Austrian Economics Forum Spring '12 #6--Fractional Reserve Banking?

The final session of the Spring Semester Austrian Economics Forum at NC State University cover the topic of Banking.  There are basically two camps in the Austrian School when it comes to banking—100% reserve banking and free banking with fractional reserves.  For this session we covered the article “Fractional Reserve Free Banking: Some Quibbles” by Philipp Bagus and David Howden in The Quarterly Journal of Austrian Economics (2010, vol. 13, no. 4, pp. 29-55) and Selgin’s response found here or here.

Personally, I am in the free banking camp, but I think that there are strong economic arguments for getting close to 100% reserves.  As I will explain below, it might be the case that while the objections to Fractional Reserve Free Banking (FRFB) are true, they might be so small that the positives outweigh the negatives.

Overall, I cannot express how disappointed I was with the Bagus and Howden article.  We have already covered Bagus’ book, The Tragedy of the Euro, in the first session this semester (here) and I thought the sections that we read were thin.  While there is a decent underlining argument there, the scholarship was weaker than what I was expecting.  Unfortunately, this article proved to have the same flaw—weak scholarship.  Furthermore, Howden gave a named lecture at the Mises Institute’s Austrian Scholar’s Conference.  He explained what he meant by a “quibble.”  He meant that the argument for free banking was so weak that to argue in favor of it is a mere quibble!  [Wow!] 

When presenting an argument of an opponent, one should always give the benefit of the doubt, define the terms in the most generous manner and cast it in the most favorable light.  If you can still destroy the argument, then your case is solid.  Unfortunately, this is not the approach that Bagus and Howden take in their article.  They assume narrow interpretations and unfavorable conditions.  Simply put, they are not generous to their opponents.  As a result, the FRFB side can point out that the overly narrow case does not apply and that the argument was misconstrued.  In the session, the criticism actually fell less on Bagus and Howden and more on the editorial staff and reviewers at the QJAE.  Basically, the sentiment was, “How did this article see the light of day?”

Due to the poor scholarship, Selgin is able to destroy their argument and make them look ridiculous and arrogant, which is too bad because Bagus and Howden are not dumb guys.  Let’s take a quick look at the exchange, from Selgin…

According to Bagus and Howden (2010, p. 36), “Selgin starts his analysis by assessing changes in the demand for money, not distinguishing between the demand for commodity money (money proper) and money substitutes.” Actually, my chapter concerning how free banks deal with changes in the demand for money is titled “Changes in the Demand for Inside Money” (my emphasis), where “inside money” means more or less the same thing as Bagus and Howden’s “money substitutes.”

It is simple points such as these that allow Selgin to skewer Bagus and Howden.  It is as if they simply did not take the time to understand Selgin’s argument.  If this was an isolated incident, maybe we can let that slide by, but it is unrelenting.  Bagus and Howden are simply misrepresenting the FRFB argument. 

Last summer, I finished reading Rothbard’s Conceived in Liberty, which is a history of the American Revolution.  From there I was propelled into reading Rothbard’s A History of Money and Banking in the United States.  Then in the Fall I had to teach a Money and Banking Class and so I reread and then assigned Rothbard’s The Mystery of Banking, The Case Against the Fed, The Case for a100% Gold Dollar, and What Has Government Done to Our Money?  To round myself off for this year, I read through White’s Free Banking in Britain, Selgin’s The Theory of Free Banking and Sechrest’s Free Banking.  (I also read, a while ago, Horwitz’s Microfoundations and Macroeconomics.)  So I have been getting myself grounded for the 100% Reserve versus FRFB roundtable panel at FEE’s Introduction to Austrian Economics Summer Seminar (link here).

So here is my analysis (take away) from the ongoing exchange.  First, I think that those who support the Free Banking position are better debaters than those on the 100% Reserve side.  I say this because it seems that the 100%ers are willing to fall back to the moral argument as opposed to fighting on economic ground.  While there is nothing inherently wrong in arguing against the legitimacy of converting a bailment into a deposit (an asset for the bank), my point is that it is not an economic argument.

