Selgin on Fractional Reserve Banking

George Selgin explains his views on fractional reserve banking (FRB) in this interview:

“RF: Do you consider fractional reserve banking inherently problematic? Does free banking require a commodity standard so private banks don’t issue too much currency? ....

Selgin: .... As for fractional reserve banking, I think it’s a wonderful institution and that it’s crazy to argue that we need to get rid of it to have a stable monetary regime. Those self-styled Austrian economists, mostly followers of Murray Rothbard, who insist on its fraudulent nature or inherent instability are, frankly, making poor arguments. I don’t think the evidence supports their view, and that they overlook overwhelming proof of the benefits that fractional reserve banking has brought in the way of economic development by fostering investment ….

That’s quite unlike the situation you have when you have a monopoly bank of issue. Even in the presence of a gold standard, when the privileged banks’ IOUs are themselves claims to gold, a monopoly bank of issue can expect other banks to treat its paper notes and its deposit credits, which are close substitutes, as reserve assets — that is, to treat them as if they were gold themselves. As a result of that tendency, which exists only because the recipient banks are deprived of the right to issue their own paper currency, the less privileged banks become dependent on the monopoly currency provider and, therefore treat its notes as reserve money. Now that monopoly bank has the power to generate more reserves for the whole system and it, in turn, is free of the discipline of the clearing mechanism. That’s where central banks’ power comes from. This is what allows central banks to promote a general overexpansion of credit and inflation. What I just described is exactly the sort of thing that triggered many of the financial crises of the 19th century.”
Stephen Slivinski, “Interview, George Selgin,” Federal Reserve Bank of Richmond, Winter 2009.

It is certainly true that, in the face of rising demand for money, 19th-century nations created credit and paper money in increasing amounts:

“[the] reconciliation of high rates of economic growth with exchange-rate and gold-price stability [in the 19th century] was made possible … by the rapid growth and proper management of bank money, and could hardly have been achieved under the purely, or predominantly, metallic systems of money creation characteristic of the previous centuries. Finally, the term ‘gold standard’ could hardly be applied to the period as a whole, in view of the overwhelming dominance of silver during its first decades, and of bank money during the latter ones. All in all, the nineteenth century could be far more accurately described as the century of an emerging and growing credit-money standard, and of the euthanasia of gold and silver moneys, rather than as the century of the gold standard.” (Triffin 1985: 153).

Triffin (1985: 152) estimates that in 1800 bank money or credit money probably constituted less than 33% of the money supply. But by 1913 paper currency and bank deposits accounted for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10%. Thus growth rates in the 19th century were only sustained by a massive expansion of credit money, and what economic growth that did occur was not achieved under the type of “pure” gold standard that existed in previous centuries.

But Selgin gets his history wrong in one important respect.

Now, having admitted that FRB is a highly useful institution for fostering investment, Selgin opposes central banks as promoting “general overexpansion of credit and inflation” and causing financial crises. Yet America had no central bank for most of the 19th century, and financial crises hit that nation regularly. By contrast, Britain had the Bank of England in the 19th century and was not subject to financial crises as severely and frequently as America. In the UK, between 1866 and 1914, there were no serious financial crises, and “Baring Crisis” of 1890 was in fact dealt with by the Bank of England (Wood 2005: 112):

“During the gold standard years Britain suffered no major financial crises in which the stability of its financial system was threatened; the maturation of a Bank of England conscious of its lender-of-last-resort responsibilities, together with a banking system composed of large banks with countrywide branch networks, limiting the scope for crisis. The United States, in contrast, possessed no central bank, and its financial system was characterized by a large number of geographically restricted unit banks and periodic surges of bank failures” (Bayoumi et al. 1996: 9).

In response to this, free banking proponents like Selgin will probably complain that the US “free banking” period was not really free at all, because of state regulations, such as those that restricted branch banking in the US. But that does not refute the contention that a lender-of-last-resort central bank in the US could have prevented many of these liquidity crises, despite the weakness of branch banking. And it certainly won’t fly in the case of Australia in the 19th century, where there was minimal regulation which was mostly ignored anyway, and where there was no central bank. Australia suffered a devastating property bubble in the 1880s and financial crisis in the 1890s, followed by depression (Hickson and Turner 2002).

Selgin also ignores the role that financial regulation can play in directing the flow of credit and preventing asset bubbles. We largely eliminated serious asset bubbles and financial crises in the West after 1945 with a system of effective financial regulation, until the neoliberal era deregulation (late 1970s onwards). With Keynesian macroeconomic management and financial regulation, the post-WWII era was the golden age of capitalism (1945–1973), with superior real GDP growth and real wage growth and low unemployment.


BIBLIOGRAPHY

Bayoumi, T., Eichengreen, B. and M. P. Taylor, 1996. “Modern perspectives on the gold standard: Introduction,” in T. Bayoumi, B. Eichengreen, and M. P. Taylor (eds), 1996. Modern Perspectives on the Gold Standard, Cambridge University Press, Cambridge. 3–16.

Hickson, C. R. and J. D. Turner, 2002. “Free Banking Gone Awry: The Australian Banking Crisis of 1893,” Financial History Review 9: 147–167.

Triffin, R. 1985. “Myth and Realities of the Gold Standard,” in B. Eichengreen and M. Flandreau (eds), The Gold Standard in Theory and History, Routledge, London and New York. 140–16

Wood, J. H. 2005. A History of Central Banking in Great Britain and the United States, Cambridge University Press, Cambridge and New York.