Thursday, August 27, 2015

Austrian Cycle Theory: More Than a Theory of Inflation Driven Boom and Bust

Yesterday, David Henderson asked me "can you look at the stock price drops of the last week and say with much confidence that they are strongly confirming of ABCT?" I responded that we cannot know for certain. The more I thought about it, the more I thought that this is not the right question to be asking.

Austrian business cycle theory is an extension of price theory. As long as expectations are convergent, we can expect prices to tend toward an array that reflect underlying scarcities and demands. If expectations are not convergent, then we can expect increased volatility. As humans, we gain much of our knowledge by observation of others. This leads to a tendency for expectations to be subject to herding (Koppl and Yeager 1996). The more uncertain the future, the more likely expectations will be disparate. For at least as long as disagreeing agents remain solvent, this volatility will persist. Discoordination persists as relative prices fail to reflect  underlying economic reality. 

We can be certain that the mechanics of Austrian cycle theory are always in operation. 

The effect of discoordination of relative prices is always in force. Entrepreneurs and firms in the market are often able to withstand the volatility. This does not change that these agents are interacting with distorted prices. Movements in relative prices always affect the production structure. Sometimes price distortions do not greatly impact system stability. Sometimes they generate numerous insolvencies. In the current crisis, Austrian cycle theory seems to hold in China as myriad distortions have left the market in disarray. 

Confusion arises from the Austrian emphasis on inflation and inflation's relationship to the natural rate. Murphy argues that "the Federal Reserve was setting us up for another crash." How was it setting us up for another crash? Murphy points to the Fed's increased balance sheet as evidence that it has set the economy on course for a slump. He provides the traditional argument that the interest rate has been pushed below the natural rate.
However, what happens if interest rates fall not because of a genuine increase in saving by the public, but rather because central banks flood the financial sector with newly created money? According to the Austrians, this typical remedy merely sets off an unsustainable boom. Entrepreneurs still get the green light to start longer term investment projects, but the economy lacks the real savings necessary to bring them to fruition.
This version of the story is not as powerful as most Austrians think. Firms can substitute toward cheaper inputs as prices rise. Consumers can substitute away from goods that have become to expensive. Projects can be completed, but they may be completed at a loss. If losses accumulate, credit markets may seize for as long as their is a perception of high risk and/or a rate of expected deflation. The structure of production may lengthen, but discoordination occurs on more than one dimension. The story presented by Murphy is incomplete.

The core of Austrian cycle theory is not overconsumption or overproduction. Garrison's presentation with its use of the Hayekian triangle and emphasis on interest rates, demonstrate this version of Austrian cycle theory (edit 926 EST). The theory is more general than this. All relative price distortions lead to overproduction of some goods and under production of others. Inflation tends to make overproduction more common, as reflected by Garrison's movement off of the production possibilities frontier. Central bank policy contributes to this, especially when changes in the money stock are substantial and central bank action is unpredictable. 

This logic applies to more than central banks. All state intervention into the economy tends to be distortionary. The greater the magnitude of the intervention. the less sensitive is the structure of production to the actual needs of consumers. Unlike private agents, the state is not especially responsive to profit and loss as its funds derive from a different revenue stream: taxes. When relative prices are perpetually distorted by interventions and policy uncertainty, profit and loss becomes less effective in promoting expectations that reflect the underlying economic reality.

Thinking about prices and coordination:
Hayek - Socialist Calculation I, II, and III 
Hayek - Economics and Knowledge 
Hayek - The Use of Knowledge in Society 
Mises - Economic Calculation in the Socialist Commonwealth

 

Wednesday, August 26, 2015

Re: David Henderson: A Defense of Austrian Business Cycle Theory

At EconLog David Henderson is asking:
Question for Bob Murphy and other proponents of the Austrian Business Cycle Theory: is there any evidence conceivable that, if you believed it, would convince you that your theory is wrong?
This was in response to Robert Murphy who David quotes:
As shocking as these developments [drops in stock prices and increased volatility] may be to some analysts, those versed in the writings of economist Ludwig von Mises have been warning for years that the Federal Reserve was setting us up for another crash.
The logic that is implied by Murphy's statement, that Austrians have been warning about this for years, does not imply that they are right about the current problem. Saying "we were right" does not make it so. Murphy's story has not inspired David's confidence. Perhaps I can inspire some confidence.

