businesses and they take the certification that exists on the coin and transfer it to another medium like a piece of paper which historically we call bank notes so they would write an issue, print up a piece of paper that would say the XYZ bank is holding in reserve for redemption of this note $5 of gold or whatever the money name would be in this system so the certification wouldn't have to remain on the coin it could be taken on a separate medium. Of course in our economy this is done electronically right we have checking account balances these are just electronic records of the claims that we have the redemption claims that we have to money proper so we can go down to our bank and we can ask them to cash out $100 from our checking account and go to the ATM and cash out $200 and they will provide us with this redemption on demand at par. This by the way is what's necessary for money substitutes to come into existence these certifications, these redemption certifications if they are issued in such a way that they're available to the bearer the person who possesses them on demand at par then they could be accepted as substitutes for money in lieu of money this would be the case because the existence of these certificates a bank note or a checking account balance provides some additional measure of convenience and safety compared to lugging around the coins themselves and so the customers would be willing to pay fees to obtain the money substitute production, the bank note or to administer the checking account balances for the convenience of being able to swipe debit cards instead of lugging around gold coins or to just carry $10,000 worth of purchasing power in one bill that you can slip in your shoe and carry around anonymously and buy things as opposed to lugging around gold and silver so again this would just be a business the bank would charge fees for the production of the money substitute the money certificate as long as again customers valued the benefit of the money substitute sufficiently they'd pay fees high enough to cover the cost of administering the production and administration of the money substitute so this would be all just regulated again by normal commercial profit and loss principles so we know that this too would occur on the market this is just the logic of the regular process of entrepreneurial decision making in the realm of economic calculation applied to these elements, these monetary elements now let's take a look I want to do this just for comparative purposes let's assume legally speaking just for the sake of making a comparison that the bank issues money certificates that are in fact claims and not titles of ownership to the money so that's a legal issue that again we're not going to go into how that would work itself out but let's just say that so I want to do that so that I can make the comparison and the contrast between this effect that the issue of money certificates would have on the bank's balance sheet with the effect that fiduciary issue would have on the bank's balance sheet so let's suppose we have a bank and this is just a T account of what happens if a customer comes in and deposits $1,000 in his or her checking account so money this would be gold or silver whatever the commodity money is in coinage and then receives a checkable deposit an account balance in their checking account of $1,000 so this sort of an arrangement is called a 100% reserve bank or again our terminology before is this checkable deposit is a money certificate because it's backed by a 100% reserve of money that the bank is holding for redemption of the checkable coin so that we can see that this could be an arrangement that would arise on the market and again we've explained how a bank can financially soldier on in their business providing 100% reserve they do this by charging fees to the customer so that's how the system would work now notice the two points that I've made here that the issue of this money certificate the issue of the checkable deposit leaves the bank both liquid and solvent it has an instantaneous liability the customer can come back anytime he or she wants and redeem the checkable account for money and the bank has an equivalent amount of money to the checkable account and so their asset can be tapped to pay the liability so they're completely liquid when they do this and they're also completely solvent right there's no insolvency here the nominal value of their checkable deposits and the nominal value of their money is equivalent so there's no problem right their asset values couldn't fall nominally relative to their liability values when they do this so the financial integrity of the bank is intact when they issue money certificates I make a point to this obviously because if there's fiduciary issue by the bank then we get a different result and so again this is I'm setting this up just for comparative reasons the second thing we want to note is that the issue of the money certificate does not change the stock of money so if we want to add up the total stock of money that exists in an economy in any point in time we would add together all of the money which in this case would be again coins of whatever commodity and then all of the money substitutes but of course if there are money certificates like in this example then the money proper is no longer serving as a medium of exchange it's being held as reserve by the way this is a general principle that how we categorize economically a particular item that people a particular good that people have is the way that they use it just because a gold coin is in fact an amount of gold and it has a stamp on it and so on and so forth it doesn't necessarily mean that a person would always use it as a medium