Archives for posts with tag: Economics

For an Institute for Humane Studies program I wanted to participate in you had to write a short essay on how a famous article or book is misguided and inimical to liberty. I wrote the essay below for the occasion, and I’m pretty happy of how it turned out, so I’m sharing it here. Some readers will instantly recognize the heavy influence of chapter 6 of Lawrence H. White’s Theory of Monetary Institutions—get this book.

The seminal paper by Diamond & Dybvig (1983) on bank runs is misguided and inimical to liberty. It suggests that banks are inherently unstable, always on the verge of suffering a “redemption run” at any unrelated ‘sunspot,’ and that it is absolutely necessary that bank runs be suppressed, and that deposit insurance is the most effective way to do it. In their model, if banks ought to survive it has to be through intervention into the financial system. The basic features of this model are still present in most publications on financial stability to this day.

First, unlike the model would suggest, bank runs are generally not responsible for the initial shock. Gorton (1988) studies the National Banking Era in the US, and finds that for each of the 7 crisis he identifies, bank runs were rather the result of a previous event announcing a possible depreciation of banking assets. Likewise, Calomiris (1991) finds that over 1875–1913 all banking panics (generalized run on all banks) happened within the quarter following an abrupt increase in business failures. Mishkin (1991) studies bank panics from 1857 to 1988, and finds that for all but that of 1873, panics occur well after the recession has started.

Secondly, banks that do go bankrupt because of a bank run are those that are pre-run insolvent. Banks that are solvent can generally borrow from other banks and other institutions, historically clearinghouses, have a large repertoire of possible solutions to help banks is crisis. While bank runs and associated liquidity problems can be aggravating factors, even in the worst bank panic episodes they are causes of bank failure only in exceptional circumstances (Kaufman 1987, 1988). Even in the most fruitful historical era in terms of banking panics and runs, the American National Banking Era, runs were a primary cause of failure in only one case out of 594 bank bankruptcies (Calomiris 1991, 154). Calomiris & Mason (1997) study the banking panic of June 1932 in Chicago and find that no pre-run solvent banks failed. Reviewing this literature, Benston & Kaufman (1995, 225) conclude that “the policy implications of the Diamond & Dybvig (1983) model are not very useful for understanding the workings of the extant banking and payments system.”

A third reason is that most runs have in fact been partial “verification” runs. Depositors eventually figure out that the bank will likely survive the crisis, and runs stop. This is impossible in the Diamond & Dybvig (1983) framework; once initiated the run must always go through and make the bank fail. Ó Gráda & White (2003) study a single bank from the 1850s. They investigate depositor behavior through individual account data, and particularly through the panics of 1854 and 1857. The bank survived both. They find that runs are not sudden, but involve a learning mechanism where random beliefs are progressively dropped, while behavior motivated by legitimate signals become more important over time. Panic does not displace learning in the market processes of bank runs.

Finally, if Diamond & Dybvig (1983) is correct, it should apply to all fractional-reserve banking systems without deposit insurance. But, as evidenced by the US-centric literature cited, bank runs are much more common in U.S. history than elsewhere, and bank panics are specific to the American National Banking Era and attributable to bank regulation of that era, such as the ban on branch banking that made mergers with insolvent banks impossible, and the bond deposit system that limited emission at a critical time (Smith 1991). Bordo (1990, 24) compares bank panics internationally and comments that “the difference in the incidence of panics is striking.” While over the 1870–1933 the US had four panics, there were none in Britain, France, Germany, Sweden, and Canada despite the fact that “in all four countries, the quantitative variables move similarly during severe recessions to those displayed here for the U.S.” Table 2-1 in Schwartz (1988, 38–39) report that from 1790 to 1927 the U.S. experienced 14 panics, while the Britain, the only other country with as many observation, experienced 8, all of them before 1867.

Not only does Diamond & Dybvig (1983) suggest bank runs have much higher costs than evidence does, but it also shrouds its benefits. My research suggests that bank runs could play an important role in initiating insolvency procedures earlier, before the bank can enlarge its losses, and therefore limit systemic externalities.


