WEBVTT NOTE Trivial Objections to Fractional Reserve Free Banking 1 00:00:00.000 --> 00:00:03.680 Our next speaker is the Murray Rothbard Memorial Lecturer. 2 00:00:03.680 --> 00:00:06.440 I'm going to give him a very good introduction 3 00:00:06.440 --> 00:00:07.840 because he deserves it, number one, 4 00:00:07.840 --> 00:00:11.280 but number two, a few years ago he poured 5 00:00:11.280 --> 00:00:14.760 some water over my head in a restaurant 6 00:00:14.760 --> 00:00:16.080 for no apparent reason. 7 00:00:16.080 --> 00:00:17.880 So I don't want to give him any reason now 8 00:00:17.880 --> 00:00:20.320 because whatever might happen might be even worse. 9 00:00:20.320 --> 00:00:25.320 There is some water here, I'm getting out of here. 10 00:00:25.320 --> 00:00:38.320 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. 11 00:00:38.320 --> 00:00:51.320 He has published articles in the Journal of Business Ethics, American Journal of Economics and Sociology, Economic Affairs, Review of Austrian Economics, 12 00:00:51.320 --> 00:00:54.440 Business and Society Review, Libertarian Papers, 13 00:00:54.440 --> 00:00:56.320 Corbyn Journal of Austrian Economics 14 00:00:56.320 --> 00:00:59.560 and other scholarly outlets. 15 00:00:59.560 --> 00:01:02.280 He's a co-author with Philip Baggis of Deep Freeze, 16 00:01:02.280 --> 00:01:05.600 Iceland's Economic Collapse, which I highly recommend 17 00:01:05.600 --> 00:01:08.420 as an illustration of the financial crisis. 18 00:01:08.420 --> 00:01:11.720 And he's also the editor of Institutions in Crisis, 19 00:01:11.720 --> 00:01:14.920 European Perspectives on the Recession. 20 00:01:14.920 --> 00:01:17.520 So I present David Howden. 21 00:01:17.520 --> 00:01:39.520 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. 22 00:01:39.520 --> 00:01:48.520 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? 23 00:01:48.520 --> 00:01:52.520 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. 24 00:01:52.520 --> 00:02:01.520 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. 25 00:02:01.520 --> 00:02:12.520 Fractional Reserve Free Banking is competitive banks, all issuing notes against one another, all issuing their own notes, but they're all fractionally reserved. 26 00:02:12.520 --> 00:02:23.520 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, 27 00:02:23.520 --> 00:02:30.520 and indeed what I want to show is that it incentivizes economic agents to actually institute and create a central bank. 28 00:02:30.520 --> 00:02:34.760 So if your original intent is to try to get rid of this institution, if you replace it 29 00:02:34.760 --> 00:02:38.680 with something which ends up causing it in the end, it's not a good alternative. 30 00:02:38.680 --> 00:02:43.440 And I hope to end with a historical example here with the creation of the Federal Reserve 31 00:02:43.440 --> 00:02:46.600 to just illustrate how this happened over time. 32 00:02:46.600 --> 00:02:51.160 So the first thing that I really want to show to you all is how does this fractional reserve 33 00:02:51.160 --> 00:02:55.220 free banking system actually develop or evolve over time? 34 00:02:55.220 --> 00:03:00.040 Imagine a banking system with several private competitive banks all issuing notes against 35 00:03:00.040 --> 00:03:06.040 and 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. 36 00:03:06.040 --> 00:03:12.040 Any note that a bank issues, if you take that note back to the bank, you can redeem it for the base money. 37 00:03:12.040 --> 00:03:18.040 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. 38 00:03:18.040 --> 00:03:21.040 So the inside money is just a claim to that gold. 39 00:03:21.040 --> 00:03:32.040 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. 40 00:03:32.040 --> 00:03:37.040 So what actually happens when banks issue all this inside money and it goes out into the economic system? 41 00:03:37.040 --> 00:03:44.040 Well, if I issue inside money to somebody they take it and they deposit it in their bank and the bank ends up with this claim that's not their own. 42 00:03:44.040 --> 00:03:50.040 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 43 00:03:50.040 --> 00:03:54.040 And that bank is supposed to send over the base money to clear the debt, or to pay it off. 44 00:03:56.040 --> 00:04:07.040 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. 45 00:04:07.040 --> 00:04:11.040 So how do banks actually issue this base money, or what's the mechanism behind it? 46 00:04:11.040 --> 00:04:24.040 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. 47 00:04:24.040 --> 00:04:37.040 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 in reserves to actually meet these demands when they come due. 48 00:04:37.040 --> 00:04:43.040 If the velocity of money is slow or is low, that means that money is circulating slowly through the economy. 49 00:04:43.040 --> 00:04:50.040 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. 50 00:04:50.040 --> 00:04:57.040 Well, what happens with a fractional reserve free banking system in what we could call a mature stage? 51 00:04:57.040 --> 00:05:07.040 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. 52 00:05:07.040 --> 00:05:17.040 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? 53 00:05:17.040 --> 00:05:23.040 Well, in a fractional reserve free banking system, so the theory goes, there's two types of problems we could talk about. 54 00:05:23.040 --> 00:05:32.040 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? 55 00:05:32.040 --> 00:05:37.040 Well, if it's only one bank doing this, it's not really such a problem, it's a self-correcting problem, in fact. 56 00:05:37.040 --> 00:05:45.040 You'd have one bank doing it, and there would be too much inside money going out into the system, this would all come home, all the chickens come home to roost, 57 00:05:45.040 --> 00:05:50.600 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. 58 00:05:50.600 --> 00:05:56.720 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? 59 00:05:56.720 --> 00:06:03.120 If, for example, every bank decided to issue inside money at an increasing rate of 10% a year, let's just say, 60 00:06:03.120 --> 00:06:06.400 but they all did it at the exact same rate or at the exact same time, 61 00:06:06.400 --> 00:06:10.480 all the claims coming back would cancel out with all the other claims to all the other banks. 62 00:06:10.480 --> 00:06:19.480 So nobody would really be losing any base money, 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. 63 00:06:19.480 --> 00:06:26.480 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. 64 00:06:26.480 --> 00:06:33.480 Well, if such a thing happened, do you think that's problematic for this fractional reserve free banking system, because there'd be an over issuance of inside money, right? 65 00:06:33.480 --> 00:06:38.480 We'd have high levels of inflation and all the ensuing problems that go along with it. 66 00:06:38.480 --> 00:06:46.480 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. 67 00:06:46.480 --> 00:06:50.480 Think about what defines the reserve requirement for all of the banks in the system. 68 00:06:50.480 --> 00:06:54.480 They have to hold on to base money in the form of what's called a precautionary reserve. 69 00:06:54.480 --> 00:07:01.480 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. 70 00:07:01.480 --> 00:07:08.480 The precautionary reserve requirement comes from really, well there's two ways you could look at it. 71 00:07:08.480 --> 00:07:15.480 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, 72 00:07:15.480 --> 00:07:20.480 all of your redemption demands cancel out with one another. So nobody would actually need to hold on to any base money. 73 00:07:20.480 --> 00:07:22.480 That's the bad case scenario that we look at. 74 00:07:22.480 --> 00:07:27.480 And that would be the scenario that would lead to all of these banks over issuing all of this inside money. 75 00:07:27.480 --> 00:07:36.480 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. 76 00:07:36.480 --> 00:07:40.480 And the short run problem is the variance of all the redemption demands that come back to you increases. 77 00:07:40.480 --> 00:07:50.480 In any given time period in the short run, you don't know if you're going to have a million dollars in claims coming back to you, or a thousand, or if you're going to be a net debitor or creditor in the clearing system. 78 00:07:50.480 --> 00:08:20.480 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 79 00:08:20.480 --> 00:08:50.480 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 we can demand money is because we have the money supply. 80 00:08:50.480 --> 00:08:56.480 The reason you would possibly demand base money is if you didn't have faith that inside money was actually redeemable for that amount. 81 00:08:56.480 --> 00:09:02.480 But in the fractional, in the mature fractional reserve free banking system, nobody worries about its stability, so nobody demands to have base money. 82 00:09:02.480 --> 00:09:06.480 We're all content using the inside money that gets issued by the banks. 83 00:09:06.480 --> 00:09:13.480 Banks, for their part, in the mature free banking system, fractional reserve free banking system, they don't demand base money anymore either. 84 00:09:13.480 --> 00:09:18.480 And that's because they know that they've reached this mature stable level of issuances, 85 00:09:18.480 --> 00:09:27.480 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. 