Arnold Kling vs. Anarchocapitalism

Arnold Kling states:

I am not claiming that private governance in the absence of government support is impossible. I am claiming that it is costly.

Does anyone claim that private governance in the absence of government support costs nothing? Governance is a function and all functions have some costs. The problem with government by a State is that it is a coercive monopoly, which usually implies high costs and risks, low quality and much corruption.

Kling then gives a poor hypothetical example:

Take an example of a complex economic activity that involves a lot of specialization and trade. The famous pencil, or a toaster, or an I-phone. The parties involves in the process of assembling such goods involves do not know one another. They cannot gauge reputations, nor can they even know whether other parties care about their reputations.

Maybe Kling means that parties do not know all other parties involved in these complex processes: this is true because it would be very difficult; but it is completely unnecessary. Parties know (as well as is efficient and possible) the parties they directly interact with: their providers and their clients. They need to trust the quality of the products and services bought, and that they will be delivered in time, and if they extend credit to customers they need to know their solvency. This knowledge is always imperfect, but it is not zero.

Financial intermediation vs. maturity and risk transformation

Arnold Kling gets financial intermediation wrong.

Financial intermediation is not the same as maturity and risk transformation. A financial intermediary obtains funds from savers, lends them to borrowers (consumers or investors), and charges an intemediation fee or margin. A financial intermediary does not have to perform maturity and risk mismatch. A prudent financial intermediary does not perform maturity or risk mismatch or does it minimally.

Maturity and risk mismatch (or transformation) happens when the assets of an entity, usually a bank or similar, are longer term and riskier than its liabilities: it borrows short and riskless and lends long and riskier. It is the fundamental cause of financial crises. Some financial intermediaries perform maturity and risk mismatch because shorter less risky debt has a lower interest rate than longer riskier debt. Economics is about tradeoffs: an agent cannot perform maturity and risk mismatch and earn higher benefits without becoming more fragile.

Some banks and shadow banks tend to perform maturity and risk mismatch because of cheap central bank refinancing, clumsy regulation and supervision, implicit or explicit guarantees (systemic risk, too big to fail), and deposit insurance (depositors don’t control the banks).

Economic agents prefer to issue long term and risky debt, and hold riskless, short-term assets. This is a particular case of sellers wanting to give low quality at high price and buyers wanting to receive high quality at low price. If sellers sell at high prices and buyers buy at low prices, quality is probably compromised without at least one of the parties knowing it. But the true quality of the product (in this case credit) will show itself with time.

Banks are not only financial intermediaries: they are also payment managers that issue their own liabilities as monetary substitutes; this is the reason why banks can be very leveraged. Maturity and risk matching is performed by prudent fractional reserve banks. It makes no sense for 100% banks.

More on Arnold Kling and banking

He writes:

I would like to see this whole issue analyzed in terms of signaling. With free banking, I suspect that we would get cyclical movements in the perceived soundness of banks. People would grow to trust the signals of at least some banks more and more, until those banks abuse that trust. Then, when people lose money, the trust will drop way off.

The same thing happens under regulated banking, of course. Which is where those government guarantees come in.

The question I have is whether a system of government guarantees produces an overall higher level of economic growth. It could do so by giving people more confidence in financial intermediaries on average through time.

It could be that putting the symbol “FDIC insured” on the door of banks is a very inexpensive signaling mechanism with a lot of social benefits. It could be argued that without that signaling mechanism, financial intermediation would be much more costly than it is today.

I am not saying that this is definitely true. However, I do think that it is the key issue in banking theory. It is all about the costs and benefits, including moral hazard and regulatory costs, of different signaling mechanisms.

Signaling is an important issue in the evolution of cooperation. Signals that work by providing accurate information are hard to fake, usually by being expensive: inexpensive signals do not work well. The best signals are simple and sincere ones: if a bank wants to signal financial soundness it can do so by being financially sound and proving it with good and clear accounting. Trust is hard to gain, and entities like corporations with long lives and stable, continuous and repetitive relationships cannot risk jeopardizing their reputation: abusing trust is not a long term successful strategy; signaling is an investment in trademark.

The possibility of cheating always exists, but government regulation is not only not a good solution, but probably the worst possible one.  The best way to minimize cheating is to make people responsible for their own dealings, so that they stay alert and can at least learn from their mistakes. Having many decentralized motivated cheater detectors is far more powerful that having a few technocrats in charge of a rating bureaucracy. Confidence is not necessarily a good thing: trust is useful when the trusted entities work efficiently; simply promoting confidence creates an environment of naive trust ideal for cheaters to prosper. Those people not interested in investigating the true situation of the entities they deal with can use the services of professional raters, but there is no guarantee that the raters will be completely honest or impartial. Guarantees are never perfect or final, but government guarantees create an illusion of safety. Free competition is necessary in the provision and supervision of all goods and services: government insurance not only socializes the cost; what is more problematic is that is establishes unique official standards of conduct that are not known with certainty to be adequate (and most certainly are not), but are generally and wrongly perceived to be so (there are no alternatives to compare with).

Regarding cyclical movements, they are probably a feature of systems with a strong dependence on a single important entity, and this is the case with government regulation: since it cannot be perfect maladjustments will tend to accumulate until they are no longer sustainable and the system breaks down. A monopolistic regulator trying to stabilize the system it controls will probably destabilize it even more by failing in the intensity and the timing of its interventions.

A system with many competitive elements and interactions can compensate the fluctuations of some elements with the opposite fluctuations in other elements. Complex adaptive systems are like homeostatic organisms: too complex to be purposefully designed or controlled, they adapt by means of multiple decentralized interactions. Banks are not only controlled by their depositors and shareholders: they are also limited by the competition of other banks which can inform potential customers of the dangers associated with the risky behaviors of the least trustworthy firms (and of course companies can lie about their competition). The distributed information of market watchers can be gathered in the secondary markets of private bank notes where all people are free to prove their knowledge by means of their financial bets.

Arnold Kling on bank regulation

Arnold Kling is always very interesting and informative.

But he writes:

We want to provide consumers with bank deposits that are insured. To protect taxpayers, we want to prevent insured banks from taking significant risks. Therefore, banks should be very closely regulated.

Who is that “we”? How does he know what “we” want? What if insuring bank deposits turned out to be expensive and in itself risky (moral hazard)? I do not want to provide consumers with bank deposits that are insured: I want depositors to look after the safety of their own deposits, and in this way control the banks. Taxpayers and the state need not be involved in insuring or regulating banks. Functional and legitimate regulation comes from below, from competitive and evolving contractual arrangements between interested parties, not from far away and detached bureaucrats.

And of course the state should be separated from money production and management.