My research is on financial stability, but I like to dabble on the economics of fictional stories every once in a while. This is too good not to share.

I think discussions on plurality of emission deserve a place back in money and banking classes, especially with regards to modern monetary challenges. In this video, Larry White gives a quick introduction to some of the features of free banking systems.

Something I’ve been hearing a lot is that the French classical-liberal school of economics disappeared, somewhere around the end of the 19th century and the beginning of the 20th century, because of the professionalization of economics. The argument, as it goes, is that classical-liberals had been petitioning the government for Chairs of political economy in Law faculties for nearly 40 years. When they were finally created for provincial faculties in 1883, only the agrégés de droit, doctors in French and Roman law who had passed a public contest, were allowed to fill these jobs. These agrégés, it is said, were both not sufficiently formed in political economy, and opposed to classical liberalism as a professional deformation. They were naturally inclined to accept the teachings of the German historicists. “Thus the liberal school which, in blatant contradiction to its own politico-economic principles, had campaigned long and hard for a State solution to a perceived educational problem, was hoist with its own petard” writes Salerno.

In a sense I am sympathetic to this interpretation, why would the Chairs of political economy have bitten the hand that feeds them? However, the situation is much more nuanced than this account allows for. It is not the case that “not one of the liberal candidates was an agrégé and only two or three were docteurs en droit”. Out of 13 newly created Chairs, at least two were occupied by classical-liberals. Those were Alfred Jourdan, in Aix-en-Provence, and Edmond Villey in Caen. Even the historical Chair at the Paris Law faculty was at the time occupied by a classical liberal, Paul Beauregard, later substituted by Auguste Souchon (also classical-liberal) before he accepted a newly created Chair of rural economics. Other Chairs, outside Law faculties, were also created and given to classical liberals, such as that of the Collège de France to Henri Baudrillart, and later to Pierre-Émile Levasseur. Classical-liberal economists of the Say-Bastiat kind were among the newly professionalized economists, though other sensitivities were perhaps disproportionately represented.

The charge that classical-liberals that weren’t agrégés de droit disappeared because they were barred from entry into the Chaire d’économie politique is also more nuanced. Starting in 1891, the law agrégation featured an economics option, and starting in 1896, before classical-liberals can be said to have disappeared, economics had their own distinct agrégation. The classical-liberal had their representative on this jury through Pierre-Émile Levasseur. It is however good to remember that there were very few agrégés jobs to be granted, and Chairs were at the time “handed from father to son invoking cooptation, from father-in-law to son-in-law, from uncle to nephew and nephew through marriage”, in a way that left very little place to them. The classical-liberals were not strangers to this brand of corporatism, as this previous quote is from Walras’ autobiography and describes his experience with the classical-liberals and their early stranglehold over French institutions.

The opposition, still according to Salerno, was embodied by the journal co-created by Charles Gide to compete with the Journal des économiste, the main classical-liberal publication. Indeed, the Revue d’économie politique was created in 1887 by those agrégés de droit holding Chairs, seemingly in direct reaction to an attack by French free banker Jean-Gustave Courcelle-Seneuil on the quality of economic teachings in Law faculties. Yet, among its editorial committee, half were classical-liberals for the first few years, until Alfred Jourdan passed away. While it did publish German historicism, it also published decidedly “Paris school” oriented articles, and even the writings of Austrian economists such as Menger and Böhm-Bawerk. Even its mission statement was not  dedicated to the “avowed programme of reaction against the doctrines of the optimist Liberal school, and the propagation of foreign, especially German economic schools”, like Charles Gide would later retcon, but an eclectic mix of all those things and more, like sociology, reflecting the very diverse influences of French law professors holding Chairs of political economy. If it should be linked to Charles Gide’s person, it could be said that it reflected Charles Gide’s ‘jack of all trades’ interests rather than his penchant for German historicism, or even interventionism.

