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After I published my recent post on “The Myth of the Myth of Barter,” I tweeted the link to it to David Graeber himself, as I thought his response might be interesting.

Was it ever! Before you could say Jack Robinson, Graeber let loose a fusillade of tweets, each more vicious than the last, calling my post “wildly simple-minded & wrong,” “one of the most embarrassing examples of ideological blindness & arrogant stupidity I’ve ever read,” and that sort of thing. Graeber even asked, in apparent disbelief, “This guy was a professor somewhere?” Think what you will of his understanding of monetary economics, or of his scholarship in general: when it comes to vitriolic hyperbole, Professor Graeber is no dilettante. Indeed, there were a lot more barbs besides these, and there have no doubt been others since. But as Graeber has blocked me on Twitter, presumably to prevent me from replying, I can no longer retrieve most of them.*

But interesting as Graeber’s response was, it fell rather short of the sort of substantive reply I’d hoped to elicit from him. The closest Graeber came to that was a tweet claiming that my post was just a rehash of arguments Robert Murphy had made some time ago, to which Graeber had already responded, and another saying that he wasn’t about to waste his time repeating what he’d already said.

In fact I’d read Graeber’s reply to Murphy. What’s more, I quoted from that reply, to which I supplied a link, in my original post, which I would scarcely have been tempted to do had I believed it answered my own complaints about Graeber’s work.

As a matter of fact, it does nothing of the sort.

My complaints, you may recall, were (1) that Graeber had wrongly accused Smith and Menger of supposing that there was no alternative to either barter or monetary exchange — that is, of supposing that there were no such things as gift-giving and other sorts of non-quid-pro-quo goods transfers, or societies that relied upon such — and (2) that Graeber lacked a proper grasp of some of the most elementary principles of economics, and of the modern theory of value in particular.

Far from defending his work against either of these complaints in his reply to Murphy, Graeber repeats there the very assertions that prompted me to complain in the first place. Once again he declares that Smith, Menger, and Jevons “[a]ll assumed that in all communities without money economic life could only have taken the form of barter” and that “economists originally predicted all (100%) non-monetary economies would operate through barter.” Anthropologists, in contrast, “discovered … an at first bewildering variety of arrangements, ranging from competitive gift-giving to communal stockpiling to places where economic relations centered on neighbors trying to guess each other’s dreams.”

Here I cannot resist quoting again the most relevant passage from Menger’s 1892 essay, “Geld”:

Voluntary as well as compulsory unilateral transfers of assets (that is, transfers arising neither from a ‘reciprocal contract’ in general nor from an exchange transaction in particular, although occasionally based on tacitly recognized reciprocity), are among the oldest forms of human relationships as far as we can go back in the history of man’s economizing. Long before the exchange of goods appears in history, or becomes of more than negligible importance…we already find a variety of unilateral transfers: voluntary gifts and gifts made more or less under compulsion, compulsory contributions, damages or fines, compensation for killing someone, unilateral transfers within families, etc.

That Menger wrote this more than three decades before the 1924 publication of Marcel Mauss’s The Gift, and therefore well ahead of what Graeber describes in his book as “the vast anthropological literature…starting with” that work’s appearance (p. 90, my emphasis), only makes Menger’s understanding all the more impressive.

Graeber can insult me all he likes. What he cannot do is pretend that I have not shown one of his most basic claims to be flat-out wrong, at least when it comes to the economist responsible for the most famous and complete elaboration of the theory that money was an outgrowth of barter. (That Graeber is also wrong about Smith will seem no less evident to anyone who bothers to read that profound and circumspect Scotsman with a modicum of generosity.)

Nor does Graeber’s response to Murphy supply any reason for me to modify my assessment of his understanding of basic economics. On the contrary: he repeats here as well his view that “money is simply a mathematical system whereby one can compare proportional values, to say 1 of these is worth 17 of those.” This, as I said before, is what Aristotle believed; it is also what economists stopped believing around 1871.

In his reply to Murphy, as in his book, Graeber recognizes that barter does occur, saying that it “typically occurs between strangers,” as if this were an exception of little importance. But as I said in my earlier post, it is precisely through trade “among strangers” that non-commercial societies give way to commercial ones; and it is in enabling this transition that money comes to acquire great importance.

But can money really develop, as Smith and Menger suggest it can, as a spontaneous outcome of trade among strangers? It is regarding this possibility only that Graeber’s reply to Murphy offers some new arguments. Graeber insists that money can’t emerge this way, because trade among strangers is a matter of “occasional interactions among people never likely to meet each other again,” and “because rare and occasional events won’t lead to the emergence of a system of any kind.” If, on the other hand, “there are ongoing trade relations between strangers…it’s because each side knows the other side has some specific product(s) they want to acquire — so there is no ‘double coincidence of wants’ problem” for money to overcome:

You don’t cross mountains, deserts, and oceans, risking death in a dozen different ways, so as to show up with a collection of goods you think someone might want, in order to see if they happen to have something you might want.

Really? If you ask me, that last sentence seems to contain a reasonable description of what countless merchants did in fact do for centuries, and what many still do to this day. What’s far-fetched is Graeber’s contrary suggestion that traders never crossed mountains etc. unless they were absolutely certain that they could trade whatever they brought with them for whatever was to be had where they were headed. And it is precisely because trade was risky that traders had reason to “show up” at markets where goods they wanted were on offer equipped with goods of their own that they imagined were relatively “saleable” (to use Menger’s term) in the markets in question.

Now, one has only to introduce the possibility that stranger A might first cross mountain B to acquire good C from stranger D so as to then cross mountain E in the hope of using C to acquire F from stranger G, together with other such possibilities, to have the ingredients it takes to allow Menger’s (or, for that matter, Smith’s) theory of money’s development to go through. Allowing for the particular salience of certain goods — their popularity as ornament or in ceremonial uses — makes the development all the more likely.**

In short, Graeber’s supposed refutation of the possibility that money can develop through trade among strangers amounts to little more than a completely unwarranted assertion to the effect that, because overcoming the “lack of a double coincidence” hurdle is risky, no one will bother trying, notwithstanding the potential gains to be had by doing so. That assumption may seem reasonable to one who believes, as Graeber does, that trade is a zero-sum game. But it is not reasonable in light of economists’ understanding of voluntary exchange as a source of mutual gain. More importantly, it is not what persons who actually venture to engage in trade believe.

I suspect that, if he responds to this post at all, Graeber will simply maintain, by way of another burst of ≤140-character philippics, that I still haven’t undermined any of his book’s more important claims. Still it would be nice if, instead of pretending to have already answered my arguments, or merely being nasty, he would attempt to offer a substantive reply. After all that obloquy, I could use a weal tweet.

___________________________________

*Nor can I tweet this post to him. But that needn’t stop some of you from doing so.

**Don’t get your knickers in a twist, my chartalist friends: I do not intend to deny that public authorities and other such “big players” may play an important part in influencing this process.

[Cross-posted from Alt‑M.org]

According to Gary Gorton and Ellis W. Tallman, in their  recently released NBER Working Paper, some were.

