Category Archives: Economics

The Theory of Free Banking

[This is an old post that was lost when the first version of this blog was hacked back in 2011. I found it using the Wayback Machine, so I wanted to re-post it.]

The current financial crisis has inspired growing concern over the ability of the Federal Reserve to handle the money supply and juggle the number of objectives it has been tasked with.  While opinions vary wildly, including many who would like to see the Fed’s activities expanded, there has been an unprecedented growth in the movement to outright abolish the United States’s central bank.  Popular opinion has begun to shift against the Fed due to its inability to properly accomplish any of its general objectives, including stabilizing prices and fighting unemployment.  Furthermore, its role as a general supervisor of banking activity has come under close scrutiny, and it is beginning to be seen more as a cause of moral hazard more so than as an efficient oversight mechanism — (for worse) the state has been forced to jump into the role of regulator.

While recent events have ballooned anti-Fed sentiment, the intellectual movement against monopolized currency systems is not new.[1] The modern debate has been led by the Austrian school, and the theoretical argument has been sealed by Ludwig von Mises and Friedrich Hayek.  Both intellectuals went through great lengths to prove how industrial fluctuations — business cycles — are caused by currency monopolies,[2] guaranteed by means of government authority.  Unfortunately, the Austrian lesson fell on deaf ears.  For the majority of the economics profession, business cycles were caused by deficiencies in aggregate demand, whether caused by unbridled speculation or an insufficient quantity of money.  For these economists, the Federal Reserve became a key tool for the restoration of prosperity.

Friedrich Hayek’s 1974 Nobel Memorial Prize and the consequent publishing of two major monographs, Choice in Currency[3] and Denationalisation of Money[4], led to a major revival in interest in Austrian ideas during the mid-1970s. Hayek reminded those willing to listen that a monopolized currency regime was not the only choice, and that free banking is a theoretically established alternative.

Broadly speaking, two branches of the Austrian school have formed respective of the question of what a free banking industry would look like.  The first can be referred to as the “full reserve bankers”, believing that a bank’s supply of money substitute[5] should be fully backed by commodity money.  The second, usually considered opposed to the first, are commonly referred to as “free bankers” — even though it should be realized that both branches argue in favor of deregulated banking — and believe that an unregulated banking industry would practice fractional reserve banking, and that it is the central banking regime that corrupts the issue of fiduciary media.[6] The bevy of literature that represents both branches is too large to refer to in detail, but it suffices to say that the past forty years has seen a flourishing of theory on the issue.

The main literary representative of the free banking school is George Selgin’s The Theory of Free Banking, published in 1988.[7] It was inspired by earlier work written by Lawrence White, Kevin Dowd, and others.  In it, Selgin provides a very complete theory of banking in an unregulated, competitive industry.  While Selgin has not managed to persuade all his peers, and in fact there are powerful and equally as convincing arguments against fractional reserve banking theory, Selgin’s model deserves to be understood.

While the academics who lead the debate may know exactly what they are talking about, many of the interested followers have been left in the dark.  The present essay is an attempt to paraphrase the free banker’s argument, as presented in Selgin’s The Theory of Free Banking, in an effort to clarify just what exactly the “fractional reserve bankers” are supporting.

Free Banking Theory

Before delving into the meat and bones of George Selgin’s free banking model it is worth to first briefly explore the development of a banking system in a free society.[8] Preceding the development of banking banking is the emergence of a medium of exchange, which occurs as a result of the problematic nature of barter — it is difficult, transitioning towards the impossible, in a larger division of labor to consistently find others with what is called a “double coincidence of wants”.  Sooner or later, indirect barter will necessarily be adopted, where individual A exchanges his goods for another set of goods with which individual A will use to barter for what he actually wants, allowing him to primitively circumvent the lack of an initial double coincidence of wants.  Progressively, individuals find that there are certain goods that people generally want more than others, and ultimately the good that best fulfills the qualities of money emerges as the medium of exchange.[9]Historically, while many different types of goods have been used as money, the ones which ultimately emerged from an early period of trial and error have been metallic commodities, especially gold and silver.  For our purpose, we can assume that the medium of exchange of our free society is gold.  We can also assume that merchants begin to first mark, and then stamp, coins as a means of minimizing the necessity of weighing and assessing coins — competition forces merchants to strive towards reliability, minimizing the opportunity for fraud.

Banks develop from two major early roles.  Merchants who engage in long range exchanges find it convenient to have foreign-exchange brokers settle debts by means of ledger-account transfers.  Wealthy individuals who begin to form relatively large sums of commodity money begin to prefer to hold these stocks in much safer deposits.  Thus banks form as money warehouses and as institutions capable of settling debts between merchants.  While at first banks tend to lend only their own wealth, earned from the services provided to their clientele, they ultimately begin to loan out their customer’s deposits — initially, time deposits.  As explained below, ultimately banks may begin to lend out their customer’s demand deposits, usually offering interest on those accounts in return.

