My pet project in life is to get more people to understand the workings — and brilliancy — of banks. “Financial intermediation,” as jargon-y and unappealing as that sounds, is an amazing thing. Banks do many things at once, and almost all consumers and firms in a modern developed economy have access to — and benefit from — their services. Legal institutions and regulations impact the way banks operate and banking systems develop. We might say that regulation “shapes” the path of banking and accounts for the vastly different outcomes we observe both today and historically. For the last session of the Harwood Graduate Colloquium on monetary institutions, we focus on banking systems and the regulation of banks.
What do banks do?
Across almost any institutional setting, banks bundle several distinct services. First, they facilitate payments — both by keeping funds safe and by providing a wide variety of payment options such as debit cards or payment apps. In historical free banking, for instance, private banks issued their own distinct notes (redeemable liabilities for the bank) that circulated widely in the community and allowed consumers to make payments with each other using the banks’ liabilities. In this sense, banks were “in the business of reducing transaction costs.”
Second, banks channel funds between savers and borrowers by connecting those parties to each other more efficiently than they could have done on their own. There is some historical dispute here regarding how efficient banks may have been, as most lending in 18th- and 19th-century France seems to have taken place through notaries, matched and administered through peer-to-peer (a mechanism that might be coming back through cryptocurrencies as well as P2P marketplaces).
They also facilitate the processing and monitoring of outstanding loans, since a specialized loan officer at a bank can more effectively and efficiently monitor the performance than decentralized individuals can. In the process, banks also create “risk smoothing” features since they assume the investment risk and return from lending while offering consumers a set interest rate on their deposits — regardless of how the investment turns out.
Third, an added benefit that bank lending has over decentralized peer-to-peer lending or broader financial-market funding is the non-public information about a borrower that a bank obtains by virtue of seeing transactions going through your account. Banks have “inside information” about you as a client and your financial status. This makes banks ideally situated to fulfill customers’ financial needs and process and supply financial services.
While chapter 3 in Lawrence White’s book The Theory of Monetary Institutions focuses on the theory of note-issuing banks, it also gets to the core of monetary competition. In particular, it illustrates the adverse-clearing mechanism so crucial for a free banking system and how it works to check and limit aggressive bank expansion — a topic of relevance even today. The presence of note-issuing free banks, in theory and history, allows for a flexible money supply and effortless shifts between bank deposits and currency (“liability transformation”).
In contrast to White’s chapter is George Selgin’s paper on the American experience of suppressing state bank notes by levying a 10 percent tax on them. It illustrates the impact that regulation may have on banking as well as many core issues that are crucial to monetary theory and monetary competition, including Gresham’s law, network effects, and asymmetric information. Additionally, there’s a brief comparison between American and Canadian banking history that well captures the value of studying different banking systems to figure out how regulations impact banks’ behavior.
The two last papers (Josh Hendrickson’s “Contingent Liability” article and Todd Keister’s chapter on liquidity and monetary policy) are much more recent and deal with questions of bank liability, bank reserves, Basel III regulations, and their connection to monetary policy. Together, they ask a lot of questions about banking regulation and bring most readers up to speed on current in-depth debates in central banking (“macroprudential regulation,” in jargon).
Hendrickson’s overview article in Cato Journal dives into the workings of contingent liability, the default legal structure for most banks in most countries up until the 20th century (partners in Goldman Sachs, for instance, were unlimitedly liable for the firm’s debts until the 1980s, and shareholders of American Express had unlimited liability until 1965).
Since the financial crisis over a decade ago, governments and central banks around the world have attempted to implement a plethora of regulations aimed at making banks safer. Extended shareholder liability, as it operated in centuries past, would seem like an easier and superior way of achieving safer banks by aligning the incentives of shareholders with depositors — essentially a way of disciplining bank management to get them to behave prudently.
Keister’s chapter explores the so-called liquidity coverage ratio (LCR) — a Basel regulation that has come into place in recent years — and how it might change the way banks structure their short-term liquidity. In a typical instance of “fighting the last war,” regulators have attempted to solve the problem of evaporating liquidity in short-term funding markets that banks faced in the lead-up to the financial crisis. LCRs now force banks to hold more liquid assets and reduce their reliance on short-term funding. Keister shows how the demand for such liquid assets has thereby changed, which has impacted interest rates — and, Keister argues, might obstruct how well central banks can perform monetary policy going forward.
In sum, the virtue of using monetary and financial history in informing our views about the present lies in its ability to greatly widen the range of regimes that we are familiar with. The past, as L.P. Hartley famously said, is a foreign country, and doing things differently under diverse circumstances and institutions provides us with options for how we could structure our financial and monetary arrangements today.
Modern banking is a wonderful technology. Understanding how regulation shapes it and contributes to the outcomes we observe is of great importance.
Joakim Book
Joakim Book is a writer, researcher and editor on all things money, finance and financial history. He holds a masters degree from the University of Oxford and has been a visiting scholar at the American Institute for Economic Research in 2018 and 2019. His writings have been featured on RealClearMarkets, ZeroHedge, FT Alphaville, WallStreetWindow and Capitalism Magazine, and he is a frequent writer at Notes On Liberty. His works can be found at www.joakimbook.com and on the blog Life of an Econ Student;
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The Dark History of Swedish Socialism (Video)
Everyone knows that socialism is newly fashionable as an idea and system. With that has come a certain level of whitewashing of the real history. I’m not just speaking of the totalitarian variety with its poverty, inflation, starvation, and mass death. It’s especially true of the kinder, gentler versions, which turn out to be not so kind or gentle.
