On not doing due diligence: Bagus and Howden on free banking

On not doing due diligence: Bagus and Howdenon free banking

Anthony J. Evans & Steven Horwitz

Published online: 21 May 2011# Springer Science+Business Media, LLC 2011

Abstract In their recent article in the Quarterly Journal of Austrian Economics,Bagus and Howden (2010) present “quibbles” with fractional-reserve free banking.Specifically, they raise what they call “unaddressed issues” in this system, with aparticular emphasis on Selgin (1988). We deem their arguments to be moresubstantial than “quibbles” and see them as part of a longstanding debate aboutfundamental aspects of monetary theory. We respond to their objections and attemptto specify how debate between the two sides might proceed more productively.

Keywords Business cycles . Central banking . Free banking .Monetary equilibrium

JEL classification B53 . E31 . E32 . E41 . E42 . E51 . G21

1 Introduction

In their recent article in the Quarterly Journal of Austrian Economics, Bagus andHowden (2010) present “quibbles” with fractional-reserve free banking. Specifically,they raise what they call “unaddressed issues” in this system, with a particularemphasis on Selgin (1988). We deem their arguments to be more substantial than“quibbles” and instead as part of a longstanding debate about fundamental aspects ofmonetary theory. Unfortunately, their focus on Selgin’s book, canonical as it is, leadsthem to raise concerns that have been addressed in other, uncited by Bagus andHowden, contributions to the free banking literature. If the article was written as abook review, this might be excusable. However, creating the impression of a review

Rev Austrian Econ (2012) 25:149–157DOI 10.1007/s11138-011-0155-3

A. J. EvansESCP Europe, 527 Finchley Rd, London NW3 7BG, UKe-mail: [email protected]

S. Horwitz (*)St. Lawrence University, Canton, NY, USAe-mail: [email protected]

of the whole literature and then limiting so much of their discussion to one text (evenan admittedly seminal one) as a way to criticise that entire literature is a derelictionof their scholarly responsibilities.

There are two aspects of the article that we welcome. We are encouraged that theyare “abstaining from a discussion of legal and ethical issues” (p.30), becausealthough these are important, they often distract from an understanding of theeconomic arguments. As Mises said, “such discussion…must proceed from aconcept of money based, not on legal definitions and discriminations, but on theeconomic nature of things” (1912, p.67). It is also good that their work has beenpublished in an academic journal, given that the quality of commentary on theseissues tends to be low (mostly because in the Internet age, the costs of commentaryare so low). If there is to be any constructive dialogue with regard to the fractional-vs. full-reserve free banking debate, it is most likely to take place as an academicconversation.

With this in mind, we will specify at the outset that our intended audience isBagus and Howden and those who agree with their conclusions. We do not intend tokick-start another round of debates with no hope for reconciliation and have takenthe time to write this article as a genuine attempt to constructively engage. To thisend, our reply will be split into four sections. Section 1 will list what we consider tobe basic errors made by Bagus and Howden in their reading of the Selgin book andother sources. If our reading of these quotes is correct, we would expect Bagus andHowden to clarify or retract their claims about the authors being quoted. If theauthors mean what they say, and our understanding is as we think, there is littlechance of agreeing on more complex issues. Therefore, we wish to clarify the simplethings first.

In Section 2, we will respond to a number of assertions made about the freebanking literature. As previously noted, we think that by attempting to limit theirdiscussion to one text, Bagus and Howden give the impression of being reluctant toengage critically with their subject matter. We will not attempt a rebuttal of theirclaims; however, we will demonstrate that their claims are contested in the freebanking literature. Since Bagus and Howden do not provide citations to these otherworks in the free banking literature, we will assume that they are not familiar withthis evidence.

