Friday Flashback: We Are All Free Banking Theorists Now*

free banking, Diamond and Dyvbig, Alternative Money University, monetary education, economic education

free banking, Diamond and Dyvbig, Alternative Money University, monetary economics education

(Originally appeared December 7, 2014)

(*And we always have been.)


Yesterday, while giving Cato's interns an impromptu talk about my work, I found myself saying something that seems worth putting in writing. This was that the difference between me and Larry White and Kevin Dowd, among others, and most other monetary economists, isn't that we theorize about free banking, and they don't. It's that we're mindful of our free-banking theories, whereas they're mostly heedless of their own.

Consider: an economist says that central banks prevent or limit the severity of financial crises, or that without mandatory deposit insurance even sound banks are likely to face runs, or that banks can never be expected to hold enough capital unless we force them to, or that commercially-supplied banknotes will tend to be discounted. All such claims–which is to say any claims about the need for or consequences of government intervention in banking–depend, if not on an explicit understanding of the nature and workings of a laissez-faire banking system, then on some implicit understanding. And this understanding in turn implies a theory of some sort, for reference to experience alone won't suffice for drawing the sort of sweeping conclusions I'm talking about. It follows that all economists who have anything to say about the effects of government intervention in the banking system are either self-proclaimed free banking theorists or are free banking theorists who don't admit (and perhaps don't realize) it.

The rub is that tacit or subconscious theories of free banking–the sort people rely upon when they are "doing" free banking theory without being conscious of it–are likely to be bad theories because, being unstated, they can't be challenged, and, being unchallenged, they don't tend to be systematically corrected. A self-conscious free banking theorist confronted with some claim of banking-market failure might point to his own theory suggesting that no such failure exists, and might also point to contrary evidence. But he can't generally infer, and therefore can't directly contradict, the theory behind the claim.

If even economists who've never heard of free banking, or who dismiss both it and the people who take it seriously, nevertheless subscribe to some free banking theories of their own, where do their theories come from? As I can't read other economists' minds, I can't pretend to know the answer. However, I can, and I will, hazard a guess or two.

Consider, if you will, your typical fresh PhD, having monetary or (more commonly) macroeconomics as a specialty, as might have been disgorged by any save a handful of the doctoral programs in the U.S. sometime during, say, the last 30 years. In all likelihood that graduate never took a class on economic history, let alone one on monetary history or (least likely of all) the history of economic thought. Nor is he or she likely to have become familiar with even present day monetary institutions through any other coursework, most of which is devoted to mastering either statistical methods or highly abstract models. As for the monetary sequence itself, it is likely to have involved toying with Overlapping Generations models, which don't even get the definition of money right, or Woodford-style neo-Wicksellian economics, which (unlike the Swedish real McCoy) strives to avoid using the "m" word altogether. Some better students, to be sure, will make up for the lack of institutional meat in their bland graduate-school porridge by grabbing the occasional vitamin from the library. But even when I went to school (NYU, class of '86), that sort of thing was relatively rare. Today, to judge from the many grad students I talk to, a student who dare's to do it, besides risking failure by having less time left to study for prelims, is sure to be regarded as a weirdo.

After graduation, perhaps? So far as most economists employed in research universities are concerned, Fuggedaboudit. Publish or perish means, for the vast majority, polishing up the three-articles that comprise their dissertation, and then milking the same highly-specialized human capital that sufficed for producing those "chapters" for all it's worth, which, with luck, will be additional articles enough to get one over the tenure threshold. With the tenure clock ticking inexorably, and journals taking their sweet time to return reports, who can afford to be intellectually curious? After tenure? Not likely, since most tenured faculty, having developed a shtick which, with the help of some elegant variations, may serve as well in getting them promoted again as it did in getting them tenured, still won't get around to learning stuff that they now regard, with perfect justice, as perfectly irrelevant to mastering their profession. Better to angle for department head, or (for those with higher aspirations) to take up golf.

The upshot of all this is that most of what our monetary economist knows or believes about monetary institutions he or she learned as an undergraduate. And what was that? To infer from the contents of most principles and money and banking textbooks, very little, and much of it misleading. Of monetary history, in particular, such books (1) say very little, if anything at all; (2) refer (if written for the U.S. market or by U.S.-trained economists) only to U.S. experience; and (3) get that wrong. Reading such books, you are quite likely to learn (for examples) that banking started out as a big swindle, that before the Civil War U.S. banks were hardly regulated at all and that, for that reason, American's were saddled with all sorts of banknotes, most of which were worth far less than their face values; that the Federal Government nationalized the currency supply, forcing state banks out of the business, during the Civil War because it was suddenly inspired to establish a uniform currency; that post-Civil War panics were inevitable given that we still lacked a central bank; that during the Great Depression people staged runs willy-nilly on good and bad banks alike until, in early 1933, they lost confidence in every last one of 'em, thus proving beyond doubt the necessity of nationwide deposit insurance; and that the Fed is an independent central bank, having become so in 1951. My conjecture, in short, is that tacit theories of free banking are most likely cobbled together, unconsciously and therefore haphazardly, from such substandard undergraduate building material.