The Bagus and Howden article does identify the weak points of the FRFB position, but they discredit their position against FRFB with their sloppy scholarship.  There are two major (economic) weaknesses in the FRFB position and it is due to these weaknesses that I have strong reservations on the FRFB position.

Before we can get into these points, we first need to make the distinction between the different types of credit.  A problem in the literature is that it seems that each author has his own way of defining credit and thus the arguments become confusing.  I will use the definitions Machlup uses in The Stock Market, Credit and Capital Formation (1931).  He distinguishes between transfer credit and created credit.  (While there is a third category, we don’t need to worry about it here.)

Transfer credit is the sort that stems from my placing money into a loaning institution and it is borrowed by another.  This form of a loan matches the deposit banking that Rothbard outlines in The Mystery of Banking.  The second type of credit is the sort that materializes out of nowhere.  An example of this is when the Federal Reserve buys a bond and credits the sellers account.  Where did that new money come from?  It came from a big, black hole of nothingness.  The money (credit) was created.

So the first weakness in Selgin’s presentation of the FRFB system is that he starts his analysis with an economy, and a banking system, that is fully loaned up.  In other words, he is starting with banks balancing their “average net reserve demand” equal to zero. (Selgin 1988, p. 73)  I think that this is a weakness, not because of the logic that Selgin engages in, but because that this assumes way a major point of credit fueled inflation—the process to get to a fully loaned up system.  I think that it is true that if we start with a fully loaned up banking system with no malinvestments, then yes, the system is fairly stable.  However, if in the process of getting to this fully loaned up state, we create malinvestments along the way, then the system is not stable.  There will be the classic Austrian Boom/Bust Cycle.

The next weakness that is found in the FRFB system centers on the precautionary reserves.  If the banking system is fully loaned up, it is vulnerable to any fluctuations in people’s willingness to hold on to cash (or not hold onto cash).  Thus, each bank will hold onto some reserves to insulate itself from the day-to-day fluctuations and from any unforeseen changes in market conditions.  The bank will lose money if it holds onto too much cash reserves and put itself at risk if it holds onto too few.  So far, so good.  This choice is an entrepreneurial one and markets should be able to handle this. 

So here is my concern.  Suppose that for whatever reason there is an increase in the demand to hold onto cash.  This holding onto cash is deferred consumption.  In other words, it is saving.  Now, if nothing else happens there is a decrease in the demand for the goods and services that the cash holders are choosing not to buy.  This change in demand will then spread throughout the economy and the relative price changes will signal to entrepreneurs how to re-coordinate the economy. 

Many who support FRFB system (like Selgin and Horwitz) argue that this savings can be converted into transfer credit.  If the cash holders are holding onto an additional $1,000 per time period (e.g., each month), then the banks can loan out that additional sum of $1,000.  They argue that this is merely transfer credit and not created credit.  Therefore, this is not a problem to worry about.  While, it is true that this is not created credit, because the cash holders are indeed saving, there are, however, a few concerns.

First, as soon as these cash holders revert to their prior spending/cash holding patterns, then the banks need to call in those loans.  In the example above, the banks need to call in the $1,000.  Calling in loans may create a large disruption in the economic patterns.  If a business started a project and the loan is called in, there is no effective difference between liquidating this sort of a project and liquidating a malinvestment from an artificial boom.

Secondly, when the loan is made, there are nonneutral economic effects that stem from this loan.  When businessman A gets the loan, he will create a spending pattern that is unique.  New equilibria are generated.  This pattern will necessarily be different from the pattern generated by the reduction in demand by the saver.  While this may not seem to big a major problem to a well functioning economy, it is a point of concern to the extent that these patterns are at odds with the savers.  Most likely, the extent of concern on this point seems to be an empirical matter. 

