Would a System of Free Banking Automatically Reflect the Natural Rate of Interest and the Market Reserve Ratio?

I notice a tendency for economists that are friendly to free markets to overstate the case for free markets. There is a difference between saying that markets work well and saying that markets work perfectly or even near perfectly. The first claim allows for system wide errors in coordination while the second bears a resemblance to the strong form of the efficient markets hypothesis and real business cycle theory.

Lawrence White and George Selgin promote free banking in this manner. Banks under this system are said to be constrained by competition and the threat of losses in reserves that result from an over-issue of currency. No systemic over-issue can occur as disequilibrium is not allowed by the model. In “How Would the Invisible Hand Handle Money?” they write,

The standard inventory-theoretic model of reserve demand indicates, however, that a bank’s prudential or precautionary demand for reserves depends on the anticipated variance and not just the mean or expected value of the bank’s reserve losses. Although perfect in-concert expansion does not affect any bank’s mean clearing losses, it does increase the variance of each bank’s clearing losses, and does therefore increase each bank’s precautionary demand for reserves. The reserve ratio remains well anchored. [emphasis mine] (1724)

The model presented by Selgin and White is a long run model that employs representative banks that optimizes reserve levels according to the cost of issuing currency and the revenue earned from the issue. This sort of analysis overlooks short-run deviations that occur in a world of heterogeneous, competing firms and imperfect information. In their model, competition leads banks to adjust their reserves according to the market chosen reserve level, but this process takes time. It is unclear whether or not information asymmetries will temporarily prevent anchoring of the reserve ratio.

White states his thesis explicitly in terms of the boom and bust in an article for Cato,

The boom-bust scenario could not have happened under a commodity standard with free banking. Under that regime any incipient housing boom would have been automatically and promptly dampened, before a severe bust became inevitable.

White notes on the previous page that the recent boom and bust was caused not only by monetary expansion by the Federal Reserve.

A disproportionate share of that credit flowed into housing, channeled there by federal subsidies and mandates for widening home ownership by relaxing mortgage creditworthiness standards. The dollar volume of real estate lending grew by 10–15 percent per year for several years—an unsustainable path.

Until the crisis, these mortgages were very liquid, thanks in large part to the willingness of the government sponsored enterprises known as Fanny Mae and Freddie Mac to purchase them. For a time, this, in combination with high ratings that the securities received from Moody’s and S&P, promoted and maintained elevated prices in the housing market. But scarcity of liquidity ended the bull market in securities. The drop in prices that followed would have brought down Fannie and Freddie for good if not for the U.S. Treasury placing the two GSE’s into conservatorship.

But could this have occurred under a free banking system? Again, White does not think so.

… a commodity standard with free banking minimizes monetary shocks. Its strong self-regulating properties stop the banking system from overfinancing an investment surge, the way the Fed did for the housing market, to the point where it becomes an unsustainable boom full of the malinvestments that make a severe bust unavoidable.

This assumes that the Federal Reserve was the prime driver of over investment. It is likely that overinvestment in the housing sector would have occurred even under a free banking system, though in this case it is still due to an intervention. The incentives provided by the GSEs were powerful enough on their own to funnel investment into the housing sector even under a system of free banking. The Federal Reserve probably augmented the bubble, but I am not convinced that the existence of the Federal Reserve was a necessary condition for a “severe bust” nor am I convinced that the market rate of interest does not overshoot the natural rate as banks expand credit during booms and contract credit during busts. Banks must take risks in order to compete. Those banks that invest in too many failing projects will themselves fail. Ex ante it is unclear which banks these will be just as it is unclear what is the market level of reserves or what is the natural rate of interest. Only ex post can we conjecture what value or range of values may have fulfilled these standards.

Expect development of these thoughts coming weeks and the some consideration of the possibility bubbles driven by credit expansion in a free market.