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Wednesday, July 01, 2015

Free Banking

With the Greek banking fiasco continuing, I think this is a good time to reintroduce the concept of completely unregulated banking, usually known as "free banking." The following excerpts are from the post Why free-banking (I've added emphasis here and there).
The need for and convenience of a central bank are usually taken for granted. To say that a central bank is a good institution and, therefore, needed, is not enough. Unfortunately, the assumption that central banks are necessary seems to weigh more heavily than the facts that suggest otherwise. [...]

Historical records, however, show that free banking outperforms central banks in most, if not all, of the cases.
Let's reiterate what free banking is:
A free banking regime is such where the market for money and banking is free of specific regulation (save, of course, illegal activities such as the violation of third party property rights.) Let me be clear. The absence of a central bank is not equivalent to free banking.  The absence of regulation is equivalent to free banking.
It's likely you're either completely unfamiliar or not particularly well-versed on the topic of free banking. However, there are more successful examples of free banking than you might guess and there are reasons they've worked well:
The literature on free banking is vast. Let me just give a brief description and comment on a couple of illustrative historical cases. First, under free banking, each bank is free to issue their own convertible banknotes. Convertible to what? To whatever functions as base money in the economy. Historically, this has been gold, but this does not need to be the case. It could be, like Selgin describes in his Theory of Free Banking, that the Federal Reserve shuts down the FOMC and that the USD becomes the base money to which private convertible banknotes are convertible. ... 
Second, because all banknotes are convertible to the same base money, there is no multiplicity of units of account. Under this regime, there should be no fear of confusion about the multiplicity of prices. If today you travel to Hong Kong, Ireland, or Scotland, you’ll see a strong presence of private money in circulation, but you won’t see multiplicity of units of account. ...
Third, the stability of the system comes from banks competing with each other for deposits and therefore for base money. ... Free banking shows a remarkably good performance...
Is free banking a viable possibility going forward? In the United States, I doubt it, but just considering how the concept works and its past successes give us the opportunity to incrementally improve the current system in order to avoid future problems such as Greece and Detroit:
If one looks at historical facts, rather than just let be guided by pre-conceived ideas, the need and superiority of central banking next to alternative monetary regimes is thrown into serious doubt. Surely, free banking is long gone and gold, which was used as base money under these cases, is not money anymore.
Why then look at free banking? I can mention at least two reasons: (1) To do away with the almost ideological position that a central bank is needed. This position, or assumption, needs to be questioned rather than taken as fact if we want to come up with innovative alternatives to our monetary regime. (2) Even if the old free banking system based on gold standard is not feasible, it certainly helps us to come up with reform that can improve the status-quo.
And improving the status-quo of a highly regulated world wide banking system with frequent failures would be a very good thing.

34 comments:

Bret said...

I decided to throw this post in the mix since we were discussing the Greek banking crisis in other threads.

erp said...

Taking the U.S. off the gold standard: another reason to condemn socialist Nixon.

Clovis e Adri said...

Bret,

Looks like a potentially interesting subject, just not helped by the arguments in the original link.

For example, the author tells us that: "Why was there no bank run? Succinctly, because the reserves that the Ayr Bank was losing were being transferred to other more efficiently managed banks."

... and makes not the least effort to reconcile that affirmation with simple algebra. I can not see how didn't a lot of people end up with worthless money in their hands and their assets lost to a black hole.

Not to mention the elephant in the room: with no central banks (or not relevant ones at least, if they are not to be regulators), where is the base money supposed to come from?

The idea of pegging money to how much metal you dig out from a hole wasn't really smart. It was justified in a time of low and slow information, but now makes as much sense as driving horses in wagons instead of cars today.

erp said...

Paper money has no intrinsic value that's why it was backed up by gold which does.

Clovis e Adri said...

Erp,

Neither paper nor gold have intrinsic value. They are both defined by us. It is easier to define (and to recognize, hence led to safer transactions) value in gold than in paper, which explains why in slower and dumber times we used it. Nowadays that's no longer true, so why to keep it?

Ultimately you need an enforcer of your unit of value, and that's a role only the state, up to now, can play properly. Notice the govt is not defining value - the price of things will still be determined by the market, not the govt.

Even in the wild world of internet and Bitcoin, that currency still needed external reference to the ones enforced by govts.

erp said...

