Coordination Problem

Is Expanding the Money Supply Costless for Free Banks?

Steven Horwitz

Over at the Mises blog, it is claimed that there is "no cost of production" associated with expanding the supply of money under free banking.  Specifically:

"the bankers can *unilaterlly* affect the demand for their products by simply raising or lowering the interest on loans they offer; they effectively face *no* costs of production. These market “signals” aren’t really market-based at all because their origin in based not on private property but entirely on the will of the bankers. This is what distinguishes them (banks under free banking) from other businesses in the economy as a whole, who face costs of production they cannot unilaterally control."

The bundle of bad economics and misunderstanding of free banking in that quote is quite a sight to behold.

Let's start with the "no costs of production" argument.  It's amazing that this argument even gets raised given that White and Selgin's theoretical models of the profit-maximizing decision facing free banks were all about demonstrating the rising marginal costs facing free banks when they expand.  You can't make their claim that the money supply is determinate without it. 

The key cost is the increased risk of illiquidity as excess supplies of bank liabilities are returned to the overissuing banking for redemption in one form or another.  As free banks expand, more of their notes and deposits will get returned for outside money directly over the counter or indirectly through the bank clearing mechanism.  For a given quantity of outside money (e.g. gold), expanding their liaibilities means a rising risk of being caught with insufficient outside money to pay off those redemptions. This increased risk is not a "physical" cost of production, but it is a cost of production nonetheless. 

Critics need only get as far as p. 4 of White's Free Banking in Britain to see the variable "L (expected liquidity costs)" in his model, along with claim that "expected liquidity costs increase with an increase in [notes] or [deposits]" for a given quanity of specie on the next page.  The bottom of p. 5 and the top of p. 6 catalog the various rising marginal costs facing banks expanding their note issuance and deposit creation. 

So to claim that free banks face "no costs of production" requires either that one is ignorant of the core claim of the free banking literature and/or that one is adopting a notion of "costs of production" that is deeply at odds with the subjectivism and marginalism of Austrian economics.  In either case, this anti-FB argument fails and fails miserably.

The liquidity cost point provides the response to the second point, which is that somehow free bankers don't face costs of production they cannot unilaterally control.  When one understands that the relevant cost of production is the risk of illiquidity, which itself depends on the preferences of liability holders, then there's absolutely nothing different about free banks from any other firm on the market facing an upward sloping marginal cost of production curve.  They are indeed "based on private property" - namely, the private property of the owners of bank notes and deposits who will decide whether or not to exchange that private property for outside money or a deposit credit at another bank. 

It's worth noting that free banks face rising costs of underproduction as well.  To the degree that free banks produce too few notes and deposits, they will face rising opportunity costs in terms of the foregone interest on the loans they could make to bring those notes and deposits into existence.  Finding the joint minimum of the costs of over- and under-issuance is one way to look at the entrepreneurial task facing free banks.

The process by which free banks face rising costs of production and are thereby constrained to produce the quantity of their liabilities their customers wish to hold (and no more or no less) is thus absolutely no different from the process facing every firm in all competitive markets.  That, in fact, is the core of the argument for free banking, which is to apply the (Austrian) theory of the market process to the production of money.  The claim that free banks are somehow different is without merit.

Love and Murder in Stalin's Kremlin

|Peter Boettke|

That is the subject of Paul Gregory's latest book, which explores the lives, struggles and ultimate tragedy of Nikolai Bukharin and his wife Anna Larina.  Gregory sent me the book with an inscription that reads it is not for the economics, but for the story that he wrote this.  And it is an amazingly well told story that makes its reader peer deep into the human tragedy that was Stalinism.  I highly recommend Politics, Murder and Love in Stalin's Kremlin.

In the field of economics, Paul Gregory has made more use of the Soviet archives than any other scholar, and as a result in the field of post-communist studies he has (with the aid of a theoretical framework that takes advantage of both a solid neoclassical understanding of price theory, and a new institutional understanding of organizations, bureaucracy and politics) helped us understand the true history of the Soviet political-economic system.  I am actually returning next year to my roots in comparative systems economics after a few years hiatus from teaching the PhD course in the field, and Paul Gregory will be one of my main guides when thinking through what we have learned about the political economy of Soviet socialism since the collapse of communism.  HINT: It was VERY bad.

Is the Fat Lady Singing for the US Economy?

|Peter Boettke|

I'd like to see a serious discussion of John Judis's "The Case for Economic Doom and Gloom," New Republic (May 11, 2010).  What arguments persuade?; What arguments fail to persuade?  What argument and evidence would persuade you to the opposite conclusion?

HT: Scott Beaulier at The Economic Way of Thinking.