Together with the changing role of banks, these financial institutions begin to progress towards the invention of the bank note.  Initially, banks offer promissory notes transferable by endorsement and nonnegotiable checks.  These evolve into negotiable notes and checks, and bank-issued paper notes become money substitute, circulating in the market as a legitimate substitute to gold coin.  From here on out, bank notes may be referred to as “inside money” and gold money as “outside money”.  Money substitute begins to replace outside money with greater frequency due to its advantages, including bulk and weight.  The greater circulation of inside money also eventually forces competing banks, through the profit motive, to accept competing notes, creating the need for inter-bank clearings, which leads to the development of clearinghouses.  Clearinghouses serve the purpose of allowing multilateral clearings of debt between multiple banks, further reducing the necessary quantity of commodity money held in reserve by individual banks.  Clearinghouses eventually take on greater responsibility, as the banking system evolves, including becoming credit information bureaus — archiving information on particular bank clients who may have poor credit histories, and sharing this information between banks — and as a limited banks of last resort, lending to individual banks in times of crisis.

Here we begin to see one way by which banks may begin practicing fractional reserve banking.  The greater demand for inside money as a substitute for outside money decreases demand for outside money in circulation.  We begin to witness a greater use of bank notes and a greater amount of gold money sitting idle in bank warehouses.  This surplus of commodity money allows banks to export gold or sell it for nonmonetary use, causing many of the circulating bank notes to become fiduciary media.  In Selgin’s model of free banking, this method of outside money substitution becomes the principle cause behind falling reserve ratios, as banks find it profitable to sell their gold reserves — the fall in demand for outside money allows them to do so without repercussion, with banks and clearinghouses maintaining only enough gold to clear debts and meet obligations with their customers. This does not entail the creation of more money.  At this point, the quantity of money in circulation remains the same, as gold is taken out of circulation in exchange for bank notes — any increases in the supply of money are caused by an increase in the quantity of gold used as a medium of exchange.

It is important to realize that in a free banking industry we would see the emergence of competing currencies, with banks issuing their own notes and striving to establish methods by which the consumer can tell their note apart from others.  Given this competition, it is within the banks’s interest to guarantee the reliability of their note, especially in terms of the possibility of fraud (counterfeiting).

If we assume that for some period of time the replacement of outside for inside money has completed in accordance with consumer demand, we can begin to investigate possible changes in the supply of fiduciary media.  Banks profit by increasing their holdings of interest-earning assets, which it does by either increasing clientele or by losing reserves.  Banks are liable to a liquidity cost, where the bank must maintain sufficient reserves to meet obligations, and to costs related to their effort to maintain demand for their liabilities (interest offered on deposits, for example).  The former cost is represented by the principle of adverse clearings, guaranteeing that banks which over-issue fiduciary media will see an increase in returning liabilities (or immediately payable obligations) forcing them to reduce the quantity of outstanding fiduciary media.  The principle of adverse clearings depends on the following assumptions,

  1. Bank notes issued in surplus of the demand for that particular note will result in the expenditure of the surplus notes;
  2. The majority of spent surplus notes will end up in possession of competing banks;
  3. Banks return rivals’s notes for redemption;
  4. The majority of notes entering the clearing mechanism are of the over-issued kind.[10]

Individuals tend to demand a certain amount of money, meaning that they hold a given quantity of money as a means of making expenditures in the short-term.  Notes received in excess of that demanded are spent, and, perhaps not immediately deposited, remain in circulation for a short amount of time.  Ultimately, merchants will deposit bank notes in surplus of that necessary to make change — checkable deposits are more convenient than loose bank notes and earn interest.  Banks which hold rivals’s bank notes will return these for redemption in inter-bank clearings.

The fourth assumption is more difficult to defend and ultimately relies on the concept of note-brand discrimination.  It is within a bank’s interest to give their clients reason to holdtheir notes and instead spend their rivals’s notes.  Bank notes represent an interest-rate free loan to the bank, and thus banks look forward to maximizing the amount of time that loan remains in effect.  Furthermore, without such discrimination excess creation of fiduciary media by one bank will result in the bearing of a larger portion of the returning liabilities by non-expansionary banks.  The principle of adverse clearings does not require perfect or absolute note-brand discrimination, only that customers commonly discriminate between bank notes.  We can see, though, that there are multiple reasons why banks would attempt to incite such discrimination, as it is within their financial interests to do so.[11]

Knowing that an individual bank’s ability to issue fiduciary media is strictly governed by the amount of liabilities the bank has to clear at any given moment in time, we can deduce that the opportunity to issue more fiduciary media arises only when the quantity of returning liabilities falls.  This opportunity presents itself when the demand for money rises.  Imagine that the aggregate quantity of money held increases, reducing the quantity of money in circulation for a certain period in time.  For certain banks — those which notes are being held —, this leads to a fall in the amount of liabilities returning for redemption, or a fall in the volume of obligations that bank must meet at that moment in time (a “decline in the rate of turnover of inside money”[12]).  This temporary fall in returning liabilities allows relevant banks to increase the volume of outstanding liabilities by issuing fiduciary media through the loan market.  Free bankers illustrate this principle through the notion of a money equilibrium, or by what they refer to as — indirectly — meeting the demand for money.

In theory, an increase in fiduciary media as a result of a rise in demand for money does not constitute a rise in the quantity of money in circulation.  The individual who increases his cash balances decreases the quantity of money in circulation for the amount of time in which he fails to allot that bank note towards present expenditure.  In a world of where equilibrium is attainable — an ideal, non-existent world — the amount of money issued by banks would equal the amount of money temporarily removed from circulation.  In reality, we can expect minor fluctuations in the quantity of money in circulation, as banks either under-issue or over-issue in response to a fall in the rate of turnover of liabilities.