The core of Austrian Business Cycle Theory proposes that changes in the money stock, whether due to gold discoveries (when that mattered) or credit expansion, alter relative prices. This leads to overproduction in some sectors and under production in others. As long as these distortions remain small, the economy will probably not be greatly destabilized. If the array of relative prices, which reflects consumer demands and existing and expected supplies, are continually pushed away from an array that actually reflects these factors, instability grows more likely and business fluctuations may increase in size or number.

Expectations may help offset the distortion; they may not. We are accustomed to thinking of expectations in macroeconomics as expectations about the price level. As long as velocity remains relatively stable, agents may form expectations that often approximate future changes in the price level. This is not the object of significance in the Austrian story. It may have features that coincide with price level movements. The argument stresses that movements in and the formation of expectations about a price level are not the prime cause of fluctuations, although high levels of expected deflation can be responsible for dysfunctional credit markets, as they were during the Great Depression. Typical monetarist analysis, despite all of its success and usefulness (i.e., the cash balance interpretation of depression) does not account for the story concerning relative prices.

We can expect that, in the short run, relative prices will be distorted and that this distortion increases as the size of the injection increases. We cannot expect a full and immediate adjustment of prices as knowledge exists only in dispersed bits. Those bits of knowledge are born from varying interpretations that have contributed to and been formed in part by the agent's interpretive (cognitive) structure. Distortion derived from interpretation increases as agents face greater uncertainty (edit 1826 EST) (Koppl 2002). We've been living in an atmosphere of elevated uncertainty for a decade.

Tuesday, August 25, 2015

Realist Theory and Complex Methods: The Path Toward Integration

In its purest form, economic theory describes its domain of study as it actually exists. Reality is not comprised of homogeneous agents who choose quantities of goods according to the mariginal unit of utility gained per dollar spent. If only life were so simple! In the real world, agents have no option but to make choices that confront scarcity of time and resources. These choices are often aided by some standard or algorithm. In some cases, choices appear to be random. Despite this, order in society is apparent enough to suggest to the observer with even a slight inclination toward introspection that the persons around her act with ends in mind; that there must be some process by which society organizes itself toward the ends of its agents.

James Buchanan identifies much of this order in the form of rules that govern human action and interaction. Douglas North took this a step further, arguing that the rules and order that appear in society first arise in a mind or minds. The rules of the mind come to impact the rules of the game and their structure. This may happen simply through duplication of the rule governed action by others, or may rely on a complex, iterative processes of instantiation. Herbert Simon showed us that humans are ecologically rational, using the information present in their surroundings to guide their actions. This is a process of necessity for humans to function in a world that is best described as an open system and where one's own computational power is limited both by physical and structural constraints of the mind. Hayek (1952; 1960; 2014) delved further into the nature of rules, perception, interpretation, and action, providing a general language that made many readers confuse his economics for something approaching philosophy.

The wisdom of those great economists who have come before us serves as foundation for a new framing of economics. This starts with a reconstruction of the agent along the lines suggested by the economists above mentioned, as well as researchers in the adjacent disciplines which include philosophy, sociology, cognitive science, computational and computer science. Carl Menger dreamed of building a robust economic system that integrated essential innovation in formal knowledge of mind, human action that flows from the mind, and the society that arises as a result of human action. In some ways, Mises (1949) fulfilled this dream in human action. However, unaddressed problems concerning epistemology made his contribution fodder for those who do not appreciate the implications of his argument. Hayek corrected much of this with his work from the Abuse of Reason project. It is no coincidence that he is highly cited by those who study the emergence of institutions.

Many recognize that Hayek's work in this domain is valuable, but I have yet to see a substantial integration of his ideas with the core of economic theory. Many researchers in institutional economics have picked up the torch that he passed. Elinor Ostrom credits Hayek (1937, 1945) for her understanding of the emergence of social institutions that help to govern the commons. A similar appreciation is true for North and Denzau, as well as more recent work from Boettke, Coyne, and Leeson. The latter of these note that Hayek "was among the first to emphasize these aspects of spontaneously emergent institutions (333)." Koppl (2002) advises us to consider the internal state of the economic agent with reference to his perception of the external world. He argues that agents form expectations according to types that they have constructed or borrowed from others. (When I approach a cashier, I do not necessarily expect to make a friend, but I can be nearly certain that he will facilitate my purchase.) Agents have mental maps - private ontologies - which are comprised of a mixture of anonymous and personal typifications and rules that are believed to govern the existence and interactions of objects represented by these typifications.

