Pondering on Mises


I'm feeling a bit wet – intellectually – and I need some robust Austrian School economists to dry me out.

I've been boning up on the great Austrian economist, Ludwig von Mises, for a short book on him I'm writing for the excellent Institute of Economic Affairs. Mises got notoriously irritated with people who questioned the need for a gold standard or thought that fractional reserve banking was a good thing. Er...like me.

On gold, i can see the point that once you let politicians print money, you're asking for trouble. And we've certainly got it. But do we really want the world's money to depend on the production of some metal – particularly one that Russia controls so much of? Russia bullies other countries over oil for political reasons: would we really expect it to act as an honest banker to a world dependent on its gold?

Friedman tried to solve this by suggesting a monetary rule – that the money supply should expand at an even pace, roughly in line with production – or by a commodity currency, backed not by a single metal but by a basket of goods. But such rules are only practical if the politicians do indeed stick to them. So that's not promising. But it seems to me that if we can work out a way to get such rules to work, it's better than having the entire world monetary system rooted in a single commodity that just a few countries control. Shouldn't we focus our intellectual energy on that, rather than on restoring gold?

Fractional reserve banking is the system whereby banks don't keep all of your savings in their vaults – they lend the money out to people who need it to build businesses and the like, keeping enough on hand to assure savers that they can withdraw what they want, when they want it. It doesn't work, of course, if all savers all want their money out at the same time: and the fear that the bank might not be able to immediately pay back savers in full leads to a 'run on the bank' that produces exactly that effect.

One solution to this is free banking, where banks issue their own notes. If people are concerned about the probity of a particular bank, they will agree to take its notes only at a discount – accepting its dollars only for 95 cents, say. It may not prevent bank failures entirely, but it sends early warning signals to the bank that it needs to mend its ways.

Personally, I'd prefer that my money was being lent out to create new businesses, and earning interest for me, rather than sitting in a vault with the bank charging me to look after it. So two cheers for fractional reserve banking. You don't need 100% of your cash sitting in the vault. What you do need is some insurance for when lots of savers all want their money out on the same day. Your house doesn't burn down every day: you simply want insurance for when such bad things happen. The same is true with your savings in the bank.

Again, this isn't easy. When the financial sector goes into spasm as it did last year, then the traditional insurers are in spasm too because the two markets are so closely interdependent. The old idea was that the central bank should be the 'lender of last resort' in these circumstances. If, like Mises, you don't like central banks much either, the same question persists. Shouldn't we be applying our brains to creating some insurance system to back up the fractional reserve banking system, rather than demanding that the banks lock their savers' cash in unproductive vaults?