Understanding that the demand for money fluctuates on an individual by individual basis, as the demand for money is decided by the individual market agent, the ability to issue fiduciary media as a result in the increase in the demand for money ultimately rests on the rule of large numbers.  In other words, there is a difference in the time that an individual may temporarily increase his cash holdings and the time allotted for the repayment of a newly issued loan.  The individual may decrease his cash holdings within a matter of days, while the new loan may have been issued for a period of months, or even years.  To cope with this disconnect, banks rely on the fact that the actions of independent market agents will largely offset each other.  For example, one individual may decrease his cash holdings while another individual increases his.

Of the two forces which operate to create fiduciary media, a fall in demand for outside money and a rise in demand for inside money, the former is likely to be the most important.  Given that changes in the demand for money between individuals are expected to offset each other, it could be argued that theoretically the aggregate demand for money should remain stable — the opportunities for individual banks to expand credit would be very slight and very temporary, with a long-run trend of a stable volume of outstanding liabilities.  Empirically, while after the 1970s the velocity of money (loosely related to the demand for money — a rise in demand for money usually translates into a fall in its velocity) has lost some stability, it usually had a historic tendency of remaining stable during periods of economic growth.[13] The issue of fiduciary media in response to changes in cash balances, therefore, would be extremely limited.

Short Macroeconomic Note

Given the nature of the free banking model, or of “meeting the demand for money”, free bankers also tend to support the theory of monetary (dis)equilibrium.  Roughly speaking, monetary equilibrium theory suggests that discoordination between demand for and supply of money can cause macroeconomic fluctuations, or the business cycle.  At the very least, a radical rise in the demand for money without an equal increase in the supply of money can exacerbate these industrial fluctuations, as it forces prices to adjust to changes in the quantity of money in circulation — it forces prices to fall, initially and temporarily pricing certain goods off the market and making some businesses unprofitable.  Some see the ability to increase money in the face of a rise in demand for money as a means of avoiding that painful downward readjustment of prices.[14]

Do changes in the demand for money cause business cycles?  It has been found that changes in the velocity of money usually follow changes in the supply of money, not vice versa.[15] In other words, the demand for money faces extreme increases only as a resultof monetary disturbances.  This is in line with Austrian business cycle theory, as the Austrians rightly attribute monetary disturbances to previous periods of severe intertemporal disequilibrium — usually caused by sustained over-issue of fiduciary media, which is a product of a monopolized currency system.  An increase in demand for money can be considered a secondary consequence of the causal factor behind industrial fluctuations, and that is malinvestment caused by intertemporal disequilibrium.[16] The dramatic fall in the quantity of money is caused by a credit contraction set off by necessary bankruptcies and the consequent radical reduction of outstanding bank liabilities.

Can an increase in the supply of money offset an otherwise necessary readjustment of prices?  For the sake of simplicity, let us assume an aggregate increase in demand for money that reduces spending towards industries A, B, and C.  This necessitates a fall in the prices of industries A, B, and C’s outputs, and therefore changes spending patterns on those same industries’s inputs (those industries now spend less on whatever capital goods were used for production of their own goods).  As a result of an increase in demand for money, banks issue an equal amount of money through the loanable funds market.  Will this prevent the readjustment of prices taking place as a result in consumer preference?  In order for this answer to be ‘yes’, all newly created money would have to be spent on exactly the same things the original money was bound to be spent on; in our example, all new money would have to be spent on industries A, B, and C, in exactly the same proportions as that sum of money would otherwise have been spent in lieu of an increase in demand for money.

Inflation, however, is not mechanical.  There is no mechanism which guarantees that new money will be spent in the same way as money held would have otherwise been spent.  The fact is that the new fiduciary media is likely to go to entirely different individuals, and thus preferences are likely to be entirely different.  The price readjustment will continue to occur, but the new money will allow different individuals to bid up prices by spending on industries D and E.

Is this inherently destabilizing?  If it was, then capitalism would be inherently unstable on account of the fact that individuals are constantly changing preferences — this is the source of dynamism on the market, and the entire reason why entrepreneurs can constantly profit by anticipating or best responding to these changes in preference.  Some industries face a fall in demand for their products, and others a rise; this is the nature of the market.

The attempt to vindicate monetary equilibrium theory by applying it to free banking is ultimately harmful to the accuracy of the theory behind the latter.  It confuses the microeconomic tenets of banking operations in a free market and the more controversial concept of monetary disequilibrium.  Free banking cannot stop changes in the structure of production — the changes are a natural part of an economy.

The Time Has Come

How a free banking industry would develop is a hotly contested issue.  George Selgin’s model is not universally accepted, and in fact has been the target of much criticism.  These criticisms are worthy of review, although given space limitations the present essay can only make brief reference to them (a short list of criticisms can be found on Economic Thought: “Fractional Reserve Banking Debate”).  Issues such as that of fraud and of the potential inherent instability of fractional reserve banking have been brought up.

However, this disagreement should not be an impediment to the deregulation of the banking industry.  The beauty of both the fractional reserve banking model and the full reserve banking model is that they both can naturally grow out of a free market.  In other words, it is ultimately up to the market (the consumer) to decide whether preference lies with full reserves or fractional reserves.  If the latter is a stable form of banking then it is likely to be adopted, and if it is not stable then consumers will opt for banks which maintain full reserves.