So much for academic economists, or at least for the vast majority of them under the age of 60. If you want an academic economist who really knows his monetary institutions, a good rule of thumb is, the older the better. Try Dick Timberlake (92), or Leland Yeager (90), or Alan Meltzer (86), or Axel Leijonhufvud (81), or Charles Goodhart (78), or David Laidler (76). But beware that, even among Laidler's cohort, there are plenty who don't seem to be know a bank from a hole in the ground, or a redeemable banknote from (say) a durable good.

True, economists who work for the Fed, or at least for research departments of the various reserve banks, are another matter. Their jobs tend to encourage them to be familiar with at least some real-world monetary institutions; and I know quite a few, not all of them yet 60, who know their monetary history pretty well, including a fair bit about free banking. Having actually heard of it and thought about it, their theories of free banking, if still implicit, are at least reasonably well informed. They also tend to be rather more interested in, and favorably disposed to, what we avowed free-banking theorists have been saying, than their academic counterparts.

Would that this were also true of the Fed's higher ups, including its highest-ups of all. Alas, officially at least, their understanding of free banking is not much better than that of our lowly tenure-grubbing assistant professor. Consider even Ben Bernanke, a Fed chair regarded as an expert monetary history. To judge from his GWU lectures, at least, his general take on U.S. monetary experience doesn't seem all that different from the conventional textbook wisdom I mentioned a few paragraphs ago. The Fed's other "educational" productions, aimed at general readers (as opposed to its research intended for other experts) are for the most part even worse.

Some persons hearing me claim that many economists, including those who want nothing to do with free banking theory, are free banking theorists themselves, albeit ones who don't know it (and whose theory is likely to be the poorer for it) will, I imagine, think to themselves, "What in the blazes is Selgin thinking? Of course free banking's critics have a theory, and not just a tacit one. They've got a theory and they know it. They've got…Diamond and Dybvig! What's more, it's a real theory, a rigorous theory, with equations and optimization and all, not like the loosey-goosey stuff free-bankers churn out. What more can Selgin possibly want?"

A lot more, actually. Because, notwithstanding all its bells and whistles and tweakability (the quality of lending itself to publishable variations), the Diamond-Dybvig model isn't a formal representation of free banking at all. It's a formal representation of the same cartoon version of free banking that, if I guess correctly, informs most tacit free banking theories. More precisely, it's a formal model that takes as its starting point the assumption than an unregulated banking system is one that might at any moment fall victim to random yet system-wide runs.

I'm not saying that the D-D model is anything less than ingenious. In fact, it isn't easy at all to come up with a model that obeys the rule of not having agents do anything that doesn't increase their expected utility, and yet have it imply occasional if not frequent disasters. In this case, it took some doing. Diamond and Dybvig had to assume away, among other things, (1) the difference between a bunch of idiosyncratic banks and a single representative bank; (2) bank equity, which would otherwise drive a wedge between adverse shocks and bank insolvency; (3) any distinction between banks' reserves and an economy's consumption goods (which makes consumption equivalent to disintermediation); (4)…well, read Kevin Dowd's excellent survey if you want the whole rather long list. The gist of it all, anyway, is that in Diamond and Dybvig we have, not a formal model explaining the workings of some actual banking system, laissez-faire or otherwise, but a formal and in that sense only "rigorous" re-telling of a hackneyed textbook banking myth.

Does any of this prove that the self-aware free banking theorizing of myself, Kevin Dowd, Larry White, and others is any good? Of course it doesn't. Our theories might be perfectly lousy, and I suppose some of them are so. But at least we've arrived at these theories deliberately, after consulting evidence from actual free (or at least relatively free) banking systems, and with due attention to criticisms that our attempts have elicited. Of course it's possible nonetheless that some of the tacit theories informing the case for intervention are, for all their slap-dashed-ness, closer to the mark. But what are the odds? Better, I'm sure, than those of a chimp typing War and Peace. But not nearly enough to bet on.

But the point of my remarks isn't to pass judgement on the views of critics of free banking. It is merely to encourage more of them to join in a more explicit debate concerning what a free banking system would look like, and how well it might perform.