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Free Banking and Monetary Calculation

In my Freeman column this week, I discussed the importance of monetary calculation in enabling entrepreneurs to know both what to produce and how to produce it.  The ability to make use of money prices to formulate a forward-looking budget and to calculate backward-looking profits/losses is crucial to entrepreneurial planning and the learning process of the market.  In that piece I didn't have the space to make an additional point that I'd like to note here.

For monetary calculation to be maximally effective, the monetary system matters.  Specifically, the more sound that money is, the more reliable is monetary calculation.  This is a point that Mises made in this 1920 article about economic calculation in the socialist commonwealth and one I developed in a HOPE paper in 1998.  In an economy subject to periodic inflation and deflation, the reliability of money prices is reduced, and what we might call the "epistemic burden" on entrepreneurs is increased as they have to sort out whether a given price change is due to real or nominal factors.  Where money is sound, price movements carry a less ambiguous message. They still require interpretation, but with one less major complicating factor than under inflation or deflation.

Given that different monetary regimes will be more or less likely to avoid inflation and deflation, the monetary system matters for the effectiveness of monetary calculation.  If free banking is better than the alternatives at avoiding monetary disequilibria, then it is also better at creating a sound environment for monetary calculation.  And, if so, it will be better at promoting economic growth.

Many of these ideas are at the core of my Microfoundations and Macroeconomics:  An Austrian Perspective, which if you haven't read, you should!

  • Paul Marks

    Your use of the words "inflation" and "deflation" troubles me. You imply (although do NOT formally say) that these terms mean a rise or fall in the "price level" – the Irving Fisher position. As Ludwig Von Mises warned this obsession with the "price level" is highly misleading and damaging.

    Of course it led Fisher to both miss the inflation (i.e. the increase in the money supply) that led to the 1921 bust and the (Benjamin Strong) inflation that led to the 1929 crash. It would also (of course) lead people to miss the inflation (the Alan Greenspan) inflation that led to the present crises. It is the sort of thinking that says "what inflation? prices are not going up" (as if inflation meant a rise in the "price level" rather than a rise in the money supply).

    As for free banking….

    Of course anyone should be allowed to set up a money lending business (i.e. a bank) and there should not be such things as Central Banks or "deposit insurance" or other absurdities. However, that is a very different thing from, for example, the ideas of the "Banking School" of the early 19th century – whose ideas Ludwig Von Mises (whom you cite) explicitly opposed.

    Creating "money" via book keeping tricks (i.e. money that no one has ever really saved – but which banks lend out) may or may not be "fraud" (that is for lawyers to argue about), but it is certainly highly damaging from an economic point of view.

    Talk of only introducing such credit-money for "the needs of trade" or only with "responsibe people in charge" is waffle (so I am glad you do not come out with it). However, Irving Fisher style talk of doing so "in line with rises in output so that the price level remains stabe" is also nonsense – highly damaging nonsense. Although even Fisher had doubts about banks being the ones to increase the money supply in this way (he seems to have favoured direct government action rather than a web of bank book keeping tricks – the shell game or smoke and mirrors con that makes up "modern banking").

    A last point that should not need to be written – but, in modern times, sadly does.

    There is a vast difference between an increase in the money supply by "natural" means and that by book keeping tricks.

    For example, assume that silver is money (not a "silver standard" talking of "standards" is normally an open door to fraud), and a large number of easy to work silver mines are discovered.

    It seems likely that an increase in the money supply (i.e. the silver that buyers and sellers are choosing to use as money) will occur. Whilst one should (of course) avoid talk of the "price level" (Fisher sillyness), it also seems likely that the prices (in silver) of goods and services will be higher than they otherwise would be (had the new sources of silver not been discovered).

    However, this will NOT have the same effects as a massive banking credit bubble.

    People saving some of the new silver (rather than using it to buy goods and services) will NOT have the same effects as the banks pretending that such saving had occured (when it has not).

    Contra Keynes, credit expansion is not "a form of saving" and it is not as "real as any other form".

