I have for some time wanted the young and talented Lee Kelly to write a guest post for The Market Monetarist. I am happy that he now has done so. Anybody who follows the market monetarist blogs will be familiar with Lee’s name and his always insightful comments.

So thank you Lee and I hope you in the future will write many more posts for my blog.

Lars Christensen

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Guest post: Nick Rowe, Barter, and Free Banking

By Lee Kelly

Nick Rowe recently wrote about the increasing use of barter and makeshift monies during recessions. The market monetarist explanation for the last recession describes how attempts to engage in mutually beneficial exchange are frustrated by a shortage of money; this suggests that people would seek alternatives–such as barter and makeshift monies – to realise desired transactions. While such incentives would be expected to increase with the severity of the shortage, there are unfortunately too many other factors at play to draw precise quantitative predictions. That said, if there were no increase in barter or even a decrease, then I would tentatively consider the market monetarist explanation falsified, and it would require one heck of a good counterargument for me to reverse that judgement.

Alex Tabarrok has presented some evidence comparing the Great Depression and the recent recession. Evidence that barter and makeshift monies increased during the Great Depression is very strong–market monetarism passes the test. However, evidence regarding the last recession is less conclusive; there are suggestions of an increase in barter and makeshift monetary arrangements but nothing substantial.

Although I wouldn’t have expected anything comparable to the Great Depression, like Tabarrok, I’m surprised at just how weak of an effect appears to have been. My own observations are of a slight increase in barter, and the relative success of Bitcoin during the recession is suggestive, but there is little more than anecdotal evidence to go on for now. The evidence–or lack thereof–presented by Tabarrok should pose an interesting challenge to market monetarists.

In any case, my purpose here is actually to explain a little about the underlying theory of this explanation and how it dovetails with an arguments for free banking. An increasing use of barter and makeshift monies in during a shortage of money takes on a whole different meaning when viewed from the perspective of free market in money and banking. But first, let me try and keep everyone on the same page by clarifying just what is meant by a ‘shortage of money’ or an ‘excess demand for money’?

What is an Shortage or Excess Demand for Money?

The term ‘shortage’ has a precise meaning in economics. A shortage occurs when the market price of some good is below its equilibrium price. In such cases, there are more people willing to buy at the prevailing price than are willing to sell, leaving an excess demand. Holding supply and demand constant, the market normally clears such disequilibria by increasing prices until shortages are eliminated. However, a shortage may persist indefinitely when there is a price ceiling, i.e. an upper limit to some price usually mandated by a government. If the equilibrium price of some good is greater than its price ceiling, then rising prices are unable to entirely eliminate shortages.

Normally, when demand is frustrated by a price ceiling, the excess goes somewhere else. For example, a binding price ceiling on apples would frustrate demand, leaving some people who want to buy apples unable to find willing sellers at the prevailing price. What do people who want apples do instead? Maybe they buy pears, oranges, bananas, or whatever–probably something that serves a similar purpose. In any case, the excess demand for apples spills over into higher demand for other kinds of fruit.

Money is special. All else being equal, an increase in the demand for money is automatically a shortage of money. An excess demand for money cannot be cleared by increasing its price, because money doesn’t have a price of its own. To reach equilibrium, every other price must haphazardly grope its way there by a roundabout path of deflation. A shortage of money is unlike a shortage of anything else, because money is the medium of exchange. An excess demand for apples will probably just result in more spending on other fruit, but an excess demand for money results in less spending altogether. With an insufficient quantity of the medium of exchange to facilitate desired transactions, potential output is sacrificed–this manifests as the temporary lull in economic activity called a recession.

Barter and Makeshift Monies From a Free Banking Perspective

The relation between a shortage of money and barter is similar to the relation between a shortage of cars and cycling. Suppose the government imposes a binding price ceiling on cars and supply is elastic. While there will always be some driving and some cycling, the shortage of cars results in people cycling more than if the supply of and demand for cars were in equilibrium. However, cycling cannot substitute for all journeys that would otherwise be taken by car, and so those journeys simply never happen. Likewise, only a fraction of transactions frustrated by a shortage of money can be completed using substitutes like barter or makeshift monies.

What does this have to do with free banking? In a world where central banks operate an effective monopoly over money, there is only one monetary policy. If the central bank pursues bad monetary policy, then the economy is constantly rocked by surpluses or shortages of money. But what if people had a better alternative than barter or makeshift monies? What if there were multiple competing issuers of money? What if our eggs weren’t all in one basket?

Free banking theory envisions a world where each money issuer has their own “monetary policy”, and a shortage or surplus created by one issuer is a profit opportunity for all others. When attempts to engage in mutually beneficial exchange are frustrated by a shortage of money, then people will seek alternatives. In an ideal free banking scenario, those alternatives are readily available monies created by institutions poised to soak up any excess demand for money. A free banking system is, in this way, robust against errors of monetary policy that can devastate an economy dependent on a central bank.

No system is perfect, and I’m aware of the futility of advocating free banking. However, I’m very much in favour of theorising about free banking. It is often only when ideas are contrasted with alternatives that we tease out hidden assumptions. Insights that seem deep and elusive from one perspective can become trivial and obvious from another.

Normally, economists understand market failure and government intervention in the light of ideal markets, but all such norms are reversed when it comes to money and banking. Many insights that are hard to come with conventional thinking, such as nominal GDP targeting, are relatively straightforward when understood in the light of free banking. The idea that people will seek alternatives to a given money when it’s suffering from a shortage of surplus is not just implicit in free banking, but is at the the core of what it means for there to be monetary competition in the first place.

© Copyright (2012) Lee Kelly