So, why did the French liberal school disappear? There are several reasons, that do include French corporatism in Law faculties that had been adverse to them. A large chunk of the explanation, I believe, lies in the fact that eventually the classical-liberals became dilettante, more interested in doing politics and other activities than publishing. Their production diminished, and eventually disappeared only to have to be “rediscovered” in France in the 1970s. The disappearance of the French liberal school, in a certain sense, is to be found in too little professionalization rather than too much. The attraction of German historicism also shouldn’t be neglected, as the Methodenstreit seems to have made in France much more adepts of German methodologies rather than the Austrian’s. It would require more research, but it might even have “turned” some classical-liberals.

This is kind of awesome, a Sylvester the Cat episode that teaches some econ 101. A Wikipedia page says it was the fruit of a collaboration between Warner Bros. and NYU’s Institute of Economic Affairs, and there are actually two more such episodes out there.

Here’s something I wrote, up for comments. Here’s the abstract:

A 2000 paper by Philippe Aghion, Patrick Bolton, and Mathias Dewatripont off ers a model where what they describe as a free banking system is vulnerable to contagious bank runs through clearinghouse loans. The paper ignores key contributions to both free banking and financial history literature, such that the paper is of little relevance to the understanding of the stability of both free banking systems and clearinghouse arrangements. Our criticism concentrates on the institutions of banking absent or misrepresented. It is argued that it is not clear whether the paper even features banks.

Thirteen years is a very long delay for a comment, but I was not able to find anything addressing this paper, and since it is still cited in almost every literature review on systemic risk, I thought it deserved a comment. Suffice to say, I don’t think think free banking can be dismissed in 6 pages, without giving a proper definition and citing any work on the subject matter.

My usual collaborators in our department seem to be abroad or on vacation this week, so please think of this as a crowdsourced seminar and please do leave a comment.

Most papers on the random withdrawal theory of bank runs suggest that bank runs are not only self-fulfilling prophecies, that alone is bad enough, but that once the run is motion nothing can stop it. This has serious implications, if bank runs are self-fulfilling prophecies that can’t be stopped then you would expect that there would be a lot of bank failures that are only due to bank runs. You’d expect there would be contagious bank runs. Especially during the National Banking era, which was rife with banking panics. This table suggests otherwise.

Source: p. 183 of U.S. Comptroller of the Currency. Annual Report Vol. 1 1920. Washington, D.C.: U.S. Government Printing Office.

Source: p. 183 of U.S. Comptroller of the Currency. Annual Report Vol. 1 1920. Washington, D.C.: U.S. Government Printing Office.

Out of 594 bank failures during the National banking era, only 9 had bank runs as their primary cause. Out of those 9, two were banks closed in anticipation of runs. Out of the remaining 7 bank failures, 6 were eventually restored to solvency by the receivership, so I’m going to assume the losses weren’t that important. Only 4 bank failures out of those 9 occured before the advent of the Federal Reserve, including one case where the bank was closed prior to the run, and the bank that was not restored to solvency by the receivership.

Other bank failures might have been sped up by bank runs, but it was not the primary cause of failure. This means that the run, while certainly costly, might have been salutary and closed down the bank before its managers could enlarge losses. It also suggests that bank runs are, in most cases at least, not self-fulfilling prophecies, and that partial “verification” runs can occur.

So, what this means is that, over the whole National Banking Era, we only have only one potential case of contagious bank run leading to an unsalvable bank failure. I say potential and not definitive, because it might be the case that the failure was, after all, more a result of predation than a result of the bank run. What I mean by that is that it is pretty much always in the interest of other banks, and clearinghouses, to come to the rescue of banks in difficulty, because they can profit from those situations. It wouldn’t be surprising to me that what appears to be the only national bank failure due to contagious bank runs, is actually a case of other banks letting it die so that it can acquire its assets at a discount.

More research is obviously necessary on all of this, especially on the outcome of the receiverships.


Source: page 90 of O’Connor, J. F. T. 1938. The Banking Crisis and Recovery under the Roosevelt Administration. Chicago: Callaghan and Co.

