The anti-fractional reserve banking (FRB) Austrians sometimes allege that FRB would not have survived without governmental intervention. By this, they usually mean that governments sometimes allowed suspension of specie during financial crises. While that is true, many times governments have legislated to stop banks from inserting “option clauses” in their demand deposit contracts allowing them suspend specie payments for a temporary period.
The so-called “option clause” (to suspend specie payments temporarily) was used freely in private FR banking contacts in Scotland from 1730–1765, Sweden from 1864–1903 and Canada during the 19th century (Selgin 1996: 247). The banks required no government support or intervention to allow them to suspend specie payment in liquidity crises, to stop runs and bank collapses.
The option and discretion to create an option clause in a bank’s FR contract gave the bank the right, in some circumstances, to suspend payments temporarily until it was able to obtain the liquidity needed for meeting obligations (Barth et al. 2001: 30). When its customers accepted such a contract, this was a perfectly voluntary and successful example of free contact: a “wicked” or “evil” government was not needed to enforce temporary suspensions of specie payment in such a case.
If that “option clause” was in your contract and the bank decided to suspend for a temporary period, this was not fraud, but free contract. Nor was government required for this process to arise and operate in free markets with fractional reserve banking. Nor was government required for the origin and success of fractional reserve banking.
Barth, J. R., Brumbaugh Jr., R. D. and G. Yago (eds.), 2001. Restructuring Regulation and Financial Institutions, Kluwer Academic Publishers, Boston, Mass. and London.
Selgin, George A. 1996. Bank Deregulation and Monetary Order, Routledge, London and New York.
Tuesday, January 31, 2012
Fractional Reserve Banking, Option Clauses, and Government
Posted by Lord Keynes at 6:21 PM
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I've read White's "Free Banking in Britain" as well as Rothbard's "History of Economic Thought" (relevant since he writes extensively about the Currency v. Banking School) and his "The Myth of Free Banking in Scotland".ReplyDelete
I originally got White's book mainly because Selgin said his second edition refuted Rothbard's claims (about the defects in the Scottish Free Banking system).
(Again, I'm not anti FRB, contractually. I'm just a Rothbardian economically).
While what Selgin writes is true, as after 1765 option clauses were banned on banknotes in Scotland, the biggest defect I think in the Scottish banking system was that Scotland still was able to suspend specie payments (allegedly because it could piggyback off of the English-Rothbard) during the Napoleonic Wars, and afterwards was able to keep specie reserves extremely low because there was much cajoling when people tried to redeem certificates.
London also had somewhat adverse affects, since the Scottish banks did have liquidity in the London market and "secondary reserves", which allowed them to exchange for their notes instead of specie. Not to say that they pyramided off the BOE, but it seems like they were able to get away with this because specie payments were suspended. And while they could exchange notes for English "reserves" to customers, they still could suspend "specie" payments because they didn't have to give them specie.
Finally, Scotland was bailed out by England during the crisis of 1793. White does note, correctly that it wasn't the Bank of England that gave out the loans nor Scottish banks that received them, but rather the British government and Scottish businesses. Still, this inadvertently was a bailout for the Scottish banks, because if the value of the companies' stock/bonds that banks hold for equity goes up as a result of the bailout, then they will be better able to "weather" panics and not have to contract, etc.
I'm not a historian of Scotland though, and what I said above is based off of my readings of White and Rothbard.
In Rothbard's Mystery of Banking, he illustrates that a free banking system, one where many banks freely compete, naturally tends to force banks to use a high reserve ratio. So, there is no need for a law that would limit reserve ratios.ReplyDelete
This is because, if there are many banks, it is less likely that two people would share the same bank. Thus, a person writing a check to another person would result in a withdrawl of specie from one bank and deposited to another. Banks would be forced to maintain high reserve ratios to meet these withdrawls.
I would imagine that a bank that invoked its "option clause" often would be viewed as inconvenient by its customers, and its customers will choose a different bank.