For several decades prior to the Fed’s establishment, Gorton and Tallman note, “private bank clearinghouses provided lending facilities and assisted member banks when they needed help.” The pattern of such assistance, they say, reflected a privately-adopted TBTF policy that “was a reasonable response to the vulnerability of short-term debt to runs that could threaten large banks and thereby the entire banking system.”

These clearinghouse bailouts appear, furthermore, to have succeeded in averting more serious crises. Since, according to Gorton and Tallman’s understanding, “[t]he logic of modern bailouts is the same” as that adopted by 19th-century clearinghouses, they conclude that TBTF remains a reasonable policy today, and not, as many suppose, an invitation to excessive bank risk taking.

But there’s a flaw in Gorton and Tallman’s reasoning, and I’m afraid it’s a lulu. The flaw consists of their failure to understand what “Too Big to Fail” means. That meaning has been clear from the time Congressman Stewart McKinney first popularized the notion during a hearing concerning the Continental Illinois bailout. “Mr. Chairman,” McKinney said, “Let us not bandy words. We have a new kind of bank. It’s called too big to fail. TBTF, and it’s a wonderful bank.”

In case it isn’t obvious, Congressman McKinney was being sarcastic. What was “wonderful,” in the sense of “amazing,” was the fact that Continental would remain a going concern despite it’s having been rendered insolvent by bad loans it had made or purchased. The point is that, if TBTF means anything, it means that certain financial institutions are exceptions to Walter Bagehot’s “classical” rule according to which last-resort loans and other kinds of emergency aid should be confined to solvent financial firms. It is precisely because TBTF can mean putting insolvent firms on government life-support that critics of the policy see it as a source of moral hazard.

All of this appears, somehow, to have escaped Gorton and Tallman’s attention. For otherwise they could not have failed to note the crucial difference between “the logic of modern bailouts” and that underlying the private pre-Fed bailouts that their paper describes. For while clearinghouses did occasionally rescue “big” banks, they never rescued insolvent ones. Instead, as is clear from the evidence that Gorton and Tallman themselves muster, clearinghouses went to great lengths to assure themselves of a bank’s solvency before they’d lend it a nickel. “If a bank possesses good assets and is merely temporarily embarrassed,” a 1901 source cited in the paper explains, “it is good policy of the [clearinghouse] association to prevent [its] failure.” That’s not too big to fail. It’s too sound to fail.

And while it’s true that, according to the same source, clearinghouses were especially concerned to prevent “important” members from failing, because such failures try “the weak points of all the banks,” such banks still had to have plenty of “good assets” to qualify for help. During the Panic of 1884, for example, the failure of the Metropolitan National Bank might have had disastrous consequences for its many correspondents. Yet the New York Clearing House agreed to offer it support in the form of clearinghouse loan certificates only after its examiners determined that the Metropolitan “had sufficient assets in good condition” to warrant that support. In short, “Bigness” (or “interconnectedness”) may have been a necessary condition for clearinghouse support. But it was never a sufficient condition.

In a TBTF regime, in contrast, “bigness,” or “interconnectedness,” can suffice. Hence Continental Illinois. Hence other bailouts of larger, insolvent financial firms since them, including the Fed’s rescues of Citigroup and AIG during the recent crisis. As Tom Humphrey points out,

the Fed ignored the classical advice never to accommodate unsound borrowers when it helped bail out insolvent Citigroup and AIG. Judging each firm too big and interconnected to fail, the Fed argued that it “had no choice” but to aid in their rescue since each formed the hub of a vast network of counterparty credit interrelationships vital to the financial markets, such that the failure of either firm would allegedly have brought collapse of the entire financial system. Fed policymakers overlooked the fact that Bagehot already had treated this argument, and had shown that interconnectedness of debtor-creditor relationships and the associated danger of systemic failure constituted no good reason to bail out insolvent firms.

The difference between the “logic” of the private-market financial firm rescues of the pre-Fed era, in which the rescuers themselves had “skin in the game,” and today’s taxpayer-supported rescues, is a difference of no small importance. It is why we worry about TBTF these days, while no one worried about it back then.

I hope I won’t be misunderstood as intending to suggest that there’s no merit in Gorton and Tallman’s research, because that isn’t my intention at all. In fact I consider their inquiry into clearinghouse rescues of the pre-Fed era quite valuable. The problem isn’t the research itself, but the fact that Gorton and Tallman draw the wrong lesson from it. The lesson isn’t that TBTF is a dandy doctrine, and that those looking for the causes of financial-system fragility today should look elsewhere. It’s that private, 19th-century financial actors appeared to have managed last-resort lending more responsibly than their modern, government-appointed counterparts.

[Cross-posted from Alt‑M.org]

Financial reform has taken a prominent role in the current presidential debates, particularly between Clinton and Sanders. As Clinton is seen as the candidate of the status quo, her defenders have taken to arguing that the Dodd-Frank Act is “working.”

A recent example of such an argument is Paul Krugman’s claim that, thanks to Dodd-Frank, “banks are being forced to hold more capital.” But is Krugman’s claim true?

Before turning to the numbers, we should consider just how capital has been regulated before and since Dodd-Frank. Prior to Dodd-Frank, the primary source of regulatory authority for capital was found in Section 38 of the Federal Deposit Insurance Act (FDIA). The relevant clauses of that section read as follows:

(c) CAPITAL STANDARDS.–

(1) RELEVANT CAPITAL MEASURES.–

(A) IN GENERAL.–Except as provided in subparagraph (B)(ii), the capital standards prescribed by each appropriate Federal banking agency shall include–

(i) a leverage limit; and

(ii) a risk-based capital requirement.

(B) OTHER CAPITAL MEASURES.–An appropriate Federal banking agency may, by regulation–

(i) establish any additional relevant capital measures to carry out the purpose of this section; or

(ii) rescind any relevant capital measure required under subparagraph (A) upon determining (with the concurrence of the other Federal banking agencies) that the measure is no longer an appropriate means for carrying out the purpose of this section.

The first thing to notice is the lack of a ceiling. Although Section 38(c)(3)(B) requires that a bank’s capital be “not less than 2 percent of total assets,” there’s no maximum. Also notice how 38(c)(1)(B)(i) above allows regulators to set additional capital requirements. In plain English, bank regulators, prior to Dodd-Frank, could have pretty much required whatever capital levels they wanted.

It was under this FDIA authority that U.S. bank regulators began the “Basel III” process, the first consultative paper for which was published in December 2009, a good seven months before Dodd-Frank was signed into law. Basel III itself was introduced in December 2010, and most of the work of implementing Basel III had been completed before Dodd-Frank’s passage. Despite what Paul Krugman says, the increases in bank capital that have occurred since the crisis, in so far as they were a result of changes in the law, were largely a consequence of these developments, rather than of Dodd-Frank. Were Dodd-Frank to be repealed in its entirety, our current bank capital standards would largely be unchanged.

Hasn’t Dodd-Frank also helped? It’s true that Dodd-Frank is not without some mention of capital. The “Collins Amendment” (Section 171) mandates that capital requirements for bank holding companies be no less stringent than those applied to depositories. Setting aside the fact that the previous law already allowed regulators to impose the same requirement, the fact is that this additional regulation doesn’t matter much, because most holding companies have few assets relative to their subsidiaries. Let’s also set aside the fact that the average observed Tier I capital for holding companies at the time of Dodd-Frank was already equal to that for depositories.

