Inequality vs Inequality. NASSIM N TALEB

There is inequality and inequality.

The first is the inequality people tolerate, such as one’s understanding compared to that of people deemed heroes, say Einstein, Michelangelo, or the recluse mathematician Grisha Perelman, in comparison to whom one has no difficulty acknowledging a large surplus. This applies to entrepreneurs, artists, soldiers, heroes, the singer Bob Dylan, Socrates, the current local celebrity chef, some Roman Emperor of good repute, say Marcus Aurelius; in short those for whom one can naturally be a “fan”. You may like to imitate them, you may aspire to be like them; but you don’t resent them.

The second is the inequality people find intolerable because the subject appears to be just a person like you, except that he has been playing the system, and getting himself into rent seeking, acquiring privileges that are not warranted –and although he has something you would not mind having (which may include his Russian girlfriend), he is exactly the type of whom you cannot possibly become a fan. The latter category includes bankers, bureaucrats who get rich, former senators shilling for the evil firm Monsanto, clean-shaven chief executives who wear ties, and talking heads on television making outsized bonuses. You don’t just envy them; you take umbrage at their fame, and the sight of their expensive or even semi-expensive car trigger some feeling of bitterness. They make you feel smaller.

There may be something dissonant in the spectacle of a rich slave.

The author Joan Williams, in an insightful article, explains that the working class is impressed by the rich, as role models. Michèle Lamont, the author of The Dignity of Working Men, whom she cites, did a systematic interview of blue collar Americans and found present a resentment of professionals but, unexpectedly, not of the rich.

It is safe to accept that the American public –actually all public –despise people who make a lot of money on a salary, or, rather, salarymen who make a lot of money. This is indeed generalized to other countries: a few years ago the Swiss, of all people almost voted a law capping salaries of managers . But the same Swiss hold rich entrepreneurs, and people who have derived their celebrity by other means, in some respect.[ii]

Further, in countries where wealth comes from rent seeking, political patronage, or what is called regulatory capture (by which the powerful uses regulation to scam the public, or red tape to slow down competition), wealth is seen as zero-sum. What Peter gets is extracted from Paul. Someone getting rich is doing so at other people’s expense. In countries such as the U.S. where wealth can come from destruction, people can easily see that someone getting rich is not taking dollars from your pocket; perhaps even putting some in yours. On the other hand, inequality, by definition, is zero sum.

In this chapter I will propose that effectively what people resent –or should resent –is the person at the top who has no skin in the game, that is, because he doesn’t bear his allotted risk, is immune to the possibility of falling from his pedestal, exiting the income or wealth bracket, and getting to the soup kitchen. Again, on that account, the detractors of Donald Trump, when he was a candidate, failed to realize that, by advertising his episode of bankruptcy and his personal losses of close to a billion dollars, they removed the resentment (the second type of inequality) one may have towards him. There is something respectable in losing a billion dollars, provided it is your own money.

In addition, someone without skin in the game –say a corporate executive with upside and no financial downside (the type to speak clearly in meetings) –is paid according to some metrics that do not necessarily reflect the health of the company; these (as we saw in Chapter x) he can manipulate, hide risks, get the bonus, then retire (or go to another company) and blame his successor for the subsequent results.

We will also, in the process, redefine inequality and put the notion on more rigorous grounds. But we first need to introduce the difference between two types of approaches, the static and the dynamic, as skin in the game can transform one type of inequality into another.

Take also the two following remarks:

True equality is equality in probability


Skin in the game prevents systems from rotting

The Static and the Dynamic

Visibly, a problem with economists (particularly those who never really worked in the real world) is that they have mental difficulties with things that move and are unable to consider that things that move have different attributes from things that don’t –it may be trivial but reread Chapter [3] on IYIs if you are not convinced. That’s the reason complexity theory and fat tails are foreign to most of them; they also have (severe) difficulties with the mathematical and conceptual intuitions required for deeper probability theory. Blindness to ergodicity which we will define a few paragraphs down, is indeed in my opinion the best marker separating a genuine scholar who understands something about the world, from an academic hack who partakes of a ritualistic paper writing.