86 00:09:27.480 --> 00:09:34.480 For reasons that we'll look at later, this is a very important point in the development of the fractional reserve free banking system. 87 00:09:34.480 --> 00:09:44.480 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, 88 00:09:44.480 --> 00:09:49.180 Money, what we have to look at is are there ways that banks can actually evade or get 89 00:09:49.180 --> 00:09:53.300 around this precautionary reserve requirement? Remember, the only reason banks hold on to 90 00:09:53.300 --> 00:09:57.600 precautionary reserves is to guard them against all of these redemption demands that come 91 00:09:57.600 --> 00:10:01.440 back to them in the clearing system. Well, the redemption demands, we said in the long 92 00:10:01.440 --> 00:10:04.660 run they net out to zero, so you don't actually have to hold on to anything. And it's only 93 00:10:04.660 --> 00:10:08.380 a problem in the short run because even if everybody expands in unison, remember the 94 00:10:08.380 --> 00:10:12.460 variance of all of these redemption demands increases in the short run, creating a need 95 00:10:12.460 --> 00:10:28.460 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 onto to limit these redemption demands. 96 00:10:28.460 --> 00:10:37.460 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 onto these reserves. 97 00:10:37.460 --> 00:10:47.460 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. 98 00:10:47.460 --> 00:10:53.460 The first one is through what we could call an interbank lending market, an interbank loans market. 99 00:10:53.460 --> 00:10:59.460 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. 100 00:10:59.460 --> 00:11:12.460 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. 101 00:11:12.460 --> 00:11:19.460 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. 102 00:11:19.460 --> 00:11:23.460 Or I could just hold on to that money and pyramid the money that I issue on top of it. 103 00:11:23.460 --> 00:11:27.460 It wouldn't qualify as base money. It could if I put it back into the clearing system and 104 00:11:27.460 --> 00:11:31.460 ask for base money in return, but on its own it's not really worth anything. 105 00:11:31.460 --> 00:11:36.460 It doesn't stop me from issuing money on top of it, although it's probably not likely that I would do this. 106 00:11:36.460 --> 00:11:40.460 More likely what would happen is that an interbank lending market would develop. 107 00:11:40.460 --> 00:11:45.460 Banks with excess reserves, too much, would just loan money to banks which don't have enough reserve. 108 00:11:45.460 --> 00:11:49.460 Now, you would think that this would take care of the need for precautionary reserves, right? 109 00:11:49.460 --> 00:11:54.460 In that case, even banks that have negative clearing balances, even banks that don't have enough money in their reserves, 110 00:11:54.460 --> 00:12:00.460 would still be able to issue money, because they could just borrow it from those banks which have too much in their reserves. 111 00:12:00.460 --> 00:12:06.460 In fractional reserve free banking literature, there's a thread which says, well, this is possible, but it's just not very likely. 112 00:12:06.460 --> 00:12:13.460 The reason it's not a very likely course of action is because if a bank held on to another bank's inside money, it's a big opportunity cost. 113 00:12:13.460 --> 00:12:31.460 opportunity cost. Money by definition is zero interest yielding, so you can't make any money by holding on to 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. 114 00:12:31.460 --> 00:12:38.460 Well, the fact of the matter is, if you think about how banking, about how this payment system works, it actually doesn't have an opportunity cost. 115 00:12:38.460 --> 00:12:42.460 Because in the long run, remember that your reserve balance is always net out to zero. 116 00:12:42.460 --> 00:12:44.460 All credits and all debits net out to zero. 117 00:12:44.460 --> 00:12:49.460 The money that you would have to pay if you were in a negative balance to borrow money to settle your redemption demands 118 00:12:49.460 --> 00:12:54.460 perfectly offsets in the long run the money that you would make by lending to other banks to clear their own balances. 119 00:12:54.460 --> 00:13:01.460 So in the long run, there's actually no cost for banks to organize into an interbank lending market. 120 00:13:01.460 --> 00:13:07.460 To give you some examples of these cases where they actually pop up, let's think about China today. 121 00:13:07.460 --> 00:13:10.380 Today, China has accumulated a massive amount, 122 00:13:10.380 --> 00:13:11.880 I suppose massive is a good word, 123 00:13:11.880 --> 00:13:13.900 of U.S. dollars and U.S. treasuries. 124 00:13:13.900 --> 00:13:16.060 Now they don't actually return these to the states 125 00:13:16.060 --> 00:13:18.440 in order to get base money or goods and services 126 00:13:18.440 --> 00:13:19.420 back in exchange, right? 127 00:13:19.420 --> 00:13:21.900 They hold onto them as their own reserve balances 128 00:13:21.900 --> 00:13:24.140 and then use that to pyramid their own issuance 129 00:13:24.140 --> 00:13:25.880 of inside money on top of. 130 00:13:25.880 --> 00:13:27.860 Incidentally, I don't use this as an example 131 00:13:27.860 --> 00:13:29.800 of fractional reserve free banking, 132 00:13:29.800 --> 00:13:31.900 I just use it to illustrate that the incentive structure 133 00:13:31.900 --> 00:13:35.140 actually does exist for somebody to not return money 134 00:13:35.140 --> 00:13:37.660 when it comes to them in order to get base money in return. 135 00:13:37.660 --> 00:13:40.780 A more maybe likely example or an easier example 136 00:13:40.780 --> 00:13:42.340 for most people to think of is just 137 00:13:42.340 --> 00:13:45.460 the modern banking system, let's look in the Federal Reserve, 138 00:13:45.460 --> 00:13:47.520 where there is an interbank lending market, right? 139 00:13:47.520 --> 00:13:48.940 That's what the discount window is 140 00:13:48.940 --> 00:13:50.460 or that's what the discount rate is 141 00:13:50.460 --> 00:13:51.900 for the banking system in the States. 142 00:13:51.900 --> 00:13:53.580 Banks that don't have enough reserve balances 143 00:13:53.580 --> 00:13:55.580 can borrow from other banks that have too much money 144 00:13:55.580 --> 00:13:58.580 in their reserves in order to shore up their reserves 145 00:13:58.580 --> 00:14:00.220 at the end of the day. 146 00:14:00.220 --> 00:14:02.820 These are good examples of one system or one method 147 00:14:02.820 --> 00:14:04.220 that banks can use to try to evade 148 00:14:04.220 --> 00:14:06.220 Precautionary Reserve Requirement 149 00:14:06.220 --> 00:14:08.220 Well, how else can banks get around this requirement? 150 00:14:08.220 --> 00:14:10.220 Well, think about how the clearing period works. 151 00:14:10.220 --> 00:14:12.220 It's not a long run problem, it's just a short one. 152 00:14:12.220 --> 00:14:15.220 In the long run, all of your clearing balances net out to zero. 153 00:14:15.220 --> 00:14:17.220 So you don't actually have to keep any precautionary reserves. 154 00:14:17.220 --> 00:14:20.220 It's only in the short run, with an increased variance in clearing balances, 155 00:14:20.220 --> 00:14:24.220 that you need to keep something in the vault to honor the redemption demands. 156 00:14:24.220 --> 00:14:28.220 Well, if that being as it may, one way that you could reduce the need for precautionary reserves 157 00:14:28.220 --> 00:14:30.220 is just to lengthen out your clearing period. 158 00:14:30.220 --> 00:14:33.220 If you just make it longer and longer, so you hold on to inside money 159 00:14:33.220 --> 00:14:37.900 for a longer period of time before you put it back into the payment system to be cleared, 160 00:14:37.900 --> 00:14:42.220 you should net out increasingly to zero or to 10 to zero in the long run. 161 00:14:42.220 --> 00:14:46.220 Let's look at what actually determines the optimal clearing period length. 162 00:14:46.220 --> 00:14:50.480 Well, if you shorten up the clearing period, you clear your money quicker, right? 163 00:14:50.480 --> 00:14:54.500 If you have inside money from another bank, you're returning it to that bank to get the 164 00:14:54.500 --> 00:14:57.740 base money that you want in a shorter period of time. 165 00:14:57.740 --> 00:15:01.560 For banking system, this mitigates the default risk involved because as long as you have 166 00:15:01.560 --> 00:15:09.560 If 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. 167 00:15:09.560 --> 00:15:12.560 You're really exposed to default risk in this case. 168 00:15:12.560 --> 00:15:19.560 Banks have an incentive when at increasing amounts of default risk to shorten up the clearing period in the payment system. 169 00:15:19.560 --> 00:15:26.560 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. 170 00:15:26.560 --> 00:15:29.560 The first of all is clearing costs money, right? 171 00:15:29.560 --> 00:15:33.560 To actually go through this procedure to add up all the debits and credits is costly itself. 172 00:15:33.560 --> 00:15:38.560 The second reason is the balances that you have to clear are greater in the short run than they are in the long run. 173 00:15:38.560 --> 00:15:42.560 So if you're concerned with reducing the cost of clearing, you'd lengthen out the clearing period. 