The Collins Amendment to Dodd-Frank also restricted the use of trust preferred securities (TruPS) as capital. But here again, although the restriction is sensible, bank regulators already had the ability to insist upon it. More importantly TruPS, at the time of Dodd-Frank, represented only about 11 percent of Tier 1 capital for bank holding companies. So while the Federal Reserve should have never affirmatively approved of the use of TruPS as capital (another fine regulatory decision by the Fed), TruPS were never more than a relatively small portion of capital. If that’s what counts as “reform” then color me unimpressed.

Section 165 of Dodd-Frank goes further than these other measures, by setting a minimum leverage requirement for the largest banks. It is one of the few capital regulations in Dodd-Frank that could make a difference. Unfortunately, at just 6%, the requirement is quite low. The minimum is also not based on assets-to-equity but on debt-to-equity. In other words, the change is largely cosmetic.

OK, enough with the law. Just how much has bank capital increased since the passage of Dodd-Frank? It all depends on what you mean by capital. According to the FDIC, at the end of 2015, commercial banks had “total equity capital” of $1.8 trillion. This is certainly higher than the $1.5 trillion that existed at the time of Dodd-Frank’s passage. But bank assets also increased. What matters is the ratio of bank capital to total bank assets. At the passage of Dodd-Frank that ratio was 11.1. At year-end 2015, it was 11.2. So much for Krugman’s massive increase in bank capital.

The minor increase in the overall bank capital-to-assets ratio becomes even less impressive when one realizes that it has been driven almost exclusively, not by new legal requirements, whether from Dodd-Frank of from Basel III, but by an increase in banks’ “undivided profits” — that is, in banks’ retained earnings that have yet to be distributed to shareholders. When most people think of capital, they mean the sort that represents “skin in the game,” or common equity. So what’s been the trend there? At the passage of Dodd-Frank, banks held $55.5 billion in common stock and perpetual preferred shares. At year-end 2015, that number was $52.7 billion. This decline is even more shocking when measured relative to assets, falling from 0.4 percent of assets to 0.3 percent of assets. Seems the so called claim about increased bank capital isn’t actually true, if you look at what most people would consider capital. There are still other ways to look at capital. The chart below, from the FDIC, illustrates the trend in the four most commonly used capital ratios. Total risk-based capital, the top line, actually shows a decline since the passage of Dodd-Frank. The other three measures show very minor increases. I’d say they were essentially flat. And even that relatively weak trend is the result of the Basel process, not Dodd-Frank.

Some apparent increases in bank capital relative to risk-weighted assets are due to the fact that banks have massively shifted into low risk-weight assets. Under a system of risk weighted capital, the required capital is a function of the target capital level times the risk weight of the volume of the asset. For example whole mortgages have historically had a risk weight of 50%. So if one holds $100 million in whole mortgages and the target capital is 8%, then actual capital is not $8 million but rather $4 million (8 x 0.5). Needless to say the risk weights have come under considerable scrutiny, especially since assets like Greek government debt were given risk weights of zero.

Since Dodd-Frank, commercial banks have more than doubled their holdings of U.S. Treasuries, which require zero capital. Banks have also increased their holdings of mortgage-backed securities and municipal debt, which also have low risk weights. The point is that banks haven’t really raised lots of new capital as much as they’ve gamed the risk-weights to appear to have more capital (apparently they’ve fooled Krugman).

Now there are lots of reasons to like or dislike Dodd-Frank. Its impact on bank capital isn’t one of those reasons, as said impact has largely been illusionary.

[Cross-posted from Alt‑M.org]

So far as some people are concerned, when it comes to bashing economists, any old stick will do.

That, at least, seems to be true of those anthropologists and fellow-travelers who imagine that, in demonstrating that certain forms of credit must be older than either monetary exchange or barter, they’ve got some of the leading lights of our profession by the short hairs.

The stick in this case consists of anthropological evidence that’s supposed to contradict the theory that monetary exchange is an outgrowth of barter, with credit coming afterwards. That view is a staple of economics textbooks. Were it nothing more than that, the attacks would hardly matter, since finding nonsense in textbooks is easier than falling off a log. But these critics have mostly directed their ire at a more heavyweight target: Adam Smith.

In The Wealth of Nations, Smith observes that

When the division of labour has been once thoroughly established, it is but a very small part of a man’s wants which the produce of his own labour can supply. He supplies the far greater part of them by exchanging that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men’s labour as he has occasion for. Every man thus lives by exchanging, or becomes in some measure a merchant, and the society itself grows to be what is properly a commercial society.

But when the division of labour first began to take place, this power of exchanging must frequently have been very much clogged and embarrassed in its operations. One man, we shall suppose, has more of a certain commodity than he himself has occasion for, while another has less. The former consequently would be glad to dispose of, and the latter to purchase, a part of this superfluity. But if this latter should chance to have nothing that the former stands in need of, no exchange can be made between them. The butcher has more meat in his shop than he himself can consume, and the brewer and the baker would each of them be willing to purchase a part of it. But they have nothing to offer in exchange, except the different productions of their respective trades, and the butcher is already provided with all the bread and beer which he has immediate occasion for. No exchange can, in this case, be made between them. He cannot be their merchant, nor they his customers; and they are all of them thus mutually less serviceable to one another. In order to avoid the inconveniency of such situations, every prudent man in every period of society, after the first establishment of the division of labour, must naturally have endeavoured to manage his affairs in such a manner as to have at all times by him, besides the peculiar produce of his own industry, a certain quantity of some one commodity or other, such as he imagined few people would be likely to refuse in exchange for the produce of their industry.

What’s wrong with that? In the words of Cambridge anthropologist Caroline Humphrey, as quoted in a recent article on the subject in The Atlantic  (the appearance of which inspired the present post), what’s wrong is that “No example of a barter economy, pure and simple, has ever been described, let alone the emergence of money… . All available ethnography suggests that there has never been such a thing.”

Now, the mere lack of historical or anthropological evidence of past barter economies is itself no more evidence against Smith’s account than it is evidence in favor of it: after all, if barter tends to get as “clogged as embarrassed” as Smith maintains, we should not be surprised to find no evidence of societies that relied on it. That lack might only mean that societies either came up with money quickly, or perished equally quickly. Instead of refuting Smith’s theory, in other words, the lack of evidence of barter may simply reflect survivorship bias. Julio Huato, in his astute review of Graeber’s book, makes the point most cogently: “Graeber’s attitude,” he writes,

is like that of a chemist rejecting the idea that unstable radioactive isotopes of a certain chemical element exist and tend to evolve into stable isotopes because the former are only exceptionally found in nature, while the latter are common.

But the problem with Smith’s understanding, according to Graeber, isn’t merely that anthropologists can find no evidence of barter societies. It is, rather, that those same anthropologists have plenty of evidence of societies that subsisted, if they didn’t thrive, despite neither having money nor relying upon barter. Instead of relying on “quid-pro-quo” exchanges, whether direct or indirect, they managed by resorting to subtle forms of credit, if not outright gift-giving.

