Backing, Shmacking

by George Selgin March 4th, 2015 12:14 pm

Somali Shilling

I really ought to know better by now than to complain about the "backing" theory of money--the view that the value of, not just some sorts of money, but money of any sort, depends on the assets commanded by the money's suppliers. I've never been able to convince the theory's more determined proponents of the error of their ways, and I risk provoking them to mount their hobby horse every time I bring it up.

But the backing theory keeps rearing its ugly head whether I mention it or not, as it did in the pages of Monday's Wall Street Journal, in an article asking "Do Cryptocurrencies Such as Bitcoin Have a Future?" And I'll be damned if I'm going to just sit idly by while it threatens to amble its way into some as-yet uninfected brains.

The specific perpetrator in this instance was one Eric Temoigne, an assistant professor of economics at Lewis & Clark College, who invoked the ghastly fallacy in defense of his assertion that "There is no financial logic behind bitcoins’ face value":

Monetary instruments are securities. As such, they have a term to maturity (instantaneous) and an issuer—often a central bank or private banks—that promises to pay the bearer the full face value. Gold coins are a collateralized form of such security. Paper, cheap metal, and electronic entries are the forms such securities take today. The characteristics of these securities allow them to circulate at a stable nominal value (par) in the right financial infrastructure and as long as the creditworthiness of the issuer is strong. This provides a reliable means to complete transactions and, more important, service debts.

Bitcoins, meanwhile, violate all of the rules of finance. There is no central issuer guaranteeing payment at face value to the bearer; in fact, there is no underlying face value, and subsequently no imputed value at maturity, which means they are completely impractical for use in servicing of debt. The fair price of bitcoins as measured by the discounted value of future cash flows is zero.

Although Mr. Temoigne never actually uses the word "backing," his argument is standard "backing" fare, distinguished only in being more explicit than some other statements in referring to all forms of money as "securities." This explicitness is welcome, for it is precisely in treating all forms of money this way, whether expressly or only tacitly, that the "backing" theory goes awry.

Many types of money are, to be sure, properly regarded as securities, that is, as IOUs or promises to pay. Bank deposits fit this description. So do competitively issued, non-legal tender banknotes, like those issued by Scottish banks today, and by almost all commercial banks a century or more ago. Central-bank-issued notes qualified as well back when they were themselves convertible claims to some underlying form of money, such as gold or silver coins. Finally, a paper currency which, though temporarily irredeemable, is expected eventually to be redeemed in some other kind of money--what von Mises terms "credit money"--also qualifies. Examples of the last include Bank of England pounds during the Bank Restriction period, and U.S. Treasury notes ("Greenbacks") before 1879.

Of course "backing" matters in the case of exchange media that either are convertible into some more basic form of money, or are expected to become convertible into such at some future date. The likelihood that a bank will be able to honor its promises to pay obviously depends on the quality of the assets "backing" its IOUs. When the expected present value of those assets ceases to equal or exceed the value of its liabilities, the bank is insolvent, and its creditors, face the prospect of not having their debts paid in full. Likewise, the prospects for resumption of payments on temporarily suspended monetary IOUs vary with the value of their issuers' non-monetary assets. The announcement of the Peace of Amiens substantially boosted the value of the paper pound, while that of renewed hostilities had the opposite effect. All of this is indeed perfectly in accord with the logic concerning how securities of all sorts are valued.

But in imagining that other sorts of money are also securities, proponents of the backing theory commit what philosophers like to call a "category mistake." Free-floating "fiat" moneys are not securities. Precious metal objects are not securities. Finally, bitcoins and altcoins are not securities. These actual or potential exchange media aren't claims to some underling medium into which they are, or are expected to become, redeemable. Consequently their values don't depend on the likelihood that they can be converted into something else, or on their providers' overall wealth as it informs that likelihood. Instead, their value depends on their own supply, and on the demand for them as exchange media (and for other uses, if they have such), with no role for calculations or speculation concerning the prospect of their being converted into something else.

The assets possessed by a fiat-money-issuing central bank--that is, by a bank that issues inconvertible paper, with no promise to ever redeem it in a specific amount of some other money--play no part in determining its currency's purchasing power. Such a central bank might, therefore, swap all its better assets for junk, without influencing that purchasing power in the slightest. And guess what? The Fed and the ECB have done just that in recent years, jettisoning their good assets to make room for doubtful mortgage-backed securities and Greek bonds; yet far from seeing their currencies depreciate substantially, as the backing theory predicts would happen, both, and the ECB in particular, struggled to keep them from appreciating excessively relative to stated inflation targets. It's hard to imagine a cleaner refutation of the "backing" theory than this. Oh, wait! I almost forgot about the "disowned" Iraqi Swiss dinars that remained in use in northern Iraq years after being repudiated by Iraq's Central Bank, and the "orphaned" Somali shillings that continued to be valued and used long after looters gutted the Central Bank of Somalia. Alas, no amount of empirical evidence appears sufficient to refute the backing theory in the eyes of its more obstinate champions.

To be fair to those champions, they are merely giving their intellectual stamp of approval to a view that has always had a substantial popular following. Consider, for example, the dummies.com definition of a fiat money system as one "based on a government’s mandate that the paper currency it prints is legal tender for making financial transactions. Legal tender means that the money is backed by the full faith and credit of the government that issues it. In other words, the government promises to be good for it."

"Promises to be good for it?" And just what is this "it"? It is...well, nothing, actually. Because modern Federal Reserve Notes are, in fact (in former New York Fed President John Exter's famous formulation), so many "IOU nothings."

It's a bit more disappointing to find the backing theory endorsed by government officials, as it is in an otherwise competent CRS brief on the history of Gold Standard:

The U.S. monetary system is based on paper money backed by the full faith and credit of the federal government. The currency is neither valued in, backed by, nor officially convertible into gold or silver. Through much of its history, however, the United States was on a metallic standard of one sort or another

and in boilerplate included in the U.S. Comptroller General's annual Financial Report on the United States Government:

FRBs issue Federal Reserve Notes, which are the circulating currency of the United States. These notes are collateralized by specific assets owned by the FRBs, typically U.S. government securities. Federal Reserve Notes are backed by the full faith and credit of the United States Government.

In fact the only "faith" that matters for a fiat currency is the public's "faith" in the monetary authorities, that is, the public's willingness to believe that those authorities will refrain from issuing oodles of the stuff. "Credit" has nothing to do with it: once again, a piece of "fiat" money is not a credit instrument. It is not a promise to pay anything. Consequently its issuer's credit standing is of no immediate consequence. (It matters indirectly because, were the U.S. government unable to borrow by selling actual Treasury securities, it might be tempted to issue greater sums of fiat money instead, provided it could get the Fed to go along with the plan.)*

More troubling still are endorsements of the backing theory by Federal Reserve experts. Those experts are supposed to know something about how the value of the U.S. dollar is determined. Yet that doesn't prevent some of them from saying things like "Since 1971, U.S. paper money has been backed by the 'full faith and credit' of the U.S. government", or "Compared with commodity money, which has an intrinsic value, such as gold, or official fiat money backed by a sovereign entity, the current market value of bitcoin to any given user hinges entirely on her expectation of others’ willingness to accept it later at a sufficiently greater value". In truth neither bitcoin nor Federal Reserve dollars have "intrinsic" value, understood in the usual sense to mean non-monetary value. And as for governments being able to prop-up the value of fiat money by means of legal tender laws, tell that to all the governments that imagined that doing so would suffice to rule-out hyperinflation.

Most disturbing of all is the fact that some central bankers themselves appear to subscribe to the backing theory. Take, for example, Alan Greenspan's remarks concerning Bitcoin, given in the course of a December 2013 Bloomberg News interview. :

"It’s a bubble,” Greenspan, 87, said today in a Bloomberg Television interview from Washington. “It has to have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it. Maybe somebody else can.”

