Tuesday, March 8, 2011

Free Banking, Part Two

Human Action, Chapter 17 Section 12

“Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular - one is tempted to say normal - feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.”

What a powerful statement. In this paragraph, Mises makes clear that free banking is the best check on un-backed credit expansion, yet also in a free market, credit expansion is to be expected, and presumably tolerated within the context of a competitive market environment.

Both statements are worthy of further examination. Free banking – unregulated and fully competitive banking – is the best check on credit expansion. Most would see the opposite. Unregulated banks, it is often believed, would be most likely to exceed prudent levels of credit and leveraged. The greed and profit motives in the bankers must be checked by regulation and government oversight to ensure that prudence is maintained in the sector.

Mises says the opposite – that free banking would not go to the excess of credit expansion with the subsequent booms and busts that are visible in centralized, state-controlled banking.

A few minutes of reflection makes clear why this would be so. In the current system, we have seen first-hand the privatizing of profits and the socializing of loss. In such a system, there is no natural market discipline of potential insolvency that would help regulate the banks. the possibility of banks runs, historically employed when the reputation of the bank was in question, has been virtually eliminated with the advent of deposit insurance, again a creature of the state.

Excesses today, in the cartelized monopoly system, inherently pour disease to virtually every institution given that one policy fits all. However, imagine a system where all banks are subject to profit AND loss, where contractual terms have the same meanings as with other everyday businesses, where different banks are free to institute unique currencies, loan and credit policies, etc. in other words, imagine banking to be an industry like many others.

We have no examples of import where EVERY company of an industry was at risk of simultaneous insolvency. Instead we have examples of competition bringing out better quality and lower costs, tailoring services and products in order to capture specific market segments, we have trial and error of new products, on a small scale, thus giving natural opportunity for innovation without introducing systemic risk.

This is what is in store with free banking. The market – being all of the customers and competitors of each and every bank – will regulate each bank. If lending practices are overly lenient, depositors will reduce exposure to the subject institution.

The second statement is equally important. In it Mises suggests that it is possible and even expected that some banks will practice expanding credit. He is speaking here of fractional-reserve lending. He does not call for government regulation, he does not call for criminal prosecution, he does not suggest this “evil” must be avoided at all costs. He requires that all relevant information regarding the bank’s financial condition and commitments be public, such that customers have the opportunity to make informed decisions.

He is perfectly satisfied that, to the extent the practice must be regulated, the market will regulate the practice. If one institution gets carried away, the competitive market will limit the damage to the subject institution and to its customers. He calls for no further punishment or sanctions.

In other words, at least from my read of this section, Mises leaves room for credit expansion in a free market banking regime, as long as fraud resulting from false financial or other documentation is avoided.

“Today even the most bigoted étatists cannot deny that all the alleged evils of free banking count little when compared with the disastrous effects of the tremendous inflations which the privileged and government-controlled banks have brought about.”

Even today, after the most obvious failures of financial institutions throughout the world, it is rare to hear anyone make such a statement. Almost all commentators view more or different regulation as the answer.

What a tribute to the genius and foresight of Mises, that he made these statements a century ago, while much of the world was still on some version of a gold standard, before the central banking in the United States, before the inflation of WWI, the Great Depression, the various banking calamities including the S&L crisis in the US, and most obviously the final deathblow of the crash of 2007 / 2008.

Truly a genius.

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