As our Atlantic correspondent explains:

If you were a baker and needed meat, you didn’t offer your bagels for the butcher’s steaks. Instead, you got your wife to hint to the butcher’s wife that you two were low on iron, and she’d say something like, “Oh really? Have a hamburger, we’ve got plenty!” Down the line, the butcher might want a birthday cake, or help moving to a new apartment, and you’d help him out.

Far be it for me to deny that trade of this sort happens, even in modern societies, or even that entire communities have at various times depended on it. Heck, I once taught a short course on economic anthropology an entire section of which was devoted to gift giving and other sorts of “ceremonial exchange.” What I do deny, and vigorously, is anthropologist David Graeber’s claim that the existence of gift economies undermines, not just Adam Smith’s account of money’s origins, but “the entire discourse of economics.”

Hear our correspondent once again:

According to Graeber, once one assigns specific values to objects, as one does in a money-based economy, it becomes all too easy to assign value to people, perhaps not creating but at least enabling institutions such as slavery…and imperialism… .

There you have it. By claiming that societies could thrive only by means of monetary exchange, Adam Smith is supposed to have given shape to an “economic discourse” according to which all things, including people, are bound to be valued in terms of money, thereby “enabling” slavery and imperialism and…well, the whole capitalist catastrophe.

That nothing could be more grotesquely unjust to Adam Smith than Graeber’s attempt to paint him as an enabler of slavery and imperialism is (or ought to be) painfully obvious. But if fair play is not Professor Graeber’s forte, neither is a solid, or even a more than exceedingly superficial, understanding of the tenets of modern economics. Had Graeber’s purpose been, not to document economists’ ignorance of anthropology, but to show that at least one anthropologist doesn’t know the first thing about economics, I dare say that he could have done no better than to write Debt: The First 5000 Years.

Consider the opening passage of “The Myth of Barter,” Graeber’s second chapter, and the one in which he sets-out his central claim that Smith, by getting the story of money wrong, took a fateful wrong turn:

What is the difference between a mere obligation, a sense that one ought to behave in a certain way, or even that one owes something to someone, and a debt , properly speaking? The answer is simple: money. The difference between a debt and an obligation is that a debt can be precisely quantified. This requires money.

“A history of debt,” Graeber observes two paragraphs later, “is thus necessarily a history of money.”

This is simple, all right. But a moment’s thought reveals that it is also simply wrong. One can incur a debt by borrowing some non-monetary good or goods, just as well as by borrowing money, where repayment is also to be made in goods, and is no less precisely quantified than a monetary obligation might be. To say, “Give me a hamburger today and I’ll repay you two hamburgers on Tuesday,” is to offer to go into debt to the tune of (precisely) two hamburgers. That money is both fungible and relatively (though in practice not infinitely) divisible makes it an especially convenient object of debt contracts. But that is a difference in degree rather than in kind.

Far from being innocuous, the error with which Graeber’s chapter opens is but one crack in the severely-flawed foundation upon which his entire critique of both modern economics and commercial society rests. That foundation consists of the view that money is, not only uniquely (and precisely) quantifiable, but something capable of precisely measuring the value of other things:

What we call “money” isn’t a “thing” at all; it’s a way of comparing things mathematically, as proportions: of saying one of X is equivalent to six of Y.

Monetary exchange, in turn,

is all about equivalence. It’s a back-and-forth process involving two sides in which each side gives as good as it gets. …[E]ach side in each case is trying to outdo the other, but, unless one side us utterly put to rout, it’s easiest to break the whole thing off when both consider the outcome to be more or less even.

In other words, monetary exchange, being but an “impersonal” matter of mathematics, is a contest that must result either in a stalemate, with neither side winning, or in a bargain by which one side rips the other off. Gift exchange, on the other hand, “is likely to work precisely the other way around — to become a matter of contests of generosity, of people showing off who can give more away.”

I leave it to the reader to imagine how, by means of repeated appeals to this sort of reasoning, Graeber manages to paint Adam Smith (and most economists since) as an apologist for slavery, imperialism, and pretty much every ungenerous and unkind activity under the sun.

There’s just one problem. Just as money is in truth no more “quantifiable” than hamburgers, so, too, is it the case than money is no more a “measure” of value than a hamburger is. By that I mean, not that a hamburger is also capable of measuring the value of other things, but that neither it nor any sort of money is capable of doing so.

The idea that money is a “measure of value,” like the related idea that exchanges are necessarily exchanges of equivalents, is among the hoariest of economic fallacies. It plays a prominent part in Aristotle’s economics — and, not coincidentally, in Aristotle’s condemnation of all sorts of “capitalist” activity. Smith himself, in subscribing to a modified labor theory of value, was unable to break free of it. It is more than a little ironic that Graeber, in flinging all sorts of undeserved criticism at Smith, cleaves to him when it comes to his one indisputable mistake.

The notion that money is a “measure of value” is but a particular instance — albeit one that has managed to linger on in some economics textbooks — of the mistaken belief that economic exchanges are exchanges of equivalents. In his book Money: The Authorized Biography, Felix Martin, like Graeber, takes the “measure of value” notion seriously, and attempts to build from it a critique of both modern economics and modern monetary economies. In reviewing that work, I explained Martin’s mistake by observing that when a diner sells me bacon and eggs for $4.99, “that doesn’t mean that bacon and eggs are worth $4.99, ‘universally’ or otherwise. It means that to the diner they are worth less, and to me, more.”

Grasp this little strand of truth. Pull on it. Keep on pulling. And watch Martin’s critique unravel. Graeber’s critique, with its fatuous dichotomy of generous credit transactions on one hand and antagonistic monetary transactions on the other, rests on the same fallacy, and is no less gimcrack.

My concern, though, isn’t with Graeber’s sweeping condemnation of modern economics, or of the economic arrangements for which modern economists are supposedly to blame. It’s with his particular claim that there’s no merit in Smith’s account of the origin of money, or in the later accounts of other economists, including Carl Menger. Despite what these economists have argued, money couldn’t have grown out of barter, Graeber insists, because the “fabled land of barter” that these accounts posit never existed. Instead, credit came first, sometimes in subtle and elaborate forms that made it indistinguishable from gift-giving; then came money, in the form of coins. Barter, finally,

appears to be largely a kind of accidental byproduct of the use of coinage or paper money: historically it has mainly been what people who are used to cash transactions do when for one reason or another they have no access to currency (my emphasis).

So, how true is Graeber’s account, and just how fatal is it to the “fable” that economists like to tell? For answers, we need look no further than the evidence Graeber himself supplies. For on close inspection, that evidence itself suffices to show that, notwithstanding the fact that credit is older than barter, Smith’s theory is, after all, not all that far removed from the truth.

A paradox? Nothing of the sort. The simple explanation is that, while subtle forms of credit or outright gift giving may suffice for affecting exchanges within tightly-knit communities, exchange within such communities hardly begins to take advantage of opportunities for specialization and division of labor that arise once one allows for trade, not just within such communities, but between them, that is, for trade between or among strangers. One need only recognize this simple truth to resuscitate Smith’s theory from Graeber’s seemingly fatal blow. Simple forms of credit may come first; but such credit only goes so far, because it depends on a repeated interaction, and the trust that such interaction both allows and sustains. That affection and other such “moral sentiments,” to use Smith’s own term, also play a large part is evident from the fact that, within families even today, monetary exchange and barter play hardly any role: every family is, if you like, a vestigial “gift” economy.