The work of all of these mentioned have helped move economics toward the cusp of a change that has been building throughout the last half-century. Their work is part of a line realist theories that trace their lineage back to early economists like David Hume and Adam Smith who were not afraid to recognize, and even awed at, the complexities inherent in social interaction. These contributions represent a more scientific rendition classical political economy. This is synonomous with Wagener's "entangled political economy."  Their work is integral to the resuscitation and development of a paradigm of realism to underlie the work of economists.

Not long after the Samuelsonian turn in economics, theorists on the margins of the discipline - and some like Arrow who was certainly not on the margin - began to employ a new set of tools. These tools are part of the complexity paradigm. Researchers within this practice investigate emergent processes and the objects and structures that the processes generate. Of primary concern for economic theorists are agent based models. Some popular models include Shelling's (1971) segregation model, Axelrod's (1997) conflict model, and Gode and Sunder's (1993) zero-intelligence trader model. Theoretical contributions are arising from this line of inquiry. Gode and Sunder show that the process of coordination is an outcome of simple rules governing the buying and selling of goods. Axtell (2005) demonstrates that exchange is a process of social compuation! These theorists have created a number of innovation that other economic theorists can integrate into their own practice and understanding.

Now to bring these treasures together into a cohesive framework. A robust economic theory must explicitly identify its objects of concern, relationships between objects, and processes that govern these. Emphasis on rule-based perception and coordination is critical for understanding the core of social processes. Perception is at the foundation of agent action. Agent-based modeling provides a method to which a methodologically robust rendition of economic theory can be applied. Integration of these will provide us models that not only explain and demonstrate economic theory. The same platform also allows us to produce models whose predictions take economic process into account.

Wednesday, June 3, 2015

Hayek's "Degrees of Explanation": Moving Away from the Apodictic Certainty Derived from the "Axiom" of Human Action

In "Degrees of Explanation", Hayek defends a system of analysis that approaches knowledge in a deductive manner. His proposed methodology is unique in that it is not Misesian, though it bares some similarities. Core knowledge need not be "apriori" in the sense that Mises employs the term. As Kant claimed in his Critique of Pure Reason, apriori claims must be established in empirical observation. Since they are core claims within an argument or, more generally, within a system, we must be especially confident about these claims.

Mises begins his analysis with a single fact. Humans act. Of course he does more than this. In contextualizing his analysis, Mises argues that,
Complex phenomena in the production of which various causal chains are interlaced cannot test and theory. Such phenomena, on the contrary, become intelligible only through an interpretation in terms of theories previously developed from other sources. In the case of natural phenomena the interpretation of an event must not be at variance  with the theories satisfactorily verified by experiments. (31)
This is true for the study of society as well.
Praxeology is a theoretical and systemic, not a historical, science. Its scope is human action as such, irrespective of all environmental, accidental, and individual circumstances of the concrete acts. Its cognition is purely formal and general without reference to the material content and the particular features of the actual case. It aims at knowledge valid for all instances in which the conditions exactly correspond to those implied in its assumptions and inferences. (32)
So far, we see nothing unreasonable. Research in one field should be consistent with, or at least take account of research in other fields. Mises then goes on to make more extreme statements.
Its statements  and propositions are not derived from experience. They are, like those of logical and mathematics, a priori. They are not subject to verification or falsification on the grounds of experience and facts. They are both logically and temporally antecedent to any comprehension of historical facts. (32)
A consistent reading of Mises suggests that these arguments are necessary as an analytical starting point. The trouble is that he does not frame them as such. In attempting to defend the scientific nature of social analysis, which includes economic analysis, Mises makes an argument that is stronger than the facts themselves merit. The facts that we employ are, as far as agents with finite knowledge can know, more true or less true. The facts support analysis of social order must be well-supported by prior research. The task of a good theorist is to identify those facts that are implied by the facts that one takes as given. This should lead to new areas of research that can either support or invalidate the extrapolation. This isn't what Mises is saying, though I wish it was.

