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Let A Thousand Forms Of Banking Bloom

May 23, 2009

The Mises Blog links to an interview with George Selgin on free banking, published by the Fed, no less.  The comments section has a long and enthusiastic debate on the relative merits of full and fractional reserve banking.  I will attempt not to get sucked into the details of my own particular opinions on these systems, but rather stick to a higher-level defense of diversity and experimentalism.

One of the major issues I have with Austrian economics is the belief that one can determine things about the real world through a priori reasoning and that such reasoning dominates empirical studies.  As Selgin remarks in an early comment:

we have centuries of evidence concerning uninsired fractional-reserve banking systems, including plenty concerning relatively free systems, such as those of Scotland, Canada, Switzerland, and elsewhere. Consider just Scotland and Canada. What does the evidence from these episodes show? Briefly: that bank runs were extremely rare; that notes almost always circulated at par; and, most obviously, that many free fractional reserve banks survived and prospered without any government guarantees (though some did fail, of course, as must happen to firms in any competitive industry).

Let’s by all means have an open debate about the merits of fractional reserve banking. But let us please make it an informed debate, rather than one based on sheer speculation. 

And then, frustratedly, in a later one:

history doesn’t always provide us with abundant examples of arrangements we are inclined to consider ideal. Consider the 100-percent reserve system. Many of you have insisted on its advantages, and have made empirical claims concerning them. Yet there are absolutely no historical examples you can point to, apart from perhaps a single instance or so, long ago, and short-lived at that. Compared to this meager empirical evidence concerning the workings and consequences of 100-percent reserve banking, the evidence free bankers have to draw upon in support of their claims is very substantial indeed.

Finally, if I’m annoyed at 100-percent reserve types, it’s because of the sort of insistence upon a priori reasoning,and corresponding resistence to empirical evidence, of which they are so often guilty, which I point to above and have pointed to in many of my other posts. Of course it get’s annoying when people insist that, say, all swans “must” be white, despite your having pointed out gaggle after gaggle of perfectly black ones!

This insistence on finding optimal theories a priori through reasoning is, in my belief, antithetical to actual progress in most areas.  The world is a messy, complex place, and in general it is far better to go try something out, from which you can learn, and which can always be revised, than to sit around trying to perfect it and convince other people of its perfection.  While I am not much of a scholar on Austrian economics, my understanding is that Hayek saw part of the advantage of a free market as allowing decentralized learning through experimentation.

And this is why I favor markets for huge problems like governments and banking which currently face poor incentives and undergo little learning. There is no need to figure out a priori which system is the best. Under free banking, full reserve and fractional reserve banks can compete for customers. Those who wish greater security can go with full reserve, those who prefer to earn a little interest can go with fractional reserve. During booms, I suspect money will tend to shift to the latter, during busts, the former.

Each individual will get to back their beliefs about banking with their own cash, and any benefits or costs of their chosen approach will accrue to them individually. If fractional works better, those who invest in fractional can laugh at the Rothbardian fuddy-duddies for not earning interest. If full works better, those who choose full can laugh at the gambling fools who dared to let their money be loaned out in hope of interest.

Such a joy that we have this marvelous meta-system of the free-market where we can allow multiple solutions, so that each camp gets to use their preferred system and we generate empirical evidence about all the options, rather than mandating a single solution for all. In this wonderful system, arguments over relative merits become much less heated, because we are merely trying to convince others to use our favored solution for themselves, so they can receive the same benefits, rather than to convince a majority that our favored solution is the best, just so that we can use it ourselves.

For me, the difference between those two situations is overwhelming.  In one, I am empowered, calm, rational, and tolerant of differences – because those differences have little effect on my options.  In the other, I am disempowered, angry, and intolerant, because I am at the mercy of others, who currently have foolish faith in fiat money and the Fed.

Hence I recommend to the Austrians, the Mises Institute, and all those who are sure that they know a better solution to some problem in society: do not push your solution.  Do not try to convince the majority of it.  You can have far greater impact by pushing the meta-solution, a world where we let A Thousand Nations Bloom.  If your solution really is better, it will win.  If it isn’t, it won’t – but it shouldn’t.  The meta-solution will allow competition between a thousand forms of banking, a thousand ways to privatize the courts, a thousand policies for immigration, and far more besides.

These long debates of the relative merits of various options a priori are a waste of our limited time and resources, because we lack a framework in which they can be tried.  Let’s build that framework, and try out the numerous options we already know about.  Then we can return to the debate while developing empirical evidence – and each enjoying life under our preferred system.

  1. RWW permalink
    May 27, 2009 4:56 pm

    While [a priori] reasoning is very valuable, it’s meaningless if you don’t test your theories in the real world.

    Nonsense. Would you say the same of other properly a priori sciences, such as mathematics? Are volumes found by integration meaningless until you test them in the real world?

    As a scientist I understand the huge importance of empirical learning.

    In its proper place. But when you try to force empiricism where it has no useful place, such as the study of economics through individual human action, you are engaging in what has come to be known as scientism.

    It is possible to have a complete and logically consistent theory that has no relation to the real world.

    Not if it is deduced from true/meaningful axioms, such as those of mathematics and praxeology (i.e. Austrian economics).

    There is certainly knowledge to be gained by empirical means, even in economics, and especially pertaining to average customer reaction to a certain course of action (such as the decision to engage in fractional reserve banking), but the deductive methodology is very much preferable when it is feasible, since we need not “test” its conclusions. What we can say a priori about fractional reserve banking in a free market is that it will be naturally checked (not necessarily eliminated!) by the threat of runs. There is currently no such check.