It’s absurd to suppose that Smith himself failed to recognize that credit (or something like it) functions in place of either barter or money in families; and hardly more so to suppose that he denied that it might do the same in somewhat larger but still tightly-knit communities. Little Adam Smith did not, presumably, bargain with his mother over bed and board, or find his efforts to secure those and other necessities “embarrassed and choked” for want of either double coincidences or cash. Nor could anyone aware of passages like the following, from Smith’s Theory of Moral Sentiments, suppose that he considered mutual aid unimportant except within nuclear families:

In pastoral countries, and in all countries where the authority of law is not alone sufficient to give perfect security to every member of the state, all the different branches of the same family commonly chuse to live in the neighbourhood of one another. Their association is frequently necessary for their common defence. They are all, from the highest to the lowest, of more or less importance to one another. Their concord strengthens their necessary association; their discord always weakens, and might destroy it. They have more intercourse with one another, than with the members of any other tribe. The remotest members of the same tribe claim some connection with one another; and, where all other circumstances are equal, expect to be treated with more distinguished attention than is due to those who have no such pretensions. It is not many years ago that, in the Highlands of Scotland, the Chieftain used to consider the poorest man of his clan, as his cousin and relation. The same extensive regard to kindred is said to take place among the Tartars, the Arabs, the Turkomans, and, I believe, among all other nations who are nearly in the same state of society in which the Scots Highlanders were about the beginning of the present century.

If Smith recognized, at least implicitly, that, in families and other tight-knit communities, “credit” serves in place of either barter or money, Graeber for his part is forced to admit that, when it comes to trade between strangers, credit won’t serve:

Now, all this (meaning the lack of evidence of a “fabled land of barter”) hardly means that barter does not exist — or even that it’s never practiced by the sort of people Smith would have referred to as “savages.” It just means that it’s almost never employed, as Smith imagined, between fellow villagers. Ordinarily, it takes place between strangers, even enemies (my emphasis).

Later Graeber writes,

What all … cases of trade through barter have in common is that they are meetings with strangers who will, likely or not, never meet again, and with whom one certainly will not enter into any ongoing relations. …

…Barter is what you do with those to whom you are not bound by ties of hospitality (or kinship, or much of anything else).

No doubt. But how big a problem is this for Smith? Let pass the silly remark about “savages.” (An anthropologist ought, one would think, to be capable of resisting the temptation to pass judgement on an 18th-century Scotsman’s choice of words according to 21st-century notions of political correctness.) The question is, what did Smith really “imagine”? His story of the butcher and the baker notwithstanding, his reference to pastoral societies makes it perfectly evident that he understood the difference between conduct among “villagers” and conduct among strangers. His theory of the origins of money ought to be understood accordingly. It is a theory of how, when opportunities for trade arise among strangers, bringing with them further scope for the division of labor, trade will be “choked and embarrassed” if it must occur by means of barter, but will cease to be so once barter gives way to the employment of money. In portraying such cases as exceptions to the rule that “credit” proceeds barter, Graeber simply fails to understand that such “exceptions” are all that matters in assessing Smith’s theory.

Nor will it do to suggest that Smith’s understanding of money’s origins confuses what happens within societies or communities with what happens between them. Such a view depends on arbitrarily rigid definitions of “community” and “society” that overlook these concepts’ inherently elastic nature: formerly separate communities cease to be so precisely to the extent that commerce takes place between them. Smith, for his part, recognizes this. Moreover he understands that the rise of commerce, meaning commerce among strangers, serves in turn to reduce the relative importance of ties of kinship and such, further increasing thereby the importance of monetary exchange. Here is the passage from the Theory of Moral Sentiments that immediately follows the previously-quoted one on pastoral societies:

In commercial countries, where the authority of law is always perfectly sufficient to protect the meanest man in the state, the descendants of the same family, having no such motive for keeping together, naturally separate and disperse, as interest or inclination may direct. They soon cease to be of importance to one another; and, in a few generations, not only lose all care about one another, but all remembrance of their common origin, and of the connection which took place among their ancestors. Regard for remote relations becomes, in every country, less and less, according as this state of civilization has been longer and more completely established. It has been longer and more completely established in England than in Scotland; and remote relations are, accordingly, more considered in the latter country than in the former, though, in this respect, the difference between the two countries is growing less and less every day. Great lords, indeed, are, in every country, proud of remembering and acknowledging their connection with one another, however remote. The remembrance of such illustrious relations flatters not a little the family pride of them all; and it is neither from affection, nor from any thing which resembles affection, but from the most frivolous and childish of all vanities, that this remembrance is so carefully kept up. Should some more humble, though, perhaps, much nearer kinsman, presume to put such great men in mind of his relation to their family, they seldom fail to tell him that they are bad genealogists, and miserably ill-informed concerning their own family history. It is not in that order, I am afraid, that we are to expect any extraordinary extension of, what is called, natural affection.

In short, a generous reading of Smith, far from making him out to be a right bungler when it comes to matters ethnographic, yields a relatively sophisticated view, according to which kinship and “credit” first predominate, but then give way, as strangers meet, first to barter, but eventually to monetary exchange, which in turn allows for the growth of commerce, which ends up reducing the role of kinship and kin-based credit relationships.

If Graeber’s reading of Smith is ungenerous, his reading of Carl Menger is…well, it’s obvious that Graeber hadn’t read Menger at all, for if he had he could not possibly have written that Menger improved upon Smith’s theory mostly “by adding various mathematical equations” to it, or that Menger “assumed that in all communities without money, economic life could only have taken the form of barter.” (Nor, for that matter, could he have failed to note that the senior Menger, unlike his mathematician son, spelled Carl with a “C.”) Instead, Graeber would have had to admit that Menger understood perfectly well that “credit,” in Graeber’s loose sense of the term, is older than either monetary exchange or barter.

Menger’s appreciation of the importance of what he sometimes referred to as “no-exchange” economies is especially evident in his 1892 article, “Geld,” in the Handwörterbuch der Staatswissenschaften, from which his more well-known article “On the Origins of Money” is extracted. According to Menger,

Voluntary as well as compulsory unilateral transfers of assets (that is, transfers arising neither from a ‘reciprocal contract’ in general nor from an exchange transaction in particular, although occasionally based on tacitly recognized reciprocity), are among the oldest forms of human relationships as far as we can go back in the history of man’s economizing. Long before the exchange of goods appears in history, or becomes of more than negligible importance…we already find a variety of unilateral transfers: voluntary gifts and gifts made more or less under compulsion, compulsory contributions, damages or fines, compensation for killing someone, unilateral transfers within families, etc.*

Far from exemplifying Graeber’s claim that economists “begin the story of money in an imaginary world from which credit and debt have been entirely erased,” Menger explicitly recognizes that

people had probably tried to satisfy their wants, over immeasurable periods of time, essentially in tribal and family no-exchange economies until, aided by the emergence of private property, especially personal property, there gradually appeared multifarious forms of trade in preparation for the exchange proper of goods. …Only then, and hardly before the extent of barter and its importance for the population or for certain segments of the population had made it a necessity, was the objective basis and precondition for the emergency of money established.