Research is picking up on what I would call the homogenization theory of systemic risk. Instead of resorting to financial contagion or another propagation mechanism, this theory comes from the realization that bank failures are clustered not so much because failure spills over from banks to banks, but because banks’ balance sheets are relatively homogeneous. If banks invest in similar assets, then it is no wonder that they fail simultaneously, or to a lesser degree, it is no wonder that failure at a first bank triggers a reassessment crisis.

In a Journal of Financial Intermediation article (2010), Wolf Wagner makes the bold claim that it is in fact diversification that makes banks more homogeneous. To understand this claim, take Haldane & May’s example in Nature (2011);

Suppose you have N banks and N distinct, uncorrelated asset classes, each of which has some very small probability, ε, of having its value decline to the extent that a bank holding solely that asset would fail. At the inhomogeneous extreme, assume each bank holds the entirety of one of the N assets: the probability for any one bank to fail is now ε, whereas that for the system is a vastly smaller ε^N. At the opposite, homogeneous extreme, assume all banks are identical, each holding 1/N of every one of the N assets: the probability for any one bank to fail can now be calculated as N^N (ε^N)/N!, and this is obviously also the probability for all N of these banks to fail.

Now, Wagner takes his own version of this example at face value and claims that “diversification also makes the banks more similar to each other by exposing them to the same risks”. The optimal level of diversification, according to Wagner, is actually much lower than the “natural” level of diversification. This makes diversification driven homogenization an interesting market failure.

However, this is obviously only true if you’re completely oblivious to the world’s open-endedness. There is not “N” class of assets that banks can invest in, and the number of classes of assets is ever expanding. The only limit to the classes of assets you’re going to run into is human ingenuity and entrepreneurial spirit. While Wagner formulates no policy recommendation (but others do), this is still a good example of the kind of misplaced concreteness economic modeling is riddled with.

So, if diversification is not responsible for banks’ homogeneity, what is? Jeffrey Friedman and Wladimir Kraus offer in Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation a convincing explanation of why that would be the case. Basel 2 capital rules’ risk weighting of assets created arbitrage possibilities that made mortgage backed securities particularly interesting for banks. Interestingly enough, in Haldane & May’s own words: “Tentative evidence comes from the fact that the world’s five largest banks have shown increasing concentrations of assets over the last ten years, in contrast to the top five hedge funds, whose less concentrated systems can give greater scope for diversity.” This would tend to support Friedman & Kraus; Basel 2/3 regulated banks are more homogeneous  while much more loosely regulated hedge funds are less.

The word zombie is sometimes used to refer to firms that are virtually insolvent, in a state where they can merely afford to service their debt, or to refer to government sponsored vehicles where bad assets are stashed to clear banks’ balance sheets from underperforming loans. The zombies I’m concerned with here, however, are actual flesh eating undeads. I think zombie fiction is especially interesting to economists because it mirrors a lot of debates going on within the profession.

A lot of people do not understand what zombies are all about and miss out on some great fiction. While it is true that zombies are the most brainless horror flick monsters around, it does not mean that zombie movies are senseless gore films. In fact, there’s a long tradition of using zombies in media as a plot device to push a social commentary and reflect on human behavior. Because zombies are clumsy, mindless, and generally easy to trick or avoid, zombie stories are not so much about the zombies, but about the survivors and how they cooperate. Zombie fiction allow us to witness miscooperation leading to dire consequences without having to experience these situations, just like economists use economic models (in the very loose sense) to reflect upon economic miscooperation because they don’t have the luxury of experimenting.

Because zombies are so easy to overcome, storylines have relied on other threats, which you could call zombie survival market failures. From an economist’s point of view, a lot of zombie stories involve variants of close-ended non-cooperative games, where egos and foul play get in the way of happy Pareto optimal endings. The model for human behavior is generally one where humans would have perfect chances of surviving if they could execute their plan, but where adverse selection and moral hazard make it so that they cannot spontaneously coordinate themselves. That is, humans have good expectations about what needs to be done to survive the post-apocalyptic world, but plan conflicts, absence of a consensus, betrayal and unenforceable contracts ultimately always lead to some of the most tragic possible outcome.