Let us make a few definitions:

Static inequality is a snapshot view of inequality; it does not reflect what will happen to you in the course of your life

Consider that about ten percent of Americans will spend at least a year in the top one percent and more than half of all Americans will spent a year in the top ten percent[1]. This is visibly not the same for the more static –but nominally more equal –Europe. For instance, only ten percent of the wealthiest five hundred American people or dynasties were so thirty years ago; more than sixty percent of those on the French list were heirs and a third of the richest Europeans were the richest centuries ago. In Florence, it was just revealed that things are really even worse: the same handful of families have kept the wealth for five centuries.[iii]

Dynamic (ergodic) inequality takes into account the entire future and past life

You do not create dynamic equality just by raising the level of those at the bottom, but rather by making the rich rotate –or by forcing people to incur the possibility of creating an opening.

The way to make society more equal is by forcing (through skin in the game) the rich to be subjected to the risk of exiting from the one percent

Or, more mathematically

Dynamic equality assumes Markov chain with no absorbing states

Our condition here is stronger than mere income mobility. Mobility means that someone can become rich. The no absorbing barrier condition means that someone who is rich should never be certain to stay rich.

Now, even more mathematically

Dynamic equality is what restores ergodicity, making time and ensemble probabilities substitutable

Let me explain ergodicity –something that we said is foreign to the intelligentsia; we will devote an entire section as we will see it cancels most crucial psychological experiments related to probability and rationality. Take a cross sectional picture of the U.S. population. You have, say, a minority of millionaires in the one percent, some overweight, some tall, some humorous. You also have a high majority of people in the lower middle class, school yoga instructors, baking experts, gardening consultants, spreadsheet theoreticians, dancing advisors, and piano repairpersons. Take the percentages of each income or wealth bracket (note that income inequality is flatter than that of wealth). Perfect ergodicity means that each one of us, should he live forever, would spend the proportion of time in the economic conditions of segments of that entire cross-section: out of, say, a century, an average of sixty years in the lower middle class, ten years in the upper middle class, twenty years in the blue collar class, and perhaps one single year in the one percent. (Technical comment: what we can call here imperfect ergodicity means that each one of us has long term, ergodic probabilities that have some variation among individuals: your probability of ending in the one percent may be higher than mine; nevertheless no state will have a probability of zero for me and no state will have a transition probability of one for you).

The exact opposite of perfect ergodicity is an absorbing state. The term absorption is derived from particles that, when they hit an obstacle, get absorbed or stick to it. An absorbing barrier is like a trap, once in, you can’t get out, good or bad. A person gets rich by some process, then having arrived, as they say, he stays rich. And if someone enters the lower middle class (from above); he will never have the chance to exit from it and become rich should he want to, of course –hence will be justified to resent the rich. You will notice that where the state is large, people at the top tend to have little downward mobility –in such places as France, the state is chummy with large corporations and protects their executives and shareholders from experiencing such descent; it even encourages their ascent.

And no downside for some means no upside for the rest.

Take for now that an absorbing state –staying rich –causes path dependence, the topic of Part X.

Pikketism and the Revolt of the Mandarin Class

There is a class often called the Mandarins, after the fictional memoirs of the French author Simone de Beauvoir, named after the scholars of the Ming dynasty that gave their name to the high Chinese language. I have always been aware of its existence, but its salient –and pernicious –attribute came to me while observing the reactions to the works by the French economist Thomas Pikkety.

Pikkety followed Karl Marx by writing an ambitious book on Capital. I received the book as a gift when it was still in French (and unknown outside France) because I found it commendable that people publish their original, nonmathematical work in social science in book format. The book, Capital in the 21st Century, made aggressive claims about the alarming rise of inequality, added to a theory of why capital tended to command too much return in relation to labor and how absence of redistribution and dispossession would make the world collapse. The theory about the increase in the return of capital in relation to labor was patently wrong, as anyone who has witnessed the rise of what is called the “knowledge economy” (or anyone who has had investments in general) knows. But there was something far, far more severe than a scholar being wrong.

Soon, I discovered that the methods he used were flawed: Picketty’s tools did not show what he purported about the rise in inequality. I soon wrote two articles, one in collaboration with Raphael Douady that we published in Physica A: Statistical Mechanics and Applications, about the measure of inequality that consists in taking the ownership of, say the top 1% and monitoring its variations. The flaw is that if you take the inequality thus measured in Europe as a whole, you will find it is higher than the average inequality across component countries; the bias increases in severity with extreme processes. The same defect applied to the way inequality researchers used a measure called Gini coefficient, and I wrote another paper on that. All in all, the papers had enough theorems and proofs, to make them about as ironclad a piece of work one can have in science; I insisted on putting the results in theorem form because someone cannot contest a formally proved theorem without putting in question his own understanding of mathematics.

