[Previously published at The Cobden Centre, 25 August 2011. Available in PDF at SSRN.]

Banking theory remains one of the most heatedly debated areas of economics within Austrian circles, with two camps sitting opposite each other: full reservists and free bankers. The naming of the two groups may prove a bit misleading, since both sides support a free market in banking. The difference is that full reservists believe that either fractional reserve banking should be considered a form of fraud or that the perceived inherent instability of fiduciary expansion will force banks to maintain full reserves against their clients’ deposits. The term free banker usually refers to those who believe that a form of fractional reserve banking would be prevalent on the free market.

The case for free banking has been best laid out in George Selgin’s The Theory of Free Banking.1 It is a microeconomic theory of banking which suggests that fractional reserves will arise out of two different factors,

Over time, “inside money” — banknotes (money substitute) — will replace “outside money” — the original commodity money — as the predominate form of currency in circulation. As the demand for outside money falls and the demand for inside money rises, banks will be given the opportunity to shed unnecessary reserves of commodity money. In other words, the less bank clients demand outside money, the less outside money a bank actually has to hold. A rise in the demand to hold inside money will lead to a reduction in the volume of banknotes in circulation, in turn leading to a reduction of the volume of banknotes returning to issuing banks. This gives the issuing banks an opportunity to issue more fiduciary media. Inversely, when the demand for money falls, banks must reduce the quantity of banknotes issued (by, for example, having a loan repaid and not reissuing that money substitute).

Free bankers have been quick to tout a number of supposed macroeconomic advantages of Selgin’s model of fractional reserve banking. One is greater economic growth, since free bankers suppose that a rise in the demand for money should be considered the same thing as an increase in real savings. Thus, within this framework, fractional reserve banking capitalizes on a greater amount of savings than would a full reserve banking system.

Another supposed advantage is that of monetary equilibrium. An increase in the demand for money, without an equal increase in the supply of money, will cause a general fall in prices. This deflation will lead to a reduction in productivity, as producers suffer from a mismatch between input and output prices. As Leland Yeager writes, “the rot can snowball”, as an increase in uncertainty leads to a greater increase in the demand for money. This can all be avoided if the supply of money rises in accordance with the demand for money (thus, why free-bankers and quasi-monetarists generally agree with a central bank policy which commits to some form of income targeting).2

Monetary (dis)equilibrium theory is not new, nor does it originate with the free bankers. The concept finds its roots in the work of David Hume3 and was later developed in the United States during the first half of the 20th Century.4 The theory saw a more recent revival with the work of Leland Yeager, Axel Leijonhufvud, and Robert Clower.5 The integration of monetary disequilibrium theory with the microeconomic theory of free banking is an attempt at harmonizing the two bodies of theory.6 If a free banking system can meet the demand for money, then a central bank is unnecessary to maintain monetary stability.

The integration of the macro theory of monetary disequilibrium into the micro theory of free banking, however, should be considered more of a blemish than an accomplishment. It has unnecessarily drawn attention away from the merits of fractional reserve banking and instead muddled the free bankers’ case. Neither is it an accurate or useful macroeconomic theory of industrial misbalances or fluctuations.

The Nature of Price Fluctuations

The argument that deflation resulting from an increase in the demand for money can lead to a harmful reduction in industrial productivity is based on the concept of sticky prices. If all prices do not immediately adjust to changes in the demand for money then a mismatch between the prices of output and inputs goods may cause a dramatic reduction in profitability. This fall in profitability may, in turn, lead to the bankruptcy of relevant industries, potentially spiraling into a general industrial fluctuation. Since price stickiness is assumed to be an existing factor, monetary equilibrium is necessary to avoid necessitating a readjustment of individual prices.

Since price inflexibility plays such a central role in monetary disequilibrium, it is worth exploring the nature of this inflexibility — why are prices sticky? The more popular explanation blames stickiness on an entrepreneurial unwillingness to adjust prices. Those who are taking the hit rather suffer from a lower income later than now.8 Wage stickiness is also oftentimes blamed on the existence of long-term contracts, which prohibit downward wage adjustments.9

Austrians can supply an alternative, or at least complimentary, explanation for price stickiness.10 If equilibrium is explained as the flawless convergence of every single action during a specific moment in time, Austrians recognize that an economy shrouded in uncertainty is never in equilibrium. Prices are set by businessmen looking to maximize profits by best estimating consumer demand. As such, individual prices are likely to move around, as consumer demand and entrepreneurial expectations change. This type of “inflexibility” is not only present during downward adjustments, but also during upward adjustments. It is “stickiness” inherent in a money-based market process beset by uncertainty.

