Banking and the law of large numbers

14/11/2011 § 4 Comments

Brad DeLong has been wrestling with a paragraph from Ludwig von Mises. DeLong’s interpretation of banking really resonated with me:

From my point of view, liquidity creation, duration transformation, and simple diversification are all attempts to make the law of large numbers work for us. They are largely successful attempts not to buy liquidity, immediacy, and insurance from those who want to sell them, but rather to create them out of whole cloth–via clever applications of the principles of probability.

I probably liked it because probabilities and blackjack intrigue me. Relying on having enough transactions to keep actual claims on reserves fairly close to predicted, human society has figured out how to grease the wheels of commerce.

I wanted to add two things. What I remember of Doug Henwood’s account of Marx’s critique is that the problem is with proliferation of financial instruments. It isn’t fractional reserve per se, it’s the continual development of ever-more complex and opaque fractions of fractions. The recent experience with mortgage-backed securities bears out the critique. First, the investors in CDOs didn’t know what was in the bundles they were buying. Secondly, what people claimed was in the bundles of mortgages actually wasn’t, because the necessary legalities hadn’t been observed.

That gives rise to the second point. Fractional reserves is another case in which the concept is great, but one can take it too far. I don’t hand out pieces of paper saying ‘backed by Bill’s house’, but the bank effectively is. Somewhere between the two is a social optimum. Searching for that sweet spot of maximum liquidity, immediacy, and insurance (with appropriate preference weightings) has proven to be a messy affair.

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§ 4 Responses to Banking and the law of large numbers

  • I’ve always been warm to Selgin and White’s Free Banking as a way of finding that sweet spot. Folks who want 100% guarantees of being able to get cash immediately pay high monthly banking fees; folks prepared to wait and prepared to take some risk get paid interest.

  • I’m not sure that DeLong is right about Mises or Hayek, though he’s right about the version of Mises that comes through the folks at Auburn. Mises liked gold, I’d thought, because of how it emerged as currency – the Menger story on the creation of money. And because it couldn’t as easily be quietly inflated. Not because of any inherent goodness of work in mining. There are plenty of metals that are at least as hard to mine as gold, if it’s a work standard. And didn’t Hayek write in favour of de-nationalizing money, ah yes. There it is.

    Click to access denationalisation.pdf

    That’s a few miles away from a gold standard.

    DeLong can be serious about history of thought. Sometimes he chooses not to be. I’ll be damned if Mises or Hayek thought there was no value in being clever. The whole damned Austrian theory of entrepreneurial alertness is fundamentally based on a form of cleverness!

    • Bill says:

      I find it pays to be a bit careful about what DeLong says other people say. I haven’t gone back to Marx or Mises to see what they actually said, but thanks for the Hayek link.

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