In light of such evidence — which, bear in mind, comes from a work published several decades before Mauss’s pathbreaking work on gift exchange — the attention given to Graeber’s critique, and the fact that even some economists saw merit in it (if only temporarily), tells us that there is, after all, at least one impulse among humans that’s more deep-seated than their “propensity to truck, barter, and exchange.” I mean, of course, their propensity to let themselves be thoroughly bamboozled.

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*From the English Translation “Money,” by Leland Yeager (with Monika Streissler). In Michael Latzer and Stefan W. Schmitz, eds., Carl Menger and the Evolution of Payments Systems: From Barter to Electronic Money (Cheltenham, UK: Edward Elgar), pp. 25–108.

[Cross-posted from Alt‑M.org]

Last month, the Treasury Department announced new steps to boost the market for private mortgage bonds, not backed by the government or any federal entity, in order to increase homeownership and improve access to credit for working-class Americans who might be having trouble borrowing money to buy a house. The Administration’s latest effort to boost the market for private mortgage lending begs an essential question: What are the societal benefits to homeownership, and would more investment in homeownership help the economy?

It’s a long-discussed question, of course. The pro-home-building folks aver that homeownership fosters civic involvement and helps people become more tied to their community, which encourages other behavior beneficial for the economy. And for a good proportion of homeowners the majority of their net wealth is in their home, so it can be an important source of savings.

But another way to look at it is that correlation is not causation: The reason that homeowners are more civic-minded and involved in the community is because such people are much more likely to have the wherewithal to save enough to make a downpayment on a house. Ed Glaeser, the renowned housing economist from Harvard, puts little stock in the notion that homeownership has significant positive societal externalities.

What’s more, there’s some evidence that high homeownership rates have downsides as well. In the last four decades the predilection for moving has slowed significantly: only half as many people moved across state or county lines in any year this decade as was the case in the 1950s, for instance. This is problematic because it means that our economy is worse at matching up workers with where the available jobs are. The lingering unemployment in many rust-belt states would be less if some of their unemployed could be persuaded to move to another community where there are jobs. There has been a decades-long move of people from the midwest to the Sunbelt, of course, but the data suggest there’s ample room for more. This hasn’t happened in part because people are tied down by the homes that they own and are reluctant to sell while they are underwater. That people are unable to ignore sunk costs isn’t economically rational, of course, but it nevertheless governs how many people consider whether to move.

In other words, an argument could be made that instead of taking measures to boost homeownership, a better approach to jumpstarting the economy might be to reduce incentives to homeownership and let the proportion of people who own homes fall. There’s no reason to think that lower homeownership rates would reduce spending on housing: people have to live somewhere, and fewer home owners would simply mean more renters. If the average size of a family’s home shrinks slightly because of it, it’s hard to see what the harm would be in that — home sizes increased by one-third from the 1980s to the early 2000’s, so it’s not like we’re returning to the world of tenements. The net result of pulling back on homeownership incentives would be that new families would wait another year or two before buying the home that becomes their family home, and fewer singles would buy — salutary developments, I would argue.

And I’m morally obligated here to point out that the costliest incentive for homeownership — the mortgage interest deduction — does absolutely nothing to increase homeownership rates, since only the wealthiest third of all households can avail themselves of its benefits. The amount of the tax subsidy from the deduction that goes to homeowners in Greenwich Connecticut is an order of magnitude greater than the benefits for people in Mossville, Illinois.

Above all else we need to help policymakers get away from this mindset that our ample housing subsidies benefit the economy by creating jobs building homes. Demand-side fiscal incentives — and that’s 90% of the current political arguments for housing subsidies — are a chimera. If we spent less on housing we’d spend more somewhere else in the economy. This notion that the economy consists of various silos — like housing and autos — and that a reduction in any of these is an unmitigated bad thing is a lousy way to approach how an economy works. The more we spend on building new houses the less money is available for investments in things that might actually boost the productive capacity of an economy. In other words, the demand-side incentives of housing may reduce the productive capacity of the economy (the supply side of the economy) and with it long-term economic growth.

There’s no disputing that our capital markets aren’t working efficiently at the moment. Some of this has to do with the collective shell shock many financial institutions still have over the financial market implosion in 2008. However, government activities like the passage of Dodd-Frank, the management of Fannie Mae and Freddie Mac, the attempt by the CFPB to wipe out title and payday loan companies (with not a few installment loan companies caught in the crossfire), and the punitive fines assessed on various banks for their alleged misdoings (or in the case of the Bank of America, for simply doing what it was asked to do by the government) have left banks extremely hesitant to make anything but the safest loans. It’s hard to see what the government can do to convince lenders they won’t be accused of exploiting borrowers with poor credit risks again if there’s another recession in the near future.

Capital markets need better and smarter regulation, but the fact that homeownership rates are falling is not a reason to act.

[Cross-posted from Alt‑M.org]

Henry James, T.S. Elliot famously remarked, “Had a mind so fine that no idea could violate it.” Similarly, more than a few economics papers involve formal models so fine that no facts can violate them.

Two recent examples purport to demonstrate the instability and inefficiency of “private money.” One, on “Private Money and Banking Regulation,” appeared in the September 2015 Journal of Money, Credit and Banking (JMCB).  Its authors are Cyril Monnet, a Professor at the University of Bern, and Daniel Sanches, an economist at the Philadelphia Fed. The other, by Sanches alone, is called “On the Inherent Instability of Private Money,” and is about to be published in the Review of Economic Dynamics (RED, for short).

That the models in these papers are indeed “fine,” meaning first-rate, from a strictly analytical point of view, can’t be gainsaid. They meet all of the exacting requirements of those economists who insist that a model’s institutional features should be “essential” in the sense Frank Hahn had in mind when he argued that monetary GE models should provide an essential role for money. The features must, in other words, overcome frictions inherent in the model environment that would otherwise condemn optimizing agents to lower levels of utility. In particular, the models in question supply “essential” roles for indirect exchange, banks, and banknotes. Yet they are tractable enough to allow their authors to draw inferences from them concerning both the stability and the efficiency of private currency. So far as the realm of formal economic modeling is concerned, these are highly impressive achievements.

As the two papers are similar in their arguments and conclusions, I won’t bother to distinguish between them except when necessary. The gist of the argument in each case is that, assuming perfect competition, private money (meaning competitively-supplied, redeemable bank notes) won’t work, because people will have good reason to distrust the banks that issue it. That’s so because the bankers’ willingness to redeem their notes depends on how profitable the banking business is. If it is profitable enough, they can be trusted to redeem their notes, because they’re better-off staying in business than reneging on their promises. The trouble is that, with perfect competition, the continuation or “franchise” value of staying in the currency business could well end up being so low that banks are tempted to drop out. Consequently, prospective note-holders aren’t able to rule out the possibility that private money will become worthless. To put it in Sanches’s more technical language, under perfect competition “there exist multiple equilibrium allocations characterized by a self-fulfilling collapse of the value of privately issued liabilities that circulate as a medium of exchange.” A competitive, private currency system is, Monnet and Sanches conclude, “inherently unstable.”