Taking the Con Out of Economics: Symposium in JEP

|Peter Boettke|

Even on its worst days, economics is a fascinating subject.  Smart and clever people equipped with an outstanding set of tools striving to use those tools of reasoning not just for points in a game of one-upmanship, but seriously trying figure out slices of the world we live in.  However, economics can get derailed.

I have tried to tell the narrative of 20th century economics in a variety of ways --- the metaphor of an hour glass (which is derivative from the story that David Warsh tells) is one of my favorites, but the transformation in the classical period of a discipline that sought to derive universal propositions through logical deductions in natural language and empirical observations to a highly formal discipline with the goal of still deriving universal propositions to the emergence in the 1990s of a highly technical discipline that abandoned the search for universal propositions and instead resulted in a form of "formalistic historicism".

In the mid- to late-1990s, empirical economics took over as the dominant mode of discourse in the discipline, and if theory could produce any result imaginable it would be sophisticated econometrics that would adjudicate between competing hypotheses.  But, of course, empirical economics had its issues as well.

The Journal of Economic Perspectives has a symposium on credibility in empirical economics that is well worth looking at.  

Personally, I am more attracted to theory rather than empirics, and as a result I am drawn more to Acemoglu's argument on the one hand, and Greif's argument that historical economics is more than cliometrics, on the other.  In my review essay of the Bates et al book, Analytic Narratives, I argue that the efforts at "rational choice" political and economic history represent that way out of our difficulties as a discipline in avoiding the games that smart and clever people play and keeping us instead on the path of seriously achieving understanding of the social world.  But I have to admit that this methodological revolution has been slower in coming around than I had hoped.  Why do you think that is?

One Way of Looking at our Spending Binge

Steven Horwitz

While looking at a variety of data on the US economy over the last 35 years, I discovered an interesting way to look at what's happened to the federal budget in the last couple of years.  If you compute non-defense spending as a percentage of GDP, you find that since 1976 it has been remarkably stable, wobbling between 14 and 16.5%, averaging 15.14%.  Until, that is, FY 2009 and 2010, during which the numbers are 19.09% and 19.31% respectively, about a full 4 percentage points higher on average. 

Given the fairly narrow band in which that figure moved for over thirty years, the last two are indeed exceptional. Their exceptional nature is further reflected if one views the deficit/GDP ratio, which has been at or above 10% for those two years, the highest since WWII, and well above the 2.5% average for the 30 years prior.

Make of this what you will.

More Evidence that the Word "Capitalism" Might be a Problem

Steven Horwitz

Some of you may have seen a variety of blog posts in the last week or two discussing the results of a Pew survey in which people were asked whether they viewed a variety of political terms positively or negatively.  Tim Cavanaugh at Reason has most of the data and a libertarian perspective on it.  The results are not too bad for libertarian-minded folks.

Today, however, I discovered a new wrinkle in that data.  A blogger asked the Pew folks for the data broken down by age group, which you can see here.  There's several interesting things in that data but I want to highlight just one:

People aged 18-29 were the most positive of any age group about the word "libertarian" but the most negative of any age group about the word "capitalism." 

At first this seems contradictory and one's first thought might be that young people don't know the meaning of one term or the other.  Or both.  But I have a different hypothesis.  I suspect they might generally know the meaning of libertarian, or at least know enough to have a decent idea.  But I also suspect that they think "capitalism" describes the status quo in the US.  After all, don't both left-wing critics and right-wing apologists talk about our capitalist economy?  Isn't that how most Americans describe it?  Given both the mess we're in at the moment and the ways in which young people have likely heard lots of "anti-capitalist" ideas in high school and college, who is surprised that they have the most negative view?

I recently had a two-part Freeman Online piece about why we might want to think about ditching the term "capitalism," and along with Sheldon Richman, Roderick Long, Gary Chartier, and Charles Johnson, I was part of a panel on that topic at APEE last month.  Though we have different takes on it, what we all seem to agree on is that "capitalism" is too often used to describe the awful results of the mixed economy, which works to the disadvantage of those of us who might wish to use it to describe the free market ideal. 

If my hypothesis above is correct, it's perhaps another reason to dump the term.  Looking at those Pew results and the enthusiasm of young folks for Ron Paul in 2008, I think this generation might well be more open to libertarian ideas than any before it.  But if "libertarian" equals "capitalism" and their understanding of capitalism is the status quo, we've got a major marketing problem.

It's too bad the Pew folks didn't also ask what people thought about the phrase "free market" or "free enterprise."  I'm willing to bet a nice steak dinner that young folks are much more positive about either of those terms than "capitalism."  Those of us who want freer/freed markets and want to appeal to younger people might think seriously about not using the word "capitalism."  There's a lot of reasons to drop the term and the apparent negative connotation it has especially among the young is yet another on that list.