I hope you enjoy and learn from this video I made based on Phil Magness’s revealing article “Even Swedish Socialism Was Violent.”
Taleed Brown
Taleed Brown, Media Production Specialist at AIER, is a creative professional with experience in digital marketing and content creation. He is Co-founder of Atlanta based startup Bespoke Black Media and has a YouTube channel with more than 5 million collective views. He’s been featured on The Rubin Report, FEE.org, and has spoken at the Anarchapulco conference.
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The Wonderful Surprises of Comparative Advantage
Human society is permeated with comparative advantage. When each person specializes in performing that task, or small set of tasks, for which he or she has a comparative advantage — and then exchanges the fruits of this labor for goods and services produced by others — everyone who participates in this system of specialization and exchange is enriched. Even those individuals whose economic fortunes dip with a change in the pattern of consumer spending remain vastly wealthier than they would be were they not part of this catallaxy of specialized production and trade.
No adequate understanding of the economy is possible without an understanding of comparative advantage. Fortunately, to obtain this understanding isn’t very difficult. And this understanding is filled with interesting surprises.
Surprise #1
In my previous column I explained surprise number one: your technical superiority over Jones at producing some good or service does not imply that you are economically more efficient than Jones at producing that good or service. Your comparative advantage might well be in the production of some other output.
For example, you might be able to build backyard decks faster than Jones can. But if you’re an even better physician than is Jones, your comparative advantage will be in working at supplying medical care rather than in building decks. You will gain by specializing in supplying medical care and buying deck-building services from Jones.
Surprise #2
Here’s surprise number two: if you further improve your skills at doing the task for which you have a comparative advantage, you thereby make yourself an economically even worse performer of other tasks.
Using an example from my earlier column, your cost of building a deck with your own hands is $6,000 higher than is Jones’s cost of building the deck for you, despite the fact that you could build the deck in a mere one month while the time required for Jones to build it is two months. The reason is straightforward. Because you earn $240,000 annually by working as a physician, the amount of income you would forgo by taking one month off from your job to build the deck is $20,000. Jones, in contrast, earns an annual salary of only $84,000 — meaning that, while he must take two months off of work to build your deck, the total amount of income that he sacrifices by doing so is only $14,000.
It pays you to hire Jones, at any price less than $20,000, to build your deck.
But suppose that your skills as a physician improve so much that your annual income rises from $240,000 to $252,000. Were you now to take off from your job the one month necessary for you to build the deck, you would forgo income of $21,000 — a sum $1,000 more than you would forgo if your income remained at $240,000. The cost to you of building your deck personally has risen by $1,000. Your improved skills as a physician make it even more inefficient — more costly — for you to build the deck yourself.
Even though your technical skills as a carpenter haven’t at all changed, by becoming a better physician, you thereby become — economically — a worse deck builder!
Surprise #3
Grasping this interesting fact reveals yet a third, and perhaps even more startling, surprise: Your becoming a better physician makes Jones, compared to you, economically an even better deck builder even if his carpentry skills do not improve. Before you became a better physician, Jones’s cost of building a deck was lower than your cost of doing so by $6,000. But once you become a better physician, Jones’s cost of building the deck — while still $14,000 — is lower than your cost of doing so by $7,000.
Put differently, your increased comparative advantage at supplying medical care increased Jones’s comparative advantage at building decks. Jones potentially benefits from you becoming a better doctor!
Why only “potentially”? By becoming a better physician you do not automatically increase the amount you pay to Jones to build your deck. In my earlier example — when your annual pay as a physician was $240,000 — you paid Jones $17,000 to build the deck. If with an income of $252,000 you still pay Jones $17,000, he doesn’t gain from your having become a better doctor.
But if your and other homeowners’ demands for Jones’s deck-building services are sufficiently intense, you will offer to pay him an amount close to what it would cost you to build the deck yourself. Before your annual income as a physician rose from $240,000 to $252,000, you would have paid Jones to build your deck an amount up to, but not more than, $20,000. But now that you’re earning $252,000 each year, you’re willing to pay Jones up to $21,000, for this amount would be your cost of building the deck yourself.
Your becoming a better physician raises not only your income, but potentially raises also the incomes of your trading partners. This consequence of comparative advantage helps to explain why in wealthy countries, it’s not only skilled workers, such as engineers and lawyers, but also low-skilled workers, such as janitors and hotel maids, who earn higher real incomes than do their counterparts in poor countries.
Thus, it’s in each of our interests to applaud the improved skills and productivity of the vast majority of our fellow human beings even when our own skills and productivity remain unchanged. To understand comparative advantage is to understand why we should celebrate rather than fear the economic growth of other countries.
Donald J. Boudreaux
Donald J. Boudreaux is a senior fellow with American Institute for Economic Research and with the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University; a Mercatus Center Board Member; and a professor of economics and former economics-department chair at George Mason University. He is the author of the books The Essential Hayek, Globalization, Hypocrites and Half-Wits, and his articles appear in such publications as the Wall Street Journal, New York Times, US News & World Report as well as numerous scholarly journals. He writes a blog called Cafe Hayek and a regular column on economics for the Pittsburgh Tribune-Review. Boudreaux earned a PhD in economics from Auburn University and a law degree from the University of Virginia.