In fact, the news for fans of private money is even worse, for the conclusion doesn’t just apply to the special case of perfect competition. Although allowing for banking industry concentration and associated market power makes for a greater likelihood that bankers will honor their promises, by increasing banker’s expected profits, it doesn’t necessarily rule out a collapse. And even if returns were high enough to avert a collapse, in the absence of further regulation banks would earn monopoly profits rather than pay a return on currency sufficient to guarantee an “optimum quantity of money” in the sense made famous by Milton Friedman. Private money would, in short, be either unstable or inefficient.

If unregulated private money won’t work, what will? The obvious solution is a government currency monopoly, regulated so as to assure a return on currency sufficient to achieve an optimum money stock. But it’s also possible, according to Sanches and Monnet, to achieve an optimal and stable outcome by having the government guarantee bankers a minimum after-tax income regardless of the demand for banknotes, using a subsidy financed by a lump-sum tax on currency users. The guaranteed minimum income rules out the panic equilibrium.

So much for a summary. The question is, do these models really make a persuasive case that unregulated private currency won’t work, and that governments can do substantially better? Like many economists, I subscribe to the old-fashioned view that a theory, if it’s any good, will yield conclusions that are, or at least appear to be, consistent with relevant experience, meaning, in this instance, the empirical evidence, so far as we are aware of it, concerning arrangements — and unregulated or lightly-regulated ones especially — in which currency did in fact consist of redeemable notes, supplied by competing, private banks. Alas, judged against such experience, rather than for their ingenuity, Sanches and Monnet’s models must be considered failures, comparable to André Sainte-Laguë’s demonstration that bumblebees cannot fly.

One might well wonder how such clever model-building could go so awry. One might suppose that Sanches and Monnet, themselves believing that theories should agree with facts, consulted relevant empirical work in constructing their theories. But that supposition is, to judge by what their papers reveal, not correct. Between them those papers hardly refer to relevant empirical cases at all, or (despite containing sections labeled “Related Literature”) to other works addressing those relevant cases.

To be precise, the papers’ only references to historical evidence consists of tangential ones, in the JMCB paper, to studies of antebellum U.S. experience. Yet even the evidence to which these few studies point isn’t generally consistent with Sanches and Monnet’s theory. Instead of illustrating the instability of private money, or of the tendency of the value of private notes to collapse, the Suffolk System, which is referred to by one of the cited papers (albeit one that merely comments on another theoretical work), was famous for keeping the notes of all New England banks circulating at par, that is, at their full specie values, throughout the region. The Suffolk did this, moreover, for more than three decades. During that time only one temporary system-wide suspension of New England bank notes took place, following the Panic of 1837; and even then New England notes continued to be received at par at the Suffolk Bank. (During the 1857 panic, the banks of Maine alone suspended payments temporarily.) In short, banking historian and former Comptroller of the Currency John Jay Knox appears to have been fully justified in regarding the Suffolk episode as proof “that private enterprise could be entrusted with the work of redeeming the circulating notes of the banks, and it could thus be done as safely and much more economically than the same service can be performed by the Government.” To say that this conclusion appears inconsistent with one of the main implications of Sanches and Monnet’s models is putting things mildly.

As for antebellum “free banking” episodes, to which the other cited works refer, although it’s true that large numbers of banks failed in several (but by no means all) U.S. “free banking” systems, these failures were mainly due, not to the public’s sudden loss of confidence in their notes, or to the bankers’ decision to voluntarily close-up shop because their business no longer seemed profitable enough, but to the depreciation of securities they were compelled by law to purchase as a condition for issuing notes. And, although some fly-by-night or “wildcat” banking also took place, here, too, the trouble was usually traceable to ill-designed bond-deposit requirements that allowed banks to operate with little if any capital, while simultaneously assuring people that those banks’ notes were entirely secure and backed by the state. Because Michigan’s first, disastrous free banking experiment occurred during the post-1837 suspension of specie payments, the problem of wildcatting was compounded by the fact that Michigan’s free bankers could, as Hugh Rockoff notes in one of the cited papers, “issue bank notes with practically no cost to themselves and unchecked by the need to redeem the notes in specie.”

Though it was exceptional, the Michigan episode is nevertheless significant, for if the inferences that Sanches and Monnet draw from their private money model can be said to fit any actual private money episode, Michigan’s first “free banking” episode is it. And no wonder, because on close inspection, the “banks” and “banknotes” in the Sanches and Monnet models, and in Sanches’ RED model especially, involve features of that unique episode that were absent from other past private money systems.

Although Sanches and Monnet refer to the “private money” in their models as “bank notes” and “privately issued liabilities,” and also to bankers’ willingness (or lack thereof) to “keep their promises” by “redeeming” their notes, such language masks the fact that the “bank notes” in their models differ from most of their historical counterparts in not being fixed-value claims to any definite quantity of real goods, let alone instantly redeemable ones. This is particularly evident in the RED paper, which states that “A banker who issues a note at date t is expected to retire it at date t + 1 at the current market value” (my emphasis), and that the note in question “is equivalent to a debt instrument with a market-determined real return of Φ_t+1/Φ_t,” where Φ_t+1/Φ_t is the ratio of the note’s redemption value to its initial value. The same paper then goes on to observe that, although “it is possible to construct an equilibrium with the property that the value of privately issued notes is stable over time…it is also possible to construct other equilibrium in which the exchange value of notes is not constant over time.” Specifically, an equilibrium path exists along which notes’ purchasing power declines monotonically. Because a bank’s franchise value depends on the purchasing power of its notes, this equilibrium path must eventually result in notes ceasing to be convertible. The only sustainable equilibrium is therefore the stationary one. It is, nevertheless, not the case that that the notes in question have a contractually-fixed redemption value. The model is therefore, strictly speaking, not a model of “redeemable” bank notes in the generally-understood sense of the term, but of something much more like irredeemable private fiat money: like the notes in the RED model, actual fiat monies may be “redeemable” in the sense that they have some positive but variable exchange value, but they are certainly not redeemable according to the conventionally-understood meaning of that term.*

The finding that a system of private fiat money may not succeed in winning the public’s confidence, let alone in achieving an “optimum” quantity of money, is neither surprising nor new. A substantial literature now exists on the topic, dating back to Benjamin Klein’s pioneering work. (Chapter 12 of Larry White’s Theory of Monetary Institutions supplies an excellent review.) And though some contributions to that literature suggest that a competitive fiat money system can work under special conditions, the general consensus — and one to which we free banking theorists have long subscribed — is that such a system is unlikely to command any confidence. Indeed, Larry and I have argued that it is precisely for that reason that private banking systems of the past have had to rely, occasional suspensions aside, on “goods-back guarantees,” meaning offers to convert paper money into fixed amounts of real goods, to make private notes acceptable.