The 100%ers are assuming that prices are flexible and will quickly adjust.  The FRFB supporters are assuming that prices are not quite as flexible and so they convert the savings into transfer credit.  However, to me this seems to be compounding the problem instead of solving it.  If prices adjust slowly, then why are we creating a second pattern to overlay which will reinforce or offset the prior pattern generated from savings?  I think that prices are stickier as we get closer to consumers.  While gasoline prices change by the penny each day, most consumer items target price points (e.g., $9.99, $29.99, etc.).  As we move further away from the consumer, we see less fixation on price points, but we do see more longer term contracts.  Again, this is a call for further research.  I suspect that there is some economic research on this, but since the other schools of economic thought tend to ignore the structure of production, I doubt that the answers are readily available.  If someone has a suggestion of where to look, I would be interested in these sources.

Problems and Prices on FEE TV

Hollywood is known for making "magic," likewise the staff at FEE TV should also be congratulated for making me look presentable. Thank you guys.

FEE--Introduction to Austrian Economics Summer Seminar 2012

For the week of June 4^th – 9^th, the Foundation for Economic Education (FEE) held the first seminar for the summer in Atlanta.  This is the 50^th anniversary for FEE to host a summer seminar.  I am honored that this has been my 10^th year to lecture to students for FEE.

This past week was an introduction to Austrian Economics.  Steve Horwitz and I suggested a schedule for this year and we are grateful that it was accepted without revision.  I am really pleased with how well the lectures were integrated.  I can’t really think of any particularly unique issue that we didn’t at least mention.  The lectures were videoed and FEE will be posting them later this summer.  When they come out, I will link to them on the left-side of this blog. (You can see some earlier lectures posted there now.)

I gave four lectures for FEE and participated in a roundtable discussion on the controversy between fractional reserve free banking and 100% reserve banking. 

My first lecture was “Menger and the Early Austrians.”  In it, I talk about four major contributions Menger made.  Since I covered issues of capital and interest in a later lecture, I focused on Böhm-Bawerk’s approach to value theory and his refutation of Marx.  Then, I walked through the books that Wieser wrote, with (of course) some analysis of each.  And I finished by covering some of the insights made by David Green, Philip Wicksteed, and William Smart.  The PowerPoint to the “Menger and the Early Austrians” lecture is found here.

The second lecture was “Praxeology, Supply and Demand.”  Here I began by comparing the methodology of the Austrians with the mainstream.  I presented the mainstream’s approach to methodology and critique it.  In contrast, I presented the Austrian methodology and build up the Laws of Demand and Supply from first principles.  We then built a model of the market.  I finished the lecture by comparing the manner in which the mainstream derives demand curves using indifference curve analysis.  The mainstream’s approach suggests that there is an income effect and a substitution effect for each price change.  The Austrians tend to think that policies that are derived from this thinking are equivalent to hocus-pocus.  The bottom-line is that when the mainstream derives demand curves in this fashion, they are comparing two levels of total utility and looking at the marginal rate of substitution.  When the Austrians derive demand curves, we are looking at the marginal utility derived from the next unit.  While both approaches use marginal analysis, they are not the same.  The PowerPoint to the “Praxeology, Supply and Demand" lecture is found here.

The third and fourth lectures really build upon each other.  The third was “Capital and Interest” and the fourth was “Business Cycles.”  In “Capital and Interest,” I criticize the mainstream’s approach of allowing objective factors to control the interest rate and also the notion that capital can be represented by a homogeneous pool.  In contrast, the Austrians hold that interest rates are determined by subjective time preference for both the supply of loanable funds (savings) and the demand for loanable funds (borrowing).  Furthermore, Austrians hold that capital is mostly complementary.  As a result, capital has a structure that cannot be ignored.  If we do so, we miss some significant aspects to economic theorizing.  The PowerPoint to the “Capital and Interest” lecture is found here.

The last lecture was on “Business Cycles.”  I began by developing Garrison’s three interlocking graph model.  It contains the Loanable Funds Market, the Production Possibilities Frontier Curve, and the Structure of Production.  We then walked through how the model works for various macroeconomic fluctuations and finished with working through the stages of the Austrian Theory of the Business Cycle.  The lecture finished with examining how the other modern macroeconomic theories explain the boom and bust of a business cycle.  The PowerPoint to the “Business Cycle” lecture is found here.