It is true that government interventionism oftentimes makes prices more inflexible than they would be otherwise. Examples of this are wage floors (minimum wage), labor laws, and other legislation which makes redrawing labor contracts much more difficult. These types of labor laws handicap the employer’s ability to adjust his employees’ wages in the face of falling profit margins. Wages are not the only prices which suffer from government-induced inflexibility. It is not uncommon for government to fix the prices of goods and services on the market; the most well-known case is possibly the price fixing scheme which caused the 1973–74 oil crisis. There is a bevy of policies which can be enacted by government as a means of congesting the pricing process.

But, let us assume away government and instead focus on the type of price rigidity which exists on the market. That is, the flexibility of prices and the proximity of the actual price to the theoretical market clearing price is dependent on the entrepreneur. As long as we are dealing with a world of uncertainty and imperfect information, the pricing process too will be imperfect.

Price rigidity is not an issue only during monetary disequilibrium, however. In our dynamic market, where consumer preferences are constantly changing and re-arranging themselves, prices will have to fluctuate in accordance with these changes. Consumers may reduce demand for one product and raise demand for another, and these industries will have to change their prices accordingly: some prices will fall and others will rise. The ability for entrepreneurs to survive these price fluctuations depends on their ability to estimate consumer preferences for their products. It is all part of the coordination process which characterizes the market.

The point is that if price rigidity is “almost inherent in the very concept of money”,11 then why are price fluctuations potentially harmful in one case but not in the other? That is, why do entrepreneurs who face a reduction in demand originating from a change in preferences not suffer from the same consequences as those who face a reduction in demand resulting from an increase in the demand for money?

Price Discoordination and Entrepreneurship

In an effort to illustrate the problems of an excess demand for money, some have likened the problem to an oversupply of fiduciary media. The problem of an oversupply of money in the loanable funds market is that it leads to a reduction in the rate of interest without a corresponding increase in real savings. This leads to changes in the prices between goods of different orders, which send profit signals to entrepreneurs. The structure of production becomes more capital intensive, but without the necessary increase in the quantity of capital goods. This is the quintessential Austrian example of discoordination.

In a sense, an excess demand for money is the opposite problem. There is too little money circulating in the economy, leading to a general glut.12 Austrian monetary disequilibrium theorists have tried to frame it within the same context of discoordination. An increase in the demand for money leads to a withdrawal of that amount of money from circulation, forcing a downward adjustment of prices.

But there is an important difference between the two. In the first case, the oversupply of fiduciary media is largely exogenous to the individual money holders. In other words, the increase in the supply of money is a result of central policy (either by part of the central bank or of government). Theoretically, an oversupply of fiduciary media could also be caused by a bank in a completely free industry but it would still be artificial in the sense that it does not reflect any particular preference of the consumer. Instead, it represents a miscalculation by part of the central banker, bureaucrat, or bank manager. In fact, this is the reason behind the intertemporal discoordination — the changing profit signals do not reflect an underlying change in the “real” economy.

This is not the issue when regarding an excess demand for money. Here, consumers are purposefully holding on to money, preferring to increase their cash balances instead of making immediate purchases. The decision to hold money represents a preference. Thus, the decision to reduce effective demand also represents a preference. The fall in prices which may result from an increase in the demand for money all represent changes in preferences. Entrepreneurs will have to foresee or respond to these changes just like they do to any other.13 That some businessmen may miscalculate changes in preference is one thing, but there can be no accusation of price-induced discoordination.

The comparison between an insufficient supply of money and an oversupply of fiduciary media would only be valid if the reduction in the money supply was the product of central policy, or a credit contraction by part of the banking system which did not reflect a change in consumer preferences. But, in monetary disequilibrium theory this is not the case.

None of this, however, says anything about the consequences of deflation on industrial productivity. Will a rise in demand for money lead to falling profit margins, in turn causing bankruptcies and a general period of economic decline?

Whether or not an industry survives a change in demands depends on the accuracy of entrepreneurial foresight. If an entrepreneur expects a fall in demand for the relevant product, then investment into the production of that product will fall. A fall in investment for this product will lead to a fall in demand for the capital goods necessary to produce it, and of all the capital goods which make up the production processes of this particular industry. This will cause a decline in the prices of the relevant capital goods, meaning that a fall in the price of the consumer good usually follows a fall in the price of the precedent capital goods.14 Thus, entrepreneurs who correctly predict changes in preference will be able to avoid the worst part of a fall in demand.

Even if a rise in the demand for money does not lead to the catastrophic consequences envisioned by some monetary disequilibrium theorists, can an injection of fiduciary media make possible the complete avoidance of these price adjustments? This is, after all, the idea behind monetary growth in response to an increase in demand for money. Theoretically, maintaining monetary equilibrium will lead to a stabilization of the price level.