174 00:15:42.560 --> 00:15:48.560 But in doing so, you also increase the default risk that you face as an individual bank in the clearing period. 175 00:15:48.560 --> 00:15:54.560 Well, what I would look at is, let's look at what happened to clearing period links throughout history. 176 00:15:54.560 --> 00:16:05.560 If the default risk of the clearing process stayed constant, you would think that banks have an incentive to start lengthening out this period, that reduces the cost of the whole clearing process. 177 00:16:05.560 --> 00:16:12.560 If history is any guide, it's that the default risk of a banking system is not constant, in some periods it's really high, in some periods it's really low. 178 00:16:12.560 --> 00:16:21.560 Incidentally, right now, the payment system in the States, the Fedwire payment system, is the large value clearing system that we have in America. 179 00:16:21.560 --> 00:16:25.260 America. It's a real-time clearing system in that when payments come into it, they are 180 00:16:25.260 --> 00:16:29.880 sequentially cleared or paid off as they come in. So there's no default risk essentially 181 00:16:29.880 --> 00:16:34.000 because they're all cleared instantaneously. One way that you can think about it right 182 00:16:34.000 --> 00:16:39.480 now, if anybody's been looking at excess reserve balances that banks have right now, part of 183 00:16:39.480 --> 00:16:44.020 it is that excess reserves allow you to actually make use of the Fedwire system. You can actually 184 00:16:44.020 --> 00:16:47.740 clear your balances instantaneously. If you had a banking system exposed to high amounts 185 00:16:47.740 --> 00:17:03.840 is to look at a historical example, when banking was first developing, as it spread over wider 186 00:17:03.840 --> 00:17:08.820 and wider geographic areas, so as money that banks were issuing, inside money, were spreading 187 00:17:08.820 --> 00:17:11.980 over wider and wider geographic areas, they were getting returned through the clearing 188 00:17:11.980 --> 00:17:13.940 system to banks. 189 00:17:13.940 --> 00:17:18.140 But if you think about it, inside money which is issued from a bank far away from you, you 190 00:17:18.140 --> 00:17:19.420 don't know that much about it. 191 00:17:19.420 --> 00:17:22.700 You don't know if the bank has prudently run, you don't know what your odds are of actually 192 00:17:22.700 --> 00:17:24.240 getting the money back. 193 00:17:24.240 --> 00:17:27.180 You would think in these systems that there's a natural incentive for the clearing period 194 00:17:27.180 --> 00:17:31.700 to start being shortened in order to compensate for the increased default risk that the growing 195 00:17:31.700 --> 00:17:33.000 banking system has. 196 00:17:33.000 --> 00:17:37.940 As it grows, there's uncertainty or at least you have less knowledge about what all the 197 00:17:37.940 --> 00:17:42.940 banks are like in this system, so you start demanding to clear this money more frequently 198 00:17:42.940 --> 00:17:47.940 There's a natural incentive for the clearing period to start shortening up over time. 199 00:17:47.940 --> 00:17:52.940 Well, at the same time, banks have an incentive to start lengthening out the clearing period, right? 200 00:17:52.940 --> 00:17:54.940 Because that starts reducing the cost of doing the process. 201 00:17:54.940 --> 00:17:57.940 So we've got two battling costs involved, or two battling incentives. 202 00:17:57.940 --> 00:18:00.940 On the one hand, you want to shorten it to get rid of the default risk. 203 00:18:00.940 --> 00:18:02.940 On the other hand, you want to reduce the cost and lengthen it. 204 00:18:02.940 --> 00:18:07.940 Even if you looked at the clearing period of a banking system, you said, oh, it's getting shorter. 205 00:18:07.940 --> 00:18:14.940 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. 206 00:18:14.940 --> 00:18:26.940 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. 207 00:18:26.940 --> 00:18:32.940 At the same time, they could be lengthening the clearing period to reduce the cost of the clearing process. 208 00:18:32.940 --> 00:18:38.940 In one example, if you think about what would happen, think about this course of events. 209 00:18:38.940 --> 00:18:42.940 If you increase the clearing period, banks are able to start issuing more inside money. 210 00:18:42.940 --> 00:18:47.940 There's a big problem if banks issue too much inside money because that breeds instability in the banking sector. 211 00:18:47.940 --> 00:18:50.940 It also potentially could trigger an Austrian business cycle. 212 00:18:50.940 --> 00:18:55.940 Well, if you breed instability in the banking sector, all of a sudden default risk increases by the banks. 213 00:18:55.940 --> 00:19:00.940 So in response, those banks which originally increased the clearing period to reduce the cost of settlement, 214 00:19:00.940 --> 00:19:15.540 The third way that banks can evade these precautionary reserves is through the actual issuance of 215 00:19:15.540 --> 00:19:17.460 inside money itself. 216 00:19:17.460 --> 00:19:23.760 As banks expand and start issuing greater and greater levels of inside money, we could 217 00:19:23.760 --> 00:19:25.340 have a boom which is propagated. 218 00:19:25.340 --> 00:19:27.100 A boom has two effects. 219 00:19:27.100 --> 00:19:30.640 On the one hand it can increase the values of assets and on the other hand it can also 220 00:19:30.640 --> 00:19:34.640 to increase the negotiability or the ease of sale of those same assets. 221 00:19:34.640 --> 00:19:39.640 Both of those can potentially allow a bank to further increase the amount of inside money that it has. 222 00:19:39.640 --> 00:19:43.640 Let's look at an increase in the value of your assets if you're a bank. 223 00:19:43.640 --> 00:19:50.640 So you issue more inside money, and as a result, the value of the assets on your balance sheet increase in value. 224 00:19:50.640 --> 00:19:56.640 Well, that increase in value on your assets then allows you to issue even more inside money, so it's a self-propagating cycle. 225 00:19:56.640 --> 00:20:26.640 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, it's a $200,000 mortgage which is then going to decline in value over the years as it's paid off. Well some banking systems do have assets that 226 00:20:26.640 --> 00:20:38.640 In my book with Philip Baggis, Deep Freeze Iceland's Economic Collapse, we document one of the peculiarities of Iceland's banking system throughout the recent crisis. 227 00:20:38.640 --> 00:20:44.640 The asset side of most banks' balance sheets in Iceland was composed of equity, stock and Icelandic companies. 228 00:20:44.640 --> 00:20:52.640 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, 229 00:20:52.640 --> 00:21:00.140 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. 230 00:21:00.140 --> 00:21:04.140 It was a self-propagating inflationary spiral. 231 00:21:04.140 --> 00:21:06.840 Now, this was a peculiarity to the Icelandic economy. 232 00:21:06.840 --> 00:21:10.540 If you take a banking system like Ireland would be a good example. 233 00:21:10.540 --> 00:21:14.540 The assets in the Icelandic banking system were more of the conventional mortgages, right? 234 00:21:14.540 --> 00:21:17.340 They're fixed in value, so you don't get this effect. 235 00:21:17.340 --> 00:21:22.540 That doesn't necessarily have to be an inflationary means that applies to all economies. 236 00:21:22.540 --> 00:21:29.540 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. 237 00:21:29.540 --> 00:21:33.540 In the inflationary boom, assets are easier to sell than they otherwise would be. 238 00:21:33.540 --> 00:21:41.540 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? 239 00:21:41.540 --> 00:21:48.540 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. 240 00:21:48.540 --> 00:22:00.540 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 onto fewer precautionary reserves as opposed to before. 241 00:22:00.540 --> 00:22:05.540 These three methods of reducing the amount of precautionary reserves that a bank is holding onto, 242 00:22:05.540 --> 00:22:18.540 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. 243 00:22:18.540 --> 00:22:25.540 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. 244 00:22:25.540 --> 00:22:32.540 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. 245 00:22:32.540 --> 00:22:37.540 Well, if banks are issuing greater amounts of inside money, the stability of such a system is called into question. 246 00:22:37.540 --> 00:22:47.540 It might not be self-stabilizing. The self-stabilizing aspect is that banks hold onto a finite amount of precautionary reserves and this limits the amount of inside money that they can issue. 247 00:22:47.540 --> 00:22:54.540 If you don't hit that limit, banks continue issuing more and more inside money and instabilities get bred. 248 00:22:54.540 --> 00:23:01.540 To have a mature or a stable fractional reserve free banking system, all three of these methods would have to be met. 249 00:23:01.540 --> 00:23:25.540 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. 250 00:23:25.540 --> 00:23:29.540 That's the first big problem that we have with a fractional reserve free banking system. 251 00:23:29.540 --> 00:23:36.040 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. 252 00:23:36.040 --> 00:23:40.040 And later on we'll look at some historical examples to illustrate how this was actually done. 253 00:23:40.040 --> 00:23:45.040 So what are some other objections that we might have with a fractional reserve free banking system? 