“I do not understand where the backing of Bitcoin is coming from,” the former Fed chief said. “There is no fundamental issue of capabilities of repaying it in anything which is universally acceptable, which is either intrinsic value of the currency or the credit or trust of the individual who is issuing the money, whether it’s a government or an individual.”

"Capabilities of repaying it"! Tell us, Mr. Greenspan, just when does the Fed plan to "repay" the holders of all those Federal Reserve "liabilities" created during your watch, let alone the far vaster quantity created since? And what will it "repay" them with?

If you imagine that Mr. Greenspan can answer these questions, you imagine too well.**
*Even when used, less inappropriately, in reference to actual U.S. government securities, the "backed by the full faith and credit" language is misleading: unlike private debtors the U.S. government doesn't have to possess a stock of valuable, productive or interest-earning assets in order to service its debts. Its securities are instead "backed" by a combination of (1) its power to tax and (2) its ability to rely, at least to some extent, on the Fed's willingness to monetize its debt.
**A commentator thinks I am being too harsh here, as Greenspan merely assumes that Federal Reserve dollars, being "universally acceptable," differ from bitcoins in not having to be secured by a promise of repayment. Greenspan's language isn't the easiest to follow, but I still think his statements beg the question. For my further remarks see the comments below.


What Fed Officials Really Don't Want You to Know (Hint: They are Telling You)

by George Selgin February 18th, 2015 7:55 pm


This morning I had a query from someone asking me to share my thoughts about the Federal Reserve Transparency Act, better known as the bill to "Audit the Fed." Having given him a brief answer, I thought I might say a little more here.

Although Rand Paul promises that his measure will shed much-needed light on the Fed's undertakings (the Senate version of his measure was even called "The Federal Reserve Sunshine Act"), the truth is that it's unlikely to reveal any new facts of importance beyond what existing Fed audits--including those provided by Title XI of the Dodd-Frank Act (which provides for a GAO audit of the Fed's crisis-related emergency lending)--can themselves reveal.

True, unlike existing measures Paul's bill would also let the GAO "audit" the Fed's conduct of monetary policy, including its open-market operations and financial dealings with other central banks. But if "sunshine" is the first word that pops into your head when contemplating this possibility, you probably have had a little too much of it already. Certainly you have not read many GAO reports.

Don't get me wrong: the GAO does its job's well, and a report by it on the Fed's conduct of monetary policy would probably be a much better read than most academic papers on the same topic. But if you're looking forward to seeing the GAO give the FOMC a good thrashing, or to any other sort of scintillating reading, you're barking up the wrong tree, because what you're likely to be in for instead is a bunch of charts and tables, accompanied by a competent but very measured and detached review of the Fed's activities, of the sort that might prove very handy for assessing the Fed's performance, but that is hardly likely to be the least-bit earth-shattering.

But if some dry-as-dust report is all we're talking about, why are Fed officials so up in arms about the proposal? That's a good question. Fed officials themselves claim that Paul's measure would give Congress the power to "harass" the Fed, thereby allowing it (in Dallas Fed President Richard Fisher's words) "to bend monetary policy to the will of politicians." But as my colleague Mark Calabria explains, the measure wouldn't allow anything of the sort. Evidently these Fed officials were too busy arranging the Fed's wagons in a big circle to take time to actually read the measure they were so anxious to defend their institution against. Had they bothered they might have noticed that the it calls for the GAO, and not "Congress" (or any body of "politicians") to report on the Fed's policies. They might even have taken a moment to recall that the GAO is an independent agency--just like the Fed's own Board of Governors--whose head, the Comptroller General of the U.S., is a non-partisan professional appointed by the President--rather like their own Chairman. Finally, they might have chewed a little on the GAO's own description of its mission, which is "to support the Congress in meeting its constitutional responsibilities and to help improve the performance and ensure the accountability of the federal government for the benefit of the American people."

In short, what we have here is one independent agency of the U.S. government insisting on its right to be uniquely exempt from review by another independent agency charged with making sure that Congress and its departments and agencies perform their Constitutional duties successfully and efficiently. That's not fighting to preserve independence. It's fighting to avoid accountability.

Come to think of it, perhaps Paul's proposal will reveal some deep, dark Fed secret after all. Perhaps it already has.


Fragile by Design: A Free Banker's Perspective

by George Selgin February 9th, 2015 10:02 am

My review essay, forthcoming in International Finance, on Charles Calomiris and Stephen Haber's very important book.


A Free-Banking Fantasy

by George Selgin January 28th, 2015 2:02 pm

gold atm

Everyone fantasizes about something now and then. But even I was surprised (and not at all displeased) to discover that at least one person besides me--Warren Gibson--fantasizes about...free banking! Better yet, he's invited anyone who wishes to stroll down fantasy lane with him to witness his vision of what a Wells Fargo branch might look like, if only governments would leave it and other banks alone.

I hope my readers will accept Warren's kind invitation. And the last thing I want to do is to spoil his personal pipe-dream. Still I can't help wanting to take advantage of the tantalizing picture Warren paints to dispel some common misconceptions about free banking, and especially about what a future free banking system is likely to look like.

"The first thing we notice," say Warren as we enter his fantasy bank, "is a display case showing a number of gold coins and a placard that says, “available here for 1,000 Wells Fargo Dollars each, now and forever.”

Hold it right there. In the past competitively-supplied banknotes, including those of free banking systems in Scotland and elsewhere, were convertible into either gold or silver, because back then "real" money consisted of gold or silver coins. But if you think that a return to free banking in the future would mean returning to a gold (or silver) standard, you'd better keep dreaming. Banks themselves, first of all, aren't in the business of establishing new monetary standards. A banker's job is to get people to trade whatever basic money they already employ, which is to say whichever basic money is in common use, for his or her bank's IOUs. Those IOUs will, in turn, be made redeemable in the same sort of money they were substituted for in the first place. That "Gold has physical properties that have endeared it to people over the ages—durability, divisibility, scarcity to name a few," though true, is irrelevant once some other stuff, whatever its physical properties, has come to be generally accepted in its place. The long and short of it is that, were I able to wave a magic wand right now, eliminating all obnoxious banking laws, disbanding the FOMC, and privatizing the Fed's remaining bits, including its clearing and settlement facilities, chances are we'd still find ourselves be on a paper dollar standard. Sheer momentum alone would tend to keep the dollar going, while the fact that the supply of basic dollars could no longer be expanded would, if anything, make the dollar appreciate. That's not saying that the new dollar standard would be perfect--far from it. But neither will it go "poof" and have gold appear, like magic, in its place.

So our future Wells Fargo may be allowed to issue all the IOUs it wants to, including circulating paper ones. But odds are that, unless other steps were taken to re-establish a gold standard, its IOUs will be promises to pay, not gold, but old-fashioned Federal Reserve dollars.

Warren manages, thank goodness, to avoid another popular misconception about free banking: the neo-Rothbardian claim that it would lead in practice to 100-percent reserves. "Wells Fargo," Warren says, "practices fractional reserve banking." But what, Warren imagines his companion asking, keeps Wells from issuing way more banknotes and other IOUs than it should? "The market will stop them, that’s who," says Warren. He's right, but "the market" can't work as he imagines it will. "In my scenario," Warren says,

Consumer Reports and a number of lesser known organizations track Wells Fargo and other banks. These organizations post daily figures online showing the number of Wells Fargo dollars (WF$) outstanding and the amount of gold holdings that the bank keeps in reserve to back these dollars. Premium subscribers, I imagine, can get an email alert any time a bank’s reserves fall below some specified levels. Large depositors will notify Wells Fargo of their intention to begin withdrawing deposits and/or demanding physical gold. Small depositors piggyback on the vigilance efforts of big depositors. They know it is not necessary for them to pester the bank when the big guys are doing it for everybody.