The reason these errors were not known was because economists who worked with inequality were not familiar with… inequality. Inequality is the disproportion of the role of the tail –rich people were in the tails of the distribution.[2] The more inequality in the system, the more the winner-take-all effect, the more we depart from the methods of tin-tailed Mediocristan in which economists were trained. Recall that the wealth process is dominated by winner-take-all effects, the type described in The Black Swan. Any form of control of the wealth process –typically instigated by bureaucrats –tended to lock people with privileges in their state of entitlement. So the solution was to allow the system to destroy the strong, something that worked best in the United States.

The problem is never the problem; it is how people handle it. What was worse than the Piketty flaws was the discovery of how that Mandarin class operates. They got so excited by the rise of inequality that their actions were like fake news. Economists got so excited they praised Piketty for his “erudition” from his discussing Balzac and Jane Austen, the equivalent to hailing as a weightlifter someone seen carrying a briefcase. And they completely ignored my results –and when they didn’t, it was to declare that I was “arrogant” (recall that the strategy of using theorems is that they can’t say I was wrong, so they resorted to “arrogant” which is a form of scientific compliment). Even Paul Krugman who had written “if you think you’ve found an obvious hole, empirical or logical, in Piketty, you’re very probably wrong. He’s done his homework!”[iv], when I pointed out the flaw to him, when I met him in person, evaded it –not necessarily by meanness but most likely because probability and combinatorics eluded him, by his own admission.

Now consider that the likes of Krugman and Piketty have no downside in their existence –lowering inequality brings them up in the ladder of life. Unless the university system or the French state go bust, they will continue receiving their paycheck. Donald Trump is exposed to the risk of ending having his meals in a soup kitchen; not them.

Cobbler Envies Cobbler

Envy does not travel long distance, or across so many social classes. The envy-driven feelings that usually –as we saw in the works of Williams and Lamont –do not originate from the impoverished classes, concerned with the betterment of their condition, but with that of the clerical class. Simply, it looks like it is the university professors (who have arrived) and people who have permanent stability of income, in the form of tenure, governmental or academic, who bought heavily in the argument. From the conversations, I became convinced that these people who counterfactual upwards (i.e. compare themselves to those richer) wanted to actively dispossess the rich. As will all communist movements, it is often the bourgeois or clerical classes that buy first into the argument.[1]

Aristotle, in his Rhetoric postulated that envy is something you are more likely to encounter in your own kin: lower classes are more likely to experience envy towards their cousins or the middle class than towards the very rich. The expression Nobody is a prophet in his own land making envy a geographical thing (mistakenly thought to originate with Jesusουδείς προφήτης στον τόπο του in Luke and a similar expression in Mark) originates with that passage in the Rhetoric. Aristotle himself was building on Hesiod’s: cobbler envies cobbler, carpenter envies carpenter. Later, La Bruyere wrote jealousy is found within the same art, talent and condition.

So I doubt Piketty bothered to ask blue-collar Frenchmen what they want, as Lamont did. I am certain that they would ask for a new dishwasher, or faster train for their commute, not to bring down some rich businessman invisible to them. But, again, people can frame questions and portray enrichment as theft, as it was before the French Revolution, in which case the blue-collar class would ask, once again, for heads to roll.[2]

[1] “τὸ συγγενὲς γὰρ καὶ φθονεῖν ἐπίσταται.”, Rhetoric 1388a, citing originally from Aeschylus, frag. 304.

[2] La Bruyere: L’émulation et la jalousie ne se rencontrent guère que dans les personnes du même art, de même talent et de même condition.

Data, Shmata

Another lesson from Piketty’s ambitious volume: it was loaded with charts and tables. But what we learn from professionals in the real world is that data is not necessarily rigor. One reason I –as a probability professional –left data out of The Black Swan (except for illustrative purposes) is that it seems to me that people flood their story with numbers and graphs in the absence of logical argument. Further, people mistake empiricism with flood of data. Just a little bit of significant data is needed when one is right, particularly when it is disconfirmatory empiricism, or counterexamples for rules: only one point is sufficient to show that Black Swans exist.