  • Steve Horwitz


    I define inflation and deflation as Mises did: an excess or deficiency of the supply of money in comparison to the demand to hold money at the current price level. In fact, I make that argument in the book and here: I completely agree with George Selgin's work on the productivity norm that argues that falling prices (or rising ones!) due to changes in productivity are beneficial and should not be offset by monetary policy in the name of stabilizing the price level.

    As for free banking… I am all in favor of fractional reserve banking as I think it's neither fraudulent nor inflationary/deflationary when coupled with genuinely competitive money creation with commodity backing.

  • Paul Marks


    I am glad you agree that "inflation" means an increase in the money supply (not an increase in the "price level" – the false, Irving Fisher, view of "inflation").

    As for "deflation" – if a credit-money bubble has been created, then (as Mises and many others pointed out) a deflationary "bust" is inevitable (the false credit "money" must go). And efforts to "save the financial system" (by the government or Central Bank producing more "narrow money" to prop up the bubble of bank credit "broad money") are, of course, both an example of corporate welfare and a classic example of missing-the-point.

    As for "fractional reserve banking".

    I have no objection to a money lender (called a "bank" or not) lending out a "fraction" of the savings entrusted with them – 100% of these savings if they wish.

    Although the word "deposit" is highly misleading for money that is to be lent out (not "deposited"), but that is a language problem (as long as people KNOW that a "deposit" is nothing of the kind – the money is lent out and the "depositors" do NOT have the money till when and IF the money is paid back). As long as people do not think they have "money in the bank" (when, of course, the money is lent out) and do not think this (nonexistent "money in the bank") can be "inusured" (when, of course, it is at risk – because it has been lent out) then I have no problem with a bank lending out (for example) nine tenths of the savings they are entrusted with.

    However, lending out a "fraction" of savings is NOT what the term "fractional reserve banking" is normally used to mean.

    When most people say "a fraction of" they are NOT thinking of (for example) "ninty nine tenths".

    Nine tenths of a something is a "fraction" – ninty nine tenths is not a "fraction" in ordinary speech (although it may indeed be in formal mathematics).

    Now whether lending out more "money" than was ever really saved (i.e. money that, properly speaking DOES NOT EXIST) is "fraud" or not is a legal debate.

    I am not interested in whether or not you "regard as fraudlant" "money" that was never saved (i.e. "money" that does not exist – book keeping tricks).

    I am not interested in having a legal debate with you. As long as you accept that this practice is ECONOMICALLY HARMFUL.

    If you do not accept that "credit expansion" (i.e. the "cheap money" policy of trying to reduce interest rates by lending out "money" than no one ever saved – i.e. "money" that does not exist) is harmful, then do NOT cite Ludwig Von Mises.

    Part of the fundemental basis of economics (against the opinions of the "monetary cranks" whether "moderates" like the early 19th century "Banking School" or more extreme forms of monterary cranks) is the debate over REAL SAVINGS.

    To an economist (in the classical sense of this term) saving must be SACRIFICE (the "self denial" bit of "thrift, hardwork and self denial").

    One can not "have a cake and eat the cake".

    If money is consumed (spent on goods and services) no "thrift" (real saving) has occured.

    The effort to have "cheap money" (i.e. lower interest rates generated by credit expansion – i.e. the lending out of "money" that no one has really saved) has TERRIBLE ECONOMIC CONSEQUENCES – i.e. boom-busts.

    Now you can reject all that if you wish to do so.

    But if you choose to reject it then do not claim any kinship with the "hard money" (i.e. real savings) tradition in economics – for you have none.

    I apologise if the above seems harsh in its tone – but bitter experience has taught me that these things should be expressed in very clear terms.

    Either lending is from REAL SAVINGS or it is also from credit expansion.

    If credit expansion is involved there will be a boom-bust.

    That has been known since (at least) the days of Richard Cantillion (John Law's partner in "legal" crime) back in the 1700s.

    This truth must be faced (and faced squarely) – not dodged.

    Of course that is the true answer to the question one hears with every major bust.

