by Arash Molavi Vasséi
In a previous post, Andreas refers to George Selgin’s recent discussion of the place of fractional reserve banking in the Austrian Business Cycle Theory (ABCT). There, Selgin takes a swipe at the monetary pillar of the ABCT. According to the Austrian model, fractional reserve banking is inclined to create money out of “thin air” and, therewith, admits investment spending in excess of “voluntary saving”. This imbalance, allegedly induced by a decline in reserve ratios, is reflected in a Wicksellian interest rate gap, which is supposed to impact prices and the allocation in a systematic way (the real pillar of the ABCT). Selgin argues that fractional reserve banking does not account for the Austrian business cycle, and Andreas expresses sympathy for this view.
Basically, Selgin’s argument relies on the money multiplier and Laurence Laughlin’s Law of Reflux (when he invokes “deposit destruction”). I agree with the general direction of the argument, but go further and approach the problem from a completely different angle: under the assumptions of the ABCT, which includes competitive and frictionless banking, the creation of inside money cannot account for the business cycle, Austrian or otherwise. I go even further: given competitive and frictionless banking, inside money does not affect relative prices and allocations; it does not induce a real-balance or hot-potato effect, even if it circulates as a means of payment; control over inside money does not solve the indeterminacy problem, despite its ‘moneyness’.
If inside money has macroeconomic implications, this is because of non-monetary frictions or banking regulation. Of course, this is the view expressed by James Tobin, Fischer Black, and Eugene Fama. I know that Andreas and Mr. Selgin do not share this view. I would like to know why. Subsequently, I list some arguments to be picked apart. Please, prove me wrong!
Banks, like all intermediaries, transform liabilities that debtors are able to issue into liabilities creditors are willing to hold. Whenever an ultimate debtor is able to issue new liabilities, this is because somewhere on this planet some ultimate creditors are willing to increase their net financial positions accordingly. These ultimate creditors are not necessarily the ones that accept the additional risk associated with the new liability. By risk stripping and adjustments in gross financial positions, this risk can be channeled to third parties.
Deposits, the characteristic liabilities of the commercial banking sector, are the result of such an asset transformation. Risky, non-tradeable credit portfolios satisfying low-reputation borrowers are transformed into interest-bearing senior liabilities that find their way into the portfolios of households, firms and governments as (1) safe stores of value, and (2) are used to transfer wealth. More precisely, bank accounts grant access to a reputation-based central ledger technology (CLT), which banks cooperate to provide, and which is required to run through a public ledger operated by the central bank. Economic agents can use their balances to transfer wealth (cum current income), which is recorded as a debit, in exchange for commodities or securities. A transfer received is accordingly recorded as a credit. In this sense, deposits are ‘liquid wealth’, which for many translates into ‘moneyness’.
This fact accounts for a widespread misunderstanding. Specifically, there exists a long-lived belief that deposits and cash should trade as perfect substitutes (e.g., Mises’s “money substitutes”‘), probably due to the convertibility services associated with the banking sector (i.e., the promise to redeem on demand at par value). This belief implies that, in equilibrium, deposits do not return-dominate cash, which links them to the hot-potato effect. The correct belief, I think, is that deposits should be rather treated as close substitutes for short-term senior debt like T-bills, irrespective of their ‘moneyness’ or convertibility. Let me explain why:
- Given unregulated banking, deposits are free of risk if all (diversifiable) credit risk is allocated to shareholders and to those who invest in a bank’s ‘non-core’ liabilities. The ability of banks to create riskless liabilities is, therefore, nothing special but relies on Modigliani-Miller mechanisms that, in principle, apply to all balance sheets (or partially fail to apply in case of differential taxation, asymmetric information, etc.). Risk stripping is basically how to do it, at least under conditions that admit ‘linear pricing’. In principle, all financial intermediaries could provide some form of access to the CLT, in which case deposits would be claims to just some other types of managed portfolios.
- Deposits issued by different unregulated banks are made homogeneous by a sufficiently large equity buffer, i.e., by one that shields deposits from capital gains and losses ‘almost surely’ (with probability one), say 30, 40, or 50%. The $-denominated value of individual accounts is only affected by executed transactions and the accumulation of interest at the risk-free rate, adjusted for a competitive fee to cover the resource costs of the CLT. In principle, however, the CLT could operate on risky deposits, that is, on standing facilities that do admit capital gains and losses. In this case, deposits are heterogeneous with respect to their risk-return profiles. We would witness differential risk premia, which is what preserves the ‘moneyness’ of deposits since differential risk premia establish indifference at the margins of choice.
- In the free banking case, the deposit market is regulated by competitive interest rates. There is no dispute over the fact that deposits differ from other short-term senior debt in that they also provide access to the CLT. All else being equal, this ‘specialty’ of bank debt constitutes a comparative advantage and accounts for some extra demand. Yet moneyness, though necessary, is not sufficient to account for a convenience yield. In addition, aggregate deposits must be in suboptimal low supply. Otherwise, the use of the CLT via deposits involves zero opportunity costs. The substitutionality of deposits and currency decreases in relative deposit supply, and the deposit yield converges to the risk-free rate (adjusted for fees).
- Is there any reason to believe that competitive and frictionless banking fails to produce an efficient supply of deposits? No, because a convenience yield would constitute an arbitrage opportunity, at least under the standard assumption of zero marginal resource costs of deposit production. Free entry and optimization imply no-arbitrage, so deposits become arbitrary close substitutes to T-bills and the like. The supply of deposits is not determined, but it is bounded from above by the total demand for safe assets. By increasing the overall supply of deposits, the banking sector crowds out the demand for other types of “information-insensitive” assets without any implications for equilibrium prices and allocations. Since the deposits market is equilibrated by interest rates, there is no hot-potato effect.
- To survive the market process under uncertainty, all economic agents build up a liquidity buffer to synchronize the inflow and outflow of funds at the cost of decreasing average portfolio returns. The optimal liquidity buffer of unregulated banks and other firms that issue redeemable liabilities is just larger than the optimal buffer of firms that don’t. Higher prudence is a difference of degree, not of kind. Convertibility services grant the possibility to exit the reputation-based CLT in favor of “memoryless” and, thus, anonymous P2P transactions (e.g., due to libertarian or criminal preferences for anonymity; a collapse of bank reputation; etc). This makes a commercial bank’s senior liabilities run-prone, accounting for multiple equilibria. In contrast to Selgin, I am happy to live in a world where central banks select for the good equilibrium at zero costs (as lenders of last resort). In the good equilibrium, there is no difference in kind between the liquidity management of banks and that of other financial intermediaries.