This view, however, is the result of an overly aggregated analysis of prices. It ignores the microeconomic price movements which will occur with or without further monetary injections. Money is a medium of exchange, and as a result it targets specific goods. An increase in the demand for money will withdraw currency from this bidding process of the present, reducing the prices of the goods which it would have otherwise been bid against. Newly injected fiduciary media, maintaining monetary equilibrium, is being granted to completely different individuals (through the loanable funds market). This means that the businesses originally affected by an increase in the demand for money will still suffer from falling prices, while other businesses may see a rise in the price of their goods. It is only in a superfluous sense that there is “price stability”, because individual prices are still undergoing the changes they would have otherwise gone.

So, even if the price movements caused by changes in the demand for money were disruptive — and we have established that they are not — the fact remains that monetary injections in response to these changes in demand are insufficient for the maintenance of price stability.

Implications for Free Banking

To a very limited degree, free banking theory does rely on some aspects of monetary disequilibrium. The ability to extend fiduciary media depends on the volume of returning liabilities; a rise in the demand for money will give banks the opportunity to increase the supply of banknotes. However, the complete integration of monetary disequilibrium theory does not represent theoretical advancement — if anything, it has confused the free bankers’ position and unnecessarily contributed to the ongoing theoretical debate between full reservists (many of which reject the supposed macroeconomic benefits of free banking) and free bankers.

We know that an increase in the demand for money will not lead to industrial fluctuations, nor does it produce any type of price discoordination. Like any other movement in demand, it reflects the preferences of the consumers which drive the economy. We also know that monetary injections cannot achieve price stability in any relevant sense. Thus, the relevancy of the macroeconomic theory of monetary disequilibrium is brought into question. Free banking theory would be better off without it.

This suggests, though, that a rejection of monetary disequilibrium is not the same as a rejection of fractional reserve banking. It could be the case that a free banking industry capitalizes on an increase in savings much more efficiently than a full reserve banking system. Or, it could be that the macroeconomic benefits of fractional reserve banking are completely different from those already theorized, or even that there are no macroeconomic benefits at all — it may purely be a microeconomic theory of the banking firm and industry. These aspects of free banking are still up for debate.

Notes:

1. George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue (Totowa, New Jersey: Rowman & Littlefield, 1988). Also see George A. Selgin, Bank Deregulation and Monetary Order (Oxon, United Kingdom: Routledge, 1996); Larry J. Sechrest, Free Banking: Theory, History, and a Laissez-Faire Model (Auburn, Alabama: Ludwig von Mises Institute, 2008); Lawrence H. White, Competition and Currency(New York City: New York University Press, 1989).

2. Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium (Indianapolis, Indiana: Liberty Fund, 1997), pp. 218–219.

3. Ibid., p. 218.

4. Clark Warburton, “Monetary Disequilibrium Theory in the First Half of the Twentieth Century,” History of Political Economy 13, 2 (1981); Clark Warburton, “The Monetary Disequilibrium Hypothesis,” American Journal of Economics and Sociology 10, 1 (1950).

5.Peter Howitt (ed.), et. al., Money, Markets and Method: Essays in Honour of Robert W. Clower (United Kingdom: Edward Elgar Publishing, 1999).

6. Steven Horwitz, Microfoundations and Macroeconomics: An Austrian Perspective (United Kingdom: Routledge, 2000).

7. Some of the criticisms presented here have already been laid out in a forthcoming journal article: Phillip Bagus and David Howden, “Monetary Equilibrium and Price Stickiness: Causes, Consequences, and Remedies,” Review of Austrian Economics. I do not support all of Bagus’ and Howden’s criticisms, nor do I share their general disagreement with free banking theory.

8. Yeager 1997, pp. 222–223.

9. Laurence Ball and N. Gregory Mankiw, “A Sticky-Price Manifesto,” NBER Working Paper Series 4677, 1994, pp. 16–17.

10. Horwitz 2000, pp. 12–13.

11. Yeager 1997, p. 104.

12. Yeager 1997, p. 223. Yeager quotes G. Poulett Scrope’s Principles of Political Economy, “A general glut — that is, a general fall in the prices of the mass of commodities below their producing cost — is tantamount to a rise in the general exchangeable value of money; and is proof, not of an excessive supply of goods, but of a deficient supply of money, against which the goods have to be exchange.”

13. Joseph T. Salerno, Money: Sound & Unsound (Auburn, Alabama: Ludwig von Mises Institute, 2010), pp. 193–196.

14. This is Menger’s theory of imputation; Carl Menger, Principles of Economics (Auburn, Alabama: Ludwig von Mises Institute, 2007), pp. 149–152.