Fractional reserve bullion banking and gold bank runs – Frankenstein Free Banking

The bullion banking and inter-BB clearing system described yesterday has a lot in common with free banking, which is "the competitive issue of money by private banks as opposed to the centralised and monopolised issuance of currency under a system of central banking."

That quote comes from George Selgin's 1988 paper The Theory of Free Banking: Money Supply under Competitive Note Issue, which provide a good explanation of it. It is 192 pages however, so I would only recommend it to the most dedicated. I'll do my best to draw out the parts of Selgin's paper relevant to our topic.

The key features of a free banking system as described in Selgin's paper include:

• no central bank, ie no monopoly of currency issue
• each bank issues its own branded bank notes
• banks compete against each other for deposits and loans
• banks hold physical gold as reserves (not government fiat)
• people are paid in different branded bank notes and deposit these with their bank
• banks settle/clear the notes of other banks deposited with them by their clients with gold
• banks establish a clearinghouse to facilitate inter-bank settlements

For the moment let us leave the question of a central bank and consider the above in terms of what I have described over the past few posts. In the case of bullion banking, while there are no physical gold notes circulating, we can consider unallocated accounts as equivalent of the branded bank note - unallocated is specific to the BB with whom you hold it. The BBs do compete with each other in a light touch regulatory environment, depending on the jurisdiction., and the BBs hold physical gold reserves and settle in physical gold via a clearinghouse.

Note: I'm going to refer to a number of conclusions Selgin comes to in his paper, which he bases on logic and historical evidence of episodes of free banking. I am not a monetary expert but to this lay reader his conclusions seem well argued. Happy for people to disagree with his conclusions but if you haven't bothered to engage with Selgin's work, don't expect me to engage, particularly if you are rasing criticisms he addresses in his paper.

One of the key conclusions that Selgin comes to in his paper is that under free banking the supply (creation) of money only responds to changes in demand for money by people. In other words, central bank created inflation as we know it does not occur and "the value of the monetary unit is stabilized, and events in the money market do not disturb the normal course of production and exchange."

The implication for bullion banking is that, if it operates along free banking lines, then there is no excess unallocated gold created, that is, no "inflation" in gold credit and thus no resulting deflation/fall in the fiat price of gold (eg if there was 10oz vs $10 then the price is $1 per oz; if you double the ounces, then 20oz chases $10, price becomes $0.5 per oz).

 

The reason for this is that if an individual BB creates/lends too much gold credit (unallocated) then when its clients use/transfer that unallocated to clients with accounts at other BBs, it will result in that BB owing gold to its competitor BBs and they will request physical to settle the growing LPMCL imbalance resulting from that BBs over lending. So all BBs are restricted in their unallocated gold lending to the extent of their physical reserves.

However, Selgin notes that the mathematics of inter-bank clearing mean that if all banks expand credit at the same rate, then there will not be any adverse inter-bank clearing balances between them. He notes only two controls over such collusive (or game theory type response - ie if you are expanding credit, I will/have to as well) behaviour:

1. The growth in money supply will result in a grow in clearings, which will bring with it a growth in the variability of clearing debits and credit. This will require banks to increase their precautionary reserves, and this increase in reserves constrains money creation.
2. The redemption of physical gold by the public (ie, the reduction in bank reserves).

For bullion banking, the implications are that inflationary gold credit creation (which would push the fiat price of gold down) is restricted only if there are a few prudent BBs that do not follow their competitors. If not, and all BBs increase at the same rate, there will be inflationary gold credit but it will stabilise at some higher level (than than required by legitimate gold credit demand) due to the variability of clearing issue.

However, we know that central bankers hold gold and lend it to BBs, so we do not have a true free banking system. However, it is also not like a fiat system as gold can't be printed, so it is a half way house with bits from both, or a Frankenstein Free Bullion Banking system.

 

Selgin notes that with a monopolised currency supply, central banks can create more reserves and "since such expansion is a response to the exogenous actions of the monopoly bank and not to any change in the money-holding behavior of the public, it involves “created” credit and is disequilibrating".

 

So in our Frankenstein Free Bullion Banking system, the lending of gold to the BBs by a central bank increases the BBs reserves and thus increases the BBs' ability to create more gold credit (unallocated). This inflation in gold supply naturally results in its fiat price falling. If so, why then would a central bank actually sell its precious physical gold if it wanted to manipulate the gold price when it can do so via reserve expansion instead? An answer to this rhetorical question tomorrow.