What is clear is that the existing state of affairs, or that of a monopolized currency system and a cartelized banking industry, is a major source of macroeconomic instability.  Both the theoretical and empirical evidence suggest that the time has come to replace it with a much more stable form of banking, and the same evidence convincingly argues that this is a product of freedom and deregulation.  We are not arguing for some deregulation, or deregulation in favor of the banking class, rather full fledge deregulation which places the entrepreneur (the banker, in our case) at the mercy of the market (the consumer).  Only then can we enjoy the fruits of a stable, sustainable economy.

[1] For a review of the early literature on central and free banking see: Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative (Indianapolis, Indiana: Liberty Fund, 1990).

[2] For Mises and Hayek, the market represents a network of relationships of exchange between individuals of a society — the division of labor — coordinated through the pricing process; Jonathan M. Finegold Catalán, “The Foremost Austrian Contribution to Economic Science.”  Government intervention in this pricing process represents sources of severe discoordination, while intervention in the supply of money causes substantial intertemporal discoordination between savings and investment, leading to malinvestment and industrial fluctuations.

[3] Friedrich Hayek, Choice in Currency (Auburn, Alabama: Ludwig von Mises Institute, 2009).

[4] Friedrich Hayek, Denationalisation of Money: The Argument Refined (London, United Kingdom: Institute of Economic Affairs, 1990).

[5] Whereas money refers to the actual commodity which makes up whatever medium of exchange is being employed — commonly gold —, money substitute is “a perfectly secure claim to an equivalent sum”.  For example, a paper note represents a claim to a given sum of commodity money, and thus is a money substitute.  Ludwig von Mises, The Theory of Money and Credit (Indianapolis, Indiana: Liberty Fund, 1980), pp. 63–67.

[6] Fiduciary media is money substitute not backed by commodity money.  Ibid., p. 155, 525–526.

[7] George Selgin, The Theory of Free Banking (Totowa, New Jersey: Rowman & Littlefield, 1988).

[8] What is briefly explained in the present essay is devoted an entire chapter in Selgin’s book; ibid., pp. 16–34.

[9] Carl Menger, Principles of Economics (Auburn, Alabama: Ludwig von Mises Institute, 2007), pp. 257–262; Ludwig von Mises, Human Action (Auburn, Alabama: Ludwig von Mises Institute, 1998), pp. 405–407; Murray Rothbard, Man, Economy, and State with Power and Market (Auburn, Alabama: Ludwig von Mises Institute, 2009), pp. 187–195.

[10] Selgin (1990), pp. 40–42.

[11] Selgin offers a convincing case for note-brand discrimination; ibid., pp. 42–47.

[12] Ibid., p. 67.

[13] Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, New Jersey: Princeton University Press, 1963), p. 592.

[14] For an introduction to monetary (dis)equilibrium theory, see Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium (Indianapolis, Indiana: Liberty Fund, 1997).  Also, see George Selgin, Bank Deregulation and Monetary Order (London, United Kingdom: Routledge, 1996), pp. 142–162.

[15] Roger W. Garrison, Time and Money (London, United Kingdom: Routledge, 2001), p. 234.

[16] Murray Rothbard, in fact, makes this argument in his explanation of the causes of the 1929 business cycle which set off the Great Depression.  See Murray Rothbard, America’s Great Depression (Auburn, Alabama: Ludwig von Mises Institute, 2000), p. 15.


Do More Immigrants Mean Lower Wages?

In an interview with Ezra Klein, Bernie Sanders says,

What right-wing people in this country would love is an open-border policy. Bring in all kinds of people, work for $2 or $3 an hour, that would be great for them. I don’t believe in that. I think we have to raise wages in this country, I think we have to do everything we can to create millions of jobs.

It’s true that we’re usually taught that if you increase the supply of labor, wages will go down. But, remember, that’s if we assume all else is equal. Famous left-wing economist Paul Krugman might disagree with that assumption.

In his famous work on trade theory — what won him the Nobel prize —, Krugman argues that a larger population implies a greater demand for goods, and therefore labor, because…you know…there’s more people. So what does this imply with regards to wages? If industries, or the economy as a whole through the division of labor, can benefit from economies of scales, it means lower prices and higher real wages.

So, if Bernie Sanders were really interested in raising incomes, he’d be an open borders advocate.

Mathematics as a Signal

Some economists justify the use of math in economics as a means of keeping their model straight. What if it has another purpose? What if it’s a signal?

In economics, a signal is a means of communicating something to others. For example, suppose that a large group of employers is looking for candidates with a certain skill, say the ability to sit down, study a topic, and train themselves on it (e.g. if you’re a digital analyst, you may want to train yourself on JavaScript). Prospective candidates who can do that will want to separate themselves from prospective candidates who can’t, so the former develop a signal. Let’s, for the sake of an example, say that this signal is a degree from a four-year university. The degree shows that you can be given a book and you can attend a few hours of lecture every week, and that you can learn the material (supposedly, right?).

Ideally, the signal should have a cost. Restated, it should be costly for someone to attain that signal. In our example, the optimal cost is one that is costly enough to dissuade candidates who don’t fit the employers’ criteria and not too costly that it dissuades those who do fit the criteria.

Math could be interpreted as a signal, at least as far as its use in economics in concerned. Suppose we’re interested in differentiating good economic theorists who can make enlightening insights on complex topics from average economic theorists who aren’t so good at doing that. Math, specifically the kind of math you learn for economics, is not easy to learn. There’s a cost, and that’s the amount of time spent studying it (time you could have spent studying/doing something else). The cost is high enough to weed a lot of people out.