of exchange so to give you a modern example I don't know this for sure but I suspect that Donald Trump has like the first dollar he ever earned framed and a placard on his wall or one of his many houses I guess you know okay well that dollar is not a medium of exchange anymore right it's not part of the money supply it's been used somehow else in some other way so that's what the bank is doing they're now using what is for other people the medium of exchange they're using as a reserve and so if they take a thousand dollars out of the money supply in coins and they replace it that's why they're called money substitutes right they replace it with an equivalent amount of checkable deposits so the total money stock has not changed that's the point the banks cannot inflate the money stock in a system like this they cannot change the money stock the money stock is completely determined by the profitability of the production of money production of the commodity money when banks issue money certificates all they're doing is changing the form of the medium of exchange to satisfy the preference of customers customers like to have checkable deposits instead of coins then more of those would be produced by the banks and if people like to have coins they like the physical connection to the coins then there would be fewer checkable accounts right but the money stock overall would not change that's the basic point by the way here's a nice quote of this here this person who I'm quoting calls the money certificate a bank money okay so we wouldn't use that terminology because it's sort of ambiguous the bank money just offsets the amount of ordinary money gold or currency placed in the bank's fault no money creation has taken place 100% reserve banking system has a neutral effect on money and the macro economy because it has no effect on the money supply now that's not Mises or Hayek or Rothbard that's Paul Samuelson so on a few points I agree wholeheartedly with Paul Samuelson so he understands this principle as well of course as we'll see later in the talk Paul Samuelson thinks this is a very bad monetary system and that it would be great to have fiduciary media whereas Austrians tend to think the other way okay okay so in this system commodity money and 100% reserve banking we have no monetary inflation right the production of money is completely determined we said before just by the economic calculation of profit and loss for mining and minting the commodity whatever it happens to be so in my analytics here we have the purchasing power of money money's price and the quantity of money this is the total stock of money the total amount of the money commodity and the money certificates that are being used as a medium of exchange at any given point in time of course that is fixed and then we have a total demand that people have to possess this money has a good and the interplay of the total demand and total stock of money determined then the purchasing power of the money just like it would for any good right like the housing stock in Auburn the number of houses that exist in Auburn and the total demand that people have for houses in Auburn determine the price of housing of a house in Auburn so it's the same analysis right so the only thing that can lead to an increase in the stock of money by production is if the total demand for money goes up because if the total demand for money goes up then the market value of money is higher and yet the costs of production are the same and so there's profitability in producing more money and then money production would ramp up and it would moderate as we suggested before the price of money the additional supply would keep the price of money from being as high as otherwise and the additional bidding by the entrepreneurs for the factors of production to produce this money would bid up the costs of production and so at some intermediate point we would reach a new equilibrium or stable point so exactly the same dynamic is in motion again for houses in Auburn so if demand for houses goes up in Auburn then there would be more profit for production and the construction companies would ramp up production they'd find more land sites and developments and by the way you can see this sort of thing going on around us this week right in fact it's even ramped up beyond just construction of houses we see all these big building cranes around campus there's a massive building activity that's going on here in Auburn okay so that's how money production would be regulated in this system okay now let's move on to the credit activity of banks so we've seen the monetary function of banks is first and foremost to provide money certificates that satisfy customers desire to have a more safe and convenient form of the medium of exchange now banks also perform a credit function and here they perform the function of financial intermediation or their middlemen or the intermediate credit and we all know what middlemen do middlemen buy wholesale and sell retail and the reason they can get this markup between the wholesale price that they pay to buy the products and the resale price that they charge to the customer is because they provide the customer with some benefit convenience and safety we all know that when we shop at Walmart it's unlimited returns right that's the big benefit that's one of the reasons we shop at Walmart because if we can buy a product use it for a week we don't like it take it back get a full refund the producer a little more problematic right there are other benefits too I won't go into all the details it's the same thing with banks intermediating credit so I'm a saver I would have a very difficult time getting the best interest rate in the market because Fortune 500 