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The grumpier economist

In his generally thought-provoking blog The Grumpy Economist, John Cochrane refers to a recent paper and a paper earlier this year that he wrote. (The title of the blog, by the way, comes from the name his children teasingly gave him after hearing one too many of his dinner-table rants. I suspect it is how most children who have economists as parents think of them.)

In the earlier paper, “Toward a Run-Free Financial System,” Cochrane writes (page 4), “Our government should take over its natural monopoly position in supplying interest-paying money, just as it took over a monopoly position in supplying nineteenth-century bank notes, and for the same reason: to eliminate crises, which have the same fundamental source.”

Cochrane’s specialty is finance, not monetary economics, but I hold the University of Chicago to a higher standard here than such Podunk outfits as Berkeley (where Cochrane earned his Ph.D.) or Harvard. Even a Chicago professor whose specialty is elsewhere within economics should avoid gross errors of historical fact in American monetary history, given the many Chicago professors and students who have done so much to gather and interpret facts ignored by others.

First, government had no natural monopoly position in supplying bank notes. The federal government did not issue notes on a level playing field with privately issued notes and drive the private notes out of circulation. Rather, in 1863 the federal government passed a law requiring federally chartered banks to hold federal bonds as collateral against notes issued, and in 1865 and 1866 it passed acts imposing prohibitively high tax rates on notes issued by state-chartered banks and nonbank issuers. Even after ending the state bank and nonbank notes, federally issued “greenbacks,” gold certificates and silver certificates did not drive the notes of federally chartered banks out of circulation. They remained until finally prohibited by law from circulating further, in 1935.

Second, notes issued by the U.S. government in fact have historically had considerably higher risk of nonpayment than notes issued by U.S. banks. In 1933 the U.S. government defaulted on 100% of its notes with respect to the obligation to redeem them in gold. American citizens were not legally allowed to hold gold again no questions asked until 1975. In the meantime, the dollar had depreciated from $20.67 per troy ounce to nearly $200 per troy ounce.

Third, government control of the note supply was a cause of crisis in the United States, not a path to eliminating them. The “inelasticity” of the note supply in the late 19th century United States contributed to periodic financial crisis from 1873 to 1914. People wanted to convert deposits into notes, but government-imposed restrictions on note issue prevented them from doing so. The result, in those days when deposit accounts were much less widespread among the public, was a shortage of currency that prevented people from making payments and undertaking transactions they wanted to make, which were made by their counterparts in Canada and other countries that had looser restrictions on the ability of banks to convert deposits into notes. Even after the Federal Reserve began operations in November 1914, there was a note shortage during the Great Depression, as seen by the temporary increase, before further issues were outlawed, of notes issued by federally chartered banks. (Details about the regulations I have referred to are available in this old article I wrote.)

Enough of my own grumpiness for now. In a later post I will have some more general, ungrumpy comments on whether risk-free banking is really possible.


  1. Look forward to the post.

    What happened to the commenters on this blog anyway? Not many comments at all lately.

    I wonder if "The Grumpy Economist" will reply to you or just ignore the fact his history is totally off. For someone who supposedly has a "free market point of view" he sure loves to see natural monopolies where there aren't any.

  2. Good job of saying what needed to be said.
    I'm often surprised how easily Cochrane abandons free market principles and falls into anti-free-banking views.

    One quibble: "default" is too strong of a word for the suspension of gold convertibility. The fed did stop paying out gold for refluxing notes, but other channels of reflux (the bond channel, the loan channel, and the tax channel) remained open. Think of a leaky vacuum hose. Plugging one hole in the hose is ineffective as long as other holes remain unplugged.

    1. Convertibility into gold entirely ceased for Americans. To the extent the gold standard was an implicit contract, the government broke the contract. One can argue that under the circumstances it was helpful because it enabled the executive branch to offset to some extent the blunders of the Federal Reserve. It was still a default, and Carmen Reinhart and Kenneth Rogoff, in their work on the history of sovereign defaults, have classified it as such.

      1. Kurt:

        The problem is that to most people, "default" means the fed stopped redeeming frn's for anything at all, while "suspension of gold convertibility" refers to just gold. If the fed had dumped all its assets in the ocean, that would be a default. But that's not whet the fed did. The fed held on to all of its assets, and still maintained non-gold convertibility.

        1. If someone promises to pay gold and then does not pay gold – that is a default. Ditto if someone promises to pay copper and then does not pay copper.

          People do not make a contract to be paid in "anything at all" – they make a contract to be paid in a specific thing, and if they are not paid in that thing (that is default).

          As for the assets of the Federal Reserve what would these be? Government IOUs? One might as well talk of the "assets" of the Social Security system.

          As for money lending…….

          If a person (or enterprise – acting for others, for real savers) has one hundred ounces of gold (or one hundred ounces of silver, or of copper – or of whatever it is) then they can lend out a maximum of 100 ounces – not 101 ounces (and certainly not 1000 ounces or ten thousand ounces).

