George Selgin’s flawed criticism of the Chicago full reservers.

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.