George
Selgin is an economics prof at University of Georgia, and I recommend his articles
and books to anyone. He has an encyclopedic knowledge of the history of
banking. Plus he writes in a clear, simple, witty style.
But in this
article he makes a criticism of the pro-full reserve Chicago school which does
not stand inspection. The particular Chicago individuals he cites are Irving Fisher,
Milton Friedman, Henry Simons and Loyd Mints.
But beware:
the arguments and counter-arguments are a bit complicated.
Selgin
claims that the above “full reservers” thought that the bank instability they
attributed to fractional reserve stemmed from variations in the public’s desire
to hold banknotes (as distinct from holding money in the form of deposits at
banks)
Selgin then
points out that by the 1930s, the production of banknotes by private banks was
virtually forbidden: i.e. the only form of banknotes were central bank or Fed
notes. And as he rightly points out, any increased desire by the public to hold
banknotes is a much bigger problem for a commercial bank where that bank cannot
produce their own notes, as compared to where it can. Reason is that when the
public withdraw central bank produced notes, that is a drain on a commercial
bank’s reserves, whereas if the commercial bank can produce its own notes there
is no such drain (and I’ll enlarge on that point below).
So, argues
Selgin, the instability was attributable not to any inherent flaw in fractional
reserve, but rather to commercial banks’ inability to produce their own banknotes.
What did the Chicago school actually
say?
However, the
first big problem with Selgin’s argument is that the Chicago school advocates
of full reserve banking just didn’t
attribute instabilities to anything to do with banknotes - at least not as far
as I can see.
For example,
Fisher’s work “100% Money and the Public Debt” doesn’t say anything about note
withdrawal contributing to bank failures. What Fisher does say (p.10-11) is that
BANK RUNS were a big problem. And a bank run stems not from a change in how the
public wants to hold its money, but from a complete and total distrust of particular
banks.
And in a
paper of about 6,000 words in Econometrica entitled “The Debt-Deflation Theory
of Great Depressions” by Fisher, the words “banknote”, “note” and “cash” do not
appear.
As for
Friedman, he advocated full reserve in his 1948 paper “A Monetary and Fiscal
Framework for Economic Stability.”
But Friedman
certainly didn’t say anything about the demand for notes vis a vis demand for
deposits. Friedman just seems to be concerned about stability in general.
Moreover, it
is well known that Friedman’s main explanation for the 1930s depression was Fed
incompetence.
Whence the big cash withdrawals in
the 1930s?
The next big
problem in Selgin’s argument concerns the REASON why cash withdrawals were
taking place in the 1930s. Well it’s not too hard to fathom, and it’s nothing
to do with random variations in the amount of physical cash that people wanted
to hold. The explanation was that banks were toppling like nine pins in that
decade, thus many people rather than keep a deposit in their local tinpot bank,
preferred to hold notes produced by the Fed, the US central bank. Those notes
were as good as gold. Deposits in your local tinpot bank were quite likely
nowhere near as good as gold.
Selgin tries
to wriggle out of the latter point with the following.
“But while
the notes of certain banks would undoubtedly have been distrusted . . . . plenty of banks remained both trusted and
solvent, and their notes could have supplied the needs of the country as a
whole, since notes (unlike bank deposits) can travel wherever they are most
wanted.”
Well I
suggest that is just plain unrealistic for 1930s America. To illustrate, if you
lived in Southern Missouri were you really likely to see many banknotes issued
by the Bank of San Francisco? And even if you did see some of them, would you
really trust them given that you’d have known that banks were failing left,
right and centre? Is a farmer in Southern Missouri really likely to be an
expert on the credit worthiness of the ten thousand banks that existed around
America at that time?
The
demand for physical cash at harvest time.
Another
possible explanation for withdrawals of banknotes is a phenomenon to which
Selgin himself draws attention on some of his articles, namely that in the
1800s and early 1900s there was a significant increase in demand for banknotes
at harvest time. Reason is that farmers came by large amounts of money at that
time of year on selling their crops and they then spend a proportion of that in
goods in their local town. In short, given a rise in economic activity, there
is a rise in demand for banknotes.
But the
1930s were hardly a period of above normal “economic activity”. Quite the
reverse.
That is, far
from the increased demand for banknotes being attributable to a boom, there
must have been some other reason for people withdrawing banknotes from banks.
And it’s obvious enough what that reason was: it was, to repeat, the fact that
they didn’t trust their local tinpot bank.
To summarise
so far, it looks like Selgin’s criticism of the Chicago school full reservers
needs a lot more work before his argument can be described as “robust”.
And finally
I’ll expand, as promised, on the private bank note production versus central
bank note production question.
Private banknote production.
Where
private banks can issue their own banknotes, those notes as far as the bank is
concerned are little different to deposits. That is, if customers of a
particular bank suddenly decide they want to raise the proportion of their
money held in physical cash rather than in deposits, that is of no great
concern to the bank: the bank can quickly print extra notes if need be. As
mentioned above, that happened regularly at harvest time.
In contrast
to letting private banks print their own notes, there is the regime we are all
used to nowadays, namely a regime under which only the central bank produces
banknotes. But that raises a problem for private banks when their customers
want to hold more banknotes: the problem is that private banks have to eat into
their reserves to obtain those central bank banknotes, as pointed out above.
Now if a
bank is going to stick to a prudent level of reserves, or to a legally enforced
level of reserves, that means that when customers decide to hold more
banknotes, a private bank will have to call in loans, or temporarily cease
granting loans, which of course has a deflationary effect. And it’s an effect
you just don’t need in the middle of a depression like the 1930s depression.
Worse still,
if the relevant bank COULD NOT call in loans then bank faced insolvency. So
Selgin’s claim that forbidding private banks from issuing their own notes makes
life more difficult for commercial banks than if the latter are able to produce
their own notes is certainly valid. But that point is completely irrelevant
where withdrawals take place because people DON’T TRUST the bank at all.