The last activity was a roundtable on 100% reserve banking vs. fractional reserve free market banking.  All four of the faculty participated in this discussion.  We started by first explaining why the current system of fiat banking with a Central Bank was a terrible system.  Then we explained how 100% reserve banking would work and then how fractional reserve free banking (with competitive note issuance) would work.  We then voiced our concerns about each system and then took questions from the students.  Since this was the last time we were talking before the group, we opened the last 15 minutes up to any question the students had on Austrian Economics.  There are no PowerPoint slides associated with this so I cannot link to anything right now.  However, when FEE posts it on the web, I’ll be sure to link to it.

I want to thank FEE for hosting another very good summer seminar.  The students asked some of the best quality questions we have heard for quite some time.  And the FEE staff did a marvelous job.  I appreciate the fact that the supporters of FEE have been able to keep this program going and also to be able to do it at such a high quality level.  Thanks!

Austrian Economics Forum Spring '12 #5--Efficiency in an Open-Ended Universe

The fifth Austrian Economics forum centered on Roy Cordato's book, Efficiency and Externalities in an Open-Ended Universe.  In particular we focused on Chapter 3, "Catallactic Efficiency: Welfare Economics."  


In traditional welfare economic analysis, we make judgments about net effects of policy.  Does this policy help more people than it hurts, or is it the reverse?  Usually, this means that the economist must make a comparison between people's subjective utilities.  This analysis is called "interpersonal utility comparisons."  Since values are subjective, such a feat is impossible.  There is no way we can judge how much a person values something, and nearly all economists agree on this point.  However, this is where the Austrians an the neoclassicals part company.


The neoclassical economists will waive their hands and say that interpersonal utility comparisons are impossible, but then they do exactly that; they make interpersonal utility comparisons.  There are some theoretical constructs that confront the problem head-on, like the Pareto Optimality measure of efficiency.  However, these sorts of approaches have very little real world application.  For example, the Pareto condition says that a policy is good if, and only if, at least one person is made better-off while no one is made worse-off.  In the real world, this is never the case.  And so, as a mental exercise, such methods are fine, but the reality is that these end up calling for maintaining the status quo.


Cordato's chapter avoids this problem.  


The first thing that needs to be made clear is the distinction between positive and normative economics.  Positive economics is pure theory.  Normative economics is a value judgement made by the analyst.  For example, positive economic analysis says that whenever the price is below the market clearing price, there will be a shortage.  An example of a normative judgment is the statement that we should set the price below the market clearing price.  Normative economics deals with "should statements."  We should do policy X but should not do policy Y.  Cordato's chapter sets positive economics aside and focuses exclusively on normative economics.


The next thing that we need to examine is the concept of an open-ended universe.  So what's that?  The opposite of a closed universe, duh.  (I know, not helpful, but I couldn't resist.)   A closed universe is one that has a final state of rest, an equilibrium point toward which the market tends.  The neoclassical position tends to start in this state, which is fine for positive analysis.  However, we are dealing with normative analysis for the real world and the real world is definitely not in equilibrium.  Even if the real world does manage to get itself into an equilibrium, it would only be there for a moment.  This is because the demand curve is based upon things like tastes and preferences and the supply curve is based upon things like expectations.  When any of those factors change, the curves shift and a new market clearing relationship emerges.  


Kirzner's approach says that we are constantly chasing these market clearing prices.  It is the entrepreneurs' actions that coordinate the economy and move us closer to market equilibria.  Cordato argues that for normative economic analysis, we should jettison the very notion of equilibrium.  Let me be clear, Cordato is not saying we should jettison equilibrium altogether.  In fact, he does say that it is perfectly legitimate to still use it for positive economic analysis.  (Personally, I like the concept of "harmony" better, but that is a different discussion.)  


It is when we deal with normative economics that we should discard equilibrium.  The reason is that we have no idea where such an equilibrium would be.  We cannot argue that in the real world that each transaction moves us closer to an equilibrium, because each transaction adds new information into the system--information that was unknown before.  As new information is added into the system, the theoretical equilibrium changes.  Thus, it is impossible to determine (either before or even after the fact) whether a trade moves us "closer" to an equilibrium or not.  So an open-ended universe says that we cannot know where these equilibria are and whether a transaction moves us closer to or further from any of these points.