Sorry to disagree. It is governments that are fleeting and corruptible, while gold has traditionally been held as valuable throughout time and place, but it could be cockle shells or anything else.

Clovis e Adri said...

Erp,

---
but it could be cockle shells or anything else.
---
Right, or anything else. Including paper stamped with dead people faces.

Bret said...

Ok. I have to admit that though I've been tangentially aware of the concept of free-banking and some of its history (such as free banking in Scotland), I haven't studied it closely enough to answer questions or defend it, so maybe it wasn't the best idea on my part to post something about this topic. However, if you haven't heard of it before, I was hoping you might find it interesting or even intriguing.

Though many economists are considering the concept of free-banking (not necessarily for the United States), as far as I can tell, the main expert is George Selgin who wrote The Theory of Free Banking: Money Supply under Competitive Note Issue (available for free online in many formats). I've been meaning to read it for decades, but haven't ever gotten around to it. Maybe this will finally spur me to do so.

Clovis wrote: "Ultimately you need an enforcer of your unit of value..."

Yes, and the enforcement mechanism is natural and that is that you owe taxes in that fiat currency. There are more than 150 fiat currencies in the world, some issued by quite unstable regimes, and yet, for the most part, those currencies are moderately stable. The only thing that makes them so is that taxes have to be paid in the currency. Otherwise, they would be unusable for other transactions. That may be hard to see when considering the dollar, euro, or even real. But perhaps easier with the Ethiopian birr.

Clovis wrote: "Neither paper nor gold have intrinsic value."

It's an interesting discussion whether or not gold has intrinsic value. I would argue it had intrinsic value for thousands of years because we (and other animals) are attracted to shiny stuff. Gold and jewels were the only permanently shiny things for thousands of years and happened to be suitably rare to be used as a unit of account with intrinsic value. We buy gold things to have and to hold and to look at. We (for the most part) don't buy dirty green pieces of paper to have and to hold and to look at.

Now, there are lots of allows and other materials that are (mostly) permanently shiny. I personally think gold is an ugly color and greatly prefer stainless steel or platinum. But I think it is still embedded in the psyche of many humans to be attracted to gold and therefore it still has a sort of intrinsic value.

Clovis asks: "where is the base money supposed to come from?"

Back to Selgin and colleagues. They think that the base money would still be the dollar. The free banks would use dollar deposits as their reserves. The Fed would be put on auto pilot to expand (or possibly occasionally contract) the underlying dollar supply to keep NGDP growth constant. Then there would be no politics, no cronyism, and no regulation. It could be that some banks would choose to use different reserves over time such as gold. That would be decided by the market.

Note that the Fed could be put on auto-pilot completely independently of free banking and I think that probably would be a good thing (the economist Scott Sumner is a leading proponent of NGDP targeting). If that happened, the best places for the free banking experiment to happen would be a smaller country that's just suffered a government banking collapse. For example, Zimbabwe, whose government issued currency collapsed a few years back and they're pretty much using the US dollar at the moment anyway.

erp said...

Clovis,

No, because paper stamped with dead people’s faces isn’t accepted in virtually every part of the globe as having intrinsic value. The U.S. dollar was the closest thing to it, but that was because it was backed by gold … and of course, We, the People.

Now it has neither.

Harry Eagar said...

'it still has a sort of intrinsic value'

About one-third less (compared to dollars) than a couple years ago. It is not so easy to account for that if it has intrinsic vale.

erp said...

Harry, you seem to have trouble with your vocabulary words.

Look it up. Intrinsic does not mean static.

Peter said...

Bret:

If I buy a GM product and then GM fails, I still have my car. Not so when my bank fails.

erp said...

Peter, what do you think happens to your car when the bank holding your car loan fails?

Peter said...

You continue making the payments you agreed to pay to the bank's trustee in bankruptcy.

Clovis e Adri said...

Bret,

---
However, if you haven't heard of it before, I was hoping you might find it interesting or even intriguing.
---
To the extent I've heard about it before, it was often in not so good terms.

To take an example you just cited, Zimbabwe is much closer to a free banking system than us, yet somehow it doesn't look much inspiring.

Or to take a citation on Selgin's book [Chapter 11]:

"Elsewhere various Chicago economists-especially Milton Friedman
(1959, 4-9)-have criticized free banking on the grounds that it
leads to unlimited inflation, involves excessive commodity-money
resource costs, and encourages fraud."

