Thursday, April 19, 2012

Ludwig von Mises and Free Banking

It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a 'dismal science.' But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.

Murray Rothbard

Forgive me, Murray….

I have read almost none of von Mises directly, yet there is no single economist that has captured my thinking more than he has. I believe this is so because Austrian economics fits very naturally into my views of how man interacts with man. Nothing captures this better than the idea of Human Action. Humans act. This concept captures so much wisdom on so many levels.

I am not an Austrian economics scholar.  As indicated, I have read little of Mises directly. However, I have an interest in the issues around money, credit, and banking.  As I am a strong proponent of free-market thinking and an opponent of state-backed interference, I looked specifically for what Mises had to say about free banking.

This led me to a specific section in Human Action: chapter 17, section 12.  Certainly I expect Mises wrote much more on the subject, and it is likely that I am not capturing the full intent of his meaning by focusing only on this one section.  However, as this section seems generally supportive of the concept of free-market determined banking, I am satisfied to end my search here (at least for now). Certainly, one could suggest that I have found what I was looking for and therefore do not want to look further.  This is true. However, as I have yet come across a good reason to advocate state-enforced regulation in banking, I find no need at this time to look further into Mises’ writing.  In this section, he is quite open to and in fact advocates a free market in banking and credit, it appears.

Mises covers much ground in this one small section. I will attempt to capture the key points and properly expand on these.  I will break up the analysis and commentary into four sections, as follows:

1) Competitive, Free-Market Banking

Mises holds that competitive free banking (no government intervention or support) is the only proper way to regulate banking.

2) The Risk of Being "Fooled" Into Taking and Holding Dubious Banknotes

Mises describes the reasons he does not believe this will be of concern.

3) Bills of Exchange

Mises describes the inflationary nature of Bills of Exchange

4) Gresham's Law

Mises rightly describes Gresham's Law, with good money driving out bad if all money trades freely.

Competitive, Free-Market Banking

But now, we assume further, one bank alone embarks upon an additional issue of fiduciary media while the other banks do not follow suit. The clients of the expanding bank - whether its old clients or new ones acquired on account of the expansion - receive additional credits, they expand their business activities, they appear on the market with an additional demand for goods and services, they bid up prices….In order to settle the payments due to non-clients, the clients must first exchange the money-substitutes issued by their own - viz., the expanding bank-against money. The expanding bank must redeem its banknotes and pay out its deposits….The instant approaches in which the bank will - after the exhaustion of its money reserve - no longer be in a position to redeem the money substitutes still current. In order to avoid insolvency it must as soon as possible return to a policy of strengthening its money reserve. It must abandon its expansionist methods.

Mises makes a powerful statement here. Leave banks free to compete. Accept that one or more banks might issue excess credit. Understand that, as market participants recognize this they will demand instant redemption. This will force the issuing bank to either reduce the excess or quickly go out of business before doing much damage.  In such an environment, the risk does not become systematic; no bank becomes “too big to fail.”

Mises does not make any statement advocating the outlaw of such an expansionary practice, at least not in this section. He is quite clear that it is the market that will best regulate banks, and that clients of the expanding bank and especially clients of its more conservative competitors will be vigilant regarding the bank's risky practices.  Additionally, the banks will have reason to police each other.

This is just as one would expect an advocate of free markets to consider the situation. Elsewhere in this section he describes how government intervention inherently results in complacency on the part of market participants.

But even if the 100 per cent reserve plan were to be adopted on the basis of the unadulterated gold standard, it would not entirely remove the drawbacks inherent in every kind of government interference with banking. What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract.

Here, Mises states that even a 100% reserve standard, if backed by the government, does not remove the risks of government interference in banking. Treat banks as you treat every other business, under general laws and contract, and the market will regulate the banking industry in a much more effective manner than would the government.

But, some people may ask, what about a cartel of the commercial banks? Could not the banks collude for the sake of a boundless expansion of their issuance of fiduciary media? The objection is preposterous. As long as the public is not, by government interference, deprived of the right of withdrawing its deposits, no bank can risk its own good will by collusion with banks whose good will is not so high as its own.

A bank’s good name is everything - there is no such thing as a cushion of reserves that will protect the bank once its good name is questioned. In this light, Mises states that a bank wouldn't voluntary join hands with banks other than those of unquestioned integrity. It takes years to develop goodwill, and minutes to destroy it. Without a good reputation, a bank in a free-market environment would not last long in the market - a significant barrier to purposely risky behavior.