Terrific: Wells Fargo is free to go wild until Consumer Reports gets 'round to publishing its annual Fractional Reserve Bank special, in which Wells, assuming it is still around, earns it "unsatisfactory" rating, whereupon a run wipes it out at last. Runs, you see, are a little like pregnancy, in that there's no having part of one only. And if you think it makes sense for a worried depositor, large or small, to "notify" his bank before running, I strongly urge you to keep your money under a mattress. Finally, even if Consumer Reports or some other (presumably private) watchdog could somehow manage to supply real-time reports on Wells Fargo's reserve ratio, just how are consumers supposed to distinguish a reserve ratio that's just dandy from one that portends disaster? As we'll see, they can't do it by just guessing--and especially so if their guesses are as wildly off as Warren's are. (More on that below.)

If having people spy on its reserves won't suffice to keep a liberated Wells Fargo of the future in check, what will? The answer is still "the market," as Warren likes to say. But it's more precise than that: it's the competitive market for bank money, including paper banknotes, that matters. In that market a bank's notes, like checks drawn on it, make their way to (mostly rival) banks within a matter of days after being put into circulation. The rivals then return them to their source for payment. After offsetting payments are "netted out," banks' remaining dues to one another are settled in basic money. Consequently, any bank that's overgenerous in its lending doesn't have to wait for some watchdog agency to complain about its reserve ratio: it gets the message, and quickly, by seeing its reserves chipped away by its rivals.* In missing this, by the way, Warren paradoxically misses the key advantage of having multiple suppliers of convertible currency instead of just one. Free banking without a role for competition is like Hamlet...(blah blah blah).

As I mentioned, Warren avoids the misconception that a free Wells Fargo would resemble a Rothbardian money warehouse. Still, in imagining that Wells' fractional-reserve status would be "clearly outlined in the contract that depositors sign and...printed on their banknotes," he risks giving credence to the related misconception that the language on current bank depositor agreements and current and past redeemable banknotes is somehow misleading. In fact, no one who actually bothers to read a modern bank depositor's agreement can have any doubt that he or she isn't doing business with a mere warehouse. And though the phrase "fractional reserves" never appeared on past commercial banknotes, such notes, I've noted here previously, far from pretending to be warehouse receipts, were clear proof of debts contracted between their issuers and their holders.

Warren's free-banking fantasy is also fantastically off in its suggestion that a future free bank might hold reserves equal to a very substantial fraction--he uses 40% in his illustration--of its banknotes and deposits. Such high numbers reflect the view, traceable to Henri Cernuschi and repeated by von Mises, that open competition would force banks to hold much higher reserves than they've gotten away with historically. But consider: even the goldsmith bankers of the mid-17th century, when there was no question of banks being propped-up by government guarantees, implicit or otherwise (there was as yet no Bank of England to serve them as a last-resort lender), typically kept reserves equal to less than 30% of their liabilities--and this despite having relatively few, larger clients and very few ways to diversify.

The goldsmiths were also, one must admit, not the safest bankers ever. But consider the Scottish free banking system. Once the dust settled from the Ayr Bank's fantastic collapse, that system remained almost perfectly safe for the better part of a century, and yet managed to do so on specie reserves that frequently fell below two percent of their liabilities. Here again, the banks had no lender of last resort to turn to, Rothbard's suggestion to the contrary notwithstanding: although Scottish banks naturally placed funds in, and occasionally borrowed from, the London money market, they could never expect help from that quarter when they most needed it, which was during emergencies that tended to be felt most acutely there.

When one considers all the technological progress in interbank settlement technology, together with a still-more impressive increase in both opportunities for banks to engage in liability management and to employ highly-liquid securities as secondary reserves, its hard to imagine why the reserve ratios of any future free bank would be higher than that of Scottish banks two centuries ago. It's therefore unnecessary as well to worry that, were a future free banking system somehow to revert to a gold standard after all, its doing so would involve substantial real resource costs.

Warren's vision of his imaginary Wells Fargo's way of dealing with runs is, I think, generally spot-on, though I'm not sure that clearinghouses would get involved in extending emergency credit as he imagines might happen. (They did so in the U.S.; but that was a peculiar response to artificial restrictions placed upon their members' ability to issue their own banknotes.) He's also correct in arguing that having competing banks of issue doesn't mean having multiple monetary standards, though he makes free banks' inclination to adhere to a single standard appear to be merely a matter of doing what's most convenient for their customers, rather than what they cannot avoid doing in a business dedicated in the first place to receiving, and making promises to repay, some preexisting standard money. To repeat: banks aren't in the business of choosing monetary standards. Unlike a light bulb, a bank IOU isn't something its issuer can toy around with. That's why you will never see such a note with "New and Improved!" written across it, except perhaps in reference to changes in its physical design. (And even that would be tacky.)

Finally, to end on another positive note, Warren is to be commended for arguing that, were a future free banking system to witness occasional bank runs and failures, and even were it to inflict occasional losses on bank depositors and note holders, this would be no proof of its inadequacy. "Under my free banking scenario," he says, "depositors must take some responsibility for their actions." Show me a banking system where they don't have to do so, and I'll show you one that ends up being, not a dream, but a nightmare.
*Note, please, that this "adverse clearings" mechanism for constraining rival banks of issue has nothing to do with the fallacious "real bills doctrine" or with John Fullarton's related notion that bankers would be constrained to do no more than accommodate the "needs of trade" by means of the "reflux" of excess notes via loan repayments. Call it the "bad penny" theory of credit control.


Should a Bank in Difficulties Receive Assistance?

by Kevin Dowd January 24th, 2015 5:44 am

This was the question put to me by [UK] Treasury Committee Chairman Andrew Tyrie MP when I appeared before the Committee on January 6th to give evidence on the Bank of England’s latest Financial Stability Report.

This is a question to which many of us on our side have given much thought and I believe it to be the single most important question in the whole field of bank regulatory policy.

I was nonetheless caught off-guard when Mr. Tyrie asked it at the beginning of the session – I was expecting questions on the Bank’s latest nonsense, the results of its new stress tests – and my initial response was less than it should have been. But no excuse: it was a perfectly reasonable and entirely foreseeable question – the obvious question, even – and I still didn’t see it coming. Reminds me of the blunders I would occasionally make when I played competitive chess: I obviously haven’t improved much.

Thankfully, he asked me the same question again at the close of the session, and his doing so allowed me to give the correct answer clearly, an emphatic ‘No’. However, by this point there was no time to elaborate on the reasons why a bank in difficulties should be denied assistance.

These reasons go straight to the whole can of worms and my follow-up letter to Mr. Tyrie should, I hope, help to set the record straight.

My message to other advocates of free markets is that leaving aside the usual bailouts-are-bad stuff, we really should give more thought to what an Armageddon Plan B might look like: Yes, no bailouts would be best, even in our intervention-infested system, but in that case why do we humour lender-of-last-resort and, more to the point, if the government is even considering intervention in what it (rightly or wrongly) sees as an emergency in which something-really-ought-to-be-done-NOW, then what should we advise it to do - other than ‘Don’t’?

Mark my words: if we don’t give the government constructive advice, it will do what it always does when a crisis breaks out: it will panic and the chances of any sensible policy response will be zero.

So here is the text of the letter, dated January 12th:

“Dear Mr. Tyrie,

I would like to thank you for the opportunity to give evidence to the Treasury Committee at its meeting on January 6th.

At that meeting you asked me if the authorities should assist a bank that gets into difficulties.