At my alma mater, math is used as a signal to differentiate those who intend to move on to grad school and those who don’t. You can get an economics degree from San Diego State University with only precalculus, trigonometry, and “business calculus.” But, if you want to go to grad school, the straightforward economics degree isn’t usually good enough. Instead, you get a “specialization is quantitative economics,” which necessitates a higher level calculus class and then a mathematical economics class, which pretty much sums up 13 semesters of math (derivatives, integrals, and matrix algebra, pretty much). That specialization serves as a signal to boards which regulate the entry of masters and PhD candidates.

In the academic world, perhaps math signals certain capabilities, including the ability to think about complex subjects and derive accurate results. Note, this is a generalization, and I’m sure there’s plenty of very good economists who aren’t so good at math, or at least don’t use math much in their work — in fact, I know good economists who fit this characterization. But, maybe they’re the exception to the rule?

Do Unpaid Internships Make You Worse Off?

This morning, I read a LinkedIn article on unpaid internships, where I saw the following,

First off, it is worth noting that getting a paid internship in college is a very smart idea. The National Association of Colleges and Employers recently did a survey of people who graduated in 2013 with a bachelor’s degree and found that a graduate who did a paid internship while in college made an average starting salary of $51,930 – compared to a $37,087 average salary for workers who didn’t do an internship.

But here’s a shocking statistic from that same survey: 2013 graduates who did an unpaid internship while in college actually made less than students who got no internship at all – $35,721 a year, on average, compared to the aforementioned $37,087. Pretty bad deal – work for free and then make $1,366 a year less when it’s time to work for money.

There’s something wrong with that interpretation.

Let’s consider a single representative of a recent graduate. She has three options available to her, ordered from best to worst:

  1. Take a paid internship and later land a $51,930 salary
  2. Skip the internship and go straight for a full-time job with a $37,087 salary
  3. Take an unpaid internship and later take a job with a $35,721 salary

What determines which option she’ll take? Obviously, all recent graduates will want (1), but not all recent graduates will get that opportunity. Only the best will. Let’s say our graduate isn’t in that tier. She can opt for (2), but after we eliminate all those who achieved (1) we still have to choose the best of what remains to fill the limited number of full-time jobs available. That’s a second tier of candidates. Let’s say our representative doesn’t fit that category either. So, without options (1) and (2), the only thing she can do is (3).

What the author of this article wants to do is eliminate option (3), so that the only thing our candidate can do is be unemployed and hope that some time soon she’ll be able to fit into (1) or (2).

In any case, notice his wording. He’s saying that taking an unpaid internship leaves you worse off than choosing to work without that internship experience. That’s misleading, because to a lot of people who choose option (3), option (2) was never really a choice they weren’t sufficiently qualified. Option (3) leaves you better off, however, than not having a job at all!

A much more direct, if a bit more crass, way of putting my point is, those differences in incomes might represent differences in the skills different candidates have to offer. If someone takes an unpaid internship and over the long-run ends up making an average salary of $35,721, maybe it’s because they couldn’t compete against those other candidates who ended up getting jobs directly out of college or a paid internship.

So, it’s not that they’re getting bamboozled by employers. It’s that the unpaid internship was really their best choice, because (1) and (2) were really never on the table for them.

Kirzner, Mises, the Entrepreneur, and the Market Process

Daniel Kuehn has a string of interesting posts on Israel Kirzner and they have pulled me from my slumber.1 I want to defend Kirzner, but at the same time I agree with Daniel that maybe Austrians have ignored “mainstream” contributions to market process economics. While I can’t claim to be superbly well read on Kirzner, I do feel comfortable making the claim that maybe Kirzner’s (main) contribution was much more narrow than many Austrians suspect the entrepreneur’s role in the market process, rather than the market process in general.

First things first, I suspect one of the following happened: (a) Daniel misunderstood Kirzner; (b) Kirzner did not communicate his argument well. (I’ve already commented on this on Daniel’s blog, but hopefully he won’t mind if I repeat myself here.) Daniel claims that Kirzner made an elementary mistake is confusing value for prices. If that’s true, I agree with Daniel. But, then I think that Kirzner articulated his point poorly.

If I interpreted Competition and Entrepreneurship correctly, Kirzner cares about prices not values. Specifically, and following Mises, he argues that the entrepreneur’s role is to notice disequilibria between factor and final good markets. To illustrate this line of reasoning in terms of equilibrium, suppose that the final goods market is producing at qc(uantity) < qc*, and let’s assume that this implies that the the price for factors of production is pf < pf*, such that if the entrepreneur buys at pf he’ll be able to sell at a price that corresponds to qc*, but at a cost that corresponds to qc. Kirzner is explaining pure profits, not surplus value.

It is, I think, more-or-less the same point that Frank Knight makes in “Profit and Entrepreneurial Functions,”

In the theory of competition, all adjustments “tend” to be made correctly, through the correction of errors on the basis of experience, and pure profit accordingly tends to be temporary. While it exists, in a positive form, it may obviously be regarded as a phenomenon of monopoly, and some distinction, which can never be clear, must be made between temporary profit and permanent monopoly revenue.

— p. 128.

(Kirzner, however, would disagree with the notion that profits are a monopoly phenomenon.)

What of the claim that the “mainstream” ignores the market process? I can’t agree with this argument, because I think there is a large “mainstream” literature out there that talks exactly about the market process, although perhaps not in a way that Austrians can readily identify. In fact, I think that there are several theories out there which go beyond Kirzner and, actually, explore many areas that Kirzner maybe didn’t recognize.

