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Those “Other” 100 Percent Reserve Banking Advocates

(This one’s especially for GPO.)

In the aftermath of the U.S. banking crises of the 1930s, it became common for American economists to speak of the “inherent” instability of fractional-reserve banking and of the “perverse elasticity” of money supply in fractional-reserve banking systems.

What the economists in question had in mind was the tendency in existing fractional reserve banking systems for any increase in the public’s preferred ratio of currency holdings to holdings of bank demand deposits to result in a decline in bank lending, and hence in a decline in the overall money stock, and to do so despite the lack of any decline in the public’s overall desire for money balances of one kind or another. It was chiefly owing to this phenomenon that, during the first few years of the Great Depression, the U.S. (M2) money stock collapsed to just two-thirds its pre-depression level.

It was in response to this supposedly inherent drawback of fractional reserve banking that several prominent economists—including Henry Simons, Irving Fisher, Loyd Mints, and (eventually) Milton Friedman—began offering or endorsing proposals for “100 Percent Money,” meaning money consisting either of basic money itself or of bank deposits fully backed by basic money. Although these proposals closely resembled later proposals for 100-percent reserve banking forwarded by Murray Rothbard and his Austrian-School followers, they differed in treating either fiat or “commodity-bundle” central bank money rather than either gold or silver as the ideal form of basic money, and also in not basing their arguments on any appeal to ethics: unlike their Austrian counterparts, the “Chicago” 100-percenters (for want of a more accurate designation) did not claim that fractional-reserve banks swindled their customers. Instead they condemned them solely for contributing to monetary instability.

But were the “Chicago” arguments for 100-percent money any sounder than their “Austrian” counterparts? Is it true that fractional reserve banking is “inherently unstable” in the manner they claimed? As even a careful reading of their own writings shows, it is not. In truth what the Chicago 100-percenters treated as an “inherent” problem of fractional reserve banking isn’t inherent to it at all. Instead it is a problem stemming from government regulations interfering with or altogether prohibiting banks from issuing their own circulating banknotes on the same terms as those by which they are allowed to create exchange media that consist of demand deposits. In the U.S., banknote issue has almost always been subject to special restrictions. But these restrictions became increasingly severe after the outbreak of the Civil War, finally culminating in the complete suppression of commercial banknotes in 1935. Consequently, on the eve of the Great Depression it was impossible for most commercial banks to issue any banknotes at all, and it was very difficult for the rest to do so. Banks therefore had to count heavily on the Fed to meet any considerable increase in the public’s demand for circulating money by creating more units of basic money. Otherwise the banks might be stripped of cash reserves, and forced either to severely contract their lending or to close their doors, if not to do both.

Had U.S. banks remained free to issue notes on the same terms, and subject to the same fractional-reserve requirements, as applied to their deposits, changes in the public’s demand for currency needn’t have had any such “perverse” consequences. On the contrary: so long as the terms are similar a bank has no reason to care what share of its outstanding IOUs consists of notes, and what share consists of circulating paper. The bank’s liquidity depends only on the sum of both sorts of IOUs, relative to its holdings of reserves of basic money. Whether “basic money” means gold or silver or claims against a central bank also doesn’t make any difference. Indeed, a bank might well prefer to have clients hold its notes, rather than keep deposits with it, since deposits sometimes bear interest, while notes do not. Confronted with a heavy demand for currency, a free bank happily disgorges more of its paper IOUs, while writing off some of its deposits. Because its reserves, reserve ratio, and liquidity all remain the same as before, it doesn’t have to stop lending, and therefore doesn’t contribute to any decline in the basic-money multiplier. In short, under free banking, in theory at least, an increased demand for currency doesn’t have any “perverse” consequences. Nor does it appear to have had any such consequences in fact in the relatively free banking systems of Scotland, Canada, and elsewhere. In these systems, although changes in the public’s preferred currency-deposit ratio happened frequently—the ratio always rose during the harvest season, for one thing—credit crunches and banking crises were extremely uncommon.

When, on the other hand, banks aren’t free to issue their own notes, or can do so only to a very limited extent, they have no choice but to satisfy customers’ demand for more currency by handing over scarce reserves, and thereby reducing their liquidity. To restore that liquidity, they must then restrict their lending, which, other things equal, means reducing the banking-system money-multiplier. If the central bank in turn fails to make compensating additions to the stock of basic money, the equilibrium money stock must decline. In the U.S., in the early 30s, the public’s preferred overall currency-to-deposit ratio rose sharply, while the Fed for the most part stood by. Hence the Great (Monetary) Contraction.