My answer is ‘No’ but I should like to elaborate.

Consider first a free or laissez-faire banking system in which there is no central bank, no financial regulation and no other state interventions such as deposit insurance. In such a system, competitive pressures would force the banks to be financially strong; bankers who ran down their banks’ capital ratios or took excessive risks would eventually lose their depositors’ confidence and be run out of business, so losing their market share to more conservative and better-run competitors. Bankers themselves would have serious skin in the game and therefore have strong incentives to keep their banks sound: for them, bank failure would be personally costly. Banks would then be tightly governed and conservatively risk-managed, and the banking system as a whole would be highly stable.

There would still be occasional failures due to the incompetence of individual bankers, but these would be few and far between, and not pose systemic threats.

These claims from free-banking theory are broadly confirmed by the historical experiences of the many free or loosely regulated banking systems of the past, most notably the experiences of Scotland pre-1845 and 19th century Canada.

In such a system, there is no good case for official assistance to any bank in difficulties. A bank failure would be painful to those involved, but the possibility of bankruptcy is unavoidable in any industry in a healthy capitalist economy, and this includes the banking industry. Letting a badly run bank fail also sends out the right signals – it encourages other bankers to avoid the same mistakes, it encourages depositors to be careful with the banks they choose and it avoids the moral hazards inevitably created by any policy of assistance.

Modern banking systems differ from these systems because of the presence of extensive systems of state intervention, including a central bank, a central bank lender of last resort function, deposit insurance, capital adequacy regulation and other forms of financial regulation. In different ways, each of these interventions makes the banking system less stable: central banks through erratic and usually loose monetary policies, which create inflation and fuel asset price cycles, and generally destabilise the macroeconomy; the lender of last resort and deposit insurance by creating moral hazards that lead to excessive risk-taking by bankers; capital regulation by creating short-termist incentives for banks to reduce their capital (e.g., by playing games with risk models and risk weights); and financial regulation generally by its large compliance costs and its stifling of innovation. Over time, these interventions have made the banking system weaker and weaker, even though their usual stated intention was to strengthen the banking system rather than to weaken it.

However, even with the banking system already seriously weakened by a long history of misguided government interventions, the best policy response is still to refuse assistance to banks in difficulties. I say this for two main reasons:
• the systemic effects of bank difficulties tend to be exaggerated even in a systemic crisis, sometimes grossly so; and
• interventionist policy responses tend to make matters even worse.

The ideal response by policymakers is to refuse assistance point-blank – and to announce such a policy in advance so the bankers know where they stand.

Policymakers should follow the advice of Lord Liverpool, who was PM at the time of the last systemic banking crisis pre-2007, that of December 1825. In May that year, he foresaw the looming crisis and warned the House of Lords about the “general spirit of speculation, which was going beyond all bounds and was likely to bring about the greatest mischief on numerous individuals.” He wished it to be “clearly understood” that those involved “entered on their speculations at their own peril and risk” and he thought it his duty to declare that he would “never advise the introduction of any bill for their relief; on the contrary, if any such measure were proposed, he would oppose it” and he hoped Parliament would reject it.

In our current system such a response would require political leadership with uncommon vision and nerves of steel. When the next crisis occurs, it will explode unexpectedly, taking policymakers off guard. They will be under extreme pressure to respond quickly – probably within hours – on the basis of inadequate information, whilst bankers lobby intensely for immediate assistance: if we don’t get bailed out, the world will end, etc., the usual scare mongering. Under such circumstances, it would be extremely difficult for even the best political leadership to avoid being dragged into making the same mistakes made repeatedly in previous crises.

These mistakes include:
• panicky rescues, which are later shown to be unnecessary, ill-judged and in some cases illegal;
• the abandonment of previous ‘commitments’ to let badly run institutions fail;
• bankers being rewarded for their failures by being made personally better off than they would have been had their banks been allowed to fail; and
• more regulation or regulatory reshuffles accompanied by the usual empty promises that ‘it’ won’t happen again, made by the very people who had no idea what they were doing when they were in charge the last time round.

So how can we avert such outcomes? A good start would be an Act to prohibit future assistance: as much as possible within the confines of our constitution, we should seek to tie the government to the mast. “Much as I would like to help you”, the PM can say, “my hands are tied.”

But even with this Act in place, there is still the difficult question: if the government does respond to the next crisis, then what should it do?

To that question I would propose a publicly disclosed Plan B, whose main features would include:
• a programme to keep the banking system as a whole operating at a basic level to prevent widespread economic collapse;
• fast-track bankruptcy processes to resolve problem banks and, where possible, return them to operation as quickly as possible;
• a prohibition of cronyist sweetheart deals for individual banks or bankers;
• provisions to ensure that senior managers of any failed banks are made strictly liable to severe personal financial penalties;
• a holding-to-account of senior bankers, regulators and policymakers, including the opening of criminal investigations into the activities of any banks that fail;
• the establishment of a legal regime that imposes high standards of personal liability on senior bankers;
• the restoration of sound accountancy standards; and
• a radical programme to deregulate the banking industry.
This programme would include the abolition of the current regulatory structure including the PRA and FCA, the ending of deposit insurance, the UK’s withdrawal from the Basel system of capital regulation, and the reform (and preferably, abolition) of the Bank of England. These reforms would rein-in the out-of-control moral hazards that permeate our current banking system and restore the personal responsibility, tight governance and conservative risk-taking that are the keys to a sound banking system.

Contingency planning for the next crisis should also provide for only two possible responses by the authorities: either Plan A (i.e., do nothing) or Plan B as just set out. Any intermediate response should be prohibited, as that would merely open the door to the usual mistakes that the authorities are prone to make in such circumstances.

In short, in response to your question about whether a bank should receive assistance, my answer would be ‘No’, but if we are to avoid another bungled policy response when the next crisis occurs it would be wise to have a credible Plan B in place to address upfront the Armegeddon scenario of a possible systemic collapse. And if it does intervene, the government should use the opportunity to clean up banksterism once and for all and restore a sound banking system based on the principles of personal responsibility and laissez-faire.

Yours Sincerely

Kevin Dowd,
Durham University/Cobden Partners [etc.]”

There is a lot more to say on this subject, but one of the points that emerges most clearly for me is the pressing need for free-market narratives of the financial crisis, blow-by-blow accounts of how it should and might have been. In this context – and off the top of my head – I would particularly recommend the following (with apologies to those whose work I have overlooked):

John A. Allison, The Financial Crisis and the Free Market Cure, McGraw-Hill 2013, esp. chapters 14-17.

Richard Kovacevich, “The Financial Crisis: Why the Conventional Wisdom has it All Wrong”, Cato Journal Vol. 34, No. 3 (Fall 2014): 541-556.

Vern McKinley, “Run, Run, Run: Was the Financial Crisis Panic over Institution Runs Justified?” Cato Policy Analysis 747, April 10, 2014

George Selgin, “Operation Twist-the-Truth: How the Federal Reserve Misrepresents its History and Performance”, Cato Journal Vol. 34, No. 2 (Spring/Summer 2014): 229-263.

These are all US-oriented of course and we badly need to work on similar narratives for the UK, Ireland and Europe.

But going back to the Treasury Committee, most of the discussion was on the regulatory risk models – or more precisely, on what is wrong with regulatory risk modelling and in particular, the Bank’s stress tests. I have to say, too, that I was greatly heartened to see the skepticism of the MPs towards the models and their openness towards our ideas, much of which is obviously down to the pathbreaking work that Steve Baker is doing on the Committee. But let me come to all that in another posting.

[Slightly adapted from a blog published on the Cobden Centre website, January 20 2015.]