Section 3 focuses on definitions and in particular the concepts of “inflation” and“savings”. It is not our aim to convince Bagus and Howden to accept ourdefinitions; we merely attempt to get them to acknowledge that other scholarsmight be using these terms in ways different from their usage. We feel that theirarticle would have been significantly more charitable had they resisted thetemptation to impose their definitions when applying certain terms to the freebanking literature. The result is that their arguments are often question begging asthey assume away the very points in contention in the literature by notacknowledging alternative definitions. Section 4 responds to two specific examplesthat Bagus and Howden draw upon. We do not claim our responses will becompletely satisfactory, and we hope that they will be able to clarify and expandupon their examples in response to our critique. Our goal is only to claim that asstated, their examples do not achieve their ends.

150 A.J. Evans, S. Horwitz

2 You can’t be serious?

We start off with sentences that baffled us. We will submit our understanding ofwhat the authors meant, and explain why we think they have made an error. We donot feel that these are necessarily central parts of their argument, so we hope that ifour interpretation is correct Bagus and Howden can retract them.

"fractional reserve free bankers are left with a glaring theoretical hole: whenshould banks alter the monetary base" (p.37)

The sentence is puzzling because it suggests that a bank is able to alter themonetary base. Elsewhere in their article, Bagus and Howden list threemechanisms by which banks enable credit creation. The first is that “increases inbase money by the production of commodity money may increase reserves andallow for credit expansion” (p.47). What constitutes the “monetary base” dependson the monetary regime, and Bagus and Howden are not clear about what regimethey have in mind. But under a commodity standard, banks are unable to changethe quantity what is known as “outside money”. This is especially confusing giventhat Bagus and Howden had already acknowledged that free bankers haveadvocated the freezing of the fiat monetary base (albeit in a footnote, p.46). Inshort, the instrument through which free banks can alter the money supply is theirdesired reserve ratios, not the absolute amount of the monetary base. By conflatingthe two, Bagus and Howden run the risk of conflating fiat money with fiduciarymedia of exchange.

They also run the risk of conflating the two in their example on page 39. Tosupport their argument that fiduciary media can be created ex nihilo, they use anexample of the US government adding a zero to every bank note and demanddeposit. However, this could not happen under a fractional-reserve free bankingsystem, because by definition the monetary base is not under government control.They confuse fiat currency with fiduciary media. This is an instance of a moregeneral problem found in the literature critical of fractional-reserve banking: thecritics blame what are, in fact, problems of central banking on fractional-reservebanking. Not all fiduciary media are fiat money, so what is true of the latter is notnecessarily true of the former.1

“The mystery that remains is how a bank will know that A has increased hisdemand for cash holdings (which he has, in fact, already satisfied byabstaining from spending)” (p.45)

The mystery here is solved by Bagus and Howden’s own sentence: by abstainingfrom spending, person A accumulates the cash holdings that he demands. It is this

1 Also, it could be debated whether their example constitutes an increase in the money supply at all. AsMises points out, if the government issues a decree that uniformly applies to all money units (such as“what was previously called a half-dollar is now called a whole dollar”), this is not so much a change inthe quantity of money as a change in the name of the currency (1912, p.167).

On not doing due diligence: Bagus and Howden on free banking 151

action that alerts banks to the fact that the demand for money has risen. There is nomystery here, as Bagus and Howden provide the solution!

“An increase in the demand for money services (real cash balances) cannot besatisfied by an increase in the production of money because an increase in themoney supply decreases, ceteris paribus, the purchasing power and conse-quent services of each and every monetary unit.” (p.46)

The key part of this sentence is their use of the assumption of ceteris paribus. Anincrease in the money supply will indeed, ceteris paribus, decrease the purchasingpower of money. However, if there has been an increase in the demand for moneyservices, all else isn’t constant. In other words, increases in the money supply willnot decrease the purchasing power of each unit if there has been an increase in thedemand for money services, as the latter is but another way of saying that thepurchasing power of each unit is increasing, which is in turn offset by the increase inthe money supply. The result of the entire process described in the quote is nochange in money’s purchasing power.