Mises also makes no statement against the forming of cartels – as long as the government does not in some manner deprive the customers from full and complete exercise of their property and contract rights.

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 offers 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.  He goes so far as to describe banks that expand credit “within very narrow limits” as cautious!

These 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 – 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 offer insight as to 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 affect the entire system. However, imagine a system where all banks are subject to not just profit, but also 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.  Profit and loss is the best mechanism created by man to conserve resources and to curb excesses.  Those institutions that cannot efficiently utilize resources are soon drummed out of business.  Such events certainly provide better discipline than does today’s “heads I win, tails you lose” banking system.

Other than the banking sector, we have no examples of import where virtually every major 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 does not call for government regulation, he does not call for criminal prosecution, and 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.  Even on this last point, I suspect that Mises would suggest that the market would be the best mechanism for making public the right amount of data and information regarding an individual bank’s practices.

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.  After the booms and busts of the last 100 years of central bank “innovation” and intervention, it would seem that those who advocate a central bank would be the ones on the defensive, as opposed to those advocates of free banking.

Dubious Banknotes

A lot of nonsense has been written about a perverse predilection of the public for banknotes issued by dubious banks. The truth is that, except for small groups of businessmen who were able to distinguish between good and bad banks, banknotes were always looked upon with distrust. It was the special charters which the governments granted to privileged banks that slowly made these suspicions disappear. The often advanced argument that small banknotes come into the hands of poor and ignorant people who cannot distinguish between good and bad notes cannot be taken seriously. The poorer the recipient of a banknote is and the less familiar he is with bank affairs, the more quickly will he spend the note and the more quickly will it return, by way of retail and wholesale trade, to the issuing bank or to people conversant with banking conditions.

If the governments had never interfered, the use of banknotes and of deposit currency would be limited to those strata of the population who know very well how to distinguish between solvent and insolvent banks.

In these passages Mises makes a valuable point: by their very nature banknotes will only be used to any great extent by reasonably sophisticated businessmen, those qualified to make a distinction between good and bad notes. For many of the rest, they will go to redeem notes quickly, not being always sure of the quality of the institution behind the note.  Inherently, this will diminish the use of such notes.

Faith in bank notes was increased only as the government became involved, making users of notes less concerned about the true backing. Government claimed it became involved only for the good of the poor and less capable clients...but these were the same people who avoided keeping notes for any length of time anyway.  Of course, the real reason the government became so involved was to reduce the need for individuals to properly diligence their bank (thus enabling all sorts of expansionary banking practices), and reduce the possibility of traditional bank runs.

We see this same complacency today, for example with FDIC insurance: how many people think at all about the solvency of their bank? Absent such "insurance", how long would a troubled bank stay in business? How much more concerned and therefore sophisticated would depositors be about the home for their funds?

Here again, Mises does not call for a banishment of any practice (other than by implication the practice of government interference). Instead, he sees in the free market certain built-in mechanisms to minimize the likely abuses by less-than-scrupulous businessmen.

Bills of Exchange

The notion of "normal” credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle.

Mises makes the statement that there is no such thing as a "normal" credit expansion. This statement strikes me to mean that there is no "rule" that can be applied to money supply growth; no standard increase that can be viewed as normal. No Taylor rule. No Milton Friedman acceptable range of 3% to 5% per year.  No expansion to (somehow) take into account the “growth” of the economy, thus growing consistent with economic activity.

Inherently, this must be so. There is no formula that can better determine the necessary supply of money and credit better than the market can. The market determines appropriate supply and demand for countless products, most of which are far more complex than the "product" of money and credit. Why is it that somehow credit is too difficult to be left to market forces, when it is nothing more complex than one actor with excess savings making his savings available to another who requires credit?  Compared to building a car or farming a field, the problem of money and credit is rather a simple one for the market to solve.

The Banking School taught that an over issuance of banknotes is impossible if the bank limits its business to the granting of short-term loans. When the loan is paid back at maturity, the banknotes return to the bank and thus disappear from the market.

However, this happens only if the bank restricts the amount of credits granted. (But even then it would not undo the effects of its previous credit expansion. It would merely add to it the effects of a later credit contraction.)

