In-Concert Overexpansion and the Precautionary Demand for Bank Reserves

By Selgin, George | Journal of Money, Credit & Banking, May 2001 | Go to article overview

In-Concert Overexpansion and the Precautionary Demand for Bank Reserves


Selgin, George, Journal of Money, Credit & Banking


IMAGINE A CLOSED BANKING SYSTEM with a fixed supply of reserves and no statutory reserve requirements. Suppose that the public does not hold high-powered money, or holds only a constant amount of high-powered money, so that increased bank lending does not result in any withdrawal of reserves from the banking system. Finally, suppose that, by accident or by design, all the banks in the system expand their loans in unison, by identical amounts. What limits the banks' collective ability to expand their balance sheets?

The conventional answer is: nothing. Were any single bank or group of banks to expand independently of the rest, then that bank or group of banks would soon face adverse interbank clearings: the expanding banks' loan customers would write checks on their borrowed balances, and those checks would eventually find their way to rival banks. The outcome would be a transfer of reserves from the expanding banks to their more conservative rivals. However, many economists argue, no similar loss of reserves confronts any member of a system of banks expanding in concert: although the banks' gross clearing debits increase, so do their gross clearing credits, leaving net positions unchanged. An in-concert expansion of bank money, involving an increasing bank money multiplier, can therefore continue indefinitely. Such, at least, is the commonly held view, which I call the "in-concert overexpansion" doctrine.

The purpose of this note is, first, to review statements of the in-concert overexpansion doctrine in both early and recent monetary writings and, second, to show that, despite being widely endorsed, the doctrine and arguments for legal restrictions based upon it are inconsistent with orthodox microeconomic theories of the demand for bank reserves. If these theories are valid, fears that bank deregulation could encourage in-concert overexpansion are unfounded.

THE DOCTRINE IN THE LITERATURE

The in-concert overexpansion doctrine dates back to Thomas Doubleday (1826, pp. 30-31) and Thomas Joplin (1826) (Mints 1945, pp. 104-105; Wood 1939, pp. 38-39). The doctrine played an important part in the currency/banking/free banking school debates, with members of the currency school urging it against their rivals' claims concerning the ability of interbank clearings to limit systemwide expansions of bank money. The currency school position became dominant by 1860, having by then largely supplanted the view, dating back to Adam Smith, "that clearing operations would be equally effective in limiting both the individual banker and the system" (Mints 1945, p. 205).

By the late nineteenth century, the in-concert overexpansion doctrine had become conventional wisdom. Knut Wicksell (1936 [1898], pp. 111-13) relied upon it in arguing that a concerted worldwide expansion of bank credit (with all banks lending at a common rate of interest, below the natural rate) would only be checked, under a gold standard, by an increase in the demand for gold for industrial purposes. Wicksell's argument implies that, absent legal restrictions on commercial bank lending and deposit creation, a fiat standard might support unlimited inflation, even in the presence of a limited stock of base money.(1)

In his 1918 textbook Eugene Agger (1918, p. 101) observed matter-of-factly that, in the event of a general expansion, "there is no check" on the banking system:

   While expansion for a single bank tends to increase debits at the clearing
   house, general expansion increases credits as well. Under the general
   expansion the balance may remain practically undisturbed and the net result
   may be simply an enlarged business on a smaller volume of reserves.

The same view was expressed a few years later by Chester Arthur Phillips (1921, pp. 77-78), whose Bank Credit has, perhaps more than any other work, helped shape the modern understanding of the limits to creation of bank money:

   [L]oss of cash as a result of increased loans, which is a powerful check on
   the loan expansion of an individual bank, tends to become inoperative if
   all banks within a credit area expand their loans with equal rapidity. … 

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