254 00:23:45.040 --> 00:23:49.040 Well, if you're issuing inside money, you're stimulating investment, right? 255 00:23:49.040 --> 00:23:50.540 Investable funds have increased. 256 00:23:50.540 --> 00:23:56.040 And as we know, in an Austrian business cycle, one of the problems is a mismatch between the investment that's taking place 257 00:23:56.040 --> 00:24:01.040 and the supply of real savings that's available in the economy to finance these investment projects. 258 00:24:01.040 --> 00:24:09.040 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. 259 00:24:09.040 --> 00:24:15.040 We only want to issue additional amounts of inside money when the supply of real savings is increased as well. 260 00:24:15.040 --> 00:24:22.040 Now, there's a little bit of a disagreement about what savings actually are in the fractional reserve free banking literature. 261 00:24:22.040 --> 00:24:24.040 There's two ways you can really look at it. 262 00:24:24.040 --> 00:24:32.040 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. 263 00:24:32.040 --> 00:24:40.040 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. 264 00:24:40.040 --> 00:24:46.040 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. 265 00:24:46.040 --> 00:24:51.040 A more correct way to look at it is to say that the act of saving is non-consumption, right? 266 00:24:51.040 --> 00:24:55.040 You have income and whatever you don't consume is what you have available for investable funds. 267 00:24:56.080 --> 00:25:00.800 Now in most fractional reserve free banking literature, the actual form of your savings 268 00:25:00.800 --> 00:25:04.880 doesn't have any consequence on the system. To give you a good example, imagine that you had 269 00:25:04.880 --> 00:25:09.520 bought a thousand dollar bond, you held on to it for several years and then it reached maturity, 270 00:25:09.520 --> 00:25:14.000 so it was cashed out to you. You end up with a thousand dollars which you then deposit in the 271 00:25:14.000 --> 00:25:19.280 bank as a deposit. The form of savings has changed in this economy but the total level has not. 272 00:25:19.280 --> 00:25:25.280 There's still a thousand dollars of savings. It was just in the form of a bond before, and now it's in the form of a bank deposit. 273 00:25:25.280 --> 00:25:28.280 Now there's several problems with viewing savings in such a way. 274 00:25:28.280 --> 00:25:35.280 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. 275 00:25:35.280 --> 00:25:38.280 Imagine that you had a thousand dollars at home in your vault. 276 00:25:38.280 --> 00:25:47.280 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. 277 00:25:47.280 --> 00:25:51.780 The second you deposit it in the vault, it goes into the fractional reserve free banking system. 278 00:25:51.780 --> 00:25:56.580 The bank sense that there is now an increase in the reserves, but no need for that increase in reserves, 279 00:25:56.580 --> 00:25:59.780 so they issue increasing amounts of inside money against it. 280 00:25:59.780 --> 00:26:03.380 The amount of inside money is increased, but the amount of savings hasn't in the system, right? 281 00:26:03.380 --> 00:26:08.980 You've just taken a thousand dollars, which was in cash in your pocket, or in your vault at home, or any other location, 282 00:26:08.980 --> 00:26:13.780 and deposit it in the banking system, and the banking system has now increased the amount of money 283 00:26:13.780 --> 00:26:16.880 that it's issuing against that same amount of savings. 284 00:26:16.880 --> 00:26:19.380 Maybe not all savings are created equally. 285 00:26:19.380 --> 00:26:23.380 What's the difference between lending money to a company in the form of a bond 286 00:26:23.380 --> 00:26:26.380 versus depositing that money in a bank? 287 00:26:26.380 --> 00:26:30.380 Well, when you lend money to a company in the form of a bond, that company spends the money. 288 00:26:30.380 --> 00:26:33.380 Let's just assume that they use it to pay their employees. 289 00:26:33.380 --> 00:26:37.380 And those employees use that money to finance consumption expenditure. 290 00:26:37.380 --> 00:26:40.380 And the money doesn't necessarily end its way back into the bank. 291 00:26:40.380 --> 00:26:45.380 It could just continually stay in circulation, financing consumption expenditure forever. 292 00:26:45.380 --> 00:26:56.380 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? 293 00:26:56.380 --> 00:27:02.380 Once again, we have inside money increasing in issuance just because the form of savings has actually changed. 294 00:27:02.380 --> 00:27:09.380 But what's different about the actual savings? In both cases, we still have $1,000 worth of savings, whether it's in a bond or whether it's in a bank account. 295 00:27:09.380 --> 00:27:13.380 How about what it actually means to hold cash in order to save? 296 00:27:13.380 --> 00:27:18.380 Holding cash or holding inside money in a banking system is the same thing as saying you demand bank liabilities. 297 00:27:18.380 --> 00:27:22.380 Your cash is just a liability for the banking sector. 298 00:27:22.380 --> 00:27:29.380 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. 299 00:27:29.380 --> 00:27:34.380 On the first hand, you're not spending income, right? You're saving money in other words. 300 00:27:34.380 --> 00:27:41.380 At the other time, or at the same time, you are not demanding to redeem bank liabilities that you already hold on to, right? 301 00:27:41.380 --> 00:27:51.380 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. 302 00:27:51.380 --> 00:28:02.380 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 withdraw their base money from the banking system, right? 303 00:28:02.380 --> 00:28:04.600 take away one of these demands completely. 304 00:28:04.600 --> 00:28:07.420 They say anybody who holds a bank account or inside money 305 00:28:07.420 --> 00:28:10.500 doesn't want to redeem that for base money in the system. 306 00:28:10.500 --> 00:28:12.860 But in fact, of course, that is one of the main reasons 307 00:28:12.860 --> 00:28:15.560 that somebody could want to reduce their cash holding 308 00:28:15.560 --> 00:28:17.100 in the economy. 309 00:28:17.100 --> 00:28:20.420 The final problem with this savings debate is 310 00:28:20.420 --> 00:28:22.420 cash holdings, you can actually increase it 311 00:28:22.420 --> 00:28:24.700 not by necessarily increasing your savings 312 00:28:24.700 --> 00:28:26.820 or your real savings, but just by divesting 313 00:28:26.820 --> 00:28:28.500 in real investment projects. 314 00:28:28.500 --> 00:28:39.500 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. 315 00:28:39.500 --> 00:28:44.500 So every year you end up with $100, but you have to replace one of those machines to save it. 316 00:28:44.500 --> 00:28:51.500 Of that $100, let's say that you consume $50 and you spend, you save or reinvest $50 every year. 317 00:28:51.500 --> 00:28:54.500 So we're in some equilibrium where there's no cash holdings. 318 00:28:54.500 --> 00:28:58.340 and then let's say that one year for whatever reason your uncertainty increases 319 00:28:58.340 --> 00:29:01.540 so you start reinvesting only thirty dollars of that hundred 320 00:29:01.540 --> 00:29:05.180 let's say that your consumption stays the exact same so you still consume fifty 321 00:29:05.180 --> 00:29:08.900 you buy a smaller machine and you only save or reinvest thirty dollars 322 00:29:08.900 --> 00:29:11.780 now you have some cash holdings of twenty dollars right 323 00:29:11.780 --> 00:29:15.260 what's actually happened in the system well evidently enough cash holdings have 324 00:29:15.260 --> 00:29:18.380 increased they increased from zero to twenty dollars 325 00:29:18.380 --> 00:29:19.420 not surprising 326 00:29:19.420 --> 00:29:22.420 what happened to inflation well consumption prices 327 00:29:22.420 --> 00:29:27.220 have risen relative to prices in the higher orders of production. 328 00:29:27.220 --> 00:29:32.420 And the reason that is, is because consumption expenditure has risen relative 329 00:29:32.420 --> 00:29:37.500 to saving or investment expenditure, right? We must have a relative inflation happening 330 00:29:37.500 --> 00:29:39.380 on the consumption side of things. 331 00:29:39.380 --> 00:29:42.340 There's fewer goods available to sustain the structure of production, right? We've 332 00:29:42.340 --> 00:29:46.480 only reinvested thirty dollars, so we only have savings of thirty dollars in the system. 333 00:29:46.480 --> 00:29:50.540 Time preference must have necessarily increased, and the capital structure is also 334 00:29:50.540 --> 00:29:54.820 less intensive than it was before. 335 00:29:54.820 --> 00:29:59.140 How does a fractional reserve free banking system respond to such an event? 336 00:29:59.140 --> 00:30:02.340 Well, the amount of reserves that they have has increased, right? 337 00:30:02.340 --> 00:30:04.700 The cash holdings has increased by $20. 338 00:30:04.700 --> 00:30:09.020 So if cash holdings have increased, the banking system takes this as a sign that there is 339 00:30:09.020 --> 00:30:13.420 a decreased demand, an increased demand to hold onto cash and they start issuing more 340 00:30:13.420 --> 00:30:15.140 inside money against it. 341 00:30:15.140 --> 00:30:19.980 Well that inside money is being loaned out in order to finance investment activity. 