companies don't want to deal with me and my $2,000 that I want to lend they'd have to have a separate legal contract with me and so on they just want to borrow $100 million all at once from one lender and so banks can pool these funds and provide these benefits and the whole sale interest rate that I get from the bank might actually be higher than any interest rate that I get relative to risk might actually be better than anything else that I could get on my own if I just pursue on my own now again this is just an empirical question we know that there's a lot of crowd funding now and this sort of thing is providing some bypass for the little guy for us little people to be able to kind of directly fund things and to get the retail rate that's great the internet sort of breaks down a little bit the benefit to the wholesaler so we can bypass Walmart maybe go directly to the producer and get these benefits get a better price or whatever it might be but the point is if that these innovations wiped away the entire benefit then there'd be no intermediaries so this is just again subject to the same principle profit and loss as any other operation of an entrepreneur on the market as long as banks are doing this function then in earning this interest rate differential they earn their revenue stream and the differential between the wholesale interest rate they pay I'd say a certificate of deposit interest rate that they pay to me is a saver and the retail interest rate that they get when they lend to an entrepreneur and if they're not able to get that revenue stream well then they just don't do this business so to the extent that they do it they're satisfying this demand that savers have for these benefits that they provide so this is the idea so credit intermediation in this initial step as we think about credit intermediation we can see that it too is regulated by profit and loss by the way let me make a side note here for those of you more sophisticated on this issue we'll get to this in a minute for the rest of you but financial intermediation does not require the banks to play the yield curve they're not borrowing short and lending long here banks might do that but that's not what we're talking about here this is a more fundamental principle they're just borrowing at a particular time structure and they're lending into the same time structure they can even earn an interest rate differential doing that because they're providing services to the saver again it's an empirical question as to how this works out how these different elements work out but here we're just providing the logic of it right it's logically the case that this could happen and probably in history this was initially how banks began the credit function okay so let's take an example of this to see this in a little bit more detail so on the again on the right hand side we have a bank's balance sheet here liabilities and equity where they're borrowing money from savers and they're taking out the savers are taking out CDs with the bank like a one-year CD a certificate deposit and some other customers want five-year CDs and other customers want 15-year CDs and so they're going to the bank and the bank's offering different interest rates for these based upon the interest rates that they can get by lending into the credit markets in these time structures and so there'd be a yield curve right which should typically with short interest rates lower than long and the and the bank if they're perfectly intermediating they would just take the the CD fund that's provided by the customer in a certain time structure and lend it directly into that time structure of investments now again they don't have to do this but the point is they're able to precisely match the time structure of their borrowing with the time structure of their lending and again this would leave them completely liquid and completely solvent that is to say as solvent as they can anticipate with respect to the payoff of these loans there's always uncertainty involved in the payoff of the loan but aside from that the point is they're completely liquid when they do this now they may find as a matter of empirical matter they may find that a lot of these shorter term CDs by customers roll over year after years they find that 60% of the old customers roll over the CDs or new customers come in and roll them over and that may provide them with the ability to make longer term loans on their short CDs but this is just an empirical question for the entrepreneurs to figure out the point is they can remain completely liquid in financial intermediation they don't have to borrow short and lend long and put themselves in an ill liquid position they might do that but it's not necessary for them in order to intermediate credit okay then the other thing the other point the last point on this is that credit intermediation also then would not change the savers the amount of credit that savers provide the banks are simply borrowing that fund and then lending that those same funds to investors so they're not the fund of credit from what savers are providing to them they're just intermediating that pool of credit and so the whole structure of credit is determined by people as we say in economics people's time preferences their willingness to save and invest the funds and postpone their current consumption into the future to earn the rate of return on the investments that they make and you know if you're interested in this area well we have a whole lecture on interest later in the week okay so this would be the picture how would it be the case in an economy like this for let's say interest rates to move and the credit supply to change well just like with money production this would have to be based