WEBVTT NOTE A Defense of Free Banking and Monetary Disequilibrium Theory 1 00:00:00.000 --> 00:00:06.240 I want to thank Professor Salerno for allowing me the opportunity to present a defense of free banking. 2 00:00:06.240 --> 00:00:12.520 There's been a lot of debate over the theory of free banking and monetary disequilibrium theory, 3 00:00:12.520 --> 00:00:16.880 and due to time constraints, I won't be able to address all of the objections. 4 00:00:16.880 --> 00:00:24.720 In a forthcoming paper, I will give a more thorough response to all the recent objections. 5 00:00:24.720 --> 00:00:30.720 I'm going to try to leave some time for questions at the end. I look forward to your questions. 6 00:00:30.720 --> 00:00:34.720 And I believe that if you apply the insights that I provide today, 7 00:00:34.720 --> 00:00:41.720 you'll be able to answer most of the unresolved questions that are related to the topic. 8 00:00:41.720 --> 00:00:54.040 So, let's see, I also want to start off with saying why I support free banking, so that 9 00:00:54.040 --> 00:00:58.960 no one can ever in the future say that it's about price stickiness or anything. 10 00:00:58.960 --> 00:01:06.480 I support it because it's conducive to Say's law, it promotes a natural interest rate, a 11 00:01:06.480 --> 00:01:13.440 and the Wixellian interest rate, and it's conducive to personal freedom and innovation. 12 00:01:13.440 --> 00:01:22.720 Alright, so the prime concern by Philip Baggis and David Howden is would a free banking system 13 00:01:22.720 --> 00:01:25.720 allow expansion in concert? 14 00:01:25.720 --> 00:01:33.940 And this is related to the interbank lending market would be a mechanism which banks would 15 00:01:33.940 --> 00:01:37.000 to be able to borrow reserves from each other. 16 00:01:37.000 --> 00:01:38.840 And by expanding in concert, 17 00:01:38.840 --> 00:01:41.720 you get kind of a prisoner's dilemma situation 18 00:01:41.720 --> 00:01:44.240 where if everyone behaves a certain way, 19 00:01:44.240 --> 00:01:47.000 then you get a suboptimal outcome. 20 00:01:47.920 --> 00:01:51.120 And by not losing reserves to each other, 21 00:01:51.120 --> 00:01:52.960 then they can all expand, right? 22 00:01:54.240 --> 00:01:57.120 De Soto made the same argument in his book. 23 00:01:58.340 --> 00:02:02.240 And lastly, the Austrian business cycle necessarily ensues. 24 00:02:03.940 --> 00:02:11.940 So, a lot of the literature thus far has been focused on reserve management. 25 00:02:11.940 --> 00:02:17.460 For example, Seligen's book on the theory of free banking, and this is warranted because 26 00:02:17.460 --> 00:02:21.740 one of the prime concerns about the need for a central bank is to be the lender of last 27 00:02:21.740 --> 00:02:25.900 resort in case of a liquidity crisis. 28 00:02:25.900 --> 00:02:33.740 But unfortunately, by overly focusing on reserve management, it's left the argument open to 29 00:02:33.740 --> 00:02:41.340 to the argument about expansion and concert, I believe. 30 00:02:41.340 --> 00:02:48.420 So we have to look at how banks actually operate fully to be able to understand this. 31 00:02:48.420 --> 00:02:53.620 So banks face risk beyond liquidity risk, and bank credit is not only constrained by 32 00:02:53.620 --> 00:02:58.440 institutionally determined reserve ratios, such as the often-recited, you know, banks 33 00:02:58.440 --> 00:03:01.860 lend out 10 times what they have in reserves. 34 00:03:01.860 --> 00:03:06.420 So what actually determines the supply of inside money, that's money created by the 35 00:03:06.420 --> 00:03:14.140 banks, is the risk-adjusted net interest margins, capital adequacy and liquidity, and in a mature 36 00:03:14.140 --> 00:03:21.660 banking system, liquidity actually gets priced into the net interest margins because banks 37 00:03:21.660 --> 00:03:24.660 lend to each other. 