Some will object to my suggestion that freedom of note issue would have avoided the Great Contraction by noting that currency withdrawals at the time, instead of being routine withdrawals such as were then still typical of the harvest season, reflected distrust of the banks. In that case, a bank's own notes might have been considered no safer than its deposits, so that central bank money would have been preferred to either. But while the notes of certain banks would undoubtedly have been distrusted, there’s no evidence that banknotes would have generally fallen out of favor: plenty of banks remained both trusted and solvent, and their notes could have supplied the needs of the country as a whole, since notes (unlike bank deposits) can travel wherever they are most wanted. The sole exception to this occurred in late February 1933, when a general run broke out. But this was, as Barry Wigmore has shown, actually a run for gold based, not on any general loss of confidence in the nations’ commercial banks, but on (justified) fears that the incoming president would devalue the dollar.

Further evidence that freedom of note issue would have helped comes from the one step taken in that direction during the banking crisis. This consisted of a rider to the Federal Home Loan Bank Act known as the “Glass-Borah Law.” That law briefly and modestly relaxed the regulatory limits on national banks’ ability to issue national banknotes, by extending the sorts of collateral the banks could have backing those notes. The Glass-Borah Law resulted in a substantial and much needed increase in the supply of currency, although it still left the banks too restricted to avoid massive reserve losses. Just how far a more generous measure, including steps to allow state as well as national banks to issue their own currency, might have gone in limiting or even preventing the crisis is a question crying out for further research.

Why, then, did “Chicago” 100-percenters insist on treating the “perverse” behavior of the U.S. money stock in the 30s as a problem inherent to fractional-reserve banking rather than as a consequence of government regulation? As their own writings make clear, at least some of them actually admitted that freedom of note issue was a theoretical solution to the problem. In his A Program for Monetary Stability (1960, p. 69), for instance, Milton Freidman observed:

To keep changes in the form in which the public holds its cash [that is, money] balances from affecting the amount there is to be held, the conditions of issue must be the same for currency and deposits. . . . The first solution would involve permitting banks to issue currency as well as deposits subject to the same fractional reserve requirements and to restrict what is presently high-powered money to use as bank reserves.

Yet Friedman went on to reject this solution in favor of the 100-percent reserve alternative. He did so because he believed then that freedom of note issue itself raised insuperable problems. This stance, which was presumably shared by other “Chicago” 100-percenters, was itself due to misinterpretation of the American “free banking” experience. Friedman himself eventually came to admit his mistake in light of research by modern free bankers (see Friedman and Schwartz 1986), though his reversal was somewhat half-hearted (see my “Milton Friedman and the Case Against Currency Monopoly”). Whether Simons or Mints or Fisher or any of the other “Chicago” 100-percenters would ever have done likewise is of course something we shall never know.


  1. Some will object to my suggestion that freedom of note issue would have avoided the Great Contraction by noting that currency withdrawals at the time, instead of being routine withdrawals such as were then still typical of the harvest season, reflected distrust of the banks. In that case, a bank's own notes might have been considered no safer than its deposits, so that central bank money would have been preferred to either.

    Do you believe that all the increase in currency demand would have been satisfied by an increase in the supply of banknotes? Surely some people really would have preferred to hold base money (especially if they had been reading Freedom of banknote issue would have alleviated the problem, but there would still have been a contraction of the money supply (holding the supply of base money constant).

    I mention this because even with otherwise free banking, there appears to remain a case to be made for a central bank. Fractionally reserve free banks might be able to maintain monetary equilibrium by adjusting the supply of inside money to changes in demand, but they cannot adjust the supply of outside money to changes in demand — for that we seem to need a fiat monetary base and a central bank. A supply of a commodity base like gold would adjust only very sluggishly, if at all, to changes in demand for base money; it would also be vulnerable to changes in demand for uses other than money. A fixed supply (or fixed growth rate for) a fiat money would also be unable to adjust to changes in demand. Or perhaps do you believe that free banks would come to some other arrangements that would not suffer these drawbacks.

    Is this just a case of the perfect being the enemy of the good? That is: while in theory a fiat monetary base could be superior to some kind of commodity base, in practice, given political institutions and incentives, it is likely to produce a worse monetary system.