Probability, statistics, and data science are principally logic fed by observations –and absence of observations. For many environments, the relevant data points are those in the extremes; these are rare by definition; and it suffices to focus on those few but big to get an idea of the story. If you want to show that a person is richer than, say $10 million, all you need is show the $50 mil in his brokerage account, not, in addition, list every piece of furniture in his house, including the $500 painting he has in his study and a count of the silver spoons in his pantry. So I’ve discovered, with experience, that when you buy a thick book with tons of graphs and tables used to prove a point, something is alarmingly suspicious. It means something didn’t distil right! But for the general public and those untrained in statistics, such tables appear convincing –another way to substitute the true with the complicated. For instance, the science journalist Steven Pinker did that with his book, The Better Angels of Our Nature, concerning the decline of violence in modern human history. My collaborator Pasquale Cirillo and I, when we put his “data” under scrutiny, found out that that either he didn’t understand his own numbers (actually, he didn’t), or he had a story in mind and kept adding charts not realizing that statistics isn’t about data but distillation, rigor and avoiding being fooled by randomness –but no matter, the general public of IYI colleagues found it impressive for a while.

Ethics of Civil Service

People who like bureaucracies and the state have trouble understanding that having rich people in a public office is very different from having public people become rich –again it is the dynamics, the sequence that matters. Rich people in public office have shown some evidence of lack of total incompetence –success may come from randomness, of course, but we at least have a hint of some skill in the real world, some evidence that the person has dealt with reality. This is of course conditional of the person having had skin in the game –and it is better if the person felt a blowup, has experienced at least once the loss part of his or her fortune and the angst associated with it.

A good rule for society is to oblige those who start in public office to pledge never subsequently to earn from the private sector more than a set amount; the rest should go to the taxpayer. This will ensure sincerity in, literally, “service” — where employees are supposedly underpaid because of their emotional reward from serving society. It would prove that they are not in the public sector as an investment strategy: you do not become a Jesuit priest because it may help you get hired by Goldman Sachs later, after your eventual defrocking –given the erudition and the masterly control of casuistry generally associated with the Society of Jesus.

Currently, most civil servants tend to stay in civil service –except for those in delicate areas that industry controls: the agro-alimentary segment, finance, aerospace, anything related to Saudi Arabia…

Currently, a civil servant can make rules that are friendly to an industry such as banking — and then go off to J.P. Morgan and recoup a multiple of the difference between his or her current salary and the market rate. (Regulators, you may recall, have an incentive to make rules as complex as possible so their expertise can later be hired at a higher price.)

So there is an implicit bribe in civil service: you act as a servant to industry, say Monsanto, and they take care of you later on. They do not do it out of a sense of honor: simply, it is necessary to keep such a system going and encourage the next guy to play by the rules. The IYI cum scumbag Tim Geithner–with whom I share a Calabrese barber –was overtly rewarded by the industry he helped bail out.

Watch former heads of state such as Bill Clinton or Tony Blair use the fame that the general public gave them to make hundreds of million in speaking fees –indeed for these two sleek fellows, public service was the most effective step towards enrichment. The difference between a salesman and a charlatan is that the latter doesn’t deliver what he claims to be selling. Ironically the pair Clinton-Blair appeared less greedy than the typical ego-driven businessman who seeks elections.


[1] 39% of Americans will spend a year in the top 5 % of the income distribution, 56 % will find themselves in the top 10%, and 73% percent will spend a year in the top 20 %.

[2] The type of distributions –called fat tails –associated with it made the analyses more delicate, far more delicate and it had become my mathematical specialty. In Mediocristan changes over time are the result of the collective contributions of the center, the middle. In Extremistan these changes come from the tails. Sorry, if you don’t like it but that is purely mathematical.

La necesaria comprensión de la Revolución Rusa (I)

Adjunto un breve reflexión sobre el magnífico libro Gulag: la historia de los campos de concentración soviéticos, de Anne Applebaum, premio Pulitzer en 2004, y editado por el sello de Random House Debate que dirige Miguel Aguilar. Applebaum, al igual que uno de sus maestros Richard Pipes (también editado por Debate), destaca la relativamente poco conocida historia de la Revolución Rusa y de los regímenes comunistas en general, a veces incluso idealizada por algunos, y que sin duda no tiene el estigma de otras ideologías como el nazismo o el fascismo pese a que el comunismo ha causado el mismo tipo de sufrimiento, terror y muerte, sino más.