on a change in people's preferences so if people prefer to hold more money as we saw before then they increase their demand for money and this would make it more profitable to produce money and then money production would ramp up to meet this increased demand for money so similar thing happens in credit markets if people's time preferences go down as I pictured it here then they're willing to increase their supply of saving and decrease their demand for saving and this would permit the credit supply to expand and then banks would have more credit to intermediate maybe the savers would try to directly invest this or something but at least the total supply of credit provided would be increased and interest rates would fall so that too is just part of the normal process of the market of course the reverse could happen in both these cases right demand for money could go down time preferences could go up and then we just reverse the analytical effects okay now let's turn to the question of fiduciary issue so we see we've just looked at the economics of how would the system the banking system function what whether the economic analytics of a banking system where there's commodity money that they're working with and then they're producing money certificates and intermediating credit so we've seen that this is a perfectly viable system of banking you know it's a perfectly reasonable profitable potentially profitable business line for entrepreneurs and they would come into this and allocate their resources just like they would allocate resources and other lines of production so now let's introduce the case of fiduciary media and again we won't worry about the legal issues involved let's just say whatever is necessary legally to be in place it's in place so now we have fiduciary issue so how does this compare and contrast then to the case of 100% reserve well here we need to see first of all the fiduciary media comes into existence through credit creation so this is the whole profitability justification that the banks would have for issuing fiduciary media so this is how we define fiduciary media fiduciary media or money substitutes for which the bank holds just a fraction of money in reserve instead of 100% reserve now in my example they're holding on this $1,000 of cash reserve the bank is holding a 10% reserve right they've got $10,000 in checking deposits but only a thousand in a reserve against that 10,000 now how do they go from 100% reserve a thousand cash reserve a thousand in some customers checking account to 10,000 in the checking account and the simplest way they could do this is just make a loan to one of their customers of $9,000 they just make a loan and then they write the loan balance into that customer's checking account that would be the simplest and most straightforward way for them to do this they just create credit out of thin air notice they're not intermediating this credit they're not borrowing these funds from anybody they're just writing the money to the checking account of a customer who has come in and asked for a loan and of course bankers just well like any businessman of course knows that there can be there can be additional customers that they could service at certain prices right so it's just a question of you know at what price and will that price be sufficient to cover costs and if it is well then the entrepreneur is happy to satisfy this customer so that's the issue right that's the question would the bank do this and then we'll see there are certain nuances as to whether the bank can do this within the framework of the market that's a different question here we're just saying would the bank have incentive to do this are they interested in doing this and here I hope you see right away that the answer to this is clearly yes because the bank would earn the interest on this $9,000 loan wherever they lend this right they're charging interest for this loan they're earning this interest and yet they're not paying any interest to any saver to borrow the $9,000 right so this is better financially than credit intermediation at least on those grounds it's better right because if they're intermediating the $9,000 they'd have to borrow it from a saver they'd have to pay the saver interest and now they don't have to pay that interest this by the way raises another interesting question and we won't pursue all the nuances of this but you might think about this the bank when it issues fiduciary media since it just creates the funds out of thin air without borrowing them from someone else it raises the question of who in the economy then has to reduce their expenditures on things in order to accommodate this borrower who gets the $9,000 this person is going to take the $9,000 and go out and buy something and somebody's not going to get the goods that they would have gotten had this person not been extended this loan right you see when credit is intermediated the person whose expenditures on goods goes down enters into a contract with the bank to provide this this funding and so we know exactly whose expenditures are going down and it's all contractually and mutually advantageous but here it's just people in general right by the way it's very similar to the issue of fiat money which again we're not going to talk about in this discussion but the same thing a very similar thing when the government just prints fiat money right who bears the opportunity cost of them being able to spend it and get these additional goods and the answer is well there's just people in general who don't contract to do this they're being ripped off right and put it in neutral economic language they're having resources their wealth is being redistributed right without their consent really they don't