"a “wicked” or “evil” government was not needed to enforce temporary suspensions of specie payment in such a case"ReplyDelete
Then why were there suspensions, that too repeated and prolonged, that too enforced by government?
The UK Building societies often had withdrawal restrictions on their accounts until very recently.ReplyDelete
Probably until they got a clearing account at the BoE.
But, banks can clear with each others' notes. Reserves of outside money are still necessary to clear any amount above the amount of other banks' banknotes you may have (or gold may actually go the other way, too), but if you can clear against each other's bank notes then the amount of gold reserves you need goes down.
In a free market, it seems to me that private FRB notes would be clearly marked as distinct from warehouse receipts and the distinction would be well known to both depositors and payees. Further, I would think that prices in FRB notes would have to be translated into a species equivalent price and there would different sets of prices. Thus, any “artificial” boom set off by FRB notes would be obviously so denominated in FRB prices which would contain the boom (if there was a boom at all). Further, not only are such FRB notes a different animal than warehouse receipts, but they would be fundamentally different than historic FRB notes used as official government currency. Under the latter system, it’s easy to envision the entire society being misled by official FRB prices (since everything is stated in those prices), but not so much in a private, competing system.ReplyDelete
Thus, LK’s constant assertion of functional equivalence between official currency FRB and private competing FRB is misplaced (probably because he refuses to understand the concept of economic calculation).
Rothbard also addressed that in the book. He said that banks have an incentive to request the specie from their competitors, and not just hold onto their competitor's bank notes. This is because they can loan out that specie and take advantage of fractional reserve lending themselves, rather than letting their competitor enjoy the advantage. Also, a bank note carries the inherent risk that the bank has insufficient reserves, or is insolvent, or has made bad loans. That is also incentive for one bank to request specie from its competitor instead of carry their bank note.
"Thus, LK’s constant assertion of functional equivalence between official currency FRB and private competing FRB is misplaced"ReplyDelete
I have never asserted that there is a "functional equivalence between official currency FRB and private competing FRB" - you're just making it up.
"In a free market, it seems to me that private FRB notes would be clearly marked as distinct from warehouse receipts and the distinction would be well known to both depositors and payees. Further, I would think that prices in FRB notes would have to be translated into a species equivalent price and there would different sets of prices."ReplyDelete
The value of the private fractional reserve banknotes would depend on the reputation and solvency of the banks concerned. There is no reason why, in theory, many of them would circulate at par.
"This is because they can loan out that specie and take advantage of fractional reserve lending themselves, rather than letting their competitor enjoy the advantage. Also, a bank note carries the inherent risk that the bank has insufficient reserves, or is insolvent, or has made bad loans."ReplyDelete
And this overlooks the possibility of private banking cartels/oligopolies, where they agree to accept each other's banknotes.
Notes are redeemable for a given amount of outside money. The prices of inside money and outside money are linked, and one in the same.
If the system worked flawlessly (absolutely, speaking), the quantity of money in circulation remains the same -- even with fiduciary expansions (because, fiduciary expansion by X amount of notes is preempted by an increase in X amount of notes being held [left uncirculated]).
You didn't understand what I said. I said that when bank A sends bank B x amount of bank B's notes, bank B can meet some of these returning notes with notes from bank A. I.e. there will be liabilities returning in both directions, and so not all clearing notes will necessitate movement of outside money.
Why would Bank A be holding onto Bank B's notes in the first place? They have incentives not to do so.
As LK said, conceivably they could form a cartel. But cartels are naturally unsustainable as suggested by game theory.
There would be no demand for money warehouses, except things like safety deposits. Why would you want to pay a bank to hold your money, when you can be paid by a bank to hold your money?ReplyDelete
Jonathan M.F. Catalán,ReplyDelete
Out of interest, do you oppose or support free banking (with voluntary FRB)?
I consider myself a free banker.ReplyDelete