Not too far later (39), Mises makes the claim that is perhaps the most problematic for his treatise:
Action and reason are congeneric and homogeneous; they may even be called two different aspects of the same thing. That reason has the power to make clear through pure ratiocination the essential features of action is a consequence of the fact that action is an offshoot of reason. The theorems attained by correct praxeological reasoning are not only perfectly certain and incontestable, like the correct mathematical theorems. They refer, moreover, with the full rigidity of their apodictic certainty and incontestability to the reality of action [emphasis mine] as it appears in life and history. Praxeology conveys exact and precise knowledge of real things.
Two problems arise here.

1) Mises does not explicitly direct interpretation away from social atomism. Perhaps all action is the result of reason, but we must ask, "Whose reason?" Must action and reason be coterminous? Can the reason of one man or many lead to action in someone not directly connected to them? What is the range of action, local or non-local, that results from reason exercised at some time t. The reason of humankind echoes throughout society in its institutions. These are established through a combination of reason and blind groping, through the process of trial and error. Without the use of reason, an agent might take action in the same way that wolves learn the social norms of a wolf pack. Perhaps this fits Mises's definition of reason as applied with a means/ends framework, but I doubt that Mises would apply it in this manner as he argues that "animals are unconditionally driven by the impulse to rpeserve their own lives and by the impulse of proliferation (19)." The relationship between reason and action is more complex than Mises admits here; I suspect that this is the result of Mises's ideological emphasis and the collectives zeitgeist that was in the air of academic conversation at the time.

2) Mises claims that "the theorems attained by correct praxeological reasoning" are "perfectly certain and incontestible." Mises is playing a logical trick here. His statement is true to the extent that conclusion arise from "correct praxological reasoning". But in what situation can I confirm that I have engaged in "correct" analysis? Every theory must always have a disclaimer attached to it that says, "we consider fact A implied by our theory true as long as facts B, C, D, etc... hold as true." We don't live in a world with perfect knowledge, but if we did, we would be apodictically certain. Just as this statement about apodictic certainty is a tautology - useful as it may be - so is Mises claim, but he does not explicitly identify it as a tautology. And his defense of economics that follows is a defense contingent on the truth of the facts upon which praxeology relies. A more honest approach admits that we cannot know that the claims of economists are true with apodictic certainty, even if they apply the system that Mises uses. The best that one can say is that he or she employs a system that makes full use of available, time-tested knowledge (even this claim may be too much due to the asymmetries of interpretation).

In "Degrees of Explanation", Hayek engages a softer claim.
It is, no doubt, desirable that in working out such deductive systems the conclusions should be tested against the facts at every step. We can never exclude the possibility that even the best accredit law may cease to hold under conditions for which it has not yet been tested. But while this possibility always exists, its likelihood in the case of well-confirmed hypothesis is so small that we often disregard it in practice. The conclusions which we can draw from a combination of well-established hypotheses will therefore by valuable though we may not be in a position to test them.
Later in the same paper, he claims,
We shall here have to proceed in our deductions, not from the hypothetical or unknown to the known and observable, but - as used to be thought to be the normal procedure - from the familiar to the unknown.
There is no need to claim that we have apodictic certainty of any kind. Our analysis is a certain as the facts that represent the core claims that support the analysis. In this sense, theory represents facts and arrangements of facts that we are most certain about, assuming that deductions were correctly carried out.

In this spirit, Hayek writes in "Economics and Knowledge",
My criticism of the recent tendencies to make economic theory more and more formal is not that they have gone too far but that they have not yet been carried far enough to complete the isolation of this branch of logic and to restore to its rightful place the investigation of causal processes [emphasis mine] , using formal economic theory as a tool in the same way as mathematics.
Hayek points the way toward forming a more perfect praxeological system. If we are to take Popper seriously, we must accept that we will never have such a perfect system. Theory represents knowledge in most general and most perfect form that we can expect. It is from this light that Daniel Klein's revised iteration of Peter Boettke's claim that "The best reading of Mises is a Hayekian one and the best reading of Hayek is a Misesian one" holds (2012, 30):
I might concur with Peter Boettke that the most charitable reading of Mises is a Hayekian one. The most charitable reading of Hayek, however, is not a Misesian one (32).

Tuesday, June 2, 2015

My Review of Nigel Dodd's "Social Life of Money" is up at EH.net

Read it here.

Brief summary of review: In ideologically charged fashion, Dodd pulls together diverse perspectives concerning money role in society. The author eschews theories of money that stress price theory and Say's identity in favor or analyses that consider the social and political roles of money.