    "Where did the money go?"

    It did not "go" anywhere (although some of the wealthy and politically connected may well have managed to transfer the "money" into real wealth before the bubble burst) – because the "money" never really existed in the first place.

    Whether it is "fraud" or not is a legal issue – but ECONOMICALLY it is terrible.

  • MichaelM

    Money isn't savings.

    You cannot eat money.

    You can burn it but it's a lot less useful than most other flammable materials.

    You cannot really build anything useful with it (well, kind of, but not really — an old friend of mine used to have people who had visited her house create little works of art on one dollar bills and she would tack them to her wall).

    You really can't do anything with it except exchange it fr real savings.

    Real savings are real goods and services that can be used to satisfy a want/eliminate a discomfit. Coins, bills, deposits, credit cards, every kind of money, every kind of credit, is just a claim on the reservoir of real savings. The extension of credit is a speculative activity (like any other investment) attempting to discover just how big that reservoir actually is, since no one person or group of people actually knows or can know. No individual market, no single economy actually has any clue, any totalized representation of how much real savings is available for consumption or investment.

    You're right that this activity (speculative search for saved — that is, unconsumed — real resources) can lead to trouble when there is no feed-back mechanism that forces speculators to stop when they reach the limit of available real savings. In a central banking system, even one where the central bank's liabilities are redeemable in a base money, credit can be extended beyond the capacity of real savings to provide supply at the standing price level, leading to a boom bust cycle, exactly how you describe. However, a free banking system along the lines described by many of the authors on this blog does have such a mechanism: Free bank liabilities move through an economy in tune with the real demand to hold cash balances, which matches up with economic agents' evaluation of the size of the pool of savings. When the limit of available savings, including the real savings not represented by base money deposited in a bank, is reached then the suppliers of credit start to see their own liabilities start returning to them at a higher rate than before, forcing them adjust their behavior.

    This is actually a kind of boom-bust cycle, too, but it's one that happens on the micro-economic level, blowing a speculative bubble and allowing it to contract in line with the real value produced by the activity it generates. There is a reason that productivity gains have exploded in the centuries since modern fractional reserve banking was generated: It's a much more efficient process than pre-FRB money lending and other credit creation mechanisms. The only real issue is that irresponsible suppliers of credit can get themselves in trouble, just like irresponsible suppliers of any other good or service, and they have made a habit over the centuries of seeking protection from state authorities for against their downside so they can enjoy ever increasingly-riskless upsides.

    Paul, does every single freaking post on this blog have to full of a diatribe by you on the economic and legal crimes of fractional reserve banking? Have you ever thought that you might be contributing to the lack of interest this blog has generated just because people are tired of reading the same exact thing being posted by you every single time one of the actual contributors manages to find the time in their no doubt extremely busy lives to sharing something with the rest of us?

    You know, you might be right. I might be wrong. Whatever. That doesn't actually justify dominating this blog's comment section with your beliefs. Haven't you ever had to deal with people before? Just because you can say something doesn't actually always mean you should.

  • Paul Marks

    MichealM "savings are goods and services" – no that is exactly what savings are NOT.

    Savings are that part of your income you choose NOT to spend – NOT to use to buy goods and services.

    Of course you may choose to lend out your savings (or entrust them to a money lender "a bank" to lend out for you) and the person or group who borrow the savings may spend them on goods and services – but you have NOT done that. You have made a SACRIFICE of consumption (perhaps in the hope of greater consumption later).

    "Paul does every single freaking post…"

    Yes it appears it has to be – at people seem unable to grasp even basic economics (such as what the word "savings" means).

    I am not gatecrashing – this is not a site on wargaming or stamp collecting.

    It is a site on economics – specifically on monetary policy and banking.

    So it is not too much to ask for the people around here to actually know what they are talking about – at least the basic principles of it.

    I am certainly not claiming to be an expert – but I do know the basics (for example what the word "savings" means and what it does NOT mean). I will not tolerate people setting themselves up as "authorites" on a subject when they either do not know the basics – or (worse) choose to PRETEND they do not know.