While this analysis is close to the Lachmann/Shackle position of economic kaledics, it is not the same.  The difference is that Cordato says that the use of equilibrium is legitimate when doing positive economics.  Lachmann and Shackle reject the concept of equilibrium for both normative and positive economics.


So then how are we to judge which policy is better, or in economic jargon, which policy is welfare enhancing?  Cordato proposes that we use a standard of "Catallactic Efficiency."  Catallaxy is an alternate word for the economy/economics.  It comes from the Greek root "katallasso" (καταλλάσσω), which means trade or exchange.  It also means "to befriend."  


Anyway, Cordato argues that methodological individualism holds that each person has his own set of goals and his own set of information.  "[Efficiency] is to be judged by the extent to which the catallaxy encourages individuals existing in a social context, to pursue their own goals as consistently as possible." (page 62)  Cordato continues,

By its very nature, then, questions of catallactic efficiency must focus on the institutional settings in which individual actors operate.  In particular there are two overriding issues.  The first centers around the institutional settings that will best facilitate the use and discovery of information, the appropriateness and relevance of which can only be known by those who need to discover and use it.  The second concerns the institutional setting that will allow individuals to gather the necessary physical resources [and use them].  pages 62-3.

So there are two conditions to be met: the first is the ability to discover information and the second is the ability to use resources to achieve the goals sought.  The conclusion is that a laissez-faire policy is best for enhancing the welfare of the community.


Such an approach, I believe, fits well with Mises' conception of Interventionism.  Mises argued that there were three manners in which the government could intervene in an economy.  The first is the role of the impartial judge and enforcer of private property rights. When there is a dispute, the government can resolve the dispute.  Mises thought that this was a normal and healthy function of government.  The second manner is when the government buys items from the market.  Suppose that the government wants to publish its annual budget.  To do so, it needs paper.  The government taxes people and then spends that money on paper.  While there are distortionary effects that result from the governmental action, the normal market process is intact.  The demand curves for the items that the taxed people would have purchased are reduced and the demand curve for paper is increased.  The market mechanism operates normally.  


The third type of intervention is where the government stops or hinders the market mechanism from operating normally.  In this form, the government prevents trades to take place by rules, regulations, or price controls.  For example, if the government passes a law that says all toys need to be tested for lead before they can be sold, this interferes with the normal market process.  If the government says that during "a state of emergency" prices can only rise above the 30-day average by 10% interferes with the normal market process.  In the first example, people will not be able or willing to sell toys and in the second, the goods  will not be rationed according to price.  Long lines will emerge and shortages will persist.


Cordato's "Catallactic Efficiency" standard and Mises' third type of interventionism go hand-in-hand.  They both focus the analyst's attention to the coordination process of the market.  How is new information generated and incorporated into the greater social order?  When obstacles restrict the market's ability to do this, we have catallactic inefficiency and interventionism.

Austrian Economics Forum Spring '12 #4--Kirzner & Cwik

For our fourth meeting, it was decided that we would discuss the paper that I presented at the Austrian Scholars' Conference in Auburn.  While I love to talk about myself, I decided to include a paper by Kirzner as well. 

The Kirzner paper is "The alert and creative entrepreneur: a clarification."  Basically, this is Kirzner responding to supporters and critics of Capitalism and Entrepreneurship, and then telling them that they are all wrong.

Kizner says that his work is not about how to become a successful entrepreneur.  Rather his work focuses on how the market process is set in motion be entrepreneurial decisions.

The interesting points he puts forward is an almost rewritting of his stance on Schumpeter.  He says that everyone knows of Schumpeter's creative-destroyer and so he did not want to dwell on that aspect of entrepreneurship.  He wanted to show how entrepreneurship coordinates the economy.