Go Patriots! Baseball Edition

|Peter Boettke|

Our basketball program at GMU is outstanding and Coach Larranaga is one of the best tacticians and motivators in the college game today.  He also runs a first-class program with expectations of discipline and excellence on and off the court.  The way Larranaga runs his program is true across the board for our athletic program.  We are a mid-major program where the term student-athlete is still very accurate.

Last fall I had in my honors college course 2 stars on the women's volleyball team that made the NCAA tournament, and one of our top golfers on the men's team.  They all earned very strong grades.  In the past, I had a student-athlete who was one of the top wrestler's in his weight class in NCAA D1 and also one of the strongest students in my class.  I am not saying every athlete that competes for GMU are stellar student-athletes, but quite a number of them are.  As someone who also competed throughout college, the time commitment to play at that level is not trivial and to balance your training let alone the travel schedule involved with competing with your books takes discipline and a strong commitment to succeeding in both athletic and academic endeavors.  And this is a joint effort of the AD, the coaches, and the athletes.

This past week I learned that one of my former Honors College students -- Dan Palumbo -- was just named Academic-Athletic All-District.  Dan is set to graduate this week with a degree in finance with a GPA of 3.84 and is currently hitting .402 for the season.

Congratulations to Dan and good luck to the Patriots baseball team as they finish up their season and head into the CAA Tournament.  And for those in Fairfax this weekend, they play VCU and I plan to make a game and cheer for Dan and his teammates, including my son Stephen's former HS teammate (basketball) Brandon Kuter -- there will not be any alley-oops from Boettke to Kuter on this playing field, but there will be a fastball that clocks upwards to 90mph, and obviously a first-basemen who not only knows the Modigliani-Miller theorem but how to hit a slider.

My Appearance on Freedom Watch

Steven Horwitz

Here's me and the Judge.

The "Siren's Song of Stability," European Version

Steven Horwitz

Back in the heady days of September of 2008, I had an entry here that made the following point:

One of the things market capitalism does best is enable us to peer through the fog of uncertainty that surrounds human action.   Prices provide signals for capitalists to interpret to try to provide the goods and services people will want in the future.  Profits tell them they've done well at it, losses tell them they haven't.  The competitive process is how we learn what it is people want and how best to produce it - and who is best at doing so.  Competition is, in Hayek's words, a "discovery procedure."  Competition sucks if you're one of the competitors.  It makes you have to constantly be on your toes, watching for new entrants, new innovations, and changes in the relevant variables.  How much easier life would be in a more stable and predictable world where capitalists didn't have to serve the fickle consumer!  If we cut short this discovery process, and especially the mechanism of profit and loss, the benefits to the capitalists will not come from behaving in ways that benefit the rest of us.

"The Market" (which, as Heyne, Boettke, and Prychitko note, is a particularly bad metaphor for millions of individual decisions) rallied late last week as the bailout plan was conceived and publicized.  Today, as the plan has got some pushback (though not always for the right reasons), "The Market" has taken another dive.  The explanation, I think, is that capitalists prefer the stability and predictability of the known over anything unknown, especially when it promises to socialize their losses on the rest of us.  Capitalists have long despised the uncertainty and unpredictability of a truly free market and have frequently succeeded at using the state to reduce that uncertainty (see also Gabriel Kolko and other historians of the Progressive Era).  Of course this has benefited them, but it has harmed the economy and the citizenry in the process.

This is precisely why those of us concerned with preserving whatever bits of capitalism we have left should be largely ignoring "The Market's" response to the various bailout plans.  What's good for GM or the financial sector is not necessarily what's good for America.  In fact what's good for America, might be very, very bad for the financial sector.  The desire for stability and predictability has been the calling card of dirigisme regimes since the dawn of capitalism, whether they called themselves "socialist", "fascist", or just plain "interventionist."  It is but a thinly disguised power grab by those who own the means of production, and who will profit at our expense, rather than profiting by serving us better.  "Stability" is a siren song that we must do our best to ignore, lest we enable them to make an even bigger mess than they already have.

As we see the market rally this morning on news of the near-trillion dollar European bailout, we should keep this point in mind.  What's good for capitalists is often NOT what's good for capitalism, not to mention the long-term well-being of most of the citizenry.  Yes, I'm happy my TIAA-CREF will be doing better, but I'm far more concerned that we continue to bailout the short-sighted, immature behavior of our European counterparts.  At the current rate, it may be only a matter of time before we see the Greece scenario play out in individual states or at the federal level here.

The desire for "stability" is indeed the siren's song of the end of freedom.

SDAE Session List Now Available

Steven Horwitz

For those CP readers who might have proposed a session for the Society for the Development of Austrian Economics sessions at the Southern Economic Association meetings this November in Atlanta, or for those who are just interested, the list of sessions is now online here.

Thanks to Dick Wagner for putting together what looks like an excellent set of sessions.