The Treasury and the Fed

by Larry White January 22nd, 2015 12:09 am

Dear WSJ Editors:
Your letter-writer Robert Eisenbeis (“Treasury and the Fed’s Cash Flow, Jan. 19) is missing the forest for the trees. He is correct that the act by which the Fed rebates its interest earnings on Treasury bonds back to the Treasury does not itself generate revenue for the government, any more than a husband transfering funds to his wife is a source of household revenue. But he is completely wrong to assert that “Your editorial ‘The Fed Cash Machine’ (Jan. 12) is wrong in implying that the Fed has been a ‘huge money-maker for the Treasury.’” The Fed certainly has been a huge money-maker for the federal government. The huge money-making comes earlier, before the rebate, when the Fed purchases additional Treasury debt for itself in the open market. The Fed pays by increasing its own monetary liabilities, making a profit for the government by converting Treasury debt into lower-yielding Fed debt (bank reserves or zero-yielding currency). As Eisenbeis himself notes, the Treasury debt "has effectively been retired" by this act. Expansion in the Fed's liabilities is an undeniable source of government revenue. To deny this would be like denying that a husband is contributing to household revenue when he pays his wife’s bills by running a counterfeiting operation in the garage.


Something Nice about Austrian Economics

by George Selgin January 11th, 2015 10:05 am

Austrian Economists

I know, I know: I haven't been terribly kind to Austrian economics on this blog, or rather, I have been positively unkind to certain sorts of Austrian economists, and especially to Late Pleistocene types who insist, on a-priori grounds (and against all sorts of evidence to the contrary) that fractional reserve banking can't work well, or wouldn't survive in a free market, or is inherently fraudulent. But before you scold me again about my bad attitude, try trying to talk some sense into this bunch over a span of several decades, and then see if you're still so inclined.

It's also true that I no longer consider myself an "Austrian" economist, and that I haven't done so for decades. I could list a dozen reasons why, starting with the shivers I get whenever I imagine being mistaken for a Homo-Austriapatheticus*, or some other sort of paleo-Austrian, and my aversion to even the slightest whiff of "enthusiasm," to use that term as Hume did. I'm convinced, furthermore, that the world would be better off if half of everything written containing the phrase "Austrian economics," excepting works pertaining to the history of economic thought, had never been written, and if the rest had omitted the phrase. This last observation isn't really as damning as it seems since, would that I could, I'd consign about two-thirds of all other academic writings on economics to oblivion. Still, I can't blame my Austrian friends for wondering whether I have anything nice to say about their school of thought.

Which brings me to my purpose, which is to put my criticisms of Austrian economics into their proper perspective and, in doing so, to blow a raspberry or two at those other economists who pride themselves in their smug contempt for "Austrian economics," and who, in displaying that contempt, can't be troubled to distinguish the blatherings of the pre-Neolithic crowd from the enduring contributions of the School's leading lights.

I can think of no better way to proceed than to harken back to the time of my own first exposure to those leading lights. It was back in 1980, when I was supposed to be earning a Master's degree in Resource Economics at the University of Rhode Island. I say "supposed to" because, after a few months in that program, I was pretty much fed-up with it. I'd imagined that resource economics, and marine resource economics in particular (which is what URI specialized in) would be a great way to combine my two interests, which were economics and marine biology. Think "Adam Smith with an aqua-lung" and you get the idea. But nothing doing: the economics of the program, far from resembling anything Smith had to say, consisted mainly of one Hamiltonian after another. Nor did I go scuba diving, or head off to sea, as I'd done often enough as an undergrad. Hell, I didn't even get to wade around a friggin' fishpond, as I'd done the summer before in Auburn, Alabama.  Instead I diverted myself by swimming a mile or more every morning at Charlestown Beach, and by working my way through the economics section of URI's library.

Actually it wasn't the whole economics section so much as the HG part that held my interest. During 1980, as you may know, the CPI inflation rate reached its highest post-WWII level, just shy of 15 percent, and was seldom below 13 percent. The big economics question was why; and that question concerning what real prices were up to interested me a heckuva lot more than any professorial prattle about "shadow" prices could.

What many of you won't know, unless you were there, is just how bad standard explanations for the inflation were. Keep in mind that for the most part the economics profession back then was still high on Keynesian economics--not the namby-pamby "New" sort taught in many of today's grad programs, but the 200-proof Hansen-Samuelson IS-LM elixir to which Paul Krugman and a few other nostalgics have lately become addicted. And if there's one thing an economist trained in what Axel Leijonhufvud calls the ISLaMic Arts doesn't want to have to deal with, it's pesky questions about movements in the CPI, or any other measure of the price level. You see, the whole wiz-bang apparatus of old-fashioned Keynesian economics is held-together by one carefully-concealed premise: to wit, the premise that the general price level may be regarded, not as a variable, but as a parameter--that is, something given. What's more, that "given" price level is assumed (though no old-fashioned Keynesian would ever admit it, much less express the fact in plain English) to be well above the value that might otherwise clear the market for money balances. Let this little engine of an assumption have its way, and it will handily pull the whole Keynesian freight-train, cute little IS-LM caboose included, along with it. But search every boxcar of that train all you like, the one cargo you will never find is a decent account of how the price level itself is determined, or why it should ever change.

No wonder, then, that the best explanation all those inebriated economists could come up with for the fact that prices were rising faster than ever was that unions or OPEC or both were getting more powerful, and were therefore able to "push" costs up. There was a grain of truth to such theories, of course: costs were going up, along with prices generally; and OPEC had certainly been flexing its muscles. But all the monopoly power in the world couldn't squeeze blood from a stone, or squeeze more and more and yet still more income from a public that had only so much to spend. Something else was enabling the unions and enabling OPEC. Everyone now knows what that was--assuming that Paul Krugman does. But back then very few did.

So there I was, in the stacks at URI, reading book after book in my quest to get to the bottom of the inflation, and finding every last one of them perfectly useless. Then I read Henry Hazlitt's The Inflation Crisis and How to Resolve It, and felt the way Colonel Nicholson must have felt when Colonel Saito finally let him out of his punishment hole--I mean that Hazlitt's bright light almost hurt after so many weeks confined in the dark dungeon of textbook Keynesianism. True, if you read Hazlitt's book today you might find fault with parts of it, as I undoubtedly would as well. But just try reading any of those other books I went through, and you'll agree that they were infinitely worse.

So much for my first, favorable impression of Austrian economics, for although Hazlitt himself was a journalist, he pointed to the Austrian economists as his own guides. I didn't stop with him of course, but kept reading, moving on to more general works on monetary theory, while making a point of including more Austrian works on my reading list. At last I felt ready to tackle von Mises' Theory of Money and Credit, and once again I was struck by how superior it seemed to non-Austrian works covering similar ground. The more I read, the more often I got that same feeling. I don't mean that there were no non-Austrian books that I also liked. I simply mean that the Austrian books I read, mainly by Mises, Böhm-Bawerk, Hayek, and Menger--were always among my favorites. They still are.**

My classroom experience, in the meantime, only served to reinforce my impression that, compared to the Austrian economics I was reading, mainstream economics ca. 1980 was lousy. In one class I remember being confronted by a large IS-LM diagram, made to seem even larger by my habit of sitting in the front row, just opposite the black- (actually green) board. The professor, sticking to the Keynesian script, showed us how, by increasing M, the government could lower i while raising y. (Note that little "y." Without it, IS-LM looses a lot of its mystique.) Up goes my hand--another bad habit. Prof.: "What is it now, Selgin?" Me: "Well, according to this diagram, if we just boost M enough we can borrow for practically nothing, and have all the output we like. So why don't we do that?" Prof. (impatiently): "Well, at some point you get full employment and then things are different." Me: How do we know we aren't at that point already?" Prof. (annoyed): "Well, there are still some unemployed people, aren't there?" Me: "But... " Prof.: "We need to move on."