En próximas entregas: La Revolución Rusa, Richard Pipes (Debate, 2016).

La tiranía del igualitarismo

Desde el advenimiento de la crisis, y ya de antes, que uno de los temas que suele centrar la agenda política en los países desarrollados es el tema de la igualdad: es decir, los (supuestos) perjuicios e injusticias que se derivan cuando en una sociedad no todos tienen la misma riqueza o renta. Se trata de un tema en el que se suele ver un (falso, aunque solo en parte) “trade off” entre igualdad y libertad: lo cierto es que, bien analizado, libertad e igualdad van de la mano, eso sí igualdad ante la ley, igualdad de oportunidades, igualdad desde un punto de vista moral, no la “obsesión igualitaria” con la que algunos pretenden justificar todo tipo de ataques a la libertad y la propiedad.

El analizar las dos concepciones principales, desde un punto filosófico de la igualdad, es el objeto del último libro del economista liberal chileno Axel Kaiser, La tiranía de la igualdad (Deusto, 2017). El libro es una mordaz crítica a muchos de los mitos y errores de concepto que se dan en el debate político a la hora de explotar un tema sensible, que levanta pasiones y muchos sentimientos, y que se ha convertido en uno de los principales campos de batalla para la captación de voto desde la izquierda y también desde la derecha.


Uno de los principales mensajes del libro es que la igualdad no es un problema. La igualdad más bien es una distracción, letal por cierto, del problema principal que no es otro que la pobreza. Al final, y como desgrana el autor en un texto tremendamente ágil y claro, es que la búsqueda de la igualdad supone atentar contra la libertad, la prosperidad y la moral imposibilitando un orden social pacífico. El libro, que tiene una fuerte carga de profundidad, explora los orígenes de la filosofía política liberal donde uno de sus principales axiomas es, precisamente, la igualdad ante la ley. El liberalismo es una filosofía política individualista donde el individuo tiene derechos frente a la colectividad.

Desde los moralistas ingleses del s. XVII y XVIII hemos entendido que todas las personas son iguales desde un punto de vista moral, político y jurídico. Una idea potente en la que se asientan el sistema político (con sus variantes formales) que conocemos como democracia liberal y que recoge, por ejemplo, la Declaración de Independencia de Estados Unidos. El liberalismo clásico, por lo tanto, no se preocupa del resultado (que depende de la habilidad, talento, ambición, ganas, suerte de cada uno), sino por el procedimiento, es decir que todos hayamos sido tratados de igual manera. Esta visión es la que permite que diferentes individuos puedan perseguir fines tan dispares como vender ordenadores, montar un hotel o jugar al fútbol sin agredir los derechos de los demás mientras consiguen sus objetivos. Este foco en el procedimiento nos lleva a preocuparnos por la igualdad ante la ley y la justicia (por eso es ciega, por qué no atiende a circunstancias particulares), el Imperio de la Ley, o la defensa de los derechos inalienables de las personas empezando por el derecho a la vida y la propiedad. Hoy, todo dicho sea de paso, terriblemente erosionados y de ahí también el estado de estancamiento económico y social relativo que arrastramos desde hace años.

Por el contrario, adoptar una visión de la igualdad consecuencialista, donde lo que cuenta son los resultados, es un enfoque que irremediablemente su consecución, argumenta perfectamente Kaiser, implica una agresión para con la igualdad ante la ley, la seguridad jurídica de las personas y conculca los derechos de las personas. Se trata, en definitiva, de un enfoque equivocado que llevado a la práctica resulta inmoral y liberticida: inmoral por qué es injusto, por ejemplo, que dos estudiantes, uno que sabe mucho y otro que sabe poco, saquen la misma nota; liberticida por qué la implementación de políticas que buscan la igualdad de resultado suponen una agresión a los derechos de propiedad de las personas en un dilema irresoluble.

El desconocimiento muchas veces de cómo realmente funciona la economía y que es realmente el liberalismo ha dado lugar a un sinfín de confusiones en el plano político y social con respecto a este debate hoy dominado por el dogma de lo público. Sin embargo, la igualdad SÍ es importante. Por eso es uno de los axiomas del liberalismo. La historia reciente de los últimos tres siglos es una lucha por la conquista de la igualdad, pero de una igualdad moral, una igualdad que no agrede derechos, una igualdad que respeta la propia naturaleza del hombre y que reconoce el carácter singular, único e irrepetible de cada ser humano.

