When evolution fails: the Free Banking edition

These days, much of the free banking debate focuses on the history of banking. On one side are the free banking advocates who point to the vastly increased macroeconomic stability that occurred in free banking systems. On the other are the free banking haters, such as Lord Keynes from the blog Social Democracy for the 21st Century, who argue that these periods reveal no such thing. Either the economies in question were far from stable, Lord Keynes says, or their banking systems were nothing like free banking. What’s clear from the diametrically opposed viewpoints is that biased readings of history will not help us decide whether free banking is an improvement or a deterioration on our current monetary system.

What matters, instead, is the theory underlying the idea. For this reason I went to the source itself — George Selgin’s The Theory of Free Banking: Money Supply Under Competitive Note Issue.

In the book, Selgin argues that a free banking system would be far better at smoothing out business cycles than a banking system supported by a central bank. To use the language of my book, a free banking system better matches the actual rate to the ideal rate, which is the rate necessary for full employment and stable inflation.

The rationale is elegant. Whenever hoarding jumps, the theory goes, the amount of money flowing between banks falls, since more money is stagnant in bank accounts. In a free banking system (and, crucially, only in a free banking system) banks can “see” this fall in spending and increase their lending by lowering actual interest rates. In a nutshell, the idea is that banks can precisely offset new hoarding with new loans, preventing demand from ever falling.

The opposite occurs in response to reduced hoarding. At full employment, additional loans would trigger inflation, so banks would respond by raising actual rates and curtailing lending.  (For those interested in a more detailed explanation, please read Selgin’s book, which is elucidating and extremely well written.)

Compared to our current system, free banking advocates say, this mechanism is much more reactive. Today our central banks adjust actual rates only in response to economic data, meaning that they’re often too slow in their tightening and loosening. A free banking system, on the other hand, can detect changes in demand long before they show up in the data.

Best of all, the system will evolve to perfection. Any bank that doesn’t respond to changes in spending will eventually fail, since it’s those banks that most accurately match actual rates to ideal rates that will reap the largest profits.

But is all this true, or have free banking advocates gone a little too giddy? Is this a case of good evolution or bad evolution?

In the case of combatting inflation – i.e. raising actual rates – it is likely evolution would succeed. Any free bank that doesn’t respond to higher spending by curtailing lending would put themselves in a precarious position with respect to reserves. And eventually, yes, that bank would fail.

In the case of combatting unemployment by lowering actual rates, however, a better outcome is unlikely. In fact, it’s entirely possible that the game theory equilibrium of such a system is to raise actual rates in response to a fall in spending.

Why might such a pernicious outcome occur? The main problem is that, while a free banking system may be more reactive to demand swings than our current system, it still doesn’t react instantaneously.

How many days, for instance, does a prudent bank wait before deciding that lower spending is permanent? And once it decides to expand loans by lowering actual rates, how long does it take for all rates (not just bank rates) to fall and for asset prices to rise? And finally, how quickly will borrowers and savers respond to lower rates and higher asset prices by increasing spending? What if in the intervening time the declining economy has caused expectations to collapse? At this venture, it would hardly matter how close to 0% banks lower their rates. If borrowers are on vacation, spending will not rebound.

The result, of course, is a repeat of the dreaded downward demand spiral we saw in 2008.

And herein lies the problem of free banking: if a downward demand spiral is still possible, then what incentives do banks have to increase lending in response to a jump in hoarding? Is a bank really going to bet its future on the belief that all banks will lower actual rates, and that spending will respond in time? Or, fearful of an economic collapse and afraid to be the sole bank increasing lending during a panic, will it instead postpone new loans?

All banks want to survive, and the downside to an economic collapse is failure. The only way a bank can reduce the chance of bankruptcy is by cutting its exposure to risky loans and investments. In other words, it survives by raising actual rates. And so contrary to free banking advocates, the optimum decision in an economy where death spirals can still occur is, I believe, to raise actual rates in response to significant decreases in spending.

The free bankers are right in theory: evolution is a powerful selector. Sadly, in practice, the optimal behaviour in a free banking system is likely one that promotes slump after slump after slump.

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