A Defense of Free Banking and Monetary Disequilibrium Theory

0:00I want to thank Professor Salerno for allowing me the opportunity to present a defense of free banking. There's been a lot of debate over the theory of free banking and monetary disequilibrium theory, and due to time constraints, I won't be able to address all of the objections. In a forthcoming paper, I will give a more thorough response to all the recent objections. I'm going to try to leave some time for questions at the end. I look forward to your questions. And I believe that if you apply the insights that I provide today, you'll be able to answer most of the unresolved questions that are related to the topic. So, let's see, I also want to start off with saying why I support free banking, so that no one can ever in the future say that it's about price stickiness or anything.

0:58I support it because it's conducive to Say's law, it promotes a natural interest rate, a and the Wixellian interest rate, and it's conducive to personal freedom and innovation. Alright, so the prime concern by Philip Baggis and David Howden is would a free banking system allow expansion in concert? And this is related to the interbank lending market would be a mechanism which banks would to be able to borrow reserves from each other. And by expanding in concert, you get kind of a prisoner's dilemma situation where if everyone behaves a certain way, then you get a suboptimal outcome.

1:47And by not losing reserves to each other, then they can all expand, right? De Soto made the same argument in his book. And lastly, the Austrian business cycle necessarily ensues. So, a lot of the literature thus far has been focused on reserve management. For example, Seligen's book on the theory of free banking, and this is warranted because one of the prime concerns about the need for a central bank is to be the lender of last resort in case of a liquidity crisis. But unfortunately, by overly focusing on reserve management, it's left the argument open to to the argument about expansion and concert, I believe.

2:41So we have to look at how banks actually operate fully to be able to understand this. So banks face risk beyond liquidity risk, and bank credit is not only constrained by institutionally determined reserve ratios, such as the often-recited, you know, banks lend out 10 times what they have in reserves. So what actually determines the supply of inside money, that's money created by the banks, is the risk-adjusted net interest margins, capital adequacy and liquidity, and in a mature banking system, liquidity actually gets priced into the net interest margins because banks lend to each other. So how banks make profits, you know, the bottom line is determined by interest income from and their assets, minus net charge-offs and delinquencies for bad debt, plus non-interest income fees, origination fees, stuff like that, interest expense minus, or minus interest expense minus operating expense employees overhead, plus or minus gains and losses on portfolio, minus taxes.

3:54So if you factor out the operating stuff, what you get is the difference between what banks lend at and the rate they have to borrow at to pay depositors and other sources of funding. And that is your net interest margins. So if we look at, if we expand on this, you get your return on assets minus your net charge Delinquency rates, which you could restate as risk to the portfolio, minus your cost of funds, which includes bonds, deposits and reserves borrowed or lent. Borrowing reserves, you're going to be paying interest. If you have excess reserves, you're going to lend it, add interest and earn interest.

4:44After that you get your risk adjusted net interest margins and we know from micro 101 that profit maximization occurs when marginal revenue equals marginal cost. Therefore the inside money supply is endogenously a function of bank profitability which is derived from the risk adjusted net interest margins. Since the interbank lending rate affects the rate the banks pay to attract deposits, the interbank lending market coordinates the allocation of credit to its most highly valued uses. So this means the interbank lending market is the price signal that restricts rather than enables excess money creation unless you have a central bank to manipulate this and the misprice signal, in our case, the federal funds rate.

5:39So when the Fed does this, it changes the bank's cost of funds and causes them to misprice risk. So since the central banks generally target inflation around the world, they usually have interest rates too low in the boom time when inflation is low, providing too much liquidity, and then too high. They raise the interest rates once price inflation starts to show up, and then they cause a credit crunch. So now let's apply this to a scenario to show how the inter-bank lending market restricts over expansion of credit. Bank A is privy to a loaner investment that yields above average expected returns relative to risk.

6:27and the bank has average cost of capital, so a ceteris paribus assumption, right? The bank will approve the loan and credit the borrower's account. Now in order to prevent losing reserves, the bank will attract new deposits by raising interest paid on their deposits and that'll, by attracting deposits, that'll raise their competitor's cost of funds too. 2, or they'll borrow the reserves on the interbank lending rate and that'll also raise the rate the banks lend at, and either way the risk adjusted net interest margins are compressed and the profits of the rest of the banks go down.