342 00:30:19.980 --> 00:30:23.420 Well, if it's financing investment activity, we have a little bit of a disconnect, right? 343 00:30:23.420 --> 00:30:27.820 Cash holdings actually increased because people wanted to invest less, and the banking system 344 00:30:27.820 --> 00:30:31.700 has now responded by promoting more investment activity. 345 00:30:31.700 --> 00:30:37.080 It doesn't seem to make sense with what people originally wanted their increased cash holdings 346 00:30:37.080 --> 00:30:39.840 to actually finance. 347 00:30:39.840 --> 00:30:43.500 Another problem that we might look at is asking the question, can a fractional reserve free 348 00:30:43.500 --> 00:30:47.460 banking as it issues inside money against base money, actually get the money to where 349 00:30:47.460 --> 00:30:48.460 it's needed? 350 00:30:48.460 --> 00:30:53.460 Now, it's never a problem for a bank to sense if there's an increased demand for money, right? 351 00:30:53.460 --> 00:30:59.460 As velocity slows, the clearing system slows down, asking for redemption demands for base money, 352 00:30:59.460 --> 00:31:03.460 so banks can issue more and more inside money against it. That's not problematic for a bank to detect. 353 00:31:03.460 --> 00:31:08.460 It is problematic for a bank to try to detect where that money is actually supposed to go. 354 00:31:08.460 --> 00:31:12.460 In fact, one way to look at it is to say this is just a bank's job, their financial intermediaries. 355 00:31:12.460 --> 00:31:18.460 Their job is just to take money in and then find out the best place to possibly loan it on risk-adjusted terms. 356 00:31:18.460 --> 00:31:21.460 They just look for the very best bet that they possibly can. 357 00:31:21.460 --> 00:31:24.460 Well, what happens when you increase your cash holdings? 358 00:31:24.460 --> 00:31:27.460 There's actually two things that you're doing at the same time. 359 00:31:27.460 --> 00:31:32.460 Anytime you increase your cash holdings, you're aiming to increase your real cash balances, 360 00:31:32.460 --> 00:31:37.460 your price-adjusted amount of savings, or cash holdings rather. 361 00:31:37.460 --> 00:31:41.460 When you curtail your consumption and you start holding a greater cash balance, 362 00:31:41.460 --> 00:31:45.460 In cash balance, you've increased the nominal units of cash balance that you have, right? 363 00:31:45.460 --> 00:31:48.460 There's more money units sitting in your bank account than there was previously. 364 00:31:48.460 --> 00:31:53.460 But at the same time, if you're not consuming them, you also end up with some downward pressure on the price level, 365 00:31:53.460 --> 00:31:55.460 and that's increasing further your real cash balance. 366 00:31:55.460 --> 00:31:57.460 The two effects reinforce one another. 367 00:31:57.460 --> 00:32:00.460 You save more money or you hold a greater amount of nominal cash units, 368 00:32:00.460 --> 00:32:07.460 and as prices fall, that further increases the real value of that cash balance. 369 00:32:07.460 --> 00:32:14.460 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. 370 00:32:14.460 --> 00:32:18.460 So why don't we take it to the bank and see what happens? The second you see what happens, rather. 371 00:32:18.460 --> 00:32:25.460 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. 372 00:32:25.460 --> 00:32:28.460 The interesting thing is what happens to that inside money, who actually gets it? 373 00:32:28.460 --> 00:32:33.460 Well, they have to loan it out to somebody or they have to find somebody to actually take on that inside money. 374 00:32:33.460 --> 00:32:36.460 That person that takes the inside money is going to have to spend it. 375 00:32:36.460 --> 00:32:40.460 They might not spend it on something which is going to benefit you in any way. 376 00:32:40.460 --> 00:32:44.460 In fact, they're probably going to spend it in a way which increases the general price level. 377 00:32:44.460 --> 00:32:49.460 And if the price level goes up because they're spending money, that has all of a sudden reduced your real cash balance. 378 00:32:49.460 --> 00:32:52.460 They've done something which has frustrated your original goal, right? 379 00:32:52.460 --> 00:32:56.460 You saved money in a bid to try to get a set amount of real cash balance. 380 00:32:56.460 --> 00:33:01.460 And then somebody has spent that money because it's been reissued through the fractional reserve free banking system 381 00:33:01.460 --> 00:33:06.820 system to cause the price level to go up which in turn reduced your real cash balance. 382 00:33:06.820 --> 00:33:10.820 Your original impetus has been frustrated as the case may be. 383 00:33:10.820 --> 00:33:13.780 Here's maybe a better example for the investors in the room. 384 00:33:13.780 --> 00:33:16.700 Think about an investor who one day looks at the market and thinks that the market is 385 00:33:16.700 --> 00:33:21.380 overbought and in return they decide to cash out some of their equities, convert the money 386 00:33:21.380 --> 00:33:24.500 into cash and deposit it in their bank and then maybe they'll get back in the market 387 00:33:24.500 --> 00:33:28.220 once they think that it's gone down to a reasonable level. 388 00:33:28.220 --> 00:33:31.260 Now you cash out your equities, you take the cash, you deposit it in the bank. 389 00:33:31.260 --> 00:33:33.020 The bank sees its reserves go up. 390 00:33:33.020 --> 00:33:34.020 What does it do in response? 391 00:33:34.020 --> 00:33:36.220 It issues inside money against this. 392 00:33:36.220 --> 00:33:40.660 Now let's assume that inside money is borrowed from somebody and used to finance stock speculation. 393 00:33:40.660 --> 00:33:43.200 Now you've got an increase in equity prices. 394 00:33:43.200 --> 00:33:45.980 The original reason that you cashed out your equity has been frustrated. 395 00:33:45.980 --> 00:33:49.620 Notice it doesn't necessarily have to be an absolute increase in equity prices. 396 00:33:49.620 --> 00:33:53.060 It's probably gone down because you've withdrawn money and then it's only gone up a little 397 00:33:53.060 --> 00:33:56.460 bit because somebody else has reinvested that money in it. 398 00:33:56.460 --> 00:34:06.460 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. 399 00:34:06.460 --> 00:34:15.460 But through the fiduciary abilities of the fractional reserve free banking system, we've actually put upward pressure on the prices of equities and frustrated your effort in the first place. 400 00:34:15.460 --> 00:34:24.460 We have a disconnect between what people are actually doing by increasing their cash balances and the results that the fractional reserve free banking system actually breeds. 401 00:34:24.460 --> 00:34:29.020 Now, these examples, they're really just indicative of maybe a wider problem. 402 00:34:29.020 --> 00:34:33.980 The wider problem has to do with what some of the macroeconomic effects of fractional 403 00:34:33.980 --> 00:34:36.460 reserve free banking actually are. 404 00:34:36.460 --> 00:34:39.900 The idea of fractional reserve free banking is fairly simple to understand if we just 405 00:34:39.900 --> 00:34:44.260 maybe look at the equation of exchange here. 406 00:34:44.260 --> 00:34:49.580 Money times its velocity is equal to prices times real GDP or number of transactions or 407 00:34:49.580 --> 00:34:51.020 however you want to actually reckon y. 408 00:34:51.020 --> 00:34:52.020 Why? 409 00:34:52.020 --> 00:34:55.340 Well, let's assume that the price level is sticky or fixed in place. 410 00:34:55.340 --> 00:34:58.380 In the short run, it seems to be a decent assumption, right? 411 00:34:58.380 --> 00:35:01.820 Prices don't instantaneously fall down or at least they don't necessarily always fall 412 00:35:01.820 --> 00:35:02.820 down. 413 00:35:02.820 --> 00:35:07.580 Well, in response, if you have a banking system that sees changes in velocity, decreases or 414 00:35:07.580 --> 00:35:11.340 increases, if P can't adjust and you don't do anything to the money supply, all of a 415 00:35:11.340 --> 00:35:14.200 sudden Y is going to have to be the variable that adjusts. 416 00:35:14.200 --> 00:35:18.340 If you had a decrease in the velocity of money, this would translate into a decrease in real 417 00:35:18.340 --> 00:35:21.900 and Real GDP, or a decrease in real incomes. 418 00:35:21.900 --> 00:35:26.780 As a result, fractional reserve free bankers, they base at least part of their theory on 419 00:35:26.780 --> 00:35:31.340 this whole idea that we should alter the money supply to offset changes in the velocity of 420 00:35:31.340 --> 00:35:36.260 money in order to maintain nominal spending or nominal output, the right-hand side of 421 00:35:36.260 --> 00:35:38.020 that equation. 422 00:35:38.020 --> 00:35:42.580 There's important differences maybe between what free bankers are saying are going to 423 00:35:42.580 --> 00:35:46.500 happen in this equation of exchange and what we might expect to happen. 424 00:35:46.500 --> 00:35:51.600 In particular, we might look if this is a consistent story with Austrian business cycle. 425 00:35:51.600 --> 00:35:58.600 Some free bankers, or fractional reserve free bankers, I should say, allege that 100% reservers 426 00:35:58.600 --> 00:36:00.900 can't have their cake and eat it too. 427 00:36:00.900 --> 00:36:05.160 And by this they mean that a price level can't be sufficiently flexible to allow monetary 428 00:36:05.160 --> 00:36:11.060 expansion to cause relative price maladjustments and ensuing business cycles, and also maintain 429 00:36:11.060 --> 00:36:16.420 at the same time that the price level is sufficiently flexible that it would offset changes in velocity 430 00:36:16.420 --> 00:36:20.460 in order to maintain nominal expenditure. 