Here Mises recognizes that the bank must remain disciplined in its issuance of notes. The more important point is in the second sentence.  Mises makes the point that expansion is expansion. The negative ramifications of expansion may be limited, due to the short time window, but it is still expansion, with all of the potential distortions this will cause.

The regular course of affairs is that the bank replaces the bills expired and paid back by discounting new bills of exchange. Then to the amount of banknotes withdrawn from the market by the repayment of the earlier loan there corresponds an amount of newly issued banknotes.

The individual notes will disappear in short order when redeemed, but the expansion does not end. Redeemed notes are replaced with new notes; thus, the expansion is permanent.

In these few sentences, Mises lays bare what should be obvious to all about Bills of Exchange. They are expansionary to the money supply and credit. The expansion, even if of a limited duration, will result in all the negative consequences of any credit expansion. Further, the expansion is not limited, as redeemed bills are constantly replaced by newly issued notes.

Having said this, other than expressing the economic / monetary risks associated with Bills of Exchange, I do not see Mises calling for a banning of such a practice.  I concur.  In a free market for money, credit, and banking, participants should be free to transact in whatever manner they choose.

Gresham's Law

Gresham's Law is often stated: bad money drives out good. This is incomplete, and an incomplete statement of Gresham's Law. It is more accurately stated: Bad money drives out good if their exchange rate is set by law.

I would slightly modify even this proper understanding of Gresham’s Law. If different "money" is free to trade, without any hindrance from legal tender laws, tax preferences, etc., bad money will not drive out good, nor necessarily will good money drive out bad. Different "monies" will find their value in the market, and will trade.

However, if one money is protected by legal tender, and the valuation is fixed by government, then yes, the bad money will drive out the good. All will get rid of the over-valued (by government decree) money, as it MUST be accepted by the counter-party, and accepted at a value higher than the market would determine.

Mises addresses this idea as follows:

If, however, the things concerned are not money-substitutes and are traded at a discount below their face value, the assignment of legal tender quality is tantamount to an authoritarian price ceiling, the fixing of a maximum price for gold and foreign exchange and of a minimum price for the things which are no longer money-substitutes but either credit money or fiat money. Then the effects appear which Gresham's Law describes.

If, by decree, the "thing" that is no longer a money substitute must be accepted not at the discounted value of the market, but at the inflated value of the decree, this money will always be spent first, and it will drive the truly "good" money out of circulation. Why would someone spend a 100 cent dollar when a 90 cent dollar must be accepted by the counter-party at 100 cents? Bad money will drive out good money.

Mises then addresses what would happen in a free banking environment, where competing currencies trade freely without legal tender. In fact, he is for the more the merrier, as in the following:

However, freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865:

I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.

He proposes that the good money will drive out the bad. In a freely competitive environment, where multiple banknotes would be issued, he sees the entire concept of banknotes disappearing, in favor, presumably, of good coin.

I think this will be true for the absolutely worst banknotes. However, it strikes me that most will continue to trade, but not at face value. Perhaps this is what Mises is getting at with the following:

But if any doubts exist concerning their prime character, people will hurry to get rid of them as soon as possible. They will keep in their cash holdings money and such money-substitutes as they consider perfectly safe and will dispose of the suspect banknotes.

For safety, people will keep the most secure notes, the notes issued by banks with the best reputation. They will preferably spend the suspect notes, or more likely take them to the issuing bank for 100 per cent redemption.  But it is clear, for one individual to spend the notes he considers dubious, another person must be willing to accept these. Thus I return to the idea that, in a fee market, the bad money may not be driven out, but only trade at a value acceptable to market participants.

Such will be the check on any bank, and this I return full circle to Mises and free-banking. He sees the market perfectly capable of "policing" if you will, the various banks participating in the market. Once the reputation of a bank is in question, notes will be brought to the bank to be redeemed. Unless the bank is acting properly in its reserves, it will soon find itself depleted. The end comes quickly when the reputation is in question.

Based on my understanding of this one section of Human Action, I conclude that Mises is a supporter of free-banking.  While he would not approve of every practice that might result, he envisions that the free-market is the best regulator of dubious and otherwise poor practices.  To the extent this conclusion of mine holds true when a broader body of Mises’ work is included, I find myself in complete agreement.

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