          And once the commodity has been lent out the person or enterprise does not have this commodity any more – till when and IF it is repaid.

          Sadly "bankers" think they can operate by different logical rules than money lenders, that they live in a different universe. But they can not (not in the end – for the credit "boom" leads to bust).

  3. What the "Grumpy Economist" says follows naturally from ignoring the essential principle that all lending should be from REAL SAVINGS (from the actual sacrifice of consumption).

    If lending is to come from book keeping tricks (not just from REAL SAVINGS) – then it is indeed natural to suppose that government should take over.

    In the 19th century THIS FORM of "free banking" was known as "free trade in swindling" – i.e. lending out "money" that does not really exist. Such a policy inevitably leads to boom-bust events and discredits free enterprise and the free market.

    There should no more be a free market in swindling than there should be in house breaking or picking pockets. Those who support the lending out of "money" that does not really exist, unintentionally, pave the way for the NATIONALISATION of finance (which is what the "grumpy economist" is really suggesting).

    If money lending is a matter of getting REAL SAVINGS and lending them out – then the arguments of the "grumpy economist" collapse. But if banking (and so on) is a matter of book keeping tricks (lending out "money" that has never really been saved) then the door is open (wide open) for such statists.

    1. I'm confused what your point is. If the bank issues more notes than it has proper collateral for it risks going bankrupt. Who is lending out money that doesn't have collateral backing it in a free banking system? One that did this, as soon as the notes were redeemed at a different bank would pay for it when it was time to clear/settle accounts.

      You keep chanting "REAL SAVINGS" but I don't see how you differentiate "REAL SAVINGS" from any other collateral?

      1. He's effectively critiquing fractional reserve banking. In other words, a bank cannot issue a (warehouse) bailment for my demand accounts, then lend out that money to others in the form of loans.

        That can only be done with time deposits (like a CD) or investment capital.

        1. I understood that much, but the amount a bank can realistically loan out cannot exceed it's excess reserves in a competitive note system.

          So again. what's his point? If he doesn't want the bank loaning out his deposits then he can purchase a safety deposit box and put the cash in there instead.

          The whole anti-fractional reserve argument can only be understood by those who haven't even taken 10 minutes to think how banking works. I'm ashamed I once believed it all until I actually learned some elementary stuff about how banks operate in such a system.

          1. damag0r:

            You are right that all money has collateral backing, but banks actually CAN realistically lend more than their excess reserves. This is easiest to see with a note-issuing bank. A bank with only $100 of coins in reserves can issue maybe $300 of its notes. The "extra" $200 of notes was issued in exchange for a "deposit" of $200 worth of borrowers' IOU's.

            The trick, of course, is that the public must want that extra $200 in circulation.

            The same process that works for notes also works for deposits.

  4. I was disappointed to read Prof Cochrane's WSJ op-ed for the same reasons noted in the other comments above. I typically find his takes informative and at least readable, but his apologia for State control of the monetary supply, and essentially an effective nationalization of the banking industry was off-putting.

    1. Nationalising the creation of money is not actually the same as nationalising banks. As Irving Fisher said, “We could leave the banks free, or at any rate far freer than they are now, to lend money as they please, provided we no longer allowed them to manufacture the money which they lend.”

      And Positive Money which thinks along similar lines to Cochrane also wants to nationalise the creation of money, but it is very specific about NOT WANTING to nationalise banks.

      1. This assumes that "manufacturing" extra money (from nothing) is a good thing – and the only thing to be decided is whether bankers do it, or the government does it.

        This is precisely what those of us who hold to the importance of contracts (for example that a promise to pay in silver means paying in physical silver) deny.

        Extra credit money (extra "effective demand") is not extra wealth.

  5. I note the normal denials that the banking system lends out more "money" than was ever really saved.

    The trouble with such denials is that they are counter factual. If they were not counter factual then "broad money" (bank credit) would never be bigger than the "monetary base" (cash money) – credit bubbles, boom-busts would not be a feature of history (and they are a feature of history – a massive feature of history).

    How can one discuss serious matters with people who just assume away (declare "impossible") the facts of human experience?

    In reality not only is it "possible" for the banking system to engage in credit expansion (to lend out more "money" than was every really saved) – but it is what the banking system repeatedly has done.

    Indeed in other contexts defenders of the bankers BOAST about how the banking system "expands the money supply" (supposedly this is good for the "needs of trade" – the central fallacy of the early 19th century "Banking School"). If bankers were just honest money lenders (not engaged in "crediting to the account" and other such) then it would indeed not be "possible" for bankers to expand the money supply, but they are NOT just honest money lenders (that is the problem).

    Of course state intervention makes everything worse (including state intervention to protect bankers for having to honour "cash on the nail" contracts or go bankrupt – really bankrupt, close down) – but denying the problem exists (or is a problem) is no good.

  6. The concept of "backing" is deeply unhelpful – indeed misleading.

    If people have agreed to be paid in silver – then silver is money (it is not "backing" for something else that is the money).

    Ditto if people have agreed to be paid in gold or any other commodity.

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