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Monetary Central Planning and the State, Part 38: Free Banking and the Coordination of Savings and Investment

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In any extended social system of division of labor, the crucial economic problem is how the vast network of interdependent market participants will successfully communicate with each other about their diverse and changing demands for goods and the ability to supply them. In the competitive free market, this problem is solved by a functioning price system. The prices for finished consumer goods and the factors of production smoothly and rapidly register every change in any corner of the market concerning a desire in demand and a willingness and ability to supply.

The price system of the market economy serves as what Friedrich A. Hayek has called an extended telecommunications device to inform everyone about changes that may be relevant to his own individual plans. Changes in prices assist in dispersing information about the need for persons to adjust their own activities to better coordinate their own actions with those with whom they may trade for mutual benefit.

Interest rates are meant to serve the same function in coordinating the intertemporal choices of the participants of the market. The decision of some participants to save requires a process of coordination with the decisions of others who wish to invest for purposes of increasing the quantity and quality of goods that can be available at various times in the future. A decision not to spend and instead to defer the possibility to consume can take two forms.

First, an individual can choose to allocate a portion of the income he has earned and lend it to another who wants to have financial access to more goods and services in the market for investment purposes than his own income and savings would permit him to purchase or hire. This person can either directly lend to a prospective borrower or do so indirectly by placing his savings in a financial institution that serves as an intermediary in selecting the prospectively most profitable enterprises to which to lend the savings placed in its care.

Second, a person can choose to save more and consume less by decreasing the rate of spending out of his income during a given income period. In other words, he chooses to increase the average cash balance he holds during that income period. This, too, represents a decline in the person’s potential demand for the amount of consumer goods his money income would permit him to purchase in the market. Suppose, for example, that at the previously prevailing prices in the market, this person had purchased four boxes of breakfast cereal, two quarts of milk, and three loaves of bread during the period between receiving his paychecks. And now, instead, he chooses to purchase during that income period three boxes of breakfast cereal, one quart of milk, and two loaves of bread.

His demand for these consumer goods will have decreased, and at the end of the income period he would find himself holding a positive cash balance of a certain amount that represented his deferred consumption. By holding on to this portion of his earned income in the form of cash, he has increased his savings. And the resources and labor that had been devoted to the manufacture of the consumer goods he no longer demands are free to be used in different ways.

Conveying information

How would a change in a person’s preferences for consumption and savings be conveyed through the market under a system of competitive, free banking? A person could reduce his consumption and shift a greater portion of his income into a time deposit with his private bank, which promises a rate of interest with the understanding that the depositor will not withdraw that sum of money for a stipulated period of time, say a year.

That sum of money will then be available for the bank to extend as a one-year loan to a borrower, who agrees to pay back the loan, with interest, at the end of the year. With the loan, the borrower will enter the market and increase his demand for the resources and labor services that have been freed from their former employment in the production of more direct consumption goods for new uses in more “roundabout” investment activities.

On the other hand, as we have seen, a person could increase his savings by decreasing his rate of consumption spending and adding to his average cash-balance holding. How would information about this form of additional savings be conveyed to the private bank with which he holds gold deposits and bank notes or possesses a checking account representing a sum equal to the gold to which he held title?

An explanation has been concisely offered by George Selgin in his Theory of Free Banking (1988):

“A general increase in the demand for … money [to hold as a larger average cash balance] is equivalent to a general decline in the rate of turnover of [bank-note and checking-account] money. Bank notes change hands less frequently, and the holders of demand deposits write fewer (or perhaps smaller) checks. As a result, bank liabilities pass less frequently into the hands of persons or rival issuers who return them to their points of origin for redemption. The reduction in turnover of liabilities leads directly to a fall in the volume of bank clearings. When this happens banks find they have excess reserves relative to the existing level of their liabilities, and so they are able to increase their holdings of interest-earning assets, which they do by expanding the supply of [bank-note and checking-account] money [in the form of additional loans to prospective borrowers].”