431 00:36:20.460 --> 00:36:24.180 Yet there's important differences between the Austrian business cycle theory 432 00:36:24.180 --> 00:36:28.300 and this monetary equilibrium theory, the use of 433 00:36:28.300 --> 00:36:31.780 the equation of exchange that we should know. The first is just looking at the 434 00:36:31.780 --> 00:36:34.940 price level. What actual price level are we concerned with? 435 00:36:34.940 --> 00:36:38.340 Well, the Austrian business cycle theory never says anything about this capital P 436 00:36:38.340 --> 00:36:41.580 up here, capital P being the general price level that pervades throughout the 437 00:36:41.580 --> 00:36:42.460 economy. 438 00:36:42.460 --> 00:36:46.020 Austrian business cycle theory is of course concerned with all of the little or 439 00:36:46.020 --> 00:36:57.020 is concerned with the relative misadjustments or mispricings of all of those lowercase P's or individual prices. 440 00:36:57.020 --> 00:37:03.020 Monetary equilibrium theorem and fractional reserve free bankers as a consequence are really concerned with the general price level. 441 00:37:03.020 --> 00:37:09.020 They're concerned with changing the money supply to offset changes in P because that general price level is fixed in place. 442 00:37:09.020 --> 00:37:12.020 But nobody says anything about the price level being fixed in place. 443 00:37:12.020 --> 00:37:15.020 Nowhere in the Austrian business cycle do we rely on this. 444 00:37:15.020 --> 00:37:23.020 We only rely on prices not perfectly adjusting or getting out of sync with one another. 445 00:37:23.020 --> 00:37:33.020 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? 446 00:37:33.020 --> 00:37:39.020 If a fractional reserve free banking system has the ability to over-issue inside money, and we already explained why that is, 447 00:37:39.020 --> 00:37:46.020 I don't know why that is. There's the three reasons that a bank can expand inside money beyond what its precautionary reserves would normally allow for. 448 00:37:46.020 --> 00:37:52.020 Then all of a sudden you have financial or banking instability, right? Or banking crises even, if you will. 449 00:37:52.020 --> 00:38:01.020 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. 450 00:38:01.020 --> 00:38:08.020 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? 451 00:38:08.020 --> 00:38:16.020 When you're uncertain or when you're in an uncertain economic atmosphere, you increase your demand to hold on to money or your cash balances as a response. 452 00:38:16.020 --> 00:38:22.020 Now as a result, entrepreneurs in a fractional reserve free banking system have a different variable to pay attention to. 453 00:38:22.020 --> 00:38:28.020 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. 454 00:38:28.020 --> 00:38:34.020 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. 455 00:38:34.020 --> 00:38:42.020 What about the actual forces that are in play in this monetary equilibrium theory versus in the Austrian business cycle? 456 00:38:42.020 --> 00:38:49.020 In monetary equilibrium theory, we have a real force at play, and the real force is the stickiness of that price level, right? 457 00:38:49.020 --> 00:38:56.020 The idea that prices are downward, sticky or rigid, so that they don't instantaneously adjust to offset changes in the velocity of money. 458 00:38:56.020 --> 00:39:01.020 In the Austrian business cycle theory, the forces that we're dealing with are mostly illusory. 459 00:39:01.020 --> 00:39:05.020 They're illusory in the sense that they're profits that we think are there that are actually not. 460 00:39:05.020 --> 00:39:12.020 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, 461 00:39:12.020 --> 00:39:19.020 the discount rate that you're using to determine the present value of long-dated projects is going to be decreased, 462 00:39:19.020 --> 00:39:23.020 and if you decrease the discount rate, you increase the present value of these projects. 463 00:39:23.020 --> 00:39:29.020 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. 464 00:39:29.020 --> 00:39:39.020 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. 465 00:39:39.020 --> 00:39:50.020 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. 466 00:39:50.020 --> 00:40:00.020 There are a couple of good examples of this in literature. Jesus Huerta de Soto, as far back as 1998, fit an Austrian business cycle into a prisoner's dilemma scenario. 467 00:40:00.020 --> 00:40:09.020 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 for gain and they lose relative profits. 468 00:40:09.020 --> 00:40:17.020 This is formalized a little bit later in a formal prisoner's dilemma scenario by Tony Corelli and Greg Dempster, if anybody is interested. 469 00:40:17.020 --> 00:40:23.020 The last big problem that I want to talk about is the incentive structure that actually gets created through the fractional reserve free banking system. 470 00:40:23.020 --> 00:40:29.020 Now, the whole reason you would put it in place is because you have a problem with central banking and you want to get rid of that problem. 471 00:40:29.020 --> 00:40:39.020 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. 472 00:40:39.020 --> 00:40:43.020 You've maybe offset a central bank for a couple of years until it gets created. 473 00:40:43.020 --> 00:40:47.740 What I want to show here is that the fractional reserve free banking system definitely does 474 00:40:47.740 --> 00:40:52.540 create the incentive structure to create a central bank, or at least in some places. 475 00:40:52.540 --> 00:40:53.540 How do central banks emerge? 476 00:40:53.540 --> 00:40:56.260 There are a couple of different theories we can look at this. 477 00:40:56.260 --> 00:41:00.060 Fractional reserve free bankers seem to favour the theory that the emergence of a central 478 00:41:00.060 --> 00:41:02.720 bank is in response to the fiscal needs of a state. 479 00:41:02.720 --> 00:41:04.160 This is evident in several countries. 480 00:41:04.160 --> 00:41:06.980 The creation of the Bank of England is a really good example. 481 00:41:06.980 --> 00:41:11.660 The King of England needed money to finance wars, he was unable to raise it on his own, 482 00:41:11.660 --> 00:41:17.660 So he monopolized or created the Bank of England in order to finance his campaigns. 483 00:41:17.660 --> 00:41:21.440 What we offer here, what I'm going to offer you, is an endogenous theory of central bank 484 00:41:21.440 --> 00:41:25.860 creation set up by two sets of clearly defined incentives. 485 00:41:25.860 --> 00:41:30.020 The first set of incentives is, all of your banks within the fractional reserve free banking 486 00:41:30.020 --> 00:41:34.300 system, they all want to expand in unison, this in concert expansion that allows them 487 00:41:34.300 --> 00:41:36.420 to issue increasing amounts of inside money. 488 00:41:36.420 --> 00:41:39.540 And we said there's three ways that they can do this to get around their precautionary 489 00:41:39.540 --> 00:41:51.540 set up an inter-bank loans market, lengthen out the clearing period of the payment system, or endogenously increase the negotiability of the assets through an inflationary process. 490 00:41:51.540 --> 00:42:03.540 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. 491 00:42:03.540 --> 00:42:10.540 In other words, we need somebody to ensure that everybody expands or increases their money supply at the exact same rate. 492 00:42:10.540 --> 00:42:17.540 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. 493 00:42:17.540 --> 00:42:22.540 If you think about an over issuance of inside money, which we said is possible, that breeds banking crises, 494 00:42:22.540 --> 00:42:28.540 which then are problematic for depositors that aren't able to get all of the base money they originally deposited in the banking system. 495 00:42:28.540 --> 00:42:36.540 As a result, we have a need or a desire to implement a central bank in order to honor these deposits. 496 00:42:36.540 --> 00:42:40.340 There's two key differences between these two incentives. 497 00:42:40.340 --> 00:42:41.740 The first is in who demands them. 498 00:42:41.740 --> 00:42:46.840 In the first case, the actual bankers of the fractional reserve free banking system demanded the coordinating agent. 499 00:42:46.840 --> 00:42:53.140 In the latter case, depositors who were suffering the consequences of an unstable banking system 500 00:42:53.140 --> 00:42:55.840 demanded a central bank to protect their deposits. 501 00:42:55.840 --> 00:43:01.080 In the first case, the central bank was demanded to be the coordinating agent, to make sure everybody played by the same rules. 502 00:43:01.080 --> 00:43:08.480 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, 503 00:43:08.480 --> 00:43:13.680 so that depositors wouldn't lose any of the cash that they deposited in them originally. 504 00:43:13.680 --> 00:43:22.520 Because central banks can be notoriously difficult to define, what I want you to do is think in your mind of a spectrum. 505 00:43:22.520 --> 00:43:39.520 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. 506 00:43:39.520 --> 00:43:51.520 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 grey skies. 