Selgin (1988, p.55) “invokes a monetary misperception argument, also used byreal business cycle theorists” (p.46)

Firstly, we are not sure why they choose to make a reference to real businesscycle theory (RBC), but the whole point of RBC is that nominal variables such aschanges in the money supply do not have an impact on real variables; hence, the“real” in real business cycle theory. We suspect they are thinking of Lucas’ islandmodel, but there are important differences between the New Classical school andRBC. RBC makes use of a rational expectations assumption as do the NewClassicals (and New Keynesians for that matter), but it is a distinct category oftheories from monetary misperception models. This is a mistake that anyone familiarwith the last few decades of macroeconomics should not be making.

3 Read, read, read

Throughout their article, Bagus and Howden make sweeping statements about thelimitations of the free banking literature. However, we feel that these issues havebeen addressed. Our aim here is not to argue that they have been addressedadequately (although we believe this to be the case), but since Bagus and Howdenfail to even acknowledge this literature, we assume that they are not aware of it. Andif they are not aware of it, their analysis is deeply misleading.

"Selgin (1988) first elaborated the combination of these disequilibria with thedoctrine of fractional reserve free banking" (p.31)

Without wishing to underplay Selgin’s contribution, Bagus and Howden seemkeen to present fractional-reserve free banking as a relatively recent innovation.However, Horwitz (2000, pp. 75–80) gives great attention to the historicalfoundations of monetary equilibrium approaches to what we would now call“macroeconomics”, with its roots in Swedish, British, and indeed Austrian monetarytheory. We find it telling that Bagus and Howden fail to cite Mises’ Theory of Money


and Credit (1912), or indeed Hayek’s Prices and Production (1931) or TheDenationalisation of Money (1990), since these are among the texts that inspired somuch of the monetary equilibrium approach. Our intention is not to ignite a debateabout “what Mises really believed”, merely to state that a dutiful scholar has anobligation to offer a fair portrayal of the origins of the fractional-reserve free bankingapproach—and the proponents of free banking have provided textual evidence thatthese origins are undeniably Misesian, as well as Wicksellian, Robertsonian,Hayekian, Warburtonian, to mention only a few.

"free bankers fail to distinguish between the demand for money proper andthat of money substitutes" (p.36)

As previously mentioned, Bagus and Howden seem to neglect the distinctionbetween inside and outside money, but Selgin (1988) makes explicit reference tothese two types of money (p.54).2 They go on to say that free bankers have failed todistinguish between the “various reasons that money is demanded” (p.37), withouteven citing Horwitz (1990), which is devoted precisely to this issue.3

"free bankers repeat the error of the old Banking school" (p.38)

We find it deeply uncharitable for Bagus and Howden to link free banking withthe old Banking School, without citing the detailed treatment that White (1984)provides to separate the two. IndeedWhite provides a summary table (Table 5.1, p. 135)that clearly outlines the differences between Currency School, Banking School, andFree Banking School approaches. In particular, Bagus and Howden attribute theBanking School’s “needs of trade” argument to Free Bankers, ignoring White’s explicitcritique (1984, p.123). Modern “Free Bankers” also criticise the Banking School’sconcept of the “Law of Reflux”, and instead point to a “principle of adverse clearings”(see Selgin 1988, p.40 and Horwitz 1994). The difference between the two is at theheart of White’s criticism of the Banking School. Again, it is possible that White iswrong, but Bagus and Howden do not even acknowledge or engage with hisarguments.

"it creates a tendency towards the creation of a central banking system" (p.49)

To be fair to Bagus and Howden, they do attempt to argue why this is the case,and they rely on Heurta de Soto (2006, p.713). We suggest that they also readGoodhart (1988) and Congdon (2009), who argue that central banks evolvenaturally. Indeed Dowd (1990) responded to Goodhart’s argument in an articlecalled “Did central banks evolve naturally?” That Bagus and Howden fail to cite it isa major oversight. Horwitz (1992) devotes a whole chapter to the origins of theFederal Reserve System pointing out how it emerged not from the problems offractional-reserve free banking, but of a variety of government interventions in thepre-Fed system that prevented it from behaving in the desirable ways free banking

2 Indeed Bagus and Howden refer to “inside money” (p.31), suggesting that they should also realise thatthe distinction between these two types of money has been dealt with in the free banking literature.3 This is an especially good example of the sloppiness of Bagus and Howden’s argument. Although theypurport to be focusing on Selgin (1988) they make sweeping statements about the entire free bankingliterature.


systems do. The “tendency towards central banking” is hardly an original argumentand it has been responded to by partisans of free banking.

