Credit Expansion, the Prisoner's Dilemma, and Free Banking as Mechanism Design

Abstract:     
Despite the distinctive character of the Austrian approach to "microfoundations for macroeconomics", the literature on free banking contains a number of arguments which make use of game-theoretic concepts and models such as the well-known Prisoner's Dilemma model. While there can be no general a priori presumption against the possible usefulness of game-theoretic concepts for Austrian theorizing, in the context of the debate on free banking such concepts and models have been used with varying degrees of perspicacity. One example which is elaborated in the paper is concerned with the interaction configuration between independent banks in a fractional-reserve free banking system, which has sometimes been modeled as a One-Shot Prisoner's Dilemma game. This conceptualization does not provide a sufficient argument for the in-concert overexpansion thesis, nor for the thesis that fractional-reserve free banking will tend to lead to the establishment of a central bank. The author drops the implicit assumption that there exists a one-to-one correspondence between the outcome matrix and the utility matrix. When it is acknowledged that banks in a fractional-reserve free banking system need not necessarily adopt a myopic, self-regarding perspective but may recognize the long-run harmony of interests between the banking sector and society at large, a different conceptualization and a different matrix representation emerge.

Number of Pages in PDF File: 48

Keywords: Economic Mechanism Design, Business Cycle Theory, Prisoner's Dilemma, Free Banking

JEL Classification: D01, E31, E32, E42, E52, E58, E66, G18, K39

Accepted Paper Series