He then argues that many misinterpreted his writings to say that the entrepreneur was a passive noticer of opportunities.  He says that a false tension was created between the Schumpeterian "bold, disruptive, innovators or [the] passively alert, harmony-restoring responders to changes that have already occurred."  He then states,

[T]here must be scope for both a creative ("Schumpeterian") entrepreneur (one who generates pure profit) and a "passive," alert ("Kirznerian") entrepreneur (one who snuffs out given profit opportunities by promptly exploiting them.) p. 149 (italics in the original)

Cordato argued that his own work tends to connect the two positions.  He argued that we live in an "open-ended universe."  He means that there is no such thing as a final equilibrium to strive for.  In fact, as new information is added, the equilibrium point changes. 

It was based upon this point that we decided that the next week would center on Cordato's book, Efficiency and Externalities in an Open-Ended Universe.  And so we tabled further discussion on this point for the next week.

****************************************************************************
Then the discussion turned to my paper, "Greed in Public and Private Institutions."

My paper, as is too often the case, was based upon frustration.  There is a general attitude that anything that happens in the private sector is due to greed, but when we switch to the nonprofit sector, motives are now made of pure light.  Indeed!

Of course people in every walk of life are greedy.  (As an aside, economists throw out the word "greed" because it cannot be precisely defined.  A typical definition of greed is the wanting of something too much.  However, what is "too much"?  Who decides?  As a result, economists use levels of self-interest.)  Self-interest is omnipresent and it propels Adam Smith's butcher, brewer and baker to serve others.  On the other hand, we have a separation of self-interest and the interest(s) of the overall organization.  It is a question of aligning incentives.  In other words, we are examining a principal-agent problem.  What if Bernie Madoff, Ken Lay or other suitable villain was in charge of the State Department or the US Treasury?  Would we even know what they would be up to?

My paper suggests that two questions arise: Can the institution efficiently allocate resources to satisfy the most intense wants and desires of consumers?  And can the principal-agent problem be overcome to ensure that the leadership will carry out its intended purpose or will the leadership use the entity as a means to a selfish (greedy) end?

In my paper, I looked at three institutional settings: for-profit companies, bureaucracies and nonprofits.  I conclude that the for-profit sector can answer both of the questions.  The bureaucracies cannot calculate efficiency, but it does issue rules, orders and regulations to control and guide the behavior of beaucrats.  It is in this way that bureaucracies have a chance of overcoming the principal-agent problem.  The nonprofit sector, on the other hand, is incapable of answering either question.

Overall, the discussion was friendly and supportive.  During the course of the discussion, Cordato asked a good question, "When it comes to bureaucracies, who are the principals?"  I did not have a ready answer for him.  When I wrote the paper, I had Mises' Bureaucracy in the back of my mind.  In it, he uses the model of a king that basically is in charge issuing orders.  And so in my mind, the king was the principal and the bureaucrat was the agent.  How that translates into a representative government is much more complex.  Although, the point that there is a potential solution remains.

Additionally, a student suggested that when it comes to the nonprofit organizations, we can split them into two groups.  The first group is primarily donation driven, while the second is endowment supported.  The first group "has its feet to the fire."  They must be very aware of what the donors expect, otherwise the funding disappears.  The second group is insulated from today's donors because an endowment has been built up.  (For example, think of colleges and universities that have large endowments.)  They are able to upset today's donors because they have the resources in place for tomorrow.  Of course, such an institution cannot upset significant donors forever, but they have a lot more room to be independent.  This insight certainly adds to the discussion that I make in separating the true-believers from the careerists.

US Debt Limit Analogy

Here is a short 3-min video making an analogy to the US Debt.  Just because we raised the limit last year, it does not mean that the problem has gone away.  If anything it has and will continue to get worse.

Enjoy.  For my thoughts on what to do to solve the debt problem, I have advocated partial repudiation of the national debt.  It is found here: http://tillmanspeaks.blogspot.com/2011/07/repudiation-should-we-repudiate.html

FEE TV

In the world of stranger things have happened, FEE has decided to post the following video of me.  In it I talk about the foundational difference between Austrian Economics and the mainstream.  I believe that they have done a good job (especially given what they had to work with!)