Nor do the terms “reneging” and “defaulting” mean the same thing in the Sanches-Monnet models as they do in real-world banking systems. Bankers in these models renege, not because they are unable to meet their obligations, but because, judging it no longer worthwhile to go on being bankers, they decide to quit the banking business. A sort of “liquidation” does occur, but it is one in which the bankers themselves consume the goods they acquired in exchange for their notes. The result is much as if the bankers absconded, wildcat style, taking any assets they’d acquired with them. Noteholders, in any event, have no recourse to retiring bankers’ assets, for if they did their notes would not become worthless. The notes, in other words, do not even qualify as meaningful (in the sense of enforceable) claims to some positive but variable quantity of real goods. Banking crises happen, in the Sanches-Monnet model economies, not because note holders believe that their banks are in danger of becoming insolvent, but because they believe them to be in danger of becoming insufficiently profitable. Insolvency doesn’t enter into it because, strictly speaking (and unless I’m missing something), it isn’t possible for a Sanches-Monnet bank to become insolvent.

This last observation brings me to a second feature of most real-world private financial firms, though not of Michigan’s wildcats, that is conspicuously absent from Sanches and Monnet’s models, namely, bank capital. When a Sanches-Monnet banker, finding that the franchise value of his business has fallen below a critical level, “makes a decision to renege on his promises as the dissolution of his note-issuing business,” he sacrifices nothing apart from that franchise value itself, having no other “skin in the game”: no initial investment, and certainly no double or unlimited liability, to which bank owners were subject in many historical private currency arrangements. (See also here.)

Think about this. A “banker” offers you a note, which he promises to “redeem,” not whenever you like, but at a future date, and not in a definite quantity of goods, but (in the RED model) in some uncertain amount. If the banker chooses to renege, that is, to offer nothing at all for the goods, he loses nothing save whatever profit he might have earned by staying in business. The banker promises to invest the proceeds obtained in exchange for the note, but you have no idea how. The bank has no capital, so that any adverse change to the value of its assets must affect the value of its liabilities by a like amount. Finally, no court will find the banker obliged to pay you, or other note-holders; and no other government agency even pretends to protect you from any loss you might incur should your bank close-up shop.

Will you trade valuable goods for such a note? Neither would I. Nor, I suppose, would any sane person. (In Michigan in 1837 people did accept similar notes because state government authorities assured them that the notes were fully secured by good collateral, and also because there were no other notes to be had.) That the sort of “private money” we’re talking about won’t fly seems, in fine, self-evident, once its basic features are set forth in plain language. To go to the length of developing a fully-articulated model economy for the sake of reaching the same conclusion hardly seems necessary.

It’s a shame that Sanches and Monnet didn’t make more than a cursory effort to familiarize themselves with the actual nature and performance of past private currency arrangements, for had they done so they presumably would have constructed a very different sort of model, and reached very different (and perhaps more interesting) conclusions. Instead of confining themselves to a few desultory references to banking in antebellum U.S., they might have read some portion of the heaps of books and articles concerning those historical banking systems that came closer than any U.S. episode did to representing genuine monetary “laissez faire.” They might, for starters, have familiarized themselves with the famously stable pre-1844 Scottish free banking episode. They might also have gotten to know the pre-1935 Canadian system, which was almost as stable. They might even have gleaned a clue or two about unregulated private currency from the less well-known, and less long-lasting, free banking episodes of Australia, Switzerland, Ireland, Colombia, France, or Chile. They would have noticed how bank capital and (in some instances) extended liability served in these arrangements to win prospective note holders’ trust. What they certainly could not have done was to write the papers they’ve written, while still imagining that by so doing they were shedding light on what typically happens when currency provision is left to the private marketplace.

So far I’ve emphasized the matter of stability, concerning which the predictions of the Sanches and Monnet models are most glaringly at odds with experience. While free banking systems were often stable, it doesn’t follow that they supplied “optimum” quantities of money in Milton Friedman’s sense. To the extent that they didn’t, their performance agrees with one of the main conclusions Sanches and Monnet draw from their models. But if free banking systems did not fully meet Friedman’s ideal, it’s unlikely that they veered very far from it, or that any regulated system could do better.

One obvious respect in which historical private money systems departed from Friedman’s ideal was in not paying explicit (that is, nominal) interest on circulating banknotes. In The Theory of Free Banking, I acknowledged that, although competition will tend to drive free banks “to pay competitive rates of interest on…deposits,” bank notes might still be held in sub-optimal quantities owing to the difficulty of paying interest on circulating notes. But I also noted that the consequence, instead of consisting of sub-optimal quantity of money, might well consist of a cross-subsidy of deposits such as would enhance the demand for them enough to compensate for the sub-optimal demand for currency. What’s more, even the relatively minor inefficiency implicit in such a cross subsidy would be limited to the extent that private currency suppliers engaged in non-price competition.

But to regard the absence of an explicit interest return on circulating private bank notes as “sub-optimal” is to suppose that some alternative arrangement could do better. And for that supposition there is, I believe, no sound basis. The circulating notes of government monetary authorities have also tended to be non-interest bearing, and remain so to this very day, despite many authorities’ wish that this weren’t necessarily the case. The explanation lies in the practical impossibility of keeping tabs on banknotes’ owners when the notes change hands frequently and anonymously, as they must do if they are to be convenient exchange media in transactions for which non-circulating forms of money will not serve. Because government monetary authorities must reckon with the same transactions costs as of paying interest on circulating notes as their private counterparts, they cannot come closer to Friedman’s ideal by that means. Moreover, because competitive pressures do not prevent them from earning monopoly profits, they are likely to stray even further from that ideal, even taking the rate of inflation, and hence the real return on non-interest-bearing notes, as given.

And what about the interventions that Sanches and Monnet recommend? Might they at least help to nudge things closer to Friedman’s ideal? I wouldn’t count on it. Their proposal, you may recall, is to have the government tax currency users and use the proceeds to subsidize banks enough to keep their franchise values from falling below some critical level. But Sanches and Monnet also assume — and the assumption is absolutely critical to their model — that “agents” apart from bankers themselves “do not observe the amount of collateral (if any) an individual banker holds in reserve to secure his circulating liabilities.” Alternatively, “agents” do not know the value of their banks’ assets. A bank’s franchise value is, however, strictly a function of the quantity of assets it has on hand. Consequently, in order to implement the policy in question, the government must have access to information unobtainable by anyone else. If this vaguely reminds you of the flaw in Diamond and Dybvig’s argument for deposit insurance, give yourself a gold star. And give yourself another if you are wondering, as I am, how the government would manage the subsidies in question in a world in which some bankers are just-plain incompetent.

And that, you may rest assured, is a world that doesn’t just exist on paper.

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*Although Sanches recognizes that the indeterminacy of the equilibrium value of “bank notes” in his model resembles that of fiat money in other writings, he does not seem to appreciate how the similarity arises owing in large part to the fact that nothing in his model obliges his bankers contractually to redeem their notes at a definite rate.

The JMCB paper differs from the RED paper in that bankers there offer to redeem notes issued in sub-period 1 for a predetermined amount of a good in sub-period 2; still, the notes’ purchasing power when first issued can differ from their eventual redemption value. The “notes” in question are therefore neither fiat money in the usual sense of the term nor ordinary banknotes but zero-coupon bearer bonds that mature after a set period, rather like Continental dollars, according to Farley Grubb’s understanding of the latter. In referring to the notes in their model as “debt instruments…redeemable on demand,” Sanches and Monnet appear to overlook the distinction between “after one sub-period” and “on demand.”

[Cross-posted from Alt‑M.org]