And on he went. As for me, I was ready to move on as well, though not at URI, and I said as much to another professor with whom I'd originally planned to study. Fortunately for me, not long afterwards he happened to come across a copy of the latest Austrian Economics Newsletter, which he passed on to me. It was the one with Israel Kirzner's photo on the front page. That was the first I'd heard about a surviving remnant of the Austrian school, run by a student of Mises himself.  The knowledge would eventually come in handy, for not long afterwards, after finally quitting the URI program, I  found myself working as a "combustion engineer," climbing the insides of power-plant smokestacks when I wasn't sitting on my hands in a laboratory in Stamford, Connecticut.  In other words, I was  finally at sea, in a manner of speaking, without the foggiest idea of what to do next.

Luckily for me, one of the Austrian works I'd read while at URI was Hayek's Denationalisation of Money. Hazlitt introduced me to the school, and Mises and Böhm-Bawerk showed me the prodigies of scholarship of which its representatives were capable. But it was Hayek who opened my eyes to a vast, unexplored realm for new research. So when, while I was loitering inside that lab, I came across a tiny notice in Reason magazine, offering small grants for summer research, a ready-made proposal was also loitering inside my brain. I duly wrote the thing down and mailed it off to IHS, which was still in good-old Menlo Park back then, receiving from them 1500 smackers in return. Best of all, I got to know Walter Grinder, who was to become a great mentor to me, as he has been to so many others.

That was how I came to write my first paper on free banking. It was called "Free Banking and the Monopoly in Money," and it wasn't all that bad, considering.  Still it never saw, and never will see, the light of day. But it did something better than that, by introducing me, with Walter Grinder's help, to Larry White, who was finishing his own dissertation at the time, and was about to enter the job market. After reading a few chapters of his work, I wrote Larry asking him to let me know when he got a job, because I planned to be his first student. For safety's sake, and remembering that copy of the AEN, I also applied to the NYU Austrian program. As luck would have it, Larry got his first job there, and I got a midnight call from Israel Kirzner himself telling me I'd been granted a fellowship. I remember Kirzner saying, "I...h..h...ope I h..h..aven't...w..w...aken you," and replying, "Professor Kirzner, with this news you could call any time!"

So off to NYU I went, and let me tell you, you couldn't have asked for a better education than I got from the Austrian program there. And I don't mean the education I got from the ordinary NYU PhD program, which the Austrian fellows had to endure along with everyone else.  The regular NYU program was run-of-the mill, or somewhat worse than run-of-the-mill, thanks to the fact that NYU back then suffered from a severe inferiority complex, which it tried to assuage mainly by making its grad students suffer through more, and tougher, mathematics than the Ivy league rivals of which it was jealous. I know this because I compared notes with students attending those schools. Among other things, none of them ever had to sit through a lecture like the one I and all my classmates got upon first entering the NYU program, in which we were told to have a good look at the students sitting at our sides, because only one of each set of three would be around a year later. "What corny B movies did this jerk get that from?" I asked myself. But a year later it wasn't just two out of three who had dropped out: it was two and counting. I ought to know, because more than once I came within a hair's breadth of becoming dropout number three.

No, sir: what made NYU great back then was the Austrian program. Thanks to it, not only did I get to learn the history of economic thought from Israel Kirzner and economic methodology from Fritz Machlup. I got to attend one of the best economic workshops anywhere: the famous Austrian seminar that's still going strong. I learned more economics by sitting in that seminar than I did from all my required classes combined, which were mostly devoted to applied mathematics and statistics. Better still, I got to spend time with a bunch of grad students who were passionate about economics. Passionate. Just attend a few student sessions--or sessions of any sort for that matter--at the AEA or SEA or Econometric Society meetings, and see how much passion you come across. Then tell me there wasn't anything special about those NYU students.

And they were no less passionate about economics outside of class. All of them read, and some read voraciously, papers and books on economics that weren't on any course syllabus. That was a rare thing among economics grad students even in those days; today econ grad students who make time for extracurricular reading--or who merely believe that such reading might possibly be worthwhile--are rare as hens' teeth. I know that because I served on plenty of faculty recruitment committees while working at UGA, and so got to see the sort of material other schools, including some top ones, churned out. For example, I remember mentioning William Stanley Jevons to a candidate whose dissertation was on monetary search models, and getting a blank stare for an answer. ('Twas Jevons who came up with the phrase, "double coincidence of wants.") That, by the way, was one of the better candidates. On another occasion my fellow recruiters and I thought we might succeed in getting candidates to stop droning on about their boring macro dissertations by asking them to name for us their favorite dead macroeconomists. After half a dozen couldn't think of anyone--not even Keynes, for crying out loud!--and another named Milton Friedman, who was then very-much alive, we gave up.

Nor were my fellow grad students at NYU merely interested in Austrian economics. The whole history of economic thought, and much else besides, interested them. More than a few were hard-core bibliophiles, three of whom lived on different floors of the same rickety lower East Side tenement. Their apartments were furnished with nothing save a mattress and stacks of books, with a narrow chasm, reminiscent of the one at Petra, running through the stacks from the bathroom to the mattress, and another one like it running from the mattress to the kitchen. After seeing them I expected the tenement to come crashing down any day, inspiring a headline in the Daily News, or perhaps the Post, screaming, "Bookworms Buried Alive in Alphabet City Avalanche!" Despite that, I got hooked on books myself, and so ended up standing outside of the Strand first thing every Saturday morning, with several other Austrian nuts, waiting for the opening bell to ring so that we could all pounce on the New Arrivals table that had been freshly stocked the night before. I emerged from those raids with my knuckles bloodied, but also, occasionally, with some damned hard-to-find books. What's more, by gosh, I read them. And I learned a lot of economics that way, and a fair bit about other subjects. Other subjects! In grad school!

But just how valuable, some of you may wonder, could the economics in all those old books have been? I will tell you: far more valuable than the vast majority of things I learned in my regular grad school classes, including what I learned from articles on the reading list. You see, the stuff that was considered leading-edge back then, which is what most of the classes were about, is now for the most part as dead and forgotten as the Kings of Nineveh. And that same fate awaits most of what's being taught in today's econ programs. Yet Smith, Bagehot, and Wicksell, and many others beside, are as alive as ever, if not more alive than ever. That, of course, is what it means for a work to count as a classic. But where I went to school, at least, it seemed that the Austrians were the only ones who appreciated the fact, for never once did any of my non-Austrian professors ever venture to suggest that I might make good use of my time reading something that was as much as a decade old, let alone older than that.***

Worse than that was the obvious disdain shown by many (though by no means all) of NYU's non-Austrian economics faculty toward their Austrian colleagues. I well remember the day when the usually courtly Fritz Machlup came to class visibly upset. He'd just been informed, he told us, that the international finance class he'd taught for decades had been taken from him and assigned to some young Turk. Imagine: Fritz Machlup, himself then already a classic, but not quite tooled-up enough to be worthy of teaching "real" economics (as oppose to soft stuff like methodology) to NYU students! Then there was the time when my first-semester micro teacher asked me to join him after class for a drink. Somehow I'd managed to impress him, and though I was too much of a tyro to realize it at the time, he meant to get me to write under him. Of course he couldn't have succeeded, as I was determined to work on free banking with Larry. But even if I hadn't been it wouldn't have happened, for the first thing he said once we were sitting at the bar was, "You seem pretty smart. So why are you wasting time with those Austrians?", to which I replied, thoughtlessly but without guile, "Because I think they're the best economists here." I suppose that the rest of that drinking session wasn't much fun for either of us. Fortunately I can't remember, and anyway the fellow was a good sport, for I still got an A in his class.