  2. Lee, unless there was a sudden increase in the number of persons reading and believing in what they read at, there's no reason why the percentage of persons not trusting banks should have risen. That some percentage distrusted them already would simply have meant that they already would have refused to hold any form of bank money.

    More seriously, my article itself points out that more research is needed to determine to what extent free note issue might have avoided the Great Contraction. But so far as your particular claim about panic-based runs on base money justifying central banks is concerned: this is an argument different from that emphasized by 100-percenters, and one I have addressed at length elsewhere, including here. Very briefly: the evidence isn't consistent with the common belief that panic or contagion-based runs have been an important cause of monetary instability unless they've involved runs on central banks themselves (as in 1933 and later "speculative attacks" on fixed FX rate systems). On the whole, for this as well as many other reasons, including the fact that it generally goes hand-in-hand with prohibitions on private note issue, central banking has on the whole contributed far more to monetary instability than it has taken away.

    Finally, the mere fact that FR-systems are bound to be more vulnerable to possible runs for basic money doesn't mean that 100-percent systems are better. The latter are very costly in terms of forgone opportunities for productive intermediation. The question then is whether, and under what circumstances, is fractional reserve banking worth the extra risk.

  3. Gary North posted today on fractional reserves.

    I've seen no indication that he has read or understood or engaged in the arguments in favor of fractional reserve banking. I'd love to see a Selgin/North debate where he couldn't ignore your points.

  4. Regarding Lee Kelly's point about trust in banks, I think a very persuasive point you (George Selgin) made in one of your Econtalks was that, in those instances in which free banks failed (I am assuming in Scotland?), depositors were almost always protected, not by the level of reserves (which were often very low), but the (commonly) high levels of bank capital. Is it fair to think that, in that situation, the level of bank A's reserves has more to do with satisfying other banks that they can expect to get paid by bank A in base money as part of the net settlement process and that therefore they can accept deposits of bank A's notes and cheques?

    Am I right in thinking that 100% systems (even 100% fiat systems) must be more vulnerable to monetary disequilibrium, given that under FRB systems, the reserve ratio can adjust endogenously? If so, since the greatest threat to the solvency of the banking system is excess demand for money, perhaps 100% systems present the greater threat of bank runs, although they would be runs on non-demand-deposit liabilities.

  5. Chuck, I'd honestly rather not engage Gary North. I have a policy of not dealing with people who write "FED" as if it were an acronym. I have found that this policy saves me much futile effort.

  6. There is an old story (Sorry, but I can't lay my hands on it just now.) about a run on the Bank of England in which the bank paid out so much gold that a bank clerk noticed an old chest in the vault that had been hidden for years by stacks of gold coins. In the chest he found old Bank of England bank notes, and he asked permission to hand out the notes to the customers in lieu of gold coins. The desperate manager allowed it. The customers accepted the notes and the bank run (and the accompanying recession) ended.

    There are many historical examples of recessions being averted by emergency issues of more money. I notice one on p. 99 of Lombard Street, where the Bank of England averted a panic (1825) by lending "money by every possible means".

    Of course, if the bank is insolvent, the freedom to issue notes will do no good unless the bank is also able to suspend convertibility during a panic. Otherwise, a bank that has issued $100 of notes, but has only $99 of assets, will see its notes reflux as fast as they can be issued, at a loss of 1% on each transaction.

    1. Mike, the story was, believe it or not, popularized by Marx, in v. 3 of Capital; it is supposed to have happened during the Panic of 1825, when the Bank found leftover £1 notes from the post-1797 restriction period. I believe Marx gives Thomas Tooke as his source, but as I'm overseas now I can't look into Tooke to see what he has to say.

      If a bank is insolvent, its insolvent: no one, certainly not me, is claiming that feedom of note issue can keep an insolvent bank going, or that it would be desirable that it could. But your description of losses connected to note's "reflux" makes no sense to me. A bank's ability to redeem returned notes is a function of its liquid reserves, not of the overall value of its assets. You can't redeem a note with a loan, however good or bad the loan may be. Insolvency mustn't be confused with illiquidity. The "reflux" (I much prefer the term "note exchange," to avoid association with Fullarton's wacky ideas) tests banks' liquidity, bit not necessarily their solvency.

      1. The losses I was talking about happen when a bank has issued 100 dollar notes (each convertible into 1 oz. of silver) but the bank's assets are worth only 99 oz. total. Knowledgeable traders will value each dollar note at .99 oz., so if the bank maintains convertibility at 1 oz/dollar, then the bank pays out 1 oz in exchange for notes worth .99 oz., losing .01 oz. on each dollar returned to the bank. A bank run results.

