Henry Simons' Banking Model and Economic Stability
Originally published in Instituto Juan de Mariana on the 28th of September 2023.
The monetary realm has been one of the key focuses of Javier Milei's economic proposals as a presidential candidate in Argentina. This is not surprising considering the inflation the country has suffered in recent years. Dollarization is undoubtedly the star proposal in this area, that is, replacing the Central Bank of Argentina with the U.S. Federal Reserve. However, Milei doesn't limit himself solely to this monetary proposal; he also advocates for the banking model promoted by Henry Simons. Under this system, banks would be divided into two departments: one for deposits, where these would be backed 100% by treasury balances, and another for investments, where the bank would engage in investments not financed by demand deposits, but by what will be referred to in this article as "term investment instruments." Let's illustrate this with a balance sheet:
Bank’s Balance Sheet under Simons’ Banking Model
For Simons, this was a fundamental step in achieving what he called a "good financial society" (Henry Simons 1951, p. 243). His financial reform aimed to simplify credit schemes within the economy (Friedman 1967, p. 2), avoiding the catastrophic effects of credit expansion and contraction throughout the economic cycle (Simons 1951, p. 243). According to Simons, this flexibility was exacerbated in a system where private banks created the majority of the money supply day by day (Friedman 1967, p. 5), resulting in a maturity mismatch—and risk—that led to an unstable financial system. This reminds us of the transition from robust to speculative finance pointed out by Minsky (Mehrling 1999). In short, Simons opposed the creation of monetary substitutes—demand liabilities payable in a real or financial asset—and, consequently, fractional reserve banking.
First of all, it is the central bank, not private banks, that causes banks to consistently mismatch maturities. When a commercial bank lacks liquidity and can no longer access interbank markets (such as the Repurchase Market Agreements or the Fed Funds Market), it turns to the central bank’s discount window to obtain liquidity. While it is not negative that banks cooperate in such circumstances to avoid banking panic, what is truly harmful is that banks can access liquidity almost without limits, perpetuating this temporal mismatch between their liabilities and assets. This situation is further aggravated when central banks can issue their liabilities without any restriction, i.e., under the fiat monetary system.
In a gold standard system, this acts as a restriction on the over-issuance of fiduciary media: when banks see their gold reserves reduced, they reduce credit, and conversely, they increase it when reserves grow. Since the suspension of convertibility into this real asset, the central bank no longer has any limitation on creating reserves to provide liquidity to banks that borrow short-term and lend long-term. In short, private banks operate under perverse incentives introduced by central banks, as in a competitive environment, any bank executing such a strategy would be driven to bankruptcy.
Fractional-reserve banking allows financing of business projects that would otherwise never come to reality, but the temporal and risk profile of savings and investment must be coordinated. The fact that this occurs today does not mean that fractional reserve banking inevitably leads to the economic cycle as understood by the Austrian School. Credit expansion is not negative but a natural phenomenon in economies with growing economic development. Instead, mismatches emerge when long-term investments are financed by issuing current liabilities. Let’s look at this through a balance sheet:
Another inherent problem in Henry Simons' banking model is price stability, which he already addressed when he stated that the weakness of a fixed money supply is that there could be fluctuations in velocity. Let’s examine this using the quantity theory of money, where M represents the money supply, V the velocity, P the price level, and Q the quantity of goods produced in the economy—all in terms of variations:
Since velocity is the inverse of both fiscal and non-fiscal demand (Rallo 2017):
Simons was concerned about changes in the velocity—and demand—for money that would cause distortions in the general price level, which should be the central bank's monetary policy guide (Simons 1951, p. 174). Let’s rewrite the quantity theory in terms of demand:
However, even if we assume that money demand (k) remains constant, it is difficult to think that: 1) the money supply could adjust centrally—i.e., through the central bank’s decisions—to all other variables; 2) enough credit could be issued to meet the needs of agents through term deposits or other instruments; and 3) the resulting monetary standard would be stable in terms of the general price index. This is because not all prices are flexible to changes in nominal spending (money supply), nor are they to the same degree. Some prices will adjust sooner than others, leading to a modification of the price structure not based on agents’ subjective preferences but as a result of monetary imbalances (Rallo 2019).
In conclusion, Simons’ banking model is dysfunctional and could not meet the basic characteristics of a stable monetary standard, where the money supply must adjust to demand—regardless of what Austrian economists argue that any amount of money is optimal—and where credit is essential both for this and for real savings to be channeled in the form of sight liabilities—ultimately fiduciary media. Additionally, the entire banking model is based on a mistaken assumption: that fractional reserves are the ultimate cause of credit expansion that distorts the real economy, inducing the economic cycle. As we have pointed out, as the qualitative theory of money suggests, what we should be concerned about is the maturity mismatch and the deterioration of the liquidity of financial assets (Rallo 2019).
References
Friedman, M. (1967). The Monetary Theory and Policy of Henry Simons . The Journal of Law & Economics, 10, 1–13.
Mehrling, P. (1999). The vision of Hyman P. Minsky. Journal of Economic Behavior & Organization, Elsevier, vol. 39(2), 129-158.
Rallo, J.R. (2017). Contra la Teoría Monetaria Moderna. Ediciones Deusto.
Rallo, J.R. (2019). Una Crítica a la Teoría Monetaria de Mises. Unión Editorial.
Rallo, J. R. (August 23rd, 2023). Por qué no me gusta el modelo de banca de Javier Milei.
Simons, Henry (1951). Economic Policy for a Free Society. University of Chicago Press.