To be fair, he then goes on to argue why that is not necessarily the case. He first ponders on the two contrary views, Discretion X Fixed Rules, to conclude that:

"Thus monetary policy has reached an impasse. Under a strict
monetary rule, and especially in the case of the base-freeze proposal,
the really desirable end of monetary policy-achieving monetary
equilibrium-has to be sacrificed to the much lower, cruder end of
merely preventing the authorities from introducing more instability
into the system than might exist in the absence of any intervention,
capricious or otherwise. Is such an inflexible arrangement the best
that can be hoped for? So long as one clings to the assumption of
centralized control and centralized currency supply, there is reason to
believe that it is. We have seen, in chapter 7, why discretion, even in its
best guise, is likely to hurt more than it helps."

He then offers that, once you de-centralize control, it is all good:

"By supplying an alternative form of
pocket and till money-competitively issued bank notes-to accommodate
changing public demands, free banking reduces the public's
reliance upon base money as currency for use in everyday payments.
In this way base money is allowed to remain in bank reserves to settle
clearing balances. Fiat base money can thus be made to play a role
similar to the one played by commodity money in the "typical" free
banking system which has been given prominence through most of
this study. Base money never has to move from bank reserves to
circulation or vice-versa, so that, in such a system, there is no question
of any need for reserve compensation to offset the ebb and flow of
currency demand."

He further argues:

"For most of the 20th century the only claims allowed (we are as usual
considering ones redeemable on demand only) have been checkable
deposits. What is proposed, therefore, is that commercial banks be
given the right to issue their own notes, redeemable on demand for
Federal Reserve Dollars, on the same assets that presently support
checkable deposit liabilities. Once the public becomes accustomed to
using bank notes as currency, the stock of high-powered money can
be permanently frozen according to a plan such as Friedman's without
negative repercussions due to changes in the relative demand for
currency. This simple proposal does not involve any interference whatsoever
with the dollar as the national monetary unit. Yet, it would make it
possible for Federal Reserve high-powered money to be used exclusively
as bank reserves, for settling interbank clearings, while allowing
bank notes to take the place of Federal Reserve Dollars in fulfilling
the currency needs of the public."


For lack of space, I'll follow with a few points in the next comment...

Clovis e Adri said...

Here we go:

1) Please notice Erp - and anyone else who thinks it was a bad idea to substitute gold for colorful paper - the actual proposal here is to substitute govt paper for many different bank issued papers. Looks a lot more safe than gold, right?

2) The same way you enter in a store or supermarket and look for stickers of "Visa", "Mastercard", "American Express" to check if your plastic works here, the idea above, as far as I understand it, is: you'd enter in a store and look for stickers like "We Accept Citibank Money", "We accept Bank of America greens!", or "We Prefer Donald Trump Notes"...

To which I ask myself, what's the difference to the credit cards then?

To make my point, some economists point out that "shadow banking" was partially to blame for the 2008 crisis - that a lot of debt was unaccounted for and out of control under credit cards and other kind of cards (like retail stores cards). So there we have again a "freer banking system" taking the blame.


3) It may be just ignorance by my part, Bret, but I tend to think of money fulfilling two rules: i) defining units of value (to which we give value in itself) and ii) providing for medium of exchange, where the value of money itself is absolutely irrelevant, it only serves the purpose of transfering one kind of value to another kind.

Free banking looks to be all about item (i), while item (ii) looks to be much, much more important. As it happens, it also looks like that govt centralization is way more effective to fulfill (ii) than a free banking system (I am not sure about it, I did not read the book to see all his counterarguments).

To take an analogy: govt many times is necessary to provide for another medium of exchange of goods, other than money, that we use a lot: highways and roads. We had this discussion here before. We could just wait for the free market to provide for all the highways and roads a country need to prosper, yet it rarely happened to be the case, right?

4) Also, if Free Banking is all that thrill, why is it that Scotland and Australia gave up on it?

erp said...

Peter, ah but if the feds take over to avoid bankruptcy aka General Motors and others, that may not be possible. What then?

erp said...

Clovis, right? No and your faith in governments is puzzling since you are well aware of their failures over time and place.

Stop asking yourself. I'll tell you. Credit card companies provide a service for a fee. Banks did the same before they were co-opted into providing services at the behest of the redistributionists.

