Money, Bank Credit, and Economic Cycles - The Ludwig von Mises ...

Bank Credit Expansion and Its Effects on the Economic System 387insurable. The technical-economic reason it is impossible toinsure uncertainty stems basically from the fact that humanaction itself brings about or creates the events which an attempt ismade to insure. In other words, withdrawals of deposits areinvariably influenced by the very existence of the insurance,and therefore the necessary stochastic independence betweenthe existence of the “insurance” (a fractional-reserve requirementsupposedly established according to the law of largenumbers and bankers’ experience) and the occurrence of thephenomenon (bank crises and runs which provoke the massivewithdrawal of deposits), precisely what is meant to be insuredagainst, does not exist. 95 A detailed demonstration of the closeconnection between the attempt to apply the law of largenumbers in the form of a fractional-reserve requirement andthe fact that this “insurance” inevitably triggers massive withdrawalsof deposits is simple. The development of the Austriantheory, or circulation credit theory of the business cycle(covered in this chapter), makes it possible. Indeed fractionalreservebanking permits the large-scale granting of loans95 In short we are referring to the phenomenon of moral hazard, whichM.V. Pauly has already theoretically analyzed. According to Pauly, theoptimality of complete insurance is no longer valid when the method ofinsurance influences the demand for the services provided by theinsurance policy [“The Economics of Moral Hazard,” American EconomicReview 58 (1968): 531–37]. Another relevant article is Kenneth J.Arrow’s “The Economics of Moral Hazard: Further Comments,” originallypublished in American Economic Review 58 (1968): 537–53. HereArrow continues the research he started on this phenomenon in his 1963article, “Uncertainty in the Welfare Economics of Medical Care,” AmericanEconomic Review 53 (1963): 941–73. Arrow holds the view that moralhazard is involved whenever “the insurance policy might itself changeincentives and therefore the probabilities upon which the insurancecompany has relied.” These two articles by Arrow appear in his book,Essays in the Theory of Risk-Bearing (Amsterdam, London and New York:North Holland Publishing Company, 1974), pp. 177–222; see esp. pp.202–04. Finally two further sources which warrant consideration are:chapter 7 (devoted to uninsurable risks) of Karl H. Borch’s importantbook, Economics of Insurance (Amsterdam and New York: North Holland,1990), esp. pp. 317 and 325–30; as well as Joseph E. Stiglitz’s article,“Risk, Incentives and Insurance: The Pure Theory of Moral Hazard,”published in The Geneva Papers on Risk and Insurance 26 (1983): 4–33.