        A bank with adequate assets can always buy reserves with which to redeem its notes, but a bank with inadequate assets will never be able to buy enough reserves. Also, a note-holder might rationally accept a dollar's worth of a bank's loans in lieu of $.99 of cash.

        If a bank is insolvent, its best course is usually to suspend convertibility, as free banks usually did in times of stress. That way the bank's notes will sell at a discount (.99 oz./$), but at least a bank run is avoided.

        So along with saying that banks should be free to issue paper notes, I would add that they should also be free to suspend convertibility. As I recall the old-style free banks often paid interest on their notes during suspensions in order to compensate customers for their trouble.

        1. Mike, if a bank is insolvent, suspension gains it nothing: it merely increases the loss, and especially so if the bank pays interest on suspended liabilities (as they did under the Scottish "option clause" arrangement). As Gary Gorton has shown, and as I have argued in my article "In Defense of Bank Suspension," mutually-agreeable ("incentive-compatible") suspension options will be excercised only by illiquid but solvent banks. Insolvent banks will best serve their creditors by shutting down.

          1. Suspension leaves the bank's net worth unaffected. Even if the bank pays 3% interest on its suspended notes, it presumably does so because it is thereby enabled to earn 4% interest somewhere else.

            If an insolvent bank has 99 oz of assets backing $100, then it can suspend, liquidate, or endure a run. A run is clearly the worst option. But it's easy to imagine cases where suspension is less disruptive than liquidation, and the fact that suspension clauses were so common during free banking periods seems to show that suspension is often preferable to liquidation.

            The same is true of central banks: "‘In this desponding state, when all men dreaded, with the utmost anxiety, the event that was seen to be inevitable, and not far distant, and which it was supposed would involve the kingdom in general bankruptcy and intire ruin, the 26th February, 1797, was the crisis that gave the happy turn, and almost instantly dismissed all the horrors and fears that surrounded us; restored complete confidence…’”

            In any case, I'd expect that as a good free banker you'd agree that if a bank wants to issue notes with suspension clauses, that's the bank's business, and customers should be able to choose whether to use that bank's notes or not.

  7. George,

    Thanks for the response.

    I was not really making the "lender of last resort" argument. An ideal monetary base would adjust its supply to changes in demand and resolve monetary disequilibrium without difficult changes in the price level. It seems to me that only a fiat monetary base with a central bank (targeting something like total nominal income) could approach this ideal. I know you have suggested freezing the current monetary base and building free banking upon that foundation, but why not have the central bank adjust the supply of base money to changing demand? Why freeze the base? Is this just a matter of the potential benefits (less monetary disequilibrium) not being worth the likely costs (politicised incentives, corruption, Keynesians, etc.)?

    1. Lee, the simple answer is that, just because we can imagine an ideal central bank doing just what we would have it do, it doesn't follow that any actual central bank can be expected to conform to our desires. Nor will a mere central bank promise suffice. Economists have wasted much ink talking as if central banks could be expected to implement their ideal policies. Experience suggests that such talk is idle. If a reform exists that offers no scope for promise breaking–that sets an automatic mechanism in motion that roughly conforms to some ideal–that's a much more prudent option. The frozen base idea can do this, in principle. That's why I prefer to argue its advantages to trying to win-over discretionary central bankers to NGDP targetting. Any such victory would last only until the next macro fad, or fiscal or financial crisis, caused it to be unceremoniously dumped. In short, one way or the other, discretionary central banking has got to go.

  8. Well, was there a well defined theory of fractional reserve banking available at that time? At least, one comparable to yours? Hayek, if I recall correctly, also criticized fractional reserve banking as a source of instability in Monetary Theory and the Trade Cycle, but argued that this instability was somewhat "justified" on the grounds that frb leads to higher growth. But, he was criticizing a monopolized institution. Did these "Chicago full reservists" recognize a difference between frb in a free industry versus frb in a monopolized/cartelized industry?

  9. Thanks largely to C. A. Phillips' Bank Credit (1931), the theory of the money multiplier under FR banking was reasonably well developed. I believe Jon that at least some did recognize, along with Friedman, that the instability they were concerned with was really an attribute of FR systems with monopolistic note issue. But also like Friedman, they dismissed the competitive note issue alternative out of hand, believing that it would lead to wildcat banking, or unlimited inflation, or excessive counterfeting, and so forth.