understand even maybe what's going on they just see prices rising and the purchasing power their income is dropping so that's a big difference between the two systems right fiduciary issue provides this kind of redistribution of income or wealth distribution which doesn't exist in 100% reserve system okay so this point about let's examine this point a little bit more carefully about the profitability of production here just to reiterate this so the banks are in interest on the created credit and yet they don't have to pay to bear the opportunity cost of the people whose resources are being transferred to the borrower again to use an analogy it would be as if we could see clearly the inefficiency in this if we said what if the government stepped in and paid all of the costs of production for a particular entrepreneur to produce his or her good what if they paid all the costs of production then how would the entrepreneur's production decisions change well the answer is pretty obvious right they'd ramp up production tremendously and we didn't really care if that required them to lower their prices a bit to get more customers because their costs of production are negligible so this is the sort of effect we get we get production outside of the realm of economic calculation now this is the last point anyway on the slide where we haven't talked about this point it must be the case in that the bank has some other principle besides profit and loss to regulate the production of the fiduciary media they must use some other principle besides profit and loss they can't use profit and loss because if they say let's make every loan with fiduciary media that's profitable to make well then they'll extend loans add an item and they'll bankrupt their bank right they have to have some sort of arbitrary policy to say well we won't make loans in this area of the economy or we will keep a certain capital ratio right a reserve ratio or something like this to moderate the extent the fiduciary issue so that too comes into play in this system and not in the 100% reserve system there's this question of the policy that the bank adopts to regulate the issue of fiduciary media this become we'll see this is a very important theoretical point when we get to the end of the talk okay well the other thing we want to point out about this system is of course that fiduciary media issue makes banks illiquid now they have instantaneous liabilities that are much larger than their instantaneous assets they have checking account balances that are payable on demand at part of their customers weigh in excess of their monetary reserve and so they're by nature illiquid and of course they'll banks in the real world and again we're not going to talk about all these legal aspects we can figure this out pretty quickly banks in the real world then will lobby governments to provide them with some kind of legal protection to this illiquidity you know the guarantee of bailouts or the securitization of their assets so that they can quickly sell them and become more liquid and things like this right so we get all of this all of this apparatus of intervention of the states into financial markets can in fact be a logical consequence of this kind of a system in 100% reserve banking system we wouldn't have any of this it wouldn't be necessary to have this sort of apparatus of protection to the banking system the banks also can become insolvent because if the bank has 100% reserve and they're just intermediating credit they're going to lend to the most credit worthy projects and investors but if they just create credit out of thin air they have to lend to borrowers that don't have the credit status they have to lend to less credit worthy borrowers into projects that are less likely to pay off and so they become insolvent the quality of their assets is affected by fiduciary issue as well now financial markets can become more volatile because this credit creation as we know and you'll talk about later in more detail the business cycle analysis can generate asset price bubbles I've already mentioned the building boom here around Auburn my wife was walking downtown the other day walked by a realty store and just picked up a flyer brought it home back to the hotel where we're staying to show me it's a little dinky house very unimpressive very sort of lower middle class looking house in a neighborhood right near downtown they want $415,000 for this house $415,000 I mean this isn't New York City Auburn is just a little po-dunk place right well it's bigger than my town of Grove City but $415,000 would buy you like the second nicest house in Grove City a great big huge house with 5 acres or 10 acres of land and so on there's definitely some sort of an asset price inflation going on right here in River City so we get these asset price bubbles and then of course this changes the profitability of production of these assets so construction equipment prices go up and so we get we get the business cycle elements from all of this again you'll talk in more detail about that later the other thing is it creates some instability in the whole banking system because this house that I mentioned here in Auburn at $415,000 is an old house it was built in 1970s or something and its price is probably doubled from what it was 10 years ago it's not a newly produced house right it's caught up in the asset price inflation along with all the newly produced things simply because it's a substitute good to the things whose prices have risen right so people just arbitrage between these opportunities they don't go for the new house a million dollars they go for the older houses at lower prices and they bid those up too and so now banks balance sheets swell and the customers