507 00:43:51.520 --> 00:44:21.520 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 508 00:44:21.520 --> 00:44:26.920 Banking System, and eventually turns itself into the central bank as the case may be. 509 00:44:26.920 --> 00:44:31.680 One long-standing theory by Gary Gorton for the emergence of the Fed in the States or 510 00:44:31.680 --> 00:44:35.760 the general emergence of a central, well, the specific emergence of the Fed in the States 511 00:44:35.760 --> 00:44:39.200 saw it as just the nationalization of the private clearing system. 512 00:44:39.200 --> 00:44:42.880 In fact, many of the Fed's functions today can be directly traced back to the functions 513 00:44:42.880 --> 00:44:47.600 that the private clearing system in the States had under its free banking period. 514 00:44:47.600 --> 00:44:52.040 The biggest similarity that we could maybe see is the use of the discount window and 515 00:44:52.040 --> 00:44:56.920 the discount rate today in the Fed, which evidently is a little bit less used now with 516 00:44:56.920 --> 00:45:01.440 the increase in excess reserves that the banking system has compared to several years ago, 517 00:45:01.440 --> 00:45:05.480 but is still an important feature of the Federal Reserve nonetheless. 518 00:45:05.480 --> 00:45:10.960 The use of the discount window was actually first used in the Panic of 1857, which was 519 00:45:10.960 --> 00:45:13.320 during the period of free banking in the States. 520 00:45:13.320 --> 00:45:18.400 There was a banking panic when depositors increased their demand for redemptions of 521 00:45:18.400 --> 00:45:19.960 base money from the banking system. 522 00:45:19.960 --> 00:45:23.000 The fractional reserve free banking system didn't have enough base money to honour all 523 00:45:23.000 --> 00:45:24.600 of these redemption demands. 524 00:45:24.600 --> 00:45:30.060 So in response the private clearinghouse system under the free banking regime in the States 525 00:45:30.060 --> 00:45:36.080 issued what we would call clearinghouse loan certificates to aid in this process. 526 00:45:36.080 --> 00:45:39.880 The problem really was that there wasn't enough base money to go around to offset all of the 527 00:45:39.880 --> 00:45:42.240 demands for inside money in the system. 528 00:45:42.240 --> 00:45:44.940 Well, the demand for base money in the system came from two forms. 529 00:45:44.940 --> 00:45:49.120 One was from depositors cashing in their deposits to take out base money. 530 00:45:49.120 --> 00:45:52.120 The other was the need for base money in the clearing system itself, right? 531 00:45:52.120 --> 00:45:55.880 Banks were sending back their inside money to their banks of issuers and in return had 532 00:45:55.880 --> 00:45:58.640 to pay base money to settle these claims. 533 00:45:58.640 --> 00:46:02.280 Well the clearinghouse system ended up issuing loan certificates. 534 00:46:02.280 --> 00:46:06.400 These were loans which were collateralized or backed by banking assets that the system 535 00:46:06.400 --> 00:46:07.640 had. 536 00:46:07.640 --> 00:46:10.680 And banks were allowed to use these in the payments or the settlement system. 537 00:46:10.680 --> 00:46:17.540 So they no longer had to use base money, they were allowed to use these loan certificates 538 00:46:17.540 --> 00:46:20.460 in order to settle their claims just as well. 539 00:46:20.460 --> 00:46:23.740 In this way, the clearinghouse loan certificates were an easy way for the banking system to 540 00:46:23.740 --> 00:46:29.900 economize on the amount of scarce reserves that it had and in order to allow bank depositors 541 00:46:29.900 --> 00:46:34.400 the ability to continue withdrawing base money from the system. 542 00:46:34.400 --> 00:46:36.840 There was also a risk sharing agreement which was achieved. 543 00:46:36.840 --> 00:46:41.780 If one bank failed in the system, all of the other banks would share this loss relative 544 00:46:41.780 --> 00:46:44.560 to the amount of remaining capital that they had. 545 00:46:44.560 --> 00:46:50.480 This risk-sharing agreement was a form of agreement to offset any losses that one bank 546 00:46:50.480 --> 00:46:52.280 might have in this system. 547 00:46:52.280 --> 00:46:56.180 There's some important notes that we should make about this use of clearinghouse certificates 548 00:46:56.180 --> 00:46:58.180 in 1857. 549 00:46:58.180 --> 00:47:04.400 The free banking period in the States was the period defined as 1837 to 1862, that 25-year 550 00:47:04.400 --> 00:47:05.400 span. 551 00:47:05.400 --> 00:47:12.400 Section 57 is evidently at the tail end of this period. It's in the free banking period, but only at the very end of it. 552 00:47:12.400 --> 00:47:18.400 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. 553 00:47:18.400 --> 00:47:24.400 All demand for money has to be the demand for inside money only. So no bank should actually have to hold on to any of this base money. 554 00:47:24.400 --> 00:47:31.400 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. 555 00:47:31.400 --> 00:47:36.760 It wasn't caused by the Civil War because that wasn't until four years later, right? 1861. 556 00:47:36.760 --> 00:47:47.480 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. 557 00:47:47.480 --> 00:48:00.280 1857 is 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. 558 00:48:00.280 --> 00:48:04.600 Well, as panics continued, all of a sudden there was further needs to economize on the 559 00:48:04.600 --> 00:48:07.600 scarce amount of base money in the system. 560 00:48:07.600 --> 00:48:11.800 It was no longer apparent that the banking system could remain solvent or liquid just 561 00:48:11.800 --> 00:48:15.640 by using clearinghouse loan certificates in the clearing system. 562 00:48:15.640 --> 00:48:19.460 They also needed to issue them to the general public so that the public would not be withdrawing 563 00:48:19.460 --> 00:48:20.680 base money from the system. 564 00:48:20.680 --> 00:48:23.120 You had to get rid of this demand as well. 565 00:48:23.120 --> 00:48:28.420 As the case may be, later on in the banking panics of 1893 and 1907, these clearinghouse 566 00:48:28.420 --> 00:48:40.420 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. 567 00:48:40.420 --> 00:48:55.420 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. 568 00:48:55.420 --> 00:48:56.420 Banking. 569 00:48:56.420 --> 00:48:59.860 Now, if we looked at the mature free banking system, how many years do you think we need 570 00:48:59.860 --> 00:49:03.580 to give it in order for it to reach its long-term stable situation? 571 00:49:03.580 --> 00:49:07.740 I would suspect that 20 years of free banking is a sufficient period of time for this mature 572 00:49:07.740 --> 00:49:11.660 free banking system to emerge where we no longer have this demand for base money any 573 00:49:11.660 --> 00:49:14.860 longer. 574 00:49:14.860 --> 00:49:19.660 In the panic of 1857, just to revisit it, there was a prominent bank that failed and 575 00:49:19.660 --> 00:49:23.340 a massive drain on reserves that actually necessitated the need for these clearing house 576 00:49:23.340 --> 00:49:24.340 certificates. 577 00:49:24.340 --> 00:49:34.340 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. 578 00:49:34.340 --> 00:49:39.340 This is the rational response, and it's what most free banking theory would actually suggest should happen. 579 00:49:39.340 --> 00:49:49.340 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, 580 00:49:49.340 --> 00:49:53.980 together, put it at the disposal of the clearinghouse system in order to allocate to maintain liquidity 581 00:49:53.980 --> 00:49:55.140 among all the banks. 582 00:49:55.140 --> 00:49:58.780 Now obviously strong banks in the system didn't like this idea, they were being punished for 583 00:49:58.780 --> 00:50:00.180 being prudent. 584 00:50:00.180 --> 00:50:04.180 Weak banks in the system did like this idea because they were being kept afloat at the 585 00:50:04.180 --> 00:50:06.540 expense of the stronger banks. 586 00:50:06.540 --> 00:50:10.060 It was voluntarily agreed upon despite the fact that the stronger banks didn't like it 587 00:50:10.060 --> 00:50:12.620 because it did benefit everybody at the end of the day. 588 00:50:12.620 --> 00:50:17.280 The way it benefited them was it allowed the banking system to continue issuing greater 589 00:50:17.280 --> 00:50:25.200 levels of inside money and the inflationary gains that would come from it. 590 00:50:25.200 --> 00:50:30.640 One notable feature of this reserve pooling fund was if we compare it, and remember it 591 00:50:30.640 --> 00:50:34.000 happened under a regime of free banking in America, to the central banking schemes that 592 00:50:34.000 --> 00:50:38.960 existed in Europe at the time, at the exact same time, it was a much stronger, more centralized 593 00:50:38.960 --> 00:50:42.720 system than anything that occurred in Europe over that same time period. 594 00:50:42.720 --> 00:50:46.360 The pooling of reserves and the risk-sharing agreements that were in place in America in 595 00:50:46.360 --> 00:50:53.060 1857 were a more centralized and a more closer approximation to what we would consider a 596 00:50:53.060 --> 00:50:57.620 central bank than even the official central banks operating in Europe at the exact same 597 00:50:57.620 --> 00:51:00.420 time had actually implemented. 