Lo contrario, como también recuerda el autor, significa poner el énfasis en la envidia, un sentimiento como los celos, que quién lo sufre difícilmente lo puede controlar. Este es un análisis que ha realizado con gran solvencia la brillante economista de la Universidad de Chicago Dierdre McCloskey cuyo Bourgeois Equality es, sin duda, el mejor análisis y más completo que se ha hecho sobre el tema de la desigualdad y en donde en la ecuación del análisis se ha añadido la variable ética, no únicamente una visión utilitaria (aparte de manirrota y pobremente construida) como es el caso de Piketty (véase la crítica de Rallo), Stiglitz o, más recientemente, Branko Milanovic (de nuevo, con replica magnífica de Rallo). Como siempre digo, buena lectura.


Los límites de la economía psicológica

Adjunto la reseña al interesante libro de Richard Thaler Todo lo que aprendí con la psicología económica, editado por Deusto (2016). Se trata de una buena lectura que sirve para comprender la falla de la economía neoclásica y como la también llamada economía del comportamiento no plantea un método alternativo y conviene ser cautos a la hora de substituir el ‘homo economicus‘ por el ‘homo psicologicus’. Sin embargo, sí que los descubrimientos del Premio Nobel Daniel Kahneman y Cía. arrojan interesantes insights sobre algunos de los sesgos y mecanismos que configuran nuestra manera de pensar y de tomar decisiones.

9788423425549Reseña en PDF

David Gordon on Mervyn King: Central Bankers are Losing Faith in their own Alchemy. Cobden

Mervyn King is the British Ben Bernanke. An eminent academic economist, who now teaches both at New York University and the London School of Economics, King was from 2003 to 2013 Governor of the Bank of England. In short, he is a very big deal. Remarkably, in The End of Alchemy he frequently sounds like Murray Rothbard.

King identifies a basic problem in the banking system that has again and again led to financial crisis.

“The idea that paper money could replace intrinsically valuable gold and precious metals, and that banks could take secure short-term deposits and transform them into long-term risky investments came into its own with the Industrial Revolution in the eighteenth century. It was both revolutionary and immensely seductive. It was in fact financial alchemy — the creation of extraordinary financial powers that defy reality and common sense. Pursuit of this monetary elixir has brought a series of economic disasters — from hyperinflation to banking collapses.”

How exactly is this alchemy supposed to work?

“People believed in alchemy because, so it was argued, depositors would never all choose to withdraw their money at the same time. If depositors’ requirements to make payments or obtain liquidity were, when averaged over a large number of depositors, a predictable flow, then deposits could provide a reliable source of long-term funding. But if a sizable group of depositors were to withdraw funds at the same time, the bank would be forced either to demand immediate repayment of the loans it had made, … or to default on the claims of depositors.”

Readers of Rothbard’s What Has Government Done to Our Money? will recognize a familiar theme.

Many have sought to salvage the alchemy of banking by resorting to a central bank. By acting as a lender of last resort, a central bank can bail out banks in need of funds to satisfy anxious depositors and thus avert the danger of a bank run. The alchemy of transforming deposits into investments can now proceed.

Though he was one of the world’s leading central bankers, King finds fault with this “solution.” A local bank can be rescued by getting money from the central bank, but the process generates new problems. Thomas Hankey, a nineteenth-century Governor of the Bank of England, pointed out some of these in response to Walter Bagehot, the classic defender of the central bank as the lender of last resort:

[i]f banks came to rely on the Bank of England to bail them out when in difficulty, then they would take excessive risks and abandon “sound principles of banking.” They would run down their liquid assets, relying instead on cheap central bank insurance — and that is exactly what happened before the recent [2008] crisis. The provision of insurance without a proper charge is an incentive to take excessive risks — in modern jargon, it creates “moral hazard.”

Given the dangers of financial alchemy, what should we do about it? Again, King strikes a Rothbardian note. He writes with great sympathy for one hundred percent reserve banking.

Even though the degree of alchemy of the banking system was much less fifty or more years ago than it is today, it is interesting that many of the most distinguished  economists of the first half of the twentieth century believed in forcing banks to hold sufficient liquid assets to back 100 percent of their deposits. They recommended ending the system of “fractional reserve banking,” under which banks create deposits to finance risky lending and so have insufficient safe cash reserves to back their deposits.