of the home owners go down to the bank and say hey I'd like to take out a second mortgage on my house I've got $150,000 equity in my house and the banks say oh sure that looks great $415,000 house and now we've got $200,000 mortgage on the house great so that's how this whole thing plays out and again you'll hear more talks on this later so we won't dwell on this my point is this sort of thing doesn't happen in a 100% reserve system this is a big difference between the two systems okay so here we then can define monetary inflation in an analytically precise way monetary inflation is not any time the money supply increases monetary inflation is an increase in the money stock outside the confines of economic calculation there's no monetary inflation in a commodity money system there's just the regular production of money that responds to changes in demand that's not inflation anymore than we would call an increase in the production of smart phones inflation when demand for smart phones goes up no that's just a regular market right but here we have a distinction this is inflation and what inflation does of course is progressively push down the purchasing power of money so we would see this potential effect at least in the system of fiduciary issue and the very last thing that we want to look at in this time period is whether or not this can be regulated whether this inflationary effect of pushing down the purchasing power of money can be kept in abeyance in a fiduciary issue system now same thing happens to credit so credit can be expanded just out of thin air and so the supply of credit can increase and this will just push down interest rates right there's no necessity to have a lowering time preference here to get a greater supply of credit and lower interest rates we can this system permits the just sort of artificial pushing down of interest rates and then again this sets in motion the business cycle so we call this credit expansion so we can have monitoring inflation and credit expansion in the fiduciary system oh another quote the transformation into fractional reserve banks holding fractional rather than 100% reserves against deposits was in fact revolutionary it led to the leveraged financial institutions that dominate our financial system today again not Mises Rothbard Paul Samuelson again mention that the difference of course is I mentioned before Paul Samuelson likes this system he thinks this is great wow you know this is a wonderful revolution what would we be without it this also is not to harp on trump too much but this is also his line right he doesn't like to fed but boy he loves their low interest rates that's great keep pushing interest rates down you know why because their argument is this stimulates production and again the counter argument of Austrian business cycle theory is it stimulates a boom that then inevitably is liquidated right so it's a boom yeah sure you get a boom but then this is inevitably all washed away by the bust so again that theory will be entertained in a later lecture what we want to do is just look at this very last point there's another argument that's used in favor of the fiduciary system that's somewhat more moderate than this kind of Keynesian argument about you know pushing down interest rates and expanding the supply of credit permitting the investment in more capital and making us wealthier and this is the claim that if we have a free banking system with fiduciary issue even if the base money if the money say we had commodity money or even fiat money if even if that base money supply were fixed as long as banks are able to issue fiduciary media then they will simply issue it only to accommodate increases in money demand as we spoke about before and this would basically leave the purchasing power of money the same over time so that's the claim that's made to justify fiduciary issue by this group of economists who base this claim on what's called monetary disequilibrium theory the claim in the latter part of my sentence where it says otherwise if you don't have a system like this you can get harmful price deflation so obviously in 100% reserve banking system you could have a period of price deflation because the demand for money could go up as we pictured it on my slide and the response of the increased production of money would be insufficient to bring the purchasing power of money back down to its original level the purchasing power of money would stay above its original level and other prices of goods would be lower so it is possible now let me just briefly respond to how in the 100% reserve commodity money system what is the argument then the counter argument to that basic point and I pointed as I suggested before is a huge literature on this and a great big debate so we can't go into all the nuances but the basic point in response is this it is certainly the case that entrepreneurs could adopt a commodity like gold that was insufficiently they were insufficiently able to produce enough to prevent a significant price deflation what would happen in a case like this and the answer is the entrepreneur would simply select some other commodity as money that's the answer they would just select something else that's more readily produced so they would just move from gold to silver and that would solve the problem of excessive price deflation the very question though is who's to judge what's excessive price deflation right is it the entrepreneurs who are actually in the business of producing the goods and so on or can we do this sort of abstractly as economists can we say oh no we need a system a monetary system that keeps the purchasing power of money exactly the same by the way that kind of claim should strike you as extremely odd would