Decoding Glasner on reflux, inside and outside money, and reflux

I had a few comments on a recent David Glasner post. Basically, I was trying to understand the way he reconciles various aspects of the monetary system, namely, inside and outside money, the arbitrage mechanism that links these two assets, and the price level.

David responded to me-

Inside money cannot trade at a discount relative to outside money because inside money is issued on the condition of its being convertible into outside money, so they always are exchangeable at par. If too much inside money is created (i.e., more than the public desires to hold given the relative attractiveness of holding inside money relative to alternatives including outside money) it refluxes back to the issuing banks. 

David says that excess inside money (say convertible bank notes) will reflux back to an issuing bank. But the only way this can happen, as far as I can see, is if somehow that bank's inside money trades at a slight discount to outside money (gold). David in his first sentence above says that inside money cannot trade at a discount. But how else can a reflux process emerge if one can't fall to a discount with the other?

So a temporary price discrepancy is necessary to enforce reflux and keep the quantity of outside money equal to demand. But what happens if inside money - say convertible bank notes - and outside money - fiat notes - are considered perfect substitutes by their users? After all, they can both be used to pay taxes, buy stuff, and "store value" over time.

David, for instance, points out that-

Because inside money and outside money are fairly close substitutes, the value of outside money is determined simultaneously in the markets for inside and outside money, just as the value of butter is determined simultaneously in the markets for butter and margarine. 

The problem here is... if inside and outside money are perfect substitutes, then given an excess issuance of convertible bank notes by a bank, why would the price discrepancy between inside and outside money that is necessary to drive reflux ever arise to begin with?

Rather, in an effort on the part of individuals and firms to rid themselves of their extra balances (either inside or outside money, they are indifferent) they will spend away both willy nilly. In spending away outside money, they will cause the price level to increase (the value of outside money to fall). David points this out:

If, however, the quantity of inside money increases because the public wants to hold the additional balances and are induced to hold inside money instead of outside money, then the value of outside money will tend to fall (causing the value of inside money to fall as well) unless the value of outside money is maintained by some form of convertibility or a price rule.

But doesn't this mean that issuing banks might cause infinite inflation by issuing inside money no one wants, thereby confirming Milton Friedman's wariness of free banking?

It would if currency users did in fact treat inside and outside money as equal.

But we live in a competitive banking system in which multiple banks issue inside money and receive other bank's inside money via cheque deposits and money transfers. Furthermore, currency users do not have uniform views about the quality of various money-like assets. Unlike individuals, competitive banks are picky and prefer to hold outside money rather than another bank's inside money. Put differently, banks are very sensitive to the store-of-value nature of inside money... they tend to view it as a financial asset characterized by risk and return, and not as a medium of exchange, and therefore view inside money as inferior to outside money due to its riskiness. Furthermore, holding another bank's inside money because they value its liquidity would be silly, since the bank already has its own liquidity factory. Thus the moment they receive another bank's inside money, a bank returns it to that issuer as fast as they can, settling with outside money. A reflux mechanism is thereby enforced by interbank settlement.

In sum, excess issuance of inside money by banks will not cause the price level to rise - it will cause the inside money to return to issuer.