Reply To: Bank Reserves


1. There seems to be some agreement on free enterprise in money and banking. Entrepreneurs should be able to attempt innovations and have them succeed or fail on the basis of the resulting profit and loss. There is sharp disagreement about what the outcome of the attempt to implement fractional-reserve, money substitutes would be. Free bankers argue that such a system will provide for adjustment of the money stock to changes in money demand while leaving the purchasing power of money stable. Misesians argue that such an attempt will result in nearly 100 percent reserves of money substitutes.

Take a look at this talk by Joe Salerno:

2. In a free-market, commodity money would be produced by private enterprise. Just like the production of any other good, the production of money would be regulated by profit and loss. If the demand for money increased, then it would be more profitable to produce and money-commodity-producing entrepreneurs would buy more inputs to expand production. The additional production of coins would moderate their higher purchasing power and the additional demand for inputs would bid up input prices. The result would be an elimination of additional profit and an economizing movement of resources out of other goods and into commodity money production. If entrepreneurs have chosen a commodity whose supply is insufficiently expandable in the face of increased demand for money (so that problematic price deflation occurs), then they would simply chose another commodity to use as money that did not face such a problem (for example, silver instead of gold.)

The high purchasing power (in contrast to a rapidly rising purchasing power) of gold would not pose a problem. Entrepreneurs would create money substitutes that can have any denomination necessary for making transactions. For example, a check of any amount can be drafted on a person’s checking account at a bank.

Whatever the money stock happens to be, all the transactions that people desire to conduct can be consummated. If the money stock is half as large, all the transactions can be made as long as prices are half as high. If the money stock is twice as large, all the transactions can be made at prices twice as high. This insight was first advanced by David Hume.

3. In a free market, entrepreneurs could operate profitable businesses providing assessments of financial institutions. Auditing companies, private rating agencies, etc. would spring up to accommodate consumer demand for such assessments. There are many examples of businesses that do so currently for consumer-goods markets.

Of course, rating agencies today are heavily intertwined with the state and its regulatory apparatus. For example, the state dictates what financial reports must be made and what accounting rules must be used to report asset values.

4. Banks would earn fees from customers who valued the convenience and safety of the banks’ money substitutes relative to using coins. As long as customers valued sufficiently their checking accounts relative to coins as a medium of exchange to provide revenue to the banks by paying fees that were high enough to cover the banks’ costs of producing and administering the checking accounts, then banks could profitably produce them. Customers may also value the protective storage of their coins relative to holding their coins themselves, which would be another source of fees banks could charge for 100 percent reserve, money substitutes.

Banks earn revenue from intermediating credit. They borrow funds from savers, pool them and lend them to investors. As middlemen, banks can provide valuable services to savers, such as assuming the risk of default on loans to investors and pooling funds of small savers to make larger loans with lower transactions costs. As long as savers value these services, they would be willing to accept lower (wholesale) interest rates to lend to banks that, in turn, can lend to investors at higher (retail) interest rates. If the revenue from the interest-rate differential covers the costs of providing the middleman services, then banks can be profitable.

5. It does have its merits.

He seems to suggest that it might awaken the public to the need for monetary reform since it makes the wealth transfer to the state apparent. Whereas the Fed system is opaque.