we ever say this about any other good would we say in other words the ideal system of production for smartphones is that their price always stays the same you know we have a system somehow rigged in such a way that every time our demand for smartphones goes up the increased supply just meets it at the point where the price stays the same no we think that's sort of nutty we think quite to the contrary we think that prices are going to go all over the place right in a market system there's nothing wrong with that they could go up one year and down the next and sideways for several years none of those conditions are particularly debilitating to the market they seem to be all adequate now remember again I'm not going into all the nuances here back and forth about this debate so this is something we can engage in discussion about so I don't want to sort of reduce this argument to just these basic points there are other things to consider so anyway this is how the argument runs then the argument is that any issue of fiduciary media that people did not want to hold they would then redeem and that would be the mechanism that would keep the money supply exactly in sync with increased money demand money demand increases and that allows the banks to circulate if you will or keep in people's hands more fiduciary issue and the people who get it want it because they're demanding more money and so that would be the mechanism that regulates this system okay so what are the arguments against this well real briefly again the arguments against that mechanism why would we suspect that that mechanism is probably not going to operate the way that the proponents of this do claim is because as Mises pointed out when we went in credit in 1912 there are two cases when we think about the issue of fiduciary media there are two cases one is a banking system which allows for the issue of fiduciary media in response to money demand and then there's a case of independent banks and we'll get to independent banks in a minute now if we have a banking system what this means is that the banks make agreements with each other to hold and redeem each other's money substitutes at par on demand and this would allow then for fiduciary issue to be increased overall in the system right and that but the question then becomes what makes us think that it would exactly this sort of system would expand fiduciary media to exactly offset the increase in money demand what if the increase what if it what if there was an over issue an initial over issue of fiduciary media wouldn't it be the case that the borrowers would just spend the new money and prices would rise and then at higher prices that is a lower purchasing power of money wouldn't people want to hold the additional money that's what we pictured before in the slide right the amount of money that people wish to hold depends upon its purchasing power and so naturally if the banks overshoot the mark then and prices adjust to that overshooting then the money will not be redeemed at least not necessarily the money substitutes will not be redeemed because people will want to hold additional money in the face of higher prices for things so that seems to be the point and the same thing with credit expansion credit expansion lowers the interest rates so fiduciary media can't adjust credit to the needs of trade or something like this because the needs of trade depend on the interest rate how much is demanded depends upon the interest rate so if they over issue fiduciary media the banks do and create too much credit and they push the interest rate down then the commercial interests are happy with that they won't say oh you know I got to pay back my loans right so it's hard to see exactly where the system is self-regulating ok then finally what about independent banks what would happen in Mises' second case what if we have truly independent banks that don't form these alliances that allow for fiduciary issue to increase well here we know that the clientele of each bank would be strictly limited and that banks would be interested in taking customers from each other right and in building their clientele base and so when banks get money substitutes issued by other banks the banks themselves would redeem them to try to injure their competition and so we had you know historians like to call the period in the 19th century wildcat banking because they don't like this sort of competition they don't like actual free open competition in banking something's wrong with it but that would be the case with independent banks it's not clear at all that if you had independent banks you could issue additional fiduciary media at all this was again Mises' conclusion he thought that if you had real free banking with independent banks the issue of fiduciary media would not continue you would have basically 100% reserve banking for any additional issue beyond whatever the reserve ratio was that people would accept so we know that the reserve ratios can't be lowered by banks just by issuing more fiduciary media right which would allow them to accommodate more credit creation and so on in an independent banking system it's customers, it's you and I who determine this what the ratios are that banks can hold safely by our redemption so this would not be a path toward expansion and finally the only other way in which the money supply could be expanded is if there are additional reserves but as we've seen in this system the additional reserves only come through money production of the commodity and so the banks again have no independent ability to increase the money supply to accommodate increases in money demand it just wouldn't be a mechanism for it to occur alright so at this point I'll stop, thank you very much