4 Agreeing on terms

Consider the following passage (contained within a footnote): “the argument thatprices are downward rigid and that an economy is improved with inflation if thedemand for money increases is outside the scope of this article” (p.33). This is arevealing quote because one of the major sources of disagreement centres on thedefinition of inflation. From a monetary equilibrium perspective, inflation occurs ifthe supply of money exceeds the demand for money. It is therefore possible for anincrease in the supply of money to not constitute “inflation”. We understand that thisappears odd to someone who defines inflation as any increase in the money supply,but our aim in this paper is not to start a debate about which is the most accuratedefinition. We merely want to acknowledge that there is a difference, and note thatBagus and Howden do not acknowledge this difference. By referring to this processas “inflation” they are using their preferred definition, even though the whole debateis about what constitutes inflation! This is virtually the textbook definition of“begging the question,” which is, of course, an invalid argumentative strategy.

If they had written “the argument that prices are downward rigid and that an economyis improved with an increase in the money supply”, they would make the exact samepoint, but without begging the question of whether it’s inflation. By asserting that thisprocess constitutes “inflation”, they are severely obfuscating debate. In addition, Bagusand Howden overlook the fact that the monetary equilibrium theorists’ definition ofinflation is the same one adopted by Mises in The Theory of Money and Credit (1912,p. 272), which should suggest that the right definition is what is at issue here and thattheir quoted statement above merely begs the question.

They also claim that, “free bankers suffer from…a fear of deflation (or, at least, aspecial strain of it)” (p.33). However, they choose to ignore the free bankers’ equalfear of inflation, which is completely symmetrical to the “fear” of deflation. This isunderstandable if their point is that both sides of the debate agree on the negativeeffect of artificial credit creation in causing Austrian-style boom bust cycles(although it avoids the question of why full reservers deem the relative price effectsthat come with price increases to be harmful but those that accompany money-generated price declines to be benign in comparison). The fact they add the caveatsuggests they do not want to lump free bankers in with those who genuinely do feardeflation in all its forms, but what is the “strain” they allude to?4 Some additionalexplication of that caveat would have helped their readers see what is at stake here,rather than just leaving the accusation of “fearing deflation” out there without therelevant context.

4 We suspect that Bagus and Howden might be attempting to make a distinction between those who fearmonetary and price deflations (such as many modern central bankers), with those who fear monetary butnot price deflations. We believe this to be an accurate distinction to draw, given that the subtitle of one ofSelgin’s books is the “case for a falling price level in a growing economy” (Selgin 1997). However it isnotable that this work isn’t even cited in their article.


To repeat, we do not intend to start a debate about the appropriate definition ofinflation. Our point is that there are ways in which we can use terms that are faithfulto our intellectual opponents. We are simply criticising Bagus and Howden forfailing to distinguish between alternative definitions. Indeed it is not only inflationthat is important to the debate but also the concept of savings.