Bridges, roads, schools, parks and other public services are part of the government's portfolio bought and paid for by taxpayers. They are in no way comparable to currency.

BTW - Instead of the "Dismal Science," economics should be called the "Dismissible Science." To call them crackpots is to tarnish pots with cracks in them. :-)

Stick to physics. The natural world is far less unfathomable than the minds of our betters intent on our destruction.

Clovis e Adri said...

Erp,

On the "right" quote, I guess you've lost my hint at sarcasm.

And bridges, roads, etc, are indeed "paid for by taxpayers" - guess what, the currency system is also built on taxpayers back. As Bret rightly mentioned, "The only thing that makes them [stable] is that taxes have to be paid in the currency."

---
Stick to physics. The natural world is far less unfathomable than the minds of our betters intent on our destruction.
---
Oh, I'll stick to Physics, don't worry, I do not intend to publish anything in Economics so soon. For me, it is only feasible if I par with someone who really knows Economics, so I get to worry more about the mathematics.

erp said...

Currency system? Do you mean printing, etc. Then yes, but otherwise it's merely a convenience as are credit cards -- gold is heavy.

Knows economics -- more sarcasm?

Bret said...

Peter wrote: "If I buy a GM product and then GM fails, I still have my car. Not so when my bank fails."

I don't think that comparison makes much sense. One is a consumer item, the other an investment. If your Apple stock goes down, then tough luck. If interest rates rise and your bond portfolio loses value, oh well. Indeed, if one of the bond issuers goes bankrupt, too bad for you. The bank is essentially a bond issuer.

Oh, and, nobody says you can't insure a bank account. That would be like a put option. Like all other insurance, it cost money but reduces risk. Another way to reduce risk is don't put a huge amount of money in a single checking account; use multiple checking accounts.

Bret said...

Clovis wrote: "Zimbabwe is much closer to a free banking system than us, yet somehow it doesn't look much inspiring."

Well, compared to the previous money regime where the non-free banking government controlled fiat currency suffered one of the most impressive hyperinflations of all time, it looks pretty damn good.

Also, I'm not sure how free the Zimbabwe free banking system is. They don't issue their own notes and it may well still be pretty regulated.

erp said...

Bret, we thought to put a substantial amount of cash in a safe deposit box, but now apparently cash can be summarily confiscated, so we are removing it a bit at a time and using it to buy stuff, even groceries just like we did in the good old days before credit cards.

Can any of you youngsters picture it. Cash or walking around with a check book. On trip, bank checks -- a really colossal pain in the neck.

Oh, how we suffered. :-(

Bret said...

Clovis wrote: "To which I ask myself, what's the difference to the credit cards then?"

You're looking only on the consumer side. Consider the investment/loan side and the implications for the fractional reserve concept.

Clovis wrote: "I tend to think of money fulfilling two rules: i) defining units of value (to which we give value in itself) and ii) providing for medium of exchange..."

The primary purpose of money is to convey information via the price mechanism in order to match production and demand which then leads to i and ii. From reading the various articles, I can certainly see why you're focusing on the consumer side, they sure do focus a lot on banknote issuance. Because of that, I'm actually less confident on the concept now, but I had previously thought that the idea was that then deposits, loans, investments, etc. as well as transactions were all made in terms of specific banknotes instead of the underlying reserves (whether that was gold or dollars). Then the total money supply was determined by free bank actions as opposed to the federal reserve and, in theory, would provide a better medium for price information because the money supply, under the competitive scenario, would better reflect the underlying needs.

Anyway, now I'm more confused than I was before I posted, so I have to go back and study it some more.

Clovis wrote: "if Free Banking is all that thrill, why is it that Scotland and Australia gave up on it?"

Off the top of my head I recall that the Bank of England decided that it wanted the money monopoly for all of the British Isles, so the government took over the Scottish banks.

It's sort of like asking why the communists took over various economies if free markets could work. Because they wanted the power and because they could. It didn't end up meaning that communism worked better than free markets.

Peter said...

If your Apple stock goes down, then tough luck...

Bret, old swot, if you are going to try and make the case for unregulated banking, you really should bone up on the difference between a bank shareholder and a bank customer. My bank reported record profits last year and I'm still waiting for my dividend as a loyal customer with a low-interest savings account. Maybe I'll just flog my account on the market instead.