So the truth is that I owe a great deal to Austrian economics, and particularly to the Austrian economists, both actual and in the making, with whom I interacted at NYU. Had it not been for the Austrians, I might still be toying with Lagrangian multipliers, or struggling to figure out why interest rates don't behave as if they served to clear the market for money balances. Worse, I might never have been exposed to the works of so many great economists, the great Austrians among them, from which I continue to draw knowledge to this day. Finally, I would never had learned about free banking, or met Larry White, or gotten to write for Freebanking.org, assuming that it would still have existed. For that and a lot more, I say to my Austrian friends: thanks for everything, and keep on inspiring others.

*Please note that the term refers to a tiny subspecies of the Austrian economics genus. I contemplated having a link to the Wikipedia page of an actual Homo-Austriapatheticus specimen, but decided not to because I might get sued, or stoned.

**Nota Bene:  The phrase "Austrian economics" does not occur anywhere in these works, unless in introductions added long after their original appearance.

***Nor did the fact that some of the new stuff we were learning also had lasting value make reading older things any less valuable. For example, although the then counter-revolutionary New Classical economics I was taught was indeed valuable, I found it far easier to grasp than I might have thanks to having read the essays by Albert Hahn gathered together in The Economics of Illusion, which contained the gist of it, though written decades before, and in plain English.


Why Discuss It?

by George Selgin January 3rd, 2015 3:47 pm

I've been busy lately preparing a long-delayed review essay on Charles Calomiris' and Stephen Haber's Fragile by Design. Although, having argued the same point for many years now, I was bound to approve of that book's thesis to the effect that banking systems, rather than being inherently unstable, are made so by bad government policies, the fact that I did only made it all the more disappointing to encounter in the same work the opinion that talk about free banking (referred to obliquely and inaccurately as "libertarian utopianism") is a waste of time because governments aren't about to embrace the idea.*

That encounter goaded me to reach for my copy of John Morley's superb 1898 essay, On Compromise, in which he asks,

How far, and in what way, ought respect either for immediate practical convenience, or for the current prejudices, to weigh against respect for truth? For how much is it well that the individual should allow the feelings and convictions of the many to count, when he comes to shape, to express, and to act upon his own feelings and convictions? Are we only to be permitted to defend general principles, on condition that we draw no practical inferences from them? Is every other idea to yield precedence and empire to existing circumstances, and is the immediate and universal workableness of a policy to be the main test of its intrinsic fitness?

In a nutshell, Morley's answer to all of these questions is, "Not a bit"--not, at least, so long as one wishes to avoid the "disingenuousness of self-illusion" and consequent "depressing deference to the existing state of things, or to what is immediately practical," that are the inevitable "result of compromising truth in the matter of forming and holding opinions":

An excessive devotion to what is 'practical' tends to make people habitually deny that it can be worth while to form an opinion, when it happens at the moment to be incapable of realization, for the reason that there is no direct prospect of inducing a sufficient number of persons to share it. 'We are quite willing to think that your view is the right one, and would produce all the improvements for which you hope; but then there is not the smallest chance of persuading the only persons able to carry out such a view; why therefore discuss it?' No talk is more familiar than this. As if the mere possibility of the view being a right one did not obviously entitle it to discussion; discussion being the only process by which people are likely to be induced to accept it, or else to find good grounds for finally dismissing it.

"Seen from the ordinary standards of intellectual integrity," Morley says, it is contemptible enough that many politicians should be unwilling to entertain an idea until they're convinced that it is "capable of being at once embodied in a bill." Still "there are excellent reasons why a statesman immersed in the actual conduct of affairs, should confine his attention to the work which he finds to do." But the fact that politicians are so preoccupied

furnishes all the better reason why as many other people as possible should busy themselves in helping to prepare opinion for the practical application of unfamiliar but weighty and promising suggestions, by constant and ready discussion of them upon their merits... As it is, everybody knows that questions are inadequately discussed, or often not discussed at all, on the ground that the time is not yet come for their solution. Then when some unforeseen perturbation, or the natural course of things, forces on the time for their solution, they are settled in a slovenly, imperfect, and often downright vicious manner, from the fact that opinion has not been prepared for solving them in an efficient and perfect manner.

If, while reading that last sentence, the words "Dodd-Frank" bounced around your cerebrum, you get the point.

Calomiris' and Haber's uncharitable treatment of the free banking literature--and, within the academy at least, nothing can be more uncharitable than to dismiss ideas while also taking care to avoid referring to, let alone actually addressing, the works professing those ideas--compels me to quote one more passage from On Compromise. This time the words, instead of being Morley's own, are ones he himself quotes from Isaac Taylor's Natural History of Enthusiasm:

An opinion gravely professed by a man of sense and education demands always respectful consideration--demands and actually receives it from those whose own sense and education give them a correlative right; and whoever offends against this sort of courtesy may fairly be deemed to have forfeited the privileges it secures.

I have a lot more to say about Fragile by Design, and especially about how its authors' commitment to a reductive sort of Public Choice theory causes them to adulterate a generally sound understanding of the legislative causes of financial crises with an excessively pessimistic, if not a fatalistic, view of the possibility of reform. But if I ever wish to get around to saying it, I had better stop blogging.
*See pp. 491-2. Although Calomiris and Haber never refer to "free banking" as such, except in its degenerate antebellum U.S. variant, that it is free bankers of the Freebanking.org sort they have in mind is evident enough from the views they attribute to "libertarian utopians," such as their treatment of the Scottish system as most closely approximating their ideal.


A lot of data, and good-bye

by Kurt Schuler December 31st, 2014 9:43 pm

Readers interested in monetary data should see a book-length working paper, just issued, called Currency Board Financial Statements, that I prepared with Nicholas Krus. It is the further fruit of the Digital Archive on Currency Boards, which Nick played the largest part in gathering. Spreadsheets that accompany the paper give annual balance sheet data and sometimes more frequent statistics of currency in circulation. As I said in a previous post, free banking needs something like it (and I am working on the archive part, although others will have to photograph the source documents and digitize the data). The data on currency boards will be useful to anyone interested in the economic history of the many countries concerned before they established central banks, which in many cases has only been during my lifetime. Be warned that working paper is a kind of catalog of cases and is not intended to be read from front to back. It is a first version; we expect to obtain and post more data over the next year or so.

The working paper is a preliminary project for the last book I ever intend to write on currency boards, with Steve Hanke and Nick Krus as my coauthors. We are trying to make our work definitive since we don't think anybody after will be quite as concerned to get the data as we are. Because of the work involved with the book, which will not be finished until at least 2016, and forthcoming changes to the Free Banking blog, this will be my last post. I approve of the forthcoming changes, but some of them will make this blog a less suitable place for me to express opinions. I will continue to post items on monetary history or data occasionally at the blog of the Center for Financial Stability, where I edit the Historical Financial Statistics data set. In 2015 Historical Financial Statistics will expand to  incorporate the data from my working paper and much else, and I welcome potential contributions of monetary data of free banking systems, or other economic statistics, from readers of the Free Banking blog.



More on Counterfeit Currency

by George Selgin December 30th, 2014 5:58 pm


As devoted followers of this blog already know, one of my (many) free-banking hobbyhorses concerns counterfeiting. Assuming similar penalties for convicted counterfeiters, is a system of competing suppliers of redeemable paper currency more or less likely to encourage counterfeiting than a currency monopoly? Having sketched-out some basic ideas on the topic, I'd like to see more economists address it systematically, instead of just deferring to conventional wisdom. That wisdom has long had it that a system of competing banks of issue encourages counterfeiting, because, as the variety of legitimate banknotes increases, so does the cost of information required to distinguish legitimate notes from fake ones. So (the argument goes), whatever its other merits or shortcomings, central banking at least has the virtue of reducing the volume of spurious paper money.