  • MichaelM

    OK Paul, who in the heck gave you license to define 'basic economics'?

    Why is it that your understanding of this complex, incomplete science is superior to everybody's who doesn't agree with everything you say?

    Dude, you're literally here trying to teach to men who have been economics professors and professional economists for decades. How old are you again? Being patronizing is bad enough when you've earned the right, it's downright horrible when you just do it because you think you're better than everybody else. You say you're not an expert, but then you go ahead and set yourself up as an authority over people who really do have some credible claim to expertise.

    Monetary savings are nominal savings. They're the accounting trick used to try and keep track of the value of real savings: Those goods and services that go unconsumed because you don't spend your nominal savings on them.

    There's so much more to economics than reading some Mises and some Rothbard and spending a lot of time on

  • Paul Marks

    MichaelM – I do not need a license. Indeed I would shove the license down the throat of the first man who told me I needed one to speak the truth.

    Savings are that part of one's income that one chooses NOT to consume. NOT to spend on goods and services.

    Live with it.

    By the way – for my next "complex", "scientific" discovery that is "superior to everybody" I will declare that 1+1=2.

    I will also declare that water is wet. And that bears s…. in the woods.

    What anoyes me is NOT that I think you people do not know something I know (why would I be irritated by that – surely I should swell with pride or whatever). No you know this stuff just as well as I do – and so do the people who write the posts here (indeed they know it better than I do).

    No, it is the double-talk (the academic CANT) that irritates me. The PRETENCE that people do not know things they do know.

    I know people they have good reasons for what they do – "we have to save the financial system – the consequences would be TERRIBLE if it collapsed".

    Perhaps I might agree with lying (indeed lie my own head off) if I thought it really would avoid those terrible consequences – after all (I could tell myself) it is NOT lying, not if I make the form of words complex enough.

    "It may mislead those who do not read carefully – but it is NOT lying" – I know the drill.

    However, the present financial system CAN NOT be saved – so let us cut out the academic cant.

    Lending out "money" that no one has saved is a CON – a smoke and mirrors game, a ponzi scheme, a shell game (call it what you will).

    Once the con was much smaller than it is today (but it was con and a HARMFUL con even then) – but with such things as the introduction of Central Banking and the breaking of all the old principles (such as even a partial link to a commodity – such as gold or silver) the con got out of hand – totally out of hand.

    Places like the City of London and Wall Street were always places where the con (and other cons) occured – but lots of other things (GOOD things) went on in such places also.

    However, in modern times the con has grown and grown.

    Now the "financial system" is not an imperfect world with lots of bad things happening in it (it was always that – one could live with it, because the bad side was limited both by laws and by customs), these days the con IS the "financial system".

    It has grown so big and so overpowering that has swept over everything else.

    The corruption (the cancer) of it has eaten away at everything else.

    The financial system can not be saved – it is too far gone.

    That does NOT mean that new banks (and so on) will not be built on the rubble of the collapsed fiancial system – but there will be rubble, from the present system's collapse.

    And it will not be long before the decline of the present economy is obvious – indeed it will become obvious in 2013.

    You see I AGREE that the "consequences will be TERRIBLE" – but I do not agree they can be avoided now.

    Hence I am not going to play the lying game – oh sorry the "it is not lying" double talk and dodges game.

    The game is over – or nearly so.

    Yes the end will be terrible – but at least it will be the end.

  • MichaelM

    Paul, I have a loaf of bread. I could eat the whole thing in one sitting, but instead I eat two slices and put the rest away.

    How is that not saving?

    Did no one save until the invention of money?

    How is it that savings has to be in money? Why exactly is that?

    Why are you being so stubborn about freaking semantics?

  • Paul Marks

    Of course money is a lot older than coinage. Silver (just weights of silver) were (for example) being used as money for many centuries before there were coins.

    Still you are asking about goods – if someone is (for example) paid in salt, they can indeed eat the salt or (YES) "save it".