Monday, April 6, 2015

How the Credit Cycle Forms the Basis of the Business Cycle

Within the world that we have constructed, agents and objects take on discrete states.  Agents do not experience the world continuously, but rather, in chunks. For example, when an agent purchases some quantity of a good, very often that good can only be sold in whole units. For example, an agent must purchase some discrete number of computers as defined by an integer. Wholesalers must hold some quantity of goods on hand. Agents and firms must constantly adjust their output to avoid shortages or relieve surpluses of goods and services.

Sometimes economic data changes so quickly that suppliers are unable to avoid loss. Particularly troublesome is a scenario where total demand for goods collapses. This is the bust that comprises the latter part of the boom-bust cycle. After a period of relative prosperity, firms may find themselves holding excess stocks of goods that they can only discard if they lower prices. By lowering prices, the marginal revenue earned by the firm falls. In  extreme cases, the firm finds itself subject to an accounting loss. This is a signal to the firm that it has overproduced and must therefore slow production. By slowing production, the firm will also need to cut expenditures on inputs. This is equivalent to a decrease in demand for intermediate goods produced by firms higher in the supply chain. This reduction in expenditures also includes a reduction of the quantity of labor hired by the firm. 

The bust represents a cluster of errors by entrepreneurs and firms. A large proportion of market participants find that they have erred in their expectation of the future and face subsequent losses. These losses accumulate such that total demand for goods and services – i.e., aggregate demand – falls across the economy. Losses extend beyond only those agents who had taken large risks. Prices and output plummet as agents seek to acquire money to repay debts and increase the security of their positions. The process continues until agents regain confidence in the market, however, the timing of the rebound is far from certain.

What is the nature of the business cycle and why does it occur? The first of these questions can be answered succinctly:

A business cycle is a cyclical fluctuation in the aggregate economic activity of a nation, or a cyclical change in the rate of economic growth.” Business cycles involve coherent changes in output quantities and prices of consumer goods and capital goods, input costs, employment and wage rates, profits, productivity, investment, total and per capita income, the quantity of money, volume of credit and interest rates. (Wood 1997)

The business cycle represents a recurring pattern of a increases and decreases in the value of goods and services produced across all markets, The cause of the business cycle is not exactly obvious. Many economists have attempted to explain the causes of these fluctuations, but few have adequately explained a substantial number of features of the cycle. The most salient explanation of which I am aware comes from Ralph Hawtrey. Hawtrey describes the elements that comprise aggregate demand:

. . . The consumers’ outlay is the whole effective demand for everything that is produced, whether commodities or services. The trader who buys to sell again is merely an intermediary passing on a portion of this demand to one of his neighbours. The cyclical alternations in effective demand must therefore be alternations in the consumers’ outlay. (Hawtrey 1919, 52)

Consumer outlays fluctuate concurrently with production as incomes of both laborers and capital owners are dependent upon total productivity. In a world where money was super-neutral or in a world where capital could somehow trade costlessly for other capital, the business cycle would not exist as a recurring phenomena. But this is not the world that we live in. Exchange occurs indirectly. Agents sell their goods and labor for money in order purchase goods and services from other agents. This would not be a problem except that there occur periods where either the stock of money, demand for money, or both, fluctuate. Fluctuations in the money stock and income are dominated by changes in total volume of credit extended. In a world with a static monetary base, changes in the volume of credit extended are driven primarily by changes in expectation of the value of goods and services produced. An investor who purchases a bond must expect that the borrower can repay his loan and the interest it accumulates. When businesses borrow, the money soon ends up in the hands of the laboring class.

It may be pointed out that the consumers’ outlay is increased as soon as producers begin to borrow. The producers and their employees have more to spend while the orders are still uncompleted. (Hawtrey 1919, 55)

A increase in consumer income translates to an increase in aggregate demand assuming that agents spend at least a portion of this increase. In industries where the new money is spent to purchase goods that otherwise would not have been purchased, prices will tend to increase and so too will production in the short-run relative to prices given the same scenario absent credit expansion. The reverse is also true. A contraction of total credit expanded promotes a fall in incomes.

