I keep reading that, while under free banking credit expansion would be checked by the limited clientele of each bank, if there is a central bank that pumps in reserves for everybody at the same rate, then every bank can expand together and no bank will lose reserves to another on net.
But I don't understand why this is true. Even if every bank increases reserves, it's still the case that nonclients of a bank will call upon it for redemption, causing reserves to flow out. How does central banking overcome the problem of interbank redemption?
I'm not completely sure about the answer to your question, but I just wanted to make sure you were aware of some of the resources on the subject that might help...
Sorry Tunk I just wrote out a response about the differences in price discrepancies between with/without central banking but did not know how to tie that back into the matter of note redeemability.
Is this the reason that non-clients wish to redeem their notes, generally: when bank's embark on expansionary policies they become more vulnerable to shifting market data. Holding the note is riskier and so the non-client wishes to switch from a riskier note to a less risky note.
So maybe the central bank either takes away the less risky note by making all banks more expansionary and removing the risk-reducing option. There's no point in cashing in the notes of an expansionary bank to another bank, when all banks are equally expansionary. Either that or in providing a backstop to all banks should they falter, they remove risk as a consideration from the minds of noteholders?
The Anarch is to the Anarchist what the Monarch is to the Monarchist. -Ernst Jünger
Well, according to what I've understood from Rothbard, the reason why nonclients will call for redemption just has to do with the fact that they are clients of a different bank with which they have their own deposit arrangements that they prefer. So if Bank A creates a demand deposit and loans it to John, who then spends the money on goods from Harry who is a client of Bank B and not of Bank A, Harry will obviously want the money in John's account transferred to his own so he can issue checks against it. So he has his bank call on Bank A for redemption. It doesn't necessarily have anything to do with depreciation of the notes. (And under central banking banks aren't allowed to issue their own notes anyway.)
In this lecture, Rothbard says that this limit on credit expansion disappears because if every bank expands their reserves and pyramids on top of them, then they won't lose reserves to each other on net because they can just clear the debt, i.e. each redemption "cancels" the other redemption out. But he doesn't illustrate this, he just asserts it, and I really don't understand.
But why in the first place does the client of Bank B want to switch his Bank A notes for Bank B notes? Why did he choose Bank B over Bank A? Is not the reason that people prefer one bank to the next either the greater returns they receive or the safety of their savings, both things being indicative of a risk preference. When choosing a bank as one's depository the considerations one makes must all stem from initially risk/reward consideration, no? What are deposit arrangements, specifically? What reason does one have to trade notes against others if not for their value on the market, in current terms or in terms of the (subjectively) likely future.
Yeah I find that Rothbard tosses around the term 'pyramiding' a little loosely.
He's a client of Bank B for whatever reason that he's a client of Bank B. It doesn't really matter with respect to my question. All that matters is that he will ask his bank to redeem all checks/notes from banks other than his own, under central banking or free banking. But under central banking, supposedly if all banks, say, triple their reserves simultaneously and pyramid on top of them, no reserves will have to flow anywhere despite demands for redemption, since the debts can all be cleared.
As far as I understand the matter (aand obviously I'm still a layman), debts can be cleared if a group of people are in debt to each other by exactly the same amount as others in the group are indebted to them. So if Bank A owes Bank B $10 worth of reserves and is also owed the same amount from Bank B, the debt can be cancelled right there without any need to transfer money. But why will this necessarily be the result if all banks increase their reserves by the same rate? That's what I want to know.
I still think that the depreciation of notes is required to explain this. When all banks expand their note circulation equally, there is no 'stronger' note or 'weaker' note. Clearing houses do not set prices on different paper. So there is no reason for anyone to 'get in' or 'get out' of any kind of note, if there are no more 'solid' options on the market. There is a reason that the person is a client of Bank B. What is that reason? What is the reason that one deposits money? And what is the reason that one trades notes for others?
George Selgin explains that very well in his book "The Theory of Free Banking". Scottish banks do not usually practice credit expansion in concert. Remember the note dueling era.
"Initially there might not be much movement towards rationalization of note exchange. That Ruritania’s banks accept one another’s notes at par does not mean that they exchange notes regularly. In Scotland par acceptance without regular note exchange was present before 1771. During that period, banks’ sought to bankrupt their rivals by “note dueling”—aggressively buying large amounts of their rival’s notes and presenting them for redemption all at once.22 For a bank to stay solvent during such raids it has to keep substantial reserves, so that its contribution to the process of fiduciary substitution is small. Charles Munn reports that one Scottish provincial bank at one point kept reserves equal to 61.2 percent of its inside-money liabilities to protect itself against raids by its rivals."
"Once again the difficulty is resolved by considering the determinants of precautionary reserve demand. Under in-concert expansion no member of a system of banks expanding in unison (and in the face of an unchanged demand for money) will experience any increase in its average net reserve demand; the change in expected value of its clearing credits will be exactly equal to the change in expected value of its clearing debits. But the growth in total clearings will bring about a growth (though perhaps less than proportionate) in the variance of clearing debits and credits, which increases the precautionary reserve needs of every bank. Thus, given the quantity of reserve media, the demand for and turnover of inside money, and the desire of banks to protect themselves against all but a very small risk of default at the clearinghouse at any clearing session, there will be a unique equilibrium supply of inside money at any moment. It follows that spontaneous in-concert expansions will be self-correcting even without any “internal drain” of commodity money from bank reserves."
"The latter component is the bank’s “precautionary reserve demand.”7 It protects the bank, not from such adverse clearings as might be predicted given a determinate structure of the demand for the bank’s liabilities, but from temporary, random fluctuations in these adverse clearings above their expected value." (from chapter 6, again)
One more thing (chapter 9) :
Note and deposit exchange rates would reflect potentials for capital losses depending on the soundness of underlying bank loans and investments. Chapter 2 showed how note brokerage systematically eliminates note-discounting except when it is based on risk-default generally acknowledged by professional note dealers, including banks themselves. In short, note brokerage produces information on bank-specific risk. [...] After confirming through the newspaper that there is no discount on the notes he holds, a bank customer would feel no urge to redeem them in a hurry.
Also, when you ban competitive note issue, you eliminate the one bank-issued demand liability for which there can be an active secondary market. Suppose you have a bank that’s insolvent, then expert market participants would discount its notes. Conversely, if the notes aren’t discounted, nobody has to worry. “Naive” bank customers could just check the market price of their notes to know whether they’d better run on their banks or not. So information from the secondary note market can prevent runs and panics from spreading randomly. If you shut down that market, as you do when you prohibit competition in note issue, you create a basis for bank-run contagions that wouldn’t exist otherwise.
Selgin:Under in-concert expansion no member of a system of banks expanding in unison (and in the face of an unchanged demand for money) will experience any increase in its average net reserve demand; the change in expected value of its clearing credits will be exactly equal to the change in expected value of its clearing debits.
Sorry if I'm being irritating, Topffer, but could you explain this logic, in a step-by-step way? Selgin is asserting this without illustrating it, just like Rothbard, and expecting his audience to grasp it. But I'm still new to all this. Why would reserves flowing out always be equal to reserves flowing in if all banks expand in concert?
I discuss the argument at greater length here.
Selgin,