Trying to fit banking into free-market fundamentalism runs up against three problems: The first is that it's absolute nonsense to talk about "informed consumers" deciding whether their bank will be solvent in the medium or long term. How could they possibly know? The second is there is no voluntary assumption of risk like there is in the stock market. The third is that, in the event of a bank failure, a typical customer will find his bank loans are secured and survive but his savings accounts (or pension funds) disappear, which tends to put the public off its biscuits.

The banking system operates on trust, which implies a trust relationship with customers. Granted regulation has been woefully incompetent at enforcing this at times, but I think you have to propose something to replace it. If your only answer is "the discipline of the market", why would people put their savings in banks at all? Your advice to keep your money in multiple small accounts in different banks indicates to me you don't have as much confidence in that market discipline as you say.

People(and institutions like charities, pension funds etc.)put their money into banks at low interest because they do not want it exposed to the inherent risks of an investment portfolio. That's why they forgo the potential for higher gains. You seem to want to force them to assume the risks without holding out the promise of the gains.

erp said...

Peter, you are right that trust is the major ingredient in banking as in most things in life. Boring staid old banks run by crusty old curmudgeons are notoriously trustworthy, but don't usually provide the thrill of gambling.

There's plenty of opportunity for people who want to take a chance on bigger rewards for greater risk. We humans aren't all the same, so why do you like to assume that there's a one-size-fits-all answer to every question?

Asking for more regulations is like holding a career day for foxes in the hen house.

Peter said...

I assure you, erp, I don't have a one-size-fits-all solution. I'm simply pointing out that Bret seems to assume people put money in their banks in order to maximize their returns, when many people, if they are "buying" anything, think they are buying safety and security.

I assume we have some interest in whether our wonderful ideas crafted on Great Guys Weblog could be sold to the public? So far, I can't see it, although I do have this fantasy of Bret running for office on a platform of unregulated banking and telling folks "The primary purpose of money is to convey information via the price mechanism in order to match production and demand which then leads to i and ii. Vote for me!"

erp said...

What a notion! Problem is people like GGG (I add the third 'G' for geniuses) don't run for office. In fact, I don't think scientists, mathematicians, engineers, etc. make good political leaders because what you jokingly propose for Bret's campaign slogan probably seems perfectly reasonable to them -- the general public not so much.

Harry Eagar said...

'now apparently cash can be summarily confiscated'

How else will the Kenyan finance the death panels, FEMA camps and gun confiscations?


Does it ever bother you, erp, that none of your fears are realized?

erp said...

You're right Harry, my fears were so mild compared to what has been realized, I realize I was far too naive in my fearfulness.

Bret said...

Harry wrote: 'now apparently cash can be summarily confiscated'

Yes, apparently it can.

Erp is absolutely right not to hold a significant amount of money in cash in this country.

Clovis e Adri said...

Erp,

The best advice I can give you is, don't announce to the whole internet that you have a safe box full of cash. Really, there are things more dangerous than your confiscatory govt out there.


Bret,

---
You're looking only on the consumer side. Consider the investment/loan side and the implications for the fractional reserve concept.
---
There are reasons to look closely at the consumer side: it only works if people actually believe it.

Now, looking to the other side (investment and fractional reserve), and glancing at Selgin's arguments (only glancing, I did not get them completely), things look a bit iffy.
He defends the whole system would be, ultimately, more stable because competition and dynamical equilibrium.

IOW, he thinks the "good banks" would survive while the "bad banks" not, so excessive inflation and fraud, as feared by Milton Friedman for example, wouldn't be so much of an issue in the long run.

The problem is, (i) how long would it take for that to happen?, (ii) How frequent would be deviations of that equilibrium, and what would happen in such?

For the picture I have is that a lot of people, for some unknown (and possibly long) time, would need to lose all their assets in the bad banks until everyone figured out the good ones. And no one would know how long the good ones would stay sober either.

Anyway, I guess the free banking crowd will need to do a better job of defending those ideas. Not everyone has the time and will to go through obscure books to figure that out.

erp said...

Thank you Clovis, that is indeed good advice, but the money is no longer in the safe deposit box. Now it's under the mattress -- just kidding :-)

Bret said...

Clovis wrote: "I guess the free banking crowd will need to do a better job of defending those ideas."

I agree with that. Thanks for your questions, I've made a list and will endeavor to get them answered over the next few months.