Wednesday, 20 September 2017


A Prisoner’s Dilemma in Free Banking?

April 20, 2012
in Blog

Everything looks monopolistic if you leave out competition.

There are several criticisms to the system of free banking. One of them relies on the conclusion that such system will converge to the presence of a central bank. This is, for instance, the position of Charles Goodhart and Huerta de Soto. From the Austrian school point of view, Huerta de Soto’s argument, which can be found in his book “Money, Bank Credit, and Economic Cycles” (pp. 664-671), is also made by Phillip Bagus and David Howden. However, Huerta de Soto’s application of the prisoner’s dilemma to free banking is incorrect.

Huerta de Soto offers a scenario with two banks that face two strategies: to expand the issuance of banknotes, or to not expand the issuance of banknotes. The following table (p. 667) is presented as a tragedy of the commons that “is typically used to illustrate the classic ‘prisoner’s dilemma.’”

It is convenient, in this game, for both Banks A and B to expand the issue of banknotes and obtain large profits. It is over this structure that some criticisms against free banking are built. This setup, however, suffers from important limitations.

A prisoner’s dilemma?

It is first to be noted that the game used by Huerta de Soto does not represent a prisoner’s dilemma. Such a game has strictly dominant strategies for each player that result in a Pareto inferior Nash equilibrium (i.e. both players will choose to defect, even though mutual cooperation is the optimal outcome for each). In other words, economic agents, in this case prisoners, would be better off by cooperating rather than individually confessing to their crime. That is the result of a prisoner’s dilemma (without repetition).

The game offered by Huerta de Soto, however, has a Nash equilibrium with “large benefits for both,” which is a Pareto optimal solution. This is not a prisoner’s dilemma game. There is no dilemma in the game.

What about competition?

By making use of a game with these characteristics, there is no place for freedom of entry and exit of other competitors by definition. Without freedom of entry and exit there is no competition. But competition is a key aspect of the free banking system. If Banks A and B decide to expand and, as Huerta de Soto and other critics claim, that is a fraudulent act, why it is not allowed for other banks to enter into the market and offer 100-percent reserve deposits? The entry of banks that would capture customers from the irresponsible banks is ruled out by construction.

Such a limitation imposes a significant separation between the analysis offered and the object of the criticism: free banking dynamics.

Precautionary reserves

Even if the expected amount of reserve for both Banks can remain stable while both of them expand in concert, the volatility of their reserves does increase. This means that the capability to expand banknotes in concert is limited by the market itself. This is a problem explicitly mentioned by George Selgin, whom Huerta de Soto cites in this section of his book, but that he fails to address.

Since the volatility of their reserves increases, banks see themselves forced to increase the amount of their reserves to be able to respond to a higher amounts of adverse clearing and withdrawals. Even though there is some space for concerted expansion, this becomes significantly limited.

The dynamics that take place under free banking are very important, especially for the problem of financial stability and convergence to a central bank. The use of the prisoner’s dilemma fails in two important areas. First, the problem offered is not a prisoner’s dilemma. Second, the problem ‒whether or not a prisoner’s dilemma‒ is not a fair representation of how free banking works. Whatever merits such line of argumentation can have, they do not apply to the case of free banking. In addition to this limitation, it should be added that historical records show that free banking was not only stable, but that most central banks were originated under a common denominator: fiscal deficits, not financial instability.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.