Think of George A. Romero’s Night of the Living Dead, the movie to which we owe modern zombies. It’s a huis clos movie where the survivors take shelter in a farm surrounded by flesh eating ghouls. Leaving aside the rather clumsy class struggle theme, the demise of the group is not so much due to the living dead trying to break in, but rather to the failure of survivors to cooperate and agree on a plan. The group on the ground level has a plan to resist zombie attacks that requires the unanimous cooperation of the group taking refuge in the cellar. The group in the cellar needs the collaboration of the other one for their radio, apparently a precious asset during zombie invasions. The zombies ultimately feed on their failure to agree. Other zombie movies by Romero explored similar themes, where safe havens that could have been shared are ultimately invaded and destroyed, leaving everyone worse off. This is the dominating theme in what I would call first generation zombie fiction, with more recent entries such as Zombieland also touching on it.

These behaviors can seem a little wooden, and overly pessimistic about human nature. In the face of certain death people would know exactly what to do to survive, but wouldn’t be able to do it because they value coming out on top of an argument or being in charge more highly than being alive? Moreover, in a post-apocalyptic world where a broken leg or a simple cut that gets infected can be the end of you, why is it that it is always failure to cooperate that leads to death instead of tragic unforeseen events?

Of course, in real life people do figure out how to coordinate themselves, and they’re rather inventive in the ways they do. Just think of the diversity and plurality of answers to coordination challenges; how some resources are managed by private firms, some by non-profit organizations, some by something in-between. And just think of the inscrutable mix of a lot of types of organizations and institutions that have emerged from our cooperation efforts to guard and enforce these agreements. It is true however that in a situation of urgency there’s no reason the survival learning process would be quick enough, and survivors adapt timely – zombies are not very forgiving. Still, the overall message of classic zombie fiction seems both overly pessimistic about human collaboration, and overly optimistic about human expectations.

Fortunately, what could be called a second generation of zombie storytelling “models” human cooperation better. In Left 4 Dead, Mountain Man, or Day by Day Armageddon for example, zombie apocalypse survivors do collaborate toward a plan, and there is clearly less betrayal toward  one’s own certain death. In these narratives, survivors lose their peers not necessarily due to a failure to coordinate, but because of truly unforeseen events. There is a sense that danger is unpredictable and all around the survivors. They don’t need a final zombie attack to come before they’ve agreed on a course of action for zombies to feast on human sashimi.

Having imperfect survivors that are capable of learning and innovating, yet are radically ignorant (instead of “socially challenged” Judas) changes the whole dynamic of zombie invasions. It allows authors to explore other themes such as anti-militarism. An example of a common theme is that government response always worsens the problem because of the knowledge problem, ordering survivors to seek shelters in areas that have already fallen prey to zombies. The only time where the military actually improves the situation is through insubordination or desertion. Often in those stories the only path to survival is individual initiative and rugged survivalism, an admittedly caricatural version of entrepreneurship. Of course this is not true of all zombie fiction, the popular zombie novel World War Z is not much else than a glorification of the war economy and government crisis management.

But mostly, having more realistic ideal types allows authors in The Walking Dead graphic novels (it’s less obvious on the TV show) to have groups of survivors experiment with a host of governance structures as their context and goals evolve. These range from a state of spontaneous leaderless voluntary cooperation, to characters imposing their tyranny upon a small community, with varying levels of success at their survival efforts. For example, the Governor leads his group with an iron fist, ultimately suppressing the feedback that would have signaled the Governor that his plan was wasteful. In Rick’s group, on the other hand, projects are generally more bottom-up initiatives validated or rejected by peers, and are much more successful. The franchise often explores problems associated with welcoming new survivors and their effect on enforcement and guarding costs.

Since it is customary to finish with an unsolicited policy advice, an implication derived from zombie fiction that will make it sound way more serious than it was ever meant to be; in times of crisis the law of association is more important than ever to increase the division of labor and make each party’s efforts more productive. Funny how, for zombie apocalypses just like for real world problems, themes emanating from Austrian economics seem to capture the problem of human cooperation better than mainstream economics, huh?

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