38 00:03:24.660 --> 00:03:30.140 So how banks make profits, you know, the bottom line is determined by interest income from 39 00:03:30.140 --> 00:03:36.460 and their assets, minus net charge-offs and delinquencies for bad debt, plus non-interest 40 00:03:36.460 --> 00:03:45.020 income fees, origination fees, stuff like that, interest expense minus, or minus interest 41 00:03:45.020 --> 00:03:50.500 expense minus operating expense employees overhead, plus or minus gains and losses on 42 00:03:50.500 --> 00:03:54.940 portfolio, minus taxes. 43 00:03:54.940 --> 00:04:02.300 So if you factor out the operating stuff, what you get is the difference between what banks 44 00:04:02.300 --> 00:04:08.980 lend at and the rate they have to borrow at to pay depositors and other sources of funding. 45 00:04:08.980 --> 00:04:13.020 And that is your net interest margins. 46 00:04:13.020 --> 00:04:20.060 So if we look at, if we expand on this, you get your return on assets minus your net charge 47 00:04:20.060 --> 00:04:36.060 Delinquency rates, which you could restate as risk to the portfolio, minus your cost of funds, which includes bonds, deposits and reserves borrowed or lent. 48 00:04:36.060 --> 00:04:44.060 Borrowing reserves, you're going to be paying interest. If you have excess reserves, you're going to lend it, add interest and earn interest. 49 00:04:44.060 --> 00:04:56.060 After that you get your risk adjusted net interest margins and we know from micro 101 that profit maximization occurs when marginal revenue equals marginal cost. 50 00:04:56.060 --> 00:05:09.060 Therefore the inside money supply is endogenously a function of bank profitability which is derived from the risk adjusted net interest margins. 51 00:05:09.060 --> 00:05:15.700 Since the interbank lending rate affects the rate the banks pay to attract deposits, the 52 00:05:15.700 --> 00:05:22.780 interbank lending market coordinates the allocation of credit to its most highly valued uses. 53 00:05:22.780 --> 00:05:29.660 So this means the interbank lending market is the price signal that restricts rather 54 00:05:29.660 --> 00:05:35.860 than enables excess money creation unless you have a central bank to manipulate this 55 00:05:35.860 --> 00:05:39.860 and the misprice signal, in our case, the federal funds rate. 56 00:05:39.860 --> 00:05:50.860 So when the Fed does this, it changes the bank's cost of funds and causes them to misprice risk. 57 00:05:50.860 --> 00:05:54.860 So since the central banks generally target inflation around the world, 58 00:05:54.860 --> 00:05:58.860 they usually have interest rates too low in the boom time when inflation is low, 59 00:05:58.860 --> 00:06:02.860 providing too much liquidity, and then too high. 60 00:06:02.860 --> 00:06:07.860 They raise the interest rates once price inflation starts to show up, and then they cause a credit crunch. 61 00:06:09.860 --> 00:06:18.860 So now let's apply this to a scenario to show how the inter-bank lending market restricts over expansion of credit. 62 00:06:18.860 --> 00:06:27.860 Bank A is privy to a loaner investment that yields above average expected returns relative to risk. 63 00:06:27.860 --> 00:06:33.860 and the bank has average cost of capital, so a ceteris paribus assumption, right? 64 00:06:33.860 --> 00:06:36.860 The bank will approve the loan and credit the borrower's account. 65 00:06:36.860 --> 00:06:45.860 Now in order to prevent losing reserves, the bank will attract new deposits by raising interest paid on their deposits 66 00:06:45.860 --> 00:06:54.860 and that'll, by attracting deposits, that'll raise their competitor's cost of funds too. 67 00:06:54.860 --> 00:07:03.860 2, or they'll borrow the reserves on the interbank lending rate and that'll also raise the rate 68 00:07:03.860 --> 00:07:10.940 the banks lend at, and either way the risk adjusted net interest margins are compressed 69 00:07:10.940 --> 00:07:15.620 and the profits of the rest of the banks go down. 70 00:07:15.620 --> 00:07:20.060 So how does this relate to monetary disequilibrium theory? 