Wednesday, 20 September 2017

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Polycentric banking?

April 11, 2016
in Blog

One of the most interesting areas within the analysis of governance regimes is the literature on polycentricity.  Polycentric governance systems are characterized by fractured and concurrent authority.  In other words, in polycentric systems, power is decentralized, and there is no final authority that possesses what is typically thought of as sovereignty—the right to make final decisions, beyond which there is no appeal.

Governance systems must possess both to be polycentric; mere decentralization is not enough.

Interestingly enough, this concept can be applied to money, banking, and finance as well, as Vlad Tarko and I explain in a recent paper.  In Western economies, these sectors are actually more monocentric than polycentric.  Authority is relatively concentrated in central banks and various regulatory agencies, beyond which there is no authority that can override decisions and check potential mistakes or abuses.  You don’t need to be a systems engineer to know that monocentric systems, in any area, can be worrying in terms of stability—fewer points of failure means increased likelihood of shocks destabilizing the whole system.

In contrast, historical free banking systems were much further along the polycentric side of the spectrum.  There were no central banks as we currently understand them, and regulatory authority was almost nonexistent.  All banks and other financial organizations were free to compete and offer products, constrained by the general law of property contract, and torts.  This ‘legal embeddedness’ meant that private liability-issuing banks were constrained by a set of rules that prevented predatory behavior.  Importantly, this set of rules was difficult to co-opt for any one actor’s private gain.  Another important underlying institution was some sort of commodity standard, which preserved the integrity of the deposit contract and aligned banks’ incentives with those of their depositors, as well as third parties who would be affected by banks’ activities.  Finally, the rise of the clearinghouse provided an effective and voluntary source of oversight in terms of safety, information sharing, and emergency loans during potential liquidity crunches.  These emergency loans were made by private actors, to other private actors.  There was no monopoly money issuer that could create purchasing power ex nihilo, and so the potential for moral hazard was insignificant.

Thus the free banking systems of the 17th and 18th centuries (and later in some places) have a good claim to be characterized as polycentric.  Mistakes made by any one bank tended not to have global economic effects; if these banks persisted in their errors, they would be forced to close.  No one actor could become disproportionately powerful to destabilize the system for its own benefit.  Small wonder that periods of free banking tended to result in short-run stability, as banks internalized incentives to maintain monetary equilibrium, and long-run growth, due to the existence of a vibrant and healthy capital allocation sector.  I will elaborate more on the virtues of polycentric governance systems for money, banking, and finance in subsequent posts. Stay tuned.