Unlike inflation, we believe that Bagus and Howden are defining savings in thesame way as free bankers—meaning the act of abstaining from consumption. Thedisagreement instead arises in how this relates to the market for loanable funds.Bagus and Howden (p. 39) write: “Horwitz suggests that the creation of depositsincreases the supply of savings, as depositors are lenders of real loanable funds. Inother words, the mere creation of credit and the corresponding new depositsconstitute an increase in real savings.” We reject this interpretation because theymisrepresent the causality. Bagus and Howden claim that Horwitz is saying thatcreating deposits increases the supply of savings, which suggests that the causalityruns from money creation to savings. However, the Horwitz quote in questionclearly says the reverse:

Savers supply real loanable funds based on their endowments and intertem-poral preferences. Banks serve as intermediaries to redirect savings to investorsvia money creation. Depositors give banks custody of their funds, and bankscreate loans based on these deposits. (1992, p.135)

The order is that savers provide funds to banks by increasing their deposits, andthen those new deposits, which banks receive as reserves, serve as the basis for loansto the bank’s borrowers. Those loans are credited to the borrower’s deposit account.So it is not the case that the “creation of deposits increases the supply of savings” butprecisely the opposite: increases in the supply of savings (“real loanable funds”)enable banks to create new loans and additional supplies of money. In other words,savings in the form of holding larger bank balances makes possible the funds forinvestment that are created through the lending process.

On p. 39, Bagus and Howden interpret Horwitz’s claim that “demanding bankliabilities is an act of savings” as saying he believes there is no difference between a$1,000 bank deposit and purchasing a $1,000 30-year bond. Once again, this is amisreading of the plain text. Most 30-year bonds are not “bank liabilities,” ratherthey are liabilities of the firms or governments issuing them, so they are not relevantto Horwitz’s claim. Holding actual bank liabilities, such as demand or time deposits,is clearly an act of savings as the holder is abstaining from consuming the valuerepresented by those deposits. The question of the length of time those savings willbe held is precisely the problem that bankers must solve in their entrepreneurial role.The free banking literature argues that experience plus the knowledge and incentivesprovided by the adverse clearings process and its effect on bank risk and profits willenable banks to discover how best to distribute the maturities of their assets giventhe demands of their depositors.5

5 Bagus and Howden also make the accusation that Horwitz “abstracts from the duration of savings”(p.40). At this point, Bagus and Howden appear to want to shift the debate to one over maturitytransformation (or maturity “mismatching”). We know that they are more amenable to mismatching beingacceptable than other advocates of full reserves (Bagus and Howden 2009) and would simply say that thisis a separate debate.


5 A response to examples

Bagus and Howden present two examples in their article and these warrants aresponse. Indeed they are important enough to merit greater detail and form a largerpart of their article. Although we do not feel that they have been presented insufficient detail to permit an exhaustive rejoinder, we will make an effort to reply.

“Following the logic of their argument, they must maintain that the divestmentof capital (i.e., the tearing down of machinery and factories, etc.), in order toincrease cash balances is a sign of an increased demand for money andrepresents an increase in savings” (p.41)

With a sufficiently abstract example, the destruction of capital (i.e., the tearingdown of machinery) can appear to be inconsistent with an increase in savings.However why would (indeed why do) entrepreneurs destroy capital? Is it notbecause their subjectively perceived value of that capital good is no longer higherthan its exchange value? It is not clear to us that we can unambiguously concludethat the divestment of capital is always an expression of higher time preference. Thisseems to ignore two key attributes of capital goods: that they are subjective (andtherefore not a consequence of the physical property of the good), and that they arecomplementary (and are thus likely to require capital expenditure in order tomaintain them). In short, this example is too flippant. If Bagus and Howden spelledout in more detail their point, we would be in a better position to respond.

“Let us assume that individual A holds a quantity of money proper, such asgold coins (or fiat paper money), under his mattress for safekeeping. Now hedecides to transfer the coins to a bank—there has been a crime in hisneighborhood recently and he regards the bank as a more secure warehousethan his mattress. Following the free bankers’ reasoning, bank reserves andthe willingness to hold bank liabilities now increase, and banks can and shouldexpand credit in response. Yet there is no increase in A’s savings in thisexample; the coins (cash holdings) have just changed location” (p.43)

It is not clear to us what conclusion Bagus and Howden are attempting to drawhere. Changing the location of an economic good is not a trivial matter—it is thedifference between a capital good and a consumer good after all (Mises, Ludwig von1912, p.97–99). The ability of fractional-reserve banks to hold enough reserves tosatisfy redemption requests rests on the institutional framework in which theyoperate. Bagus and Howden seem to be assuming that because gold would have thesame exchange value in the two circumstances, they are simply identical goods. Butalthough bank deposits are a form of saving, not all forms of saving have identicaleconomic effects. Indeed this is one of the chief virtues of a fractionally reservedsystem—the costs of the monetary system are far lower because there is no need tokeep a large quantity of gold stored in unproductive uses.

