Sunday, October 19, 2008

Panics, Bank Runs and Public Goods

I have been watching the cable news networks with some amusement as the financial empty suits have been repeatedly calling for "calm" and "trust." I cannot count how many times I've heard it stated, "this is a crisis of confidence - the worst thing we can do is to lose faith in the system because it will become a self-fulfilling prophecy." FDR said essentially the same thing when he said that "the only thing we have to fear is fear itself." This quote is often seen on TV in connection with the rise of Nazism, but it had nothing to do with that - it was the banking crisis that Roosevelt was talking about.

It is the nature of fractional reserve banking that if all depositors do demand all their demand-deposits at once, the banking system will collapse. Note that the uniform sort of fractional reserve banking we have today only exists in a regulatory environment which makes it less profitable to pursue other reserve ratios by protecting the low reserve banks from losses and failures by socializing risk (pushing off the costs of bank runs or massive loan defaults onto the taxpayers).

In a free market of banking, we would expect to see a wide variety of reserves from the extremely risky to the extremely conservative with most depositors placing their money somewhere in the middle - just like the stock market. Each bank - and each depositor in each bank - would be taking sole responsibility for the risks they accept in return for the rewards they reap (in terms of higher interest rates earned by means of lower reserve ratios). When the credit system became too wound up, people would eventually get jittery (just as they do today) and start pulling money out. Those banks who had overextended their positions would collapse and those banks who had restrained themselves from overexpansion of credit would survive. After a few months, the market would readjust and, lessons learned (painfully, for the most risk-prone), be improved.

So, that brings me back to the issue of confidence. David Friedman discusses exactly this problem in the context of the battlefield in a fascinating little article, The Economics of War which discusses the economic decisions facing the individual soldier on the battlefield. He says,

"We do not know all of the objectives that any individual has, but we do know that for most of us, staying alive is high on the list. The general commanding an army and the soldier in the front line have, in one sense, the same objectives. Both want their side to win, and both want both of them to survive the battle. The soldier, however, is likely to rank his own survival a good deal higher and the general's survival a good deal lower in importance than the general does. One consequence of that disagreement is that the general may rationally tell the soldier to do something and the soldier may rationally not do it. Neither is necessarily making a mistake; each may be correctly perceiving how to achieve his ends.

Consider a simple case. You are one of a line of men on foot with long spears; you are being charged by men on horses, also carrying spears (and swords and maces and...). You have a simple choice: you can stand and fight or you can run away. If everyone runs away, the line collapses and most of you get killed; if everyone stands, you have a good chance of stopping the charge and surviving the battle. Obviously you should stand.

It is not so obvious. I have described the consequences if everyone runs or everyone stands, but you are not everyone; all you control is whether you run or fight. If you are in a large army, your decision to run will only very slightly weaken it. If you run and everyone else fights and wins, some of them will be killed and you will not. If you run and everyone else fights and loses, at least they will slow down the attack - giving you some chance of getting away. If everyone runs and you stand to fight, you will certainly be killed; if everyone runs and you run first, you at least have a chance of getting away. It follows that whatever everyone else is going to do, unless you believe that your running away will have a significant effect on who wins (unlikely with large armies), you are better off running. Everyone follows this argument, everyone runs, the line collapses, you lose the battle and most of you get killed.

The conclusion seems paradoxical; I started by assuming that people want to live and correctly choose the means of doing so and ended by predicting that people will behave in a way that gets most of them killed. But rationality is an assumption about individuals, not about groups. Each individual, in my simple example of the economics of war, is making the correct decision about how he should act in order to keep himself alive. It so happens that the correct decision for me (running away) decreases the chance of being killed for me but increases it for everyone else on my side, and similarly for everyone else's correct decision; individually, each of us is better off (given what everyone else is doing) than if he stood and fought, but we are all worse off than we would be if each of us had failed to reach the correct conclusion and we had all stood and fought."

