Does fractional reserve banking endanger the economy? A debate

On April 16, 2018, two free market economists debated a topic that has long divided libertarians. Fractional reserve banking refers to banks' standard practice of keeping only a portion of their depositors' money on hand and loaning out the rest.

In The Mystery of Banking (1983), the anarcho-capitalist economist Murray Rothbard called fractional reserve banking "a shell game, a Ponzi scheme, a fraud in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts." Other libertarian economists, such as Larry White and Steve Horwitz, have argued that the practice is perfectly defensible.

At The Soho Forum, a debate series in New York City that is sponsored by the Reason Foundation, Robert Murphy debated George Selgin over the following resolution: "Fractional Reserve banking poses a threat to the stability of market economies."

Murphy, a research assistant professor with the Free Market Institute at Texas Tech University, argued for the affirmative. He has a Ph.D. in economics from NYU has addiliations with the Institute for Energy Research, the Mises Institute, the Fraser Institute, and the Independent Institute. He has authored hundreds of articles and several books explaining economics to the layperson, including Choice: Cooperation, Enterprise, and Human Action.

Selgin, who opposed the resolution, is a senior fellow and director of the Center for Monetary and Financial Alternatives at the Cato Institute and professor emeritus of economics at the University of Georgia. His research covers a broad range of topics within the field of monetary economics, including monetary history, macroeconomic theory, and the history of monetary thought. He is the author of The Theory of Free Banking, Bank Deregulation and Monetary Order, Less Than Zero: The Case for a Falling Price Level in a Growing Economy, and most recently Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage.

The Soho Forum runs Oxford-style debates, in which the audience votes on the resolution at the beginning and end of the event. The side that gains more ground is victorious. ​In this case, Selgin won by convincing 14 percent of the audience to switch over to his side.

Fiat money vs. the gold standard

Scott Sumner and Larry White take on monetary policy in this Econ Duel.

Throughout the 19th century and up until the Great Depression, the gold standard was used in the United States. It was largely abandoned in the 20th century.

But what is the gold standard? It’s a system for defining the value of a currency in terms of gold. In other words, you could exchange your $20 paper bill for actual gold at one point in history.

Under a fiat money system, such as the one we have in the U.S. today, that $20 paper bill is inconvertible. You can’t exchange it for a backing store of value because there isn’t one.

In this Econ Duel, economists Scott Sumner and Larry White, who both focus on monetary theory and policy, debate the positives and drawbacks to the gold standard vs. fiat money, and the role of central banks.

On the side of the gold standard, White argues that, when properly implemented without a central bank intervening, it provides a more predictable price level and lower average inflation.

Sumner, taking up the banner for fiat money, argues that the gold standard is simply a rule that worked well in the 19th century and that a good fiat money system is, for this day and age, a better alternative.

The rise and fall of the gold standard

There is a new Cato Policy Analysis piece out on The Rise and Fall of the Gold Standard in the United States (pdf) by George Selgin. The executive summary reads,

There is, in informal discussions and even in some academic writings, a tendency to treat U.S. monetary history as divided between a gold standard past and a fiat dollar present. In truth, the legal meaning of a “standard” U.S. dollar has been contested, often hotly, throughout U.S. history, and a functioning (if not formally acknowledged) gold standard was in effect for less than a quarter of the full span of U.S. history.

U.S. monetary policy was initially founded upon a bimetallic dollar, convertible into either gold or silver. Although officially committed to bimetallism, from 1792 to 1834 the United States was functionally on a silver standard. From the Civil War until 1879, a fiat “greenback” standard predominated with the exception of a few states, such as California and Oregon, where a gold standard continued to operate.

Between 1870 and 1879 numerous countries embraced gold monometallism. France ended the free coinage of silver in 1873, while the rest the Latin Monetary Union followed in 1876. But it was above all Germany’s switch to gold that prompted the United States to demonetize silver and embrace gold. Thus began the era of the Classical Gold Standard in the United States.

The Classical Gold Standard Era lasted until about War World I, when as common in times of war countries abandoned their commitment to convertibility. What followed World War I was the Gold Exchange Standard, whose failure resulted from its dependence upon central bank cooperation. Post World War II, the Gold Exchange Standard was replaced by the Bretton Woods System and its reliance on a fiat dollar. Bretton Woods finally came to an end when President Nixon closed the “gold window” on August 15, 1971.

This paper reviews the history of the gold standard in the United States, explaining both how that standard came into being despite having been neither formally provided for nor informally established at the nation’s inception, and how it eventually came to an end. It concludes that the conditions that led to the gold standard’s original establishment and its successful performance are unlikely to be replicated in the future.