  10. Mr Selgin

    Would you be against a civil law or common-law jurisprudence (in order to have both types of legal systems in perspective) that would make clear labelling mandatory to distinguish “100% reserve notes and deposits” and “non-100%reserves notes and deposits?”

    Should not “non-100% reserves notes and deposits” be labelled something like: “promises of payment”?

    And don´t you find probable that in such a system, 100% reserves monies and non-100% reserve monies could have a different market value, at least in some points of time, for, at least, some of the issuers? Can historical examples to be interpreted with great assurance that there was in place such an institutional differentiation between certificates of specie (like 100% reserve notes and deposits) and fractional notes and deposits?

  11. I’ve found many of George Selgin’s articles to be interesting and informative, but it seems to me he has gone off the rails above.

    His argument is based on the idea that Fisher, Friedman etc based their 100% reserve ideas on something to do with “the public’s preferred ratio of currency holdings to holdings of bank demand deposits”.
    Fisher’s work “100% Money and the Public Debt” doesn’t say anything about that. What Fisher does say (p.10-11) is that BANK RUNS are a big problem. That is, the public’s desire to cut ALL EXPOSURE to particular private banks was the problem in the 1930s (as Lee Kelly suggests in his first comment above).
    Selgin answers Kelly’s point by claiming “there's no reason why the percentage of persons not trusting banks should have risen.” All I can say is that I’m living on a different planet to George. On my planet there was a crash in 1929 followed by a long recession during which (unsurprisingly) hundreds of banks went bust.

    Moreover, as George rightly points out in various of his articles, demand for banknotes rises when there is increased economic activity (e.g. at harvest time). Now given the DECLINE IN economic activity in the 1930s, why on earth would there have been a RISE IN demand for banknotes? I’m baffled.

    As for Friedman, he advocated full reserve in his 1948 paper “A Monetary and Fiscal Framework for Economic Stability”. That is available here:

    But Friedman certainly didn’t cite Selgin’s “demand for notes vis a vis demand for deposits” point. Friedman just seems to be concerned about stability in general.

    1. Really, Mr. Musgrave, you ought to read more carefully before accusing others of having "gone of the rails." Regarding my answer to Mr. Kelly, for instance, to have avoided quoting me out of context you might have read on to the very next paragraph, which begins, rather significantly, with the words "More seriously."

      As for Friedman and the currency ratio, it proves little to find a particular work in which he doesn't stress the point (he does do so in his Program for Monetary Stability, among other places). But as it happens, even in the paper you refer to he observes (p. 210) that his specific proposal there has among its two main objectives that of eliminating "extraneous or perverse reactions of our present monetary and fiscal structure," including (ibid., n. 9) "the tendency under the existing system of fractional reserve banking for the total volume of money to change when there is a change in the proportion of its total stock of money the community wishes to hold in the form of deposits." Although Friedman here doesn't distinguish between ordinary (including seasonal) changes in the relative demand for currency, and extraordinary ones linked to banking panics, the context makes clear that he mainly has the former in mind: the article was, after all, published in 1949, by which time deposit insurance had, for the time being at least, addressed the problem of panics. That Friedman elsewhere (see Program) acknowledges that the "perverse reactions" he has in mind might also be avoided by allowing banks to issue their own redeemable notes on the same fractional-reserve basis as that supporting their deposits also suggests that he isn't thinking about runs.

      To fully understand the importance Friedman and others attached to routine swings in currency demand one must be aware of critical assessments of the problems of the pre-Fed National Currency System, with their strong emphasis on the seasonal "inelasticity" of the supply of National bank notes. Of course it's true that the banking panics of thew early 1930s gave a further impetus to proposals for 100-percent banking. I never intended to imply otherwise. But it is essential that people understand how rare panic-based increases in currency demand have been: as Calomiris, Gorton, and Kaufman, among others, have documented, they've been rare even in U.S. history (the panic of February-March 1933 was the most notorious instance, and that was largely fueled by fears of devaluation rather than of systemwide bank insolvency); elsewhere they have been even rarer. In perpetuating the historically invalid view that bank runs, and system-wide runs in particular, are a frequent and inescapable occurrence under any fractional reserve arrangement, the Austrian anti-fractional reserve crowd play into the hands of central bankers, who use that same belief to justify their powers and privileges.

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