Now, this is very much like the problem of confidence in the banking system. If we all keep our money in the system, it will not collapse and we will all be pretty much OK. If we all pull our money out, the system will collapse and we will all be economically devastated. But I am not everyone. If I pull my money out, that will not in itself cause the system to collapse. So reasons each of us, we each pull our money out and the system collapses. Confidence in the fractional reserve banking system is what economists call a "public good" - most of the benefit of taking the risk of leaving your money in the system goes to others.

The most unimaginative and blunt solution to any public goods problem is the use of force - and this is the solution typically favored by the voting public. Friedman also discusses the use of force to create the public good of "holding the line" on the battlefield:

"So far I have discussed the economic problem of war without saying anything about solutions. Obviously I am not the first person in history to realize that soldiers sometimes run away, or even the first to suggest that they do so, not because they are struck with some mysterious panic, but as a sensible response to the circumstances they find themselves in. Commanders throughout history have been confronted with the problem and have come up with a variety of ways to make it in the interest of their soldiers to fight and, if possible, in the interest of the enemy soldiers to run away.

One solution has become proverbial. You march your army across a bridge, line it up for the battle with a river (hopefully unswimmable) behind it, then burn the bridge. Since there is now nowhere to run to, much of the argument for running away disappears. Of course, if you lose the battle, you all get killed. This is called burning your bridges behind you."

Closing the gold window in 1971, anyone? Or banning short sales?

"Another solution is to punish soldiers who run away. One way is to have a second line of soldiers whose job is to kill any member of the first line who runs. This unfortunately ties up quite a lot of your army; if the front line all gets killed, the second line runs away, unless there is a third line to kill them for doing so. A less expensive (but also less effective) solution is to keep track of who runs away and hang them after the battle. In order for this to work, you have to have a pretty good chance of winning the battle, or at least surviving it with your command structure intact; an army that has just been routed is unlikely to have time to punish the soldiers who ran first. This suggests one reason why some commanders are so much more successful than others; once a commander has won a few battles, his soldiers expect him to win the next one. If the battle is going to be won, it is prudent not to run away - and since nobody runs away, the battle is won. This is what is called a self-fulfilling prophecy. A French military theorist, Ardant du Pica, argued that the traditional picture of a charge, in which the charging column smashes into the defending line, is mythical. At some point in a real charge, either the column decides that the line is not going to run and stops, or the line decides that the column is not going to stop, and runs.

This brings me to the much-maligned British army of the eighteenth century, We all learn in elementary school about the foolish British, who dressed up their troops in bright scarlet uniforms and lined them up in rigid formations for the brave American revolutionaries to shoot at. The assumption (as in the nationalistic histories of most nations) is that we were smart and they were dumb and that explains it all. I am in no sense an expert in eighteenth-century military history, but I think I have a more plausible explanation. The British troops were armed with short-range muskets and bayonets, hence the relevant decision for them, as for the spearmen of a few centuries before, was to fight or to run. In order to make sure they fought, their commanders had to be able to see if someone was starting to run; rigid geometric formations and bright uniforms are a sensible way of doing so.

Bright uniforms serve the same purpose in another way as well√£they make it more difficult for soldiers who run away to hide from the victorious enemy, and thus decrease the gain from running away. Of course the fugitive can always take off his uniform, assuming he has enough time (perhaps that was why they had so many buttons), but young men running around the countryside in their underwear are almost as conspicuous as soldiers in red uniforms."

I think this last section best describes the solutions that the establishment would prefer. We need to mark and punish those who withdraw their money during a panic. I wouldn't be surprised if something like this is proposed. In fact, if you think about it, FDR's gold seizure was just such an action. Holding gold was the same as withdrawing your money from "the system" in 1933... those who did were severely punished.

All I can say is that those who think you can have people "voluntarily" maintain confidence in a system, where such confidence is a public good are delusional. You either use the blunt instrument of threat of violent force to maintain discipline, or you accept that people will break rank and run or hide when things get scary. Personally, I'd rather not live in a fascist society. Most Americans today, it seems, disagree.

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