7:15So how does this relate to monetary disequilibrium theory? Well time preference determines the saving rate, the average rate of interest, or the and the axillian natural rate, but liquidity preference determines the allocation of wealth between money and risk assets and the shape of the yield curve. So since banks are involved in maturity transformation and inter-temporal markets of the capital, what the signals they deal with are the yield curve to determine how to make that trade Off Across Time. So a steep yield curve signals the banks to increase the money supply.

8:02So the banks respond to those price signals of the yield curve. Risk aversion and high liquidity preference of the public leads to risk assets such as stocks to sell at a discount, which increases their yields, and interest paid on deposits Bankers purchase securities, so when this happens, banks will purchase the securities, the risk assets, and they'll make new loans, which simultaneously creates new deposits, deposits, and it returns the asset prices into equilibrium with their yields, and at the same time provides liquidity to satisfy society's preferred allocation of wealth.

9:01So as Austrians we know time preference determines the rate of interest, which would be the average rate of interest, but liquidity preference has an influence on yield curve and the differential Model Between Money and Risk Assets. If you're familiar with the CAPM model, the securities market line, which determines that if a security has an above expected return or below average return relative to risk, the shape of that or the slope of that line would be determined by the liquidity preference One of the claims is that the demand for money is relatively stable, so you wouldn't have these problems in a free market, you wouldn't need to have banks to adjust the money supply.

10:06But unfortunately, or however you look at it, that's not true, because the evidence I provide here over the last about a hundred years from Fed data, we're looking at change in the currency held by the public, and so this is a pretty good indicator of the demand for money because it shows if the public holds more demand for currency, they're going to pull money out of the banks, usually this shows the transaction demand for money especially. And so what you see here is that at the beginning of the year, after the holidays, the public reduces their demand to hold currency. And then especially in the autumn time and especially once you get near the holidays, you have a huge relatively demand for people to have currency for spending, right?

11:03So if you had a fixed supply of money, this would pose a problem because you'd have almost 3.5% change, that would fall on a change in the price level in a two month period. That's what Seldzins talk about by confusing the entrepreneurs as to whether there's a fall off in demand for their own goods or whether it's economy wide. Either way, they're going to be less profitable and it's not due to the real economic factors. So I think this This really supports the case for free banking and having flexible money supply, the response to market signals. Now, Austrians have gotten some criticism lately over why hasn't there been enough inflation as much as you guys predicted.

11:57So applying this model that I just have presented about risk adjusted net interest margins determining the money supply. So we can look at the Federal Reserve's policy of operation twist and we see how it's keeping the yield curve flat and so what this does is it leads to reduce profitability of you know the marginal loan so the banks have less incentive to expand so the feds trying to create demand for loans or or reinflate the housing bubble by having interest rates low but the banks that's not going to incentivize the Banks to make those loans at such low interest rates, and that's why only the most creditworthy borrowers are able to get credit right now.

12:46So it's a typical, like a price ceiling, if you put a price ceiling you're going to have shortages. So banks are compensating by increasing their interest income, fees, you've seen debit card The Federal Reserve and Bank of America charge fees just to have an account. They're finding new ways to generate income since their interest income is reduced right now. Plus you have the interest rate on reserves, also reduces the opportunity cost of holding reserves, which effectively reduces net interest margins. So that, I would say, is why we haven't had inflation, and I would say that a good predictor that you probably won't have very high inflation until long-term interest rates go up.

13:45I'll say a couple more things, Baggis and Howden talked about how free banking ultimately leads to cartels and they also talked about how negotiability of reserves is affected by asset prices being inflated due to money being created. I'll address more of these in a forthcoming paper I even talked about. They mentioned the Panic of 1857, so we take a little closer look at whether that really meets the criteria they're discussing. But in regards to their third claim about increased negotiability of reserves, well, this sounds a little confusing because reserves are the numeraire Reservations to which all transactions occur and since money is a unit of count and it trades with no bid-ask spread.

14:49So reserves are always going to have a constant negotiability, I'm a little confused on what they mean by that. Plus if their concern is really about liquidity and its relation to flexibility and asset prices of the bank's asset side of the balance sheet. Well, then banks do have, I mean, pretty much what banks do is asset liability management and to manage their liquidity risks over time. So banks have an economic incentive to manage the risks and they'll hold capital to offset that risk in that situation. I'll leave it there.