The business cycle arises when the expectations of a substantial number of investors and entrepreneurs are upset, meaning that at the time of initial investment these agents expected incomes to be higher than turned out. If enough borrowers are unable to repay their loans, bank who suffer these defaults must begin to slow their rate of credit expansion so as to allow there reserve ratios to recover. An increase in the reserve ratio is equivalent to a decrease in the broader money stock. This contraction leads to a fall in incomes which worsens the problem. With less credit available, firms must begin to rely more on savings for repayment of debt. This further contracts the money stock. Firms whose managers sense that the business outlook has turned for the near future also begin to increase their balances of cash and reduce their reliance on borrowing, both of which lead to reductions in the total stock of credit, and therefore, money. (Hawtrey 1919, 14). As agents sense that the economy is in a state of consolidation, many begin to form expectations of price deflation. Demand falls in the short-run and the fall in prices accelerates. Only after banks have increased reserve ratios to a level that pleases managers, and ultimately depositors, may banks interrupt this fall in prices by expanding credit on net. They must wait to expand credit, however, until businesses feel safe to expand production.

This story of credit expansion and contraction gives the theorist a starting point from which to build an understanding of the business cycle. Credit seems the primary driver, but what drives credit? It is expectation by financiers that will be an increase in production that drives the expansion of credit. The process of credit creation creates a natural oscillation in productivity, and therefore, oscillating expectations concerning productivity. Credit is not the only driver of expectations. Innovation brings new products and increases the efficiency of production. The expansion of production made possible by new technology certainly affects the expectations of financiers and bankers and of producers. New technology raises opportunity for economic profit and therefore serves to attract the funds of perceptive financiers. Not only must entrepreneurs sense profit opportunities, but financiers must be apt to perceive that the entrepreneur is correct. (It is worthwhile to consider how they accomplish this. Consider that as a rule of thumb, successful venture capitalists, which are one class of financiers, are sure to bet on a person, which includes that person’s network, vision, and creativity, not simply an idea.) Thus Schumpeter is to some extent correct when he claims:

We agree with him [Hawtrey], first, in recognizing that the fundamental cause, whilst in its nature independent of the machinery of money and credit, could not without it produce the particular kind of effect it does. (86)

He is incorrect in claiming:

Booms and consequently depressions are not the work of banks: their cause is a non-monetary one and entrepreneurs’ demand is the initiating cause even of so much of the cycle as can be said to be added by the act of banks. (86)

I have shown that there exists a natural fluctuation in credit driven by errors in expectations of entrepreneurs and financiers, the effects of those errors on the position and expectations of banks, and therefore, on the available stock of money and demand for a portion of that stock. The high level of expected profits that emerges from knowledge of an innovation attracts more capital into the market than would otherwise exist. As long as the expectation of economic profit exists, the innovation will increase total credit extended in the market. If expectations of creditors are on average correct, this expansion of technology is responsible for a long-run increase in the volume of production and its real value to consumers. It is possible that a sector centered around a new innovation will attract a large portion of available credit during an expansion, but this would only serve to increase the amplitude of cycles where financiers overinvested in the sector of innovation.

Aside from encouraging credit expansion, innovations that increase efficiency tend also to devalue capital whose role the innovation has displaced. What was the fate of the horse and buggy after Henry Ford began production of the model-T? Was it not appropriate that the mass production of telephones and computers contributed to the waning of the telegram? This capital lost most of its value as agents in society no longer demanded them. This devaluation of capital can hardly be blamed for a tendency toward depression for the whole economy. Neither overinvestment in new innovation or devaluation of obscelescent capital are necessary or sufficient to generate the cycle in its most essential form.


There a number of other models that describe the business cycle, some of them ad hoc. These include, in no particular order, Lucas’s Island Model, New Keynesian theories of market imperfections, Real Business Cycle Theory, and the Austrian Business Cycle. Of special note are modern monetarist theories concerning fluctuations in the money stock and money demand as they are closely related to the creit cycle. I have posted on these before, including in this short summary. For more on the Austrian Business Cycle see here and here.

