Entrepreneurial Error Does Not Equal Market Failure

Barnett and Block (2015).

Bagus and Howden (2016).

We quote here from Bagus (2010) because it makes use of the same reasoning as all of BH’s work on the ethicality and legality of maturity transformation and fractional-reserve banking. Other articles we have written on the topic (e.g., Bagus and Howden 2013, 2016, Bagus et al. 2015) only reject this outcome implicitly by not referring to it. Instead, our focus has always exclusively been on maturity transformation in the unhampered market. Howden and Gabriel (2015) discuss the role of the interest rate in halting excessive maturity mismatching in the unhampered economy. We do treat maturity transformation as a damaging economic force when fostered by governmental guarantees in Bagus and Howden (2010a), though that article only tangentially deals with the core issue of the present debate, namely, how ethical, legal, or economically beneficial fractional-reserve banking is.

BH assessed the case of excessive maturity mismatching as a cause of Iceland’s recent crisis, identifying it as a result of government liquidity and solvency guarantees (Bagus and Howden 2011, Chap. 2).

A free market with the possibility of profits with no losses is akin to the bliss of heaven with no threat of hell.

Bagus and Howden (2009, p. 399) write: “However, while the practice (BSLL) is not illicit per se, it is greatly assisted and developed through the presence of a fractional-reserve banking system, and can sometimes breed detrimental effects.” BB (2015) cite this sentence and comment: “The point is, if BSLL can sometimes breed detrimental effects’ [fn omitted] and it should be allowed by law as these authors contend, then it constitutes a market failure, an implication with which, we contend, BH will be, or at least should be, uncomfortable.” Actually, BH are not uncomfortable in the least. First, we state clearly and many times that maturity mismatching, i.e., BSLL, is greatly assisted by fractional-reserve banking which we (like BB) do not consider to be a free-market practice. Second, we defend a free market that allows for individual errors which by definition always have detrimental effects, at least for the actor and potentially also for third parties. However, these detrimental effects of individual error do not constitute market failure which is the widespread and correlated nature of individual errors.

Traditional analysis of the savings requirement for long-dated investments focuses on the concept of the subsistence fund, both in its stock form available before the investment is undertaken and in its flow form as the ongoing product of simultaneous investments. On the subsistence fund, see von Strigl (2001) and Braun (2014).

The perishability of fish is a constraint in this example that we abstract from this point for simplicity. In any case, money is a perfectly nonperishable savings tool and is the primary means of saving employed today.

We say “necessarily different” here as the duration of the loan is known ex ante, but the duration of investment is only revealed ex post facto. Since the expected investment maturity cannot be known in the present with any degree of certainty, whether the maturity of the loan and the investment it funds are matched can never be known at the initiation of an investment project and will only potentially be revealed at the project’s completion.

Davidson (2014) maintains similarly that maturity mismatching does not cause distortions in a free market. We claim, a fortiori, that maturity mismatching is not only neutral but may also be welfare enhancing.

Block and Davidson (2011) maintain that the ethics of fractional-reserve banking is more a fundamental and important issue than its economic consequences.

Davidson (2014, 86) refers to another important difference between credit expansion and maturity mismatching. While credit expansion artificially lowers interest rates, thus inducing entrepreneurial error, in the unhampered market maturity mismatching’s effect on interest rates is to raise short-term and reduce long-term rates. Maturity mismatching flattens the yield curve to a level more in line with overall uncertainty and the availability of savings.

In our example, when the entrepreneur pays down his bank loan, credit contracts and the bank increases its reserve ratio. In practice, when a bank loan is paid down, banks often use the additional reserves to grant another loan. In other words, even though workers save all of the $1000 and the entrepreneur pays down his bank loan, there may be an artificial boom when the bank grants a further loan to another entrepreneur.

Howden (2010) shows that the more distant one is from the source of the initial credit expansion, the lesser will be the knowledge of whether a loan is backed by real savings or credit expansion. Investments made without this knowledge will be more fragile as they have a reduced understanding of the true resource constraint limiting their investments in both magnitude and duration.

This was, after all, one of the primary forces that drove the fractional-reserve free banking industry in America to demand the imposition of the Federal Reserve (Bagus and Howden 2012a, Sect. 3; Howden 2014).

Even though the contract is void (i.e., no court would enforce it) the parties can still dissolve the contract mutually and agree to another valid contract (i.e., debt renegotiation). For instance, B could convince C to give him the Picasso back after one year.

Already Lysander Spooner criticized the contract theory based on promises. See also Barnett (1986, 1992) for problems associated with a contract theory relying on promises. On the title-transfer theory of contract see Evers (1977) and Rothbard (1982). For a recent overview see Kinsella (2003).

As Davidson (2015, p. 8) puts it: “There is no half-way measure in the case of money. Because of money’s very nature, money’s title cannot be divided into different kinds of ownership privileges in the way of an easement or a rental contract. Consequently, there can only be one right associated with it: Full unrestricted ownership.”

Davidson (2015) shows that Barnett and Block's confusion arises because those authors fail to recognize that the English language employs two very different meanings for the terms "loan" and "claim."

Indeed, it is nonsensible to speak of savings without making reference to the investment that embodies them (Braun 2014, Chap. 19).

More generally, the ethicality of maturity mismatching does not depend on the loan being self-liquidating (or a real bill) or not.