Back in 2007 this prevailing view got a major boost when Harvard University Press published A Nation of Counterfeiters, by Stephen Mihm, a professor of history at UGA, where I was also employed at the time. Mihm views the extensive counterfeiting of U.S. banknotes prior to the Civil War as an inevitable consequence of the failure of the Federal government to assume responsibility for supplying the nation with paper currency. According to HUP's blurb for his book,

Few of us question the slips of green paper that come and go in our purses, pockets, and wallets. Yet confidence in the money supply is a recent phenomenon: prior to the Civil War, the United States did not have a single, national currency. Instead, countless banks issued paper money in a bewildering variety of denominations and designs—more than ten thousand different kinds by 1860. Counterfeiters flourished amid this anarchy, putting vast quantities of bogus bills into circulation.

In a brief essay published elsewhere, Mihm observes that

The antebellum era’s counterfeiting problem was a consequence of the nature of the money supply at this time. There is a tendency to assume that the greenback is a timeless creation, that the nation-state has always taken the lead in issuing and safeguarding the currency. Nothing could be further from the truth. Prior to the Civil War, the United States exercised little control over the money that circulated within its borders, having abdicated that responsibility decades earlier.

In fact, the roots of the problem date back at least to the previous century, when the colonists began issuing paper money contrary to the wishes of the imperial authorities.

In fact, as I tried to convince Stephen back when, and as a glance at several other nations' experience might have suggested to him, the "roots" of the U.S. counterfeiting problem did not go nearly so deep as he supposed. The problem was not that the Federal government refused to enforce a monopoly of currency. It was that, by refusing to regard banking as a form of "commerce," it tolerated state and territorial governments' interference with the development of nationwide branch banking, not to mention their occasional inclination to outlaw banking altogether. Hence the proliferation of so many thousands of tiny banks, and the corresponding lack of facilities for the prompt clearing and redemption of rival banks' notes. Rampant counterfeiting of banknotes wasn't a problem in Canada before the Bank of Canada's establishment in 1935, or in Scotland before Peel's Act was applied there. By treating the antebellum situation as a result of the absence of a Federal monopoly rather than as that of an excess of state-government interference with free trade in banking, Mihm reinforces the quite misleading notion--the source of so much mischief--that with respect to currency, as opposed to most other necessities, competition is a bad thing.

As for the simple transactions-cost argument favoring a single currency supplier over multiple ones, the trouble with it, as I tried to explain in my "Notes" linked above, is that it's far too simple. Sure, more notes mean higher information costs, and therefore more counterfeiting other things equal. But the case here is one in which other things are manifestly unequal. Most importantly, in a system of competing currency suppliers, and especially one involving a well-developed system of bank branches and clearinghouses, issuers will routinely return their rival's notes for payment, just as banks "return" checks drawn upon their rivals for payment, virtually if not actually, today. Non-note-issuing banks do not, on the other hand, routinely return a central bank's notes for payment, even if those notes are mere claims to precious metal, preferring instead either to retain them as vault cash or to exchange them for central bank deposit balances.

Though this might seem a small difference, it has very large implications, because it means that, although a competitive system does involve more distinct varieties of legitimate banknotes, if nothing like the huge numbers of banks seen in the antebellum U.S., it also involves much shorter average circulation periods (the length of time between initial issuance and return to their source) for those notes. This short circulation period in turn means more frequent occasions for expert scrutiny and detection of counterfeits, and a correspondingly greater chance of would-be counterfeiters getting nabbed.

A competitive bank of issue also has a greater incentive, ceteris paribus, than a monopoly issuer does to protect itself against counterfeiters, by catching them and by making its notes hard to replicate, because, having but a relatively small share of the total currency market to itself, it incurs greater harm from any absolute nominal sum of counterfeits of its notes. A monopoly issuer of fiat money, at the opposite extreme, offers an especially tempting target to counterfeiters, both because it's notes are only returned for "payment" (in fresh currency) once they have been badly worn, and because it needn't fear being ruined even by large quantities of undetected replicas of its notes, and so is less inclined to embellish those notes with cutting-edge anti-counterfeiting devices.

In short, the answer to the question whether competition encourages or discourage counterfeiting isn't a matter of mere logic, simple or otherwise, but one that must be resolved by referring to experience.

Alas, the nature of the subject is such as makes quantitative evidence scarce even today--a situation not helped by the tendency of enforcement agencies to treat their counterfeiting data as classified information--and almost completely unavailable for centuries past. "Anecdotal" evidence from plural note issue systems not hampered by the same infirmities as antebellum U.S. arrangements must therefore carry the day. But even that sort of evidence is hard to come by. Consequently I was very pleased to discover, in reading some old British banking-controversy documents recently, some relevant testimony. The source is Charles Lyne's generally excellent pamphlet, published anonymously in 1821, entitled "A Review of the Banking System of Britain: With Observations on the Injurious Effects of the Bank of England Charter" etc. The "lower orders," Lyne notes (pp. 78-82),

are very unfond of Bank of England notes, from the numerous forgeries committed upon them; and unless, during the existence of a "run" on their provincial Banks, generally prefer their paper, however doubtful they may suspect them to be, ultimately, in the point of security. The prohibition of provincial issues under £5, would have greatly increased the forgeries of Bank of England notes, which were to supersede them, and these forgeries are already sufficiently numerous...; on the other hand, the circulation of each provincial Bank being confined, in a great measure, to a comparatively small section or division of the country, any attempt to circulate forgeries upon it, are almost immediately detected. Besides, there Bankers are so sensibly alive to the injurious effects of a successful forgery on their notes, that they ferret out the forgers with the eagerness of men whose interests are deeply at stake; and with so many local checks of this description, provincial forgeries are rarely attempted. When they do take place, the public is seldom allowed to lose much by them; for the Banks find it more for their own interest, to receive, as genuine, two or three hundred pounds of forgeries, than to excite public alarm by refusing to do so, which might injure their circulation very materially... Every pound so paid for forgeries, communicates, if possible, additional energy to to their exertions for detection of the criminals, and usually produces improvements in the paper, water marks, engraving, signatures, &c. of the notes of such Bankers, which render their imitation more difficult afterwards. From every inquiry, the loss sustained by the Banks, and the public, from forgeries of Scots notes, betwixt 1815 and 1820, did not exceed £500 in all, or £100 annually.

So supine were the directors of the Bank of England on this point, that they not only disregarded all remonstrances respecting the execution of their notes until very lately, but also retained the forged notes presented to them, granting the holder merely what was termed an investigator's ticket, specifying the date, sum, and marks on the forgery; so ineffectual a method of enabling the holder to trace back through whose hands it had passed, that it looked rather like a bounty or protection to forgers... . But the interest which an individual feels in the case of a £1 or £2 forgery, is seldom sufficiently powerful in itself, to lead to the detection of the makers; and even when aided by the exertions of the Bank's law agents or officers, there must be fewer chances of detection, than if the Bank's circulation was more local or of smaller in amount, another reason why rival issuing Banks should be established in London.

Although one pamphleteer's observations can't be expected to settle the larger debate, I note that Lyne's claims concerning the relative abundance of fake Bank of England notes compared to that of Scottish bank notes agrees with testimony to the same effect from a number of other sources. What he adds that's new is the claim that the notes of English provincial banks--then limited by law to six or fewer partners--were also less frequently imitated than their Bank of England counterparts. Such testimony should at very least suffice to warn students of banking history to resist drawing conclusions about the pros and cons of currency competition based solely on U.S. experience.

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