Wednesday, April 1, 2015

The Emergence of the Clearinghouse

We continue our journey through the evolution of banking with the rise of the clearinghouse association. First, let’s review the evolution of economic development thus far. Imagine a world of scarcity where we have instantiated agents. These agents own property and take action according to their preferences. As agents interact, direct (barter) exchange arises. Each agent trades some good or goods that he owns for some other good or goods that he or she values more than the item or bundle given up. In each exchange, agents pays only as much for a good or goods as they are willing. Sometimes, a good desired by an agent can only be acquired by multiple exchanges. Imagine that agent A owns an apple, agent B owns an orange, and agent C owns an avocado. Agent A is willing to trade her apple for an avocado, but agent C will only trade her avocado for an orange. It just so happens that Agent B would like to trade his orange for an apple. Agent A, sensing an opportunity to attain her desired end, trades her apple for agent B’s orange. Then she trades the orange for an avocado. This is indirect exchange. Over time, some types of commodities, say oats, come into use for indirect exchange. The commodity used for indirect exchange comes to gain value for its use in indirect exchange. This value is its exchange value.

Eventually, one or several of these moneys comes to dominate markets of indirect exchange. Money has developed whose price tends to reflect its supply and demand. One interesting feature of a commodity money is that its quantity is, in the long run, dependent on its supply and demand. If money becomes dearer due to an increase in demand for it, its price will rise and thereby increase the quantity of money supplied. A fall in demand will allow the quantity supplied in a given time period to fall. Thus, the quantity of money stock is self-regulated with respect to changes in demand.

Commodity moneys are costly for agents carry. If the commodity money is not standardized, it may be difficult to measure. If it is heavy, like gold or silver, it may be costly, or even dangerous, to carry on one’s person. Owing, at least in part, to these reasons, agents find that they benefit from leaving their money entrusted to a third party at a secure location. The agent will likely receive a deposit slip in exchange which can be used as money. Thus we have the emergence of fiduciary currency. Eventually, the agent or firm entrusted with the gold realize that they might profit from lending out some portion of the existing deposits. This allows the latent media to earn a return. This return allows the agent or firm to pay interest on deposits. The cost of holding gold is no longer borne by the agent who owns the commodity. Fractional-reserve banking is born.

Any bank in operation chooses to keep on hand some commodities whose value is equal to a portion of its reserves. This is needed in the case that some depositors want to immediately withdraw their currency from the bank. If too many depositors attempt to withdraw from the bank simultaneously, the bank may risk being unable to make a repayment. Absent any institution designed to aid the bank in such a crisis, the bank will have to borrow from another bank in order to stave off hysteria. Of course, if no other bank is willing to lend to the bank, it will have to close until it can acquire the funds. This option is a last resort as it will certainly attract the attention of risk-averse depositors. Bankers realize that they have incentive to minimize the occurrence of this scenario as a wave of collapses may have repercussions for the entire economy. It so happens that a clearinghouse association is an organization in prime position to provide stability during a run. 

A clearinghouse is the location at which multiple banks may hold some of their reserves and keep their records. By holding their reserves and records at a common location, banks can clear debits and credits between one another and use the reserves on hand to pay remaining debts between one another. The clearinghouse is also a nexus for information concerning the creditworthiness of borrowers, thus serving a role in risk mitigation. The clearinghouse might also mitigate risk by producing temporary currency during a crisis. The clearinghouse has plenty of reserves on hand. During a crisis the clearinghouse, ostensibly drawing from these reserves, can lend out emergency currency. This emergency currency allows banks that consider themselves to be at risk and that the clearinghouse deems to be only illiquid - not insolvent - to build up their reserves without depleting the supply of available credit. Since credit is employed predominantly for business, a net decrease in available credit typically diminishes the level of future production, and consequently, real income. Likewise, a collapse in the credit markets leads to a collapse in production until the collapse reverses (assuming it reverses). A wave of banking failures, like the one that occurred during the Great Depression, can turn an economic recession into a depression. For the sake of self-preservation, the clearinghouse has incentive to prevent such an extreme crisis.


Given the risk of a credit crisis, the clearinghouse also takes on a proactive role in regulating the positions of its member banks. If may, at random or on the suspicion of a bank’s malhealth, withdraw a large amount of funds from a member bank in order to test its capacity to handle adverse clearings. This serves to discourage excessive risk taking by member banks and represents yet another means of promoting the stability within the system. 

Having mechanisms that promote stability does not suggest that the system is itself perfect. Every system has bugs. There will always be some banks that take on excessive risk. There will always be failures. Irresponsible banks must fail or else they corrupt the whole system. The significance of the clearinghouse system is not that it prevents any instability, but that it places bounds on that instability. Regulation and stability are themselves properties of the system as entrepreneurs earn profit by finding ways to mitigate risk.