Consider the debate between Ludwig Lachmann and Kirzner. Both agreed that there are equilibrium and disequilibrium “forces” at work; they disagreed on what the net outcome has to be. Kirzner believed that markets ultimately equilibrate, while Lachmann held the much more ambiguous position that we can’t know for certain, at least in an a priori sense. Doesn’t the literature on job market search frictions and monopsonistically competitive labor markets prove Lachmann right? Things like employee loyalty to their firm, or imperfect knowledge of labor markets, other forms of transaction costs (e.g. transportation costs), suggest that maybe there comes a point where markets won’t equilibrate further (given a set of institutions). Finally, don’t these results contribute to our understanding of the market process?

Speaking of institutions, doesn’t Akerlof’s “Market for Lemons” paper, when properly interpreted, give us quite a bit of insight on the market process and institutional change? Coming back to the Lachmann-Kirzner debate, Akerlof’s insight actually seems to back Kirzner if markets don’t equilibrate [the way we want them to] under one set of institutions, we’ll develop new institutions to get them there. Moreover, to posit that agents will introduce new rules (e.g. reputation, guarantees, et cetera) seems to implicitly assume that there are agents willing to capitalize on new profit opportunities.

Likewise, I interpret New Trade Theory as belonging to the study of the market process. Paul Krugman, and others, provided insight on how markets respond to changes in population size and, more fundamentally, how markets can form at all, if we assume that there are no comparative advantages at t0. This is a dynamic theory at heart, so it must say something about the market process (something that many Austrians have been quick to dismiss). Perhaps New Trade Theory has a more narrow focus than, say, Mises’ discussion of profit and loss, but that doesn’t mean that it doesn’t offer any process theory insight at all.

Sure, maybe these theories are framed in terms of equilibrium not unlike Kirzner’s theory, mind you , but they’re suggestive of the fact that maybe the “mainstream” thinks more about the market process than Austrians give them credit for. So, in this regard, I completely agree with Daniel. In fact, I could go as far as to claim that, rather than Austrian contributions being underestimated by the “mainstream,” perhaps the Austrians have underestimated “mainstream” contributions. Or, maybe there’s a little bit of both going on.


1. This site has been loading very slowly. The servers I contract through aren’t working out, but hopefully I’ll be able to move the site to new servers soon.

Fractional Reserve Banking Made Simple

I’m about to kick a dead horse, but every once in a while you see the horse’s ghost gallop about the internet. The notion that fractional reserve banking is “fraudulent” and “unstable” is a “brain worm” that deserves to be extinguished.

Part of what a bank does is intermediate between savers and borrowers. When you put your money into a savings account, the bank will lend it out. Fractional reserve banking works the same way, but deals with relatively liquid type of deposits. There’s nothing fraudulent about it.

I’m relatively young and I don’t make a big income, so I keep a good amount of money in a demand deposit. If I ever unexpectedly need it, it’s there. Most of the time, it just sits there. Anything not being presently consumed is being saved for future consumption, so those dollars are savings — just like a savings deposit, but (given regulatory rules) with no interest and greater liquidity. The bank will lend these savings out.

Are there two claims on the same money? In a sense, yes, but that’s true with just about any savings vehicle. The money you’re lending is yours, you’re just not currently spending it, so it can be lent out. You might argue that the problem with fractional reserves is when depositors go to the bank to withdraw their money. This isn’t an issue unique to deposit banking. It’s called a maturity mismatch and it can happen with any kind of asset. In fact, it’s something that is inherent to banking: banks borrow short and lend long.

The “trick” is to manage these different assets and rely on the law of large numbers to make sure you always have the sufficient liquidity to pay-off short-term liabilities. That’s what successful banks accomplish. Without the ability to juggle assets of different term lengths, the intermediation industry is going to be very inefficient.

What’s the relationship between fractional reserves and economic crises? Some see that many financial crises are preceded by bank runs, so they conclude that it must have been the maturity mismatch that was at fault. It’s strange, actually, that some Austrians would believe this, because they’re the ones always stressing about their peers mistaking the symptoms (the crash) for the cause (credit expansion). Business cycles are caused by excess supplies of money, which change the distribution of profits. When money supply growth begins to slow down this distribution changes — thus, the sudden loss in profitability for large swaths of industry.

Just because too much sugar is bad for you doesn’t mean all sugar is bad. There’s nothing inherently destabilizing with fractional reserve banking as long as excess money is minimized. What’s the difference between “excess money” and lending on fractional reserves?

Like with any other economic good, there is a point at which demand and supply are equal. Unlike many other economic goods, money has to clear in multiple markets. When the demand for money increases, ignoring for a minute the ability to increase supply, the prices of other goods that exchange for money have to decrease in order to clear against the higher relative value of the currency. If prices don’t clear and exchange suffers, we call that a shortage of money. On the other hand, if there’s more money than people are willing to hold, this is called excess money. It will continue to circulate (the “hot potato” effect) until it returns for redemption or the price level increases, the relative value of money falls, and demand and supply are again equal to each other.

That a bank lends on fractional reserves doesn’t really say anything about whether there is excess money. When the demand for money increases, the volume of deposits might swell (the amount of liabilities returning to the bank for redemption will fall) and it will allow the bank to issue credit. In this case, the banking system is increasing the supply of money to meet the heightened demand. That’s why, if you’re worried about the business cycle, blaming fractional reserve banking is the wrong way to go. What you should really be worried about is surplus money.

