Free Banking and Precautionary Reserves: Some Technical Quibbles

IN THIS ARTICLE we consider an argument put forth by Selgin (1988) in support of the claim that a fractional reserve free banking (FR/FB) system is stable. Selgin argues that, even under an in-concert expansion of fiduciary media by the individual banks, there will be internal mechanisms acting as a brake on such expansion if it is unwarranted by demand to hold such media. Specifically, such banks hold precautionary or risk-adjusted reserves against expected losses, and even if the expectation of reserve losses remains zero, the variance of such losses (adverse clearings) increases under an in-concert expansion and, detecting this increase, the individual banks will recognize the need to hold greater reserves and so effectively contract their note issue. We take issue with this argument on the basis of the fact that such detection would require that characteristics of the underlying data-generating process for the clearings be obtainable from pathwise realizations of that process. In other words, there is an implicit assumption of stationarity (or more strongly, ergodicity) in Selgin’s argument, and this assumption is at odds with wellknown empirical facts of non-stationarity associated with most economic time series. We also point out ways in which techniques of risk management commonly found in the modern financial industry are unlikely to be effective in addressing this problem.