598 00:51:00.420 --> 00:51:06.480 In fact, there's interesting quotes in historians of banking theory, here's a quote from Cannon. 599 00:51:06.480 --> 00:51:11.120 Clearing houses became instruments for united actions among the banks in ways that did 600 00:51:11.120 --> 00:51:15.960 did not exist even in the imagination of those who were instrumental in their inception. 601 00:51:15.960 --> 00:51:21.000 It's not that banking system necessarily wanted to approximate a central banking system. 602 00:51:21.000 --> 00:51:25.420 It's that the incentive structure that it created bred a closer approximation to a central 603 00:51:25.420 --> 00:51:29.320 banking system to emerge. 604 00:51:29.320 --> 00:51:33.080 Whether the banking system, the free banking system liked it or not, the clearinghouse 605 00:51:33.080 --> 00:51:36.960 increasingly took on roles that more closely approximated a central bank in ways that 606 00:51:36.960 --> 00:51:38.840 they didn't even foresee. 607 00:51:38.840 --> 00:51:53.840 Incidentally, 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. 608 00:51:53.840 --> 00:51:59.840 This is putting a redemption on the amount of base money that you can withdraw from the banking system. 609 00:51:59.840 --> 00:52:05.840 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? 610 00:52:05.840 --> 00:52:17.840 In America, it was unique because there was a withdrawal on redemptions or the use of clearing house 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. 611 00:52:17.840 --> 00:52:26.840 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. 612 00:52:26.840 --> 00:52:31.840 Well, if you think about how depositors felt about all this, they were starting to get a little bit upset. 613 00:52:31.840 --> 00:52:37.840 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. 614 00:52:37.840 --> 00:52:39.840 So what do you think they started calling for? 615 00:52:39.840 --> 00:52:49.840 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. 616 00:52:49.840 --> 00:52:58.840 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? 617 00:52:58.840 --> 00:53:11.840 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. 618 00:53:11.840 --> 00:53:18.840 In America, the implementation of the clearinghouse as a private lender of last resort really solved two problems. 619 00:53:18.840 --> 00:53:24.840 One was it solved the problem of suspending convertibility of bank deposits into base money, and second, it solved an important legal issue. 620 00:53:24.840 --> 00:53:31.840 In America, the suspension of payments was actually considered illegal and amounted to default under banking law at the time. 621 00:53:31.840 --> 00:53:42.840 The final stage on the road to actually developing a central bank, and the last one I want to look at, is creating a central bank as a regulator of the banking system. 622 00:53:42.840 --> 00:53:54.840 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. 623 00:53:54.840 --> 00:54:03.840 Or if they have money there and the bank is not acting prudently, they make their withdrawals, which causes a drain on reserves and causes the bank to change its lending behaviour. 624 00:54:03.840 --> 00:54:09.840 As soon as you implement a lender of last resort in a banking system, you take away this regulatory role from depositors. 625 00:54:09.840 --> 00:54:15.840 role from depositors. No depositor has an incentive anymore to monitor the solvency or liquidity position of their own bank. 626 00:54:15.840 --> 00:54:25.840 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 portfolios. 627 00:54:25.840 --> 00:54:33.840 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. 628 00:54:33.840 --> 00:54:40.840 in the last resort. Now, more commonly we think of this regulatory role as being caused by the advent of deposit insurance, right? 629 00:54:40.840 --> 00:54:47.840 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. 630 00:54:47.840 --> 00:55:01.840 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. 631 00:55:01.840 --> 00:55:17.840 By the time the Fed was actually developed, let's say 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. 632 00:55:17.840 --> 00:55:27.840 It had gradually, continually progressed from a free banking system, and because of the instabilities that it had endogenously bred, it continued to alter itself until it more closely approximated a central bank. 633 00:55:27.840 --> 00:55:34.840 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. 634 00:55:34.840 --> 00:55:44.840 In fact, we have a quote on the Congressional Record, and this is from the Senate sponsor during the creation of the Federal Reserve, Robert Owen, who states, and I quote, 635 00:55:44.840 --> 00:55:49.680 Quote, this bill, for the most part, is merely putting into legal shape that which hitherto 636 00:55:49.680 --> 00:55:51.840 has been illegally done. 637 00:55:51.840 --> 00:55:55.220 The creators of the Federal Reserve actually didn't think that they were creating something 638 00:55:55.220 --> 00:55:59.600 which was a difference of kind, only a difference of magnitude. 639 00:55:59.600 --> 00:56:03.440 The key difference that Robert Owen talks about was the monopoly of note issuance, which 640 00:56:03.440 --> 00:56:08.960 incidentally didn't occur under the private clearinghouse system that existed in the States 641 00:56:08.960 --> 00:56:12.260 prior to the creation of the Federal Reserve. 642 00:56:12.260 --> 00:56:16.140 The monopoly on the issuance of currency is a very important stage that we have to explain 643 00:56:16.140 --> 00:56:19.620 because that's one of the key features that defines the Federal Reserve or any central 644 00:56:19.620 --> 00:56:22.100 bank in the modern world. 645 00:56:22.100 --> 00:56:26.300 Well, what we really have to look at is the stakeholders involved in the creation of the 646 00:56:26.300 --> 00:56:30.260 Fed and the incentive structure that all three of them faced. 647 00:56:30.260 --> 00:56:31.260 Depositors first. 648 00:56:31.260 --> 00:56:32.500 Depositors make up the majority of voters. 649 00:56:32.500 --> 00:56:38.160 In fact, I'm going to guess that every single voter is also a cash depositor somewhere. 650 00:56:38.160 --> 00:56:42.760 People were retiring, or getting tired rather, of the fact that there was a suspension of 651 00:56:42.760 --> 00:56:46.520 payments and they weren't able to withdraw base money from the banking system. 652 00:56:46.520 --> 00:56:50.440 They called on a lender of last resort or somebody with a monopoly on note issuance 653 00:56:50.440 --> 00:56:55.500 to shore up their banks to make sure they could always get base money out of the system. 654 00:56:55.500 --> 00:56:58.920 Banks had the incentive to have a coordinator to make sure that they all played by the rules 655 00:56:58.920 --> 00:57:03.180 to benefit everybody together and not just benefit any individual bank. 656 00:57:03.180 --> 00:57:06.740 They saw a central bank as the creator of this coordinating force, somebody that would 657 00:57:06.740 --> 00:57:13.740 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 a central bank. 658 00:57:36.740 --> 00:57:42.620 to Law. If you think about it, the behavior that the fractional reserve free banking system 659 00:57:42.620 --> 00:57:48.180 actually utilized is a little bit like a cartel. Now cartels are inherently unstable, right? 660 00:57:48.180 --> 00:57:52.200 Nobody thinks that cartels can last forever. Murray Rothbard, in the back of Man Economy 661 00:57:52.200 --> 00:57:57.020 and State, has an interesting little part where he says, if a cartel is unstable, what 662 00:57:57.020 --> 00:58:00.620 is the cartel supposed to do, or what are they going to do? And the answer that Rothbard 663 00:58:00.620 --> 00:58:04.640 gives is, they monopolize themselves. Instead of having multiple companies all operating 664 00:58:04.640 --> 00:58:25.640 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 node issuance, or the central bank, the Federal Reserve, in order to stabilize that cartel. 665 00:58:25.640 --> 00:58:28.640 I want to just end where I start. 666 00:58:28.640 --> 00:58:40.640 On the one hand, I think they're trivial because many of the objections should be second-hat to all of us. 667 00:58:40.640 --> 00:58:47.640 The idea that the price level overall is not what matters but the relative price adjustments, 668 00:58:47.640 --> 00:58:51.640 that's something that all Austrians always know or second-hat to us. 669 00:58:51.640 --> 00:58:55.640 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 670 00:58:55.640 --> 00:59:01.680 in the sense that the system should never have been put forward in the first place. 671 00:59:01.680 --> 00:59:05.560 The second reason why I think these are trivial objections is because a fractional reserve 672 00:59:05.560 --> 00:59:09.480 free banking system can only be advocated if you actually think that it's going to 673 00:59:09.480 --> 00:59:14.560 replace with a better system the central banking system that we currently have. 674 00:59:14.560 --> 00:59:19.400 And yet if that very same system creates the central bank, it can't be the preferred alternative, 675 00:59:19.400 --> 00:59:23.880 which is why I can't support such a system and think that a free banking system operating 676 00:59:23.880 --> 00:59:28.040 Banking under 100% reserves, which eliminates all of these problems, should be the preferable 677 00:59:28.040 --> 00:59:29.040 choice.