How do we accomplish limiting the ability of banks to create liabilities, without enforcing full reserves? Through coordinating monetary institutions (rules or constraints), which may include:

  • In a competitive banking system, banks holding other banks’ liabilities will send them in for redemption, draining on the issuing bank’s assets. If a bank over-issues money, it will suffer from illiquidity. If a bank under-issues money, they will be foregoing the revenue they could have earned had they maximized the use of their assets.
  • If banks could pay competitive interest on demand deposits, they’d have to raise this rate to attract new deposits to fund their lending. But, as the supply of loanable funds increases, the rate of interest on these loans will fall. If the latter rate (on loans) falls below the former (on deposits), the bank is making a loss.

That’s why it pains me when I read Austrians cheering for recent IMF studies and old Chicago research papers supporting 100 percent reserves. They’re worrying too much about the symptom and they don’t realize that they’re supporting the cause: bad monetary institutions (after all, it’s not like these IMF and old Chicago School economists are advocating for free banking).

Techno Economics

The Electric Daily Carnival is a major music festival that takes place every year in a number of cities, originally in the U.S. but not spread to U.K. and Mexico. You may remember an article of mine on EDC, which I wrote back in 2011.There I discussed some qualitative aspects, with my mind on prohibition in particular. I discussed how the market helps mitigate some of the adverse consequences of drug use, while the government tends to do the opposite of help.

Dancing Astronaut has an interesting infographic on with hard data on EDC’s economic impact on Las Vegas. They find that total spending amongst attendees was $158 million, and broken up into more specific categories the distribution of that income looks as follows:

  • $52.2 million → Food and beverage
  • $29 → Hotel rooms
  • $25.6 → Transportation
  • $22. 7 → Gaming
  • $15.2 → Entertainment
  • $13.7 → Retail spending

$20 million eventually became tax revenue. According to the infographic, $131.9 million represents “increased labor income,” which I’m assuming means wages/salary. To put that figure into context, that’s 83.5 percent of total cash flow.

To me this says something about the “labor v. capital” inequality question. Sure, EDC, hospitality, and most of these other industries are labor-intensive. Other sectors of the economy, particularly manufacturing, might see distributions of income between the two factors that are different. But, aren’t we see seeing a structural shift towards the service sector? Aren’t we moving back to a labor-intensive dominant economy? In Capital, Thomas Piketty ascribes human capital to labor. It seems to me, when comparing margins, the return to human capital is quickly growing relative to the return to much of the physical capital the growing service industry uses.

Ancient Athens’ Economic Freedom Ranking

The abstract:

We use the Economic Freedom Index to characterize the institutions of the Athenian city-state in the fourth century BCE. It has been shown that ancient Greece witnessed improved living conditions for an extended period of time. Athens in the fourth century appears to have fared particularly well. We find that economic freedom in ancient Athens is on level with the highest ranked modern economies such as Hong Kong and Singapore. With the exception of the position of women and slaves, Athens scores high in almost every dimension of economic freedom. Trade is probably highly important even by current standards. As studies of contemporary societies suggest that institutional quality is probably an important determinant of economic growth, it may also have been one factor in the relative material success of the Athenians.

— Andreas Bergh and Hampus Lyttkens, “Measuring Institutional Quality in Ancient Athens.”

I Welcome the Terminator

Before I start with anything else, I apologize for the lack of writing. I work at a marketing agency and I just have not had much time for anything else recently. In fact, I haven’t been thinking much about economics at all. I’m stimulated when I read, and I haven’t found the opportunity to finish what I’m currently working through (The Order of Public Reason), so I’ve felt uninspired lately — I totally get where Nick Rowe is coming from, although my mean is well below his. Not being able to think or read about econ totally sucks, by the way!

I did, however, enjoy a “nice” economics discussion during last weekend’s Shabbat dinner. Someone asked me if I thought robots could ever completely replace workers. I said ‘no.’ I should have added the caveat that if it turns out the answer is ‘yes,’ we should all be quite happy about it. I, for one, am looking forward to the day that I no longer have to work, because we live in a world of superabundance. Of course, in order to imagine a world where robots replace the human labor force we have to assume superabundance, because as long as there’s something else to produce there’s always work to be done (and an income to make).

Bastiat put the case more-or-less like this. Does the home worker complain about replacing hand washing laundry with a washing machine? No, because that person now has time to do something else — the robot helped to complete two tasks within the same amount of time; it makes the home worker better off. The benefits of capital don’t stop at washing machines. The reason we employ machines is to increase our productivity and make us better off. The more we can produce, the more we can consume.

What about “labor saving capital?” Remember, there is a difference between partial and general equilibrium. McDonalds might have a touch-screen computer replace its cashiers, to reduce its payroll, but that doesn’t mean that there is nothing else that cashier can do. That person can find work as a construction worker, or a bus driver, or a graphic designer, or whatever that person can find a demand for. Maybe one day someone will create a program to auto-write premium website content, which allows marketing agencies to let go of all of their content writers. While writing no longer be a skill in demand, there are still many other types of jobs content writers can do — “worst case,” they can bag groceries.

