Steve Horwitz is a professor of economics at St. Lawrence University in Canton, New York, and Wikipedia cites him as one of the main defenders of fractional reserve banking. So let’s have a look at his arguments. (Horwitz’s article, Wikipedia)
Horwitz’s first claim is that fractional reserve does not create money because any money deposited in one bank must have come from another bank (or indeed from the above mentioned first bank). Thus while £X deposited in bank Y does enable bank Y to create far more than £X worth of money, that is cancelled out by the fact that the bank from which the £X was taken has to rein in money.
Horwitz makes this point in the five paragraphs starting “I don’t want to rehearse…”. And it takes him well over 600 words to make the point! Talk about hot air!
However Horwitz’s above point does not stop commercial banks expanding the money supply in boom, nor does it prevent them and their customers destroying money in a recession, that is, deleveraging. In other words Horwitz’s point does not destroy one of the main criticisms of fractional reserve, namely that it promotes instability.
As to the way commercial banks engage in the above “instability promotion”, most opponents of fractional reserve probably know how this is done, but I’ll briefly spell them out anyway. First, banks do not always make full use of their reserves: witness the current huge excess reserves they are currently sitting on. In this scenario it is clearly nonsense to claim that reserves themselves would pose a restraint a sudden expansion in bank lending.
Second, the reality is that central banks expand the monetary base (i.e. reserves) to make possible an increased desire by commercial banks’ to lend. Reason is that if central banks don’t do this, they lose control of interest rates. Put another way, central banks are monopoly suppliers of bank reserves, and as it explains the economics text books, a monopoly can control the price of its product or the volume supplied, but not both.
Central bank policy is the root problem
Horwitz’s next point (para starting “Injections of new currency) is that in view of the above “inability” of fractional reserve to create money, the only real source of new money is the central bank (when it increases the monetary base or bank reserves). Good point. In other words given an increased desire to lend by commercial banks, it is the above mentioned tendency of central banks to accommodate this desire that is the root of the problem (2).
But it must be remembered that if central banks don’t “accommodate”, interest rates will rise (as intimated above) which is traditionally seen as undesirable. In fact it is not undesirable: had the increased desire to borrow and stoke asset prices prior to the crunch (or the 1929 crash) been thwarted by increased interest rates, those two disasters would never have happened or at least would have been mitigated.
And that raises an obvious objection, namely that it might seem that those increased interest rates would stifle economic activity. The answer to that objection is that, as advocated in Positive Money’s submission to the Independent Banking Commission and as advocated by Modern Monetary Theory, demand should be regulated by adjusting net government spending, not by interest rate adjustments. Had the latter policy been in operation prior to the crunch, consumers would have directed less of their spending power towards boosting house prices, and more towards more mundane forms of spending.
Excess demand for money
Horwitz then advocates free banking, and he tells us that “From a monetary-theoretic perspective, if free banks create more liabilities when the demand to hold those liabilities has increased, the results will not be inflationary, rather this warranted increase in the total money supply will prevent a deflationary excess demand for money from setting in.”
The flaw in that argument is that Horwitz does not seem to have got the difference between commercial bank created money and central bank created money. His latter point is perfectly valid in respect of central bank created money. That is, given an “excess demand for money”, the problem can be solved by increasing the quantity of central bank money.
But there is a big problem in applying this idea to commercial bank money, namely that for every extra pound of such money, there is an extra pound of debt – or “negative money”. Put another way, increasing commercial bank money by £X does not increase private sector net financial assets by so much as one penny!
Incidentally advocates of Modern Monetary Theory are well versed in the latter point, except that they tend to use different phraseology: central bank money is referred to as “vertical money” and commercial bank money is called “horizontal money” (1.).
Reserve ratios under free banking
Horwitz then seems to lose all contact with reality when he tells us that “in a free banking system, the reserve ratio is determined by the banks themselves”, and “If free banks see an opportunity to safely reduce their reserve ratios to enhance their profitability….”
He does not seem to have noticed that over the last decade or so banks have taken ever increasing risks in the knowledge that if the risks don’t pay off, taxpayers come to the rescue. That is, banks are far too irresponsible to be allowed to determine their own reserve or capital ratios.
Of course, if we dispensed with too big to fail banks, and replaced them with numerous smaller banks, then Horwitz’s point begins to make sense: the failure of one bank would possibly not matter. But we are a long way from that scenario at the moment.
Conclusion
The opponents of fractional reserve have very little to fear from one of the main advocates of fractional reserve, Prof Steve Horwitz.
References
1. E.g. see: http://bilbo.economicoutlook.net/blog/?p=381
2. For more on this, see Steve Keen’s “Roving Cavaliers of Credit”: http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/
