Antifragile banking and monetary systems.

• Author: White, Lawrence H.

"Fragility" is the well-known property of being easily breakable, of failing under moderate stress. The opposite property is "antifragility," a term coined by Nassim Nicholas Taleb (2012a) and the title of his recent book. Taleb (2012b) defines antifragility as the property exhibited by "things that gain strength from stressors and get stronger from failure, like evolution." An antifragile thing or system is stress-loving. What doesn't kill it makes it stronger. We exercise, for example, because our muscles grow stronger from moderate stress. Robustness, an intermediate concept, is the property of being unaffected either way by moderate stresses. Taleb illustrates the threefold distinction this way: We stamp "handle with care" on a package containing something fragile; we needn't stamp any instructions on a package containing something robust, because it won't be affected by handling; but we would stamp "please handle roughly" on a package containing something antifragile, because such handling would make it emerge stronger.

Here I consider how we might achieve ant/fragile banking and monetary systems. There are reforms that can marginally reduce fragility, but I will argue that to achieve ant/fragility will require a serious turn away from "one-practice-fits-all" centralized regulation and toward a free market's mixture of innovation and strict discipline. In banking it will require an end not only to "too big to fail" bailouts of uninsured creditors and counterparties, but also to other forms of taxpayer-backed depositor and creditor guarantees. Deposit guarantees, contrary to intention and despite their immediate run-suppressing effects, in the long run have fostered moral hazard and thereby contributed to banking system fragility. In monetary policy, it will require an end to centralized monetary policy. The centralization of money issue has eliminated the market-based disciplinary and error-correction mechanisms that once governed money creation, thereby putting all our monetary eggs in one basket and creating monetary system fragility.

The Banking System Is Not Naturally Fragile

Many economists--and certainly regulators--will object that to make the banking system antifragile is a futile undertaking because banking is naturally fragile, meaning, inherently prone to collapse in the absence of government guarantees to depositors (and by extension guarantees to all short-term creditors). (1) For example, Nobel laureate economist Robert Lucas (2011: 20), in the slides accompanying a recent lecture that is otherwise favorable to free markets, states flatly that "a fractional reserve banking system will always be fragile, a house of cards." In such a view the best that can be done is to institute government guarantees to mitigate fragility, or perhaps to outlaw fractional reserve banking, as recommended by Kotlikoff (2010) among others, by banning the modern practice of providing payments services through checking accounts whose balances are demandable debts.

The most widely cited model of banking in the economics literature today is the Diamond-Dybvig (1983) model, which depicts a very fragile bank. A depositor run will easily break it, and a run can easily occur, triggered merely by self-justifying worries that others will run. A form of deposit insurance is needed to fix the problem. Many have taken from the model (and from the large theoretical literature built on it) the lesson that any modern banking system is naturally fragile. Models depicting banks as naturally fragile seem descriptively plausible to those whose familiarity with banking history is limited to the United States. The United States did have a series of banking panics between 1873 and 1933, and the introduction of federal deposit insurance in 1933 did finally stop that decade's panics.

A more thorough look at theory and empirical evidence indicates clearly that banking is not naturally fragile. Theoretically, the fragility result of the Diamond-Dybvig model is itself fragile: it does not survive small modifications that make the model's assumptions more realistic. (2) Calomiris and Gorton (1991: 110) have aptly summarized the evidence from historical studies of banking panics: "The conclusion of this work and cross-country comparisons is that banking panics are not inherent in banking contracts--institutional structure matters."

The view of banking institutions as naturally fragile is implausibly anti-Darwinian. It defies the Darwinian principle of natural selection ("the survival of the fittest"). Given a few centuries, financial institutions that are inherently prone to collapse should be expected to collapse and thereby to disappear over time, while sturdier structures should be expected to survive. The inherent-fragility view of banking cannot explain how modern banking survived, much less how it flourished and spread across the world, as it did for the seven-plus centuries between its emergence around 1200 (Lopez 1979: 12) and the arrival of official safety nets after 1900 in the form of government-sponsored lenders of last resort and national deposit insurance.

Antifragile banking systems can be historically observed under "free banking" regimes where legal restrictions and privileges were at a minimum. Leading cases include Australia, Canada, Chile, the New England region of the United States, Scotland, Sweden, and Switzerland (see Dowd 1992b, Briones and Rockoff 2005). These systems did not have zero bank failures, but they emerged from them chastened and stronger. They fulfill the criteria that Taleb (2012b) enunciated in an interview with CNBC: "What is fragile should break early, and not too late.... I want a [banking] system that gets better after every shock. A system that relies on bailouts is not such a system."

A well-known episode provides an example of the resilience of a free banking system. Adam Smith in The Wealth of Nations (Book II, Chapter II, para. 73) noted the spectacular rise and 1772 crash of Douglas, Heron & Company, better known as the Ayr Bank, which has been more recently described by Hugh Rockoff (2011) as "the Lehman Brothers of the day." In Smith's words the bank's "design was generous; but the execution was imprudent." Rockoff notes that the Ayr Bank's proprietors approached the Bank of England (at that time a private firm) for bridge financing, but the terms offered were so...