The day humans no longer have work to do is the day we live in superabundance. What does superabundance mean? I believe human wants are limitless, but let’s say that there is a point of comprehensive satiation, defined as Y. As long as capital, or robots if you’d like, produce less than Y, say X, there are YX goods that still need to be produced. That’s the stuff that humans can produce. Suppose X is a very large number which is actually not that far off from Y. To make it clearer, what if capital produced 95 percent of economics goods and humans only the other five? We can all agree that it would be pretty awesome if we had machines doing most of the work for us, so that we can enjoy the combined fruits of “our” (robots don’t need to consume, after all — Bender aside). At the point where capital produces Y, we have reached superabundance; there is nothing else we want. It’s what Nirvana would be if the Buddhists were materialists.

I’m all for robots taking our jobs. It makes us better off, because it allows us to consume more than we previously could (we can consume more for the same amount of labor we expend). What’s unfortunate is that we’re still a long way off from being completely replaced by robots in the labor force. Although, I did overhear my company talking about replacing its content writers with content generators (is there a content generator that writes as well as a trained copywriter?). What I find surprising, in any case, is that only one person at the Shabbat table agreed with me on this.

Tenure as a Division of Power

A California judge recently declared tenure unconstitutional. A lot of people are rejoicing, because they think this means that bad teachers will no longer be excessively protected from being fired. While the public school system needs a remake, to put it lightly, people might be jumping the gun on tenure. It may have costs, but tenure also has benefits. The problem with public schooling isn’t tenure, anyways; the problem runs down to the roots, school administrations.

Tenure limits administration’s power on teachers. It can give teachers the independence to choose their own approach to educating their students. Sometimes it turns out badly. More often, it stops the administration from dictating the curriculum. It puts a limit on pressure placed on the teacher to change their curriculum for the worse. This element of the debate reminds me of the argument in favor of independent central banking. Some people noticed the Federal Reserve’s poor response to the recession and called for an end to central bank independence. The problem with that is a central bank directly controlled by government is one in a position to help that government at the expense of the people — such as when government uses its central bank to finance its spending. The benefits may outweigh the costs.

School administrations can be very political. I have first-hand experience through my dad, who is a high school teacher. Yes, I did let him know what most libertarians think about public schools. If it wasn’t for tenure, my dad would have probably been fired a long time ago. You might be thinking, “He probably deserved it because he was a horrible teacher.” You would be wrong. The administration pressures him to raise the grades of students who don’t do their homework, who don’t study, who fool around in class, and who generally just don’t care about their education. The administration wants to look good in front of the parents and they want their statistics to shine. These create perverse incentives. My dad is an AP Spanish teacher and to punish him they took away his AP Spanish Literature class. AP test scores in that class plummeted. The administration doesn’t always punish instructors for good reasons, they do it for very bad reasons.

Few people look at the administration. Maybe this might catch your attention: Sweetwater Union High School District, in San Diego country, was recently rocked by a corruption scandal. Top school administrators were caught siphoning “gifts” received for preferring certain contractors over others. That shows how much they care about the kids.

Oftentimes schools push sports rather than academics, because that’s what some parents want — some parents couldn’t care less about their children’s education, or they think that there isn’t a trade-off when they push for funding elsewhere. Yes, many parents are negligent; you see this a lot in lower income schools (see also “Have and Have Nots“). The administration wants to look good, and this creates perverse incentives. Removing an institution that limits their ability to control  teachers risks making our schools worse off.

I am not saying teachers are saints. I oppose teacher unions. I told my dad it was ridiculous that he was protesting the reduction in his salary after the economy collapsed. He doesn’t seem to understand that if there’s less money to pay him, he might have to take a salary reduction or else risk losing a job (actually, he has seniority — tenure aside —, so it would just be a hypothetical future hire who is now unemployed). I also disagreed with his decision to oppose a recent reduction in healthcare benefits. I thought, “Great for the taxpayer.” But, actually, no. As is turns out, most of the money saved from reduced healthcare benefit was just allocated somewhere else — and definitely not towards improving the quality of the schooling, because the teachers had to fight to reduce things like classroom size, as well.

Finally, it’s worth mentioning that tenure, strictly speaking, doesn’t protect teachers from teaching poorly. Bad teachers can be fired. It might be more difficult, but that’s because the reasons for firing the teacher have to be legitimate and well documented. The thing is, the administration is so bad at doing its job that it’s negligent at the time of monitoring and documenting bad teaching. School administrations are a libertarian’s worst nightmare: extremely inefficient bureaucracies. Bad teaching is more common than it should be not because the administration has its hands tied, but because the administration is inept.

By the way, libertarians should be receptive to the notion that tenure is an institution that establishes some degree of “teacher independence.” In many cases, your favorite libertarian thinker is able to publish a constant stream of libertarian-oriented literature only because he or she has tenure. Otherwise, that person would be writing on some other topic — some topic that would keep that person employed —, at the expense of the libertarian movement. But, tenure doesn’t necessarily cause these professors to reduce the quality of their teaching. (Sometimes the worst teachers are the most liked by the administration, because they’re the ones who focus too much on their research and too little on their students. Publishing in top journals makes the school look good, though.) Oftentimes, tenure creates a positive effect on education, like the ability for a tenured professor to teach the students more on Friedrich Hayek or Robert Nozick than the curriculum normally allows for.

Blaming teachers is the easy thing to do. But, sometimes the easy way is the wrong way. Maybe the problem with public schooling runs deeper. We need to focus more on the machinery of the system, a machinery prone to corruption and waste.