Saturday, March 31, 2012

Lee Kelly on Money and Free Banking

Lee, a guy who used to comment on here a lot, has a guest post at Lars Christensen's blog. It's definitely worth the read. The beginning goes over the standard story on excess money demand and general gluts, and talks a little about trends in barter and alternative monies.

Then he gets into the alternative of free banking. Now what I still don't understand about free banking is why people think it would solve the problem better than central banking. These discussions always seem to get through the problems with central banking - which I think we all know like the back of our hand by now - and then it moves to free banking as an alternative, but it always seems to wrap up before we really explore free banking! I don't blame Lee for this - he was under no obligation to satisfy my curiosity! But maybe I could get readers here to build my faith in free banking a little.

What you want is a more elastic money supply. I might even go as far as saying that what you want is a perfectly elastic money supply because it's absurd to economize on resource consumption just to get more of the medium of exchange. We should economize on resource consumption because we make tradeoffs with other scarce resources! Why economize on real goods just to make tradeoffs with green pieces of paper that don't earn a return? I'm not sure if that's right - maybe we don't want a perfectly elastic money. But we want a more elastic money supply for all the traditional reasons we've always wanted it: because an excess demand for money is completely pointless and for many people quite painful.

So what I would think free bankers would want to demonstrate to skeptics like me is that free banking offers a more stable and more elastic money supply. Is there any reason to think this?

Why do we demand money? While Lee is right that excess demand for money results in general gluts, it can also be caused by general gluts (yes, you read that right). Remember when people talk about a general equilibrium in the context of a general glut, they're usually thinking of a point in time. But a lot of the sales at that point in time are contingent on expectations about the future. All investment is contingent on expectations. And of course, a lot of consumption is too. We smooth consumption over time, and if we are concerned about our income stream in the future we're going to cut some consumption today. General swings in expectations about the future can result in an excess demand for money (which can of course further generalize the glut, through the more traditional mechanism that Lee outlines).

We know how central banking reacts to this, and the answer is "as well as the central bankers react". The incentives of the central bankers are often OK - particularly here in the U.S. where we have a dual mandate. The biggest problems come from things like knowledge problems, reaction times, etc.

The fact that knowledge problems are a potential issue in central banking is what (understandably) piques many peoples' interest in free banking. But what is a banker's incentive under free banking? If asset values are falling because of a general depression of expectations about future economic performance, it seems to me that banks are not going to be making money readily available, they're going to be worrying about their own solvency. And that's the critical difference: central bankers don't worry about solvency or profits, but free bankers do. For that reason I just can't get my head around why people think free bankers would do better in a crisis situation.

There are a couple pieces of evidence. First is the relative absence of systems of free banking. I get some predictable push-back when I talk about this (to anticipate one form of push-back - yes I know about the good old days in Scotland), and obviously its not proof of anything. But it is indicative, I think. If free banking were really that much better you would think it would be naturally selected into more widespread existence.

But you can also just look at the behavior of banks under central banking. As the Fed discovered in the 1930s, and as they're discovering today, bankers don't always do the socially optimal thing. The money that the Fed actually has control over has been much more responsive than broader monetary aggregates that banks have control over:

Obviously this isn't competing monies exactly, but I'd be interested in someone explaining to me why the same fears and conservatism on the part of banks wouldn't stymie the generation of new money in a system of free banking. That's my concern. It's not - as Boettke and Smith suggest - an idealization of central bankers thats holding me back. It's that I don't understand why free banking would provide more elastic money, and I don't feel like anyone has explained to me why I should expect it to.


  1. Man, I had JUST decided to do the gender economics field in addition to the labor field because the gender courses basically offered the opportunity to do a lot more work in labor than my labor field courses alone would afford.

    Now writing this post makes me want to do my second field in monetary economics after all. Oh well - I'm still doing the macro track, and maybe I can take a monetary class as an elective/seminar course.

  2. Daniel
    >For that reason I just can't get my head around why people think free bankers would do better in a crisis situation.

    I like Lee Kelly's writing a lot too. This is a particularly interesting piece, as he's not really advocating free banking as much as advocating thinking about free banking. At any rate, I think the answer you're asking for is probably as follows: with free banking there will be no crises in the first place, as crises are caused by government intervention. It's the same script as the Austrians. This angle absolves one from putting forward a coherent post-crisis response (note how in say, "Human Action" what little discussion there is about boom/bust is all about the boom). Which is particularly handy if, like the Austrians, you don't actually have one.