    I guess they could do that with bread – but it would go bad rather fast.

    Again the point is the same – one makes a SACRIFICE, one chooses NOT to consume in order to save.

    "Why are you being so stubborn about freaking semantics".

    Because (deliberatly?) obscure language is used as a cover for a CON (a deception).

    This con was always bad news – but it has got bigger and bigger (and government has encouraged it every step of the way).

    Now it has got so big that it is going to destroy the world – at least the world as we have known it.

    You may well be young and strong enough to survive what is going to happen – I am not.

    I am going to die – and I am going to die soon, and in very nasty (and humilating) circumstances.

    I am rather irritated by this.

  • MichaelM

    So you admit that non-monetary goods can be savings.

    So why is it so hard to admit that REAL SAVINGS consists of all this non-monetary savings?

    Did you really miss the Smithian boat of noticing that money isn't itself wealth?

  • Paul Marks

    You are missing my basic point Michael – and yet you complain about the number of times I repeat it.

    I will repeat it yet again.

    I have never denied that if people are (for example) paid in salt they can save salt.

    What I deny is that if you have 100 sacks of salt you can can lend out 1000 sacks of salt and pretend that the other 900 sacks of salt (which DO NOT EXIST) are "real savings".

    If you do not understand the concept of a credit bubble (i.e. so called "broad money") I think that reading Richard Cantillion would do you more good that reading Adam Smith.

    Otherwise you may fall into the "price stability" fallacy (as if the antics of Benjamin Strong in the 1920s or Alan Greenspan in recent year, did not happen or were not harmful).

    The very fallacy that (I suspect) Kurt S. falls into in his brief article over at Cato – which he links to in his latest post here.

  • MichaelM


    Let's say that again.


    Your understanding of how the banking system operates is woefully inadequate for the discussion we're having here. Credit expansion occurs when the banking system as a whole starts to treat bank liabilities as a stock of reserves to lend on. Any bank that tried to lend more than it had would be insolvent instantly, by definition. The first instance of illiquidity would break it.

    Not all extension of credit beyond the stock of bank liabilities is going to be bad, though. As I explained before, because the whole constellation of real saved resources ISN'T represented in the existing stock of bank liabilities. The process of discovering this stock appears stochastic as credit expands and contracts in response to good and bad speculative bets. It's only when you have massive expansions and contractions in response to massive bets that are only really possible in the presence of a privileged lender (that is, a central bank, or central bank like entity) that you get 'recessions' and 'depressions' in response to the contraction.

  • Paul Marks

    Michael the words "capital" and "reserves" are YOUR words (not mine).

    I am talking about SAVINGS.

    As for your abuse (my understanding is "woefully inadequate" and other such) I could fire abuse straight back at you. But I am not going to bother.

    The point remains the same.

    If total savings are X then total lending can not be greater than X – not without terrible consequences.

    The whole "credit expansion" ("broad money" – call it what you will) game is no good.

    "Cheap money" is, in the end, the most expensive form of money there is – because it undermines the basic structure of the economy and leads to a terrible bust (as the credit bubble, the "credit expansion", collapses).

    And no amount of abuse from you can alter that fact.

  • Paul Marks

    By the way – there is a simple way to test someone who talks about "capital" and "reserves".

    Simply ask them to show the money. Show you this "capital" and "reserves" they are talking about – the actual cash.

    There can be armed guards about (I have no problem with that) – I have no desire to steal the money.

    Just ask them to show you the "capital" and "reserves".

    It the money ACTUALLY EXISTS there would be no problem with a polite request to see it.

    As you say "no bank lends out more".

    So, according to you, "broad money" (bank credit) is never bigger than the monetary base (as no bank lends out more – either on its own or in interaction with others).

    So no credit bubble can ever be created – because there is no credit expansion. As no bank lends out more than the money it is has (called by YOU, NOT ME, by the names "capital" and "reserves" and available to be observed by silly paranoid people like me).

    So no bust can occur – because no credit bubble "boom" can occur.

    So all is well.


    I can sleep better now.