The problem here is their assumption that the individual regards the bank as atype of “warehouse” at all. If A actually puts his gold into a secure warehouse (e.g., asafety deposit box), then the money supply would not change. The fractional-reserveprocess would only apply if the person puts the coin into a fractional-reserve bank


account—i.e. provides a callable loan. And this occurs whether the new gold comesfrom under a mattress or out of a mine.

6 Conclusion

This is not supposed to be a theoretically rich point-by-point rebuttal. In short, we donot think the quality of the article warrants extended serious academic attention.However, it is unfortunate that so many errors and such misrepresentations of theviews of defenders of free banking made it through to publication. Our aim has beenprimarily to clear up confusion about definitions and point Bagus and Howden toliterature that deals with their objections. We do not claim that our understanding ofmonetary theory is perfect, and we do not doubt that advocates of full reservebanking can make important contributions to the debate about the future of monetaryinstitutions. Indeed, we are trying to help such arguments by challenging Bagus andHowden to improve the quality of their analysis. The quality of any argument can bejudged by the accuracy and quality of the arguments presented on the other side.That Bagus and Howden both misrepresent the views of free bankers and fail to citeliterature that addresses their criticisms severely damages the credibility of theircritique.

References

Bagus, P., & Howden, D. (2009). The legitimacy of loan maturity mismatching: a risky, but not fraudulent,undertaking. Journal of Business Ethics, 90(3), 399–406.

Bagus, P., & Howden, D. (2010). Fractional reserve free banking: some quibbles. Quarterly Journal ofAustrian Economics, 13(4), 29–55.

Congdon, T. (2009). Central banking in a free society, Hobart paper 166. London: Institute of EconomicAffairs.

Huerta de Soto, J. (2006) Money, bank credit and economic cycles. Melinda A. Stroup (trans.). Auburn,Ala.: Ludwig von Mises Institute.

Dowd, K. (1990). Did central banks evolve naturally? A review essay of Charles Goodhart’s ‘Theevolution of central banks’. Scottish Journal of Political Economy, 37(1), 96–104.

Goodhart, C. (1988). The evolution of central banks. Cambridge, MA: MIT Press.Hayek, F. A. (2008 [1931]). Prices and production. Auburn, AL: Ludwig von Mises Institute.Hayek, F. A., & Friedrich, A. (1990). Denationalisation of money—the argument refined, Hobart paper

special, no. 70 (3rd ed.). London: Institute of Economic Affairs.Horwitz, S. (1990). A subjectivist approach to the demand for money. Journal des Economistes et des

Etudes Humaines, 1(4), 459–471.Horwitz, S. (1992). Monetary evolution, free banking, and economic order. Boulder, Colo.: Westview

Press.Horwitz, S. (1994). Complementary non-quantity theory approaches to money: Hilferding’s finance capital

and free-banking theory. History of Political Economy, 26(2), 221–238.Horwitz, S. (2000). Microfoundations and macroeconomics. New York: Routledge.Mises, Ludwig von (1912 [1981]) The theory of money and credit Indianapolis: Liberty FundSelgin, G. (1988). The theory of free banking: money supply under competitive note issue. Totowa, NJ:

Rowman and Littlefield.Selgin, G. (1997). Less than zero, Hobart paper N. 132, London: Institute of Economic Affairs.


Documents

On not doing due diligence: Bagus and Howden on free banking