71 00:07:20.060 --> 00:07:23.820 Well time preference determines the saving rate, the average rate of interest, or the 72 00:07:23.820 --> 00:07:30.340 and the axillian natural rate, but liquidity preference determines the allocation of wealth 73 00:07:30.340 --> 00:07:36.200 between money and risk assets and the shape of the yield curve. 74 00:07:36.200 --> 00:07:44.900 So since banks are involved in maturity transformation and inter-temporal markets of the capital, 75 00:07:44.900 --> 00:07:51.140 what the signals they deal with are the yield curve to determine how to make that trade 76 00:07:51.140 --> 00:07:54.900 Off Across Time. 77 00:07:54.900 --> 00:08:02.180 So a steep yield curve signals the banks to increase the money supply. 78 00:08:02.180 --> 00:08:07.480 So the banks respond to those price signals of the yield curve. 79 00:08:07.480 --> 00:08:12.680 Risk aversion and high liquidity preference of the public leads to risk assets such as 80 00:08:12.680 --> 00:08:19.220 stocks to sell at a discount, which increases their yields, and interest paid on deposits 81 00:08:19.220 --> 00:08:43.820 Bankers purchase securities, so when this happens, banks will purchase the securities, 82 00:08:43.820 --> 00:08:49.180 the risk assets, and they'll make new loans, which simultaneously creates new deposits, 83 00:08:49.180 --> 00:08:55.620 deposits, and it returns the asset prices into equilibrium with their yields, and at 84 00:08:55.620 --> 00:09:01.580 the same time provides liquidity to satisfy society's preferred allocation of wealth. 85 00:09:01.580 --> 00:09:08.620 So as Austrians we know time preference determines the rate of interest, which would be the average 86 00:09:08.620 --> 00:09:18.940 rate of interest, but liquidity preference has an influence on yield curve and the differential 87 00:09:18.940 --> 00:09:24.860 Model Between Money and Risk Assets. 88 00:09:24.860 --> 00:09:33.020 If you're familiar with the CAPM model, the securities market line, which determines that 89 00:09:33.020 --> 00:09:39.700 if a security has an above expected return or below average return relative to risk, 90 00:09:39.700 --> 00:09:46.380 the shape of that or the slope of that line would be determined by the liquidity preference 91 00:09:46.380 --> 00:09:57.820 One of the claims is that the demand for money is relatively stable, so you wouldn't have 92 00:09:57.820 --> 00:10:06.140 these problems in a free market, you wouldn't need to have banks to adjust the money supply. 93 00:10:06.140 --> 00:10:13.060 But unfortunately, or however you look at it, that's not true, because the evidence 94 00:10:13.060 --> 00:10:21.460 I provide here over the last about a hundred years from Fed data, we're looking at change 95 00:10:21.460 --> 00:10:28.000 in the currency held by the public, and so this is a pretty good indicator of the demand 96 00:10:28.000 --> 00:10:34.260 for money because it shows if the public holds more demand for currency, they're going to 97 00:10:34.260 --> 00:10:40.380 pull money out of the banks, usually this shows the transaction demand for money especially. 98 00:10:40.380 --> 00:10:47.220 And so what you see here is that at the beginning of the year, after the holidays, the public 99 00:10:47.220 --> 00:10:50.020 reduces their demand to hold currency. 100 00:10:50.020 --> 00:10:55.180 And then especially in the autumn time and especially once you get near the holidays, 101 00:10:55.180 --> 00:11:03.260 you have a huge relatively demand for people to have currency for spending, right? 102 00:11:03.260 --> 00:11:09.460 So if you had a fixed supply of money, this would pose a problem because you'd have almost 103 00:11:09.460 --> 00:11:18.940 3.5% change, that would fall on a change in the price level in a two month period. That's 104 00:11:18.940 --> 00:11:23.740 what Seldzins talk about by confusing the entrepreneurs as to whether there's a fall 105 00:11:23.740 --> 00:11:31.460 off in demand for their own goods or whether it's economy wide. Either way, they're going 106 00:11:31.460 --> 00:11:38.340 to be less profitable and it's not due to the real economic factors. So I think this 107 00:11:38.340 --> 00:11:46.020 This really supports the case for free banking and having flexible money supply, the response 108 00:11:46.020 --> 00:11:48.020 to market signals. 