    • NOTAL permalink
      May 28, 2009 12:14 am

      Patri: You make a compelling argument regarding the voluntary nature of it all, including the merchants and the banks creating fractional notes.

      It is very interesting that you point to mathematics. When I was writing my first comment, that is exactly the field I was thinking of. Within mathematics there are different systems (specifically, I was thinking of Euclidean and Non-Euclidean Geometries) which are mutually exclusive, but are each, within themselves, consistent. So if you were going to randomly pick an axiomatic mathematics to try to solve a real world problem, then, yes I would say the same. If you were going to pick a mathematics based on axioms that have been empirically demonstrated time and time again, only then would I automatically accept any conclusions.

      You are right on when you say that the axioms must be true. But the axioms of Praxeology are generally true, but not universally or necessarily true, so the conclusions are no stronger that that until demonstrated in the real world.

  2. May 24, 2009 8:02 pm

    okay so back to loans. why is it called fractional reserve banking? what does the bank do with your deposits?
    well remember that your loan is worth X- some amount. The bank needs to cover the discount. It uses deposits to do this, despite the fact that demand deposits are liabilities and not assets.

    in terms of the number of loan dollars you can see that the number of actual cash the bank has is quite low, probably only a few percent of the value of all the loans.

    this is fractional reserve banking.

    I’ve seen professionally trained economists get this wrong even though you can find this out by interviewing any of the higher up accountants at a bank.

  3. May 24, 2009 7:58 pm

    fractional reserve banks dont lend deposits. that’s not how banking works. when you take out a loan from the bank you aren’t receiving other people’s money. your promise to pay (legally binding) becomes a form of money (a piece of paper with value). With this signed paper the bank is allowed to write the amount of the loan into your account. No money is subtracted from any other place. Of course your promise to pay X dollars by 2030 isn’t worth X dollars now, it’s worth X minus some amount based on the risk that you’ll default, the nominal interest rate, etc. This discount is determined by the market for loans.

    the banking crisis happened when everyone forgot that you can only really price something by selling it. If you have a bunch of loans that you think you can sell at some price due to a computer model you’re taking a risk. The computer model only works because no one is actually selling that many loans. In other words the computer model assumes that the supply and demand for loans is relatively stable (or growing in the case of the housing boom). Well, what happens when instability hits and a bunch of banks try to sell off some loans at the same time? oops, suddenly you have quite a high supply. Demand drops and prices drop. Suddenly the loans are selling for lower than the paper price you used in your model. So the bank panics and tries to sell more loans to cover its obligations….I think you can see the pattern. You now have a death spiral as everyone tries to dump their loans, creating a glut and putting prices in the basement. Now you have toxic assets.

  4. May 24, 2009 1:43 am

    how would you respond to the response that I could see a Rothbardian making; that allowing any fractional reserve banking dilutes the money supply and therefore immorally steals the purchasing power of the money that belongs to everyone else?

    This is a good point about the potential interdependence between the systems. However, calling it immoral is erroneous for the same reason as the ridiculous Rothbardian characterization of fractional reserve as immoral. Namely, it can be implemented solely through consensual, contractual interactions, with no force or fraud, which must be moral in the Rothbardian viewpoint.

    If I pass off a note from a fractional reserve bank as if it is a full reserve note, that is immoral fraud. But if the customers of the FRB know it is fractional, if the merchants accepting the notes and checks know it is fractional, if everything is done above-board via consensual interactions, how can it possibly be considered force or fraud? Thus, how can it be immoral?

    Whether or not it dilutes the money supply depends on the market judgement of the chance of default on a FRB’s note. The FRB notes will trade at par only if the market judges that they are “as good as gold” :). If the market is worried about insolvency or some other failure of the fractional system, then FRB notes will trade at a discount.

    I think part of the problem with the anti-FRB view is the elevation of money to some special status. Suppose that our FRB is structured as a money-market fund – it issues shares, each of which are worth a certain amount of gold. If you hold shares, you slowly earn more shares over time via interest. In other words, rather than a demand account in a bank, instead we are describing this as shares in a money-market fund. But it is implemented in exactly the same way – the money market fund makes some investments to earn some interest, tries to maintain enough liquidity for redemptions, has a convertibility clause, all the things a good FRB would do. Functionally, it is exactly the same. If merchants choose to accept these money-market fund dollars alongside regular dollars, I suppose one might characterize that as imprudent if one believes that every FRB is bound to fail, but how can one call it immoral?

  5. NOTAL permalink
    May 23, 2009 11:47 pm

    Great post. Over the past year or so I have really dug into Austrian Economics. I think that Austrian explanations are able to make perfect sense out of what is happening in the world today. However one thing that has really irked me about Austrian Economics is the absolute reverence for a priori reasoning. While this type of reasoning is very valuable, it’s meaningless if you don’t test your theories in the real world. As a scientist I understand the huge importance of empirical learning. It is possible to have a complete and logically consistent theory that has no relation to the real world.

    You make a great point about the importance of testing banking models (or anything else) in the real world. It is the only way to conclusively determine what is the best way to do something.

    As a side point, how would you respond to the response that I could see a Rothbardian making; that allowing any fractional reserve banking dilutes the money supply and therefore immorally steals the purchasing power of the money that belongs to everyone else?

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