Fractional-reserve banking and private banks

Doesn’t this mean that private, competitive free banks would be operating on the basis of fractional reserves, i.e., issuing bank notes and extending checking accounts to borrowers in excess of the amount of gold reserves necessary to continuously meet in full the potential redemption demands of their depositors for their own original gold deposits? Yes, it does. Doesn’t this mean that such private banks, by promising to redeem all notes and checking accounts on demand for gold deposited with them, would be promising something that could not be fulfilled if a sufficient number of bank-note and checking-account holders all were to demand their gold all at once? Yes, in principle, that is true too. Is this a system of sound and truthful banking? It depends.

If such banks declaratively specify that they are fractional-reserve institutions on the face of their notes and checks, promising to pay normally on demand but not being always able to meet all obligations at once under certain circumstances, there is no apparent reason for claiming that such private, fractional-reserve banks are operating on a fraudulent basis. Furthermore, as free-banking advocate Kevin Dowd has suggested, private, fractional-reserve banks might find it advantageous to offer depositors “option clauses.” A bank would contractually promise that if, for whatever reason, it failed to redeem notes and checking accounts on demand for a specified period of time, the bank would pay a compensating penalty fee for its failure to immediately meet its obligation to its depositors or note holders.

Protecting against bank runs

Part of the entrepreneurial art of private, competitive free banking would be for the managers of such banks to anticipate correctly the average amount of gold-reserve withdrawal demands from depositors and from other banking institutions when bank representatives regularly meet to settle their respective note and check claims against one another. And, as we have seen, any over-issuance of bank notes or checking accounts by means of the lending process would soon provide negative feedback to the bank managers as a heavier-than-expected withdrawal of gold reserves signaled the need to begin following a more cautious and conservative lending policy. (See “Monetary Central Planning and the State, Part 36: Free Banking and the Competitive Limits to Monetary Expansion,” Freedom Daily, December 1999.)

In fact, this point suggests the market mechanism through which each private bank would discover whether any of its respective depositors and note holders were choosing to increase their savings preferences through a decrease in their rate of spending by holding a larger portion of their income in the form of an enlarged average cash balance.

Because customers had decreased their rate of spending and held larger average bank balances, fewer of that bank’s notes and checks would be passing into the hands of sellers of goods or to other banking institutions, and thus fewer of them would be presented to the issuing bank for redemption.

A private system of check and balance

Suppose that the managers of a bank had made the calculation that, on average, only 10 percent of outstanding note and checking-account liabilities tended to be presented for redemption by depositors or through the clearing process. On the basis of, say, $100 of gold reserves, that bank could have in circulation $1,000 worth of notes and checking accounts and have just enough gold on hand to meet the regular amount of redemption claims made against it during a period of time.

Now suppose that because of an increase in savings in the form of larger cash-balance holdings, only $90 worth of notes and checks begin to be returned to the bank for redemption during the pertinent period of time. The bank could then lower its rate of interest to attract additional borrowers and increase its lending by $100. Total notes and checking accounts issued by this bank would then be $1,100 on the basis of that same $100 of gold reserves. The bank would have decreased the ratio of notes and checking accounts to gold reserves to something closer to 9 percent instead of 10 percent. But the increased notes and checks outstanding in the form of loans are in fact tending to just compensate for and reflect the greater amount of savings in the form of larger average cash-balance holdings.

The issuing bank therefore responds to the note holders’ decision to increase their cash-balance form of savings by increasing its investment loans by an amount that more or less just reflects the change in the savings preference of income earners. The rate of gold-reserve withdrawals by depositors and note holders as a percentage of outstanding bank-note and checking-account liabilities acts as one of the sources of information to the bank that decisions by income earners to save more and consume less should have its balancing response in a decrease in interest rates, more lending, and greater investment spending.

Each private, competitive bank would increase or decrease its respective outstanding note issue and checking-account liabilities to smoothly and effectively see that its lending policies properly reflected the savings preferences of its depositors and note holders. The free-banking system would have its own internal market-response process to ensure the tendency for a coordination of the savings and investment decisions of the multitude of market participants.

 

Professor Ebeling is the Ludwig von Mises Professor of Economics at Hillsdale College, Hillsdale, Michigan, and serves as vice president of academic affairs for The Future of Freedom Foundation.

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).