  3. This is exactly why need to read Selgin's TFB. (available free at Liberty Fund)

  4. I think as well as the kind of commodity-money based free banking models exemplified by TFB, where some of the objections raised by Daniel are relevant it is possible to envisage other models that bypass these objections.

    For example a private company with enough capital could launch an electronic currency where it simply pegged its currency unit against any basket of commodities it chooses and guarantees to maintain that value over time. It makes a profit by taking a tiny percentage of each transaction using the currency. As it guarantees to maintain the value of the currency unit it is implicitly inflation-targeting and when money demand increases (and there is deflationary pressure) it will act increase the money supply (most likely by buying assets) to stabilize prices.

    Unlike in a free banking model where one may question the likelihood of an increase in the money supply via the loan market when expected future demand is low this model would have no such impediment to "counter cyclical behavior" since the transmission mechanism is not via banks. Banks may choose to lend in this currency but the stabilizing mechanism does not depend upon it.

    One could envisage competition between money-providers based upon transaction costs, the basket of goods that are targeted, the amount of capital backing the currency and other factors.

  5. "But what is a banker's incentive under free banking?"

    Ultimately, I think you should read Selgin's Theory of Free Banking or White's Theory of Monetary Institutions for the full version of this, but I will paraphrase as best I can. Under a system of free banking, a banks incentive is the same as the incentive for any other firm, to profit maximize. Banks do this by satisfying six inframarginal conditions which White outlines, essentially balancing the marginal benefits and costs of banknotes, loans, deposits. One of those costs is the liquidity cost, which is the cost of having to borrow additional reserves on short notice if your reserves run out. When the velocity of money changes, these liquidity costs change too.

    If velocity falls, a bank will find that the average amount of their banknotes brought in for redemption has fallen as well. This means for the same level of reserves, a banker faces a lower probability of incurring liquidity costs, or with a lower amount of reserves can face the same probability of incurring liquidity costs. Profit maximizing banks will expand their note issue to satisfy the excess demand for money because it is profitable to do so. In the reverse situation, when velocity increases, the average quantity of notes returned over a fixed period increases. This increases the probability of running out of reserves, which causes banks to contract note issue. Banks that fail to respond in this manner will be less profitable than their competitors, and be driven out of business over time.

    Thats the bare bones of it, obviously a blog post comment isn't the best place to elaborate on the full argument. I really would suggest both of those books if you are interest in free banking, or monetary theory in general. Even if you don't agree with it, I think it is an important argument to understand.

    Also, much more than the Scottish case, I would point to the Swedish case, and even more so to the Canadian case of Free Banking. Bordo has a solid paper on the Canadian system, and Selgin has an excellent presentation he gave recently ennumerating the differences in the institution and outcomes of banking between the US and Canada between 1860 and 1940. He has a really excellent graph showing you exactly what you want to see at 15:30.

    Anyhow, hope this helps. Keep up the interesting posts.

    1. Right, but this is why I posted the reservations at the end and why I posted the long Keynes quote.

      Certainly holding all else equal you're going to issue more notes when the demand for notes increases because it will be more profitable.

      But all else ISN'T equal, and that's my whole concern. When demand for money increases, business activity is declining and asset values are declining. Declining asset values makes issuing more notes LESS profitable, not more. So it's not clear to me at all why free banking is going to issue more notes when demand for notes increases.

      Central bankers, of course, don't have this problem.

    2. Well, the graph you have posted is a bit misleading. The Fed is paying bankers IOR which encourages them to just sit on their hands and wait for one thing. Also, business activity and asset values decline only very slightly in the face of a normal recession, generally not enough to offset the increased float that can be earned on additional currency issue. These two things only decline significantly AFTER a failure of monetary policy to respond to a change in velocity. In my opinion, one of the reasons we do not see a Great Depression or a Great Recession before the era of central banking is because the profit incentive leads banks to expand in a timely manner to changes in velocity.

      While you are correct in your assertion that central bankers do not have to worry about profitability, I think you overlook how that can wreak havoc on a nations economy. Would any bank that was concerned about profits have allowed their cover ratios to balloon to 60% or 90% as the central banks of the US and France did respectively in the years just prior to and during the Great Depression?


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