Like Rothbard, King calls attention to the insights of the nineteenth-century Jacksonian William Leggett. King cites an article of 1834 in which Leggett said:

Let the [current] law be repealed; let a law be substituted, requiring simply that any person entering into banking business shall be required to lodge with some officer designated in the law, real estate, or other approved security, to the full amount of the notes which he might desire to issue.

King may to an extent resemble Rothbard; but unfortunately he is not Rothbard; and alert readers will have caught an important difference between King’s idea of one hundred percent reserve banking and Rothbard’s. King’s notion, unlike Rothbard’s, still allows banks to expand the money supply. The “liquid assets” need not be identical with the deposits: they need only be easily convertible into money should the need arise to do so.

King’s own plan to “end the alchemy” allows for substantial monetary expansion. He calls his idea the “pawnbroker for all seasons (PFAS)” approach. This is a form of “liquidity” insurance. Banks would have to put up in advance as collateral with the central bank some of their assets. This would act as a “form of mandatory insurance so that in the event of a crisis a central bank would be free to lend on terms already agreed.” So long as the insurance had been paid, though, the central bank would still bail the bank out in a crisis by giving it more money. Contrast this with the plan suggested in the quotation from Leggett, in which if a bank could not redeem its notes, depositors could proceed directly against the bank’s assets. This allows no monetary expansion; and Rothbard’s plan is of course more restrictive still.

Having come so close to Rothbard, why does King shrink from the final step? Why does he still allow room for monetary expansion? He fears deflation.

Sharp changes in the balance between the demand for and supply of liquidity can cause havoc in the economy. The key advantage of man-made money is that its supply can be increased or decreased rapidly in response to a sudden change in demand. Such an ability is a virtue, not a vice, of paper or electronic money. … The ability to expand the supply of money in times of crisis is essential to avoid a depression.

But if the demand for liquidity suddenly increases, when the monetary stock is constant, cannot falling prices for goods satisfy the demand? King, here following Keynes, is skeptical. “Wage and price flexibility does help to coordinate plans when all the markets relevant to future decisions exist. But in practice they do not, and in those circumstances cuts in wages and prices may lower incomes without stimulating current demand.” Prices may keep falling indefinitely.

Other possibilities of coordination failure also trouble King, and underlying them is an important argument. Following Frank Knight, he distinguishes between risk and uncertainty.

Risk concerns events, like your house catching fire, where it is possible to define precisely the nature of that future outcome and to assign a probability to the occurrence of the event based on past experience. … Uncertainty, by contrast, concerns events where it is not possible to define, or even imagine, all possible future outcomes, and to which probabilities cannot therefore be assigned.

We live in a world of radical uncertainty, and thus we cannot be sure that relying on market prices to adjust to changes in the demand to hold money suffices to avert catastrophe. It is for this reason that resort to monetary expansion sometimes is needed.

This argument moves altogether too fast. It does not follow from the fact that Knightian uncertainty prevails widely that one must take seriously the possibility that prices and wages would fall indefinitely. In a situation of uncertainty, we cannot, by hypothesis, calculate probabilities; but this does not require that we take outlandish possibilities as likely occurrences that must be averted by the government. Some reason needs to be given for supposing that prices will continue to fall indefinitely. Why would entrepreneurs not be able to correct the situation, without resorting to monetary expansion? We are not faced with a dichotomy between exact mathematical calculation, in the style of an Arrow-Debreu equilibrium, and blind groping in the dark.

King himself acknowledges that in the American depression of 1920 to 1921, no resort to the government was needed.

The striking fact is that throughout the episode there was no active stabilization policy by the government or central bank, and prices moved in a violent fashion. It was, in the words of James Grant, the Wall Street financial journalist and writer, “the depression that cured itself.”

It is encouraging that King cites the Austrian economist James Grant, but he draws from his work an insufficient message. “The key lesson from the experience of 1920–21 is that it is a mistake to think of all recessions as having similar causes and requiring similar remedies.” In view of the manifold invidious consequences, fully acknowledged by King, of government intervention, should we not rather emphasize the need to rely on the unhampered market? King nevertheless merits praise for coming close, in his own way, to many Austrian insights.