109 00:11:48.020 --> 00:11:54.700 Now, Austrians have gotten some criticism lately over why hasn't there been enough inflation 110 00:11:54.700 --> 00:11:57.780 as much as you guys predicted. 111 00:11:57.780 --> 00:12:04.260 So applying this model that I just have presented about risk adjusted net interest margins determining 112 00:12:04.260 --> 00:12:06.580 the money supply. 113 00:12:06.580 --> 00:12:36.580 So we can look at the Federal Reserve's policy of operation twist and we see how it's keeping the yield curve flat and so what this does is it leads to reduce profitability of you know the marginal loan so the banks have less incentive to expand so the feds trying to create demand for loans or or reinflate the housing bubble by having interest rates low but the banks that's not going to incentivize the 114 00:12:36.580 --> 00:12:42.900 Banks to make those loans at such low interest rates, and that's why only the most creditworthy 115 00:12:42.900 --> 00:12:46.500 borrowers are able to get credit right now. 116 00:12:46.500 --> 00:12:53.500 So it's a typical, like a price ceiling, if you put a price ceiling you're going to have 117 00:12:53.500 --> 00:12:56.100 shortages. 118 00:12:56.100 --> 00:13:04.420 So banks are compensating by increasing their interest income, fees, you've seen debit card 119 00:13:04.420 --> 00:13:10.420 The Federal Reserve and Bank of America charge fees just to have an account. 120 00:13:10.420 --> 00:13:18.420 They're finding new ways to generate income since their interest income is reduced right now. 121 00:13:18.420 --> 00:13:24.420 Plus you have the interest rate on reserves, also reduces the opportunity cost of holding reserves, 122 00:13:24.420 --> 00:13:30.420 which effectively reduces net interest margins. 123 00:13:30.420 --> 00:13:45.420 So that, I would say, is why we haven't had inflation, and I would say that a good predictor that you probably won't have very high inflation until long-term interest rates go up. 124 00:13:45.420 --> 00:14:12.420 I'll say a couple more things, Baggis and Howden talked about how free banking ultimately leads to cartels and they also talked about how negotiability of reserves is affected by asset prices being inflated due to money being created. 125 00:14:12.420 --> 00:14:16.420 I'll address more of these in a forthcoming paper I even talked about. 126 00:14:16.420 --> 00:14:27.420 They mentioned the Panic of 1857, so we take a little closer look at whether that really meets the criteria they're discussing. 127 00:14:27.420 --> 00:14:40.420 But in regards to their third claim about increased negotiability of reserves, well, this sounds a little confusing because reserves are the numeraire 128 00:14:40.420 --> 00:14:47.180 Reservations to which all transactions occur and since money is a unit of count and it 129 00:14:47.180 --> 00:14:49.500 trades with no bid-ask spread. 130 00:14:49.500 --> 00:14:55.100 So reserves are always going to have a constant negotiability, I'm a little confused on what 131 00:14:55.100 --> 00:14:57.940 they mean by that. 132 00:14:57.940 --> 00:15:04.660 Plus if their concern is really about liquidity and its relation to flexibility and asset 133 00:15:04.660 --> 00:15:13.420 prices of the bank's asset side of the balance sheet. Well, then banks do have, I mean, pretty 134 00:15:13.420 --> 00:15:20.380 much what banks do is asset liability management and to manage their liquidity risks over time. 135 00:15:20.380 --> 00:15:29.700 So banks have an economic incentive to manage the risks and they'll hold capital to offset that risk 136 00:15:29.700 --> 00:15:36.700 in that situation. I'll leave it there.